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Chapter 6: Fundamentals of Product & Service Costing

Introduction

This chapter provides an overview of alternative cost systems for product and service costing.
Details and extensions to the basic models described here are presented in the following three
chapters. We follow two principles in our discussion: The cost system should be oriented to the
needs of the decision makers (that is, the users of the information) and cost system should be
designed so that its benefits exceed its costs (Lanen, 2008).

Our goal in this chapter is to provide the feeling or intuition behind costing system, not the
procedural details. In the three chapters that follow, we take a more in depth look at three
costing systems: Job costing, process costing and activity based costing (Lanen, 2008).

Learning Objectives:

According to Lanen (2008), after studying this chapter, you should be able to:

1. Explain the fundamental themes underlying the design of cost systems.

2. Explain how cost allocation is used in a cost management system.

3. Explain how a basic product costing system works.

4. Understand how overhead cost is allocated to products.

5. Explain the operation of a two-stage allocation system for product costing.

6. Describe the three basic types of product costing systems: job order, process, and
operations.

Cost System

Keys to a good cost system

A good cost system is oriented to the needs of the decision makers and designed so that benefits
exceed costs (Lanen, 2008).
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LO1 Explain the fundamental themes underlying the design of cost systems.

Cost Management System

The objective of the cost management system is to provide information about the costs of the
goods and services sold by the firm and the process used to produce the goods and services
(Lanen, 2008).

A well-designed cost system accumulates and reports costs that are relevant to the decisions that
managers make.

Why Calculate the Cost of a Product?

For decision making What should we sell? What sales price?

What is the cost of goods sold? What is the cost of inventory?

Designing a Cost System

The following three points relate to designing a new cost system for managerial purposes.

1. Cost system should have a decision focus. Cost systems must meet the needs of decision
makers, who are the customers (or users) of cost accounting

2. Different cost information is used for different purposes. Cost information is often used
to assess departmental profitability; other information is used to review customer
profitability.

3. Cost information for managerial purpose must meet the cost benefit test. Cost
information can always be improved. However, the benefits of improvement (i.e. better
decision making) must outweigh the costs of making the improvements.

LO2 Explain how cost allocation is used in a cost management system.

Cost Allocation and Product Costing

Chapter 1 introduced cost allocation and product costing. For a retail firms, the calculation of the
product costs was straightforward: it was the cost paid on the wholesaler plus any cost to
transport the product to the retailer. Its not quite so simple for manufacturing or service firms
that buy different resources (material, labor, supplies etc.) and combines them into two or more
finished products. For these firms, the cost management system must in some way allocate the
costs of the resources to the finished products (Lanen, 2008).

Cost Flow Diagram

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The cost flow diagram is helpful as you study product costing by providing a graphical
representation of the product costing process. Cost flow diagram illustrates how costs from the
cost pools flow or are assigned and allocated to the cost object. In this case, the cost object, the
item we are costing, is the product. Please look this exhibit. This cost flow diagram shows that
the direct materials and direct labor are traced directly to the products. However, overhead is an
indirect cost and cannot be traced directly to the products. Therefore, it must be allocated
(Lanen, 2008).

The Inventory Accounts

Raw Materials

Beg. Inventory + Purchases = Raw Materials Available for Production- Raw Materials
Transferred to WIP = Ending Inventory

Work-In-Process

Beg. Inventory + Direct Materials Transferred from Raw Materials + direct labor +
Manufacturing overhead = Total manufacturing costs - Cost of Goods Completed
and Transferred to Finished Goods

= Ending Inventory

Finished Goods
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Beg. Inventory + Cost of Goods Completed and Transferred from WIP = Goods
Available for Sale - Cost of Goods Sold = Ending Inventory

Inventory accounts are assets on the balance sheet. Product costs go into inventory when the
cost is incurred. Look at the three inventory accounts. Remember, product costs become
expenses when the goods are sold. The cost of goods sold, or the transfer out of finished goods
goes to the income statement. At this time the product costs become an expense (Lanen, 2008).

LO3 Explain how a basic product costing system works.

How costs and units move through inventories.

The basic cost flow model equation

Beginning Balance ( BB) + Transfers In ( TI) - Transfers Out (TO) = Ending Balance (ED)

BB + TI - TO = ED

The basic cost flow model: beginning balance plus transfers in minus transfers out equals ending
balance is true for all three inventory accounts: Raw Materials (RM), Work-In-Process (WIP),
and Finished Goods (FG) (Lanen, 2008).

Example: Costing with no work in process inventories

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The inventory equation is true for both units and costs. Lets look at Baxter Paint. At the
beginning of April, Baxter Paint had no work-in-process inventory. 100,000 gallons of paint
were started during the month of April. All 100,000 gallons were finished and transferred out of
work-in-process and in to finished goods.

The basic cost flow model equation

Baxter Paint : April WIP Inventory : Units

BB + TI - TO = ED 0 + 100,000 gallons - 100,000 Finished goods

gallons = 0

Look at work-in-process costs. Baxter Paint had no beginning balance. During April Baxter
added the following costs to work-in-process:

direct materials direct labor Overhead Total

$400,000 $100,000 $500,000 $1,000,000

Baxter Paint : April WIP Inventory : Costs

BB + TI - TO = ED 0 + $1,000,000 - $1,000,000 = 0 Finished goods

$1,000,000 / 100,000 gallons The cost per gallon of paint is $10.

Another Example: Costing with Ending WIP Inventory

Given: Gallons

Beginning WIP -0-

Started in May

Total 110,000

Ending WIP (50% Complete) 20,000

Transferred Out 90,000

Baxter Paint : April WIP Inventory- Units

BB + TI - TO = ED 0 + 110,000 - 90,000 = 20,000 Finished goods

( half finished )
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$1,000,000 / 100,000 gallons The cost per gallon of paint is $10.

Equivalent Units

When products remain in ending work-and-process inventory we use equivalent units.

How do we account for Baxters 20,000 gallons of paint that are only half finished? 20,000
gallons of paint half finished are equivalent to 10,000 gallons of finished paint. When products
remain in ending work-and-process inventory we use equivalent units. 90,000 gallons of paint
transferred out plus 10,000 equivalent gallons of finished paint in ending inventory equals
100,000 equivalent gallons of paint.

Total Equivalent units

Gallons finished (20,000 * 50 %) 10,000

Gallons transferred to finished goods 90,000

Total Equivalent units equivalent 100,000

PRODUCT COST

If Baxter Paint transferred in $990,000 of cost during the month of May the question we ask is:
where are those costs at the end of the period? What is the cost of the 90,000 gallons transferred
to finished goods and what is the cost of the 20,000 gallons still in work-in-process?

Given:

direct materials direct labor overhead Total

$390,000 $100,000 $500,000 $990,000

Baxter Paint : April WIP Inventory- Units

BB + TI - TO = ED 0 + $990,000 - ? = ? Finished goods

Compute the cost per equivalent gallon of paint. Baxter incurred $990,000 of cost and produced
100,000 equivalents gallons of paint so the paint cost $9.90 per gallon ($990,000/100,000).
Because 90,000 gallons were transferred out, assign $891,000 (90,000 gallons x $9.90) to the
ending work-in-process inventory.

Given:
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direct materials direct labor overhead Total

$390,000 $100,000 $500,000 $990,000

Equivalent gallon

Items Units Percentage Costs

Gallons finished (20,000 * 50 %) 10,000 10% $ 99,000 work in process

Gallons transferred to finished goods 90,000 90 % $ 891,000 finished goods

Total Equivalent units equivalent 100,000 100 % $ 990,000

Costing Multiple Products

In a firm with multiple products a manager making pricing decisions needs cost information at
the product level. Look at Grange Boats. Grange produces two boat models: C-27s and the C-
20s. How do we cost these two individual products?

Units C27s C20s Total

Units produced 10 30 40

Direct labor hours 2,000 3,000 5,000

Machine Hours 1,000 3,000 4,000

Costs

Direct Material $40,000 $36,000 $76,000

Direct labor $72,000 $78,000 $150,000

Direct Materials Direct Labor

Cost Pools $ 76,000 $150,000

Cost Objects C-27s $40,000 C-20 $72,000

$36,000 $78,000

Direct materials and direct labor can be traced to the individual products.
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LO4 Understand how overhead cost is allocated to products.

Assigning the cost of manufacturing overhead is not done directly. First, determine how to
allocate the budgeted manufacturing overhead costs between the two products. The allocation
base we have selected is direct labor hours.

Predetermined Overhead Rates

Indirect costs are allocated using a predetermined overhead rate. The POHR is the cost per unit
of the allocation base used to charge overhead to products.

What are the estimated costs?

POHR = Estimated overhead $ / Estimated allocation base

What activity drives the overhead costs?

Why use estimates?

Products need to have costs applied during the period. The exact amount of indirect costs are not
known until the end of the period (Lanen, 2008).

Grange Boats

Suppose Grange Boats estimates overhead cost for the period of $180,000. Grange also
estimates a total of 5,000 direct labor hours will be worked during the period.

C27s C20s Total

Direct labor hours 2,000 3,000 5,000

Estimated Overhead Costs $180,000

POHR = $180,000 /5,000 POHR = $36 /

DLH

Allocating OH to the Products

Cost pool $ 180,000

Cost allocation rule Direct Labor Hours , $36/DLH

Cost objects C27s C20s

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$ 72,000 ($36/DLH * 2000 $ 108,000 ($36/DLH * 3000

hrs) hrs)

Grange Boats

Units C27s C20s Total

Units produced 10 30 40

Direct labor hours 2,000 3,000 5,000

Machine Hours 1,000 3,000 4,000

Costs

Direct Material $40,000 $36,000 $76,000

Direct labor $72,000 $78,000 $150,000

OH @ $20/DLH 72,000 108,000 180,000

Total $184,000 $222,000 $406,000

Cost per unit $18,400 $7,400

LO5 Explain the operation of a two-stage allocation system for product costing.

Two-Stage Allocation Systems

Lets look a little closer at the overhead costs for Grange. A closer inspection of the overhead
accounts suggests that some of the overhead seems to be related more to machine utilization than
direct labor. If this is the case, we can use two allocation bases to allocate overhead to the
products. First we will assign the overhead cost pool of $180,000 to the intermediate cost pools.
$108,000 of overhead is labor-related and $72,000 is machine-related. The labor-related costs
will be allocated using direct labor costs and the machine-related costs will be allocated using
machine hours.
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Cost pool Over head : $180,000

Intermediate cost pools Labor related : $108,000 Machine related :$72,000

Cost allocation rule Direct labor costs Machine hours

Intermediate cost pools Labor related : $108,000 Machine related :$72,000

Cost allocation rule Direct labor costs 72 % Machine hours : $ 18

($108,000 / $150,000) =$72,000 / 4000 MHS

Cost objects C27s C20s

DLC= $51,840 ($72000 * $56,160 ($78,000 * 72 %)

72 %)

MH= $18,000 ( 1000 hrs $18) $54,000 ( 3000 hrs $18)

Allocated overhead $69,840 $110,160

Labor-related overhead costs of $108,000 divided by $150,000 direct labor costs will be
allocated at the rate of 72% of direct labor cost. Machine-related costs of $72,000 divided by
4,000 machine hours will be allocated at the rate of $18 per machine hour. The $108,000 of
labor-related costs are allocated $51,840 to the C-27s and $56,160 to the C-20s. The $72,000 of
machine-related costs are allocated $18,000 to the C-27s and $54,000 to the C-20s.

Grange Boats, Revisited

C27s C20s Total

Costs

Direct Material $40,000 $36,000 $76,000

Direct labor $72,000 $78,000 $150,000

OH @ 72% DLC 51,840 56,160 108,000

OH @ $18/MH 18,000 54,000 72,000

Total $181,840 $224,160 $406,000

Cost per unit $18,184 $7,472

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Using the two-stage allocation process we see the total cost allocated to C-27s is $181,840. The
total cost allocated to C-20s is $224,160. The cost per unit changed substantially.

LO6: Describe the three basic types of product costing systems: job order, process, and
operations.

Product Costing Systems

Job Costing Operation Costing Process Costing

An accounting system that
traces costs to individual units
or to specific jobs, contracts,
or batches of goods.
A hybrid costing system often
used in manufacturing of
goods that has some common
characteristics plus some
individual characteristics.
An accounting system used
when identical units are
produced through a series of
uniform production steps.

Examples : Custom Homes , Examples : Automobile , Examples: corn flakes or facial

Movies and Services Computer and clothing tissues and paints.

Different companies have different production and costing systems. A job costing system is used
when costs can be traced to a specific job, for example, building custom homes or making a
movie or providing a service. But imagine a company making corn flakes or facial tissues. Here
it would be very difficult to trace costs to an individual box of corn flakes or box of facial
tissues. This company would use process costing, an accounting system that traces costs to a
production process. The details of these two costing systems are discussed in Chapters 7 and 8
(Lanen, 2008).

Chapter 6: END!!

Course work

P6-41

P6-42-b
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REFERENCES

Lanen , N.W. , Anderson ,W.Sh. & Maher ,W.M. ( 2008). Fundamentals of cost accounting.

New York : McGraw-Hill Irwin.