Cost Accounting Mechanics

Overview
• We will focus on some common cost accumulation and cost
accounting procedures used by many firms
• Important to understand how cost information is presented
before we figure out how to use this information for decision
making
• We will use a series of numerical examples to illustrate these
procedures
Three Types of Firms
Manufacturing firms
Manufacture
product. Use
Buy raw labor, Stock
materials and Sell products
material and completed
supplies to customers
other items
manufacturin
g costs

Merchandising firms

Buy
Stock
completed Sell products
completed
items from to customers
items
suppliers

Service firms
Cost Classification and Tracking
Recognition and Measurement and
measurement Classification Assignment
report

Total Direct Directly Traced

Costs Costs

Cost Objects
Directly
Traced Allocated
Indirect Cost
Costs Pools

A costing system allows us to estimate the cost of

products and services.
Where Are Costs Incurred?
Support departments can serve Direct costs incurred here
each other as well!! Total costs

Support Production/
departments functional units
1

1 Costs of support departments first allocated

2
to production units; e.g., Human
Resources, IT, general administration
Individual
In each department, accumulate costs products/
2
services
allocated from support departments and
direct costs incurred in the department, and
allocate to individual products using some
“reasonable” basis
Ultimate Objective
To understand how accounting systems compute the costs of
various products and/or services offered by a firm
• We will examine the relevance of these cost numbers in the
next session
Allocating Support Department Costs

• Introduction
Where Are Costs Incurred?
Support departments can serve each Total costs Direct costs incurred here
other as well! (“Reciprocal” use)

Support Production/
departments functional units
1

1 Costs of support departments first allocated

2
to production units e.g., Human Resources,
IT, general administration
Individual
products/
services

We will focus on this

Data (Annual Budget)
  Service consumed by

Human Routine Intensive

  IT Total
Resources care care

Costs incurred $500,000 $350,000 $600,000 $750,000  

Service provided by 
IT (hours)   500 500 1,500 2,500
Human Resources
15   55 15 85
(head count)
Number of cases     5,200 1,400  
Three Methods
1. Direct method
2. Step-down method
3. Reciprocal method
Allocating Support Department Costs

• Direct Method
Direct Method
Ignore services provided by one support department to another
support department

That is, ignore “reciprocal” use

Direct method
  Service consumed by

Human Routine Intensive

  IT Total
Resources care care

Costs incurred $500,000 $350,000 $600,000 $750,000  

Service provided by 
IT (hours)   500 500 1,500 2,500
Human Resources
15   55 15 85
(head count)
Number of cases     5,200 1,400  
Direct Method (Assignment 1)
  Service consumed by
Human Routine Intensive
  IT Total
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000  
Service provided by 
IT (hours)   500 1,500 2,000
Human Resources (head count)   55 15 70
Number of cases     5,200 1,400  

    Service consumed by
Human Routine Intensive
    IT
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000
Service provided by        
IT ($500,000)   125,000 375,000
Human Resources   ($350,000) 275,000 75,000
        1,000,000 1,200,000
Number of cases       5,200 1,400
Cost per case     $192.31 $857.14
           
  IT rate $250 per hour    
  Human Resources rate $5,000 per person    
Allocating Support Department Costs

• Step-Down Method
Options
• Direct method
• Ignore all interactions or reciprocal use among support departments
• This is Assignment 1
• Step-down method
• Choose which support department to consider first, say IT
• Allocate it first to all the departments, including the remaining support
departments (in this example, the Human Resources department)
• Eliminate this department from further consideration
• Go to the next service department, and repeat the process
• Note that you will not be allocating any cost to support departments already
eliminated in the previous step
Step-Down: IT First (Assignment 2)
  Service consumed by
Human Routine Intensive
  IT Total
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000  
Service provided by 
IT (hours)   500 500 1,500 2,500
Human Resources (head count) 15   55 15 70
Number of cases     5,200 1,400  

    Service consumed by
Human Routine Intensive
    IT
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000
Service provided by        
IT ($500,000) 100,000  100,000 300,000
Human Resources   ($450,000) 353,571 96,429
        1,053,571 1,146,429
Number of cases       5,200 1,400
Cost per case     $202.61 $818.88
           
  IT rate $200 per hour    
  Human Resources rate $6,428.57 per person    
Step-Down: Human Resources First (Assignment 3)
 
Human Routine Intensive
  IT Total
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000  
Service provided by 
Human Resources (head count) 15 55 15 85
IT (hours) 500  500 1,500 2,000
Number of cases     5,200 1,400  

    Service consumed by
Human Routine Intensive
    IT
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000
Service provided by        
Human Resources $61,765 ($350,000)  $226,471 $61,765
IT ($561,765) $140,441 $421,323
        966,912 1,233,088
Number of cases       5,200 1,400
Cost per case     $185.94 $880.78
           
  Human Resources rate $4,117.65 per person    
  IT rate $280.88 per hour    
Allocating Support Department Costs

• Reciprocal Method
Reciprocal Method
• Considers all interactions (reciprocal use) among support
departments
• Let us review the data…
Data
  Service consumed by

Human Routine Intensive

  IT Total
Resources care care

Costs incurred $500,000 $350,000 $600,000 $750,000  

Service provided by 
IT (hours)   500 500 1,500 2,500
Human Resources
15   55 15 85
(head count)
Number of cases     5,200 1,400  
Reciprocal Method
• Considers all interactions among service departments
• That is:
• IT = 500,000 + (15/85)* HR
• HR = 350,000 + (500/2500)* IT
• Solve for IT and H
• IT = $582,317, HR = $466,463
• So, we have…
Reciprocal Method (Assignment 4)
 
Human Routine Intensive
  IT Total
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000  
Service provided by 
Human Resources (head count) 15 55 15 85
IT (hours) 500  500 1,500 2,500
Number of cases     5,200 1,400  

    Service consumed by
Human Routine Intensive
    IT
Resources care care
Costs incurred $500,000 $350,000 $600,000 $750,000
Service provided by        
Human Resources $82,317 ($466,463)  $301,829 $82,317
IT ($582,317) $116,463 $116,463 $349,390
        $1,018,292 $1,181,707
Number of cases       5,200 1,400
Cost per case     $195.83 $844.08
           
  IT rate $232.93 per hour    
  Human Resources rate $5,487.80 per person    
Why Is This Important?
Look at the numbers

Method IT rate HR rate Cost per case

Routine Intensive
     
care care
Direct method        
(Assignment 1) $250 $5,000 $192 $857
Step-down IT first        
(Assignment 2) $200 $6,429 $203 $819
Step-down HR first        
(Assignment 3) $281 $4,118 $186 $881
Reciprocal        
(Assignment 4) $233 $5,488 $196 $844
Points to Note
• There are three methods for allocating support department
costs
• Direct Method – Ignores all “reciprocal” use among support
departments
• Step-down Method – takes “reciprocal” use into account partially
(going one way). Sequence in which support department costs are
allocated is important. Most commonly used
• Reciprocal Method – takes “reciprocal” use into account completely.
Not as widely used.
• Theoretically, it is difficult to justify any one method.
Cost Classification for Product Costing

• Terminology
Where Are Costs Incurred?
Support departments can serve Total costs Direct costs incurred here
each other as well!!

Support Production/
departments functional units
1

Individual
In each department, accumulate costs products/
2
services
allocated from support departments and
direct costs incurred in the department, and
allocate to individual products using some
“reasonable” basis
We will focus on this next
With Multiple Production Departments
Support Support Support
department 1 department 2 department 3
1

Overheads Overheads Overheads

DL 2 DL 2 DL 2
DM DM DM

Work-in-process

Finished
Raw material
goods
We will focus on 2 next
Cost Classification
Direct materials
Variable
manufacturin
g Direct labor
Product costs
(inventoriable cost) Variable
overhead
Manufacturin
g
Fixed overhead
overhead
Total costs

Variable selling and

administration

Selling and
administration
Period costs
Fixed selling
and
administration
Names for Groups of Costs

Direct materials
Prime costs

Direct labor

Conversion
Variable overhead costs
Capacity costs
Fixed overhead
Job-Order/Product Costing Systems

• Introduction
Job-Order/Product Costing System
In job-order costing systems
• Each job/order/batch is given an identifying symbol (usually a
number).
• All direct costs are directly charged to each job
• Indirect costs are allocated to each job

Job-order costing is also used by service companies.

Examples include hospitals, automobile repair firms,
architectural design, landscaping, consulting, legal, and
accounting.
Job-Order Costing
Direct Costs Key point:

Direct Materials Charge direct

material and
Job 1 direct labor costs
to each job as
work is
Direct Labor performed.
Job 2

Job 3

Direct costs do not pose a problem because of traceability.

Indirect Manufacturing Costs (Overhead)
• These are costs necessary to produce that cannot be
directly traced to a specific product/job/order/batch in an
economical manner.
• They are therefore allocated (assigned) to products.

Goal: assign overhead in a way that links the overhead costs to the
cost object in a meaningful and systematic manner.
Allocating Overhead Costs Steps:
Form groups with
1. Form cost pools “related” costs
a. Select the appropriate cost pools
Choose how to allocate the
b. Trace all indirect costs to cost pools costs of each group!

2. Select an allocation base

Assign the costs to the
3. Allocate cost pools to the cost object different cost objects.

Allocation base Cost

Cost Pool
Object
Form Cost Pools and Select Allocation Basis
• Cost pool: A grouping of individual costs, the sum of which is
allocated using a single allocation base.
• Cost pools could include:
1. Total departmental costs (e.g., costs incurred by maintenance or personnel departments)
2. Costs of major activities (equipment setups)
• Allocation base: how to allocate overhead
• Allocation base examples: machine hours, labor cost, labor hours, number of
units, etc.
• Ideally, the allocation base is a cost driver that causes overhead
Job-Order/Product Costing Systems

• Overhead Application
Use of Predetermined Overhead Rates (POHR)
• Most companies calculate overhead rates at the time of
budgeting i.e., at the time of planning for a period
• We call it the predetermined overhead rate (POHR):

Budgeted total manufacturing

overhead cost for the coming period
POHR =
Budgeted total units in the
allocation base for the coming period
The Need for a POHR
Predetermined overhead rates (POHR) that rely upon
estimated data are often used because:
• Actual overhead for the period is not known until the end of
the period, thus inhibiting the ability to estimate job costs
during the period.

• Difficult to bid for a job in the middle of a period!!

Overhead Application
Apply overhead cost to products/jobs using a predetermined
overhead rate.
• End-of-period adjustments
• At the end of the period, actual overhead may not turn out to be the
same as applied overhead (which is based on estimates). So some
adjustments have to be made for:

Under/over-applied overhead = applied overhead – actual overhead

Difference Between Inflows and Outflows
• Under-applied • Over-applied
Overhead Control Overhead Control

Applied Actual

Actual Applied

Under- Over-
applied applied
Job-Order Costing Example

Machining Assembly Total

Budgeted Mfg. overhead $4,000,000 $3,080,000 $7,080,000

Actual Mfg. overhead $4,260,000 $3,050,000 $7,310,000

Budgeted direct labor cost $1,500,000 $5,600,000 $7,100,000

Actual direct labor cost $1,450,000 $5,780,000 $7,230,000

Budgeted machine hours 400,000 100,000 500,000

Actual machine hours 425,000 110,000 535,000
 Resource costs
$7,080,000

Machining Assembly
$4,000,000 $3,080,000

Driver: Machine hours Driver: Labor cost

Denominator: 400K hours Denominator: $5.60 MM

Job A Job B
Job-Order Costing Example
• Predetermined overhead rate (machining) =
• Predetermined overhead rate (assembly) =
• We can use these rates to value:
• A new or an existing product
• A specific job/contract
• Inventories (in the aggregate)
Using OH Rates to Value Inventory
Suppose there is an unfinished job in ending WIP. What is its
value? (i.e., after allocating overhead?)
Machining Assembly Total
Direct materials $24,500 $6,700 $31,200
Direct labor 27,900 58,600 86,500
Machine hours 360 150

Solution:
Machining Assembly Total
Direct materials $24,500 $6,700 $31,200
Direct labor 27,900 58,600 86,500
Overhead 3,600 32,230 35,830
Total value $153,530
Job-Order Costing Example
Overhead under-applied or over-applied in machining?

Applied overhead
- Actual overhead
= Under applied ($10,000)

Overhead under-applied or over-applied in assembly?

Applied overhead
- Actual overhead
= Over-applied
Disposition of Over/Under-Applied Overhead
• Page 606–608 in the book
• Three methods permitted
1. Write off entire amount to COGS
2. Prorate (i.e., allocate) among WIP, FG, and COGS accounts
3. Re-compute the rates
• Which method to use?
• Write off to COGS is the easiest method. OK if amount is not large
• Proration (i.e., allocating among) among WIP inventory, FG inventory, and
COGS is common. Uses end-of-year balances as the basis
• Re-computing rates is most accurate. Easy if system is computerized
Disposition of Over/Under-Applied Overhead
• Writing off the over/under-applied overhead to COGS
• If overhead is over-applied (i.e., applied overhead > actual overhead),
• COGS is overstated
• “Writing off” will bring down COGS and income will increase
• If overhead is under-applied (i.e., applied overhead < actual overhead),
• COGS is understated
• “Writing off” will increase COGS and income will decrease

• Proration (i.e., allocating among) among WIP inventory, FG inventory,

and COGS
• Spread the over/under-applied in proportion to the ending balances in these
accounts
Problem 1: McMaster Fabrication

Refer to Session 2 Problem Set

Cost Flows in Aggregate

• Introduction
Cost Flows in Aggregate
Direct
materials Overhead
Direct labor
(from costs
inventory)

Opening WIP Ending WIP

(value of Costs added for (value of
Cost of goods
unfinished jobs + materials, labor, - unfinished jobs = manufactured
at start of and overhead at end of
month) month)

Opening
Cost of goods Ending finished Cost of
finished goods + - =
manufactured inventory goods sold
inventory
Problem 2: Iron Pit Foundry

Refer to Session 1 Problem Set

JLR Enterprises
JLR Enterprises provides consulting services throughout California and uses job-order costing system to accumulate the cost
of client projects. In contrast, other costs incurred by JLR, but not identifiable with specific clients, are charged to jobs using a
predetermined overhead application rate. Clients are billed directly for chargeable costs, overhead, and a markup. JLR's
director of cost management, Brent Dean, anticipates the following costs for the upcoming year:

Percentage of cost directly

Cost
traceable to clients
Professional staff salaries
$2,500,000 80%
Administrative support
Staff 300,000 60%
Travel 250,000 90%
Photocopying 50,000 90%
Other operating costs 100,000 50%
Total $3,200,000

The firm desires to make a $640,000 profit for the firm, and adds a percentage markup on total cost to achieve that goal.
It uses budgeted direct costs as the basis for allocating indirect costs.
Bidding for Remco Inc.
• During the year, JLR wants to bid on a project for Remco Inc.
The following costs are estimated for this project:
Professional staff salaries $41,000
Administrative support staff $2,600
Travel $4,500
Photocopying $500
Other operating costs $1,400

• What should be the bid?

Overhead Allocation in Billing

Budgeted cost % traceable to clients

Professional salaries $2,500,000 80%
Admin support staff 300,000 60%
Travel 250,000 90%
Photocopying 50,000 90%
Other operating costs 100,000 50%
Total $3,200,000 n/a
The firm desires a total profit of $640,000 before tax.
Costing a Service Job

• Total direct/traceable costs =

• Indirect/non-traceable costs =

• Overhead rate =

• Mark up percentage =
Problem 3: Costing a Service Job
Billing for Remco:
• Traceable costs =
• Overhead charge =
• Total costs =
• Mark-up =
• Bill amount =
Points to Note
• In a manufacturing company,
• Costs are accumulated in work-in-process accounts
• Direct costs are charged and indirect manufacturing costs or overhead
costs are allocated
• Cost of goods manufactured is the amount transferred from work-
in-process to finished goods
• Cost of goods sold is the amount charged against revenues when
goods are sold
• This flow applies to all “product” costs
• Period costs are expensed directly to the income statement!
 Questions/comments ?
? ?
?
? ?
? ?
? ?
?
? ? ?
? ?
?
? ? ? ?
? ?
? ?
?
? ?