SCHOOL OF BUSINESS ADMINISTRATION AND ACCOUNTANCY
MANSRV1
COST ACCOUNTING AND
CONTROL/COSTING AND
PRICING
A Self-regulated Learning Module
MANSRV1
COST ACCOUNTING AND CONTROL/COSTING AND
PRICING
Course Description
This course is designed to orient the students to cost accounting and control framework of business.
It exposes the students to different product costing procedures. It includes accounting procedures for
main products and incidental products that are manufactured simultaneously in a common process. It
encompasses the costing techniques and procedures for companies that use standard costs as a
benchmark for costing the products. The students must be able to assemble financial statements
prepared under standard costing procedures. While its emphasis particularly dwells on the
manufacturing concern, it also highlights the elements and features applicable to the nonmanufacturing concerns. The course aims to help the student understand the factors and aspects
necessary to come up with an effective cost system. It explores on the details of the key components
of manufacturing from one department to the next, specifically materials, labor, and overhead and
transcends into the understanding the flow of costs during the work in process stage until the
completion of goods. It will aid them in the production of the necessary deliverables and reports
pertinent to the cost system. It will enhance the analyzing and problem-solving skills of students whilst
teaching them the requisites of assessing the role of cost accounting as an indispensable tool for
management in planning and control for decision-making. It also discussed is the impact of
environmental concerns on cost.
Course Objectives
At the end of the course, the students should be able to:
→ prepare the job order cost sheets under job order costing and the costs of production report
under process costing.
→ Demonstrate how materials, labor, and overhead costs are added to a product at each stage
of the production cycle.
→ construct the financial statements of manufacturing companies involved in joint products and
by-products.
→ Formulate overhead using predetermined rates and Activity-Based costing.
→ Asses how cost-volume-profit are related and use CVP analysis as a planning and decisionmaking aid. - Prepare a budget and use budgets for performance evaluation after flexing the
budget
→ analyzes the variances created by production whenever the actual costs incurred differ from
the costs set to be incurred
→ analyzes the factors and aspects necessary to come up with an effective cost system
→ use cost accounting as a tool for management in planning, control, and decision-making
Module Objectives
This module focuses on cost accounting and control framework of business. It exposes the students
to different product costing procedures. It includes accounting procedures for main products and
incidental products that are manufactured simultaneously in a common process. It will enhance the
analyzing and problem-solving skills of students whilst teaching them the requisites of assessing the
role of cost accounting as an indispensable tool for management in planning and control for
decision-making. It also discussed is the impact of environmental concerns on cost
References:
The reference materials for this module are –
A. BOOKS
Agamata, F. T (2020).Managerial Advisory Services (A Comprehensive Guide), Manila: GIC
Enterprises, Co.
Brewer, Garrison and Noreen (2018). Introduction to Managerial Accounting.8 th Edition:
McGrawHill.
Cabrera, E. B. (2020) Management Advisory Services. Manila: GIC Enterprises & Co., Inc.
Horngen, Charles T. (2019) Cost accounting: a managerial emphasis. Boston: Pearson
Lanen, William N. (2019) Fundamental of cost accounting. Boston : McGraw/Irwin
Raiborn, C.A. and Kinney, M.R. (2018).Cost Accounting.USA: Cengage Learning, Inc.
B. Journals / Magazines
Accounting Today
Journal of Accountancy
Business World Top 1000 Corporations
The Economist
Entrepreneur (US)
Harvard Business Review
C. Electronic Sources
Deloitte. (2015, May 01). Retrieved July 20, 2017, from https://www.iasplus.com/en
Philippine Institute of CPAs. (2015, November 13). Retrieved July 20, 2017, from
http://www.picpa.com.ph/
Securities and Exchange Comission. (2016, April 21). Retrieved July 20, 2017, from
http://www.sec.gov.ph/
Investopedia. (2015, October 12). Retrieved July 20, 2017, from http://www.investopedia.com/
Bureau of Internal Revenue. (2016, April 12). Retrieved July 20, 2017, from
https://www.bir.gov.ph/
Institute of Chartered Accountants of England and Wales. (2016, May 21). Retrieved July 20,
2017, from https://www.icaew.com/
Generally Accepted Accounting Principles in the United States . (2017, March 12). Retrieved July
20, 2017, from http://cpaclass.com/gaap/gaap-us-01a.htm
International Financial Reporting Standards. (2017, January 11). Retrieved July 20, 2017, from
http://www.ifrs.org/
Instructor:
Rhoda Marie C. Manansala, CPA, MBA
Email: rmmanansala@e.ubaguio.edu
Viber: +639257272830
Messenger: Marie Rhoda
TABLE OF CONTENTS
LESSON 1 ...............................................................................................................................................................11
AN INTRODUCTION TO COST TERMS AND PURPOSES .......................................................................................11
GM Collapses Under the Weight of its Fixed Costs ..............................................................................................11
Costs and Cost Terminology .............................................................................................................................. 12
DIRECT COSTS AND INDIRECT COSTS ..............................................................................................................13
COST-BEHAVIOR PATTERNS: VARIABLE COSTS AND FIXED COSTS.............................................................. 14
Cost Drivers .................................................................................................................................................... 14
Relevant Range ...............................................................................................................................................15
TOTAL COSTS AND UNIT COSTS ......................................................................................................................15
BUSINESS SECTORS ......................................................................................................................................... 16
TYPES OF INVENTORY....................................................................................................................................... 17
COMMONLY USED CLASSIFICATIONS OF MANUFACTURING COSTS............................................................. 17
INVENTORIABLE AND PERIOD COSTS .............................................................................................................. 17
INVENTORIABLE COSTS ................................................................................................................................ 17
PERIOD COSTS .............................................................................................................................................. 18
FLOW OF REVENUE AND COSTS FOR A MANUFACTURING-SECTOR COMPANY ...................................... 18
FLOW OF REVENUES AND COSTS FOR A MERCHANDISING COMPANY .................................................... 19
PRIME COSTS AND CONVERSION COSTS........................................................................................................ 19
DECISION POINTS ............................................................................................................................................. 19
PROBLEM FOR SELF-STUDY ............................................................................................................................ 21
SOLUTION: .................................................................................................................................................... 22
ASSIGNMENT MATERIAL .................................................................................................................................. 24
LESSON 2 ...............................................................................................................................................................33
JOB ORDER COSTING ............................................................................................................................................33
Job-Order Costing—An Overview .......................................................................................................................33
Measuring Direct Materials Cost ........................................................................................................................ 34
Job Cost Sheet................................................................................................................................................ 35
Measuring Direct Labor Cost .............................................................................................................................. 35
Computing Predetermined Overhead Rates ...................................................................................................... 36
Applying Manufacturing Overhead ..................................................................................................................... 37
Manufacturing Overhead—A Closer Look .......................................................................................................... 38
The Need for a Predetermined Rate ............................................................................................................... 40
Choice of an Allocation Base for Overhead Cost ............................................................................................ 40
Computation of Unit Costs ............................................................................................................................. 41
Job-Order Costing—The Flow of Costs............................................................................................................... 41
The Purchase and Issue of Materials .................................................................................................................. 42
Labor Cost .......................................................................................................................................................... 43
Manufacturing Overhead Costs.......................................................................................................................... 44
Applying Manufacturing Overhead ................................................................................................................ 44
The Concept of a Clearing Account ................................................................................................................ 46
Nonmanufacturing Costs ................................................................................................................................... 47
Cost of Goods Manufactured ............................................................................................................................. 48
Cost of Goods Sold ............................................................................................................................................. 48
Schedules of Cost of Goods Manufactured and Cost of Goods Sold ............................................................... 50
Underapplied and Overapplied Overhead—A Closer Look ................................................................................. 53
Computing Underapplied and Overapplied Overhead ................................................................................... 53
Disposition of Underapplied or Overapplied Overhead Balances ................................................................... 55
Closed Out to Cost of Goods Sold .................................................................................................................. 56
Allocated between Accounts .......................................................................................................................... 56
Which Method Should Be Used for Disposing of Underapplied or Overapplied Overhead? ............................57
A General Model of Product Cost Flows ..............................................................................................................57
Multiple Predetermined Overhead Rates ........................................................................................................... 58
Job-Order Costing in Service Companies ........................................................................................................... 58
Review Problem: Job-Order Costing .............................................................................................................. 60
Solution to Review Problem ........................................................................................................................... 61
ASSIGNMENT MATERIAL .................................................................................................................................. 63
True / False Questions .................................................................................................................................... 63
Multiple Choice Questions ............................................................................................................................. 64
PROBLEM SOLVING ...................................................................................................................................... 74
LESSON 3 ...............................................................................................................................................................75
Accounting for Raw Materials .................................................................................................................................75
Accounting for Raw Materials .............................................................................................................................75
Material Cost ...................................................................................................................................................75
Direct and Indirect Material Cost .................................................................................................................... 76
MATERIAL COST CONTROL.............................................................................................................................. 76
Purchase and Procurement ............................................................................................................................ 76
STORING PROCEDURES ................................................................................................................................... 80
STORES, LOCATION ...................................................................................................................................... 80
Centralized vs. Decentralized Stores .............................................................................................................. 80
Storekeeper — Functions and Responsibilities ............................................................................................... 81
STORES RECEIPT AND INSPECTION............................................................................................................. 81
STORES ISSUE, TRANSFER AND RETURN .................................................................................................... 82
STORES LEDGER .......................................................................................................................................... 84
STOCKCONTROL........................................................................................................................................... 86
Economic Order Quantity (EOQ) ....................................................................................................................... 87
ABC Analysis ...................................................................................................................................................... 88
ABC analysis is a technique of selective control of inventory by classifying all items of stores into
three categories, namely, – ......................................................................................................................... 88
PERPETUAL INVENTORYSYSTEM .............................................................................................................. 90
PHYSICAL VERIFICATION OF STOCK ......................................................................................................... 90
CONTINUOUS STOCK TAKING ................................................................................................................... 91
STOCK
VERIFICATION PROCEDURE...................................................................................................... 91
STOCK DISCREPANCIES .............................................................................................................................. 91
MATERIAL CONTROL........................................................................................................................................ 92
PAYMENT FOR PURCHASE ......................................................................................................................... 93
MATERIAL COST PRICE ............................................................................................................................... 93
STORAGE AND HANDLING LOSS ............................................................................................................... 93
PRICING ISSUES OFMATERIAL ..................................................................................................................... 93
SELF-TEST QUESTIONS .................................................................................................................................... 94
ASSESSMENT .................................................................................................................................................. 100
Multiple Choice: ........................................................................................................................................... 100
LESSON 4 .............................................................................................................................................................110
Accounting for Labor ............................................................................................................................................110
INTRODUCTION ...............................................................................................................................................110
Direct and Indirect Labor Cost .......................................................................................................................110
MANPOWER PLANNING, RECRUITMENT AND TRAINING.............................................................................. 111
ATTENDANCE AND TIMERECORDING ............................................................................................................ 111
Timekeeping ................................................................................................................................................. 111
TIMEBOOKING ............................................................................................................................................. 112
METHODS AND INCENTIVE SCHEMES ............................................................................................................ 113
Remuneration systems .................................................................................................................................. 113
Time Rate at Ordinary Level ..........................................................................................................................114
TIME RATE AT HIGH WAGES LEVEL ..........................................................................................................114
GRADUATED TIME RATE ............................................................................................................................114
Straight Piece Rate ........................................................................................................................................ 115
PIECE RATE WITH GUARANTEED DAILY RATE ........................................................................................ 115
DIFFERENTIAL PIECE RATE ........................................................................................................................ 115
COMBINATION OF TIME AND PIECE RATES ............................................................................................116
BONUS SYSTEM – INDIVIDUAL BONUS ...................................................................................................118
Rowan Plan .......................................................................................................................................................119
Barth Scheme....................................................................................................................................................119
BASIC PRINCIPLES OFREMUNERATION ......................................................................................................... 124
Work Study ...................................................................................................................................................125
Measurement of Labor Efficiency and Productivity ...........................................................................................125
Job Evaluation ...............................................................................................................................................125
Merit Rating .................................................................................................................................................. 127
PAYROLL PROCEDURE ................................................................................................................................... 128
WAGES SHEET ............................................................................................................................................. 129
Computerized Payroll ................................................................................................................................... 129
Internal Control of Wages............................................................................................................................. 129
LABOR ANALYSIS AND ACCOUNTING ............................................................................................................130
IDLE TIME ANDOVERTIME ............................................................................................................................... 131
Idle Time ....................................................................................................................................................... 131
Overtime ....................................................................................................................................................... 133
LABORTURNOVER........................................................................................................................................... 133
Assessment .......................................................................................................................................................143
Multiple Choice .............................................................................................................................................143
LESSON 5 .............................................................................................................................................................150
Accounting for Factory Overhead .........................................................................................................................150
INTRODUCTION ...............................................................................................................................................150
Why Allocate Overhead Costs? ......................................................................................................................... 151
Approaches in Allocating Overhead Costs ........................................................................................................152
Plantwide Allocation .....................................................................................................................................152
Department Allocation .................................................................................................................................. 155
Using Activity-Based Costing to Allocate Overhead Costs ............................................................................... 156
Advantages and Disadvantages of ABC........................................................................................................ 165
ABC Cost Flows ............................................................................................................................................ 166
Allocation of Service Department Costs ........................................................................................................... 168
Direct Method of Allocation ............................................................................................................................. 169
Step Method of Allocation ............................................................................................................................ 171
Reciprocal Method of Allocation ................................................................................................................... 172
SELF-TEST QUESTIONS ................................................................................................................................... 175
Assessment ...................................................................................................................................................... 195
Multiple Choice ............................................................................................................................................ 195
LESSON 6 ............................................................................................................................................................ 226
ACCOUNTING AND CONTROL OF DEFECTIVE AND SPOILED GOODS ............................................................. 226
Spoilage, Rework, and Scrap ............................................................................................................................ 226
Normal and Abnormal Spoilage. .......................................................................................................................227
Accounting for Spoiled Goods, normal and abnormal .......................................................................................227
Accounting for Rework..................................................................................................................................... 228
Accounting for Scrap ........................................................................................................................................ 229
SELF-TEST QUESTIONS .................................................................................................................................. 230
ASSESSMENT .................................................................................................................................................. 232
LESSON 7.............................................................................................................................................................. 237
STANDARD COSTING AND VARIANCE ANALYSIS .............................................................................................. 237
Overview of Standard Cost Variances ............................................................................................................... 237
Standard Costs—Setting the Stage ............................................................................................................... 237
Setting Direct Materials Standards .............................................................................................................. 238
Setting Direct Labor Standards .................................................................................................................... 238
Setting Variable Manufacturing Overhead Standards .................................................................................. 239
Using Standards in Flexible Budgets ................................................................................................................ 240
A General Model for Standard Cost Variance Analysis ..................................................................................... 241
Using Standard Costs—Direct Materials Variances .......................................................................................... 243
ASSIGNMENT MATERIAL ................................................................................................................................ 261
Multiple Choice ............................................................................................................................................ 261
LESSON 1
AN INTRODUCTION TO COST TERMS AND PURPOSES
LEARNING OBJECTIVES:
1.
2.
3.
4.
5.
6.
Define and illustrate a cost object
Distinguish between direct costs and indirect costs
Explain variable costs and fixed costs
Interpret unit costs cautiously
Distinguish inventoriable costs from period costs
Explain why product costs are computed in different ways for different purposes
GM COLLAPSES UNDER THE WEIGHT OF ITS FIXED COSTS
After nearly 80 years as the world’s largest automaker, General Motors (GM) was forced to file for bankruptcy
protection in 2009. Declining sales and the rise of Japanese competitors, such as Toyota and Honda, affected GM’s
viability given its high fixed costs – costs that did not decrease as the number of cars that GM made and sold
declined.
A decade of belt-tightening brought GM’s variable costs – costs such as materials costs that vary with number of
cars that GM makes – in line with those of the Japanese. Unfortunately for GM, a large percentage of its operating
costs were fixed because union contracts made it difficult for the company to close its factories or reduce pensions
and health benefits owed to retired workers.
To cover its high fixed costs, GM needed to sell a lot of cars. Starting 2001, it began offering sales incentives and
rebates, which for a few years were somewhat successful. GM also expanded aggressively into China and Europe.
But in 2005, growth efforts slowed, and GM lost $10.4 billion. As a result, GM embarked on a reorganization plan
that closed more than a dozen plants, eliminated tens of thousands of jobs, slashed retirement plan benefits for its
40,000-plus salaried employees, and froze its pension program.
Despite these cuts, GM could not reduce its costs fast enough to keep with the steadily declining market for new
cars and trucks. In the United States, as gas prices rose above $4 a gallon, GM’s product mis was too heavily
weighted toward gas-guzzling trucks, pickup trucks and sport utility vehicles, all of which were experiencing sharp
decreases in sales.
In late 2008, as the economic crisis worsened, GM announced plans to cut $15 billion in costs and raise $5 billion
through the sale of assets, like its Hummer brand of off-road vehicles. “We’re cutting to the bone,” said Fritz
Henderson, GM’s president. “But given the situation, we think that’s appropriate.”
It was appropriate, but it wasn’t enough. By November 2008, GM had lost more than $18 billion for the year, and
the government loaned the company $20 billion to continue operations. Ultimately, its restructuring efforts fell
short, and the weight of GM’s fixed costs drove the company into bankruptcy. In court papers, the company claimed
$82.3 billion in assets and $172.8 billion in debt.
When it emerges from bankruptcy, GM will be a much smaller company with only four brands of cars (down from
eight), more than 20,000 fewer hourly union workers, and as many as 20 additional shuttered factories.
As the story of General Motors illustrates, managers must understand costs in order to interpret and act on
accounting information. Organizations as varied as the United Way, the Mayo Clinic and Sony generate reports
containing a variety of cost concepts and terms that managers to run their businesses. Managers must understand
these concepts and terms to effectively use the information provided. This chapter discusses cost concepts and
terms that are the basis of accounting information used for internal and external reporting.
(Sources: Loomis, Carol. 2006. The tragedy of General Motors. Fortune, February 6; New York Times, 2009. Times topics: Automotive Industry crisis,
December 6. http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/auto_industry/index.html; Taylor, III, Alex. 2005. GM hits
the skids. Fortune, April 4; Vlasic, Bill and Nick Bunkley. 2008. GM says US cash is its best hope. New York Times, November 8.)
COSTS AND COST TERMINOLOGY
Accountants define cost as a resource sacrificed or foregone to achieve a specific objective. A cost (such as direct
materials or advertising) is usually measured as the monetary amount that must be paid to acquire goods or
services. An actual cost is the cost incurred (a historical or past cost), as distinguished from a budgeted cost, which
is a predicted or forecasted cost (a future cost).
When you think of cost, you invariably think of it in the context of finding the cost of a particular thing. We call this
thing a cost object, which is anything for which a measurement of costs is desired. Suppose that you were a
manager at BMW’s Spartanburg, South Carolina, plant. BMW makes several different types of cars and sport
activity vehicles (SAVs) at this plant. What cost objects can you think of?
EXAMPLES OF COST OBJECTS AT BMW
Cost Object
Illustration
Product
A BMW X5 sports activity vehicle
Service
Telephone hotline providing information and assistance to BMW dealers
Project
R&D project on enhancing the DVD system in BMW cars
Customer
Herb Chambers Motors, the BMW dealer that purchases a broad range of BMW vehicles.
Activity
Setting up machines for production or maintaining production equipment
Department
Environmental, health and safety department
You will see that BMW managers not only want to know the cost of various products, such as BMW X5, but they
also want to know the costs of things such as projects, services, and departments. Managers used their knowledge
of these costs to guide decisions about, for example, product innovation, quality and customer service.
Now think about whether a manager at BMW might want to know the budgeted cost of a cost object, or the actual
cost. Managers almost always need to know both types of costs when making decisions. For example, comparing
budgeted costs to actual costs helps managers evaluate how well they did and learn about how they can do better
in the future.
How does a cost system determine the costs of various cost objects? Typically, in two basic stages: accumulation,
followed by assignment. Cost accumulation is the collection of cost data in some organized way by means of an
accounting system. For example, at its Spartanburg plant, BMW collects (accumulates) costs in various categories
such as different types of materials, different classifications of labor, and costs incurred for supervision. Managers
and management accountants then assign these accumulated costs to designated cost objects, such as the
different models of cars that BMW manufactures as the plant. BMW managers use this cost information in two main
ways:
1.
2.
When making decisions, for instance, on how to price different models of cars or how to invest in R&D and
marketing and
For implementing decisions, by influencing and motivating employees to act and learn, for example, by
rewarding employees for reducing costs.
DIRECT COSTS AND INDIRECT COSTS
•
•
Direct costs of an object are related to the particular cost object and can be traced to it in an economically
feasible (cost-effective) way.
Indirect costs of a cost object are related to particular cost object but cannot be traced to it in an
economically feasible (cost-effective) way.
COST ASSIGNMENT TO A COST OBJECT
The term cost tracing is used to describe the assignment of direct costs to a particular cost object. The cost
allocation is used to describe the assignment of indirect costs to a particular object. Cost assignment is a general
term that encompasses both (1) tracing direct costs to a cost object and (2) allocating indirect costs to a cost
object.
Factors Affecting Direct/Indirect Cost Classifications
•
•
•
The materiality of the cost in question
The smaller the amount of a cost – that is, the more immaterial the cost is – the less likely that it is
economically feasible to trace that cost to a particular cost object.
Available information-gathering technology
Improvements in information-gathering technology make it possible to consider more and more costs as
direct costs.
Design of operations
Classifying a cost as direct is easier if a company’s facility is used exclusively for a specific cost object, such as a
specific product or a particular customer.
Be aware that a specific cost may be both a direct cost of one object and an indirect cost of another cost object.
That is, the direct/indirect classification depends on the choice of the cost object. A useful rule to remember is
that the broader the definition of the cost object the higher in the proportion of total costs that are direct costs
and the more confidence a manager has in the accuracy of the resulting cost amounts.
COST-BEHAVIOR PATTERNS: VARIABLE COSTS AND FIXED COSTS
Costing systems record the cost of resources acquired, such as materials, labor and equipment, and track how those
resources are used to produce and sell products or services. Recording the costs of resources acquired and used
allows managers to see how cost behave. Consider two basic types of cost behavior patterns found in many
accounting systems.
A variable cost changes in total in proportion to changes in the related level of total activity or volume.
A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total
activity or volume. Costs are defined as variable or fixed with respect to a specific activity and for a given time
period.
Some costs have both fixed and variable elements and are called mixed or semi-variable costs.
COST DRIVERS
A cost driver is a variable, such as the level of activity or volume that causally affects costs over a given time span.
An activity is an event, task, or unit of work with a specified purpose – for example, designing products, setting up
machines, or testing products. The level of activity or volume is a cost driver if there is a cause-and-effect
relationship between a change in the level of activity or volume and a change in the level of total costs. For example,
if product-design costs change with the number of parts in a product, the number of parts is a cost driver of productdesign costs. Similarly, miles driven is often a cost driver of distribution costs.
The cost driver of a variable cost is the level of activity or volume whose change causes proportionate changes in
the variable cost. For example, if product-design costs change with the number of parts in a product, the number
of parts is a cost driver of product-design costs. Similarly, miles driven is often a cost driver of distribution costs.
Costs that are fixed in the short run have no cost driver in the short run but may have a cost driver in the long run.
Consider the costs of testing, say, 0.1% of the color printers produced at a Hewlett-Packard plant. These costs
consist of equipment and staff costs of the testing department that are difficult to change and, hence, are fixed in
the short run with respect to changes in the volume of production. In this case, volume of production is not a cost
driver of testing costs in the short run. In the long run, however, Hewlett-Packard will increase or decrease the
testing department’s equipment and staff to the levels needed to support future production volumes. In the long
run, volume of production is a cost driver of testing costs. Costing systems that identify the cost of each activity
such as testing, design or set up are called activity-based costing systems.
RELEVANT RANGE
Relevant range is the band of normal activity level or volume in which there is a specific relationship between the
level of activity or volume and the cost in question. For example, a fixed cost is fixed only in relation to a given wide
range of total activity or volume (at which the company is expected to operate) and only for a given time span
(usually a particular budget period).
The basic assumption of the relevant range also applies to variable costs. That is, outside the relevant range,
variable costs, such as direct materials, may not change proportionately with changes in production volume. For
example, above a certain volume, direct material costs may increase at a lower rate because of price discounts on
purchases greater than a certain quantity.
TOTAL COSTS AND UNIT COSTS
Unit Costs
Generally, the decision maker should think in terms of total costs rather than unit costs. In many decision contexts,
however, calculating a unit cost is essential.
Consider the booking agent who has to make the decision to book Paul McCartney to play at Shea Stadium. She
estimates the cost of the event to be $4,000,000. This knowledge is helpful for the decision, but it is not enough.
Before a decision can be reached, the booking agent also must predict the number of people who will attend.
Without knowledge of both total cost and number of attendees, she cannot make an informed decision on a
possible admission price to recover the cost of the event or even on whether to have the event at all. So she
computes the unit cost of the event by dividing the total cost ($4,000,000) by the expected number of people who
will attend. If 50,000 people attend, the unit cost is $80 ($4,000,000 /50,000) per person; if 20,000 attends, the unit
cost increases to $200 ($4,000,000/20,000).
Unless the total cost is “unitized” (that is, averaged with respect to the level of activity or volume), the $4,000,000
cost is difficult to interpret. The unit cost combines the total cost and the number of people in a handy,
communicative way.
Accounting systems typically report both total cost amounts and average cost per unit amounts. A unit cost, also
called an average cost, is calculated by dividing total cost by the related number of units. The units might be
expressed in various ways. Examples are automobiles assembled, packages delivered, or hours worked. Suppose
that, in 2011, its first year of operations, $40,000,000 of manufacturing costs are incurred to produce 500,000
speaker systems at the Memphis plant of Tennessee Products. Then the unit cost is $80:
𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑒𝑑
=
$40,000,000
500,000 𝑢𝑛𝑖𝑡𝑠
= $80 per unit
If 480,000 units are sold and 20,000 units remain in ending inventory, the unit cost concept helps in the
determination of total costs in the income statement and balance sheet and, hence, the financial results reported
by Tennessee Products to shareholders, banks and the government.
Cost of goods sold in the income statement, 480,000 units x $80 per unit
Ending inventory in the balance sheet, 20,000 units x $80,000 per unit
Total manufacturing costs of 500,000 units
$38,400,000
1,600,000
$40,000,000
Unit costs are found in all areas of the value chain – for example, units costs of product design, of sales visits, and
of customer-service calls. By summing unit costs throughout the value chain, manager calculate the unit cost of the
different products or services they deliver and determine the profitability of each product or service. Managers use
this information, for example, to decide the products in which they should invest more resources, such as R&D and
marketing, and the prices they should charge.
BUSINESS SECTORS
1.
2.
3.
Manufacturing-sector companies purchase materials and components and convert them into various
finished goods. Examples are automotive companies such as Jaguar, cellular phone producers such as
Nokia, food-processing companies such as Heinz, and computer companies such as Toshiba.
Merchandising-sector companies purchase then sell tangible products without changing their basic form.
This sector includes companies engaged in retailing (for example, bookstores such as Barnes and Noble or
department stores such as Target), distribution (for example, a supplier of hospital products, such as
Owens and Minor), or wholesaling (for example, a supplier of electronic components, such as Arrow
Electronics).
Service-sector companies provide services (intangible products) – for example, legal advice or audits – to
their customers. Examples are law firms such as Wachtell, Lipton, Rosen & Katz, accounting firms such as
Ernst and Young, banks such as Barclays, mutual fund companies such as Fidelity, insurance companies
such as Aetna, transportation companies such as Singapore Airlines, advertising agencies such as Saatchi
& Saatchi, television stations such as Turner Broadcasting, Internet service provides such as Comcast,
travel agencies such as American Express, and brokerage firms such as Merrill Lynch.
TYPES OF INVENTORY
Manufacturing companies purchase materials and components and convert them into various finished goods.
These companies typically have one or more of the following three types of inventory:
1.
2.
3.
Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing products (for
example, computer chips and components needed to manufacture cellular phones.)
Work-in-process inventory. Goods partially worked on but not yet completed (for example, cellular
phones at various stages of completion in the manufacturing process). This is also called work in progress.
Finished goods inventory. Goods (for example, cellular phones) completed but not yet sold.
Merchandising-sector companies purchase tangible products and then sell them without changing their basic form.
They hold only one type of inventory, which is products in their original purchased form, called MERCHANDISE
INVENTORY. Service-sector companies provide only services or intangible products and so do not hold inventories
of tangible products.
COMMONLY USED CLASSIFICATIONS OF MANUFACTUR ING COSTS
1.
2.
3.
Direct Material Costs are the acquisition costs of all materials that eventually become part of the cost
object (work in process and then finished goods) and can be traced to the cost object in an economically
feasible way. Acquisition costs of direct materials include freight-in (inward delivery) charges, sales taxes,
and custom duties. Examples of direct materials costs are the steel and tires used to make the BMW X5,
and the computer chips used to make cellular phones.
Direct manufacturing labor costs include the compensation of all manufacturing labor than can be traced
to the cost object (work in process and then finished goods) in an economically feasible way. Examples
include wages and fringe benefits paid to machine operators and assembly line workers who convert direct
materials purchased to finished goods.
Indirect manufacturing costs are all manufacturing costs that are related to the cost object (work in
process and then finished goods) but cannot be traced to that cost object in an economically feasible way.
Examples include supplies, indirect materials such as lubricants, indirect manufacturing labor such as plant
maintenance and cleaning labor, plant rent, plant insurance, property taxes on the plant, plant
depreciation, and the compensation of plant managers. This cost category is also referred to as
manufacturing overhead costs or factory overhead costs.
INVENTORIABLE AND PERIOD COSTS
INVENTORIABLE COSTS
Inventoriable costs are all costs of a product that are considered as assets in the balance sheet when they are
incurred and that become costs of goods sold only when the product is sold. For manufacturing-sector companies,
all manufacturing costs are inventoriable costs. For merchandising-sector companies, inventoriable costs are the
costs of purchasing the goods that are resold in the same form. These costs comprise the costs of goods themselves
plus any incoming freight, insurance, and handling costs for those goods. Service-sector companies provide only
services or intangible products. The absence of inventories of tangible products for sale means there are no
inventoriable costs.
PERIOD COSTS
Period costs are all costs in the income statement other than cost of goods sold. Period costs, such as marketing,
distribution and customer service costs, are treated as expenses of the accounting period in which they are incurred
because they are expected to benefit revenues in that period and are not expected to benefit revenues in the future
periods. Some costs such as R&D costs are treated as period costs because, although these costs may benefit
revenues in a future period if the R&D efforts are successful, it is highly uncertain if and when these benefits will
occur. Expensing period costs as they are incurred best matches expenses to revenues.
For manufacturing-sector companies, period costs in the income statement are all non-manufacturing costs (for
example, design costs and costs of shipping products to customers). For merchandising-sector companies, period
costs in the income statement are all costs not related to the cost of goods purchased for resale. Examples of these
period costs are labor costs of sales floor personnel and advertising costs. Because there are no inventoriable costs
for service-sector companies, all costs in the income statement are period costs.
FLOW OF REVENUE AND COSTS FOR A MANUFACTURING-SECTOR COMPANY
The figure above highlights the differences between inventoriable costs and period costs for a manufacturing
company. The manufacturing costs of finished goods include direct materials, other direct manufacturing costs
such as direct manufacturing labor, and manufacturing overhead costs such as supervision, production control, and
machine maintenance. All these costs are inventoriable: They are assigned to work-in-process inventory until the
goods are completed and then to finished goods inventory until the goods are sold. All nonmanufacturing costs,
such as R&D, design, and distribution costs, are period costs.
FLOW OF REVENUES AND COSTS FOR A MERCHANDISING COMPANY
PRIME COSTS AND CONVERSION COSTS
Prime costs are all direct manufacturing costs. (Direct Materials Costs + Direct Manufacturing Labor Costs)
Conversion costs are all manufacturing costs other than direct material costs. Conversion costs represent all
manufacturing costs incurred to convert direct materials into finished goods.
Note that direct manufacturing labor costs are part of both prime costs and conversion costs.
DECISION POINTS
The following question-and-answer format summarizes the chapter’s learning objectives. Each decision presents a
key question related to a learning objective. The guidelines are the answers to that question.
Decision
Guidelines
1.
What is a cost object?
A cost object is anything for which a separate measurement of cost is
needed. Examples include a product, a service, a project, a customer, a
brand category, an activity, and a department.
2.
How do managers decide
whether a cost is a direct or an
indirect cost?
A direct cost is any cost that is related to a particular cost object and can be
traced to that cost object in an economically feasible way. Indirect costs are
related to the particular cost object but cannot be traced to it in an
economically feasible way. The same cost can be direct for one cost object
and indirect for another cost object. Cost tracing is used to describe the
assignment of direct costs to a cost object and cost allocation to describe
the assignment of indirect costs to a cost object.
3.
How do managers decide
whether a cost is a variable or a
fixed cost?
A variable cost changes in total in proportion to changes in the related level
of total activity or volume. A fixed cost remains unchanged in total for a
given time period despite wide changes in the related level of total activity
or volume.
4.
How
should
estimated?
be
In general, focus on total costs, not unit costs. When making total cost
estimates, think of variable costs as an amount per unit and fixed costs as a
total amount. The unit cost of a cost object should be interpreted cautiously
when it includes a fixed-cost component.
5.
What are the differences in the
accounting for inventoriable
versus period costs?
Inventoriable costs are all costs of a product that are regarded as an asset in
the accounting period when they are incurred and become cost of goods
sold in the accounting period when the product I sold. Period costs are
expensed in the accounting period in which they are incurred and are all of
the costs in an income statement other than cost of goods sold.
6.
Why do managers assign
different costs to the same cost
objects?
Managers can assign different costs to the same cost object depending on
the purpose. For example, for the external reporting purpose in a
manufacturing company, the inventoriable cost of a product includes only
manufacturing costs. In contrast, costs from all business functions of the
value chain often are assigned to a product for pricing and product-mix
decisions.
costs
PROBLEM FOR SELF-STUDY
Foxwood Company is a metal-and wood-cutting manufacturer, selling products to the home construction market.
Consider the following data for 20x1.
Sandpaper
Materials-handling costs
Lubricants and coolants
Miscellaneous Indirect Manufacturing Labor
Direct Manufacturing Labor
Direct Materials Inventory, Jan.1, 20x1
Direct Materials Inventory, Dec. 31, 20x1
Finished Goods Inventory, Jan. 1, 20x1
Finished Goods Inventory, Dec.31, 20x1
Work-In-Process, Inventory, Jan.1, 20x1
Work-In-Process, Inventory, Dec.31, 20x1
Plant-leasing costs
Depreciation – plant equipment
Property taxes on plant equipment
Fire insurance on plant equipment
Direct Materials purchased
Revenues
Marketing promotions
Marketing salaries
Distribution costs
Customer-service costs
$ 2,000
70,000
5,000
40,000
300,000
40,000
50,000
100,000
150,000
10,000
14,000
54,000
36,000
4,000
3,000
460,000
1,360,000
60,000
100,000
70,000
100,000
1. Prepare an income statement with a separate supporting schedule of cost of goods manufactured. For all
manufacturing items, classify costs as direct costs or indirect costs and indicate by V or F whether each is
basically a variable cost or a fixed cost (when the cost object is a product unit). If in doubt, decide on that
basis of whether the total cost will change substantially over a wide range of units produced.
2. Supposed that both the direct material costs and the plant-leasing costs are for the production of 900,000
units. What is the direct material cost of each unit produced? What is the plant-leasing cost per unit?
Assume that the plant-leasing cost is a fixed cost.
3. Suppose Foxwood Company manufactures 1,000,000 units next year. Repeat the computation in
requirement 2 for direct materials and plant-leasing costs. Assume the implied cost-behavior patterns
persist.
4. As a management consultant, explain concisely to the company president why the unit cost for direct
materials did not change in requirement 2 and 3 but the unit cost for plant-leasing costs did change.
SOLUTION:
2. Direct material unit cost = Direct materials used / units produced
= $450,000/900,000 units = $0.50 per unit
Plant leasing-unit cost = Plant-leasing cost / units produced
= $54,000 / 900,000 = $0.06 per unit
3. The direct material costs are variable, so they would increase in total from $450,000 to $500,000 (1,000,000
units x $0.50 per unit). However, their unit cost would be unaffected: $500,000/1,000,000 units = $0.50 per
unit.
In contrast, the plant-leasing cost of $54,000 are fixed, so they would not increase in total. However, the
plant-leasing cost per unit would decline from $0.06 to $0.054: $54,000/1,000,000 units = $0.054 per unit.
4. The explanation would begin the answer to requirement 3. As a consultant, you should stress that the
unitizing (averaging) of costs that have different behavior pattens can be misleading. A common error is
to assume that a total unit cost, which is often a sum of variable unit cost and fixed unit cost, is an indicator
that total costs change in proportion to changes in production levels. You must be wary, especially about
average fixed cost per unit. Too often, unit fixed costs is erroneously regarded as being indistinguishable
from unit variable cost.
ASSIGNMENT MATERIAL
True / False Questions
1.
Selling costs can be either direct or indirect costs.
2.
A direct cost is a cost that cannot be easily traced to the particular cost object under consideration
3.
Property taxes and insurance premiums paid on a factory building are examples of period costs.
4.
Conversion cost equals product cost less direct labor cost.
5.
Thread that is used in the production of mattresses is an indirect material that is therefore classified as
manufacturing overhead.
6.
Direct labor is a part of prime cost, but not conversion cost.
7.
Conversion cost is the sum of direct labor cost and direct materials cost
8.
Direct material costs are generally fixed costs.
9.
Product costs are recorded as expenses in the period in which the related products are sold.
10. Depreciation on manufacturing equipment is a product cost.
11. Manufacturing salaries and wages incurred in the factory are period costs.
12. Depreciation on office equipment would be included in product costs.
13. Rent on a factory building used in the production process would be classified as a product cost and as a fixed
cost.
14. A fixed cost remains constant if expressed on a unit basis.
15. Total variable cost is expected to remain unchanged as activity changes within the relevant range.
16. Country Charm Restaurant is open 24 hours a day and always has a fire going in the fireplace in the middle of
its dining area. The cost of the firewood for this fire is fixed with respect to the number of meals served at the
restaurant.
17. Committed fixed costs represent organizational investments with a multi-year planning horizon that can't be
significantly reduced even for short periods.
18. Commissions paid to salespersons are a variable selling expense.
19. Variable costs are costs that vary, in total, in direct proportion to changes in the volume or level of activity.
20. The planning horizon for a committed fixed cost usually encompasses many years.
21. Cost behavior is considered linear whenever a straight line is a reasonable approximation for the relation
between cost and activity.
22. The high-low method uses cost and activity data from just two periods to establish the formula for a mixed
cost.
23. The engineering approach to the analysis of mixed costs involves a detailed analysis of what cost behavior
should be, based on an industrial engineer's evaluation of the production methods to be used, the materials
specifications, labor requirements, equipment usage, production efficiency, power consumption, and so on.
24. The contribution margin is the amount remaining from sales revenues after variable expenses have been
deducted.
25. A contribution format income statement for a merchandising company organizes costs into two categories—
cost of goods sold and selling and administrative expenses.
26. The traditional format income statement provides managers with an income statement that clearly
distinguishes between fixed and variable costs and therefore aids planning, control, and decision making.
27. In a contribution format income statement, the gross margin minus selling and administrative expenses
equals net operating income.
28. A traditional format income statement organizes costs on the basis of behavior.
29. In a traditional format income statement for a merchandising company, the selling and administrative
expenses report all period costs that have been expensed as incurred.
30. The contribution format is widely used for preparing external financial statements.
31. Contribution margin equals revenue minus all fixed costs.
32. The potential benefit that is given up when one alternative is selected over another is called an opportunity
cost.
33. A cost that differs from one month to another is known as a differential cost.
Multiple Choice Questions
34. The nursing station on the fourth floor of Central Hospital is responsible for the care of orthopedic surgery
patients. The costs of prescription drugs administered by the nursing station to patients should be classified
as:
A. direct patient costs.
B. indirect patient costs.
C. overhead costs of the nursing station.
D. period costs of the hospital.
35. All of the following costs would be found in a company's accounting records except:
A. sunk cost.
B. opportunity cost.
C. indirect costs.
D. direct costs.
36. The costs of the Accounting Department at Central Hospital would be considered by the Surgery Department
to be:
A. direct costs.
B. indirect costs.
C. incremental costs.
D. opportunity costs.
37. Which of the following is classified as a direct labor cost?
Wages of assemblyWages of a factory supervisor
line workers
A) No
No
B) Yes
Yes
C) No
Yes
D) Yes
No
A. Option A
B. Option B
C. Option C
D. Option D
38. In a manufacturing company, direct labor costs combined with direct materials costs are known as:
A. period costs.
B. conversion costs.
C. prime costs.
D. opportunity costs.
39. The property taxes on a factory building would be an example of:
Prime Cost Conversion Cost
A) No
Yes
B) Yes
No
C) Yes
Yes
D) No
No
A. Option A
B. Option B
C. Option C
D. Option D
40. Which of the following would most likely be included as part of manufacturing overhead in the production of
a wooden table?
A. The amount paid to the individual who stains the table.
B. The commission paid to the salesperson who sold the table.
C. The cost of glue used in the table.
D. The cost of the wood used in the table.
41. Property taxes on a manufacturing facility are classified as:
Conversion cost Period cost
A) Yes
No
B) Yes
Yes
C) No
Yes
D) No
No
A. Option A
B. Option B
C. Option C
D. Option D
42. Indirect labor is a(n):
A. Prime cost.
B. Conversion cost.
C. Period cost.
D. Opportunity cost.
43. The salary paid to the maintenance supervisor in a manufacturing plant is an example of:
Product Cost Manufacturing Overhead
A) No
Yes
B) Yes
No
C) Yes
Yes
D) No
No
A. Option A
B. Option B
C. Option C
D. Option D
44. All of the following would be classified as product costs except:
A. property taxes on production equipment.
B. insurance on factory machinery.
C. salaries of the marketing staff.
D. wages of machine operators.
45. The cost of direct materials cost is classified as a:
Period cost Product cost
A) Yes
Yes
B) No
No
C) Yes
No
D) No
Yes
A. Option A
B. Option B
C. Option C
D. Option D
46. Which of the following costs is classified as a prime cost?
Direct materials Indirect materials
A) Yes
Yes
B) No
No
C) Yes
No
D) No
Yes
A. Option A
B. Option B
C. Option C
D. Option D
47. Inventoriable costs are also known as:
A. variable costs.
B. conversion costs.
C. product costs.
D. fixed costs.
48. Fresh Wreath Corporation manufactures wreaths according to customer specifications and ships them to
customers using United Parcel Service (UPS). Which two terms below describe the cost of shipping these
wreaths?
A. variable cost and product cost
B. variable cost and period cost
C. fixed cost and product cost
D. fixed cost and period cost
49. If the level of activity increases within the relevant range:
A. variable cost per unit and total fixed costs also increase.
B. fixed cost per unit and total variable cost also increase.
C. total cost will increase and fixed cost per unit will decrease.
D. variable cost per unit and total cost also increase.
50. Within the relevant range:
A. variable cost per unit decreases as production decreases.
B. fixed cost per unit increases as production decreases.
C. fixed cost per unit decreases as production decreases.
D. variable cost per unit increases as production decreases.
PROBLEM SOLVING
CASE 1
A number of costs are listed below.
Cost Description
1. Cost of a measles vaccine administered at an outpatient clinic at a hospital
2.
Cost of a replacement battery installed in a car at the auto repair shop of an
automobile dealer
3. Accounting professor's salary
4.
Cost of electronic navigation system installed in a yacht at a yacht
manufacturer
Cost Object
The outpatient clinic
The auto repair shop
A particular class
A particular yacht
5. Cost of wiring used in making a personal computer
A particular personal
computer
6. Supervisor's wages in a computer manufacturing facility
A particular personal
computer
7. Cost of lubrication oil used at the auto repair shop of an automobile dealer
The auto repair shop
8. Cost of heating a hotel run by a chain of hotels
A particular hotel guest
9. Cost of heating a hotel run by a chain of hotels
The particular hotel
10. Cost of tongue depressors used in an outpatient clinic at a hospital
A particular patient
Required:
For each item above, indicate whether the cost is direct or indirect with respect to the cost object listed next
to it.
CASE 2
The CHA CHA Company began operations several years ago. The company's product requires materials that
cost $25 per unit. The company employs a production supervisor whose salary is $2,000 per month.
Production line workers are paid $15 per hour to manufacture and assemble the product. The company rents
the equipment needed to produce the product at a rental cost of $1,500 per month. The building is
depreciated on the straight-line basis at $9,000 per year.
The company spends $40,000 per year to market the product. Shipping costs for each unit are $20 per unit.
The company plans to liquidate several investments in order to expand production. These investments
currently earn a return of $8,000 per year.
Required:
Complete the answer sheet below by placing an "X" under each heading that identifies the cost involved. The
"Xs" can be placed under more than one heading for a single cost, e.g., a cost might be a sunk cost, an
overhead cost, and a product cost.
Direct
Direct Direct
Variable Fixed
Manufacturing Period Opportunity Sunk
Materials Materials Labor
Cost
Cost
Overhead Cost Cost
Cost
Cost
Cost
Cost
Cost
Materials
Production
supervisor
salary
Production
line worker
wages
Equipment
rental
Building
depreciation
Marketing
costs
Shipping cost
Return on
present
investments
LESSON 2
JOB ORDER COSTING
Learning Objectives
At the end of the module, the student should have
1. Compute a predetermined overhead rate.
2. Apply overhead cost to jobs using a predetermined overhead rate.
3. Compute the total cost and average cost per unit of a job.
4. Understand the flow of costs in a job order costing system and prepare appropriate journal entries to
record costs.
5. Use T-accounts to show the flow of costs in a job-order costing system.
6. Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement.
7. Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in
Manufacturing Overhead to the appropriate accounts.
JOB-ORDER COSTING—AN OVERVIEW
Under absorption costing, product costs include all manufacturing costs. Some manufacturing
costs, such as direct materials, can be directly traced to particular products. For example, the cost of the airbags
installed in a Toyota Camry can be easily traced to that particular auto. But what about manufacturing costs like
factory rent? Such costs do not change from month to month, whereas the number and variety of products made
in the factory may vary dramatically from one month to the next. Because these costs remain unchanged from
month to month regardless of what products are made,
they are clearly not caused by—and cannot be directly traced to—any particular product. Therefore, these types of
costs are assigned to products and services by averaging across time and across products. The type of production
process influences how this averaging is done.
Job-order costing is used in situations where many different products, each with individual and unique features, are
produced each period. For example, a Levi Strauss clothing factory would typically make many different types of
jeans for both men and women during a month. A particular order might consist of 1,000 boot-cut men’s blue denim
jeans, style number A312. This order of 1,000 jeans is called a job. In a job-order costing system, costs are traced
and allocated to jobs and then the costs of the job are divided by the number of units in the job to arrive at an
average cost per unit.
Job-order costing is also used extensively in service industries. For example, hospitals, law firms, movie studios,
accounting firms, advertising agencies, and repair shops all use a variation of job-order costing to accumulate costs.
Although the detailed example of job-order costing provided in the following section deals with a manufacturing
company, the same basic concepts and procedures are used by many service organizations.
To introduce job-order costing, we will follow a specific job as it progresses through the manufacturing process.
This job consists of two experimental couplings that Yost Precision Machining has agreed to produce for Loops
Unlimited, a manufacturer of roller coasters Couplings connect the cars on the roller coaster and are a critical
component in the performance and safety of the ride. Before we begin our discussion, recall from the previous
chapter that companies generally classify manufacturing costs into three broad categories: (1) direct materials, (2)
direct labor, and (3) manufacturing overhead. As we study the operation of a job-order costing system, we will see
how each of these three types of costs is recorded and accumulated.
MEASURING DIRECT MATERIALS COST
The blueprints submitted by Loops Unlimited indicate that each experimental coupling will require three parts that
are classified as direct materials: two G7 Connectors and one M46 Housing. Since each coupling requires two
connectors and one housing, the production of two couplings requires four connectors and two housings. This is a
custom product that is being made for the first time, but if this were one of the company’s standard products, it
would have an established bill of materials. A bill of materials is a document that lists the type and quantity of each
type of direct material needed to complete a unit of product.
When an agreement has been reached with the customer concerning the quantities, prices, and shipment date for
the order, a production order is issued. The Production Department then prepares a materials requisition form
similar to the form in Exhibit 2–1 . The materials requisition form is a document that specifies the type and quantity
of materials to be drawn from the storeroom and identifies the job that will be charged for the cost of the materials.
The form is used to control the flow of materials into production and also for making entries in the accounting
records. The Yost Precision Machining materials requisition form in Exhibit 2–1 shows that the company’s Milling
Department has requisitioned two M46 Housings and four G7 Connectors for the Loops Unlimited job, which has
been designated as Job 2B47.
Exhibit 2–1
JOB COST SHEET
After a production order has been issued, the Accounting Department’s job-order costing software system
automatically generates a job cost sheet like the one presented in Exhibit 2–2 . A job cost sheet records the
materials, labor, and manufacturing overhead costs charged to that job.
After direct materials are issued, the cost of these materials are automatically recorded on the job cost sheet. Note
from Exhibit 2–2 , for example, that the $660 cost for direct materials shown earlier on the materials requisition
form has been charged to Job 2B47 on its job cost sheet. The requisition number 14873 from the materials
requisition form appears on the job cost sheet to make it easier to identify the source document for the direct
materials charge.
Exhibit 2–2
MEASURING DIRECT LABOR COST
Direct labor consists of labor charges that are easily traced to a particular job. Labor charges that cannot be easily
traced directly to any job are treated as part of manufacturing overhead. As discussed in the previous chapter, this
latter category of labor costs is called indirect labor and includes tasks such as maintenance, supervision, and
cleanup. Most companies rely on computerized systems to maintain employee time tickets. A completed time
ticket is an hour-by-hour summary of the employee’s activities throughout the day. One computerized approach to
creating time tickets uses bar codes to capture data. Each employee and each job have a unique bar code. When
beginning work on a job, the employee scans three bar codes using a handheld device much like the bar code
readers at grocery store checkout stands. The first bar code indicates that a job is being started; the second is the
unique bar code on the employee’s identity badge; and the third is the unique bar code of the job itself. This
information is fed automatically via an electronic network to a computer that notes the time and records all of the
data. When the task is completed, the employee scans a bar code indicating the task is complete, the bar code on
his or her identity badge, and the bar code attached to the job. This information is relayed to the computer that
again notes the time, and a time ticket, such as the one shown in Exhibit 2–3 , is automatically prepared. Because
all of the source data is already in computer files, the labor costs can be automatically posted to job cost sheets. For
example, Exhibit 2–3 shows $45 of direct labor cost related to Job 2B47. This amount is automatically posted to the
job cost sheet shown in Exhibit 2–2. The time ticket in Exhibit 2–3 also shows $9 of indirect labor costs related to
performing maintenance. This cost is treated as part of manufacturing overhead and does not get posted on a job
cost sheet.
Exhibit 2–3
COMPUTING PREDETERMINED OVERHEAD RATES
Recall that product costs include manufacturing overhead as well as direct materials and direct labor. Therefore,
manufacturing overhead also needs to be recorded on the job cost sheet. However, assigning manufacturing
overhead to a specific job involves some difficulties.
There are three reasons for this:
1. Manufacturing overhead is an indirect cost. This means that it is either impossible or difficult to trace these
costs to a particular product or job.
2. Manufacturing overhead consists of many different types of costs ranging from the grease used in
machines to the annual salary of the production manager. Some of these costs are variable overhead costs
because they vary in direct proportion to changes in the level of production (e.g., indirect materials,
supplies, and power) and some are fixed overhead costs because they remain constant as the level of
production fluctuates (e.g., heat and light, property taxes, and insurance).
3.
Because of the fixed costs in manufacturing overhead, total manufacturing overhead costs tend to remain
relatively constant from one period to the next even though the number of units produced can fluctuate
widely. Consequently, the average cost per unit will vary from one period to the next.
Given these problems, allocation is used to assign overhead costs to products. Allocation is accomplished by
selecting an allocation base that is common to all of the company’s products and services. An allocation base is a
measure such as direct labor-hours (DLH) or machine-hours (MH) that is used to assign overhead costs to products
and services. The most widely used allocation bases in manufacturing are direct labor-hours, direct labor cost,
machine-hours, and (where a company has only a single product) units of product.
Manufacturing overhead is commonly assigned to products using a predetermined overhead rate. The
predetermined overhead rate is computed by dividing the total estimated manufacturing overhead cost for the
period by the estimated total amount of the allocation base as follows:
Predetermined overhead rate = Estimated total manufacturing overhead cost
Estimated total amount of the allocation base
The predetermined overhead rate is computed before the period begins using a four-step process. The first step is
to estimate the total amount of the allocation base (the denominator) that will be required for next period’s
estimated level of production. The second step is to estimate the total fixed manufacturing overhead cost for the
coming period and the variable manufacturing overhead cost per unit of the allocation base. The third step is to use
the cost formula shown below to estimate the total manufacturing overhead cost (the numerator) for the coming
period:
Y = a 1+bX
where,
Y = The estimated total manufacturing overhead cost
a = The estimated total fixed manufacturing overhead cost
b = The estimated variable manufacturing overhead cost per unit of the allocation base
X =The estimated total amount of the allocation base
The fourth step is to compute the predetermined overhead rate. Notice, the estimated amount of the allocation
base is determined before estimating the total manufacturing overhead cost. This needs to be done because total
manufacturing overhead cost includes variable overhead costs that depend on the amount of the allocation base.
APPLYING MANUFACTURING OVERHEAD
To repeat, the predetermined overhead rate is computed before the period begins. The predetermined overhead
rate is then used to apply overhead cost to jobs throughout the period. The process of assigning overhead cost to
jobs is called overhead application. The formula for determining the amount of overhead cost to apply to a
particular job is:
For example, if the predetermined overhead rate is $8 per direct labor-hour, then $8 of overhead cost is applied to
a job for each direct labor-hour incurred on the job. When the allocation base is direct labor-hours, the formula
becomes:
MANUFACTURING OVERHEAD—A CLOSER LOOK
To illustrate the steps involved in computing and using a predetermined overhead rate, let’s return to Yost Precision
Machining and make the following assumptions. In step one, the company estimated that 40,000 direct labor-hours
would be required to support the production planned for the year. In step two, it estimated $220,000 of total fixed
manufacturing overhead cost for the coming year and $2.50 of variable manufacturing overhead cost per direct
labor-hour. Given these assumptions, in step three the company used the cost formula shown below to estimate its
total manufacturing overhead cost for the year:
Y + a + bX
Y = $220,000 + ($2.50 per direct labor-hour x 40,000 direct labor-hours)
Y = $220,000 + $100,000
Y = $320,000
In step four, Yost Precision Machining computed its predetermined overhead rate for the year of $8 per direct laborhour as shown below:
Predetermined overhead rate = Estimated total manufacturing overhead cost
Estimated total amount of the allocation base
=
$320,000
40,000 direct labor-hours
= $8 per direct labor-hour
_
The job cost sheet in Exhibit 2–4 indicates that 27 direct labor-hours (i.e., DLHs) were charged to Job 2B47.
Therefore, a total of $216 of manufacturing overhead cost would be applied to the job:
Overhead applied to Job 2B47
=Predetermined overhead rate x Actual direct labor-hours charged to Job 2B47
= $8 per DLH x 27 DLHs
= $216 of overhead applied to Job 2B47
This amount of overhead has been entered on the job cost sheet in Exhibit 2–4. Note that this is not the actual
amount of overhead caused by the job. Actual overhead costs are not assigned to jobs—if that could be done, the
costs would be direct costs, not overhead. The overhead assigned to the job is simply a share of the total overhead
that was estimated at the beginning of the year. A normal cost system, which we have been describing, applies
overhead to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred
by the jobs.
Exhibit 2–4
THE NEED FOR A PREDETERMINED RATE
Instead of using a predetermined rate based on estimates, why not base the overhead rate on the actual total
manufacturing overhead cost and the actual total amount of the allocation base incurred on a monthly, quarterly,
or annual basis? If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the
allocation base can produce fluctuations in the overhead rate. For example, the costs of heating and cooling a
factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall. If the overhead
rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate
would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed
in the winter and one completed in the spring, would be assigned different manufacturing overhead costs. Many
managers believe that such fluctuations in product costs serve no useful purpose. To avoid such fluctuations, actual
overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed
annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular
job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining
would not be known until the end of the year, even though the job will be completed and shipped to the customer
in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates
in their cost accounting systems.
CHOICE OF AN ALLOCATION BASE FOR OVERHEAD COST
Ideally, the allocation base in the predetermined overhead rate should drive the overhead cost. A cost driver is a
factor, such as machine-hours, beds occupied, computer time, or flight-hours, that causes overhead costs. If the
base in the predetermined overhead rate does not “drive” overhead costs, product costs will be distorted. For
example, if direct labor-hours is used to allocate overhead, but in reality overhead has little to do with direct laborhours, then products with high direct labor-hour requirements will be over costed.
Most companies use direct labor-hours or direct labor cost as the allocation base for manufacturing overhead. In
the past, direct labor accounted for up to 60% of the cost of many products, with overhead cost making up only a
portion of the remainder. This situation has changed for two reasons. First, sophisticated automated equipment
has taken over functions that used to be performed by direct labor workers Because the costs of acquiring and
maintaining such equipment are classified as overhead, this increases overhead while decreasing direct labor.
Second, products are becoming more sophisticated and complex and are changed more frequently. This increases
the need for highly skilled indirect workers such as engineers As a result of these two trends, direct labor has
decreased relative to overhead as a component of product costs.
In companies where direct labor and overhead costs have been moving in opposite directions, it would be difficult
to argue that direct labor “drives” overhead costs. Accordingly, managers in some companies use activity-based
costing principles to redesign their cost accounting systems. Activity-based costing is designed to more accurately
reflect the demands that products, customers, and other cost objects make on overhead resources.
Although direct labor may not be an appropriate allocation base in some industries, in others it continues to be a
significant driver of manufacturing overhead. Indeed, most manufacturing companies in the United States continue
to use direct labor as the primary or secondary allocation base for manufacturing overhead. The key point is that
the allocation base used by the company should really drive, or cause, overhead costs, and direct labor is not always
the most appropriate allocation base.
COMPUTATION OF UNIT COSTS
With the application of Yost Precision Machining’s $216 of manufacturing overhead to the job cost sheet in Exhibit
2–4 , the job cost sheet is complete except for two final steps. First, the totals for direct materials, direct labor, and
manufacturing overhead are transferred to the Cost Summary section of the job cost sheet and added together to
obtain the total cost for the job. 1 Then the total product cost ( $1,800 ) is divided by the number of units (2) to
obtain the unit product cost ( $900 ). This unit product cost information is used for valuing unsold units in ending
inventory and for determining cost of goods sold. As indicated earlier, this unit product cost is an average cost and
should not be interpreted as the cost that would actually be incurred if another unit were produced. The incremental
cost of an additional unit is something less than the average unit cost of $900 because much of the actual overhead
costs would not change if another unit were produced.
JOB-ORDER COSTING—THE FLOW OF COSTS
We are now ready to discuss the flow of costs through a job-order costing system.
Exhibit 2–5 provides a conceptual overview of these cost flows. It highlights the fact that product costs flow through
inventories on the balance sheet and then on to cost of goods sold in the income statement. More specifically, raw
materials purchases are recorded in the Raw Materials inventory account. Raw materials include any materials that
go into the final product. When raw materials are used in production, their costs are transferred to the Work in
Process inventory account as direct materials. 2 Work in process consists of units of product that are only partially
complete and will require further work before they are ready for sale to the customer. Notice that direct labor costs
are added directly to Work in Process—they do not flow through Raw Materials inventory. Manufacturing overhead
costs are applied to Work in Process by multiplying the predetermined overhead rate by the actual quantity of the
allocation base consumed by each job. 3 When goods are completed, their costs are transferred from Work in
Process to Finished Goods. Finished goods consist of completed units of product that have not yet been sold to
customers The amount transferred from Work in Process to Finished Goods is referred to as the cost of goods
manufactured. The cost of goods manufactured includes the manufacturing costs associated with the goods that
were finished during the period. As goods are sold, their costs are transferred from Finished Goods to Cost of Goods
Sold. At this point, the various costs required to make the product are finally recorded as an expense. Until that
point, these costs are in inventory accounts on the balance sheet. Period costs (or selling and administrative
expenses) do not flow through inventories on the balance sheet. They are recorded as expenses on the income
statement in the period incurred.
Exhibit 2–5
To illustrate the cost flows through a company’s general ledger, we will consider a single month’s activity at Ruger
Corporation, a producer of gold and silver commemorative medallions. Ruger Corporation has two jobs in process
during April, the first month of its fiscal year. Job A, a special minting of 1,000 gold medallions commemorating the
invention of motion pictures, was started during March. By the end of March, $30,000 in manufacturing costs had
been recorded for the job. Job B, an order for 10,000 silver medallions commemorating the fall of the Berlin Wall,
was started in April.
THE PURCHASE AND ISSUE OF MATERIALS
On April 1, Ruger Corporation had $7,000 in raw materials on hand. During the month, the company purchased on
account an additional $60,000 in raw materials. The purchase is recorded in journal entry (1) below:
Remember that Raw Materials is an asset account. Thus, when raw materials are purchased, they are initially
recorded as an asset—not as an expense.
Issue of Direct and Indirect Materials During April, $52,000 in raw materials were requisitioned from the storeroom
for use in production. These raw materials included $50,000 of direct and $2,000 of indirect materials. Entry (2)
records issuing the materials to the production departments.
The materials charged to Work in Process represent direct materials for specific jobs.
These costs are also recorded on the appropriate job cost sheets. This point is illustrated in Exhibit 2–6, where
$28,000 of the $50,000 in direct materials is charged to Job A’s cost sheet and the remaining $22,000 is charged to
Job B’s cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.)
The $2,000 charged to Manufacturing Overhead in entry (2) represents indirect materials. Observe that the
Manufacturing Overhead account is separate from the Work in Process account. The purpose of the Manufacturing
Overhead account is to accumulate all manufacturing overhead costs as they are incurred during a period.
Exhibit 2–6
Before leaving Exhibit 2–6 , we need to point out one additional thing. Notice from the exhibit that the job cost
sheet for Job A contains a beginning balance of $30,000. We stated earlier that this balance represents the cost of
work done during March that has been carried forward to April. Also note that the Work in Process account
contains the same $30,000 balance. Thus, the Work in Process account summarizes all of the costs appearing on
the job cost sheets of the jobs that are in process. Job A was the only job in process at the beginning of April, so
the beginning balance in the Work in Process account equals Job A’s beginning balance of $30,000.
LABOR COST
In April, the employee time tickets included $60,000 recorded for direct labor and $15,000 for indirect labor. The
following entry summarizes these costs:
Only the direct labor cost of $60,000 is added to the Work in Process account. At the same time that direct labor
costs are added to Work in Process, they are also added to the individual job cost sheets, as shown in Exhibit 2–7 .
During April, $40,000 of direct labor cost was charged to Job A and the remaining $20,000 was charged to Job B.
The labor costs charged to Manufacturing Overhead ($15,000 ) represent the indirect labor costs of the period, such
as supervision, janitorial work, and maintenance.
MANUFACTURING OVERHEAD COSTS
Recall that all manufacturing costs other than direct materials and direct labor are classified as manufacturing
overhead costs. These costs are entered directly into the Manufacturing Overhead account as they are incurred. To
illustrate, assume that Ruger Corporation incurred the following general factory costs during April:
Utilities (heat, water, and power) . . . . . . . . . . . $21,000
Rent on factory equipment . . . . . . . . . . . . . . . . 16,000
Miscellaneous factory overhead costs . . . . . . .
3,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000
The following entry records the incurrence of these costs:
In addition, assume that during April, Ruger Corporation recognized $13,000 in accrued property taxes and that
$7,000 in prepaid insurance expired on factory buildings and equipment. The following entry records these items:
Finally, assume that the company recognized $18,000 in depreciation on factory equipment during April. The
following entry records the accrual of this depreciation:
In short, all actual manufacturing overhead costs are debited to the Manufacturing Overhead account as they are
incurred.
APPLYING MANUFACTURING OVERHEAD
Because actual manufacturing costs are charged to the Manufacturing Overhead control account rather than to
Work in Process, how are manufacturing overhead costs assigned to Work in Process? The answer is, by means of
the predetermined overhead rate. Recall from our discussion earlier in the chapter that a predetermined overhead
rate is established at the beginning of each year. The rate is calculated by dividing the estimated total
manufacturing overhead cost for the year by the estimated total amount of the allocation base (measured in
machine-hours, direct labor-hours, or some other base). The predetermined overhead rate is then used to apply
overhead costs to jobs. For example, if machine-hours is the allocation base, overhead cost is applied to each job
by multiplying the predetermined overhead rate by the number of machine-hours charged to the job.
To illustrate, assume that Ruger Corporation’s predetermined overhead rate is $6 per machine-hour. Also assume
that during April, 10,000 machine-hours were worked on Job A and 5,000 machine-hours were worked on Job B (a
total of 15,000 machine-hours). Thus, $90,000 in overhead cost ($6 per machine-hour 3 15,000 machine-hours 5
$90,000) would be applied to Work in Process. The following entry records the application of Manufacturing
Overhead to Work in Process:
The flow of costs through the Manufacturing Overhead account is shown in Exhibit 2–8 . The actual overhead costs
on the debit side in the Manufacturing Overhead account in Exhibit 2–8 are the costs that were added to the account
in entries (2)–(6). Observe that recording these actual overhead costs [entries (2)–(6)] and the application of
overhead to Work in Process [entry (7)] represent two separate and entirely distinct processes.
Exhibit 2–8
THE CONCEPT OF A CLEARING ACCOUNT
The Manufacturing Overhead account operates as a clearing account. As we have noted, actual factory overhead
costs are debited to the account as they are incurred throughout the year. When a job is completed (or at the end
of an accounting period), overhead cost is applied to the job using the predetermined overhead rate, and Work in
Process is debited and Manufacturing Overhead is credited. This sequence of events is illustrated below:
As we emphasized earlier, the predetermined overhead rate is based entirely on estimates of what the
level of activity and overhead costs are expected to be, and it is established before the year begins. As a result, the
overhead cost applied during a year will almost certainly turn out to be more or less than the actual overhead cost
incurred. For example, notice from Exhibit 2–8 that Ruger Corporation’s actual overhead costs for the period are
$5,000 greater than the overhead cost that has been applied to Work in Process, resulting in a $5,000 debit balance
in the Manufacturing Overhead account. We will reserve discussion of what to do with this $5,000 balance until later
in the chapter.
Exhibit 2–8
For the moment, we can conclude from Exhibit 2–8 that the cost of a completed job consists of the actual direct
materials cost of the job, the actual direct labor cost of the job, and the manufacturing overhead cost applied to the
job. Pay particular attention to the following subtle but important point: Actual overhead costs are not charged to
jobs; actual overhead costs do not appear on the job cost sheet nor do they appear in the Work in Process account.
Only the applied overhead cost, based on the predetermined overhead rate, appears on the job cost sheet and in
the Work in Process account.
NONMANUFACTURING COSTS
In addition to manufacturing costs, companies also incur selling and administrative costs. These costs should be
treated as period expenses and charged directly to the income statement. Nonmanufacturing costs should not go
into the Manufacturing Overhead account. To illustrate the correct treatment of nonmanufacturing costs, assume
that Ruger Corporation incurred $30,000 in selling and administrative salary costs during April. The following entry
summarizes the accrual of those salaries:
Assume that depreciation on office equipment during April was $7,000. The entry is as follows:
Pay particular attention to the difference between this entry and entry (6) where we recorded depreciation on
factory equipment. In journal entry (6), depreciation on factory equipment was debited to Manufacturing Overhead
and is therefore a product cost. In journal entry (9) above, depreciation on office equipment is debited to
Depreciation Expense. Depreciation on office equipment is a period expense rather than a product cost.
Finally, assume that advertising was $42,000 and that other selling and administrative expenses in April totaled
$8,000. The following entry records these items:
The amounts in entries (8) through (10) are recorded directly into expense accounts—
they have no effect on product costs. The same will be true of any other selling and administrative
expenses incurred during April, including sales commissions, depreciation on sales equipment, rent on office
facilities, insurance on office facilities, and related costs.
COST OF GOODS MANUFACTURED
When a job has been completed, the finished output is transferred from the production departments to the finished
goods warehouse. By this time, the accounting department will have charged the job with direct materials and
direct labor cost, and manufacturing overhead will have been applied using the predetermined overhead rate. A
transfer of costs is made within the costing system that parallels the physical transfer of goods to the finished
goods warehouse. The costs of the completed job are transferred out of the Work in Process account and into the
Finished Goods account. The sum of all amounts transferred between these two accounts represents the cost of
goods manufactured for the period. In the case of Ruger Corporation, assume that Job A was completed during
April.
The following entry transfers the cost of Job A from Work in Process to Finished Goods:
The $158,000 represents the completed cost of Job A, as shown on the job cost sheet in Exhibit 2–8 . Because Job
A was the only job completed during April, the $158,000 also represents the cost of goods manufactured for the
month. Job B was not completed by the end of the month, so its cost will remain in the Work in Process account
and carry over to the next month. If a balance sheet is prepared at the end of April, the cost accumulated thus far
on Job B will appear as the asset “Work in Process inventory.”
COST OF GOODS SOLD
As finished goods are shipped to customers, their accumulated costs are transferred from the Finished Goods
account to the Cost of Goods Sold account. If an entire job is shipped at one time, then the entire cost appearing on
the job cost sheet is transferred to the Cost of Goods Sold account. In most cases, however, only a portion of the
units involved in a particular job will be immediately sold. In these situations, the unit product cost must be used to
determine how much product cost should be removed from Finished Goods and charged to Cost of Goods Sold.
For Ruger Corporation, we will assume 750 of the 1,000 gold medallions in Job A were shipped to customers by the
end of the month for total sales revenue of $225,000. Because 1,000 units were produced and the total cost of the
job from the job cost sheet was $158,000, the unit product cost was $158. The following journal entries would record
the sale (all sales were on account):
Entry (13) completes the flow of costs through the job-order costing system. To pull the entire Ruger Corporation
example together, journal entries (1) through (13) are summarized in Exhibit 2–9 . The flow of costs through the
accounts is presented in T-account form in Exhibit 2–10 .
Exhibit 2–9
Exhibit 2-10
SCHEDULES OF COST OF GOODS MANUFACTURED AND COST OF GOODS SOLD
This section uses the Ruger Corporation example to explain how to prepare schedules of cost of goods
manufactured and cost of goods sold as well as an income statement. The schedule of cost of goods manufactured
contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and it
summarizes the portions of those costs that remain in ending Work in Process inventory and that are transferred
out of Work in Process into Finished Goods. The schedule of cost of goods sold also contains three elements of
product costs—direct materials, direct labor, and manufacturing overhead—and it summarizes the portions of
those costs that remain in ending Finished Goods inventory and that are transferred out of Finished Goods into Cost
of Goods Sold.
Exhibit 2–11 presents Ruger Corporation’s schedules of cost of goods manufactured and cost of goods sold. We
want to draw your attention to three equations that are embedded within the schedule of cost of goods
manufactured. First, the raw materials used in production are computed using the following equation:
Exhibit 2–11
For Ruger Corporation, the beginning raw materials inventory of $7,000 plus the purchases of raw materials of
$60,000 minus the ending raw materials inventory of $15,000 equals the raw materials used in production of
$52,000. Second, the total manufacturing costs are computed using the following equation:
For Ruger Corporation, the direct materials of $50,000 plus the direct labor of $60,000 plus the manufacturing
overhead applied to work in process of $90,000 equals the total manufacturing costs of $200,000. Notice, the direct
materials used in production ($50,000) is included in total manufacturing costs instead of raw materials purchases
($60,000). The direct materials used in production will usually differ from the amount of raw material purchases
when the raw materials inventory balance changes or indirect materials are withdrawn from raw materials
inventory. You should also make a note that this equation includes manufacturing overhead applied to work in
process rather than actual manufacturing overhead costs. For Ruger Corporation, its manufacturing overhead
applied to work in process of $90,000 is computed by multiplying the predetermined overhead rate of $6 per
machine-hour by the actual amount of the allocation base recorded on all jobs, or 15,000 machine-hours the actual
manufacturing overhead costs incurred during the period are not added to the Work in Process account.
The third equation included in the schedule of cost of goods manufactured relates to computing the cost of goods
manufactured:
For Ruger, the total manufacturing costs of $200,000 plus the beginning work in process inventory of $30,000
minus the ending work in process inventory of $72,000 equals the cost of goods manufactured of $158,000. The
cost of goods manufactured represents the cost of the goods completed during the period and transferred from
Work in Process to Finished Goods.
The schedule of cost of goods sold shown in Exhibit 3–11 relies on the following quation to compute the unadjusted
cost of goods sold:
The beginning finished goods inventory ($10,000) plus the cost of goods manufactured ($158,000) equals the cost
of goods available for sale ($168,000). The cost of goods available for sale ($168,000) minus the ending finished
goods inventory ($49,500) equals the unadjusted cost of goods sold ($118,500). Finally, the unadjusted cost of
goods sold ($118,500) plus the underapplied overhead ($5,000) equals adjusted cost of goods sold ($123,500). The
next section of the chapter takes a closer look at why cost of goods sold needs to be adjusted for the amount of
underapplied or overapplied overhead.
Exhibit 2–12 presents Ruger Corporation’s income statement for April. Observe that the cost of goods sold on this
statement is carried over from Exhibit 2–11. The selling and administrative expenses (which total $87,000) did not
flow through the schedules of cost of goods manufactured and cost of goods sold. Journal entries 8–10 show that
these items were immediately debited to expense accounts rather than being debited to inventory accounts.
Exhibit 2-12
UNDERAPPLIED AND OVERAPPLIED OVERHEAD —A CLOSER LOOK
This section explains how to compute underapplied and overapplied overhead and how to dispose of any balance
remaining in the Manufacturing Overhead account at the end of a period.
COMPUTING UNDERAPPLIED AND OVERAPPLIED OVERHEAD
Because the predetermined overhead rate is established before the period begins and is based entirely on
estimated data, the overhead cost applied to Work in Process will generally differ from the amount of overhead
cost actually incurred. In the case of Ruger Corporation, for example, the predetermined overhead rate of $6 per
hour was used to apply $90,000 of overhead cost to Work in Process, whereas actual overhead costs for April proved
to be $95,000 (see Exhibit 2–8 ). The difference between the overhead cost applied to Work in Process and the
actual overhead costs of a period is called either underapplied or overapplied overhead. For Ruger Corporation,
overhead was underapplied by $5,000 because the applied cost ($90,000) was $5,000 less than the actual cost
($95,000). If the situation had been reversed and the company had applied $95,000 in overhead cost to Work in
Process while incurring actual overhead costs of only $90,000, then the overhead would have been overapplied.
What is the cause of underapplied or overapplied overhead? Basically, the method of applying overhead to jobs
using a predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount
of the allocation base incurred during the period. If, for example, the predetermined overhead rate is $6 per
machine-hour, then it is assumed that actual overhead costs incurred will be $6 for every machine-hour that is
actually worked. There are at least two reasons why this may not be true. First, much of the overhead often consists
of fixed costs that do not change as the number of machine hours incurred goes up or down. Second, spending on
overhead items may or may not be under control. If individuals who are responsible for overhead costs do a good
job, those costs should be less than were expected at the beginning of the period. If they do a poor job, those costs
will be more than expected.
To illustrate these concepts, suppose that two companies—Turbo Crafters and Black & Howell—have prepared the
following estimated data for the coming year:
Note that when the allocation base is dollars (such as direct materials cost in the case of Black & Howell) the
predetermined overhead rate is expressed as a percentage of the allocation base. When dollars are divided by
dollars, the result is a percentage.
Now assume that because of unexpected changes in overhead spending and indemand for the companies’
products, the actual overhead cost and the actual activityrecorded during the year in each company are as
follows:
For each company, note that the actual data for both cost and the allocation base differ from the estimates used
in computing the predetermined overhead rate. This results in underapplied and overapplied overhead as follows:
For Turbo Crafters, the amount of overhead cost applied to Work in Process ($272,000) is less than the actual
overhead cost for the year ($290,000). Therefore, overhead is underapplied.
For Black & Howell, the amount of overhead cost applied to Work in Process ($135,000) is greater than the actual
overhead cost for the year ($130,000), so overhead is overapplied. A summary of these concepts is presented in
Exhibit 2–13 .
DISPOSITION OF UNDERAPPLIED OR OVERAPPLIED OVERHEAD BALANCES
If we return to the Ruger Corporation example and look at the Manufacturing Overhead T-account in Exhibit 2–10 ,
you will see that there is a debit balance of $5,000. Remember that debit entries to the account represent actual
overhead costs incurred, whereas credit entries represent overhead costs applied to jobs. In this case, the actual
overhead costs incurred exceeded the overhead costs applied to jobs by $5,000—hence, the debit balance of
$5,000. This may sound familiar. We just discussed in the previous section the fact that the overhead costs incurred
($95,000) exceeded the overhead costs applied
($90,000), and that the difference is called underapplied overhead. These are just two ways of looking at the same
thing. If there is a debit balance in the Manufacturing Overhead account of X dollars, then the overhead is
underapplied by X dollars On the other hand, if there is a credit balance in the Manufacturing Overhead account of
Y dollars, then the overhead is overapplied by Y dollars What do we do with the balance in the Manufacturing
Overhead account at the end of the accounting period?
The underapplied or overapplied balance remaining in the Manufacturing Overhead account at the end of a period
is treated in one of two ways:
1. Closed out to Cost of Goods Sold.
2. Allocated among the Work in Process, Finished Goods, and Cost of Goods Sold accounts in proportion to
the overhead applied during the current period in ending balances.
CLOSED OUT TO COST OF GOODS SOLD
Closing out the balance in Manufacturing Overhead to Cost of Goods Sold is simpler than the allocation method. In
the Ruger Corporation example, the entry to close the $5,000 of underapplied overhead to Cost of Goods Sold is:
Note that because the Manufacturing Overhead account has a debit balance, Manufacturing Overhead must be
credited to close out the account. This has the effect of increasing Cost of Goods Sold for April to $123,500:
After this adjustment has been made, Ruger Corporation’s income statement for April will appear as shown earlier
in Exhibit 3–12 . Note that this adjustment makes sense. The unadjusted cost of goods sold is based on the amount
of manufacturing overhead applied to jobs, not the manufacturing overhead costs actually incurred. Because
overhead was underapplied, not enough cost was applied to jobs. Hence, the cost of goods sold was understated.
Adding the underapplied overhead to the cost of goods sold corrects this understatement.
ALLOCATED BETWEEN ACCOUNTS
Allocation of underapplied or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods
Sold is more accurate than closing the entire balance into Cost of Goods Sold. This allocation assigns overhead costs
to where they would have gone had the estimates included in the predetermined overhead rate matched the actual
amounts.
Had Ruger Corporation chosen to allocate the underapplied overhead among the inventory accounts and Cost of
Goods Sold, it would first be necessary to determine the amount of overhead that had been applied during April to
each of the accounts. The computations would have been as follows:
Based on the above percentages, the underapplied overhead (i.e., the debit balance in Manufacturing Overhead)
would be allocated as shown in the following journal entry:
Note that the first step in the allocation process was to determine the amount of overhead applied in each of the
accounts. For Finished Goods, for example, the total amount of overhead applied to Job A, $60,000, was divided by
the total number of units in Job A, 1,000 units, to arrive at the average overhead applied of $60 per unit. Because
250 units from Job A were still in ending finished goods inventory, the amount of overhead applied in the Finished
Goods Inventory account was $60 per unit multiplied by 250 units or $15,000 in total.
If overhead had been overapplied, the entry above would have been just the reverse, because a credit balance would
have existed in the Manufacturing Overhead account.
WHICH METHOD SHOULD BE USED FOR DISPOSING OF UNDERAPPLIED OR OVERAPPLIED
OVERHEAD?
The allocation method is generally considered more accurate than simply closing out the underapplied or
overapplied overhead to Cost of Goods Sold. However, the allocation method is more complex. We will always
specify which method you are to use in problem assignments.
A GENERAL MODEL OF PRODUCT COST FLOWS
Exhibit 2–14 presents a T-account model of the flow of costs in a product costing system. This model can be very
helpful in understanding how production costs flow through a costing system and finally end up as Cost of Goods
Sold on the income statement.
MULTIPLE PREDETERMINED OVERHEAD RATES
Our discussion in this chapter has assumed that there is a single predetermined overhead rate for an entire factory
called a plantwide overhead rate . This is a fairly common practice—particularly in smaller companies. But in larger
companies, multiple predetermined overhead rates are often used. In a multiple predetermined overhead rate
system each production department may have its own predetermined overhead rate. Such a system, while more
complex, is more accurate because it can reflect differences across departments in how overhead costs are incurred.
For example, in departments that are relatively labor intensive overhead might be allocated based on direct laborhours and in departments that are relatively machine intensive overhead might be allocated based on machinehours When multiple predetermined overhead rates are used, overhead is applied in each department according to
its own overhead rate as jobs proceed through the department.
JOB-ORDER COSTING IN SERVICE COMPANIES
Job-order costing is used in service organizations such as law firms, movie studios, hospitals, and repair shops, as
well as in manufacturing companies. In a law firm, for example, each client is a “job,” and the costs of that job are
accumulated day by day on a job cost sheet as the client’s case is handled by the firm. Legal forms and similar inputs
represent the direct materials for the job; the time expended by attorneys is like direct labor; and the costs of
secretaries and legal aids, rent, depreciation, and so forth, represent the overhead.
In a movie studio such as Columbia Pictures, each film produced by the studio is a “job,” and costs of direct materials
(costumes, props, film, etc.) and direct labor (actors, directors, and extras) are charged to each film’s job cost sheet.
A share of the studio’s overhead costs, such as utilities, depreciation of equipment, wages of maintenance workers,
and so forth, is also charged to each film.
In sum, job-order costing is a versatile and widely used costing method that may be encountered in virtually any
organization that provides diverse products or services.
REVIEW PROBLEM: JOB-ORDER COSTING
Hogle Corporation is a manufacturer that uses job-order costing. On January 1, the beginning of its fiscal year, the
company’s inventory balances were as follows:
Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000
Work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000
Finished goods . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . $30,000
The company applies overhead cost to jobs on the basis of machine-hours worked. For the current year, the
company’s predetermined overhead rate was based on a cost formula that estimated $450,000 of total
manufacturing overhead for an estimated activity level of 75,000 machine hours
The following transactions were recorded for the year:
a. Raw materials were purchased on account, $410,000.
b. Raw materials were requisitioned for use in production, $380,000 ($360,000 direct materials and $20,000
indirect materials).
c. The following costs were accrued for employee services: direct labor, $75,000; indirect labor, $110,000;
sales commissions, $90,000; and administrative salaries, $200,000.
d. Sales travel costs were $17,000.
e. Utility costs in the factory were $43,000.
f. Advertising costs were $180,000.
g. Depreciation was recorded for the year, $350,000 (80% relates to factory operations, and 20% relates to
selling and administrative activities).
h. Insurance expired during the year, $10,000 (70% relates to factory operations, and the remaining 30%
relates to selling and administrative activities).
i. Manufacturing overhead was applied to production. Due to greater than expected demand for its
products, the company worked 80,000 machine-hours on all jobs during the year.
j. Goods costing $900,000 to manufacture according to their job cost sheets were completed during the
year.
k. Goods were sold on account to customers during the year for a total of $1,500,000. The goods cost
$870,000 to manufacture according to their job cost sheets.
Required:
1.
2.
3.
4.
Prepare journal entries to record the preceding transactions.
Post the entries in (1) above to T-accounts (don’t forget to enter the beginning balances in the inventory
accounts).
Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close any
balance in the Manufacturing Overhead account to Cost of Goods Sold. Do not allocate the balance
between ending inventories and Cost of Goods Sold.
Prepare an income statement for the year.
SOLUTION TO REVIEW PROBLEM
ASSIGNMENT MATERIAL
TRUE / FALSE QUESTIONS
1. The use of a predetermined overhead rate in a job-order cost system makes it possible to compute the total
cost of a job before production is begun.
2. If direct labor-hours is used as the allocation base in a job-order costing system, but overhead costs are not
caused by direct-labor hours, then jobs with high direct labor requirements will tend to be under-costed
relative to jobs with low direct labor requirements.
3. The formula for computing the predetermined overhead rate is:
Predetermined overhead rate = Estimated total manufacturing overhead cost ÷ Estimated total amount of
the allocation base
4. When the predetermined overhead rate is based on direct labor-hours, the amount of overhead applied to a
job is proportional to the estimated amount of direct labor-hours for the job.
5. The cost of a completed job in a job-order costing system typically consists of the actual direct materials cost
of the job, the actual direct labor cost of the job, and the manufacturing overhead cost applied to the job.
6. Job cost sheets are used to record the costs of preparing routine accounting reports.
7. In a job-order cost system, direct labor is assigned to a job using information from the employee time ticket.
8. The cost categories that appear on a job cost sheet include selling expense, manufacturing expense, and
administrative expense.
9. When completed goods are sold, the transaction is recorded as a debit to Cost of Goods Sold and a credit to
Finished Goods.
10. The following entry would be used to record depreciation on manufacturing equipment:
Work in Process
XXX
Accumulated Depreciation
XXX
11. The sum of all amounts transferred from the Work in Process account to the Finished Goods account
represents the Cost of Goods Sold for the period.
12. Indirect materials are charged to specific jobs.
13. When a job is completed, the goods are transferred from the production department to the finished goods
warehouse and the journal entry would include a debit to Work in Process.
14. Manufacturing overhead is overapplied if actual manufacturing overhead costs for a period are greater than
the amount of manufacturing overhead cost that was charged to Work in Process
15. If the actual manufacturing overhead cost for a period exceeds the manufacturing overhead cost applied,
then manufacturing overhead would be considered to be underapplied.
MULTIPLE CHOICE QUESTIONS
16. Emco Company uses direct labor cost as a basis for computing its predetermined overhead rate. In
computing the predetermined overhead rate for last year, the company misclassified a portion of direct labor
cost as indirect labor. The effect of this misclassification will be to:
A. understate the predetermined overhead rate.
B. overstate the predetermined overhead rate.
C. have no effect on the predetermined overhead rate.
D. cannot be determined from the information given.
17. Departmental overhead rates are generally preferred to plant-wide overhead rates when:
A. the activities of the various departments in the plant are not homogeneous.
B. the activities of the various departments in the plant are homogeneous.
C. most of the overhead costs are fixed.
D. all departments in the plant are heavily automated.
18. In computing its predetermined overhead rate, Brady Company included its factory insurance cost twice. This
error will result in:
A. the ending balance of Finished Goods to be understated.
B. the credits to the Manufacturing Overhead account to be understated.
C. the Cost of Goods Manufactured to be overstated.
D. the Net Operating Income to be overstated.
19. Which of the following entries would correctly record the application of overhead cost?
A. Work in Process XXX
Accounts Payable
XXX
B. Manufacturing Overhead XXX
Accounts Payable
XXX
C. Manufacturing Overhead XXX
Work in Process
D. Work in Process
Manufacturing Overhead
XXX
XXX
XXX
20. What journal entry is made in a job-order costing system when $8,000 of materials are requisitioned for
general factory use instead of for use in a particular job?
A. Work in Process
$8,000
Manufacturing Overhead
B. Work in Process
$8,000
$8,000
Raw Materials
$8,000
C. Manufacturing Overhead $8,000
Work in Process
$8,000
D. Manufacturing Overhead $8,000
Raw Materials
$8,000
21. A proper journal entry to record issuing raw materials to be used on a job would be:
A. Finished Goods XXX
Raw Materials
B. Raw Materials
XXX
XXX
Work in Process
XXX
C. Work in Process XXX
Raw Materials
D. Raw Materials
XXX
XXX
Finished Goods
XXX
22. Which of the following entries would record correctly the monthly salaries earned by the top management of
a manufacturing company?
A. Manufacturing Overhead
XXX
Salaries and Wages Payable
B.
Salaries Expense
XXX
XXX
Salaries and Wages Payable
C.
Work in Process
XXX
XXX
Salaries and Wages Payable
D.
XXX
Salaries and Wages Payable XXX
Salaries Expense
XXX
23. In a job-order costing system, the use of indirect materials that have been previously purchased is recorded
as a credit to:
A. Work in Process inventory.
B. Manufacturing Overhead.
C. Raw Materials inventory.
D. Finished Goods inventory.
24. On the Schedule of Cost of Goods Manufactured, the final Cost of Goods Manufactured figure represents:
A. the amount of cost charged to Work in Process during the period.
B. the amount of cost transferred from Finished Goods to Cost of Goods Sold during the period.
C. the amount of cost placed into production during the period.
D. the amount of cost of goods completed during the current year whether they were started before or
during the current year.
25. Overapplied manufacturing overhead means that:
A. the applied manufacturing overhead cost was less than the actual manufacturing overhead cost.
B. the applied manufacturing overhead cost was greater than the actual manufacturing overhead cost.
C. the estimated manufacturing overhead cost was less than the actual manufacturing overhead cost.
D. the estimated manufacturing overhead cost was less than the applied manufacturing overhead cost.
26. Buker Corporation bases its predetermined overhead rate on the estimated machine-hours for the upcoming
year. Data for the upcoming year appear below:
Estimated machine-hours
74,000
Estimated variable manufacturing overhead
$7.67 per machine-hour
Estimated variable manufacturing overhead $1,630,960
The predetermined overhead rate for the recently completed year was closest to:
A. $22.04
B. $29.59
C. $7.67
D. $29.71
27. Hibshman Corporation bases its predetermined overhead rate on the estimated machine-hours for the
upcoming year. At the beginning of the most recently completed year, the Corporation estimated the
machine-hours for the upcoming year at 10,000 machine-hours. The estimated variable manufacturing
overhead was $6.82 per machine-hour and the estimated total fixed manufacturing overhead was $230,200.
The predetermined overhead rate for the recently completed year was closest to:
A. $29.84 per machine-hour
B. $23.15 per machine-hour
C. $23.02 per machine-hour
D. $6.82 per machine-hour
28. CR Corporation has the following estimated costs for the next year:
Direct materials
$4,000
Direct labor
$20,000
Rent on factory building
$15,000
Sales salaries
$25,000
Depreciation on factory equipment $8,000
Indirect labor
$10,000
Production supervisor’s salary
$12,000
CR Corporation estimates that 20,000 labor-hours will be worked during the year. If overhead is applied on
the basis of direct labor-hours, the overhead rate per hour will be:
A. $2.25
B. $3.25
C. $3.45
D. $4.70
29. Jameson Corporation uses a predetermined overhead rate based on direct labor-hours to apply
manufacturing overhead to jobs. The Corporation has provided the following estimated costs for the next
year:
Direct materials
$5,000
Direct labor
$19,000
Rent on factory building
$16,000
Sales salaries
$24,000
Depreciation on factory equipment
$7,000
Indirect labor
$11,000
Production supervisor's salary
$14,000
Jameson estimates that 24,000 direct labor-hours will be worked during the year. The predetermined
overhead rate per hour will be:
A. $2.00
B. $2.79
C. $3.00
D. $4.00
30. Paulson Corporation uses a predetermined overhead rate based on machine-hours to apply manufacturing
overhead to jobs. The Corporation has provided the following estimated costs for next year:
Direct materials
$25,000
Direct labor
$22,000
Advertising expense
$15,000
Rent on factory building
$13,500
Depreciation on factory equipment
$6,500
Indirect materials
$10,000
Sales salaries
$28,000
Insurance on factory equipment
$12,000
Paulson estimated that 40,000 direct labor-hours and 20,000 machine-hours would be worked during the
year. The predetermined overhead rate per machine-hour will be:
A. $1.60
B. $2.10
C. $1.00
D. $1.05
31. Aksamit Corporation bases its predetermined overhead rate on the estimated machine-hours for the
upcoming year. Data for the most recently completed year appear below:
Estimates made at the beginning of the year:
Estimated machine-hours
Estimated variable manufacturing overhead
62,000
$7.03 per machine-hour
Estimated total fixed manufacturing overhead $1,486,140
Actual machine-hours for the year
61,100
The predetermined overhead rate for the recently completed year was closest to:
A. $23.97
B. $31.00
C. $7.03
D. $31.35
32. Sirmons Corporation bases its predetermined overhead rate on the estimated labor-hours for the upcoming
year. At the beginning of the most recently completed year, the Corporation estimated the labor-hours for
the upcoming year at 70,000 labor-hours. The estimated variable manufacturing overhead was $9.93 per
labor-hour and the estimated total fixed manufacturing overhead was $1,649,200. The actual labor-hours for
the year turned out to be 74,000 labor-hours. The predetermined overhead rate for the recently completed
year was closest to:
A. $32.22
B. $9.93
C. $33.49
D. $23.56
33. The Work in Process inventory account of a manufacturing Corporation shows a balance of $18,000 at the
end of an accounting period. The job cost sheets of the two uncompleted jobs show charges of $6,000 and
$3,000 for materials, and charges of $4,000 and $2,000 for direct labor. From this information, it appears that
the Corporation is using a predetermined overhead rate, as a percentage of direct labor costs, of:
A. 50%
B. 200%
C. 300%
D. 20%
34. The following T-accounts have been constructed from last year's records at C&C Manufacturing:
Raw Materials
Bal 10,000 (b) 252,000
(a) 247,000
5,000
Work In Process
Bal
6,000 (f)
(b)
161,000
(c)
154,000
(e)
192,500
506,000
7,500
Finished Goods
Bal
0 (g) 500,000
(f) 506,000
6,000
Manufacturing Overhead
(b)
91,000 (e) 192,500
(c)
26,000
(d)
78,000
195,000
192,500
2,500 (h)
2,500
Cost of Goods Sold
(g)
500,000
(h)
2,500
C&C Manufacturing uses job-order costing with a predetermined overhead rate and applies manufacturing
overhead to jobs based on direct labor costs. What is the predetermined overhead rate?
A. 125%
B. 120%
C. 100%
D. 105%
35. Bradbeer Corporation uses direct labor-hours in its predetermined overhead rate. At the beginning of the
year, the estimated direct labor-hours were 17,500 hours. At the end of the year, actual direct labor-hours for
the year were 16,000 hours, the actual manufacturing overhead for the year was $233,000, and
manufacturing overhead for the year was underapplied by $15,400. The estimated manufacturing overhead
at the beginning of the year used in the predetermined overhead rate must have been:
A. $249,375
B. $217,600
C. $228,000
D. $238,000
36. Dagger Corporation uses direct labor-hours in its predetermined overhead rate. At the beginning of the year,
the total estimated manufacturing overhead was $423,870. At the end of the year, actual direct labor-hours
for the year were 19,400 hours, manufacturing overhead for the year was underapplied by $5,650, and the
actual manufacturing overhead was $418,870. The predetermined overhead rate for the year must have been
closest to:
A. $21.59
B. $20.76
C. $21.30
D. $21.85
37. Sawyer Manufacturing Corporation uses a predetermined overhead rate based on direct labor-hours to apply
manufacturing overhead to jobs. Last year, the Corporation worked 57,000 actual direct labor-hours and
incurred $345,000 of actual manufacturing overhead cost. The Corporation had estimated that it would work
55,000 direct labor-hours during the year and incur $330,000 of manufacturing overhead cost. The
Corporation's manufacturing overhead cost for the year was:
A. overapplied by $15,000
B. underapplied by $15,000
C. overapplied by $3,000
D. underapplied by $3,000
38. Clear Colors Corporation uses a predetermined overhead rate based on direct labor costs to apply
manufacturing overhead to jobs. At the beginning of the year the Corporation estimated its total
manufacturing overhead cost at $350,000 and its direct labor costs at $200,000. The actual overhead cost
incurred during the year was $362,000 and the actual direct labor costs incurred on jobs during the year was
$208,000. The manufacturing overhead for the year would be:
A. $12,000 underapplied.
B. $12,000 overapplied.
C. $2,000 underapplied.
D. $2,000 overapplied.
39. Cribb Corporation uses direct labor-hours in its predetermined overhead rate. At the beginning of the year,
the estimated direct labor-hours were 17,900 hours and the total estimated manufacturing overhead was
$341,890. At the end of the year, actual direct labor-hours for the year were 16,700 hours and the actual
manufacturing overhead for the year was $336,890. Overhead at the end of the year was:
A. $22,920 underapplied
B. $17,920 overapplied
C. $17,920 underapplied
D. $22,920 overapplied
40. Brusveen Corporation applies manufacturing overhead to jobs on the basis of direct labor-hours. The
following information relates to Brusveen for last year:
Estimated Actual
Direct labor-hours
15,000
14,800
Manufacturing overhead cost
$300,000 $287,120
What was Brusveen's underapplied or overapplied overhead for last year?
A. $4,000 underapplied
B. $8,880 underapplied
C. $8,880 overapplied
D. $9,000 underapplied
41. Collins Corporation uses a predetermined overhead rate based on direct labor cost to apply manufacturing
overhead to jobs. The following information applies to the Corporation for the current year:
Direct labor-hours:
Estimated for the year
24,000
Actual hours worked
19,500
Direct labor cost:
Estimated for the year
$300,000
Actual cost incurred
$210,000
Manufacturing overhead:
Estimated for the year
$240,000
Actual cost incurred
$185,000
The manufacturing overhead cost for the current year will be:
A. $17,000 overapplied
B. $17,000 underapplied
C. $55,000 overapplied
D. $55,000 underapplied
42. At the beginning of the year, manufacturing overhead for the year was estimated to be $477,590. At the end
of the year, actual direct labor-hours for the year were 29,000 hours, the actual manufacturing overhead for
the year was $472,590, and manufacturing overhead for the year was overapplied by $110. If the
predetermined overhead rate is based on direct labor-hours, then the estimated direct labor-hours at the
beginning of the year used in the predetermined overhead rate must have been:
A. 29,300 direct labor-hours
B. 28,987 direct labor-hours
C. 28,993 direct labor-hours
D. 29,000 direct labor-hours
43. Galbraith Corporation applies overhead cost to jobs on the basis of 70% of direct labor cost. If Job 201 shows
$28,000 of manufacturing overhead applied, the direct labor cost on the job was:
A. $40,000
B. $19,600
C. $28,000
D. $36,400
44. Job 593 was recently completed. The following data have been recorded on its job cost sheet:
Direct materials
$3,190
Direct labor-hours
Direct labor wage rate
71 labor-hours
$15 per labor-hour
Machine-hours
175 machine-hours
The Corporation applies manufacturing overhead on the basis of machine-hours. The predetermined
overhead rate is $14 per machine-hour. The total cost that would be recorded on the job cost sheet for Job
593 would be:
A. $6,705
B. $3,219
C. $5,249
D. $4,255
45. The following data have been recorded for recently completed Job 323 on its job cost sheet. Direct materials
cost was $2,260. A total of 37 direct labor-hours and 141 machine-hours were worked on the job. The direct
labor wage rate is $13 per labor-hour. The Corporation applies manufacturing overhead on the basis of
machine-hours. The predetermined overhead rate is $14 per machine-hour. The total cost for the job on its
job cost sheet would be:
A. $3,259
B. $2,741
C. $4,715
D. $2,287
46. Spectrum Manufacturing had the following information in its records at the end of the year:
Predetermined overhead rate
125% of direct labor costs
Estimated direct labor costs
$87,500
Actual direct labor costs
$84,000
Manufacturing Overhead
11,000
13,000
78,000
47.
48.
49.
50.
What was the balance in Manufacturing Overhead, and when closed what will the effect be on gross
margin?
A. $3,000 underapplied, and increase
B. $3,000 overapplied, and increase
C. $3,000 underapplied, and decrease
D. $3,000 overapplied, and decrease
Parsons Corporation uses a predetermined overhead rate based on direct labor-hours to apply manufacturing
overhead to jobs. Last year, Parsons Corporation incurred $250,000 in actual manufacturing overhead cost.
The Manufacturing Overhead account showed that overhead was overapplied $12,000 for the year. If the
predetermined overhead rate was $8.00 per direct labor-hour, how many hours did the Corporation work
during the year?
A. 31,250 hours
B. 30,250 hours
C. 32,750 hours
D.
29,750 hours
During October, Dorinirl Corporation incurred $60,000 of direct labor costs and $5,000 of indirect labor costs.
The journal entry to record the accrual of these wages would include a:
A. credit to Work in Process of $60,000
B. credit to Work in Process of $65,000
C. debit to Work in Process of $65,000
D.
debit to Work in Process of $60,000
Soledad Corporation had $36,000 of raw materials on hand on December 1. During the month, the
Corporation purchased an additional $71,000 of raw materials. The journal entry to record the purchase of
raw materials would include a:
A. credit to Raw Materials of $71,000
B. debit to Raw Materials of $71,000
C. credit to Raw Materials of $107,000
D. debit to Raw Materials of $107,000
At the beginning of December, Sneeden Corporation had $32,000 of raw materials on hand. During the
month, the Corporation purchased an additional $71,000 of raw materials. During December, $75,000 of raw
materials were requisitioned from the storeroom for use in production. The credits entered in the Raw
Materials account during the month of December total:
A. $32,000
B. $75,000
C. $71,000
D.
$103,000
PROBLEM SOLVING
CASE 1
Christofferse Corporation bases its predetermined overhead rate on the estimated machine-hours for the
upcoming year. Data for the most recently completed year appear below:
Estimates made at the beginning of the year:
Estimated machine-hours
38,000
Estimated variable manufacturing overhead
$3.33 per machine-hour
Estimated total fixed manufacturing overhead $548,720
Actual machine-hours for the year
33,700
Required:
Compute the company's predetermined overhead rate for the recently completed year.
CASE 2
Bakerston Company is a manufacturing firm that uses job-order costing. The company's inventory balances were
as follows at the beginning and end of the year:
Beginning Balance Ending Balance
Raw materials
$14,000
$22,000
Work in process $27,000
$9,000
Finished goods
$77,000
$62,000
The company applies overhead to jobs using a predetermined overhead rate based on machine-hours. At the
beginning of the year, the company estimated that it would work 33,000 machine-hours and incur $231,000 in
manufacturing overhead cost. The following transactions were recorded for the year:
• Raw materials were purchased, $315,000.
• Raw materials were requisitioned for use in production, $307,000 ($281,000 direct and $26,000 indirect).
• The following employee costs were incurred: direct labor, $377,000; indirect labor, $96,000; and administrative
salaries, $172,000.
• Selling costs, $147,000.
• Factory utility costs, $10,000.
• Depreciation for the year was $127,000 of which $120,000 is related to factory operations and $7,000 is related
to selling, general, and administrative activities.
• Manufacturing overhead was applied to jobs. The actual level of activity for the year was 34,000 machine-hours.
• Sales for the year totaled $1,253,000.
Required:
a. Prepare a schedule of cost of goods manufactured.
b. Was the overhead underapplied or overapplied? By how much?
c. Prepare an income statement for the year. The company closes any underapplied or overapplied overhead to
Cost of Goods Sold.
LESSON 3
ACCOUNTING FOR RAW MATERIALS
Learning Objectives
At the end of the chapter, the student should have
1. properly identified the source documents for raw materials
2. properly accounted raw materials using the different methods presented
3. computed the ending inventory balance using different valuation methods
ACCOUNTING FOR RAW MATERIALS
Materials management is a function responsible for coordination of planning, sourcing, purchasing, moving,
storing and controlling materials in an optimum manner so as to provide predetermined services to the
customer at a minimum cost. It is therefore desirable that every materials manager should try to apply
proper materials planning, purchasing, handling, storing materials so as to achieve the desired objective of
minimizing materials procurement and stock holding costs. Recently, the integrated materials management
concept has gained greater acceptance. This has necessitated professional development managers so that
they can fulfil the requirements of an integrated materials management function which demands an ability
to bring together conflicting and yet interrelated functions, viz. materials planning, purchasing, receiving
and inspection, stores, inventory control, scrap and surplus disposal. The economic pressures in the form
of inflation and credit squeeze have placed exacting demands on the materials manager. In an integrated
setup, the materials manager who is responsible for all such interrelated function, is in a position to exercise
control and coordinate with an overview that ensures proper balance of the conflicting objectives of the
aforesaid individual functions. The important advantages of integrated materials management are better
accountability, better performance, better growth and adaptability to electronic data processing.
Material cost to be effective involves the cooperation of various departments viz: purchasing department,
receiving and inspection department, stores, production and stock control department.
MATERIAL COST
Having discussed about the basic principles, methods and objectives of cost accounting, we now turn to
study the details of each aspect of costing. To start with, each element of cost will be taken up separately.
Let us begin with the first element of cost that is material– Material is the most significant element of cost
and accounts for anywhere between 40% to 70% of the total cost of production. Cost control activities are,
therefore, directed mostly towards selection, purchase, storage and consumption of material.
The following are the salient features of material cost control:
a. The quality and specification of materials shall commensurate with the requirements of the product,
so that neither too expensive or superior nor cheap or inferior material shall be selected for use in
product.
b. The purchasing shall aim at minimum price to suppliers and timely procurement and shall avoid
urgent purchases at higher cost.
c. Storage of materials shall be such that there will be neither overstocking, and thereby blocking
Capital, nor running out of stock and creating interruption in production process.
d. Wastage and losses shall be avoided at every stage of operation i.e. from storing till usage in
production.
e. Materials should be classified and accounted for both in physical units and value in such a way
that information about availability in stock can be obtained promptly so as to assist production,
planning as well as timely buying.
DIRECT AND INDIRECT MATERIAL COST
Materials or stores control relates to both direct and indirect materials. Direct materials are those
materials which enter into and form part of the product, such as flour, fat and sugar in biscuits, and
include:
a. all materials specially purchased for a job order or a process,
b. all materials issued from the stores against a particular job order number or process,
c. allcomponentsorassemblypartspurchasedforuseinthejobsandprocessdirectly,
d. all materials or processed materials transferred from one process or operation to the other, and
e. all primary packing materials such as poly bag, gunny bag cardboard box, etc. Indirect materials are
those which cannot be traced as a part of the product, such as,
f. Consumable stores used in the operation,
g. Lubricating oil, grease, fuel oil, etc.
h. Tools, jigs, and fixtures, etc.
i. Sundry stores of small value like cotton waste, broom stick, etc.
Grouping of materials under direct and indirect may often become a matter of convenience, and materials
of small value may not be treated as direct cost even if it is possible to identify the same. For example,
thread used in stitching a shirt may be calculated and charged as direct material cost, but the cost of such
collection will not justify the segregation. Costing system has to be cost-effective.
MATERIAL COST CONTROL
Material cost control involves the following activities,
a. Purchase and procurement
b. Receipt and inspection
c. Storage, Issue and consumption
d. Stock control
e. Valuation and accounting
PURCHASE AND PROCUREMENT
In a big organization, purchasing may be an independent function reporting to the chief of operations. It
may be under production department if the size of the organization is very small. Under either circumstance,
the purchase department must be equipped with efficient staff fully conversant with the production process
and requirements. Purchasing is a very specialized job and requires the skill of an expert buyer. Both cost
and quality of the product depend to a large extent on the judgement of the buyer.
CENTRALIZED AND DECENTRALIZED PURCHASE
If the organization has several units scattered over a wide area, it may be beneficial to have centralized
purchasing for those items of materials, which are used commonly by all units. This will impart better control
on purchasing, can obtain better terms of payment, and reduction in price. This will also lead to the economy
in the process and cost of buying. The centralized buying, however, is limited to the materials of relatively
high value and common usage by all units. If the quantum requirement by each unit is small and materials
are dissimilar between the units, it will be more economical to have decentralized buying. Each unit will buy
locally and enjoy the benefit of lower price, lower transportation cost and less wastage in handling. In a big
multiunit organization, centralized buying is done for a few major materials, while decentralized or local
buying is adopted for the other materials.
PURCHASE PROCEDURE
The purchase procedure starts with the receipt of purchase requisition from indenting
departmentsandendswiththereceiptofadvances/excesspaymentsandreplacementofrejected materials. The
procedure follows the steps, such as,
1. Receiving purchase requisitions.
2. Inviting quotation and enquiries.
3. Receipt of quotation.
4. Finalization and placement of purchase order.
5. Follow-up of orders, receipt and quality-check.
6. Follow-up of payments with the accounts Department.
7. Follow-up of advances, rejections and replacements.
PURCHASE REQUISITION
Purchase requisition is received from—
1. General and engineering stores for replenishment of stocks based on inventory position,
2. Production planning department for materials required as per production schedule,
3. Engineering department for machines, spares and equipment, Administration, selling and other
departments for purchase of stationery, office equipment, etc. including capital items, in preprinted
forms, duly signed by the indenter and authorized by the Department Head.
4. Generally, for regular items of materials, Storekeeper initials the purchase requisition and factory
manager authorizes it. If materials are required as per Bill of Materials or specification sheet, the
production planning and control department initiates the purchase requisition and the departmental
head authorizes it. A specimen copy of the purchase requisition is shown below:
PURCHASE REQUISITION
Department.
Cost center
Please purchase the
Item No.
No
Date.
department
Code No.
Description of material
Checked by..........
To be filled in by the purchase dept.
Purchase order No.
Name of supplier
Circulation:
Unit
Qty.Reqd.
Approved by..........
Date.
Delivery date
1.Purchase department
2. Production planning and control
3. File copy
Date Reqd.
INVITING QUOTATION ENQUIRY
On receipt of the approved purchase requisition, the purchase department shall invite pricequotations from the approved suppliers It is a good custom to enlist suppliers of repute for timely supply of
quality materials. The list is periodically updated after considering vendor performance.
RECEIVING AND FINALIZING OF QUOTATION AND PLACING PURCHASE ORDERS
After receiving quotations from the suppliers, the purchase officers shall tabulate them in a sheet of paper
indicating the details of each offer covering items, quantity, rate, time and delivery terms, terms of payment,
etc. The accepted offer is marked on the comparative statement and signed by the department head as
authority to issue order to the supplier. Normally lowest offer is accepted, unless other considerations such
as quality, urgency, etc. prevail over it. Purchase order is placed in the official order form which is usually
serially numbered and maintained in different sets for raw materials, packing materials, engineering stores
and other general stores including stationery and printing. Purchase orders are prepared in a set of
seven/eight copies for distribution as follows:
— Original and acknowledgments copy to supplier for acceptance.
— Copy to department initiating the purchase requisition.
— Copy to accounts (bill section) for payments authority.
— Copy to EDP/production planning and control for information and record.
— Two copies to stores (one for receiving material and retaining in the department, and the other to
return to accounts department through quality control department after inspection).
— Copy for purchase department for follow up.
Conditions of purchase, indicating detail instructions as to indemnify against dispute with the third party,
method of settlement of disputes, arbitration and the liquidated damages in case of non-supply within
scheduled time etc. are printed on the reverse side of the order.
FOLLOW UP OF ORDER
Purchase orders are followed up scrupulously by purchase department till the material is received in stores,
accepted after quality inspection, and replacement received for rejected materials. Amendments for the
order regarding quantity, rate, delivery date, etc. are made after obtaining approval for the same.
Coordination with accounts department is also done by purchase department in case of any difficulty.
Adjustments for advance payment or recovery of excess advance from suppliers are also coordinated by
the purchase department.
INTERNAL CONTROL OVER PURCHASE
For effective internal control over purchase, it is imperative that the functions of placing order,
receivingandapprovingmaterialsandpaymentofsuppliersbillaresoentrusted that one department’s function is
automatically checked by a subsequent department. The system is interlocked in the following way:
(a) Purchase order is placed only on the basis of purchase requisition.
(b) Store keeper receives materials on the authority of purchase orders only.
(c) Stores received are physically checked by the storekeeper, but quality is approved by quality control
department.
(d) Accountsmakethepaymentofsupplier’sbillsonthebasisofsupplier’sbillaccompanied with receipted
challan, authority of purchase order and proof of actual receipt of Stores of approved quality as per
stores receipt note.
ESSENTIALS OF PURCHASING PROCESS
A good purchasing procedure ensures purchase of right quality, right quantity, at right time, at right price
and from right supplier. Purchase of right quality of material is possible by referring to the specification of
each material mentioned in the Purchase requisition or bill of materials. A bill of material is a complete
schedule of raw-materials and components or processed materials required for a job or work order along
with blueprint of drawing and charts. Purchase department must follow the bill of materials meticulously
while procuring them. If the specified quality is not available, the department concerned must be consulted
before accepting alternate or substitute material. It should be remembered that quality of the product
depends on the quality of inputs.
Purchase of right quantity depends on such factors as average consumption, inventory levels i.e.,
maximum, minimum, reorder level, quantity already on order, financial considerations, such as availability
of funds, interest on capital, quantum of discount allowed, etc. besides consideration of cost of storage
space. There should not be overstocking thereby blocking capital and storage space. On the other hand,
production should not suffer for want of material and thereby incur loss for stock-out. A good purchasing
system balances these two situations by skillfully determining Economic Order Quantity (or E.O.Q.) at a
point, where cost of ordering and cost of carrying the inventory will be minimum. If the purchase quantity is
increased, the cost of ordering decreases, but the cost of carrying increases. If the quantity is reduced, then
the cost of ordering increases with the decrease of the cost of carrying. At economic order quantity, carrying
cost equals to ordering cost.
The skill of purchase often depends on the judgement of right time to buy. Urgent material and spare-parts
required for machine-breakdown shall be purchased immediately. But others, depending on the nature of
requirement can be procured economically by using judgement. Average consumption and reordering level
are often considered for timing of purchase. Sometimes, rate contract is entered with major suppliers for
a specified period of time, say, six months or one year, within which price shall remain same, but quantity
will vary from month to month. Rate contract is entered for avoiding price fluctuation of major materials.
Purchase of material should be made at right price. It does not mean lowest price, but points to most
economical price. Seasonal conditions and market fluctuations are considered while agreement is made
between the purchaser and the supplier. The price agreement as well as the purchase order shall clearly
indicate—
(a) The basic price of the material per unit,
(b) The excise duty, octroi and sales tax applicable,
(c) Transportation, packing and insurance, whether FOR work or FOR destination,
(d) Trade and cash discounts applicable, and
(e) Charges for returnable containers
As regards item (c) above, it shall be made clear as to which expense will be borne by the buyer and which
one by supplier. Otherwise, it will create dispute at the time of payment of invoices.
Lastly, the purchase department shall procure materials from the right source. A star as possible purchases
are made from the manufacturer or authorized wholesalers of the various inputs in order to avoid
middlemen, ensuring quality and keeping price at minimum. The department is therefore equipped with
market reports, trade journals, catalogues & price-lists and list of suppliers While selecting suppliers, the
department shall ensure that the supplier is reliable, having good market reputation for timely delivery of
quality goods at price quoted and have the capacity to fulfil the contract both financially and productionwise. Such list of suppliers is periodically updated with the help of Analysis of Vendor Performances once
a year.
STORING PROCEDURES
STORES, LOCATION
In order to keep material handling cost and wastage due to multiple handling to a minimum, the location
and layout of stores should be decided very Carefully.
The following factors may be considered while deciding about the location:
(a) Heavy stores should be located nearer to the receiving station.
(b) Bulky materials should be stored near to the user departments.
(c) Free access should be provided for reaching the bins and racks.
(d) Unnecessary movements and transfer from one location or bin to another should be avoided.
(e) Access to stores for verification should be easy.
CENTRALIZED VS. DECENTRALIZED STORES
Centralized store is more economic and easier to control compared to decentralized stores at different
production canters However, the decision depends on the size, nature of business and feasibility of
operation of individual business. The advantages of centralized stores are as follows:
(a) Lower stock level and less investment.
(b) Less stock records.
(c) Better supervision and control.
(d) Less expensive to administer.
(e) Bulk buying at lower cost.
(f) Better inventory control.
(g) Better security arrangements.
The main disadvantages of centralized control are increased material handling and transportation cost and
inconvenience and delay. Besides, the risk of loss due to fire, flood, etc. is higher. Any breakdown in
transportation system may affect movement of materials with a consequential loss of production. To obviate
the aforesaid difficulties, it is convenient to have sub-stores also in addition to central stores similar to petty
cash system.
Imprest system of stores is used for replenishment of stores, so as to bring the stock to a predetermined
level. The storekeepers of sub-stores are made responsible to the chief storekeeper. The system is very
useful in a large factory with different production departments using various standard materials regularly.
In some organizations, two bin system of inventory control is used, wherein materials are kept in
two bins. One of the two bins contain sufficient stock for usage during the period between the date of placing
order and the receipt of fresh supply of the material. Purchase requisition is issued as soon as the second
bin is tapped.
STOREKEEPER — FUNCTIONS AND RESPONSIBILITIES
The stores department should be under the control of a storekeeper. He is responsible for receipt,
storage and issue of materials. His duties and responsibilities are as follows:
(a) To receive materials, arrange for inspection and accept them after proper verification of
documents.
(b) To prepare stores received note promptly and circulate the copies to otherdepartments.
(c)
To store the accepted materials of right quantities against authorized storesrequisitions.
(d) Toissuecorrectmaterialsofrightquantitiesagainstauthorizedstoresrequisitions.
(e) To enter receipt, issues and return of materials in the bin cards, and to maintain other
storesrecords.
(f)
To issue purchase requisition when reordering level isreached.
(g) Tocheck bin card balances with the physical quantities in the bins periodically.
(h) To follow rotation of stocks to avoid holding oldstocks.
(i) Toreportonwaste,scrap,slow-moving,non-movingandobsoleteitems.
(j) Tomaintainstoresinatidymannerforeasyaccesstobinatanytime.
(k) To prevent entry of unauthorizedperson.
STORES RECEIPT AND INSPECTION
With the receipt of materials from the supplier, the storekeeper shall refer to the challan to find out purchase
order concerned, and shall prepare a Stores Received Note (SRN), a specimen of which is as follows
Stores Received Note
Supplier’sname:
Code
Purchase order no.:
Description
No.
Date
:
CodeNo. Unit
Carrier’s name :
Quantity
received
Received by
Bill No...... Date..........
Circulation :
1.
2.
3.
4.
Quantity
rejected
Quantity
checked
by
:
:
Challan no.&Date :
Quantity
Bin Card
accepted
reference
Quantity
inspected
by
Entered in
bin card
by
Accounts through Q.C.
EDP/production planning and control
Stores through Q.C.
File copy.
After verification with the specifications given in the purchase order and physical counting, the storekeeper
shall enter the quantity columns, and send two copies of the SRN to quality control department along with
sample material for inspection an approval of quality. When the materials are accepted by the quality control
department, one copy of the SRN is sent to stores for recording in bin card, while the first copy is sent to
accounts department as a record of acceptance of materials ordered and supplied by the vendor. Stores
received note is checked and priced out by accounts department with reference to purchase order.
Invoices when received are checked with priced SRN for issue of pay order.
When materials are rejected by the quality control department, the purchase department informs
the supplier for replacement free of cost. The storekeeper shall keep the rejected material separately for
return to supplier. If payment has already been made, the accounts department shall raise a debit note on
the supplier, when rejected store is not replenished.
STORES ISSUE, TRANSFER AND RETURN
Movement of materials from store takes place on the basis of the following documents:
MATERIAL REQUISITION NOTE(MRN)
This is an authorization to the storekeeper to issue material duly signed by the authorized person of the
receiving department. This is an acknowledgment of material received by the user department. It contains
necessary details like job number, name of the department, description, code no., unit and quantity of the
material requisitioned.
Generally,thematerialrequisitionnoteispre-numbered.Itformsthebasisofmaterialaccounting,
and
therefore, all columns should be filled in clearly and legibly for correct accounting of materials
issued from stores to production, maintenance and other departments. A specimen copy of MRN
is shown below:
Material Requisition Note
Department
:
Job/Work order no.:
Description
Serial no.
Date
CodeNo.
Unit
Checkedby Authorizedby
Quantity
Enteredin
BinCard
No.
Quantity
:
:
Rate
Value issued
Cost officeuse
Storesledger
Storekeeper Folio No. Pricedby
Circulation:
1.
2.
3.
4.
Stores
Cost accounts
Material control department
Filecopy
The indenting department shall fill in first four columns, and send the MRN in a set of three copies
depending on the requirement of the organization. The stores department shall fill in ‘Quantity Issue’
column and send 2nd &3rd copies to accounts and material control department, and post the quantity
issued in the bin card and note the same in stores copy of the MRN. The accounts department shall record
the issue in the Stores ledger and value the material issued for proper accounting. Material control will
record the issues in their control card for future action.
MATERIAL TRANSFER NOTE(MTN)
This document is used to record transfer of materials from one department or job to another. When excess
material remains in one department, and another neighboring department need the same, it becomes easier
and economical to transfer the material rather than receiving back in stores, and again issue them.
However, the MTN should be prepared correctly to avoid in correct accounting. It is preferable to use prenumbered forms for better control. A specimen copy is shown below:
Material Transfer Note
Department issuing :
Department receiving:
Description
Serial no.
Date
Code No.
Authorized
Dept.....
Unit
Received by
Dept.....
Quantity
Stores ledger
No.
Rate
:
:
Value
Cost office use
Priced by
Circulation :
5.
6.
7.
8.
Receiving department
Cost department
Stores
Issuing department
MATERIAL RETURN NOTE(MRN)
This document is an authorization to return excess materials to stores. This form also should be
pre-numbered and filled in carefully in order to avoid wrong accounting. A specimen copy of the format is
as follows: –
Prime Cost
Material Transfer Note (To store)
Department issuing
Job no.
Description
:
:
Serial no.
Date
Code No.
Unit
Authorized Dept..... Received by
Dept.....
Circulation:–
9.
10.
11.
12.
Stores;
Cost department;
Material control department;
Issuing department
Bin no.
Quantity
Rate
:
:
Value
Cost office use Stores ledger
foliono.
Priced by
The material return note is an internal document for returning excess material to stores. This format shall
not be used for returning any material to the outsider. Returning materials to outsider should be done by
way of a letter, duly accompanied with gate pass.
MATERIALS ISSUED TO OUTSIDERS
Materials are issued to outside parties on account of the following:
(a) Re-work or rectification of defects in the materials supplied
(b) Conversion of a basic material into useful component or assembly. For example, card board can
be purchased in Jumbo rolls and can be sent for conversion into cartons of various sizes for
packing biscuits.
In all such cases, detailed records are maintained in stores, production planning & control and accounts to
watch the movement and reentry of the goods in the stores. Control is established by using returnable gate
pass, while the materials leave the factory. All reworked, rectified, reprocessed and converted materials
shall enter the store with a reference on the challan, so that cross-reference is established.
MATERIAL RECORDS
For stores control, two sets of records are maintained. First one is Bin Cards by Stores, and the
second one is stores ledger by accounts (cost) department. Bin cards account for quantity only, while stores
ledger indicates value also.
BIN CARD. This refers to quantitative details of receipt, issue and balance. Entries are made
immediately on receipt or issue of a material. This is known as bin card, as the cards are usually kept
attached to the bins in which materials are kept. The card also indicates maximum, minimum and reordering
levels.
BIN CARD
Bin no.
Description
Code
Unit
:
:
:
:
Receipt
Date
Srn/mtnNo. Qty.
Location :
Issue
Mrn.No.
Qty.
Maximum
:
Minimum
:
Ordering
:
Reorder qty. :
Balance
Physical
Quantity
Verification
STORES LEDGER
The stores ledger (also called as priced stores ledger) is maintained in the cost accounting
department and contains the same information as in bin card with addition of rate and value of materials.
Generally, stores ledger is maintained in a loose-leaf ledger form. The number of ledger cards are the
same as in case of bin cards, and the two sets are reconciled when physical inventory is taken. The
sources of posting in bin cards and stores ledger are the same. Hence, there should not be any quantity
difference between the two. Any discrepancy in quantity must by reconciled periodically. A specimen of
stores ledger account is as follows:–
Stores Ledger Account
Material :
CodeNo. :
Location :
Date
Srn
FolioNo.
Maximumqty.
Minimumqty.
Qty.
Receipt
Unit
Amt.
P.
Mr.
No.
Qty
Issue
Unit
Amt.
P.
:
:
:
Balance
Qty. Unit Amt. mtn.
PNo.
The difference between Bin Card and Stores Ledger may be as follows :
Bin card
Stores ledger
i)
ii)
iii)
iv)
A record of quantities only.
Kept in the stores department
i)
ii)
A record of both quantity and value
Kept in the cost accounting department.
Maintained by the storekeeper.
iii)
Maintained at the cost department.
Posted as soon as the
transaction takes place.
iv)
Posted long after transaction takes
place.
v)
Each transaction is individually
posted once a month
Bin card balance is
physical quantity
v)
Transactions are summarized and posted
vi)
Balance in stores ledger is reconciled
with bin card for quantity, and with general
Ledger for total value.
vi)
STOCK CONTROL CARD
Sometimes, a second set of quantitative record is maintained in the stores, called stock control
cards which are similar to bin card with additional information as regards stock on order. While bin cards
are kept attached to bins or racks for easy identification of stock, the stock control cards are kept in cabinets
or trays or loose-leaf binders
Advantages or stock control cards are as follows:
(a) Records are maintained in a compact way.
(b)
Reference to the stock records is facilitated.
(c)
Overallideaofstock-holdingcanbehadbyrunningthroughthestorebins&racks.
(d)
Division of labor between record keeping and material handling is possible.
STOCKCONTROL
Stock levels are maintained in such a way that there is no overstocking, so that chances of loss
through damage, deterioration in quality, risk of obsolescence, etc. are avoided along with unnecessary
blocking of capital or paying interest on borrowed funds. At the same time, there shall be no stock-out
situation, leading to interruption of production and loss of sale and profit. The production planning and
control or material control department looks after this aspect of stores-management by fixing maximum,
minimum and ordering level and reorder quantity for stock items i.e., standardized items of regular use.
Within these guidelines noted in each bin card/stock control card, the storekeeper places requisitions with
the purchase department for replenishment of stock. But how these levels are determined?
REORDER LEVEL
This is the level at which the Scorekeeper initiates purchase requisition for fresh supplies of
materials. Reorder level takes into account the maximum consumption during lead time and unexpected
delay in receiving fresh supply. Lead time means time necessary to obtain delivery of materials from date
of order. In case of unusual delay, stock should not reach zero level. Reorder level is, therefore, calculated
as maximum reorder period multiplied by maximum consumption.
MINIMUM LEVEL
This represents a level which the stock will reach with fresh delivery of material provided the fresh
delivery is made within the reorder period and usage remains normal during the period. Stock is normally
not allowed to fall below this level. This is considered as buffer stock for use in emergency. If, however
stock level falls below minimum level it will be called Danger Level, when emergency measure should be
taken to replenish stock. Otherwise, there will be stock-out situation, with consequential loss of production.
Minimum level is, therefore, computed as reorder level less normal consumption during normal reorder
period.
MAXIMUM LEVEL
This represents stock level above which stock should not be allowed to rise. The main purpose of this
level is to ensure that capital is not blocked up unnecessarily in stores. The maximum stock level is
computed as reorder level plus reorder quantity minus minimum consumption during reorder period. This
level is a control indicator and if the stock exceeds this level, the consumption pattern and reorder period
should be reviewed. The maximum stock level is fixed after considering the following factors also:
i) Storage facilities available.
ii) Cost of maintaining stores including insurance cost.
iii) Availability of funds.
iv) Possibility of loss by deterioration, evaporation, etc. and risk of obsolescence.
v) Possibility of price fluctuation. For instance, in case of seasonal materials, price may be low in
season and high in off-season.
vi) Government restriction on import or procurement.
vii) Economic order quantity.
It is important to note that setting of stock levels requires correct projection of usage pattern, lead-time
and estimate of reordering quantity, stock-levels, therefore, cannot be established where:
(a) rate of consumption is erratic,
(b) material is not in common use,
(c) market of the particular material is uncertain.
STOCK TURNOVER AND AVERAGE STOCK–HOLDING
Stock turnover ratio indicates how many times stock is rotated, on an average, during
a
particular period, say a year. This is calculated for different groups of materials separately in the following
way:
Stock turnover ratio = cost of materials used during the period divided by average stock of materials
held during the period.
Average stock holding is obtained by –
(a) Averaging opening and closing stocks,
(b)
Averaging maximum and minimum levels of stock, or
(c)
Minimum stock plus half of reorder quantity.
REORDER QUANTITY
This refers to the quantity to be covered in a single purchase order. While deciding the reorder
quantity, the following factors are considered:
(a) Consumption pattern of the material.
(b) Nature of the material i.e., risk of deterioration, evaporation, etc.
(c) Risk of price-fluctuation.
(d) Seasonal consideration as to the price and availability of supplies.
(e) Storage space availability.
(f) Quantum of discount.
(g) Carrying cost and ordering cost.
CARRYING COST AND ORDERING COST
Cost of carrying stock includes rent, insurance and other cost of storage, interest on capital blocked,
losses and pilferage, risk of obsolescence, etc. Cost of ordering consists of the cost of placing an order,
setting up of production-run, transportation and receiving cost. Carrying costs are mostly variable, while
ordering costs are mostly fixed and partly variable with the number of orders Carrying cost increases with
the increase in reorder quantity, while ordering cost decreases with the increase in number of orders Thus,
carrying cost and ordering cost move in opposite direction.
ECONOMIC ORDER QUANTITY (EOQ)
The concept of Economic Order Quantity or EOQ has emerged out of this behavior of carrying cost
and ordering cost. EOQ is the quantity fixed at a point where total cost of ordering and the cost of carrying
the inventory will be the minimum. EOQ may be arrived at by tabular method by preparing purchase order
tables, showing the ordering cost, carrying cost and total cost of various sizes of purchase orders, or can
be established by algebraic equation or by graph.
Let us take an illustration:
Material: Air tight box
Code No.: P 3002 Monthly usage :250pcs.
Cost of placing and receiving one order P60. Cost of materials per unit P10
Carrying cost = 10% of inventory value. Find out EOQ
EOQ
2  Annual requirements  Cost per order
Cost per unit of material  Carrying cos t
2  3000  60
10  0.10
360000
=
600units
EOQ model is based on the following assumptions:
(i) Material cost per unit remains unaffected by order size.
(ii) Orders will be received on the expiry of lead time.
(iii) Variable inventory carrying cost per unit and ordering cost per order remain constant throughout
the order.
(iv) Production and sales can before cast perfectly.
ABC ANALYSIS
ABC analysis is a technique of selective control of inventory by classifying all items of stores into three
categories, namely, –
Category A:
A few items accounting for substantial usage in term of total monetary value (10% items
covering 75%value.
Category C:
Large number of items of small value (70% items covering 10% value).
Category B:
In between items A and C(20%itemsrepresenting15%value).
The main object of the analysis is to decide guidelines for selective control over inventories. It is
extremely difficult to control effectively if there is large number of items in stock. This system ensures stricter
control over a few materials, which represents bulk of the cost, so that the direction of control is more costeffective. This system also saves time and investment by taking action on the three categories of stores by
using discretion. Generally, category A items deserve very strict control with say weekly control reports,
maximum follow-up, efforts to reduce lead time, etc., category B items require moderate control, while less
expensive control may be applied to category C items. However, care should be taken for critical items,
which are in category B or C, but extremely important from the view of production process. For example,
ginger powder may be a C class item, but without this material, production of Gingernut biscuit cannot take
place. Adequate attention should be given to take care of such items, since ABC analysis in no way ranks
stocks in terms of importance.
The procedure for preparing ABC analysis is as follows:
(i) Determine the cost and usage of each material over a given period.
(ii) Multiply unit cost by estimated usage to obtain net value of each material.
(iii) List all items with quantity and value and arrange them in descending value.
(iv) Accumulatevalueandaddupnumberofitemsandcalculatepercentageontotalinventory in value and in
number.
(v) Draw a curve of percentage items and percentage value.
(vi) Mark off from the curve the rational limits A, B, C categories.
The advantages of this method are—
(i) It ensures closer control on costly items in which large amount of capital is tied up.
(ii) With the scientific control of inventories, the stock turnover rate can be maintained within a
range of 6 to12.
(iii) Clerical costs are reduced and inventory is balanced and maintained at the optimum
possible level.
(iv) The storage cost is reduced under this method as reasonable quantity of high valued items
are maintained in the stores.
ABC analysis may be well-conceived with the help of graphs or charts:
ABC analysis, popularly known as “Always Better Control” is based on Pareto’s Law, developed by
an Italian economist in the nineteenth century. He observed that a minority of population owned the majority
of his country’s wealth. Same principle has been applied to stocks which show that majority of inventory
value will be represented by relatively few items.
Just-in-time (JIT) purchasing: Business enterprises are now giving in creating attention to
reducingstocklevelstoaminimumbycreatingcloserrelationshipwithsuppliersandarranging more frequent
deliveries of small quantities. The objective of just-in-time (JIT) purchasing is to purchase goods so that
delivery immediately precedes their use. This ensures holding of stocks as minimum as possible.
With this system of purchasing the company and the supplier work in close cooperation. The
company generally guarantees for large quantity of purchases. The suppliers, on the other hand, guarantee
proper quality of materials at reasonable (or lower) prices as and when needed. With this arrangement,
there is no need to move goods received into stores because the goods (of proper quality) are delivered
direct to the shop floor. Moreover, it is unlikely that raw material stock will consist of different consignments
of materials purchased at different prices. Thus, FIFO, LIFO and average cost issue prices will be the same.
The main advantages of JIT purchasing are —
(i) Itresultsinenormoussavingsinmaterialshandlingandinvestmentsinstocks.
(ii) It reduces the clerical costs of recording stores issue. As purchase price of different lots will not
fluctuate to a great extent, the issue prices under FIFO, LIFO or average cost methods will be the
same.
The Pareto distribution: The Pareto (80/20) distribution is similar in concept to ABC method of stock
control. Its name is derived from an economist, Vilfredo Pareto, who suggested that 80% of a nation’s
wealth is held by 20% of its population and so the remaining 80% of the population hold only 20% of its net
wealth. This 80/20 analysis has been applied to stocks so that 20% of stores items account for 80% of the
value of stocks in hand. This indicates that rigorous stock control methods should be applied to these 20%
of items in order to derive maximum benefits from stock control. The remaining 80% of items do not
require such rigorous control methods applied to them because the cost and effort might not be justified by
the savings obtainable.
VED analysis: Vital, Essential and Desirable (VED) analysis is done mainly for control of spare parts
keeping in view the criticality to production. Vital spares are spares the stock-out of which even for a short
time will stop production for quite some time. The stock-out cost of vital items will stop production for quite
some time. The stock-out cost of vital items is very high. Essential spares are spares the absence of
which cannot be tolerated for more than a few hours a day and the cost of lost production is high. Such
spares are essential for the production to continue. The desirable spares are those which are needed but
their absence for even a week or so will not lead to stoppage of production. Some spares, though
negligible in value, may be vital for the production to continue and require constant attention. Such spares
may notreceivetheattentiontheydeserveiftheyaremaintainedunderABCanalysismethodbecause their
consumption value is small.
FSN analysis: Here the items are classified according to Fast-moving (F), Slow moving (S) and Nonmoving (N) on the basis rate of consumption. The non-moving items are items not
consumedforalongperiodsay24months.Suchnon-movingitemsblockquitealotofcapital and as such they
should be disposed of as quickly as possible without further deteriorating. The classification of fast- and
slow-moving items are determined on the basis of stores turnover and it helps in proper arrangement of
stocks in stores and distribution and handling methods.
PERPETUAL INVENTORYSYSTEM
Perpetual Inventory System is “a system of records maintained by the controlling department, which
reflects physical movement of stocks and their current balance”. In other words, it is a technique of
controlling stocks by maintaining stock records, such as bin cards in stores and stores ledger in accounts,
in such a manner that the stock balance is available at any point of time i.e., perpetually. Under this system,
stores balance is recorded after each transaction of receipt, issue or transfer This facilitates regular stock
verification physically which obviates the stoppage of work for stock-taking.
The success of perpetual inventory system depends on the following:
(a) Maintenance of bin card and stores ledger up-to-date.
(b) Reconciliation of quantity balance shown by bin cards with that in stores ledger
(c) Continuous verification of physical stock with bin card quantity.
(d) Reconciliation of discrepancies arising out of physical verification, as well as comparison with
stores ledger.
(e) Remedial action to remove the cause of discrepancies.
(f) Correction of stock-records.
PHYSICAL VERIFICATION OF STOCK
Checking of stock by physical verification is an essential feature of stock control. Such checking may
be periodic or continuous. Under periodic stock verification system, all the items of stocks are to be verified
once a year at the time of preparing annual accounts resulting in the following difficulties:
(i) Loss due to stoppage of production for stock-taking.
(ii) Shortage of experienced stock-verifiers, if all items of stores are to be verified at a time.
(iii) Thus, quality of verification suffers
(iv) Discrepancies revealed during verification are rectified only at the end of the year.
(v) Element of “surprise check” which helps to detect irregularities are absent.
Periodic verification is, therefore, carried out in those areas, which are not covered under continuous
stock verification, such as, work-in-progress, stock on shop-floor, laboratory, canteen, etc.
CONTINUOUS STOCK TAKING
It consists of counting and verifying a number of items daily throughout the year, so that all items of
stores are covered at least once during the year. The frequency may be three to four times depending on
the nature of the material. Such verification is carried out by experienced technically trained persons, as
per program planned to cover all items by rotation. The advantages of continuous stock-taking are as
follows:
(i) Stoppage of production is not necessary.
(ii) Experienced staff can be appointed as stock verifiers, who can apply their skill in the
assignment.
(iii) Stock discrepancies are brought out promptly, and corrective actions taken fast.
(iv) Surprise checks act as a moral check on the store’s personnel.
(v) Helps identification of slow-moving, dormant, obsolete and unserviceable stocks.
(vi) Final accounts as well as Half-yearly accounts can be completed quickly.
STOCK VERIFICATION PROCEDURE
The stock verification procedure differs under continuous and periodic stock verification system.
Under continuous stock verification plan, the stock verifier counts or weighs or measures the physical
quantity of a particular item, and records his results in the ‘stock verification sheet’ or in ‘bin card’. Stock
verification sheet is a preprinted form having columns for ‘quantity as per bin card’, ‘quantity as per physical
count’, ‘difference’ and ‘remarks. The stock-verifier records the bin card balance, result of physical count
and difference, if any, and puts his remarks regarding reasons for difference and obtains the signature
of the storekeeper. Where result of stock verification is recorded on the bin card itself, the stock verifier
puts his initial and date against the balance quantity, if the latter agrees with the physical count. In case of
discrepancy, a stock difference memo will be prepared and circulated to departments concerned for action.
In case of periodic stock verification, normally inventory tags are used. Inventory Tags are serially
numbered and contain stores description and code no., location, unit code, quantity, signature of stock
verifier and date of verification, and have two identical portions with perforation in between, so that after
verification, the lower part can be taken by stock verifier while the upper part remains attached to the bins.
Inventory tags shall be used for every material at each of the bins, racks in the stores, sub-stores and in
the shop-floor for unused stores and work-in-process. Tags are sent to raw material, packing material and
engineering stores and production departments well in advance. When tags are tied up with all items, the
stock verifier starts picking up the tags from one end and completes verification of every section without
break. Quantities are then totaled up and recorded in the stock sheet, showing physical stock, book balance
and difference.
STOCK DISCREPANCIES
The discrepancies between physical stock and stores ledger balance may occur due to various reasons.
Some of these are normal, natural and unavoidable, such as,
(i) Breaking bulk,
(ii) Evaporation loss, shrinkage and drying loss or absorption gain,
(iii) Volume fluctuation due to temperature,
(iv) Units of purchase and issues being different i.e. purchased by weight, but issued by quantity.
The avoidable causes of discrepancies are as follows:
(i) Incorrect entries in bin cards.
(ii) Storage in wrong bins.
(iii) Short or excess issues or wrong issues of material.
(iv) Excess or shortage in packages or bundles not checked at the time of receipt.
(v) Pilferage and theft.
After reconciling the discrepancies and rectifying clerical and accounting errors, a Stores Adjustment
Note is prepared, wherein the stock-difference quantities are listed material wise with code no., and valued
at cost, and the net amount shall be transferred from stock account to stock difference adjustment account
for disposal, after investigation of the difference, to either factory overheads or costing profit and loss
account. Bin cards and stores ledger quantities shall be immediately rectified to the physical quantity
verified.
MATERIAL CONTROL
Wehaveseenthatinamanufacturingconcern,theproductiondepartmentneedsraw-materials, processed
materials, components and consumable stores for manufacture, the purchase department procures
such materials of right quality and right quantity from various suppliers, the stores department receives
and stores them after quality approval by quality control department and finally issues them to production
department. Thus, it is evident that a perfect coordination between these departments are absolutely
necessary in order to keep the cost under control. Otherwise, situations like stock-out, production
distress purchase at higher price, wastage due to wrong quality, with consequential loss of customers
will occur. In big organizations, a material control or production planning and control department is created
to coordinate the activities of sales, production, purchase, stores, quality control and accounts
departments. It ensures effective control at each stage of operation right from placingpurchaserequisitions
till the disposal of scraps and obsolete materials. The essential requirements of the system encompasses
the following :
a) Classification, codification, standardization and rationalization of all stores into raw- material —
classified into standard and nonstandard items, packing materials, components and assemblies,
engineering stores and machine parts, loose-tools, laboratory supplies, inspection materials,etc.
b) Determining standard or norm for consumption of stores as well as stockholding at variouslevels.
c)
Useofstandardformsanddocuments.
d) Planning of material requirements by reviewing sales plan, position of finished stock and work-inprocess, production plan, stock-status in stores, and expected arrival as per ordersplaced.
e) Continuous updating of stock position with the information available from purchase, stores,
production and dispatchdepartments.
f) Arranging conversion of basic raw materials into components through convertors or contractlabor.
g) Preparing regular reports to management indicating stock-holding, ordering position,
consumption,criticalitems,excessstorage,slow-moving,non-moving,dormant,surplus
andobsoletestocks,etc.byquantityandvalue.
PAYMENT FOR PURCHASE
Supplier’s bills are received by accounts through inward mail or reception. Generally, bills are
enteredinaregister,indicatingsupplier’sname,billno.,dateandamount,sothattherecordof payment, such as
date of passing the bill for payment, cheque no. and date may be maintained therein. The process starts
with the receipt of the accounts copy of the purchase order in advance. Accounts copy of Stores Received
Note is received from stores after the quality control certifies about the quality of the accepted materials.
Bill is scrutinized with reference to purchase order, receipted challan and stores receipt note regarding
accepted quantity, rate and terms of payment. The following points need special attention before passing
pay-order on the supplier’sbill.
(a) Discountallowedforpromptpaymenti.e.cashdiscountapartfromtradediscount.
(b) Incidental charges recoverable from the bill, for example, the cost of material includes
freightandinsurance,butthematerialhasbeencollectedbyowntransport.
(c) Recoveryofdemurragecharges,ifdispatchdocumentsarenotreceivedintime.
(d) Sales tax declaration forms, ifapplicable.
(e) Rent or deposit for returnable containers
MATERIAL COST PRICE
Materialcostpriceshallincludeallexpensesincurredonplacingthematerialinstoresoratany other hired or
owned location as required by the purchase order. Such price shall include cost, insurance, freight, excise
duty, sales tax, octroi and any other special charges such as rent or deposit for container, interest charges
for credit period allowed, and will be reduced by the followingcredits:
(a) Trade discount - Normally, net of discount is shown as invoice price. This includes quantum of
discount allowedperiodically.
(b) Cash discount - is shown separately in the invoice as an allowable amount since it is
optionalforthebuyer.Ifcashdiscountisavailable,itshouldnotbeincludedinmaterial cost, as it is a purely
financialincome.
STORAGE AND HANDLING LOSS
Material cost price is inflated to cover normal storage and handling losses, which arise because of the
following reasons:
(a) Units of receipt and units of issue may differ. For example, aluminum foil is purchased
byweight,butusedbysquaremeter.
(b) Natural losses due to evaporation, shrinkage ordrying.
(c)
Someofthematerialsmaygainorlossduetochangeintemperature.
In case of such materials, cost per unit is inflated to ensure that such losses are recovered while the material
is issued to production. For example, if there is a natural loss of 10% of a material, which is purchased @
P10 per Kg., the unit price for the same will be:
= P10 / 9 = P1.11 per kg.
However, where any abnormal loss occurs, the same should be charged to the profit and loss account.
PRICING ISSUES OFMATERIAL
Materials issued from stores should be valued at the rate they are carried in stock. Materials are valued at
cost and entry in the stores ledger is made with every receipt. Different lot of materials may be received at
different prices. Hence, when issues are made from stock, it may happen that materials from more than
one lot may have to be issued. Which price will be applicable in such case? Actual cost or average price,
market price or notional price? Various methods for pricing materials issued from stores are classified in
the following manner:
A. COST PRICE METHODS:
i) Specific price
ii) First in, first out (FIFO)
iii) Last in, first out(LIFO)
iv) Highest in, first out(HIFO)
v) Base stockprice.
B. AVERAGE PRICEMETHODS:
i)
ii)
iii)
iv)
v)
vi)
Simpleaverage
Weightedaverage
Periodic simpleaverage
Periodic weightedaverage
Moving simpleaverage
Moving weightedaverage
C. CURRENT PRICE METHODS:
i) Replacementprice
ii) Next in, first out(NIFO)
D. NOTIONAL PRICE METHODS:
i) Standardprice
ii) Inflatedprice
iii) Re-useprice
SELF-TEST QUESTIONS
QUESTION 1:
(a) ‘ZEE’ is a product manufactured out of three raw materials ‘M’, ‘N’ and ‘Q’. Each unit of ZEE
requires10Kgs,8Kgs, and6Kgs.ofM, N and Q respectively. The reorder levels of ‘M’ and ‘N’
are 15000 kgs. and 10000 Kgs. respectively while the minimum level of ‘Q’ is 2500 Kgs. The
weekly production of ZEE varies from 300 to 500 units, while the weekly average production
is 400 units. You are required to compute –
(i) the minimum stock level of M,
(ii) the maximum stock level of N and
(iii) the reorder level of Q.
The following additional data are given:
M
Reorder quantity (in Kgs.)
Delivery (in weeks)
Minimum
Average
Maximum
20,000
2
3
4
N
15,000
4
5
6
Q
20,000
3
4
5
ANSWER :
(a) Maximum stock level is that quantity of material above which the stock of any item should not generally
be allowed to exceed. This level is fixed after taking into account such factors as :
i) rate of consumption of material
ii) storage space available
iii) lead time from date of placing the order
iv) nature of material
v) amount of capital needed and is available
vi) incidence of storage and insurance costs
vii) risk of obsolescence and deterioration
viii) reorder quantity.
Maximum level = Reorder level + Reorder quantity – (Minimum consumption
× Minimum reorder period).
Minimum stock level is the lower limit below which the stock of any item should not normally be allowed to
fall. This is also known as safety stock or buffer stock. The prime considerations in fixing minimum stock
level are —
i) average rate of consumption
ii) time required for replacement to avoid stoppage of production.
Minimum stock level = Reorder level – (Normal consumption × Normal reorder period i.e. average delivery
time)
(b) (i) Minimum stock level of M
= Reorder level – (Normal usage or average usage × Average delivery time)
= 15,000 kgs. – (400 units of Zee × 10 kg. per unit × 3 weeks)
= 15,000 – 12,000 = 3,000 kgs.
(ii)
Maximum stock level of N
= Reorder level + Reorder quantity – (Min. consumption × Minimum reorder period)
= 10,000 kgs. + 15,000 kgs. – (300 × 8 × 4) kgs. = 15,400 kgs.
(iii) Reorder level of Q = Maximum reorder period × Maximum usage
= 5 × 500 × 6 = 15,000 kgs.
QUESTION 2:
Shown below is an extract from the stores ledger card for material X.
Receipts
Date
Qty.
Issues
Value
Total
P.
P
Qty.
Balance
Value
Total
P.
P.
April 1
April 12
10
10.50
105.00
April15
April20
12
10.29
123.48
Oty.
Value
Total
P
P
8
84.40
18
189.40
30
312.88
4
April 21
15
REQUIRED :
Value the issues of April 20 and 21 using each of FIFO, LIFO and periodic weighted average
methods and under each of the above three methods, show the value of the closing stock.
[NOTES TO STUDENTS]
1. Under FIFO, issues are taken from the oldest items in stock, under LIFO from the most
recently purchased. Whatever the order of use, the full quantity of a purchase is used
upbeforethebalanceofanissueistakenfromthenextpurchase(atadifferentprice).
2. Under periodic weighted average valuation, the issue price is calculated by reference to
all of the purchases in a period.
3. If you cannot answer part (c) from knowledge, conduct a quick experiment using
simple figures to consider how large or small cost of sales will be and how the value of
stock carried forward will be affected if costs are rising.]
Answer :
Issues
Quantity
Value
P.
FIFO
April 20
April 21
P.
Closing stockbalance
Quantity
Value
P.
4
10.55
42.20
4
10
12
10.55
10.50
10.29
4
10
1
10.55
10.50
10.29
42.20
105.00
10.29
157.49
11
10.29
P.
42.20
105.00
123.48
270.68
113.19
LIFO
April20
April21
4
8
7
10.29
41.16
8
10
8
10.29
10.50
10.55
10.29
10.50
82.32
73.50
155.82
3
8
10.50
10.55
82.32
105.00
84.40
271.72
31.50
84.40
115.90
WEIGHTED AVERAGE
The closing stock on April 15 can be analyzed as follows.
Quantity
Value
Amount
8
10
12
P.
10.55
10.50
10.29
P.
84.40
105.00
123.48
30
312.88
Weighted average price = P312.88/30= P10.43
Issues
Quantity
Value
P
April 20
April 21
4
15
10.43
10.43
Closing stock balance
Quantity
Value
P
41.72
156.45
P
26
11
10.43
10.43
P.
271.18
114.73
QUESTION 3 :
Z Ltd had the following transactions in one of its raw materials during April 20X3.
Required
Opening stock
40 units
April 4
Bought
140 units
10
Used
90 units
12
Bought
60 units
13
Used
100 units
16
Bought
200 units
21
Used
70 units
23
Used
80 units
26
Bought
50 units
29
Used
60 units
Compute for the ending raw materials inventory balance using
a. FIFO
b. LIFO
c. Weighted Average
@ P10 each
@ P11 each
@ P 20 each
@ P 10 each
@ P 20 each
ANSWER :
[Notes to students : Note that the information in part (a) describes a period of fluctuating
(not
consistentlyrising)prices;takecareifyouusepart(a)toillustrateyouranswer.Somevariation
is possible, but the layout shown below (with correct entries) would have earned you
full marks. Presentation is everything here the neater and more careful your edger, the
less likely you are to makemistakes]
(a)
(i)
LIFOMethod
Receipts
Date
Units
Price
P
Issues
Units
Price
P.
StockBalance
Value
P.
Units
Price
P
Value
P
40
140
180
10
11
400
1,540
1,940
40
50
90
60
150
10
11
400
550
950
720
1,670
40
10
50
200
250
10
11
April Bif
4
140
11
10
12
90
90
60
60
40
100
200
990
990
12
13
16
11
12
11
720
440
1,160
10
21
70
10
12
700
10
40
400
110
510
2,000
2,510
10
400
23
26
29
80
50
10
12
10
11
10
110
1,300
1,810
40
10
50
100
50
150
10
11
10
400
110
500
1010
600
1610
40
10
40
90
10
11
10
800
12
50
10
60
10
130
180
12
600
100
700
400
110
400
910
(ii)
FIFOMethod
Receipts
Units Price Units
P
Date
Issues
Price
P.
Value
P
April b/fd
4
140
11
10
12
60
200
50
400
550
950
90
10
100
11
12
50
20
70
80
12
10
10
600
200
800
800
60
10
600
990
120
1110
10
21
23
26
10
11
12
13
16
40
50
90
12
29
Units
Stock Balance
Price
Value
P
P
40
10
400
140
180
11
1,540
1,940
90
60
150
11
12
990
720
1,710
50
200
250
12
10
600
2,000
2,600
180
100
50
150
40
50
90
10
10
12
1,800
1,000
600
1,600
400
600
1,000
10
12
(b) Price of issues under FIFO andLIFO
Date
10
13
21
23
29
FIFO
P.
950
1,110
800
800
600
4,260
LIFO
P.
990
1,160
700
800
700
4,350
(c) Using the weighted average method each issue is charged out at a rate determined by
dividing the total value of stock at that time by the total number of units held. Thus the
issue on 10 April would be charged out at
90
180
× P1,940 = P 970
This is higher than the FIFO price and lower than the LIFO cost. The effect of rising
prices can be seen in the first two entries in the stores ledger prepared for part (a).
(Not in later entries since the price is fluctuating.)
(i)
(ii)
The profit and loss account is affected by stock issues and the charge (and hence
the cost of sales) will be greater under LIFO than FIFO, and somewhere in
between using the weighted average method.
The balance sheet (closing stock) is affected by the stock balance which is
greater under FIFO than LIFO, and would be somewhere in between under the
weighted average method.
ASSESSMENT
MULTIPLE CHOICE:
1.
The cycle of materials procurement and use includes all of the following steps except for:
A.
determining the cost of goods sold
B.
the production budget
C.
preparing the receiving report
D.
maintaining the materials ledger
E.
engineering to determine materials specifications
2.
In a well-controlled materials system, the Purchasing Department performs all of the following activities
except the:
3.
4.
5.
6.
A.
placing of purchase orders with suppliers
B.
receiving of purchase requisitions
C.
maintaining of information on market prices for goods used
D.
preparation of purchase orders
E.
approving and checking of invoices
The purchase requisition is a document used to:
A.
initiate the return of merchandise to the vendor
B.
inform the purchasing agent of a need for a materials item
C.
initiate payment for merchandise received
D.
inform the Purchasing Department of a receipt of goods
E.
authorize the vendor to supply merchandise or materials
The expense that theoretically is not a correct part of inventory cost is:
A.
freight-in
B.
freight-out
C.
inspection costs
D.
accounting costs for materials received
E.
purchasing costs
Theoretically, cash discounts permitted on purchased raw materials should be:
A.
added to other income, whether taken or not
B.
added to other income, only if taken
C.
deducted from inventory, whether taken or not
D.
deducted from inventory, only if taken
E.
none of the above
The materials requisition:
A.
is the list of materials requirements for each step in the production sequence
B.
informs the purchasing agent of the quantity and kind of materials needed
C.
contracts for quantities to be delivered
D.
certifies quantities received and reports results of inspection and testing
E.
7.
8.
9.
10.
11.
12.
13.
authorizes the storeroom to deliver types and quantities of materials to a given department
The purchase order:
A.
is the list of materials requirements for each step in the production sequence
B.
informs the purchasing agent of the quantity and kind of materials needed
C.
contracts for quantities to be delivered
D.
certifies quantities received and reports results of inspection and testing
E.
authorizes the storeroom to deliver types and quantities of materials to a given department
The bill of materials:
A.
is the list of materials requirements for each step in the production sequence
B.
informs the purchasing agent of the quantity and kind of materials needed
C.
contracts for quantities to be delivered
D.
certifies quantities received and reports results of inspection and testing
E.
authorizes the storeroom to deliver types and quantities of materials to a given department
The receiving report:
A.
is the list of materials requirements for each step in the production sequence
B.
informs the purchasing agent of the quantity and kind of materials needed
C.
contracts for quantities to be delivered
D.
certifies quantities received and reports results of inspection and testing
E.
authorizes the storeroom to deliver types and quantities of materials to a given department
The purchasing department performs all of the following functions except:
A.
receives purchase requisitions for materials, supplies, and equipment
B.
keeps informed concerning sources of supply, prices, and delivery schedules
C.
prepares and places purchase orders
D.
compares quantities received with the suppliers' packing list
E.
arranges for the reporting among the purchasing, receiving, and accounting departments
The purchase requisition may originate with all of the following except:
A.
a storeroom employee
B.
a materials record clerk
C.
a receiving department clerk
D.
a research, engineering, or other department employee who needs materials of a special nature
E.
a computer
The receiving department does all of the following except:
A.
unloads and unpacks incoming materials
B.
keeps informed concerning sources of supply, prices, and delivery schedules
C.
matches materials received with descriptions on purchase orders
D.
arranges for inspection, when necessary
E.
routes accepted materials to the appropriate departments
A cost of having too few items on hand in inventory is:
14.
15.
A.
frequent stockouts
B.
excessive insurance costs
C.
payment of additional warehouse space
D.
spoilage costs
E.
costs of obsolescence
Of the following, the expense that is not relevant to determining the most economic quantity to order is:
A.
additional costs to store inventory
B.
rental of warehouse space under a ten-year lease
C.
interest expense of financing purchases
D.
spoilage costs
E.
variable costs of placing an order
A company has been ordering more than the economic order quantity. This would result in:
A.
more frequent order points
B.
carrying costs greater than order costs
C.
equal safety stock costs and carrying costs
D.
carrying costs less than order costs
E.
insufficient safety stock costs
16.
Annual demand for squash racquets is 50,000 units, and carrying costs amount to $2 per unit. Order
costs for the company amount to $5. The optimum order quantity in units for squash racquets is (rounded to the
nearest unit):
A.
191
B.
500
C.
250
D.
100
E.
625
17.
A company orders 10,000 units (a one-year supply) of Zap at one time. Zap costs $1 per unit, and order
costs amount to $500 each time an order is placed. The costs to carry Zap in inventory amount to 20% of the
materials cost. For an entire year, the inventory carrying costs and order costs are:
A.
$2,000
B.
$200
C.
$500
D.
$1,000
E.
$1,500
18.
If the average lead time and usage figures are used for determining the order point, then the probability
of a stockout is:
A.
.005%
B.
50%
C.
5%
D.
100%
E.
2.5%
19.
There are 1,000 Trolls in stock, and 1,500 are due in from orders that were placed previously. The
company sells Trolls at the rate of 100 per day and finds that it takes an average of 20 days for an order to be
received. Because usage and lead times are known with certainty and because the company has determined
that an order must be placed now, the desired safety stock quantity must be equal to:
20.
A.
500
units
B.
1,000
units
C.
2,500
units
D.
100
units
E.
1,500
units
The use of quantitative models can be modified to improve the management of inventory by:
A.
including only fixed costs in the EOQ analysis
B.
employing a minimum safety stock level because delivery time and inventory usage rates may
C.
purchasing inventory only once a year to save on ordering cost
D.
purchasing inventory monthly to save on carrying cost
vary
E.
eliminating semi variable costs from any consideration in the EOQ analysis because of the
difficulty of estimating those costs
21.
An inventory control technique that reviews quantities on hand periodically and orders sufficient
quantities to bring inventory up to a desired level expressed as a number of days' or weeks' supply is the:
22.
A.
two-bin method
B.
ABC inventory control method
C.
order cycling method
D.
min-max method
E.
automatic order point system
The factor that need not be considered when calculating an inventory economic order quantity (EOQ) is:
A.
annual sales of a product
B.
safety stock level
C.
order-placing costs
D.
storage costs
E.
risk of inventory obsolescence and deterioration
23.
Brad Company has correctly computed its economic order quantity as 500 units. However, management
would rather order in quantities of 600 units. How will Brad's total annual purchase order cost and total annual
carrying cost for an order quantity of 600 units compare to the respective amounts for an order quantity of 500
units?
A.
higher purchase order cost and lower carrying cost
B.
lower purchase order cost and higher carrying cost
C.
higher purchase order cost and higher carrying cost
D.
lower purchase order cost and lower carrying cost
E.
none of the above
24.
The inventory cost flow method that involves computations based on broad inventory pools of similar
items is:
A.
dollar-value lifo
B.
average cost
C.
moving average
D.
fifo
E.
regular quantity of goods lifo
25.
For its economic order quantity model, a company has a $10 cost of placing an order and a $2 annual
cost of carrying one unit in stock. If the cost of placing an order increases by 20%, the annual cost of carrying
one unit in stock increases by 25%, and all other considerations remain constant, the economic order quantity
will:
26.
A.
decrease
B.
increase
C.
remain unchanged
D.
either increase or decrease, depending on the reorder point
E.
either increase or decrease, depending on the safety stock
For inventory management, ignoring safety stocks, a valid computation of the reorder point is:
A.
order costs plus carrying costs
B.
the square root of the anticipated demand during lead time
C.
the anticipated demand per day during lead time times lead time in days
D.
the economic order quantity
E.
the economic order quantity times the anticipated demand during lead time
27.
The Cappalari Company wishes to determine the amount of safety stock that it should maintain for
Product D to result in the lowest cost. The following information is available:
Stockout cost
$
80
per occurrence
Carrying cost of safety stock
$
2
per unit
5
per year
Number of purchase orders
The options available to Cappalari are as follows:
Units of
Probability of Running
Safety Stock
out of Safety Stock
10
50%
30
30%
50
10%
55
5%
The number of units of safety stock that will result in the lowest cost is:
28.
A.
30
B.
50
C.
55
D.
10
E.
none of the above
The following information is available for Odyssey Company's Material Y:
Annual usage in units
10,000
Working days per year
250
Normal lead time in working days
30
Maximum lead time in working days
70
Assuming that the units of Material Y will be required evenly throughout the year, the order point would be:
29.
A.
2,000
B.
2,800
C.
2,105
D.
1,200
E.
1,600
The following information relates to Hudson Company's Material A:
Annual usage in units
7,200
Working days per year
240
Normal lead time in working days
20
Maximum lead time in working days
45
Assuming that the units of Material A will be required evenly throughout the year, the safety stock and order point
would be:
Safety Stock
Order Point
A.
750
1,350
B.
600
750
C.
600
1,350
D.
750
600
E.
none of the above
30.
Penguin Company manufactures winter jackets. Setup costs are $2.00. Penguin manufactures 4,000
jackets evenly throughout the year. Using the economic order quantity approach, the optimal production run
would be 200 when the cost of carrying one jacket in inventory for one year is:
31.
A.
$0.10
B.
$0.20
C.
$0.40
D.
$0.05
E.
none of the above
The following data refer to various annual costs relating to the inventory of a single-product company:
Unit transportation-in on purchases
$
Storage per unit
Insurance per unit
.20
.12
.
Annual interest foregone from alternate investment of funds
Annual number of units required
10
$
800
10,000
What is the annual carrying cost per unit?
A.
$.30
B.
$.42
C.
$.50
D.
$.32
E.
$.22
32.
Bliss Company has an order point at 1,400 units, usage during normal lead time of 600 units, and an
EOQ of 2,000 units. Its maximum inventory, assuming normal lead time and usage, would be:
A.
3,400 units
B.
2,000 units
C.
1,200 units
D.
2,800 units
E.
4,000 units
33.
The inventory model that follows the concept that 80% of the value of an inventory is in 20% of the
inventory items is the:
A.
ABC plan
B.
economic order quantity (EOQ) model
C.
just-in-time inventory system
D.
materials requirements planning (MRP) system
E.
zero inventory model
34.
The materials control method that is based on the premise that the quantities of most stock items are
subject to definable limits is the:
A.
cycle review method
B.
min-max method
C.
two-bin method
D.
ABC plan
E.
none of the above
35.
The materials control method that is based on physical observation that an order point has been reached
is the:
A.
cycle review method
B.
min-max method
C.
two-bin method
D.
ABC plan
E.
none of the above
36.
If the cost of goods sold computed when inventory is costed using the fifo method is less than when
using the lifo method:
A.
prices decreased
B.
prices remained unchanged
C.
prices increased
D.
price trend cannot be determined from the information given
E.
prices went up and down
37.
The method of inventory pricing that best approximates specific identification of the actual flow of costs
and units in most manufacturing situations is:
A.
first-in, first-out
B.
last-in, first-out
C.
base stock
D.
average cost
E.
none of the above
38.
The following information was available from the inventory records of the Anthony Company for January
20X7:
Unit
Total
Units
Cost
Cost
2,000
$ 9.775
$19,550
January 6, 20X7
1,500
10.300
15,450
January 26, 20X7
3,400
10.750
36,550
January 7, 20X7
1,800
January 31, 20X7
3,200
Balance at January 1, 20X7
Purchases:
Sales:
Balance at January 31, 20X7
1,900
Assuming that Anthony maintains perpetual inventory records, what should be the inventory at January 31,
20X7, using the average cost inventory method rounded to the nearest dollar?
A.
$19,998
B.
$19,523
C.
$19,703
D.
$19,950
E.
none of the above
39.
The following information was available from the inventory records of the Anthony Company for January
20X7:
Balance at January 1, 20X7
Purchases:
January 6, 20X7
January 26, 19X7
Sales:
January 7, 19X7
January 31, 19X7
Balance at January 31, 19X7
Units
2,000
Unit
Cost
$ 9.775
Total
Cost
$19,550
1,500
3,400
10.300
10.750
15,450
36,550
1,800
3,200
1,900
Assuming that Anthony does not maintain perpetual inventory records, what should be the inventory at January
31, 19X7, using the average cost inventory method rounded to the nearest dollar?
A.
$19,950
B.
$19,998
C.
$19,523
D.
$19,702
E.
none of the above
40.
In a period of rising prices, using which of the following inventory cost flow methods would result in the
highest ending inventory?
A.
fifo
B.
average cost
C.
weighted average cost
D.
moving average cost
E.
lifo
PROBLEM
1. Determination of Optimal Order Quantity. Micro Corp. uses 1,000 units of Chip annually in its production.
Order costs consist of $10 for placing a long distance call to make the order and $40 for delivering the order by
truck to the company warehouse. Each Chip costs $100, and the carrying costs are estimated at 15.625% of the
inventory cost.
Required:
(1)
Compute the economic order quantity for Chip and the total order costs and carrying costs for the year.
(2)
Determine the best order quantity if Chip is purchased only in multiples of 25 units. (Round answers to
the nearest whole dollar.)
2. Order Point, Inventory Levels, Ordering Cost. Charleston Company has developed the following data to assist
in controlling one of its inventory items:
Economic order quantity
1000
liters
Average daily use
100
liters
Maximum daily use
120
liters
Working days per year
250
days
Safety stock
140
liters
Cost of carrying inventory
$1.00
per liter per year
Lead time
7
working days
Required: Compute the following:
(1)
Order point
(2)
Average inventory
(3)
Maximum inventory assuming normal lead time and usage
(4)
Cost of placing one order
3. Safety Stock. Jefferson & Sons Inc. would like to determine the safety stock to maintain for a product so that
the lowest combination of stockout cost and carrying cost would result. Each stockout will cost $100; the
carrying cost for each safety stock unit will be $2; the product will be ordered ten times a year. The following
probabilities of running out of stock during an order period are associated with various safety stock levels:
Safety Stock Level
25
units
Probability of Stockout
50
50
25
75
10
100
5
%
Required: Determine the combined stockout and safety stock carrying cost associated with each level
and the recommended level of safety stock.
LESSON 4
ACCOUNTING FOR LABOR
Learning outcomes of the lesson
At the end of the unit, the students must have:
1. properly identified the different strategies in human resource management
2. properly accounted labor cost using the different methods presented
3. computed the payroll using different schemes of computing compensation
4. properly accounted the treatment of idle time and overtime.
INTRODUCTION
Labor cost is a significant element of cost specially in an organization using more manual operations. It
is the cost of human endeavor in the product and requires coordinated efforts for its control. The
management objective of keeping labor cost as low as possible is achieved by balancing productivity with
wages. The object is often achieved by paying higher wages to limited satisfied workmen with high
productivity. Low wages do not necessarily mean low labor cost. In recent labor agreements, it has been
found that substantial increase in wages has been granted against corresponding increase in productivity,
thereby reducing labor cost per unit.
The gain is reflected both in labor cost as well as in overheads expense per unit, since overheads are
distributed over larger volume. Again, the productivity of labor is quite flexible. Given right type of
motivation and incentive, it can reach amazing scale. It does not have any limitation like machines. Lastly,
in India, under existing regulations, wages may be considered as fixed cost or committed cost rather than
discretionary cost. Once hired, it is very difficult to remove a worker, and therefore, efforts should be made
to make best use by imparting proper training, giving better tools and providing favorable working
conditions. To this end in view, the management has to design methods of controlling labor cost.
In a large organization, the control of labor cost involves the coordinated efforts of the following
departments
(a)
Personnel department — This department is responsible for manpower planning,
recruitment, training, maintaining records of staff and workmen and reporting to
chief inspector of factories and to top management on performance, overtime,
absenteeism, leave, etc.
(b)
Industrial engineering department — This department prepares plans and
specifications of each job, supervises production activities, undertakes time and
motion studies, performs job-analysis, etc.
(c)
Time-office — This department is primarily responsible for collection of data
relating to attendance, time spent on jobs or process by the workmen, and
providing information on attendance and leave to Payroll department.
(d)
Payroll department — This department is responsible for computing total and net
earnings of each worker, preparation of payroll and maintenance of various records
relating to payroll.
(e)
Cost department — This department collects and classifies all cost data relating
to labor utilization by departments, and allocates them to respective job or process
as per available documents.
DIRECT AND INDIRECT LABOR COST
Labor cost may be classified into direct and indirect labor. Direct labor refers to the time spent in altering the
construction, composition, conformation or conditions of the products manufactured. Thus, the time spent by a
worker, identifiable with a particular job or process or operation is a direct labor and is considered directly variable
with the output. All other labor hours spent for the running of the factory in general, and cannot be directly identified
with a job or process or operation are treated as Indirect labor. Examples of indirect labor are salaries and wages
paid to Inspectors, supervisors, maintenance staff, assistants in purchase, stores and offices, security staff, etc.
Again, workers- of production department engaged in productive job or process are called direct workers Labor
hours of direct workers, which cannot be identified with a job or process, such as idle time, waiting time, etc. shall
be treated as Indirect labor. Same treatment is made when direct workers assist maintenance staff in machine
repairs Strictly speaking the distinction between direct and indirect labor depends on the nature of work,
practicability and expediency. The distinction is important because while direct labor is charged to product cost,
indirect labor is treated as a part of overheads expense. Direct labor being variable can be easily controlled. But
indirect labor cost has to be controlled by preparing budget for each department and comparing actuals against
budget periodically.
MANPOWER PLANNING, RECRUITMENT AND TRAINING
Personnel or human resources department generally assess the requirement of man power at various levels of
the organization. Factors such as nature of activities, operations, promotions and retirement, rate of labor turnover,
etc. are considered along with legal restrictions, if any, arising out of labor laws in force. Again, in India the labor
laws restrict lay off of workers, unless approval is obtained from the Government. Hence, extreme care is normally
taken before hiring a worker or filling a vacancy.
Personnel department initiates action for recruitment after obtaining authorization from proper authority. The
department looks for the correct candidate from within the organization, failing which releases advertisement in the
paper or contacts agency or employment exchange. After screening, candidates are normally put to test and
interview in one or two rounds. Appointment letter is issued to the successful candidates specifying position, grade,
job description and other usual terms and conditions of service. A copy of the letter is accepted and returned by
the candidate, which is maintained in his service file. Copies of the same letter are sent to payroll department as
authorization for inclusion in pay-sheet, and to the head of the department concerned for information and record.
Thepersonneldepartmentarrangesforinductionandtrainingprogramofthenewlyappointed
employee.
The
department maintains service history cards for all employees giving details of his name, address, date of birth,
qualifications, experience, dates of joining and separation, change in pay and service and leave records.
ATTENDANCE AND TIMERECORDING
Labor cost is essentially purchase of time from the employees at a price. Hence, the recording of his arrival,
departure and utilization of time in productive and other activities should be accurate. There are two aspects of
recording:
(a) Attendance-i.e. entry-time to the factory, and department, and exit time.
(b) Time-booking - i.e., distribution of time present and paid over jobs or process or operations
as well as in idle time or other indirect work.
The record of attendance is used for satisfying statutory requirements and for calculating earning of the employee
while the record of time-booking helps allocating costs to jobs or process or operations and overheads expenses.
TIMEKEEPING
Various methods of recording attendance are available, which may be grouped under manual and
mechanical methods, as under:
(a) Manual methods:
(1)
(2)
Attendance register method: Under this method, an attendance register is kept at the
entrance of the factory and the worker’s in and out timing at the factory gate are noted,
either by the worker himself or by a staff of the time office. Later, entries are made to the
individual attendance records of the workmen.
Disc method: Under this method, metal discs bearing employee’s numbers allotted by
the personnel department are placed on hooks on a board provided either at the gate or
at the entrance of the department. On entering the factory, the worker removes the disc
bearing his number from the board and places it in a box kept for this purpose. The box is
taken away as soon as normal reporting time is over. A worker coming late will pick up
the disc and put it in the “Late” box provided in the department. Such late box is normally
changed every half an hour up to the maximum late attendance time allowed. The time
keeper records the attendance in the register on the basis of these discs.
(b) Mechanical methods:
Under this method, attendance cards are used in time clocks installed at the entrance of the factory
or department. On entering the factory, the worker takes his card from ‘OUT’ racks and press it inside
the clock, which will print arrival time in ‘IN’ column. He then places it in ‘IN’ rack of the department where
he reports for duty. Late attendance is normally reported in red ink. Similarly, when the employee leaves
the factory, he collects the card from the ‘IN’ rack and punches the time in the clock and keeps it in the
‘OUT’ rack. It is necessary that the timekeeping staff are present at the time of punching the cards to
supervise the procedure. The clock cards are Collected by the timekeeping staff daily or weekly for
recording in Statutory Attendance Register. Such cards are normally used for two-week period.
Some of the recent time clocks are hooked with mainframe computer, so that with the recording of time,
the data is automatically processed for the purpose of the payroll as well as daily, weekly and monthly
reports.
Correct recording of attendance time is very important where wages are paid on the basis of time
worked. Where payment is made by results, such as, by piece rate method, it would still be necessary
to record correctly the ‘in’ and ‘out’ timings.
TIMEBOOKING
Time booking refers to actual utilization of time in the concerned department, job or process or operation.
Proper accounting of labor cost requires an analysis of time purchased, whether the same is recorded manually
or by clock cards. The following documents are generally maintained for the purpose, depending upon the size
of the organization, the degree of mechanization, the extent of accuracy required, etc.
(a) Job card or job ticket
(b) Daily timesheet
(c) Weekly time sheet.
JOB-CARD OR JOB-TICKET
A job card or job ticket is used to record the time spent on each job, having a specified work order or job
order number. Job cards may be of two types, one, which is a job order cost card, and contains
information regarding material consumption as well as time spent by operators The other one is, in
effect, a job ticket, which is issued to an operator by the supervisor and contains only the operation details.
When the operator starts the work, he records the time either manually or through time recording clock
on the card. The finishing time is recorded when the operation is completed. If there is any break in
between, thentime
‘out’ and time ‘in’ are also recorded indicating hours not used on job and shall be considered indirect labor
hours When the job is completed, the operator deposits the card with the supervisor, and collects the
next job ticket. At the end of each day, the time-keeper collects all these cards and records the time for
each job or process or operation.
DAILY TIME SHEET
Daily time sheets are maintained where card time recorders are not used. Each worker is provided with
a daily time sheet, in which he records the particulars of time spent on each job. This is mostly used
where
a
number
of
small
jobs
are
undertaken
during
the
working
hours
Thesheetiscompleteddailyandhandedovertothesupervisorconcerned,whointurn,initials
thesameafterscrutiny,asacheckforcorrectness.
WEEKLY TIME SHEET
Weekly time sheets are similar to daily time sheets with the difference that the worker records
alljobsundertakenduringtheweek.Sincethereisatendencytofillinthesheetsfrommemory once or twice a
week instead of daily posting, chances of error creeping in the actual time spent are more. Often idle time
or waste time is not reported correctly. This can be avoided by signingtheSheetdailybytheSupervisor.
RECONCILIATION OF ATTENDANCE HOUR WITH TIME BOOKED
Time recorded at the gate or at the department as evidenced by clock card or attendance register must
reconcile with the hours spent in the department in job or process or operation along with idle or wasted
time. Time office should compare the number of workmen as per time office record with that shown by
the department within the working hours i.e., within the same shift. Thereafter, total working hours of all
workmen in the department must tally with the hours spent in the various jobs and operations and idle
time. For this purpose, and for accounting of indirect labor cost, along with the job card, an idle time card
indicating reasons for waiting and time spent for each reason should be prepared by each worker.
Similarly, idle time details shall be mentioned in daily time sheet and weekly timesheet.
If clock card shows more hours as compared to total time booked on various jobs/products or operations,
the difference is reported as idle time. If total hours booked are more than those recorded on clock cards,
the error is rectified in consultation with the supervisor and workmen concerned. Where time keeping has
been computerized, the reconciliation of attendance hours with time booked is done through computers
METHODS AND INCENTIVE SCHEMES
Remuneration is the reward for labor and service while incentives are stimulation for extra effort
to perform more efficiently by way of monetary and/or non-monetary inducements. Remuneration
includes salaries and wages, commission, various allowances and statutory bonus. Monetary incentives
refer to those payments which are made in excess over time-rates and piece-rates, and are related to
the output of either an individual or a group. We shall discuss in detail afterwards.
REMUNERATION SYSTEMS
Wages are paid either on time basis or on output basis. When employees are paid as per hours
worked irrespective of the quantum of output produced, the system is called time-rate. When payment
is made on the basis of production or output only ,it is called piece-rate. A combination of both time-rate
and piece-rate is also used. When incentives and bonus are added, various methods of remuneration
may be obtained, which are classified as follows:
(A) Time rates
i)
ii)
iii)
Ordinary level
High wage level
Graduated
(B) Piece rates
i) Straight piece rate
ii)
With guaranteed daily rate.
iii)
Differential piece rates
—
Taylor Plan
—
Merrick Plan
(C) Combination of time & piece rates
i)
Emerson’s efficiency scheme
ii)
Gantt task bonus scheme
iii)
Bedaux scheme
(D) Bonus system
Individual bonus —
i)
Halsey scheme
ii)
Halsey Weir scheme
iii)
Rowan scheme
iv)
Barth scheme
v)
Accelerating premium bonus.
(E) Bonus system
Group bonus —
i)
Priestman’s production bonus
ii)
Rucker plan
iii)
Scanlon plan
iv)
Towne gain sharing plan
(F) Other incentive schemes
Monetary —
i)
Profit-sharing
ii)
Co-partnership
The aforesaid methods are discussed hereinafter.
TIME RATE AT ORDINARY LEVEL
Under this method, payment is made on the basis of time worked, irrespective of the output.
Payment may be made daily, weekly, fortnightly or monthly according to the convention and convenience
of the organization. However, such payment must be in conformity with the existing legislation including
Minimum Wages Act. Normal wages are calculated for hours worked multiplied by hourly rate of wages.
Any overtime work is paid extra.
Application of time rate system is preferred in the following cases:–
1. Where the work demands high degree of skill and quality of production is of utmost
importance.
2. Where services cannot be directly measured, e.g., general helper, supervisory and
clerical staff.
3. Where machine performs the job and workers have no control over the output as in
process industries.
4. Where work is not repetitive, and
5. Where the unit is small and the work requires close supervision.
Advantages of the system are as follows:
(a) Easy to understand and operate.
(b) Easy to calculate, and hence, less clerical work involved.
(c) Easier to negotiate rate with the employees and the unions.
Disadvantages of the system are as follows:
(a) No incentive to increase the output.
(b) No distinction between slow, inefficient, fast and efficient workers
(c) Fails to attract better workers
(d) Cost per unit is not known in advance.
TIME RATE AT HIGH WAGES LEVEL
This method is similar to the earlier one, with the difference that time rates are fixed at a higher level
compared to rates prevailing in the industry in the neighboring areas. Overtime is normally not paid. The
object is to attract efficient employees who can meet with higher level of productivity, thereby reducing
cost per unit in respect of labor as well as overheads. It is very difficult to maintain high level of efficiency
over a long period unless adequate measure is taken to keep a careful watch over performance of
individual employees. Alternatively, the management can create a work-culture by which the employees
are motivated to maintain a sustained level of high productivity.
GRADUATED TIME RATE
Under this method, time rate consists of two elements, such as basic rate which is fixed with the nature
of job, and variable element like dearness allowance which depends on local cost of living index, and
merit awards for personal qualities of the employee. Though the scheme is favorable to both employer
and employees, the determination of a wage index is difficult. The system is complicated and difficult to
administer multiple rates for each class of workers
STRAIGHT PIECE RATE
Under this system, payment is made on the basis of a fixed amount per unit of output irrespective of
time taken. Worker’s earning equals to the number of units produced multiplied by rate per unit. Piecerate may be fixed on the basis of standard time required to produce one unit. The rate is expressed per
standard hour. For example, if rate per straight piece rate is P 2 per unit, and two units can be produced
in one standard hour, then standard hour piece rate will be fixed at P 4. Hence, if a worker produces 10
pieces, it will be expressed as 5 standard hours and the worker will earn P 4 × 5 = P20.
Considerable care and judgment are required for fixing piece-rate, as any loose norm will
increase labor cost and too high standard will create discontent and may lead to labor unrest. Again,
once norm is fixed low, it is very difficult to change it. Piece-rate should, therefore, be determined after
time and motion study followed by trial runs. Another requirement for Piece-rate system is that the jobs
should be repetitive and standard type, and there should be sufficient jobs to feed the workers
continuously. Daily rate as per Minimum Wages Act may have to be paid whose piece-rate will be less
than time-rate.
Advantages of the piece-rate system are as follows :–
a) The system is simple to operate and easy to understand.
b) Workers get payment by results, and hence, shall continue to improve and earn more.
c) Employer is benefited by reduced overhead cost per unit.
d) Labor cost per unit is known in advance and helps price fixation.
Disadvantages of the system are as follows :–
a) There is risk of quality to suffer.
b) Increasing production may lead to more defective and spoilage, loss of material,
damage of tools and machines, unless supervision is intensified.
c) Overstrainonthepartoftheworkerswillcausefrequentabsenteeismandbadhealth.
d) Involves more clerical work and document.
e) Maintenance of discipline for arrival and departure may be a problem.
PIECE RATE WITH GUARANTEED DAILY RATE
Under this system, daily or hourly rate is guaranteed to those workmen who cannot achieve the piecerate norm, and whose earning remains below minimum wages level prescribed by the payment of
Minimum Wages Act. When piece-rate earnings fall below time-rate earnings, his time-rate earnings are
paid. An alternative plan is guaranteed wages according to time rate plus a piece-rate payment for units
above a required minimum. Such a system can operate with a fair production volume or standard by
conscientious workers, who will not push the guaranteed time-rate to a high level and thereby, defeating
the purpose of piece-rate.
DIFFERENTIAL PIECE RATE
F.W. Taylor, the father of scientific management, introduced differential piece rates in terms of
money—a lower piece rate for those who failed to achieve the standard, and a higher piece rate for those
who achieved or excelled the performance standard.
Workers were paid as per rates applicable to their output. The difference between the lower and higher
piece rates were kept so wide, that an efficient worker was amply rewarded, while as low worker was
punished. There was no guaranteed minimum wages. This is called Taylor’s Differential Piece Rate
System.
The following table illustrates the unit cost and earning relationships of five workers who are paid as per
this plan :–
1. Standard production 12 pieces perhour.
2. Normal piece rate @ P1 perpiece.
3. Differential to be applied @ 90% when below standard, and @ 110% when at or
above standard.
Worker
A
B
C
D
E
Output
in 8 hrs
Pcs.
90
95
96
100
110
Lower Higher
rate
rate
P
P
0.90
1.10
0.90
1.10
0.90
1.10
0.90
1.10
0.90
1.10
Total
earning
P
81.00
85.50
105.60
110.00
121.00
Hourly
earning
P
10.125
10.688
13.200
13.750
15.125
Overhead
per pce.
P
2.778
2.632
2.604
2.500
2.273
NOTE : If overhead per day is P 250, the overhead cost per unit reduces significantly with increased
output.
Advantages of the system are as follows:
a) Simple to understand and calculate.
b) High incentive attracts efficient worker.
c) Where overheads are high, it is more beneficial as reduction of cost per unit of
overheads cost more than compensates increased labor cost.
Disadvantages of the system lies in the fixation of higher and lower piece rate differential as any error
may cause a disastrous effect.
Merrick Multiple Piece Rate plan enlarged the differential into three rates, recognizing the difference
between beginners, average workers and superior workers None of the rates are below normal rate. In
fact, the first piece-rate is adopted at 83 % of the normal rate as indicated below:
Efficiency level
— Up to831/3%
— Beyond 831/3% and
— Above100%
Piece rate applicable
Normal
10% above normal rate up to 100%
30% above normal rate
Thus, this plan rewards the efficient worker and encourages the less efficient workers to increase
their output. This method also does not guarantee day wages.
COMBINATION OF TIME AND PIECE RATES
EMERSON’S EFFICIENCY SCHEME
The main features of this scheme are:–
a) Day wages are guaranteed.
b) A standard time is set for each job or operation. Alternatively, a volume of output is taken as
standard.
c) Workerispaidhishourlyratebelow662/3%efficiency.
d) From 66 2/3% till 100% efficiency, payment is made at step bonus rate running from1
%at662/3%levelto20%at100%leverTheappropriateratecanbereadfromspecially compiled tables.
e) Additional bonus of 1 % of the hourly rate is added for each 1 % increase of efficiency above
100%.
The following example will illustrate the plan: Time-rate — P 8 per hour. Standard production per week
of 40 hours: 600 Pcs.
Efficiency standard
%
662/3–
76
81
86
96
–
–
–
–
75
80
85
95
100
Bonus
%
1
2
4
10
20
Calculation:
Worker
pcs.
A
B
C
D
E
F
C
H
Production
per week
390
400
460
500
550
580
600
620
Efficiency
%
65
67
77
83
92
97
100
103
%
1
2
4
10
20
20
23
Bonus
Amount
P
3.20
6.40
12.80
32.00
64.00
64.00
73.60
Total wages Cost per
unit
P
320.00
323.20
326.40
332.80
352.00
384.00
384.00
393.60
P
0.82
0.81
0.79
0.67
0.64
0.66
0.64
0.63
GANTT TASK AND BONUS SCHEME
This is a combined time, bonus and piece-rate plan using the differential piece-rate principle. Its main
features are :–
•
•
•
•
•
Daily wages are guaranteed.
Standards set and bonus is paid if work is completed within the Standard time allowed.
Performance below standard is paid on the hourly rate basis.
Performanceatstandardispaidwithbonusofusually20%ofthetime-rate.
Performance above standard is paid at high piece-rate on his total output. The
Supervisor may also receive bonus, if the workers under him qualify for it.
The piece-rate and bonus rates are fixed for each job and when a job is completed, the worker moves
on to the next job. His earning, therefore, consists of his daily wages plus the sum of all bonuses of the
job, if he reaches above standard. Thus, this plan provides an incentive for
efficientworkertoreachahighlevelofperformanceandalsoprotectsthelessskilledworkers. This plan is
particularly suited to quality production conditions and where fixed overheads are high relative to labor
cost.
Advantages:
f) Very effective scheme, providing both adequate security and real incentive.
g) Simple to understand.
h) Stimulates better supervision.
Disadvantages :
a) Extreme care should be taken to fix the standard and piece-rate.
b) High guaranteed time-rate may frustrate the scheme.
BEDAUX OR POINTSCHEME
Under this system, hourly rate is guaranteed up to standard, and beyond that benefits from
timesavedaresharedbetweenworkersandsupervisorsintheratioof75:25.Bedauxexpressed his standards
in terms of Bedaux Point or “B” which is equal to one minute. An average worker is expected to earn 60
Bs in one hour without any extra effort. The standard “B” in each job is determined by accurate time and
work study. For example, if standard points for a job is 480 Bs and actual number of points earned in
eight hours is 560 Bs, and the rate of pay is P 8 per hour. As per the original Bedaux Point Plan, his
earning will beas follows :–
(P8 × 8) + (75% of 80/60 × P8)
= P 64 + 0.75 × (80/60) × 8
= P 64 + P 8
= P 72.
According to modified Bedaux scheme, the workers receive 100% of the bonus instead of original 75%.
This scheme is suitable where the output can be measured accurately under standardized condition.
Advantages of the system lies in the fact that it is flexible and can be used as an excellent basis for
scientific management and evaluation of job. It requires strong managerial control.
Disadvantages of the system are as follows:
i) Expensive to operate due to more clerical work.
j)
Needs strict supervision to control wastage, as workers tend to hurry up.
BONUS SYSTEM – INDIVIDUAL BONUS
Three schemes under this system combine time wages with bonus for time saved. Under Halsey Plan,
the worker receives his guaranteed time wages whether he completes the job or operation within standard
hour fixed. However, he gets bonus equal to 50% of wages for the time saved in addition to his normal
time wages.
Under Halsey-Weir plan, the premium is set at 30% of the time saved. Other features are similar to Halsey
Plan. For example, Normal hourly rate is P 5 per hour, Standard hour for a job is 8 hours, and time taken
is 6 hours, then the total earnings under Halsey plan will be:
(8 × P 5) + 50% of (8 – 6) × P 5 = 40 + 50% of 10 = P 45
and under Halsey-Weir plan will be :
(8 × P5) + 30% of (8 – 6) × P5 = 40 + 30% of P 10 = P 43.
Advantages
a) Simple to understand and operate.
b) Efficient workers will be able to increase their earnings, while slow workers will not
be penalized as they are assured of day wages.
c) Employer will save 50% of the wages for time saved, and will therefore be interested
to maintain machinery and equipment in good running condition.
Disadvantages
a) Increase in productivity results in lower conversion cost. As a result, employer gains
more with the worker’s efficiency. Therefore, the workers may object to share their
bonus with the employer.
b) Compared to other incentives schemes, this is not strong enough to induce efficient
workers to work harder.
ROWAN PLAN
Under this system, bonus is determined by the ratio of time saved to the allowed time. Normal time wages
is guaranteed. Standard time is determined by multiplying actual output with time allowed per unit. Taking
normal wage rate at P12 per hour and standard performance as 12 units per hour, the earning of workers
for 40 hours a week will be as follows:
Worker
Output
Standard
hours
produced
Time
saved
Bonus
Units
Total
earning P
Earning per
hour P
P
A
432
36
–4
Nil
480.00
12.00
B
480
40
—
Nil
480.00
12.00
C
528
44
4
43.64
523.64
13.09
D
600
50
10
96.00
576.00
14.40
E
720
60
20
160.00
640.00
16.00
Calculation:
Bonus = (Time saved/Time allowed) × Basic wages.
Let us take time allowed for Worker C i.e. 528 × ( 1/12 ) = 44 hours
Hence, bonus payable will be 4 divided by 44 times P480=P43.64. It is evident from the above table
that though it provides sufficient incentive to workers to improve their efficiency, they can earn only a
part of the savings. This may work as a safeguard against workers indifference to quality in order to
increase their earnings.
BARTH SCHEME
Under this scheme, day wages are not guaranteed and payment is also not proportional to
output. Wages are arrived at by multiplying hourly rate by the square root of the product of time allowed
and time taken. In other words,
Earning = Hourly rate ×
For example, if hourly rate is P 3, time allowed is 5 HP and actual time taken is 6 Hrs, the earnings will
be :
= 3×
= 3 × 5.48 =P16.44
and hourly rate will be P 2.74.
If he does in time, he gets P 3 × 5 = P 15.00.
Ifhedoesthejobin4hours,hisearningswillbe
= 3×
= 3 × 4.47 =P 13.41
and his hourly rate will be @ P 3.35.
It is evident that when efficiency increases, the rate of increase in the total earnings fall. This plan is
useful for beginners, trainees and unskilled workers
ACCELERATING PREMIUM BONUS
Under this scheme, bonus increases at a faster rate. There is no simple formula for the scheme.
Generally, it is not considered suitable for workers, but is eminently suitable for supervisors and foremen
who have to extract maximum output from workers.
A popular scheme is available by the graph of y = 0.8x 2 where x is percentage efficiency and y
is earnings.
Percentage efficiency x
x2
y =0.8x2
Percentage earning=y×100
100
120
130
150
1
1.2
1.3
1.5
1
1.44
1.69
2.25
0.8
1.15
1.35
1.80
80
115
135
180
GROUP BONUS SCHEMES
We have so far discussed about bonus payable to individual worker on the basis of their effort.
However, in some areas, bonus scheme for a group of workers is required, specially when,
d) It is difficult to assess the performance of individual workers,
e) The output depends on the combined effort of the workers, and,
f)
to create interest among the indirect workers who contribute generally for
increase of overall output.
Group incentive scheme may be applicable for small groups to the factory as a whole. The
advantages of the scheme are as follows:–
i) Comparatively easy to measure the output.
ii) Economic administration as less clerical work is involved.
iii) Creates a team spirit.
The disadvantages are that efficient workers are not properly rewarded, and inefficient workers
share equally with the efficient ones. The various group bonus schemes are given below.
PRIESTMAN’S PRODUCTION BONUS
Under this method, a standard in terms of units or points is fixed. If actual output measured
similarly exceeds the standard, the workers will receive a bonus in proportion to the increase. For
example, if actual output is 1200 tons as against 1000 tons standard for the month, the workers
will get a bonus equal to 20% of their wages, since output is 20% above the standard.
RUCKER PLAN
Under this plan, employees receive a constant proportion of value added. Value added’
is defined as the increase in realizable value resulting from an alteration in form, location or
availability of a product or service, excluding the cost of purchased material and services. Unlike
conversion cost, value added includes profit. Value added can therefore be calculated as:
(a) Sales value less cost of all purchased materials and services such as,
power and fuel; or
(b) Direct labor plus production overheads plus gross profit.
If the ratio of direct labor to value added at 75 per cent, is taken as standard, and if actual ratio is
72 percent, then 3 percent of actual value added is distributed as bonus, so that the ratio of direct
labor to value added is retained at 75%. Generally, two thirds of bonus earned in a month is
distributed, and balance one third is carried forward to a reserve fund to be used in a month in
which performance falls below standard.
This plan appears to be a more satisfactory method than the normal profit sharing method,
because the workers may be motivated to seek opportunities to perform the jobs more efficiently,
use machines and materials more economically and reduce value added to earn more.
SCANLON PLAN
This plan is similar to Rucker plan, except that the ratio of direct labor to sales value of
production is adopted instead of direct labor to value added.
TOWNE GAIN SHARING PLAN
A
s per this plan, 50% of gain is calculated on the basis of reduction of labor cost against
standard labor cost is paid to individual workers pro-rata in addition to their wages.
OTHER INCENTIVE SCHEMES
These schemes do not relate to the performance of the individual or group workers
directly. Workers receive additional remuneration, a share in the company or better amenities
and perquisites to remain attracted to the company and share with its prosperity. Such indirect
incentives may be grouped under:
(a) Indirect monetary incentives, and
(b) Indirect non-monetary incentives
Indirect monetary incentives include profit sharing and co-partnership, which are becoming more
important nowadays.
PROFIT-SHARING
Profit sharing refers to a scheme of additional payment to the employees over and above
their normal wages and incentives - whether individual or group - by way of sharing the profit
earned during the year. Such payments are made in cash after finalization of accounts at certain
mutually agreed rate between the employer and the employees. In India, this distribution of
available surplus becomes a source of perennial dispute between the employers and the
employees. The Payment of Bonus Act, was introduced in 1965 with a view to settle such
disputes. The minimum and maximum bonus payable has been fixed at 8 1/3% and 20%
respectively up to a certain wage limit. The minimum bonus is payable, even if no profit is
generated.
Apart from profit bonus, there are some other schemes wherein a portion of the profit is
invested by the employer, so that after retirement or separation from the organization, the
employee gets some benefit.
CO-PARTNERSHIP
Under this scheme, employees are allowed to have a share in the capital as well as profit of the
business. The shares held by the employees may or may not have voting rights. Companies often
allow loans to buy shares. This scheme is expected to create a sense of belonging and
partnership, which will encourage them to be more careful in using costly materials and
machineries, and contribute effectively towards prosperity and growth of the company.
However, the following limitations may come in the way of reaching its objective:
(i) Quantum of dividend is too small, and that too is paid long after the year ending.
(ii) Profit depends upon managerial efficiency, and has no direct relationship
with worker’s efficiency.
(iii) It weakens worker’s loyalty to trade union.
INCENTIVE TO INDIRECT LABOR
Performance of indirect workers such as supervisors, maintenance, stores, office and canteen
staff cannot be measured directly, and therefore, introduction of incentive scheme for them poses
a problem. But it is essential to provide incentive to them as much as to the direct workers due to
the following reasons:
a) Indirect workers maintain the facilities for production. Without this, it would be difficult for
direct workers to get incentives for better performance.
b) It is unfair to deprive indirect workers from incentives because it is difficult to measure
their performance.
c) If direct workers enjoy incentives, and indirect workers remain without incentives, it Would
lead to gross dissatisfaction among the latter resulting in poor maintenance and ultimately
lead to labor unrest.
On the other hand, an incentive system for indirect workers will assist in maintaining high efficiency
levels at service cost centers and will create a good team spirit between direct and indirect workers
For the purpose of incentives, indirect workers may be grouped as under:
(a) Those working with direct workers, such as supervisors, inspectors,
checkers, transport workers, etc.
(b) Those rendering general service, such as, sweepers, canteen workers,
maintenance workers, stores, dispensary, time office and other office staff,
etc. For the first group, bonus may be based on the output of direct workers
with whom they are attached. Under this group, wherever standard can be
established say, for material handling, inspection, regular repair, etc.
incentive can be based on those standards. For the second group, bonus to
be paid shall be determined on a wider basis considering output of
department or the factory as a whole, or a percentage of bonus payable to
direct workers, etc.
In designing the incentive scheme, the following general principles should be considered:
1. Payment of incentives should be made at regular interval, preferably biweekly or
monthly
2. Payments should be related to results which should also be published.
NON–MONETARY INCENTIVES
Incentives to the workmen could be given by way of good working environment, facilities
for various needs of the employees and some free benefits which are not related to job functions.
The range of non-monetary incentive is too wide. The objectives of such incentives are as follows
:–making condition of employment more attractive,
(a) promoting better health,
(b) reducing absenteeism,
(c) encouraging loyalty,
(d) minimizing labor turn over, and
(e) maintaining a happy and contented staff.
Non-monetary incentives may be offered in several ways, - some of which may be free, while
others may be subsidized. A few examples are quoted below: –
(a) Canteen — free or subsidized.
(b) Fair Price shop —subsidized.
(c) Medical facilities for employee and his family.
(d) Education and training facilities — to the employee and his children.
(e) Recreation club
(f) Housing facility
(g) Other welfare facilities like holding sports, annual day, long service awards.
(h) Funds contribution-subsidies to sick and benevolent funds.
BASIC PRINCIPLES OFREMUNERATION
Having discussed the various methods of remunerating labor, it is necessary to sum up the principles
underlying the methods. It is true that methods differ from unit to unit according to industry practice,
requirements of individual concerns, labor rates prevailing in the neighboring localities, cost of living index
and employer’s capacity to pay. The basic principles to be considered while selecting a wage payment
system are mentioned below:
1. The method of payment should be simple, easy to understand and to calculate.
2. Fair wages for day’s work should be assured.
3. Wage rate should be commensurate with the demand of the job, requiring
individual skill, effort and initiative of the worker. In other words, there
should be proper reward for work done.
4. Systemshouldprovideincentivetoachievehigherproductivity.Ahigheroutputre
duces labor cost as well as overhead cost per unit.
5.
Workers should be satisfied with the method of payment.
6.
The system should be economical to administer.
7.
The system should assure quality of the product.
8. The system should control waste of material as well as detectives.
It should be remembered that the system of wage payment affects labor cost directly. A
small incentive amount increases labor cost, but at the same time increases output. A higher output
reduces overhead cost per unit, since the fixed overhead expenses are distributed over a larger
unit of output. This is very important where fixed expense is significant and represents sizeable
amount of the total cost.
In order to introduce a good remuneration system, it is necessary to know the contents of the job or
operation that an employee is expected to perform. A detailed analysis of each job and operation will reveal
its characteristics and scope for improvement, and lead to establish methods for measurement of efforts
involved and productivity to be achieved. In big organizations, industrial engineer or time study engineer
undertakes various work studies, while personnel department prepares job evaluation and merit rating for
this purpose.
WORK STUDY
Work study consists of method time and motion study in relation to the performance of a job or
operation. Time study involves the technique of establishing an allowed time standard to perform a given
task, based upon measurement of the work content of the prescribed method, with due allowance for fatigue
and for personal and avoidable delay. [Read “Motion and Time Study” by Benjamin W. Niebel). Time study
is concerned with the determination of standard time required by a worker of average ability, under normal
condition to perform a task. Motion study technique, developed by F.B.Gilbraith, is defined by Benjamin W.
Niebel as “the study of the body motion used in performing an operation, with the thought of improving the
operation by eliminating unnecessary motion and simplifying necessary motions and then establishing the
most favorable motion sequence for maximum efficiency”. Time and motion study is incomplete without
method study, which is concerned with determining the proper method of performing a job. All the three i.e.
time, motion and method study are parts of the total work study which helps management in effective use
of human efforts.
The steps in time and motion study are the following:
i) Identify the work.
ii) Observe the workers performing the job.
iii) Record all the relevant parts of performing job by present method.
iv) Note down wasteful movements and restructure proposed method giving
due allowance for fatigue, interference, etc.
v) Critically examine the proposed method, and develop the most practical,
acceptable and effective method
vi) Install that method as standard practice
The time and motion study serves the following purposes:
a) Standardizing jobs, operations, etc. by providing the best method of
operating within the time allowed
b) Standardization of equipment, methods, materials and working conditions.
c) c)Fixation of wage-rates including piece rates and incentive schemes.
d) Assessing manpower requirements correctly
e) Cost control through proper planning
MEASUREMENT OF LABOR EFFICIENCY AND PRODUCTIVITY
JOB EVALUATION
Job evaluation is a process of analysis and assessment of each job determining its worth
in
relationtoallotherjobswithinanorganizationinordertoprovideabasisforwagesandsalary
structure. It helps determination of correct grade of labor for each job or operation, and
establishes the rationale for differentials in wages and salaries between different groups of
employees.
The objectives of job evaluation is to evolve a systematic job, wages and salary structure
according to characteristic features of each job. Job evaluation also imparts the following
advantages:
a) It helps employer to explain why one job is worth more or less than the other.
b) It helps personnel department to plan manpower requirement, selection and
training of employees. It also helps in placement, promotion and transfer of
employees.
c) It promotes reliability, equity and fair play in the design of wage structure
and removes anomalies, if any.
Methods of job evaluation can be classified into four groups as given below:
(i) Ranking method
(ii) Grading method
(iii) Point rating method
(iv) Factor comparison method.
RANKING METHOD
Under this method, jobs are graded from lowest to highest or vice versa according to
relative requirements and responsibilities. The task of ranking each job is preceded by a careful
job analysis and job description. Each job is valued in terms of other and is based on a survey of
a few broad qualities required of all jobs in varying degrees.
GRADING METHOD
Under this method, a number of grades are fixed and arranged in order of importance. It
takes into account the nature of duty, complexities involved, degree of supervision required,
responsibility and efforts demanded and job description. Once the grades are defined, each job is
studied and assigned to the appropriate grade. Pay scales are normally fixed for each grade. The
entire grading method i.e. review of jobs, placing in the appropriate grades and selection of payscales are done by a committee of experts, who have considerable experience in the subject.
POINT RATING METHOD
Under this method, basic factors common to most of the jobs which determine their
relative worth in the organization are considered. The number of such factors could be many, but
it is convenient to restrict them to a limited number, such as :–
(a) education,
(b) training and experience,
(c) skill,
(d) physical efforts required,
(e) responsibility,
(f) working conditions, and
(g) complexity of duty.
Each of the above job factors is given a relative weightage and is allotted a number of
points.
Thejobsarerankedintheorderofpointsscoredandareplacedinthenumberofpredetermined
grades. Pay-scales are thereafter fixed for each of these grades. Jobs fitted into the grades will
have the same pay scale.
Illustration I
POINT-RATING CHART
Factors
Education
Training and experience
Skill
Efforts
Responsibility
Working conditions
Total points
Job-A
5
10
20
5
20
60
II. GRADING AND PAYSCALE
Points range
40- 70
71 - 90
91 - 100
101 - 110
Job-B
10
5
20
15
10
15
75
Grade
IV
III
II
I
Job-C
15
10
30
20
10
85
Job-D
20
10
25
10
30
10
105
Monthly pay-scale (P)
1000-50-1500
1400-100-2400
2000-150-3500
3000-200-5000
The point rating method is very simple to understand and operate, but the assignment
of points to the factors are arbitrary and may differ from person to person. To obviate such
weakness, it may be required to collect a number of observations and then remove the element
of business from the results.
FACTOR COMPARISON METHOD
Like point rating method, this method also considers a few key factors common to a few
key jobswhichareevaluated.Thekeyjobsateachlevelwithintheexistingwages/salariesstructure are
ranked against each factor at a time. Instead of ranking them as a whole, each of the factors is
assigned by adding up the money value of all factors All other jobs are evaluated
againstthekeyjobsonthebasisofmoneyvaluesassignedtovariousfactorsinthekeyjobs.
MERIT RATING
Merit rating is a systematic evaluation of an employee’s personality and performance by his
superior in his existing job. The assessment is made to find out the worth of each employee
considering his suitability on the job in relation to various factors, namely,—
(a) Education, training andexperience,
(b) Jobknowledge,
(c) Initiative and aptitude forwork,
(d) Cooperation,
(e) Attendance and discipline,and
(f) Ability to get along withothers,
It will be evident that some of the factors are directly related to the employees work, while
others are not related to his work but his association with others as a member of the group or
organization. Points are allotted to each factor and the total points scored will be his merit rate.
The object of merit rating is to reward an employee on the basis of his merit. Increments and
promotions are the normal outcome of merit rating system.
Merit rating is different from job valuation, as the former rates the employees on the job,
while the latter rates the job itself. Job evaluation is the assessment of the relative worth of jobs
within an organization, while merit rating is the assessment of the performance of employees in
relation to their jobs. Job evaluation helps to set up a rational wage and salary structure, whereas
merit rating helps to determine fair wages for each employee.
Further advantages of merit rating system are noted below:.
1. Since reward is related with merit rating, it acts as an incentive to the workers
to improve himself as well as his productivity.
2. Merit rating creates competition among member of staff and workmen.
3. It eliminates discrepancies among workers by linking reward to merit, and
hence, tends to improve labor relations and reduces labor turnover.
The only limitation that merit rating system suffers comes from human factor involved in deciding
the points. Thus, the rating may be arbitrary, influenced by past records, and therefore, may not
attract the workers
PAYROLL PROCEDURE
Salaries and wages are prepared in payroll department, which is normally a section of accounts
department. All permanent records of an employee are maintained in the payroll department
starting from his letter of appointment and report of resumption of duty by the departmental
foreman concerned. Periodical change in wage rate arising out of normal increment or promotion
is intimated by the personnel department. Thus, all permanent details such as name, token No.,
department, wage-rate, provident fund membership No., etc. are recorded on the wages sheet in
advance i.e., before the details of actual work during the wage-period are prepared by Personnel
department, and sent to payroll. When wages are paid on the basis of time, Time-Cards are sent
to payroll department after tallying the hours present with hours worked and idle and rest time.
Similarly, piecework cards are authorized by the department concerned certifying accepted units
of production and such cards form the basis for wage payment under Piece-rate. For monthly paid
staff, a copy of the attendance register is sent to payroll department for the preparation of wages
sheet.
Athirdsetofinformationissenttopayrolldepartmentforvariousdeductionstobemadefrom the wages. It
is important to note that deductions from wages are required to be authorized. Some of the
deductions are statutory viz. income-tax, professional tax, , provident fund contribution, etc. Other
allowable deductions are house rent, cooperative society dues, advance taken by workers, etc.
Payroll is prepared with the aforesaid information either serially by token numbers or department
wise. It is advisable to prepare department wide payroll due to the following advantages: –
a) Payroll preparation work can be divided
b) Departmental labor rate can be developed.
c) c) Reconciliation can be easier
d) Wage payment can be made in respective departments with the payroll.
e) Assistinthepreparationofbudgetandcontrolofdepartmentallaborcost.
In the payroll, the employee’s name, ticket No., hours worked - normal and overtime, Wage rate and
dearness allowance rates shall be mentioned. His gross earnings shall be computed with each component
such as basic wages, dearness allowance, overtime wages, overtime premium, house-rent allowance, shift
allowance, attendance bonus, incentive bonus, etc. Similarly, details of all deductions and net wages
payable are indicated. Payee’s signature is obtained against net wages figure. A specimen of wages sheet
is reproduced below:–
WAGES SHEET
Department:
For the month of:
Ticket No. Hours
Name
workers
hourly
rate
Normal
HP
Overtime
HP
Overtime
premium
Dearness House
allowance rent
allowance
Gross
wages
DEDUCTIONS
Income
tax
Professi EISC
onal tax
PF
Others
Total
Net
wages
Signatures
COMPUTERIZED PAYROLL
With the increased use of computer, large organizations as well as small concerns have
computerized payroll. In big organizations, a database is created with all permanent. details of each worker,
and thereafter, information is continuously fed in the computer starting from timekeeping and time-booking
till preparation and accounting of payroll.
WAGES DISBURSEMENT
Wages sheets, after computation are verified by a second person to avoid any error. They are
authorized by a responsible officer, and then handed over to the cashier for payment. It is a good practice
to withdraw the net amount payable from the bank, and then use the same amount for filling the pay
envelopes. Each envelope shall contain the pay slip and the cash equivalent to net payable amount. Pay
slip contains all the details of an employee as it appears in the wage-sheet. This is obtained by duplicating
process while preparing wages-sheet manually. Under computerized system the pay slip is printed along
with the payroll and itself can be used as envelope. Actual disbursement can take place from cash
department or from the shop- floor, depending on the size of the organization, and convenience of
identification of the employees.
INTERNAL CONTROL OF WAGES
Internal control at every stage i.e. from timekeeping till actual disbursement is necessary to check fraudulent
payment of wages. Hours attended are reconciled with hours booked, which again should tally with the
hours paid as per payroll. This will check inclusion of dummy workers in the payroll. Number of workmen
and hours worked as shown in attendance register must tally with the time cards and total hours clocked
therein. Timekeeping or personnel department staff shall not take part in the computation of payroll, while
payroll department staff shall not disburse wages. Cashier or his staff should disburse wages against
production of identity card in the presence of departmental supervisor.
In the preparation of payroll, the following checks should be observed:
a) Basic information of each employee should be periodically verified with the
records of personnel department.
b)
Any change in the basic records such as addition and deletion of names
transfer, promotions, change in rates of pay, etc. shall be properly
authorized and duly verified after incorporating the change.
c) Overtime working should be properly authorized.
d) Calculation of incentive schemes should be verified independently by accounts.
e) Payment of wages to a workman on other than payday should be made after
verification of the identity of the worker. Unpaid wages should be maintained
in a register for proper control.
f) Payment of wages should not be made in cash to any worker on behalf of
an absentee worker, unless the former requests for the same in writing and
the latter obtains approval from his department head
LABOR ANALYSIS AND ACCOUNTING
Analysisofwagesisessentialforaccountingpurposes.Suchanalysisismadeinwagesanalysis book or
in a computerized statement. Gross-wages paid to direct and indirect labor are distributed over
work-in-progress account for jobs or process for direct labor and overheads control account for all
indirect labor is shown in.
WAGES ANALYSIS
PERIOD:
Cost
centre
DEPARTMENT:
Total
P
Work-lnprocess.
control
a/c
P
Factory
overhead
control
a/c
P
Admn.
overhead
control
a/c
P
—————
Selling/Distrn.
overhead
control
a/c
P
Total
Wages analysis is prepared with the help of :–
(i)
timecard,
(ii) piece-rate card,
(iii) job cards, and
(iv) idle timecard,
so that the hours worked is fully accounted for in respect of job or process as well as idle time or wasted
time. If overtime is worked, the accounting of the same shall be noted in the overtime authorization slip or
time card. In case of direct labor, the time booking will be either on job order/work order number or process
account. All indirect labor hour swill be collected understanding order numbers or account code numbers
Once wages sheet is prepared, hourly rate of each worker and the departmental rate will be available. labor
hours will be multiplied by the wage rates to arrive at the expense under each standing order No./ Accounts
Head. Where computerized system is not available, a statement of wages summary is prepared in the
following manner before preparing wages analysis
WAGESSUMMARY
COST CENTER:
PERIOD :
——————
Ticket No. Job order
Standing
No.
order No.
Hours
worked
Pieces
produced
Gross
wages
——————
Rate
Labor
per hour
cost
Rate per
piece
Total labor cost of each of the Cost Centers will be posted in Wages Analysis Statement.
ACCOUNTING OF WAGES
In an integrated accounting system, the wages is accounted for in the following manner by using time cards,
attendance hours, job cards, piece rate card and idle time card:
IDLE TIME ANDOVERTIME
IDLE TIME
Idle time refers to that portion of hours paid which are not utilized for productive purposes. This
is reflected in the time card as the hours not booked in job or work order, and during which time
the worker remains idle.
Idle time can be classified under normal and abnormal idle time. Normal idle time represents
inevitable loss of labor hours arising out of the following situations:
a) Time lost between factory gate and place of work, tea break, lunch break, etc.
b) Time lost in setting the machine, tools, change-over from one job to another,
fatigue, etc.
c) Time lost in power-failure, machine breakdown, waiting for material, etc.
Out of the above causes, some are inherent in the process and controllable to a great extent.
While time lost due to external causes such as general power-failure are uncontrollable in the
hands of the management. Thus, it is possible to identify normal idle time, and any loss of time
beyond the normal allowed hours shall be called abnormal idle time, such as:
a) Excessive machine-breakdown.
b) Excessive internal power failure.
c)
Excessive waiting time for material, instructions, etc.
d) Too much time to rectify defectives.
e) Strike, lockout, fire, floods, etc.
It is evident that most of the abnormal idle time arises out of abnormal situations. It is important
to segregate normal and abnormal idle time arising out of internal as well as external reasons for
accounting and control purposes.
Idle time can be controlled by adopting the following measures: –
a) Preparation and analysis of labor utilization report with breakdown of idle time.
b) Minimizing machine breakdown by adopting preventive maintenance.
c) Proper material and production planning, and follow-up system.
d) Timely purchase of materials and components.
A specimen format of labor utilization report and idle time report is appended hereinafter :
Labor Utilization Report
Department:
Week ending:
Ticket
No.
present
Normal
hours
Overtime
hours
Total
hours
Booked
tojobs
Idle
hours
Idle Time
Report
%Idle
Standard
HPto
Hoursof
totalhP
jobs
productive hours
Department:
Total
idle
hours
Machine Power
break- failure
down
% ofStd.
HPto
Week ending:
Change No
over material
No
Others
component
Total hours
attended
incl. of
O.T.
% Idle
hours
to total
hours
A careful analysis of the reasons for idle time will disclose the problem areas. Attention of the
management should be focused to the controllable areas for effective remedial action.
ACCOUNTING OF IDLE TIME
Normal idle time of all workers should be collected understanding order number and charged to
factory overheads. However, some of the normal idle time of direct workers, which are associated
with the job or work order, such as, time taken for machine setting, change-over or tool setting,
can be added to the product cost as direct wages by inflating the hourly rate of wages. For
example, if such idle time is normally 10% of total hours and wages paid for 8 hours is P 72, then
direct labor cost will be P 72 divided by 7.2 (i.e. 8 hours less 0.8 hrs.)
= 10 per hour.
Abnormal idle time cost shall be collected as per standing order numbers or accounts code
numbers and shall be charged to costing profit and loss account. Under no circumstances,
abnormal idle time can be charged to product-cost.
OVERTIME
The control of overtime is very important, because of its tendency to increase and to become a
normal practice for earning extra money. It has harmful effect on the health and morale of the
workers, besides unfavorable effect on productivity. It may also lead to high absenteeism.
Theovertimehoursshould,therefore,becontrolledrigorously.Exceptingunavoidablereasons,
overtimeworkshouldnotbeallowed.Sanctionedovertimeworkshouldbesupervisedproperly
toensurefullutilizationoftime.Dailyorweeklyovertimereportshouldbereviewedbyhigher
management.
Overtime is normally paid at a rate higher than normal wages. Usually, it is one and half or double
the normal wage-rate. The extra amount over the normal wage-rate is called overtime premium.
Normal wages form part of direct labor cost. The charging of overtime premium needs
consideration of the circumstances under which overtime was undertaken, and accordingly, the
standing order number will be debited.
ACCOUNTING OF OVERTIME PREMIUM
a) If overtime is paid to complete a job at the request of the customer, overtime
premium is charged to the job order concerned.
b) If overtime is undertaken in order to cope up with increased production,
overtime premium is treated as factory overheads. Alternative method is to
distribute the overhead premium over all the jobs undertaken during normal
as well as overtime hours at an average rate
c) If overtime is paid for any capital order, such as, fabrication of a machine to
be used internally, the overtime premium shall be charged to capital work
order account.
d) If overtime is worked to recover production loss due to abnormal conditions
such as, strike, lock out, flood, etc., the premium should be charged to costing
profit and loss account.
Overtime work should be controlled in the following ways —
a) No overtime work shall be allowed without prior authorization.
b) If overtime is unavoidable, then it should be planned in advance, and actual
overtime hours should be compared against plan.
c) Overtimehourswithnormalworkinghoursshouldbereporteddaily.Amonthlyover
time report showing overtime hours, and cost compared to the previous
month as well as plan should be submitted to higher authority.
d) Cost of overtime work vis-a-vis recruitment of additional worker should be
reviewed periodically.
LABORTURNOVER
Labor turnover is defined as the rate of change of labor force in an organization during a specified
period. Change in labor force takes place due to separations and new appointments, and
therefore, cannot be avoided totally. However, a high labor turnover ratio adds to high cost and
low productivity. It shall therefore be kept at as minimum level as possible by analyzing the causes
and initiating remedial measures to control it. The labor turnover rate depends upon many factors,
such as, nature of the industry size and location of the unit, proportion of male or female in labor
composition, etc.
MEASUREMENT OF LABOR TURNOVER
Measurement of labor turnover should be made department wise and for skilled and
highly skilled labor separately instead of a blanket rate.
There are three distinct methods of measuring labor turnover based on separation and
replacement of labor. The methods of computing labor turnover are:
(a) Separation method labor turnover
Number of separations in a period
Avg. no. of employees in
100
the period
(b) Replacement method Labor turnover=
Number of replacements in a
period
Avg. no. of
100
employees in the period
However, new recruitment for some expansion project should not be
included in the total of replacements.
(c) Flux method Labor turnover
1
(No. of separations No. of replacements in a period)
2
Avg. no. of employees in the period
100
In the above three methods, average number of employees denotes the simple average
of the number of employees at the beginning and at the end of the period on pay roil.
Thechoiceofaparticularmethoddependsontheemphasisgivenonseparationorreplacements
or both. However, whichever method is adopted should be followed all through for effective
comparison and analysis.
CAUSES OF LABOR TURNOVER
Various causes of labor turnover can be broadly divided into the following three categories:
(a) Personal causes:
i)
ii)
iii)
iv)
v)
Dissatisfaction with job, remuneration, locality or environment.
Domestic reasons like marriage.
Change for betterment.
Retirement due to superannuation or ill health.
Death. In the above cases the employer can hardly do anything to prevent it.
(b) Unavoidable causes:
i)
ii)
iii)
iv)
Redundancy due to seasonal nature of business.
Shortage of resources like, material, power, finance, etc.
Change of plant location.
Drop in market demand for the product.
v)
Discharge for disciplinary action.
In the above cases, the employer has to ask some of the employees to leave the organization.
(c) Avoidable causes:
i)
ii)
iii)
iv)
v)
vi)
Dissatisfaction with job or remuneration.
Unsatisfactory working conditions.
Lack of career prospect.
Bad relationship with superior and co-workers
Lack of transport, accommodation, medical and other facilities.
Lack of amenities like sports and recreation centers, schools, etc.
In respect of the above causes, the management can take remedial action to keep such
separations at the minimum.
EFFECT OF LABOR TURNOVER
Generally, high labor turnover results in increased cost and low productivity due to the following
situations:
(a) It disturbs regular work force. Inclusion of new employees’ retards flow of
production, since efficiency of new workers will be lower than others Lower
rate of production will increase overall cost of production.
(b) It increases defectives and spoilage, and may adversely affect machines
and equipment for inefficient handling.
(c) For new recruits, selection, training and orientation expenses leads to increased cost.
A very high labor turnover has adverse effect not only on the organization or industry concerned, but it
has repercussions on the society at large. It is a loss, which may lead to higher cost and higher prices with
consequential cost effective to employ labor as before. However, a low labor turnover indicates dynamism
and mobility. Specially, among young and energetic workers there shall always be some movement for
better future.
COST OF LABOR TURNOVER
The cost of labor turnover can be grouped under two categories:
(a)
Preventive costs represent those expenses which are incurred, as the
heading signifies, to keep the labor turnover at a low level by maintaining a
satisfied and contented employee. These costs include the following:
(i)
(ii)
(iii)
Personnel administration
(iv)
(v)
(vi)
Employee development program
Medical facilities
Welfare activities, such as, sports and recreation facilities, education
for children, housing facilities, subsidized canteen, etc.
Better retirement benefits
Attractive remuneration
(b)
Replacement costs are those which arise due to labor turnover. The
expenses start with the recruitment process, and ends with the new entrant
becoming an efficient worker, and include the following:
(i)
(ii)
(iii)
(iv)
(v)
Cost of recruitment, training and induction of new workers
Loss of production due to the time lag between separation and
recruitment, and low productivity of the new workers
Cost of excessive defectives and spoilage.
Costassociatedwithabnormalbreakageoftoolandmachineriesbynewentrants.
Cost of additional supervision required for new entrants
The cost of labor turnover can be expressed as a ratio of the average number of workers
employed or replaced.
Illustration:
No. of employees at the beginning
No. of employees at the end
Replacements
Preventive cost
a) Personnel administration
-
a) Personnel administration
b) Medical facilities
c) Welfare expenses
d) Retirement scheme
TOTAL
1,960
2,040
160
P
14,000
14,000
6,000
25,000
55,000
100,000
REPLACEMENT COST:
a) Recruitment & training
b) 40% wages of new entrants
not charged to direct labor
c) Loss of production
d) Cost of defectives scraps. reworking
e) Other costs like tool & machine
breakage etc.
TOTAL
Total cost of labor turnover
Average No. of employees = (1960 + 2040) divided by 2 = 2000 Cost
per employee = P124000 divided by 2000 = P 62
Cost per replacement = P 124000 divided by 160 = P 775
8,000
6,000
6,000
2,000
2,000
24,000
1,24,000
TREATMENT OF LABOR TURNOVER
The cost of labor turnover is generally treated as overhead expenses. Expenses are
collected as per standing order numbers and are charged to overheads expense. Sometimes
replacement
costisidentifiedasadepartmentaloverheadifthereplacementismadeinaparticulardepartment.
However, the normal practice is to collect the total cost of replacement and apportion on the basis
of number of employees in each department.
CONTROL OF LABOR TURNOVER
Labor turnover ratio should be watched closely by management. For this purpose labor
turnover can be analyzed by age group, by length of service and by sex. and the current rate
should be compared with the industry ratio and local trend. A monthly report on the labor turnover
should be presented to the management highlighting the causes for separation for which exit
interview should invariably be taken with the person leaving the organization. The report may be
submitted as per following format:
LABOR TURNOVER REPORT
Department:
Particulars
A. Number of employees at the beginning
B.
Number of employees at the end
C.
Average employees during the month.
D.
Number of separations
E.
Number of employees joined
F.
LABOR TURN OVER RATIO
(D divided by C)
This month
Period :
Last month Year to date This
month Last month
SELF-TEST QUESTIONS
PROBLEM 1.
Labor Costs Under Straight Piecework Plan. The following labor data for the past week were prepared
for B. Masterson, an employee of Boot Hill Corp.:
Day
Monday ..................................................................................
Tuesday .................................................................................
Wednesday ............................................................................
Thursday ................................................................................
Friday .....................................................................................
Units Produced
110
125
120
135
130
Hours Worked
8
8
8
8
8
Masterson's wage rate is $15 per hour, and the standard production rate is 15 units per hour.
Required: Determine the daily wages for Masterson and the labor cost per unit for units produced during
each day of the week, assuming that the company is on a straight piecework incentive wage plan and that
a worker is guaranteed a wage of $15 per hour. (Round the unit labor cost to two decimal places.)
SOLUTION
Day
Monday ........................
Tuesday .......................
Wednesday ..................
Thursday ......................
Friday ...........................
Excess Units
Produced
-5
-15
10
Bonus
-$ 5
-15
10
Regular Pay
$120
120
120
120
120
Unit Labor
Cost
$1.09
1.00
1.00
1.00
1.00
Total Pay
$120
125
120
135
130
Base wage rate/standard production rate
= $15 per hour/15 units per hour
= $1 labor cost per unit for units produced each day
PROBLEM 2.
Labor Cost Under 100-Percent Bonus Plan. B. Parker, an employee of B. Robber and Company,
submitted the following data for work performed last week:
Day
Monday ...............................................................................................................
Tuesday ..............................................................................................................
Wednesday .........................................................................................................
Thursday .............................................................................................................
Units Produced
Each Day
22
24
30
21
Friday ..................................................................................................................
27
During the week, Parker worked 8 hours each day and was paid a flat hourly wage of $10, plus a bonus
based on the 100% bonus plan. Standard production is 3 units per hour. The bonus is computed on a
daily basis.
Required: Prepare a report for Parker, showing daily earnings, the daily efficiency ratio, and the labor
cost per unit produced each day. (Round labor cost per unit to two decimal places.)
SOLUTION
Daily
Day
Earnings
Monday ....................................................
$ 80
Tuesday ...................................................
80
Wednesday ..............................................
100
Thursday ..................................................
80
Friday .......................................................
90
Daily
Efficiency Ratio
.9167
1.0000
1.2500
.8750
1.1250
Labor Cost per Unit
Produced Each Day
$3.64
3.33
3.33
3.81
3.33
PROBLEM 3.
Effect of Wage Increase on Higher Productivity; Pricing a Unit of Output. Walo Widget Inc. is in the
process of completing labor negotiations for the coming year. Part of these negotiations call for an
increase in the base wage rate for direct labor from $10 to $12 per hour, with a corresponding increase in
fringe benefits. At present, fringe benefits amount to 35% of total wages, and this percentage will remain
unchanged with the new contract. The present labor standards call for 8 direct labor hours per unit of
output. Other conversion costs amount to $40 per unit, of which 75% is for variable costs. Materials
costs amount to $8 per unit. Administrative costs are fixed and amount to $10 per unit at the present
production level. Products are sold with a gross margin of 30% on sales.
Required:
(1)
Compute the current selling price of a unit of output.
(2)
Compute the new selling price to be charged if there is no increase in productivity as a result of
the new labor contract.
(3)
Compute the selling price to be charged if the new labor contract were accompanied by a 20%
increase in productivity.
(Round all computations to the nearest whole cent.)
SOLUTION
(1)
Present
Production costs:
Direct labor cost...............................................
Fringe benefits.................................................
Variable cost....................................................
Fixed cost ........................................................
Materials cost ..................................................
Total ................................................................
Selling price10 .......................................................
1
$10 per hour x 8 hours = $80 per unit
$12 per hour x 8 hours = $96 per unit
2
(2)
With Wage
Increase
$
$
80.001
28.004
30.007
10.008
8.00
156.00
$
222.86
$
(3)
With Wage and 20%
Productivity Increase
$
$
96.002
33.605
30.00
10.00
8.00
177.60
$
80.043
28.016
30.00
8.339
8.00
154.38
$
253.71
$
220.54
3
$12 per hour x (8 hours/1.20 units) = $12 per hour x 6.67 hours = $80.04 per unit
35% x $80 unit direct labor cost = $28 per unit
5
35% x $96 unit direct labor cost = $33.60 per unit
6
35% x $80.04 unit direct labor cost = $28.01 per unit
7
75% x $40 = $30 per unit
8
25% x $40 = $10 per unit
9
$10/1.20 units = $8.33 per unit
10
Production costs/(1 - .30 gross profit ratio) = Selling price
Present: $156/.70 = $222.86
With wage increase: $177.60/.70 = $253.71
With wage and 20% productivity increase: $154.38/.70 = $220.54
4
PROBLEM 4.
Learning Curve Effect on Total Cost. Armstrong-Glenn (A-G) Inc. is preparing to bid on the
construction of seven additional rocket carrier frames for launching communication satellites. Under a
special contract, the company has already built one frame with the following costs:
Materials .............................................................................................................................
Labor (60,000 hrs.) .............................................................................................................
Variable overhead:
50% of direct labor cost.................................................................................................
On the basis of materials used......................................................................................
Total ....................................................................................................................................
$
800,000
750,000
375,000
150,000
$ 2,075,000
Variable overhead based on materials used represents materials storage cost. For seven frames, this
cost would be $1,050,000. The company was informed that the maximum acceptable bid is $2,000,000
per unit. However, A-G will not place a bid unless it can recover its costs plus a $600,000 gross profit per
frame. An 80% learning curve is in effect.
Required:
(1)
Determine the total direct labor hours required for all eight frames.
(2)
Determine the total cost for the seven frames covered by the new bid.
(3)
Determine the profit (or loss) per unit if a bid of $2,000,000 per frame is offered. (Round all
amounts to the nearest whole dollar.)
(4)
Should A-G accept the contract at a bid price of $2,000,000 per frame?
SOLUTION
(1)
Accumulated Number of
Times Task Is Performed
1
2
4
8
Accumulated Average Time
per Task Unit (in Hours)
60,000
48,000 (60,000 x .8)
38,400 (48,000 x .8)
30,720 (38,400 x .8)
8 units x 30,720 average hours per unit
= 245,760 total direct labor hours required
(2)
(3)
(4)
Cost for 7 frames covered by bid:
Materials (7 units @ $800,000)..........................................................................
Labor (245,760 total hours - 60,000 hours for first unit)
x (12.50 per hr.) ...........................................................................................
Variable overhead: 50% of $2,322,000..............................................................
Materials storage as given .................................................................................
Total...................................................................................................................
Bid price per unit ................................................................................................
Per-unit cost ($10,133,000/7) ............................................................................
Gross profit per unit ...........................................................................................
$
5,600,000
2,322,000
1,161,000
1,050,000
$ 10,133,000
$
$
2,000,000
1,447,571
552,429
No. The profit per unit will be less than the required profit per unit by $47,571
($552,429 - $600,000 required profit).
PROBLEM 5.
Organizational (Gainsharing) Plan. The Humanistic Company employs an organizational incentive plan
for its entire manufacturing facility. For the year 19B, 850 employees were eligible, and each participated
equally.
The plan provides for a gainsharing pool totalling 30% of the value of wages being saved. The
saving is computed by determining the prior year's productivity ratio (standard hours for work done
divided by total actual direct and indirect labor hours). This ratio (rounded to six decimal places) is then
divided into the standard hours for the work being done during the current year. The resulting figure is
compared to current year's actual direct and indirect labor hours.
Standard hours for work done ........................................................................
Total actual direct and indirect labor hours ....................................................
19B
776,000
1,695,000
19A
725,000
1,650,000
The 19B average hourly pay plus labor fringe benefits was $21.
Required: Compute the gainsharing incentive, rounded to the nearest dollar, in total and per employee.
SOLUTION
19A productivity ratio =
725,000 ) 1,650,000 = .439394
Hours needed for 19B production at 19A productivity ratio =
776,000 ) .439394 .........................................................................................................
Less total actual direct and indirect labor hours ..................................................................
Hours saved ..................................................................................................................
Value of wages saved = 71,069 x $21 = $1,492,449
Employee gainsharing incentive total =
$1,492,449 x 30% = $447,735
Gainsharing incentive per employee =
$447,735 ) 850 employees = $527
1,766,069
1,695,000
71,069
ASSESSMENT
MULTIPLE CHOICE
1.
To check the accuracy of hours worked, one would ordinarily compare clock cards with:
A.
employee earnings records
B.
personnel records
C.
job tickets
D.
labor variance reports
E.
time recorded in the payroll journal
2.
Uno Manufacturing Corporation has found that the production of a certain product is subject to an
80% learning curve. Production is in lots of 100 units, with 8 hours required for the first lot each time the
product is manufactured. The total time to produce 400 units is:
A.
19.52 hours
B.
24 hours
C.
32 hours
D.
20.48 hours
E.
25.6 hours
3.
A company started a new process and during the first week found that the number of units
produced was considerably less than standard. As time progressed, the company noted that production
increased until it reached the standard level several weeks later. After that, there was little improvement
in production rates, which was probably a result of:
A.
installation of a standard cost system
B.
better incentive plans
C.
a labor efficiency variance
D.
the learning phenomenon
E.
education of newly hired employees
4.
A ratio that is employed in connection with the productivity and performance standard to measure
the operating achievement of an operation is the:
A.
productivity-efficiency ratio
B.
physical output per labor-hour ratio
C.
base-rate ratio
D.
fringe-cost ratio
E.
performance-report ratio
5.
The document that is used to secure information as to the type of work performed is the:
A.
labor voucher
B.
time ticket
C.
daily efficiency report
D.
clock card
E.
requisition
6.
The incentive program that bases an employee's bonus on meeting an objective stated in terms
of time per output unit is:
A.
group learning-curve plan
B.
100-percent group bonus plan
C.
straight piecework plan
D.
Emerson efficiency system
E.
100-percent bonus plan
7.
The company division that is responsible for recording the direct labor cost on the appropriate
production reports and the indirect labor cost on the departmental cost analysis sheets is:
8.
A.
Timekeeping Department
B.
Production Planning Department
C.
Personnel Department
D.
Payroll Department
E.
Cost Department
To curtail the wage-price spiral requires that:
A.
wage increases must be greater than unit cost increases
B.
productivity increases must be greater than or equal to wage increases
C.
unit cost increases must be greater than wage increases
D.
direct labor cost increases must be in the form of fringe benefits
E.
aggregate labor cost increases must not be in the form of fringe benefits
9.
An 80% learning curve was in effect for a certain industry. The first time the task was performed,
it required a time of 800 minutes. When the task was performed for the eighth time, the cumulative
average time per task, rounded to the nearest minute, equaled:
A.
6,400
minutes
B.
800
minutes
C.
512
minutes
D.
410
minutes
E.
3,277
minutes
10.
The Webb Company's new process will be carried out in one department. The production process
has an expected learning curve of 80%. The costs subject to the learning effect for the first batch
produced by the process were $10,000. Using the simplest form of the learning function, the cumulative
average cost after the sixteenth batch is:
A.
$10,000.00
B.
$5,120.00
C.
$3,276.80
D.
$4,096.00
E.
$8,000.00
11.
If a firm is considering the use of learning-curve analysis in the determination of labor cost
standards for a new product, it should be advised that this technique generally is most relevant to
situations in which the production time per unit decreases as additional units are produced and the unit
cost:
A.
increases or decreases unpredictably
B.
increases slightly
C.
increases substantially
D.
decreases
E.
does not change
12.
A construction company has just completed a bridge over the Snake River. This is the first bridge
the company ever built, and it required 100 weeks to complete. Now having hired a bridge construction
crew with some experience, the company would like to continue building bridges. Because of the
investment in heavy machinery needed continuously by this crew, the company believes it would have to
bring the average construction time to less than one year (52 weeks) per bridge to earn a sufficient return
on investment. The average construction time will follow an 80% learning curve. To bring the average
construction time (over all bridges constructed) below one year per bridge, the crew would have to build
approximately:
13.
A.
3
additional bridges
B.
7
additional bridges
C.
8
additional bridges
D.
15
additional bridges
E.
2
additional bridges
Which of the following may be scheduled in production planning by the use of learning curves?
A.
subassembly production
B.
delivery dates of finished products
C.
labor assignments
D.
purchases of materials
E.
all of the above
14.
15.
The assumption(s) that characterizes better human resource management is:
A.
there is a vast pool of ideas in the workforce waiting to be tapped
B.
people who do the work are best qualified to improve it
C.
decision making should be pushed down to the lowest level possible
D.
worker participation increases commitment to company objectives
E.
all of the above
To be successful, an incentive wage plan must:
A.
provide for proportionately more pay for output above standard
B.
set fair standards so that extra effort will result in bonus pay
C.
result in immediate reward every payday
D.
be applicable to situations in which a worker can increase output
E.
all of the above
16.
The incentive wage plan in which the production standard is computed in minutes per piece and
is then translated into money per piece is the:
A.
double-time plan
B.
straight piecework plan
C.
100-percent bonus plan
D.
group bonus plan
E.
none of the above
17.
An incentive wage plan under which a worker's production is divided by the standard quantity,
resulting in an efficiency ratio by which the base wage rate is multiplied, is the:
A.
group bonus plan
B.
straight commission plan
C.
straight piecework plan
D.
100-percent bonus plan
E.
none of the above
18.
The department responsible for recruiting and employment procedures, training programs, job
descriptions, and job evaluations is the:
A.
Payroll Department
B.
Personnel Department
C.
Cost Department
D.
Production Planning Department
E.
Timekeeping Department
19.
The department responsible for work scheduling, release of job orders to the producing
departments, and the dispatching of work in the factory is the:
20.
A.
Timekeeping Department
B.
Payroll Department
C.
Personnel Department
D.
Cost Department
E.
Production Planning Department
The department that supervises, controls, and collects the clock card and job ticket is the:
A.
Cost Department
B.
Production Planning Department
C.
Timekeeping Department
D.
Payroll Department
E.
Personnel Department
21.
The department that records the job classification, department, and wage rate for each employee
is the:
22.
A.
Personnel Department
B.
Cost Department
C.
Production Planning Department
D.
Timekeeping Department
E.
Payroll Department
The incentive wage plan in which employee suggestions are the heart of the plan is:
A.
organizational incentive plan
B.
straight piecework plan
C.
100-percent bonus plan
D.
group bonus plan
E.
all of the above
23.
The incentive wage plan in which the central theme is that all employees have the capacity to
make valuable contributions to an organization is:
A.
group bonus plan
B.
100-percent bonus plan
C.
straight piecework plan
D.
gainsharing plan
E.
none of the above
24.
The incentive wage plan in which the company sets a predetermined formula and if improvement
above a certain amount occurs, all employees including management participate in the bonus is the:
25.
A.
Taylor plan
B.
Halsey plan
C.
Gantt plan
D.
Emerson plan
E.
Scanlon plan
The learning-curve formula is:
A.
y = axb
B.
y = abx
C.
x = aby
D.
a = bx + y
E.
none of the above
26.
In highly automated manufacturing where direct labor is small relative to other production costs
and not easily traceable to specific jobs, direct labor costs may be charged directly to:
27.
are:
A.
Income Summary
B.
Factory Overhead Control
C.
Work in Process
D.
Cost of Goods Sold
E.
none of the above
Symbols that can be processed electronically to identify numbers, letters, or special characters
A.
clock cards
B.
optical scanners
C.
time tickets
D.
bar codes
E.
none of the above
28.
When scheduling delays occur throughout the week and results in a specific job being completed
during an overtime shift, the overtime premium is charged to:
A.
Accrued Overtime Premium Receivable
B.
Work in Process
C.
the job worked on during the overtime premium
D.
an extraordinary loss account
E.
Factory Overhead Control
29.
An employee is paid a base rate of $800 per week for 52 weeks. The employee is entitled to a
two-week vacation each year. Factory Overhead Control is debited each week for accrued vacation pay
of:
A.
$15.38
B.
$30.77
C.
$20
D.
$32
E.
$16
30.
To spread the cost of vacation pay over production throughout the year, the weekly payroll entry
would include a debit to which of the following accounts for the vacation pay portion of the entry?
A.
Payroll
B.
Liability for Vacation Pay
C.
Cash
D.
Work in Process
E.
Factory Overhead Control
31.
If an employee earns $10 per hour and receives time-and-a-half for hours worked in excess of 40
per week, in a week when 45 hours were worked the overtime premium would be:
A.
$25
B.
$50
C.
$10
D.
$5
E.
none of the above
32.
To spread the cost of bonus payments over production throughout the year, the weekly payroll
entry would include a debit to which of the following accounts for the bonus pay portion of the entry?
A.
Cash
B.
Factory Overhead Control
C.
Work in Process
D.
Payroll
E.
Liability for Bonus Pay
LESSON 5
ACCOUNTING FOR FACTORY OVERHEAD
Learning outcomes of the lesson
At the end of the Chapter, the students must have:
1. Explained the reason why organizations allocate overhead costs to products
2. Compare and contrast allocating overhead costs using a plantwide rate, department rates, and
activity-based costing
3. Computed the unit cost of a product using the five steps of activity-based costing
4. Properly allocated the service department cost to the producing departments using the different
methods presented
INTRODUCTION
Cindy Hall is the owner and chief executive officer of SailRite Company. SailRite builds wo models of
sailboats that are sold at hundreds of retail boat showrooms throughout the world. At its inception several
years ago, the company produced only the Basic model, which is 12 feet long and designed for two sailors.
Very few options are available for this model, and the production process is relatively simple. Because
many owners of the Basic model wanted to move to a bigger, more sophisticated boat, SailRite developed
the Deluxe model two years ago. The Deluxe model is 14 feet long and designed for three sailors. Many
additional features are available for this model, and the production process is more complex than for the
Basic model. Last year, SailRite sold 5,000 units of the Basic and 1,000 units of the Deluxe.
Although sales of both models increased last year over the year before, company profits have steadily
declined. Cindy, the CEO, is concerned about this trend and discusses her concerns with John Lester, the
company’s accountant; Mary McCann, the vice president of marketing; and Bob Schuler, the vice president
of production.
Ever since we introduced the Deluxe model our profits have taken a beating. I need some
Cindy (CEO):
input on what we should do to get this turned around.
I’m not sure you can blame our salespeople. We’ve asked them to push the Deluxe model
Mary
because of the high profit margins, and our sales force has really responded. Sales have
(Marketing
steadily increased over the last couple of years, and customers seem to love our sailboats.
Vice
President):
I don’t think the problem is with our products, and using our current costing system, we make $320
in profit for each Basic model and $850 for each Deluxe model. We need to take a close look at
how the cost of each boat is determined. Overhead costs have increased significantly since we
started producing the Deluxe boat—to about 45 percent of total production costs—and yet we use
only one overhead rate based on direct labor hours to allocate these costs. I don’t see how this can
Bob
(Production
lead to an accurate cost, and I assume we set the price based on the cost of each boat.
Vice
President):
We certainly considered the cost in our pricing structure. Are you telling me the cost information
Cindy:
I have isn’t accurate?
No, the cost information you have is fine for financial reporting, but not for pricing products. When
John
we were producing only the Basic model, overhead allocation wasn’t an issue. All overhead costs
(Accountan
were simply assigned to the one product. Now that we have two products, overhead is allocated
t)
based on direct labor hours as Bobstated. We are required to allocate overhead for financial
reporting purposes, but I wouldn’t use this cost information for internal pricing purposes.
I can tell you that the production process for the Deluxe model is much more complicated than
Bob:
the one for the Basic model, so I would expect to see significantly higher costs attached to the
Deluxe boat.
What I’m hearing is that we need better cost information. I think it’s time we move to a more
John:
sophisticated costing system called activity-based costing. Give me time to do some
research. Let’s meet next week.
This dialogue between the accountant and top management emphasizes theimportance of having accurate
cost information for decision-making purposes. Very few costing systems provide “perfect” product cost
information. Overhead (indirect manufacturing costs) can be allocated in a number of different ways and
result in a number of different costs for the same product. The goal is to find a system of allocation that best
approximates the amount of overhead costs caused by each product. Sophisticated costing systems are
expensive, however. Organizations like SailRite must continually ask the question: Will the benefits of
having improved cost information outweigh the costs of obtaining the information?
Several options are available to allocate overhead costs. Before we discuss these options, it is important
to understand why overhead costs are allocated at all.
WHY ALLOCATE OVERHEAD COSTS?
Question: Recall that costs for direct labor and direct materials are easily traced to products. When SailRite
produces a sailboat, the direct materials include items such as fiberglass to build the hull, mast, sails, and
rope. Direct labor includes the employees building the boat.Accounting for these costs is fairly simple.
Indirect manufacturing costs (also called manufacturing overhead or overhead) include electricity to run the
factory, rent for the factory building, and factory maintenance. These costs are not easily traced to products
and pose a much more complicated challenge for SailRite. Accounting for indirect manufacturing costs
typically requires allocating overhead using predetermined overhead rates. Why do managers insist on
allocating overhead costs toproducts?
Answer: Three important reasons that managers allocate overhead costs to products are described in the
following:
Provide information for decision making. Setting prices for products is one example of a decision that must
be made by management. Prices are often established based on the cost of products. It is not enough to
simply include direct materials and direct labor. Overhead must be considered as well.
Promote efficient use of resources. Several different activities are performed to produce a product, such as
purchasing raw materials, setting up production machinery, inspecting the final product, and repairing
defective products. All of these activities consume resources (consuming resources is another way of
stating that a cost is associated with each of these activities). If products are charged for the use of these
activities, managers will have an incentive to be efficient in utilizing the activities.
APPROACHES IN ALLOCATING OVERHEAD COSTS
Question: Managers at companies such as Hewlett-Packard often look for better ways to figure out the cost
of their products. When Hewlett-Packard produces printers, the company has three possible methods that
can be used to allocate overhead costs to products—plantwide allocation, department allocation, and
activity-based allocation (called activity-based costing). How do managers decide which allocation method
to use?
Answer: The choice of an allocation method depends on how managers decide to group overhead costs
and the desired accuracy of product cost information. Groups of overhead costs are called cost pools. For
example, Hewlett Packard’s printer production division may choose to collect all factory overhead costs in
one cost pool and allocate those costs from the cost pool to each product using one predetermined
overhead rate. Or Hewlett Packard may choose to have several cost pools (perhaps for each department,
such as assembly, packaging, and quality control) and allocate overhead costs from each department cost
pool to products using a separate predetermined overhead rate for each department. In general, the more
cost pools used, the more accurate the allocation process.
PLANTWIDE ALLOCATION
Question: Let’s look at SailRite Company, which was presented at the beginning of the chapter. The
managers at SailRite like the idea of using the plantwide allocation method to allocate overhead to the two
sailboat models produced by the company. How would SailRite implement the plantwide allocation method?
Answer: The plantwide allocation method uses one predetermined overhead rate to allocate overhead
costs. [1] One cost pool accounts for all overhead costs, and therefore one predetermined overhead rate
is used to apply overhead costs to products. You learned about this approach inChapter 2 where one
predetermined rate—typically based on direct labor hours, direct labor costs, or machine hours— was used
to allocate overhead costs. (Remember, the focus here is on the allocation of overhead costs. Direct
materials and direct labor are easily traced to the product and therefore are not a part of the overhead
allocation process.)
Using SailRite Company as an example, assume annual overhead costs are estimated to be $8,000,000
and direct labor hours are used for the plantwide allocation base. Management estimates that a total of
250,000 direct labor hours are worked annually. These estimates are based on the previous year’s
overhead costs and direct labor hours and are adjusted for expected increases in demand the coming year.
The predetermined overhead rate is $32 per direct labor hour (= $8,000,000 ÷ 250,000 direct labor hours).
Thus, as shown in Figure 5.1 "Using One Plantwide Rate to Allocate SailRite Company’s Overhead",
products are charged $32 in overhead costs for each direct labor hour worked.
Figure 5.1 Using One Plantwide Rate to Allocate SailRite Company’s Overhead
Product Costs Using the Plantwide Allocation Approach at SailRite
Question: Assume SailRite uses one plantwide rate to allocate overhead based on direct labor hours.
What is SailRite’s product cost per unit and resulting profit using the plantwide approach to allocate
overhead?
Answer: The calculation of a product’s cost involves three components—direct materials, direct labor, and
manufacturing overhead. Assume direct materials cost $1,000 for one unit of the Basic sailboat and
$1,300 for the Deluxe. Direct labor costs are $600 for one unit of the Basic sailboat and $750 for the
Deluxe. This information, combined with the overhead cost per unit, gives us what we need to determine
the product cost per unit for each model.
Given the predetermined overhead rate of $32 per direct labor hour calculated in the previous section,
and assuming it takes 40 hours of direct labor to build one Basic sailboat and 50 hours to build one
Deluxe sailboat, we can calculate the manufacturing overhead cost per unit.
Manufacturing overhead cost per unit is $1,280 (= $32 × 40 direct labor hours) for the Basic boat
and $1,600 (= $32 × 50 direct labor hours) for the Deluxe boat. Combine the manufacturing overhead
with direct materials and direct labor, as shown in Figure 5.2 "SailRite Company Product Costs Using
One Plantwide Rate Based on Direct Labor Hours", and we are able to calculate the product cost per unit.
Figure 5.2 SailRite Company Product Costs Using One Plantwide Rate Based on Direct Labor Hours
*$1,280 = 40 direct labor hours per unit × $32 rate.
**$1,600 = 50 direct labor hours per unit × $32 rate.
The average sales price is $3,200 for the Basic model and $4,500 for the Deluxe. Using the product cost
information in Figure3.2"SailRiteCompanyProductCosts Using One Plantwide Rate Based on Direct Labor
Hours", the profit per unit is $320 (=$3,200 price– $2,880 cost) for the Basic model and $850 (= $4,500
price – $3,650 cost) for the Deluxe. Recall from the opening dialogue that SailRite’s overall profit has
declined ever since it introduced the Deluxe model even though the data shows both products are profitable.
Question: The managers at SailRite like the idea of using the plantwide allocation approach, but they are
concerned that this approach will not provide accurate product cost information.
Although the plantwide allocation method is the simplest and least expensive approach, it also tends to be
the least accurate.In spite of this weakness, why do some organizations prefer to use one plantwide
overhead rate to allocate overhead to products?
Answer: Organizations that use a plantwide allocation approach typically have simple operations with a few
similar products. Management may not want more accurate product cost information or may not have the
resources to implement a more complex accounting system. Aswe move on to more complex costing
systems, remember that these systems are more expensive to implement. Thus the benefits of having
improved cost information must outweigh the costs of obtaining the information.
DEPARTMENT ALLOCATION
Question: Assume the managers at SailRite Company prefer a more accurate approach to allocating
overhead costs to its two products. As a result, they are considering using the department allocation
approach. How would SailRite form cost pools for the department allocation approach?
Answer: The department allocation approach is similar to the plantwide approach except that cost pools
are formed for each department rather than for the entire plant, and a separate predetermined overhead
rate is established for each department. Remember, total estimated overhead costs will not change.
Instead, they will be broken out into various department cost pools. This approach allows for the use of
different allocation bases for different departments depending on what drives overhead costs for each
department. For example, the Hull Fabrication department at SailRite Company may find that overhead
costs are driven more by the use of machinery than by labor, and therefore decides to use machine hours
as the allocation base. The Assembly department may find that overhead costs are driven more by labor
activity than by machine use and therefore decides to use labor hours or labor costs as the allocation base.
Assume that SailRite is considering using the department approach rather than the plantwide approach for
allocating overhead. The cost pool in the Hull Fabrication department is estimated to be $3,000,000 for the
year, and the cost pool in the Assembly department is estimated at $5,000,000. Note that total estimated
overhead cost is still $8,000,000 (= $3,000,000 + $5,000,000). Machine hours (estimated at 60,000 hours)
will be used as the allocation base for Hull Fabrication, and direct labor hours (estimated at 217,000 hours)
will be used as the allocation base for Assembly. Thus, two rates are used to allocate overhead (rounded
to the nearest dollar) as follows:
1. Hull Fabrication department rate: $50 per machine hour (= $3,000,000 ÷ 60,000hours)
2. Assembly department rate: $23 per direct labor hour (= $5,000,000 ÷ 217,000hours)
As shown in Figure 5.3 "Using Department Rates to Allocate SailRite Company’s Overhead", products
going through the Hull Fabrication department are charged $50 in overhead costs for each machine hour
used. Products going through the Assembly department are charged $23 in overhead costs for each direct
labor hour used.
Figure 5.3 Using Department Rates to Allocate SailRite Company’s Overhead
The department allocation approach allows cost pools to be formed for each department and provides for
flexibility in the selection of an allocation base. Although Figure 5.3 "Using Department Rates to Allocate
SailRite Company’s Overhead" shows just two rates, many companies have more than two departments
and therefore more than two rates. Organizations that use this approach tend to have simple operations
within each department but different activities across departments. One department may use machinery,
while another department may use labor, as is the case with SailRite’s two departments. This approach
typically provides more accurate cost information than simply using one plantwide rate but still relies on the
assumption that overhead costs are driven by direct labor hours, direct labor costs, or machine hours. This
assumption of a causal relationship is increasingly less realistic as production processes become more
complex.
The plantwide and department allocation methods are “traditional” approaches because both typically use
direct labor hours, direct labor costs, or machine hours as the allocation base, and both were used prior to
the creation of activity-based costing in the 1980s.
USING ACTIVITY-BASED COSTING TO ALLOCATE OVERHEAD COSTS
Question: Suppose the managers at SailRite Company decide that the benefits of implementing an activitybased costing system would exceed the cost, and thus the company should use activity-based costing to
allocate overhead. What are the five steps of activity-based costing, and how would this method work for
SailRite?
Answer: Activity-based costing (ABC) uses several cost pools, organized by activity, to allocate overhead
costs. (Remember that plantwide allocation uses one cost pool for the whole plant, and department
allocation uses one cost pool for each department.) The idea is that activities are required to produce
products—activities such as purchasing materials, setting up machinery, assembling products, and
inspecting finished products. These activities can be costly. Thus, the cost of activities should be allocated
to products based on the products’ use of the activities.
ABC in Action at SailRite Company
Five steps are required to implement activity-based costing. As you work through the example for SailRite
Company, once again note that total estimated overhead costs remain at $8,000,000. However, the total is
broken out into different activities rather than departments, and an overhead rate is established for each
activity. The five steps are as follows:
Step 1. Identify costly activities required to complete products.
An activity is any process or procedure that consumes overhead resources. The goal is to understand all
the activities required to make the company’s products. This requires interviewing and meeting with
personnel throughout the organization. Companies that use activity-based costing, such as Hewlett
Packard and IBM, may identify hundreds of activities required to make their products. The most challenging
part of this step is narrowing down the activities to those that have the biggest impact on overhead costs.
After meeting with personnel throughout the company, SailRite’s accountant identified the following
activities as having the biggest impact on overhead costs:
•
Purchasingmaterials
•
Setting upmachines
•
Runningmachines
•
Assemblingproducts
•
Inspecting finishedproducts
Step 2. Assign overhead costs to the activities identified in step 1.
This step requires that overhead costs associated with each activity be assigned to the activity (i.e., a cost
pool is formed for each activity). For SailRite, the cost pool for the purchasing materials activity will include
costs for items such as salaries of purchasing personnel, rent for purchasing department office space, and
depreciation of purchasing office equipment.
The accountant at SailRite developed the following allocations after careful review of all overhead costs
(remember, these are overhead costs, not direct materials or direct labor costs):
*We should note that this is not the direct labor cost. Instead, this represents overhead costs associated
with assembling products, such as supplies and the factory space being used for assembly.
At this point, we have identified the most important and costly activities required to make products, and we
have assigned overhead costs to each of these activities. The next step is to find an allocation base that
drives the cost of each activity.
Step 3. Identify the cost driver for each activity.
A cost driver is the action that causes (or “drives”) the costs associated with the activity. Identifying cost
drivers requires gathering information and interviewing key personnel in various areas of the organization,
such as purchasing, production, quality control, and accounting. After careful scrutiny of the process
required for each activity, SailRite established the following cost drivers:
Activity
Cost Driver
Estimated Annual Cost
Driver Activity
10,000 requisitions
Purchasing
materials
Setting up
machines
Running machines
Purchase
requisitions
Machine
2,000 setups
setups
Machine hours 90,000 hours
Assembling
products
Inspecting finished
products
Direct labor
hours
Inspection
hours
250,000 hours
20,000 hours
Notice that this information includes an estimate of the level of activity for each cost driver, which
is needed to calculate a predetermined rate for each activity in step 4.
Step 4. Calculate a predetermined overhead rate for each activity.
This is done by dividing the estimated overhead costs (from step 2) by the estimated level of cost driver
activity (from step 3). provides the overhead rate calculations for SailRite Company based on the
information shown in the previous three steps. It shows that products will be charged $120 in overhead
costs for each purchase requisition processed, $800 for each machine setup, $30 for each machine hour
used, $6 for each direct labor hour worked, and $50 for each hour of inspection time.
Figure 5.4 Predetermined Overhead Rates for SailRite Company
Step 5. Allocate overhead costs to products.
Overhead costs are allocated to products by multiplying the predetermined overhead rate for each activity
(calculated in step 4) by the level of cost driver activity used by the product. The term applied overhead is
often used to describe this process.
Assume the following annual cost driver activity takes place at SailRite for the Basic and Deluxe
sailboats: [1]
Activity
Basic Sailboat
Deluxe Sailboat
Total
Purchasing materials
7,000 requisitions
3,000 requisitions 10,000 requisitions
Setting up machines
1,100 setups
900 setups
2,000 setups
Running machines
50,000 hours
40,000 hours
90,000 machine hours
Assembling products
200,000 hours
50,000 hours
250,000 direct labor hours
Inspecting finished products
12,000 hours
8,000 hours
20,000 inspection hours
shows the allocation of overhead using the cost driver activity just presented and the overhead rates
calculated in. Notice that allocated overhead costs total $8,000,000. This is the same cost figure used for
the plantwide and department allocation methods we discussed earlier. Activity- based costing simply
provides a more refined way to allocate the same overhead costs to products.
Figure 5.5 Allocation of Overhead Costs to Products at SailRite Company
*Overhead allocated equals the predetermined overhead rate times the cost driver activity.
**Overhead cost per unit for the Basic model equals $5,020,000 (overhead allocated) ÷ 5,000 units
produced, and for the Deluxe model, it equals $2,980,000 ÷ 1,000 units produced.
The bottom of shows the overhead cost per unit for each product assuming SailRite produces 5,000 units
of the Basic sailboat and 1,000 units of the Deluxe sailboat. This information is needed to calculate the
product cost for each unit of product, which we discuss next.
Product Costs Using the Activity-Based Costing Approach at SailRite
Question: As shown in , SailRite knows the overhead cost per unit using activity-based costing is $1,004
for the Basic model and $2,980 for the Deluxe.Now that SailRite has the overhead cost per unit, how will
the company find the total product cost per unit and resulting profit?
Answer: Recall from our discussion earlier that the calculation of a product’s cost involves three
components—direct materials, direct labor, and manufacturing overhead. Assume direct materials cost
$1,000 for the Basic sailboat and $1,300 for the Deluxe. Direct labor costs are $600 for the Basic sailboat
and $750 for the Deluxe. This information, combined with the overhead cost per unit calculated at the
bottom of , gives us what we need to determine the product cost per unit for each model, which is
presented in . The average sales price is $3,200 for the Basic model and $4,500 for the Deluxe. Using the
product cost information in , the Basic model yields a profit of $596 (= $3,200 price – $2,604 cost) per unit
and the Deluxe model yields a loss of $530 (= $4,500 price – $5,030 cost) per unit.
Figure5.6SailRiteCompanyProductCostsUsingActivity-BasedCosting
As you can see, overhead is a significant component of total product costs. This explains the need for a
refined overhead allocation system such as activity-based costing.
Comparison of ABC to Plantwide Costing at SailRite
After going through the process of allocating overhead using activity-based costing, John Lester (the
company accountant) called a meeting with the same management group introduced at the beginning of
the chapter: Cindy Hall (CEO), Mary McCann (vice president of marketing), and Bob Schuler (vice
president of production). As you read the following dialogue, refer to , which summarizes John’s findings.
Cindy:
What do you have for us, John?
I think you’ll find the results of our most recent costing analysis very interesting. We used an
John:
Bob:
approach called activity-based costing to allocate overhead to products.
I recall being interviewed last week about the activities involved in the production process.
Yes, here’s what we found. The old allocation approach indicates that the Basic boat costs
$2,880 to build and the Deluxe boat costs $3,650 to build. Our average sales price for the Basic is
$3,200 and $4,500 for the Deluxe. You can see why we pushed sales of the Deluxe boat—it has
a profit of $850 perboat.
John:
Cindy:
John, from your analysis, it looks as if we were wrong about the Deluxe boat being the most
profitable.
We do have some startling results. Using activity-based costing, an approach I think is much
John:
more accurate, the Deluxe boat is not profitable at all. In fact, we lose $530 for each Deluxe boat
sold, and the profits from the Basic boat are much higher than we thought at $596 per unit.
I see direct materials and direct labor are the same no matter which costing system we use.
Cindy:
Why is there such a large variation in overhead costs?
Good question! When we used our old approach of one plantwide rate based on direct labor
hours, the Deluxe process consumed 20 percent of all direct labor hours worked—that is, 50,000
Deluxe hours divided by 250,000 total hours. Therefore the Deluxe model was allocated 20
percent of all overhead costs. Using activity-based costing, we identified five key activities and
assigned overhead costs based on the use of these activities. The Deluxe process consumed
more than 20 percent of the resources provided for every activity. For example, running
machines is one of the most costly activities, and the Deluxe model used about 44 percent of the
resources provided by this activity. This is significantly higher than the 20 percent allocated
using direct labor hours under the old approach.
John:
Bob:
This certainly makes sense! Each Deluxe boat takes a whole lot more machine hours to produce
than the Basic boat.
Thanks for this analysis, John. Now we know why company profits have been declining even
Cindy:
though sales have increased. Either the Deluxe sales price must go up or costs must go
down—or a combination of both!
Figure 3.7 Activity-Based Costing Versus Plantwide Costing at SailRite Company
*From .Figure 5.2
**From . Figure 5.5
Question: SailRite has more accurate product cost information using activity-based
costing to allocate overhead. Why is the overhead cost per unit so different using
activity-based costing?
Answer: provides a more thorough look at how the Deluxe product consumes a significant
share of overhead resources—much higher than the 20 percent that was being allocated
based on direct labor hours. Let’s look at in detail:
•
The ABC column represents overhead costs allocated using the activitybased costing shown back in.
•
The DLH (direct labor hours) column represents overhead costs allocated
using direct labor hours as the allocation base where 80 percent was
allocated to the Basic boat (= 200,000 hours ÷ 250,000 total hours) and
20 percent allocated to the Deluxe boat (= 50,000 hours ÷ 250,000 total
hours).
•
The Diff. (difference) column shows the difference between one allocation method and the other.
Notice the shift in the allocation of overhead costs using activity-based costing. A total of
$1,380,000 in overhead costs shifts to the Deluxe sailboat, which amounts to $1,380 per boat
(= $1,380,000 ÷ 1,000 boats).
Figure 5.8 Detailed Analysis of Overhead Allocations at SailRite Company
*Amounts in this column come from Figure 5.5
**Amounts in this column are calculated by multiplying 80 percent for the Basic boat (20 percent for the
Deluxe) by the total overhead cost for the activity. For example, the total overhead cost for purchasing
materials is $1,200,000 (see ) and $1,200,000 × 80 percent = $960,000. Using the plantwide approach
(one plantwide rate based on direct labor hours), $960,000 is the amount allocated to the Basic sailboat for
this activity, and $240,000 is the amount allocated to the Deluxe boat.
The primary reason that using activity-based costing shifted overhead costs to the Deluxe sailboat
is that producing each Deluxe boat requires more resources than the Basic boat. For example, the Basic
boat requires 50,000 machine hours to produce 5,000 boats, and the Deluxe boat requires 40,000 machine
hours to produce 1,000 boats. The number of machine hours required per boat produced is as follows:
You can see from this analysis that the Deluxe boat consumes four times the machine hours of the Basic
boat. At a rate of $30 per machine hour, the Deluxe boat is assigned $1,200 per boat for this activity ($30
rate × 40 machine hours) while the Basic boat is assigned $300 per boat ($30 rate × 10 machine hours).
ADVANTAGES AND DISADVANTAGES OF ABC
Question: Activity-based costing undoubtedly provides better cost information than most traditional costing
methods, such as plantwide and department allocation methods. However, ABC has its limitations. What
are the advantages and disadvantages of using activity-based costing?
Answer: The advantages and disadvantages of ABC are as follows:
Advantages
More accurate cost information leads to better decisions. The cost information provided by ABC is
generally regarded as more accurate than the information provided by most traditional costing methods.
This allows management to make better decisions in areas such as product pricing, product line changes
(adding products or eliminating products), and product mix decisions (how much of each product to produce
and sell).
Increased knowledge of production activities leads to process improvements and reduced costs.
ABC requires identifying the activities involved in the production process (step 1) and assigning costs to
these activities (step 2). This provides management with a better view of the
detailed activities involved (purchasing materials, machine setups, inspections, and so forth) and the cost
of each activity. Managers are more likely to focus on improving efficiency in the most costly activities,
thereby reducing costs.
Disadvantages
ABC systems can be costly to implement. ABC systems require teamwork across the organization and
therefore require employees to take time out from their day-to-day activities to assist in the ABC process
(e.g., to identify costly activities). Assigning costs to activities takes time, as does identifying and tracking
cost drivers. And assigning costs to products requires a significant amount of time in the accounting
department. Imagine having 15 cost pools (activities), each with a predetermined overhead rate used to
assign overhead costs to the company’s 80 products—not an unrealistic example for a large company. The
accounting costs incurred to maintain such a system can be prohibitively high.
Unitizing fixed costs can be misleading. Product costing involves allocating costs from activity centers to
products and calculating a product cost per unit. The problem with this approach is that fixed costs are often
a large part of the overhead costs being allocated (e.g., building and machinery depreciation and supervisor
salaries). Recall that fixed costs are costs that do not change in total with changes in activity.
Looking back to the SailRite example using activity-based costing, the Deluxe sailboat cost $5,030 per unit
to produce based on production of 1,000 units (as shown in ). If SailRite produces 2,000 units of the Deluxe
boat, will the unit cost remain at $5,030? Probably not. Asignificant portion of overhead costs are fixed and
will be spread out over more units, thereby reducing the cost per unit. We address this issue at length in
later chapters. The point here is that managers must beware of using per unit cost information blindly for
decision making, particularly if a significant change in the level of production is anticipated.
The benefits may not outweigh the costs. Companies with one or two products that require very little
variation in production may not benefit from an ABC system. Suppose a company produces one product.
The overhead costs can be divided into as many cost pools as you like, but all overhead costs will still be
assigned to the one product. (We should mention, however, that management would benefit from
understanding the activities involved in the process and the costs associated with each activity. It’s the
allocation to the one product—steps 4 and 5 of ABC—that would provide little useful information in this
scenario.)
Companies that produce several different products may believe that the benefits of implementing ABC will
outweigh the costs. However, management must be willing to use the ABC information to benefit the
company. Companies like Chrysler Group LLC have been known to try ABC, only to meet resistance from
their managers. Until managers are willing to use the ABC information to make improvements in the
organization, there is no point in implementing such asystem.
ABC COST FLOWS
Question: How are overhead costs recorded when using activity-based costing?
Answer: We presented the flow of costs for a job costing system in , including how to track actual overhead
costs and how to track overhead applied using a separate manufacturing overhead account. The cost flows
are the same for an activity-based costing system, with one exception. Instead of using one plantwide
overhead rate to allocate (or apply) overhead to products, an ABC system uses several overhead rates to
allocate overhead. The entry to record this allocation—whether it involves one rate or multiple rates—is the
same as the entry in.
Simply debit work-in-process inventory and credit manufacturing overhead for the amount of overhead
applied. (Some companies use separate work-in-process inventory and manufacturing overhead accounts
for each activity. For the sake of simplicity, we do not use separate accounts.)
For example, assume production of SailRite’s Basic sailboats has the following cost driver activity for one
week of operations:
*From Figure 5.4
The entry to record overhead applied to the Basic sailboats for the week is as follows:
Recall from that the manufacturing overhead account is closed to cost of goods sold at the end of the
period. If actual overhead costs are higher than applied overhead, the resulting underapplied overhead is
closed with a debit to cost of goods sold and a credit to manufacturing overhead. If actual overhead costs
are lower than applied overhead, the resulting overapplied overhead is closed with a debit to manufacturing
overhead and a credit to cost of goods sold.
Recap of Three Allocation Methods
We have discussed three different methods of allocating overhead to products—plantwide allocation,
department allocation, and activity-based costing. Remember, total overhead costs will not change in the
short run, but the way total overhead costs are allocated to products will change depending on the method
used.
Presents the three allocation methods, using SailRite as an example. Notice that the three pie charts in
the illustration are of equal size, representing the $8,000,000 total overhead costs incurred by SailRite.
Figure 5.9 The Three Methods of Overhead Allocation
Overhead Rates:
1 Allocated based on direct labor hours (DLH): $8,000,000 ÷ 250,000 DLH = $32 per DLH.
2 Allocated based on direct labor hours (DLH): $5,000,000 ÷ 217,000 DLH = $23 per DLH.
3 Allocated based on machine hours (MH): $3,000,000 ÷ 60,000 MH = $50 per MH.
4 Allocated based on direct labor hours (DLH): $1,500,000 ÷ 250,000 DLH = $6 per DLH.
5 Allocated based on inspection hours (IH): $1,000,000 ÷ 20,000 IH = $50 per IH.
6 Allocated based on purchase requisitions (PR): $1,200,000 ÷ 10,000 PR = $120 per PR.
7 Allocated based on machine setups (MS): $1,600,000 ÷ 2,000 MS = $800 per MS.
8 Allocated based on machine hours (MH): $2,700,000 ÷ 90,000 MH = $30 per MH.
ALLOCATION OF SERVICE DEPARTMENT COSTS
Throughout the chapter, we have emphasized cost allocations only in the operating departments of a
company. These operating departments perform the primary purpose of the company—to produce goods
and services for consumers. Examples of operating departments are the assembly departments of
manufacturing firms and the departments in hotels that take and confirm reservations.
The costs of service departments are allocated to the operating departments because they exist to support
the operating departments. Examples of service departments are maintenance, administration, cafeterias,
laundries, and receiving. Service departments aid multiple production departments at the same time, and
accountants must allocate and account for all of these costs. It is crucial that these service department
costs be allocated to the operating departments so that the costs of conducting business in the operating
departments are clearly and accurately reflected.
Accountants allocate service department costs using some type of base. When the companies’ managers
choose bases to use, they consider such criteria as the types of services provided, the benefits received,
and the fairness of the allocation method. Examples of bases used to allocate service department costs
are number of employees, machine-hours, direct labor-hours, square footage, and electricity usage.
There are three methods for allocating service department costs:
The first method, the direct method, is the simplest of the three. The direct method allocates costs
of each of the service departments to each operating department based on each department’s share of the
allocation base. Services used by other service departments are ignored.
The second method of allocating service department costs is the step method. This method
allocates service costs to the operating departments and other service departments in a sequential process.
The sequence of allocation generally starts with the service department that has incurred the greatest costs.
After this department’s costs have been allocated, the service department with the next
highest costs has its costs allocated, and so forth until the service department with the lowest costs has
had its costs allocated. Costs are not allocated back to a department that has already had all of its costs
allocated.
The third method is the most complicated but also the most accurate. The reciprocal method
allocates services department costs to operating departments and other service departments. Under the
reciprocal cost, the relationship between service departments is recognized and cost is allocated to and
from each service department for services provided.
DIRECT METHOD OF ALLOCATION
The direct method allocates costs of each of the service departments to each operating department based
on each department’s share of the allocation base. Services used by other service departments are ignored.
This means the direct method does not recognize service performed by other service departments. For
example, if Service Department A uses some of Service Department B’s services, these services would be
ignored in the cost allocation process. Because these services are not allocated to other service
departments, some accountants believe the direct method is not accurate.
Example: A company has 2 service departments, Maintenance and Administration, and 2 operating
departments (Department 1 and 2 for simplicity). The costs of the maintenance department are allocated
based on the machine-hours used. For the administration department, the cost allocation is based on the
number of employees. The following information is provided:
Service Dept
Maintenance
Costs
$8,000
Machine-hours used
1,000
Number of Employees 100
Administration
$4,000
2,000
200
Operating Dept
1
$32,000
1,500
250
2
$36,000
2,500
150
Remember how we calculate predetermined overhead rates? We will need that same formula again. The
formula to calculate the allocation rate will be slightly modified for service department cost but will be:
Service Dept Cost / TOTAL Cost Driver (operating depts only)
Notice, we use the operating department cost drivers only since we are allocating the service department
cost to operating departments only and not to another service department. Maintenance uses machinehours as the cost driver or basis and Administration uses number of employees. We can calculate the
service department allocation rates as follows:
To allocate the service department costs to each operating department, we will take the amount of the cost
driver (machine hours for maintenance and employees for administration) x the allocation rate we just
calculated.
Notice how the total maintenance amount allocated to the two departments (3,000 + 5,000) equals the
maintenance department cost of $8,000. The same applies to administration as the total cost is $4,000
and we allocated a total of $4,000 (2,500 + 1,500). We can summarize the changes to the costs of each
department:
STEP METHOD OF ALLOCATION
The second method of allocating service department costs is the step method. This method allocates
service costs to the operating departments and other service departments in a sequential process. The
sequence of allocation generally starts with the service department that has incurred the greatest costs.
After this department’s costs have been allocated, the service department with the next highest costs has
its costs allocated, and so forth until the service department with the lowest costs has had its costs allocated.
Costs are not allocated back to a department that has already had all of its costs allocated.
In the step method, we typically begin with the highest service cost first. We will start with
Maintenance and allocate the cost to all remaining operating AND service departments (administration,
operating dept 1 and operating dept 2). When calculating the allocation rate, we never use the service
department cost driver itself (so do not use the maintenance machine hours used).
We would allocate maintenance to Administration, Operating Departments 1 and 2 using the machine hours
for each department x the maintenance rate per machine hour (round final answer to nearest dollar).
Next, we would allocate the administration department. The total administration cost has changed
since we have the original department costs of $4,000 + maintenance cost allocated above of $2,667
making the new administration cost $6,667. Administration will be allocated based on number of
employees. We will use the operating departments only since we have already allocate all of maintenance
costs and there are no other service departments.
We would allocate administration to the operating departments only by taking each department
number of employees x the administration rate per employee (round final answer to nearest dollar).
The final cost allocation would appear as follows:
Remember, the step method recognizes a one-way relationship between service departments and once
the service department cost has been allocated out to other departments, we do not go back and give
additional costs to that department.
RECIPROCAL METHOD OF ALLOCATION
The final method, is the reciprocal method. Although it is the most accurate, it is also the most
complicated. In the reciprocal method, the relationship between the service departments is recognized.
This means service department costs are allocated to and from the other service departments.
Step 1: Determine allocation bases
Just like you would for direct or step,we need to calculate the allocation base EXCEPT the only thing you
are excluding is the department cost you are trying to allocate — ALL other departments are included.
We can calculate the allocation base amount for each service department as follows:
Step 2: Setup the formulas.
Since maintenance costs are allocated to administration and administration cost is allocated to maintenance
— things get interesting. You will need to determine the TOTAL cost being allocated to both the
Administration and Maintenance Departments first.
(a) Total Maintenance cost = Maintenance department cost + cost allocated to maintenance from
administration.
(b) Total Administration cost = Administration department cost + cost allocated to administration from
maintenance.
We will work with the administration cost formula in (b) first:
Total Administration cost = Administration department cost + cost allocated to administration from
maintenance. From step 1, we know the cost allocation to administration from maintenance is (2/6 x total
maintenance cost). We still do not know what total maintenance cost but we can plug in this new formula.
Total Administration cost = $ 4,000 administration department cost + (2/6 x total maintenance cost)
We can insert the formula from (a) for total maintenance cost into the total administration cost formula (b)
as follows:
Total Administration cost = $4,000 admin department cost + [2/6 x (Maintenance department cost + cost
allocated to maintenance from administration) ]
We can see from step 1 that administration cost is allocated to maintenance as total administration cost x
20%. Adding this to our formula, we now have:
Total Administration cost = $4,000 admin department cost + [2/6 x ($8,000 Maintenance department cost
+ (total admin cost x 20%) ) ]
Using algebra, we can assign Total Administration Cost a variable of A giving the formula:
A = 4,000 + [ 2/6 x ($8,000 + 0.20)A]
A = 4,000 + (2/6 x 8,000) + (2/6 x 0.20A)
A = 4,000 + 2,666.67 + 0.067A — rounded
A = 6,666.67 + 0.067A
1.0A – 0.067A = 6,666.67
0.933A = 6,666.67
A or total administration cost = $7,145 rounded
Total maintenance cost can be calculated as $8,000 department cost + $1,429 (7,145 x 20%) allocated
from administration for a total of $9,429.
Step 3: Show cost allocations
Now that you have the TOTAL Cost of Maintenance and Personnel, it is time to allocate it using the Total
Cost amounts from Step 2 and the percentages from Step 1.
SELF-TEST QUESTIONS
PROBLEM 1
Determining Overhead Rate; Expected Actual Capacity Method. Desmond Corp. estimates that its
production for the coming year will be 10,000 widgets, which is 80% of normal capacity, with the following
unit costs: materials, $40; direct labor, $60. Direct labor is paid at the rate of $24 per hour. The widget
shaper, the most expensive piece of machinery, must be run for 20 minutes to produce one widget. Total
estimated overhead is expected to consist of $400,000 for variable overhead and $400,000 for fixed
overhead.
Required: Compute the overhead rate for each of the following bases, using the expected actual capacity
activity level:
(1)physical output
(2)materials cost
(3)direct labor cost
(4)direct labor hours
(5)machine hours
(Round all amounts to the nearest whole number.)
SOLUTION
(1)
(2)
(3)
Estimated overhead (EOH)
$800,000
=
= $80 overhead per widget
Estimated units of production 10,000 widgets
EOH
$800,000
_ 100 =
_ 100 = 200% of materials cost
Estimated materials cost
$40 _ 10,000 widgets
EOH
$800,000
_ 100 =
_ 100 = 133% of direct labor cost
Estimated direct labor cost
$60 _ 10,000 widgets
(4)
EOH
$800,000
=
Estimated direct labor hours 25,000 hours
1
1
= $32 per direct labor hour
Labor cost per widget $60
=
= 2.5 direct labor hours per widget
Labor widg et rate
$24
2.5 direct labor hours per widget x 10,000 widgets = 25,000 estimated direct labor hours
(5)
EOH
$800,000
=
Estimated machine hours 3,333 hours
1
1
= $240 per machine hour
20 minutes per widget
= 1 / 3 machine hour per widget
60 minutes per hour
1/3 hour per widget x 10,000 widgets = 3,333 estimated machine hours
NOTE: Since the following problem is identical to Problem 1, except for the activity level used, do not test
on both problems at the same time.
PROBLEM 2.
Determining Overhead Rate; Normal Capacity Method. Desmond Corp. estimates that its production
for the coming year will be 10,000 widgets, which is 80% of normal capacity, with the following unit costs:
materials, $40; direct labor, $60. Direct labor is paid at the rate of $24 per hour. The widget shaper, the
most expensive piece of machinery, must be run for 20 minutes to produce one widget. Total estimated
overhead is expected to consist of $400,000 for variable overhead and $400,000 for fixed overhead.
Required: Compute the overhead rate for each of the following bases, using the normal capacity activity
level:
(1)physical output
(2)materials cost
(3)direct labor cost
(4)direct labor hours
(5)machine hours
(Round answers to the nearest whole dollar or percentage.)
SOLUTION
(1)
(2)
(3)
(4)
$800,000
= $64 overhead per widget
12,500 widgets
$800,000
_ 100 = 160% of materials cost
($40 _ 12,500 widgets)
$800,000
_ 100 = 107% of direct labor cost
($60 _ 12,500 widgets)
$800,000
= $25.60 or $26 per direct labor hour
(2.5 hours _ 12,500 widgets)
PROBLEM 3.
Factory Overhead Application. St. Louis Sounds Inc. manufactures audio equipment. The company
estimates the following costs at normal capacity and other items for the coming period:
Direct materials .......................................................................................
$300,000
Direct labor .............................................................................................
520,000
Factory overhead (fixed) .........................................................................
300,000
Factory overhead (variable) ....................................................................
240,000
Normal capacity ......................................................................................
100,000 direct labor hours
Expected production ...............................................................................
80,000 direct labor hours
Required: Compute the overhead application rate for fixed, variable, and total overhead per direct labor
hour, using both the normal capacity and the expected actual capacity activity levels.
SOLUTION
Overhead per Direct Labor Hour
At Expected
Overhead
Actual Capacity
At Normal Capacity
$300,000
Fixed .........................................
Variable.....................................
-----------------
$300,000
= $3.75
80,000 DLH
100,000 DLH
$192,000
$240,000
-----------------
=
2.40
80,000 DLH
Total ..........................................
------------------
------------------
=
$3.00
=
2.40
100,000 DLH
$6.15
$5.40
PROBLEM 4
Overhead Allocation and Rates. To determine an overhead application rate for its Machining and
Assembly Departments, the management of Knight Co. requested the following overhead cost data for
June:
Item
Machining
Assembly
Department
Department
Total
Number of employees .......................................................
60
40
100
Square footage .................................................................
15,000
10,000
25,000
$ 2,000
$ 2,500
--
department (excluding indirect labor) ........................
$ 90,000
$75,000
$165,000
Materials used ..................................................................
60,000
90,000
150,000
Factory rent.......................................................................
?
?
33,000
Other building costs ..........................................................
?
?
60,000
Payroll Department cost....................................................
?
?
18,000
?
?
75,000
Monthly average wage per employee
(direct and indirect) ....................................................
Overhead directly chargeable to
Freight-in and other Receiving
Department costs ......................................................
In each department, 80% of the employees are direct laborers. Overhead is charged to production on the
basis of direct labor dollars. The allocation basis for other data is as follows: all building costs, square
footage; Payroll Department cost, number of employees; freight-in and other Receiving Department
costs, materials used.
Required:
(1)
Compute the total overhead chargeable to the Machining and Assembly Departments.
(2)
Compute the overhead application rate as a percentage of direct labor cost for each department.
(Round to the nearest whole percent.)
SOLUTION
(1)
Machining
Department
Overhead directly chargeable ........................................................................... $
90,000
Indirect labor:
20% x 60 x $2,000 .....................................................................................
24,000
20% x 40 x $2,500 .....................................................................................
Assembly
Department
$ 75,000
20,000
Factory rent:
15,000
$33,000 x --------- ......................................................................................
25,000
19,800
10,000
$33,000 x --------- ......................................................................................
25,000
Other building costs:
15,000
$60,000 x --------- ......................................................................................
25,000
13,200
36,000
10,000
$60,000 x --------- ......................................................................................
25,000
Payroll Department cost:
60
$18,000 x ------ ..........................................................................................
100
24,000
10,800
40
$18,000 x ------ ..........................................................................................
100
Freight-in and other Receiving Department costs:
$60,000
$75,000 x ----------- ....................................................................................
$150,000
$90,000
$75,000 x ----------- ....................................................................................
$150,000
Total overhead ................................................................................................. $
(2)
Direct labor costs:
80% x 60 x $2,000 ..................................................................................... $
80% x 40 x $2,500 .....................................................................................
Overhead as a percentage of direct labor cost:
$210,600/$96,000 ......................................................................................
$184,400/$80,000 ......................................................................................
7,200
30,000
45,000
210,600
$ 184,400
96,000
$
80,000
219%
231%
PROBLEM 5
Overhead Application; Correction of Net Profit (or Loss). Pomeroy Printers Inc. uses job order costing.
Printers' wages are charged to direct labor, while typesetters' wages are charged to overhead and comprise
30% of applied overhead. Overhead is applied at the rate of 150% of direct labor cost. During July, only
two jobs were started and completed. Relevant data from these jobs were:
Item
Materials cost..........................................................................................
Direct labor .............................................................................................
Overhead applied ...................................................................................
Total cost of job.................................................................................
Selling price ............................................................................................
Gross profit from job .........................................................................
Job 1776
$ 5,000
10,000
15,000
$ 30,000
30,000
$
0
Job 1865
$ 3,000
8,000
12,000
$ 23,000
35,000
$ 12,000
Management determines that the typesetters' wages should be a direct labor cost and that Job 1776
required 1/3 of the total typesetting cost incurred, while Job 1865 required 2/3.
Required:
(1)
Determine the total typesetters' wages for July.
(2)
Determine the corrected direct labor costs for Jobs 1776 and 1865.
(3)
Determine the correct gross profit (or loss) for each job. (Round the new overhead rate to the
nearest whole percent and the total overhead to the nearest dollar.)
SOLUTION
(1)
$8,100 [30% x ($15,000 + $12,000)]
(2)
Job 1776
$ 10,000
+ 2,700 (1/3 x $8,100)
$ 12,700
Job 1865
$ 8,000
+ 5,400 (2/3 x $8,100)
$ 13,400
(3)
Item
Materials cost..........................................................................................
Direct labor .............................................................................................
Overhead applied1 ..................................................................................
Total cost of job.................................................................................
Job 1776
$ 5,000
12,700
9,144
$ 26,844
Job 1865
$
3,000
13,400
9,648
$ 26,048
Selling price ............................................................................................
30,000
35,000
Gross profit from job .........................................................................
1
$
3,156
Total overhead
$18,900
=
= 72.41% or 72% overhead applied
Direct labor cost $12,700 + $13,400
$
8,952
PROBLEM 6
Overhead Distribution Via Direct Method. Geo-trig Inc. has three producing departments (Sine, Cosine,
and Tangent) and two service departments (Rhombus and Triangle). Data that summarize overhead
activity for January are:
Producing Departments
Service Departments
Sine
Cosine
Tangent
Rhombus
Triangle
Total overhead before service
department allocations .................. $50,000
$80,000
$30,000
$40,000
$20,000
Square footage
occupied .......................................
3,000
4,000
3,000
1,000
1,500
Number of employees .........................
50
30
20
10
10
Rhombus costs are distributed on the basis of square footage occupied, while Triangle costs are distributed
on the basis of number of employees. The direct method is used for allocating service department costs
to producing departments.
Required: Prepare a schedule indicating the detailed components of overhead costs for the producing and
service departments, including the directly assigned and allocated overhead.
SOLUTION
Sine
Total overhead before service
department allocations .......................
Allocation of Rhombus costs:
(Base = square footage)
3,000
Sine: ---------- x $40,000 .....................
10,0001
Producing Departments
Cosine
Tangent
Service Departments
Rhombus
Triangle
$50,000
$ 80,000
$30,000
$40,000
12,000
--
--
(12,000)
--
16,000
--
(16,000)
--
--
12,000
(12,000)
10,000
--
--
(10,000)
--
6,000
--
(6,000)
20
Tangent: ------ x $20,000 ....................
100
--
--
4,000
(4,000)
Total overhead .........................................
$72,000
$102,000
$46,000
4,000
Cosine: --------- x $40,000...................
10,000
3,000
Tangent: --------- x $40,000 .................
10,000
Allocation of Triangle costs:
(Base = number of employees)
50
Sine: ------ x $20,000 .........................
1002
30
Cosine: ---- x $20,000 ........................
100
1Denominator
=
or
2Denominator =
or
3,000 + 4,000 + 3,000 = 10,000 square feet
30% + 40% + 30%
50 + 30 + 20 = 100 employees
50% + 30% + 20%
$20,000
PROBLEM 7
Distribution of Direct and Indirect Overhead Costs to Producing Departments. Chaing Chemical
Co. operates with three producing departmentsCBlending, Testing, and Terminal. The overhead items
and amounts for the period, along with the bases for their allocation, are listed below.
Item
Amount
Building depreciation................................................................ $ 24,000
Janitorial cost ...........................................................................
33,000
Materials receiving cost ...........................................................
48,000
Payroll Department cost........................................................... 126,000
Power.......................................................................................
75,000
Allocation Basis
Square footage
Square footage
Materials usage
Number of employees
Horsepower of equipment
Other relevant data are:
Number of employees ..................................
Direct labor hours ........................................
Horsepower of equipment ............................
Kilowatt-hours ..............................................
Square footage ............................................
Directly chargeable overhead cost ..............
Direct materials ...........................................
Blending
Department
25
62,000
60,000
4,000
2,000
$ 125,000
$ 75,000
Testing
Department
40
104,000
15,000
1,000
2,000
$ 75,000
$ 25,000
Terminal
Department
19
54,000
5,000
6,000
2,000
$87,500
--
Total
84
220,000
80,000
11,000
6,000
$287,500
$100,000
Required: Prepare the overhead distribution for each producing department, including the detail for each
item of allocated overhead and the overhead rate based on direct labor hours for each department
(rounded to the nearest cent).
SOLUTION
Blending
Department
Directly chargeable cost ...................................................... $125,000
Building depreciation:
2,000
$24,000 x ---------...........................................................
6,000
Testing
Department
$ 75,000
Terminal
Department
$ 87,500
8,000
8,000
8,000
11,000
11,000
11,000
12,000
--
Janitorial cost:
2,000
$33,000 x ---------...........................................................
6,000
Materials receiving cost:
$75,000
$48,000 x ------------ .......................................................
$100,000
$25,000
$48,000 x ------------ .......................................................
$100,000
Payroll Department cost:
25
$126,000 x ---- ..............................................................
84
36,000
--
37,500
40
$126,000 x ---- ..............................................................
84
--
60,000
--
19
$126,000 x ---- ..............................................................
84
--
--
28,500
Power:
60,000
$75,000 x ---------...........................................................
80,000
56,250
15,000
$75,000 x ---------...........................................................
80,000
--
14,063
--
5,000
$75,000 x ---------...........................................................
80,000
--
--
4,688
Total overhead ....................................................................
$273,750
$180,063
$139,688
Overhead rate per direct labor hour ....................................
4.42
1.73
2.59
PROBLEM 8
Overhead Allocation Via the Step Method. Granny's Nut Co. operates with three producing
departments (Cutting, Dividing, and Shelling that are serviced by two service departments Equipment
Maintenance and General Plant). Costs are allocated using the step method with the service department
servicing the greatest number of other departments allocated first. General Plant is allocated on the basis
of square footage and Equipment Maintenance is allocated on the basis of direct labor hours. Relevant
May data are:
Producing Departments
Cutting
Dividing
Shelling
Service Departments
Equipment
General
Maintenance
Plant
Overhead before
allocation of service
department costs .......................... $105,000
$93,000
$87,000
$56,000
$30,000
Square footage ...................................
8,000
12,000
6,000
4,000
-Machine hours used............................
6,000
2,000
7,000
--Direct labor used .................................
5,000
6,000
9,000
--Required: Prepare a schedule indicating the allocation of service department costs to producing
departments and the rate per machine hour for applying overhead in each producing department. (Round
to the nearest cent.)
SOLUTION
Producing Departments
Cutting
Overhead before
allocation of service
department costs ............................... $105,000
Allocation of service
department costs:
General Plant:
8,000
--------- x $30,000 ......................................
8,000
30,000
12,000
--------- x $30,000 ......................................
-30,000
6,000
--------- x $30,000 ......................................
-30,000
4,000
--------- x $30,000 ......................................
-30,000
Equipment Maintenance:
5,000
--------- x $60,000 ......................................
15,000
20,000
6,000
--------- x $60,000 ......................................
-20,000
9,000
--------- x $60,000 ......................................
-20,000
Total overhead ......................................... $128,000
Machine hours..........................................
6,000
Overhead application rate .........................
$21.33
Dividing
Shelling
Service Departments
Equipment
General
Maintenance
Plant
$93,000
$ 87,000
$56,000
$30,000
--
--
--
(8,000)
12,000
--
--
(12,000)
--
6,000
--
(6,000)
--
--
4,000
(4,000)
--
--
(15,000)
--
18,000
--
(18,000)
--
--
27,000
(27,000)
--
$123,000
2,000
$61.50
$120,000
7,000
17.14
PROBLEM 9
Overhead Distribution Via the Simultaneous Method. Orleans Corp. operates two producing
departments, C and D, and two service departments, E and F. The overhead before allocation of service
department costs, together with the usage of services from the service departments, is:
Department
Producing:
C .....................................................................
D .....................................................................
Service:
E......................................................................
F ......................................................................
Overhead Before
Allocation of Service
Department Costs
Services Provided by
E
F
$18,000
29,000
30%
30%
-80%
8,000
1,400
$56,400
-40%
20%
--
Required: Prepare the overhead distribution, using the simultaneous method to allocate the service
departments' costs to the producing departments.
SOLUTION
Let: E
F
Substituting: E
.92E
E
Substituting: F
= $8,000 + .2F
= $1,400 + .4E
= $8,000 + .2($1,400 + .4E)
= $8,280
= $9,000
= $1,400 + .4E
= $1,400 + .4($9,000)
= $5,000
Distribution of Overhead
Producing Departments
Service Departments
C
D
E
F
Overhead before
allocation of service
department costs ...........................
Distribution of Department E:
$9,000 x 30% .................................
$9,000 x 40% .................................
Total distributed ...................................
Distribution of Department F:
$5,000 x 80% .................................
$5,000 x 20% .................................
Total distributed ...................................
Overhead after distribution ...................
Proof: $20,700 + $35,700 = $56,400 total
$18,000
$29,000
$ 8,000
$
1,400
2,700
---
2,700
---
--(9,000)
-3,600
--
---$20,700
4,000
--$35,700
-1,000
-$
0
--(5,000)
$
0
PROBLEM 10
Multiple Overhead Rates. American Manufacturing Inc. (AMI) has a diverse product line with some jobs
requiring much labor and little machine use, and others requiring the opposite mix. Because no single
base for a predetermined overhead rate will provide AMI management with reliable product cost
information, overhead is classified into two cost pools, and two predetermined overhead rates are used.
For 19A, it is estimated that total overhead costs will consist of $200,000 of overhead related to the
expenditure of direct labor dollars and $800,000 of overhead related to machine usage. Total machine
usage is expected to be 40,000 hours for the year, and total direct labor dollars are expected to be
$400,000.
Job 711 required $1,500 of direct materials, 60 hours of labor at $15 per hour, and 5 hours of machine
time. Job 727 required $2,500 of direct materials, 45 hours of labor at $15 per hour, and 35 hours of
machine time.
Required:
(1)
(2)
(3)
(4)
(5)
Calculate AMI's predetermined overhead rates for 19A.
Determine the total cost of Job 711.
Determine the total cost of Job 727.
If AMI had used a single predetermined overhead rate based on direct labor dollars to apply all
overhead costs, what would have been the predetermined rate?
Based on your computations in (1) and (4) above and considering the two jobs in (2) and (3)
above, what would be the competitive implications of using the single predetermined overhead
rate and quoting prices at cost plus a small markup?
SOLUTION
(1)
The dual predetermined overhead rates are:
$200,000
= $.50 per direct labor dollar
$400,000direct labor dollars
and
$800,000
= $20 per machine hour
40,000 machine hours
(2)
Job 711
Direct material......................................................................................................................
Direct labor (60 x $15) .........................................................................................................
Applied overhead:
$900 x $.50 = 450
5 x $ 20 = 100.....................................................................................................
Total .....................................................................................................................................
(3)
Job 727
Direct material......................................................................................................................
Direct labor (45 x $15) .........................................................................................................
Applied overhead:
$675 x $.50 = 337.50
35 x $ 20 = 700.00 ................................................................................................
Total .....................................................................................................................................
(4)
$ 1,500
900
550
$ 2,950
$ 2,500.00
675.00
1,037.50
$ 4,212.50
A single predetermined overhead rate based on direct labor dollars would be:
$200,000+ $800,000
= $2.50 per direct labor dollar
$400,000direct labor dollars
(5)
The competitive implications of a single overhead rate are that on jobs requiring much labor and
little machine time (e.g., Job 711), AMI will compute its costs at too high a level and will, therefore,
quote too high a price to the customer. These jobs will probably be lost to competitors who know
their costs better. On jobs requiring much machine time and little labor (e.g., Job 727), AMI will
calculate its costs at too low a level and will, therefore, quote too low a price, but will generate
less profit than expected or perhaps even a loss.
PROBLEM 11
Levels of Activity Drivers
Required: Each of the following is a potential activity driver. Identify the most likely level of each activity
driver by writing U for a unit-level driver, B for a batch-level driver, and P for a product-level driver.
1.Number of setups
2.Number of work orders
3.Machine hours
4.Pounds of product
5.Number of part numbers
6.Design hours
7.Number of design changes
8.Marketing promotions
9.Direct materials dollars
10.Loads of materials moved
SOLUTION
1. B
6. P
2. B
7. P
3. U
8. P
4. U
9. U
5. P
10. B
PROBLEM 12
Distortion of Batch-Level Costs. Maupin Company's existing cost system accumulates all overhead in
a single cost pool and allocates it based on direct labor hours. Last year, overhead costs totaled
$1,500,000, and Product A used 3,000 of the 30,000 total direct labor hours. An ABC study revealed that
of the total overhead cost for last year, $100,000 represented batch-level costs; these batch-level costs
are driven by work orders; and a total of 500 work orders were issued, of which 25 were for Product A.
Required: With respect to batch-level costs only, calculate the existing cost system's direction and
amount of cost distortion for Product A.
SOLUTION
The existing system allocated 3,000/30,000 = 10% of all overhead to Product A last year; but A
accounted for only 25/500 = 5% of batch-level activity. So, with respect to batch-level costs only, the
existing system overstated A's cost last year by a total of:
(10% - 5%) x $100,000 = $5,000 overstatement
PROBLEM 13
Value-Added and Non-Value-Added Activities. Sequential Company's sole product, a unique end
table made from lumber, is produced and sold in the following sequence of steps:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
(m)
(n)
(o)
(p)
(q)
(r)
(s)
wood received and inspected at receiving dock
wood moved to stores inventory
wood moved to Cutting Department
wood cut to size
moved to Planing Department
placed in queue to await planing
wood smoothed and shaped
moved to Inspection Department
inspected
moved to in-process storage area
moved to Assembly Department
various parts of the table are assembled
placed on hand truck to await material handler
moved to Staining Department
tables stained
moved to Inspection Department
inspected
moved to Shipping Department
tables shipped
Required: Which of the steps add value to the product?
SOLUTION
Activities (d), (g), (l), and (o) are the only ones which add value.
PROBLEM
14
Allocation Rates and Driver Rates. The Barre Division of Scranton Company manufactures many highvolume products and many low-volume products. Selected information follows for Barre's most recent
year of operations:
Indirect costs:
Machine related:
Machine operation ............................................................................................................
Machine setup ..................................................................................................................
Total machine overhead ............................................................................................
Materials related:
Materials handling ............................................................................................................
Other materials-related.....................................................................................................
Total materials overhead ...........................................................................................
Other overhead ................................................................................................................
Total overhead .................................................................................................................
Machine hours ........................................................................................................................
Pounds of materials ................................................................................................................
Setup hours.............................................................................................................................
Purchase orders......................................................................................................................
Direct labor hours....................................................................................................................
$
75,000
50,000
$ 125,000
$
45,000
60,000
$ 105,000
$ 190,000
$ 420,000
10,000
50,000
1,000
1,200
25,000
Barre's existing cost system allocates all machine-related overhead based on machine hours and all the
remaining overhead based on direct labor hours. However, a recent study determined that machine
setup costs and material handling costs are primarily related to setup hours, and other materials-related
costs are primarily related to the number of purchase orders issued. Barre does not keep significant
materials inventories on hand.
Required:
(1)
(2)
Calculate the two overhead rates in Barre's existing cost system for the most recent year.
Calculate the overhead (driver) rates that an ABC system would use for the most recent year,
making only the changes suggested by the results of the recent study.
SOLUTION
$125,000 of machine- related overhead
= $12.50 per machine hour
10,000 machine hours
$295,000 of remaining overhead costs
= $11.80 per direct labor hour
25,000 DLH
(1)
$75,000 of machine operation overhead
= $7.50 per machine hour
10,000 machine hours
$50,000 of machine- setup overhead + $45,000 of materials handling overhead
= $95 per setup hour
1,000 setup hours
$60,000 of other materials- related cost
= $50 per purchase order
1,200 purchase orders
$190,000 of _ other overhead _
= $7.60 per direct labor hour
25,000 DLH
(2)
PROBLEM 15
Comparison of ABC and Traditional Costing; Two Products. Blaine Company produces two
products, Nifty and So-So, and uses a costing system in which all overhead is accumulated in a single
cost pool and allocated based on machine hours. Blaine's management has decided to implement ABC
because a cost study has revealed significant amounts of overhead cost related to setup activity and
design activity. The number of setups and the number of design hours will be the activity drivers for the
two new cost pools, and machine hours will continue as the base for allocating the remaining overhead.
Selected information follows for Blaine Company's most recent year of operations:
Units produced ......................................................................
Nifty
500
So-So
15,500
Total
16,000
Direct material cost:
Per unit ...........................................................................
Total ...............................................................................
$
200
$100,000
$
20
$ 310,000
$ 410,000
Machine hours ......................................................................
Direct labor cost ....................................................................
Setups ...................................................................................
Design hours .........................................................................
3,000
$ 50,000
120
6,000
47,000
$ 350,000
80
4,000
50,000
$ 400,000
200
10,000
Overhead:
Setup-related..................................................................
Design-related ................................................................
Other ..............................................................................
Total overhead ...............................................................
$ 250,000
350,000
900,000
$1,500,000
Required:
(1)
(2)
Calculate the total and per-unit costs reported for the two products by the existing costing system.
Calculate the total and per-unit costs reported for the two products by the ABC system.
SOLUTION
(1)
Blaine Company
Product Costs from Existing Cost System
Overhead Rate:
$1,500,000 of overhead divided by 50,000 machine hours = $30 per machine hour
Direct material.......................................................................
Direct labor ...........................................................................
Overhead:
$30 x 3,000 ....................................................................
$30 x 47,000 ..................................................................
Total cost ..............................................................................
Units produced ......................................................................
Cost per unit .........................................................................
(2)
Nifty
$100,000
50,000
So-So
$ 310,000
350,000
Total
$ 410,000
400,000
1,410,000
$2,070,000
15,500
$
133.55
1,500,000
$2,310,000
90,000
$240,000
500
$ 480.00
Blaine Company
Product Costs from Activity-Based Costing System
Overhead Rate:
$250,000 setup-related costs divided by 200 setups = 1,250 per setup
$350,000 design-related costs divided by 10,000 design hours = $35 per design hour
$900,000 of other overhead divided by 50,000 machine hours = $18 per machine hour
Direct material.......................................................................
Direct labor ...........................................................................
Overhead:
$1,250 x 120 setups .......................................................
$1,250 x 80 setups .........................................................
$35 x 6,000 design hours ...............................................
$35 x 4,000 design hours ...............................................
$18 x 3,000 machine hours ............................................
$18 x 47,000 machine hours ..........................................
Total cost ..............................................................................
Units produced ......................................................................
Cost per unit .........................................................................
Nifty
$ 100,000
50,000
So-So
$ 310,000
350,000
Total
$ 410,000
400,000
100,000
250,000
140,000
350,000
846,000
$1,746,000
15,500
$ 112.65
900,000
$2,310,000
150,000
210,000
54,000
$ 564,000
500
$1,128.00
ASSESSMENT
MULTIPLE CHOICE
Set 1
1.All of the following phrases are used as alternate terminology for "factory overhead" except:
A.
manufacturing expense
B.
indirect manufacturing cost
C.
factory expense
D.
factory burden
E.
other expense
2.The component of per-unit costs that remains constant as the production level varies is:
A.
general and administrative expenses
B.
commercial expenses
C.
variable factory overhead
D.
fixed factory overhead
E.
heat, light, and power
3.To express factory overhead as a percentage of direct materials dollars, estimated factory overhead is
divided by estimated:
A.
machine hours
B.
normal capacity
C.
units of materials used
D.
materials cost
E.
materials requisition usage
4.Estimated factory overhead is $600,000, and the hours usage of machinery is expected to be 150,000.
Factory overhead is applied at the rate of $10 per direct labor hour. The wage rate for direct
labor is $6 per hour, and the total number of estimated direct labor hours for the period is:
A.
100,000
B.
150,000
C.
300,000
D.
600,000
E.
60,000
5.An objection to the use of a factory overhead rate based on direct labor dollars is that:
A.
these items are difficult to measure
B.
a job is charged with more overhead when a highly paid operator works on the job than
when a low-paid operator performs the work
C.
overhead is allocated in relation to units produced by workers
D.
overhead rates will be distributed inequitably when there are no wage differentials in
the department
E.
costs of applying this method are excessive
6.A company expects to produce an average of 75,000 units per year, but last year production equaled
60,000 units. For the coming year, estimated production is 90,000 units. Estimated
overhead costs are $900,000, and overhead is applied at the rate of $10 per unit. The
company bases its overhead rates on:
A.
theoretical (engineering) capacity
B.
a short-term planning approach
C.
historical capacity costs
D.
expected actual capacity
E.
normal capacity
7.Direct costing differs from absorption costing in that:
A.
direct materials and direct labor do not become a part of product cost under direct
costing
B.
the variable portion of overhead cost does not become a part of product cost under
direct costing
C.
the fixed portion of overhead cost does not become a part of product cost under direct
costing
D.
marketing and administrative expenses become a part of product cost under direct
costing
E.
direct costing does not differ from absorption costing
8.Application rates for factory overhead best reflect anticipated fluctuations in sales over a cycle of years
when they are computed under the concept of:
A.
practical capacity
B.
expected actual capacity
C.
theoretical capacity
D.
maximum capacity
E.
normal capacity
9.Underapplied factory overhead related to a significant decrease in production should be charged to:
A.
Finished Goods Inventory
B.
Cost of Goods Sold
C.
Work in Process Inventory and Finished Goods Inventory
D.
Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold
E.
Work in Process Inventory
10.Brownfield Company applies factory overhead on the basis of direct labor hours. Budget and actual
data for direct labor and overhead for the year are as follows:
..........................................................................................
Budget
Actual
Direct labor hours ........................................................................
600,000
550,000
Factory overhead costs ............................................................... $720,000
$640,000
The factory overhead for Brownfield for the year is:
A.
underapplied by $40,000
B.
overapplied by $20,000
C.
overapplied by $40,000
D.
underapplied by $20,000
E.
neither underapplied nor overapplied
11.A company manufactures plastic products for the home and restaurant market. The company also
does contract work for other customers and utilizes a job order costing system. The flexible
budget covering next year's expected range of activity is:
Direct labor hours .............................................
50,000
80,000
110,000
Machine hours .................................................
40,000
64,000
88,000
Variable overhead costs...................................
$100,000
$160,000
$220,000
Fixed overhead costs .......................................
150,000
150,000
150,000
Total overhead costs ........................................
$250,000
$310,000
$370,000
A predetermined overhead rate based on direct labor hours at expected actual capacity is
used to apply total overhead. Management has estimated that 100,000 direct labor hours will
be used next year. The predetermined overhead rate per direct labor hour to be used to apply
total overhead to individual jobs next year is:
A.
$3.70
B.
$3.88
C.
$3.36
D.
$3.50
E.
none of the above
12.At the end of the last fiscal year, Tiger Company had the following account balances:
Overapplied Overhead .........................................................................................
Cost of Goods Sold ..............................................................................................
Work in Process Inventory ...................................................................................
Finished Goods Inventory ....................................................................................
$ 1,000
980,000
38,000
82,000
The most common treatment of the Overapplied Overhead would be to:
A.
carry it as a deferred credit on the balance sheet
B.
report it as a miscellaneous operating revenue on the income statement
C.
credit it to Cost of Goods Sold
D.
prorate it between Work in Process Inventory and Finished Goods Inventory
E.
prorate it among Work in Process Inventory, Finished Goods Inventory, and Cost of
Goods Sold
13.Overapplied factory overhead would result if:
A.
factory overhead costs incurred were less than costs charged to production
B.
factory overhead costs incurred were unreasonably large in relation to units produced
C.
factory overhead costs incurred were greater than costs charged to production
D.
theoretical capacity were used in computing the overhead rate
E.
the plant were operating at less than normal capacity
14.Clyde Company found that the differences in product costs resulting from the application of
predetermined overhead rates rather than actual overhead rates were very significant when
actual production was substantially less than planned production. The most likely explanation
is that:
A.
costs of overhead were substantially less than anticipated
B.
overhead was composed chiefly of variable costs
C.
several products were produced simultaneously
D.
fixed factory overhead was a significant cost
E.
costs of overhead items were substantially higher than anticipated
15.Avery Co. uses a predetermined factory overhead rate based on direct labor hours. For the month of
October, Avery's budgeted overhead was $300,000 based on a budgeted volume of 100,000
direct labor hours. Actual overhead amounted to $325,000 with actual direct labor hours
totaling 110,000. How much was the overapplied or underapplied overhead?
A.
$5,000 overapplied
B.
$5,000 underapplied
C.
$30,000 overapplied
D.
$30,000 underapplied
E.
none of the above
16.The absolute maximum capacity possible under the best conceivable operating conditions is a
description of which type of activity level used in the computation of overhead rates?
A.
theoretical
B.
normal
C.
practical
D.
expected actual
E.
currently attainable (expected)
17.All of the following are terms used to describe the phenomenon measured in the denominator of an
overhead rate, except the:
A.
base
B.
overhead cost base
C.
overhead rate base
D.
overhead allocation base
E.
all of the above are acceptable terms
18.The budget for a given factory overhead cost during a given period was $80,000. The actual cost for
the period was $72,000. Considering these facts, it can be said that the plant manager has
done a better-than-expected job in controlling the cost if:
A.
the cost is a discretionary fixed cost and actual production equaled budgeted
production
B.
the cost is variable and actual production equaled budgeted production
C.
the cost is variable and actual production was 90% of budgeted production
D.
the cost is fixed and the actual production was less than budgeted production
E.
the cost is variable and actual production was 80% of budgeted production
19.In highly automated manufacturing, all of the following may be appropriate bases for factory overhead
application except:
A.
machine hours
B.
direct labor hours
C.
number of setups
D.
number of inspections
E.
movement of materials
20.The transactions-base approach to overhead application gives particular consideration to:
A.
the amount of direct labor cost
B.
the number of machine hours
C.
overhead costs that are not driven by volume of output
D.
special, high-volume production items
E.
homogeneous production processes
21.When the amount of overapplied factory overhead is significant, the entry to close Overapplied Factory
Overhead will most likely require:
A.
a debit to Cost of Goods Sold
B.
debits to Cost of Goods Sold, Finished Goods Inventory, and Work in Process
Inventory
C.
a credit to Cost of Goods Sold
D.
credits to Cost of Goods Sold, Finished Goods Inventory, and Work in Process
Inventory
E.
none of the above
22.The type of activity level that results when theoretical capacity is reduced by allowances for
unavoidable interruptions is:
A.
practical capacity
B.
expected actual capacity
C.
normal capacity
D.
excess capacity
E.
none of the above
23.The condition that results either from greater productive capacity than the company could ever hope to
use or from an imbalance in equipment or machinery is termed:
A.
theoretical capacity
B.
practical capacity
C.
idle capacity
D.
excess capacity
E.
none of the above
24.The method of product costing in which only variable overhead is included in the overhead rate is:
A.
absorption costing
B.
direct costing
C.
conventional costing
D.
full costing
E.
none of the above
25.All of the following are names for the product costing method in which both fixed and variable costs
are included in overhead rates, except:
A.
absorption costing
B.
conventional costing
C.
direct costing
D.
full costing
E.
all of the above
Set 2
1.A department that would be classified as a producing department is:
A.
Production Control
B.
Utilities
C.
Finishing
D.
Medical
E.
Shipping
2.A department that would be classified as a service department is:
A.
Refining
B.
Receiving
C.
Mixing
D.
Assembly
E.
Finishing
3.In determining the right method for allocating equipment depreciation to departments, the best
recommendation is to:
A.
use the cost of equipment in the department as a basis for allocation
B.
allocate on the basis of square footage used in a given department
C.
charge the amounts to General Plant
D.
use algebraic techniques
E.
allocate on the basis of companywide rates
4.The most reasonable basis for allocating worker's compensation insurance is:
A.
departmental payroll
B.
building depreciation
C.
kilowatt-hours
D.
number of employees
E.
materials used
5.A company is attempting to allocate the costs of electricity in various departments. The variable portion
of electricity expense is to be allocated using kilowatt-hours. The information needed in
order to allocate the fixed portion of the current period's electricity expense is:
A.
rated horsepower of equipment
B.
number of machines in each department
C.
estimated materials consumption
D.
number of employees
E.
square footage in each department
6.The method for allocating service department costs that requires the least clerical work is:
A.
use of square footage in each department
B.
step method
C.
allocation to other service departments only
D.
simultaneous method
E.
direct method
7.Rapid Falls Corp. has three producing departments, A, B, and C, with 50, 30, and 20 employees,
respectively, in each department. Factory payroll costs other than direct labor are
accumulated in a Payroll Department account and are assigned to producing departments on
the basis of number of employees. The total payroll in each department was: A, $300,000;
B, $275,000; C, $325,000; and Payroll, $50,000. Other costs accumulated in the Payroll
Department amounted to $200,000. The amount of Payroll Department costs chargeable to
Department C is:
A.
$125,000
B.
$100,000
C.
$40,000
D.
$10,000
E.
$50,000
8.The following statement that best describes cost allocation is:
A.
a company, as a general rule, should allocate indirect costs randomly or based on an
"ability-to-bear" criterion
B.
a company can affect total income the most strongly by using the algebraic method of
allocating indirect costs
C.
a company can maximize or minimize total company income by selecting different
bases on which to allocate indirect costs
D.
a company should select an allocation base to raise or lower reported income on given
products
E.
a company's total income will remain unchanged no matter how indirect costs are
allocated
9.Carmichael Manufacturing Company has two production departments (Fabrication and Assembly) and
three service departments (General Factory Administration, Factory Maintenance, and
Factory Cafeteria). A summary of the year's costs and other data for each department prior to
allocation of service department costs appears below.
Labor costs.......................................
Material costs ...................................
Overhead .........................................
Direct labor hours .............................
Number of employees ......................
Square footage occupied .................
Fabrication
$1,950,000
$3,130,000
$1,650,000
562,500
280
88,000
Assembly
$ 2,050,000
$ 950,000
$ 1,850,000
437,500
200
72,000
General Factory
Administration
$90,000
--$70,000
31,000
12
1,750
(
Factory
Factory
(
Maintenance
Cafeteria
(
$82,100
$87,000
(
$65,000
$91,000
(
$56,100
$62,000
(
27,000
42,000
(
8
20
(
2,000
4,800
Total $203,200
$240,000
The costs of the General Factory Administration Department, Factory Maintenance
Department, and Factory Cafeteria are allocated on the basis of direct labor hours, square
footage occupied, and number of employees, respectively. There are no manufacturing
overhead variances.
Assuming that Carmichael elects to distribute service department costs under the direct
method of cost allocation, the amount of Factory Maintenance Department costs that would
be allocated to the Fabrication Department is (round all final calculations to the nearest
dollar):
A.
$106,091
B.
$91,440
C.
$0
D.
$111,760
E.
none of the above
)
)
)
)
)
)
)
)
10.Carmichael Manufacturing Company has two production departments (Fabrication and Assembly) and
three service departments (General Factory Administration, Factory Maintenance, and
Factory Cafeteria). A summary of the year's costs and other data for each department prior
to allocation of service department costs appears below.
Fabrication
$1,950,000
$3,130,000
$1,650,000
562,500
280
88,000
Assembly
$2,050,000
950,000
$1,850,000
437,500
200
72,000
General Factory
Administration
$90,000
--$70,000
31,000
12
1,750
$160,000
)
)
)
)
)
)
)
)
Labor costs.......................................
Material costs ...................................
Overhead .........................................
Direct labor hours .............................
Number of employees ......................
Square footage occupied .................
..................................................
(
Factory
Factory
(
Maintenance
Cafeteria
(
$82,100
$87,000
(
$65,000
$91,000
(
$56,100
$62,000
(
27,000
42,000
(
8
20
(
2,000
4,800
Total $203,200
$240,000
The costs of the General Factory Administration Department, Factory Maintenance
Department, and Factory Cafeteria are allocated on the basis of direct labor hours, square
footage occupied, and number of employees, respectively.
The amount of General Factory Administration Department costs that would be allocated
to the Assembly Department under the direct method is (round all final calculations to the
nearest dollar):
A.
$70,000
B.
$90,000
C.
$0
D.
$63,636
E.
none of the above
11.Carmichael Manufacturing Company has two production departments (Fabrication and Assembly) and
three service departments (General Factory Administration, Factory Maintenance, and
Factory Cafeteria). A summary of the year's costs and other data for each department prior
to allocation of service department costs appears below.
Labor costs.......................................
Material costs ...................................
Overhead .........................................
Direct labor hours .............................
Number of employees ......................
Square footage occupied .................
(
(
(
(
(
(
(
(
Factory
Maintenance
$82,100
$65,000
$56,100
27,000
8
2,000
Fabrication
$1,950,000
$3,130,000
$1,650,000
562,500
280
88,000
Assembly
$2,050,000
$950,000
$1,850,000
437,500
200
72,000
General Factory
Administration
$90,000
--$70,000
31,000
12
1,750
Factory
Cafeteria
$87,000
$91,000
$62,000
42,000
20
4,800
The costs of the General Factory Administration Department, Factory Maintenance
Department, and Factory Cafeteria are allocated on the basis of direct labor hours, square
footage occupied, and number of employees, respectively.
Assuming that Carmichael elects to distribute service department costs to other service
departments using the step method of cost allocation and that the order of distribution is
based on the dollar amount of costs originating in the service departments, how much of the
total Factory Cafeteria cost would be allocated to the Factory Maintenance Department?
(Round all final calculations to the nearest dollar.)
A.
$96,000
B.
$3,840
C.
$6,124
D.
$0
E.
none of the above
)
)
)
)
)
)
)
)
12.Carmichael Manufacturing Company has two production departments (Fabrication and Assembly) and
three service departments (General Factory Administration, Factory Maintenance, and
Factory Cafeteria). A summary of the year's costs and other data for each department prior
to allocation of service department costs appears below.
Labor costs.......................................
Material costs ...................................
Overhead .........................................
Direct labor hours .............................
Number of employees ......................
Square footage occupied .................
(
(
(
(
(
(
(
(
Factory
Maintenance
$82,100
$65,000
$56,100
27,000
8
2,000
Fabrication
$1,950,000
$3,130,000
$1,650,000
562,500
280
88,000
Assembly
$2,050,000
$950,000
$1,850,000
437,500
200
72,000
General Factory
Administration
$90,000
--$70,000
31,000
12
1,750
Factory
Cafeteria
$87,000
$91,000
$62,000
42,000
20
4,800
The costs of the General Factory Administration Department, Factory Maintenance
Department, and Factory Cafeteria are allocated on the basis of direct labor hours, square
footage occupied, and number of employees, respectively.
How much of the Factory Maintenance Department costs would be allocated to the
Factory Cafeteria under the step method, assuming that the order of distribution is based on
the dollar amount of costs originating in the service departments? (Round all final
calculations to the nearest dollar.)
A.
$148,910
B.
$0
C.
$5,787
D.
$5,856
E.
none of the above
)
)
)
)
)
)
)
)
13.Acie Company has two service departments and three production departments, each producing a
separate product. For a number of years, Acie has allocated the costs of the service
departments to the production departments on the basis of the annual sales dollars. In a
recent audit report, the internal auditor stated that the distribution of service department costs
on the basis of annual sales dollars would lead to serious inequities. It was recommended
that maintenance and engineering service hours be used as a better service cost allocation
basis. For illustration purposes, the following information was appended to the audit report:
Service Departments
)
Maintenance
Maintenance hours used ...............................
Engineering hours used ................................
Department direct costs ................................
(
(
(
(
(
Department A
800
800
$80,000
Production Departments
Department B
200
400
$90,000
Engineering
400
400
$12,000
$54,000
)
)
)
)
Department C
200
400
$50,000
Using the simultaneous method, what would be the total Engineering Department cost after
allocation of interservice department costs, but before allocation to the Maintenance and
Production Departments?
A.
$60,000
B.
$57,000
C.
$12,000
D.
$54,000
E.
none of the above
14.Acie Company has two service departments and three production departments, each producing a
separate product. For a number of years, Acie has allocated the costs of the service
departments to the production departments on the basis of the annual sales dollars. In a
recent audit report, the internal auditor stated that the distribution of service department costs
on the basis of annual sales dollars would lead to serious inequities. It was recommended
that maintenance and engineering service hours be used as a better service cost allocation
basis. For illustration purposes, the following information was appended to the audit report:
Service Departments
)
Maintenance
Maintenance hours used ...............................
Engineering hours used ................................
Department direct costs ................................
(
(
(
(
(
Department A
800
800
$80,000
Production Departments
Department B
200
400
$90,000
400
$12,000
Department C
200
400
$50,000
Engineering
400
$54,000
)
)
)
)
Using the simultaneous method, what would be the total Maintenance Department cost after
allocation of interservice department costs, but before allocation to the Engineering and
Production Departments?
A.
$72,000
B.
$12,000
C.
$60,000
D.
$24,000
E.
none of the above
15.Acie Company has two service departments and three production departments, each producing a
separate product. For a number of years, Acie has allocated the costs of the service
departments to the production departments on the basis of the annual sales dollars. In a
recent audit report, the internal auditor stated that the distribution of service department costs
on the basis of annual sales dollars would lead to serious inequities. It was recommended
that maintenance and engineering service hours be used as a better service cost allocation
basis. For illustration purposes, the following information was appended to the audit report:
Service Departments
)
Maintenance
Maintenance hours used ...............................
Engineering hours used ................................
Department direct costs ................................
(
(
(
(
(
Department A
800
800
$80,000
Production Departments
Department B
200
400
$90,000
400
$12,000
Engineering
400
$54,000
)
)
)
)
Department C
200
400
$50,000
Using the step method of cost allocation, what amount of maintenance cost would be
allocated to Department A, assuming that the service departments are distributed in the order
of total dollars of direct departmental costs?
A.
$0
B.
$25,500
C.
$15,200
D.
$3,187.50
E.
none of the above
16.Acie Company has two service departments and three production departments, each producing a
separate product. For a number of years, Acie has allocated the costs of the service
departments to the production departments on the basis of the annual sales dollars. In a
recent audit report, the internal auditor stated that the distribution of service department costs
on the basis of annual sales dollars would lead to serious inequities. It was recommended
that maintenance and engineering service hours be used as a better service cost allocation
basis. For illustration purposes, the following information was appended to the audit report:
Service Departments
)
Maintenance
Maintenance hours used ..............................
Engineering hours used ...............................
Department direct costs ...............................
400
$12,000
(
(
(
(
(
Department C
200
400
$50,000
Department A
800
800
$80,000
Production Departments
Department B
200
400
$90,000
Engineering
400
)
)
)
)
$54,000
Using the step method of cost allocation, what amount of engineering cost would be
allocated directly to Department A, assuming that the service departments are distributed in
the order of total dollars of direct departmental costs?
A.
$11,400
B.
$21,600
C.
$10,800
D.
$22,800
E.
none of the above
800/2,000 x $54,000 = $21,600
17.A factor to be considered in deciding the kinds of departments required for establishing accurate
departmental overhead rates with which to control costs is:
A.
location of operations, processes, and machinery
B.
responsibilities for production and costs
C.
number of departments or cost centers
D.
similarity of operations, procedures, and machinery in each department
E.
all of the above
18.Services available for the benefit of producing departments and other service departments can be
organized by:
A.
establishing a separate service department for each function
B.
combining several functions into one department
C.
placing service costs in a department called "general factory cost pool"
D.
none of the above
E.
all of the above
Learning Module for Independent Learning
207
19.Entities that have practiced departmentalization for many years, by grouping their activities into
categories such as occupancy, sales promotion, purchasing, and delivery are:
A.
hospitals
B.
retail stores
C.
banks
D.
insurance companies
E.
colleges
20.An automotive company has three divisions. One division manufactures new replacement parts for
automobiles; another rebuilds engines; and the third does repair and overhaul work on a line
of trucks. All three divisions use the services of a central payroll department. The best
method of allocating the cost of the payroll department to the various operating divisions is:
A.
total labor hours incurred in the divisions
B.
value of production in the divisions
C.
direct materials costs incurred in the divisions
D.
machine hours used in the divisions
E.
none of the above
21.The Janitorial Department provides cleaning services to all departments of a large store. Management
wishes to allocate the janitorial costs to the various departments that benefit from the service.
The most reasonable allocation base for janitorial costs would be:
A.
sales of each department
B.
square footage of each department
C.
number of employees in each department
D.
total direct costs of each department before any allocations
E.
none of the above
22.A hospital has a $100,000 expected utility bill this year. The Janitorial, Accounting, and Orderlies
Departments are service functions to the Operating, Hospital Rooms, and Laboratories
Departments. Floor space assigned to each department is:
Department .........................................................................................
Square Footage
Janitorial ..............................................................................................
1,000
Accounting ..........................................................................................
2,000
Orderlies..............................................................................................
7,000
Operating ............................................................................................
4,000
Hospital Rooms ...................................................................................
30,000
Laboratories ........................................................................................
6,000
..................................................................................................
50,000
How much of the $100,000 will eventually become the Hospital Rooms Department total
costs, assuming use of the direct method of allocation based on square footage?
A.
$60,000
B.
$72,000
C.
$75,000
D.
$80,000
E.
none of the above
Learning Module for Independent Learning
208
23.Serpent Corp. distributes service department overhead costs directly to producing departments
without allocation to the other service department. Information for the month of June is as
follows:
Service Departments
Maintenance
Utilities
Overhead costs incurred ................................................
$20,000
$10,000
Service provided to department:
Maintenance ............................................................
-10%
Utilities .....................................................................
20%
-ProducingCA............................................................
40%
30%
ProducingCB............................................................
40%
60%
Totals .............................................................................
100%
100%
The amount of Maintenance Department costs distributed to ProducingCA Department for
June was:
A.
$8,000
B.
$8,800
C.
$10,000
D.
$11,000
E.
none of the above
24.Multiple overhead rates are most commonly used when:
A.
production consists of long runs of a single product
B.
the company has more than one production department
C.
manufacturing operations are labor intensive
D.
production consists of a diverse product line
E.
none of the above
25.An example of a nonvolume-related overhead base would be:
A.
direct materials cost
B.
number of setups
C.
machine hours
D.
direct labor dollars
E.
none of the above
Set 3
1.A base used to allocate the cost of a resource to the different activities using that resource is a(n):
A.
resource driver
B.
activity driver
C.
final cost object
D.
driver
E.
none of the above
2.A base used to allocate the cost of products, customers, or other final cost objects is a(n):
A.
resource driver
B.
activity driver
C.
final cost object
D.
driver
E.
none of the above
Learning Module for Independent Learning
209
3.Examples of activities at the batch level of costs include:
A.
cutting, painting, and packaging
B.
scheduling, setting up, and moving
C.
designing, changing, and advertising
D.
heating, lighting, and security
E.
none of the above
4.Examples of activities at the product level of costs include:
A.
cutting, painting, and packaging
B.
scheduling, setting up, and moving
C.
designing, changing, and advertising
D.
heating, lighting, and security
E.
none of the above
5.Examples of activities at the plant level of costs include:
A.
cutting, painting, and packaging
B.
scheduling, setting up, and moving
C.
designing, changing, and advertising
D.
heating, lighting, and security
E.
none of the above
6.Examples of activities at the unit level of costs include:
A.
cutting, painting, and packaging
B.
scheduling, setting up, and moving
C.
designing, changing, and advertising
D.
heating, lighting, and security
E.
none of the above
7.Examples of unit-level costs are:
A.
portions of electricity and indirect materials
B.
salaries of schedulers and setup personnel
C.
salaries of designers and programmers
D.
depreciation and insurance on buildings
E.
none of the above
8.Examples of product-level costs are:
A.
portions of electricity and indirect materials
B.
salaries of schedulers and setup personnel
C.
salaries of designers and programmers
D.
depreciation and insurance on buildings
E.
none of the above
9.Examples of plant-level costs are:
A.
portions of electricity and indirect materials
B.
salaries of schedulers and setup personnel
C.
salaries of designers and programmers
D.
depreciation and insurance on buildings
E.
none of the above
Learning Module for Independent Learning
210
10.Examples of batch-level costs are:
A.
portions of electricity and indirect materials
B.
salaries of schedulers and setup personnel
C.
salaries of designers and programmers
D.
depreciation and insurance on buildings
E.
none of the above
11.Examples of unit-level activity drivers include:
A.
units of output and direct labor hours
B.
number of batches and material moves
C.
number of products and design changes
D.
square footage occupied
E.
all of the above
12.Examples of batch-level activity drivers include:
A.
units of output and direct labor hours
B.
number of batches and material moves
C.
number of products and design changes
D.
square footage occupied
E.
all of the above
13.Examples of product-level activity drivers include:
A.
units of output and direct labor hours
B.
number of batches and material moves
C.
number of products and design changes
D.
square footage occupied
E.
all of the above
14.Examples of plant-level activity drivers include:
A.
units of output and direct labor hours
B.
number of batches and material moves
C.
number of products and design changes
D.
square footage occupied
E.
all of the above
15.Unit-level costs are costs that:
A.
inevitably increase whenever a unit is produced
B.
are caused by the number of batches produced and sold
C.
are incurred to support the number of different products produced
D.
are incurred to sustain capacity at a production site
E.
none of the above
16.Plant-level costs are costs that:
A.
inevitably increase whenever a unit is produced
B.
are caused by the number of batches produced and sold
C.
are incurred to support the number of different products produced
D.
are incurred to sustain capacity at a production site
E.
none of the above
Learning Module for Independent Learning
211
17.Unit-level drivers are:
A.
inversely proportional to the volume of output
B.
measures of activities that vary with the number of batches produced and sold
C.
measures of activity that vary with the number of different products produced and sold
D.
for assigning plant-level costs
E.
none of the above
18.Traditional costing systems are characterized by their use of which of the following measures as bases
for allocating overhead to output:
A.
unit-level drivers
B.
batch-level drivers
C.
product-level drivers
D.
plant-level drivers
E.
none of the above
19.ABC systems are characterized by their use of which of the following measures as bases for allocating
overhead to output:
A.
unit-level drivers
B.
batch-level drivers
C.
product-level drivers
D.
plant-level drivers
E.
all of the above
20.All of the following are distinctions that usually exist between traditional and ABC costing systems,
except that:
A.
the number of overhead cost pools tends to be lower in ABC systems
B.
the number of allocation bases tend to be higher in ABC systems
C.
costs within an ABC cost pool tend to be more homogeneous than the costs within a
traditional system's cost pool
D.
all ABC systems are two-stage costing systems, while traditional systems may be oneor two-stage
E.
all of the above are distinctions
21.All of the following are distinctions that usually exist between traditional and ABC costing systems,
except that:
A.
the number of overhead cost pools tends to be higher in ABC systems
B.
the number of allocation bases tend to be higher in ABC systems
C.
costs within an ABC cost pool tend to be more homogeneous than the costs within a
traditional system's cost pool
D.
all ABC systems are one-stage costing systems, while traditional systems may be oneor two-stage
E.
all of the above are distinctions
Learning Module for Independent Learning
212
22.Compared to an ABC system, a traditional costing system reports:
A.
a lower unit cost for high-volume products and a higher unit cost for low-volume
products
B.
a higher unit cost for high-volume products and a lower unit cost for low-volume
products
C.
the same unit costs for high- and low-volume products as does an ABC system
D.
either higher or lower unit cost for high-volume products than an ABC system
depending upon the level of fixed costs
E.
none of the above
23.Activity-based management (ABM) is:
A.
a costing system in which multiple overhead cost pools are allocated using bases that
include one or more nonvolume related factors
B.
a base used to allocate the cost of a resource to the different activities using it
C.
the use of information obtained from ABC to make improvements in the firm
D.
a base used to allocate the cost of an activity to products and customers
E.
none of the above
24.All of the following are ways that activities can be managed to achieve improvements in a process,
except:
A.
activity induction
B.
activity elimination
C.
activity selection
D.
activity sharing
E.
all of the above are ways in which activities may be managed
25.All of the following are examples of non-value-added activities except:
A.
ordering
B.
receiving
C.
assembling
D.
inspections
E.
setting up
Set 4
1. Hettich Corporation uses an activity-based costing system with the following three activity cost
pools:
Activity Cost Pool
Total Activity
Fabrication ............................... 20,000 machine-hours
Order processing...................... 200 orders
Other ........................................ Not applicable
The Other activity cost pool is used to accumulate costs of idle capacity and
organization-sustaining costs.
Learning Module for Independent Learning
213
The company has provided the following data concerning its costs:
Wages and salaries..................
Depreciation .............................
Occupancy ...............................
Total .........................................
$480,000
120,000
200,000
$800,000
The distribution of resource consumption across activity cost pools is given below:
Wages and salaries....................
Depreciation ...............................
Occupancy .................................
Fabrication
55%
10%
25%
Activity Cost Pools
Order Processing Other
20%
25%
45%
45%
40%
35%
Total
100%
100%
100%
The activity rate for the Order Processing activity cost pool is closest to:
A)
$1,400 per order
B)
$1,600 per order
C)
$1,150 per order
D)
$800 per order
2. Orzel Corporation has provided the following data concerning its overhead costs for the coming
year:
Wages and salaries...............
Depreciation ..........................
Rent ......................................
Total ......................................
$240,000
120,000
180,000
$540,000
The company has an activity-based costing system with the following three activity cost
pools and estimated activity for the coming year:
Activity Cost Pool
Assembly ..............................
Order processing...................
Other .....................................
Total Activity
10,000 labor-hours
500 orders
Not applicable
The Other activity cost pool does not have a measure of activity; it is used to accumulate
costs of idle capacity and organization-sustaining costs.
The distribution of resource consumption across activity cost pools is given below:
Wages and salaries..........
Depreciation .....................
Rent .................................
Activity Cost Pools
Order
Assembly Processing Other
30%
50%
20%
15%
35%
50%
5%
65%
30%
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100%
100%
100%
214
The activity rate for the Assembly activity cost pool is closest to:
A)
$2.70 per labor-hour
B)
$9.00 per labor-hour
C)
$9.90 per labor-hour
D)
$16.20 per labor-hour
3. Laguna Corporation has provided the following data concerning its overhead costs for the coming
year:
Wages and salaries...............
Depreciation ..........................
Rent ......................................
Total ......................................
$260,000
100,000
180,000
$540,000
The company has an activity-based costing system with the following three activity cost pools and
estimated activity for the coming year:
Activity Cost Pool
Assembly ..............................
Order processing...................
Other .....................................
Total Activity
50,000 labor-hours
400 orders
Not applicable
The Other activity cost pool does not have a measure of activity; it is used to accumulate costs of idle
capacity and organization-sustaining costs.
The distribution of resource consumption across activity cost pools is given below:
Wages and salaries..........
Depreciation .....................
Rent .................................
Activity Cost Pools
Order
Assembly Processing Other
60%
20%
20%
5%
60%
35%
30%
30%
40%
Total
100%
100%
100%
The activity rate for the Order Processing activity cost pool is closest to:
A)
$415 per order
B)
$405 per order
C)
$495 per order
D)
$270 per order
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4. Poskey Corporation uses an activity-based costing system with three activity cost pools. The
company has provided the following data concerning its costs and its activity based costing system:
Costs:
Wages and salaries...............
Depreciation ..........................
Utilities ..................................
Total ......................................
$400,000
160,000
100,000
$660,000
Distribution of resource consumption:
Wages and salaries.................
Depreciation ............................
Utilities ....................................
Assembly
40%
20%
25%
Activity Cost Pools
Setting Up Other
40%
20%
35%
45%
55%
20%
Total
100%
100%
100%
How much cost, in total, would be allocated in the first-stage allocation to the Assembly activity
cost pool?
A)
$187,000
B)
$264,000
C)
$217,000
D)
$165,000
5. Ginger Corporation uses an activity-based costing system with three activity cost pools. The
company has provided the following data concerning its costs and its activity based costing system:
Costs:
Wages and salaries...............
Depreciation ..........................
Utilities ..................................
Total ......................................
$360,000
140,000
160,000
$660,000
Distribution of resource consumption:
Wages and salaries.................
Depreciation ............................
Utilities ....................................
Activity Cost Pools
Assembly Setting Up Other
10%
80%
10%
5%
50%
45%
15%
60%
25%
Total
100%
100%
100%
How much cost, in total, would be allocated in the first-stage allocation to the Setting Up activity
cost pool?
A)
$528,000
B)
$454,000
C)
$418,000
D)
$396,000
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6. Grandolfo Corporation uses an activity-based costing system with three activity cost pools. The
company has provided the following data concerning its costs and its activity based costing system:
Costs:
Wages and salaries...............
Depreciation ..........................
Utilities ..................................
Total ......................................
$300,000
200,000
140,000
$640,000
Distribution of resource consumption:
Wages and salaries.................
Depreciation ............................
Utilities ....................................
Assembly
45%
20%
15%
Activity Cost Pools
Setting Up Other
35%
20%
40%
40%
55%
30%
Total
100%
100%
100%
How much cost, in total, would be allocated in the first-stage allocation to the Other activity cost
pool?
A)
B)
C)
D)
$192,000
$182,000
$128,000
$192,000
7. Futter Corporation uses an activity-based costing system with three activity cost pools. The
company has provided the following data concerning its costs:
Wages and salaries............
Depreciation .......................
Occupancy .........................
Total ...................................
$440,000
180,000
220,000
$840,000
The distribution of resource consumption across the three activity cost pools is given below:
Wages and salaries............
Depreciation .......................
Occupancy .........................
Fabricating
55%
20%
10%
Activity Cost Pools
Order Processing
Other
35%
10%
35%
45%
50%
40%
Total
100%
100%
100%
How much cost, in total, would be allocated in the first-stage allocation to the Fabricating activity
cost pool?
A)
$84,000
B)
$300,000
C)
$238,000
D)
$462,000
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8.Duerr Corporation uses an activity-based costing system with three activity cost pools. The company
has provided the following data concerning its costs:
Wages and salaries............
Depreciation .......................
Occupancy .........................
Total ...................................
$400,000
180,000
200,000
$780,000
The distribution of resource consumption across the three activity cost pools is given below:
Wages and salaries............
Depreciation .......................
Occupancy .........................
Fabricating
55%
10%
35%
Activity Cost Pools
Order Processing
Other
20%
25%
50%
40%
40%
25%
Total
100%
100%
100%
How much cost, in total, would be allocated in the first-stage allocation to the Order Processing
activity cost pool?
A)
$250,000
B)
$286,000
C)
$156,000
D)
$312,000
9. Grammer Corporation uses an activity-based costing system with three activity cost pools. The
company has provided the following data concerning its costs:
Wages and salaries............
Depreciation .......................
Occupancy .........................
Total ...................................
$240,000
160,000
140,000
$540,000
The distribution of resource consumption across the three activity cost pools is given below:
Wages and salaries............
Depreciation .......................
Occupancy .........................
Fabricating
30%
20%
5%
Activity Cost Pools
Order Processing
Other
45%
25%
35%
45%
65%
30%
Total
100%
100%
100%
How much cost, in total, would be allocated in the first-stage allocation to the Other activity cost
pool?
A)
B)
C)
D)
$135,000
$174,000
$162,000
$180,000
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10. Radakovich Corporation has provided the following data from its activity-based costing system:
Activity Cost Pool
Assembly ........................
Processing orders ...........
Inspection........................
Total Cost
$436,240
$60,896
$82,767
Total Activity
28,000 machine-hours
1,600 orders
1,410 inspection-hours
The company makes 230 units of product F60N a year, requiring a total of 480 machine-hours, 50
orders, and 30 inspection-hours per year. The product's direct materials cost is $12.70 per unit and its
direct labor cost is $45.93 per unit. The product sells for $126.60 per unit.
According to the activity-based costing system, the product margin for product F60N is:
A)
$6,251.70 per unit
B)
$4,490.70 per unit
C)
$6,393.70 per unit
D)
$15,633.10 per unit
11. Rosenbrook Corporation has provided the following data from its activity-based costing system:
Activity Cost Pool
Assembly ........................
Processing orders ...........
Inspection........................
Total Cost
$710,770
$39,690
$119,116
Total Activity
37,000 machine-hours
1,800 orders
1,940 inspection-hours
Data concerning one of the company’s products, Product H73N, appear below:
Selling price per unit.....................................
Direct materials cost per unit........................
Direct labor cost per unit ..............................
Annual unit production and sales .................
Annual machine-hours .................................
Annual orders...............................................
Annual inspections .......................................
$125.10
$34.94
$49.21
460
510
80
10
According to the activity-based costing system, the product margin for product H73N is:
A)
$7,275.90 per unit
B)
$6,661.90 per unit
C)
$18,837.00 per unit
D)
$8,425.90 per unit
12. Belsky Corporation has provided the following data from its activity-based costing system:
Activity Cost Pool
Assembly ........................
Processing orders ...........
Inspection........................
Total Cost
$313,490
$49,476
$73,882
Total Activity
29,000 machine-hours
1,400 orders
1,060 inspection-hours
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The company makes 490 units of product Q19S a year, requiring a total of 1,080 machine-hours,
60 orders, and 20 inspection-hours per year. The product's direct materials cost is $46.42 per unit and its
direct labor cost is $20.22 per unit.
According to the activity-based costing system, the average cost of product Q19S is closest to:
A)
$97.64 per unit
B)
$66.64 per unit
C)
$93.31 per unit
D)
$94.79 per unit
13. Ravelo Corporation has provided the following data from its activity-based costing system:
Activity Cost Pool
Assembly ........................
Processing orders ...........
Inspection........................
Total Cost
$498,520
$54,263
$77,589
Total Activity
44,000 machine-hours
1,100 orders
1,110 inspection-hours
Data concerning the company’s product L19B appear below:
Annual unit production and sales ..........
Annual machine-hours ..........................
Annual number of orders.......................
Annual inspection hours ........................
Direct materials cost..............................
Direct labor cost ....................................
430
990
70
20
$37.74 per unit
$10.45 per unit
According to the activity-based costing system, the average cost of product L19B is closest to:
A)
$48.19 per unit
B)
$82.31 per unit
C)
$85.56 per unit
D)
$77.53 per unit
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Use the following to answer questions 14-16:
Esmail Company is a wholesale distributor that uses activity-based costing for all of its overhead costs.
The company has provided the following data concerning its annual overhead costs and its activity based
costing system:
Overhead costs:
Wages and salaries ..............
Other expenses ....................
Total ......................................
$380,000
220,000
$600,000
Distribution of resource consumption:
Wages and salaries ................
Other expenses ......................
Activity Cost Pools
Customer
Filling Orders
Support
Other
55%
35%
10%
25%
55%
20%
Total
100%
100%
The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining costs.
The amount of activity for the year is as follows:
Activity Cost Pool
Activity
Filling orders ......................... 4,000 orders
Customer support ................. 60 customers
396 + 4,233 = 4,629
14. What would be the total overhead cost per order according to the activity based costing system?
In other words, what would be the overall activity rate for the filling orders activity cost pool? (Round to
the nearest whole cent.)
A)
$60.00
B)
$66.00
C)
$82.50
D)
$37.50
15. What would be the total overhead cost per customer according to the activity based costing
system? In other words, what would be the overall activity rate for the customer support activity cost pool?
(Round to the nearest whole dollar.)
A)
$3,500
B)
$5,500
C)
$4,233
D)
$4,500
16. To the nearest whole dollar, how much wages and salaries cost would be allocated to a customer
who made 6 orders in a year?
A)
$2,264
B)
$2,530
C)
$1,998
D)
$3,995
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Use the following to answer questions 17-19:
Eskenazy Company is a wholesale distributor that uses activity-based costing for all of its overhead costs.
The company has provided the following data concerning its annual overhead costs and its activity based
costing system:
Overhead costs:
Wages and salaries ..............
Other expenses ....................
Total ......................................
$580,000
120,000
$700,000
Distribution of resource consumption:
Wages and salaries ................
Other expenses ......................
Activity Cost Pools
Customer
Filling Orders
Support
Other
15%
75%
10%
55%
25%
20%
Total
100%
100%
The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining costs.
The amount of activity for the year is as follows:
Activity Cost Pool
Filling orders .........................
Customer support .................
Activity
2,000 orders
20 customers
17. What would be the total overhead cost per order according to the activity based costing system?
In other words, what would be the overall activity rate for the filling orders activity cost pool? (Round to
the nearest whole cent.)
A)
$52.50
B)
$76.50
C)
$122.50
D)
$192.50
18. What would be the total overhead cost per customer according to the activity based costing
system? In other words, what would be the overall activity rate for the customer support activity cost pool?
(Round to the nearest whole dollar.)
A)
$26,250
B)
$17,500
C)
$23,250
D)
$8,750
19. To the nearest whole dollar, how much wages and salaries cost would be allocated to a customer
who made 7 orders in a year?
A)
$22,055
B)
$17,682
C)
$13,309
D)
$26,618
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Use the following to answer questions 20-21:
Fornia Florist specializes in large floral bouquets for hotels and other commercial spaces. The company
has provided the following data concerning its annual overhead costs and its activity based costing
system:
Overhead costs:
Wages and salaries ..............
Other expenses ....................
Total ......................................
$ 70,000
60,000
$130,000
Distribution of resource consumption:
Activity Cost Pools
Wages and salaries ................
Other expenses ......................
Making
Bouquets
70%
45%
Delivery
20%
25%
Other
10%
30%
Total
100%
100%
The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining costs.
The amount of activity for the year is as follows:
Activity Cost Pool
Making bouquets ....................
Delivery ...................................
Activity
40,000 bouquets
4,000 deliveries
20. What would be the total overhead cost per bouquet according to the activity based costing
system? In other words, what would be the overall activity rate for the making bouquets activity cost pool?
(Round to the nearest whole cent.)
A)
$1.46
B)
$1.90
C)
$1.87
D)
$2.28
21. What would be the total overhead cost per delivery according to the activity based costing
system? In other words, what would be the overall activity rate for the deliveries activity cost pool?
(Round to the nearest whole cent.)
A)
$7.25
B)
$7.31
C)
$8.13
D)
$6.50
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Use the following to answer questions 22-23:
Foro Florist specializes in large floral bouquets for hotels and other commercial spaces. The company
has provided the following data concerning its annual overhead costs and its activity based costing
system:
Overhead costs:
Wages and salaries ..............
Other expenses ....................
Total ......................................
$ 80,000
40,000
$120,000
Distribution of resource consumption:
Activity Cost Pools
Wages and salaries ................
Other expenses ......................
Making
Bouquets
50%
60%
Delivery
40%
10%
Other
10%
30%
Total
100%
100%
The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining costs.
The amount of activity for the year is as follows:
Activity Cost Pool
Making bouquets ....................
Delivery ...................................
Activity
20,000 bouquets
6,000 deliveries
22. What would be the total overhead cost per bouquet according to the activity based costing
system? In other words, what would be the overall activity rate for the making bouquets activity cost pool?
(Round to the nearest whole cent.)
A)
$3.00
B)
$3.20
C)
$3.30
D)
$3.60
23. What would be the total overhead cost per delivery according to the activity based costing
system? In other words, what would be the overall activity rate for the deliveries activity cost pool?
(Round to the nearest whole cent.)
A)
$8.00
B)
$5.00
C)
$6.00
D)
$2.00
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Use the following to answer questions 24-26:
Dimaio Company uses an activity-based costing system with three activity cost pools. The company has
provided the following data concerning its costs and its activity based costing system:
Costs:
Manufacturing overhead ..............................................
Selling and administrative expenses ............................
Total .............................................................................
$580,000
240,000
$820,000
Distribution of resource consumption:
Manufacturing overhead ...........................
Selling and administrative expenses .........
Order
Size
50%
5%
Activity Cost Pools
Customer
Support
Other
40%
10%
75%
20%
Total
100%
100%
The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining costs.
You have been asked to complete the first-stage allocation of costs to the activity cost pools.
24. How much cost, in total, would be allocated in the first-stage allocation to the Order Size activity
cost pool?
A)
$302,000
B)
$41,000
C)
$225,500
D)
$410,000
25. How much cost, in total, would be allocated in the first-stage allocation to the Customer Support
activity cost pool?
A)
$328,000
B)
$412,000
C)
$471,500
D)
$615,000
26. How much cost, in total, should NOT be allocated to orders and products in the second stage of
the allocation process if the activity-based costing system is used for internal decision-making?
A)
$0
B)
$106,000
C)
$82,000
D)
$164,000
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LESSON 6
ACCOUNTING AND CONTROL OF DEFECTIVE AND SPOILED GOODS
LEARNING OBJECTIVES
1. Distinguish among different types of spoilage, rework, and scrap.
2. Identify the differences between normal and abnormal spoilage.
3. Account for spoilage in job costing.
4. Account for rework in job costing.
5. Account for scrap.
SPOILAGE, REWORK, AND SCRAP
Three categories of costs that result from defects in the manufacturing process are spoilage, rework, and
scrap. Companies develop accounting techniques for identifying and quantifying the cost of manufacturing
defects in order to properly record and report the value of inventory and cost of goods sold, and to develop
and analyze proposed or implemented cost-reduction and quality-management strategies.
Spoilage are unacceptable units of production. Rework are unacceptable units of production subsequently
repaired. And scrap are leftover material
Spoilage, rework, and scrap have distinctive definitions in cost accounting that may not be the definition
commonly used. It is important that these terms be used properly, as each receives a different accounting
treatment.
Spoilage is units of production that do not meet the specifications required by customers for good units and
are discarded or sold at reduced prices.
Rework is units of production that do not meet the specifications required by customers but are repaired
and sold as good finished units.
Note that rework is units that are repaired and sold as first quality units before they are shipped to
customers. Do not confuse rework with remanufactured items. These are items that have been returned by
customers for various reasons and cannot be sold as new items.
Scrap is residual material that results from manufacturing a product. It has low or zero sales value.
In manufacturing its products for the month of September 20X8, El Dorado Corporation incurred normal
spoilage of $7,000 and abnormal spoilage of $3,000. How much spoilage cost should El Dorado charge
as inventoriable for the month of September 20X8?
Answer:
$7,000
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NORMAL AND ABNORMAL SPOILAGE.
Spoilage is divided into two types: normal spoilage and abnormal spoilage.
Normal spoilage is spoilage inherent in the production process. It is viewed arising even in an efficient
manufacturing process. Typically, normal spoilage is included as a part of the cost of good units
manufactured.
Abnormal spoilage is spoilage that is not considered a part of the production process and does not arise
under efficient operating conditions. Abnormal spoilage is regarded as avoidable and controllable.
To highlight the abnormal spoilage, companies calculate the units of abnormal spoilage and record the cost
in a “Loss from Abnormal Spoilage” account, which appears as a separate line item in the income statement.
Some companies regard all spoilage as abnormal in order to make all spoilage visible.
Spoilage from a manufacturing process was discovered during an inspection of work-in-process. In a
process-costing system, the cost of the spoilage would be added to the cost of the good units produced if
the spoilage is
Normal
Abnormal
a.
Yes
Yes
b.
Yes
No
c.
No
No
d.
No
Yes
ACCOUNTING FOR SPOILED GOODS, NORMAL AND ABNORMAL
The concepts of normal and abnormal spoilage also apply to job-costing systems. Abnormal spoilage is a
period cost and treated as an expense of the period in which it occurs. Normal spoilage is inventoriable and
included as a cost of the product.
Companies frequently distinguish between normal spoilage attributable to a specific job from normal
spoilage common to all jobs. When normal spoilage is considered attributable to a specific job, that job
bears the cost of the spoilage. When normal spoilage is considered attributable to all jobs, it is a
characteristic of the production process and is allocated as a manufacturing overhead cost.
With more emphasis today on quality and reducing defects, companies are treating less spoilage as normal
spoilage than in the past. Many companies now consider all spoilage to be abnormal. Although this may
not be technically true, this treatment tends to highlight the total amount of spoilage.
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Under process costing and job costing, the accounting treatment for the normal spoilage (assume related
to normal factory operations) is
Process costing
Job costing
a.
Loss account is charged.
Loss account is charged.
b.
Upon transfer, spoilage costs
Loss account is charged.
are transferred along with other
costs.
c.
d.
Upon transfer, spoilage costs are
Manufacturing overhead
transferred along with other costs.
control is charged.
Manufacturing overhead control
No entry.
is charged.
ACCOUNTING FOR REWORK
Units that are reworked are units that have been inspected and found to be unacceptable. However,
these units are such that they can be repaired and sold as acceptable finished units.
Normal rework attributable to a specific job is charged to that job.
If it is normal rework common to all jobs, the costs are charged to manufacturing overhead and spread
over all jobs. If the rework is considered abnormal, the costs of the rework are charged to a “Loss from
Abnormal Rework” account.
Illustration
During August 20x8, Stirtz Company incurred the following costs on Job 924 for the manufacture of 600
scoreboard clocks:
Original cost accumulation:
Direct materials
$2,250
Direct manufacturing labor
1,800
Manufacturing overhead (150% of direct manufacturing labor)
2,700
$6,750
Direct costs of reworked 15 units:
Direct materials
$150
Direct manufacturing labor
240
$390
The rework costs were attributable to exacting specifications of Job 924, and the full rework costs were
charged to the specific job. The cost per finished unit of Job 924 was?
Solution
Original Cost Accumulation
Direct Costs of Rework
Overhead Applied (240  150%)
Total Cost
$ 6,750
390
360
$7,500
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$7,500/600 clocks = $12.50
ACCOUNTING FOR SCRAP
Scrap is the leftover material resulting from manufacturing a product. It has a low (or zero) sales value. An
example of scrap is the sawdust that emerges when trees are sawed into lumber. Sawdust can be used
for certain things, but it has a very low value. Planning can sometimes lower the amount of scrap, but
some scrap is inevitable in certain manufacturing processes.
Two aspects of accounting for scrap are:
Planning and control, including physical tracking. Inventory costing, including when and how scrap affects
operating income.
One way of accounting for scrap is to recognize it at the time of sale. No inventory records are maintained
for scrap. When sold, cash or accounts receivable is debited and scrap revenues is credited.
When scrap has more than an insignificant value, it is assigned an inventory valuation equal to its sales
value and a materials account is debited with a credit to work-in-process or manufacturing overhead.
When sold, cash or accounts receivable is debited with the inventory account being credited.
Illustration
MedTech, Inc. manufactures surgical instruments to the exacting specifications of various
customers. During April 2005, Job 911 for the production of 4,500 instruments was completed at the
following costs per unit:
Direct materials
$ 60
Direct manufacturing labor
20
Allocated manufacturing overhead
80
$160
Final inspection of Job 911 disclosed 100 defective units and 50 spoiled units. The defective
instruments were reworked at a total cost of $12,000, and the spoiled instruments were sold to a jobber
for $3,000.
1. What would be the unit cost of the good units produced on Job 911?
Production costs
$160  4,500 units
Rework costs
$720,000
12,000
$732,000
Revenue from sale of spoiled units
Net Cost
(3,000)
$729,000
739,000/4450 good units =
163.62 or $164
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2. If the costs associated with spoilage and reworked units are considered as normal to
manufacturing operations, the unit cost of the good units produced on Job 911 is?
$160, the computed units cost will no longer change because it is accounted as part of overhead.
SELF-TEST QUESTIONS
1 The Joe's Pottery manufactures pottery products. All direct materials are included at the inception of the
production process. For April, there was no beginning inventory in the processing plant. Direct materials
totaled $155,000 for the month. Work-in-process records revealed that 2,500 tons were started in April
and that 1,500 tons were finished; 500 tons were spoiled as expected. Ending work-in-process units are
complete in respect to direct materials costs. Spoilage is not detected until the process is complete.
Required:
a. What is the cost per equivalent unit if spoiled units are recognized or ignored?
b. What are the costs assigned to completed units when spoilage units are recognized or when they are
not recognized?
c. What are the costs transferred out if spoilage units are recognized or ignored?
d. What are the amounts allocated to the work-in-process ending inventory when spoilage units are
recognized or ignored?
Answer:
a.
Recognized
Ignored
Cost to account for
$155,000
$155,000
Divided by equivalent units
2,500
2,000
Cost per equivalent unit
$ 62
$ 77.50
b. Assigned to good units completed:
(1,500× $62)
(1,500 × $77.50)
c.
Transferred out Finished
Normal spoilage (500 × $62)
Total
d. Ending work-in-process inventory:
(500 × $62)
(500 × $77.50)
$93,000
$116,250
$93,000
31,000
$124,000
$116,250
0
$116,250
$ 31,000
$38,750
2. Robotoys Incorporated manufactures and distributes small robotic toys. Because most of its orders are
via telephone or fax, numerous orders have to be reworked. The average cost of the reworked orders is
$11.30: $4.15 for labor, $5.00 for more materials, and $2.15 for overhead. This ratio of costs holds for the
average original order. On a recent day, the shop reworked 83 orders out of 700. The original cost of the
83 orders totaled $1,909. The average cost of all orders is $24.34, including rework, with an average
selling price of $34.50.
Required:
Prepare the necessary journal entry to record the rework for the day if the shop charges such activities to
Robo Department Overhead Control. Prepare journal entries to record all relevant rework charges as well
as to transfer the reworked items finished goods to Finished Goods Inventory.
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Answer:
Robo Department Overhead Control
Materials Control (83 × $5.00)
Wages Payable Control (83 × $4.15)
Shop Overhead Control (83 × $2.15)
Finished Goods
Work-in-Process Control
937.90
415.00
344.45
178.45
1,909
1,909
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ASSESSMENT
1) Managers often cite reductions in the costs of spoilage as a(n):
A) major justification for implementing a just-in-time production system
B) measurement of improved output quality
C) immaterial item that is not to be tracked
D) indication of improvement in the accounting system
2) Unacceptable units of production that are discarded or sold for reduced prices are referred to as:
A) reworked units
B) spoilage
C) scrap
D) defective units
3) Unacceptable units of production that are subsequently repaired and sold as acceptable finished goods
are:
A) reworked units
B) spoilage
C) scrap
D) defective units
4) Costs of poor quality production include the:
A) opportunity cost of the plant and workers
B) effect on current customers
C) effect on potential customers
D) All of these answers are correct.
5) Material left over when making a product is referred to as:
A) reworked units
B) spoilage
C) scrap
D) defective units
6) A production process which involves spoilage and rework occurs in:
A) the manufacture of high precision tools
B) semiconductor units
C) the manufacture of clothing
D) All of these answers are correct.
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7) Spoilage that is an inherent result of the particular production process and arises under efficient
operating conditions is referred to as:
A) ordinary spoilage
B) normal spoilage
C) abnormal spoilage
D) None of these answers is correct.
8) Spoilage that should NOT arise under efficient operating conditions is referred to as:
A) ordinary spoilage
B) normal spoilage
C) abnormal spoilage
D) None of these answers is correct.
9) Costs of normal spoilage are usually accounted for as:
A) part of the cost of goods sold
B) part of the cost of goods manufactured
C) a separate line item in the income statement
D) an asset in the balance sheet
10) Costs of abnormal spoilage are usually accounted for as:
A) part of the cost of goods sold
B) part of the cost of goods manufactured
C) a separate line item in the income statement
D) an asset in the balance sheet
11) The loss from abnormal spoilage account would appear:
A) on the balance sheet
B) as a detailed item in the retained earnings schedule of the balance sheet
C) as a detailed item on the income statement
D) Either A or B is correct.
12) Normal spoilage should be computed using as the base the:
A) total units completed
B) total good units completed
C) total actual units started into production
D) None of these answers is correct.
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13) Companies that attempt to achieve zero defects in the manufacturing process treat spoilage as:
A) scrap
B) reworked units
C) abnormal spoilage
D) normal spoilage
14) Which one of the following conditions usually exists when comparing normal and abnormal spoilage
to controllability?
Normal Spoilage
Abnormal Spoilage
A) Controllable
Controllable
B) Controllable
Uncontrollable
C) Uncontrollable
Uncontrollable
D) Uncontrollable
Controllable
15) NOT counting spoiled units in the equivalent-unit calculation results in:
A) lower cost per good unit.
B) higher cost per good unit
C) better management information
D) Both A and C are correct.
16) Recognition of spoiled units when computing output units:
A) highlights the costs of normal spoilage to management
B) distorts the accounting data
C) focuses management's attention on reducing spoilage
D) Both A and C are correct.
17) Which of the following entries reflects the original cost assignment before production items are
reworked?
A) Work-in-Process Control
XXX
Materials Control
XXX
Wages Payable Control
XXX
Manufacturing Overhead Allocated
B) Finished Goods Control
XXX
XXX
Work-in-Process Control
C) Manufacturing Overhead Allocated
XXX
XXX
Materials Control
XXX
Wages Payable Control
XXX
Work-in-Process Control
XXX
D) Materials Control
XXX
Wages Payable Control
XXX
Work-in-Process Control
XXX
Manufacturing Overhead Allocated
XXX
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18) Accounting for rework in a process-costing system:
A) accounts for normal rework in the same way as a job-costing system
B) requires abnormal rework to be distinguished from normal rework
C) if the rework is normal, then rework is accounted for in the same manner as accounting for normal
rework common to all jobs
D) All of these answers are correct.
19) In accounting for scrap, which one of the following statements is FALSE?
A) Normal scrap is accounted for separately from abnormal scrap
B) In accounting for scrap, there is no distinction between the scrap attributable to a specific job and
scrap common to all jobs
C) Initial entries to scrap accounting records are most often made in dollar terms
D) All of these answers are correct.
20) When the amount of scrap is immaterial, the easiest accounting entry when recording scrap sold for
cash is:
A) Sales of Scrap
Cash
B) Cash
Manufacturing Overhead Control
C) Cash
Sales of Scrap
D) Accounts Receivable
Sales of scrap
21) Assume the amount of scrap is material and the scrap is sold immediately after it is produced. If the
scrap attributable to a specific job is sold on account, the journal entry is:
A) Work-in-Process Control
Cash
B) Work-in-Process Control
Accounts Receivable
C) Accounts Receivable
Work-in-Process Control
D) Work-in-Process Control
Accounts Payable
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22) If scrap, common to all jobs, is returned to the storeroom and the time between the scrap being
inventoried and its disposal is quite lengthy, the journal entry is:
A) Work-in-Process Control
Materials Control
B) Materials Control
Work-in-Process Control
C) Manufacturing Overhead Control
Materials Control
D) Materials Control
Manufacturing Overhead Control
23) The accounting for scrap under process costing is similar to the accounting under:
A) job costing when scrap is different for each job
B) job costing when scrap is common to all jobs
C) process costing when scrap is different for each job
D) process costing when scrap is a common to all jobs
24) Which of the following is NOT a major consideration when accounting for scrap?
A) keeping detailed records of physical quantities of scrap at all stages of the production process
B) inventory costing including when and how scrap affects operating income
C) planning and control including physical tracking
D) decisions as to whether to group scrap with reworked units
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LESSON 7
STANDARD COSTING AND VARIANCE ANALYSIS
Learning outcomes of the Lesson
1.
2.
3.
4.
5.
Compute the direct materials price and quantity variances and explain their significance.
Compute the direct labor rate and efficiency variances and explain their significance.
Compute the variable manufacturing overhead rate and efficiency variances and explain their
significance.
Compute and interpret the fixed overhead budget and volume variances.
Prepare journal entries to record standard costs and variances.
OVERVIEW OF STANDARD COST VARIANCES
STANDARD COSTS—SETTING THE STAGE
A standard is a benchmark for measuring performance. Standards are found everywhere. Auto service
centers like Firestone and Sears , for example, often set specific labor time standards for the completion of certain
tasks, such as installing a carburetor or doing a valve job, and then measure actual performance against these
standards. Fast-food outlets such as McDonald’s and Subway have exacting standards for the quantity of meat
going into a sandwich, as well as standards for the cost of the meat. Your doctor evaluates your weight using
standards for individuals of your age, height, and gender. The buildings we live in conform to standards set in
building codes.
Standards are also widely used in managerial accounting where they relate to the quantity and acquisition
price of inputs used in manufacturing goods or providing services. Quantity standards specify how much of an input
should be used to make a product or provide a service. Price standards specify how much should be paid for each
unit of the input. If either the quantity or acquisition price of an input departs significantly from the standard,
managers investigate the discrepancy to find the cause of the problem and eliminate it.
Next we’ll demonstrate how a company can establish quantity and price standards for direct materials,
direct labor, and variable manufacturing overhead and then we’ll discuss how those standards can be used to
calculate variances and manage operations.
The Colonial Pewter Company makes only one product—an elaborate reproduction of an 18th century
pewter statue. The statue is made largely by hand, using traditional metalworking tools. Consequently, the
manufacturing process is labor intensive and requires a high level of skill.
Colonial Pewter has recently expanded its workforce to take advantage of unexpected demand for the
statue as a gift. The company started with a small cadre of experienced pewter workers but has had to hire less
experienced workers as a result of the expansion. The president of the company, J. D. Wriston, has called a meeting
to discuss production problems. Attending the meeting are Tom Kuchel, the production manager; Janet Warner,
the purchasing manager; and Terry Sherman, the corporate controller.
J. D.: I’ve got a feeling that we aren’t getting the production we should out of our new people.
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Tom: Give us a chance. Some of the new people have been with the company for less than a month.
Janet: Let me add that production seems to be wasting an awful lot of material particularly pewter. That stuff is
very expensive.
Tom: What about the shipment of defective pewter that you bought—the one with the iron contamination? That
caused us major problems.
Janet: How was I to know it was off-grade? Besides, it was a great deal.
J. D.: Calm down everybody. Let’s get the facts before we start attacking each other.
Tom: I agree. The more facts the better.
J. D.: Okay, Terry, it’s your turn. Facts are the controller’s department.
Terry: I’m afraid I can’t provide the answers off the top of my head, but if you give me about a week I can set up a
system that can routinely answer questions relating to worker productivity, material waste, and input prices.
J. D.: Let’s mark it on our calendars.
SETTING DIRECT MATERIALS STANDARDS
Terry Sherman’s first task was to prepare quantity and price standards for the company’s only significant
raw material, pewter ingots. The standard quantity per unit defines the amount of direct materials that should be
used for each unit of finished product, including an allowance for normal inefficiencies, such as scrap and spoilage.
After consulting with the production manager, Tom Kuchel, Terry set the quantity standard for pewter at 3.0
pounds per statue.
The standard price per unit defines the price that should be paid for each unit of direct materials and it
should reflect the final, delivered cost of those materials. After consulting with purchasing manager Janet Warner,
Terry set the standard price of pewter at $4.00 per pound.
Once Terry established the quantity and price standards he computed the standard direct materials cost
per statue as follows:
3.0 pounds per statue x $4.00 per pound = $12.00 per statue
SETTING DIRECT LABOR STANDARDS
Direct labor quantity and price standards are usually expressed in terms of labor-hours or a labor rate. The
standard hours per unit defines the amount of direct labor-hours that should be used to produce one unit of finished
goods. One approach used to determine this standard is for an industrial engineer to do a time and motion study,
actually clocking the time required for each task. Throughout the chapter, we’ll assume that “tight but attainable”
labor standards are used rather than “ideal” standards that can only be attained by the most skilled and efficient
employees working at peak effort 100% of the time. Therefore, after consulting with the production manager and
considering reasonable allowances for breaks, personal needs of employees, cleanup, and machine downtime,
Terry set the standard hours per unit at 0.50 direct labor-hours per statue.
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The standard rate per hour defines the company’s expected direct labor wage rate per hour, including employment
taxes and fringe benefits. Using wage records and in consultation with the production manager, Terry Sherman
established a standard rate per hour of $22.00. This standard rate reflects the expected “mix” of workers, even
though the actual hourly wage rates may vary somewhat from individual to individual due to differing skills or
seniority.
Once Terry established the time and rate standards, he computed the standard direct labor cost per statue
as follows:
0.50 direct labor-hours per statue 3 $22.00 per direct labor-hour 5 $11.00 per statue
SETTING VARIABLE MANUFACTURING OVERHEAD STANDARDS
As with direct labor, the quantity and price standards for variable manufacturing overhead are usually
expressed in terms of hours and a rate. The standard hours per unit for variable overhead measures the amount of
the allocation base from a company’s predetermined overhead rate that is required to produce one unit of finished
goods. In the case of Colonial Pewter, we will assume that the company uses direct labor-hours as the allocation
base in its predetermined overhead rate. Therefore, the standard hours per unit for variable overhead is exactly the
same as the standard hours per unit for direct labor—0.50 direct labor-hours per statue.
The standard rate per unit that a company expects to pay for variable overhead equals the variable portion
of the predetermined overhead rate. At Colonial Pewter, the variable portion of the predetermined overhead rate
is $6.00 per direct labor-hour. Therefore, Terry computed the standard variable manufacturing overhead cost per
statue as follows:
0.50 direct labor-hours per statue x $6.00 per direct-labor hour = $3.00 per statue
This $3.00 per unit cost for variable manufacturing overhead appears along with direct materials ($12 per
unit) and direct labor ($11 per unit) on the standard cost card in Exhibit 7–1 . A standard cost card shows the standard
quantity (or hours) and standard price (or rate) of the inputs required to produce a unit of a specific product. The
standard cost per unit for all three variable manufacturing costs is computed the same way. The standard quantity
(or hours) per unit is multiplied by the standard price (or rate) per unit to obtain the standard cost per unit.
Exhibit 7-1
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USING STANDARDS IN FLEXIBLE BUDGETS
Once Terry Sherman created the standard cost card shown in Exhibit 7–1 , he was ready to use this information to
calculate direct materials, direct labor, and variable manufacturing overhead variances. Therefore, he gathered the
following data for the month of June:
Originally budgeted output in June . . . . . . . . . . . . . . . . . . 2,100 statues
Actual output in June . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 statues
Actual direct materials cost in June * . . . . . . . . . . . . . . . . . $24,700
Actual direct labor cost in June . . . . . . . . . . . . . . . . . . . . . $22,680
Actual variable manufacturing overhead cost in June . . .
$7,140
*There were no beginning or ending inventories of raw materials in June; all materials purchased were used.
Using the above data and the standard cost data from Exhibit 7–1 , Terry computed the spending and
activity variances shown in Exhibit 7–2 . Notice that the actual results and flexible budget columns are each based
on the actual output of 2,000 statues. The planning budget column is based on the planned output of 2,100 statues.
The standard costs of $12.00 per unit for materials, $11.00 per unit for direct labor, and $3.00 per unit for variable
manufacturing overhead are each multiplied by the actual
output of 2,000 statues to compute the amounts in the flexible budget column. For example, the standard direct
labor cost per unit of $11.00 multiplied by 2,000 statues equals the direct labor flexible budget of $22,000 . Similarly,
the three standard variable cost figures are multiplied by 2,100 units to compute the amounts in the planning
budget column. For example, the direct labor cost for the planning budget is $23,100 ( = $11.00 per unit x 2,100
units).
The spending variances shown in Exhibit 7–2 are computed by taking the amounts in the actual results
column and subtracting the amounts in the flexible budget column. For all three variable manufacturing costs, this
computation results in a positive number because the actual amount of the cost incurred to produce 2,000 statues
exceeds the standard cost allowed for 2,000 statues. Because, in all three instances, the actual cost incurred exceeds
the standard cost allowed for the actual level of output, the variance is labeled unfavorable (U). Had any of the
actual costs incurred been less than the standard cost allowed for the actual level of output, the corresponding
variances would have been labeled favorable (F).
The activity variances shown in the exhibit are computed by taking the amounts in the flexible budget
column and subtracting the amounts in the planning budget column.
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Exhibit 7-2
For all three variable manufacturing costs, these computations result in negative numbers and what are
labeled as favorable (F) variances. The label favorable is used in these instances because the standard cost allowed
for the actual output is less than the standard cost allowed for the planned output. Had the actual level of activity
been greater than the planned level of activity, all of the computations would have resulted in positive numbers and
unfavorable (U) activity variances.
While the performance report in Exhibit 7–2 is useful, it would be even more useful if the spending
variances could be broken down into their price-related and quantity related components. For example, the direct
materials spending variance in the report is $700 unfavorable. This means that, given the actual level of production
for the period, direct materials costs were too high by $700—at least according to the standard costs. Was this due
to higher-than-expected prices for materials? Or was it due to too much material being used? The standard cost
variances we will be discussing in the rest of the chapter are designed to answer these questions.
A GENERAL MODEL FOR STANDARD COST VARIANCE ANALYSIS
Standard cost variance analysis decomposes spending variances from the flexible budget into two elements—one
due to the price paid for the input and the other due to the amount of the input that is used. A price variance is the
difference between the actual amount paid for an input and the standard amount that should have been paid,
multiplied by the actual amount of the input purchased. A quantity variance is the difference between how much
of an input was actually used and how much should have been used and is stated in dollar terms using the standard
price of the input.
Why are standards separated into two categories—price and quantity? Price variances and quantity variances
usually have different causes. In addition, different managers are usually responsible for buying and using inputs.
For example, in the case of a raw material, the purchasing manager is responsible for its price and the production
manager is responsible for the amount of the raw material actually used to make products. Therefore, it is
important to clearly distinguish between deviations from price standards (the responsibility of the purchasing
manager) and deviations from quantity standards (the responsibility of the production manager).
Exhibit 7–3 presents a general model that can be used to decompose the spending variance for a variable cost into
a price variance and a quantity variance. 2 Column (1) in this exhibit corresponds with the Actual Results column in
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Exhibit 7–2 . Column (3) corresponds with the Flexible Budget column in Exhibit 10–2 . Column (2) has been inserted
into Exhibit 7–3 to enable separating the spending variance into a price variance and a quantity variance.
Exhibit 7–3
Three things should be noted from Exhibit 7–3 . First, it can be used to compute a price variance and a quantity
variance for each of the three variable cost elements—direct materials, direct labor, and variable manufacturing
overhead—even though the variances have different names. A price variance is called a materials price variance in
the case of direct materials, a labor rate variance in the case of direct labor, and a variable overhead rate variance
in the case of variable manufacturing overhead. A quantity variance is called a materials quantity variance in the
case of direct materials, a labor efficiency variance in the case of direct labor, and a variable overhead efficiency
variance in the case of variable manufacturing overhead.
Second, all three columns in the exhibit are based on the actual amount of output produced during the period. Even
the flexible budget column depicts the standard cost allowed for the actual amount of output produced during the
period. The key to understanding the flexible budget column in Exhibit 7–3 is to grasp the meaning of the term
standard quantity allowed (SQ). The standard quantity allowed (when computing direct materials variances) or
standard hours allowed (when computing direct labor and variable manufacturing overhead variances) refers to the
amount of an input that should have been used to manufacture the actual output of finished goods produced during
the period. It is computed by multiplying the actual output by the standard quantity (or hours) per unit. The
standard quantity (or hours) allowed is then multiplied by the standard price (or rate) per unit of the input to obtain
the total cost according to the flexible budget. For example, if a company actually produced 100 units of finished
goods during the period and its standard quantity per unit of finished goods for direct materials is 3 pounds, then
its standard quantity allowed (SQ) would be 300 pounds ( = 100 units x 3 pounds per unit). If the company’s standard
cost per pound of direct materials is $2.00, then the total direct materials cost in its flexible budget would be $600
( = 300 pounds x $2.00 per pound).
Third, the spending, price, and quantity variances—regardless of what they are called—are computed exactly the
same way regardless of whether one is dealing with direct materials, direct labor, or variable manufacturing
overhead. The spending variance is computed by taking the total cost in column (1) and subtracting the total cost
in column (3). The price variance is computed by taking the total cost in column (1) and subtracting the total cost in
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column (2). The quantity variance is computed by taking the total cost in column (2) and subtracting the total cost
in column (3). In all of these variance calculations, a positive number should be labeled as an unfavorable (U)
variance and a negative number should be labeled as a favorable (F) variance. An unfavorable price variance
indicates that the actual price (AP) per unit of the input was greater than the standard price (SP) per unit. A favorable
price variance indicates that the actual price (AP) of the input was less than the standard price per unit (SP). An
unfavorable quantity variance indicates that the actual quantity (AQ) of the input used was greater than the
standard quantity allowed (SQ). Conversely, a favorable quantity variance indicates that the actual quantity (AQ)
of the input used was less than the standard quantity allowed (SQ).
With this general model as the foundation, we will now calculate Colonial Pewter’s price and quantity variances.
USING STANDARD COSTS—DIRECT MATERIALS VARIANCES
After determining Colonial Pewter Company’s standard costs for direct materials, direct labor, and variable
manufacturing overhead, Terry Sherman’s next step was to compute the company’s variances for June. As
discussed in the preceding section, variances are computed by comparing actual costs to standard costs. Terry
referred to the standard cost card in Exhibit 7–1 that shows the standard direct materials cost per statue was
computed as follows:
3.0 pounds per statue x $4.00 per pound = $12.00 per statue
Colonial Pewter’s records for June showed that the actual quantity (AQ) of pewter purchased was 6,500 pounds at
an actual price (AP) of $3.80 per pound, for a total cost of $24,700. All of the material purchased was used during
June to manufacture 2,000 statues. 3 Using these data and the standard costs from Exhibit 7–1 , Terry computed
the price and quantity variances shown in Exhibit 7–4 .
Exhibit 7–4
Notice that the variances in this exhibit are based on three different total costs— $24,700, $26,000, and $24,000.
The first, $24,700, is the actual amount paid for the actual amount of pewter purchased. The third total cost figure,
$24,000, refers to how much should have been spent on pewter to produce the actual output of 2,000 statues. The
standards call for 3 pounds of pewter per statue. Because 2,000 statues were produced, 6,000 pounds of pewter
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should have been used. This is referred to as the standard quantity allowed for the actual output and its
computation can be stated in formula form as follows: Standard quantity allowed for actual output = Actual output
x Standard quantity If 6,000 pounds of pewter had been purchased at the standard price of $4.00 per pound, the
company would have spent $24,000. This is the amount that appears in the company’s flexible budget for the
month. The difference between the $24,700 actually spent and the $24,000 that should have been spent is the
spending variance for the month of $700 U. This variance is unfavorable (denoted by U) because the amount that
was actually spent exceeds the amount that should have been spent.
The second total cost figure in Exhibit 7–4, $26,000, is the key that allows us to decompose the spending variance
into two distinct elements—one due to price and one due to quantity. It represents how much the company should
have spent if it had purchased the actual amount of input, 6,500 pounds, at the standard price of $4.00 a pound
rather than the actual price of $3.80 a pound.
The Materials Price Variance
Using the $26,000 total cost figure in column (2) of Exhibit 7–4, we can make two comparisons—one with the total
cost of $24,700 in column (1) and one with the total cost of $24,000 in column (3). The difference between the
$24,700 in column (1) and the $26,000 in column (2) is the materials price variance of $1,300, which is labeled as
favorable (denoted by F). A materials price variance measures the difference between an input’s actual price and its
standard price, multiplied by the actual quantity purchased.
To understand the price variance, note that the actual price of $3.80 per pound of pewter is $0.20 less than the
standard price of $4.00 per pound. Because 6,500 pounds were purchased, the total amount of the variance is
$1,300 ( = $0.20 per pound x 6,500 pounds). This variance is labeled favorable (F) because the actual purchase price
per pound is less than the standard purchase price per pound. A price variance is labeled unfavorable (U) if the actual
purchase price exceeds the standard purchase price.
Generally speaking, the purchasing manager has control over the price paid for goods and is therefore responsible
for the materials price variance. Many factors influence the prices paid for goods including how many units are
ordered, how the order is delivered, whether the order is a rush order, and the quality of materials purchased. If any
of these factors deviates from what was assumed when the standards were set, a price variance can result. For
example, purchasing second-grade materials rather than top-grade materials may result in a favorable price
variance because the lower-grade materials may be less costly. However, the lower-grade materials may create
production problems. It also bears emphasizing that someone other than the purchasing manager could be
responsible for a materials price variance. For example, due to production problems beyond the purchasing
manager’s control, the purchasing manager may have to use express delivery. In these cases, the production
manager should be held responsible for the resulting price variances.
The Materials Quantity Variance
Referring again to Exhibit 7–4 , the difference between the $26,000 in column (2) and the $24,000 in
column (3) is the materials quantity variance of $2,000, which is labeled as unfavorable (denoted by U). The
materials quantity variance measures the difference between the actual quantity of materials used in production
and the standard quantity of materials allowed for the actual output, multiplied by the standard price per unit of
materials. It is labeled as unfavorable (favorable) when the actual quantity of material used in production is greater
than (less than) the quantity of material that should have been used according to the standard.
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To understand the materials quantity variance, note that the actual amount of pewter used in production
was 6,500 pounds. However, the standard amount of pewter allowed for the actual output is 6,000 pounds.
Therefore, too much pewter was used to produce the actual output—by a total of 500 pounds. To express this in
dollar terms, the 500 pounds is multiplied by the standard price of $4.00 per pound to yield the quantity variance of
$2,000 U. Why is the standard price of pewter, rather than the actual price, used in this calculation? The production
manager is ordinarily responsible for the quantity variance. If the actual price were used in the calculation of the
quantity variance, the production manager’s performance evaluation would be unfairly influenced by the efficiency
or inefficiency of the purchasing manager.
Excessive materials usage can result from many factors, including faulty machines, inferior materials quality,
untrained workers, and poor supervision. Generally speaking, it is the responsibility of the production manager to
see that material usage is kept in line with standards. There may be times, however, when the purchasing manager
is responsible for an unfavorable materials quantity variance. For example, if the purchasing manager buys inferior
materials at a lower price, the materials may be unsuitable for use and may result in excessive waste. Thus, the
purchasing manager rather than the production manager would be responsible for the quantity variance.
Thus far, we have shown how to compute direct materials variances using the general model depicted in Exhibit 7–
4; however, these variances can also be calculated using basic mathematical equations. Exhibit 7–5 shows how
Colonial Pewter can compute its direct materials variances using the equations-based approach.
Exhibit 7–5
7.3 Using Standard Costs—Direct Labor Variances
Terry Sherman’s next step in determining Colonial Pewter’s variances for June was to compute the direct labor
variances for the month. Recall from Exhibit 7–1 that the standard direct labor cost per statue is $11, computed as
follows:
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0.50 hours per statue x $22.00 per hour = $11.00 per statue
In addition, Colonial Pewter’s records for June showed that 1,050 direct labor-hours were actually worked. Given
that the company paid its direct labor workers a total of $22,680 (including payroll taxes and fringe benefits), the
average actual wage rate was $21.60 per hour ( = $22,680 / 1,050 hours). Using these data and the standard costs
from Exhibit 7–1 , Terry computed the direct labor rate and efficiency variances that appear in Exhibit 7–6 .
Notice that the column headings in Exhibit 7–6 are the same as those used Exhibits 7–3 and 7–4 , except
that in Exhibit 7–6 the terms rate and hours are used in place of the terms price and quantity.
Exhibit 7–6
The Labor Rate Variance
Using the $23,100 total cost figure in column (2) of Exhibit 7–6, we can make two comparisons—one with the total
cost of $22,680 in column (1) and one with the total cost of $22,000 in column (3). The difference between the
22,680 in column (1) and the $23,100 in column (2) is the labor rate variance of $420 F. The labor rate variance
measures the difference between the actual hourly rate and the standard hourly rate, multiplied by the actual
number of hours worked during the period.
To understand the labor rate variance, note that the actual hourly rate of $21.60 is $0.40 less than the standard rate
of $22.00 per hour. Because 1,050 hours were actually worked, the total amount of the variance is $420 ( = $0.40
per hour x 1,050 hours). The variance is labeled favorable (F) because the actual hourly rate is less than the standard
hourly rate. If the actual hourly rate had been greater than the standard hourly rate, the variance would have been
labeled unfavorable (U).
In most companies, the wage rates paid to workers are quite predictable. Nevertheless, rate variances can arise
based on how production supervisors use their direct labor workers. Skilled workers with high hourly rates of pay
may be given duties that require little skill and call for lower hourly rates of pay. This will result in an unfavorable
labor rate variance because the actual hourly rate of pay will exceed the standard rate specified for the particular
task. In contrast, a favorable rate variance would result when workers who are paid at a rate lower than specified in
the standard are assigned to the task. However, the lower-paid workers may not be as efficient. Finally, overtime
work at premium rates will result in an unfavorable labor rate variance if the overtime premium is charged to the
direct labor account.
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The Labor Efficiency Variance
Referring back to Exhibit 7–6 , the difference between the $23,100 in column (2) and the $22,000 in column (3) is
the labor efficiency variance of $1,100 unfavorable (U). The labor efficiency variance measures the difference
between the actual hours used and the standard hours allowed for the actual output, multiplied by the standard
hourly rate.
To understand Colonial Pewter’s labor efficiency variance, note that the actual amount of hours used in production
was 1,050 hours. However, the standard amount of hours allowed for the actual output is 1,000 hours. Therefore,
the company used 50 more hours for the actual output than the standards allow. To express this in dollar terms, the
50 hours are multiplied by the standard rate of $22.00 per hour to yield the efficiency variance of $1,100 U.
Possible causes of an unfavorable labor efficiency variance include poorly trained or motivated workers; poorquality materials, requiring more labor time; faulty equipment, causing breakdowns and work interruptions; poor
supervision of workers; and inaccurate standards. The managers in charge of production would usually be
responsible for control of the labor efficiency variance. However, the purchasing manager could be held responsible
if the purchase of poor-quality materials resulted in excessive labor processing time.
Another important cause of an unfavorable labor efficiency variance may be insufficient demand for the company’s
products. Managers in some companies argue that it is difficult, and perhaps unwise, to constantly adjust the
workforce in response to changes in the amount of work that needs to be done. In such companies, the direct labor
workforce is essentially fixed in the short run. If demand is insufficient to keep everyone busy, workers are not laid
off and an unfavorable labor efficiency variance will often be recorded.
If customer orders are insufficient to keep the workers busy, the work center manager has two options—either
accept an unfavorable labor efficiency variance or build inventory. A central lesson of Lean Production is that
building inventory with no immediate prospect of sale is a bad idea. Excessive inventory—particularly work in
process inventory—leads to high defect rates, obsolete goods, and inefficient operations. As a consequence, when
the workforce is basically fixed in the short term, managers must be cautious about how labor efficiency variances
are used. Some experts advocate eliminating labor efficiency variances in such situations—at least for the purposes
of motivating and controlling workers on the shop floor.
Direct labor variances can also be computed using equations instead of the general model depicted in Exhibit 7–6 .
Exhibit 7–7 shows how Colonial Pewter can compute its direct labor variances using the equations-based approach.
Exhibit 7–7
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7.4 Using Standard Costs—Variable Manufacturing Overhead Variances
The final step in Terry Sherman’s analysis of Colonial Pewter’s variances for June was to compute the variable
manufacturing overhead variances. The variable portion of manufacturing
overhead can be analyzed using the same basic formulas that we used to analyze direct materials and direct labor.
Recall from Exhibit 7–1 that the standard variable manufacturing overhead is $3.00 per statue, computed as follows:
0.50 hours per statue x $6.00 per hour = $3.00 per statue
Also recall that Colonial Pewter’s cost records showed that the total actual variable manufacturing
overhead cost for June was $7,140 and that 1,050 direct labor-hours were worked in June to produce 2,000 statues.
Terry’s analysis of this overhead data appears in Exhibit 7–8 .
Exhibit 7–8
Notice the similarities between Exhibits 7–6 and 7–8 . These similarities arise from the fact that direct labor-hours
are being used as the base for allocating overhead cost to units of product; thus, the same hourly figures appear in
Exhibit 7–8 for variable manufacturing overhead as in Exhibit 7–6 for direct labor. The main difference between the
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two exhibits is in the standard hourly rate being used, which in this company is much lower for variable
manufacturing overhead than for direct labor.
7.4 Variable Manufacturing Overhead Variances
The Variable Manufacturing Overhead Rate and Efficiency Variances
Using the $6,300 total cost figure in column (2) of Exhibit 7–8 , we can make two comparisons—one with the total
cost of $7,140 in column (1) and one with the total cost of $6,000 in column (3). The difference between the $7,140
in column (1) and the $6,300 in column (2) is the variable overhead rate variance of $840 U. The variable overhead
rate variance measures the difference between the actual variable overhead cost incurred during the period and the
standard cost that should have been incurred based on the actual activity of the period. The difference between the
$6,300 in column (2) and the $6,000 in column (3) is the variable overhead efficiency variance of $300 U. The variable
overhead efficiency variance measures the difference between the actual level of activity and the standard activity
allowed for the actual output, multiplied by the variable part of the predetermined overhead rate.
To understand Colonial Pewter’s variable overhead efficiency variance, note that the actual amount of hours used
in production was 1,050 hours. However, the standard amount of hours allowed for the actual output is 1,000 hours.
Therefore, the company used 50 more hours for the actual output than the standards allow. To express this in dollar
terms, the 50 hours are multiplied by the variable part of the predetermined overhead rate of $6.00 per hour to yield
the variable overhead efficiency variance of $300 U.
The interpretation of the variable overhead variances is not as clear as the direct materials and direct labor
variances. In particular, the variable overhead efficiency variance is exactly the same as the direct labor efficiency
variance except for one detail—the rate that is used to translate the variance into dollars. In both cases, the variance
is the difference between the actual hours worked and the standard hours allowed for the actual output. In the case
of the direct labor efficiency variance, this difference is multiplied by the standard direct labor rate. In the case of
the variable overhead efficiency variance, this difference is multiplied by the variable portion of the predetermined
overhead rate. So when direct labor is used as the base for overhead, whenever the direct labor efficiency variance
is favorable, the variable overhead efficiency variance will also be favorable. And whenever the direct labor
efficiency variance is unfavorable, the variable overhead efficiency variance will be unfavorable. Indeed, the variable
overhead efficiency variance really doesn’t tell us anything about how efficiently overhead resources were used. It
depends solely on how efficiently direct labor was used.
Variable manufacturing overhead variances can also be computed using equations instead of the general model
depicted in Exhibit 7–8 . Exhibit 7–9 shows how Colonial Pewter can compute its variable overhead variances using
the equations-based approach.
Exhibit 7–9
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7.5 Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System
In this unit, we will investigate how the predetermined overhead rates that we discussed in the job-order costing
chapter earlier in the module can be used in a standard costing system. Throughout this unit, we assume that an
absorption costing system is used in which all manufacturing costs—both fixed and variable—are included in
product costs.
Predetermined Overhead Rates
The data in Exhibit 7-10 pertain to MicroDrive Corporation, a company that produces miniature electric motors.
Note that the company budgeted for 50,000 machine-hours based on production of 25,000 motors. At this level of
activity, the budgeted variable manufacturing overhead was $75,000 and the budgeted fixed manufacturing
overhead was $300,000.
Exhibit 7-10
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Recall from the job-order costing chapter that the following formula is used to set the predetermined overhead rate
at the beginning of the period:
Predetermined overhead rate = Estimated total manufacturing overhead cost
Estimated total amount of the allocation base
The estimated total amount of the allocation base in the formula for the predetermined overhead rate is called the
denominator activity .
As discussed in the job-order costing chapter, once the predetermined overhead rate has been determined, it
remains unchanged throughout the period, even if the actual level of activity differs from what was estimated.
Consequently, the amount of overhead applied to each unit of product is the same regardless of when it is produced
during the period. MicroDrive Corporation uses budgeted machine-hours as its denominator activity in the
predetermined overhead rate. Consequently, the company’s predetermined overhead rate would be computed as
follows:
Predetermined overhead rate = $375,000/ 50,000 MHs = $7.50 per MH
This predetermined overhead rate can be broken down into its variable and fixed components as follows:
Variable component of the predetermined over head rate = $75,000 / 50,000 MHs = $1.50 per MH
Fixed component of the predetermined overhead rate = $300,000 / 50,000 MHs = $6.00 per M H
For every standard machine-hour recorded, work in process is charged with $7.50 of manufacturing overhead, of
which $1.50 represents variable manufacturing overhead and $6.00 represents fixed manufacturing overhead. In
total, MicroDrive Corporation would apply $300,000 of overhead to work in process as shown below:
Overhead applied = Predetermined overhead rate x 3 Standard hours allowed for the actual output = $7.50 per
machine-hour x 40,000 machine-hours = $300,000
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Overhead Application in a Standard Cost System
To understand fixed overhead variances, we first have to understand how overhead is applied to work in process in
a standard cost system. Recall that in the job-order costing chapter we applied overhead to work in process on the
basis of the actual level of activity. This procedure was correct because at the time we were dealing with a normal
cost system. However, we are now dealing with a standard cost system. In such a system, overhead is applied to
work in process on the basis of the standard hours allowed for the actual output of the period rather than on the
basis of the actual number of hours worked.
Exhibit 7-11 illustrates this point. In a standard cost system, every unit of a particular product is charged with the
same amount of overhead cost, regardless of how much time the unit actually requires for processing.
Exhibit 7-11
Budget Variance
Two fixed manufacturing overhead variances are computed in a standard costing system—a budget variance and a
volume variance. These variances are computed in Exhibit 7-12. The budget variance is simply the difference
between the actual fixed manufacturing overhead and the budgeted fixed manufacturing overhead for the period.
The formula is:
Budget variance = Actual fixed overhead - Budgeted fixed overhead
If the actual fixed overhead cost exceeds the budgeted fixed overhead cost, the budget variance is labeled
unfavorable. If the actual fixed overhead cost is less than the budgeted fixed overhead cost, the budget variance is
labeled favorable.
Applying the formula to the MicroDrive Corporation data, the budget variance is computed as follows:
Budget variance = $308,000 - $300,000 - $8,000 U
According to the budget, the fixed manufacturing overhead should have been $300,000, but it was actually
$308,000. Because the actual cost exceeds the budget by $8,000, the variance is labeled as unfavorable; however,
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this label does not automatically signal ineffective managerial performance. For example, this variance may be the
result of waste and inefficiency, or it may be due to an unforeseen yet prudent investment in fixed overhead
resources that improves product quality or manufacturing cycle efficiency.
Volume Variance
The volume variance is defined by the following formula:
Volume variance = Budgeted fixed overhead - Fixed overhead applied to work in process
When the budgeted fixed manufacturing overhead exceeds the fixed manufacturing overhead applied to work in
process, the volume variance is labeled as unfavorable. When the budgeted fixed manufacturing overhead is less
than the fixed manufacturing overhead applied to work in process, the volume variance is labeled as favorable. As
we shall see, caution is advised when interpreting this variance.
To understand the volume variance, we need to understand how fixed manufacturing overhead is applied to work
in process in a standard costing system. As discussed earlier, fixed manufacturing overhead is applied to work in
process on the basis of the standard hours allowed for the actual output of the period. In the case of Micro Drive
Corporation, the company produced 20,000 motors and the standard for each motor is 2 machine-hours. Therefore,
the standard hours allowed for the actual output is 40,000 machine-hours ( = 20,000 motors x 2 machine-hours). As
shown in Exhibit 7-12 , the predetermined fixed manufacturing overhead rate of $6.00 per machine-hour is
multiplied by the 40,000 standard machine-hours allowed for the actual output to arrive at $240,000 of fixed
manufacturing overhead applied to work in process. Another way to think of this is that the standard for each motor
is 2 machine-hours. Because the predetermined fixed manufacturing overhead rate is $6.00 per machine-hour, each
motor is assigned $12.00 ( = 2 machine-hours x $6.00 per machine-hour) of fixed manufacturing overhead.
Consequently, a total of $240,000 of fixed manufacturing overhead is applied to the 20,000 motors that are actually
produced. Under either explanation, the volume variance according to the formula is:
Volume variance = $300,000 - $240,000 = $60,000 U
Exhibit 7-12
The key to interpreting the volume variance is to understand that it depends on the difference between the hours
used in the denominator to compute the predetermined overhead rate and the standard hours allowed for the
actual output of the period. While it is not obvious, the volume variance can also be computed using the following
formula:
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Note that this agrees with the volume variance computed using the earlier formula.
Focusing on this new formula, if the denominator hours exceed the standard hours allowed for the actual output,
the volume variance is unfavorable. If the denominator hours are less than the standard hours allowed for the actual
output, the volume variance is favorable. Stated differently, the volume variance is unfavorable if the actual level
of activity is less than expected. The volume variance is favorable if the actual level of activity is greater than
expected. It is important to note that the volume variance does not measure overspending or underspending. A
company should incur the same dollar amount of fixed overhead cost regardless of whether the period’s activity
was above or below the planned (denominator) level.
The volume variance is often viewed as a measure of the utilization of facilities. If the standard hours allowed for
the actual output are greater than (less than) the denominator hours, it signals efficient (inefficient) usage of
facilities. However, other measures of utilization—such as the percentage of capacity utilized—are easier to
compute and understand. Perhaps a better interpretation of the volume variance is that it is the error that occurs
when the level of activity is incorrectly estimated and the costing system assumes fixed costs behave as if they are
variable. This interpretation may be clearer in the next section that graphically analyzes the fixed manufacturing
overhead variances.
Reconciling Overhead Variances and Underapplied or Overapplied Overhead
In a standard cost system, the underapplied or overapplied overhead for a period equals the sum of the overhead
variances. To see this, we will return to the Micro Drive Corporation example.
As discussed earlier, in a standard cost system, overhead is applied to work in process on the basis of the standard
hours allowed for the actual output of the period. The following table shows how the underapplied or overapplied
overhead for Micro Drive is computed.
Predetermined overhead rate (a) . . . . . . . . . . . . $7.50 per machine-hour
Standard hours allowed for the actual output [ Exhibit 7-10 ] (b) . . . . . . . . . . . 40,000 machine-hours
Manufacturing overhead applied (a) x (b) . . . . . $300,000
Total actual manufacturing overhead [ Exhibit 7-10 ] . . . . . . . . . . . . . . . . . . . . . . . . $379,400
Manufacturing overhead underapplied or overapplied . . . . . . . . . . . . . . . . . . . . . . . . . $79,400 underapplied
We have already computed the budget variance and the volume variance for this company. We will also need to
compute the variable manufacturing overhead variances. The data for these computations are contained in Exhibit
7-10 . Recalling the formulas for the variable manufacturing overhead variances from Exhibit 7–9 , we can compute
the variable overhead rate and efficiency variances as follows:
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We can now compute the sum of all of the overhead variances as follows:
Variable overhead rate variance . . . . . . . . $ 8,400 U
Variable overhead efficiency variance . . . . 3,000 U
Fixed overhead budget variance . . . . . . . . 8,000 U
Fixed overhead volume variance . . . . . . . . 60,000 U
Total of the overhead variances . . . . . . . . $79,400 U
Note that the total of the overhead variances is $79,000, which equals the underapplied overhead of
$79,000. In general, if the overhead is underapplied, the total of the standard cost overhead variances is
unfavorable. If the overhead is overapplied, the total of the standard cost overhead variances is favorable.
7.6 Journal Entries to Record Variances
Although standard costs and variances can be computed and used by management without being formally
entered into the accounting records, many organizations prefer to make formal journal entries. Formal entries tend
to give variances a greater emphasis than informal, off-the-record computations. This emphasis signals
management’s desire to keep costs within the limits that have been set. In addition, formal use of standard costs
simplifies the bookkeeping process enormously. Inventories and cost of goods sold can be valued at their standard
costs—eliminating the need to keep track of the actual cost of each unit.
Direct Materials Variances
To illustrate the journal entries needed to record standard cost variances, assume the following information:
Xavier Company produces a single product. Variable manufacturing overhead is applied to products on the basis of
direct labor-hours. The standard costs for one unit of product are as follows:
Direct material: 6 ounces at $0.50 per ounce . . . . . . . . . . . . . . . . . . . . . $ 3.00
Direct labor: 0.6 hours at $30.00 per hour . . . . . . . . . . . . . . . . . . . . . . . . 18.00
Variable manufacturing overhead: 0.6 hours at $10.00 per hour . . . . . . . 6.00
Total standard variable cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27.00
During June, 2,000 units were produced. The costs associated with June’s operations were as
follows:
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Material purchased: 18,000 ounces at $0.60 per ounce . . . . . . . . $10,800
Material used in production: 14,000 ounces . . . . . . . . . . . . . . . . . —
Direct labor: 1,100 hours at $30.50 per hour . . . . . . . . . . . . . . . . . $33,550
Variable manufacturing overhead costs incurred . . . . . . . . . . . . . . $12,980
The entry to record the purchase of direct materials would be as follows:
Raw Materials (18,000 ounces at $0.50 per ounce) . . . . . . . . . . . . . . 9,000
Materials Price Variance (18,000 ounces at $0.10 per ounce U) . . . . 1,800
Accounts Payable (18,000 ounces at $0.60 per ounce . . . . . . . .
10,800
Notice that the price variance is recognized when purchases are made, rather than when materials are
actually used in production and that the materials are carried in the inventory account at standard cost. As direct
materials are later drawn from inventory and used in production, the quantity variance is isolated as follows:
Work in Process (12,000 ounces at $0.50 per ounce) . . . . . . . . . . . . . 6,000
Materials Quantity Variance (2,000 ounces U at $0.50 per ounce) . . . 1,000
Raw Materials (14,000 ounces at $0.50 per ounce) . . . . . . . . . . .
7,000
Thus, direct materials are added to the Work in Process account at the standard cost of the materials that
should have been used to produce the actual output.
Notice that both the price variance and the quantity variance above are unfavorable and are debit entries.
If either of these variances had been favorable, it would have appeared as a credit entry.
Direct Labor Variances
Using the information from Xavier Company, the journal entry to record the incurrence of direct labor cost
would be:
Work in Process (1,200 hours at $30.00 per hour) . . . . . . . . . . . . . 36,000
Labor Rate Variance (1,100 hours at $0.50 U) . . . . . . . . . . . . . . . . . . 550
Labor Efficiency Variance (100 hours F at $30.00 per hour) . . . . . . . 3,000
Wages Payable (1,100 hours at $30.50 per hour) . . . . . . . . . . . . . . . 33,550
Thus, as with direct materials, direct labor costs enter into the Work in Process account at standard, both
in terms of the rate and in terms of the hours allowed for the actual production of the period. Note that the
unfavorable labor efficiency variance is a debit entry whereas the favorable labor rate variance is a credit entry.
Overhead Variances
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Overhead variances are not necessarily recorded in the books. The difference between actual overhead
and applied overhead is directly closed to Cost of Goods Sold. It is an option to record the variances in the closing
entries.
SELF-TEST QUESTIONS
1. The following standards have been established for a raw material used in the production of product G13:
Standard quantity of the material per unit of output ..................... 2.3 liters
Standard price of the material ....................................................... P19.00 per liter
The following data pertain to a recent month’s operations:
Actual material purchased .................................... 5,100 liters
Actual cost of material purchased ........................ P100,725
Actual material used in production ....................... 4,700 liters
Actual output........................................................ 2,040 units of product G13
Required:
a. What is the materials price variance for the month?
b. What is the materials quantity variance for the month?
c. Prepare journal entries to record the purchase and use of the raw material during the month. (All raw
materials are purchased on account.)
Answer:
a. Materials price variance = (AQ × AP) – (AQ × SP)
= P100,725 – (5,100 × P19.00) = P3,825 U
b.
Materials quantity variance = SP(AQ – SQ*)
= P19.00(4,700 – 4,692) = P152 U
*SQ = Standard quantity per unit × Actual output
= 2.3 × 2,040 = 4,692
c.
Journal entries to record the purchase and use of the raw material:
Record the purchase of the raw material:
Raw Materials
96,900
Materials Price Variance
3,825
Accounts Payable
100,725
Record the use of the raw material:
Work In Process
Materials Quantity Variance
Raw Materials
89,300
89,148
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2. The following direct labor standards have been established for product N30A:
Standard direct labor-hours......................... 3.3 hours per unit of N30A
Standard direct labor wage rate .................. P10.50 per hour
The following data pertain to the most recent month’s operations during which 400 units of product N30A
were made:
Actual direct labor-hours worked ................ 1,100
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Actual direct labor wages paid.....................
P11,385
Required:
a. What was the labor rate variance for the month?
b. What was the labor efficiency variance for the month?
c. Prepare a journal entry to record direct labor costs during the month, including the direct labor
variances.
Answer:
a. Labor rate variance = (AH × AR) – (AH × SR)
= P11,385 – (1,100 × P10.50) = P165 F
b.
Labor efficiency variance = SR(AH – SH*)
= P10.50 (1,100 – 1,320) = P2,310 F
*SH = Standard hours per unit × Actual output
= 3.3 × 400 = 1,320
c.
Journal entries to record the direct labor costs:
Work In Process
Labor Rate Variance
Labor Efficiency Variance
Wages Payable (or Cash)
13,860
165
2,310
11,385
3. The following standards for variable manufacturing overhead have been established for a company that
makes only one product:
Standard hours per unit of output ........................ 0.6 hours
Standard variable overhead rate .......................... P17.55 per hour
The following data pertain to operations for the last month:
Actual hours .........................................................
Actual total variable overhead cost ......................
Actual output........................................................
6,200 hours
P110,670
10,200 units
Required:
a. What is the variable overhead spending variance for the month?
b. What is the variable overhead efficiency variance for the month?
Answer:
a. Variable overhead spending variance = (AH × AR) – (AH × SR)
= P110,670 – (6,200 × P17.55) = P1,860 U
SH = Standard hours per unit × Actual output
= 0.6 × 10,200 = 6,120
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Variable overhead efficiency variance = SR(AH – SH)
= P17.55(6,200 – 6,120) = P1,404 U
4. Layt Clock Company has developed the following flexible budget for its overhead costs. Manufacturing
overhead at Layt is applied to production on the basis of standard machine-hours:
Machine Hours
21,600
24,000
26,400
Clocks produced ........................... 18,000
20,000
22,000
Variable overhead cost ................. P127,440
P141,600
P155,760
Fixed overhead cost...................... P171,072
P171,072
P171,072
b.
Layt was expecting to produce 22,000 clocks last year. The actual results for the year were as follows:
Number of clocks produced .................... 21,500
Machine-hours incurred.......................... 24,940
Variable overhead cost ........................... P145,899
Fixed overhead cost................................ P170,540
Required:
Compute all four manufacturing overhead variances for Layt.
Answer:
Variable Overhead Spending Variance = (AH × AR) - (AH × SR)
= P145,899 - [(P155,760/26,400) × 24,940] = P1,247 F
Variable Overhead Efficiency Variance = (AH × SR) - (SH × SR)
= [24,940 × (P155,760/26,400)] - [21,500 × (26,400/22,000) ×
(P155,760/26,400)] = P5,074 F
Fixed Overhead Budget Variance =
Actual fixed overhead cost - Budgeted fixed overhead cost
= P170,540 - P171,072 = P532F
Fixed Overhead Volume Variance =
Fixed portion of the predetermined overhead rate × (Denominator hours –
Standard hours allowed)
= P171,072 - [(P171,072/26,400) × 21,500 × (26,400/22,000)] = P3,888 U
5. Parker Company uses a standard cost system in which manufacturing overhead is applied to units of
product on the basis of standard direct labor-hours. The company's total budgeted variable and fixed
manufacturing overhead costs at the denominator level of activity are P14,000 for variable overhead and
P6,000 for fixed overhead. The predetermined overhead rate, including both fixed and variable
components, is P4 per direct labor-hour. The standards call for 2 direct labor-hours per unit of output
produced. Last year, the company produced 3,000 units of product and worked 6,200 direct labor-hours.
Actual costs were P15,500 for variable overhead and P6,300 for fixed overhead.
Required:
a. What is the denominator level of activity?
b. What were the standard hours allowed for the output last year?
c. What was the variable overhead spending variance?
d. What was the variable overhead efficiency variance?
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e. What was the fixed overhead budget variance?
f. What was the fixed overhead volume variance?
Answer:
a. Total overhead at the denominator level of activity ......................
Predetermined overhead rate .......................................................
Denominator level of activity ........................................................
P20,000
÷ P4/DLH
5,000 DLHs
b.
Actual output ................................................................................
Standard DLH per unit...................................................................
Standard DLHs allowed .................................................................
c.
Spending variance = (AH × AR) - (AH × SR)
= (P15,500) - (6,200 × P2.80*) = P1,860 F
* P14,000 ÷ 5,000 DLHs = P2.80 per DLH
d.
Efficiency variance = (AH × SR) - (SH × SR)
= (6,200 × P2.80) - (6,000* × P2.80) = P560 U
* 2 DLHs per unit × 3,000 units = 6,000 DLHs
e.
Budget variance = Actual fixed overhead - Budgeted Fixed overhead
= P6,300 - P6,000 = P300 U
f.
Volume variance = Fixed portion of predetermined overhead rate × (Denominator hours - Standard hours
allowed)
= P1.20* (5,000 - 6,000) = P1,200 F
*P6,000 ÷ 5,000 DLH = P1.20 per DLH
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3,000 units
× 2 DLHs per unit
6,000 DLHs
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ASSIGNMENT MATERIAL
MULTIPLE CHOICE
1. Which of the following statements concerning ideal standards is incorrect?
A)
Ideal standards generally do not provide the best motivation for workers.
B)
Ideal standards do not make allowances for waste, spoilage, and machine breakdowns.
C)
Ideal standards are better suited for cash budgeting than practical standards.
D)
Ideal standards may be better than practical standards when managers seek continual
improvement.
2.
Under traditional standard costing, which of the following would commonly be included when setting a
standard quantity for direct material?
An allowance for An allowance for
material wasted
material rejected
during production
during production
A)
Yes
Yes
B)
Yes
No
C)
No
Yes
D)
No
No
3.
When computing standard cost variances, the difference between actual and standard price multiplied
by actual quantity yields a(n):
A)
combined price and quantity variance.
B)
efficiency variance.
C)
price variance.
D)
quantity variance.
4.
Poor quality materials could have an unfavorable effect on which of the following variances?
Labor
Materials
Efficiency
Quantity
Variance
Variance
A)
Yes
Yes
B)
Yes
No
C)
No
Yes
D)
No
No
5.
When the actual price paid on credit for a raw material exceeds its standard price, the journal entry would
include:
A)
Debit to Raw Materials; Credit to Materials Price Variance
B)
Debit to Accounts Payable; Credit to Materials Price Variance
C)
Debit to Raw Materials; Debit to Materials Price Variance
D)
Debit to Accounts Payable; Debit to Materials Price Variance
6.
When the actual price paid on credit for a raw material is less than its standard price, the journal entry
would include:
A)
Credit to Raw Materials; Credit to Materials Price Variance
B)
Credit to Accounts Payable; Credit to Materials Price Variance
C)
Credit to Raw Materials; Debit to Materials Price Variance
D)
Credit to Accounts Payable; Debit to Materials Price Variance
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7.
When the actual amount of a raw material used in production is less than the standard amount allowed for
the actual output, the journal entry would include:
A)
Credit to Raw Materials; Credit to Materials Quantity Variance
B)
Credit to Work-In-Process; Credit to Materials Quantity Variance
C)
Credit to Raw Materials; Debit to Materials Quantity Variance
D)
Credit to Work-In-Process; Debit to Materials Quantity Variance
8.
When the actual amount of a raw material used in production is greater than the standard amount allowed
for the actual output, the journal entry would include:
A)
Credit to Raw Materials; Credit to Materials Quantity Variance
B)
Credit to Work-In-Process; Credit to Materials Quantity Variance
C)
Credit to Raw Materials; Debit to Materials Quantity Variance
D)
Credit to Work-In-Process; Debit to Materials Quantity Variance
9.
Which of the following would produce a materials price variance?
A)
an excess quantity of materials used.
B)
an excess number of direct labor-hours worked in completing a job.
C)
shipping materials to the plant by air freight rather than by truck.
D)
breakage of materials in production.
10. The standard price per unit of materials is used in the calculation of which of the following variances?
Materials price variance
A)
No
B)
No
C)
Yes
D)
Yes
Materials quantity variance
No
Yes
No
Yes
11. A labor efficiency debit balance indicates that:
A)
The wage rate paid to production workers was less the standard.
B)
The wage rate paid to production workers was above the standard.
C)
Less labor time was spent on production than was called for by the standard.
D)
More labor time was spent on production than was called for by the standard.
12. When the actual wage rate paid to direct labor workers exceeds the standard wage rate, the journal entry
would include:
A)
Credit to Wages Payable; Credit to Labor Rate Variance
B)
Credit to Work-In-Process; Credit to Labor Rate Variance
C)
Credit to Wages Payable; Debit to Labor Rate Variance
D)
Credit to Work-In-Process; Debit to Labor Rate Variance
13. When the actual wage rate paid to direct labor workers is less than the standard wage rate, the journal
entry would include:
A)
Debit to Wages Payable; Credit to Labor Rate Variance
B)
Debit to Work-In-Process; Credit to Labor Rate Variance
C)
Debit to Wages Payable; Debit to Labor Rate Variance
D)
Debit to Work-In-Process; Debit to Labor Rate Variance
14. When the actual direct labor-hours exceed the standard direct labor-hours allowed for the actual output
of the period, the journal entry would include:
A)
Credit to Wages Payable; Credit to Labor Efficiency Variance
B)
Credit to Work-In-Process; Credit to Labor Efficiency Variance
C)
Credit to Wages Payable; Debit to Labor Efficiency Variance
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D)
Credit to Work-In-Process; Debit to Labor Efficiency Variance
15. Which of the following would produce a labor rate variance?
A)
Poor quality materials causing breakage and work interruptions.
B)
Use of persons with high hourly wage rates in tasks that call for low hourly wage rates.
C)
Excessive number of hours worked in completing a job.
D)
An unfavorable variable overhead spending variance.
16. In a certain standard costing system direct labor-hours are used as the base for applying variable
manufacturing overhead costs. The standard direct labor rate is twice the variable manufacturing
overhead rate. Last period the labor efficiency variance was unfavorable. From this information one can
conclude that last period the variable overhead efficiency variance was:
A)
unfavorable and half the labor efficiency variance.
B)
favorable and half the labor efficiency variance.
C)
unfavorable and twice the labor efficiency variance.
D)
favorable and twice the labor efficiency variance.
17. If raw materials are carried in the raw materials inventory at standard cost, then it is reasonable to assume
that:
A)
the price variance is recognized when materials are purchased.
B)
the price variance is recognized when materials are placed into production.
C)
all variances are prorated between work in process, finished goods, and cost of goods sold.
D)
the raw materials account is overstated.
18. Which of the following statements is a good description of the variances that should be investigated under
the management by exception concept?
A)
all variances should be investigated.
B)
only unfavorable variances should be investigated.
C)
a small random sample of all variances should be investigated.
D)
unusually large favorable and unfavorable variances should be investigated.
19. The following direct labor information pertains to the manufacture of product Glu:
Time required to make one unit
Number of direct labor workers
Number of productive hours per week, per worker
Weekly wages per worker
Workers’ benefits treated as direct labor costs
2 direct labor-hours
50 workers
40 hours
P500
20% of wages
What is the standard direct labor cost per unit of product Glu?
A)
P30
B)
P24
C)
P15
D)
P12
20. Anderson Company purchased 20,000 pounds of direct material at P0.70 per pound. The standard cost per
pound of material is P0.60 per pound. The general ledger entry to record the issuance of materials would
include:
A)
a debit to Materials Price Variance P2,000.
B)
a credit to Materials Price Variance of P2,000.
C)
a credit to Raw Materials of P0.70 per pound times the number of pounds issued.
D)
a credit to Raw Materials of P0.60 per pound times the number of pounds issued.
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21. The following materials standards have been established for a particular raw material used in the
company's sole product:
Standard quantity per unit of output
1.0 pound
Standard price
P16.60 per pound
The following data pertain to operations concerning the product for the last month:
Actual materials purchased
2,200 pounds
Actual cost of materials purchased
P34,650
Actual materials used in production
1,900 pounds
Actual output
2,100 units
What is the materials quantity variance for the month?
A)
P3,320 F
B)
P3,150 F
C)
P4,980 U
D)
P4,725 U
22. A quantity of a particular raw material was purchased for P43,250. The standard cost of the material was
P2.00 per kilogram and there was an unfavorable materials price variance of P3,250. How many kilograms
were purchased?
A)
20,000 B)
21,625 C)
23,250 D)
24,875
23. A total of 6,850 kilograms of a raw material was purchased at a total cost of P21,920. The material price
variance was P1,370 favorable. The standard price per kilogram for the raw material must be:
A)
P0.20 B)
P3.00 C)
P3.20 D)
P3.40
24. Results of operations for the Anderson Company indicated that the actual direct labor rate for the month
of May was P9.75 while the standard rate was P10.00. The general ledger entry to record the incurrence
of direct labor cost would include:
A)
a debit to Work-In-Process for the actual number of hours times P9.75 per hour.
B)
a debit to Work-In-Process for the standard number of hours times P10.00 per hour.
C)
a debit to Work-In-Process for the standard number of hours times P9.75 per hour.
D)
a debit to Work-In-Process for the actual number of hours times P10.00 per hour.
25. The following labor standards have been established for a particular product:
Standard labor-hours per unit of output
8.0 hours
Standard labor rate
P13.10 per hour
The following data pertain to operations concerning the product for the last month:
Actual hours worked
4,000 hours
Actual total labor cost
P53,000
Actual output
400 units
What is the labor efficiency variance for the month?
A)
P10,600 U
B)
P11,080 U
C)
P11,080 F
D)
26. The following labor standards have been established for a particular product:
Standard labor-hours per unit of output
2.4 hours
Standard labor rate
P15.45 per hour
P10,480 U
The following data pertain to operations concerning the product for the last month:
Actual hours worked
5,400 hours
Actual total labor cost
P85,860
Actual output
2,200 units
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What is the labor rate variance for the month?
A)
P1,908 U
B)
P2,430 U
C)
P4,284 U
D)
P4,284 F
D)
P134,400
27. The following information pertains to Bates Company's direct labor for March:
Standard direct labor-hours
21,000
Actual direct labor-hours
20,000
Favorable direct labor rate variance
P8,400
Standard direct labor rate per hour
P6.30
What was Bates' total actual direct labor cost for March?
A)
P117,600
B)
P118,000
C)
P134,000
28. The direct labor standards for a particular product are:
4 hours of direct labor @ P12.00 per direct labor-hour = P48.00
During October, 3,350 units of this product were made, which was 150 units less than budgeted. The
labor cost incurred was P159,786 and 13,450 direct labor-hours were worked. The direct labor variances
for the month were:
Labor Rate Variance
Labor Efficiency Variance
A)
P1,614 U
P600 U
B)
P1,614 U
P600 F
C)
P1,614 F
P600 U
D)
P1,614 F
P600 F
29. The following standards for variable manufacturing overhead have been established for a company that
makes only one product:
Standard hours per unit of output 5.6 hours
Standard variable overhead rate
P19.15 per hour
The following data pertain to operations for the last month:
Actual hours
5,100 hours
Actual total variable overhead cost
P99,195
Actual output
1,100 units
What is the variable overhead efficiency variance for the month?
A)
P20,299 F
B)
P18,769 F
C)
P1,848 F
D)
P20,617 F
30. The following standards for variable manufacturing overhead have been established for a company that
makes only one product:
Standard hours per unit of output
2.8 hours
Standard variable overhead rate
P16.30 per hour
The following data pertain to operations for the last month:
Actual hours
7,600 hours
Actual total variable overhead cost P127,300
Actual output
2,500 units
What is the variable overhead spending variance for the month?
A)
P3,420 U
B)
P3,150 F
C)
P10,050 U
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P13,200 U
265
31. During the month of May, Domino Manufacturing Corporation purchased materials that had a total
standard cost of P57,000. The Materials Price Variance on these materials was P3,000 favorable. What
summary journal entry would Domino make to record this purchase and variance for May?
A)
B)
C)
Work in Process
Materials Price Variance
Raw Materials
57,000
3,000
Work in Process
Materials Price Variance
Raw Materials
54,000
3,000
60,000
Raw Materials
Materials Price Variance
Accounts Payable
57,000
57,000
3,000
54,000
Use the following to answer questions 32-34:
Stench Foods Company uses a standard cost system to collect costs related to the production of its garlic flavored
yogurt. The garlic (materials) standards for each container of yogurt produced are 0.8 ounces of crushed garlic at a
standard cost of P2.30 per ounce.
During the month of June, Stench purchased 75,000 ounces of crushed garlic at a total cost of P171,000. Stench
used 64,000 of these ounces to produce 71,500 containers of yogurt.
32. What is Stench's materials price variance for the month of June?
A)
P1,500 favorable
C)
P15,640 unfavorable
B)
P17,250 favorable
D)
P23,800 favorable
33. What is Stench's materials quantity variance for the month of June?
A)
P1,500 favorable
C)
P15,640 unfavorable
B)
P17,250 favorable
D)
P23,800 favorable
34. Assume that it takes 15 minutes of labor time to crush enough garlic to fill one container of yogurt. Because
the smell of the garlic can be unbearable, workers are given (and they take it!) 10 minutes of break time
every hour (i.e., 50 minutes of work, 10 minutes of break). How many minutes should Stench use as a
standard quantity of labor time per container of yogurt?
A)
18.0
B)
16.2
C)
17.0
D)
17.5
Use the following to answer questions 35-37:
Holiday Chemical Company uses a standard cost system to collect costs related to the production of its “bowling
ball” fruitcakes. The direct labor standard for each fruitcake is 1.25 hours at a standard cost of P11.00 per hour.
During the month of November, Holiday's fruitcake production used 9,820 direct labor hours at a total direct labor
cost of P106,547. This resulted in production of 8,500 fruitcakes for November.
35. What is Holiday's labor rate variance for November?
A)
P8,855 favorable C)
P1,473 favorable
B)
P13,047 unfavorable
D)
P14,520 unfavorable
36. What is Holiday's labor efficiency variance for November?
A)
P8,855 favorable C)
P10,328 favorable
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B)
P13,047 unfavorable
D)
P14,520 unfavorable
37. Assume that 7 ounces of pecans are included in each bowling ball fruitcake. Because Holiday wants only
the best pecans in its fruitcakes, the pecans they buy are inspected and some are discarded as
unacceptable for fruitcake production. The loss rate is expected to be 1 ounce of pecans for every 5 ounces
inspected. Under traditional standard costing, how many ounces of pecans should Holiday use as a
standard quantity per fruitcake?
A)
7.20
B)
7.80
C)
8.40
D)
8.75
Use the following to answer questions 38-39:
Debit Dave and his four teaching assistants grade all 1,000 of their managerial accounting exams as a group. The
average number of exams graded per hour by each person is as follows:
Dave Joanne
Karen
Andy
Tom
Number of exams
45
32
28
25
20
Debit Dave is considering the above information in setting a standard for grading the next examination.
38. Which amount above best represents a practical standard?
A)
45
B)
32
C)
25
D)
20
39. Which amount above best represents an ideal standard?
A)
45
B)
32
C)
25
D)
20
Use the following to answer questions 40-45:
Pardoe, Inc., manufactures a single product in which variable manufacturing overhead is assigned on the basis of
direct labor hours. The company uses a standard cost system and has established the following standards for one
unit of product:
Standard
Standard Price
Standard
Quantity
or Rate
Cost
Direct materials
1.5 pounds
P3.00 per pound
P4.50
Direct labor
0.6 hours
P6.00 per hour
P3.60
Variable manufacturing
overhead
0.6 hours
P1.25 per hour
P0.75
During March, the following activity was recorded by the company:
• The company produced 3,000 units during the month.
• A total of 8,000 pounds of material were purchased at a cost of P23,000.
• There was no beginning inventory of materials on hand to start the month; at the end of the month,
2,000 pounds of material remained in the warehouse.
• During March, 1600 direct labor hours were worked at a rate of P6.50 per hour.
• Variable manufacturing overhead costs during March totaled P1,800.
40. The materials price variance for March is:
A)
P1,000 F
B)
P1,000 U
C)
P750 F
D)
P750 U
41. The materials quantity variance for March is:
A)
P4,500 F
B)
P10,500 F
42. The labor rate variance for March is:
A)
P480 U B)
P800 U C)
C)
P480 F
43. The labor efficiency variance for March is:
A)
P5,040 U
B)
P1,200 U
P10,500 U
D)
C)
D)
P4,500 U
D)
P5,040 F
P800 F
P1,200 F
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44. The variable overhead spending variance for March is:
A)
P200 U B)
P600 U C)
P600 F
D)
45. The variable overhead efficiency variance for March is:
A)
P1,050 F
B)
P1,050 U
C)
P250 F
P200 F
D)
P250 U
Use the following to answer questions 46-49:
The Dresden Company uses standard costing for the single product the company makes and sells. The following
data are for the month of April:
•
Actual cost of direct material purchased and used: P62,400
•
Material price variance: P4,800 unfavorable
•
Total materials variance: P14,400 unfavorable
•
Standard cost per pound of material: P6
•
Standard cost per direct labor hour: P8
•
Actual direct labor hours: 3,800 hours
•
Labor efficiency variance: P1,600 favorable
•
Standard number of direct labor hour per unit of product: 2
•
Total labor variance: P680 unfavorable
46. The total number of units produced during April was:
A)
8,000
B)
12,000
C)
2,000
D)
3,800
47. The standard quantity of material allowed to produce one unit of product was:
A)
1 pound B)
4 pounds
C)
6 pounds
D)
2 pounds
48. The actual material cost per pound was:
A)
P6.50
B)
P6.00
C)
P5.00
D)
P7.20
49. The actual direct labor rate per hour was:
A)
P16.00
B)
P6.50
C)
P8.00
D)
P8.60
50. The labor rate variance was:
A)
P2,280 favorable C)
B)
P920 favorable
P2,280 unfavorable
D)
P920 unfavorable
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