Galilee College
Cost Accounting I
Course No. ACC 214
Galilee Corporate Centre • Joe Farrington Road
P.O. Box EE 16507 - Nassau, Bahamas –
Tel. (242)364-8202 Fax (242)364-1778
Email: galilee@coralwave.com
www.gcollege.org
Dr. Willis L. Johnson, Galilee College
Galilee College © 2008
1
Galilee College
Course Outline
COURSE NUMBER:
ACC 214
COURSE TITLE:
Cost Accounting I
DEPARTMENT: Accounting
CREDIT VALUE: 3.0
COURSE DURATION: 1 SEMESTER
DATE PREPARED: July 2008
PREREQUISITES
ACC 112, Principles of Accounting II
PROGRAM COORDINATOR _________________________________
REQUIRED TEXTS:
COST ACCOUNTING I
Author
Dr. Willis L.Johnson, Galilee College
Description: © Printed Material 2006
SUPPLEMENTAL MATERIALS
NONE
COURSE DESCRIPTION
A study of cost accounting principles and techniques of assembling data for
product cosing and for managerial use in planning and control and decision
making cost terminology, cost behavior, job order and process costing,
budgeting, cost-volume-profit analysis, standard costs, and relevant costs for
decision making are topics covered.
COURSE OBJECTIVES
Students will be expected to:
Demonstrate an understanding of the terms and concepts used in
cost/managerial accounting.
Demonstrate an ability to solve problems and analyze short case
situations involving topics mentioned in the course description. Some
problems will require solution using computer spreadsheets.
Demonstrate an ability to apply cost/managerial terms, concepts, and
procedures to managerial situations, formulate a solution or
recommendation, and communicate the results of the application.
2
Program Context:
This course is a second year course in the Accounting program. (This course
can also be completed in the third year )
Course Learning Outcomes:
Learning outcomes identify the knowledge, skills and attitudes that successful
students will have developed and reliably demonstrated as a result of the
learning experiences and evaluations during this course.
Evaluation Strategies and Grading:
Class Attendance
Full participation and attendance is expected for this course. Students who miss a
class are responsible for any information discussed, assigned or distributed in that
class period.
Six exams are scheduled during the semester. The lowest exam score will be
dropped. If an exam is missed for ANY REASON, that will be the exam dropped.
If a second exam is missed for ANY REASON, a ZERO will be assigned to the
second missed exam. There will be no make-up exams. Everyone is required to
take the final exam. Calculators may be used on all exams, but you may NOT
share calculators.
ATTENDANCE
CLASS TESTS
FINAL PROJECT
10%
40%
50%
100%
Note that violation of academic honesty can affect the course grade. "Cheating" on an exam
(i.e., the giving or receiving of aid) will result in a course grade of "F."
Note that classroom behavior (for example, talking to other students during lecture) can
negatively affect course grades by as much as three letter grades, e.g., an "A" can become a
"D."
GRADING SYSTEM:
A 94% 100% Excellent
B 87% 93% Good
C 75% 86% Average
4.00
3.00
2.00
D 68% - 74% Passed 1.00
F 0% - 67% Failed 0.00
COVERAGE
X
1.
2.
3.
4.
5.
6.
7.
8.
9.
Introduction to Cost Accounting
Process Costing
Job-Order Costing
Standard Costs
Variable (Direct) & Absorption (Full) Costing
Activity-Based Costing (ABC)
Joint Costing & By-Product Costing
Service Cost Allocations
Budgeting
Cost-Volume-Profit (CVP) Analysis
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COST ACCOUNTING I
ACC 214
Professor: Dr. Willis L. Johnson, CPA
Course Instructions
1. Review the notes for each chapter
2. Complete all Homework and classwork questions.
3. Upon completion of the above, complete the Final exam which is attached.
i. The final exam should be presented in typewritten format
4. Should you require additional information, please contact Dr. Johnson as
soon as possible at (242)364-8202 or 364-7386
5. Email any questions that you may have to galilee@coralwave.com,
addressed to Professor Johnson.
6. Your “completed” Work must be presented via email to enable you to
receive a grade for this course.
Note: Your work should be completed between 6 – 10 weeks. Presentation after 10
weeks will cause the reduction of grade, the maximum time with permission for
extension is 12 weeks.
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Cost Accounting I
TABLE OF CONTENTS
X
1.
2.
3.
4.
5.
6.
7.
8.
9.
Introduction to Cost Accounting
Process Costing
Job-Order Costing
Standard Costs
Variable (Direct) & Absorption (Full) Costing
Activity-Based Costing (ABC)
Joint Costing & By-Product Costing
Service Cost Allocations
Budgeting
Cost-Volume-Profit (CVP) Analysis
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Introduction to Cost Accounting
Accounting is called the language of business. The objective of financial
accounting is to provide useful information to external decision makers such as
investors and credits. On the other hand, the objective of management
accounting is to provide useful financial and non financial information to internal
decision makers.
Cost accounting is a specialized form of accounting which measures, analyzes,
and reports financial and non-financial information relating to the cost of
acquiring or using resources in an organization. Cost accounting provides
product cost information used both by external parties and by internal managers
who are responsible for planning, controlling, decision making, and evaluating
performance within the organization.
Though both management and financial accounting make extensive use of the
accounting records of the organization, there are differences between the two
fields of accounting in terms of:
Management
Financial
Accounting
Accounting
Primary users
Company
managers
Time focus
Present and future Historical
Organizational
focus
Parts (segmented) Whole (aggregate)
Time span of
reports
As needed
Quarterly and
annually
Rules and
regulations
Need not follow
GAAP
Must follow GAAP
Record-keeping
Formal and
informal
Formal
Outside parties
Managers need reliable information to develop mission statements, implement
strategy, devise and control the value chain, and evaluate performance. Cost
accountants are charged with the responsibility of providing management with
financial and non-financial information so that management's goals are achieved.
One of the keys to a company’s success is in creating value for customers.
Value can be defined as the usefulness a customer gains from a company’s
product or service. An effective way to evaluate value is through value chain
analysis.
A value chain can be defined as a set of value-adding functions or processes that
convert inputs into products and services for customers. Critical to value chain
6
analysis is a proper determination of costs. Management accountants forecast,
identify, and track costs in each function of the value chain. Their goal is to
create value while minimizing cost.
Cost accountants act as scorekeepers in assisting management to evaluate
performance. In the past companies have used historical financial information to
evaluate performance. Today many companies use the balanced scorecard, a
combination of financial and non-financial indicators and objectives to evaluate
performance.
At the outset of our discussion of cost accounting it is important to consider
professional ethics. Though many recent public abuses in accounting reporting
have had to do with improperly reporting revenue in external statements;
nevertheless, it is important to consider ethical issues relating to both costs
(expenses) and revenue.
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Chapter 1 – Process Costing
Summary
1. Process Costing is accounting for product costs of inventoriable goods or
services
 Used for continuous process manufacturing of units (homogeneous)
a. Costa are accumulated by departments or cost centers
b. WIP is stated in terms of equivalent completed units to calculate
average cost
c. Units are established on a departmental basis
i.
Period Costs are expensed when incurred. E.g. advertising, officers
salaries, depreciation
2. Job-Order Costing accounts for the cost of specific jobs or projects
Note: Process & J/O Costing use the same general ledger accounts, and cost
flow is the same
 WIP for both systems are increased for the application of Material, Labor
and FOH
3. Equivalent Units of Production
Weighted Average
1 EUP = (conversion cost: DL & FOH) EWIP
Average EU
needed to produce 1 unit of F/G
+ Completed Units/
Transferred
 Add normal spoilage or scrap if any
FIFO
Weighted
- BWIP
3. Spoilage
i.
Normal – occurs under normal, efficient operating conditions = product
cost
ii.
Abnormal – not expected under efficient operating conditions – period
cost
a. (Debit loss & Credit WIP)
4. Scrap – is normal and is a part of cost. When sold (debit cash & credit FOH
or Revenue)
5. Waste – no further use for left over material = expense
6. Rework – charge to FOH if normal
7. Product Quality costs –
i.
Costs of external failure: problems occurring after shipment (e.g.
warranty, product liability, customer complaint)
ii.
Internal failure cost: problems occurring before shipment (e.g.
downtime, rework, scrap, tooling changes)
iii.
Prevention: attempts to avoid defective output (preventive
maintenance, employee training, review of equipment design &
evaluation of suppliers)
iv.
Appraisal: Embraces quality control programs (statistical quality
control programs, inspecting, testing)
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Lecturer Notes
Process costing is a method of allocating manufacturing cost to products to
determine an average cost per unit. It is used by companies which mass
produce identical or similar products. Since every unit is essentially the same,
each unit receives the same manufacturing input as every other unit. Refineries,
paper mills, and food processing companies are examples of businesses which
use process costing.
Similarities between job order and process costing include:
Both systems have the same basic purpose—to calculate unit cost
Both systems use the same manufacturing accounts
The flow of costs through the manufacturing accounts is basically the same
However, there are some important differences between job order and
processing costing as described below.
Job Order Costing
Process Costing
Each job is different
Costs are accumulated by job
Costs are captured on a job cost sheet
All products are identical
Costs are accumulated by department
Costs are accumulated on a department
production report
Unit costs are computed by department
Unit costs are computed by job
In job costing costs are assigned to specific jobs and then, if necessary, to units
within the job. In process costing, however, costs are averaged and then
assigned directly to units. Since every unit in process costing is the same, unit
cost can be calculated by dividing total product costs by units produced.
In process costing, total production costs are accumulated by department (and
by product in each department when multi products are produced). The number
of units produced can be complicated by the fact that not all units may be 100%
complete at period end. This necessitates the calculation of equivalent units.
Equivalent units of production are the number of completed units that could have
been obtained from the inputs that went into the partially completed units. For
example if 2,000 units are 20% complete at period end, they are equivalent to
400 units (2,000*.2).
There are two methods of accounting for costs in process costing as follows:
Weighted average method
FIFO method
Under the weighted average method, a single average cost per unit is calculated
for both the units in beginning inventory and the units started in production during
the period. The FIFO method, on the other hand, separates units in beginning
9
inventory from current production so that a current period cost per unit can be
calculated.
There is a six step approach to calculating costs. Note that equivalent units are
the sum of units transferred to the next department plus the number of equivalent
units in ending inventory. Since cost inputs are entered at different times,
separate equivalent figures must be calculated for material and for conversion
costs.
Again the authors suggest a six step approach to calculating costs. Steps 1 and
2 are the same as used in the weighted average method since they refer to the
use of physical units. Note that FIFO number of equivalent units is different from
the weighted average number of equivalent units. In the FIFO method equivalent
units to be accounted for is the sum of:
Equivalent units in beginning Work in Process (100% - percent completed)
Units started and completed this period
Equivalent units in ending Work in Process
Standard costs rather than actual costs are widely used for inventory valuation.
The weighed average and FIFO methods can become complicated for
companies which produce a wide variety of very similar products. These
companies frequently employ a standard cost system and prepare production
reports using standard rather than actual costs. The computation of equivalent
units for a standard costing system are identical to those of under the FIFO
method.
EXERCISES
Class: PROCESS COSTING: Fife Fiffy uses a process cost system to manufacture
laptop computers. The following information summarizes operations related to laptop
computer model #KJK20 during the quarter ending March 31.
Units
Direct Materials
WIP Inventory, January 1
100
$70,000
Started during the quarter
500
Completed during the quarter
400
WIP Inventory, March 31
200
Costs added during the quarter
$750,000
Beginning work-in-process inventory was 50% complete for direct materials. Ending
work-in-process inventory was 75% complete for direct materials. Using the Weighted
Average & FIFO methods, Find the following for March:1. Equivalent units of production 2. Transfer out cost 3. Cost of Ending Inventory
what were the equivalent units of production with regard to materials for March?
10
Home:. PROCESS COSTING: Lint Linty uses a process cost system to manufacture
Grape Fruit Juice. The following information summarizes operations related to Grape
Fruit Juice the quarter ending June 30, 2007.
Units
Direct Materials
WIP Inventory, April 1
200
$100,000
Started during the quarter
800
Completed during the quarter
400
WIP Inventory, June 31
100
Costs added during the quarter
$950,000
Beginning work-in-process inventory was 40% complete for direct materials. Ending
work-in-process inventory was 50% complete for direct materials. Using the Weighted
Average & FIFO methods, Find the following for June:-1. Equivalent units of production
2. Transfer out cost 3. Cost of Ending Inventory what were the equivalent units of
production with regard to materials for June?
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Chapter 2 – Job-Order Costing
Summary
1. Accumulating cost by specific job
Note: Indirect material and indirect labor are FOH (do not overstate FOH)
2. When FOH applied is materially different from FOH incurred, the difference is
allocated among: F/G, CGS and EWIP
3. Cost of Good Manufactured
BWIP + Direct Materials + Direct Labor + FOH = Cost Accounted for
- EWIP
= CGM
4. Underapplied FOH:
i.
If actual fixed cost is greater than expected = underapplied FOH
ii.
If actual fixed cost is less than expected = Overapplied FOH
iii.
If actual volume is less than expected (F/C) = Underapplied FOH
iv.
If actual volume is greater than expected (F/C) = Overapplied FOH
5. Cost Accounting Entries
i.
Direct Materials Purchased
Materials Inventory
Acct. Pay/Cash
ii.
Materials transferred to WIP
WIP
Materials Inventory
xx
xx
xx
xx
iii.
Factory Salaries
WIP (Direct Labor)
xx
FOH (Indirect Labor)
xx
Wages Payable/Cash
xx
Payroll Taxes Payable/Cash
xx
 t is normal for customers to require early completion and pay an
OT premium
iv.
Manufacturing Expenses (insurance, supplies, plant depreciation,
indirect Mat.)
FOH
xx
Expenses
xx
v.
Overhead charged to WIP
WIP
FOH
xx
Goods are completed(Finished)
Finished Goods
WIP
xx
Goods are sold
Cash/Acct. Rec.
Sales
xx
vi.
vii.
xx
xx
xx
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CGS
Finished Goods
xx
xx
Note: EWIP/EFG/E Raw Materials = deferred manufacturing costs.
Lecturer Notes
In order to be successful and survive, businesses must employ some type of
product costing system. In other words, companies need to track the cost of
making a product or furnishing a service.
When a service is rendered the
customer is given an invoice detailing the material and labor “costs”.
Management needs to cost products for a number of reasons. For financial
statements purposes management needs to calculate Cost of Goods Sold on
the Income Statement and Inventory on the Balance Sheet. For internal needs
management needs product cost information to establish prices, to compare
actual with budgeted figures, to properly decide to “make or buy”, etc. Often
outsiders such as insurance companies or government agencies require product
cost information as well.
Before a product costing system can be implemented, a decision must be made
with regard to the following:
Which cost accumulation system is appropriate
Which valuation method should be used.
There are two broad cost accumulation systems: Job Order and Process
Costing. Job Order Costing is used by companies where products or services
are identifiable by individual units or batches—auto repair, tax return preparation,
case in an attorney’s office, ship construction, etc. The costs attributable to a
particular job are assigned directly to it. Process Costing is used in industries
where there is mass production of similar or identical products—food products,
chemicals, cement, etc. Since each product is identical, product cost can be
determined by dividing total manufacturing costs by total units produced. This
average cost applies equally to all units produced. At this time, it should be
noted that many companies use a hybrid cost accumulation system which
incorporates some features of job order costing and other features of a process
costing system.
There are three valuation methods which may be used as follows:
Actual Costing
Actual direct material
Actual direct labor
Actual overhead (assigned after the end of the period)
Normal Costing
Actual direct material
Actual direct labor
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Overhead applied using a predetermined overhead rate
Standard Costing
Standard direct material
Standard direct labor
Overhead applied using predetermined rate times
standard input
As mentioned above, in Job Order Costing costs are accumulated individually on
a per-job basis. In a manufacturing environment, costs are accumulated on a
Job Order Cost Sheet. Note that the direct material cost comes from material
requisition forms and the direct labor costs from employee time tickets. In normal
costing, manufacturing overhead is charged using a predetermined overhead
rate. Actual and budgeted cost data is included so that variances can be
examined immediately as the job is in process and as it is completed.
Standard costs may be used in a job order costing system. Costs are entered
into Work in Process at the standard rather than the actual rate. When the job is
complete standard costs are compared to actual costs incurred on the job so that
variances can be examined and analyzed.
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Job Order Cost Accounting – Supplementary Note
I. COST ACCOUNTIG SYSTEMS
A. Cost accounting involves
 The measuring
 The recording, and
 The reporting of product costs

Accurate product costing is critical to a company’s
success
B. Two basic cost accounting systems
(Job Order Cost System and Process Cost System)

1. JOB ORDER COST SYSTEM
Costs are assigned to each job or batch

A job may be for a specific order of inventory
May be a unit: ex.
or a Batch of units: ex.

A key feature:
15

Measures costs for each job completed - not for set
time periods
2. PROCESS COST SYSTEM
 Used when a large volume of similar products are
manufactured. Examples:
 Cost are accumulated for a specific time period
(a week or a month)
II. JOB ORDER COST FLOWS



A. In general, the cost flow parallels the physical flow
of the materials as they are converted into finished
goods.
Manufacturing costs are assigned to Work in Process
Inventory.
Cost of completed jobs is transferred to Finished Goods
Inventory.
When units are sold, the cost is transferred to Cost of
Goods Sold.
Debit WIP Inventory → FG Inventory → COGS
when:
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B. Recording Direct Materials, Direct Labor and
Overhead costs

Use a Job cost sheet to record the costs related to a
specific job on a daily basis; used to determine the
total and unit costs of a completed job.
1. DIRECT MATERIAL COSTS (DM)
 Debit Raw Materials Inventory when Purchase
direct or indirect materials
 Materials requisition slip shows written
authorization when used in production
 Debit Work-in-Process Inventory when direct
materials are Used
 Indirect Materials are treated as an overhead cost.
(i.e., Debit Manufacturing Overhead Account)
2. DIRECT LABOR COSTS (DL)
 Consists of gross earnings of factory workers,
employer payroll taxes on such earnings, and fringe
benefits incurred by the employer.
 Debit Work-in-Process Inventory when direct labor is recorded
(ie., whether paid or accrued)
 Indirect labor is treated as an overhead cost. (i.e., Debit
Manufacturing Overhead Account)
Note: Some companies use a Factory Labor account to initially record all
factory labor costs (direct and indirect labor). However, factory labor costs
17
are closed out immediately to the Work-in-Process Inventory account for
Direct Labor and to the Manufacturing Overhead account for Indirect Labor.
Your textbook teaches journal entries using this holding account for Factory
Labor, but the account balances are identical whether or not this account is
used!
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3. MANUFACTURING OVERHEAD COSTS (OH)
Manufacturing overhead is a Control Account. It is
used to keep track of two things: Actual Overhead
costs incurred and Overhead costs assigned to
inventory (also known as overhead applied).
DEBIT Manufacturing Overhead Control when
actual manufacturing overhead costs are incurred.
Note: The subsidiary ledger consists of individual
accounts for each type of overhead cost, but the
controlling entry is a debit to Manufacturing OH
CREDIT Manufacturing Overhead Control when
Overhead is Applied to production.
Must be assigned to work in process and to specific
jobs on an estimated basis by using a
PREDETERMINED OVERHEAD RATE
Based on the relationship between estimated annual
overhead costs and expected annual operating activity.
Established at the beginning of the year.



19

Expressed in terms of an activity base such as
Direct labor costs, Direct labor hours,
Machine hours, or any other activity that is
an equitable base for applying overhead
costs to jobs.
 Assigning overhead costs to inventory involves a
two-step process:
1st: Determine the Predetermined Overhead Rate:
2nd: Overhead is “Applied” or Assigned to work in process
inventory during the period based on actual activity.
 At the end of the period determine if manufacturing overhead
is UNDERAPPLIED OR OVERAPPLIED


A debit balance in manufacturing overhead means that
overhead is underapplied. (i.e., Overhead assigned to work in
process inventory is less than overhead incurred.)
A credit balance in manufacturing overhead means that
overhead is overapplied. (i.e., Overhead assigned to work in
process inventory is greater than overhead incurred.)
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
If immaterial in amount, any year-end balance in
Manufacturing Overhead is eliminated by adjusting
cost of goods sold.

If Underapplied:

If Overapplied:
Example: Overhead is expected to be $100,000 next
year. Management believes the variable portion of
overhead varies with direct labor hours, with 40,000
direct labor hours expected next year.
1) Calculate the predetermined OH Rate.
2) Apply overhead to production for January if 3,000
direct labor hours are worked.
3) If actual overhead at the end of January is $8,000,
did the company over- or under-apply overhead
during the month? Show the adjusting entry to
close the overhead account at the end of the month.
21
22
EXAMPLE #1: JOB ORDER COSTING
The Custom Division of Allied Manufacturing had
one job in process at the beginning of May (Job #A11
with accumulated costs of $500) and no beginning
finished goods inventory.
(1) Record the following journal entries:
May 1 Direct materials costing $800 were purchased
on account.
May 2 Direct materials were issued to production as
follows: Job #A11 $200
Job #A12 $300
May 10 Paid Rent totaling $1,300. Of this amount,
$800 was for the factory and $500 was for sales and
administrative facilities.
May 15 Paid factory wages for direct labor as follows: Job #A11 (100 hours) $1,000
and Job #A12 (120 hours): $1,200. The company also paid $1,500 for indirect labor in
the factory.
May 15 Manufacturing Overhead is applied at a rate
of $3 per direct labor dollar.
23
May 25 Job #A11 was completed.
May 27 Job #A11 was sold for $8,000 on account.
May 31 Other manufacturing costs incurred during
the period include: $2,000 for factory depreciation;
$400 for factory insurance; and $200 for factory
utilities.
2) Determine the balance in the Work-in-Process and
Finished Goods Inventory accounts at the end of May.
Also show the journal entry to close out the under- or
overapplied overhead at the end of the month.
24
III. COGM and COGS Schedules
NOTE: With the information added in this chapter
regarding production costs, you should note the
following updates regarding the cost of goods
manufactured and cost of goods sold schedules:

The cost of goods manufactured schedule now
shows manufacturing overhead applied rather than
actual overhead costs. That is, current production
costs include: DM Used, DL and OH Applied.
 The cost of goods sold schedule will show an
adjusting entry for over- or under-applied overhead for
the period.
25
DM Used:
COGM (completed)
Beg. DM
Beg. WIP
+ DM Purchases
+ Current Production Costs
= DM Available
DM Used
-Ending DM
DL
= DM Used
OH Applied
- Ending WIP
= COGM
COGS
Income Stmt.
Beg. FG
Sales
+ COGM
-COGS (after adjustment)
= Cost of goods Available
- Ending FG
=COGS
+/- Under/Overapplied OH
=COGS after adjustment
=Gross Margin
-Operating Exp.
= Income
26
EXAMPLE #2: JOB ORDER COSTING
The Custom Division of Allied Manufacturing had one job in process at the
beginning of May (Job #A11 with accumulated costs of $400) and no
beginning finished goods inventory.
(1) Record the following journal entries:
May 1 Direct materials were issued to production as follows:
Job #A11 $200
Job #A12 $300
May 10 Paid Rent totaling $350. Of this amount, $200 was for the factory
and $150 was for sales and administrative facilities.
May 15 Paid factory wages for direct labor as follows:
Job #A11 (100 hours) $1,000 and Job #A12 (120 hours) $1,200
May 15 Manufacturing Overhead is applied at a rate of $3 per direct labor
hour.
May 25 Job #A11 was completed and sold for $4,000 cash.
3) Determine the balance in the Work-in-Process Inventory, Finished Goods
Inventory and Cost of Goods Sold accounts at the end of May.
27
EXAMPLE 3: Job Order Costing
Foster Manufacturing began January with direct materials costing $10,000,
work-in-process costing $2,000 and finished goods inventory consisting of Job
#500 costing $13,000. All of the costs in work-in-process are associated with
Job #501. During January, the following transactions occurred for Foster
Manufacturing:
Jan. 1 Issued direct materials costing $8,000 to production
($3,000 to Job #501; $5,000 to Job #502). Also, factory supplies
costing $1,000 were issued to production.
Jan. 5 Paid salaries as follows: Administrative Salaries:
$3,000; Direct Labor: $12,000 (Job #501 $8,000 and
Job #502 $4,000); Production Manager $2,000.
Jan. 5 Manufacturing overhead costs are applied to
production based on direct labor costs at a rate of $2
per direct labor dollar.
Jan. 15 Completed Job #501.
Jan. 20 Sold Job #500 for $30,000 on account.
Jan. 31 Other overhead costs totaled $20,000 and were paid in cash.
Based on the above information, determine the balance in the following
accounts at the end of January: Direct Materials Inventory, Work-in-process
Inventory, Finished Goods Inventory and Cost of Goods Sold. Prepare a cost of
goods manufactured and a cost of goods sold schedule. Also determine the
gross profit earned on Job #501.
28
EXAMPLE 4:
KA Catering uses a job order costing system to assign costs to its catering
jobs. Overhead is applied to each job based on direct labor hours. Listed
below is data for the current year:
Budgeted Overhead: $90,000
Actual Overhead:
$77,000
Budgeted labor:
$100,000 for 10,000 hours
Actual Labor:
$ 95,000 for 9,000 hours
Required:
(1) show the journal entry to record the overhead
applied during the period
(2) Show the adjusting entry to close the overhead
account at the end of the period.
EXERCISES
Class 1
Sim Simmy’s Raw Material cost was $20,000, Direct Labour was $40,000 and
FO was 60% of Direct Labour and applied to production. 1. What was the total
manufacturing cost applied to production? 2. If the total actual cost was $90,000
how much was FO, 3. FO under or over applied?
Home 1
Glip Glippy’s overhead was applied at a rate of 200% of direct labour. The actual
overhead was $270,000. Direct Material was $100,000 and Direct Labour was
$150000. 1. What was the applied total cost? 2. What was the FO actual cost.
3. How much as FO over or under applied, 4. Was FO under or over applied?
29
Chapter 3 – Standard Costs
Summary
1. These are budgeted unit costs established to motivate optimal productivity
and efficiency
 These are predetermined, attainable unit cost.
2. Standard Cost system separates expected cost from actual cost
i.
Is applicable to:
- process and job-order costing, to service and mass production
industries
ii.
Best standards are based on attainable performance (motivate
employees)
3. Variances
 Accounts with debit balances are unfavorable
 Accounts with credit balances are favorable
Variance Calculations
i.
Direct Material
Usage/quantity =
AQ – SQ x SP
Price
AP – SP x AQ
ii.
Direct Labor
Efficiency/Hours =
Rate



iii.
AH – SH x SR
AR – SR x AH
Overhead Volume is least controllable by a production supervisor
i.
Measures effect of not operating at budgeted activity level
ii.
E.g. insufficient sales, labor strike
Overhead efficiency is wholly attributable to variable overhead
Labor Efficiency measures the efficiency of employees
Factory Overhead
i.
Total Variable Overhead: Spending variance and efficiency
variance
ii.
Spending Variance: Tot. Act. Var. O/H – (Act. Input x S Rate)
iii.
Efficiency Variance: S. Rate x (Act – Bud. Activity Base )
iv.
Two-way variance
Volume Variance: Fix O/H Bud. – Fix O/H applied based on standard
input allowed for
actual output
Controllable (budget variance): Tot. Act. O/H – (Fix O/H + Var. O/H based
on standard
rate & standard input allowed for actual output)
v.
Three-way efficiency variance
 A flexible budget can be adapted for any level of production
30
Spending Variance =
Actual input) x SR
Volume Variance =


vi.
A O/H – (Bud. Fix O/H + Bud. Var O/H on
(Bud. Fix O/H – Fix O/H applied based on
stand. Input allowed for act. Output)
Change in capacity does not affect spending variance because
variable unit costs are constant within a relevant range.
Volume variance will decrease or increase depending on the change in
capacity.
Four – Way efficiency variance
Variable:
Spending & Efficiency
Fixed:
Budget (fixed O/H spending) and volume
Lecturer Notes
Performance measurement is essential in a well-run organization. It can provide
critical information as to what works and what doesn’t; it is a way to evaluate and
motivate employees; and it can provide a means of carrying out the basic
strategy of the company. Most companies use some combination of financial
and non-financial performance measures (standards) to gauge performance.
Many companies not only use standards to measure performance but they
employ a standard cost accounting system which records both standard and
actual costs. Standard costs are the budgeted costs incurred to manufacture a
product or perform a service. A standard cost system greatly facilitates an
analysis of variances, the differences between actual costs and standard costs.
In a manufacturing environment budgeted costs are captured on a standard cost
card. In preparing a standard cost card a bill of materials is prepared and an
operations flow document establishing labor cost standards may be prepared.
Overhead standards are established using predetermined factory overhead
rates.
In a standard cost system, then, both cost and quantity standards are established
for the cost inputs of direct material, direct labor, and overhead. Actual price paid
for a cost input is compared to the standard price and actual quantity used is
compared to the standard quantity. Any difference between actual and standard
cost creates a variance, either favorable or unfavorable, and may be investigated
further. This process facilitates management by exception--depending on the
significance of the variance, management takes appropriate action. Insignificant
variances are disregarded.
31
The
form:
general
model
of
variance
analysis
takes
this
The price variance shows the difference between actual price paid and standard
price. The quantity variance measures the actual quantity used compared to the
standard quantity allowed for the output of the period.
The following illustration is used to present Cost data:
Material Price Variance
Material Quantity Variance
Labor Rate Variance
Labor Efficiency Variance
Variable Overhead Spending Variance
Variable Overhead Efficiency Variance
Fixed Overhead Spending (or Budget) Variance
Fixed Overhead Volume Variance
In a standard cost system cost inputs are entered at standard cost. Thus when
raw material is purchased it is entered at standard not actual cost. Any
difference between actual and standard cost is identified immediately and
journalized.
Note that all unfavorable variances have debit balances and favorable variances
have credit balances. Standard production costs are shown in inventory
accounts and thus have debit balances and therefore excess costs are also
debits.
At year end standard cost variances are eliminated through the use of adjusting
entries. If the variances are in total insignificant they can be closed to Cost of
Goods Sold. However, if the variances are significant they should be prorated
among ending inventories and Cost of Goods Sold.
Among the many reasons why companies use a standard cost system is that it
allows management to plan for expected costs to be incurred in manufacturing a
product or providing a service. Additionally, a standard costs system identifies
32
variances at an early point so that appropriate action can be taken at the earliest
point possible.
There are two broad types of standards--ideal standards and practical standards.
An ideal or perfection standard is the absolute minimum cost under ideal
conditions. Both total quality management and just-in-time production systems
inherently focus on ideal standards by emphasis on zero defects, zero
inefficiency, and zero downtime. Both TQM and JIT attempt to eliminate all nonvalue added activities and therefore all waste. In this respect these management
concepts are a type of ideal standard.
Practical standards can be described as a “tight but attainable” standard and
they allow for normal downtime and employee rest periods. At one time many U.
S. manufacturers utilized practical standards in evaluating performance. More
recently they have moved to a type of ideal standard.
In recent years many companies have shifted to an emphasis on conversion cost
as an element in standard costing. This is a result of the shift from labor
intensive production to machine intensive production.
EXERCISES
4. These are budgeted unit costs established to motivate optimal productivity
and efficiency
 These are predetermined, attainable unit cost.
iii.
Best standards are based on attainable performance (motivate
employees)
5. Variances
 Accounts with debit balances are unfavorable
 Accounts with credit balances are favorable
Variance Calculations
vii.
Direct Material
`Direct Labor
Usage/quantity =
AQ – SQ x SP
Efficiency/Hours =
AH – SH x SR
Price
AP – SP x AQ
Rate
AR – SR x AH
Class 1
George Georgy cost analysis showed the following:Standard
Actual
Purchases of Raw Material
$30,000
$33,000
Units Purchased
10,000
9,000
Labour Cost
$90,000
$86,000
Hours Worked
20,000
22,000
33
Find the following variances and indicate whether they are favourable or
unfavourable:1, Material price 2. Material quantity 3. Labour rate 4. Labour efficiency
Home 1
Peorge Peorgy cost analysis showed the following:Standard
Actual
Purchases of Raw Material
$39,000
$36,000
Units Purchased
13,000
12,000
Labour Cost
$86,000
$89,000
Hours Worked
24,000
26,000
Find the following variances and indicate whether they are favourable or
unfavourable:1, Material price 2. Material quantity 3. Labour rate 4. Labour efficiency
34
Chapter 4 – Variable (Direct) and Absorption (Full) Costing
Summary
1. Absorption(Full) costing is required for external reporting purposes (GAAP)
 Includes fixed and variable FOH in product cost
i. these are included in Finished Goods
2. Variable (Direct) costing treats variable FOH as a product cost, but fixed
FOH as an expense. Similar to fixed & variable selling, general &
administrative expenses)
 Direct Labor, Direct Materials, Variable FOH are handled just like
absorption costing.
 REMEMBER: Fixed FOH is expenses.
 Sales – Var. Expenses = Contribution Margin – fixed expenses =
operation income.
Lecturer Notes
Earlier we discussed actual cost systems which costs products and/or services
using actual direct material cost, actual direct labor cost, and actual overhead
cost (may not be available until the end of the period). We have also considered
normal costing system which costs products and/or services using actual direct
material cost, actual direct labor cost, and allocated overhead cost based on a
predetermined overhead rate.
Many companies use normal rather than actual costing for the following reasons:
Overhead cost can be assigned as the production occurs or the service is
rendered.
Predetermined overhead rates adjust for variations in actual overhead costs
that are unrelated to activity
Predetermined overhead rates adjust for problems of fluctuation in activity
levels that have no impact on actual fixed
overhead costs
Predetermined overhead rates allow managers to be more aware of product
and customer profitability
As mentioned above, normal costing uses a predetermined rate to allocate
overhead. The predetermined rate is calculated as follows:
Total Estimated Overhead Cost
Total Estimated Activity Base
Since overhead consists of numerous costs some of which are not immediately
available, in normal costing overhead is charged on an allocated basis. At the
beginning of the year the company calculates a predetermined overhead rate by
dividing estimated total overhead cost by estimated total units of the allocation
base. Overhead is charged to Work In Process by multiplying the predetermined
35
overhead rate by the number of actual units of allocation base used during the
period.
Since budgeted amounts are used to calculate the predetermined overhead rate
there will typically be a balance remaining in Manufacturing Overhead at the end
of the period. Note that Manufacturing Overhead is a temporary account and
must be closed out at year end. The difference between the overhead cost
applied to Work in Process and the actual overhead costs of the period is called
either under-applied or over-applied overhead.
When overhead is underapplied, manufacturing costs have been understated and when overhead is overapplied, overhead costs have been overstated. In the Manufacturing Overhead
Account actual costs are recorded on the debit side and applied costs are
recorded on the credit side. If the amount of under-applied or over-applied
overhead is immaterial, the balance can be closed out to Cost of Goods Sold.
However, if the amount of under-applied or over-applied overhead is material, it
should be pro-rated among the accounts in which applied overhead is recorded-Work in Process, Finished Goods, and Cost of Goods Sold.
Mixed costs are costs which contain both a variable and a fixed element. The
fixed element is the basic charge for having the service ready and available for
use. The variable element is the actual consumption charge. An example of a
mixed cost is the cost of a large capacity copier leased at $1,000 per month plus
$.01 per copy. Mixed costs can be represented by the equation Y = a + bX
where
Y = Total Cost
a = Total Fixed Cost
b = Unit Variable Cost
X = Activity Level
In order to predict mixed cost behavior it is necessary for the accountant to
separate the mixed cost into its fixed and variable elements. As you are probably
aware, a number of methods are available to compute the total fixed cost
component and the variable cost per unit component in a mixed cost including
the following:
High low method
Least squares method
Excel or other software applications
By means of the least squares method and Excel, the value of b (and of a) can
be calculated using all data observations. We'll do an Excel exercise where we
create a regression line of averages and compute the values of a and b.
Next we discuss flexible budgets. A flexible budget is a plan which provides
estimates of what costs should be for any level of activity within a specified
36
range. By using a flexible budget the manager can compare actual costs to what
costs should have been for that actual level of activity.
A plant-wide overhead rate is inappropriate for companies which product different
kinds of products with different input requirements.
Costs can be accumulated and presented in various ways. Cost accumulation
refers to which costs are recorded as product costs and which costs are recorded
as period costs. Cost presentation refers to how costs are shown on external
financial statements or internal management reports. Accumulation and
presentation of costs is accomplished using one of two methods, absorption
costing or variable costing.
Absorption costing (also known as full costing) treats all manufacturing costs as
product (inventoriable) costs in accordance with GAAP. Thus Direct Material,
Direct Labor, Variable Overhead, and Fixed Overhead are all charged into the
Work in Process Account. When products are completed, Finished Goods is
Debited and Work in Process credited. Only when finished units are sold are
they charged as expense (COGS) on the income statement. In absorption
costing only selling expenses and administrative expenses are treated as period
costs and charged off as expense immediately.
In variable costing only variable product costs (Direct Material, Direct Labor, and
Variable Overhead) are charged to Work in Process. In variable costing Fixed
Manufacturing Overhead is charged as a period cost. Variable product costs are
charged to Work in Process and all other expenses including variable selling and
administrative expense, fixed manufacturing overhead, and fixed nonmanufacturing expense are charged as expenses immediately. Using variable
costing a contribution income statement can be prepared in the following format:
Sales Revenue
- Variable Expense
= Product Contribution Margin
- Variable Non-manufacturing Expense
= Total Contribution Margin
- Total Fixed Cost
= Income Before Income Tax
Note that absorption costing treats classifies expenses by function whereas
variable costing classifies expenses by cost behavior.
37
EXERCISES
Class I:
Bick Bicky’s 2005 manufacturing costs for its new plant were as follows: Direct
Materials $900,000, Other Variable Manufacturing Cost $200,000, and
Depreciation of Factory building and manufacturing equipment $60,000, Other
Fixed Manufacturing Overhead cost $25,000. During 2005 Bick Bicky
manufactured 50,000 units and 20,000 were on hand at year end. What amount
should be considered product cost for (a) internal reporting purposes? and (b)
external reporting purposes? What is the value of ending inventory under both
(c) absorption costing and (d) direct costing?
Home I:
Rick Ricky’s 2005 manufacturing costs for its plant were as follows: Direct
Materials $1,100,000, Other Variable Manufacturing Cost $450,000, Additional
Raw Material put into production $60,000 and Depreciation of Factory building
and manufacturing equipment $100,000, Other Fixed Manufacturing Overhead
cost $40,000. During 2005 Rick Ricky manufactured 100,000 units and 30,000
were on hand at year end. What amount should be considered product cost for
(a) internal reporting purposes? and (b) external reporting purposes? What is the
value of ending inventory under both (c) absorption costing and (d) direct
costing? (e) under variable costing, what is the period cost?
38
Chapter 5 - Activity-Based Costing (ABC)
Summary
1. Identifies activities needed to provide products or services, and
i.
assign cost to those activities, then
ii.
reassigns costs to the products or service based on their consumption
of activities
 ABC helps manage cost by providing more detailed analyses of cost than
traditional methods
 ABC facilitates cost reduction by determining what activities do and do not
add value to the product or service.
 ABC defines cost objects as activities rather than functions or
departments
2. Cost Objects: Intermediate and final dispositions of cost pools
3. Cost Pool: an account in which a variety of similar costs are accumulated
prior to allocation to cost objects.
4. Cost Driver is a factor that causes a change in the cost pool for a particular
activity
 These are used as a basis for cost allocation.
i.
Cost assignment/allocation is based on a multiple cause-and-effect
relationship
Note:
1. ABC system uses more cost pools and allocation bases than a
traditional system.
2. Activities that are unnecessary are nonvalue-adding (raw
material & storage)
3. Value-adding (design engineering, heat treatment and drill
press)
Lecturer Notes
Activity based management (ABM) is a management system which focuses on
analyzing and controlling activities incurred in the production or performance
process in an attempt to improve customer value and enhance profitability. The
term "ABM" focuses on pricing and product mix decisions, cost reduction and
process improvement decisions, design decisions, and planning and managing
activity decisions.
ABM divides activities into two categories--value added and non-value added.
Value added activities are those which increase the worth of a product or
service. Non-value added activities, on the other hand, are those which add
nothing to the worth of a product or service. Examples of non-value activities
include wait time, inspection time, move time, etc. Value added versus non-
39
value added time can be compared using the manufacturing cycle efficiency
(MCE), computed as follows:
MCE =
Value added time
Total throughput time
Of course, a company operating in a perfect environment would have no nonvalue costs and would have an MCE of 1.
An important component of activity based management is activity based costing
(ABC). Activity based costing is a costing method which analyzes and attempts
to accurately cost specific resources which are consumed to deliver a product or
perform a service. In ABC, the calculation of direct material and direct labor is
usually uncomplicated. Emphasis is on accurately calculating overhead.
Earlier we calculated product costs using a broad averaging technique such as
direct labor hours to allocate indirect (manufacturing overhead) costs. In the
historic past when direct costs were a large percentage and indirect costs were a
small percentage of total product cost this method provided a sufficiently
adequate approximation of product cost. Changes in the economy though and
changes in the needs of management require that a new, more accurate, costing
system be implemented to supplement the traditional financial accounting costing
system.
Modern companies produce a greater and greater variety of products and
services. Broad averaging can lead to under or over costing of products or
services. This is especially true when the mix of products includes some
products which consume relatively few resources and other products which
consume relatively many resources. Activity based costing is a costing system
which focuses on all the individual resources consumed in providing a product or
service. ABC first traces costs to activities and then to products and services.
In ABC, the assignment of overhead costs first involves the division of activities
into indirect cost pools and on identification of respective cost drivers for each
activity pool. One method to accomplish this is to use a cost hierarchy and
separate activities into four general levels as follows:
Unit level costs
Batch level costs
Product/process
level costs
Organization or
facility costs
Costs of activities performed on each individual unit
Costs of activities related to a group of products
Costs of activities undertaken to support individual products
Costs of activities that cannot be traced to individual
products but that support the
organization as a whole
40
Note that in both the averaging method and the activity based costing method,
direct material and direct labor costs were the same. Also note that all costs
(both product and period) that relate to a product are computed when using
activity based costing.
Activity based costing involves a two step process. Overhead costs are first
accumulated in activity cost centers using an appropriate cost drive and second
costs are assigned out of the activity cost centers to products.
EXERCISES
Class 1: Bill Billy, entire electricity bill for the entire company was $500,000. Bill Billy had the following
departments (a) Computer (b) Plant (c) Sales & Marketing and (d) Administration. The following
information was generated from Bill Billy cost sheet:Square Actual
Electrical
Department
Feet
Meters (used) Maintenance
Computer
3,000
30,000
$10,000
Plant
4,500
40.000
$25,000
Sales & Marketing
2,500
20,000
$15,000
Administration
6,000
25,000
$20,000
In using Activity-Based Costing, what is the cost allocated to each department?
Home 1: During 2005 Based Basedy, incurred $300,000 in fuel for its manufacturing division. The
following factors relate to its activity:Fuel (tons)
Actual
Other
Facility
Consumed
Weight (lbs)
Fuel Cost
Bottling Plant
3,000
20,000
$30,000
Processing Plant
4,500
15.000
$45,000
Filling Plant
2,500
25,000
$25,000
In using Activity-Based Costing, what is the total cost of fuel for each department?
41
Chapter 6 - Joint and By-Product Costing
Summary
1. Joint Products – two or more separate products are produced by a common
manufacturing process
 Value allocated at point at which joint products become separate.
2. By-products – smaller value products are produced simultaneously from a
common manufacturing process with products of greater value and quantity
(joint products)
 By Products do not usually receive an allocation of joint cost.
3. Joint Cost – incurred prior to split-off point to produce two or more goods
manufactured simultaneously by a single process or series of processes.
 To assign joint cost, use NRV of products x joint cost
4. Separable cost can be identified with a particular joint product and allocated
to a specific unit of output.
 Cost incurred after split-off point.
Lecturer Notes
1. Definitions
a. Joint Cost: the cost of a single process that yield multiple products
simultaneously. Includes DM, DL, and mfg. Ohd up to the split-off
point
b. Split-off Point:
the point in the process at which the products
become separately identifiable.
c. Separable Costs: those costs incurred beyond the split-off point that
are identifiable with individual products
d. Main Product: the product with the highest sales value relative to
other products beyond split-off
e. Joint Products:
other products with a relative high sales value that
are not identifiable as individual products until the split-off point
f. Byproduct:
a product beyond the split-off point with a relatively low
sales value in comparison with main and joint products
g. Scrap:
products beyond split-off with minimal value (May have a
negative sales value if must be hauled away to a landfill)
2. Reasons for Allocating Joint Costs to Individual Products
a. To value inventory and COGS for external reports
b. To value inventory and COGS for internal reports (including profitability
analysis and performance evaluation)
c. For cost reimbursement under contracts where not all the separable
products go to a single customer so that allocation of the joint costs is
necessary.
42
d. For settlement of insurance claims involving separable products at or
beyond split-off.
e. For rate regulation when one or more jointly produced products or
services are subject to rate regulation based on cost. E.g. services
using telephone lines
3. Methods of Allocating Joint Costs
a. Methods where a measure is available at the Split-off point for each
separable product.
i. Sales Value at Split-off: This method allocates joint costs to
the separable products based on the relative slaves value of
each product at the split-off point
Includes the sales value of the entire production----not just
actual sales
Simple to apply because it provides a common measure
applicable to all products if sales value is readily available
Also, relates cost allocated to the revenue-generating power
of individual products. Demo 15-16
ii. Physical Measures Method:
This method uses some
measure of weight of volume common to all separable
products at the split-off point.
The problem with this method is that the physical measure
may bear no relationship to the revenue producing power of
the separable products.
For example, if a company mines
gold and lead, an ounce of gold will be much more valuable
than an ounce of lead but both would get the same allocation
when ounces is used as the measure. This causes high
value items per unit of the physical measure to show high
profits and low value items per unit of the physical measure
to show low profits. Demo 15-16
b. Methods where there isn’t a market for all of the separable products
at split-off. Therefore, some other method has to be used that
approximates the situation at the split-off point. (The allocation
must relate to the situation at split-off because joint costs cease to
have meaning beyong the splitoff point). There are two methods
that can approximate the situation at split-off.
i. Estimated Net Realizable Value Method (NRV)
The NRV for each product as a % of the total NRV of all
products, is the basis for the allocation.
Est’d NRV = Final sales value of production – Separable
Costs
(to get an estimated NRV for all products combined that is
approximately equal to joint costs, you would also need to
43
deduct selling and admin expenses and gross profit. This is
not usually done in practice just to keep things simple)
iii. Constant Gross Profit % NRV Method
This method assumes every separable product earns the
same GP% (this may not be very realistic) It starts with the
final sales value of production and subtracts the Gross Profit
(which is equal to Sales x constant GP%), and then
subtracts the Separable Costs. The result is an
approximation of the Joint Costs for each separable product
at split-off.
Steps:
1. Compute the overall GP% (called the constant GP%)
for all products combined (i.e., GP = FSVP – JC – SC
2. Calculate the GP in $ for each product (i.e., FSVP x
constant GP% determined in part 1.)
3. Calculate the Joint Costs for each product as follows:
FSVP
xx
Less: GP in $
(xx)
Less Sep. Costs
(xx)
= Joint Costs allocated xx
Note: Some products may end up with a negative
allocation of Joint costs;
Accounting for By-products
A by-product is a product having a relatively low sales value compared with the
main or joint products; by-products can be sold at split-off or processed further;
also, if sales increase, a by-product may be re-classified as a joint product at
some point.
There are several methods of accounting for by-products in terms or recognizing
when to record the cost of the by-product. We will recognize the cost of the byproduct only when production is completed.
Steps:
1. Calculate the NRV of the by product (i.e., FSVP – SC, or sometimes if
specified, FSVP – SC – normal GP).
2. Subtract this NRV of the by-product from the total joint cost and set the
amount up as by-product inventory.
By-product inventory
Joint costs
xxx
xxx
3. Allocate the revised joint cost in the usual way to the joint products using
one of the four methods
44
4. Record any sales of the by-product as follows:
A/R
xxx
By product inventory
xxx
Note: Because the NRV of the by-product is treated as a reduction in the
total joint cost allocation and because the by-product is given no status as
a separate product, there is no Sales a/c and no COGS a/c for the byproduct itself------only Balance Sheet accounts.
The sales of the by-product are either added to the sales of the other joint
products or deducted from the COGS of the other joint products.
These
Sales or COGS adjustments are done on the financial statement and not
in the accounting records. (This procedure assumes that the selling price
and inventory cost per unit of the by-product are both valued at the NRV
per unit of the by-product)
EXERCISE
Class 1: Clent Clenty produces joint products GLUE and CLUE, and a by-product
BLUE, each of which incurs separable production cost after split-off. Information
concerning a batch produced at a $600,000 joint cost before split-off follows:Separable
Product
Costs
Sales Value
GLUE
$8,000
$80,000
CLUE
22,000
40,000
BLUE
30,000
What is the joint cost assigned to GLUE and CLUE if cost are assigned using the relative
net realizable value?
Home 1: Blent Blenty produces joint products LED and PAINT, and a by-product INK,
each of which incurs separable production cost after split-off. Information concerning a
batch produced at a $600,000 joint cost before split-off follows:Separable
Product
Costs
Sales Value
LED
$20,000
$100,000
PAINT
30,000
90,000
INK
(produced 1,000 gallons with a sales price of $50 per gallon after further
processing at a total cost of $20,000)
What is the joint cost assigned to LED and PAINT if costs are assigned using the relative
net realizable value?
45
Chapter 7 - Service Cost Allocations
Summary
1. Fixed cost of service departments should be allocated to production
departments in lumps-sum mounts on the basis of the service departments
budgeted cost of long-term capacity to serve.
Criteria: Cause & effect, Benefits Received, Fairness and Ability to bear
2. Direct Method (most common) – allocates service department cost directly to
the producing departments without recognition of services provided among
the service departments
3. Step Method (Step-down Method) – allocates service cost to other
departments as well as to production departments
 Does not provide for reciprocal allocations
4. Reciprocal Method – allows reflection of all reciprocal services among service
departments using simultaneous equations
Lecturer Notes
A common cost is the cost of operating a facility, operation or activity that is
shared by
two or more users. There are two methods of allocating common costs.
1. Stand Alone Method
This method emphasizes equity or fairness in that each user bears a
proportionate share of stand alone cost based on their individual stand alone
cost. That is, each user is treated as if they were a stand alone entity.
Share of common cost =
cost for user #1
stand alone cost of user #1 x actual total common
sum of stand alone
costs for all users
2. Incremental Method
This method ranks the individual user cost objects and then uses this ranking to
allocate the common costs among the various users.
The first ranked user object is call the primary party. This user is allocated costs
up to the amount of the costs that would be incurred if the cost object were
operated as a stand-alone entity and this was the only user.
The second ranked user is called the incremental party. It is allocated the extra
costs that result from there being two users rather than one.
If there are more than two users, than all the users need to be ranked in a
sequence.
Under this method, the primary user always receives the highest allocation of the
46
common cost.
Primary user -----> allocate the stand alone cost that would exist if this user was
the only user
Incremental user -----> allocate the remainder of the common cost to this user
(total common cost – stand alone cost for primary user)
EXERCISES
CLASS:
Serve Servey Photocopying Department provides photocopy services for both Departments A and
B and has prepared its total budget using the following information for the next year:Fixed Costs
$100,000
Budgeted Usage:Variable Costs
$0.03 per page
Dept. A
1,200,000
pages
Available capacity
4,000,000 pages
Dept. B
2,400,000
pages
Instructions: Assuming that the single-rate method is used and the allocation base is budgeted
usage. How much photocopying cost will be allocated to Dept. A and Dept. B in the budget year?
HOME:
Food Foody Restaurant provides meal for all of its staff in its 4 chains. Chain 1, Chain 2, Chain 3
and Chain 4. Food Foody has prepared its total budget using the following information for the next
year:Fixed Costs
$300,000
Budgeted Number of Plates:Variable Costs
$1.20 per plate
Chain 1: 250,000 Plates Chain 2:
350,000 plates
Available capacity
2,000,000 plates
Chain 3: 450,000 Plates Chain 4:
550.000 plates
Instructions: Assuming that the single-rate method is used and the allocation base is budgeted
number of plates. How much meal cost will be allocated to Chain 1, Chain 2, Chain 3 and Chain 4.
47
Chapter 8 – Budgeting
Summary
1. A flexible budget is designed to allow adjustment of the budget to the actual
level of activity before comparing the budgeted activity with actual results.
 A set of static budgets prepared in anticipation of varying levels of activity
 It permits evaluation of actual results when actual and expected
production differ
 A flexible budget can be prepared for any production level within a
relevant range
i. When production levels decrease within a range, total cost will decrease
 These are adjusted during the budgeted period
 Applicable for the entire production facility Cash, Marketing, Sales, Cost,
etc.,
Note: setting standard costing facilitates preparation of a flexible budget
2. A static budget is prepared for just one level of activity
 Total variable cost varies with the activity level
 Fixed cost is fixed within a relevant range
 Not useful for evaluating variance if expected sales are not reached.
 When sales are less than budget: variable cost = favorable. fixed
cost = unfavorable
3. The Master Budget contains estimates by management from all functional
areas based on one specific level of production.
 A master budget is based on one level of production.
 Recognize organizations goals and objectives
4. In budget calculations, REMEMBER: fixed cost will not change. Therefore,
variable cost will change as activity is change.
5. Zero-base budgeting is a budget and planning process in which each
manager must justify a department’s entire budget every year, or period.
 Objective is to encourage periodic reexamination of all costs
i.
to reduce or eliminate costs
Lecturer Notes
Effective planning, both long term and short term, is crucial to the success of any
business organization. Budgeting is the process of formalizing plans and
translating them into financial and non-financial goals and expectations. The
budget, the end result of budgeting, is a detailed plan for the acquisition and use
of financial and other resources over a specified time period.
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There are many advantages of budgeting including:
It requires managers to set goals and objectives and allocate the means
to achieve the goals and objectives
It is a means of communicating and coordinating plans and objectives
throughout the organization
It provides a means by which performance can be evaluated
The master budget is an overall budget of an organization and includes and
incorporates the budgets of all sub-units of the business.. It consists of both
operating and financial budgets. An operating budget is expressed in both units
and dollars. A financial budget is a budget that aggregates the detail in the
operating budgets.
The master budget begins with a sales forecast and once the sales expectation
is formalized, the production budgets can be prepared.
Production budgets are prepared in the following format:
Budgeted unit sales
Add: Desired ending inventory
Total units needed
Less: Beginning inventory
Required production
The operating budgets for include:
Sales Budget
Production Budget
Purchases Budget
Direct Labor Budget
Overhead Budget
Selling and Administrative Budget
Any capital expenditures in the current period need to be incorporated in the
master budget.
Once the operating budgets have been prepared, a cash budget can be
developed. Note that the cash budget takes the following form:
Beginning cash balance
Add:
Cash collections
Equals:
Cash available
Less:
Cash disbursements
Equals:
Excess (deficiency) of cash
Less:
Minimum desired ending cash balance
Equals:
Financing borrowings or repayments
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If credit is extended to customers, then cash receipts will tail cash sales.
Pro forma financial statements are prepared as part of the master budget
process and they include:
Cost of Goods Sold Schedule
Income Statement
Ending Balance Sheet
Statement of Cash Flows
EXERCISES
Both CLASS and HOME problems are based on the Following:Bud Budy company is formulating its plans for the coming year, including the preparation of its cash budget.
Historically, 20% of the company’s sales are cash sales. Except for its 5% bad debt, the remaining credit
sales are collected as follows:-.
Sales
$
$
Collections on Account Percentage
January
3,900,000
May
6,500,000
In 1st Month
30%
February
4,200,000
June 6,900,000
In 2nd Month
40%
March
5,000,000
July
7,200,000
In 3rd Month
25%
April
6,100,000
August 8,000,000
CLASS: Prepare a schedule to show the total cash receipts from sales and collections on account for the
month of April.
HOME: Prepare a schedule to show the total cash receipts from sales and collections on account for the
month of August.
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Chapter 9 - Cost-Volume-Profit (CVP) Analysis
Summary
1.
2.
3.
4.
5.
Break-Even-Point: The sales volume at which total revenue equals total cost
Breakeven = Variable cost + Fixed Cost
Breakeven = Sales – Variable Cost = Contribution Margin – Fixed Cost
Breakeven Sales = (Fixed Cost / Contribution Margin Ratio)
Breakeven Sales in Unit = (Fixed cost / unit contribution margin)
 Breakeven analysis assumes that over the relevant range unit variable
cost remains constant within the relevant range.
 It also assumes that cost and revenues are linear. (one straight line)
6. Contribution Margin = (Fixed Cost / BEP sales) or Sales – Variable Cost
i. Margin of safety: Budget Sales – Breakeven Volume
 An increase in cost will increase BEP and decrease the margin of
safety
7. High-low method: estimates variable cost by dividing the difference in cost
incurred at the highest and lowest observed levels of activity by the difference
in activity.
 Once the variable cost is found, the fixed portion is determinable.
Lecturer Notes
CVP analysis is an examination of the relationships of prices, costs, volume, and
mix of products. It involves the separation of costs into their variable and fixed
categories at the outset of the analysis. Once variable and fixed costs are
isolated, a contribution margin income statement can be prepared in which total
and per unit contribution margin can be analyzed. Then meaningful "what if"
analysis can be done such as trading off variable costs for fixed costs, increasing
fixed costs and expected volume, reducing price and studying the impact on
sales volume and profits, etc.
Break-even analysis is an important aspect of CVP analysis. The break-even
point is that level of sales where total revenue exactly equals total expenses.
Calculation of BEP is demonstrated in the following example.
Sample BEP Problem
Per Bike
Percentage
Sales Price
Less Variable Cost
Contribution Margin $200
$500
100%
300
60%
40%
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Fixed Cost totals $80,000 per month
Equation Method
1.
1.
Using dollars
$500X - $300X - $80,000 = 0
$200X = $80,000
X = 400 bikes
2.
Using percentages X - .6X - $80,000 = 0
.4X = $80,000
X = $200,000
Unit Contribution Method
1.
1.
Using dollars - Fixed Cost $80,000 = 400 bikes
Unit CM
2.
2.
$200
Using percentages - Fixed Cost $80,000 = $200,000
Unit CM
.4
Of course, companies do not wish to just break even. We can expand our break-even calculations
to include a computation of Target Net Income. For example, let’s assume the above company
wants to earn of profit of $40,000. What level of revenue would generate profits of $40,000?
Equation Method
X - .6X -$80,000 = $40,000
.4X = $120,000
X = $300,000
Unit Contribution Method
Fixed Costs + Target Net Income
Unit CM
$80,000 + $40,000 = $300,000
.4
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The Margin of Safety is the excess of budgeted sales over the break-even
volume of sales.
Margin of safety = Total budgeted (or actual) sales – Break-even Sales. The
margin of safety shows the amount by which sales can decrease before losses
are incurred. It can be computed in dollars or in a percentage as follows:
Margin of safety percentage =Margin of Safety in $/Total Budgeted (or actual)
Sales
Cost structure refers to the relative proportion of fixed and variable costs existing
in an organization.
An automated manufacturing plant would have a high
proportion of fixed costs whereas a direct labor intensive plant would have a high
proportion of variable costs. Any organization has some choice as to its cost
structure.
A company’s cost structure has a significant effect on the way in which profits
fluctuate in response to changes in sales volume. The greater the proportion of
fixed costs in a firm’s structure, the greater will be the impact on profit from a
given percentage change in sales revenue. This results from the fact that firm
with relatively higher fixed costs (and relatively lower variable costs) will have a
higher contribution margin ratio.
Operating leverage is a measure of how sensitive net income is to percentage
changes in sales. Operating leverage is greatest in companies which have a
high proportion of fixed costs relative to variable costs. A firm with high fixed
costs and low variable costs has high operating leverage, the ability to highly
increase net income from an increase in sales revenue. In other words, after the
break-even point has been reached, a larger amount of contribution margin will
fall to the bottom line in a high fixed cost structure than if the cost structure had
been comprised mostly of continuing high variable costs, which continue to eat
away at net income after the break-even point is reached. Of course, the risk is
also greater because if the break-even point is not reached, losses will be greater
in the firm with high operating leverage.
The degree of operating leverage at a given level of sales is computed as
follows:
Degree of Operating Leverage
=
Contribution Margin
Net Income
So far in our discussion of CVP relationships we have focused on a firm selling a
single product. Of course, most businesses sell more than one product and thus
we need to discuss CVP analysis involving more than one product. Sales mix
refers to the relative proportions in which a company’s products are sold.
Managers try to achieve that product mix which will maximize profits.
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EXERCISES
Both CLASS and HOME problems are based on the Following:Prof Proffy sells its single product at a price of $60.00 per unit and incurs the following variable cost per unit
of product:Direct Material
$16.00
Fixed costs are $880,000
Direct Labour
12.00
Income Tax Rate 30%
Manufacturing Overhead
7.00
Total Variable Man. Cost $35.00
Selling expenses
5.00
Total variable costs
$40.00
CLASS: 1. If production and sales volume is 4,000 units of product per month, what is the annual after-tax
income or loss?
2. What is Prof Proffy Contribution Margin?
3. How many units must Prof Proffy sell to break even?
HOME: Fixed Cost is now $1,000,000, selling price is now $75.00 per unit, direct material and direct labour
have increased by 20% and 10% respectively, and the income tax rate is now 40%.
1. If production and sales volume is 7,500 units of product per month, what is the annual after-tax
income or loss?
2. What is Prof Proffy Contribution Margin?
3. How many units must Prof Proffy sell to break even?
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Galilee College
Costing I
Final Exam
Instructions
A. Complete all problems
1. Service Cost Allocations
CLASS:
Teck Tecky Water Services provides water for Departments A,B and C and has prepared its total
budget using the following information for the next year:Fixed Costs
$300,000
Budgeted Gallon Usage:Variable Costs
$0.10 per gallon
Dept. A
2,500,000 gallons
Available capacity
10,000,000 gallons
Dept. B
2,000,000 gallons
Dept C
1,500,000 gallons
Instructions: Assuming that the single-rate method is used and the allocation base is budgeted
usage. How much water cost will be allocated to Dept. A, B and C in the budget year?
2. Budgeting
Fost Fosty company is formulating its plans for the coming year, including the preparation of its cash
budget. Historically, 10% of the company’s sales are cash sales. Except for its 5% bad debt, the remaining
credit sales are collected as follows:-.
Sales
$
$
Collections on Account Percentage
June
3,900,000
October
6,500,000
In 1st Month
25%
July
4,200,000
November
6,900,000
In 2nd Month
35%
August
5,000,000
December
7,200,000
In 3rd Month
20%
September
6,100,000
In 4th Month
15%
CLASS: Prepare a schedule to show the total cash receipts from sales and collections on account for the
month of December 2007.
3. Cost-Volume-Profit (CVP) Analysis
Sport Sporty sells its single product at a price of $75.00 per unit and incurs the following variable cost per
unit of product:Direct Material
$20.00
Fixed costs are $1,000.000
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Direct Labour
15.00
Manufacturing Overhead
10.00
Total Variable Man. Cost $45.00
Selling expenses
10.00
Total variable costs
$55.00
Income Tax Rate 25%
CLASS: 1. If production and sales volume is 10,000 units of product per month, what is the annual after-tax
income or loss?
4. What is Sport Sporty Contribution Margin?
5. How many units must Sport Sporty sell to break even?
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