Financial & Managerial
Accounting 2002e
Belverd E. Needles, Jr.
Marian Powers
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Santa Fe Community College
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1
Chapter 16
Cost Concepts and
Cost Allocation
LEARNING OBJECTIVES
1. State how managers use information about
costs in the management cycle.
2. Identify various approaches managers use to
classify costs.
3. Define and give examples of the three
elements of product cost and compute a
product unit cost for a manufacturing
organization.
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3
LEARNING OBJECTIVES
5. Describe the flow of product-related activities,
documents, and costs through the Materials
Inventory, Work in Process Inventory, and
Finished Goods Inventory accounts.
6. Prepare a statement of cost of goods
manufactured and an income statement for a
manufacturing organization.
7. Define cost allocation and explain how cost
objects, cost pools, and cost drivers are used to
apply manufacturing overhead.
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4
LEARNING OBJECTIVES
7. Calculate product unit cost using the traditional
allocation of manufacturing overhead costs.
8. Calculate product unit cost using activity-based
costing to allocate manufacturing overhead costs.
9. Apply costing concepts to a service organization.
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5
Costs Information and the
Management Cycle
OBJECTIVE 1
State how managers use information
about costs in the management cycle.
Operating Costs and the Management Cycle
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7
Planning Stage
 Uses
of operating cost information
and product costs in the planning
stage.
 Develop budgets.
 Determine selling prices or fees for
services and products.
 Plan human resource needs.
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8
Executing Stage
 Uses of operating cost information
and product costs in the executing stage.
 Make decisions about dropping a service line,
product line, or segment.
 Evaluate outsourcing opportunities.
 Estimate margins and income.
 Bid on special orders.
 Negotiate a selling price or fee.
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9
Reviewing Stage
 Uses
of operating cost information
and product costs in the reviewing stage.
 Calculate variances between estimated and
actual costs.
 Help managers determine the causes of cost
overruns and enable them to adjust future
actions to reduce potential problems.
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10
Reporting Stage

Uses of operating cost information and
product costs in the reporting stage.
 Report actual results of operating activities
on the income statement.
 Report the value of inventory on the balance
sheet.
 Report performance related to products or
services.
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11
Examples of Types and
Uses of Operating Cost Information
Type of Organization
Manufacturing
Retail
Cost information
needed by management
Cost to
purchase
the product
Cost to
provide
the service
Yes
Yes
Yes
To decide the selling price
for regular or special sales
or services provided
Yes
Yes
Yes
To value finished goods or
merchandise inventories
Yes
Yes
N/A
Uses of cost information:
To measure historical or
future profits
Cost to
manufacture
the product
Service
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12
Discussion
Q.
What are three uses of operating cost
information and product costs in the
planning stage?
A.
1. Develop budgets.
2. Determine selling prices or fees.
3. Plan human resource needs.
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13
Classifying Costs
OBJECTIVE 2
Identify various approaches managers
use to classify costs.
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14
Cost Classifications and Their Uses
Common Cost Classifications:
Classification
Breakdown
Purpose
Traceability
Direct
Indirect
Control costs by tracing
costs to a cost object
Behavior
Variable
Calculate number of units
that must be sold to obtain a
certain profit.
Fixed
Activity Based
Value adding
Identify the costs that add
value to the consumer.
Non-value adding
Financial Reporting
Product
Classify costs for the
preparation of financial
statements.
Period
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15
Overview of Cost Classification
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16
Cost Traceability
Direct Cost – conveniently traced to a cost object.
Indirect Cost – cannot be conveniently traced to a
cost object.
[Cost Object: individual product, service, department,
sales territory, etc.]
Cost Behavior
Variable Cost – changes in direct proportion to a
change in volume.
Fixed Cost – remains constant within a range of
activity or for a defined time period.
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17
Value-Adding Versus Non-Value Adding Costs
Value Adding Cost – increases the market value of a product or service.
Non-Value Adding Cost – adds cost to a product or service but does not
increase its market value.
Costs for Financial Reporting
Product (Inventoriable) Costs – costs such as direct materials, direct labor,
and manufacturing overhead, that are assigned to inventory as an asset,
until sold.
[Product Costs may be Prime Costs (Direct Materials and Direct Labor) or
Conversion Costs (Direct Labor and Manufacturing Overhead)].
Period (Non-inventoriable) Costs – costs of resources consumed, expensed
as incurred, during the accounting period and not assigned to products.
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18
The Management Cycle
OBJECTIVE 3
Define and give examples of the three
elements of product cost and compute a
product unit cost for a manufacturing
organization.
Elements of Product Costs
1. Direct materials can be conveniently and
economically traced to specific units of
product.
2. Direct labor can be conveniently and
economically traced to specific units of
product.
3. Manufacturing overhead includes all
manufacturing costs that are not direct
materials or direct labor costs. Also called
factory overhead or indirect manufacturing
costs.
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20
Manufacturing Overhead
 The
following are examples of
manufacturing overhead:
 Indirect
materials.
 Indirect
labor.
 Depreciation
associated with manufacturing
operations.
 Machinery
and tool maintenance, taxes,
insurance, rent, and utilities relating to
manufacturing.
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21
Product Unit Cost
 The
manufacturing cost of a single unit of
product.
= Direct Material + Direct Labor + Mfg. Overhead
Number of Units Produced
Or
= Sum of Costs per Unit for each Element
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22
Actual Costing Method
The
actual costing method uses the
actual cost information from the job
to calculate the unit cost of a product.
 At
the end of an accounting period, or
 At
the end of a job.
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23
Normal Costing Method
The
normal costing method combines
the actual direct materials and direct
labor costs with the estimated
manufacturing overhead costs to
determine product costs.
Used
when total actual overhead costs
are not known until the end of the year.
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24
Standard Costing Method
 The
standard costing method uses
estimated product cost information that is
used:
 As
a benchmark or target for evaluating
subsequent performance.
 For
budgeting purposes.
 For
bidding on a future job.
 For
controlling product costs.
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25
Summary of the Use of Actual
or Estimated Costs in
Three Cost-Measurement Methods
Product Cost
Elements
Actual
Costing
Normal
Costing
Standard
Costing
Direct
materials
Actual
costs
Actual
costs
Estimated
costs
Direct labor
Actual
costs
Actual
costs
Estimated
costs
Manufacturing
overhead
Actual
costs
Estimated
costs
Estimated
costs
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26
Relationships Among Product Costs
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27
Discussion
Q. What are the three elements of
product cost?
A.
1. Direct materials costs.
2. Direct labor costs.
3. Manufacturing overhead
costs.
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28
Manufacturing Inventory Accounts
OBJECTIVE 4
Describe the flow of product-related
activities, documents, and costs through
the Materials Inventory, Work in
Process Inventory, and Finished Goods
Inventory accounts.
Document Flows
Activity
Documents
Purchasing Materials
Purchase Request
Purchase Order
Receiving Report
Vendor’s Invoice
Materials Requisition and Conversion
Materials Request
Time Card
Job Order Cost Card
Vendors’ Invoices for Overhead
Product Completion and Sale
Job Order Cost Card
Sales Invoice
Shipping Document
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30
Cost Flows
 Direct
materials, labor, and overhead are
accumulated in the Work in Process
Inventory account.
 When
goods are completed the costs are
transferred to Finished Goods Inventory.
 When
the goods are sold, the costs are
transferred to Cost of Goods Sold.
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31
Manufacturing Cost Flow
Direct Materials
Inventory Account
Balance 12/31/x3: Used during
$10,000 20x4:
Total direct
$25,000
materials
purchased
during 20x4:
20,000
Balance
12/31/x4:
$5,000
Work in Process
Inventory Account
Balance 12/31/x3: Completed
$ 2,000 during 20x4:
$30,000
Direct materials
used during 20x4:
25,000
Direct labor 20x4:
12,000
Manufacturing
overhead 20x4:
6,000
Balance 12/31/x4
$15,000
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32
Manufacturing Cost Flow
Factory Payroll
Account
Direct labor
20x4:
earned during
20x4:
$12,000
Balance
12/31/x4:
$0
Work in Process
Inventory Account
$12,000
Balance 12/31x3: Completed
$ 2,000 during 20x4:
$30,000
Direct materials
used during 20x4:
25,000
Direct labor 20x4:
12,000
Manufacturing
overhead 20x4:
6,000
Balance 12/31/x4
$15,000
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33
Manufacturing Cost Flow
Manufacturing Overhead
Control Account
Total
manufacturing
overhead
incurred during
20x4:
$ 6,000
Balance
12/31/03:
$0
20x4:
$ 6,000
Work in Process
Inventory Account
Balance 12/31/x3: Completed
$2,000 during 20x4:
$30,000
Direct materials
used during 20x4:
25,000
Direct labor 20x4:
12,000
Manufacturing
overhead 20x4:
6,000
Balance 12/31/x4
$15,000
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34
Manufacturing Cost Flow
Work in Process
Inventory Account
Balance 212/31/x3: Completed
$2,000 during 20x4:
$30,000
Direct materials
used during 20x4:
25,000
Direct labor 20x4:
12,000
Manufacturing
overhead 20x4:
6,000
Finished Goods
Inventory Account
Balance 12/31/x3: Sold during 20x4:
$6,000
$24,000
Completed
during 20x4:
30,000
Balance
12/31/x4:
$12,000
Balance 12/31/x4
$15,000
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35
Manufacturing Cost Flow
Finished Goods
Inventory Account
Balance 12/31x3: Sold during 20x4:
$6,000
$24,000
Cost of Goods Sold
Account
Sold during
20x4:
$24,000
Completed
during 20x4:
30,000
Balance
12/31/x4:
$12,000
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36
Discussion
Q. What are the three manufacturing
inventory accounts?
A. 1. Materials Inventory.
2. Work in Process Inventory.
3. Finished Goods Inventory.
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37
Manufacturing and Financial
Reporting
OBJECTIVE 5
Prepare a statement of cost of goods
manufactured and an income
statement for a manufacturing
organization.
Cost of Goods Manufactured
 Cost
of goods manufactured is a key
component of the income statement for a
manufacturing company.
 Costs
of Goods Manufactured Account (for
a manufacturing co.) replaces Purchases
Account (for a merchandising co.)
 Finished
Goods Inventory replaces
Merchandise Inventory.
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39
Cost of Goods Manufactured

Determining the cost of goods
manufactured involves three steps.
1. Computing the cost of materials used.
2. Computing direct labor and manufacturing
overhead.
3. Computing cost of goods manufactured,
adjusting for beginning and ending work in
process.
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40
Cost of Goods Manufactured
The
cost of goods manufactured is
used on the income statement to
compute the cost of goods sold.
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41
Statement of
Cost of Goods Manufactured: Step 1
Angelo’s Rolling Suitcases, Inc.
Statement of Cost of Goods Manufactured
For the Year Ended December 31, 20x4
Direct Materials Used:
Direct Materials Inventory, 12/31/x3
Direct Materials Purchased
Cost of Direct Materials Available for Use
Less Direct Materials Inventory, 12/31/x4
Cost of Direct Materials Used
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$10,000
20,000
$30,000
5,000
$25,000
42
Statement of
Cost of Goods Manufactured: Step 2
Angelo’s Rolling Suitcases, Inc.
Statement of Cost of Goods Manufactured
For the Year Ended December 31, 20xx
Cost of Direct Materials Used
Direct Labor
Manufacturing Overhead
Total Manufacturing Costs
$25,000
12,000
6,000
$43,000
Note: Total Manufacturing Costs Cost of Goods Manufactured
= Product Costs added during the
manufacturing period.
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43
Statement of
Cost of Goods Manufactured: Step 3
Angelo’s Rolling Suitcases, Inc.
Statement of Cost of Goods Manufactured
For the Year Ended December 31, 20x4
Total Manufacturing Costs
Add Work in Process Inventory, 12/31/x3
Total Cost of Work in Process During the Year
Less Work in Process Inventory, 12/31/x4
Cost of Goods Manufactured
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$43,000
2,000
$45,000
15,000
$30,000
44
Income Statement
Angelo’s Rolling Suitcases, Inc.
Income Statement
For the Year Ended December 31, 20x4
Sales
Cost of Goods Sold:
Finished Goods Inventory, 12/31/x3
Cost of Goods Manufactured
Total Cost of Finished Goods
Available for Sale
Less Finished Goods Inventory,
12/31/x4
Cost of Goods Sold
Gross Margin
Selling & Administrative Expenses
Net Income
$50,000
$ 6,000
30,000
$36,000
12,000
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24,000
$26,000
16,000
$10,000
45
Discussion
Q.
What are the three steps needed to
determine the cost of goods?
A.
1. Compute the cost of materials used.
2. Compute total manufacturing costs for
the period.
3. Compute cost of goods manufactured,
adjusting for beginning and ending
work in process.
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46
Cost Allocation
OBJECTIVE 6
Define cost allocation and explain the
process of manufacturing overhead
allocation using cost objects, cost
pools, and cost drivers.
Cost Allocation
 Cost
allocation is the process of assigning
collected indirect costs to specific cost
objects using an allocation base that
represents a major function of the
business.
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48
Cost Allocation
 A cost
object is a:
 product
 process
 department
 activity
that the organization wishes to cost.
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49
Cost Allocation

A cost pool is a pool of overhead costs related
to a cost object.
 A cost
driver is an activity that causes the
cost pool to increase in amount as the cost
driver increases.
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50
Allocation of
Manufacturing Overhead
The allocation of manufacturing
overhead requires the following:

The pooling of manufacturing overhead costs that are
affected by a common activity.

The selection of a cost driver whose activity level causes
a change in the cost pool.
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51
Manufacturing
Overhead Allocation

The process of manufacturing
overhead allocation includes four
steps:
1. Planning.
2. Application.
3. Recording actual costs.
4. Reconciliation.
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52
The Manufacturing
Overhead Allocation Process
Step 1: Planning
Description:
Calculate a predetermined manufacturing
overhead rate.
When:
Before accounting period.
Procedure:
Divide the cost pool of total estimated
overhead costs by the total estimated
cost driver level.
Journal entry?
No
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53
The Manufacturing
Overhead Allocation Process
Step 2: Application
Description:
Apply manufacturing overhead costs
to production.
When:
During accounting period as units are
produced.
Procedure:
Multiply the predetermined overhead
rate for each cost pool by the actual
cost driver level.
Journal entry?
Yes
Increase Work in Process Inventory
account
Decrease Manufacturing Overhead
Control account
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54
The Manufacturing
Overhead Allocation Process
Step 3: Recording Actual Costs
Description:
Record actual manufacturing overhead
costs.
When:
During accounting period as costs
are incurred.
Procedure:
Record actual manufacturing overhead
costs when incurred.
Journal entry?
Yes
Increase Manufacturing Overhead
Control account
Decrease asset accounts
Increase contra-assets or liability
accounts
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55
The Manufacturing
Overhead Allocation Process
Step 4: Reconciliation
Description:
Calculate the difference between applied
and actual manufacturing overhead costs.
When:
At the end of the accounting period.
Procedure:
Calculate and record the difference
between the actual and applied
manufacturing overhead costs.
Journal entry?
Yes
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56
The Manufacturing
Overhead Allocation Process
Step 4: Reconciliation
Journal entry?
Yes
If applied > actual, then increase
Manufacturing Overhead Control
account
Decrease Cost of Goods Sold Account
If applied < actual, then increase Cost
of Goods Sold account
Decrease Manufacturing Overhead
Control account
Note: If difference is material, allocate to Cost of Goods Sold,
Finished Goods and Work-in-Process.
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57
The Manufacturing
Overhead Allocation Process
Year
2000
Year
2002
Year 2001
January 1
December 31
Step 1:
Planning
Step 4:
Reconciliation
Step 2:
Application
Step 3:
Recording Actual Costs
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58
Allocation of Manufacturing Overhead
 The
successful allocation of manufacturing
overhead costs depends on two factors:
 A careful
estimate of total manufacturing
overhead costs.
 A good
forecast of the activity level used as the
cost driver.
 Errors
in either estimate can cause
product unit costs to be over or under
estimated, resulting in bad pricing
decisions.
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59
Discussion
Q.
What are the four steps in the
manufacturing overhead
allocation process?
A.
1. Planning.
2. Application.
3. Recording actual costs.
4. Reconciliation.
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60
Manufacturing Overhead
Allocation Using the Traditional
Approach
OBJECTIVE 7
Calculate product unit cost using
the traditional allocation of
manufacturing overhead costs.
Predetermined Overhead Rate

The use of one predetermined overhead
rate to apply manufacturing overhead to
a product is appropriate if
organizations:
1.
Manufacture only one product, or
2.
Manufacture a few very similar products
that require the same production processes
and production-related activities.
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62
Normal Costing Method
The
normal costing method applies
manufacturing overhead costs to a
product’s cost by:
 Estimating
a predetermined
manufacturing overhead rate, and
 Multiplying
that rate by the actual level
of the cost driver consumed by that
product.
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63
Traditional Activity Bases
Traditional
activity bases are volumerelated bases such as:
 Direct
labor hours.
 Direct
labor costs.
 Machine
 Units
hours.
of production.
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64
Product Unit Cost
The
total manufacturing overhead cost
is added to the actual costs of direct
materials and direct labor in order to
determine the total product cost.
The
product unit cost is calculated by
dividing total product cost by total units
produced.
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65
Using the Traditional Approach to Assign Manufacturing
Overhead Costs to Production
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66
Assignment of Manufacturing Overhead
Costs:
Traditional Approach
Step 1: Calculate the
predetermined overhead rate.
Predetermined
Overhead Rate
=
=
$200,000
40,000 Direct
Labor Hours
$5 per Direct
Labor Hour
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67
Assignment of Manufacturing Overhead
Costs:
Traditional Approach
Step 2: Apply manufacturing
overhead costs to production.
Regular
Cost Driver Level
Cost Applied
X 25,000 DLH
$125,000
 10,000
Overhead costs applied:
Manufacturing overhead:
$5 per DLH
Number of units
Manufacturing overhead
cost per unit
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$
12.50
68
Assignment of Manufacturing Overhead
Costs:
Traditional Approach
Step 2: Apply manufacturing
overhead costs to production.
Deluxe
Cost Driver Level
Cost Applied
X 15,000 DLH
$ 75,000
Overhead costs applied:
Manufacturing overhead:
$5 per DLH
Number of units
Manufacturing overhead
cost per unit
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
$
5,000
15.00
69
Product Unit Cost:
Traditional Approach
Step 3: Product Unit Cost
Regular
Rolling Suitcase
Deluxe
Rolling Suitcase
$40.00
$42.00
Direct labor
37.50
45.00
Manufacturing overhead
12.50
15.00
$90.00
$102.00
Product costs per unit:
Direct materials
Product unit cost
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70
Discussion
Q.
What are some traditional activity bases?
A.
1. Direct labor cost.
2. Direct labor hours.
3. Machine hours.
4. Units of production.
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71
Manufacturing Overhead
Allocation Using ABC
OBJECTIVE 8
Calculate product unit cost using
activity-based costing to assign
manufacturing overhead costs.
ABC Approach
When ABC
is used, manufacturing
costs are grouped into smaller activity
cost pools.
Because
more cost pools are used,
each with their own cost driver for
allocation to products, a more
accurate product cost is obtained.
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73
ABC Approach
 Costs
from activity cost pools are assigned
to cost objects using cost drivers.
 Cost
drivers are identified and cost driver
levels are estimated for each cost pool.
 Each
cost pool rate is calculated by dividing
the estimated cost amount by the cost driver
level.
 Manufacturing
overhead is applied to the
product’s cost by multiplying the cost pool
rate by the actual cost driver amount.
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74
ABC Systems
 ABC
systems assign costs to cost objects
based on each cost object’s relative use of
overhead resources.
 The
total applied manufacturing overhead
cost is added to the cost of direct materials
and direct labor to determine the total
product cost.
 The
product unit cost is the total product
cost divided by the total units produced.
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75
Using ABC to Allocate Manufacturing Overhead Cost to Production
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76
ABC Costing Systems
 Problems
with product costs produced by
traditional volume-based costing systems
include:
 Traditional
volume based system, low volume
products are under-costed and high volume
products are over-costed.
 Organizations
face greater risk of making poor
decisions when significant product cost
distortions exist.
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77
Discussion
Q.
What are two problems with traditional
volume-based costing systems?
A.
1. Low-volume products are undercosted
and high-volume products are
overcosted.
2. Greater risk of making poor decisions.
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78
Step 1: Cost Driver Level
Estimated Cost Driver Level
Cost Driver
Regular
Deluxe
Total
Number of setups
300
400
700
Number of inspections
150
350
500
Packaging hours
600
1,400
2,000
4,000
6,000
10,000
Machine hours
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79
Step 1: (cont’d)
Activity Pool
Cost Driver Level
Activity Cost Rate
Setup $70,000

700 setups
=
$100 per setup
Inspection $60,000

500 inspections
=
$120 per inspection
Packaging $50,000

2,000 packaging hours = $25 per packaging hour
Building $20,000

10,000 machine hours =
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$2 per machine hour
80
Step 2: Apply Overhead Costs to Production
Regular Suitcase
Activity Cost Rate
Cost Driver Level
Cost Applied
$100 per setup
X
300 setups
=
$30,000
$120 per inspection
X
150 inspections
=
$18,000
$25 per packaging hr X
600 packaging hours =
$15,000
X
4000 machine hours =
$8,000

10,000 units
$2 per machine hr
Total
$71,000
=
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$7.10
81
Step 2: Apply Overhead Costs to Production
(cont’d…)
Deluxe Suitcase
Activity Cost Rate
Cost Driver Level
Cost Applied
$100 per setup
X
400 setups
=
$40,000
$120 per inspection
X
350 inspections
=
$42,000
$25 per packaging hr
X
1,400 packaging hrs =
$35,000
$2 per machine hr
X
6,000 machine hrs
=
$12,000
Total $129,000
 5,000 units
=
$25.80
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82
Step 3: Calculate Product Unit Cost
Product Costs Regular
per Unit
Suitcase
Direct Materials
Direct Labor
Manufacturing
Overhead
Product Unit
Cost
Deluxe
Suitcase
$40.00
$42.00
37.50
45.00
7.10
25.80
$84.60
$112.80
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83
Cost Allocation in
Service Organizations
OBJECTIVE 9
Apply costing concepts to a
service organization.
Service Organizations
A service
organization does not have a
physical product that can be:
 Assembled.
 Stored.
 Valued.
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85
Service Organizations
 The
most important cost in a service
organization is the professional labor cost
(like product cost in manufacturing.)
 Service
related overhead is the other
principal component of the cost of services
rendered (like manufacturing overhead.)
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86
Discussion
Q. What is the most important cost
in a service organization?
A.
Professional labor cost.
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87
OK, LET’S REVIEW . . .
1. State how managers use information about
costs in the management cycle.
2. Identify various approaches managers use
to classify costs.
3. Define and give examples of the three
elements of product cost and compute a
product’s unit cost for a manufacturing
organization.
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88
WE ALSO COVERED . . .
4. Describe the flow of product-related activities,
documents, and costs through the Materials
Inventory, Work in Process Inventory, and
Finished Goods Inventory accounts.
5. Prepare a statement of cost of goods
manufactured and an income statement for a
manufacturing organization.
6. Define cost allocation and explain the process of
manufacturing overhead allocation using cost
objects, cost pools, and cost drivers.
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89
AND FINALLY . . .
7. Calculate product unit cost using the traditional
allocation of manufacturing overhead costs.
8. Calculate product unit cost using activity-based
costing to assign manufacturing overhead costs.
9. Apply costing concepts to a service organization.
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90