C H A P T E R
3

Learning Objective 1
Understand the difficulty, yet importance, of having accurate product cost information.

Define the Three Manufacturing
Product Costs
Direct materials materials that become part of the product and are traceable to it.
Direct labor wages paid to those who physically work on the direct materials to transform them to a finished product and are traceable to those products.
Manufacturing overhead all costs incurred in the manufacturing process other than direct materials and direct labor.

Assignment of Product Costs
Product Cost
Easily assigned to products.
Direct
Materials
Costs
- Expenditure and use usually match production.
Easily assigned to products.
Direct
Labor
Costs
- Expenditure and use usually match production.
Difficult to assign to products.
Manufacturing
Overhead
Costs
- Total costs not known until the end of the period.
- Not usually assigned to specific products.
“Lumped” costs don’t match production very well.

Product Cost Systems
Why does management needs accurate product cost information?
To plan for the future.
To control current operations.
To evaluate past performance.
To deliver high-quality products to customers at the lowest price and at the fastest speed.

Product Cost Systems
What does accurate information allow management to do?
To determine the appropriate level at which to operate.
To assess the long-term profitability of various products.
To manage the costs of production activities.

Learning Objective 2
Explain the flow of goods and services in a manufacturing organization and follow the accumulation of product costs in its accounting system.

Review the Time Line of Business
BUY raw materials or goods for resale
ADD value
SELL finished inventory
COMPUTE ending inventory cost of goods sold

Measuring Cost
To accurately measure product costs, accountants must:

Determine which costs relate to manufacturing and which relate to administrative and selling functions.

Accurately identify and measure all costs associated with manufacturing.

Determine appropriate ways to assign costs incurred to products manufactured.

Outline the Flow of Cost in a
Manufacturing Process
Raw
Materials
Inventory
Finished
Goods
Inventory
Direct
Labor
Work-In-
Process
Inventory
Factory
Overhead
Cost of
Goods
Sold

Determining Cost
What are some difficulties in determining costs of manufactured products?
Multiple products produced in same facility.
Changing prices and labor rates.
Multiple manufacturing locations
(perhaps international).
Individuals performing multiple tasks.

Costs of Manufacturing Products
Discuss the Nature of Raw Materials.
Direct materials
Cost of raw materials used directly in the manufacture of products.
Kept in raw materials warehouse until used.
Examples: Rubber to make tires, steel to make cars, wood to make tables.

Example: Direct Materials Costs
Venus Vehicles purchased $2 million of steel for its new line of cars. What is the journal entry?
Raw Materials Inventory. . . . . . . . . . . 2,000,000
Accounts Payable . . . . . . . . . . . .
2,000,000
Half the new steel is requested from the warehouse for production. What is the journal entry?
Work-in-Process Inventory. . . . . . . . . .1,000,000
Raw Materials Inventory . . . . . . . .
1,000,000
Indirect materials ($250,000 of glue and bolts) are requisitioned from the storeroom. What is the journal entry?
Manufacturing Overhead. . . . . . . . . . . . 250,000
Raw Materials Inventory . . . . . . . .
250,000

Costs of Manufacturing Products
Discuss the Nature of Direct Labor.
Direct labor
Wages/payroll-related expenses of factory employees who work directly on products.
Cost of wages/benefits for assembly workers.
Does not include wages/benefits of those who do not work directly on making products.

Direct Labor Costs and Example
 Time clocks, computer entries, time sheets —
- All allow production personnel to identify specific jobs worked on.
 This information is revealed on the job cost sheet.
 Labor costs can be direct or indirect.
 Payroll records report direct labor of $50,000 and indirect labor of $50,000. Record the direct labor.
Work-in Process Inventory. .
.50,000 Wages Payable. . . .
. . . .
50,000
Record the indirect labor.
Manufacturing Overhead. . . . 50,000
Wages Payable. . . . .
. . . .
50,000

Costs of Manufacturing Products
Discuss the Nature of Factory Overhead.
Manufacturing overhead
All manufacturing costs not classified as direct materials or direct labor.
Miscellaneous materials used in production (such as glue or nails).
Costs such as utilities, depreciation, insurance, and property taxes.

Describe Some of the Characteristics of
Manufacturing Overhead Costs
 Involves more complex accounting procedures and estimation problems.
 Must often be estimated in advance of their occurrence.
 Cannot be traced directly to individual items produced during the period.
 Managers need current product cost information:
- for pricing similar jobs.
- for estimating costs for next period.
Therefore, each job is assigned a share of estimated overhead.

Describe the Two-Step Process to Apply
Manufacturing Overhead to Products
Step One
Annual expected (budgeted) manufacturing overhead
Annual expected (budgeted) activity level
(e.g., direct labor hours)
=
Predetermined overhead rate
Step Two
Predetermined overhead rate x
Actual activity level per job
=
Allocated manufacturing overhead assigned to job

Example: Determining Manufacturing
Overhead Rate
Steel Works estimates annual variable manufacturing overhead costs of $10,000 and fixed manufacturing overhead of $20,000. What is the predetermined overhead rate if the company expects to use the machines 10,000 hours?
Total estimated manufacturing overhead costs
Selected activity base (machine hours)
=
$30,000
10,000
=
$3.00 per machine hour

Example: Determining Manufacturing
Overhead Rate
Steel Works used 10 machine hours in the production of Job No. 12. Using the $3.00 predetermined overhead rate, what overhead costs will be applied to manufacturing overhead
(MOH) for this job? What is the journal entry to apply this MOH to Job No. 12?
Overhead
Rate
$3.00
x
Actual
Activity
10 hours
=
Applied
MOH
$30.00
Work-in-Process Inventory. . . . . . . . . . .
Manufacturing Overhead . . . . . . . .
30
30

Example: Transferring Completed Products to
Finished Goods Inventory and then Selling the Products
Steel Works used $100 in direct materials in Job No.
12’s production as well as 10 hours of direct labor at
$20 per hour. Using a job cost sheet, determine the job’s total cost. Now that the job is complete, prepare the entries for its transfer to Finished
Goods and its sale.
Job Cost Sheet
Job No. 12 Finished Goods Inventory . . 330
Work-in Process. . . . . . . . . . . . 330
Direct Materials $100
Direct Labor 200
MOH
Total
30
$330
Cost of Goods Sold. . . . . . . 330
Finished Goods Inventory. . . 330

Learning Objective 3
Understand the process of accounting for overhead.

Actual versus Applied Manufacturing
Overhead
Actual Overhead
 Actual annual manufacturing overhead costs.
 Needed for accurate determination of income.
 Recorded as debit to Manufacturing
Overhead.
Applied Overhead
 Amount of overhead applied to products using the predetermined overhead rate.
 Recorded as credit to Manufacturing
Overhead.

Disposition of Over- and Underapplied
MOH
Manufacturing Overhead
Actual Applied
10 20
(Cost of job is overstated)
Manufacturing Overhead
Actual Applied
20 10
(Cost of job is understated)
Overapplied Manufacturing
Overhead:
The excess of applied overhead costs over actual overhead costs for a period.
Underapplied Manufacturing
Overhead:
The excess of actual overhead costs over applied overhead costs for a period.

Treating Applied Overhead
Two methods for treating over- and underapplied MOH:
- Close over- or underapplied overhead directly to
Cost of Goods Sold.
- Easier and more commonly used, especially if amount is small.
- Debit MOH, Credit COGS.
- Allocate over- or underapplied manufacturing overhead to Work-in-Process Inventory, Finished Goods
Inventory , and Cost of Goods Sold on the basis of the ending balances in these three accounts.
- More accurate; any difference is allocated proportionately.
- More complicated; requires detailed calculations.

Learning Objective 4
Explain the flow of goods and services in a merchandising organization and follow the accumulation of product costs in its accounting system.

The Distribution Channel
The process of wholesalers purchasing from manufacturers and supplying retailers who sell to final customers.

A Typical Channel of Distribution
Manufacturer
Brand A
Manufacturer
Brand B
Manufacturer
Brand C
Manufacturer
Brand D
Manufacturer
Brand E
Manufacturer
Brand F
Wholesaler
Wholesaler
Wholesaler
Retailer
Brand A Customers
Brand B Customers
Brand C Customers
Brand D Customers
Brand E Customers
Brand F Customers

Wholesalers

Receive goods in bulk shipments; break them down for smaller shipments to retailers.

Profit —the difference between price at which they buy goods and price at which they sell goods to retailers.

Quality and timelines are also important performance measures.
To be profitable, wholesalers must be sure the right goods are received and shipped in the right manner to the right retailer for the right price at the right time.

Retailers – Define Risk and Stockturns

Often work with many wholesalers (and some manufacturers) to obtain inventory mix.

Risk is having money tied up in inventory that is not selling
(opportunity cost).

Stockturns —the faster stock (inventory) can be turned, the sooner the money is available to purchase more inventory.
Second-tier merchants who typically purchase products from wholesalers to distribute to customers. Many will often bypass wholesalers to purchase inventory directly from the original manufacturers.

Describe Merchandise Cost Flows
Accounts
Payable xxx x x
Costs incurred to ship in inventory
Inventory is purchased
Merchandise
Inventory xx x x xx x
Inventory is sold
Cost of Goods
Sold x x
Inventory is returned

Describe Accounting for Inventory
In merchandising, accounting is fairly straightforward: no raw materials, inventory, manufacturing overhead, or work-in-process accounts .
Inventory costs are often expensed as a period cost, included in Selling and General Administrative
Expenses.
Prepare journal entry for when $465 inventory is sold.
Jan. 1 Cost of Goods Sold. . . . . . . . . 475
Merchandise Inventory . . . .
Sold inventory to customers.
475

Learning Objective 5
Explain the flow of goods and services in a service organization and follow the accumulation of product costs in its accounting system

Define a Service Company
An organization whose main economic activity involves producing a nonphysical product that provides value to a customer.
Important for service firms to develop useful management accounting systems that support managing costs, quality, and timeliness in creating and delivering their product.

What are the Effects of Deregulation?
 In service sector, deregulation has changed pricing and profitability.
 Now the most efficient producers establish prices.

Service providers who don’t know their costs will:

 not be able to aggressively set prices.
not be responsive to consumer demands.
 not make enough money to stay in business.

List Similarities Between Service and
Manufacturing Firms
 Both prepare product for sale and delivery.
 Both involve direct labor and overhead.
 Both create a high-quality product that must be delivered in a timely manner while keeping costs low.
 Creative process requires highly paid skilled labor or expensive capital equipment and buildings.
 Large overhead must be allocated to the direct product provided to the customer.

Differences Between Service and
Manufacturing Firms
 Distribution channel not as prevalent in service firms.
 Most service firms deal directly with enduser.
 More customization in service firms.
 Most service firms use a job order approach rather than a process approach to cost accounting.
 Raw material inventories are insignificant or nonexistent in service firms.
 Difficult in service industry to store finished service in anticipation of later sale.

Work-in-Process Inventory
 At period’s end, there may be situations where significant effort and resources have been invested in a service product that is not yet completed.
 Revenue is not yet earned; therefore, costs should not be recognized yet as expenses. This work in process is an asset, referred to as Work-in-Process Services .
 When service is completed and delivered, service costs (overhead costs and work-in-process services) are transferred to Cost of Services.

Learning Objective 6
Understand the impact of e-business on product costing.

What Impact Has e-business Had on
Product Costs?
1.
Reduced cost of materials, since businesses can search for the best price.
2.
Better management of direct labor costs.
3.
In some cases, customers interact with technology instead of employees.
4.
Significant changes in the structure of companies which greatly affects overhead costs.

Expanded Material
Learning Objective 7
Use the FIFO method to do process costing.

Process Costing
Process costing is appropriate if what two general conditions are met?
The activity performed in each process center must be identical for all units.
The units produced as a result of passing through the process centers must be basically the same.

What are the 5 Steps in Process Costing?
Step 1 Identify units that went into the process and identify where those units are at the end of the processing time. Determine the amount of work done during the processing time period.
Step 2 Determine the amount of production costs that went into the process and compute the product costs per unit for the processing time period.
Step 3 Compute the total cost of units completed and transferred out during the processing time period.
Step 4 Compute the total cost of units remaining in process at the end of the processing time period.
Step 5 Prepare the production cost report.

Step 1: Compute Equivalent Units of
Production
Direct Materials Costs Conversion Costs
Physical
Units (lbs) % Done
Equivalent
Units % Done
Equivalent
Units
Beginning work-inprocess
Started & completed
Ending work-inprocess
4,000
44,000
2,000
0%
100%
100%
-
44,000
2,000
80%
100%
60%
3,200
44,000
1,200
Equivalent units of production
46,000 48,400
Transferred out 48,000

Step 2: Compute Product Costs per Unit
Total
Costs
Beginning work-in-process
Direct materials costs
Conversion costs
Total
Current period
Direct materials costs
Conversion costs
Total
$ 800
1,200
$ 2,000
$ 9,660
70,180
$ 79,840
Equivalent
Units
4,000
800
Total
46,000
48,400
Total
Cost per
Unit
$ 0.20
1.50
$ 1.70
$ 0.21
1.45
$ 1.66

Step 3: Compute the Costs Transferred
Out
Cost per
Unit
Equivalent
Units
Beginning work-in-process
Initial direct materials costs
Initial conversions costs
Cost to complete materials
Cost to complete conversion
Total
Started and completed
Total costs transferred out
$ 0.21
1.45
$ 1.66
-
3,200
44,000
$ 800
1,200
-
4,640
$ 6,640
73,040
$ 79,680

Step 4: Compute Costs of Ending
Work-in Process Inventory

Step 5: Prepare the Production Cost
Report
The production cost report contains the information prepared and presented in steps 1 through 4.