Traditional
Cost Management
Systems
Chapter 3
Cost Management Systems
• Cost management systems have a wide
variety of uses
• Two cost management systems have been
used traditionally to cost products and
services
– Job order costing
– Process costing
• Many companies continue to use these
two systems
Cost Management Systems
• All cost systems work in essentially the
same way:
– Expense categories are developed and then
expenses are mapped to service departments,
production centers, or activities
– Expenses are then attached to cost objects
• The way these links are made and the
activities defined is what differentiates
systems
Manufacturing costs
• The costs of producing a product can be
broken down into two broad categories:
– Direct cost – cost of a resource or activity that
is acquired or used by a single cost object
– Indirect cost – cost of a resource that was
acquired to be used by more than one cost
object
Direct and Indirect Costs
• Direct costs can be easily traced to a cost
object
• Indirect costs cannot easily be traced to a
cost object so they must be allocated or
assigned to the cost object
Job Order v. Process Costing Systems
• A job order costing system estimates the
costs of manufacturing products for
different jobs required for specific customer
orders
• A process costing system is applicable
when all units produced during a specified
time frame are treated as one unit of output
Need for Job Order Costing
• Products may differ
–
–
–
–
Materials content
Hours of labor required
Machine time required
Demand placed on support activity resources (i.e.,
manufacturing overhead)
– Special customer needs that require customized
production
• With such variety, managers need to understand
the costs of individual products so that they can
assess product and customer profitability
The Cost Flow Model
• The cost flow model essentially uses an
inventory concept to track costs
– Raw materials inventory
– Work-in-process (WIP) inventory
• Raw materials are transformed by labor and
support resources
• Costs of the resources for each job not yet
completed
– Finished goods inventory
• When the goods are sold, they are accounted for
in the expense category Cost of Goods Sold
Bidding Using Job Order Costing
• Firms are sometimes required to bid on
jobs before customers decide to place an
order with them
• Costs need to be estimated for each job in
order to prepare a bid
• Job order costing systems provide the
means to estimate these costs
• A job bid sheet provides a format for
recording the estimated costs
Job Bid Sheet
• Panel 1 identifies the customer, the
product, and the number of units required
Bid Number: J4369
Date: July 6, 2006
Customer: Michigan Motors
Product: Automobile engine valves (Valve #L181)
Engineering Design Number: JDR-103
Number of Units: 1,500
Job Bid Sheet
• Panel 2 lists all the materials required to
complete the job
Materials
Quantity
Bar steel stock 3” 3,600 lbs
Subassembly
1,500
Total direct materials
Price
$11.30
39.00
Amount
$40,680
58,500
$99,180
Job Bid Sheet
• Panel 3 lists the amount of direct labor
required for the job
Labor
Hours
Lathe operators
480
Assembly workers 900
Total direct labor 1,380
Rate
$26.00
18.00
Amount
$12,480
16,200
$28,680
Job Bid Sheet
• Panel 4 contains estimates for cost driver
costs
Support Costs
Amount
600 machine-hours @ $40/hour
$24,000
1,380 direct labor hours @$36/hour
Total support costs
49,680
$73,680
Job Bid Sheet
• Panel 5 summarizes the total costs
estimated for the job
Direct material
Direct labor
Support costs
Total costs
$ 99,180
28,680
73,680
$201,540
Job Bid Sheet
• A markup rate is applied to translate the
estimated cost into a bid price
Total costs
Add 25% markup
Bid price
Unit cost
Unit price
$201,540
50,385
$251,925
$134.36
$167.95
Job Costs And Markup
• Markup rate – percent by which job costs are
marked up
• The markup rate depends on a variety of factors:
– The amount of support costs excluded from the cost
driver rate
– The target rate of return desired by the corporation
– Competitive intensity
– Past bidding strategies adopted by key competitors
– Demand conditions
– Overall product-market strategies
Determination Of Cost Driver Rates
• Determining realistic cost driver rates has
become increasingly important with the
increase in support costs as a percentage
of total cost
• Firms now recognize that several different
factors may be driving support costs rather
than one or even two factors, such as
direct labor or machine hours
Cost Driver Rates
• All costs associated with a cost driver, such as
setup hours, are accumulated separately in a
cost pool
• Each cost pool has a separate cost driver rate
• The cost driver rate is the ratio of the cost of a
support activity accumulated in the cost pool to
the level of the cost driver for the activity
Activity cost driver rate =
Cost of support activity / Level of cost driver
Stable Cost Driver Rates
• The cost of the support activity is the cost of the
resources committed to the particular activity
• The level of the activity cost driver is the longterm capacity made available by the amount of
resources committed to a support activity
– The cost of a support activity excludes fluctuations in
costs caused by short-term adjustments such as
overtime payments
– The level of the support activity cost driver also
excludes short-term variations in demand as reflected
in overtime or idle time
Stable Cost Driver Rates
• The ratio shown is based on costs and
cost driver levels, the rate remains stable
over time:
– Rate does not fluctuate as activity levels
change in the short run
– Rate does not change simply because of
short-run changes in external factors that do
not affect the efficiency or price of the activity
resources
Fluctuating Rates
• If the rate for machine costs is based on
quarterly cost driver levels instead of the normal
levels:
– The rate increases as the demand for the machine
activity falls
– The rate decreases as the demand increases
• If the cost driver rate is based on costs and
activity levels remains fixed throughout the year
– Costs depend on the machine capacity made
available and not on the season
Problems With Fluctuating Rates
• Determination of cost driver rates based
on short-term usage results in higher rates
during periods of lower demand
– Job costs appear to be higher during time
periods when demand is lower
– Bid prices based on estimated job costs are
likely to be higher during periods of low
demand when they probably should be lower
– The higher bid price can further decrease
demand, which in turn leads to higher cost
driver rates and even higher prices
Number of Cost Pools
• The number of cost pools can vary
• The general principle is to use separate
cost pools if the cost or productivity of
resources is different and if the pattern of
demand varies across resources
• The increase in measurement costs
required by a more detailed cost system
must be traded off against the benefit of
increased accuracy in estimating product
costs
Recording Actual Job Costs
• Job order cost accounting systems record
costs actually incurred on individual jobs
as they are produced
• Copies of all materials requisition notes
and worker time cards are forwarded to
the accounting department, which then
posts them on a job cost sheet
• The system calculates total costs for the
portion of the job completed
Multi-stage Process Costing
• Continuous processing - production flows
continuously, semi-continuously, or in large
batches from one process stage to the next
• At each successive process stage, there is further
progress toward converting the raw materials into
the finished product
• In continuous processing it is necessary first to
determine costs for each stage of the process and
then to assign their costs to individual products
Multistage Process Costing Systems
• The design of product costing systems in such
process-oriented plants allows measurement of
the costs of converting the raw materials during
a time period to be made separately for each
process stage
• The conversion costs are applied to products
as they pass through successive process stages
• This system for determining product costs,
known as a multistage process costing
system, is common in process-oriented
industries
Process-Oriented Industries
• Multistage process costing systems are found in
plants engaged in continuous processing, such
as those in the chemicals, basic metals,
pharmaceuticals, grain milling and processing,
and electric utilities industries
• Also found in some discrete-parts manufacturing
plants such as those producing automobile
components, small appliances, and electronic
instruments and computers
• Common feature in these settings is that the
products manufactured are relatively
homogeneous
Comparison With Job Order Costing
• Both systems have the same objective:
– Assign material, labor, and manufacturing
support activity costs to product
• Process costing systems differ in that they:
– Do not maintain separate cost records for
individual jobs
– Measure costs only for process stages
– Determine cost variances only at the level of
the process stages instead of at the level of
individual jobs
Job Order and Multistage
Process Costing
• In job order costing production is carried
out in different jobs
• In multistage process costing, production
is carried out continuously, semicontinuously, or in large batches
Job Order and Multistage
Process Costing
• In job order costing, production
requirements are different for each
individual job
• In multistage process costing, production
requirements are homogeneous across
products or jobs
Job Order and Multistage
Process Costing
• In job order costing, variances between
actual and estimated direct material and
direct labor costs are determined for each
individual jobs
• In multistage process costing, variances
between actual and estimated costs are
determined for individual process stages
Equivalent Units of Production
• Process costing issue: units in production
that are not complete at the end of a
production period
• These partially completed units are
converted mathematically into equivalent
units of production (EUPs)
EUPs
• Equivalent units =
Number of partially completed units
Percentage completion
• Weighted-average method:
EUP = units transferred out to the next
dept. + Equivalent units in ending WIP
Service Department
Cost Allocations
Appendix 3-1
Operating Expense Allocations
•
Traditional cost accounting systems
assign operating expenses to products
with a two-stage procedure:
1. Expenses are assigned to production
departments
2. Production department expenses are
assigned to the products
•
Departmental structure influences the
first-stage allocation process
Effect Of Departmental Structure
• Departments that have direct responsibility
for converting raw materials into finished
products are called production
departments
• Service departments perform activities
that support production, such as:
• Machine maintenance
• Production engineering
• Machine setup
• Production scheduling
– All service department costs are indirect support
activity costs because they do not arise from direct
production activities
Two-Stage Cost Allocation
Conventional product costing systems assign
indirect costs to jobs or products in two stages
1. In the first stage:
–
–
System identifies indirect costs with various
production and service departments
Service department costs are then allocated to
production departments
2. The system assigns the accumulated indirect
costs for the production departments to
individual jobs or products based on
predetermined departmental cost driver rates
Two-Stage Cost Allocation (2 of 2)
Allocating Service Department
Costs To Production Departments
• There are three ways that companies
allocate service department costs to
production departments:
– Direct allocation
– Sequential allocation
– Reciprocal allocation
• The last two are used when service
departments consume services provided by
other departments
PATIENTAID EXAMPLE
Step 1 of Stage 1 cost allocations (given)
Direct Allocation Method
• The direct allocation method is a simple
method that allocates the service
department costs directly to the production
departments
– Allocations to production departments are
based on each production department’s
relative use of the applicable cost driver
– Possibility that some of the activities of a
service department may benefit other service
departments as well as production
departments is ignored
Allocation Bases Values
Allocation Ratios
Based on relative allocation basis value
300,000 / 1,200,000 = 0.250
Allocation of
Service Department Costs
• Multiply service department cost by the allocation ratios
$160,000 x 0.250 = $40,000
Stage 2 Cost Allocations
• Stage 2 allocations
– Require the identification of appropriate cost drivers
for each production department
– Assign production department costs to jobs and
products while they are worked on in the departments
• Conventional cost accounting systems use unitrelated cost drivers
• Dividing the indirect costs accumulated in each
production department by the total number of
units of the corresponding cost driver results in
cost driver rates for each department
PATIENTAID Stage 2
• The Casting Department allocates its indirect
costs to jobs based on machine hours, with total
capacity for Casting equaling 6,000 machine
hours
• Total indirect costs for Casting, after the
allocation from service departments in Step 2 of
Stage 1 was $216,000
• As a result, Casting allocates indirect costs to
jobs at a rate of $36.00 per machine hour
= $216,000/6,000 hours
PATIENTAID Stage 2
• If Job J189-4 uses 40 machine hours while in the
Casting Department, Casting will allocate $1,440
of its indirect costs to Job J189-4
= 40 hours x $36.00 per hour
• Each department will allocate indirect costs to
Job J189-4 in a similar manner, and Casting will
allocate some costs to all jobs in a similar manner
• To determine the total cost of Job J198-4, add the
Direct Material and Direct Labor cost assigned in
each department and the indirect cost allocated
from each department
• To determine the cost per unit, divide the total
cost by the number of units in Job J189-4
Cost Distortions in
A Two-Stage Allocation
• The two-stage allocation can cause some
products to be overcosted and others
undercosted if allocations are based on
unit measures but the units of different
products have different relative
consumption ratios
Cost Distortions in
A Two-Stage Allocation (2 of 2)
• Cost distortions are greater when the
difference between the relative proportion
of the cost driver for the activity and the
relative proportion of the basis for secondstage assignment of support costs is
greater
• Such distortions could be eliminated if the
costing system used the actual cost driver
for each support activity to assign costs
directly to the products
Sequential and Reciprocal
Allocation Methods
• Sequential and reciprocal allocation
methods are used when service
departments consume services provided
by other service departments
– The sequential allocation method allocates
service department costs to one service
department at a time in sequential order
– The reciprocal allocation method determines
service department cost allocations
simultaneously
Sequential Allocation Method
• The sequential method is appropriate
when there is not a pair of service
departments in which each department in
that pair consumes a significant proportion
of the services produced by the other
department in that pair
Sequential Allocation Method
• The sequential allocation method requires
that the service departments first be
arranged in order
– A service department can receive costs
allocated from another service department
only before its own costs have been allocated
to other departments
• Once a service department’s costs have
been allocated, no costs can be allocated
back to it from other departments
Sequential Allocation Method
Service
Departments
Item
Power
Production
Departments
Engineering Machining Assembly
Totals
Services Used:
Kilowatt hours
Eng’ring hours
0
0
100,000
0
480,000
2,000
220,000
2,000
800,000
4,000
Allocation ratios:
Power
Engineering
0
0
0.125
0
0.600
0.500
0.275
0.500
1.000
1.000
$320,000
$180,000
$120,000
$80,000
$700,000
Directly
identified costs
480,000/800,000 = 0.600
2,000/4,000 = 0.500
Sequential Allocation Method
Service
Departments
Item
Power
Production
Departments
Engineering Machining Assembly
Directly
identified costs
$320,000
$180,000
$120,000
$80,000
Cost Allocations:
Power
Engineering
(320,000)
0
40,000
(220,000)
192,000
110,000
88,000
110,000
$0
$0
$ 422,000
Totals
$320,000 * 0.600 = $ 192,000
($180,000 + 40,000) * 0.500 = $ 110,000
Totals
$700,000
$ 278,000 $ 700,000
Sequential Allocation Method
• The power department does not receive
engineering services, but the engineering
department uses power
• Therefore, in the sequential method:
– Power department costs are allocated first
– Engineering department costs are allocated next
• The total cost of a service department allocated
to other departments equals the amount directly
identified with the service department plus the
amount allocated earlier to the service
department from other service departments
Reciprocal Allocation Method
• If both service departments in this
example consume each other’s services,
the reciprocal allocation method is
appropriate
• The sequential method ignores or
suppresses such reciprocal relations
• The reciprocal allocation method
recognizes reciprocal interactions between
different service departments
Reciprocal Allocation Method
Service
Departments
Item
Power
Production
Departments
Engineering Machining Assembly
Totals
Services Used:
Kilowatt hours
Eng’ring hours
0
1,000
100,000
0
480,000
2,000
220,000
2,000
800,000
5,000
Allocation ratios:
Power
Engineering
0
0.200
0.125
0
0.600
0.400
0.275
0.400
1.000
1.000
$320,000
$180,000
$120,000
$80,000
$700,000
Directly
identified costs
480,000/800,000 = 0.600
2,000/5,000 = 0.400
Reciprocal Allocation Method
• Before allocating any costs to the production
departments, determine the reciprocal
allocation between service departments:
– Power’s total cost is $320,000 + 20% of the
total cost of Engineering (P=320,000+.20E)
– Engineering’s total cost is $180,000 + 12.5% of
the total cost of Power (E=180,000+.125P)
• Solve the simultaneous equations by
substitution
Reciprocal Allocation Method
•
•
•
•
•
•
•
•
•
P=320,000+.20E, with E=180,000+.125P
P=320,000+.20(180,000+.125P)
P=320,000 + 36,000 + .025P
.975P=320,000 + 36,000
P= $ 365,128
These costs will be
E=180,000+.125P
E=180,000+.125(365,128)
E=180,000+45,641
E= $ 225,641
allocated to the
production
departments using
the allocation ratios
shown previously
Reciprocal Allocation Method
Service
Departments
Item
Power
Production
Departments
Engineering Machining Assembly
Directly
identified costs
$320,000
$180,000
$120,000
$80,000
Cost Allocations:
Power
Engineering
(365,128)
45,128
45,641
(225,641)
219,077
90,256
100,410
90,257
$0
$0
$ 429,333
Totals
($320,000 + 45,128) * 0.600 = $ 192,000
($180,000 + 45,641) * 0.400 = $ 110,000
Totals
$700,000
$ 270,667 $ 700,000
Reciprocal Allocation Method
• The power department’s total costs were higher
because it also consumed some engineering
services
• Because the machining department consumed a
relatively larger amount of power, the costs
allocated to it were higher in this case
• Only the allocations were different; the total
amount of costs did not change as a result of
using a different allocation method
Final Word on Two-Stage Allocation
• The two-stage allocation method assumes
the absence of a strong direct link between
the support activities and the products
manufactured
• Activity-based costing rejects this
assumption and assumes that cost drivers
directly link the activities performed to the
products manufactured and measure the
average demand placed on each activity by
the various products