Managerial Accounting

2002e
Belverd E. Needles, Jr.
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Santa Fe Community College

Chapter 2
Cost Concepts and
Cost Allocation

LEARNING OBJECTIVES
1.
2.

3.

State how managers use information about

costs in the management cycle.
Identify various approaches managers use to
classify costs.
Define and give examples of the three
elements of product cost and compute a
product unit cost for a manufacturing
organization.

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.

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.

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

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.

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.

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.

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.

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

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.

Classifying Costs

OBJECTIVE 2
Identify various approaches managers
use to classify costs.

Cost Classifications and Their Uses

Common Cost Classifications:
Classification
Traceability
Indirect

Breakdown

Purpose

Direct Control costs by tracing

costs to a cost object

BehaviorVariable Calculate number of units that must be sold to obtain a

certain profit.
Fixed
Activity Based
Value adding
Non-value adding
Financial Reporting
statements.
Period

Identify the costs that add value to the consumer.

Product Classify costs for the

preparation of financial

Overview of Cost Classification

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.

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.

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.

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.

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

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.

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.

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.

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

Relationships Among Product Costs

Discussion
Q. What are the three elements of
product cost?
A.

1. Direct materials costs.

2. Direct labor costs.
3. Manufacturing overhead
costs.

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
Vendors 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

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.

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

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

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

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
Balance 12/31/x4
$15,000

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

Manufacturing Cost Flow

Finished Goods
Inventory Account
Balance 12/31x3: Sold during 20x4:
$6,000
$24,000
Completed
during 20x4:
30,000
Balance
12/31/x4:
$12,000

Cost of Goods Sold

Account
Sold during
20x4:
$24,000

Discussion
Q. What are the three manufacturing
inventory accounts?

A. 1. Materials Inventory.
2. Work in Process Inventory.
3. Finished Goods Inventory.

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.

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.

Cost of Goods Manufactured

The

cost of goods manufactured is

used on the income statement to
compute the cost of goods sold.

Statement of
Cost of Goods Manufactured: Step 1
Angelos 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

$10,000
20,000
$30,000
5,000
$25,000

Statement of
Cost of Goods Manufactured: Step 2
Angelos 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.

Statement of
Cost of Goods Manufactured: Step 3
Angelos 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

$43,000
2,000
$45,000
15,000
$30,000

Income Statement
Angelos 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
24,000
$26,000
16,000
$10,000

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
period.
3. Compute cost of goods manufactured,
adjusting for beginning and ending
work in process.

the

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.

Cost Allocation

A cost object is a:
product
process
department
activity

that the organization wishes to cost.

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.

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.

Manufacturing
Overhead Allocation

The process of manufacturing

overhead allocation includes four
steps:
1.

Planning.

2.

Application.

3.

Recording actual costs.

4.

Reconciliation.

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

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

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

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

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.

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

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.

Discussion
Q.

What are the four steps in the

manufacturing overhead
allocation process?

A.

1. Planning.

2. Application.
3. Recording actual costs.
4. Reconciliation.

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.

Normal Costing Method

The

normal costing method applies

manufacturing overhead costs to a
products cost by:
Estimating

a predetermined
manufacturing overhead rate, and

Multiplying

that rate by the actual level

of the cost driver consumed by that
product.

Traditional Activity Bases

Traditional

activity bases are volumerelated bases such as:

Direct

labor hours.

Direct

labor costs.

Machine
Units

hours.

of production.

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.

Using the Traditional Approach to Assign Manufacturing

Overhead Costs to Production

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

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

12.50

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

5,000
15.00

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

Discussion
Q.

What are some traditional activity bases?

A.

1. Direct labor cost.

2. Direct labor hours.
3. Machine hours.
4. Units of production.

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.

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

products cost by multiplying the cost pool
rate by the actual cost driver amount.

ABC Systems

ABC systems assign costs to cost objects

based on each cost objects 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.

Using ABC to Allocate Manufacturing Overhead Cost to Production

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.

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.

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

Step 1: (contd)
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 =

$2 per machine hour

Step 2: Apply Overhead Costs to Production

Regular Suitcase
Activity Cost Rate

Cost Driver Level

Cost Applied

$100 per setup

300 setups

$30,000

$120 per inspection

150 inspections

$18,000

$25 per packaging hr X

600 packaging hours =

$15,000

4000 machine hours =

$8,000

$2 per machine hr

Total

$71,000

10,000 units

$7.10

Step 2: Apply Overhead Costs to Production

(contd)
Deluxe Suitcase
Activity Cost Rate

Cost Driver Level

Cost Applied

$100 per setup

400 setups

$40,000

$120 per inspection

350 inspections

$42,000

$25 per packaging hr

1,400 packaging hrs =

$35,000

$2 per machine hr

6,000 machine hrs

$12,000

Total $129,000

5,000 units

$25.80

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

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.

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.)

Discussion

Q. What is the most important cost

in a service organization?
A. Professional labor cost.

OK, LETS REVIEW . . .

1.
2.
3.

State how managers use information about

costs in the management cycle.
Identify various approaches managers use
to classify costs.
Define and give examples of the three
elements of product cost and compute a
products unit cost for a manufacturing
organization.

WE ALSO COVERED . . .
4.

5.

6.

Describe the flow of product-related activities,

documents, and costs through the Materials
Inventory, Work in Process Inventory, and
Finished Goods Inventory accounts.
Prepare a statement of cost of goods
manufactured and an income statement for a
manufacturing organization.
Define cost allocation and explain the process of
manufacturing overhead allocation using cost
objects, cost pools, and cost drivers.

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.