Module 3: Traditional Costing Systems Flashcards
manufacturing costs are classified into 3 groups:
direct materials, direct labour, manufacturing overhead
how are direct costs assigned?
to appropriate cost object
how are indirect costs assigned?
collected into cost pools and then allocated to cost objects in a reasonable way and should reflect cause and effect relationship between long run use of a capacity resource by a cost object and the associated cost of that long run use
why do we use predetermined indirect cost rates?
because indirect total costs for the year are not known until after the year-end
how do we try to choose a cost driver?
one that best explains the long run behaviour of the indirect cost
4 commonly proposed activity levels used to compute cost driver rate
actual level of operations, planned, average, and practical capacity level of operations
explain actual level of operations
1) developed after completion of period by dividing actual indirect costs by actual level of cost driver
2) called actual costing
explain planned level of operations
1) planned indirect costs / planned level of cost driver
2) attempts to allocate all planned indirect costs
3) concerned with providing “accurate” costs
explain avg level of operations
1) avg use of capacity is the likely activity rate used to justify the acquisition of capacity,
2) would seem to reflect the economic basis for the level and cost of capacity
3) uses planned cost
explain practical capacity level of operations
1) provides clear decision-making insights and incentives related to dealing with the cost of idle capacity.
2) Estimating practical capacity begins with an estimate of the theoretical capacity available.
3) Subtract capacity that is not available.
- > Machines: equipment downtime for maintenance
- > Labor: vacation time, breaks, training
explain production process
beginning WIP, direct materials, direct labour, overhead -> production process -> ending WIP, units completed and transferred out
what does ending WIP become?
beginning WIP next period
5 steps to process costing
1) Identify the physical flow + percentage of completion
2) Compute equivalent units of production
3) Accumulate production costs
4) Compute production costs per equivalent unit of production
5) Allocate the production costs to ending WIP and goods completed and transferred out
template to identify physical flow in a problem and to compute equivalent units of materials and conversion
1) percentage completion of ending inventory
2) opening WIP
3) started this period
4) units to account for
5) completed and transferred out (EU and physical units of materials and conversion costs)
6) ending WIP (EU and physical units of materials and conversion costs)
7) units to account for
8) work done this period (EU of materials and conversion costs)
template to identify total materials and conversion costs to account for
1) cost in opening inventory (total production cost, material and conversion cost)
2) cost incurred this period (total production cost, material and conversion cost)
3) cost incurred to date (total production cost, material and conversion cost)
template to Allocate the production costs to ending WIP and goods completed and transferred out
1) WIP ending inventory and completed and transferred out
-> material (EU * production cost per equivalent unit of production)
-> conversion cost (EU * conversion cost per equivalent unit of production)
-> total cost of work in process
Total: total cost accounted for should be cost incurred to date
explain cost flows in organizations (what management accounting systems should reflect and the different patterns of cost flows)
In order to compute product costs, management accounting systems should reflect the actual cost flows in an organization.
define finished goods inventory
The costs of the resources for completed units that are not yet sold.
Explain cost flows in manufacturing organizations (first 3 steps)
1) materials are withdrawn from raw materials inventory as production begins
2) costs (direct materials) are moved from raw materials account to WIP account
3) manufacturing operation consumes labour and overhead items and these costs are added to WIP inventory
explain cost flows in organizations (the different patterns of cost flows and effect)
Manufacturing, retail, and service organizations have different patterns of cost flows resulting in different management accounting priorities.
explain cost flows in manufacturing organizations (last 3 steps)
4) When manufacturing is completed, the costs are transferred from work in process to the finished goods account
5) At this stage the goods are finished and are ready for sale.
6) When the goods are sold, their costs are moved from the finished goods account on the balance sheet to the cost of goods sold account on the net income statement.
graph of cost flows in manufacturing organizations
direct materials + direct labour + manufacturing overhead items -> work in process -> finished goods inventory -> cost of goods sold
graph of cost flows in retail organizations
purchases + overhead items -> store inventory -> cost of merchandise/goods sold when sale is made
examples of overhead items in retail organizations
depreciation, lighting, labor, heating
primary focus in retail organizations
profitability of product lines or departments.
graph of cost flows in service organizations
employee hours + overhead items -> project -> project cost
what is the major expense in service organizations?
employee pay
what is focus on in service organizations?
determining cost of a project or service
explain cost system distortions in service organization and why?
potential for cost system distortions is less for a service organization than a manufacturing operation because major expense is employee pay and that can be easily assigned to different projects/services
define: cost object
anything for which a cost is computed
examples of cost objects
activities, products, product lines, departments, or even entire organizations
what is a consumable resource also called?
flexible resource, variable cost
define consumable resource
cost depends on amount of resource used; resource consumed as a result of an activity
examples of consumable resource
wood in a furniture factory
define capacity-related resource
1) cost depends on amount of resource capacity that is acquired and not how much of the capacity is used
2) resource is acquired and paid for in advance of work being done
3) provides organization with capacity to make products/deliver services
what are capacity-related resources often called?
fixed costs
how are costs first classified in cost systems?
direct or indirect
what determines classification of a resource as either direct or indirect?
context specific, what the cost object is
define direct cost
cost that is uniquely and unequivocally attributable to a single cost object
what cost classification is almost all variable costs?
direct cost
define indirect cost
a cost that is not classified as direct; The cost of a resource that organizations acquire to be used by more than one cost object
examples of indirect cost
most capacity-related costs; wage paid to a supervisor in a factory that makes different products
explain 2 structures for indirect cost pools in manufacturing
1) The simplest structure in a manufacturing system is to have a single indirect cost pool for the entire manufacturing operation.
2) Indirect cost pools may have separate pools for variable and fixed manufacturing overhead costs.
define fixed manufacturing overhead
fixed indirect costs in factory setting; cost of providing production capacity in a factory
examples of fixed manufacturing overhead
depreciation on factory equipment, supervisory salaries
define: variable overhead
cost of items that are actually direct costs but are too immaterial (in relation to total product cost) to trace to individual cost objects
examples of variable overhead
glue, thread
what is variable overhead also called
indirect materials
explain the 2 indirect cost pools
1) one indirect cost pool collects the actual indirect costs incurred for the period
2) a second indirect pool accumulates the indirect cost that has been applied/allocated to production for the same period
why do we use predetermined indirect cost rates?
because the total indirect costs for the year are not known until after the year-end, organizations allocate indirect costs to production during the year using predetermined indirect cost rates.
what is the first step and second step in predetermined overhead rates?
1) Determine the cost driver that will be used to allocate the indirect costs to production
2) the estimated total factory indirect costs are divided by the practical capacity in cost driver units to compute the predetermined overhead rate.
why do organizations use multiple indirect cost pools?
to more accurately cost the resources used by the cost object.
what is one of the most important choices in costing system design and what does it require?
design of indirect cost pools, requires understanding of manufacturing system
other names for overhead rates
1) predetermined indirect cost rate
2) cost driver rate
cost driver rate/overhead rate formula
estimated total factory indirect cost (overhead cost) / practical capacity in cost driver units
define: predetermined overhead rate/cost driver rate
used to apply overhead to cost objects; The amount determined by dividing the activity expense by the total quantity of the activity cost driver (practical capacity)
define: practical capacity
The maximum amount of work that can be performed by resources supplied for production or service
define improvement in costing
the ability of the costing system to more accurately reflect the cause-and-effect relationship between the cost object and the cost of the resources used by the cost object.
2 widely used alternatives for designing multiple indirect cost pools
1) base them on organizational units, such as departments
2) or activities/processes, like manufacturing
how can cost distortions arise?
when indirect cost pools include costs that have different cost drivers
why do we use planned not actual level of capacity related costs in computing the cost driver rate?
1) the annual actual capacity-related costs are not known until the end of the the accounting period
2) using planned rather than actual capacity-related costs set a benchmark against which to compare actual capacity-related costs at the end of the accounting period
what must we do with actual and applied capacity costs?
reconcile them at year-end
3 ways to reconcile the differences in actual and applied indirect cost pools (actual > applied)
1) charge difference directly to COGS
2) prorate the differences to the ending balances in WIP inventory, finished goods inventory, and COGS based on the ending % balances of these accounts
3) decompose the difference into the difference between
- actual and budgeted indirect costs
- budgeted and applied indirect costs
and add/or subtract to COGS
define: work in progress inventory
The costs of the resources for production not yet completed
problem with actual level of operations
many accountants reject this approach because it disguises managerial insights that the other approaches provide and because all costs are estimates
problem with planned level of operations
1) most of the indirect costs are fixed; when the planned level of production changes, so does the cost driver rate, making it seem that the product cost has changed even if total fixed cost has not changed
2) When demand decreases, the cost driver rate will increase, making it seem that product cost has increased. Increasing the price in response can lead to cycle of further decreases in demand and increases in the cost driver rate, which will cause a death spiral of continuing decreases in demand
3) cost allocations are estimates, not actual or accurate costs
problem with avg level of operations
1) Buries the cost of idle capacity in product cost.
2) No clear incentive for management to increase its use of idle capacity.
3) This will create a competitive advantage for a competitor that has lower idle-capacity costs.
what is a good rule of thumb to estimate practical capacity?
set practical capacity to 80% of theoretical capacity
define job order costing
approach to costing that estimates costs for specific customers because orders vary
4 steps to job order costing
1) Each job is assigned a unique job order number for collecting costs.
2) The company collects the actual direct material and direct labor used for a specific job.
3) Indirect overhead costs are allocated to the job.
4) Once the work is completed, the collected costs are summarized.
example of job order costing
consulting work, treating patient in hospital, car repair
define process costing
approach to costing that is used when all products are identical; computes cost of manufacturing process
define equivalent units of production
In process costing, cal- culated by multiplying the number of partially completed units by the percentage of completion
2 cost terms used in process costing
1) direct material
2) conversion cost - all manufacturing costs that are not direct material cost
how are equivalent number of units calculated?
1) for completed units, the # of equivalent units = # of physical units
2) partially completed units (units in ending WIP) are converted into equivalent completed units based on level of completed work
3) if all materials are added at beginning of process, 100% of direct materials for unfinished units is in ending WIP
explain material cost per EU
total cost of direct material (cost in opening inventory and cost incurred this period) / EU of material
explain conversion cost per EU
total conversion cost (cost in opening inventory and cost incurred this period) / EU of conversion
what do we use material cost per EU and conversion cost per EU for?
to allocate manufacturing costs to the completed units and ending work in process inventory.
how do we find applied overhead cost?
(Estimated cost / estimated practical capacity) * actual capacity
