Product Costing Job Order Process Costing Allocates costs to products that are readily identifiable Average costs over large number of nearly identical units Common in construction, print shops, unique goods Common in chemical, textiles, lumber, glass, food processing Accumulate costs for specific jobs Accumulate costs by departments Produce for sale Produce for inventory Job-Order versus Process Costing Job-Order Costing Direct materials Direct labour Factory overhead Process Costing Job 100 Job 101 Finished Goods Inventory Cost of Goods Sold Finished Goods Inventory Cost of Goods Sold Job 102 Process A Direct materials Direct labour Process B Factory overhead Process C Similarities Between Job-Order and Process Costing • Both systems assign material, labour and overhead costs to products and they provide a mechanism for computing unit product cost. • Both systems use the same manufacturing accounts, including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods. • The flow of costs through the manufacturing accounts is basically the same in both systems. Differences Between Job-Order and Process Costing • • • • Process costing is used when a single product is produced on a continuing basis or for a long period of time. Job-order costing is used when many different jobs are worked on each period. Process costing systems accumulate costs by department. Job-order costing systems accumulated costs by individual jobs. Process costing systems use department production reports to accumulate costs. Job-order costing systems use job cost sheets to accumulate costs. Process costing systems compute unit costs by department. Job-order costing systems compute unit costs by job on the job cost sheet. Process Costing Process costing is used when all products are identical such as soda drinks and breakfast cereal Process costing systems use two different cost terms: – Direct material – Conversion costs—all manufacturing costs that are not direct material costs © 2012 Pearson Prentice Hall. All rights reserved. Equivalent Units of Production Equivalent units are the product of the number of partially completed units and the percentage completion of those units. We need to calculate equivalent units because a department usually has some partially completed units in its beginning and ending inventory. Equivalent Units – The Basic Idea Two half completed products are equivalent to one completed product. + = So, 10,000 units 70% complete are equivalent to 7,000 complete units. 1 Compute and Apply Costs The formula for computing the cost per equivalent unit is : Cost per equivalent = unit Cost of beginning work in process + Cost added during inventory the period Equivalent units of production Compute and Apply Costs Beginning work in process: Materials: 55% complete Conversion: 30% complete 200 units $ 9,600 5,575 Production started during May 5,000 units Production completed during May 4,800 units Costs added to production in May Materials cost Conversion cost Ending work in process Materials: 40% complete Conversion: 25% complete $ 368,600 350,900 400 units Weighted-Average Example Double Diamond Skis reported the following activity in Shaping and Milling Department for the month of May: Percent Completed Shaping and Milling Department Beginning work in process Units 200 Materials Conversion 55% 30% Units started into production in May 5,000 Units completed during May and transferred to the next department 4,800 100% 100% 400 40% 25% Ending work in process Weighted-Average Example Materials Units completed and transferred to the next department 4,800 Conversion 4,800 Work in process, June 30: 400 units × 40% 160 400 units × 25% Equivalent units of Production in during the month of May 100 4,960 4,900 Compute and Apply Costs Here is a schedule with the cost and equivalent unit information. Total Cost Cost to be accounted for: Work in process, May 1 Costs added in the Shipping and Milling Department Total cost Equivalent units $ 15,175 Materials Conversion $ $ 9,600 5,575 719,500 368,600 350,900 $ 734,675 $ 378,200 $ 356,475 4,960 4,900 Cost per equivalent unit $ 76.25 Total cost per equivalent unit = $76.25 + $72.75 = $149.00 $ 72.75 $356,475 ÷ 4,900 unitsunits = $72.75 $378,200 ÷ 4,960 = $76.25 Computing the Cost of Units Transferred Out Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 $ 715,200 Activity-Based Cost Systems Chapter 5 © 2012 Pearson Prentice Hall. All rights reserved. Traditional Costing Also called cost smoothing or peanut butter costing Spread the costs of conversion uniformly among products and services Appropriate if: – Indirect costs are a small proportion of total costs – Activities are consumed uniformly in the production process Inappropriate otherwise: leads to overcosting and undercosting of products and services Copyright 2010 Pearson Education Canada Traditional Manufacturing Costing Systems Typical volume-based cost drivers include: – Direct labor hours – Machine hours – Direct labor dollars Adequate for companies with high-volume products with similar production volumes and batch sizes Can lead to product cost distortion in an environment of high product variety © 2012 Pearson Prentice Hall. All rights reserved. Traditional Cost System Direct Material Costs Direct Labour Costs Overhead Costs Direct Trace Direct Trace DLH Allocation Products ABC Cost System Overhead Costs Direct Material Costs Direct Labour Costs Direct Trace Direct Trace Machining activity costs Assembly activity costs Inspection activity costs Processing Hours # of parts # of inspections Products Activity-Based Cost Systems Activity-based cost systems have been developed to eliminate distortion Time-driven activity-based costing systems (TDABC or Time-Driven ABC) estimate two parameters and then assign indirect costs similar to the way direct costs are assigned © 2012 Pearson Prentice Hall. All rights reserved. TDABC – First Parameter Cost rate for each type of indirect resource – Identify all costs incurred to supply the resource – Identify the practical capacity supplied by the resource – Determine the capacity cost rate of the resource by dividing its cost by the practical capacity Capacity Cost of capacity supplied = cost rate Practical capacity of resources supplied © 2012 Pearson Prentice Hall. All rights reserved. Capacity Cost Rate Example Assume that indirect labor employees supply 2,500 hours of labor in total each quarter at a cost of $84,000 The practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity of: Indirect labor cost per hour = $84,000 2,000 hours = $42 per hour © 2012 Pearson Prentice Hall. All rights reserved. TDABC – Second Parameter Estimation of how much of each resource’s capacity is used by the activities performed to produce the products and services © 2012 Pearson Prentice Hall. All rights reserved. Time-Driven ABC Use parameter estimates to assign indirect costs: Cost of using resource i by product j = Capacity cost rate of resource i x Quantity of capacity of resource i used by product j © 2012 Pearson Prentice Hall. All rights reserved. TDABC Profitability Report Managers may use insights from TDABC cost analysis to improve operations Possible actions include: – Reduce setup times – Reduce time required for purchasing – Reduce time required for scheduling production orders – Increase prices on unprofitable products – Impose minimum customer order sizes – Make decisions on desired product mix © 2012 Pearson Prentice Hall. All rights reserved. Measuring the Cost of Unused Resource Capacity Activity cost driver rates are frequently but incorrectly calculated based on capacity actually used; this leads to: – rates that are too high – the cost of unused capacity being applied to products actually produced © 2012 Pearson Prentice Hall. All rights reserved. Cost of Unused Capacity The cost of unused capacity should not be assigned to products produced or customers served during a period The cost of unused capacity remains someone’s, or some department’s, responsibility Usually you can assign the cost of unused capacity after analyzing the decision that authorized the level of capacity supplied Such an assignment is done on a lump-sum basis; it will not be assigned to individual units of products © 2012 Pearson Prentice Hall. All rights reserved. Activity-Based Costing Systems Three things to consider to improve an existing costing system: 1. Direct-cost tracing – 2. Indirect-cost pools – 3. Reduce indirect costs by classifying more costs as direct Expand the number of indirect-cost pools until the costs in each pool are homogeneous – the amount varies directly as activity varies Activity-cost drivers – – A measure of the activity performed for each cost driver The denominator that is divided into the indirect cost pool to calculate the activity cost rate Copyright 2010 Pearson Education Canada Define Activities, Activity Cost Pools, and Activity Measures At Classic Brass, the ABC team, selected the following activity cost pools and activity measures: Define Activities, Activity Cost Pools, and Activity Measures Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools. Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Traced Traced Traced Overhead Costs Cost Objects: Products, Customer Orders, Customers Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Overhead Costs First-Parameter Allocation Order Size Customer Orders Product Design Customer Relations Cost Objects: Products, Customer Orders, Customers Other Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Overhead Costs First-Parameter Allocation Customer Orders Order Size Product Design Customer Relations Other Second-Parameter Allocations $/Order $/Design $/MH $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated Calculate Activity Rates Assigning Overhead to Customers ABC at Service Companies Although ABC had its origins in manufacturing companies, many service organizations today are obtaining great benefits from this approach – In practice, the actual construction of an ABC model is nearly identical for both types of companies – This should not be surprising since, in manufacturing companies, the ABC system focuses on the “service” component of the company © 2012 Pearson Prentice Hall. All rights reserved. ABC at Service Companies Service companies in general are ideal candidates for activity-based costing – Virtually all costs are indirect and appear to be fixed – They often do not have direct, traceable costs to serve as convenient allocation bases – They must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period © 2012 Pearson Prentice Hall. All rights reserved.