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TraditionalCost 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 Price AmountBar steel stock 3” 3,600 lbs $11.30 $40,680Subassembly 1,500 39.00 58,500Total direct materials $99,180
Job Bid Sheet
• Panel 3 lists the amount of direct labor required for the job
Labor Hours Rate AmountLathe operators 480 $26.00 $12,480Assembly workers 900 18.00 16,200Total direct labor 1,380 $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 49,680
Total support costs $73,680
Job Bid Sheet
• Panel 5 summarizes the total costs estimated for the job
Direct material $ 99,180Direct labor 28,680Support costs 73,680Total costs $201,540
Job Bid Sheet
• A markup rate is applied to translate the estimated cost into a bid price
Total costs $201,540Add 25% markup 50,385Bid price $251,925Unit cost $134.36Unit price $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 long-term 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, semi- continuously, 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 DepartmentCost 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 setup
• Production engineering
• Production scheduling
– All service department costs are indirect support activity costs because they do not arise from direct production activities
• Machine maintenance
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 EXAMPLEStep 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
300,000 / 1,200,000 = 0.250
Based on relative allocation basis value
Allocation ofService 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 unit-related 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 inA 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 inA 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 second-stage 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 ReciprocalAllocation 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
Production Departments
Item Power 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
Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000
480,000/800,000 = 0.600
2,000/4,000 = 0.500
Sequential Allocation Method
Service Departments
Production Departments
Item Power Engineering Machining Assembly Totals
Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000
Cost Allocations:
Power
Engineering
(320,000)
0
40,000
(220,000)
192,000
110,000
88,000
110,000
Totals $ 0 $ 0 $ 422,000 $ 278,000 $ 700,000
$320,000 * 0.600 = $ 192,000
($180,000 + 40,000) * 0.500 = $ 110,000
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 MethodService
DepartmentsProduction
Departments
Item Power 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
Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000
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
• E=180,000+.125P• E=180,000+.125(365,128)• E=180,000+45,641• E= $ 225,641
These costs will be allocated to the production departments using the allocation ratios shown previously
Reciprocal Allocation MethodService
DepartmentsProduction
Departments
Item Power Engineering Machining Assembly Totals
Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000
Cost Allocations:
Power
Engineering
(365,128)
45,128
45,641
(225,641)
219,077
90,256
100,410
90,257
Totals $ 0 $ 0 $ 429,333 $ 270,667 $ 700,000
($320,000 + 45,128) * 0.600 = $ 192,000
($180,000 + 45,641) * 0.400 = $ 110,000
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