Atkinson, Solutions Manual t/a Management Accounting, 6E
Chapter 4
Accumulating and
Assigning Costs to
Products
QUESTIONS
The cost of the raw materials entered into production is moved from the raw
materials account to the work-in-process inventory account. The cost of
manufacturing labor and overhead items are assigned to production by
adding them to the work-in-process inventory account. Overhead costs are
assigned (or allocated or apportioned) as determined by the cost system.
When manufacturing is completed, work is transferred to finished goods
inventory, and costs are moved from the work-in-process inventory account
to the finished goods inventory account. Finally, when goods are sold their
costs are moved from the finished goods inventory account to cost of goods
sold.
Manufacturing organizations face greater challenges in product costing,
especially the assignment of overhead costs, than retail or service
organizations do. The basic idea behind all manufacturing costing systems is
to determine the costs that products accumulate as they consume
organization resources during manufacturing, as described above in 4-1. In
retail organizations, goods are purchased rather than manufactured; the cost
of the goods purchased is entered into an account that accumulates the cost
of merchandise inventory in the store. Stores incur various overhead costs
such as labor, depreciation on the store, lighting, and heating. The primary
focus in retail operations is the profitability of product lines or departments.
Therefore, retail organizations, like manufacturing operations, face the issue
of how to allocate various overhead costs to determine, for example, the cost
of purchasing and selling products, or department costs.
Service organizations that undertake major projects, such as in a
consultancy, focus on determining the cost of a project. In such situations,
the major direct cost, employee pay, is often a large proportion of the
project’s cost. The organization will also assign various overhead costs to
determine project profitability
– 102 –
,Atkinson, Solutions Manual t/a Management Accounting, 6E
A cost object is anything for which a cost is computed. Examples of cost objects
are activities, products, product lines, customers, patients, departments, or
even entire organizations.
The defining characteristic of a consumable (flexible) resource is that its cost
depends on the amount of resource that is used. Examples of consumable
resources are wood in a furniture factory, fabric in a clothing factory, and
iron ore in a steel mill. The cost of a consumable resource is often called a
variable cost because the total cost depends on how much of the resource is
consumed. The contrasting defining characteristic of a capacity-related
resource is that its cost depends on the amount of resource capacity that is
acquired and not on how much of the capacity is used. As the size of a
proposed factory or warehouse increases, the associated capacity-related cost
will increase. Examples of capacity-related costs are depreciation on
production equipment (the capacity-related resource) and salaries paid to
employees (the capacity-related resource) in a consultancy. The cost of a
capacity-related resource is often called a fixed cost because the cost of the
resource is independent of how much of the resource is used.
Direct and indirect costs are specified in relation to distinct cost objects. A direct
cost is a cost that is uniquely and unequivocally attributable to a single cost
object. If the cost fails the test of being direct it is classified as indirect with
respect to the designated cost object. For example, if the cost object is a unit
of product, then direct material (e.g., wood, steel) and direct labor are direct
costs, and manufacturing overhead costs (e.g., factory rent, supervisors’
salaries) are indirect costs. However, if a department within a plant is the
chosen cost object, then the department manager’s salary is a direct cost for
the department (assuming the manager only manages that department) and
the cost of heat for the plant is an indirect cost.
From the time of the Industrial Revolution until the early 20th century,
manufacturing operations were mainly labor paced and direct costs
comprised the majority of product costs. Since then indirect costs in the form
of automation have gradually replaced labor costs and, for many products,
are now the major component of total product costs. This increased use of
indirect costs in manufacturing has increased the need for costing systems to
deal adequately with indirect manufacturing costs.
In the context of computing a predetermined indirect cost rate, a cost driver is
the basis used to allocate indirect costs to production. Once the cost driver is
chosen, cost analysts divide expected indirect factory costs by the number of
cost driver units to compute the predetermined indirect cost rate. Cost
analysts try to choose a cost driver that best explains the long-run behavior
– 103 –
, Chapter 4: Accumulating and Assigning Costs to Products
of the indirect cost. In a labor-intensive environment the cost driver of
indirect costs in the factory might be labor hours as factory workers use
factory space, utilities, and other overhead resources to make products. In a
machine-intensive environment the cost driver of indirect costs in the factory
might be machine hours because machines consume electricity, lubricant,
and other supplies to make products.
In practice, predetermined indirect cost rates are commonly called
predetermined overhead rates or cost driver rates.
Costs need to be estimated for individual jobs in order to bid for them and to
price them competitively. Costs may differ across individual jobs because
jobs may differ in their materials content, the hours of labor required to
manufacture them, and in the demand they place on capacity-related
resources. Estimated costs are also useful for comparison with actual costs
for management control purposes.
Indirect cost rates (also called predetermined indirect cost rates,
predetermined overhead rates, or cost driver rates) are determined by
dividing expected indirect factory costs by the number of cost driver units.
Overhead cost for a job is estimated by multiplying the cost driver rate(s) by
the number of units of the cost driver(s) associated with the job.
Indirect cost pools collect overhead costs into separate groups, for each of
which a separate cost driver rate is associated.
Most organizations use multiple indirect cost pools in order to improve
costing. Cost distortions arise when an indirect cost pool includes costs with
different cost drivers and where different products use the capacities
underlying the indirect costs differentially. (The increase in measurement
costs for a more detailed cost system, however, must be traded off against
the benefit of increased accuracy in estimating product costs.)
Determination of cost driver rates based on planned or actual short-term
usage will result in rates that are too high in periods of low demand and that
are too low in periods of high demand. Thus, product costs are distorted in
such a costing system. If management uses cost-plus pricing, a death spiral
can result, as follows. If expected demand goes down, the cost driver rate
will increase, causing the cost-plus price to increase. Increasing prices cause
demand to fall, which leads to further price increases as the cost driver rate
increases the cost-plus price.
– 104 –
, Atkinson, Solutions Manual t/a Management Accounting, 6E
Unlike direct material costs and direct labor costs, overhead costs cannot be
traced easily to each job. When actual costs are recorded for a job during the
course of a fiscal period, the total overhead costs for the period and
consequently, the actual cost driver rate is not yet determined. Therefore,
costs are applied to jobs using predetermined rates.
Yes. A separate cost driver rate should be determined for each cost pool when
multiple cost drivers (where ―cost driver‖ refers to a cause of costs, as
discussed in Chapter 3) are involved, or else job cost estimates may be
distorted. The increase in measurement costs for a more detailed cost system,
however, must be traded off against the benefit of increased accuracy in
estimating product costs. Though not covered in the textbook, students may
note that if the different cost drivers vary together in the same proportion
(for example, if machine hours and direct labors hours are used in the same
proportions as the total number of units increases), then any one of them will
be sufficient.
The three options for dealing with the difference between actual and applied
capacity (overhead) costs are: (1) Charge the difference to cost of goods sold;
(2) Prorate the difference to work in process, finished goods, and cost of
goods sold; (3) Decompose the difference into two parts: the difference
between actual and budgeted indirect costs, and the difference between
budgeted and applied indirect costs.
Computing the cost driver rate by using the planned level of the cost driver will
result in rates that are too high in periods of low demand and that are too
low in periods of high demand. If management uses cost-plus pricing, a
death spiral can result, as follows. If expected demand goes down, the cost
driver rate will increase, causing the cost-plus price to increase. Increasing
prices cause demand to fall, which leads to further price increases as the cost
driver rate increases the cost-plus price. This cycle can continue until there is
no further demand, hence the term ―death spiral.‖
Estimating practical capacity begins with an estimate of theoretical capacity.
Suppose a machine is nominally available for 100 hours each week. That is,
theoretical capacity is 100 hours each week. A common rule of thumb is to
allow about 20% of theoretical capacity or, in this case, 20 hours for
activities such as maintenance, setup, and repair. In the case of labor hired
for the year, theoretical capacity is 2,080 hours (52 weeks, 40 hours per
week). However, workers on average have 3 weeks off and, with breaks,
work about 35 hours per week. Therefore, practical capacity is 1,715 hours
(49 weeks, 35 hours per week). In this case practical capacity is about 82%
– 105 –
Chapter 4
Accumulating and
Assigning Costs to
Products
QUESTIONS
The cost of the raw materials entered into production is moved from the raw
materials account to the work-in-process inventory account. The cost of
manufacturing labor and overhead items are assigned to production by
adding them to the work-in-process inventory account. Overhead costs are
assigned (or allocated or apportioned) as determined by the cost system.
When manufacturing is completed, work is transferred to finished goods
inventory, and costs are moved from the work-in-process inventory account
to the finished goods inventory account. Finally, when goods are sold their
costs are moved from the finished goods inventory account to cost of goods
sold.
Manufacturing organizations face greater challenges in product costing,
especially the assignment of overhead costs, than retail or service
organizations do. The basic idea behind all manufacturing costing systems is
to determine the costs that products accumulate as they consume
organization resources during manufacturing, as described above in 4-1. In
retail organizations, goods are purchased rather than manufactured; the cost
of the goods purchased is entered into an account that accumulates the cost
of merchandise inventory in the store. Stores incur various overhead costs
such as labor, depreciation on the store, lighting, and heating. The primary
focus in retail operations is the profitability of product lines or departments.
Therefore, retail organizations, like manufacturing operations, face the issue
of how to allocate various overhead costs to determine, for example, the cost
of purchasing and selling products, or department costs.
Service organizations that undertake major projects, such as in a
consultancy, focus on determining the cost of a project. In such situations,
the major direct cost, employee pay, is often a large proportion of the
project’s cost. The organization will also assign various overhead costs to
determine project profitability
– 102 –
,Atkinson, Solutions Manual t/a Management Accounting, 6E
A cost object is anything for which a cost is computed. Examples of cost objects
are activities, products, product lines, customers, patients, departments, or
even entire organizations.
The defining characteristic of a consumable (flexible) resource is that its cost
depends on the amount of resource that is used. Examples of consumable
resources are wood in a furniture factory, fabric in a clothing factory, and
iron ore in a steel mill. The cost of a consumable resource is often called a
variable cost because the total cost depends on how much of the resource is
consumed. The contrasting defining characteristic of a capacity-related
resource is that its cost depends on the amount of resource capacity that is
acquired and not on how much of the capacity is used. As the size of a
proposed factory or warehouse increases, the associated capacity-related cost
will increase. Examples of capacity-related costs are depreciation on
production equipment (the capacity-related resource) and salaries paid to
employees (the capacity-related resource) in a consultancy. The cost of a
capacity-related resource is often called a fixed cost because the cost of the
resource is independent of how much of the resource is used.
Direct and indirect costs are specified in relation to distinct cost objects. A direct
cost is a cost that is uniquely and unequivocally attributable to a single cost
object. If the cost fails the test of being direct it is classified as indirect with
respect to the designated cost object. For example, if the cost object is a unit
of product, then direct material (e.g., wood, steel) and direct labor are direct
costs, and manufacturing overhead costs (e.g., factory rent, supervisors’
salaries) are indirect costs. However, if a department within a plant is the
chosen cost object, then the department manager’s salary is a direct cost for
the department (assuming the manager only manages that department) and
the cost of heat for the plant is an indirect cost.
From the time of the Industrial Revolution until the early 20th century,
manufacturing operations were mainly labor paced and direct costs
comprised the majority of product costs. Since then indirect costs in the form
of automation have gradually replaced labor costs and, for many products,
are now the major component of total product costs. This increased use of
indirect costs in manufacturing has increased the need for costing systems to
deal adequately with indirect manufacturing costs.
In the context of computing a predetermined indirect cost rate, a cost driver is
the basis used to allocate indirect costs to production. Once the cost driver is
chosen, cost analysts divide expected indirect factory costs by the number of
cost driver units to compute the predetermined indirect cost rate. Cost
analysts try to choose a cost driver that best explains the long-run behavior
– 103 –
, Chapter 4: Accumulating and Assigning Costs to Products
of the indirect cost. In a labor-intensive environment the cost driver of
indirect costs in the factory might be labor hours as factory workers use
factory space, utilities, and other overhead resources to make products. In a
machine-intensive environment the cost driver of indirect costs in the factory
might be machine hours because machines consume electricity, lubricant,
and other supplies to make products.
In practice, predetermined indirect cost rates are commonly called
predetermined overhead rates or cost driver rates.
Costs need to be estimated for individual jobs in order to bid for them and to
price them competitively. Costs may differ across individual jobs because
jobs may differ in their materials content, the hours of labor required to
manufacture them, and in the demand they place on capacity-related
resources. Estimated costs are also useful for comparison with actual costs
for management control purposes.
Indirect cost rates (also called predetermined indirect cost rates,
predetermined overhead rates, or cost driver rates) are determined by
dividing expected indirect factory costs by the number of cost driver units.
Overhead cost for a job is estimated by multiplying the cost driver rate(s) by
the number of units of the cost driver(s) associated with the job.
Indirect cost pools collect overhead costs into separate groups, for each of
which a separate cost driver rate is associated.
Most organizations use multiple indirect cost pools in order to improve
costing. Cost distortions arise when an indirect cost pool includes costs with
different cost drivers and where different products use the capacities
underlying the indirect costs differentially. (The increase in measurement
costs for a more detailed cost system, however, must be traded off against
the benefit of increased accuracy in estimating product costs.)
Determination of cost driver rates based on planned or actual short-term
usage will result in rates that are too high in periods of low demand and that
are too low in periods of high demand. Thus, product costs are distorted in
such a costing system. If management uses cost-plus pricing, a death spiral
can result, as follows. If expected demand goes down, the cost driver rate
will increase, causing the cost-plus price to increase. Increasing prices cause
demand to fall, which leads to further price increases as the cost driver rate
increases the cost-plus price.
– 104 –
, Atkinson, Solutions Manual t/a Management Accounting, 6E
Unlike direct material costs and direct labor costs, overhead costs cannot be
traced easily to each job. When actual costs are recorded for a job during the
course of a fiscal period, the total overhead costs for the period and
consequently, the actual cost driver rate is not yet determined. Therefore,
costs are applied to jobs using predetermined rates.
Yes. A separate cost driver rate should be determined for each cost pool when
multiple cost drivers (where ―cost driver‖ refers to a cause of costs, as
discussed in Chapter 3) are involved, or else job cost estimates may be
distorted. The increase in measurement costs for a more detailed cost system,
however, must be traded off against the benefit of increased accuracy in
estimating product costs. Though not covered in the textbook, students may
note that if the different cost drivers vary together in the same proportion
(for example, if machine hours and direct labors hours are used in the same
proportions as the total number of units increases), then any one of them will
be sufficient.
The three options for dealing with the difference between actual and applied
capacity (overhead) costs are: (1) Charge the difference to cost of goods sold;
(2) Prorate the difference to work in process, finished goods, and cost of
goods sold; (3) Decompose the difference into two parts: the difference
between actual and budgeted indirect costs, and the difference between
budgeted and applied indirect costs.
Computing the cost driver rate by using the planned level of the cost driver will
result in rates that are too high in periods of low demand and that are too
low in periods of high demand. If management uses cost-plus pricing, a
death spiral can result, as follows. If expected demand goes down, the cost
driver rate will increase, causing the cost-plus price to increase. Increasing
prices cause demand to fall, which leads to further price increases as the cost
driver rate increases the cost-plus price. This cycle can continue until there is
no further demand, hence the term ―death spiral.‖
Estimating practical capacity begins with an estimate of theoretical capacity.
Suppose a machine is nominally available for 100 hours each week. That is,
theoretical capacity is 100 hours each week. A common rule of thumb is to
allow about 20% of theoretical capacity or, in this case, 20 hours for
activities such as maintenance, setup, and repair. In the case of labor hired
for the year, theoretical capacity is 2,080 hours (52 weeks, 40 hours per
week). However, workers on average have 3 weeks off and, with breaks,
work about 35 hours per week. Therefore, practical capacity is 1,715 hours
(49 weeks, 35 hours per week). In this case practical capacity is about 82%
– 105 –
