Product Costing: Chapters 4 & 9

Topic 4 Product Costing

• This topic covers chapters 4 and 9 from the Rohde and Seal et al. textbook.

Learning Objectives

• Understand why a cost accumulation system is important for making informed decisions.
• Learn how to calculate product costs using both traditional and activity-based costing.
• Learn to describe the differences between the two costing systems.

Product Costing

• It involves process costing and job order costing.
• Many different products are produced each period.
• Products are manufactured for order.
• Costs are traced or allocated to jobs.
• Every distinct product or job requires maintained cost records.

Process Costing

• This is used for single-product operations
• All output units are identical.
• Examples: processing paper, mixing, and bottling beverages.
• It provides a general measure of the average costs of the product.
• To calculate full cost must follow certain steps.

Assignment of Direct & Indirect Costs

• Cost Object: anything needing separate cost measurement.
• Direct Costs: Reliably and exclusively identified with a cost object and accurately traced to cost objects.
• Indirect Costs: Not directly traced to a cost object; assigned using cost allocations.

Assigning Direct Costs

• Involves suitable data processing procedures to identify and record the resources consumed by cost objects.
• Direct Labour: Time providing a service/product recorded on source documents such as time sheets/job cards.
• Direct Materials: Source documents for this are materials requisition.

Assigning Indirect Costs

• It involves plant-wide (blanket) overhead rate (PDOR).
• Departmental Rates will be assigned
• Activity Based Costing comes into play

Plant-Wide (Blanket) Overhead Rate - PDOR

• The predetermined overhead rate (POHR) is used to apply indirect costs to jobs.
• POHR determined before the period begins.
• POHR = (Total estimated manufacturing overhead for the coming period) / (Total estimated units in allocation base for the coming period).
• Ideally, the allocation base is a cost driver that causes overhead.

Use of Predetermined Rate

• It allows timely inventory valuation.
• It allows timely determination of selling prices.
• It allows timely determination of product costs.
• It facilitates budgeting/variance analysis.
• It facilitates managerial decision making.
• It prevents monthly fluctuations throughout the year.

Overhead Estimates

• Most likely any estimates are going to be accurate.
• This is due to Actual activity differing from budgeted activity.
• This is due to Actual overhead expenditure differs from budgeted overhead expenditure.
• In each case, overhead charged to each unit differs from the actual amount.

Overhead Application

• Overhead applied = POHR × Actual activity
• It is based on estimates, and determined before the period begins.
• Actual activity is based on the amount of the cost driver, incurred during the period.

Job Costing Usage

• Job Costing can be used to determine the profitability of individual jobs.
• Job Costing can assist with bidding on future jobs.
• Job Costing can evaluate professionals in charge of managing individual jobs.

PearCo Example

• PearCo applies overhead based on direct labour hours.
• Total estimated overhead for the year is €640,000,
• Total estimated labour cost is €1,400,000.
• Total estimated labour hours are 160,000.
• PearCo's predetermined overhead rate per hour calculation is €4.

Overhead Application Example

• PearCo's actual overhead for the year was €650,000.
• The figure is for a total of 170,000 direct labour hours.
• The total overhead applied to PearCo's jobs during the year calculated with PearCo's POHR x Direct Labor Hours.
• Applied Overhead = POHR × Actual Direct labour Hours which equates to €4.00 per DLH × 170,000 DLH = €680,000
• PearCo has over applied overhead for the year by €30,000.

Over Applied Overhead

• €30,000 may be allocated to work process, finished goods, goods sold or closed directly to cost of goods sold.

Adjusting Manufacturing Overhead

• Underapplied Overhead: close to Cost of Goods Sold accounts which increase Cost of Goods Sold, or if using allocation it increases Working Process, Finished Goods, Cost of Goods Sold
• Overapplied Overhead: close to Cost of Goods Sold accounts which decrease Cost of Goods Sold, or if using allocation it decreases Working Process, Finished Goods, Cost of Goods Sold

Tiger, plc. Example

• Tiger, plc. had actual manufacturing overhead costs of €1,210,000.
• The pre set overhead rate of Tiger, was €4.00 per machine hour.
• Tiger, plc. worked 290,000 machine hours during the period.
• Overhead Applied is €4.00 per hour × 290,000 hours = €1,160,000
• Under applied Overhead = €1,210,000 - €1,160,000 = €50,000

Overhead Adjustment Example

• If overhead is under applied, cost of goods sold is understated
• The adjustment will increase cost of goods sold.

Traditional Departmental Costing Systems

• Traditional Costing - Steps
• Allocate all manufacturing overheads to production and service cost centres.
• Reallocate the costs assigned to service cost centres to production cost centres.
• Compute separate overhead rates for each production centre.
• Assigning cost centre overheads to product.

Department Types

• Operating Department: carries out the central purposes of an organization.
• Service Department: provides support that facilitates the activities of operating departments.

Problem

• Allocating costs when service departments provide services to each other.
• Solve it through Direct Method or Step method.

Criticisms of Traditional Overhead Allocation

• Assumes all overhead is volume-related.
• This includes factory-wide or departmental rates that are -All related to single activity measure.
• Departmental focus, not process focus causes issues.
• Focused on costs incurred, not cause of costs.

Activity Based Costing Purpose

• It is an allocation of indirect costs based on causal activities.
• It attempts to identify "direct" link between cost and cost object.
• It results in better allocation
• It does not provide “true” cost.

How Costs are Treated Under Activity-Based Costing

• Plant-wide Overhead Rate is at the base
• Departmental Overhead Rates are next level
• Activity-Based Costing is at the top
• This is the level of complexity.

Product Costs Errors

• Volume-based costing systems (like those using direct labor or machine hours) can be misleading.
• This happens if volume isn't the real driver of indirect costs, the reported costs are misleading.

Activity Based Costing Example

• Products HV (high volume) and LV (low volume)
• HV made in large batches, LV in small batches.
• HV consumes 30% direct labor hours; LV consumes 5% direct labor hours.
• Batch-related costs: each product consumes 15%.
• Traditional system cost driver: direct labor hours; ABC system: number of batches processed.
• All overheads are (total =£1m) are batch-related.

Reported Product Costs

• Traditional System allocates overhead based on direct labor.
• The ABC System allocates Overhead based on batch.
• Traditional system reports misleading information; overheads won't decline by £300K if HV stops.
• The ABC allocates based on cause-and-effect and shows high resource use by LV.
• This Motivate adopting the wrong strategy

Examples of Cost Drivers

• Production is impacted by number of units and number of set-ups
• Marketing is impacted by number of Units and number of sales set ups
• Research & Development- impacted by research projects, personnel spent on project, and technical complexities
• Customer Service- impacted by number of service calls, number of products serviced, hours spent on services

Traditional vs Activity Based Costing Method

• Traditional allocation is from cost to products
• Activity based allocation method has two stage. The first stage goes from costs to activities and the second stage is from activities to products.

Activity Based Costing

• It differs from Traditional Costing in how overhead costs are charged to units.
• ABC charges overhead based on how much each unit consumes of the activity’s driver.
• Two major Key Terms are, Cost Pool and Cost Driver

Activity Based Costing - Steps

• Identify overhead activities
• Decide on prime driver of each overhead activity
• Record overhead activity cost in cost pools and the number of prime drivers for each overhead activity for the period
• Determine the prime driver rates
• Charge overheads to units based on their proportionate consumption of the driver of each separate overhead activity.

Arguments Supporting Activity Based Costing

• ABC provides a more accurate assessment of unit costs
• Underpins the competitive pricing of units on a cost plus basis
• ABC Provides an improved insight into possible cost reductions
• It highlights the cost of overhead activities
• ABC Helps management assess the value added proposition

Arguments Against Activity Based Costing

• It consumes increased resources to identify and record cost pools and cost driver activity
• There are many factors which influence the cost of an overhead activity in addition to the prime driver
• The selection of the prime driver of each activity is subjective
• It is considered as simply an extension of Traditional Costing

Cost Systems Design

• Simplistic Systems are inexpensive, have extensive use of arbitrary cost allocations, have low levels of accuracy and high costs of errors
• Sophisticated Systems are expensive, have extensive use of cause and effective cost allocations, have high levels of accuracy and low costs of errors

Traditional Appropriate When

• Direct costs were the dominant costs
• Indirect costs were relatively small
• Information costs were high
• There was a lack of intense global competition
• A limited range of products was produced.