principles of cost accounting.pdf

 PRINCIPLES OF COST ACCOUNTING This page intentionally left blank  PRINCIPLES OF COST ACCOUNTING 15E E D W A R D J. V A N D E R B E C K Professor Emeritus Department of Accountancy Xavier University Principles of...

 PRINCIPLES OF COST ACCOUNTING This page intentionally left blank  PRINCIPLES OF COST ACCOUNTING 15E E D W A R D J. V A N D E R B E C K Professor Emeritus Department of Accountancy Xavier University Principles of Cost Accounting, 15th Edition ª 2010, 2008 South-Western, Cengage Learning Edward J. VanDerbeck ALL RIGHTS RESERVED. No part of this work covered by the copy- right herein may be reproduced, transmitted, stored or used in any Vice President of Editorial, Business: Jack W. Calhoun form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, Acquisitions Editor: Matt Filimonov Web distribution, information networks, or information storage and Developmental Editor: Lauren Athmer retrieval systems, except as permitted under Section 107 or 108 of the Marketing Manager: Kristen Hurd 1976 United States Copyright Act, without the prior written permission of the publisher. Marketing Coordinator: Heather McAuliffe Content Project Manager: Corey Geissler Production Technology Analyst: Starratt Alexander For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 Media Editor: Scott Fidler For permission to use material from this text or product, submit all Sr. Manufacturing Coordinator: Doug Wilke requests online at www.cengage.com/permissions Production Service: Cadmus Further permissions questions can be emailed to Sr. Art Director: Stacy Shirley [email protected] Internal Designer: Jennifer Lambert, Jen2Design, LLC Cover Designer: cmiller design Library of Congress Control Number: 2009935270 Cover Image: ªGetty Images ISBN-10: 0-8400-3703-1 ISBN-13: 978-0-8400-3703-9 South-Western Cengage Learning, 5191 Natorp Boulevard Mason OH 45040, USA Cengage Learning products are represented in Canada by Nelson Education, Ltd. For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.ichapters.com Printed in the United States of America 1 2 3 4 5 6 7 13 12 11 10 09  PREFACE Why Study Cost Accounting? The 15th edition of Principles of Cost Accounting, in an easily accessible presentation, applies cost concepts, cost behavior, and cost accounting techniques to manufacturing, merchandising, and service businesses. Stu- dents learn how to determine costs of products and services more accu- rately; use the knowledge of product and service costs to set selling prices, to bid on contracts, and to analyze the relative profitability of various products and services; use techniques to measure the performance of managers and subunits within an organization; design an accounting system to fit the production and distribution system of an organization; and use the accounting system as a tool to motivate managers towards the organiza- tion’s goals. What Does the 15th Edition Offer?. Appropriate content for a one-quarter or one-semester cost accounting course.. A ten-chapter format—a distinguishing feature of the text that makes it most appropriate for shorter courses.. Directed assignments at intervals within each chapter.. A very readable and relevant text that covers the essentials of cost accounting in a logical sequence and concise manner.. The inclusion of cost accounting techniques for service businesses.. A discussion of the special purpose reports and analytical techniques used for management decision making.. Emphasis on nonfinancial performance measures via the balanced scorecard.. An increase in the number of end-of-chapter exercises, problems, and Self-Study Problems. vi Principles of Cost Accounting What Is New in the 15th Edition? The 15th edition includes the following changes:. All new chapter-opening vignettes with real-world applications.. Increased use of graphics, including Excel spreadsheet ‘‘screen shots’’ and flow diagrams.. An increase in the number of end-of-chapter self-study problems.. An increased emphasis on ethical decision making in the end-of-chapter Mini-Cases.. Newly added ‘‘real company’’ examples throughout the text.. First-time inclusion of corporate governance, lean manufacturing, de- mand software, and Web-based budgeting.. An integrated illustration of materials control procedures.. An illustration of the least squares regression method using Microsoft Excel. What Are the Features of the 15th Edition? The 15th edition includes several features that facilitate the learning process for the student and allow the instructor to teach with ease. Directed Assignments At specific points within each chapter, students are directed to appropriate end-of-chapter assignments. This allows students to work practice items without completing the entire chapter. Self-Study Problems Two demonstration problems are included at the end of each chapter, with a step-by-step explanation of how to solve them. These Self-Study Pro- blems are constructed from difficult concepts in the chapter and reinforce the techniques and procedures discussed in the chapter. An added feature is end-of-chapter problems that reference students back to Self-Study Pro- blems that are similar in topic and difficulty. End-of-Chapter Materials The end-of-chapter questions, exercises, problems, mini-cases, and Internet activities have been carefully written, revised, added to, and verified to reflect the coverage as it appears in the chapters. There has been a concerted effort to provide the instructor with a wide choice of subject matter and degree of difficulty when assigning end-of-chapter materials. Where appropriate, comprehensive review problems have been added that cover concepts from more than one chapter. Additionally, selected pro- blems may be solved using spreadsheet software.  Preface vii Integrated Learning Objectives Learning objectives begin each chapter. Each learning objective is indicated in the text where first discussed. All end-of-chapter exercises, problems, mini-cases, and Internet activities are identified by learning objectives. Key Terms Key terms are highlighted as they are introduced. They are listed, along with page references, at the end of each chapter. A comprehensive glossary is included at the end of the book, providing definitions for all the key terms. Actual companies are highlighted where their practices are discussed in the chapters. Appendixes The Institute of Management Accountants ‘‘Statement of Ethical Profes- sional Practice’’ is included in an appendix at the end of Chapter 1. An appendix at the end of Chapter 9 illustrates the four-variance and three- variance methods of analyzing factory overhead. What Supplementary Materials Are Available? A complete package of supplementary materials is available with the 15th edition of Principles of Cost Accounting to assist both instructors and students. The package includes materials that have been carefully prepared and reviewed. Available to Instructors All instructor resources are available online on the Instructor Compa- nion Web Site (www.cengage.com/accounting/vanderbeck), as well as on the Instructor Resource CD-ROM (IRCD). Solutions Manual. This manual contains the answers to all end-of-chapter questions, exercises, problems, Internet exercises, and mini-cases. Test Bank. The test bank is available in a computerized version for Windows. The user may select, mix, edit, and add questions or problems to create the type of test or problem set needed. ExamView ProTM Testing Software. The printed test bank is available in a computerized version for Windows. The user may select, mix, edit, and add questions or problems to create the type of test or problem set needed. ExamView is available on the Instructor’s Resource CD. PowerPoint Presentations. This resource provides presentations for each chapter, created specifically for this edition; thus, they follow along closely viii Principles of Cost Accounting with the text. The presentations for each chapter are also available online for students to use as an additional study resource. Instructor Resource CD-ROM (IRCD). This convenient resource includes the Test Bank, ExamView, the Solutions Manual, PowerPoint Presenta- tions, and the Instructor Spreadsheet Templates (with solutions). Instructor Spreadsheet Templates. The Instructor Spreadsheet Templates show the completed spreadsheet solutions for exercises within the end-of- chapter materials. These files are available on the IRCD, or they can be downloaded from the Instructor Companion Web Site. Instructor Companion Web Site (www.cengage.com/accounting/vander- beck). The text-specific Web site provides access to all instructor resources organized by chapter and topic, and are password protected. All of these resources are also available on the IRCD: Test Bank, ExamView, Solutions Manual, PowerPoint Presentations, and the Instructor Spreadsheet Tem- plates (with solutions). Available to Students All student resources are available online on the Student Companion Web Site (www.cengage.com/accounting/vanderbeck). Study Guide. The study guide provides a review summary for each chapter as well as questions and problems to test comprehension of chapter material. Solutions for all questions and problems are included in a separate section at the end of the study guide. Student Spreadsheet Templates. The Student Spreadsheet Templates correlate to exercises within the end-of-chapter materials. These files are available for downloading on the Student Companion Web Site. PowerPoint Presentations. This study resource provides presentations for each chapter, created specifically for this edition; thus, they follow along closely with the text. Experience Accounting Videos. Highlight progressive companies and allow you to effectively visualize critical chapter concepts—enhancing what you learn in class! The Experience Accounting Videos can be bundled at no additional cost with new copies of the text or can be purchased separately. You can access the videos at www.cengage.com/accounting/eav.  Preface ix Acknowledgments We would like to thank all of those individuals who have helped during the revision of this text by providing constructive comments and suggestions. Josephine M. Mathias Mercer County Community College Joanne E. Shurbert Concord’s Community College and Manchester Community College Ann Bikofsky College of West Chester Theresa Laws-Dahl Blackhawk Technical College Sam Lester Middle Georgia Technical College Edward Kufuor ASA Institute Jim Murray Western Technical College David A. Flannery Bryant & Stratton College, Virginia Beach James Emig Villanova University This page intentionally left blank  ABOUT THE AUTHOR Ed VanDerbeck has been a professor of accounting for 32 years and was Chair of the Department of Accountancy at Xavier University, Cincinnati, Ohio, for 24 years. Before retiring in 2008, Professor VanDerbeck special- ized in teaching cost accounting to accounting majors and managerial accounting to undergraduate and MBA students. He has taught at the two-year college level at SUNY–Delhi. He has a BA in Accounting from Binghamton University (formerly SUNY–Binghamton) and an MS in Business Administration from the University of Albany (formerly SUNY– Albany). He is licensed as a CPA (inactive) in the state of Ohio. Professor VanDerbeck has worked as an internal revenue agent, performed a faculty internship at what was formerly the Big Eight accounting firm of Touche-Ross. He has served as a developmental editor and marketing manager for accounting publications with South-Western College Publish- ing. Professor VanDerbeck is an avid tennis player and a student of casino gaming strategies. This page intentionally left blank  BRIEF CONTENTS Chapter 1 Introduction to Cost Accounting 1 Chapter 2 Accounting for Materials 63 Chapter 3 Accounting for Labor 123 Chapter 4 Accounting for Factory Overhead 169 Chapter 5 Process Cost Accounting—General Procedures 237 Chapter 6 Process Cost Accounting—Additional Procedures; Accounting for Joint Products and By-Products 287 Chapter 7 The Master Budget and Flexible Budgeting 337 Chapter 8 Standard Cost Accounting—Materials, Labor, and Factory Overhead 379 Chapter 9 Cost Accounting for Service Businesses and the Balanced Scorecard 447 Chapter 10 Cost Analysis for Management Decision Making 481 Glossary 531 Index 543 This page intentionally left blank  CONTENTS 1 Introduction to Cost Accounting 1 Uses of Cost Accounting Information 4 Determining Product Costs and Pricing, Planning and Control Professional Ethics, CMA Certification, and Corporate Governance 9 Relationship of Cost Accounting to Financial and Management Accounting 10 Costs of Goods Sold, Inventories Elements of Manufacturing Costs 15 Direct Materials, Direct Labor, Factory Overhead, Summary of Manufacturing Costs, Flow of Costs Illustration of Accounting for Manufacturing Costs 18 Cost Accounting Systems 27 Special Order, Continuous or Mass Production, Combination of Systems, Standard Costing Illustration of a Job Order Cost System 30 Work in Process in the Manufacturing Statement IMA Statement of Ethical Professional Practice 36 Principles, Standards, Resolution of Ethical Conflict 2 Accounting for Materials 63 Materials Control 64 Physical Control of Materials, Controlling the Investment in Materials Materials Control Procedures 70 Materials Control Personnel, Control during Procurement, Control during Storage and Issuance Accounting for Materials 79 Determining the Cost of Materials Issued, Accounting Procedures Just-in-Time Materials Control 91 JIT and Cost Control, JIT and Cost Flows Scrap, Spoiled Goods, and Defective Work 97 Scrap Materials, Spoiled and Defective Work xvi Principles of Cost Accounting 3 Accounting for Labor 123 Wage Plans 125 Hourly Rate Plan, Piece-Rate Plan, Modified Wage Plans Controlling Labor Cost 128 Labor Time Records, Payroll Function Accounting for Labor Costs and Employers’ Payroll Taxes 132 Employers’ Payroll Taxes, Illustration of Accounting for Labor Costs Payroll Accrual 141 Special Labor Cost Problems 144 Shift Premium, Employee Pension Costs, Bonuses, Vacation and Holiday Pay, Accounting for Bonuses, Vacations, and Holiday Pay 4 Accounting for Factory Overhead 169 Identifying Cost Behavior Patterns 170 Analyzing Semivariable Factory Overhead Costs 172 Observation Method, High-Low Method, Scattergraph Method, Limitations of High-Low and Statistical Scattergraph Methods, Least-Squares Regression Method Budgeting Factory Overhead Costs 179 Accounting for Actual Factory Overhead 180 Factory Overhead Analysis Spreadsheets, Schedule of Fixed Costs, General Factory Overhead Expenses, Summary of Factory Overhead Distributing Service Department Expenses 185 Applying Factory Overhead to Production 192 Direct Labor Cost Method, Direct Labor Hour Method, Machine Hour Method, Activity-based Costing Method Accounting for Actual and Applied Factory Overhead 198 5 Process Cost Accounting—General Procedures 237 Comparison of Basic Cost Systems 238 Materials and Labor Costs, Factory Overhead Costs Product Cost in a Process Cost System 239 Nondepartmentalized Factory, Departmentalized Factory Work in Process Inventories 240 Cost of Production Summary—One Department, No Beginning Inventory 244 Cost of Production Summary—One Department, Beginning Inventory 247 Cost of Production Summary—Multiple Departments, No Beginning Inventory 250 Cost of Production Summary—Multiple Departments, Beginning Inventory 259 Changes in Prior Department’s Unit Transfer Costs 266  Contents xvii 6 Process Cost Accounting—Additional Procedures; Accounting for Joint Products and By-Products 287 Equivalent Production—Materials Not Uniformly Applied 288 Illustrative Problem No. 1, Illustrative Problem No. 2, Illustrative Problem No. 3 Units Lost in Production 296 Units Gained in Production 298 Equivalent Production—First-In, First-Out Method 299 Illustrative Problem No. 1, Illustrative Problem No. 2 Joint Products and By-Products 309 Accounting for Joint Products, Accounting for By-Products 7 The Master Budget and Flexible Budgeting 337 Principles of Budgeting 338 Preparing the Master Budget 338 Sales Budget, Production Budget, Direct Materials Budget, Direct Labor Budget, Factory Overhead Budget, Cost of Goods Sold Budget, Selling and Administrative Expenses Budget, Budgeted Income Statement, Other Budgets, Evaluating Budget Performance Flexible Budgeting 350 Preparing the Flexible Budget, Preparing a Performance Report Based on Flexible Budgeting Preparing the Flexible Budget for Factory Overhead 355 Using the Flexible Budget, Semifixed and Semivariable Costs, Service Department Budgets and Variances, Summary of the Budgeting Process 8 Standard Cost Accounting—Materials, Labor, and Factory Overhead 379 Types of Standards 381 Standard Cost Procedures 381 Determination of Standard Costs for Materials and Labor, Recording Standard Costs for Materials and Labor Determination of Variances 384 Alternative Method of Recording Materials Cost Accounting for Variances 389 Alternative Method of Recording Materials Cost, Disposition of Standard Cost Variances Interpreting Variances 392 Features of Standard Cost Accounting 397 Illustration of Standard Cost in a Departmentalized Factory 398 Analysis of Factory Overhead Standard Cost Variances 405 Two-Variance Method of Analysis 406 Four-Variance and Three-Variance Methods of Analysis 412 Four-Variance Method of Analysis 412 Three-Variance Method of Analysis 414 xviii Principles of Cost Accounting 9 Cost Accounting for Service Businesses and the Balanced Scorecard 447 Job Order Costing for Service Businesses 448 Job Cost Sheet for a Service Business, Choosing the Cost Allocation Base, Tracing Direct Costs to the Job, Cost Performance Report Budgeting for Service Businesses 451 The Revenue Budget, The Labor Budget, The Overhead Budget, The Other Direct Expenses Budget, The Budgeted Income Statement Activity-Based Costing in a Service Firm 455 Converting Indirect Costs to Direct Costs, Multiple Indirect Cost Pools, Job Cost Sheet— Activity-Based Costing Allocations Using Simplified Costing Versus Activity-Based Costing 459 The Balanced Scorecard 463 The Four Categories of a Balanced Scorecard, Guidelines for a Good Balanced Scorecard, The Balanced Scorecard Illustrated 10 Cost Analysis for Management Decision Making 481 Variable Costing and Absorption Costing 482 Product Costs Versus Period Costs, Illustration of Variable and Absorption Costing Methods Merits and Limitations of Variable Costing 486 Segment Reporting for Profitability Analysis 488 Cost-Volume-Profit Analysis 491 Break-even Analysis, Break-even Chart, Break-even Analysis for Management Decisions, Effect of Sales Mix on Break-even Analysis Contribution Margin Ratio and Margin of Safety 499 Effect of Income Tax on Break-even Point and Net Income 501 Differential Analysis 502 Accept or Reject a Special Order, Make or Buy Distribution Costs 505 Glossary 531 Index 543  PRINCIPLES OF COST ACCOUNTING This page intentionally left blank  CHAPTER 1 Learning Objectives I n t r o d u ct i o n t o C o s t After studying this chapter, you should be able to: Accounting LO1 Explain the uses of cost accounting information. Describe the LO2 ethical res- An article in the August 22, 2008 Wall Street Journal, ‘‘Burger ponsibilities and certi- King Battles Costs with Small Whopper Jr.,’’ describes Burger fication requirements King’s attempt to ‘‘overcome high ingredient costs that are for management eating into its profit.’’ Chief Executive John Chidsey said, ‘‘To accountants, as well as corporate combat costs, Burger King is testing its $1 Whopper Jr. with governance. smaller hamburger pattie—down to two ounces apiece from 2.2 ounces—in some markets and experimenting with different Describe the LO3 beverage sizes.’’ The article went on to explain that ‘‘McDonald’s relationship is testing modifications to its $1 double cheeseburger, including of cost accounting to selling a different version and raising the price of the traditional financial and manage- double cheeseburger.’’ ment accounting. Identify the. What is the total cost to make and sell each Whopper Jr. or LO4 three basic McDonald’s double cheeseburger? elements of manufac-. How many burgers must be sold and at what prices to cover turing costs. costs and to provide shareholders with an acceptable return Illustrate on their investment? LO5 basic cost accounting procedures.. Given that fast-food prices are constrained by competitors’ prices, what other cost-cutting measures might Burger King Distinguish LO6 employ to return operations to normal profit margins? between the two basic types of cost These questions can be best answered with the aid of cost accounting systems. information introduced in this and the following chapters. Illustrate a job LO7 order cost T he importance of cost accounting information to the successful system. operation of a business has long been recognized. However, in the current global economic environment, such information is more 2 Principles of Cost Accounting Figure 1-1 Production Process for Goods and Services Inputs (factors of production) Outputs Raw materials Natural resources Goods Conversion process Human resources Capital Services crucial than ever. Automobiles from Korea, clothing from China, electronic equipment from Japan, and laptop computers from Poland are just a few examples of foreign-made products that have provided stiff competition to U.S. manufacturers both at home and abroad. As a result of these pressures, companies today are placing more emphasis on controlling costs in an attempt to keep their products competitive. For example, U.S. companies are outsourcing production and service activities to other countries, such as production operations in Honduras and Indonesia and technical support call centers in India. Cost accounting provides the detailed cost information that manage- ment needs to control current operations and plan for the future. Figure 1-1 illustrates the production process for goods and services for which cost accounting provides information. Management uses this information to decide how to allocate resources to the most efficient and profitable areas of the business. All types of business entities—manufacturing, merchandising, and service businesses—require cost accounting information systems to track their activities. Manufacturers convert purchased raw materials into fin- ished goods by using labor, technology, and facilities. Merchandisers purchase finished goods for resale. They may be retailers, who sell products to individuals for consumption, or wholesalers, who purchase goods from manufacturers and sell to retailers. For-profit service busi- nesses, such as health clubs, accounting firms, and NBA basketball teams, sell services rather than products. Not-for-profit service agencies, such as charities, governmental agencies, and some health care facilities, provide services at little or no cost to the user. The nature of the manufacturing process requires that the accounting information systems of manufacturers be designed to accumulate detailed cost data relating to the production process. It is common today for manufacturers of all sizes to have cost accounting systems that track the  Chapter 1 – Introduction to Cost Accounting 3 costs incurred to produce and sell their diverse product lines. While the cost accounting principles and procedures discussed in the text mostly emphasize manufacturers, many of the same principles apply to merchan- dising and service businesses. Cost accounting is essential to the efficient operation of fast-food restaurants, athletic teams, fine arts groups, hospitals, social welfare agencies, and numerous other entities. Chapter 9 and various other sections throughout the text illustrate cost accounting procedures for service businesses. In many ways, the activities of a manufacturer are similar to those of a merchandiser. They purchase, store, and sell goods; both must have efficient management and adequate sources of capital; and they may employ hundreds or thousands of workers. The manufacturing process itself high- lights the differences between the two: merchandisers, such as Target, buy goods in marketable form to resell to their customers; manufacturers, such as Procter & Gamble, must make the goods they sell. Once a merchan- diser has acquired goods, it can perform the marketing function. The purchase of raw materials by a manufacturer, however, is only the begin- ning of a long and sometimes complex chain of events that results in a finished product for sale. The manufacturing process requires the conversion of raw materials into finished goods through the use of labor and various other factory resources. A manufacturer must make a major investment in physical assets, such as property, plant, and equipment. To produce finished goods, a manufacturer must purchase appropriate quantities of raw materials and supplies, and develop a workforce. In addition to the cost of materials and labor, the manufacturer incurs other expenses in the production process. Many of these costs, such as depreciation, taxes, insurance, and utilities, are similar to those incurred by a merchandising concern. Costs such as machine maintenance and repair, materials handling, production setup, production scheduling, and inspection are unique to manufacturers. Other costs, such as selling and administrative expenses, are similar to those incurred by merchandisers and service businesses. The methods of account- ing for sales, cost of goods sold, and selling and administrative expenses for a manufacturer are similar to those of merchandisers. Service businesses, by comparison, have no inventories because the service is consumed at the time it is provided. Service businesses have revenue and operating expenses, but no cost of goods sold. Note that product quality is as important a competitive weapon as cost control in the global arena. Originally issued for companies marketing products in Europe, a set of international standards for quality manage- ment, known as the ISO 9000 family, was designed by the International Organization for Standardization, based in Switzerland. The standards require that manufacturers have a well-defined quality control system, that they consistently maintain a high level of product quality to enhance customer satisfaction, and that they achieve continual improvement of their performance in pursuit of these objectives. The standards are accepted in 158 countries, 106 of which are ‘‘member bodies’’ with full voting rights on 4 Principles of Cost Accounting technical and policy issues.1 Major U.S. companies such as General Electric and Procter & Gamble require their suppliers to obtain ISO 9000 certification. Uses of Cost Accounting Information Explain the Principles of cost accounting have been developed to enable manufacturers LO1 uses of cost to process the many different costs associated with manufacturing and to accounting information. provide built-in control features. The information produced by a cost accounting system provides a basis for determining product costs and selling prices, and it helps management to plan and control operations. Determining Product Costs and Pricing Cost accounting procedures provide the means to determine product costs that enable the preparation of meaningful financial statements and other reports needed to manage a business. The cost accounting information system must be designed to permit the determination of unit costs as well as total product costs. For example, the fact that a manufacturer spent $100,000 for labor in a certain month is not, in itself, meaningful; but if this labor produced 5,000 finished units, the fact that the cost of labor was $20 per unit is significant. This figure can be compared to the company’s unit labor cost for prior periods and, often, to the labor cost of major competitors. Unit cost information is also useful in making a variety of important marketing decisions such as: 1. Determining the selling price of a product. Knowing the manufacturing cost of a product aids in determining the desired selling price. It should be high enough to cover the cost of producing the item and the marketing and administrative expenses attributable to it, as well as to provide a satisfactory profit to the owners. 2. Meeting competition. If a product is being undersold by a competitor, detailed information regarding unit costs can be used to determine whether the problem can be resolved by reducing the selling price, by reducing manufacturing and selling expenses attributable to the product, or by some combination of the above that will still result in profitable sales. 3. Bidding on contracts. Many manufacturers must submit competitive bids in order to be awarded contracts. Knowledge of the unit costs attribu- table to a particular product is of great importance in determining the bid price. 4. Analyzing profitability. Unit cost information enables management to determine the amount of profit that each product earns, thereby allocat- ing the company’s scarce resources to those that are most profitable. 1 International Organization for Standardization, ‘‘ISO Members,’’ www.iso.org.  Chapter 1 – Introduction to Cost Accounting 5 It is not uncommon, however, for some companies to retain a certain product line, known as a loss leader, that yields a very low profit, or even a loss, in order to maintain the product variety that will attract those customers who also purchase the more profitable items. Planning and Control One of the most important aspects of cost accounting is the preparation of reports that management can use to plan and control operations. Planning is the process of establishing objectives or goals for the firm and determining the means by which they will be met. Effective planning is facilitated by the following: 1. Clearly defined objectives of the manufacturing operation. These objectives may be expressed in terms of the number of units to be produced, the desired quality, the estimated unit cost, the delivery schedules, and the desired inventory levels. 2. A production plan that will assist and guide the company in reaching its objectives. This detailed plan includes a description of the manufacturing operations to be performed, a projection of human resource needs for the period, and the coordination of the timely acquisition of materials and facilities. Cost accounting information enhances the planning process by provid- ing historical costs that serve as a basis for future projections. Management can analyze the data to estimate future costs and operating results and to make decisions regarding the acquisition of additional facilities, any changes in marketing strategies, and the availability of capital. The word ‘‘control’’ is used in many different ways, but from the viewpoint of the manufacturing concern, control is the process of monitor- ing the company’s operations and determining whether the objectives identified in the planning process are being accomplished. Effective control is achieved as follows: 1. Assigning Responsibility. Responsibility should be assigned for each detail of the production plan. All managers should know precisely what their responsibilities are in terms of efficiency, operations, production, and costs. The key to proper control involves the use of responsibility account- ing and cost centers. The essence of responsibility accounting is the assignment of account- ability for costs or production results to those individuals who have the most authority to influence them. It requires a cost information system that traces the data to cost centers and their managers. A cost center is a unit of activity within the factory to which costs may be practically and equitably assigned. A cost center may be a department or a group of workers; it could represent one job, one process, or one machine. The criteria for a cost center are (1) a reasonable basis on which manufactur- ing costs can be traced or allocated and (2) a person who has control over and is accountable for many of the costs charged to that center. 6 Principles of Cost Accounting With responsibility accounting, the manager of a cost center is accountable only for those costs that the manager controls. For example, labor and materials costs will be charged to the cost center, but the manager may be responsible only for the quantity of materials used and the number of labor hours worked. This manager would probably not be accountable for the unit cost of raw materials or the hourly rate paid to employees. These decisions are normally beyond the manager’s control and are the responsibility of the purchasing and human resource depart- ments, respectively. The manager may be responsible for the cost of machinery maintenance and repair due to misuse in the cost center, but not responsible for the costs of depreciation, taxes, and insurance on the machinery if the decision to purchase the machinery was made at a higher level in the organization. If production in the cost center for a given period is lower than planned, this could be due to poor supervision of production workers, which is the manager’s responsibility. If the decrease in production is caused by less-skilled workers being hired by Human Resources, how- ever, that would be beyond the manager’s control. Cost and production reports for a cost center reflect its costs, in dollars, and its production activity, in units. In a responsibility accounting system, the specific data for which the manager is responsible would be highlighted for the purpose of performance evaluation. Quite often, both a cost and production report and a separate performance report will be prepared for a cost center. The performance report will include only those costs and production data that the center’s manager can control. An illustration of a performance report appears in Figure 1-2. Note the ‘‘variance columns’’ that appear in the illustration. A variance represents the amount by which the actual result differs from the budgeted or planned amount. If the actual amount spent is less than the amount budgeted for, the variance is favorable (F); if more than budgeted, it is unfavorable (U). An in-depth discussion of budgeting and variance analysis appears in Chapters 7 and 8. These reports must be furnished at regular intervals (monthly, weekly, or daily) on a timely basis. To provide the maximum benefit, the reports should be available as soon as possible after the end of the period being reported. Reports not produced in a timely fashion are not effective in controlling future operations. 2. Periodically Measuring and Comparing Results. Actual operating results should be reviewed periodically and compared to the objectives established in the planning process. This analysis, which may be made monthly, weekly, daily, or even hourly in the case of production and scrap reports, is a major part of cost control because it compares current performance with the overall plan. The actual dollars, units produced, hours worked, or materials used are compared with the budget, which is management’s operating plan expressed in quantitative terms (units and dollars). This comparison is a primary feature of cost analysis. The number of dollars spent or the quantity of units produced has little significance until compared with the budgeted amounts. Note that the appropriateness of the Figure 1-2 Performance Report A B C D E F G H I J K L M N 1 Leonardo’s Italian Café 2 Performance Report—Kitchen 3 September 30, 2011 4 Budgeted Actual Variance 5 Expense September Year-to- September Year-to- September Year-to- 6 Date Date Date 7 Kitchen wages $5,500 $47,000 $5,200 $46,100 $300 F $900 F 8 Food 17,700 155,300 18,300 157,600 600 U 2,300 U 9 Supplies 3,300 27,900 3,700 29,100 400 U 1,200 U Chapter 1 – Introduction to Cost Accounting 10 Utilities 1,850 15,350 1,730 16,200 120 F 850 U 11 Total $28,350 $245,550 $28,930 $249,000 $580 U $3,450 U 12 F = Favorable; U = Unfavorable 7 8 Principles of Cost Accounting $157,600 actual year-to-date expenditure for ‘‘Food’’ in Figure 1-2 can be evaluated only when compared to the budgeted amount of $155,300. 3. Taking Necessary Corrective Action. The performance reports may identify problem areas and deviations from the business plan. Appropriate corrective action should be implemented where necessary. A significant variance from the plan is a signal for attention. An investigation may reveal a weakness to be corrected or a strength to be better utilized. Management wants to know not only the results of operations, but also how the results— whether favorable or unfavorable—compare with the plan, why things happened, and who was responsible. For example, management may want to determine the causes of the unfavorable year-to-date variance of $2,300 for ‘‘Food’’ in Figure 1-2. The variance may be due to an uncontrollable rise in food prices or to a controllable waste of food at the restaurant, or a combination of both. Based on the variance analysis, management must be prepared to improve existing conditions by such means as implementing more economical purchasing methods and standard portion sizes. Otherwise, the periodic measurement of activity has little value. The relationship of planning and control is illustrated in Figure 1-3. Figure 1-3 Relationship of Planning and Control for Leonardo’s Italian Café PLANNING CLEARLY DEFINED OBJECTIVE: INCREASE PROFIT BY 15% PLAN TO REACH THE OBJECTIVE: REDUCE FOOD COSTS BY 10% BUILD CORRECTIVE ACTIONS INTO PLAN CONTROL MEASURE AND COMPARE RESULTS: COMPARE BUDGETED TO ACTUAL FOOD COSTS, MONTHLY. TAKE CORRECTIVE ACTION: IDENTIFY MORE ECONOMICAL SUPPLIERS AND CONTROL FOOD WASTE  Chapter 1 – Introduction to Cost Accounting 9 Professional Ethics, CMA Certification, and Corporate Governance The Institute of Management Accountants (IMA) is the largest organiza- Describe LO2 tion of accountants in industry in the world. Comparable to the CPA the ethical certification for public accountants, the Certified Management Accountant responsibilities and certification require- (CMA) certificate—which is awarded by the IMA after the candidate ments for manage- completes a four-year college degree, two years of relevant professional ment accountants, as experience in management accounting and financial management, and a well as corporate rigorous four-part examination whose topics include business analysis, governance. management accounting and reporting, strategic management, and business applications with a strong emphasis on ethics—evidences a high level of competency in management accounting. In addition to competency, the need for ethical conduct in managing corporate affairs has never been greater. Individual employees, investors, and the economy as a whole have been negatively impacted by recent accounting scandals where management, including controllers and chief financial officers, has ‘‘cooked the books’’ to make reported financial results seem better than actual. Enron, WorldCom, Health South, Tyco Interna- tional, Rite Aid, and AOL Time Warner are just a few examples of firms that have had major accounting scandals in recent years. To help curb future abuses, the Sarbanes-Oxley Act of 2002 was written to protect shareholders and other stakeholders of publicly-traded companies by im- proving corporate governance. Corporate governance is the means by which a company is directed and controlled. Key elements of the act include:. certification by the CEO and CFO that the financial statements fairly represent the results of business operations.. the establishment of the Public Company Accounting Oversight Board (PCAOB) to provide oversight of the accounting profession.. prohibiting a public accounting firm from providing many nonauditing services to a company that it audits.. the requirement that a company’s annual report contain an internal control report that includes management’s opinion on the effectiveness of its internal controls.. the placement of responsibility for hiring, compensating, and terminat- ing the audit firm in the hands of the board of directors’ audit committee, not top management.. severe criminal penalties for the destruction or alteration of business documents and for retaliation against ‘‘whistleblowers.’’2 2 American Institute of Certified Public Accountants, ‘‘The Sarbanes-Oxley Act,’’ www. aicpa.org. 10 Principles of Cost Accounting It is equally important that the internal accounting reports prepared by management accountants be as accurate and unbiased as possible. To that end, the IMA has issued a Statement of Ethical Professional Practice that must be adhered to by its members. These standards address members’ responsibility in areas such as maintaining appropriate levels of professional competence, refraining from disclosing confidential information, avoiding conflicts of interest, and communicating information fairly and objectively. The second part of the document provides guidance for resolving ethical conflicts. The complete IMA Statement of Ethical Professional Practice may be found in the appendix to this chapter and at the IMA Web site, which is linked to the text Web site at http://www.cengage.com/accounting/vanderbeck. Relationship of Cost Accounting to Financial and Management Accounting LO3 Describe the The objective of accounting is to accumulate financial information for use relationship in making economic decisions. Financial accounting focuses on gathering of cost accounting to historical financial information to be used in preparing financial statements financial and manage- ment accounting. that meet the needs of investors, creditors, and other external users of financial information. The statements include a balance sheet, income statement, retained earnings statement, and statement of cash flows. Although these financial statements are useful to management as well as to external users, additional reports, schedules, and analyses are required for management’s use in planning and controlling operations. Management spends most of its time evaluating the problems and opportunities of individual departments and divisions of the company rather than looking at the entire company at once. As a result, the external financial statements for the whole company are of little help to management in making day-to-day operating decisions. Management accounting focuses on both historical and estimated data that management needs to conduct ongoing operations and do long- range planning. Cost accounting includes those parts of both financial and management accounting that collect and analyze cost information. It provides the product cost data required for special reports to management (management accounting) and for inventory costing in the financial state- ments (financial accounting). For example, cost accounting information is needed to determine: whether to make or buy a product component; whether to accept a special order at a discounted price; the amount at which cost of goods sold should be reported on the income statement; and the valuation of inventories on the balance sheet. The various users and uses of cost accounting data are illustrated in Figure 1-4, and Figure 1-5 shows how cost accounting intersects both financial and management accounting. ‘‘What Is Management Accounting?’’, a description prepared by the Insti- tute of Management Accountants as to the role performed by management accountants, appears on the following page.  Chapter 1 – Introduction to Cost Accounting 11 WHAT IS MANAGEMENT ACCOUNTING?1 It obviously takes more people to ‘‘do’’ the work than Management accounting is the internal business build- it does to ‘‘check’’ the work. In fact, of the five million ing role of accounting and finance professionals who finance function professionals in the U.S., more than work inside organizations. These professionals are 90% work inside organizations as management accoun- involved in designing and evaluating business pro- tants and finance professionals. Some common job titles cesses, budgeting and forecasting, implementing and for management accountants in organizations of all monitoring internal controls, and analyzing, synthe- sizes and structure include: sizing, and aggregating information—to help drive. Staff Accountant economic value.. Cost Accountant The role of management accounting differs from that. Senior Accountant of public accounting, since management accountants. Corporate or Division Planner work at the ‘‘beginning’’ of the value chain, supporting. Financial Analyst decision making, planning, and control, while audit and. Budget Analyst tax functions involve checking the work after the fact.. Internal Auditor Management accountants are valued business partners,. Finance Manager directly supporting an organization’s strategic goals.. Controller With a renewed emphasis on good internal controls. Vice President, Finance and sound financial reporting, the role of the manage-. Treasurer ment accountant is more important than ever.. Chief Financial Officer (CFO). Chief Executive Officer (CEO) To learn more about IMA and the management 1 Reprinted with permission from IMA, Montvale, N.J., accounting profession, please visit Frequently Asked ‘‘About Management Accounting’’ from www.imanet.org. Questions. Figure 1-4 Users and Uses of Cost Accounting Information Cost Accounting System (Accumulates Cost Information) Characteristics Financial Accounting Managerial Accounting Users: External Parties Internal Parties (Shareholders, Creditors, (Managers) Governments) Managers Focus: Entire Business Segments of the Business Uses of Cost Product Costs for Calculating Cost Budgeting Information: of Goods Sold (Income Statement) and Finished Goods, Work in Process, Special Decisions Such as Make or and Raw Materials Inventories (Balance Buy a Component, Keep or Replace Sheet) Using Historical Costs and a Facility, and Sell a Product at a Generally Accepted Accounting Special Price Principles Nonfinancial Information Such as Defect Rates, Percentage of Products Returned, and Percentage of On-Time Deliveries (All of the Above Using a Combination of Historical Data, Estimates, and Future Projections) 12 Principles of Cost Accounting Figure 1-5 Uses of Product Cost Data in Financial and Management Accounting Financial Accounting Managerial Accounting (for inventory costing Cost Accounting (for special reports to purposes in the (product cost management for decision- financial statements) information) making purposes) Costs of Goods Sold Merchandising concerns compute cost of goods sold as follows (the amount of purchases represents the cost of goods acquired for resale during the period): Beginning merchandise inventory Plus purchases (merchandise) Merchandise available for sale Less ending merchandise inventory Cost of goods sold Because a manufacturer makes, rather than buys, the products it has available for sale, the term finished goods inventory replaces merchandise inventory, and the term cost of goods manufactured replaces purchases in determining the cost of goods sold, as shown below (the cost of goods manufactured amount is supported by a schedule detailing the costs of material and labor and the expenses of maintaining and operating a factory.): Beginning finished goods inventory Plus cost of goods manufactured Finished goods available for sale Less ending finished goods inventory Cost of goods sold The format of the income statement for a manufacturer is not signifi- cantly different from that of a merchandiser. However, the cost accounting procedures needed to determine the cost of goods manufactured are considerably more complex than the procedures needed to determine the cost of merchandise purchased in its finished form. Note that the income statements for service businesses do not have a cost of goods sold section, because they provide a service rather than a product.  Chapter 1 – Introduction to Cost Accounting 13 Inventories If a merchandiser has unsold items on hand at the end of an accounting period, the cost of the merchandise is reflected in the current assets section of the balance sheet in the following manner: Current assets: Cash Accounts receivable Merchandise inventory On the balance sheet of a manufacturing concern, the current assets section is expanded as follows: Current assets: Cash Accounts receivable Inventories: Finished goods Work in process Materials The balance of the finished goods account represents the total cost incurred in manufacturing goods completed but still on hand at the end of the period. The balance of the work in process account includes all manufacturing costs incurred to date for goods in various stages of produc- tion but not yet completed. The balance of the materials account repre- sents the cost of all materials purchased and on hand to be used in the manufacturing process, including raw materials, prefabricated parts, and other factory materials and supplies. Raw materials for one company are often the finished product of another company. For example, rolled steel to be used in the production of Honda Accord automobiles in its Marysville, Ohio plant would be the final product of A.K. Steel, the steel mill in Middletown, Ohio, but raw materials to Honda. Prefabricated parts would include units, such as electric motors, produced by another manufacturer to be used in the assembly of a product such as copying machines. Other materials and supplies might include screws, nails, rivets, lubricants, and solvents. Service entities do not have inventories on their balance sheets because they provide a service rather than a product. A summary comparison of manufacturing, merchandising, and service businesses appears in Figure 1-6. Valuation of Inventories. Many procedures used to gather costs are unique to manufacturers. Manufacturers’ inventories are valued for external finan- cial reporting purposes by using inventory costing methods—such as first- in, first-out (FIFO); last-in, first-out (LIFO); and moving average—that are also used by merchandisers. Most manufacturers maintain a perpetual inventory system that provides a continuous record of purchases, issues, and balances of all goods in stock. Generally, these data are verified by 14 Principles of Cost Accounting Figure 1-6 Comparison of Service, Merchandising, and Manufacturing Businesses Inventory Business Sector Examples Product or Service Account(s) Service Hotels, accountants, hair Intangible benefits such as None stylists, sports franchises lodging, tax preparation, grooming, entertainment Merchandising Bookstores, electronics stores, Tangible products purchased Merchandise sports memorabilia shops, from suppliers in finished inventory beverage wholesalers form Manufacturing Segway producers, manufac- Physical products created by the Finished Goods, turers of electronic games, application of labor and tech- Work in Process, home builders nology to raw materials Materials periodic counts of selected items throughout the year. Under a perpetual system, inventory valuation data for financial statement purposes are avail- able at any time, as distinguished from a periodic inventory system that requires estimating inventory during the year for interim financial state- ments and shutting down operations to count all inventory items at the end of the year. In addition to providing inventory valuation data for the financial state- ments, the detailed cost data and perpetual inventory records provide the information necessary to control inventory levels, to ensure the timely availability of materials for production, and to detect pilferage, waste, and spoilage. Inventory valuation and control are discussed in detail in Chapter 2. Inventory Ledgers. Generally, both merchandisers and manufacturers maintain various subsidiary ledgers, such as those for accounts receivable and accounts payable. In addition, manufacturers usually maintain subsidi- ary ledgers for the general ledger inventory control accounts: Finished Goods; Work in Process; and Materials. These subsidiary ledgers are necessary to track the individual raw materials, jobs in process, and finished jobs on hand. They support the balances in the control accounts, as illustrated in Figure 1-7, and aid in managing the business on a daily basis. Figure 1-7 Relationship between General and Subsidiary Ledgers SUBSIDIARY LEDGERS GENERAL LEDGER FOR INVENTORY INVENTORY CONTROL ACCOUNTS MATERIALS LEDGER: Rolled steel Glass Rubber MATERIALS  Chapter 1 – Introduction to Cost Accounting 15 Figure 1-7 Continued JOB COST LEDGER (UNFINISHED JOBS): Job 103 Job 104 Job 105 WORK IN PROCESS FINISHED GOODS LEDGER (FINISHED JOBS): Job 101 Job 102 FINISHED GOODS Recall and Review 1 The Recall and Review exercises are aimed at testing your understanding of a key concept in the reading before you proceed to the end-of-chapter materials. Work the exercises independently and then check your solutions at the designated pages. Samson Manufacturing had finished goods inventory of $45,000 on March 1, March cost of goods manufactured of $228,000, and March 31 finished goods of $53,000. Compute the cost of goods sold for the month of March. $__________ (After working this exercise, see page 39 for the solution.) You should now be able to work the following: Questions 1–21; Exercises 1-1 to 1-3; Problems 1-1 and 1-2; Mini-Case; and Internet Exercises 1 and 2. Elements of Manufacturing Costs Manufacturing or production costs are classified into three basic ele- ments: (1) direct materials, (2) direct labor, and (3) factory overhead. Direct Materials The materials that become part of a certain manufactured product and can be readily identified with that product are classified as direct materials. Examples include lumber used in making furniture, fabric used in the production of clothing, iron ore used in the manufacture of steel products, and rubber used in the production of athletic shoes. 16 Principles of Cost Accounting Many types of materials and supplies necessary for the manufacturing process either cannot be readily identified with any particular manufactured item or have a relatively insignificant cost. Items such as sandpaper used in sanding furniture, lubricants used on machinery, and other items for general factory use are classified as indirect materials. Similarly classified are materials that actually become part of the finished product, such as thread, screws, rivets, nails, and glue, but whose costs are relatively insignif- icant, making it not cost effective to trace them to specific products. Direct Labor The labor of employees who work directly on the product manufactured, such as machine operators or assembly-line workers, is classified as direct labor. The employees who are required for the manufacturing process but who do not work directly on the units being manufactured are considered indirect labor. This classification includes department heads, inspectors, materials handlers, and maintenance personnel. Payroll-related costs, such as payroll taxes, group insurance, sick pay, vacation and holiday pay, retirement program contributions, and other fringe benefits are usually treated as indirect costs. Some companies, however, more appropriately, treat the fringe benefits paid for direct laborers as additional direct labor cost for the purpose of more precisely determining how much each hour of direct labor really costs. As manufacturing processes have become increasingly automated, direct labor cost as a percentage of total product cost has decreased for many companies. Harley-Davidson, the motorcycle manufacturer, stopped track- ing direct labor as a separate cost category because it was only 10% of total product cost but required an inordinate amount of time to trace directly to the individual products manufactured.3 Factory Overhead Factory overhead, also known as manufacturing overhead and factory burden, includes all costs related to the manufacture of a product except direct materials and direct labor. Thus, factory overhead includes the previously mentioned indirect materials and indirect labor, plus other manufacturing expenses, such as depreciation on the factory building and the machinery and equipment, heat, light, power, maintenance, insurance, and taxes. As factories have become more automated, factory overhead as a percentage of total manufacturing cost has increased dramatically. Summary of Manufacturing Costs The costs of direct materials and direct labor are sometimes combined and described as the prime cost of manufacturing a product. Prime cost plus 3 W. Turk, ‘‘Management Accounting Revitalized: The Harley-Davidson Experience,’’ Journal of Cost Management, Vol. 3, No. 4, 1990, 28–39.  Chapter 1 – Introduction to Cost Accounting 17 Figure 1-8 Prime Cost and Conversion Cost Direct Materials Prime Cost Elements of Cost Direct Labor Conversion Cost Factory Overhead factory overhead equals the total manufacturing cost. Direct labor cost and factory overhead, which are necessary to convert the direct materials into finished goods, can be combined and described as conversion cost. These relationships are illustrated in Figure 1-8. Marketing expenses, general administrative costs, and other nonfactory expenditures are not included in the costs of manufacturing. Some costs incurred by a manufacturer, however, may benefit both factory and nonfactory operations. Examples include depreciation, insurance, and prop- erty taxes on a building that houses both the factory and the administrative offices. In this situation, an allocation of cost must be made to each business function. Flow of Costs All three elements of manufacturing cost flow through the work in process inventory account. The costs of direct materials and direct labor used in production are charged (debited) directly to Work in Process. All other factory costs—indirect labor, indirect materials, and other factory expenses—are charged to the factory overhead account and later trans- ferred to Work in Process. When goods are completed, the total costs incurred in producing the goods are transferred from Work in Process to Finished Goods. When goods are sold, the costs incurred to manufacture the goods are transferred from Finished Goods to Cost of Goods Sold. Figure 1-9 illustrates the flow of manufacturing costs. Figure 1-9 Flow of Manufacturing Costs Direct Materials Work in Process Finished Goods Direct Labor (Asset) (Asset) Factory Overhead Cost of Goods Sold (Expense) 18 Principles of Cost Accounting Illustration of Accounting for Manufacturing Costs Illustrate Cost accounting procedures are used to accumulate and allocate all ele- LO5 basic cost ments of manufacturing cost in a manner that will produce meaningful data accounting procedures. for the internal use of management and for the preparation of external financial statements. The following example illustrates basic cost account- ing procedures, utilizing the terminology and principles that were discussed previously. Wicker Works, Inc., a small, newly organized corporation, manufactures wicker furniture—both tables and chairs. The firm sells products directly to retailers. The basic steps in the company’s production process are as follows: 1. Pieces of rattan, a natural fiber grown in Asia, are purchased in precut specifications. The pieces are assembled to form the frame of the table or chair. 2. The legs and back uprights of the chair and the legs and the outline of the tabletop are then wrapped in binding cane. 3. The seat and back of the chair and the tabletop are now ready to be woven into place, and the chair or table is finished. All of the previous steps are performed in a single department. The flow of manufacturing costs for Wicker Works is illustrated in Figure 1-10. Figure 1-10 Flow of Costs Related to the Production Process Materials Work in Process Finished Goods Cost of Goods Inventory Inventory Inventory Sold (Rattan, Binding (Tabletops, (Completed Tables (Manufacturing Cane) Chair Legs, etc.) and Chairs) Cost of Items Sold)  Chapter 1 – Introduction to Cost Accounting 19 The beginning balance sheet for the company on January 1 of the current year is presented as follows: Wicker Works, Inc. Balance Sheet January 1, 2011 Assets Liabilities and Stockholders’ Equity Cash.......................... $ 40,000 Liabilities...................... $ -0- Building....................... 250,000 Capital stock................... 365,000 Machinery and equipment...... 75,000 Total liabilities and Total assets.................... $365,000 stockholders’ equity.......... $365,000 Assume, for the purpose of simplification, in the following example, that the company is currently making only one style of table and no chairs. During January the following transactions are completed and recorded, in summary form: 1. Materials (rattan, binding cane, nails, tacks, staples, glue, and solvents) are purchased on account at a cost of $25,000. Materials....................................................... 25,000 Accounts Payable............................................ 25,000 The cost of materials purchased on credit increases the asset account, Materials, and the liability account, Accounts Payable. Note that only a single materials control account that contains both the cost of direct and indirect materials appears in the general ledger. 2. During the month, direct materials (rattan and binding cane) costing $20,000 and indirect materials (nails, tacks, staples, glue, and solvents for cleaning) costing $995 are issued into production. Work in Process (Direct Materials)............................... 20,000 Factory Overhead (Indirect Materials)............................ 995 Materials..................................................... 20,995 Direct materials issued are charged directly to the work in process control account because they can be readily traced to the individual jobs, but the indirect materials are charged to the factory overhead account because they cannot be easily identified with specific jobs. The factory overhead account will be used to accumulate various factory expenses that will later be allocated to individual jobs using some equitable formula. 3. Total gross wages and salaries for the month were: factory employees working on the product, $10,000; factory supervision, maintenance, and custodial employees, $3,500; and sales and administrative employees, $6,500. The entries to record the payroll and the payments to employ- ees (ignoring payroll deductions) would be as follows: Payroll......................................................... 20,000 Wages Payable............................................... 20,000 Wages Payable................................................. 20,000 Cash......................................................... 20,000 20 Principles of Cost Accounting 4. The entry to distribute the payroll to the appropriate accounts would be as follows: Work in Process (Direct Labor)................................... 10,000 Factory Overhead (Indirect Labor)............................... 3,500 Selling and Administrative Expenses (Salaries)................... 6,500 Payroll....................................................... 20,000 The wages earned by employees working directly on the product are charged to Work in Process, while the salaries and wages of the factory supervisor and the maintenance and custodial personnel, who do not work directly on the product, are charged to Factory Overhead as indirect labor. The salaries of nonfactory employees are debited to the selling and administrative expenses account. In order to focus on specific cost accounting procedures as distin- guished from general accounting procedures, the general ledger ac- count Selling and Administrative Expenses will be used to accumulate all nonmanufacturing expenses. Usually, separate general ledger control accounts would be established for individual selling and administrative expenses. 5. Depreciation expense for the $250,000 building is 6% of the building cost per year. The sales and administrative offices occupy one-tenth of the total building, and the factory operation is contained in the other nine-tenths. The expense for one month is recorded as follows: Factory Overhead (Depreciation of Building)..................... 1,125** Selling and Administrative Expenses (Depreciation of Building)... 125** Accumulated Depreciation—Building.......................... 1,250* *($250,000  0.06  1/12 ¼ $1,250; **$1,250  0.90 ¼ $1,125; $1,250  0.10 ¼ $125) The cost accounting principle illustrated here is that only those costs directly related to production should be charged to Factory Overhead. Depreciation on the portion of the building used for office space is an administrative expense and should not be treated as an element of manufacturing cost for inventory costing purposes. 6. Depreciation expense for the $75,000 of factory machinery and equip- ment is 20% of original cost per year. Factory Overhead (Depreciation of Machinery and Equipment).... 1,250 Accumulated Depreciation—Machinery and Equipment......... 1,250 ($75,000  0.20  1/12 ¼ $1,250) 7. The cost of heat, light, and power for the month was $1,500. Factory Overhead (Utilities)..................................... 1,350 Selling and Administrative Expenses (Utilities)................... 150 Accounts Payable............................................ 1,500  Chapter 1 – Introduction to Cost Accounting 21 Because one-tenth of the building is used for office purposes, it was decided that 10% of the total utilities cost should be allocated to Selling and Administrative Expenses. If there were separate meters for each part of the building, the usage could be determined directly rather than by allocation. 8. Miscellaneous selling and administrative expenses for telephone and fax, copying charges, office supplies, travel, and rental of office furniture and equipment totaled $3,750, on account. Selling and Administrative Expenses............................ 3,750 Accounts Payable............................................ 3,750 A manufacturer may incur many other expenses, but for simplicity it is assumed that Wicker Works incurred no other expenses. After posting the journal entries to the appropriate ledger accounts, Factory Over- head will reflect the following debits: Transaction Description Amount 2. Indirect materials.................................. $ 995 4. Indirect labor...................................... 3,500 5. Depreciation of building............................ 1,125 6. Depreciation of machinery and equipment.......... 1,250 7. Utilities........................................... 1,350 Total............................................ $8,220 9. The balance in Factory Overhead is transferred to Work in Process by the following entry: Work in Process................................................ 8,220 Factory Overhead............................................ 8,220 The three elements of manufacturing cost—direct materials, direct labor, and factory overhead—are now accumulated in Work in Process. The debits in the account are as follows: Transaction Description Amount 2. Direct materials.................................... $20,000 4. Direct labor........................................ 10,000 9. Factory overhead.................................. 8,220 Total............................................ $38,220 10. If we assume that all goods started in process have been finished by the end of the month, then the following entry transfers the cost of these goods from Work in Process to Finished Goods: Finished Goods................................................. 38,220 Work in Process.............................................. 38,220 22 Principles of Cost Accounting Assuming that 500 tables were produced during the month, we find that the unit cost is $76.44 ($38,220/500). The unit cost for each element of manufacturing cost is calculated as follows: Units Unit Total Produced Cost Direct materials..................... $20,000 500 $40.00 Direct labor......................... 10,000 500 20.00 Factory overhead.................... 8,220 500 16.44 $38,220 $76.44 If the same type of table is produced in future periods, the unit costs of those periods can be compared with the unit costs for this month. Any significant differences can be analyzed so that management might take appropriate action. The unit cost also serves as a basis for establishing the selling price of the tables. After also considering the selling and administrative ex- penses, management establishes a selling price that should provide a reasonable profit. The selling price may be determined by adding a mark-on percentage, which is a percentage of the manufacturing cost per unit. For example, if management decides that a 50% mark-on percentage is necessary to cover the product’s share of selling and administrative expenses and to earn a satisfactory profit, the selling price per unit, rounded to the nearest cent, would be calculated as follows: Manufacturing cost..................................................... $ 76.44 Mark-on percentage (50%).............................................. 38.22 Selling price........................................................... $114.66 In later periods, owing to intense competition, it might be found that this particular item cannot be sold at a price that will be high enough to cover all of its costs and provide a normal profit margin. Through analysis of the unit costs, management might effect cost- cutting measures or perhaps even discontinue production of the item. From this example, it is apparent that, at any given time, the cost of each item in inventory is available. It should be reemphasized that one function of cost accounting is the accurate determination of the cost of manufacturing a unit of product. This knowledge of unit cost helps management to plan and control operations and to make marketing decisions. To continue with the example, assume that the following additional transactions take place in January:  Chapter 1 – Introduction to Cost Accounting 23 11. Invoices of $25,000, representing costs of materials, utilities, and selling and administrative expenses, are paid. Accounts Payable............................................... 25,000 Cash......................................................... 25,000 12. A total of 400 tables are sold to retailers at a net price of $114.66 each. Accounts Receivable (400  $114.66)............................ 45,864 Sales........................................................ 45,864 Cost of Goods Sold (400  $76.44)............................... 30,576 Finished Goods............................................... 30,576 13. Cash totaling $33,000 is collected on accounts receivable. Cash.....................................................