ch03

2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

TraditionalCost Management

Systems

Chapter 3


3-2

Cost Management Systems (1 of 2)

• Cost management systems have a wide variety of uses– The next two chapters will focus on their role in

measuring the costs of products, services, and customers

• Two cost management systems have been used traditionally to cost products and services– Job order costing– Process costing

• Many companies continue to use these two systems


3-3

Cost Management Systems (2 of 2)

• Since the mid-1980s companies have been adopting activity-based costing (ABC) for product and customer costing

• These three systems are often portrayed as distinct; however, all cost systems work in essentially the same way:– Expense categories are developed and then expenses

are mapped to service departments, production centers, or activities

– Expenses are then attached to cost objects

• The way these links are made and the activities defined is what differentiates these systems


3-4

Job Order v. Process Costing Systems

• A job order costing system estimates the costs of manufacturing products for different jobs required for specific customer orders– Applicable in organizations that treat each individual

job as a single unit of output

• A process costing system is applicable when all units produced during a specified time frame are treated as one unit of output– Every unit made during the time period is essentially

identical


3-5

Need for Job Order Costing• Products may differ

– Materials content – Hours of labor required– Machine time required– Demand placed on support activity resources (i.e.,

manufacturing overhead)– Special customer needs that require customized

production

• With such variety, managers need to understand the costs of individual products so that they can assess product and customer profitability


3-6

The Cost Flow Model• The cost flow model essentially uses an

inventory concept to track costs– Raw materials inventory– Work-in-process (WIP) inventory

• Raw materials are transformed by labor and support resources

• Costs of the resources for each job not yet completed

– Finished goods inventory

• When the goods are sold, they are accounted for in the expense category Cost of Goods Sold


3-7

Bidding Using Job Order Costing

• Firms are sometimes required to bid on jobs before customers decide to place an order with them

• Costs need to be estimated for each job in order to prepare a bid

• Job order costing systems provide the means to estimate these costs

• A job bid sheet provides a format for recording the estimated costs


3-8

Job Bid Sheet (1 of 6)

• Panel 1 identifies the customer, the product, and the number of units required

Bid Number: J4369 Date: July 6, 2004

Customer: Michigan Motors

Product: Automobile engine valves (Valve #L181)

Engineering Design Number: JDR-103

Number of Units: 1,500


3-9


• Panel 2 lists all the materials required to complete the job

Materials Quantity Price AmountBar steel stock 3” 3,600 lbs $11.30 $40,680Subassembly 1,500 39.00 58,500Total direct materials $99,180


3-10


• Panel 3 lists the amount of direct labor required for the job

Labor Hours Rate AmountLathe operators 480 $26.00 $12,480Assembly workers 900 18.00 16,200Total direct labor 1,380 $26,680


3-11


• Panel 4 contains estimates for cost driver costs

Support Costs Amount

600 machine-hours @ $40/hour $24,000

1,380 direct labor hours @$36/hour 49,680

Total support costs $73,680


3-12


• Panel 5 summarizes the total costs estimated for the job

Direct material $ 99,180Direct labor 28,680Support costs 73,680Total costs $201,540


3-13


• A markup rate is applied to translate the estimated cost into a bid price

• A 25% markup rate is assumed in this example

Total costs $201,540Add 25% markup 50,385Bid price $251,925Unit cost $134.36Unit price $167.95


3-14

Job Costs And Markup• Most firms mark up the job costs by adding an

additional amount, or margin, to make a profit on the job

• The total job costs plus the margin equals the bid price

• The markup rate depends on a variety of factors:– The amount of support costs excluded from the cost

driver rate– The target rate of return desired by the corporation– Competitive intensity– Past bidding strategies adopted by key competitors– Demand conditions– Overall product-market strategies


3-15

Determination Of Cost Driver Rates

• Determining realistic cost driver rates has become increasingly important in recent years– Support costs now comprise a large portion of the

total costs in many industries

• Many firms now recognize that several different factors may be driving support costs rather than one or even two factors, such as direct labor or machine hours– Firms are now taking greater care in identifying which

support costs should relate to what cost driver


3-16

Cost Driver Rates• All costs associated with a cost driver, such as

setup hours, are accumulated separately– Each subset of total support costs that can be

associated with a distinct cost driver is referred to as a cost pool

• Each cost pool has a separate cost driver rate• The cost driver rate is the ratio of the cost of a

support activity accumulated in the cost pool to the level of the cost driver for the activity– Activity cost driver rate =

Cost of support activity / Level of cost driver


3-17

Stable Cost Driver Rates (1of 2)

• The cost of the support activity is the cost of the resources committed to the particular activity

• The level of the activity cost driver is the long-term capacity made available by the amount of resources committed to a support activity– The cost of a support activity, therefore, excludes

fluctuations in costs caused by short-term adjustments such as overtime payments

– The level of the support activity cost driver also excludes short-term variations in demand as reflected in overtime or idle time


3-18

Stable Cost Driver Rates (2of 2)

• The ratio shown in the previous equation is based on costs and cost driver levels, the rate remains stable over time:– It does not fluctuate as activity levels change

in the short run– It does not change simply because of short-

run changes in external factors that do not affect the efficiency or price of the activity resources


3-19

Fluctuating Rates• For example, if the rate for machine costs is

based on quarterly cost driver levels instead of the normal levels:– The rate increases as the demand for the machine

activity falls– The rate decreases as the demand increases

• In contrast, the cost driver rate based on costs and activity levels remains fixed throughout the year– Costs depend on the machine capacity made

available and not on the season


3-20

Problems With Fluctuating Rates• Determination of cost driver rates based on

short-term usage results in higher rates during periods of lower demand– Job costs appear to be higher during time periods

when demand is lower– Bid prices based on estimated job costs are likely to

be higher during periods of low demand when they probably should be lower

– The higher bid price can further decrease demand, which in turn leads to higher cost driver rates and even higher prices

• Conversely, in periods when demand is high and capacity is short, job costs will appear to be lower, and bid prices will also be low


3-21

Number of Cost Pools• The number of cost pools can vary

– Some German firms use over 1,000

• The general principle is to use separate cost pools if the cost or productivity of resources is different and if the pattern of demand varies across resources

• The increase in measurement costs required by a more detailed cost system must be traded off against the benefit of increased accuracy in estimating product costs– If cost and productivity differences between resources

are small, having more cost pools will make little difference in the accuracy of product cost estimates


3-22

Recording Actual Job Costs• Job order cost accounting systems record costs

actually incurred on individual jobs as they are produced– This process allows comparison of actual costs with

the estimated costs• Copies of all materials requisition notes and

worker time cards are forwarded to the accounting department, which then posts them on a job cost sheet

• The system calculates total costs for the portion of the job completed

• The structure of the job cost sheet is similar to that of the job bid sheet– The direct materials and direct labor costs on the job

cost sheet represent the job’s actual costs incurred


3-23

Multistage Process Costing• For many plants engaged in continuous processing

production flows continuously, semi-continuously, or in large batches from one process stage to the next

• At each successive process stage, there is further progress toward converting the raw materials into the finished product

• In continuous processing it is necessary first to determine costs for each stage of the process and then to assign their costs to individual products


3-24

Multistage Process Costing Systems• The design of product costing systems in such

process-oriented plants allows measurement of the costs of converting the raw materials during a time period to be made separately for each process stage

• The conversion costs are applied to products as they pass through successive process stages

• This system for determining product costs, known as a multistage process costing system, is common in process-oriented industries


3-25

Process-Oriented Industries• Multistage process costing systems are found in plants

engaged in continuous processing, such as those in the chemicals, basic metals, pharmaceuticals, grain milling and processing, and electric utilities industries

• We also find multistage process costing systems in some discrete-parts manufacturing plants such as those producing automobile components, small appliances, and electronic instruments and computers

• The common feature in these settings is that the products manufactured are relatively homogeneous– Few and relatively small differences occur in the

production requirements for batches of different products


3-26

Comparison With Job Order Costing• Both systems have the same objective:

– Assign material, labor, and manufacturing support activity costs to product

• Process costing systems differ in that they:– Do not maintain separate cost records for

individual jobs– Measure costs only for process stages– Determine cost variances only at the level of

the process stages instead of at the level of individual jobs


3-27

Job Order and Multistage Process Costing (1 of 3)

• In job order costing production is carried out in different jobs

• In multistage process costing, production is carried out continuously, semi- continuously, or in large batches


3-28


• In job order costing, production requirements are different for each individual job

• In multistage process costing, production requirements are homogeneous across products or jobs


3-29


• In job order costing, variances between actual and estimated direct material and direct labor costs are determined for each individual jobs

• In multistage process costing, variances between actual and estimated costs are determined for individual process stages


3-30

Service DepartmentCost Allocations

Appendix 3-1


3-31

Operating Expense Allocations

• Traditional cost accounting systems assign operating expenses to products with a two-stage procedure:

1. Expenses are assigned to production departments

2. Production department expenses are assigned to the products

• Departmental structure influences the first-stage allocation process


3-32

Effect Of Departmental Structure• Many plants are organized into departments that are

responsible for performing designated activities– Departments that have direct responsibility for

converting raw materials into finished products are called production departments

– Service departments perform activities that support production, such as:

• Machine setup

• Production engineering

• Production scheduling

– All service department costs are indirect support activity costs because they do not arise from direct production activities

• Machine maintenance


3-33

Two-Stage Cost Allocation (1 of 2)

• Conventional product costing systems assign indirect costs to jobs or products in two stages

1. In the first stage:– System identifies indirect costs with various

production and service departments– Service department costs are then allocated to

production departments

2. The system assigns the accumulated indirect costs for the production departments to individual jobs or products based on predetermined departmental cost driver rates


3-34

Two-Stage Cost Allocation (2 of 2)


3-35

Allocating Service Department Costs To Production Departments

• There are three ways that companies allocate service department costs to production departments:– Direct allocation– Sequential allocation– Reciprocal allocation

• The last two are used when service departments consume services provided by other departments(Examples based on PATIENTAID information in text)


3-36

PATIENTAID EXAMPLEStep 1 of Stage 1 cost allocations (given)


3-37

Direct Allocation Method• The direct allocation method is a simple

method that allocates the service department costs directly to the production departments– Allocations to production departments are

based on each production department’s relative use of the applicable cost driver

– It ignores the possibility that some of the activities of a service department may benefit other service departments as well as production departments


3-38

Allocation Bases Values


3-39

Allocation Ratios

300,000 / 1,200,000 = 0.250

Based on relative allocation basis value


3-40

Allocation ofService Department Costs

• Multiply service department cost by the allocation ratios

$160,000 x 0.250 = $40,000


3-41

Stage 2 Cost Allocations• Stage 2 allocations

– Require the identification of appropriate cost drivers for each production department

– Assign production department costs to jobs and products while they are worked on in the departments

• Conventional cost accounting systems use unit-related cost drivers, such as the number of units made, the number of direct labor hours (or cost), and the number of machine hours

• Dividing the indirect costs accumulated in each production department by the total number of units of the corresponding cost driver results in cost driver rates for each department


3-42

PATIENTAID Stage 2 (1 of 2)

• The Casting Department allocates its indirect costs to jobs based on machine hours, with total capacity for Casting equaling 6,000 machine hours

• Total indirect costs for Casting, after the allocation from service departments in Step 2 of Stage 1 was $216,000

• As a result, Casting allocates indirect costs to jobs at a rate of $36.00 per machine hour= $216,000/6,000 hours

• Each department will make a similar calculation


3-43

PATIENTAID Stage 2 (2 of 2)

• If Job J189-4 uses 40 machine hours while in the Casting Department, Casting will allocate $1,440 of its indirect costs to Job J189-4= 40 hours x $36.00 per hour

• Each department will allocate indirect costs to Job J189-4 in a similar manner, and Casting will allocate some costs to all jobs in a similar manner

• To determine the total cost of Job J198-4, add the Direct Material and Direct Labor cost assigned in each department and the indirect cost allocated from each department

• To determine the cost per unit, divide the total cost by the number of units in Job J189-4


3-44

Cost Distortions inA Two-Stage Allocation (1 of 2)

• The two-stage allocation can cause some products to be overcosted and others undercosted if allocations are based on unit measures but the units of different products have different relative consumption ratios

• In the Minnetka example in the textbook, Products A and B use the same number of machine hours, resulting in an equal allocation of indirect, including setup, costs per unit

• Product A, however, runs in larger batches, so one unit’s relative consumption of setup resources is lower for A than for B


3-45

Cost Distortions inA Two-Stage Allocation (2 of 2)

• Cost distortions are greater when the difference between the relative proportion of the cost driver for the activity (e.g., setup hours) and the relative proportion of the basis for second-stage assignment of support costs (e.g., machine hours) is greater

• Such distortions could be eliminated if the costing system used the actual cost driver for each support activity to assign costs directly to the products

• This logic underlies the development of activity-based costing systems discussed in the following chapter


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Sequential and ReciprocalAllocation Methods

• Sequential and reciprocal allocation methods are used when service departments consume services provided by other service departments– The sequential allocation method allocates

service department costs to one service department at a time in sequential order

– The reciprocal allocation method determines service department cost allocations simultaneously


3-47

Sequential Allocation Method (1 of 5)

• The sequential method is appropriate when there is not a pair of service departments in which each department in that pair consumes a significant proportion of the services produced by the other department in that pair


3-48


• The sequential allocation method requires that the service departments first be arranged in order– A service department can receive costs

allocated from another service department only before its own costs have been allocated to other departments

• Once a service department’s costs have been allocated, no costs can be allocated back to it from other departments


3-49


Service Departments

Production Departments

Item Power Engineering Machining Assembly Totals

Services Used:

Kilowatt hours

Eng’ring hours

0

0

100,000

0

480,000

2,000

220,000

2,000

800,000

4,000

Allocation ratios:

Power

Engineering

0

0

0.125

0

0.600

0.500

0.275

0.500

1.000

1.000

Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000

480,000/800,000 = 0.600

2,000/4,000 = 0.500


3-50


Service Departments




Cost Allocations:

Power

Engineering

(320,000)

0

40,000

(220,000)

192,000

110,000

88,000

110,000

Totals $ 0 $ 0 $ 422,000 $ 278,000 $ 700,000

$320,000 * 0.600 = $ 192,000

($180,000 + 40,000) * 0.500 = $ 110,000


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• In this example, the power department does not receive engineering services, but the engineering department uses power

• Therefore, in the sequential method:– The power department costs are allocated first– Then the engineering department costs are allocated

• The total cost of a service department allocated to other departments equals the amount directly identified with the service department plus the amount allocated earlier to the service department from other service departments


3-52

Reciprocal Allocation Method (1 of 6)

• If both service departments in this example consume each other’s services, the reciprocal allocation method is appropriate

• The sequential method ignores or suppresses such reciprocal relations

• The reciprocal allocation method recognizes reciprocal interactions between different service departments

• The example changes only to recognize Power’s use of Engineering’s services


3-53


Service Departments



Services Used:

Kilowatt hours

Eng’ring hours

0

1,000

100,000

0

480,000

2,000

220,000

2,000

800,000

5,000

Allocation ratios:

Power

Engineering

0

0.200

0.125

0

0.600

0.400

0.275

0.400

1.000

1.000


480,000/800,000 = 0.600

2,000/5,000 = 0.400


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• Before allocating any costs to the production departments, determine the reciprocal allocation between service departments:– Power’s total cost is $320,000 + 20% of the

total cost of Engineering (P=320,000+.20E)– Engineering’s total cost is $180,000 + 12.5% of

the total cost of Power (E=180,000+.125P)

• Solve the simultaneous equations by substitution


3-55


• P=320,000+.20E, with E=180,000+.125P• P=320,000+.20(180,000+.125P)• P=320,000 + 36,000 + .025P• .975P=320,000 + 36,000• P= $ 365,128

• E=180,000+.125P• E=180,000+.125(365,128)• E=180,000+45,641• E= $ 225,641

These costs will be allocated to the production departments using the allocation ratios shown previously


3-56


Service Departments




Cost Allocations:

Power

Engineering

(365,128)

45,128

45,641

(225,641)

219,077

90,256

100,410

90,257

Totals $ 0 $ 0 $ 429,333 $ 270,667 $ 700,000

($320,000 + 45,128) * 0.600 = $ 192,000

($180,000 + 45,641) * 0.400 = $ 110,000


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• Notice that the allocations were different from those obtained in the earlier illustration for the sequential method

• The power department’s total costs were higher because it also consumed some engineering services

• Because the machining department consumed a relatively larger amount of power, the costs allocated to it were higher in this case

• Notice also that only the allocations were different; the total amount of costs did not change as a result of using a different allocation method


3-58

Final Word on Two-Stage Allocation• The fundamental assumption of the two-stage allocation

method is the absence of a strong direct link between the support activities and the products manufactured– For this reason, service department costs are first

allocated to production departments using one of the conventional two-stage allocation methods previously described

• Activity-based costing rejects this assumption and instead develops the idea of cost drivers that directly link the activities performed to the products manufactured and measure the average demand placed on each activity by the various products– Activity costs are assigned to products in proportion to

the average demand that the products place on the activities, usually eliminating the need for the second step in Stage 1 allocations


3-59

If you have any comments or suggestions concerning this PowerPoint presentation,

please contact:Terry M. Lease

([email protected])Sonoma State University

ch03

Documents

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cost systems

powerpoint supplement

bid job order costing

job order costing products

job bid sheet

job order costing firms

individual job