CHAPTER 3

Product Cost
Flows and
Business
Organizations
 Learning Objective 1

Understand the difficulty,

yet importance, of having
accurate product cost
information.
Define the Three Manufacturing Product
Costs

Direct materials
materials that become part of the product and
are traceable to it.

Direct labor
wages paid to those who physically work on the
direct materials to transform them to a finished
product and are traceable to those products.

Manufacturing overhead
all costs incurred in the manufacturing process
other than direct materials and direct labor.
 Assignment of Product Costs
Product Cost

Easily Easily Difficult to

assigned to assigned to assign to
products. products. products.
Direct Direct Manufacturing
Materials Labor Overhead
Costs Costs Costs
- Expenditure - Expenditure - Total costs not known
and use until the end of the
and use period.
usually match usually match
production. production. - Not usually assigned
to specific products.
- “Lumped” costs don’t
match production
very well.
 Product Cost Systems
Why does management needs accurate
product cost information?

To plan for the future.

To control current operations.

To evaluate past performance.

To deliver high-quality products to

customers at the lowest price and
at the fastest speed.
 Product Cost Systems
What does accurate information allow
management to do?

To determine the appropriate level

at which to operate.

To assess the long-term profitability

of various products.

To manage the costs of production

activities.
 Learning Objective 2

Explain the flow of

goods and services
in a manufacturing
organization and
follow the
accumulation of
product costs in its
accounting system.
 Review the Time Line of Business

BUY SELL
ADD
raw materials or finished
goods for resale value inventory

COMPUTE

ending inventory cost of goods sold

 Measuring Cost
To accurately measure product
costs, accountants must:
 Determine which costs relate to
manufacturing and which relate to
administrative and selling functions.
 Accurately identify and measure all costs
associated with manufacturing.
 Determine appropriate ways to assign
costs incurred to products
manufactured.
 Outline the Flow of Cost in a
Manufacturing Process

Raw
Materials
Finished
Inventory
Goods
Inventory
Work-In-
Direct
Process
Labor
Inventory

Cost of
Factory Goods
Overhead Sold
 Determining Cost

What are Multiple products produced in

some same facility.
difficulties in Changing prices and labor rates.
determining Multiple manufacturing locations
costs of
(perhaps international).
manufactured
products? Individuals performing multiple
tasks.
 Costs of Manufacturing Products
Discuss the Nature of Raw Materials.

Cost of raw materials

used directly in the
manufacture of
Direct materials products.

Kept in raw materials

warehouse until used.

Examples: Rubber to
make tires, steel to
make cars, wood to
make tables.
Example: Direct Materials Costs
Venus Vehicles purchased $2 million of steel for its new line
of cars. What is the journal entry?
Raw Materials Inventory. . . . . . . . . . . 2,000,000
Accounts Payable . . . . . . . . . . . . 2,000,000
Half the new steel is requested from the warehouse for
production. What is the journal entry?

Work-in-Process Inventory. . . . . . . . . .1,000,000

Raw Materials Inventory . . . . . . . .1,000,000

Indirect materials ($250,000 of glue and bolts) are requisitioned

from the storeroom. What is the journal entry?

Manufacturing Overhead. . . . . . . . . . . . 250,000

Raw Materials Inventory . . . . . . . . 250,000
Costs of Manufacturing Products
Discuss the Nature of Direct Labor.

Wages/payroll-related
expenses of factory
employees who work
Direct labor directly on products.

Cost of wages/benefits for

assembly workers.

Does not include

wages/benefits of those
who do not work directly
on making products.
 Direct Labor Costs and Example
Time clocks, computer entries, time sheets—
- All allow production personnel to identify specific
jobs worked on.
 This information is revealed on the job cost sheet.
 Labor costs can be direct or indirect.
 Payroll records report direct labor of $50,000 and
indirect labor of $50,000. Record the direct labor.
Work-in Process Inventory. . .50,000
Wages Payable. . . . . . . . 50,000

Record the indirect labor.

Manufacturing Overhead. . . . 50,000
Wages Payable. . . . . ....
50,000
Costs of Manufacturing Products
Discuss the Nature of Factory Overhead.

All manufacturing
Manufacturing costs not classified as
direct materials or
overhead direct labor.

Miscellaneous
materials used in
production (such as
glue or nails).

Costs such as utilities,

depreciation,
insurance, and
property taxes.
Describe Some of the Characteristics of
Manufacturing Overhead Costs
 Involves more complex accounting procedures and
estimation problems.
 Must often be estimated in advance of their
occurrence.
 Cannot be traced directly to individual items
produced during the period.
 Managers need current product cost information:
- for pricing similar jobs.
- for estimating costs for next period.
Therefore, each job is
assigned a share of estimated
overhead.
Describe the Two-Step Process to Apply
Manufacturing Overhead to Products
Step One
Annual expected (budgeted)
manufacturing overhead Predetermined
=
Annual expected (budgeted) activity level overhead rate
(e.g., direct labor hours)

Step Two
Predetermined Actual activity Allocated manufacturing
x =
overhead rate level per job overhead assigned to job
Example: Determining Manufacturing
Overhead Rate
Steel Works estimates annual variable
manufacturing overhead costs of $10,000 and
fixed manufacturing overhead of $20,000. What is
the predetermined overhead rate if the company
expects to use the machines 10,000 hours?

Total estimated manufacturing overhead costs

=
Selected activity base (machine hours)

$30,000
= $3.00 per machine
10,000 hour
Example: Determining Manufacturing
Overhead Rate
Steel Works used 10 machine hours in the
production of Job No. 12. Using the $3.00
predetermined overhead rate, what overhead
costs will be applied to manufacturing overhead
(MOH) for this job? What is the journal entry to
apply this MOH to Job No. 12?

Overhead Actual Applied

Rate Activity MOH
x =
$3.00 10 hours $30.00

Work-in-Process Inventory. . . . . . . . . . . 30
Manufacturing Overhead . . . . . . . . 30
Example: Transferring Completed Products to
Finished Goods Inventory and then Selling
the Products
Steel Works used $100 in direct materials in Job No.
12’s production as well as 10 hours of direct labor
at $20 per hour. Using a job cost sheet, determine
the job’s total cost. Now that the job is complete,
prepare the entries for its transfer to Finished
Goods and its sale.
Job Cost Sheet
Job No. 12 Finished Goods Inventory . . 330
Work-in Process. . . . . . . . . . . . 330
Direct Materials $100
Direct Labor 200
MOH 30 Cost of Goods Sold. . . . . . . 330
Finished Goods Inventory. . . 330
Total $330
 Learning Objective 3

Understand the process of

accounting for overhead.
Actual versus Applied Manufacturing
Overhead
Actual Overhead
 Actual annual manufacturing overhead costs.
 Needed for accurate determination of income.
 Recorded as debit to Manufacturing
Overhead.
Applied Overhead
 Amount of overhead applied to products
using the predetermined overhead rate.
 Recorded as credit to Manufacturing
Overhead.
Disposition of Over- and Underapplied
MOH

Manufacturing Overhead Manufacturing Overhead

Actual Applied Actual Applied
10 20 20 10
(Cost of job is overstated) (Cost of job is understated)

Overapplied Manufacturing Underapplied Manufacturing

Overhead: Overhead:
The excess of applied The excess of actual
overhead costs over actual overhead costs over applied
overhead costs for a period. overhead costs for a period.
 Treating Applied Overhead
Two methods for treating over- and underapplied MOH:

- Close over- or underapplied overhead directly to

Cost of Goods Sold.
- Easier and more commonly used, especially if
amount is small.
- Debit MOH, Credit COGS.

- Allocate over- or underapplied manufacturing overhead

to Work-in-Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold on the basis of the
ending balances in these three accounts.
- More accurate; any difference is allocated
proportionately.
- More complicated; requires detailed calculations.
Learning Objective 4

Explain the flow

of goods and
services in a
merchandising
organization and
follow the
accumulation of
product costs in
its accounting
system.
 The Distribution Channel

The process of wholesalers purchasing from manufacturers

and supplying retailers who sell to final customers.
 A Typical Channel of Distribution
Manufacturer
Brand A Wholesaler Brand A Customers

Manufacturer
Brand B Brand B Customers

Manufacturer
Brand C Brand C Customers
Wholesaler Retailer
Manufacturer Brand D Customers
Brand D

Manufacturer Brand E Customers

Brand E
Wholesaler
Manufacturer Brand F Customers
Brand F
 Wholesalers
 Receive goods in bulk
shipments; break them
down for smaller
shipments to retailers.
 Profit—the difference
between price at which
they buy goods and
price at which they sell To be profitable,
goods to retailers. wholesalers must be
sure the right goods are
 Quality and timelines received and shipped in
are also important
the right manner to the
performance measures.
right retailer for the right
price at the right time.
Retailers – Define Risk and Stockturns
 Often work with many
wholesalers (and some
manufacturers) to
obtain inventory mix.
 Risk is having money
tied up in inventory that
is not selling Second-tier merchants
(opportunity cost). who typically purchase
 Stockturns—the faster products from
stock (inventory) can be wholesalers to distribute
turned, the sooner the to customers. Many will
money is available to often bypass wholesalers
purchase more to purchase inventory
inventory. directly from the original
manufacturers.
Describe Merchandise Cost Flows

Accounts
Inventory is
Payable purchased
xxx
x Merchandise
Inventory Inventory is
x sold
xx xx
Costs x x Cost of Goods
incurred to x Sold
ship in
inventory xx x
x

Inventory is x
returned
 Describe Accounting for Inventory
In merchandising, accounting is fairly straightforward:
no raw materials, inventory, manufacturing overhead,
or work-in-process accounts.
Inventory costs are often expensed as a period cost,
included in Selling and General Administrative
Expenses.
Prepare journal entry for when $465 inventory is sold.

Jan. 1 Cost of Goods Sold. . . . . . . . . 475

Merchandise Inventory . . . . 475
Sold inventory to customers.
 Learning Objective 5

Explain the flow of

goods and
services in a
service
organization and
follow the
accumulation of
product costs in
its accounting
system
 Define a Service Company
An organization Important for service
whose main firms to develop useful
economic activity management
involves producing a accounting systems
nonphysical product that support managing
that provides value to costs, quality, and
a customer. timeliness in creating
and delivering their
product.
What are the Effects of Deregulation?

 In service sector, deregulation has changed pricing

and profitability.
 Now the most efficient producers establish prices.
 Service providers who don’t know their costs will:
 not be able to aggressively set prices.
 not be responsive to consumer
demands.
 not make enough money to
stay in business.
 List Similarities Between Service and
Manufacturing Firms
 Both prepare product for sale and
delivery.
 Both involve direct labor and overhead.
 Both create a high-quality product that
must be delivered in a timely manner
while keeping costs low.
 Creative process requires highly paid
skilled labor or expensive capital
equipment and buildings.
 Large overhead must be allocated to the
direct product provided to the customer.
 Differences Between Service and
Manufacturing Firms
 Distribution channel not as prevalent in
service firms.
 Most service firms deal directly with end-
user.
 More customization in service firms.
 Most service firms use a job order
approach rather than a process approach
to cost accounting.
 Raw material inventories are insignificant
or nonexistent in service firms.
 Difficult in service industry to store
finished service in anticipation of later sale.
 Work-in-Process Inventory
 At period’s end, there may be situations where
significant effort and resources have been invested in a
service product that is not yet completed.
 Revenue is not yet earned; therefore, costs should not
be recognized yet as expenses. This work in process
is an asset, referred to as Work-in-Process Services.
 When service is completed and delivered, service
costs (overhead costs and work-in-process
services) are transferred to Cost of Services.
 Learning Objective 6

Understand
the impact of
e-business
on product
costing.
What Impact Has e-business Had on
Product Costs?

1. Reduced cost of materials, since businesses

can search for the best price.
2. Better management of direct labor costs.
3. In some cases, customers interact with
technology instead of employees.
4. Significant changes in the structure of
companies which greatly affects overhead
costs.
 Expanded Material
Learning Objective 7

Use the FIFO

method to do
process costing.
 Process Costing

Process costing is appropriate if what two

general conditions are met?
The activity performed in
each process center must
be identical for all units.

The units produced as a

result of passing through
the process centers must
be basically the same.
What are the 5 Steps in Process Costing?
Step 1 Identify units that went into the process and
identify where those units are at the end of the
processing time. Determine the amount of work
done during the processing time period.
Step 2 Determine the amount of production costs that
went into the process and compute the product
costs per unit for the processing time period.
Step 3 Compute the total cost of units completed and
transferred out during the processing time
period.
Step 4 Compute the total cost of units remaining in
process at the end of the processing time
period.
Step 5 Prepare the production cost report.
 Step 1: Compute Equivalent Units of
Production
Direct Materials Costs Conversion Costs
Physical Equivalent Equivalent
Units (lbs) % Done Units % Done Units
Beginning
work-in-
process 4,000 0% - 80% 3,200
Started &
completed 44,000 100% 44,000 100% 44,000
Ending
work-in-
process 2,000 100% 2,000 60% 1,200
Equivalent
units of
production 46,000 48,400
Transferred
out 48,000
 Step 2: Compute Product Costs per Unit
Total Equivalent Cost per
Costs Units Unit
Beginning work-in-process
Direct materials costs $ 800 4,000 $ 0.20
Conversion costs 1,200 800 1.50
Total $ 2,000 Total $ 1.70
Current period
Direct materials costs $ 9,660 46,000 $ 0.21
Conversion costs 70,180 48,400 1.45
Total $ 79,840 Total $ 1.66
Step 3: Compute the Costs Transferred
Out
Cost per Equivalent
Unit Units
Beginning work-in-process
Initial direct materials costs $ 800
Initial conversions costs 1,200
Cost to complete materials $ 0.21 - -
Cost to complete conversion 1.45 3,200 4,640
Total $ 6,640
Started and completed $ 1.66 44,000 73,040
Total costs transferred out $ 79,680
 Step 4: Compute Costs of Ending
Work-in Process Inventory

Cost per Equivalent

Unit Units
Costs for direct materials $ 0.21 2,000 $ 420
Conversion costs 1.45 1,200 1,740
Cost of ending work-in-process $ 2,160
Step 5: Prepare the Production Cost
Report

The production cost report contains

the information prepared and
presented in steps 1 through 4.