Notes on Product Costing, Absorption Costing, and Cost Allocation Methods
Absorption costing and the role of product vs. period costs
Absorption costing (full costing) assigns all manufacturing costs (direct materials, direct labor, manufacturing overhead) to products.
Product costs: DM, DL, MOH. These costs are inventoried on the balance sheet until the product is sold.
Period costs: Selling and administrative (non-manufacturing) costs expensed in the period incurred.
Uses of cost information:
Report inventories and cost of goods sold on the financial statements.
Decision making for long-term and short-term (routine and non-routine) decisions.
Planning and operational control.
Under absorption costing, product costs remain in inventories on the balance sheet until sold; period costs are expensed as incurred.
Roles and purposes of cost information (overview)
Value inventories and COGS for financial reporting.
Support decision making across time horizons (long-term decisions, and short-term, routine or non-routine decisions).
Aid planning and operational control through cost visibility.
Components and flows of product costs
Manufacturing costs consist of:
Direct materials (DM)
Direct labor (DL)
Manufacturing overhead (MOH) → indirect materials, indirect labor, depreciation of manufacturing equipment, utilities, maintenance, factory supervision, etc.
Prime costs vs. conversion costs:
Prime costs = Direct materials + Direct labor
Conversion costs = Direct labor + Manufacturing overhead
Flow of costs through accounts:
Raw materials → Work-in-Process (WIP) → Finished goods → Cost of goods sold (COGS)
Some costs are recorded as inventory (asset) until sold; COGS is expensed when goods are sold.
Inventory relationships:
Inventories on the Balance Sheet are increased by product costs and decreased when goods are sold.
COGS appears on the Income Statement when products are sold.
Product costs under absorption costing (summary diagram terms)
Manufacturing costs (DM + DL + MOH) contribute to Inventories on the Statement of Financial Position.
COGS (COGS) is the expense on the Income Statement when products are sold.
Non-manufacturing costs (Selling & Distribution, Administrative) are period costs.
Direct materials, direct labor, and manufacturing overhead (MOH)
Direct materials (traceable directly and conveniently to a product).
Direct labor (labor cost of workers directly involved in production).
Manufacturing overhead (all other manufacturing costs not directly traceable to a product):
Indirect materials, indirect labor, depreciation of factory equipment, factory utilities, maintenance, quality control, supervision, and other overhead items.
Material cost flow considerations:
Material costs can be tracked using FIFO, weighted-average (Average), or specific identification methods for costing purposes.
The allocation of MOH is needed to assign indirect production costs to individual products/jobs.
Flow of manufacturing costs (detailed)
Manufacturing costs include: Direct materials, Direct labor, Manufacturing overhead.
In the flow: Direct materials + Direct labor + MOH flow into WIP; completed goods move to Finished Goods; upon sale, COGS.
Non-manufacturing costs are expensed as incurred.
From the example visuals: Product costs are accumulated in inventories (WIP, FG) until sold; when sold, they become COGS in the income statement.
Details of manufacturing costs and cost flows (per slides 9–12)
Manufacturing costs flow: Materials → Labor → MOH → WIP → Finished Goods → COGS.
Direct materials and direct labor are the traceable costs that can be assigned to specific products.
MOH consists of costs that cannot be traced directly to a product but are necessary for production.
Prices for materials may be tracked by different cost flow assumptions (FIFO, Average, Specific Identification).
Non-manufacturing costs and manufacturing cost items (examples)
Direct materials: Fruits, sugar, packaging (illustrative product examples used in slides).
Direct labor: Workers directly involved in production.
Manufacturing overhead: Indirect materials, indirect labor (supervisors, maintenance), depreciation, utilities, insurance, taxes, etc.
Non-manufacturing costs: Selling, distribution, and administrative costs.
MOH allocation and methods of cost valuation (overview)
Objective: Allocate indirect production costs to products/jobs.
Common methods:
Actual costing
Normal costing
Standard costing
Allocation bases (cost drivers):
Plant-wide or departmental rates
Direct materials, direct labor hours, machine hours, or other cost drivers
Allocation basis should reflect the consumption of MOH by products/jobs
Key questions when allocating MOH:
Use actual or pre-determined rates?
Use a single plant-wide rate or multiple departmental rates?
What allocation basis should be used?
Actual costing vs pre-determined vs normal costing (formulas)
Actual costing: Overhead rate and application
ext{MOH Rate}_{ ext{Actual}} = rac{ ext{Actual manufacturing overhead costs}}{ ext{Actual quantity of allocation base}}
ext{MOH absorbed} = ext{MOH Rate}_{ ext{Actual}} imes ext{Actual quantity of allocation base used}
Pre-determined (applied) MOH rate (used in normal costing):
ext{MOH Rate}_{ ext{Applied}} = rac{ ext{Estimated total manufacturing overhead costs}}{ ext{Estimated total quantity of allocation base for the year}}
Then MOH absorbed to products = ext{MOH Rate}_{ ext{Applied}} imes ext{Actual quantity of allocation base used for the product/job}
Standard costing uses standard MOH costs, with variance analysis (not detailed in the slides but conceptually similar to standard costing in other chapters).
Actual costing (example calculations)
Example XYZ Co., Ltd. (furniture) MOH costs (for the month):
Indirect materials: 30,000
Indirect labor: 120,000
Supervisors’ salaries: 350,000
Insurance: 15,000
Property taxes: 5,000
Depreciation: 70,000
Utilities: 30,000
Miscellaneous: 10,000
Total MOH: 630,000
Activity data for products A and B:
Direct labor hours A: 12,000; B: 18,000 (Total DL hours: 30,000)
Machine hours A: 10,000; B: 12,500 (Total machine hours: 22,500)
Allocation options and results:
Single rate based on DL hours:
ext{MOH Rate} = rac{630{,}000}{30{,}000} = 21 ext{ per DL hour}
A MOH absorbed = 21 imes 12{,}000 = 252{,}000
B MOH absorbed = 21 imes 18{,}000 = 378{,}000
Single rate based on machine hours:
ext{MOH Rate} = rac{630{,}000}{22{,}500} = 28 ext{ per machine hour}
A MOH absorbed = 28 imes 10{,}000 = 280{,}000
B MOH absorbed = 28 imes 12{,}500 = 350{,}000
Departmental rates in the two departments (machining and assembly):
Machining dept MOH: 450,000; Allocation base: machine hours 22,500 → ext{MOH Rate}_{ ext{Machining}} = rac{450{,}000}{22{,}500} = 20 ext{ per machine hour}
Assembly dept MOH: 180,000; Allocation base: direct labour hours 24,000 → ext{MOH Rate}_{ ext{Assembly}} = rac{180{,}000}{24{,}000} = 7.5 ext{ per DL hour}
Departmental rate absorption for products A & B (example data):
Product A: Machining 10,000 hours × 20 = 200,000; Assembly 10,000 DL hours × 7.5 = 75,000; Total MOH absorbed = 275,000
Product B: Machining 12,500 hours × 20 = 250,000; Assembly 14,000 DL hours × 7.5 = 105,000; Total MOH absorbed = 355,000
Comparison (MOH absorbed) under different approaches (illustrative values):
Single rate based on DL hours: A = 252,000; B = 378,000
Single rate based on machine hours: A = 280,000; B = 350,000
Departmental rates: A = 275,000; B = 355,000
Limitations of actual costing (flow and timing issues)
It takes time to gather all MOH cost information.
Unit product cost under actual costing is sensitive to fluctuations in actual production volume each period.
MOH allocation under normal costing (pre-determined rate at year start)
Steps for normal costing system: 1) At the beginning of the year, estimate MOH costs and the allocation base quantity to determine the pre-determined rate.
No accounting record is required yet.
2) When completing a job or at month-end, apply MOH using the pre-determined rate.
3) Record actual MOH costs as incurred in their respective accounts.
4) At month-end, compare actual MOH with MOH applied and record over- or under-applied MOH.
5) At year-end, close the over/under-applied MOH account by prorating to WIP, FG, and COGS or adjust COGS only.
Example ABC Ltd (Normal Costing):
Budgeted data: Estimated MOH costs = 8,000,000; Units of production = 1,200,000; Direct materials = 4,800,000; Machine hours = 32,000; Direct labor hours = 40,000; Direct labor costs = 2,000,000.
Rate basis: single plant-wide rate using direct labor cost as the allocation base.
Example – Normal costing with single rate (DL cost basis):
Actual DL costs for the month: X = 72,000; Y = 90,000; Total DL costs = 162,000.
Indirect materials = 10,000; Indirect labor = 150,000; Others = 490,000; Total MOH incurred = 650,000.
Pre-determined MOH rate = rac{8{,}000{,}000}{2{,}000{,}000} = 400 ext{%} (i.e., 400% of DL cost).
MOH applied: X = 400% × 72,000 = 288,000; Y = 400% × 90,000 = 360,000; Total MOH applied = 648,000.
Actual MOH costs recorded: 650,000.
Month-end variance: Underapplied MOH = 2,000 (650,000 − 648,000).
Year-end close: adjust COGS or prorate to WIP/FG/COGS as appropriate.
Quick checks:
Tiger, Inc. example: Actual MOH = 1,210,000; Predetermined rate = $4.00 per machine hour; Hours = 290,000.
Applied MOH = 4.00 × 290,000 = 1,160,000.
Over/under: Actual > Applied → Underapplied by 50,000.
Correct answer: b) $50,000 underapplied.
Cost accumulation systems: Job costing vs. Process costing
Job costing
Traces costs to specific jobs.
Suitable for small quantities, batches of uniquely identifiable or tailor-made products, or services.
Uses job cost sheets; tracks costs by job with a unique job number.
Costs tracked by job: Direct materials, direct labor, and allocated MOH at job completion or periodically.
Unit product cost for a job = Total product costs for the job / Units produced for the job.
Process costing
Traces costs by department or process for large quantities of homogeneous products.
Suitable when processes produce identical units.
Costs flow through departments; unit product cost = Total product costs for the period / Units produced for the period.
Which system to use depends on the operation process and the nature of the product.
Process costing: unit cost and equivalent units (key concepts and formulas)
Unit product cost in a processing environment:
ext{Unit product cost} = rac{ ext{Total product costs for the period}}{ ext{Units of production for the period}}
Equivalent units of production (EUP):
If some units are not fully completed, convert them to an equivalent number of fully completed units.
Example concept: If 6,000 units are finished and there is 4,000 units in ending WIP at 50% complete, then total equivalent units = 6,000 + (0.50 × 4,000) = 8,000.
Cost per equivalent unit = Total costs in department / Equivalent units of production.
Process costing in multiple departments:
Compute cost per equivalent unit in each department separately (DM, DL, MOH in that department).
Allocate costs to units transferred and to ending WIP based on equivalent units in each department.
Process costing examples (highlights from slides)
Example 1 (No beginning WIP):
Departments: Preparation, Cooking, Packaging.
Units finished and transferred: 10,000 in each department.
Costs incurred per department: $10,000 (Preparation), $30,000 (Cooking), $60,000 (Packaging).
Equivalent units per department: 10,000 in each (no ending WIP).
Cost per unit per department: $1.00, $3.00, $6.00 respectively.
Transfer costs equal the costs incurred per department for the units transferred.
Example 2 (Ending WIP):
Ending WIP in Packaging department = 4,000 at 50% completion; Finished & transferred = 6,000.
Cost incurred in the department = $10,000 ( Preparation ), etc. (illustrative).
Equivalent units = 6,000 + (50% × 4,000) = 8,000; Cost per unit determined accordingly (e.g., $1.25 per unit in that department in the example).
Example 3 (Equivalent units by inputs):
Different inputs (DM, DL, MOH) can have different completion percentages; compute separate equivalent units for each input and derive per-unit costs accordingly (e.g., DM = 80 total cost with 2 units at 100%, DL = 30 with 2 units at 75%, MOH = 45 with 2 units at 75%; derive 2 units, 100% = costs / 2; 2 units, 75% = (cost) / 1.5, etc.).
Job costing vs. process costing: quick recap
Job costing: costs traced to specific jobs; best for customized or small-batch products; unit cost = total job costs / units produced for the job.
Process costing: costs traced by department/process; best for homogeneous, high-volume production; unit cost = total costs / units produced; uses equivalent units for partial completion.
Quick practice questions and checks (conceptual reminders)
Determine whether to use job costing or process costing based on product type and production process.
For MOH allocation, decide between actual vs pre-determined rates, and whether to use plant-wide or departmental bases.
Understand under- and over-applied MOH: difference between actual MOH and MOH applied; decide whether to close to COGS or prorate to WIP/FG/COGS at period-end.
Remember that normal costing uses a pre-determined MOH rate (based on estimates) for the year; actual MOH costs are recorded as incurred and compared to applied MOH.
Summary (key takeaways)
Absorption costing requires that product costs (DM, DL, MOH) be included in inventory until sale; period costs are expensed as incurred.
MOH allocation is essential because MOH cannot be traced directly to individual units; it is allocated using rates based on a chosen allocation base.
Allocation methods include Actual costing, Normal costing (pre-determined rate), and Standard costing; departmental vs. plant-wide rates affect accuracy.
The choice of allocation base (DL hours, machine hours, DL cost, etc.) and the rate calculation method impact the reported product costs and profitability.
Job costing vs. process costing: determine the best system based on customization vs. mass production; each has distinct formulas for unit costs and cost accumulation.
Equivalent units are crucial in process costing to account for partially completed units in ending WIP and to compute accurate unit costs.
Notation and equations (recap)
MOH Rate (Actual):
ext{MOH Rate}_{ ext{Actual}} = rac{ ext{Actual manufacturing overhead costs}}{ ext{Actual quantity of allocation base}}
MOH Absorbed (Actual):
ext{MOH absorbed} = ext{MOH Rate}_{ ext{Actual}} imes ext{Actual quantity of allocation base used}
MOH Rate (Applied / Predetermined):
ext{MOH Rate}_{ ext{Applied}} = rac{ ext{Estimated MOH costs}}{ ext{Estimated total allocation base}}
MOH absorbed (Applied) under normal costing:
ext{MOH absorbed} = ext{MOH Rate}_{ ext{Applied}} imes ext{Actual allocation base used}
Process costing unit cost (departmental):
ext{Unit cost in department} = rac{ ext{Total department costs}}{ ext{Equivalent units in department}}
Process costing unit product cost (period):
ext{Unit product cost} = rac{ ext{Total product costs for the period}}{ ext{Units of production for the period}}
Equivalent units (example):
If Finished = 6{,}000 units; Ending WIP = 4{,}000 units at 50% completion →
ext{Equivalent units} = 6{,}000 + (0.50 imes 4{,}000) = 8{,}000
Pre-determined rate example (400%):
ext{Pre-determined MOH rate} = rac{8{,}000{,}000}{2{,}000{,}000} = 400 ext{%}
Quick check answer example (Tiger, Inc.):
Applied MOH = 4.00 imes 290{,}000 = 1{,}160{,}000
Actual MOH = 1{,}210{,}000 $$
Underapplied MOH = 1{,}210{,}000 - 1{,}160{,}000 = 50{,}000
(Note: All figures in the notes reflect the numbers and examples from the provided transcript.)