Cost assignment, Job costing, process costing, cost object

Management accounting for decision making: Cost accounting systems

Assoc. Prof. Dr. Rafael Heinzelmann

Agenda

• Introduction

• Job costing (Bhimani et al., Chapter 3)

• Process costing (Bhimani et al., Chapter 4)

• Cost allocation (Bhimani et al., Chapter 5)

• ABC (Activity-Based Costing) (Bhimani et al., Chapter 11)

• Summary

Introduction

Cost Assignment

• Direct Costs - Costs that can be conveniently and economically traced to a specific cost object. They are directly associated with the production of a particular good or service.

  • Examples: Direct materials (e.g., wood for furniture) and direct labor (e.g., wages for an assembly line worker dedicated to a specific product).

• Indirect Costs - Costs that are related to the cost object but cannot be traced to it in an economically feasible (cost-effective) way. These costs benefit multiple cost objects.

  • Examples: Rent for a factory that produces many different products, electricity used across the entire plant, or salaries of factory supervisors. These costs must be allocated to cost objects.

Job-Costing and Process-Costing Systems

• Job-Costing Systems - These systems are used when individual products, services, or batches are distinct and unique. The cost object is an individual unit, batch, or lot of a distinct product or service, referred to as a "job." Each job consumes different amounts of resources, making it necessary to track costs separately for each one.

  • Examples: Custom-made products like specialized machines, houses built to order, consulting projects, or movie productions. This method accumulates costs for each specific job.

• Process-Costing Systems - These systems are utilized when masses of identical or similar units of a product or service are produced. The production process is continuous and homogeneous, resulting in uniform outputs. Costs are averaged across all units produced during a specific period.

  • Allocates costs among all products manufactured in that period by averaging total costs over total units.

  • Examples: Food production (e.g., cereals, beverages), chemical processing, oil refining, or mass-produced items like pencils or standard postal delivery. This method calculates an average cost per unit.

Examples of Job Costing and Process Costing

Job Costing is Used in:

• Audit engagements (PricewaterhouseCoopers)

• Consulting engagements (McKinsey & Co.)

• Advertising campaigns (Ogilvy & Mather)

• Legal cases (Hale & Dorr)

• Computer repair jobs (CompUK)

• Movie production (Universal Studios)

• Individual mail orders (LL Bean)

• Special promotions (Tesco)

• Aircraft assembly (Boeing)

• Ship construction (Litton Industries)

Process Costing is Used in:

• Bank cheque clearing (Bank of England)

• Standard postal delivery (UK Postal Service)

• Grain dealing (Arthur Daniel Midlands)

• Lumber (Weyerhauser)

• Oil refining (Shell Oil)

• Beverage production (PepsiCo)

Example of Job Costing

D.L. Sports manufactures sporting goods and plans to sell a batch of 25 machines (Job No. 100) to a gym for £104,800.

• Step 1: Identify Cost Object – The specific item or service for which costs are being measured. Here, it's Job No. 100, the batch of 25 machines.

• Step 2: Determine Direct Costs: Costs that can be directly traced to Job No. 100.

  • Direct Materials: £45,000 (specific raw materials used for these machines)

  • Direct Manufacturing Labour: £14,000 (wages of workers directly assembling these machines)

• Step 3: Select Cost-Allocation Base: A systematic way to assign indirect costs to cost objects. This base should ideally have a cause-and-effect relationship with the indirect costs.

  • Chose machine hours as the base, implying that machine usage drives manufacturing overhead.

  • Job No. 100 used 500 machine hours; total machine hours for all jobs in the period: 2,480 machine hours.

• Step 4: Identify Indirect Costs: Total manufacturing overhead costs for the period that need to be allocated.

  • Actual manufacturing overhead costs: £65,100

• Step 5: Compute Rate per Unit: Calculate the indirect cost rate using the chosen allocation base.

  • Indirect cost rate: $(\frac{\text{Total Actual Indirect Costs}}{\text{Total Actual Allocation Base}}) = \frac{\text{£65,100}}{\text{2,480 machine hours}} = \text{£26.25 per machine hour}$

• Step 6: Compute Indirect Costs Allocated to Job: Apply the indirect cost rate to the allocation base consumed by Job No. 100.

  • Indirect costs for Job No. 100: $\text{£26.25 per machine hour} \times \text{500 hours} = \text{£13,125}$

• Step 7: Compute Total Cost of Job No. 100: Sum up all direct and allocated indirect costs for the job.

  • Direct Materials: £45,000

  • Direct Labour: £14,000

  • Factory Overhead (allocated indirect costs): £13,125

  • Total Cost: £72,125

• Gross Margin Calculation: Evaluate the profitability of the job.

  • Revenues: £104,800

  • Cost of Goods Sold (Total Cost of Job): £72,125

  • Gross Margin: £32,675 (Revenue - Cost of Goods Sold)

  • Gross Margin Percentage: $(\frac{\text{Gross Margin}}{\text{Revenues}}) = \frac{\text{£32,675}}{\text{£104,800}} \approx \text{31.2\%}$

Actual Costing vs. Normal Costing

• Actual Costing System - A costing method that uses actual direct-cost rates and actual indirect-cost rates, multiplied by actual quantities of direct-cost inputs and the actual quantities of the cost-allocation base, respectively. This system provides the most accurate historical cost but requires waiting until the end of the period to know actual indirect costs, which can delay decision-making.

  • Traces indirect costs to cost objects using actual direct-cost rates based on actual quantities. While ideal for historical accuracy, it can be impractical for timely pricing and control decisions.

• Normal Costing - A costing method that uses actual direct-cost rates and actual quantities of direct-cost inputs, but budgeted (predetermined) indirect-cost rates, multiplied by actual quantities of the cost-allocation base. This approach allows for more timely cost information for decision-making throughout the period.

  • Budgeted Indirect-Cost Rate Calculation Example:

    • Total manufacturing overhead costs budgeted: £60,000

    • Total machine hours budgeted: 2,400

    • Indirect-cost rate: $(\frac{\text{Budgeted Total Indirect Costs}}{\text{Budgeted Total Allocation Base}}) = \frac{\text{£60,000}}{\text{2,400 hours}} = \text{£25 per hour}$

    • Indirect costs allocated to Job No. 100: $\text{500 Machine hours} \times \text{£25 per hour} = \text{£12,500}$

    • Cost of Job No. 100 under Normal Costing:

      • Direct Materials: £45,000

      • Direct Labour: £14,000

      • Factory Overhead: £12,500

      • Total: £71,500

  • Normal costing is widely used because it provides a reasonable estimate of product costs on a timely basis, aiding in setting prices, bidding on jobs, and managing costs before actual overheads are known.

Costing Approaches

Summary of Costing Methods

• Actual Costing:

  • Direct Costs: Uses actual direct-cost rates and actual quantities of direct inputs.

  • Indirect Costs: Uses actual indirect-cost rates and actual quantities of the allocation base.

• Normal Costing:

  • Direct Costs: Uses actual direct-cost rates and actual quantities of direct inputs.

  • Indirect Costs: Uses budgeted (predetermined) indirect-cost rates multiplied by actual quantities of the allocation base.

End-of-Period Adjustments

• Underallocated Indirect Costs: Occurs when the amount of indirect costs allocated to cost objects during a period is less than the actual indirect costs incurred. This means the budgeted rate was too low or the actual allocation base was higher than budgeted (or a combination).

  • This results in products being undercosted and requires an adjustment to increase costs (e.g., to Cost of Goods Sold).

• Overallocated Indirect Costs: Occurs when the amount of indirect costs allocated to cost objects during a period exceeds the actual indirect costs incurred. This indicates the budgeted rate was too high or the actual allocation base was lower than budgeted.

  • This results in products being overcosted and requires an adjustment to decrease costs (e.g., to Cost of Goods Sold).

Example of Process Costing

• Snowdon Ltd., a manufacturer of skiing accessories, utilizes a process costing system for its homogeneous products.

• Physical Flow of Production Units: This tracks where units are in the production process.

  • Opening work-in-progress (WIP): 0 units (meaning no unfinished units from the previous period)

  • Started during current period: 35,000 units

  • Completed and transferred out: 30,000 units

  • Closing work-in-progress (WIP): 5,000 units (35,000 started - 30,000 completed = 5,000 remaining unfinished)

Equivalent Units:

Equivalent units represent the number of completed units that could have been produced from the work effort expended during the period. This is crucial when some units are still in process at the end of the period.

• Direct Materials: Assumed to be added at the beginning of the process, so all units in WIP (both completed and in closing WIP) are 100% complete with respect to direct materials.

  • Completed and transferred out: 30,000 units

  • Work-in-progress, closing: 5,000 units (assumed 100% complete for materials)

  • Total Equivalent Units for Direct Materials: $30,000 + 5,000 = 35,000 \text{ units}$

• Conversion Costs: These are usually added gradually throughout the process (e.g., direct labor and manufacturing overhead). The closing WIP is only partially complete with respect to conversion costs.

  • Completed and transferred out: 30,000 units (100% complete for conversion)

  • Work-in-progress, closing: 1,000 units (This is calculated as 20% of 5,000 units, indicating the average completion level for these costs in the unfinished units.)

  • Total Equivalent Units for Conversion Costs: $30,000 + 1,000 = 31,000 \text{ units}$

Total Production Costs

These are the costs incurred during the period that need to be allocated to the equivalent units.

• Total Production Costs = £146,050

• Direct Materials Costs = £84,050

• Conversion Costs = £62,000

• Cost per Equivalent Unit: To allocate costs, we divide total costs by equivalent units for each cost category.

  • Direct Materials: $£\frac{\text{84,050}}{\text{35,000 equivalent units}} \approx \text{£2.4014 per equivalent unit}$

  • Conversion Costs: $£\frac{\text{62,000}}{\text{31,000 equivalent units}} = \text{£2.00 per equivalent unit}$

Assigning Total Costs

Finally, the total costs are assigned to the units that were completed and transferred out, and to the units remaining in closing work-in-progress.

• Completed and transferred out: These 30,000 units are fully complete for both materials and conversion.

  • $30,000 \text{ units} \times (\text{£2.4014} + \text{£2.00}) = 30,000 \text{ units} \times \text{£4.4014} \approx \text{£132,042}$ (Note: slight rounding difference from £132,043 in original, but the calculation is consistent here.)

• Work-in-progress closing (5,000 units): These units have received all direct materials but only 20% of conversion costs.

  • Direct Materials: $5,000 \text{ units} \times \text{£2.4014} = \text{£12,007}$

  • Conversion Costs: $1,000 \text{ equivalent units} \times \text{£2.00} = \text{£2,000}$

• Total Production Costs Accounted For: Approximately the sum of costs for completed units and closing WIP.

  • $\text{£132,042} (\text{completed}) + \text{£12,007} (\text{DM in WIP}) + \text{£2,000} (\text{CC in WIP}) = \text{£146,049}$ (This matches original total £146,050, allowing for minor rounding discrepancies from the per-unit rates.)

Cost Allocation in Brief

Purposes of Cost Allocation

Cost allocation is the process of assigning indirect costs to cost objects for various management purposes:

• Indirect costs are often traceable, but it might not be economically feasible to allocate them directly to cost objects due to the high cost of measurement. Allocation provides a way to assign these shared costs.

• Managers use cost allocation for critical decisions, including:

  • New product decisions: To determine the full cost of a new product and ensure it is priced profitably.

  • Manufacturing vs. purchasing component parts (Make-or-Buy decisions): To compare the full internal cost of making a component with the external purchase price.

  • Selling price decisions: To establish a selling price that covers all costs and generates a desired profit margin.

  • Evaluating department or division performance: To hold managers accountable for the costs incurred in their areas.

  • External reporting and statutory requirements: To value inventory and calculate Cost of Goods Sold for financial statements and tax purposes.

Criteria for Cost Allocation

The choice of cost allocation method depends on the purpose and the desired outcome. Four criteria are commonly considered:

1. Cause-and-Effect

• This is the most preferred method. Allocates costs based on the direct causal relationship between the cost object and the resource consumption. It identifies variables that cause resources to be consumed by the cost object.

  • Example: Allocating quality control (QC) costs based on hours of testing for each product, as more testing hours directly cause higher QC costs. If a product requires more complex setup, setup costs can be allocated based on the number of setups.

2. Benefits-Received

• Allocates costs in proportion to the benefits received by the cost objects from the common cost. It's used when a cause-and-effect relationship is difficult to establish.

  • Example: Dividing corporate advertising costs among divisions based on their respective revenues, assuming that divisions with higher revenues benefit more from corporate advertising. Research and development costs might be allocated based on expected future revenues from new products.

3. Fairness or Equity

• This criterion is often used in situations where costs are allocated to government contracts or regulatory purposes, aiming to establish reasonable prices or reflect a fair share of common costs. It is usually determined by negotiation or regulations rather than strict economic principles.

  • Example: Cost-plus contracts with government agencies might require allocation methods perceived as equitable to both parties.

4. Ability to Bear

• Allocates costs based on the cost object's capacity to absorb or afford the costs, typically based on profitability or operating income. This method is generally considered less desirable for decision-making because it can lead to mispricing or cross-subsidization, penalizing successful products/divisions.

  • Example: Allocating executive salaries by division operating income, where more profitable divisions bear a larger share of these costs. While it appears

ABC (Activity-Based Costing)

Traditional Costing Methods (TCM) often allocate indirect costs based on a single, volume-related cost driver, such as direct labor hours or machine hours. While simpler, this approach can lead to distorted product costs, especially in complex manufacturing environments with diverse products and varying demands on indirect resources. ABC emerged as a response to the limitations of TCM, providing a more refined system for allocating indirect costs.

ABC is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. It provides a more accurate way to allocate indirect costs by focusing on root causes (activities) that drive costs.

Key Concepts of ABC:

Activities: Events, tasks, or units of work with a specific purpose (e.g., setting up machines, inspecting products, processing orders).

Cost Pools: Grouping related costs for a specific activity (e.g., all costs associated with machine setup).

Cost Drivers: Factors that measure the consumption of activity resources by cost objects (e.g., number of setups, number of inspections, number of orders).

Cost Objects: The products, services, or customers to which costs are assigned.

Steps in Implementing ABC:

Identify major activities and the costs associated with them.

Assign costs to activity cost pools.

Identify cost drivers for each activity.

Calculate a predetermined overhead rate for each activity by dividing the total estimated activity cost by the total estimated cost driver activity.

Allocate activity costs to products or services using the activity-based overhead rates and the actual activity consumption by each cost object.

Benefits of ABC:

Improved Cost Accuracy: Provides more precise product and service costs, especially for companies with diverse products and complex production processes.

Better Decision Making: Enables more informed pricing, product mix, and make-or-buy decisions.

Enhanced Cost Control: Highlights the cost of activities, helping managers identify and eliminate non-value-added activities.

Strategic Planning: Supports strategic initiatives by providing a clearer understanding of profitability by product, customer, or distribution channel.

Limitations of ABC:

Cost of Implementation: Can be expensive and time-consuming to implement and maintain.

Complexity: Requires significant data collection and analysis, which can be challenging.

Resistance to Change: May face resistance from employees and managers due to its complexity and perceived disruption.

Not for Every Company: May not be beneficial for companies with simple operations or where indirect costs are a small proportion of total costs.

Summary

Cost accounting systems, including job costing and process costing, are essential for tracking and allocating manufacturing costs. Direct costs are easily traceable to specific cost objects, while indirect costs require systematic allocation using bases that ideally reflect cause-and-effect relationships. Actual costing provides historical accuracy but can be slow, whereas normal costing uses budgeted indirect rates for timely decision-making. End-of-period adjustments address any under- or overallocation of indirect costs. Cost allocation, driven by criteria like cause-and-effect, benefits received, fairness, and ability to bear, serves various management purposes from pricing to performance evaluation. Activity-Based Costing (ABC) further refines indirect cost allocation by focusing on activities and their drivers, offering more precise cost data for complex operations, which aids in strategic decision-making and cost control.