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TRADITIONAL PRODUCT COSTING

METHODS

Accounting Principles IIAC 2102 - Fall Semester, 1999

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Unit Product Costs

• The unit cost is the total costs associated with the units divided by the number of units produced

• The concept is deceptively simple

• The practical reality of the computation, however, can be somewhat more complex

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Key Issues Which Must Be AddressedWhen Calculating A Unit Cost

1st: What costs are included in total cost?– Does this total only include production costs?– Or only production costs plus marketing costs?– Or all the costs of the organization?

2nd: Should actual or estimated costs be used in the calculation?

3rd: How do we associate indirect costs with the product?

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Determining The Costs To Include In The Unit Cost Calculation

• The product cost definition depends on the managerial objective under consideration

• Example: “Product Cost” is defined as production costs (direct material, direct labor & manufacturing overhead) only for external financial reporting

• Note that “Product Cost” is often defined more broadly in comtemporary accounting, particularly for value-chain analysis, evaluating efficiencies, and long-term pricing

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Determining How The Costs To Be Included Should Be Measured & Assigned To Products

• Cost Measurement - determining the dollar amounts of direct material, direct labor & manufacturing overhead used in production

• Actual or Estimated Amounts - the dollar amounts included in cost measurement can be actual or estimated amounts– Estimated amounts may be used to improve timeliness of

cost information or to control costs

• Cost Assignment - The process of associating costs, once measured, with the units produced

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Importance of Unit CostsTo Manufacturing Firms

• Unit cost is a critical piece of information for a manufacturer

• Unit costs are essential for valuing inventory, determining income, and making a number of important decisions

• Whether the unit cost is defined using manufacturing costs or variable costs or total organization costs depends on the purpose for which the information is going to be used– Different costs are needed for different purposes

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Importance of Unit CostsTo Service Firms

• Conceptually, the way we measure and assign costs is the same regardless of the nature of the firm – i.e., manufacturing or nonmanufacturing firm

• The service firm must first identify the service “unit” that is being provided– Examples: a repair job, a surgery, a processed

insurance claim, a laboratory test

• Use costs to determine profitablity, evaluating the feasibility of providing a new service, making pricing decisions, etc.

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Two Basic Ways To Measure Production Costs

• Actual Costing

– The actual costs of all resources used in production are included in determining product costs

– While intuitively reasonable, this method has serious drawbacks

• Normal Costing

– The actual costs of direct materials & direct labor and overhead is applied using predetermined overhead rates are included in determining product costs

– Is the most widely used in practice

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Actual Costing

• An actual cost system includes actual costs for direct material, direct labor & factory overhead.

• Pure actual cost systems are rarely used in practice– Because such systems cannot provide

accurate unit costs on a timely basis

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Direct Material & Direct LaborIn An Actual Costing System

• Amount of actual direct materials and direct labor used by a product can be physically observed as the units are produced

• Actual prime costs can be assigned using direct tracing

• These two costs can be assigned on a timely basis

• No significant problem with either accuracy or timeliness for costing purposes

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Two Major Disadvantages Of Actual Cost Systems

(1) Delays in collecting (or determining) actual overhead costs impedes producing unit cost data on a timely basis

(2) Substantial fluctuations result in the calculated monthly unit costs of product

Note: Both these disadvantages are caused by the process of assigning actual overhead costs to products

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Delays In Collecting Or Determining Overhead Costs

• Many of the costs included in overhead costs are not known immediately at the end of each month

• Examples:– Electricity, gas (must wait for bills from utility)– Property Taxes (only receive figure once per

year)– Outside service (must wait until bill for charges

is received)

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Fluctuations In CalculatedMonthly Unit Costs

• Occurs for two major reasons:(1) Monthly fluctuations in the amount of overhead incurred

by the company- sometimes called the “numerator problem”

(2) Monthly fluctuations in the level of production, i.e.., the number of units produced

- sometimes called the “denominator problem”

• Often such variations in monthly unit cost figures do not signal differences in the underlying cost structure

• Often these variations cause great confusion

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Normal Costing

• Product costs include actual material, actual labor and overhead based on predetermined rates

• The predetermined overhead rate is calculated as follows:

Budgeted OH $/ Bugeted Activity Usage

Note: once the rate is determined, overhead is mechanically charged just as it would if an actual cost rate was being applied

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Overhead-Related Differences Between Actual and Calculated Unit Costs

• The predetermined rate is usually set once per year right before the new fiscal year begins

• This predetermined rate is likely to differ from the actual rate (which later results)

• Either actual overhead costs differ from the estimated costs or the actual level of production differs from the expected level, or both

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Assigning Product Costing In A Traditional Costing System

• Assigns only manufacturing costs to products• Can assign direct materials and direct labor to

products using either direct tracing or very accurate driver tracing

• The physically-observable relationships that exist between direct materials, direct labor and products is simply not available for overhead – Assignment of overhead must rely on driver

tracing and/or allocation

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Traditional Product Costing System

• Only unit-level activity drivers are used to assign costs to products

• Unit-level activity drivers:– are factors that cause changes in cost as units

produced change

• The use of only unit-based drivers to assign overhead to products assumes that the overhead consumed by products is highly correlated with the number of units produced

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How Unit-Based Activity Drivers Assign Overhead Costs To Products

• Either plantwide or departmental overhead rates are used to charge overhead to jobs and products

• Commonly used unit-level drivers:– Units produced– Direct labor hours– Direct labor dollars– Machine hours– Direct material

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The Four Possible Levels of ActivityReflected In The Driver

• Expected activity level– The activity output expected in the next year

• Normal activity level– The average activity output that a firm experiences in the long

term (more than one year)

• Theoretical activity level– The absolute maximum activity output if everything operates perfectly

• Practical activity level– The maximum output that can be realized if everything operates efficiently

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Selecting An Activity LevelOn Which To Base The Rate

• The most often chosen activity level for calculating the overhead rate is either the expected level or the normal level of activity

• The expected level has the advantage that the total overhead charged to products will more likely closely approximate the actual overhead incurred over a year

• The normal level has the advantage of using the same activity level each year– It produces less fluctuations from year to year in the assignment of

per unit overhead costs– It better reflects the long-run average cost being incurred

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Calculating Steps ForPlantwide Overhead Rates

• 1st: Accumulate factory overhead costs in a single cost pool

• 2nd: Select a single unit-level cost driver - direct labor hours is the most frequently-used driver

• 3rd: Select activity level to use in calculating rate

• 4th: Divide total overhead costs in pool by total activity level for selected driver

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Overhead CostsOverhead Costs

Assign CostsAssign Costs

Plantwide PoolPlantwide Pool

Cost AssignmentCost Assignment

ProductsProducts

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Applying Overhead To Jobs & Products

• To apply overhead means to charge, assign or “attach it” to a job, product, service, etc.

• The total overhead assigned to actual production at any point in time is called “applied overhead”

• Applied overhead is calculated as follows:

Total Applied = Overhead Rate x Actual Activity Output

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Overapplied & Underapplied Overhead

• Overhead Variance

- The difference between the total actual overhead incurred and the total applied overhead assigned to production

• Underapplied Overhead

- If the actual overhead is greater than the the total applied overhead

• Overapplied Overhead

- If the actual overhead is less than the the total applied overhead

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Calculation of Per Unit Costs

• 1st Step: Add total prime costs (direct materials and direct labor) plus assigned overhead

• 2nd Step: Divide the total costs calculated in the first step by the total number of units produced

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Calculating Steps ForDepartmental Overhead Rates

• 1st: Assign factory overhead costs to the production departments - Use direct tracing, driver tracing and cost allocation

to assign (distribute) overhead costs to departments

• 2nd: Select the most appropriate single unit- level cost drivers for each department - different drivers often are used for each department

• 3rd: Select activity levels to use in calculating each department’s rate

• 4th: Divide total overhead costs in each pool by total activity levels for selected drivers

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Total Applied OverheadWhen Departmental Rates Are Used

• Total applied overhead for the year is simply the sum of the amounts applied in each department

• In the case of a normal cost system, the applied overhead will equal the budgeted overhead only when the actual level of activity output measures are the same as the expected activity output measures

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Limitations of Traditional Cost Accounting Systems

• The use of plantwide and departmental overhead rates continue to work satisfactorily for many companies

• But for companies operating in an advanced manufacturing environment traditional cost systems often are inadequate and cause the company to operate with severe competitive disadvantages

• Activity-Based Costing is a contemporary approach that has been developed to deal with this new and challenging environment

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