3 C H A P T E R Product Cost Flows and Business Organizations

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 Direct Materials Costs Manufacturing Overhead Costs Direct Labor Costs - Expenditure and use usually match production. - Expenditure and use usually match production. Easily assigned to products. - Total costs not known until the end of the period. - Not usually assigned to specific products. - “Lumped” costs don’t match production very well. Difficult to assign to products.

Why does management needs accurate product cost information? 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.

What does accurate information allow management to do? 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.

Review the Time Line of Business BUY raw materials or goods for resale SELL finished inventory cost of goods sold ending inventory ADD value COMPUTE

To accurately measure product costs, accountants must: 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 Inventory Direct Labor Factory Overhead Work-In- Process Inventory Production Finished Goods Inventory Cost of Goods Sold

Determining Cost Multiple products produced in same facility. Changing prices and labor rates. Multiple manufacturing locations (perhaps international). Individuals performing multiple tasks. What are some difficulties in determining costs of manufactured products?

Costs of Manufacturing Products Discuss the Nature of Raw Materials. Cost of raw materials used directly in the manufacture of products. Direct materials 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 6

Costs of Manufacturing Products Discuss the Nature of Direct Labor. Wages/payroll-related expenses of factory employees who work directly on products. Direct labor 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

Manufacturing overhead Costs of Manufacturing Products Discuss the Nature of Factory Overhead. All manufacturing costs not classified as direct materials or direct labor. Manufacturing overhead 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 Annual expected (budgeted) activity level (e.g., direct labor hours) Predetermined overhead rate = Step Two Predetermined overhead rate x Actual activity level per job = Allocated manufacturing overhead assigned to job 10

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 10,000 = $3.00 per machine hour 13

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 Rate $3.00 Actual Activity 10 hours x = Applied MOH $30.00 Work-in-Process Inventory. . . . . . . . . . . 30 Manufacturing Overhead . . . . . . . . 30 13

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 Direct Materials $100 Direct Labor 200 MOH 30 Total $330 Finished Goods Inventory . . 330 Work-in Process. . . . . . . . . . . . 330 Cost of Goods Sold. . . . . . . 330 Finished Goods Inventory. . . 330 13

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. 26

Disposition of Over- and Underapplied MOH Manufacturing Overhead Actual 10 Applied 20 Manufacturing Overhead Actual 20 Applied 10 (Cost of job is overstated) (Cost of job is understated) Overapplied Manufacturing Overhead: The excess of applied overhead costs over actual overhead costs for a period. Underapplied Manufacturing Overhead: The excess of actual overhead costs over applied 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. 29

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 Manufacturer Brand B Manufacturer Brand C Manufacturer Brand D Manufacturer Brand E Manufacturer Brand F Wholesaler Retailer Brand A Customers Brand B Customers Brand C Customers Brand D Customers Brand E Customers Brand F Customers

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 goods to retailers. Quality and timelines are also important performance measures. To be profitable, wholesalers must be sure the right goods are received and shipped in the right manner to the 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 (opportunity cost). Stockturns—the faster stock (inventory) can be turned, the sooner the money is available to purchase more inventory. Second-tier merchants who typically purchase products from wholesalers to distribute to customers. Many will often bypass wholesalers to purchase inventory directly from the original manufacturers.

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

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.

Define a Service Company An organization whose main economic activity involves producing a nonphysical product that provides value to a customer. Important for service firms to develop useful management accounting systems that support managing costs, quality, and 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.

What Impact Has e-business Had on Product Costs? Reduced cost of materials, since businesses can search for the best price. Better management of direct labor costs. In some cases, customers interact with technology instead of employees. 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. 35

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. 36

Step 1: Compute Equivalent Units of Production 37

Step 2: Compute Product Costs per Unit 39

Step 3: Compute the Costs Transferred Out 37

Step 4: Compute Costs of Ending Work-in Process Inventory 45

Step 5: Prepare the Production Cost Report The production cost report contains the information prepared and presented in steps 1 through 4. 37