Absorption Cost Systems Chapter Nine Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Outline of Chapter 9 Absorption Cost Systems Job Order Costing Cost Flows through the T-Accounts Allocating Overhead to Jobs Permanent versus Temporary Volume Changes Plantwide versus Multiple Overhead Rates Process Costing: The Extent of Averaging Appendix A: Process Costing Appendix B: Demand Shifts, Fixed Costs, and Pricing 9-2

Connection to Other Chapters Chapter 9 describes how manufacturing firms use absorption costing to apply costs to products manufactured. Previously, chapters 7 and 8 introduced the topic of cost allocations and discussed various reasons why firms allocate costs, including decision management, decision control, cost-plus pricing contracts, financial reporting, and taxes. After chapter 9, chapters 10 and 11 will describe criticisms of absorption cost systems. Chapter 10 shows how variable costing can mitigate absorption costing’s incentives to overproduce. Chapter 11 shows how activity-based costing can mitigate absorption costing’s tendency to give inaccurate product costs. 9-3

Manufacturing versus Nonmanufacturing Settings Manufacturing settings  Product costs: costs of manufacturing goods  Period costs: nonmanufacturing costs  Costs must be allocated between cost of goods sold (expense or expired costs) and ending inventories (assets or unexpired costs) Note: Because allocation involves management’s judgment, it offers discretion in product costing and income determination. Nonmanufacturing settings (merchandising and service firms)  Product costs: costs of inventory held for resale  Period costs: all other costs  Most product costs for physical goods are directly traced to external contacts and do not require cost allocation 9-4

Two Types of Absorption Systems Absorption cost systems ensure that all manufacturing costs are assigned to products either by direct tracing or by cost allocation. Job order costing is used in departments that produce output in distinct jobs (job order production) or batches (batch manufacturing). Process costing is used in departments that produce output that is not in distinct batches or produce continuous flows, such as beverages and oil refineries. In practice, many plants use hybrids of job order and process costing. 9-5

Job Order Costing Cost object: Distinct job or batch records are maintained for each job (see Table 9-1). Direct traceable costs: Raw materials and direct labor costs are directly assigned to each job. Cost allocation: Manufacturing overhead costs (fixed and variable) that cannot be directly traced are allocated to jobs Allocation base: An input measure such as machine hours or labor hours Overhead rate: Overhead rate is set at beginning of year based on estimated total overhead costs and estimated volume. 9-6

Cost Flow Sequence See Figure 9-1 for cost flows in job order cost system. 1. Costs are accumulated in three major categories: materials, labor, and overhead. 2. Direct materials, direct labor, and overhead are assigned to the work-in-process (WIP) inventory account for each job. 3. When manufacturing is completed, the cost of units completed is transferred from WIP to the finished goods inventory. 4. When goods are sold, the costs are transferred from the finished goods inventory account to the cost of goods sold expense account. 5. If any amount remains in the overhead account at the end of the period, it must be allocated to some inventory or expense account. Review Self Study Problem

Inventory Cost Flow Accounting Assumptions Inventory cost flow assumptions change the amounts transferred out of an inventory account when input prices change over time. External importance: financial statements, taxes, cost- based contracts. Internal importance: decision making and decision control. 1. First In, First Out (FIFO): Oldest items are transferred out first. When prices are rising, FIFO reports higher net income than LIFO. 2. Last In, Last Out (LIFO): Newest items are transferred out first. When prices are rising, LIFO reports lower net income than FIFO. 3. Specific Identification: Each inventory item is individually priced. 9-8

Overhead Rate Prospective overhead rates are set at the beginning of the year (also known as predetermined overhead rates). Numerator: Estimated annual budgeted overhead dollars Denominator: Estimated annual factory volume (input measure) Possible input measures: machine hours, direct labor hours (DLH), direct material dollars, or direct labor dollars Incentive effect: Managers reduce whichever input used to allocate overhead. (Recall Chapter 7). 9-9

Over/Underabsorbed Overhead Actual overhead incurred for a year is the amount of indirect manufacturing costs incurred during the year. Absorbed overhead (also known as applied overhead) is the amount of overhead applied to work-in-process during they year using the predetermined overhead rate and the actual amount of inputs used. Underabsorbed overhead exists when actual > absorbed overhead. Overabsorbed overhead exists when actual < absorbed overhead. 9-10

Disposing of Over/Underabsorbed Overhead Overhead accounts must be cleared of over/underabsorbed overhead at the end of the year. 1. Write off all to cost of goods sold expense account.  Simplest bookkeeping procedure 2. Allocate among WIP and finished goods inventory, and cost of goods sold expense account.  Better if ending inventory levels are significant 3. Recalculate job costs with actual overhead rates.  Most complex data processing 9-11

Flexible Budgets to Estimate Overhead Recall from Chapter 6:  Static budget estimates do not change with volume.  Flexible budget estimates do change with volume. Forecast annual budgeted overhead dollars with a flexible budget: Budget = Fixed + Variable = FOH + (VOH X BV) where, FOH= Fixed overhead estimate VOH= Variable overhead rate estimate BV= Budgeted volume estimate 9-12

Budgeted Volume: Expected versus Normal Expected volume: Volume expected for the coming year.  Decision control: enhanced because transfer prices are adjusted for changing volume  Decision management: impaired because lower volume raises overhead rate, and encourages profit centers to raise prices Normal volume: Long-run average volume over economic cycle.  Decision control: impaired because managers are not held responsible for short-run volume fluctuations  Decision management: better long-run opportunity cost estimates result in better pricing decisions  Opportunity to manage earnings: setting normal volume is more subjective than expected volume 9-13

Permanent versus Temporary Volume Changes How should overhead rate estimates respond to volume changes? Permanent volume changes:  Write off assets or change estimated useful lives of assets.  Managers may be reluctant to admit that their prior projections need to be adjusted. Temporary volume changes:  Assumed to average out over economic cycles  No accounting changes should be made. 9-14

Plantwide versus Multiple Overhead Rates Choices of overhead cost allocation disaggregation: 1. Single overhead cost pool for entire plant:  Easiest to apply, but accounting costs may be very inaccurate representations of opportunity costs. 2. Many cost pools each with its own cost driver:  More data processing, but more accurate costing 3. Two-stage allocation of departmental overhead rates  Allocate to departments, and then to products. Review Self Study Problem

Plantwide versus Multiple Overhead Rates If the overhead rates contain large amounts of fixed historical costs, such as depreciation, then neither plantwide rates nor individual department rates accurately reflect the opportunity cost of capacity. 9-16

Process Costing Overview Production process is a continuous flow without discrete batches or jobs. Each process is treated as a separate cost center. Costs are averaged over large number of production units that are assumed to be essentially identical. Decision making usefulness is reduced because costs for individual batches are not available. See Appendix A for process costing details. 9-17

Appendix A: Process Costing Details See Table 9-6. Step 1:Account for physical flow of units. Step 2:Compute number of equivalent physical units and average cost per equivalent unit. Step 3:Total all the costs to be assigned. Step 4:Allocate total costs to WIP inventory and transfers to Finished Goods inventory by the number of equivalent physical units in each category. Refinements: inventory cost flow assumptions 9-18

Appendix B: Demand Shifts, Fixed Costs, and Pricing Price should be lowered when demand falls See Figures 9-5 and 9-6 Pricing decision Shutdown decision See Table