Module 3.

FIN600
Financial Management
Module 3 Topic 2
FIN600 Module 3.2

Management Accounting Concepts –

Organisational Costs
Manufacturing Cost Elements

• Product cost refers to the costs used to create a product on the manufacturing process
• Product costs are usually divided into three classes:
❖ Direct Materials
❖ Direct Labour
❖ Manufacturing Overhead/Indirect Costs 3
• Manufacturing costs are incurred within the factory area, whereas upstream and downstream
costs are sometimes called non-manufacturing costs
• In product costs manufacturing costs that can be traced to product in an economic manner
are direct product costs, indirect costs are manufacturing costs that cannot be traced to
products in an economic manner
• Whether a cost is classified as direct or indirect depends on the nature of the cost object
Direct Materials

• The raw materials that can be traced directly to units of output, and consumed in the
manufacturing process

• The materials must be easily identifiable with the resulting/finished product (otherwise they
are considered to be joint costs) 4

• Examples of direct materials – *the timber used to construct a house, *the steel included in an
automobile
Direct Labour

• The wages and associated costs of workers who are directly involved in producing units of
output or provide specific services to customers

• It also includes the payroll taxes associated with those wages, plus the cost of company-paid
medical insurance, life insurance, workers' compensation insurance, any company-matched 5
pension contributions, and other company benefits
Manufacturing Overhead

• Indirect Materials - do not have an obvious identifiable relationship with the product, not
readily assignable to product and not economic to include separately, eg glue to join wood

• Indirect labour - not readily assignable to product and not directly traceable to product, eg
cleaning labour, supervisors wages, security guard wages 6

• Other indirect manufacturing costs – not directly traceable to product eg electricity, lighting,
heating, power, rent rates, insurance
Manufacturing Costs
• Conversion costs - the cost of converting material into a product, the total of direct labour and
manufacturing overhead costs
• Prime costs - the major cost associated with producing a product, the total of direct material,
direct expenses and direct labour costs 7
Manufacturing Costs

• Contemporary costing systems analyse costs in greater detail than under conventional
costing systems
• Labour costs, and upstream and downstream costs may be classified within an activity
framework
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• In general, direct material costs tends to be the largest proportion of manufacturing cost, and
direct labour costs the smallest
• Managers need estimates of product costs:
❖ For financial accounting reports ie to determine cost of goods sold, to value
inventory on hand
❖ For decision making ie setting prices, make or buy decision
Cost flows in a manufacturing business

1) Material is purchased: cost is added to raw materials inventory

2) Direct materials are consumed in production: cost is removed from raw materials inventory
and added to work in process inventory
3) Direct labour and manufacturing overhead are accumulated in work in process inventory
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4) Products are completed: costs are transferred from work in process inventory and added to
finished goods inventory
5) Products are sold: costs are transferred from finished goods inventory to cost of goods sold
expense
6) Cost of goods sold is deducted from sales revenue to determine gross profit
Cost of Goods Manufactured Cost of Goods Sold

Work in process at beginning FG Inventory at beginning of period

Add: Manufacturing (product) costs incurred Add: Costs of Goods Manufactured
(direct materials, direct labour, Less: FG Inventory at end of period
manufacturing overhead) = Cost of Goods Sold 10
Less: Work in process at end (FG = Finished Goods)

= Cost of Goods Manufactured

Calculating the cost of goods is often quite complex and may require professional judgement
Cost of Goods Manufactured (Schedule)

Thomson Company Direct labor $371,500

Prime costs $562,900
Schedule of Cost of Goods Manufactured
Manufacturing Overhead
Material handling 26,750
Direct materials Supplies 37,800
11
Beginning inventory $47,000 Utilities 46,000
Factory supervisor salary 190,000
Add: Purchases of raw materials $160,400 Total Manufacturing Overhead $300,550
Freight in on materials $1,000
Total Manufacturing costs added $863,450
Materials available $208,400
Add: Beginning work in process $201,000
Less: Ending inventory -$17,000
Less: Ending work in process -$98,000
Direct materials used $191,400 Cost of Goods Manufactured $966,450
Cost of Goods Manufactured (Schedule)

Cost of Goods Sold Thomson Company

Schedule of Cost of Goods Sold

Cost of Goods Manufactured 966,450

Cost of Goods Manufactured 966,450
Add: Beginning FG Inventory 28,650 Add Beg FG Inventory 28,650
12
Cost of Goods avail. for sale 995,100 Less Ending FG Inventory -48,300
Cost of Goods Sold $946,800
Less: Ending Inventory of FG -48,300
Cost of Goods Sold $946,800
Cost of producing one floor lamp last year

Total Cost of Goods Manufactured/Units Produced

= $966,450 / 100,000
= $9.6645 per lamp
 Cost of Goods and the Income Statement – The a2 Milk Company

Cost of
Goods Sold

13

Gross
Profit

https://thea2milkcompany.com/wp-content/uploads/The-a2-Milk-Company_FY19-Annual-Report_double-pages-1.pdf
Manufacturing overhead allocation

• Manufacturing overhead is not directly traceable to product and is used for the benefit of
multiple cost objects
• To determine the full cost of a cost object it is necessary to allocate the indirect costs to the
cost object based on its usage of a chosen cost driver
• The allocation of certain overhead costs to produced goods is required under the rules of 14
various accounting frameworks
• Formula:

(Birt et al, 2019, p414)

• Overhead costs can be allocated by any reasonable measure, as long as it is consistently

applied across reporting periods
Manufacturing overhead allocation

To allocate manufacturing overhead steps include:

1) Identify cost behaviour patterns
2) Budget factory overhead costs
3) Calculate budgeted/predetermined factory overhead rate
4) Accumulate actual overhead costs 15

5) Apply factory overhead estimates to production

6) Calculate and analyse differences between actual and applied factory overhead

• When factory overhead expenses are not identified with a specific department, they are
charged to departments by a process of allocation
• Allocations may be made for each item of expense incurred, or expenses may be accumulated
as incurred and the allocations made at the end of the accounting period
Manufacturing overhead examples

Examples:
• Electricity • Indirect materials used in production

• Lighting • Indirect labour costs

• Heating and power • Maintenance and repairs on machines

• Rent • Depreciation of manufacturing equipment 16

• Rates • Distribution and finance costs

• Insurance
Manufacturing overhead allocation

Apportionment of Overheads to products:

• Traditional Approach
• Activity Based Costing

• Factory overhead costs may not be known until the end of the accounting period 17

• The cost of a job is needed soon after completion, so a method to estimate the amount of
factory overhead applied to a job must be established
• This enables companies to bill customers on a more timely basis and to prepare bids for new
contracts more accurately
Methods of absorbing manufacturing overheads

• Manufacturing overhead per direct labour hour

• Manufacturing overhead per machine hour
• Manufacturing overhead per $ of labour cost
• Manufacturing overhead per unit.
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Manufacturing overhead allocation

Blackboard Activity 3.2 – Chelsea Ltd

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Predetermined overhead rate
• The estimated level of indirect cost divided by the estimated level of the cost driver
• To determine the actual indirect cost rate is not possible until the end of the financial period
when actual results are known
• To overcome this delay for budgeting, controlling and planning related decisions, a
predetermined indirect cost rate is used 20
• Predetermined overhead cost rates are used to assign or allocate overhead costs to an
inventoriable product cost, and are estimated/budgeted at the start of a reporting period and
adjusted to actual at the end of the period
• The difference between a budget cost and an actual cost is called a Variance
Underapplied and Overapplied Overhead

• Variances arise when an entity over or under-estimates the expenditure level of indirect costs,
and variances are recorded in financial records as either over or under-applied overhead
• Overapplied overhead - the indirect costs applied to an inventoriable product cost are greater
than the actual costs incurred
• Underapplied overhead - the indirect costs applied to an inventoriable product cost are less 21
than the actual costs incurred
(Birt et al, 2019, p422)
Predetermined overhead rate (example)

Estimated labour hours for normal activity 10,000 hours

Estimated fixed overhead cost in total $50,000
Predetermined overhead cost rate $5 per labour hour ($50,000 / 10,000 hrs)

22
Actual hours worked on jobs 8,000 hours
Overhead costs applied to jobs (at Predetermined rate) $40,000 ($5 per hour * 8,000 hrs)

Actual fixed overhead incurred $50,000

Under-applied fixed overhead -$10,000 ($40,000 o/head estimated and recorded –

$50,000 actually incurred)
Components of the Manufacturing Statement

• A manufacturing statement, also called the schedule of cost of goods manufactured or the
schedule of manufacturing activities, is a summary of all of the manufacturing activities and
costs
• A manufacturing statement is not only used to calculate the overall cost of manufacturing, it
is also used to track each activity and expense 23
• The manufacturing statement is usually split up into four different parts:
❖ Direct materials used
❖ Direct labour
❖ Factory/Manufacturing Overhead
❖ Total cost of goods manufactured
Distributing Service Department Expense

• Service departments are an essential part of the organisation, but they do not work directly
on the product
• Production departments perform the actual manufacturing operations that physically change
the units being processed
• The costs of the service departments must be apportioned to the production departments 24

• An analysis of the service department’s relationship to other departments must be done

• Methods of Distributing Service Department:
Direct Distribution Method - Service department costs are allocated only to production
departments
Algebraic Distribution Method - Distributes costs by simultaneous equations recognizing the
relationship of services rendered by departments to each other.
Common Bases for Distributing Service Department Expenses

Service cost centre Basis for Distribution

Building Maintenance Floor space occupied by other departments

Inspection and Packing Production volume

Machine Shop Value of machinery and equipment

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Human Resources Number of workers in departments served

Purchasing Number of purchase orders

Shipping Quantity and weight of items shipped

Stores Units of materials requisitioned

Tool Room Total direct labor hours in departments served