Cost Measurement Systems

Costing Systems
Product costing involves accumulating, classifying
and assigning direct materials, direct labor, and
factory overhead costs to products, jobs, or services.
In developing a costing system, management
accountants need to make choices in three
categories of costing methods:
1. The cost measurement method to use in
allocating costs to units manufactured.
2. The cost accumulation method to use.
3. The method to be used to allocate overhead.
Cost Measurement Systems
Used for allocating both direct
manufacturing costs (direct labor and
direct materials) and indirect
manufacturing (overhead) costs in order to
value the products manufactured.
A. Standard
B. Normal
C. Actual
A. Standard Costing
A standard cost system assigns standard,
or planned, costs to units produced.

The standard cost of producing one unit of

output is based on the standard cost for
one unit of each of the inputs and the
standard usage of each input.
Allows Variance Analysis
Standard costing enables management to
compare actual costs with what the costs
should have been for the actual amount
produced.
Allows Ongoing Costing
Standard costing allows production to be
accounted for as it occurs.
Direct Materials and Direct
Labor
In a standard cost system, direct materials
and direct labor are applied to production
by multiplying the standard price or rate
per unit of direct materials or direct labor
by the standard amount of direct
materials or direct labor allowed for the
actual output.
Overhead Under Standard Costing
Overhead is generally allocated to units
produced by calculating a predetermined,
or standard, manufacturing overhead rate.

This standard manufacturing overhead rate

is budgeted overhead cost divided by the
budgeted activity level of the allocation
base.
B. Normal Costing
DM and DL costs are applied at their actual
rates multiplied by the actual amount of the
direct inputs used for production.
To allocate overhead, a normal cost system uses
the same predetermined overhead rate, but
it is called a normal or normalized rate.
The predetermined rate is multiplied by the
actual amount of the allocation base that
was used in producing the product.
C. Actual Costing
In an actual costing system, no predetermined or
estimated or standard costs are used.
The actual direct labor and materials costs and the
actual manufacturing overhead costs are
allocated to the units produced.
The cost of a unit is the actual direct cost rates
multiplied by the actual quantities of the direct
cost inputs used and the actual indirect
(overhead) cost rates multiplied by the actual
quantities used of the cost allocation bases.
 DM/DL DM / DL OH OH
Applicatio Applicatio Applicatio Allocation
Method Used With n Rate n Base n Rate Base
Standard Process Standard
Costing Costing or Standard Amount of
Job Order Amount Pre- Allocation
Standard
Costing Allowed determined Base
Rate
for Actual Standard Allowed for
Production Rate Actual
Production
Normal Job Order Actual Actual
Costing Costing Rate Actual Amount of
Actual Job Order Amount Allocation
Costing Costing Used Base
Actual for Actual Actual Used
Rate Rate
Cost Accumulation Systems
Cost Accumulation Systems
Used to assign costs to products or
services.
• Process costing
• Job order costing
• Operation costing
• Life-Cycle costing
A. Process Costing
All of the costs of the department need to
be allocated to the units that are worked on
during that period.
Costs come from:
a) Beginning work in progress
b) Transferred in from previous department
c) Incurred during the period by the
department
Process Costing
All of the costs must be in either:
a) Ending WIP inventory in the department
or process,
b) The next department in the assembly
process,
c) Ending finished goods inventory, or
d) Cost of goods sold.
Equivalent Units
In a process costing environment, some
units will be incomplete when a reporting
period ends.
The cost of the incomplete units needs to be
computed and reported at the end of the
period as work-in-progress inventory.
Costs are allocated to incomplete units on
the basis of their equivalent units.
Example: At the end of a month a manufacturing
company has 1,000 units in ending work-in-progress
inventory and those units have had all of the direct
materials added to them that they need, but only 50% of
the work needed to complete the units has been done.
• The equivalent units of direct materials in ending
work-in-progress inventory is 100% of 1,000 units, or
1,000 equivalent units.
• The equivalent units of conversion costs in ending
work-in-progress inventory is 50% of 1,000 units, or
500 equivalent units.
• The cost of the ending work-in-progress inventory is
the standard cost incurred for direct materials for
1,000 units plus the standard cost allowed for
conversion costs for 500 units.
• The cost of the completed units is the remainder of
the standard cost incurred during the period. Those
costs are transferred either to Finished Goods
Inventory or to the next department for more work to
be added.
Usually standard costs are used in a process costing
environment.
FIFO and Weighted Average
Under FIFO, it is assumed that the units in
beginning work-in-progress inventory are
completed before any other work is begun
on new units.

Under weighted average, it is assumed that

the units in beginning work-in-progress
inventory are completed at the same time
as work on newly-started units is begun.
B. Job Order Costing
All of the costs associated with a specific
job or client are accumulated and
charged to that job or client.

While direct materials and direct labor are

accumulated on an actual basis,
manufacturing overhead must be
allocated to each individual job.
C. Operation Costing
Operation costing is a hybrid, or
combination, of job-order costing and
process costing.
D. Life-Cycle Costing
Life-cycle costing is another type of costing
that is useful only for internal decision-
making.
Categories of Costs
Upstream Costs (before production)
• Research and Development
• Design
Manufacturing Costs
• Purchasing
• Direct and indirect manufacturing costs
Downstream Costs (after production)
• Marketing and distribution
• Services and warranties
Manufacturing Overhead
Allocation:
Traditional Method
Introduction to Overheads
There are two broad classifications of
overheads
• Manufacturing overheads are
necessary for the production of the
goods or services of the company.
• Nonmanufacturing overheads are not
associated with the production process.
Manufacturing Overhead Allocation
Because there is no direct connection
between the production of a unit and the
incurrence of these costs, the
manufacturing overhead costs of the
company must be allocated to the units
that are produced.
Costs Included in
Manufacturing Overhead
• Indirect materials
• Indirect labor
• General manufacturing overheads
Traditional Allocation Method
Under the traditional method, the
overhead costs are allocated to
individual products based on one
allocation basis.

The allocation basis is the measure that will

be used to divide the costs amongst the
units.
Determining the Allocation Basis
The basis that the company uses should be one that
reflects the production costs and the way overhead
costs are actually incurred.
• If the company has a very automated process,
machine hours may be the allocation base.
• If the production process requires a lot of manual
labor, direct labor hours may be the best allocation
base.
• If the different products produced vary significantly in
the number of components that go into them,
number of component parts may be the best base.
Using a Predetermined Rate
An estimated rate needs to be used during
the period so that the company will
know how much it costs them to
produce their product so that they can
set the appropriate price.
This predetermined rate will be used
throughout the period to allocate
overhead to the units that are produced.
Calculating the Predetermined Rate
The predetermined overhead rate is
calculated as follows:

Budgeted $ Amount of Manufacturing OH

Budgeted Activity Level of the Allocation Base
What Level of Activity to Use
If the company is too optimistic and estimates
that they will produce a large number of units,
the predetermined rate will be incorrectly low
per unit and their selling price will be too low.
If the company is too pessimistic and estimates
that they will produce a small number of units,
the predetermined rate will be incorrectly high
per unit and their price will be too high.
Choices for Level of Activity
1. Normal capacity
2. Theoretical, or ideal, capacity
3. Practical, or currently attainable,
capacity
4. Expected actual capacity, or master
budget capacity
Allocating the Costs to the Units
Once the predetermined rate has been
calculated, the process of allocating
overhead to the units is relatively simple.
This is done by multiplying the
predetermined rate by a given number of
units of the allocation basis that were
either actually used or that were
supposed to be used in the production of
each unit.
 OH Application OH Allocation
Method Rate Base
Standard Standard
Costing Pre-determined Amount of
Standard Allocation Base
Rate Allowed for
Actual Production
Normal Costing Actual Amount of
Actual Costing Allocation Base
Used
Actual Rate
Example: A company allocates overhead on the basis of
machine hours. Two machine hours are allowed for each unit.
The company had the following budgeted amounts for 20XX:
Budgeted
Overhead cost 250,000
Production volume (normal capacity in units) 100,000
Total machine hours200,000
The company’s actual results for 20XX were as follows:
Actual
Overhead cost 288,000
Production volume (actual units produced) 125,000
Total machine hours used 240,000
 Standard Normal Actual
Predetermined overhead rate:
250,000 ÷ 200,0001 1.25 1.25
Actual overhead rate:
288,000 ÷ 240,000 1.20
Allocation Base:
Std # of machine hours2 250,000
Actual # of machine hours 240,000 240,000
Overhead applied to production 312,500 300,000 288,000

1 Two machine hours are allowed for each unit, so 200,000 hours
were allowed for the budgeted production volume of 100,000.
2 The standard number of machine hours is the actual production

volume of 125,000 multiplied by 2 machine hours allowed per unit.

Manufacturing Overhead
Allocation:
Activity-Based Costing
Activity Based Costing (ABC)
ABC allocated overhead based on cost
drivers.
Cost Drivers
A cost driver is anything that causes costs
to be incurred each time the driver occurs.
Allocation Based on Activities
In ABC the company identifies the activities
that cause costs to be incurred, and then
allocate overhead based on those cost
drivers.
Allocation Rate
The allocation rate for ABC is calculated
just as it is for the traditional method.
Many More Allocations with ABC
ABC is mathematically the same as the
traditional method, but there are usually
many more individual allocations than with
the traditional method.
Value Added Activities
By looking at all of the activities that the
company has that incur costs, they can
identify which activities add value for the
customer.

The non-value adding activities are where

the potential benefits of ABC are.
ABC and Low-Volume Products
The use of activity-based costing can result
in greater per-unit costs for products
produced in low volume relative to other
products than would be reported under
traditional overhead allocation.
Example #1: A manufacturing firm. In a manufacturing
environment, machine setup is required every time the
production line changes from producing one product to producing
another product.
The cost driver is machine setups. An engineer might be
required to supervise the setup of the machine for the product
change. The engineer spends 20% of his or her time supervising
setups. Therefore, 20% of the engineer's salary and other
expenses will be costs to be allocated according to the amount of
time the engineer spends supervising each product's machine
setup as a percentage of the amount of time spent supervising all
product setups.
 
In addition to the engineer, other personnel are required for
machine setups. Production supervisors are also needed to
supervise machine setups, and they spend 40% of their time
doing that.
All of the costs of machine setups are collected in a "machine
setups" cost pool. Setup time spent on each product as a
percentage of setup time spent on all products is the activity
driver. The total costs in the pool are allocated to the different
products being produced based on the percentage of total setup
time used for each product.
Example #2: A service firm. Bank tellers process all
kinds of transactions. The transactions relate to the
many different banking services the bank offers.
Transactions processed are the cost drivers. How
should the tellers' time, the teller machines used by the
tellers, the supplies used by the tellers and the space
occupied by the tellers be allocated among the various
services offered by the bank (checking accounts,
savings accounts, and so forth) in order to determine
which services are most profitable?
The bank does time and motion studies to determine
the average time it takes tellers to process each type of
transaction (checking account transactions, savings
account transactions, and so forth). Then, information
on how many of each type of transactions are
processed by tellers is captured. The average time for
each type of transaction is multiplied by the number of
transactions processed. The percentage of teller time
spent on each type of transaction as a percentage of
the amount of teller time spent on all types of
transactions is the activity driver.
The tellers spend 90% of their time performing teller
transactions and 10% of their time doing something
else like answering telephones, 90% of the tellers'
salaries will be put into the "tellers" cost pool along with
100% of the costs of their teller machines, their
supplies, and the square footage occupied by their
teller stations. Then the percentage of tellers' time spent
on each type of transaction in relation to their total time
spent on all teller transactions (the activity driver) is
used to allocate the teller costs in the cost pool
proportionately among the bank's various services.