Managerial Accounting

Full Costs and Their Uses

By: Maria Eleunor B. Lucino
 Uses of Full Costs

• In Financial accounting
– Financial accounting uses full costs information
– Full cost accounting provides a bridge between
financial and management accounting
– The earliest management accounting systems
focused on the collection and reporting of full cost
information
• Use of Full costs to managers
– It help set selling prices for goods and services,
including prices set by contract as the sum of full
costs plus a specified profit
 I. Cost Concepts

• Cost – is a measurement, in monetary terms, of

the amount of resources used for some purpose
• 3 important ideas
– Use of resources – tangible goods (materials) or
intangible services (hours of labor services)
– Expressed in monetary terms – intangible services is
converted to monetary scale (P300 per hour of labor
services) to produce a meaningful total
– Always relates to a purpose – products, departments,
projects, activities – monetary measurement of
resources used is desired
 I. Cost Concepts
• Cost Object / Cost Objective – technical name for the
product, project, organizational unit, or other activity or
purpose for which costs are measured
• it must be carefully stated and clearly understood
• can be defined broadly (all the jeans manufactured in a
company in a given time period) – differences in the
resources used per style would not be measured
• or narrowly (each individually pair of jeans
manufactured) – the amount of recordkeeping involved
in measuring costs would be tremendous
 I. Cost Concepts
• Full Cost – all the resources used for a cost
object.
• if you buy a product (jeans) , you pay for the
price – that’s your full cost
• What about the full cost of producing the
product? – (each style of jeans) different
amounts of resources are used and have
different costs.
• Is the sum of its direct costs plus a fair share of
applicable indirect costs.
 I. Cost Concepts
• Items of Cost (Direct or Indirect Costs)
• Direct Costs – items of costs that are specifically
traced to, or caused by, that cost object (denim
used and earning of employees who worked directly in
making that batch of jeans)
• Indirect Costs – are elements of costs that are
associated with, or caused by, two or more cost
objects jointly but that are not directly traced to each of
them individually
• it is not possible, or at least not feasible, to measure
directly how much of the cost is attributable to a single
cost object
• ( batch of jeans include the factory manager’s salary and
factory building and equipment insurance)
 I. Cost Concepts
• Direct and indirect costs are meaningful only in the
context of a specified cost object (ex. Instead specified
to be the factory where the jeans are produced, the
factory manager’s salary and the insurance costs are
directs costs of that cost object)
• Rationale is that indirect costs are caused jointly by the
several cost objects; to argue otherwise would be to
assert that indirect costs are sheer waste (ex.
Purchasing agents salary is not traceable to a specific
batches of jeans but without him there will be no
materials on hand to make the jeans)
– Thus, some fraction of the purchasing agent’s salary – along
with other indirect costs – must be part of the total cost of each
batch of jeans
– May include administrative, secretarial, maintenance, utilities
and other costs
 I. Cost Concepts
• Applicable Accounting Principles
• cost concept and the matching of concept
generally govern the measurement of the cost
applicable to an accounting period and to the
products produced in that period.
• Permit any “systematic and rational” method of
cost assignment
• Problems of measuring full costs
• IMA (Institute of Management Accountants) –
advisory guidelines with full cost accounting
 I. Cost Concepts
• Elements of Product Costs
• Product – most common cost object of interest in a
business (tangible goods / services)
• Product Costing System – system that accumulates
and reports the costs of products cost objects
• Elements of product cost – material, labor, or services.
• a. Direct Material Cost – the quantities that can be
specifically identified with the cost object in an
economically feasible manner, priced at the unit price of
direct material
– often called “raw materials” or just “materials”
– should be distinguished from supplies or indirect materials which
are materials used in the production process but not directly
traced to individual products. ( lubricating oil for machinery, spice
in a kitchen )
 I. Cost Concepts
• Elements of Product Costs
• b. Direct Labor Cost – the labor quantities that can
be specifically identified with a cost object in an
economically feasible manner, priced at the unit
price of direct labor
• earnings of a worker who assemble parts into
finished goods or operate machines in its
production
• cost of a technician’s time spent repairing an
automobile
• c. Other Direct Costs – any cost traced to a
single product is a direct cost of that product
 I. Cost Concepts
• Elements of Product Costs
• d. Overhead Cost – all indirect production costs – all
production costs other than direct costs
• indirect labor – earnings of employees who do not
work directly on a single product but whose efforts
are related to the overall process of production
( supervisors, janitors, inspectors, etc.)
• indirect material costs - materials used in the
production process but not directly traced to
individual products. ( lubricating oil for machinery,
spice in a kitchen )
• utilities, taxes, insurance, etc.
 I. Cost Concepts
• Elements of Product Costs
 I. Cost Concepts
• Elements of Product Costs
• e. Conversion Cost – sum of direct labor cost and overhead cost
• includes all production costs needed to convert direct materials into
finished goods
• as factories become automated
– direct material costs tend to become a much more significant cost
element than direct labor
– the distinction between direct labor and indirect labor becomes
blurred
– as a result, some companies no longer distinguish between direct
labor and overhead cost – instead, the single category of
conversion cost is used
 I. Cost Concepts
• Elements of Product Costs
 I. Cost Concepts
• Elements of Product Costs
• f. Full Production Cost – sum of direct material cost
and conversion cost
• In a manufacturing firm - Full Production
Cost is called Inventory Cost
• cost at which completed goods are carried as
inventory and the amount that is reported as cost of
sales when the goods are sold
• it includes neither distribution nor selling costs, nor
those general and administrative costs that are
unrelated to production operations
• full production cost includes only the costs that are
incurred “within the four factory walls’
 I. Cost Concepts
• Elements of Product Costs
In Financial Accounting – these full production costs that flow
through inventory accounts are called
product costs to distinguish them from period
costs, which do not flow through the inventory accounts but rather
are charged as expenses of the period in
which they are incurred.
product cost object – includes non-manufacturing costs such as the
cost of selling the product.
Inventory cost – more descriptive of full production costs
Nevertheless, referring to inventory costs as product costs is well
established in practice.
 I. Cost Concepts
• Elements of Product Costs
• g. Nonproduction Costs – also called Period
costs
• Costs incurred in an organization other than
inventory costs.
• Include selling costs, research and
development costs, general and
administrative costs, and interest costs.
• In manufacturing firm – selling costs include
both marketing (order-getting) and logistics
(order-filling) costs
 I. Cost Concepts
• Elements of Product Costs
 I. Cost Concepts
• Elements of Product Costs
• h. Full Cost – sum of all the cost elements
• Includes both inventory (full production) cost and nonproduction cost.
 II. Product Costing System
• Used to measure full production costs and to
assign them to goods in a manufacturing
company
• Cost accounting systems in manufacturing firms
tend to be more complex than those in other
types of organizations.
• A knowledge of product costing in a
manufacturing company is also useful in
understanding cost accounting systems in
merchandising and service organizations.
 II. Product Costing System
• Account Flowchart
• helpful in understanding the flow of costs through a cost
accounting system
• shows the flowchart concept and essential cost flows in
manufacturing
• hypothetical figures for a month’s operations in Marker
Pen Company
• flowchart is divided into three sections;
• ( 1 ) acquisition, containing the accounts related to the
acquisition Resources
• ( 2 ) production, containing the accounts related to the
process
• ( 3 ) sales, the accounts related to the sale of products
 II. Product Costing System
• 1. During the month $ 52,000 of materials were purchased on open
account, $ 20,000 of various other assets were purchased for cash,
and $ 60,000 of accounts payable were paid. The journal entries
recording these transactions are as follows:
• a. Materials Inventory………………………52,000
• Accounts Payable………………...
52,000
• b. ( Other Asset and Liability Accounts )......20,000
• Cash……………………………… 20,000
• c. Accounts Payable……………………….60,000
• Cash……………………………… 60,000
II. Product Costing System
 II. Product Costing System
• 2. During the month, direct materials costing $ 49,000 (principally felt tips, plastics, inks, and
wicks) were withdrawn from inventory and sent to the factory to be converted into pens. This
decrease in Materials Inventory and increase in Work in Progress Inventory is recorded:
• Work in Process Inventory………………….49,000
• Materials Inventory……………… 49,000
 II. Product Costing System
• 3. During the month, direct labor employees converted this material into pens, The $20,000 that
they earned adds to the amount of work in Process Inventory, and the resulting liability increases
Wages Payable, as recorded in the following journal entry:
• Work in Process Inventory…………………20,000
• Wages Payable………………….. 20,000
 II. Product Costing System
• 4. Overhead (indirect production) costs amounting to $27,000 were
incurred during the month. Of the total, $10,600 was documented
by current invoices for such things as rent, electricity, and telephone
bills, so the offsetting credits were to Accounts Payable. Indirect
labor and supervision costs were $11,000, with the offsetting credit
to Wages Payable. The remaining $5,400 represented depreciation
on factory assets. All of theses items are here summed up in the
general account Overhead , but in practice they are usually
recorded in separate indirect cost accounts, one for each type of
cost. The journal entry is
• Overhead………………………………….27,000
• Wages Payable……………….. 11,000
• (Other assets and Liability Accounts)……
16,000
II. Product Costing System
 II. Product Costing System
• 5. Factory employees ( direct and indirect) were paid $ 32,000 cash. This decreased the liability
account Wages payable and also decreased Cash. (The payment of wages also involves FICA
taxes, withholding taxes, and other complications, which have been omitted from this introductory
diagram). The journal entry is
• Wages Payable…………………………….32,000
• Cash………………………… 32,000
 II. Product Costing System
• 6. Since the overhead costs incurred during the month are a part of the cost of the
pens worked on during that month, at month-end the total overhead cost incurred is
transferred to Work in process Inventory as in the following journal entry:
• Work in Process………………………….27,000
• Overhead…………………… 27,000
• This $27,000 credit to Overhead reduces that account’s balance to zero. The
overhead account is called a clearing account because the month’s accumulated
overhead costs are “cleared out” of this account at the end of each month. Also, note
that the actual indirect production costs were first debited to this Overhead account
( entry 4). Such debits to Overhead may take place several times during the month
as overhead costs are incurred. The month-end credit clearing entry then transferred
those costs from their temporary repository in Overhead and applied them to Work in
Process Inventory along with the direct labor costs. ( We stress understanding the
nature of the Overhead clearing account at this point because our experience has
shown that such an understanding now minimizes difficulties encountered has shown
that such an understanding now minimizes difficulties encountered later on with more
complicated aspects of overhead accounting.)
II. Product Costing System
 II. Product Costing System
• 7. Pens whose total cost was $110,000 were completed during the month and transferred to
Finish Goods Inventory. This resulted in a decrease in Work in Process Inventory, as recorded in
the following journal entry:
• Finished Goods Inventory…………………110,000
• Work In Process Inventory…….. 110,000
 II. Product Costing System
• 8. Pens with a cost of $115,00 were sold during the month. These pens were moved from
inventory and shipped to customers. On the accounting records this is reflected by a credit to
Finished Goods Inventory and a debit to Cost of Sales, as in the following journal entry:
• Cost of Sales……………………………….115,000
• Finished Goods Inventory………. 115,000
 II. Product Costing System
• 9. For these same pens, sales revenue of $180,000 was earned; this is recorded in the accounts
as a credit to Sales Revenue and a debit to Accounts Receivable. Note that the Sales Revenue
credit described here and the Cost of Sales debit described in entry 8 related to the same pens.
The difference between the balances in the Sales Revenue and Cost of Sales accounts,
therefore, represents the gross margin earned on pens sold during the month. The journal entry
for the sales transaction is
• Accounts Receivable……………………180,000
• Sales Revenue……………… 180,000
 II. Product Costing System
• 10. Accounts receivable collected during the month amounted to $150,000. some of these
collections were for sales made in the current month, but most were for sales made in previous
month. The journal entry is
• Cash…………………………………….150,000
• Accounts Receivable……….. 150,000
 II. Product Costing System
• 11. During the month, $30,000 of selling and administrative ( period) expenses were incurred.
These are recorded in the following journal entry
• Selling and Administrative Expense…………..30,000
• ( other Asset and Liability Accounts).. 30,000
 II. Product Costing System
• 12. Since SGA expenses are always applicable to the current period, the Selling and
Administrative Expense Account is closed to the Income Summary account, as in the following
journal entry:
• Income Summary…………………………….30,000
• Selling and Administrative Expense.. 30,000
 II. Product Costing System
• 13. The balances in the Sales Revenue and Cost of Sales accounts also are closed to Income
Summary. The $30,000 balance in Income Summary then reflects the pretax income for the
period. (To simplify the example, income taxes and certain nonoperating and financial
items normally appearing on income statements have been excluded) These
• Closing journal entries are
• Sales Revenue………………………………180,000
• Income Summary……………… 180,000
• Income Summary……………………………115,000
• Costs of Sales………………….. 115,000
II. Product Costing System
 II. Product Costing System
• Strictly speaking, the product costing system ends with entry 8. The other
entries are given in order to show the complete set of transactions for the
company. The income statement for the Marker Pen Company is shown in
Illustration 17-3.
 III. Nonmanufacturing Cost
• other type of cost
• For industrial firms
– Selling, general and administrative costs
• This information can lead to changes in marketing programs,
distribution channels, and possibly abandonement of some products
or customers that are too expensive to sell or service
• Some companies trace R & D costs to specific products because
some types of products are much more costly to develop than
others.
• Life cycle costing – all products’ cost, from birth to abandonement
• Birthing cost – costs necessary to develop the product and bring it
to market (cost of R & D, product testing, initial market creation, and
salesperson training.
• Abandonement cost – incurred when a product is discontinued, after
it produces significant revenues ( disposing of a plant, severance
cost, restoring polluted lands)
 III. Nonmanufacturing Cost
• a. Merchandising Companies
• Cost of sales is essentially the merchant’s invoice cost of the goods
sold
• Use full cost information for other purposes such as to measure
profitability of various selling departments within the company
• b. Service Organizations
• Including government agencies
• A. treat the services provided to a specific client as a “job” and to
establish a cost object for each job
– Accumulation of job cost objects is a job cost record
• B. Process costing – a process by which determining the cost by
averaging.
– Direct cost of service was identified, share of indirect costs was
assigned, a count is kept of the number of services performed; for a
given time period, the full cost of the service is divided by the number of
services performed gives the average per unit cost
 III. Nonmanufacturing Cost
• c. Nonprofit Organizations
• Objective is something other than a profit
• Provide services rather than tangible goods
• Accounting practices similar to profit-oriented
organizations
– Both use resources, the problem of cost
measurement is to identify the amount of resources
used for each various cost objects that the
organization has.
• Operation takes the form of goal-oriented sets of
activities called programs
 IV. Uses of Full Cost
• financial reporting
• analyses of profitability
• answering the question “What did it
cost?”
• arriving at prices in regulated industries
• normal pricing
 IV. Uses of Full Cost
• a. Financial Reporting
• the basis for reporting work in process inventory and
finished goods inventory on the balance sheet, and cost
of sales on the income statement
• also used to measure the income of the principal
segments of the business
• measure cost of sales for determining the taxable
income
• b. Analyses of Profitability
• makes it possible to make analyses of individual parts of
a business – if the part does not earn a reasonable profit
– there is an indication that there is something wrong
 IV. Uses of Full Cost
• c. What did it Cost?
• Cost-type contracts – full costs are used in contracts in
which one party has agreed to buy goods or services
from another party at a price based on cost.
• The methods to be used in the contract must be spelled
out in some detail so as to avoid misunderstanding
• d. Setting Regulated Prices
• Many prices are set not by the forces of the marketplace
but by regulatory agencies – these include prices for
residential utilities, cable, postal, insurance premiums,
etc.
• The regulatory agency allows a price equal to full cost
plus an allowance for profit
 IV. Uses of Full Cost
• e. Product Pricing
• (i) Differentiated Products and
Commodities
• Differentiated product – is a product that consumers
prefer over competing products. Differentiated because
of the ff: characteristics, advertising, warranty or credit
terms, other characteristics
– Cost measurements are used in arriving at the price of
differentiated products, but not the price of commodities
• Commodities – undifferentiated products
– Selling price is found in the marketplace, the producer sells at
this price, or not at all
 IV. Uses of Full Cost
• e. Product Pricing
• (ii) Normal Pricing
• Each product should bear a fair share of the total costs
of the business
• Selling price of a product should be high enough to;
• (1) recover its direct costs
• (2) recover a fair share of all applicable indirect costs
• (3) yield a satisfactory profit
• (iii) Profit Component of Price
• Objective of a profit-oriented business is to earn a satisfactory return
on assets employed suggests that the profit component of a
product’s price should be related to the amount of assets employed
in making the product.
• It is common pricing practice to related the profit component to costs
rather than to assets
 IV. Uses of Full Cost
• e. Product Pricing
• (iv) Time and Material Pricing
• In this method of setting prices, one pricing rate is established for direct labor and a
separate pricing rate for direct material.
• Each of these rates is constructed so that it includes allowances for indirect costs and
for profit
• The time component is expressed as a labor rate per hour, which is calculated as the
sum of :
• (1) direct salary and fringe benefit costs of the employee;
• (2) an equitable share of all indirect costs, except those
related to material;
• (3) an allowance for profit
• This rate is usually called a billing rate.
• The material component of the price includes a material loading that is added to the
invoice cost of materials used in the job.
• This loading consists of an allowance for material-handling costs and storage costs
plus an allowance for profit.
 IV. Uses of Full Cost
• e. Product Pricing
• (v) Nonprofit Organization
• Same pricing practices as those described but with one exception
• Since a nonprofit organization has no shareholder equity, it does not
need to earn profit as a return on this investment.
• Most nonprofit organizations do need a small margin above full
costs to provide a safety allowance for unforeseen contingencies
and to pay of holding current assets
• (vi) Adjusting Costs to Prices
• Pricing is usually thought of as the process of setting selling prices
• Target costing - In some situations, the process works in reverse,
the selling price that is believed to be the best standpoint of
competitive strategy as a given, the problem is to determine how
much cost the company can afford to incur if it is to earna
satisfactory profit at a given price.
 IV. Uses of Full Cost
• e. Product Pricing
• (vii) Contribution Pricing
• Company makes pricing decisions using information on
full costs as a first approximation
• Contribution pricing – individual products are sold at a
loss – at a price below full costs; though they may
increase the company’s total profit, this require cost
constructions
• (viii) Importance of Timely Cost Data
• Basis of pricing – following a market price, cost data – a.
current costs, b. estimates of near-term future cost
• Current cost is sometimes overlooked – important
specially during inflationary times – so that price increase
will be considered
 IV. Uses of Full Cost
• e. Product Pricing
• (ix) Strategic Positioning
• Cost information helps develop business strategies that
will produce sustainable competitive advantages
• Strategic Cost Management – use of cost data to
understand the company’s advantages and
disadvantages vs. competitors. Used to develop value
chain activities.
• Value chain – the set of activities required to design,
develop, produce, market, distribute, and service a
product or service.
• Helps manager plan and adopt their strategies.
 V. Summary
• Cost – the monetary amount of resources
used for some purpose (cost object)
• Cost objects – products, organization
units, projects, activities
• Full Cost – all the resources used for a
cost object
• it is the sum of direct and indirect costs