Langfield Smith 8e IRM Ch04 PDF

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CHAPTER 4PRODUCT COSTING SYSTEMSANSWERS TO REVIEW QUESTIONS4.Purpose Current/Future product costs Short-term decisions: product mix, pricing Future Longer-term strategic decisions Future Long-term pricing Future Plan future product-related costs Future Control of product costs Current Reimbursement ...

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CHAPTER 4

PRODUCT COSTING SYSTEMS ANSWERS TO REVIEW QUESTIONS 4.1 Purpose

Current/Future costs

Short-term decisions: product mix, pricing

Future

Longer-term strategic decisions

Future

Long-term pricing

Future

Plan future product-related costs

Future

Control of product costs

Current

Reimbursement contracts

Current

External reporting (inventory calculation)

Current

product

The information cannot all come from one source. The accounting system may accumulate current and past product costs but for some decision making and planning, estimates of future costs will need to be generated outside of the accounting system.

4.2

The statement is incorrect. Product costing systems are applicable to services as they too are products. While there is no inventory to cost in a service business, service costs can be useful for a range of management decisions. These decisions include the pricing of services, determining the optimal mix of services to offer, determining the impact on profits of dropping a service or adding a new service, and controlling costs.

4.3

Managers need cost information to support a range of managerial roles including short-term and strategic decision making, planning and controlling costs, and sometimes for claiming costs under cost reimbursement contracts and, while the production environment in small businesses may be less complex than in larger businesses, these needs may be just as relevant. Managers in small businesses may need to value their inventory for inclusion in their financial reports. However, small businesses may be discouraged from implementing a product costing system due to scarce resources. This attempt to contain costs can mean that, when making operating decisions, they may rely on costing figures prepared for external reporting purposes. Competitive pricing can result in them underpricing products to the point that they sell at a loss. To evaluate the profitability of products the small business must add cost items such as transportation, insurance and customs charges to its purchase or manufacturing costs. When selling price is dictated by the market it is vital to accurately assess costs and, if profitability is lacking, work on reducing costs or move to different products or markets.

4.4

This attitude is not reasonable. Product costs may be useful for a range of decisions. Even though the business is a ‘price taker’, it may well need to consider whether it should be making all of the products in the range, as some may be unprofitable. A wrong decision may cost the firm more than it would to run a product costing system. A product costing system may help to control production costs and highlight problems. The firm will need some product costs at year-end to value inventory, even if it is minimal. Managers often use costs from product costing systems for planning, controlling costs and claiming costs under cost reimbursement contracts.

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4.5

In making long-term decisions about products, such as which products to produce and what price to set, managers need a complete picture of all the costs associated with the product. In the shorter term, particularly for existing products, the manager may ignore research and development and design costs, since they have already been incurred. In this case, the relevant product cost will include the manufacturing, marketing, distribution and customer service costs associated with the product.

4.6

When direct material, direct labour and manufacturing overhead costs are incurred, they are applied to work in process inventory by debiting the account. When goods are finished, the costs are removed from the work in process account with a credit, and are then transferred to finished goods inventory by debiting that account. Subsequently, when the goods are sold, the finished goods inventory is credited and the costs are added to the cost of goods sold, with a debit.

4.7

Overapplied or underapplied overhead is caused by errors in estimating the predetermined overhead rate. These errors can occur in the numerator (budgeted manufacturing overhead), or in the denominator (budgeted level of the cost driver). It can also be caused by using inappropriate cost drivers to allocate the overheads to products. Overapplied or underapplied overhead should be closed at year end because month-to-month variations are likely to average out over the year.

4.8

Manufacturing overhead consists of all costs related to the production process, other than direct materials and labour. Because these costs are difficult to trace to specific jobs they are estimated and allocated to each job. This estimate is known as a predetermined overhead rate. Since these costs are indirectly associated with the product the predetermined rate needs to be applied to the product costs.

4.9

One of the primary purposes of using the predetermined overhead rates is to smooth out the variations that happen seasonally in overhead costs. Another benefit is to plan for costs of future projects and a predetermined rate allows managers to budget for them without waiting for the actual costs.

4.10 In Exhibit 4.15, underapplied overhead is deducted from the actual overheads to estimate the amount of overhead applied to production during the period. As a result of this calculation the total manufacturing cost reflects the actual material and labour costs, plus applied overhead. These costs form part of the cost of goods sold manufactured. In the Income Statement, the cost of goods sold expense is then adjusted by adding in the amount of underapplied overhead, to reflect the part of the actual overhead that has not been recognised in the manufacturing cost.

4.11 In a job costing system, costs are assigned to batches or job orders of production. Job costing systems are used by firms that produce relatively small numbers of dissimilar products. Job costing would be used in any situation where products are produced to customers’ specifications, such as in a dressmaking business, an architectural firm, or in a panel-beating shop. In a process costing system, production costs are averaged over a large number of product units. Process costing systems are used by firms that produce large numbers of nearly identical products, such as paint, beer or bricks. In job costing situations, the job has specific characteristics that allow it to be identified from the outset, and direct costs can be traced to the job. In a process costing environment, such as producing paint, each litre of paint is identical to every other litre and cannot be distinguished. This means that direct costs must be traced to the production process and then averaged across all units produced.

4.12 The two main steps in process costing are: 

estimating the costs of the production process



calculating an average cost per unit by dividing the cost of the process by the number of units produced.

Note that in the next chapter where these steps are explained more comprehensively there are four steps.

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4.13 In the ‘Real life’ scenario describing the cost of Australian wine, the Australian winemakers would probably use either process or a hybrid costing system (a combination of job costing and process costing). There are some processes (such as de-stemming, crushing, filtering, bottling, labelling and packaging) that are common to production of all types of wine, but some other processes (such as fermentation, maturation and stabilisation) would be different for different types of wine (such as red, white sparkling or fortified wine). In addition, different types of wine use different varieties of grapes (direct materials), which may differ considerably in purchase price. In other words, the winemaker would use hybrid costing system if they are producing different types of wine and use process costing if they are producing only wine that undergoes common processes and uses grape varieties with very similar costs.

4.14 In a hospital like Sydney’s Westmead Hospital, there are number of activities related to the primary care of each patient. The activities in a hospital are divided into number of cost centres, which include pathology, outpatient consultancy, wards, operating theatre, laundry and kitchen etc. The job costing process would include costs related to the patient from any of these cost centres for their direct services. Other non-medical services could also be recorded in the costing process.

4.15 (a)

The job costing sheet is used to summarise the costs of direct material, direct labour and manufacturing overhead that relates to a particular job.

(b)

A material requisition form authorises the transfer of raw material from the warehouse to the production department, and is used to record the cost of materials for jobs.

(c)

A labour timesheet is used to record the amount of time spent on each job.

4.16 (a)

Total manufacturing cost is the cost of materials and labour used, and the overhead applied for the period.

(b)

Manufacturing costs to account for include the cost of opening inventory for work in process.

(c)

Cost of goods manufactured is the total manufacturing cost adjusted for opening and closing inventory.

4.17 Production costs are tracked to each production department for two reasons: 

Department managers are held responsible for cost control, and so the costs for each department must be identifiable.



When there are work in process inventories at the end of an accounting period, separate costs are necessary for each department in order to calculate the value of work in process for that department.

4.18 In process costing, large quantities of identical (or nearly identical) units are produced, so it is neither possible, nor necessary, to trace costs to each individual unit. Instead, production costs are traced to a process or a department and the average unit cost is determined by dividing the total process costs by the total number of units produced. The costs of producing each unit are determined by progressively accumulating the costs for each process.

4.19 Australian accounting standard AASB 102 has several requirements relating to inventories arising from production: The cost of inventories produced is to include the costs of: 

direct materials



direct labour and on-costs



sub-contracted work



a systematic allocation of production overheads.

The balance sheet must disclose separately the accounting policies adopted for measuring inventories, including work in process and finished goods. Both of these requirements involve costs determined using job costing systems and process costing systems. The valuing of work in process using process costing is dealt with in Chapter 5.

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4.20 Under AASB 102, the cost of inventories is to exclude the cost of abnormal wastage, storage, administration and selling cost.

4.21 Proration is appropriate when the amount of underapplied or overapplied overhead is significant. It can also be argued that proration should be used if a significant proportion of production remains in the inventory. Proration prevents cost of goods sold from bearing the full impact of applying an inappropriate overhead application rate, caused by errors in estimating one or both of the elements used in the calculation of the predetermined overhead rate. Remember that both numerator and denominator in that calculation are budget estimates.

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SOLUTIONS TO EXERCISES EXERCISE 4.22 (20 minutes) Manufacturing cost flows 1 Raw Materials Inventory 454 000 348 000 106 000

Wages Payable 648 000

Manufacturing Overhead 360 000

Work in Process Inventory 36 000 348 000 648 000 360 000 240 000 1 152 000

Finished Goods Inventory 60 000 240 000 264 000 36 000

Sales Revenue 390 000

Accounts Receivable 390 000

Cost of goods Sold 264 000

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2 Comfy Seats Furniture Pty Ltd Partial Balance Sheet as at 31 December Current assets Cash

XXX

Accounts receivable

XXX

Inventory Raw materials

$ 106 000

Work in process

1 152 000

Finished goods

36 000

Comfy Seats Furniture Pty Ltd Partial Income Statement for the year ended 31 December Sales revenue

$390 000

Less: Cost of goods sold Gross margin

264 000 $126 000

EXERCISE 4.23 (30 minutes) Job or process costing: film producer Job-order costing is the appropriate product-costing system for feature film production, because a film is a unique production. The production process for each film would use labour, material and support activities (i.e. overhead) in different ways. This would be true of any type of film (e.g., filming on location, filming in the studio, or using animation).

EXERCISE 4.24 (15 minutes) Job versus process costing 1

A manufacturer of swimming pool chemicals would use process costing, as there are a limited number of products produced in large quantities in similar production processes. Direct costs can be traced to each production process and then averaged across all units produced.

2

A manufacturer of custom hot tubs and spas would use job costing, as the custom made hot tubs and spas are produced to customer specifications and direct costs (direct materials and direct labour) can be traced to each job easily and economically.

3

A financial planning business would use job costing, as each customer is unique and the direct costs (such as professional fees and other specific costs) can be traced to each client or job.

4

A producer of plastic plant pots would use process costing, as the different types of plastic pots are produced in batches in large quantities across similar production processes.

5

An ice-cream producer would use process costing, as the production of each type of ice-cream would be very similar and involve similar processes.

6

A manufacturer of custom built tool sheds would use job costing, as custom built products are produced to customers’ specifications and direct costs (direct materials and direct labour) can be traced to each job.

7

A manufacturer of paper clips would use process costing, as different types of paper clips would be very similar and they would be mass produced using the same processes.

8

An engineering consulting firm would use job costing, as each engineering project is unique and would use different amounts of resources, which could be traced to each job.

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9

A manufacturer of party balloons would use process costing, as the production of balloons would involve only a few types of products, produced in large quantities using a number of similar production processes.

10

A manufacturer of custom-built emergency rescue vehicles would use job costing, as custom-built vehicles are produced to specified customer needs. Direct costs (direct materials and direct labour) will vary and could be traced to each job.

EXERCISE 4.25 (25 minutes) Job cost sheet: manufacturer 1 Job cost sheet Job number

TB78

Description

Teddy bears

Date started

1 April

Date completed

15 April

Number of units completed

1000

Direct material Date

Requisition number

Quantity

Unit price

Cost

1 April

101

450

$0.80

$360

5 April

108

600

$0.30

$180

Direct labour Date

Time sheet number

Hours

Rate

Cost

15 April

72

500

$19

$9500

Manufacturing overhead Date

Cost driver

Quantity

Application rate

Cost

15 April

Direct labour hours

500

$12

$6000

Cost summary Amount 540 9 500

Cost item Total direct material Total direct labour

$

Total manufacturing overhead Total cost Unit cost

6 000 $16 040 $16.04 Delivery summary

Date

Units shipped

Units remaining in inventory

Cost balance

30 April

700

300

$4812*

* 300 remaining in inventory  $16.04 = $4812

2

Managers may use this information to make pricing decisions, assess product profitability, control product costs, and to estimate inventory values.

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EXERCISE 4.26 (15 minutes) Overapplied or underapplied overhead: manufacturer 1

Predetermined overhead rate = $1 050 000/84 000 hours = $12.50 per hour

2

To calculate actual manufacturing overhead: Depreciation........................................................................................................................$250 000 Property taxes...................................................................................................................... 21 000 Indirect labour..................................................................................................................... 85 000 Supervisory salaries............................................................................................................ 208 000 Electricity............................................................................................................................ 47 000 Insurance............................................................................................................................. 26 000 Factory rent......................................................................................................................... 291 000 Indirect material: Beginning inventory, 1 January.................................................................................. $ 60 000 Add: Purchases...