Chapter 02 - Product Costing Systems: Concepts and Design Issues

CHAPTER 2
Product Costing Systems: Concepts and Design Issues
Chapter Outline

A. Cost Management Challenges – There are three questions addressed in this chapter:

1. What are the significant inputs to a production process, and how do cost managers track
the flow of costs through the process?

2. How can alternative methods to calculate product costs create different incentives?

3. How should cost managers measure costs for internal decision making?

B. Learning objectives: This chapter has nine learning objectives:

1. Explain the role of product costs, period costs, and expenses in financial statements.

2. Prepare an income statement and a schedule of cost of goods manufactured and sold.

3. List the components of manufacturing cost, and diagram their flow through a
manufacturing process.

4. Explain how unit-level, variable, and fixed costs differ.

5. Understand the concepts of opportunity costs, sunk costs, committed costs, direct costs,
and indirect costs.

6. Prepare income statement using absorption, variable, and throughput costing.

7. Reconcile income under absorption, variable, and throughput costing.

8. Discuss the advantages and disadvantages of absorption, variable, and throughput costing.

C. The role of product costs, period costs, and expenses in the financial statements is explained.

1. At the most basic level, a cost can be defined as the sacrifice made, usually by the resources
given up, to achieve a particular purpose.

2. Expense is defined as the cost incurred when an asset is used up or sold for the purpose of
generating revenue.

3. Product cost is a cost assigned to goods that were either purchased or manufactured for
resale. Product costs are inventoriable.

4. Cost of goods sold is the expense measured by the cost of the units sold during a specific
period of time.

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5. Period costs are identified with the time period in which they are incurred rather than with
units of purchased or produced goods.

D. Preparing income statement and schedule of cost of goods manufactured and sold is explained.

1. Service firms provide customers a product that is consumed as it is produced. Thus, service
firms do not carry inventories of produced goods and do not have a line item for cost of
goods sold in their income statements.

2. Retail and wholesale companies (merchandising) sell tangible products that can be
inventoried. These companies show a separate line item for cost of goods sold in their income
statements. Subtracting cost of goods sold from revenues provides the gross margin. Other
expenses (selling and administrative) are subtracted to arrive at operation income.

3. At the end of the year, any inventory on hand for merchandising firms is considered an asset
which is valued at its product cost. Merchandise bought is valued at cost plus transportation
costs.

4. Manufacturing companies carry three kinds of inventory: a) inventory of raw materials for
goods bought to be converted, b) work in process inventory for goods which are being
converted, and c) finished goods inventory for items completed and ready to be sold.

5. For both merchandising and manufacturing companies, unsold inventories of any type are
considered assets until they are sold.

6. All expenses, except inventoriable costs, are considered period costs and are charged to
expense and appear in the income statement of the period incurred.

7. The components of a statement of cost of goods manufactured and sold for a manufacturing
company are: raw material inventory beginning of the period + purchases – raw
materials end of the period = raw material used; raw material used + direct labor +
manufacturing overhead = total manufacturing costs (TMC); TMC + work in process (WIP)
beginning – WIP end of the period = cost of goods manufactured (CGM); CGM + finished
goods inventory beginning = finished goods inventory ending = cost of goods sold.

8. An income statement includes the following items: Sales – cost of goods sold (as illustrated
in the above paragraph) = gross profit; gross profit – selling and administrative expenses =
operating income; operating income – income tax = net income.

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E. Components of manufacturing costs are explained.

1. Direct materials are resources such as raw materials, parts, and components that one can
feasibly observe being used to make a specific product. Insignificant items may be classified
as indirect costs as part of the overhead accounts.

2. Direct labor is the cost of compensating employees who transform direct materials into
finished product. This cost includes the fringe benefits for these workers.

3. Manufacturing overhead includes all costs of transforming materials into a finished product
other than direct materials and direct labor. Indirect materials are those that either are not a
part of the finished product but are necessary for its manufacture or are part of the finished
product but are insignificant in cost. Indirect labor cost consist of the wages of production
employees who do not work directly on the product but are required for the manufacturing
facility to operate.

4. Support services such as maintenance department do not work directly on the product but are
necessary for the production process to operate as such they are part of the overhead cost.

5. Overtime premium is the extra hourly component paid to an employee who works beyond the
time normally allowed and is usually classified as part of the overhead cost.

6. Idle time is time not spent productively by employee due to part shortage, waiting time, etc.
and is another overhead component.

7. Prime costs include direct material and direct labor. Conversion costs include direct labor
and manufacturing overhead. Notice the overlap.

8. Non-manufacturing costs include the costs of selling and administration and are among the
period costs for an entity.

9. The cost flow in a manufacturing firm is from raw materials to work in process to finished
goods and finally to cost of goods sold.

10. Understanding of costs from different angles is important for effective cost management.

11. An activity is any discrete task that an organization undertakes to make or deliver a good or
service. A cost driver is a characteristic of an activity or event that causes costs to be incurred
by that activity or event. For example, insurance claims is an activity and the primary cost
driver is possibly the number of claims processed.

F. The difference between unit level fixed and variable costs is explained:

Variable costs change in direct proportion with a change in the activity volume. We need
more material when we produce more of a product. We may also need more workers if we
want to produce more products.

Fixed costs remain unchanged as the volume of activity changes. For example, we may still
have one store manager even if our sales volume doubles. We may still pay the same rent for
our plant even if our production volume decreases substantially.

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The concept of fixed and variable costs is often discussed in terms of a relevant range where
these possibilities hold true. The classification is also dependent on the time-frame; i.e., the
shorter the time-frame, the more of the costs are fixed, and the longer, the time-frame, the
more of the costs are variable; i.e., for more sales, we ultimately need perhaps, a larger space
and a larger sales force – everything else being equal.

The question of fixed and variable may be partially based on cost driver that we choose. For
example, set up costs for machines may be a fixed cost if we consider volume of production
as the cost driver. But set up costs may be considered variable if the cost driver in question is
the number of set ups needed to produce certain products.

Cost hierarchy expands on our initial limitation of fixed and variable costs and classifies costs
into unit level, batch level, product level, and facility-related costs.

Unit level costs are incurred for every unit of product manufactured or service produced.
Example: electricity to run machines.

1. Batch-level costs are incurred for every batch of product or service

produced. Example: material handling.

2. Product-level costs are incurred for each line of product or service.

Example: product design.

3. Facility or general-operations-level costs are incurred to maintain the

overall facility and infrastructure of the organization.

G. The difference between cost of resources used and resources supplied is explained:

1. The distinction is important. Only when resources supplied merge equally with the resources
used, we are at an optimum level until other efficiencies are achieved. Otherwise, we would
either have a bottleneck where too much is supplied for the next operation to be able to use or
there might be not enough supplied for the operation for its normal needs. The management
task is to find the optimum between resources supplied and resources used.

H. The terms, committed costs, opportunity costs, sunk costs, direct costs, and indirect
costs are explained:

1. Committed cost do not vary with change in production or sales volume. For example, if we
have a labor contract that forces us to pay regardless of needs, it becomes a committed cost.

2. Opportunity cost is a foregone benefit that could have been realized from the best alternative
use of resources. The money you could have earned instead of going to school is an
opportunity cost.

3. Sunk costs are past payments for resources that cannot be changed by any current or future
decision. As such, they are irrelevant in managerial decision making.

4. In cost-management decisions, we must look for relevant costs. Costs that make a difference
with regard to choosing among certain alternative. If you want to buy a product rather than
making it, what costs do you really save if you instead decide to buy the product.

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5. Direct costs of a cost object are traceable to that cost object. We can trace material and labor
costs (direct portion) to a product but not overhead. On the other hand, we can trace salaries,
material, labor, and supplies costs to a department but not the share of costs related to the
department as claimed by personnel or facility planning departments.

6. Indirect cost of a cost object are not feasibly traceable to that cost object. For example, we
can not trace the supervisor’s cost associated with a particular product.

7. Cost object is any end to which a cost is assigned.

I. Income statements may be prepared using absorption, variable, and throughput

costing methods:

1. Absorption or full costing applies all manufacturing overhead costs to manufactured goods.

2. Variable or direct costing applies only variable manufacturing overhead to manufactured

goods as a product cost along with direct material and direct labor.

3. Assume that you produced 100 units that cost 20,000 – 75% of which is for fixed costs – and
sell for $250 a unit. If you sell 100 units (assume no beginning inventory), your profit would
be the same whether you use full costing or variable costing. Full costing income: 25,000 –
20,000 = $5,000. Variable costing income: 25,000 – 5,000 – 15,000 = $5,000. However if
you produce 100 and sell, say, 80 units, there will be a difference: Full costing income:
(250 * 80) – (200 * 80) = $4,000. Variable costing income: (250 * 80) – (50 * 80) – 15,000
= $1,000. All fixed costs under variable costing is considered period cost whereas, under full
costing, the portion of fixed costs attributable to the units not sold remains in inventory until
sold.

4. Under variable costing, we use a contribution margin format of income statement where we
subtract variable costs from revenue to arrive at contribution margin and then subtract all
fixed costs to arrive at operating income.

J. Reconcile income under absorption, variable, and throughput costing:

1. The difference in income between absorption costing and variable costing is the fixed cost
portion of cost in inventory that is deferred as asset under full costing and charged to expense
under variable costing.

2. Assume that you produced 100 units that cost 20,000 – 75% of which is for fixed costs – and
sell for $250 a unit. Sales amounted to 80 units, and there was no beginning inventory.
Income under full costing amounts to $4,000 and amounts to $1,000 under variable costing.
The difference of $3,000 between the two methods can be reconciled as the fixed cost per
unit times the number units in inventory: 20 * 150 = $3,000.

3. In a just-in-time inventory system where inventory is non-existent, there will be no difference

in income if either method is used.

4. In throughput costing all costs except material costs are considered period costs.
Reconciliation method is similar in terms of approach to the other methods.

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5. In situations with increase in inventory, income under full costing would be higher than
income under variable costing. Reverse is also true.

K. Advantages and disadvantages of absorption costing, variable costing, and

throughput costing are discussed:

1. Absorption costing is non-intuitive, confusing, and subject to manager’s manipulation of

income; i.e., produce more to show a higher level of income.

2. Absorption costing, however, is more representative of the long-term cost of the product
because it incorporates the fixed cost into the product cost.

3. Many managers prefer to use full costing for their product pricing decisions because it
provides a more realistic measure of costs.

4. Variable costing, however, is more helpful for short-term decisions with regard to pricing as
well s profitability of the firm.

L. Throughput costing was not adequately discussed in this chapter. It is the extreme in
variable costing in that it assigns only the unit-level spending for direct costs as the cost of products
or services. Accordingly, with higher production and lower sales, it would show a considerably lower
profit as compared to absorption costing or even variable costing. As more costs tend to be
considered fixed in the short-run, this methods provides another good short-term measure of
performance.

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Problem 1 – Chapter 2
LO: 6 & 7
Completion time: 40 minutes
Variable costing, absorption costing, and throughput costing
Group discussion on its merits and computation intricacies.

Omid Printing produces two thousand volumes of books in a period. The unit level costs are considered
to be material and labor and amount to $25 per book. Other variable costs amount to $25,000 for the
period. Fixed costs amount to $64,000 for the period. 1800 of these books were sold in the same time
period. The selling is $90 a copy with a 10% paid as sales commission.
Required:
1. Prepare income statement under a) absorption costing, b) variable costing, c) throughput costing.
2. Reconcile the difference in income between the three methods.
3. Discuss the advantages and disadvantages of the methods outlined.

Solution:

Cost per unit under the three method:

Material and labor 25.0
Other variable costs 12.5
Fixed costs 32.0
69.5

Throughput cost 25.0

Variable cost 37.5
Full cost 69.5

Sales volume 1800

Selling price 90
Throughput Variable Absorption
Sales 162000 162000 162000
Cost of sales 45000 67500 125100
Margin 117000 94500 36900
Sales commission 16200 16200 16200
Fixed costs 89000 64000
Income before taxes 11800 14300 20700

Difference -2500 -8900

Reconciliation 200 * 12.50 200 * 44.50
Diff. (full vs. variable) -6400
Reconciliation 200 * 32

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3. In the very short time period, there is not much we can do about fixed costs and even some of the
variable costs such as maintenance and part of utility costs. So throughput costing and variable costing
provide a more realistic picture of profitability. It is also more conservative. In the sense that if we are
unable to sell inventory or sell it at a disposable value equaling to its variable costs, variable costing or
throughput costing provides us with a more realistic picture. These methods are also more realistic in the
short-run because they do not defer fixed costs as part of inventory costs and write them off to expense.
This is more in line with the definition of fixed costs and what it means.

Problem 2.
LO 5

Assume that Printing Impression has two divisions X & Y with a home office that has a cost of $96,400
for the year. Taxes amount ot 30% of income. Other data for the two divisions for 2008 follow:
Sales $675,000 $325,000
Cost of sales 60% 40%
Selling and admin. costs $89,500 $67,500
Depreciation (included in CGS) $124,500 $21,700
Number of employees 8 2

Required: a) determine net income for each division assuming that home office charge is allocated to
each division based on sales amount, b) determine net income for each division assuming that home
office charge is allocated to each division based on number of employees, c) what is each division’s
indirect cost and is allocation an accounting or a management decision, d) what is the company’s sunk
cost for the year., e) assume that the company has a remaining life of four years anticipating the same
level of profits for the remaining years. If division Y can be sold at the end of this year for $225,000,
what is the opportunity cost in case the division is sold – assuming that the home office charge will have
to be absorbed totally by division X in this case.
Solution:

b) You can repeat the above exercise, using number of employees as a basis of allocating home office
charge (80% to X and 20% to y) and determine the net income accordingly.
c) The indirect cost is the cost to be allocated; i.e., the home office charge. Indirect costs cannot be
directly associated with the cost objective. Cost allocation is strictly an accounting rather than a
management decision. It does not affect the total income for the firm regardless of how the home office
charge is allocated.
d) The sunk cost is the depreciation amount. It is the money already spent and does not affect the cash
flow of the firm.
e) The opportunity cost for the firm is the benefit lost because of selling the division; i.e., (96,170 * 4 =
384,580) versus the amount of $225,000 to be received now. Of course, this comparison does not account
for a) time value of money (the money to be received now rather than in the course of four years. Neither
does it address the tax implication for the sale of division Y.

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Problem 3.
LO: 2

Ariana Design Company’s financial data for 2008 appears as follows:

Item 1/1/2008 12/31/2008
Raw material inventory $48,500 $93,600
Finished goods inventory $144,600 $121,700
Work in process inventory $27,400 $38,300

The company purchased $295,000 of raw materials, incurred $128,000 in direct labor costs and overhead
amounted to 200% of direct labor.
Prepare a cost of goods produced and sold report for 2008 based on the above data.

Solution:

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Sample Quiz

1. Product cost is a cost that

a. is identified with the period in which they are incurred.
b. is either purchased or manufactured for resale.
c. is manufactured as a tooling for the plant.
d. is incurred when as asset is used up or sold for the purpose of generating revenue.

Answer: b LO: 1
A product cost is a cost that is either purchased or manufactured for resale.

2. A period cost is a cost that

a. is identified with the period in which it is incurred.
b. is either purchased or manufactured for resale.
c. is manufactured as a tooling for the plant.
d. is incurred when as asset is used up or sold for the purpose of generating revenue.

Answer: a LO: 1
A period cost is a cost that is identified with the period in which they are incurred such as, a sales
commission paid for revenue generated in the period.

3. Inventoriable cost is a cost that

a. is identified with the period in which they are incurred.
b. is either purchased or manufactured for resale.
c. is manufactured as a tooling for the plant.
d. is incurred when as asset is used up or sold for the purpose of generating revenue.

Answer: b LO: 1
Inventoriable cost is another term for product cost.

4. ABC company has used 210 lbs of material X. Inventory of X at the beginning of the period was
150 lbs and 180 lbs were purchased. Inventory at the end of the period should have been
a. 100 lbs.
b. 120 lbs.
c. 140 lbs.
d. 160 lbs.

Answer: b LO: 3
[150 + 180 – 210] = 120 lbs.

5. ABC Company used 210 lbs of x at $5 a lb. direct labor amounted to 130 hours at $8 an hour.
Overhead is approximately 200% of labor, and total manufacturing cost amounted to $4,090.
Actual overhead amounted to
a. $2,080
b. $2,040
c. $2,020
d. $2,000

Answer: d LO: 3
4,090 – [(210 * 5) + (130 * 8)] = $2,000.

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6. ABC Company sold 200 units of a product at $32 a unit that cost $21 a unit. Sales commission
amounted to 10% of sales and administrative costs amounted to $1,640. Operating income
amounts to
a. $100
b. –100
c. $80
d. –80

Answer: d LO: 2
(200 * 32) – [(200 * 21) + (6,400 * .10) + 1,640)] = - $80.

7. ABC Company sold 200 units of a product at $32 a unit that cost $21 a unit. Sales commission
amounted to 10% of sales and administrative costs amounted to $1,480. Taxes are at 25% of
income. Net income amounts to
a. $60
b. –60
c. $80
d. –80

Answer: a LO: 2
(200 * 32) – [(200 * 21) + (6,400 *. 10) + 1,480)] = $80; 80 – (80 * .25) = $60.

8. NBC Company had a total material cost of $,1050, total direct labor of $1,040, and overhead
amounting to 200% of direct labor. Prime cost amounts to
a. $2,090
b. $2,080
c. $3,120
d. $4,170

Answer: a LO: 3
Prime cost: 1,050 + 1,040 = $2,090.

9. NBC Company had a total material cost of $ 1,050, total direct labor of $1,040, and overhead
amounting to 200% of direct labor. Conversion costs amount to
a. $2,090
b. $2,080
c. $3,120
d. $4,170

Answer: c LO: 3
Conversion cost: 1,040 + 2,080 = $3,120.

10. NHI Company had a total direct labor of 120 hours for the period at the rate of $8 an hour. Ten
percent of this time was on an exceptional overtime basis with a pay premium of 50% of regular
rate. Total direct labor cost amounts to
a. $960
b. $1,008
c. $1,056
d. $1,104
Answer: a LO: 3

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Direct labor: 120 hours * 8 = $960

11. NHI Company had a total direct labor of 120 hours for the period at the rate of $8 an hour. Ten
percent of this time was on an exceptional overtime basis with a pay premium of 50% of regular
rate. Overtime premium amounts to
a. $144 and should be charged to direct labor
b. $144 and should be charged to indirect labor
c. $48 and should be charged to direct labor
d. $48 and should be charged to indirect labor.

Answer: d LO: 3
Overtime premium: 120 hours * 10% * $8 * 50% = $48. Overtime premium which is not part of the
normal work routine is charged to indirect labor as part of manufacturing overhead.

12. ABC Company’s current manufacturing costs amount to $4,090 and work in process at the end of
the period amounted to $1,120. A total of 100 units at the cost of $41.80 were completed. Work
in process at the beginning of the period amounts to
a. $1,110
b. $1,120
c. $1,210
d. $1,220

Answer: c LO: 3
Work in process beginning: 4,180 + 1,120 – 4,090 = $1,210 where $4,180 = 41.80 * 100 units.

13. A cost driver is

a. any discrete task that an organization undertakes
b. any task results in delivery of goods or services
c. a characteristic of an activity or event that causes costs to be incurred by that activity or
event
d. none of the above

Answer: c LO: 4
Answer (c) is the definition of a cost driver. Answer (a ) is the definition of an activity.

14. Material handling cost is an example of

a. unit level costs
b. batch level costs
c. product level costs
d. facility related costs

Answer: b LO: 4
Material handling costs are usually related to a batch of a product

15. Machinery maintenance cost is an example of

a. unit level costs
b. batch level costs
c. product level costs
d. facility related costs

Answer: a LO: 4

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Machinery maintenance can be related to each unit of a product manufactured.

16. Product design cost is an example of

a. unit level costs
b. batch level costs
c. product level costs
d. facility related costs

Answer: c LO: 4
Product design depends on type of product and is a product level cost

17. Ryan decided to buy a car that cost him $18,000. His dad could not convince him to save the
money and earn an interest of 10% on it for the life of the car which is probably five years. No
interest is paid on the interest earned. Opportunity cost of this decision amounts to
a. $1,800
b. $9,000
c. $13,500
d. $18,000

Answer: b LO: 5
Opportunity cost is the benefit lost because of choosing another alternative: 18,000 * 10% * 5 = $9,000.

18. Saba Company decided to make part A at a cost of $12 a unit which includes $6 in material and
labor plus an overhead of 100% on direct cost. One half of overhead is fixed overhead that will
continue regardless of making the goods or buying it from outside. The relevant cost of A for this
decision is
a. $6
b. $9
c. $12
d. $15

Answer: b LO: 4
Relevant cost: 6 + (6 * 50%) = $9. The fixed costs would remain regardless of this decision.

19. With regard to fixed and variable costs, we can say that
a. fixed cost per unit remains the same regardless of output
b. total variable costs remain the same regardless of output
c. unit cost which includes a small amount of variable cost remains constant regardless of
volume
d. variable cost per unit remains the same regardless of output

Answer: d LO: 7
Variable cost per unit stays the same while unit cost and fixed cost per unit would be lower at higher
volumes.

20. If inventory ending in a manufacturing firm is higher than inventory beginning, income under
a. absorption costing income is higher than income under variable costing
b. throughput costing is higher than income under variable costing
c. variable costing income is higher than absorption costing income
d. none of the above

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Answer: a LO: 8
When inventory ending is higher, it means that production was higher than the quantity sold. Under these
conditions, absorption costing income is higher than income under variable costing or throughput costing.
Income under variable costing would also be higher than income under throughput costing. This is due to
absorption of more fixed costs by inventory which would otherwise be written off to period costs.

21. Absorption costing is

a. intuitive
b. straight-forward
c. reports fixed versus variable manufacturing cost separately on the income statement
d. none of the above

Answer: d LO: 8
Absorption costing is non-intuitive, confusing, and considers both fixed and variable costs as part of the
product cost.

22. Identify the incorrect response. Variable costing

a. is more helpful for long-term decisions
b. is more intuitive
c. separates fixed and variable costs
d. considers all fixed costs as period costs.

Answer: a LO: 8
While variable costing is more intuitive and separates costs into fixed and variable, reporting the former
as period cost, but full cost is more of a long-term measure of costs.

23. Anderson decided to produce 600 units more than it otherwise would have because the profit
reported would be 950,000 more of which Anderson receives 10% as part of his bonus:
a. this action is illegal.
b. this action is unethical.
c. this action is unethical and illegal
d. an opinion can not be reached based on the above.

Answer b LO: 9
Under the present rules, this action is not illegal. However, it is some sort of data and action manipulation
for personal gain and must be discouraged, or methods must be devised (such as variable costing method
of preparing income statement) so that the manager would not have such an incentive for manipulating
the system.

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