Chapter 6

Fundamentals of Product
and Service Costing

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost Management Systems

L.O. 1 Explain the fundamental themes underlying
the design of cost systems.

The objective of the cost management system

is to provide information about costs relevant
for decision making.
The cost system accumulates and reports costs
about processes, products, and services.

6-2

LO1

Reasons to Calculate Product

or Service Costs
For decision making
For deciding what to sell

For setting prices

For knowing the cost of goods sold
For knowing the cost of inventory

6-3

Cost Allocation and Product Costing

L.O. 2 Explain how cost allocation is used
in a cost management system.

Basic Cost Flow Diagram

Cost
pools

Direct
materials

Direct
labor

Manufacturing
overhead
Indirect

Cost
allocation
rule
Cost
objects

(allocated
by direct
labor cost)

Direct

Alpha

Beta

6-4

Basic Cost Flow Model

L.O. 3 Explain how a basic product costing system works.
How costs and units move through inventories:
Beginning
balance

Transfers
in

Transfers
out

Ending
balance

BB

TI

TO

EB

This is true for the following accounts:

Raw Materials (RM)
Work-in-Process (WIP)
Finished Goods (FG)
6-5

LO3

Costing with No Work-in-Process

Inventories
Baxter Paint begins production on April 1.
It starts and completes production of 100,000
gallons of paint in April and has no ending
work-in-process inventory.
Cost of resources used in April:

Materials
Labor
Manufacturing overhead
Total

$ 400,000
100,000
500,000
$1,000,000

6-6

LO3

Costing with No Work-in-Process

Inventories
What are the costs at the end of the period?
$1,000,000 was added to work-in-process
and then transferred out to finished goods.
Since Baxter produced 100,000 gallons of
paint, then the cost per gallon of paint is $10.

6-7

LO3

Costing with Work-in-Process

Inventories
Production for Baxter Paint for May follows (gallons):
Beginning inventory
Started in May
Total
Ending WIP (50% complete)
Transferred out

-0110,000
110,000
20,000
90,000

6-8

Costing with Work-in-Process

Inventories

LO3

BB
0

TI

110,000
+

gallons

TO
90,000
gallons

EB

20,000 gallons
=
(50% complete)

FG

6-9

LO3

Costing with Work-in-Process

Inventories

How do we cost Baxters 20,000 gallons of paint that

are only half finished?
20,000 gallons half finished is equivalent to 10,000
gallons finished.
90,000 gallons transferred out plus 10,000 equivalent gallons
of finished paint equals 100,000 equivalent gallons of paint.

Gallons of paint transferred out

Equivalent gallons of finished paint
Total equivalent gallons of paint

90,000
10,000
100,000
6 - 10

LO3

Costing with Work-in-Process

Inventories
Direct material + Direct labor + Overhead
($990,000)

90,000
gallons
(90%)

Equivalent gallons

Finished goods
inventory
$891,000

10,000
gallons
(10%)

Work-in-process
inventory
$99,000
6 - 11

Predetermined Overhead Rates

L.O. 4 Understand how overhead cost is allocated to products.
Indirect costs are allocated using a predetermined
overhead rate (POHR).

POHR is the cost per unit of the allocation base used

to charge overhead to products.
POHR = $ Base

6 - 12

Multiple Allocation Bases

and Two-Stage Systems
L.O. 5 Explain the operation of a two-stage allocation
system for product costing.

We can use two or more allocation bases to allocate

manufacturing overhead to products.

6 - 13

LO5

Cost
pool

Multiple Allocation Bases

and Two-Stage Systems
Manufacturing overhead
First stage

Machine-related
costs

Direct labor-related
costs

Cost
allocation
rules

Indirect costs

Indirect costs

(allocated in proportion
to machine hours)

(allocated in proportion
to direct labor costs)

Cost
objects

C-27s

C-20s

Second
stage

6 - 14

Multiple Allocation Bases

and Two-Stage Systems

LO5

Overhead
$180,000

Cost
pool

Intermediate
cost pools

Labor-related
$108,000

Machine-related
$72,000

Cost allocation
rule

Direct labor
costs

Machine
hours

6 - 15

Product Costing Systems

L.O. 6 Describe the three basic types of product costing
systems: job order, process, and operations.

Job costing:
An accounting system that traces costs to individual units
or to specific jobs, contracts, or batches of goods.
(custom homes, movies, services)
Process costing:
An accounting system used when identical units are
produced through a series of uniform production steps.
(cornflakes, facial tissues, paint)
6 - 16

End of Chapter 6

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.