Cost accounting essentials.

Do you have clients whose businesses involves manufacturing? Do you wish you (and they) understood better how they arrived at the cost of their products? The quality of the business advice you give your clients can be improved by understanding the different methods of product costing and how to apply them.

Careful accumulation of cost information is vital to a number of areas within a client's firm. The cost figure is used as a basis for a reasonable and competitive selling price, for forecasting future input and cash flow needs, for internal control, as well as for valuing inventory at period end. Cost figures will affect both the income statement (as cost of goods sold) and the balance sheet (as inventory). The success or failure of a firm may rest on how well the managers understand their cost functions.

Choosing a Costing Approach

Before we look at the two basic methods of product costing, the question of exactly which costs will be accumulated must be addressed. The absorption (or full) costing approach contends that all manufacturing costs, whether fixed or variable, should be attached to manufactured items, since the fixed costs are incurred for the sole purpose of producing the goods. If the goods cannot be produced without incurring a cost, that cost should become part of the cost of the goods. This approach is the standard used for financial reporting and the one we shall assume for the descriptions to follow.

A difficulty inherent in the absorption costing approach is the issue of fixed overhead costs. It is relatively simple to trace materials and labor to finished products. Variable overhead costs, too, are relatively easy to trace, since these costs vary in proportion to the level of production. Although necessary in order to keep the factory running smoothly, fixed factory overhead costs such as factory insurance bills, machine depreciation, night watchman wages and supervisor salaries cannot be so easily traced to the products. Since timely cost information is vital, management must use some rational way of assigning these overhead costs. The solution is the predetermined overhead rate.

Predetermined Overhead

In calculating a predetermined overhead rate, the first step is to decide what it is that all products have in common. This common factor becomes the basis on which the overhead is allocated. Do they all require labor? Do they all require a certain amount of time on a special machine? Does every product require a certain set-up? It is likely that the goods produced will use a proportional amount of overhead costs based on their use of this common factor.

An estimate of the total overhead costs is made and that estimate is divided by the estimate of the total units of the basis just identified to arrive at the predetermined overhead rate. For example, given an estimated $60,000 factory overhead cost and an allocation basis of 3,000 machine hours, the predetermined overhead rate would be $60,000/3,000 hours = $20 per machine hour. Thus, the amount of factory overhead to assign to any job is the overhead rate of $20 multiplied by the number of machine hours the job required for completion.

Of course, an overhead rate is only as good as the estimates that go into it. If the actual factory overhead costs are different than expected or if the allocation basis usage is not as anticipated, the amount of factory overhead applied to the products will not equal the amount of cost incurred. We will have "under-applied" or "over-applied" the overhead. While this difference or variance should be allocated between Work-In-Process, Finished Goods and Cost of Goods Sold if the amount is significant or if many items remain unsold, most firms choose to assign the variance to the Cost of Goods Sold.

An alternative strategy for attaching costs to products is called the variable (or direct) costing method. This method argues that only variable costs should be attached to manufactured goods, since only variable costs change as production changes. Since fixed overhead costs, such as machinery depreciation, insurance and supervisory salaries, can be seen as more closely related to time periods than to manufacturing levels, these costs are treated as period costs rather than as inventoriable costs.

While this method of costing products is not appropriate for financial reporting, it is quite valuable for decision-making purposes under its alias, the contribution margin. It also has the advantage of eliminating the need for a predetermined overhead rate, since the only overhead costs that will be assigned to the products are those that vary directly with production.

Methods of Product Cost Accounting

The two traditional methods of product cost accounting are job order costing and process costing. Job order costing is generally appropriate when large, unique or special-order items are produced--for instance, airplanes, grand pianos or a special order for 50 tractors. A job order system can be identified by the following characteristics:

* all costs are collected and assigned to a specific batch or job;

* costs are assigned for each completed job, rather than for set time periods;

* only one Work-in-Process inventory account is required; and

* the cost of completed goods is transferred to the Finished Goods inventory until the units are sold.

Process costing is used when identical items are mass-produced or produced in a continuous flow, such as paint, dog biscuits or nails. In manufacturing situations like these, it is generally easier to account for product costs for a given period (a week or a month) than to assign costs to a specific job or batch.

To compare this system to job order costing, note the following characteristics:

* costs are accumulated according to department or work area, with no attempt made to assign costs to a particular batch;

* costs are accumulated for a time period, rather than for completed jobs;

* several Work-in-Process accounts are used, one for each department or work area; and

* completed costs from each department become the raw materials for the subsequent department.

In the coming months, we'll explore the details of job order costing and process costing. For now, test your understanding of cost accounting basics with the following quiz! Answers will be published in the May issue.

Texarkana Tool & Die Company experienced the following overhead costs for 1992:

Indirect materials and supplies     $96,200
Repairs and maintenance             $24,900
Outside service contracts            37,300
Indirect labor                       89,100
Factory supervision                  42,900
Machinery depreciation              185,000
Factory insurance                    18,200
Property taxes                        6,500
Heat, light and power                11,700
Miscellaneous factory overhead        6,045
Total                              $517,845

All overhead costs except depreciation, property taxes and miscellaneous factory overhead are expected to increase by 10% during 1993. Depreciation should increase by 12% and a 20% increase in property taxes and miscellaneous is expected. A total of 55,600 machine hours was used as the 1992 allocation basis. This number is expected to increase by 5,850 hours in 1993.

Calculate the 1993 predetermined overhead rate. If the estimated costs actually occurred but 62,000 actual machine hours were experienced, what is the result? If a direct costing approach was being taken, which of the above costs might not be included as product costs?