Cost Finding ( Cost Definitions, Overhead Rates, Determining the Average Unit Cost, Standard Costs, Job Order Cost Versus Process Cost Sys­tems )

Cost Finding

One of the important generally accepted accounting principles (See Accounting, financial) is that assets, including inventories, shall be reported at their cost. As the inventory items are sold, the inventory asset account is reduced by the cost of the item sold, and that cost is reported in the income statement as an expense—cost of goods sold. For a retailing or wholesaling firm, the inventory cost can generally be taken from a purchase invoice, adjusted for transpor­tation costs to the warehouse and perhaps some minor preparation costs. In other words, determining the cost of inventory items (and the subsequent cost- of-goods-sold expense) is relatively easy. But in a manufacturing concern, material is purchased and converted through the use of production labor, sup­plies, equipment, plant facilities, supervision, etc., into the finished inventory ready for sale. The cost of the finished-goods inventory cannot be determined by referring to a purchase invoice. Many other items are a part of the cost. The major task of cost finding is to take the total pool of manufacturing costs and find an average cost of each unit of product produced.

The determination of the average cost per unit is made as follows: The total costs of operating the pro­duction facility for a month or a year are determined. If a single product is produced, the total number of units produced is also counted. The average cost per unit is calculated by dividing the total cost by the total number of units. In other words,

Average cost per unit:

Cost Definitions. For a single product company the only serious problem in determining the average cost per unit is distinguishing between product costs and period costs. In the formula above, to obtain the average cost per unit, only product costs are divided by units produced. Of course, most manufacturing organizations produce more than one product, so they have other problems in cost finding. But all firms must distinguish between product costs and period costs.

Product Costs. Certain costs are physically traceable to a product and are generally agreed to be a part of the cost of the product. The major examples of these product costs are direct materials and direct labor. Direct materials are the materials incorporated into the product. They may be basic materials like steel, sand, and ore, or they may be sophisticated subassemblies such as engines and computer mod­ules. In like manner, some production labor is per­formed directly on the product (perhaps using machinery and equipment). Direct labor is also phys­ically traceable to the product since one can observe and time the work done on a particular product. Thus direct labor is that production labor which is per­formed directly on the product and which can be observed being performed on the product.

Supplies, electricity, heating of the plant, and property taxes and insurance on the plant and equip­ment are examples of the production costs and are included as part of the average cost of a product. Any cost incurred solely because the firm is in manufac­turing is a product cost.

Period Costs. Costs which are not product costs are period costs. Period costs are not included in the average cost of the product produced; rather, they are considered an expense in the income statement of the period. Generally speaking, period costs include the selling expenses and general administrative expenses. A wholesaler or retailer incurs selling expenses and general administrative expenses. Of course, the nature and amount of selling and general administrative expenses depend on the nature of the company, its products, and how they are sold. But these types of costs are incurred by all businesses; therefore it cannot be argued that these costs are incurred solely as a result of being in manufacturing.

Overhead Costs. One further definition is needed before the ideas of product and period costs can be summarized. Overhead costs are all product costs other than direct materials and direct labor. Notice that a rather special definition is applied. In general conversation, general administration such as sales management, credit management, customer billing, and similar items might be considered over­head. Not so in this definition. All these items are examples of period costs. They are not product costs and therefore are not overhead. Any organization— retail, wholesale, or manufacturing—would have them.

Schematically, the distinctions and definitions just discussed can be illustrated as shown in Fig. A- 1. The significance of the distinctions is that period costs are accounted for as income statement expense items for all retailers, wholesalers, and manufactur­ers. Product costs would not exist in a retailing or wholesaling organization. For the manufacturer, they are added together and divided by the number of iunits produced during the period to determine the

 

FIG. A-1 Relationships of various cost definitions.

average cost per unit of manufactured product. This average cost per unit is first accounted for as an addi­tion to the inventory asset account. When the prod­uct is sold, the inventory (asset) is reduced and the expense (cost of goods sold) is increased.

Overhead Rates In the single product firm, the process of cost filing—determining the average cost per unit—coasts of the following three steps:

1. Determine which of the costs incurred by the firm during a year are product costs.
2. Determine the number of units of product pro­duced during the year.
3. Divide the total product costs for the year by the number of units produced.

But what if the company produces several prod­ucts in a single plant? A new problem exists. The same three-step process cannot be followed because it does not make sense to add units of different prod­ucts as if they were the same. For example, a com­pany produces color and black-and-white television sets in the same factory. Further, there are several models of each type of television. If product costs were totaled and divided by the total number of tele­vision sets produced, all units would be found to have the same cost, a conclusion which is obviously erroneous. Each type and model uses some different parts, requires different direct labor time to produce, and makes use of some different facilities.

Direct Measurement. How does cost accounting find a more reasonable answer? Since the direct material is physically incorporated into the product, it is possible to ask production workers to record the amount of material used in producing each model and type of set. Also, the direct labor workers can be asked to record on their time cards the amount of time spent producing each model and type of set. If questions arise about the accuracy of either direct material or direct labor cost, it is possible to send someone into the factory to observe the production process and to record the material and direct labor going into each model and type of set. The resulting figures should agree with records kept by the produc­tion workers, since direct materials are physically incorporated into the set and the direct labor is per­formed on a particular set. Although it requires some careful record keeping, this is the easy part of the accounting process.

Overhead Measurement. The accounting for the overhead, however, presents three different problems for consideration.

1. Most of the overhead costs will be incurred for the benefit of several or all the products rather than for a single product. There is no physical link to the product as there is in the case of direct materials and direct labor. It is plain that if the product is to be produced, the plant must be heated during the cold months of the year. The heating of the factory is a product cost and must be included in the average cost of the products produced. But the heat cost benefits not a partic­ular set but all sets produced. There is no way of tracing the amount of heat going into each set as can be done with direct labor.
2. Many costs are cyclical. For example, the heating cost is seasonal. It will be incurred in cold months and not in warm months. But should physically identical sets which were produced in the month of January be said to cost more than the same set produced in June? The accounting answer is no. If the sets were produced in the same facilities, by the same methods, and with the same general level of production efficiency, accountants argue that the sets should have the same average cost. So the heat costs should be averaged over all sets produced during the year.
3. Much production is cyclical. This is similar to the seasonality problem but relates to the fact that the number of units produced varies from month to month because of seasonal sales pat­terns. This presents no serious problems with direct materials and direct labor because these are usually variable costs, and the cost per unit is constant at any volume in the relevant range. Many overhead costs are fixed, however. What happens if the fixed total monthly costs are divided by varying monthly production totals? The average cost per unit varies from month to month for physically identical products. This is illustrated below.

	June	September
Monthly total fixed costs Monthly total production of sets Average fixed cost per unit	$35,000 10,000 sets $3.50	$35,000 14,000 sets $2.50

Again accountants argue that these cost variations should be averaged out in cost finding.

Overhead Rates. All three problems are solved by use of predetermined overhead rates which aver­age the fixed costs and serve as a basis for dividing common costs among different products. (These rates are also called burden rates.) A predetermined overhead rate is calculated and used as follows:

1. A decision is made to allocate the overhead in proportion to some base, often direct labor hours, direct labor cost, or machine hours. This deci­sion solves the common cost problem.
2. The total expected production volume for the next year is estimated. The volume is converted to units of the base selected in step 1.
3. The total overhead cost to be incurred for the next year is estimated.
4. The predetermined overhead rate is determined by dividing the total estimated overhead cost for next year by the total estimated production vol­ume, estimated in step 2. The annual estimates used in this step solve the seasonality problems mentioned earlier.
5. Overhead cost is applied (or allocated) to each product by multiplying the predetermined over­head rate by the amount of base (direct labor hours, etc.) contained in the product.

Here is an example of the process. Vinz Corpora­tion produces three products. The expected material and labor content of each product is given below.

	Product R	Product C	Product D
Materials Direct labor @ $6 per hour	$11 $ 3 (1/2 hour)	$8 $4 (2/3 hour)	$17 $ 6 (1 hour)

For next year, Vinz estimates sales of R will be 18,000 units, C will be 15,000 units, and D will be 6000 units. It is further estimated that the fixed over­head costs will total $50,000 for the year. Variable overhead is estimated to be $5 per direct labor.

How is the predetermined overhead rate found? Management examines the nature of the overhead items and discovers that the largest part of the over­head consists of supervision, fringe benefits, and other personnel-related costs. Further, the account­ing system is already recording and totaling direct labor hours incurred. Thus management decides to base the predetermined overhead rate on direct labor hours. Had the production process been more auto­mated and the overhead costs primarily machine- related costs such as property taxes, insurance, main­tenance, and depreciation, management might have decided to base the overhead rate on machine hours. If there had been heavy components of both person­nel-related costs and machine-related costs, manage­ment might have considered using two predeter­mined rates, one based on direct labor hours and the other based on machine hours. Most often a single rate is used.

The total production volume had already been estimated in units. All that was needed was to con­vert the volume estimate to direct labor hours, the base of the predetermined overhead rate. It was done as follows:

Product R Product C Product D	18,000 units @ 1/2 hour per unit 15,000 units @ 2/3 hour per unit 6,000 units @ 1 hour per unit	9,000 Hours 10,000 6,000
Total estimated volume for next year		25,000 hours

Next the total overhead cost for next year was esti­mated as follows:

Fixed overhead Total estimated overhead for next year The predetermined overhead rate is then:    Total estimated overhead for next year       Total estimated volme for next year	$ 50,000 $175,000 $ 175,000      25,000
	= $7 per direct labor hour

Determining the Average Unit Cost. The Vinz Corporation example is used to complete the illustra­tion of how the average cost per unit is calculated. During the first month of the new year, the company produced 1200 units of R, 1000 units of C, and 500 units of D. The direct materials used for each product were determined by totaling the requisitions from the materials storeroom. The direct labor cost incurred on each product was identified on time tick­ets prepared by the direct labor workers.

	Product R	Product C	Product D
Direct materials used Direct labor cost incurred	$13,464 $ 3,852 (647 hours)	$7,840 $4,200 (706 hours)	$9,010 $3,013 (506 hours)

(The reader who recalls the expected direct labor content given earlier in the entry may note that Vinz Corporation used more hours than should have been used for the number of units of products R, C, and D produced. Furtlher, the average cost per direct labor hour was slightlly below the expected rate. In a stan­dard cost systerm—to be discussed later—these facts would give rise no an unfavorable direct labor price variance.)

The average direct labor cost and direct materials cost per unit are determined by dividing the total cost for each product by th»e number of units produced in the period. The overhesad cost per unit is determined by calculating the ov-rerhead cost applied to each product during the ffiirst month and then dividing it by the number of units produced. The overhead cost applied is the predetermined overhead rate of $7 per direct labor hour times the number of direct labor hours spent on each product during the month.

Product R $7 per hour X 647 hours = $4529 Product C$7 per hour X 706 hours = $4942 Product D $7 per hour X 506 hours = $3542

The average cost per unit of product R is:

Direct materials $13,464/1200 units Direct labor $3852/1200 units Overhead $4529/1200 units	= $11.22 per unit = $  3.21 per unit = $  3.77 per unit
Average cost	= $18.20 per unit

In like manner, the average cost of the other two products produced in the first month is reckoned:

	Product C	Product D
Direct materials Direct labor Overhead	$ 7.84 $4.20 $4.94	$18.02 $ 6.03 $ 7.08
Average cost	$16.98 per unit	$31.13 per unit

Standard Costs. Standard costs are estimates of what the material, direct labor, and overhead cost per unit should be. They are often determined by adjust­ing past cost levels, as shown in the accounting rec­ords, for any inefficiencies discovered in discussions with production workers and production supervisors. Industrial engineering estimates, though expensive, are also helpful. Sometimes engineering estimates can be obtained as a by-product of designing or rede­signing the product or designing the production process.

In the initial Vinz Corporation example, the expected material and labor content of the products was given. They were not labeled as standard costs, although in fact they were. A standard overhead cost per unit was not given, but it is usually included in the standard cost for completeness. The standard overhead cost per unit is determined by applying the predetermined overhead rate to the standard direct labor content in hours. Vinz' predetermined over­head rate is $7 per direct labor hour. The standard direct labor hour content of product R is 14 hour. Thus the standard overhead cost per unit of product R is $3.50 (^1/2 hour X $7 per hour). In like manner, the standard overhead cost per unit of product C is $4.67; of product D, $7.

Advantages. The system for determining aver­age cost, discussed prior to this section, could be referred to as an actual cost or historical cost system. The primary advantage of a standard cost system over an actual cost system is that the standard cost system with up-to-date standards produces variances which signal possible cost control opportunities. Of course if the standards do not reflect attainable perfor­mance, the variances become mixed in meaning and difficult to interpret.

Another important advantage of the standard cost system is that it simplifies certain bookkeeping prob­lems by recording all inventories at their standard cost rather than their actual cost. Actual costs will fluctuate from month to month because of variations in production efficiency. Because units are entering inventory at differing costs per unit, one must follow an inventory method such as first-in first-out (FIFO) average, last-in first-out (LIFO) average, or some other method. In a standard cost system, the ending inventories are determined by multiplying the num­ber of units on hand by the standard cost per unit. The cost-of-goods-sold expense is determined by multiplying the number of units sold by the standard cost per unit.

These advantages of standard costs must be weighed against the cost of establishing the stan­dards and updating them when significant changes in production methods or prices occur.

Job Order Cost Versus Process Cost Sys­tems. The discussions thus far have implicitly assumed that cost finding (either actual or standard costing) follows the process costing system. It has been assumed that the average cost per unit is deter­mined by taking the product costs for a period of time and dividing them by the number of units produced during that period of time. While no great attention has been given to the appropriate period of time, most of the disc ission has implied that the appropri­ate period of time for determining direct material and direct labor costs is a month. For overhead, the appropriate period of time has been implied to be a year (through the predetermined overhead rate). But the time period selected is arbitrary. A month was used in the discussion because it corresponds to the reporting cycle of many manufacturers. But occasion­ally a time period of a day, a week, a quarter, or a year is used for direct materials and direct labor. In a sit­uation in which a certain product is produced in a more or less continuous process, such as a produc­tion line, continuous molding, or mixing, there is no natural dividing line, and a process cost system is applied.

In other production situations, products are pro­duced in batches or jobs. A machine shop is a good example where an order may come in for 100 units of a certain machined piece. The production of the order or batch is scheduled, and the units are pro­duced. The batches provide a natural basis for deter­mining the average material and direct labor cost per unit. Materials requisitions show the quantity of direct material requisitioned for the batch of produc­tion. Time cards show the amount of direct labor spent on the batch. When the batch is completed, it is easy to count the number of good pieces which result (which might be slightly different from the 100 ordered, depending on spoilage). Then the aver­age direct material cost is determined in the usual manner:

Average direct material cost per unit:

 

 The same approach can be followed for direct labor cost. The overhead cost is applied to the batch by using the predetermined overhead rate, and the aver­age overhead cost per unit is then also determined by dividing the total overhead cost applied to this batch by the number of good units in the batch.

Differences. In a job order cost system, the aver­age cost per unit is determined by taking the total product costs incurred in producing the batch or job and dividing them by the total number of good units in the batch or job. In a process cost system, the aver­age cost per unit is determined by dividing the total product cost incurred for a period of time by the num­ber of good units produced during that period of time. In other words, the differences between the systems are not very profound. If the product is produced in batches or jobs, then the batch or job is a convenient basis for calculating the average cost per unit. In a more or less continuous process, time is the most convenient basis for calculating the average cost per unit. Both job order and process costing can be done on an actual cost basis or a standard cost basis. Most complex manufacturing companies use both job order and process costing in different departments of the company, depending on the production process in that department.