Chapter 6: Fundamentals of product and service costing
Cost management system gives information about:
- Cost of goods sold by a firm
- Used processes and services
The idea behind a cost management system is that it is relevant to management decisions. This
information must be reported.
Five reasons to calculate product or service costs:
1. Decision making management (production, promotion etc.)
2. Decision making what goods to sell (if the costs of a product are too expensive than it may be
not a good option)
3. To determine the selling price
4. So that a company knows what are the costs of goods sols (COGS) (profit determination)
5. So that a company knows what are the costs of goods that are still stock of your company
(inventory valuation on your balance sheet)
Cost allocation and product costing For a retail firm the calculation costs are quite simple:
Costs paid to wholesaler + transport costs. It isn’t quite that simple for a manufacturing or a service firm that buys different resources
(materials, labor and supplies (like MOH)) and combines them into two or more finished products. Costs that are common to two or more cost object are likely to be allocated to those cost objects on
a somewhat arbitrary basis. Goal is to design the cost management system to ensure that we make
the best trade-off between the cost of bad decisions and the cost of developing information. Direct costs: like direct materials and direct labor are directly related to the production of a product.
(The materials that is needed for a product direct material) (If you are physically working on a
product direct labor).
Overhead costs are: administration, IT, facility (and more). Everything that isn’t directly related tot
the production of the product, but indirectly.
Fundamental theme underlying the design of cost systems for managerial purposes:
- Cost systems must have a decision focus System must be established so that there is important
data. Data can be established in different ways, that may not work for every user of the data.
- Different costs for different purposes and different users.
- Cost information for different managerial purposes cost-benefit test. Is improving cost
information worth the money? Basic cost flow model:
The same idea for the three kinds of inventory (ledger accounts) on the assets side of your balance sheet: inventory, work-
in-process inventories and finished goods inventories. Beginning balance + Transfer in – Transfer Out = Ending Balance
Costing with no-work-in-process inventories (just the word: ‘inventories’)
When a firm doesn’t work with WIP-inventories it is quite simple: purchased inventories (are just
automatically finished goods) transfers out when the goods are sold. Costing with work-in-process inventories:
When a firm does work with WIP-inventories it is more complex: purchased inventory becomes WIP-
inventory when someone or a machine works on it. When that is done it becomes finished goods
that can be sold. When the finished goods are sold than it transfers out. If you want to know the costs per unit, you have to divide the total allocated costs (materials, labor,
MOH allocated to all inventory ledger accounts on your balance sheet) by the equivalent units.
Equivalent units (units are sometimes called ‘gallons’ in the book) are the units of finished-goods-
inventory + WIP-inventory (if the WIP-inventory is fabricated for 50%, than half of all
- the WIP-inventory-units are equivalent to the finished- ----
Example: Equivalent units = 90.000 + (20.000*50%) = 100.000 Value of the total allocated costs are $990.000.
Total allocated costs/equivalent units =
$990.000/100.000 = $9,90 p/unit Value of ledger account finished-goods-inventory = 90.000*$9,90= 891.000
Value of ledger account work-in-process-inventory = (20.000*50%)*$9,90= $99,000
One allocation base:
It is easy to allocate direct materials and direct labor to products because it is often clear how much
materials and work hours a product needs to be made. Less clear are the overhead costs:
To allocate overhead costs to another cost pool (Basic Cost Flow Diagram) we take the direct labor
hours. Note: this is just an option, there are several bases to allocate on, but for this allocation direct
labor hours is the most logical.
The formula to allocate the overhead costs to another cost pool is: POHR= Estimated overhead costs/ estimated allocation base (Predetermined OverHead Rate)
(estimated is predetermined as well)
If the overhead rate is fixed for a year, this is good for votality, the costs will not rise or fall in certain periods due to
(un)fortunate events, such as the breakdown of machines. Example(data are given): POHR = $180.000/5.000 labor hours = $36 p/hour|
The 5.000 labor hours are the total hours of two products.
The two products are ‘C27’ and ‘C20’.
C27 has 2.000 labor hours and C20 has 3.000 labor hours (total 5.000). Now you have to allocate the POHR of $36 to that allocation base:
C27: 2.000 labor hours*$36 = $72.000
C20: 3.000 labor hours*36 = $108.000 +
This brings us back to the
total overhead costs of = $180.000