Ben & Jerry's Homemade, Inc., based in Waterbury, Vermont, started its first ice cream shop in a former gas station in 1978.
Making ice cream is a process—a movement of product from a mixing department to a prepping department to a pint department. The mixing department is where the ice cream is created. In the prep area, the production process adds extras such as cherries and dark chocolate to make plain ice cream into “Cherry Garcia,” Ben & Jerry's most popular flavor, or fudge-covered waffle cone pieces and a swirl of caramel for “Stephen Colbert's Americone Dream.” The pint department is where the ice cream is actually put into containers. As the product is processed from one department to the next, the appropriate materials, labor, and overhead are added to determine its cost.
“The incoming ingredients from the shipping and receiving departments are stored in certain locations, either in a freezer or dry warehouse,” says Beecher Eurich, staff accountant. “As ingredients get added, so do the costs associated with them.” How much ice cream is produced? Running plants around the clock, the company produces 18 million gallons a year.
With the company's process cost system, Eurich can tell you how much a certain batch of ice cream costs to make—its materials, labor, and overhead in each of the production departments. She generates reports for the production department heads but makes sure not to overdo it. “You can get bogged down in numbers,” says Eurich. “If you're generating a report that no one can use, then that's a waste of time.”
It's more likely, though, that Ben & Jerry's production people want to know how efficient they are. Why? Many own stock in the company.
Preview of Chapter 21
The cost accounting system used by companies such as Ben & Jerry's is process cost accounting. In contrast to job order cost accounting, which focuses on the individual job, process cost accounting focuses on the processes involved in mass-producing products that are identical or very similar in nature. The primary objective of this chapter is to explain and illustrate process costing.
The content and organization of this chapter are as follows.
Companies use process cost systems to apply costs to similar products that are mass-produced in a continuous fashion. Ben & Jerry's uses a process cost system. Production of the ice cream, once it begins, continues until the ice cream emerges, and the processing is the same for the entire run—with precisely the same amount of materials, labor, and overhead. Each finished pint of ice cream is indistinguishable from another.
A company such as USX uses process costing in the manufacturing of steel. Kellogg and General Mills use process costing for cereal production; ExxonMobil uses process costing for its oil refining. Sherwin Williams uses process costing for its paint products. At a bottling company like Coca-Cola, the manufacturing process begins with the blending of ingredients. Next, automated machinery moves the bottles into position and fills them. The production process then caps, packages, and forwards the bottles to the finished goods warehouse. Illustration 21-1 shows this process.
For Coca-Cola, as well as the other companies just mentioned, once production begins, it continues until the finished product emerges, and each unit of finished product is like every other unit.
In comparison, a job order cost system assigns costs to a specific job. Examples are the construction of a customized home, the making of a motion picture, or the manufacturing of a specialized machine. Illustration 21-2 provides examples of companies that primarily use either a process cost system or a job order cost system.
Frequently, when we think of service companies, we think of specific, nonroutine tasks, such as rebuilding an automobile engine, performing consulting services on a business acquisition, or working on a major lawsuit. However, many service companies specialize in performing repetitive, routine aspects of a particular business. For example, auto-care vendors such as Jiffy Lube focus on the routine aspects of car care. H&R Block focuses on the routine aspects of basic tax practice, and many large law firms focus on routine legal services, such as uncomplicated divorces. Service companies that perform specific, nonroutine services will probably benefit from using a job order cost system. Those that perform routine, repetitive services will probably be better off with a process cost system.
In a job order cost system, companies assign costs to each job. In a process cost system, companies track costs through a series of connected manufacturing processes or departments, rather than by individual jobs. Thus, companies use process cost systems when they produce a large volume of uniform or relatively homogeneous products. Illustration 21-3 shows the basic flow of costs in these two systems, and the following analysis highlights the basic similarities and differences between these two systems.
Explain the similarities and differences between job order cost and process cost systems.
Job order cost and process cost systems are similar in three ways:
1. The manufacturing cost elements. Both costing systems track three manufacturing cost elements—direct materials, direct labor, and manufacturing overhead.
2. The accumulation of the costs of materials, labor, and overhead. Both costing systems debit raw materials to Raw Materials Inventory, factory labor to Factory Labor, and manufacturing overhead costs to Manufacturing Overhead.
3. The flow of costs. As noted above, both systems accumulate all manufacturing costs by debits to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead. Both systems then assign these costs to the same accounts—Work in Process, Finished Goods Inventory, and Cost of Goods Sold. The methods of assigning costs, however, differ significantly. These differences are explained and illustrated later in the chapter.
The differences between a job order cost and a process cost system are as follows.
1. The number of work in process accounts used. A job order cost system uses only one work in process account. A process cost system uses multiple work in process accounts.
2. Documents used to track costs. A job order cost system charges costs to individual jobs and summarizes them in a job cost sheet. A process cost system summarizes costs in a production cost report for each department.
3. The point at which costs are totaled. A job order cost system totals costs when the job is completed. A process cost system totals costs at the end of a period of time.
4. Unit cost computations. In a job order cost system, the unit cost is the total cost per job divided by the units produced. In a process cost system, the unit cost is total manufacturing costs for the period divided by the equivalent units produced during the period.
Illustration 21-4 summarizes the major differences between a job order cost and a process cost system.
DO IT!
Compare Job Order and Process Cost Systems
Indicate whether each of the following statements is true or false.
1. A law firm is likely to use process costing for major lawsuits.
2. A manufacturer of paintballs is likely to use process costing.
3. Both job order and process costing determine product costs at the end of a period of time, rather than when a product is completed.
4. Process costing does not keep track of manufacturing overhead.
Action Plan
Use job order costing in situations where unit costs are high, unit volume is low, and products are unique.
Use process costing when there is a large volume of relatively homogeneous products.
Solution
1. False. 2. True. 3. False. 4. False.
Related exercise material: E21-1 and DO IT! 21-1.
Illustration 21-5 shows the flow of costs in the process cost system for Tyler Company. Tyler Company manufactures roller blade and skateboard wheels that it sells to manufacturers and retail outlets. Manufacturing consists of two processes: machining and assembly. The Machining Department shapes, hones, and drills the raw materials. The Assembly Department assembles and packages the parts.
As the flow of costs indicates, the company can add materials, labor, and manufacturing overhead in both the Machining and Assembly departments. When it finishes its work, the Machining Department transfers the partially completed units to the Assembly Department. The Assembly Department finishes the goods and then transfers them to the finished goods inventory. Upon sale, Tyler removes the goods from the finished goods inventory. Within each department, a similar set of activities is performed on each unit processed.
As indicated, the accumulation of the costs of materials, labor, and manufacturing overhead is the same in a process cost system as in a job order cost system. That is, both systems follow these procedures:
However, the assignment of the three manufacturing cost elements to Work in Process in a process cost system is different from a job order cost system. Here we'll look at how companies assign these manufacturing cost elements in a process cost system.
Make the journal entries to assign manufacturing costs in a process cost system.
All raw materials issued for production are a materials cost to the producing department. A process cost system may use materials requisition slips, but it generally requires fewer requisitions than in a job order cost system, because the materials are used for processes rather than for specific jobs and therefore typically are for larger quantities.
At the beginning of the first process, a company usually adds most of the materials needed for production. However, other materials may be added at various points. For example, in the manufacture of Hershey candy bars, the chocolate and other ingredients are added at the beginning of the first process, and the wrappers and cartons are added at the end of the packaging process. Tyler Company adds materials at the beginning of each process. Tyler makes the following entry to record the materials used.
Ice cream maker Ben & Jerry's adds materials in three departments: milk and flavoring in the mixing department, extras such as cherries and dark chocolate in the prepping department, and cardboard containers in the pinting (packaging) department.
In a process cost system, as in a job order cost system, companies may use time tickets to determine the cost of labor assignable to production departments. Since they assign labor costs to a process rather than a job, they can obtain, from the payroll register or departmental payroll summaries, the labor cost chargeable to a process.
Labor costs for the Machining and Assembly Departments will include the wages of employees who shape, hone, drill, and assemble the materials. The entry to assign these costs for Tyler Company is:
The objective in assigning overhead in a process cost system is to allocate the overhead costs to the production departments on an objective and equitable basis. That basis is the activity that “drives” or causes the costs. A primary driver of overhead costs in continuous manufacturing operations is machine time used, not direct labor. Thus, companies widely use machine hours in allocating manufacturing overhead costs using predetermined overhead rates. Tyler's entry to allocate overhead to the two processes is:
At the end of the month, Tyler needs an entry to record the cost of the goods transferred out of the Machining Department. In this case, the transfer is to the Assembly Department, and Tyler makes the following entry.
When the Assembly Department completes the units, it transfers them to the finished goods warehouse. The entry for this transfer is as follows.
When Tyler sells the finished goods, it records the cost of goods sold as follows.
DO IT!
Manufacturing Costs in Process Costing
Ruth Company manufactures ZEBO through two processes: blending and bottling. In June, raw materials used were Blending $18,000 and Bottling $4,000. Factory labor costs were Blending $12,000 and Bottling $5,000. Manufacturing overhead costs were Blending $6,000 and Bottling $2,500. The company transfers units completed at a cost of $19,000 in the Blending Department to the Bottling Department. The Bottling Department transfers units completed at a cost of $11,000 to Finished Goods. Journalize the assignment of these costs to the two processes and the transfer of units as appropriate.
Action Plan
In process cost accounting, keep separate work in process accounts for each process.
When the costs are assigned to production, debit the separate work in process accounts.
Transfer cost of completed units to the next process or to Finished Goods.
Solution
Related exercise material: BE21-1, BE21-2, BE21-3, E21-2, E21-4, and DO IT! 21-2.
Suppose you have a work-study job in the office of your college's president, and she asks you to compute the cost of instruction per full-time equivalent student at your college. The college's vice president for finance provides the following information.
Part-time students take 60% of the classes of a full-time student during the year. To compute the number of full-time equivalent students per year, you would make the following computation.
The cost of instruction per full-time equivalent student is therefore the total cost of instruction ($9,000,000) divided by the number of full-time equivalent students (1,500), which is $6,000 ($9,000,000 ÷ 1,500).
A process cost system uses the same idea, called equivalent units of production. Equivalent units of production measure the work done during the period, expressed in fully completed units. Companies use this measure to determine the cost per unit of completed product.
The formula to compute equivalent units of production is as follows.
To better understand this concept of equivalent units, consider the following two separate examples.
Example 1. In a specific period, the entire output of Sullivan Company's Blending Department consists of ending work in process of 4,000 units which are 60% complete as to materials, labor, and overhead. The equivalent units of production for the Blending Department are therefore 2,400 units (4,000 × 60%).
Example 2. The output of Kori Company's Packaging Department during the period consists of 10,000 units completed and transferred out, and 5,000 units in ending work in process which are 70% completed. The equivalent units of production are therefore 13,500 [10,000 + (5,000 × 70%)].
This method of computing equivalent units is referred to as the weighted-average method. It considers the degree of completion (weighting) of the units completed and transferred out and the ending work in process.
Kellogg Company has produced Eggo® Waffles since 1970. Three departments produce these waffles: Mixing, Baking, and Freezing/Packaging. The Mixing Department combines dry ingredients, including flour, salt, and baking powder, with liquid ingredients, including eggs and vegetable oil, to make waffle batter. Illustration 21-9 provides information related to the Mixing Department at the end of June.
Illustration 21-9 indicates that the beginning work in process is 100% complete as to materials cost and 70% complete as to conversion costs. Conversion costs are the sum of labor costs and overhead costs. In other words, Kellogg adds both the dry and liquid ingredients (materials) at the beginning of the waffle-making process, and the conversion costs (labor and overhead) related to the mixing of these ingredients are incurred uniformly and are 70% complete. The ending work in process is 100% complete as to materials cost and 60% complete as to conversion costs.
We then use the Mixing Department information to determine equivalent units. In computing equivalent units, the beginning work in process is not part of the equivalent-units-of-production formula. The units transferred out to the Baking Department are fully complete as to both materials and conversion costs. The ending work in process is fully complete as to materials, but only 60% complete as to conversion costs. We therefore need to make two equivalent unit computations: one for materials, and the other for conversion costs. Illustration 21-10 shows these computations.
Ethics Note
An unethical manager might use incorrect completion percentages when determining equivalent units. This results in either raising or lowering costs. Since completion percentages are somewhat subjective, this form of income manipulation can be difficult to detect.
We can refine the earlier formula used to compute equivalent units of production (Illustration 21-8, page 990). Illustration 21-11 (page 992) shows the computations for materials and for conversion costs.
PEOPLE, PLANET, AND PROFIT INSIGHT
Haven't I Seen That Before?
For a variety of reasons, many companies, including Caterpillar, General Electric, and Eastman Kodak, are making a big push to remanufacture goods that have been thrown away. Items getting a second chance include cell phones, computers, home appliances, car parts, vacuum cleaners, and medical equipment. Businesses have figured out that profit margins on remanufactured goods are significantly higher than on new goods. As commodity prices such as copper and steel increase, reusing parts makes more sense. Also, as more local governments initiate laws requiring that electronics and appliances be recycled rather than thrown away, the cost of remanufacturing declines because the gathering of used goods becomes far more efficient. Besides benefitting the manufacturer, remanufacturing provides goods at a much lower price to consumers, reduces waste going to landfills, saves energy, reuses scarce resources, and reduces emissions. For example, it was estimated that a remanufactured car starter results in about 50% less carbon dioxide emissions than making a new one.
Source: James R. Hagerty and Paul Glader, “From Trash Heap to Store Shelf,” Wall Street Journal Online (January 24, 2011).
In what ways might the relative composition (materials, labor, and overhead) of a remanufactured product's cost differ from that of a newly made product? (See page 1028.)
DO IT!
Equivalent Units
The fabricating department has the following production and cost data for the current month.
Materials are entered at the beginning of the process. The ending work in process units are 30% complete as to conversion costs. Compute the equivalent units of production for (a) materials and (b) conversion costs.
Action Plan
To measure the work done during the period, expressed in fully completed units, compute equivalent units of production.
Use the appropriate formula: Units completed and transferred out + Equivalent units of ending work in process = Equivalent units of production.
Solution
(a) Since materials are entered at the beginning of the process, the equivalent units of ending work in process are 10,000. Thus, 15,000 units + 10,000 units = 25,000 equivalent units of production for materials.
(b) Since ending work in process is only 30% complete as to conversion costs, the equivalent units of ending work in process are 3,000 (30% × 10,000 units). Thus, 15,000 units + 3,000 units = 18,000 equivalent units of production for conversion costs.
Related exercise material: BE21-4, BE21-9, E21-5, E21-6, E21-8, E21-9, E21-10, E21-11, E21-13, E21-14, E21-15, and DO IT! 21-3.
As mentioned earlier, companies prepare a production cost report for each department. A production cost report is the key document that management uses to understand the activities in a department; it shows the production quantity and cost data related to that department. For example, in producing Eggo® Waffles, Kellogg Company uses three production cost reports: Mixing, Baking, and Freezing/Packaging. Illustration 21-12 shows the flow of costs to make an Eggo® Waffle and the related production cost reports for each department.
In order to complete a production cost report, the company must perform four steps, which, as a whole, make up the process cost system.
1. Compute the physical unit flow.
2. Compute the equivalent units of production.
3. Compute unit production costs.
4. Prepare a cost reconciliation schedule.
Illustration 21-13 shows assumed data for the Mixing Department at Kellogg Company for the month of June. We will use this information to complete a production cost report for the Mixing Department.
Physical units are the actual units to be accounted for during a period, irrespective of any work performed. To keep track of these units, add the units started (or transferred) into production during the period to the units in process at the beginning of the period. This amount is referred to as the total units to be accounted for.
The total units then are accounted for by the output of the period. The output consists of units transferred out during the period and any units in process at the end of the period. This amount is referred to as the total units accounted for. Illustration 21-14 shows the flow of physical units for Kellogg's Mixing Department for the month of June.
The records indicate that the Mixing Department must account for 900,000 units. Of this sum, 700,000 units were transferred to the Baking Department and 200,000 units were still in process.
Once the physical flow of the units is established, Kellogg must measure the Mixing Department's productivity in terms of equivalent units of production. The Mixing Department adds materials at the beginning of the process, and it incurs conversion costs uniformly during the process. Thus, we need two computations of equivalent units: one for materials and one for conversion costs. The equivalent unit computation is as follows.
Helpful Hint Materials are not always added at the beginning of the process. For example, materials are sometimes added uniformly during the process.
Helpful Hint Remember that we ignore the beginning work in process in this computation.
Armed with the knowledge of the equivalent units of production, we can now compute the unit production costs. Unit production costs are costs expressed in terms of equivalent units of production. When equivalent units of production are different for materials and conversion costs, we compute three unit costs: (1) materials, (2) conversion, and (3) total manufacturing.
The computation of total materials cost related to Eggo® Waffles is as follows.
The computation of unit materials cost is as follows.
Illustration 21-18 shows the computation of total conversion costs.
The computation of unit conversion cost is as follows.
Total manufacturing cost per unit is therefore computed as shown in Illustration 21-20.
We are now ready to determine the cost of goods transferred out of the Mixing Department to the Baking Department and the costs in ending work in process. Kellogg charged total costs of $655,000 to the Mixing Department in June, calculated as shown in Illustration 21-21 (page 996).
The company then prepares a cost reconciliation schedule to assign these costs to (a) units transferred out to the Baking Department and (b) ending work in process.
Kellogg uses the total manufacturing cost per unit, $0.75, in costing the units completed and transferred to the Baking Department. In contrast, the unit cost of materials and the unit cost of conversion are needed in costing units in process. The cost reconciliation schedule shows that the total costs accounted for (Illustration 21-22) equal the total costs to be accounted for (Illustration 21-21).
At this point, Kellogg is ready to prepare the production cost report for the Mixing Department. As indicated earlier, this report is an internal document for management that shows production quantity and cost data for a production department.
There are four steps in preparing a production cost report:
1. Compute the physical unit flow.
2. Compute the equivalent units of production.
3. Compute unit production costs.
4. Prepare a cost reconciliation schedule.
Illustration 21-23 shows the production cost report for the Mixing Department. The report identifies the four steps.
Production cost reports provide a basis for evaluating the productivity of a department. In addition, managers can use the cost data to assess whether unit costs and total costs are reasonable. By comparing the quantity and cost data with predetermined goals, top management can also judge whether current performance is meeting planned objectives.
DO IT!
Cost Reconciliation Schedule
In March, Rodayo Manufacturing had the following unit production costs: materials $6 and conversion costs $9. On March 1, it had zero work in process. During March, Rodayo transferred out 12,000 units. As of March 31, 800 units that were 25% complete as to conversion costs and 100% complete as to materials were in ending work in process. Assign the costs to the units transferred out and in process.
Assign the total manufacturing cost of $15 per unit to the 12,000 units transferred out.
Assign the materials cost and conversion costs based on equivalent units of production to units in ending work in process.
Solution
Related exercise material: BE21-5, BE21-6, BE21-7, BE21-8, E21-5, E21-6, E21-7, E21-8, E21-9, E21-10, E21-11, E21-12, E21-13, E21-14, E21-15, and DO IT! 21-4.
Companies often use a combination of a process cost and a job order cost system. Called operations costing, this hybrid system is similar to process costing in its assumption that standardized methods are used to manufacture the product. At the same time, the product may have some customized, individual features that require the use of a job order cost system.
Consider, for example, the automobile manufacturer Ford Motor Company. Each vehicle at a given plant goes through the same assembly line, but Ford uses different materials (such as seat coverings, paint, and tinted glass) for different vehicles. Similarly, Kellogg's Pop-Tarts® toaster pastries go through numerous standardized processes—mixing, filling, baking, frosting, and packaging. The pastry dough, though, comes in different flavors—plain, chocolate, and graham—and fillings include Smucker's® real fruit, chocolate fudge, vanilla creme, brown sugar cinnamon, and s'mores.
A cost-benefit trade-off occurs as a company decides which costing system to use. A job order cost system, for example, provides detailed information related to the cost of the product. Because each job has its own distinguishing characteristics, the system can provide an accurate cost per job. This information is useful in controlling costs and pricing products. However, the cost of implementing a job order cost system is often expensive because of the accounting costs involved.
On the other hand, for a company like Intel, which makes computer chips, is there a benefit in knowing whether the cost of the one-hundredth chip produced is different from the one-thousandth chip produced? Probably not. An average cost of the product will suffice for control and pricing purposes.
In summary, when deciding to use one of these systems, or a combination system, a company must weigh the costs of implementing the system against the benefits from the additional information provided.
As indicated in Chapter 19, two contemporary developments in managerial accounting are just-in-time processing and activity-based costing. We explain these innovations in the following sections.
Traditionally, continuous process manufacturing has been based on a just-in-case philosophy. Companies hold inventories of raw materials just in case some items are of poor quality or a key supplier is shut down by a strike. They manufacture and store subassembly parts just in case these parts are needed later in the manufacturing process. Companies complete and store finished goods just in case they receive unexpected and rush customer orders. This philosophy often results in a “push approach.” Raw materials and subassembly parts are pushed through each process. Traditional processing often results in the buildup of extensive manufacturing inventories.
Primarily in response to foreign competition, many U.S. firms have switched to just-in-time (JIT) processing. JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed. JIT first hit the United States in the early 1980s when automobile companies adopted it to compete with foreign automakers. Many companies, including Dell, Caterpillar, and Harley-Davidson now successfully use JIT. Under JIT processing, companies receive raw materials just in time for use in production, they complete subassembly parts just in time for use in finished goods, and they complete finished goods just in time to be sold. Illustration 21-24 shows the sequence of activities in just-in-time processing.
A primary objective of JIT is to eliminate all manufacturing inventories. Inventories have an adverse effect on net income because they tie up funds and storage space that could be put to more productive uses. JIT strives to eliminate inventories by using a “pull approach” in manufacturing. This approach begins with the customer placing an order with the company, which starts the process of pulling the product through the manufacturing process. A computer at the final workstation sends a signal to the preceding workstation. This signal indicates the exact materials (parts and subassemblies) needed to complete the production of a specified product for a specified time period, such as an eight-hour shift. The next preceding process, in turn, sends its signal to other processes back up the line. The goal is a smooth continuous flow in the manufacturing process and no buildup of inventories at any point.
There are three important elements in JIT processing:
1. Dependable suppliers. Suppliers must be willing to deliver on short notice exact quantities of raw materials according to precise quality specifications (even including multiple deliveries within the same day). Suppliers must also be willing to deliver the raw materials at specified work stations rather than at a central receiving department. This type of purchasing requires constant and direct communication. Such communication is facilitated by an online computer linkage between the company and its suppliers.
2. A multiskilled workforce. Under JIT, machines are often strategically grouped around work cells or workstations. Much of the work is automated. As a result, one worker may operate and maintain several different types of machines.
3. A total quality control system. The company must establish total quality control throughout the manufacturing operations. Total quality control means no defects. Since the pull approach signals only required quantities, any defects at any workstation will shut down operations at subsequent workstations. Total quality control requires continuous monitoring by both employees and supervisors at each workstation.
The major benefits of implementing JIT processing are:
1. Significant reduction or elimination of manufacturing inventories.
2. Enhanced product quality.
3. Reduction or elimination of rework costs and inventory storage costs.
4. Production cost savings from the improved flow of goods through the processes.
The effects in many cases have been dramatic. For example, after using JIT for two years, a major division of Hewlett-Packard found that work in process inventories (in dollars) were down 82%, scrap/rework costs were down 30%, space utilization improved by 40%, and labor efficiency improved 50%. As indicated, JIT not only reduces inventory but also enables a manufacturer to produce a better product faster and with less waste.
One of the major accounting benefits of JIT is the elimination of separate raw materials and work in process inventory accounts. These accounts are replaced by one account, Raw and In-Process Inventory. All materials and conversion costs are charged to this account. The reduction (or elimination) of in-process inventories results in a simpler computation of equivalent units of production.
Activity-based costing (ABC) focuses on the activities performed in producing a product. An ABC system is similar to conventional costing systems in accounting for direct materials and direct labor, but it differs in regard to manufacturing overhead.
A conventional cost system uses a single unit-level basis to allocate overhead costs to products. The basis may be direct labor or machine hours used to manufacture the product. The assumption in this approach is that as volume of units produced increases, so does the cost of overhead. However, in recent years the amount of direct labor used in many industries has greatly decreased, and total overhead costs resulting from depreciation on expensive equipment and machinery, utilities, repairs, and maintenance have significantly increased.
In ABC costing, the cost of a product is equal to the sum of the costs of all activities performed to manufacture it. ABC recognizes that to have accurate and meaningful cost data, more than one basis of allocating activity costs to products is needed.
In selecting the allocation basis, ABC seeks to identify the cost drivers that measure the activities performed on the product. A cost driver may be any factor or activity that has a direct cause–effect relationship with the resources consumed. Examples of activities and possible cost drivers are as follows.
Two important assumptions must be met in order to obtain accurate product costs under ABC:
1. All overhead costs related to the activity must be driven by the cost driver used to assign costs to products.
2. All overhead costs related to the activity should respond proportionally to changes in the activity level of the cost driver.
For example, if there is little or no correlation between changes in the cost driver and consumption of the overhead cost, inaccurate product costs are inevitable. An example of the use of ABC is illustrated in the appendix at the end of this chapter.
Activity-based costing may be used with either a job order or a process cost accounting system. The primary benefit of ABC is more accurate and meaningful product costing. Also, improved cost data about an activity can lead to reduced costs for the activity. In sum, ABC makes managers realize that it is activities, and not products, that determine the profitability of a company—a realization that should lead to better management decisions.
SERVICE COMPANY INSIGHT
Using ABC to Aid in Employee Evaluation
Although most publicized ABC applications are in manufacturing companies or large service firms, very small service businesses can apply it also. Mahany Welding Supply, a small family-run welding service business in Rochester, New York, used ABC to determine the cost of servicing customers and to identify feasible cost-reduction opportunities.
Application of ABC at Mahany Welding's operations provided information about the five employees who were involved in different activities of revenue generation—i.e., delivery of supplies (rural versus city), welding services, repairs, telephone sales, field or door-to-door sales, repeat business sales, and cold-call sales. Managers applied activity cost pools to the five revenue-producing employees using relevant cost drivers. ABC revealed annual net income (loss) by employee as follows.
This comparative information was an eye-opener to the owner of Mahany Welding—who was Employee #5!
Source: Michael Krupnicki and Thomas Tyson, “Using ABC to Determine the Cost of Servicing Customers,” Management Accounting (December 31, 1997), pp. 40–46.
What positive implications does application of ABC have for the employees of this company? (See page 1028.)
JIT and ABC
Indicate whether each of the following statements is true or false.
1. Continuous process manufacturing often results in a reduction of inventory.
2. Companies that use just-in-time processing complete and store finished goods all the time to meet rush orders from customers.
3. A major benefit of just-in-time processing is production cost savings from the improved flow of goods through the processes.
4. An ABC system is similar to traditional costing systems in accounting for manufacturing costs but differs in regard to period costs.
5. The primary benefit of ABC is more accurate and meaningful costs.
6. In recent years, the amount of direct labor used in many industries has greatly increased and total overhead costs have significantly decreased.
Action Plan
JIT manufacturing is dedicated to having the right amounts of materials, parts, or products just as they are needed.
ABC focuses on the activities performed in producing a product. It recognizes that to have accurate and meaningful cost data, more than one basis of allocating costs to products is needed.
Solution
1. False. 2. False. 3. True. 4. False. 5. True. 6. False.
Related exercise material: BE21-11 and DO IT! 21-5.
Essence Company manufactures a high-end after-shave lotion, called Eternity, in 10-ounce plastic bottles. Because the market for after-shave lotion is highly competitive, the company is very concerned about keeping its costs under control. Eternity is manufactured through three processes: mixing, filling, and corking. Materials are added at the beginning of each of the processes, and labor and overhead are incurred uniformly throughout each process. The company uses a weighted-average method to cost its product. A partially completed production cost report for the month of May for the Mixing Department is shown below.
(a) Prepare a production cost report for the Mixing Department for the month of May.
(b) Prepare the journal entry to record the transfer of goods from the Mixing Department to the Filling Department.
(c) Explain why Essence Company is using a process cost system to account for its costs.
Action Plan
Compute the physical unit flow—that is, the units to be accounted for and the units accounted for.
Compute the equivalent units of production.
Compute the unit production costs, expressed in terms of equivalent units of production.
Prepare a cost reconciliation schedule, which shows that the total costs accounted for equal the total costs to be accounted for.
Solution to Comprehensive DO IT!
1 Understand who uses process cost systems. Companies that mass-produce similar products in a continuous fashion use process cost systems. Once production begins, it continues until the finished product emerges. Each unit of finished product is indistinguishable from every other unit.
2 Explain the similarities and differences between job order cost and process cost systems. Job order cost systems are similar to process cost systems in three ways: (1) Both systems track the same cost elements—direct materials, direct labor, and manufacturing overhead. (2) Both accumulate costs in the same accounts—Raw Materials Inventory, Factory Labor, and Manufacturing Overhead. (3) Both assign accumulated costs to the same accounts—Work in Process, Finished Goods Inventory, and Cost of Goods Sold. However, the method of assigning costs differs significantly.
There are four main differences between the two cost systems: (1) A process cost system uses separate accounts for each department or manufacturing process, rather than only one work in process account used in a job order cost system. (2) A process cost system summarizes costs in a production cost report for each department. A job cost system charges costs to individual jobs and summarizes them in a job cost sheet. (3) Costs are totaled at the end of a time period in a process cost system, but at the completion of a job in a job cost system. (4) A process cost system calculates unit cost as Total manufacturing costs for the period ÷ Units produced during the period. A job cost system calculates unit cost as Total cost per job ÷ Units produced.
3 Explain the flow of costs in a process cost system. A process cost system assigns manufacturing costs for raw materials, labor, and overhead to work in process accounts for various departments or manufacturing processes. It transfers the costs of units completed from one department to another as those units move through the manufacturing process. The system transfers the costs of completed work to Finished Goods Inventory. Finally, when inventory is sold, the system transfers costs to Cost of Goods Sold.
4 Make the journal entries to assign manufacturing costs in a process cost system. Entries to assign the costs of raw materials, labor, and overhead consist of a credit to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead, and a debit to Work in Process for each department. Entries to record the cost of goods transferred to another department are a credit to Work in Process for the department whose work is finished and a debit to the department to which the goods are transferred. The entry to record units completed and transferred to the warehouse is a credit to Work in Process for the department whose work is finished and a debit to Finished Goods Inventory. The entry to record the sale of goods is a credit to Finished Goods Inventory and a debit to Cost of Goods Sold.
5 Compute equivalent units. Equivalent units of production measure work done during a period, expressed in fully completed units. Companies use this measure to determine the cost per unit of completed product. Equivalent units are the sum of units completed and transferred out plus equivalent units of ending work in process.
6 Explain the four steps necessary to prepare a production cost report. The four steps to complete a production cost report are: (1) Compute the physical unit flow—that is, the units to be accounted for and the units accounted for. (2) Compute the equivalent units of production. (3) Compute the unit production costs, expressed in terms of equivalent units of production. (4) Prepare a cost reconciliation schedule, which shows that the total costs accounted for equal the total costs to be accounted for.
7 Prepare a production cost report. The production cost report contains both quantity and cost data for a production department. There are four sections in the report: (1) number of physical units, (2) equivalent units determination, (3) unit costs, and (4) cost reconciliation schedule.
8 Explain just-in-time (JIT) processing. JIT is a manufacturing technique dedicated to producing the right products at the right time as needed. One of the principal accounting effects is that a Raw and In-Process Inventory account replaces both the raw materials and work in process inventory accounts.
9 Explain activity-based costing (ABC). ABC is a method of product costing that focuses on the activities performed to produce products. It assigns the cost of the activities to products by using cost drivers that measure the activities performed. The primary objective of ABC is accurate and meaningful product costs.
Activity-based costing (ABC) A cost accounting system that focuses on the activities performed in manufacturing a specific product. (p. 1000).
Conversion costs The sum of labor costs and overhead costs. (p. 991).
Cost driver Any factor or activity that has a direct cause–effect relationship with the resources consumed. (p. 1000).
Cost reconciliation schedule A schedule that shows that the total costs accounted for equal the total costs to be accounted for. (p. 996).
Equivalent units of production A measure of the work done during the period, expressed in fully completed units. (p. 990).
Just-in-time (JIT) processing A processing system dedicated to producing the right products (or parts) as they are needed. (p. 998).
Operations costing A combination of a process cost and a job order cost system, in which products are manufactured primarily by standardized methods, with some customization. (p. 998).
Physical units Actual units to be accounted for during a period, irrespective of any work performed. (p. 994).
Process cost systems An accounting system used to apply costs to similar products that are mass-produced in a continuous fashion. (p. 984).
Production cost report An internal report for management that shows both production quantity and cost data for a production department. (p. 993).
Total units (costs) accounted for The sum of the units (costs) transferred out during the period plus the units (costs) in process at the end of the period. (pp. 994, 996).
Total units (costs) to be accounted for The sum of the units (costs) started (or transferred) into production during the period plus the units (costs) in process at the beginning of the period. (pp. 994, 996).
Unit production costs Costs expressed in terms of equivalent units of production. (p. 995).
Weighted-average method Method used to compute equivalent units of production which considers the degree of completion (weighting) of the units completed and transferred out and the ending work in process. (p. 990).
In this appendix, we present an example that compares activity-based costing to traditional costing. Assume that Atlas Company produces two abdominal-training products, the Ab Bench and the Ab Coaster. The Ab Bench is a high-volume item totaling 25,000 units annually. The Ab Coaster is a low-volume item totaling only 5,000 units per year. Each product requires one hour of direct labor for completion. Therefore, total annual direct labor hours are 30,000 (25,000 + 5,000). Expected annual manufacturing overhead costs are $900,000. The predetermined overhead rate is $30 ($900,000 ÷ 30,000) per direct labor hour.
The direct materials cost per unit is $40 for the Ab Bench and $30 for the Ab Coaster. The direct labor cost is $12 per unit for each product.
Illustration 21A-1 shows the unit cost for each product under traditional costing.
Let's now calculate unit costs under ABC, in order to compare activity-based costing with a traditional costing system. The first step is to determine overhead rates under ABC.
Analysis reveals that Atlas Company's expected annual overhead costs of $900,000 relate to three activities—machine setups, machining, and inspections. Illustration 21A-2 shows the cost driver and overhead rate for each activity.
In assigning costs, it is necessary to know the expected number of cost drivers for each product. Because of its low volume, the Ab Coaster requires more setups and inspections than the Ab Bench. The expected number of cost drivers for each product is as follows.
Using these data, Atlas can assign the expected annual overhead cost to each product as follows.
These data show that under ABC, overhead costs are shifted from the high-volume product (Ab Bench) to the low-volume product (Ab Coaster). This shift results in more accurate costing for two reasons:
1. Low-volume products often require more special handling, such as more machine setups and inspections, than high-volume products. This is true for Atlas Company. Thus, the low-volume product frequently is responsible for more overhead costs per unit than a high-volume product.
2. Assigning overhead using ABC will usually increase the cost per unit for low-volume products as compared to a traditional overhead allocation. Therefore, traditional cost drivers such as direct labor hours are usually not appropriate for assigning overhead costs to low-volume products.
A comparison of unit manufacturing costs under traditional costing and ABC shows the following significant differences.
The comparison shows that unit costs under traditional costing have been significantly distorted. The cost of the Ab Bench has been overstated $13 per unit ($82 − $69). The cost of the Ab Coaster has been understated $65 per unit ($137 – $72). The differences are attributable to how Atlas Company assigns manufacturing overhead. A likely consequence of the differences is that Atlas has been over-pricing the Ab Bench and possibly losing market share to competitors. It also has been sacrificing profitability by underpricing the Ab Coaster.
As illustrated in the above case, ABC involves the following steps.
1. Identify the major activities that pertain to the manufacture of specific products.
2. Accumulate manufacturing overhead costs by activities.
3. Identify the cost driver(s) that accurately measure(s) each activity's contribution to the finished product.
4. Assign manufacturing overhead costs for each activity to products, using the cost driver(s).
The primary benefit of ABC is more accurate product costing. Here's why:
1. ABC leads to more cost pools being used to assign overhead costs to products. Instead of one plantwide pool (or even departmental pools) and a single cost driver, companies use numerous activity cost pools with more relevant cost drivers. Costs are assigned more directly on the basis of the cost drivers used to produce each product.
2. ABC leads to enhanced control over overhead costs. Under ABC, companies can trace many overhead costs directly to activities—allowing some indirect costs to be identified as direct costs. Thus, managers have become more aware of their responsibility to control the activities that generate those costs.
3. ABC leads to better management decisions. More accurate product costing should contribute to setting selling prices that can help achieve desired product profitability levels. In addition, more accurate cost data could be helpful in deciding whether to make or buy a product part or component, and sometimes even whether to eliminate a product.
Activity-based costing does not change the amount of overhead costs. What it does do is allocate those overhead costs in a more accurate manner. Furthermore, if the scorekeeping is more realistic and more accurate, managers should be able to better understand cost behavior and overall profitability.
Although ABC systems often provide better product cost data than traditional volume-based systems, there are limitations:
1. ABC can be expensive to use. The increased cost of identifying multiple activities and applying numerous cost drivers discourages many companies from using ABC. Activity-based costing systems are more complex than traditional costing systems—sometimes significantly more complex. So companies must ask, is the cost of implementation greater than the benefit of greater accuracy? Sometimes it may be. For some companies, there may be no need to consider ABC at all because their existing system is sufficient. If the costs of ABC outweigh the benefits, then the company should not implement ABC.
2. Some arbitrary allocations continue. Even though more overhead costs can be assigned directly to products through ABC's multiple activity cost pools, certain overhead costs remain to be allocated by means of some arbitrary volume-based cost driver such as labor or machine hours.