Section 2.) Direct vs. Indirect and Traditional Overhead Allocation
You will find that one of the most prominent topics within cost and managerial accounting is overhead and the allocation of it. Costs like direct materials and direct labor are relatively easy because you can identify specifically how many pounds of material go into a product or how many hours of direct labor were used. It is not so easy to identify how much utility cost or supervisor cost goes to one particular unit though. These types of overhead cost are considered to be “indirect.”
The direct vs. indirect cost classification relates to the cost relationship to the product or activity. If we can identify exactly how much of a particular cost goes to the product, it is said to be direct. This would include things like direct materials and direct labor. There are some materials and labor that we either cannot directly identify as being used by one product, or it is of such a small amount that it doesn’t make sense to spend the time doing so. We call these costs indirect materials and indirect labor. Some examples of indirect materials may be thread and glue used in a vehicle production. They are in every cost, but no one is measuring the usage because it is such a small amount compared to the other utilities. Indirect labor would include things such as factory supervisor or manger cost. They are supervising staff that work on multiple products, so their cost needs to be assigned to all units. There are also indirect costs such as factory utilities, factory depreciation, etc. that somehow need to be included in each product’s cost.
In order to identify the amount of cost that goes to each product, we first have to accumulate all costs into a cost pool. The cost pool is simply a group of similar types of costs. Then, costs from the cost pools need to either be assigned or allocated to the cost objects (i.e., the product we are trying to track cost for.)
If you have direct labor or direct materials, these are directly assigned out of their respective cost pools to the cost objects that use them. However, for the manufacturing overhead costs, we must allocate the costs using the best estimate possible. This is done by identifying some sort of “cost driver”, which is something else we can measure that is believed to have “driven” or “caused” the cost.
The traditional overhead costing method generally starts with either direct labor hours or machine hours as a simple cost driver. In other words, we assume that if one product uses 10% of all of the direct labor hours (or perhaps machine hours) in the factory, that perhaps it should be assigned 10% of the manufacturing overhead cost as well. This is not intended to perfectly reflect how much overhead was used by a product, but it should give us a close enough estimate.
Mathematically, the way this is performed is by adding up all of the manufacturing overhead that is expected to be incurred in the period and dividing it by the total number of labor or machine hours expected to be used during the period. This gives you an expected overhead rate per machine hour (often referred to as the predetermined overhead rate.) It is important to note that we are developing this rate at the beginning of the period based on budgeted numbers (not actual).
For example, if we had $150,000 of expected overhead for the year and 10,000 direct labor hours expected to be used, this would give us a predetermined overhead rate of $15.
Then, every time an actual product used up actual direct labor hours during the period, it would get $15 of overhead applied (along with all of the actual direct materials and direct labor that was used during the period.) This allows the company to have an idea of whether the product is going over or under cost before the end of the period.
This method works well when all of the products can be reasonably assumed to use the same types of machines and overhead in general.
Section 3.) Activity-Based Costing
In the last section, we discussed the use of an allocation “base” (or cost driver) such as direct labor hours, machine hours, or raw materials costs to allocate overhead costs to the various products. Although this is certainly one way to allocate overhead costs it may result in something known as cost distortion in cases where multiple product lines exist. When using one or two bases to allocate costs we are assuming that the base VERY closely relates to the amount of overhead incurred. For example, we assume that the number of direct labor hours estimates the amount of cost that is going to be incurred for every single overhead-type activity (i.e., electricity in the factory, maintenance on the machines, costs related to getting a machine ready to run a batch, etc.) This assumption is generally not very valid and if we are not careful, we may over cost one item while undercosting another. This may lead to faulty decisions on pricing, profitability of a particular product line, etc.
The entire goal behind allocation is to try to estimate what item is driving the overhead cost. Do direct labor hours really drive all of the cost? Generally, no. As such, a more sophisticated allocation system known as activity-based costing is often used to better estimate costs, thus giving better information to management to make better decisions.
In activity-based costing, we take a look at all of the overhead costs and try to break them into groups, finding a base that truly relates to (or drives) the amount of that cost that will be incurred. We then create a predetermined overhead rate for that group of costs only and then allocate the cost using the actual amount of that particular base used during a particular batch. The calculation for creating the overhead rates is the same as before, it is just that more calculations will be needed due to having more bases.
The idea is that you take all of the overhead and break it into multiple cost pools (instead of just one large overhead cost pool.) Then, you identify which driver would best relate to the use of the cost from each cost pool.
In the below example, we have identified 6 different types of overhead costs, as well as some drivers that relate to the use of that cost. As you can see, we have calculated a rate per unit of activity.
Then, every time a particular product used up a production order, a setup, a material receipt, etc. it would be assigned that much overhead cost.
The use of the activity-based costing system allows for the possibility that different products may have more parts (thus use more of that type of overhead.) Or they may be manufactured in different sizes batches or with different machines.) Generally, this method gives much more accurate product costs in these cases. The drawback is that it is more time consuming to develop and maintain the information.
This below video goes through an example of the activity-based costing method.
Section 4:) Cost of Goods Manufactured Statement
Once all of the different product costs have been identified, we then have to track them throughout their various stages. Materials costs start off in the inventory asset known as raw materials. Once someone takes parts and starts to put them together into a product, direct labor and manufacturing overhead would be applied. This gives us work in process (another inventory asset.) Once the product is completely finished, it is referred to as finished goods inventory (the final inventory asset.) Once the unit is sold, it then is pulled out of the finished goods inventory asset and moved over to the cost of goods sold expense account. Notably, the cost of goods sold is NOT an inventory asset account.
The Cost of Goods Manufactured Statement is one of the more important statements in managerial accounting, as it identifies all of the manufacturing costs that have been used in production throughout the current period (i.e., direct materials, direct labor, and manufacturing overhead applied.) These are referred to as “current manufacturing costs.” It also gives us the total amount of costs related to production that was completed in this period, even if a portion of that production (and the corresponding costs) was started in prior periods.
The current manufacturing costs are reconciled with the costs of manufacturing that are left over from the prior period (i.e., costs that are still in work in process and have not yet been finished.) This is done by adding the current manufacturing costs to the beginning work in process inventory, to create a subtotal of what we “could” have in production in total. Then, we subtract out the ending work in process inventory since that is still in process (i.e., it has not yet been moved over to finished goods inventory.) This calculation gives us the cost of goods manufactured, which is essentially all of the manufacturing costs related to units that we have completed this period. This includes costs we added in this period, as well as costs that were added in prior periods. Another way to think of the cost of goods manufactured statement is that it reflects the cost of goods “completed” this period. Again, it doesn’t matter whether we started them last year or this year, as long as we completed them this period.
One other thing to note is that one period’s ending balance of any account becomes the next period’s beginning balance for that account.
In the above example, $26,500 represents the inventory that has been finished this period. This is moved into the finished goods inventory account. We may sell some of this period or it may remain in the finished goods inventory account until later periods.
Cost of Goods Sold Statement
It is important to know what costs we have that relate to goods completed in this period, because that then helps us to calculate the costs related to the goods that we sold this period. Units completed and sold generally are not the same number, so we have to go through a reconciliation similar to what we did above to calculate this. First, we take the Finished Goods Beginning Inventory and add in the Cost of Goods Manufactured. If we were not a manufacturing firm, and instead just purchased goods, then we would just add to the cost of purchases instead. By adding these two figures together, we get the Cost of Goods Available for Sale. These are the costs related to units that we could have potentially sold. From this, we then subtract out the cost related to Finished Goods Ending Inventory, since we obviously didn’t sell those ones. That gives us the Cost of Goods Sold.
This below video goes through an example of the cost of goods manufactured statement.
Section 5.) Absorption vs. Variable Costing Methods
A large part of this chapter related to whether a cost was considered to be related to the product or not. In the end, we need to be able to develop an income statement to show what revenue related to our sales, and what costs we had for the company.
To understand these two costing methods, we must first review the types of costs that a company could have. Note that we generally try to break costs into product versus period costs for the purposes of creating an income statement. In the traditional Income Statement, we learned about in financial accounting, the cost of goods sold expense would reflect all of the product costs (both variable and fixed), and then the operating expenses after the gross profit would represent all of the period costs (both variable and fixed). With this type of income statement, we don’t focus too much on the difference between variable and fixed costs.
In the Traditional Income Statement:
Product Costs include:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period Costs include:
Variable Selling and Administrative Costs
Fixed Manufacturing Overhead
Traditional Income Statement Format
Sales
Less: Cost of Goods Sold
= Gross Profit
Less: Selling and Administrative Expenses
= Net Income
This traditional income statement method is required for the purposes of external reporting under GAAP. It is referred to as the Absorption Method. This is because every unit of product absorbs a bit of the fixed manufacturing overhead.
However, there is another method that is used more commonly with managerial accounting. This is referred to as the Variable Costing method. In this method, only the variable manufacturing costs are considered to be product costs. This includes Direct Materials, Direct Labor, and Variable Manufacturing Overhead, but it excludes Fixed Manufacturing Overhead. The difference between these two methods is simply when the fixed manufacturing overhead allocated to each unit gets expensed on the income statement. Under absorption costing, it would not be expensed until the product was sold. In the meantime, it would be stored with the other inventory assets. Under the variables costing method, the entire fixed manufacturing overhead cost is expensed immediately in that period. The only time this makes a difference is when we sell less than we produce or vice versa. Then we will have a difference in expense for that period.
Contribution Income Statement Format (for Variables Costing)
Sales
Less Variable Expenses:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Variable Selling and Admin Expenses
= Contribution Margin
Less Fixed Expenses:
Fixed Manufacturing Overhead
Fixed Selling and Admin Expenses
= Net Income
Note that with the absorption method, the traditional income statement has Gross Profit as a subtotal. Under the variables costing method, we have Contribution Margin as the subtotal instead.
Differences In Profit
If the same number of units were produced and sold each period, and no excess inventory was ever kept, there would be no difference in the cost of goods sold or net income figures between the two methods. However, when more units are produced than sold or vice versa (i.e., beginning or ending inventories change) the cost of goods sold, and thus the net income, will be different under one method versus the other. The reason is that, since absorption costing only counts the fixed manufacturing overhead as an expense (cost of goods sold) in the period that it is sold, then the period in which fewer units are sold than produced will have less cost of goods sold (and higher net income) compared with the variables costing method, where the entire fixed manufacturing overhead is expensed right away.
On the other hand, the period in which more units are sold than produced will have more cost of goods sold (and less net income) compared with the variables costing method, where the entire fixed manufacturing overhead is expensed right away.
This below video goes through an example of an accounting equation video practice exercise.
Wrap-Up
We are now through the second week of managerial accounting, and have now fully covered the variable vs. fixed, product vs. period, and direct vs. indirect cost classifications. These are by far the most important of all cost classifications and together they will help you to fully understand the cost analysis that needs to be performed. Next week, we head int the topic of budgeting.
Section 1.) Product vs. Period Cost Classifications
In the last module we focused on the cost classifications of variable vs. fixed. This module, we deal with two cost classifications. These are product vs. period and direct vs. indirect.
The product vs. period classification relates to how closely the cost relates to the production process itself. If the cost relates to production (even if we can’t directly trace it to one specific unit) then we consider this to be a product cost. A cost that is not considered to be a product cost would be classified as a period cost. The main difference between the two is when the cost will be considered as an expense. With period costs, these are expensed in the period in which they were incurred. They do not relate to production, so they are never included as part of the inventory asset.
Product costs on the other hand relate to the production of inventory, so it only makes since that they will be treated as inventory initially, until the product is sold, at which time they are converted to an expense. These costs are sometimes referred to as “inventoriable” because the cost is treated as an inventory asset until sold.
Product Cost - When we can closely relate a cost to the actual manufacturing of the product, we consider this a product cost (further subclassifications discussed shortly.) These types of costs are lumped in with the various inventory accounts and will not be considered an expense until the related product is sold (i.e., matching principle) Some examples of product costs are raw materials, direct labor, and factory or manufacturing overhead (any overhead incurred in the factory itself, NOT the sales offices, etc.)
Direct Materials - These represent materials directly traced to each product
Direct Labor-These represent labor directly traced to a product. The key thing with this labor is that it MUST relate to staff actually working directly on the product. It cannot include Supervisors, Managers, or any other staff, regardless of whether they are in the factory or not.
Manufacturing/Factory Overhead -This could include indirect materials, indirect labor, or other costs that relate to the production, but not directly. Note that factory overhead can be fixed (not related to the production of just one unit) or variable (related to each individual unit that is produced.) Depending on the method used (absorption or variables costing), this manufacturing overhead will either be considered a product cost or a period cost. Specifically, under the absorption costing method, fixed manufacturing overhead is considered to be a product cost, as every product will “absorb” some of the costs. Under the variables costing method, fixed manufacturing overhead is considered to be a period cost, since only variable product costs are truly considered product costs. More on this later in the module.
Period Cost - When a product doesn’t specifically relate to the product itself, but more to the company overall, it is said to be a period cost. This means that the cost will be considered an expense in the period in which it is incurred, regardless of whether any products are sold that period. Although this is somewhat of a violation of the matching principle, sufficient information often does not exist by which to match these period costs with a particular product. Some examples of period costs are sales salaries, general and administrative overhead, advertising, etc.
This below video goes through the product vs. period cost classifications
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