2. Costing

Question 1

What is a cost object?

Answer 1

Anything for which a separate measurement of costs is desired.

Question 2

What are direct costs?

Answer 2

Direct costs of a cost object are costs that are related to the particular cost object and can be traced to the particular cost object in an economically feasible way

Question 3

What are indirect costs?

Answer 3

Indirect costs of a cost object are costs that are related to the particular cost object but cannot be traced to it in an economically feasible way (bulk of the activity)

Question 4

What are cost pools?

Answer 4

Cost pool is a grouping of individual cost items (=cost center)

Question 5

What is cost allocation base / cost driver?

Answer 5

A factor that is the “common denominator” for systematically linking an indirect cost or group of indirect costs to a cost object

Question 6

What are the different cost pool types?

Answer 6

Product cost pools: collects costs that are associated with any set of products

• Direct product cost pool: a product cost pool that is associated with a single product (i.e. direct costs are traceable to a single product)
• Indirect product pool costs: collects indirect costs, i.e. those that are not directly traceable to individual products but allocated to them according to an allocation base determined as part of the accounting system

Period costs: Expenses that are neither traceable nor allocated to products, but are associated with the time period

Question 7

What is the matching principle?

Answer 7

Product costs are expenses in the period in which the revenue is realized, period-related expenses. Period costs are charged against the income of the period.

Question 8

What is the difference in treatment between Product costs and Period costs?

Answer 8

Product costs: Included in inventory value in BS and COGS in IS

Period costs: Directly assigned to the income statement

Question 9

What are examples of cost objects?

Answer 9

• a product
• a customer
• a product-category
• a period of time
• a project (R&D or reorganization)
• an activity (quality control)
• a department

Question 10

What is the assignment of direct and indirect costs to cost objects called?

Answer 10

Direct: Tracing
Indirect: Allocation

Question 11

What is the central problem of cost allocation?

Answer 11

How to include (allocate) indirect costs that often cannot be allocated to products/services (i.e. cost objects) without ambiguity. We try to look for a causal relationship between the indirect cost and the cost object (where/if there might be one), but otherwise the choice of how to allocate can be arbitrary (degree of ambiguity in indirect cost allocation).

Question 12

What is the objective of cost accounting?

Answer 12

To assign costs to their cost objects

Question 13

What does it mean to classify costs by traceability?

Answer 13

To differentiate between direct and indirect costs

Question 14

What does traceability classification depend on?

Answer 14

• The choice of cost object
• The materiality of the cost in question
• Available information-gathering technology
• Design of operations
• Contractual agreements

Question 15

Cause-and-effect relationships may arise in several ways to determine cost drivers, like:

Answer 15

• Physical relationships (but correlation is not equal to causation)
• Contractual agreements
• Logic and knowledge of operations

Question 16

What are some examples of costs and corresponding drivers?

Answer 16

• Direct materials: # of units
• Direct labor: # of labor hours
• Quality control: # of units inspected
• Distribution: # of shipments
• Advertising: # of advertisements

Question 17

When may a job costing system be applied?

Answer 17

Distinct unit of a product or service

The product is differentiated, customised or unique, and individual jobs use different quantities of resources

Question 18

When may a process costing system be applied?

Answer 18

Masses of identical or similar units of a product or service

The product is homogeneous, and each unit presumed to receive the identical quantities of resources

Question 19

What is the 7 steps of the general approach to job costing?

Answer 19

1. Identify the job (=the cost object)
2. Identify the direct costs of the job
3. Identify the total indirect costs to be allocated
4. Select the cost allocation base (= cost driver) to use in allocating indirect costs to the job
5. Develop the rate per unit of the cost allocation base used to allocate indirect costs
6. Calculate the indirect costs allocated to the job
7. Compute the total costs of the job

Question 20

What may be a problem with job costing in the manufacturing industry?

Answer 20

Particularly in this sector we might have more than one cost driver

Question 21

What is actual costing?

Answer 21

Actual costing uses actual costs to determine the cost of individual jobs

• This method traces direct costs to a cost object and allocates indirect costs to a cost object based on the actual indirect cost rate * the actual quantity of the cost allocation base

Question 22

What is the difficulty with actual costing?

Answer 22

That you have to wait until the end of the reporting period to allocate total indirect costs, but managers often want more timely information before the end of the reporting cycle

Question 23

What is normal costing?

Answer 23

Normal costing traces direct costs to a cost object and allocates indirect costs to a cost object based on budgeted indirect cost rate * the actual quantity of the cost allocation base

• Direct costs are treated the same as under actual costing

Question 24

What are complications of normal costing?

Answer 24

• Underallocated indirect costs: allocated amount of indirect costs is lower than the amount actually incurred
• Overallocated indirect costs: allocated amount of indirect costs is higher than the amount actually incurred

Question 25

How do we deal with under/overallocation of indirect costs?

Answer 25

• Write off the under- or overallocation to cost of goods sold in the income statement – especially if trivial
• Adjust all jobs to reflect actual costs at the end of the accounting period
• Adjust individual job costs to account for (absorb) the under-/overallocation

Question 26

What are pros and cons of job order costing?

Answer 26

For highly distinct, customizable products (jobs), helps company:

1. Determine the profitability of each job

• More precise data on unique jobs = better precision in pricing

2. Keep track of productivity/efficiency of job teams

• Requires greater tracking of materials and labor
• Easier to identify and eliminate waste and inefficiency

3. Use of normal costing for benchmarking job costs in “real time”

• Increases administrative costs
• Can be imprecise, leading to risk of error
• Over-under applied OH that needs to be adjusted

Question 27

What are the different types of inventories?

Answer 27

• Direct materials inventory (raw materials)
• Work-in-process inventories (could be for range of products)
• Finished goods inventory (ready and available for sale)

Question 28

What is the general stock flow equation?

Answer 28

Opening stock + Purchases = Sales + Closing stock

Question 29

What are the three main inventory flow methods?

Answer 29

• FIFO: first in, first out
• LIFO: last in, first out
• Weighted average method

Attempt to mimic the physical flow of goods/resources through a process

Question 30

What are the basic assumptions for process costing?

Answer 30

• Each sub-process/department has its own work-in-process inventory account
• Direct materials added at beginning of process (or at discrete points)
• Direct labor and factory overhead (called conversion costs) incurred continuously throughout production

Question 31

What can we say about process costing with multiple sub-processes/departments?

Answer 31

They involve “transferred-in costs”

• As a product passes from one sub-process to another the accumulated cost (work-in-process) passes from department to department
• Transferred-in costs (or prior sub-process/department costs) are costs of work performed in earlier departments that are transferred into the current sub-process/department
• These costs are treated like direct materials added at the beginning of a process

Question 32

What can we say about inefficiencies in process costing?

Answer 32

• We might expect that there is waste or spoilage in the productive process; we would call this normal (or budgeted) production losses
• In normal costing, it is usual to try and anticipate this level of normal losses: that is, the waste in production that reflects the usual or expected level of productive inefficiency
• For purposes of process costing, we may need to adjust the product costs to reflect the actual level of waste; which might leave the company with either abnormal losses or abnormal gains.

Question 33

What are normal losses and how are they treated?

Answer 33

Normal losses (expected waste) occur under regular operating conditions and are not easily controllable. These losses should be absorbed into product(ion) cost and will impact gross profit

• Product costs included in the income statement in Cost of Sales/COGS when the sale is made.
• Accumulated costs of unsold goods goods are included in the value of inventory

Question 34

What are abnormal losses/gains and how are they treated?

Answer 34

Abnormal losses (or gains) are written off to the income statement as a period cost/benefit and will impact operating income

• Period costs are not included in the calculation of product cost or the value of inventory
• Directly assigned to the income statement typically through Operating Expenses

Question 35

What do we use to determine process cost with semi-completed goods?

Answer 35

In order to determine process costs when WIP remains at the end of a period, we need to consider equivalent units in the calculation

• An equivalent unit is a measure that converts units partially complete into equivalently fully complete units (e.g. 4 units 25% complete are equivalent to 1 unit fully complete)

Simplifying assumptions:

• DM costs are added at the beginning of the process
• Conversion costs (direct labor + OH) are added continuously during processes

Question 36

What are the steps of costing semi-completed goods?

Answer 36

1. Summarize output in physical units
2. Calculate equivalent units
3. Calculate equivalent unit costs
4. Assign costs to completed units
5. Assign costs to units in closing WIP

Question 37

What are the three general approaches for allocating overhead costs to products?

Answer 37

1. Volume-based approach: allocates overhead from a single pool of costs/drivers (job costing and process costing)
2. Departmental approach: allocates overhead from service departments to production departments and then from production departments to products
3. Activity-based approach: allocates overhead to production activities and then from production activities to products

Question 38

When may a volume-based cost allocation approach be good?

Answer 38

• Costs to be allocated are relatively small when compared to directly traceable costs

Or

• Activities supporting the product/service line are homogeneous across different product/service lines

Question 39

What are production departments?

Answer 39

A unit of a manufacturing company that is involved in producing the company’s product or service

Question 40

What is a service department?

Answer 40

A unit of the company that performs one or more support tasks for production departments

Question 41

Why is it important for decision makers to determine accurate production and service department costs?

Answer 41

To use as a basis for evaluating the cost efficiency of departments and the profitability of different products

Question 42

Why do service department exist and how are their costs treated?

Answer 42

• Service departments exist to support production departments; thus, a portion of their costs are allocated to production
• Allocating indirect costs from service departments requires a cost allocation base that reflects each production department’s share of service

Question 43

What are the 3 phases of departmental overhead allocation?

Answer 43

Phase 1:

• Trace direct costs from production departments to products
• Assign/allocate indirect costs to production departments and service departments (based on relevant drivers)

Phase 2:

• Allocate service department costs to production departments

Phase 3:

• Allocate production department costs to products

Question 44

What are the two methods to deal with the allocation issue of when multiple service departments provide services to each other?

Answer 44

1. Direct method: Ignore all interaction between service departments

• Allocate directly to production departments

2. Step down method: Ignore two-way interaction between service departments

• Allocate between service departments in one direction only
• Allocate in stages - usually starting with the largest service department first

Question 45

What is the strategic role of cost allocation?

Answer 45

1. Determine accurate department costs (and product costs) as a basis for evaluating the cost efficiency of departments (and the profitability of different products)

• Determine which parts of the business are responsible for which costs

2. Motivate managers to exert a high level of effort to achieve the goals of top management

• Get managers in different departments to focus on costs incurred within their department and understand their relationship to other departments

3. Provide the right incentive for managers to make decisions that are consistent with the goals of top management

• Design contracts that reward departmental cost control and increased profitability

4. Fairly determine the rewards earned by managers for their effort and for the effectiveness of their decision making

Question 47

What is the development behind activity-based costing?

Answer 47

• Departmental approached acknowledge the growth of indirect costs (“overhead creep”) and drivers beyond volume, but distortion may still occur in the cost center/departmental approach (pools together unrelated activities)
• Allocation shortcomings: changes in manufacturing due to product complexity, product mix heterogeneity, factory layout and automation and advanced manufacturing technologies as lending
• Activities drive most costs rather than volume; Products and services are created through performing activities, which require resources, and resources change based on a driver/factor causing the change

Question 48

What is the brief description of ABC and its aim?

Answer 48

• In brief, ABC systems assign overhead costs to activities using resource consumption drivers and then assign these costs to cost objects (e.g. products)
• The aim is to project more accurate cost flows by tracing a higher amount of costs directly to the cost objects

Question 49

How can we define the activities in ABC?

Answer 49

1. Value chains help cut the production process into stages based upon their value-added. Enables to focus on activities where companies realize competitive advantages:

• Better customer value at equivalent cost
• Equivalent customer value at lower costs

2. Production flow charts enable managers to divide the production process into various components or activities. The aim is to go into as much detail as possible

Question 50

What are some considerations about mapping value creation activities?

Answer 50

• Where to stop?
• How many activities should be included?
• Can be costly and difficult to understand
• Not all firms need ABC - preference for cost-based decision-making tool
• However, ABC is not only a method of costing, but a technique for managing the firm better

Question 51

What are the 6 steps of ABC costing?

Answer 51

1. Decompose organization into activities
2. Identify activity drivers
3. Assign costs to activities
4. Calculate activity rates
5. Calculate rate per unit of activity
6. Assign costs to products based on the activities consumed by each product

Question 52

How is ABC a technique for managing the firm?

Answer 52

• Cost reduction and process improvement decisions: Can help identify what areas need attention and where to realize cost reductions
• Design decisions: Can help identify new designs to improve performance by evaluating how product and process changes affect costs
• Market decisions: Can help identify the benefits of alternative products and market preferences by focusing on items and activities which are value and non-value adding
• Performance evaluations: Can be used to develop new forms of measuring and monitoring performance
• Product-mix decisions: Highlights product complexity issues through analysis of activities and transactions

Question 53

How can ABC help create more thorough analysis of customer profitability (CPA)?

Answer 53

• Customers are not all the same; their costs vary along with the kind of customers (customer profiles) that a firm deals with
• Allows a firm to better understand which revenues and costs are related with which customers
• Enables the measurement of the profitability of a firm’s customers or customer groups
• Make more informed decisions with regards to sales and customers (e.g. who receives discounts)

Question 54

What does CPA (customer profitability analysis) help with?

Answer 54

Helps assess a customer’s value to the company and business conditions for the company to consider

• How important is the customer as a future sales reference?
• What is the customer’s growth potential?
• What are the possible reactions of the customer to changes in sales terms or services?
• Interventions and process improvements in ABC implementation

In conjunction with ABC, requires close cooperation among management accountants, engineers, and operating managers, but also with service activities.

Question 55

What are the parts of a Statement of Cost of Goods Manufactured and Sold?

Answer 55

+ Direct Materials
+ Direct Labor
+ Factory OH
= Manufacturing costs incurred

Add: Opening WIP
Less: Closing WIP
= Cost of finished goods (completed)

Add: Opening finished inventory
Less: Closing finished inventory
= Cost of Goods Sold (should match with sum of finished jobs)