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Indirect Labor and Indirect Materials costs are what type of cost?

Conversion costs (as a component of OH)


Costs on an Income Statement

Net Sales

- COGS ----------> Product Costs

= Gross Profit

- SG&A Expenses ---------> Period Costs

= Net Profit (Loss)


Overhead Rate Methodology

  • Estimated amounts based on currently attainable capacity are always used for this formula— not historical, ideal, or theoretical amounts. This is likely to be a frequently tested concept on the CPA exam.

An overhead application rate is commonly called a predetermined ("estimated" = "budgeted") overhead rate and is computed as follows:

Estimated Total Overhead Costs / Estimated Activity Volume

  • Direct materials and direct labor are traced to the Work-in-Process (WIP) account, but overhead must be allocated to WIP. Since overhead costs are typically not directly traceable to specific units of production, an estimated overhead amount is applied to production based on a predetermined rate. Actual overhead costs are accumulated separately. At the end of the period, the applied overhead is compared to the actual overhead and an entry is made to adjust any difference.
  • The result of this calculation is the overhead allocation rate (or overhead application rate). The overhead allocation rate is normally established prior to the beginning of the period. That is, it is a predetermined rate.


Applied Overhead T-Account Entry

Actual Overhead T-Account Entry

OH Applied - sent to WIP

  • DR: Work-in-Process
    • CR: Factory Overhead Applied

Actual OH - sent from DM and DL (left side of T-Account)

  • DR: Factory Overhead Control Utilities Expense
    • CR: Accounts Payable


Closing out the OH Account - T-Account Entry

  • DR: Factory Overhead Applied
    • CR: Factory Overhead Control

Immaterial deltas are typically allocated to COGS.  

Material differences should be allocated PRO-RATA to WIP, FG and COGS based on their respective ending balances.  This will be tested on exam.  



MFG OH Overapplied to WIP vs. Underapplied MFG OH

Overapplied (allocated) = When more overhead costs are applied to products than are actually incurred, factory overhead is said to be overapplied. When the accounts are closed at the end of the period, overapplied overhead reduces Cost of Goods Sold.

Underapplied (allocated) = When actual OH is > OHA (or budgeted). When the accounts are closed at the end of the period, underapplied overhead increases Cost of Goods Sold.  For overhead to be underapplied, either the actual fixed costs must be greater than the budgeted fixed costs or the actual volume must be less than the budgeted volume.


Summary of OH Application (3 steps at 3 time periods during the year)

  1. At the beginning of the year, we calculate the predetermined overhead allocation rate (POR). For example, estimated overhead is divided by estimated direct labor hours.
  2. During the year, we periodically allocate overhead by multiplying the overhead allocation rate (POR) by the actual units of the allocation base.
  3. At the end of the year we dispose of over/underapplied overhead by taking the difference between actual overhead and applied overhead to Cost of Goods Sold.


Conversion Cost

Conversion cost is the sum of direct labor and overhead. It is so named because this is the cost of the efforts that convert raw material into finished goods.

Indirect labor is included in overhead and, thus, is part of conversion cost.


Flow of Inventory Calculation (must know this for multiple sections of CPA exam)

+ Beginning Inventory

+ Purchases

= COG Available for Sale

- Ending Inventory (reported on B/S)

= COGS (appears as line item on I/S)



Direct Materials Formula (Step 1)


+ DM Purchased

= DM Available for Use


= DM Used (flows to Total Manufacturing Costs)


Total Manufacturing Costs (Step 2)

DM Used

+ DL


= Total MFG Costs (flows to CGM)


CGM (Step 3)


+ Total MFG Costs

= WIP Available


= CGM (Flows to CGS)


CGS (Final Step in Inventory Flow, hits Income Statement)


+ CGM (i.e. Total Production Costs)

= CG Available for Sale




What inventory accounts are analyzed for:



CGM = Raw Materials and WIP

CGS = Finished Goods



Scrap is included in product costs along with normal spoilage.  

  • Scrap is the material left over after making a product. It has minimal or no sales value. Scrap is automatically included in work in process for a product because it is part of the material cost of a product. In many manufacturing settings, it is impossible to use every bit of material input. For example, the circular punch-outs for conduit boxes are scrap.
  • Normal spoilage is output that cannot be sold through normal channels. It is an inherent result of production. In many cases, it is not cost effective to attempt to reduce the normal spoilage cost to zero. It is a normal part of the production process and, therefore, its cost is included in the cost of units produced.
  • Abnormal spoilage is considered avoidable. It occurs as a result of an unexpected event, such as a machine breakdown or accident. This cost is treated as a loss rather than a normal production cost.


When a flexible budget is used, a decrease in production levels within a relevant range will do what to total costs?

Decrease total costs.  

Variable cost per unit is assumed to be constant throughout the relevant range. A decrease in production causes total variable costs to decrease, but not variable cost per unit. Also, variable cost per unit should not increase with lower production. 


Cost = FC + VC(vc/unit)

This formula is crucial in calculating many total cost questions.  Using the high-low method, remember the Rise/Run to arrive at vc/unit, then solve for FC by plugging in facts from one set of facts given.  


Activity Based Costing (ABC) vs. Traditional Cost Systems

ABC shifts costs away from high-volume simple products toward lower volume and more complex products.  Cost drivers are used as a basis for cost allocation and activities that are non-value adding are eliminated or reduced to the greatest extent possible.  

Adopting ABC will effect:

  1. more precise cost accuracy
  2. more cost pools
  3. more allocation bases

A tradition system tends to over-cost high volume products and undercost low volume products.  


  1. Re-engineering
  2. Shared Services
  3. Outsourcing
  4. Off-shoring

  1. a process analysis approach that typically results in radical change. This is a different approach from incrementally reducing and eliminating non-value added activities, and otherwise improving processes.
  2. one part of an organization provides an essential business process where previously it was provided by multiple parts of that same organization
  3. taking an internal activity and moving it to an external third party service provider
  4. moving a process outside of the country.  Off-shore operations are especially vulnerable to cultural/language issues and difficulty protecting intellectual property rights.


Absorption costing (required by SEC) vs. Direct Costing

  • ONLY difference concerns the treatment of Fixed MFG Costs.  
  • Variable Costing (Direct) treats FC as a period expense and is used only for internal decision making.  

Absorption costing: Assigns all three factors of production (direct material, direct labor, and both fixed and variable manufacturing overhead) to inventory. i.e. Fixed Cost = Product Cost

  1. The absorption model assigns all manufacturing costs to products.

Direct costing: (also known as variable costing) Assigns only variable manufacturing costs (direct material, direct labor, but only variable manufacturing overhead) to inventory.

  1. The direct model assigns only variable manufacturing costs to products.


Variable (Direct) Costing Method of Arriving at Income =  Contribution Margin Format

The contribution margin equals sales minus variable costs. Fixed costs are deducted from the contribution margin to calculate income.


- Variable MFG

- Variable SGA (these are still NOT product costs!)

= Contribution Margin

- Fixed MFG

- Fixed SGA

= Operating Income


Absorption Costing Method of Arriving at Income =  CGS Format

Fixed Mfg. OH is allocated to each item produced.  If we produce more than we sell, a portion of the Fixed Mfg. OH is capitalized as inventory (becomes an asset) until it is sold.  


- VC for units sold

- FC for units sold

= Gross Margin

- Variable SGA

- Fixed SGA

= Operating Income


Remember that variable selling and administrative expenses under the Absorption and Direct (Variable) Costing methods are:

NOT Product Costs

Remember also that under both methods it is POSSIBLE to arrive at the same net income total.  


Absorption vs. Direct (Variable) Income

If Units Sold = Units Produced

  • AC income = VC income

If Units Sold > Units Produced

  • AC income < VC Income

If Units Sold < Units Produced 

  • AC income > VC income

when we produce more than we sell, under the AC method, which capitalizes any remaining FC to inventory as an asset, income will be higher than VC income.  



Job Order Costing

Job order costing is used to accumulate costs related to the production of large, relatively expensive, heterogeneous (custom-ordered) items. Costing follows the general rules for manufacturing cost flows and is relatively straightforward.  

As with traditional costing methods, estimated amounts based on currently attainable capacity are always used for this formula.  

  • Immaterial differences between the two amounts are usually allocated to COGS.
  • If the difference is material, it should be prorated to WIP, finished goods, and COGSbased on their respective ending balances.


Applied OH

Applied Overhead = (bud. FOH/bud. volume) X (actual volume)


Process Costing

Process costing is used to accumulate costs for mass-produced, continuous, homogeneous items, which are often small and inexpensive.  Job Order Costing is exactly the opposite.

Since costs are not accumulated for individual items, the accounting problem becomes one of tracking the number of units moving through the work-in-process (WIP) into finished goods (FG) and allocating the costs incurred to these units on a rational basis. The cost allocation process is complicated because:

  • There may be partially completed items in beginning and ending inventories.
  • Each of the three factors of production (labor, material, and overhead) may be at different levels of completion, making it necessary to perform separate calculations for each factor.
  • Some costs do not occur uniformly across the process; this is particularly true for direct materials (DMs). This is why the two categories of the factors of production indicated are typically DMs and conversion costs (i.e., direct labor [DL] and overhead [OH]). DL and OH are normally included together because they are typically uniformly incurred.



CGS is called what in Process Costing?

The term "cost of goods transferred out" is often used in process costing rather than the "cost of goods finished" since the units could be transferred through several departments prior to going to FG inventory. Cost of goods finished would only accurately apply to the last department in the sequence.


Which of the following types of budgets is the last budget to be produced during the budgeting process?

  • Cash
  • Capital
  • Cost of Goods Sold
  • Marketing


The cash budget is the last budget to be prepared and includes a plan for earning and financing all of the strategic action plans of the enterprise and other incidental issues earning and requiring cash flow.


Define Static Budget

Budgeted Costs for Budgeted Output

A static budget is a comprehensive financial plan produced at the beginning of the year for the entire enterprise and does not change (or flex) during the year. Thus, it uses budgeted costs based on budgeted output.

The Master Budget is a static budget.