Defi ne product unit cost, Direct materials costs are the costs of materials used in making a product that and compute the unit

LO 4 Defi ne product unit cost, Direct materials costs are the costs of materials used in making a product that and compute the unit

can be conveniently and economically traced to specific product units. Direct cost of a product or

labor costs include all labor costs needed to make a product or service that can service.

be traced to specific product units. All other production-related costs are classi-

CHAPTER 16 Cost Concepts and Cost Allocation When a batch of products has been completed, the product unit cost is com-

puted by dividing the total cost of direct materials, direct labor, and overhead by the total number of units produced. The product unit cost can be calculated using the actual, normal, or standard costing method. Under actual costing, the actual costs of direct materials, direct labor, and overhead are used to compare the product unit cost. Under normal costing, the actual costs of direct materi- als and direct labor are combined with the estimated cost of overhead to deter- mine the product unit cost. Under standard costing, the estimated costs of direct materials, direct labor, and overhead are used to calculate the product unit cost. The components of product cost may be classified as prime costs or conversion costs. Prime costs are the primary costs of production; they are the sum of direct materials costs and direct labor costs. Conversion costs are the costs of converting direct materials into finished products; they are the sum of direct labor costs and overhead costs.

Because no products are manufactured in the course of providing services, service organizations have no materials costs. They do, however, have both direct labor costs and overhead costs, which are similar to those in manufacturing orga- nizations. To determine the cost of performing a service, professional labor and service-related overhead costs are included in the analysis.

LO 5 Defi ne cost allocation,

Cost allocation is the process of assigning collected indirect costs to a specific cost and explain how the

object using an allocation base known as a cost driver. The allocation of overhead traditional method of

costs requires the pooling of overhead costs that are affected by a common activ- allocating overhead

ity and the selection of a cost driver whose activity level causes a change in the costs fi gures into

cost pool. A cost pool is the collection of overhead costs assigned to a cost object. calculating product

A cost driver is an activity base that causes the cost pool to increase in amount as or service unit cost.

the cost driver increases.

Allocating overhead is a four-step process that involves planning a rate at which overhead costs will be assigned to products or services, assigning over- head costs at this predetermined rate to products or services during production, recording actual overhead costs as they are incurred, and reconciling the difference between the actual and applied overhead costs. The Cost of Goods Sold or Cost of Sales account is corrected for an amount of over- or underapplied overhead costs assigned to the products or services. In manufacturing companies, if the differ- ence is material, adjustments are made to the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts.

The traditional method applies overhead costs to a product or service by esti- mating one predetermined overhead rate and multiplying that rate by the actual cost driver level. The product or service unit cost is computed either by dividing the total product or service cost (the sum of the total applied overhead cost and the actual costs of direct materials and direct labor) by the total number of units produced or by determining the cost per unit for each element of the product’s or service’s cost and summing those per unit costs.

When ABC is used, overhead costs are grouped into a number of cost pools related to specific activities. For each activity pool, cost drivers are identified, and cost driver levels are estimated. Each activity cost rate is calculated by dividing the estimated activity pool amount by the estimated cost driver level. Overhead, which is divided into the activity pools, is applied to the product or service by

Stop & Review

REVIEW of Concepts and Terminology

The following concepts and terms Finished Goods Inventory Predetermined overhead were introduced in this chapter:

rate 779 (LO5) Activity-based costing

account 770 (LO3)

Prime costs 775 (LO4) (ABC) 783 (LO5)

Fixed cost 764 (LO1)

Product costs 764 (LO1) Actual costing 776 (LO4)

Indirect costs 763 (LO1)

Product unit cost 775 (LO4) Conversion costs 775 (LO4)

Indirect labor costs 774 (LO4)

Standard costing 777 (LO4) Cost allocation 779 (LO5)

Indirect materials costs 774 (LO4)

Statement of cost of goods Cost driver 779 (LO5)

Manufacturing cost flow 772 (LO3)

manufactured 767 (LO2)

Materials Inventory account

Cost object 779 (LO5)

Total manufacturing costs 773 (LO3) Cost of goods

770 (LO3)

Underapplied overhead manufactured 773 (LO3)

Nonvalue-adding cost 764 (LO1)

costs 781 (LO5)

Normal costing 777

(LO4)

Cost pool 779 (LO5) Value-adding cost 764 (LO1)

Overapplied overhead

Direct costs 763 (LO1)

Variable cost 764 (LO1) Direct labor costs 774 (LO4)

costs 781 (LO5)

Overhead costs 774 (LO4)

Work in Process Inventory account 770 (LO3)

Direct materials costs 774 (LO4)

Period costs 765 (LO1)

CHAPTER 16 Cost Concepts and Cost Allocation