Bus 7800 week 6 absorption costing

Instructor: Mary Haines, MBA, CPA

Absorption Cost
Systems
Chapter Nine
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

 Manufacturing settings
◦ Product costs: costs of goods manufactured
◦ Period costs: nonmanufacturing costs
◦ Costs must be allocated between COGS and ending
inventory.
 Nonmanufacturing settings (merchandiser & service)
◦ Product costs: costs of inventory held for resale
◦ Period costs: all other costs
◦ Most product costs for physical goods are directly traced to
external contacts and do not require cost allocation
9-3

 Absorption cost systems ensure that ALL
manufacturing costs are assigned to products
either by direct tracing or by cost allocation.
1. Process costing – used by companies that
produce identical items or continuous flow
production on assembly lines (candy bars, soft
drinks, and Clorox)
2. Job order costing used by companies that
produce custom, distinct products in batches (jet
plane, office building, and custom artwork). A batch
can be “1.”
 In practice, many plants use hybrids of job order
and process costing.
9-4

Which of the following companies would be
likely to use job-order costing rather than
process costing?
a. Scott Paper Company for Kleenex
b. Architects
c. Heinz for ketchup
d. Caterer for a wedding reception
e. Builder of commercial fishing vessels

 Production process is a continuous flow
 Each process is treated as a separate cost center.
 Costs are averaged over large number of
production units that are assumed to be
essentially identical.
 Decision making usefulness is reduced because
costs for individual batches are not available.
 Process costing details in chapter 9, appendix A
9-9

 Both systems assign material, labor and overhead
costs to products and they provide a mechanism
for computing unit product costs.
 Both systems use the same manufacturing
accounts, including Manufacturing Overhead,
Raw Materials, Work in Process, and Finished
Goods.
 The flow of costs through the manufacturing
accounts is basically the same in both systems.

 Process costing is used when a single product is
produced on a continuing basis or for a long period of
time. Job-order costing is used when many different jobs
having different production requirements are worked on
each period.
 Process costing systems accumulate costs by department.
Job-order costing systems accumulated costs by
individual jobs.
 Process costing systems compute unit costs by
department. Job-order costing systems compute unit
costs by job on the job cost sheet.

Process costing is used for products
that are:
a. Different and produced continuously.
b. Similar and produced continuously.
c. Individual units produced to customer
specifications.
d. Purchased from vendors.
Quick Check 

Any unit in an organization where materials, labor
or overhead are added to the product.
The activities performed in a processing
department are performed uniformly on all
units of production. Furthermore, the output of
a processing department must be homogeneous.
Products in a process costing environment
typically flow in a sequence from one department
to another.

Finished
Goods
Cost of
Goods
Sold
Work in
Process
Direct
Materials
Direct Labor
Manufacturing
Overhead

Finished
Goods
Cost of
Goods
Sold
Direct Labor
Manufacturing
Overhead
Jobs
Costs are traced and
applied to individual
jobs in a job-order
cost system.
Direct
Materials

Finished
Goods
Cost of
Goods
Sold
Direct Labor
Manufacturing
Overhead
Processing
Department
Costs are traced and
applied to departments
in a process cost
system.
Direct
Materials

Equivalent units are the product of the number of
partially completed units and the percentage
completion of those units.
We need to calculate equivalent units because a
department usually has some partially completed units
in its beginning and ending inventory. These partially
completed units complicate the determination of a
department’s output for a given period and the unit cost
that should be assigned to that output.

Two half completed products are
equivalent to one complete product.
So, 10,000 units 70% complete
are equivalent to 7,000 complete units.
+ = 1

For the current period, Jones started
15,000 units and completed 10,000 units,
leaving 5,000 units in process 30 percent
complete. How many equivalent units of
production did Jones have for the period?
a. 10,000
b. 11,500
c. 13,500
d. 15,000

For the current period, Jones started
15,000 units and completed 10,000 units,
leaving 5,000 units in process 30 percent
complete. How many equivalent units of
production did Jones have for the period?
a. 10,000
b. 11,500
c. 13,500
d. 15,000
10,000 units + (5,000 units × 0.30)
= 11,500 equivalent units

Equivalent units can be calculated
two ways:
The First-In, First-Out Method – FIFO is
covered in the appendix to this chapter.
The Weighted-Average Method – This method
will be covered in the main portion of the chapter.

The weighted-average method . . .
1. Makes no distinction between work done in prior or
current periods.
2. Blends together units and costs from prior and
current periods.
3. Determines equivalent units of production for a
department by adding together the number of units
transferred out plus the equivalent units in ending
Work in Process Inventory.

Direct labor
costs
may be small
in comparison to
other product
costs in process
cost systems.
Direct
Materials
Type of Product Cost
DollarAmount
Direct
Labor
Manufacturing
Overhead

Type of Product Cost
DollarAmount
Conversion
Direct labor and
manufacturing
overhead may be
combined into
one classification
of product
cost called
conversion costs.
Direct
Materials
Direct
Labor
Direct
Labor
Manufacturing
Overhead

Smith Company reported the following activity in
the Assembly Department for the month of June:
Percent Completed
Units Materials Conversion
Work in process, June 1 300 40% 20%
Units started into production in June 6,000
Units completed and transferred out 5,400
of Department A during June
Work in process, June 30 900 60% 30%

The first step in calculating the equivalent units is to
identify the units completed and transferred out of
Assembly Department in June (5,400 units)
Materials Conversion
Units completed and transferred
out of the Department in June 5,400 5,400

The second step is to identify the equivalent units of
production in ending work in process with respect to
materials for the month (540 units) and adding this to the
5,400 units from step one.
Work in process, June 30:
900 units × 60% 540
Equivalent units of Production in
the Department during June 5,940

900 units × 60% 540
900 units × 30% 270
the Department during June 5,940 5,670
The third step is to identify the equivalent units of production in
ending work in process with respect to conversion for the month
(270 units) and adding this to the 5,400 units from step one.

900 units × 60% 540
900 units × 30% 270
the Department during June 5,940 5,670
Equivalent units of production always equals:
+ Equivalent units remaining in work in
process

Beginning
Work in Process
300 Units
40% Complete
Ending
Work in Process
900 Units
60% Complete
6,000 Units Started
5,400 Units Completed
5,100 Units Started
and Completed
Materials
540 Equivalent Units 900 × 60%
5,940 Equivalent units
of production

6,000 Units Started
5,100 Units Started
and Completed
270 Equivalent Units
900 × 30%
5,670 Equivalent units
of production
Beginning
Work in Process
300 Units
20% Complete
Ending
Work in Process
900 Units
30% Complete
Conversion

Beginning Work in Process Inventory: 400 units
Materials: 40% complete $ 6,119
Conversion: 20% complete $ 3,920
Production started during June 6,000 units
Production completed during June 5,400 units
Costs added to production in June
Materials cost $ 118,621
Conversion cost $ 81,130
Ending Work in Process Inventory: 900 units
Materials: 60% complete
Conversion: 30% complete

The formula for computing the cost per
equivalent unit is:
Cost per
equivalent
unit
=
Cost of beginning
Work in Process
Inventory
Cost added during
the period
Equivalent units of production
+

Here is a schedule with the cost and equivalent
unit information.
Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, June 1 10,039$ 6,119$ 3,920$
Cost added in Assembly 199,751 118,621 81,130
Total cost 209,790$ 124,740$ 85,050$
Equivalent units 5,940 5,670

Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, June 1 10,039$ 6,119$ 3,920$
Cost added in Assembly 199,751 118,621 81,130
Total cost 209,790$ 124,740$ 85,050$
Equivalent units 5,940 5,670
Cost per equivalent unit 21.00$ 15.00$
Here is a schedule with the cost and equivalent
unit information.
$124,740 ÷ 5,940 units = $21.00 $85,050 ÷ 5,670 units = $15.00
Cost per equivalent unit = $21.00 + $15.00 = $36.00

Materials Conversion Total
Ending WIP inventory:
Equivalent units 540 270
Assembly Department
Cost of Ending WIP Inventory and Units Transferred Out

Assembly Department

Cost of Ending WIP inventory 11,340$ 4,050$ 15,390$
Assembly Department

Units completed and transferred out:
Units transferred 5,400 5,400
Assembly Department

Assembly Department

Cost of units transferred out 113,400$ 81,000$ 194,400$
Assembly Department

Costs to be accounted for:
Cost of beginning Work in Process Inventory 10,039$
Costs added to production during the period 199,751
Total cost to be accounted for 209,790$
Assembly Department
Cost Reconciliation

Costs to be accounted for:
Cost of beginning Work in Process Inventory 10,039$
Costs added to production during the period 199,751
Total cost to be accounted for 209,790$
Cost accounted for as follows:
Cost of ending Work in Process Inventory 15,390$
Cost of units transferred out 194,400
Total cost accounted for 209,790$
Assembly Department
Cost Reconciliation

Operation cost is a hybrid of job-order and
process costing because it possesses
attributes of both approaches
Operation costing is commonly used when
batches of many different products pass
through the same processing department.

The FIFO method (generally considered more
accurate than the weighted-average method)
differs from the weighted-average method in
two ways:
1. The computation of equivalent units.
2. The way in which the costs of
beginning inventory are treated.

 See Figure 9-1 for cost flows in job order cost system.
1. Costs are accumulated in 3 major categories: materials,
labor, and overhead.
2. Direct materials, direct labor, and overhead are assigned to
the work-in-process (WIP) inventory account for each job.
3. When manufacturing is completed, the cost of units
completed is transferred from WIP to the finished goods
inventory.
4. When goods are sold, the costs are transferred from the
finished goods inventory account to the cost of goods sold
expense account.
5. If any amount remains in the overhead account at the end of
the period, it must be allocated to some inventory or
expense account.
9-52

 Inventory cost flow assumptions change the amounts
transferred out of an inventory account when input prices
change over time.
 External importance: financial statements, taxes, cost-based
contracts.
 Internal importance: decision making and decision control.
1. First In, First Out (FIFO): Oldest items are transferred out
first. When prices are rising, FIFO reports higher net income
than LIFO.
2. Last In, Last Out (LIFO): Newest items are transferred out
first. When prices are rising, LIFO reports lower net income
than FIFO.
3. Specific Identification: Each inventory item is individually
priced.
9-53

 BALANCE SHEET:
◦ Raw Materials Inventory
◦ Work in Process (WIP) Inventory
◦ Finished Goods Inventory
 INCOME STATEMENT:
◦ Cost of Goods Sold (COGS)

 1. Work in Process (WIP) Inventory
 2. Finished Goods Inventory
 WIP:
◦ Direct Materials
◦ Direct Labor
◦ MOH (Mfg. Overhead)

Manufacturing
Overhead
Job No. 1
Job No. 2
Job No. 3
Charge direct
material and
direct labor
costs to each
job as work is
performed.
Direct Materials
Direct Labor

Manufacturing
Overhead,
including
indirect
materials and
indirect labor,
are allocated to
all jobs rather
than directly
traced to each
job.
Direct Materials
Direct Labor
Job No. 1
Job No. 2
Job No. 3Manufacturing
Overhead

PearCo Job Cost Sheet
Job Number A - 143 Date Initiated 3-4-09
Date Completed
Department B3 Units Completed
Item Wooden cargo crate
Direct Materials Direct Labor Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours Rate Amount
Cost Summary Units Shipped
Direct Materials Date Number Balance
Direct Labor
Manufacturing Overhead
Total Cost
Unit Product Cost

From the job cost sheet for 1,000
units of toy trucks,
Determine the costs of the job and
balance in the raw materials
account, the WIP account, and the
Finished Goods account on
4/30, 5/31/6/30 and 7/31.
Display Job Cost Sheet

Compute predetermined
overhead rates and explain
why estimated overhead
costs (rather than actual
overhead costs) are used in
the costing process.

• A job is completed, and cost must be summarized
to determine the total cost of the job.
• A job is sold.
• The end of an accounting period makes it
necessary to report the status of all jobs.
• When jobs are completed, amounts are transferred
from WIP inventory to FGI.
• When jobs are sold, balances are transferred from
FGI to CGS. Price minus CGS = Gross Profit

Manufacturing overhead is applied to jobs that are in
process. An allocation base, such as direct labor
hours, direct labor dollars, or machine hours, is used
to assign manufacturing overhead to individual jobs.
We use an allocation base because:
1.It is impossible or difficult to trace overhead costs to
particular jobs.
2.Manufacturing overhead consists of many different items
ranging from the grease used in machines to production
manager’s salary.
3.Many types of manufacturing overhead costs are fixed even
though output fluctuates during the period.

The predetermined overhead rate (POHR) used
to apply overhead to jobs is determined before
the period begins.
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
POHR =
Ideally, the allocation base
is a cost driver that causes
overhead.

Using a predetermined rate makes it
possible to estimate total job costs sooner.
Actual overhead for the period is not
known until the end of the period.

Calculated using a three-step process.

Estimate the level of
production for the
period.

Estimate total amount
of the allocation base
for the period.

Estimate total
manufacturing
overhead costs.
POHR =  ÷ 

Actual amount of allocation is
based upon the actual level of
activity (normal costing system).
Based on estimates, and
determined before the
period begins.
Overhead applied = POHR × Actual activity

For each direct labor hour worked on a particular job,
$4.00 of factory overhead will be applied to that job.
POHR = $4.00 per DLH
$640,000
160,000 direct labor hours (DLH)
POHR =
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
POHR =

The average unit cost should not be interpreted
as the costs that would actually be incurred if an
additional unit was produced.
Fixed overhead would not change if another unit
was produced, so the incremental cost of
another unit is something less than $118.

Job WR53 at NW Fab, Inc. required $200 of
direct materials and 10 direct labor hours at
$15 per hour. Estimated total overhead for the
year was $760,000 and estimated direct labor
hours were 20,000. What would be recorded as
the cost of job WR53?
a. $200.
b. $350.
c. $380.
d. $730.

Job WR53 at NW Fab, Inc. required $200 of
direct materials and 10 direct labor hours at
$15 per hour. Estimated total overhead for the
year was $760,000 and estimated direct labor
hours were 20,000. What would be recorded as
the cost of job WR53?
a. $200.
b. $350.
c. $380.
d. $730.
POHR = $760,000/20,000 hours $38
Direct materials $200
Direct labor $15 x 10 hours $150
Manufacturing overhead $38 x 10 hours $380
Total cost $730

 Actual overhead incurred for a year is the
amount of indirect manufacturing costs
incurred during the year.
 Absorbed overhead (also known as applied
overhead) is the amount of overhead applied to
WIP during the year using a predetermined OH
rate and the actual amount of inputs used.
 Under-absorbed overhead exists when actual >
absorbed overhead.
 Over-absorbed overhead exists when actual <
absorbed overhead.
9-78

Rick’s Bags manufactures golf bags and tennis totes.
BUDGET:
Variable Mfg. Overhead = $1.10 per Direct Labor Hour
Fixed Mfg. Overhead = $187,200.
Fixed selling & administration = $346,000.
Direct Labor Hours: Golf Bags (2.5 hrs) & Tennis Totes (1.8 hrs)
Production: Golf Bags (12,000) & Tennis Totes (18,000)
ACTUAL:
Direct Labor Hours: Golf Bags (34,060) & Tennis Totes (16,250)
Manufacturing overhead = $207,500.
Overhead is absorbed into products using actual direct labor hours.
a. Calculate MOH rate used to absorb overhead to golf bags & totes.
b. A batch of tennis totes is produced in May. The batch uses 1,900 DL
Hours. How much overhead is charged to this batch of tennis totes?
c. Calculate the amount of over/underabsorbed overhead at year end.
d. What does the over/under-absorbed overhead calculated in part c mean?

The difference between the overhead cost applied to
Work in Process and the actual overhead costs of a
period is referred to as either underapplied or
overapplied overhead.
Underapplied overhead
exists when the amount of
overhead applied to jobs
during the period using
the predetermined
overhead rate is less than
the total amount of
overhead actually incurred
during the period.
Overapplied overhead
exists when the amount of
overhead applied to jobs
during the period using
the predetermined
overhead rate is greater
than the total amount of
overhead actually incurred
during the period.

PearCo’s actual overhead for the year was $650,000 with a
total of 170,000 direct labor hours
worked on jobs.
How much total overhead was applied to PearCo’s jobs
during the year? Use PearCo’s predetermined overhead
rate of $4.00 per direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000

PearCo’s actual overhead for the year was $650,000 with a
total of 170,000 direct labor hours worked on jobs.
How much total overhead was applied to PearCo’s jobs
during the year? Use PearCo’s predetermined overhead
rate of $4.00 per direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
PearCo has overapplied
overhead for the year
by $30,000. What will
PearCo do?

Tiger, Inc. had actual manufacturing overhead
costs of $1,210,000 and a predetermined
overhead rate of $4.00 per machine hour.
Tiger, Inc. worked 290,000 machine hours
during the period. Tiger’s manufacturing
overhead is
a. $50,000 overapplied.
b. $50,000 underapplied.
c. $60,000 overapplied.
d. $60,000 underapplied.

Tiger, Inc. had actual manufacturing overhead
costs of $1,210,000 and a predetermined
overhead rate of $4.00 per machine hour. Tiger,
Inc. worked 290,000 machine hours during the
period. Tiger’s manufacturing overhead is
a. $50,000 overapplied.
b. $50,000 underapplied.
c. $60,000 overapplied.
d. $60,000 underapplied.
Overhead Applied
$4.00 per hour × 290,000 hours
= $1,160,000
Underapplied Overhead
$1,210,000 - $1,160,000
= $50,000

 Overhead accounts must be cleared of
over/underabsorbed overhead at the end of the year.
1. Write off all to cost of goods sold expense account.
Simplest bookkeeping procedure
2. Allocate among WIP and finished goods inventory,
and cost of goods sold expense account.
Better if ending inventory levels are significant
3. Recalculate job costs with actual overhead rates.
Most complex data processing
9-87

$30,000 may be
closed directly to
cost of goods sold.
Cost of
Goods Sold
PearCo’s Method
Work in
Process
Finished
Goods
Cost of
Goods Sold
$30,000
may be allocated
to these accounts.
OR

Assume the overhead applied in ending Work in
Process Inventory, ending Finished Goods
Inventory, and Cost of Goods Sold is shown below:
Amount
Percent of
Total
Allocation
of $30,000
Work in process 68,000$ 10% 3,000$
Finished Goods 204,000 30% 9,000
Cost of Goods Sold 408,000 60% 18,000
Total 680,000$ 100% 30,000$

Amount
Percent of
Total
Allocation
of $30,000
Work in process 68,000$ 10% 3,000$
Total 680,000$ 100% 30,000$
We would complete the following allocation of
$30,000 overapplied overhead:
10% × $30,000

Amount
Percent of
Total
Allocation of
$30,000
Work in process 68,000$ 10% 3,000$
Total 680,000$ 100% 30,000$

Alternative 1 Alternative 2
If Manufacturing Close to Cost
Overhead is . . . of Goods Sold Allocation
UNDERAPPLIED INCREASE INCREASE
Cost of Goods Sold Work in Process
(Applied OH is less Finished Goods
than actual OH) Cost of Goods Sold
OVERAPPLIED DECREASE DECREASE
Cost of Goods Sold Work in Process
(Applied OH is greater Finished Goods
than actual OH) Cost of Goods Sold
PearCo’s
Method
More accurate but more complex to compute.

What effect will the overapplied overhead
have on PearCo’s net operating income?
a. Net operating income will increase.
b. Net operating income will be
unaffected.
c. Net operating income will decrease.

May be more complex
but . . .
To this point, we have assumed that there is a
single predetermined overhead rate called a
plantwide overhead rate.
Large companies
often use multiple
predetermined
overhead rates.
May be more accurate because
it reflects differences across
departments.

 Expected volume: Volume expected for the coming year.
◦ Decision control: enhanced because transfer prices are adjusted
for changing volume
◦ Decision management: impaired because lower volume raises
overhead rate, and encourages profit centers to raise prices
 Normal volume: Long-run average volume over economic
cycle.
◦ Decision control: impaired because managers are not held
responsible for short-run volume fluctuations
◦ Decision management: better long-run opportunity cost
estimates result in better pricing decisions
◦ Opportunity to manage earnings: setting normal volume is more
subjective than expected volume
9-96

 How should overhead rate estimates respond
to volume changes?
 Permanent volume changes:
◦ Write off assets or change estimated useful lives of
assets.
◦ Managers may be reluctant to admit that their prior
projections need to be adjusted.
 Temporary volume changes:
◦ Assumed to average out over economic cycles
◦ No accounting changes should be made.
9-97

 Choices of overhead cost allocation disaggregation:
 1. Single overhead cost pool for entire plant:
◦ Easiest to apply, but accounting costs may be very
inaccurate representations of opportunity costs.
 2. Many cost pools each with its own cost driver:
◦ More data processing, but more accurate costing
 3. Two-stage allocation of departmental overhead
rates
◦ Allocate to departments, and then to products.
9-98

 If the overhead rates contain large amounts of
fixed historical costs, such as depreciation,
then neither plantwide rates nor individual
department rates accurately reflect the
opportunity cost of capacity.
9-99

Bus 7800 week 6 absorption costing

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