In Chapter 3, you were introduced to 3 types of costs associated with a manufactured product ? direct materials, direct labor, and manufacturing overhead. Explain how these costs are associated with the manufactured product. Why are some of these costs allocated to the product through costing methods such as job order costing or process costing? As part of your response, be sure to provide a specific example of a company?s manufacturing costs.

chapter 3 Product Costing: Attaching Costs to Products and Services Chris Cheadle / All Canada Photos / SuperStock Learning Objectives After studying Chapter 3, you will be able to: Understand why and how costs are attached to products and services. Describe how direct materials, direct labor, and factory overhead are costed to products. Explain why predetermined overhead rates are usually used for product costing. Calculate plant-wide and departmental factory overhead rates. Identify the main differences among alternative measures for the denominator in the overhead rate. Explain why services or products should be costed for pricing purposes by using an overhead rate computed at normal volume levels. Describe how to allocate service center costs so that they can be included in overhead rates of operating departments. sch80342_03_c03_099-142.indd 99 12/20/12 11:52 AM CHAPTER 3 Chapter Outline Chapter Outline 3.1 Costing of Products And Services 3.2 Costing of Direct Costs Costing of Direct Materials Costing of Direct Labor 3.3 Costing Factory Overhead Predetermined Overhead Rate Disposition of The Overhead Variance Multiple Overhead Rates Alternative Concepts of Volume 3.4 Cost of Providing Services 3.5 A Product Costing Illustration 3.6 Service Center Costs Direct Method Step (Sequential) Method Reciprocal Method Treatment of Revenues Allocation of Costs By Behavior 3.7 Ethical Issues For Cost Allocation What is the Cost of a Brake Job? As a high school wrestling coach working in Florida, Greg Herman satisfied his love for automobiles by working as an auto mechanic during the summer months. He also found himself occasionally repairing friends' cars year-round. Demand for his repair expertise began to boom, so Greg used his savings as seed money for a new business, Greg's Auto Repair. Greg started his enterprise with a firm hope of making a profit, and he has realized profits. However, times are changing. Revenues for this year have reached over $2 million and are expected to increase in the future. Costs are, on the other hand, increasing faster than revenues. Greg does not know what his profit margins are for brake jobs, mufflers, and body work because he has no idea what it costs him to make repairs. Most of his accounting has been a \"shoebox approach,\" in which receipts, deposit slips, and invoices go into a box. Periodically, a local CPA firm, Ginsburg & Arogeti, sends a staff accountant to sort the box's contents and prepare financial statements. Greg needs cost information about repairs, and his accounting system does not provide it. For example, he needs to know: What does it cost to make one repair of each type? Are repair costs higher this month than last month? With profits going down, which jobs are losing profit margin? And, behind all of these questions is: How should sch80342_03_c03_099-142.indd 100 12/20/12 11:52 AM Section 3.1 Costing of Products and Services CHAPTER 3 overhead costs be assigned to jobs? Greg needs an accounting system that will provide cost information for his current needs and for the future. Introduction Costs are used to accomplish an assortment of needs: to evaluate the profitability of goods and services, to aid in pricing and bidding decisions, to plan and budget operations, to evaluate performance, to control costs, and to establish inventory values for the balance sheet and cost of goods and services sold for the income statement. This chapter discusses accounting for production costs and presents ways to identify costs with products. Accounting for direct materials and direct labor comes first. Then, accounting for factory overhead covers simple to more complex situations. Finally, we discuss how service center costs are included in product cost. 3.1 Costing of Products and Services T he production of goods and services involves resources. As mentioned in Chapter 1, the costs of these resources are typically classified as materials, labor, and factory overhead. The costs are accumulated by jobs or by departments. Then they are assigned to each unit of output (product or service) based on each unit's use of the resources. These relationships for assigning costs to products or services are depicted in Figure 3.1. Figure 3.1 A view of cost linkage Resources (Costs) Activities (Departments or Jobs) Outputs (Products or Services) The principles underlying product costing are applicable to manufacturing companies and service organizations. For example, a hospital may be interested in determining the cost of a specific medical treatment or the cost of outpatient care. A furniture store may wish to know the costs associated with carrying and selling a particular line of sofas. A building contractor, on the other hand, will accumulate costs by project. If a contractor is constructing a new bridge for the state, for instance, the contractor will identify and trace the costs to the bridge project. A university may be interested in the estimation, measurement, and control of a program to train mathematics teachers. A museum may want to determine the cost of a particular exhibit for a season. Regardless of the type of organization, costs are identified as direct costs when they can be readily connected to a cost objective. Indirect costs, which cannot as easily be connected to an objective, must be allocated using some reasonable basis for allocation. Because the principles used in tracing costs are more clearly identified in a manufacturing setting, manufacturing cost methods are often adapted to a wide variety of applications. We can categorize a manufacturing process as yielding commingled products, fabricated products, or assembled products. Commingled products exist when one unit cannot be distinguished from any other unit. One pound of sugar is indistinguishable from another sch80342_03_c03_099-142.indd 101 12/20/12 11:52 AM Section 3.2 Costing of Direct Costs CHAPTER 3 pound unless contained in some way. Products in this category include flour, oil, electricity, soft drinks, textiles, processed foods, and paper. Fabricated products involve reshaping materials through a cutting, stamping, or molding operation. Examples include tires, nuts and bolts, sugar-coated breakfast cereals, and silverware. Assembled products bring parts and subassemblies together for an assembly operation. Each product passes through the same assembly operations. Examples include kitchen appliances, calculators, computers, telephones, and pickup trucks. 3.2 Costing of Direct Costs W e now discuss how to determine the costs that are directly traceable to products or jobs. These costs consist of direct materials and direct labor. Costing of Direct Materials Materials include the raw materials, purchased parts, and purchased or subcontracted assemblies and subassemblies. Direct materials are those that are identified with the production of a specific product and are easily and economically traced to the product; their costs represent a significant part of the total product cost. All other materials and supplies that become part of a product or are consumed in production are called indirect materials, which are part of factory overhead. The costs associated with acquiring materials and having them ready for production typically fall into five categories: 1. 2. 3. 4. 5. The acquisition cost (purchase price or production cost) of the materials. In-transit charges, such as freight, insurance, storage, customs and duty charges. Credits for trade discounts, cash discounts, and other discounts and allowances. The costs of purchasing, receiving, inspecting, and storing activities. Miscellaneous items, including income from the sale of scrap and spoiled units, obsolescence, and other inventory losses. Categories 1 through 3 are typically included in the cost of materials, whether direct or indirect materials. Categories 4 and 5 are treated as factory overhead. We allocate those costs to products with one of the several approaches that will be discussed later in the chapter. The document that lists all materials needed to produce one unit of each product is the bill of materials, generated by product design engineers. It lists the sequence in which the materials will enter production. Once a decision is made about the quantity of products to produce, the bill of materials is used to determine the amount of materials to be acquired. Suppose that Julz Enterprises, a manufacturer of CD players, purchased materials on account for $75,000. Upon receipt of the materials, we increase Materials and Accounts Payable by $75,000 as follows: sch80342_03_c03_099-142.indd 102 12/20/12 11:52 AM CHAPTER 3 Section 3.2 Costing of Direct Costs Materials Accounts payable 75,000 75,000 Production managers requisition from the storeroom the materials required for a specific job or product. Thus, each requisition becomes the basis for charging the cost of materials to a specific job or product. Assume that a month's requisitions at Julz Enterprises show that direct materials costing $60,000 have been transferred from the materials inventory to production. The total of $60,000 is moved from Materials to Work in Process. The latter account is a focal account for the entry of production costs. The costs of the three cost elementsdirect materials, direct labor, and factory overheadare funneled through this account, as will be shown later. It is, therefore, the control account for all in-process activity. The movement of materials used in production for the month is shown as: Materials 75,000 Work in process 60,000 60,000 The costs included in the $60,000 are also charged to the various processing departments or jobs that used the materials. These itemizations form the subsidiary ledger for the Work in Process control account. Costing of Direct Labor Factory labor is the total labor cost expended for the benefit of production. Direct labor can be specifically identified with a product in an economically feasible manner. Indirect labor is not readily traced to a product. Because of the changes in the production environment in many companies and the emphasis on a just-in-time philosophy, a new term, value-added direct labor, is being used. Value-added direct labor changes materials into a finished product. For example, value-added direct labor fabricates parts, assembles products, and finishes products. Nonvalue-added direct labor moves, inspects, stores, examines, or otherwise handles the product without adding value to the product. For our purposes, we will generally define direct labor as value added and indirect labor as nonvalue added, even though the differences are not always clear. Labor-related costs include the wages and salaries of the employees plus any additional expenditures made by an employer on behalf of an employee. These typically include bonuses, overtime premiums (i.e., the additional wages for overtime), shift differentials, idle time, employer's payroll taxes, and fringe benefits. These additional expenditures are usually treated as part of the factory overhead costs. Some of these expenditures cannot easily be traced to individual production orders. Others, such as overtime premiums and sch80342_03_c03_099-142.indd 103 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead shift differentials, are treated as factory overhead, so those products worked on during overtime hours or late shifts are not unfairly penalized. Labor time tickets or labor time reports will show how much of the labor time and cost is charged to each job or production order. For the sake of simplicity, we will assume that all of Julz Enterprises' labor is direct labor. Periodically, factory payroll is recorded by a debit to Work in Process, with offsetting credits to Wages Payable, Employees Income Tax Payable, and other liability accounts for payroll deductions. Suppose that during one month, the labor costs for Julz Enterprises were $10,000 and the workers' take-home pay totaled $7,400. The resulting transaction is shown: Work in process 60,000 Wages payable 7,400 10,000 Other labor related payables 2,600 3.3 Costing Factory Overhead F actory overhead, unlike direct materials and direct labor, cannot be requisitioned or measured directly as a cost of any particular job, production order, or service. Factory overhead consists of a variety of costs, such as indirect materials, indirect labor, insurance, depreciation, utilities, repair, and maintenanceall of which are indirectly related to the products. The indirect nature of overhead costs with respect to the products or services creates a difficulty in identifying production costs with each unit. For our purposes at this point, we take an overall, simplified approach to costing of factory overhead to products. This is to convey the concepts involved. Later in the chapter, we explain overhead costs by employing departmental rates. In Chapter 5, we extend the discussion to include activitybased costing. For the discussion that follows, factory overhead is attached to products or services by means of a cost driver that links costs to products. The cost driver chosen as a basis for overhead allocation should be related logically to both the overhead and the product. If machinery plays an important role in the manufacturing operation, the overhead costs likely consist of power cost, lubrication, maintenance, repairs, depreciation, and other costs closely related to machine operation. The benefits received by the products can probably be best measured against the cost of the machine hours used in their production. Therefore, these overhead costs should be allocated to the products on the basis of machine hours used to produce the products. For other plants whose operations are more labor intensive than capital intensive, direct labor cost or direct labor hours may be more appropriate for overhead allocation. The most common cost drivers chosen for overhead allocation are direct labor hours and direct labor cost. sch80342_03_c03_099-142.indd 104 12/20/12 11:52 AM Section 3.3 Costing Factory Overhead CHAPTER 3 Contemporary Practice 3.1 Overhead Cost Drivers in the UK A survey of manufacturing companies in the United Kingdom reports that 23.9 percent of them allocate overhead costs based on direct labor, while 22.5 percent use machine hours to allocate overhead costs to products. Other companies use cost drivers such as materials cost, units produced, and production time (Brierly, Cowton, & Drury, 2001). The total cost driver activity for the plant is divided into the total overhead cost to obtain an overhead rate. Products then are assigned overhead cost by multiplying the actual quantities of the activity by the rate calculated. Suppose that Julz Enterprises uses direct labor cost to allocate overhead. During the month in the earlier example, for which direct labor cost was $10,000, the total overhead for the plant was $15,000. Consequently, the overhead rate would be 150 percent of direct labor cost. During that month, the direct labor cost incurred to produce CD players amounted to $2,700. Hence, $4,050 ($2,700 x 1.5) of overhead cost would be allocated to the CD players. Predetermined Overhead Rate Thus far, we have discussed actual costing, where the product costs consist of actual direct materials used, actual direct labor cost, and overhead allocation based on total actual overhead costs and total actual activity. Most companies, however, use a normal cost system or a standard cost system. The latter will be covered in Chapter 7. Normal costing differs from actual costing in that overhead is allocated using a predetermined overhead rate, defined as: Predetermined overhead rate 5 Budgeted factory overhead 4 Budgeted cost driver activity With normal costing, the applied factory overhead would be determined by multiplying the predetermined overhead rate by the actual cost driver activity for the job or product. Typically, companies use a one-year time horizon to calculate predetermined overhead rates. Two major reasons exist for the use of normal costing rather than actual costing. The first is the timing of factory overhead cost incurrence. For example, air conditioning costs in the summer for many companies in the sunbelt tend to be higher than heating costs are in the winter. Should we allocate the higher air conditioning costs to products that were manufactured during the summer? The facilities and workers must be maintained regardless of the weather. In addition, discretionary costs may fluctuate widely from month to month. For instance, managers may decide to incur substantial maintenance costs during some months and very little during other months. Because of seasonal and discretionary aspects of overhead, a more stable overhead rate requires a longer time horizon, such as one year. sch80342_03_c03_099-142.indd 105 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead The second reason for the use of normal costing is the potential fluctuation in the activity represented by the cost driver. Most companies do not have a constant level of activity every month. For example, employees take vacations during the summer months, operations are scaled back to accommodate major repairs and maintenance, production ceases while a changeover in tooling occurs, or the company is closed for the week between Christmas and New Year's Day. Normal costing, by using a one-year time horizon for the overhead rate, averages costs over the units of work regardless of when work is performed. Therefore, a product is not penalized because it is produced during a period of low volume. Calculating an actual overhead rate using a one-year time horizon, prices, and other costbased decisions could not be done until the end of the year. Clearly, companies cannot operate this way. The use of a predetermined overhead rate allows costs of products and jobs to be calculated throughout the year as necessary. Moreover, a predetermined overhead rate helps managers to prepare bids on major orders or to price business from prospective customers. To illustrate the application of overhead in a normal cost system, suppose that, for 2013, Bodker Publishing Company has budgeted $50,000 for fixed overhead costs and $3 per direct labor hour for variable overhead costs. This is its overhead cost function. These budgeted costs correspond to a budget activity of 10,000 direct labor hours. The predetermined overhead rate would be computed as: [$50,000 1 $3(10,000)] 4 10,000 5 $8 per direct labor hour Assume there were 10,000 direct labor hours worked, at a rate of $10 per hour, during 2013. Assume also that $95,000 of direct materials were used. During production, various entries were made to cost the individual jobs. We could quite literally add $8 to Work in Process every time one more hour of direct labor is worked. In normal accounting activity, these transfers to Work in Process are done periodically, perhaps weekly or monthly. If done in aggregate, a summary transfer to Work in Process of all overhead applied to all jobs would show the following: Factory overhead 80,000 Work in process 95,000 100,000 80,000 As each job goes through production, an overhead charge at the predetermined rate of $8 for each direct labor hour is made to the job. Suppose Bodker Publishing Company published an economics textbook (Job 1018) that required $20,000 of direct materials and 2,000 hours of direct labor at $10 per hour. The completed cost for Job 1018 can be summarized as: sch80342_03_c03_099-142.indd 106 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead Direct materials $20,000 Direct labor (2,000 hours at $10 per direct labor hour) 20,000 Factory overhead (2,000 hours at $8 per direct labor hour) 16,000 Total cost $56,000 At its completion, the cost of a job is transferred from Work in Process to Finished Goods. For Job 1018, the transfer would be: Finished goods Work in process 95,000 56,000 56,000 100,000 80,000 Disposition of the Overhead Variance While the products are costed using a predetermined overhead rate and by crediting the Factory Overhead account, actual overhead costs are incurred and recorded as debits to Factory Overhead. Suppose Bodker Publishing Company incurred actual overhead costs amounting to $81,500 during 2010. These costs included depreciation of $11,500, expired insurance of $10,000, salaries of $40,000, and utilities of $20,000. The entries to record these actual costs are: Factory overhead 81,500 80,000 Prepaid insurance 10,000 Accumulated depreciation 11,500 Wages payable 40,000 Utilities payable 20,000 Notice that expense accounts were not debited because the above items represent product costs rather than period costs, as discussed in Chapter 1. Nonmanufacturing, or selling and administration, costs would be debited to expense accounts. Suppose Bodker Publishing Company had selling expenses of $29,000, office rent of $45,000, executive salaries of $320,000, and office utilities of $33,000. The following entries would be recorded: sch80342_03_c03_099-142.indd 107 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead Selling expenses Accounts payable 29,000 29,000 Office rent expense Rent payable 45,000 45,000 Salaries expense Wages payable 40,000 320,000 320,000 Office utilities expense Utilities payable 20,000 33,000 33,000 Since only $80,000 of factory overhead was applied during 2013, the total actual factory overhead spent was not charged to jobs. The difference, or variance, of $1,500 can be closed to Cost of Goods Sold at the end of the year, or, if desired, can be allocated to Cost of Goods Sold, Finished Goods, and Work in Process on the basis of their account balances. Since these variances tend to be relatively small, most companies simply close them out to Cost of Goods Sold. Using this approach, Bodker Publishing's entry to close out the variance is: Factory overhead 81,500 80,000 Cost of goods sold 1,500 1,500 Notice that since we did not attach all $81,500 of spending to our production, Cost of Goods Sold is increased by $1,500. If too little overhead is costed to the products, as in the above example, the variance is called underapplied or underabsorbed overhead. When this occurs, expenditures for overhead expenses exceed the amount attached to the products during the accounting period. On the other hand, if too much overhead is costed to the products, the variance is called overapplied or overabsorbed overhead. In this situation, more overhead costs are attached to the period's output than are actually spent for overhead. Underapplied factory overhead means nothing more than the actual costs were not absorbed by the products manufactured. Underapplied overhead occurs in these situations: sch80342_03_c03_099-142.indd 108 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead 1. We produced less than expected, or 2. We spent more than expected. When overhead is overapplied, the variance is credited to (i.e., subtracted from) Cost of Goods Sold. Overapplied overhead occurs in these situations: 1. We produced more than expected, or 2. We spent less than expected. In the Bodker Publishing Company example, 10,000 direct labor hours were worked. This was exactly the amount of activity that was budgeted. Therefore, the reason for the underapplied overhead variance was overspending. According to the company's cost function ($50,000 1 $3 per direct labor hour), spending should have been $80,000 but was actually $81,500. More detailed reasons for overhead variances are discussed in Chapter 7. Multiple Overhead Rates Some reasonable, causal, or beneficial relationship should exist among the costs accumulated in factory overhead accounts, the cost driver selected, and the products or services to which the costs will be allocated. Simply stated: The activity (as represented by the cost driver) is the link between the output of products or services and factory overhead spending. The implication is that more output requires more activity and, therefore, more overhead spending. For example, if a company uses direct labor hours as a cost driver, factory overhead costs should consist primarily or exclusively of costs that support direct workers. Such costs may include supervision and facilities for work places, as well as travel, training, and fringe benefits of workers. In the examples up to this point in the chapter, we have assumed that only one cost driver is appropriate for the total factory overhead. However, diversity of products and services will often result in distorted cost allocations when only one cost driver is used. The greater the differences in products, the greater the diversity that exists in the operations. The more diverse the operations, the more likely it is that one cost driver cannot assign costs to all products fairly. In these situations, departmental overhead rates will assign costs more accurately to products than will one plant-wide overhead rate. A plant-wide factory overhead rate can only be justified for a company making few and similar products. For an example, consider Fellman & Associates, a company that finishes furniture for local manufacturers. The furniture passes through two major activity centers that form the two departments in the process: sanding and painting. A summary of direct labor and overhead costs for each department during the last month follows: Direct labor Overhead sch80342_03_c03_099-142.indd 109 Sanding $ 37,000 Painting $ 26,500 Total $ 63,500 74,000 79,500 153,500 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead Overhead is allocated to products on the basis of direct labor dollars. Dividing the overhead costs by direct labor dollars gives the following departmental and plant-wide overhead rates: Sanding ($74,000 4 $37,000) 5 200% Painting ($79,500 4 $26,500) 5 300% Plant-wide ($153,500 4 $63,500) 5 241.7% Using the different rates in allocating overhead costs to a job that has $86 of Sanding direct labor and $32 of Painting direct labor (i.e., a total labor cost of $118) gives the following amounts: Plant-wide overhead rate ($118 x 241.7%) $285.21 Departmental overhead rates: Sanding ($86 x 200%) $172.00 Painting ($32 x 300%) 96.00 $268.00 The departmental rates allocate costs considering the characteristics of the product or job involved. The plant-wide rate averages all products and jobs. For Fellman & Associates, the same cost driver was selected for each department. A more common situation is where departments have different cost drivers. For example, a Fabrication Department may use direct labor hours; a Machining Department, machine time; a Production Engineering Department, direct labor cost. As a company considers ways to trace costs to products more accurately, it will look at the production and support activities more closely and choose an appropriate cost driver to allocate the overhead costs. Alternative Concepts of Volume When selecting the denominator for the overhead rate, volume can be measured in one of four ways: 1. 2. 3. 4. Ideal capacity. Practical capacity. Expected volume. Normal volume. Ideal capacity is the maximum amount of product that can be manufactured or the maximum service that can be rendered with available facilities. This is often too perfect a goal to be realized, and is generally recognized to be beyond realistic expectations. Certain interruptions and inefficiencies in production are to be expected. sch80342_03_c03_099-142.indd 110 12/20/12 11:52 AM CHAPTER 3 Section 3.3 Costing Factory Overhead Practical capacity is full utilization of facilities with allowance made for normal interruptions and inefficiencies. For example, production will be slowed or stopped at times because of breakdowns, shortages of labor and materials, or retooling. These possibilities are considered in arriving at practical plant capacity. Expected volume is the level of operation budgeted or estimated for the current period. This may be at or below practical capacity. It is the level at which management expects to operate during the next month or year. Normal volume is generally a balance between practical capacity and sales demand in the long run. Over a period of years, the peaks and valleys of customer demand are leveled by averaging, and the average level of plant utilization is considered to be normal volume. It may seem, at first, that overhead per unit should be calculated at the expected level of operation for the next year. Indeed, this is the practice of most companies. However, for product pricing purposes, a better approach is to use the normal volume. Why should normal volume be used when you already know that the company may be operating below that level? After all, a rate computed at the expected level of operation will come closer to costing all of the overhead to the products, and product cost will be more in line with actual cost. The problem with using an overhead rate based on expected, rather than normal, volume is illustrated by the following example. Assume that the normal level of operation for Cherrywood Medical Laboratory is 200,000 labor hours and that 100,000 items can be analyzed in that time. The fixed overhead for the year is budgeted at $500,000. The normal fixed overhead per item is then $5, computed as: Budgeted fixed overhead Items analyzed at normal volume 5 $500,000 5 $5 Fixed overhead per item 100,000 But management expects to operate at only 100,000 labor hours next year and to analyze 50,000 items. An overhead rate at expected volume would be $10 per item: Budgeted fixed overhead Items analyzed at normal volume 5 $500,000 5 $10 Fixed overhead per item 50,000 If the lab plans to operate below normal volume, an overhead rate computed at the expected level of operations will result in more fixed overhead being assigned to each item. If prices are set by adding a markup to total cost, the price will be higher when fewer items are analyzed. With a higher price under competitive conditions, customers may be lost, thereby aggravating a condition when volume is already below normal. For this reason, the objective is not necessarily to assign all overhead costs to products. The products should bear the normal overhead costs, and any unabsorbed fixed overhead should be recognized as a period expense. (Overabsorbed fixed overhead would likewise result in a reduction of period expenses.) Rather than allocating unabsorbed fixed overhead to products produced, this approach treats the costs of idle capacity as the costs of products the company did not produce. sch80342_03_c03_099-142.indd 111 12/20/12 11:52 AM Section 3.5 A Product Costing Illustration CHAPTER 3 3.4 Cost of Providing Services A n entity that provides services instead of tangible products may not operate with a formal cost accounting system that traces costs to jobs. Instead, all service job costs are treated as period costs and are often left in their original cost categories such as supplies expense, labor expense, depreciation expense, etc. Nevertheless, costs will be used to measure performance by type of service and by customer groups. A hotel, for example, may provide an exercise room for its guests. The cost of supplies used exclusively for the exercise room, such as rubbing lotions and bandages, along with the salaries and wages of the room's employees, such as the manager and exercise class instructors, is identified with the exercise activities. Also, costs of special equipment used, such as depreciation and maintenance expenses, and other overhead costs increased by operating this service, will be included. These costs can be used as a basis for deciding how much must be added to a guest's bill to cover all costs and allow for profit. Also, does the amount of customer patronage justify continuance of the service? Can other features be provided at a certain cost to attract more customer attention? Properly assigning costs to the exercise room will give the manager the accounting information needed to answer these questions. Some service organizations do have formal systems for determining costs associated with jobs. Accounting and legal services are examples where the firm may want costs accumulated by client number or case. In this situation, each client number or case becomes a job, with costs traced to the individual jobs. In service organizations having formal job cost systems, inventory accounts such as Work in Process Services or Cost of Unbilled Work are used to reflect the cost of resources and effort that have been expended, but where the work is not yet completed for the customer. At year-end, or whenever financial statements are being prepared, the cost of uncompleted work appears in this type of inventory account rather than in an expense account because the related revenue has not yet been earned. Examples of such situations may include: A painting contractor is in the midst of a three-week painting job. An engineering firm is in the early design stage of a four-month project. A web page design firm has another two days of work before presenting the completed work to its client. A landscaping company has only partially completed its planting of shrubs and flowers. When the work is completed, the costs are transferred to an account such as Cost of Completed Jobs or Cost of Services Provided. These accounts are analogous to Cost of Goods Sold for a manufacturing firm. Since most service firms do not have finished goods inventories, there would usually be no account analogous to Finished Goods. 3.5 A Product Costing Illustration S ummarized cost data are presented in this section for Scher Machine Company to illustrate product costing procedures using a normal costing system. Note that the entries sch80342_03_c03_099-142.indd 112 12/20/12 11:52 AM CHAPTER 3 Section 3.5 A Product Costing Illustration given are in composite form. In practice, many repetitious entries are made to record individual transactions that take place during the year. The sequential order of the cost transactions should also be considered. For example, the preparation of the budget for factory overhead and overhead rate calculations are completed before the beginning of the year. The predetermined overhead rate must be calculated from a budget of factory overhead so that products will be assigned the proper overhead cost. Only at the end of the year will the company know that 220,000 direct labor hours were used and that the actual factory overhead cost was $1,336,200. Throughout the year, the company purchases materials and incurs labor and factory overhead costs as products are continually processed, completed, and sold. At the same time, costs are traced to the products and released as expenses when the products are sold. Scher Machine Company transactions data for the fiscal year ended April 30, 2013, are as follows: 1. Materials purchased during the fiscal year totaled $840,000. 2. Direct materials requisitioned for production cost $631,400. Indirect materials costing $47,200 were also requisitioned. 3. Factory payrolls amounted to $1,874,000. The income taxes withheld from the employees' wages totaled $393,400, and the deduction for FICA taxes withheld amounted to $106,600. A distribution of the factory labor cost of $1,874,000 shows that $1,760,000 was direct labor while the remaining $114,000 was indirect labor. 4. Factory overhead at the normal operating level of 250,000 direct labor hours results in an overhead rate of $6 per direct labor hour. During the year, direct labor workers recorded 220,000 labor hours. 5. The factory overhead, in addition to the indirect materials and the indirect labor, amounted to $1,175,000. Included in this amount is depreciation of $120,000 and the employer's share of FICA taxes of $106,600. The balance of the overhead was acquired through accounts payable. 6. Jobs completed and transferred to stock during the year had costs of $2,945,200. 7. The cost of orders sold during the year was $2,320,000. 8. The Factory Overhead account is closed to Cost of Goods Sold at the end of the fiscal year. The transactions are entered in the accounts as follows: 1. Purchase of materials. (The cost of each type of materials is also entered on the individual materials inventory cards.) Materials 840,000 Accounts payable 840,000 2. Materials issued to production. (Requisitions are the basis for entries reducing materials inventory, for posting direct materials costs to each job, and for posting indirect materials costs to Factory Overhead.) sch80342_03_c03_099-142.indd 113 12/20/12 11:52 AM CHAPTER 3 Section 3.5 A Product Costing Illustration Materials 840,000 Work in process 678,600 631,400 Factory overhead 47,200 3. Factory payrolls. (A classification of labor time by jobs is shown on labor time tickets. These tickets are the basis for distributing direct labor costs to individual jobs and for posting indirect labor costs to the factory overhead subsidiary ledger.) Wages payable 1,374,000 Employees' income taxes payable FICA taxes payable 393,400 106,600 Work in process 631,400 1,760,000 Factory overhead 47,200 114,000 4. Factory overhead applied. (Factory overhead applied to products on direct labor hour basis is: 220,000 hours 3 $6 rate 5 $1,320,000.) Work in process 631,400 1,760,000 393,400 Factory overhead 47,200 1,320,000 114,000 1,320,000 sch80342_03_c03_099-142.indd 114 12/20/12 11:52 AM CHAPTER 3 Section 3.5 A Product Costing Illustration 5. Actual factory overhead. (This is in addition to indirect materials and indirect labor.) Factory overhead 47,200 Accumulated depreciation 1,320,000 120,000 1,760,000 1,175,000 FICA taxes payable Accounts payable 840,000 106,600 948,400 6. Work completed during the year and transferred to stock. (Completed jobs are removed from the file of jobs in process and moved to the subsidiary ledger supporting finished goods inventory. Ending Work in Process is $766,200.) Work in process 631,400 2,945,200 Finished goods 2,945,200 1,760,000 1,320,000 766,200 7. The cost of goods sold. (Deductions are recorded in the finished goods inventory ledger. Entries are also made in records supporting billings to customers for the sales. Ending Finished Goods is $625,200.) Finished goods 2,945,200 2,320,000 Cost of goods sold 2,320,000 625,200 8. Closing of Factory Overhead. (Total actual overhead cost from entries in Items (2), (4), and (6), is $1,336,200. Actual overhead amounting to $16,200 is not absorbed as a part of the product cost. The underapplied overhead is closed to Cost of Goods Sold.) Factory overhead Cost of goods sold 47,200 1,320,000 2,320,000 114,000 16,200 16,200 1,175,000 sch80342_03_c03_099-142.indd 115 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs 3.6 Service Center Costs M ost companies have several departments or functions involved directly or indirectly in producing goods or providing services. The development of departmental overhead rates depends on the interrelationships among these different departments. Operating departments are organizational units most closely tied to the productive effort that results in products or services to customers. In manufacturing organizations, these units are typically called producing departments. On the other hand, service centers (or support functions) provide supporting services that facilitate the activities of the operating departments. Often, service centers provide support services to one another. Service centers include, for example, maintenance, quality control, cafeterias, internal auditing, personnel, accounting, production planning and control, and medical facilities. Although they do not have a direct relationship to output, service center costs support operating departments, and, therefore, become part of the cost of a finished product or service. In some limited cases, a service center provides support services for operating departments as well as services for outside customers. Examples include engineering consulting, research and development, computer systems design, copying services, and laboratory work. Service center costs are allocated to operating departments by means of a cost driver. Any one of a number of cost drivers may be appropriate for calculating a rate depending on the nature of the support activity. Examples of cost drivers that could be used are given in Figure 3.2. The allocated service center costs become part of the total overhead costs of the operating departments. Even costs that are direct materials or direct labor with respect to service centers become overhead costs when allocated to operating departments. Figure 3.2: Cost drivers used for service centers Possible Cost Drivers for Selected Service Centers Service Center Possible Cost Drivers Purchasing Number of orders, cost of materials, line items ordered Receiving and inspection Cost of materials, number of units, number of orders, labor hours Storerooms Costof materials, number of requisistions, number of units handled, square or cubic footage occupied Personnel Number of employees, labor hours, turnover of labor Laundry Pounds of laundry, number of items processed Cafeteria Number of employees Custodial services Square footage occupied Repair and maintenance Machine hours, labor hours Medical facilities Number of employees, hours worked Factory administration Total labor hours, number of employees, labor cost Power Kilowatt hours, capacity of machines sch80342_03_c03_099-142.indd 116 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs Occasionally, companies may not allocate service center costs to operating departments, in order to ensure that the services are fully utilized by the operating managers. Some examples of this phenomenon include internal audit departments, credit-check services, libraries, and computer services. Three common approaches are available for allocating the costs of service centers: direct method, step (sequential) method, and reciprocal method. To illustrate the allocation of service center costs for the first two methods, we will use data from the School of Business at Hardknox University. The School of Business wishes to determine overhead costs per credit hour for its undergraduate and graduate programs. We will treat these as the two operating departments. The School of Business has three service centers: Building Services, Staff Services (e.g., secretarial support, computer support, and photocopying), and Administration. Budgeted data for the coming year appear as follows: Square feet occupied Employees Overhead costs Building Services 1,000 30 $165,000 Staff Services 2,000 20 90,000 Administration 8,000 20 330,000 Graduate Program 10,000 30 265,000 Undergraduate Program 20,000 90 420,000 Service centers: Operating departments: Building Services costs are allocated on square footage of classroom and office space. Staff Services and Administration costs are allocated based on number of employees (i.e., faculty and staff). Budgeted credit hours for the year are 20,000 for the Graduate Program and 60,000 for the Undergraduate Program. Direct Method Direct method allocations are made from each service center to operating departments in proportion to activity performed for each. Thus, the direct method does not assign costs to other service centers for work performed for other service centers. Allocation of service center costs uses only those cost drivers pertaining to operating departments. Once the service centers have their costs allocated, operating department overhead rates per unit of activity are calculated. Space associated with the Graduate Program is 10,000 square feet; for the Undergraduate Program, the space used is 20,000 square feet. The allocation base, therefore, totals 30,000 square feet. Building Services costs are then prorated over the two programs as follows: Graduate Program 10,000 sq. ft. 1/3 3 $165,000 5 $ 55,000 Undergraduate Program 20,000 2/3 3 $165,000 5 110,000 Total 30,000 sq. ft. Total cost sch80342_03_c03_099-142.indd 117 $165,000 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs The same approach follows for Staff Services and Administration. These are summarized as follows: Graduate Program 30 employees 1/4 3 $ 90,000 5 $22,500 Undergraduate Program 90 3/4 3 $ 90,000 5 67,500 Total 120 employees Total cost $ 90,000 Graduate Program 30 employees 1/4 3 $330,000 5 $ 82,500 Undergraduate Program 90 3/4 3 $330,000 5 247,500 Total 120 employees Total cost $330,000 Another way to perform these allocations is to divide the service center costs by the cost driver and apply the resulting rate to the operating department usage amount. For example, Building Services would have a rate of $5.50 per square foot ($165,000 4 30,000). The results of service center allocations and the subsequent calculation of overhead rates for the operating departments are summarized as follows: Building Services Staff Services Administration Costs $165,000 $90,000 $330,000 Building Services (165,000) Staff Services Undergraduate Program Administration 0 Credit hours Overhead rate per credit hour $ 0 $ 0 $420,000 110,000 22,500 (330,000) $265,000 55,000 (90,000) $ Graduate Program 67,500 82,500 247,500 $425,000 $845,000 4 20,000 4 60,000 $ 21.25 $ 14.08 Step (Sequential) Method The step (sequential) method is an attempt to consider services performed for other service centers. However, recognition of those services is a one-way process. The service centers are arranged in a sequence, and their costs are allocated one after the other. Once a service center's costs are allocated, no other costs are allocated back to that service center even though it may use resources of other service centers. The first service center's costs are allocated to all subsequent service centers and operating departments. The second service center's costs are then allocated to all subsequent service centers and operating departments, but not to the first service center. This process continues until all service centers' costs have been allocated to operating departments. The number of allocation steps will equal the number of service centers. sch80342_03_c03_099-142.indd 118 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs Since there are three service centers in the Hardknox University School of Business, there are three steps in the allocation process. We begin by allocating the costs of Building Services. The square footage for Staff Services is 2,000, Administration is 8,000, Graduate Program is 10,000, and Undergraduate Program is 20,000. The allocation base, therefore, totals 40,000 square feet. Building Services costs are then prorated over the remaining service centers and operating departments, as follows: Staff Services 2,000 sq. ft. 5% 3 $165,000 5 $8,250 Administration 8,000 20% 3 $165,000 5 33,000 Graduate Program 10,000 25% 3 $165,000 5 41,250 Undergraduate Program 20,000 50% 3 $165,000 5 82,500 Total 40,000 sq. ft. Total cost $165,000 Staff Services receives an allocation of Building Services costs. This allocation must be added to the costs already charged to the Staff Services department to determine the allocation of Staff Services costs. The new total Staff Services costs are $98,250 ($90,000 1 $8,250). The next step in the allocation process is as follows: Administration 20 employees 2/14 3 $98,250 5 $14,035* Graduate Program 30 3/14 3 $98,250 5 21,054 Undergraduate Program 90 9/14 3 $98,250 5 63,161 Total 140 employees Total cost $ 98,250 *\tThis\tfigure\thas\tbeen\trounded\tdown. After allocating Building Services and Staff Services costs, the Administration costs for the next step of the allocation are $377,035 ($330,000 1 $33,000 1 $14,035). These costs are allocated as follows: Graduate Program 30 employees 25% 3 $377,035 5 $94,259 Undergraduate Program 90 75% 3 $377,035 5 282,776 Total 120 employees Total cost $377,035 The results of service center allocations and the subsequent calculation of overhead rates for the operating departments are summarized as follows: sch80342_03_c03_099-142.indd 119 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs Building Services Staff Services Administration Costs $165,000 $90,000 $330,000 $265,000 $420,000 Building Services (165,000) 8,250 33,000 41,250 82,500 14,035 21,054 63,161 94,259 282,776 $ 0 $ Administration Undergraduate Program $98,250 (98,250) Staff Services Graduate Program 0 $377,035 (377,035) $ 0 Overhead rate per credit hour $421,563 $848,437 4 20,000 Credit hours 4 60,000 $21.08 $14.14 How do you arrange the order of service centers? The general rule is to sequence service centers according to the amount of services provided to other service centersgoing from greatest to least. What constitutes \"greatest amount of service\"? One interpretation is according to the center serving the greatest number of other service centers. Another is the amount of cost in the service center; the service center with the highest costs goes first. It is not clear which interpretation should be applied. The real issue is to set up a sequence that will provide reasonable and logical allocations. Reciprocal Method Neither the direct method nor the step method of service center allocation recognizes mutual rendering of services among service centers. A third method, the reciprocal method, does consider that service centers can perform services in a mutual fashion for each other. The method, however, is more complex than the direct and step methods because it involves solving simultaneous equations. Specifically, the number of simultaneous equations will equal the number of service centers. When this number is large, a computer becomes necessary to solve the equations. For simplicity, we will restrict our analyses to cases of two service centers. The reciprocal method involves a two-stage procedure: Stage 1: Set up and solve the following two equations for S1 and S2: S1 5 DC1 1 k1S2 S2 5 DC2 1 k2S1 where: Si 5 DCi 5 k1 5 k2 5 sch80342_03_c03_099-142.indd 120 cost of service center i after the reciprocal allocation (i 5 1, 2) the direct costs traceable to service center i (i 5 1, 2) the percentage of S2 cost allocated to S1 the percentage of S1 cost allocated to S2 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs Stage 2: Allocate the costs of each service center derived in Stage 1 (i.e., S1 and S2) to all other service centers and operating departments. To illustrate, suppose Lubel Brothers, Inc. manages real estate properties for various owners. The firm has two operating departments: Indoor Malls, with directly traceable overhead costs of $200,000 per month, and Outdoor Shopping Centers, with directly traceable overhead costs of $320,000 per month. The departmental overhead rates are based on direct labor hours. There are also two service centers: Storerooms, having directly traceable costs of $48,000 per month, and Custodial Services, having directly traceable costs of $250,000 per month. Storerooms costs are allocated on the basis of number of storeroom requisitions, while Custodial Services costs are allocated on the basis of number of employees. These facts are summarized in the following table: Department Costs Requisitions Employees Labor Hours Indoor Malls $200,000 1,000 84 13,000 Outdoor Shopping Centers 320,000 8,000 12 3,000 Storerooms 48,000 - 24 - Custodial Services 250,000 1,000 - - First, we set up the two equations for Stage 1: S 5 $48,000 1 .2C C 5 $250,000 1 .1S where: S 5 Cost of Storerooms after the reciprocal allocation C 5 Cost of Custodial Services after the reciprocal allocation The allocation percentages were determined as follows: k1 5 24/(24 1 12 1 84) 5 24/120 5 .2 k2 5 1,000/(1,000 1 8,000 1 1,000) 5 1,000/10,000 5 .1 Notice that the denominators for calculating the allocation percentages consist of all centers and departments other than the one from which the costs are being allocated. This is so because in Stage 2 the costs will be allocated to all other service centers and operating departments. We now solve the two equations by first substituting the second equation into the first: S 5 $48,000 1 .2($250,000 1.1S) .98S 5 $98,000 S 5 $100,000 sch80342_03_c03_099-142.indd 121 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs Now we obtain C by inserting $100,000 into our second equation: C 5 $250,000 1 .1($100,000) C 5 $260,000 Having solved for S and C, we proceed to Stage 2, where we allocate these costs as follows: (a) Of the $100,000 from S, 10 percent (1,000/10,000) is allocated to Custodial Services, 10 percent (1,000/10,000) is also allocated to Indoor Malls, and 80 percent (8,000/10,000) is allocated to Outdoor Shopping Centers. (b) Of the $260,000 from C, 20 percent (24/120) is allocated to Storerooms, 70 percent (84/120) is allocated to Indoor Malls, and 10 percent (12/120) is allocated to Outdoor Shopping Centers. The resulting allocations, total operating department overhead costs, and departmental overhead rates are summarized in the following table: Storerooms Costs Storerooms Custodial Services Indoor Malls Outdoor Shopping Centers $48,000 $250,000 $200,000 $320,000 (100,000) 10,000 10,000 80,000 52,000 (260,000) 182,000 26,000 $392,000 $426,000 Custodial Services Totals (after allocation) 0 $ 0 Direct labor hours 13,000 3,000 Overhead rate per direct labor hour $30.15 $142.00 All $298,000 of service center costs ($48,000 1 $250,000) have been fully allocated to the operating departments. To confirm: $10,000 1 $80,000 1 $182,000 1 $26,000 5 $298,000. Two other issues influence the way we allocate service center costs: treatment of revenues and allocation of costs by behavior. These issues are presented next. Treatment of Revenues Most service centers simply incur costs and generate no revenues. A few, such as a cafeteria, may charge employees or other outside parties for the services they perform. Any revenues generated should be offset against the service center costs. For both the direct method and the step method, we allocate the costs less the offset. In this manner, other service centers and operating departments will not be required to bear costs for which the service center has already been reimbursed. sch80342_03_c03_099-142.indd 122 12/20/12 11:52 AM CHAPTER 3 Section 3.6 Service Center Costs Allocation of Costs by Behavior Whenever possible, service center costs should be separated into variable and fixed classifications and allocated separately. As a general rule, variable costs should be charged to other service centers and operating departments on the basis of the actual activity that controls the incurrence of the cost involved. The service centers and departments directly responsible for the incurrence of servicing costs are, therefore, required to bear the cost in proportion to their actual usage of the service involved. The fixed costs of service centers represent the cost of providing capacity. As such, these costs are most equitably allocated to consuming service centers and operating departments on the basis of predetermined amounts. In this way, the amount of costs allocated is determined in advance of the period in which service is provided. Once determined, the amount does not change from period to period. Typically, the amount allocated is based either on peak-period or long-run average servicing needs. This approach of allocating variable costs on the basis of actual activity and fixed costs using predetermined percentages is sometimes referred to as the dual-rate method of allocation. The following example will illustrate undesirable consequences of not separating the allocation of fixed and variable costs. Suppose that Azer Website Designers has an Administration support center that services two operating centers: Domestic and International. Based on needs forecast by these two operating centers, Azer hired staff and incurred other fixed costs amounting to $1,200,000 per year. Sixty percent of this cost derived from the needs of Domestic. In addition, Administration incurs costs that vary with the amount of labor hours worked in the operating centers. This averages about $1 per hour. $1,200,000 1 $1 1 400,000 1 200,000 2 5 $3 per hour 400,000 1 200,000 In 2013, Domestic worked 400,000 hours and International worked 200,000 hours. If fixed and variable costs are not separated, the allocation rate would be determined as follows: Allocation rate 5 The 2013 allocations to each of the operating centers would be: Domestic: $3 per hour 3 400,000 hours 5 $1,200,000 $1,200,000 1 $1 1 100,000 1 200,000 2 5 $5 per hour 100,000 1 200,000 International: $3 per hour 3 200,000 hours 5 $600,000 In 2014, International works the same 200,000 hours, but Domestic's work drops off to only 100,000 hours. The allocation rate for 2011 would change as follows: Allocation rate 5 The 2014 allocations to each of the operating centers would be: Domestic: $5 per hour 3 100,000 hours 5 $500,000 International: $5 per hour 3 200,000 hours 5 $1,000,000 sch80342_03_c03_099-142.indd 123 12/20/12 11:52 AM Section 3.7 Ethical Issues for Cost Allocation CHAPTER 3 Note that International's share of costs increased by $400,000 ($1,000,000 - $600,000) even though it worked the same number of hours both years. Because fewer hours were worked in Domestic, the allocation rate increased. This resulted in more fixed Administration cost charged to International than in the previous year. To avoid this inequity, each year the dual-rate method would assign $720,000 in fixed cost to Domestic (.6 x $1,200,000) and $480,000 to International (.4 x $1,200,000). These allocations are in accordance with the forecasted needs that generated the total fixed cost of $1,200,000. For the variable costs, the dual-rate method would assign $1 per hour each year. Thus, with the dual-rate method, International would be assigned a total cost of $680,000 each year ($480,000 1 $200,000), while Domestic would be assigned $1,120,000 in 2013 ($720,000 1 $400,000) and $820,000 in 2014 ($720,000 1 $100,000). 3.7 Ethical Issues for Cost Allocation O ften, a department or division's performance is evaluated on the basis of profits after overhead costs have been allocated. Consequently, the choice of cost drivers can affect performance evaluation. One wishing to reward some managers and penalize others could attempt to do so by unethically selecting cost drivers that would shift overhead costs to the desired entities. When the prices of certain services or products are cost-based while others are marketdriven, managers are often tempted to shift much of the overhead costs to those costbased services or products. This can be accomplished by: 1. Including in the overhead cost pool items which are not business expenses (e.g., entertainment expenses unrelated to the business). 2. Arbitrary selection of cost drivers. When using the step method of allocating support costs, another way to shift overhead costs is: 3. Arbitrary ordering of support centers. Clearly, the inclusion of nonbusiness expenses is unethical. The arbitrary selection of cost drivers or of the order of support centers is not as clear. On one hand, management has an obligation to the company's owners to maximize profits using any allowable methods. On the other hand, there is a question of fairness to the parties purchasing the products or services. Moreover, when the government happens to be the other party, the issue extends to one of fairness to taxpayers. sch80342_03_c03_099-142.indd 124 12/20/12 11:52 AM CHAPTER 3 Chapter Summary Contemporary Practice 3.2 Increasing Revenues by Changing Cost Allocations An experiment with individuals in graduate and executive education managerial accounting classes, who averaged about six years of full-time work experience, tested whether they would arbitrarily change an established logically-based cost allocation procedure to one which is more arbitrary in order to increase profits. The scenario was one in which the company was selling one of its products on a cost-plus basis, and by allocating more overhead costs to this product rather than to other products, more revenues could be generated since the revenues for this cost-plus product would be based on the higher cost assigned to it. The study estimated that about 41 percent of the participants would arbitrarily change the cost allocation procedure in order to increase revenues and thereby meet a targeted pretax income figure (Schneider, 2004). Chapter Summary O ne of the objectives in cost accounting is to determine the cost to provide a given service, to manufacture a given quantity of product, or to complete some project. We accumulate the costs of materials, labor, and overhead separately. Materials are identified as direct or indirect. If direct, the materials are charged directly to the specific product. Indirect materials costs are included in factory overhead costs. Labor costs follow the same type of distinctions. Factory overhead is budgeted and divided by a cost driver that relates overhead costs to the products. This yields a rate that is used to allocate overhead to services or products. If the overhead consists largely of labor-related costs and labor support costs, such as supervision and fringe benefit costs, the cost driver selected may be direct labor hours. The cost driver \"direct labor hours\" serves as a bridge between the product and the overhead costs. On the other hand, machine hours may be more appropriate if a large part of the overhead is lubrication, maintenance, and other costs generally related to machine operation. Other cost drivers may, however, be better links between costs and outputs. Both overhead costs and the cost driver should be budgeted at a normal level of operations rather than just the expected volume for the coming period. Factory overhead rates can be plant-wide or departmental, depending on the diversity of the products. Actual costs are accumulated, and comparisons of actual and estimated costs for each product help management to control costs. Actual overhead incurred can be compared with the overhead applied to the services or products. If actual factory overhead is less than the overhead applied to products (or if overhead is overapplied), the variance is usually closed out to Cost of Goods Sold. The overhead costs of operating departments include allocations of service center costs. The direct method allocates service center costs directly to operating departments without any intervening allocations to service centers. The step method involves a sequence sch80342_03_c03_099-142.indd 125 12/20/12 11:52 AM CHAPTER 3 Problem for Review of allocations where service center costs are allocated to other service centers as well as operating departments. The reciprocal method simultaneously allocates service center costs among service centers and operating departments. Any revenues earned by service centers should be deducted from the costs allocated. Ideally, variable costs should be allocated separately from fixed costs. Problem for Review You find that the cost records at Oberman Printing Company have been poorly maintained. Some information has been entered, but other information is missing. Fortunately, the information given is correct. The costs for jobs 686, 687, and 688 are to be determined. The direct materials cost is $528 for Job 686 and $715 for Job 687. The cost of direct materials requisitioned during the month for all other jobs, except Job 688, is $4,820. No jobs were in process at the beginning of the month. The total cost of direct materials requisitioned during the month was $6,913. Labor is paid at a uniform rate of $10 an hour. Job 686 required 82 direct labor hours, and job 688 required 43 direct labor hours. A total of 760 direct labor hours were worked during the month. The direct labor cost of all other jobs, with the exception of the three jobs being considered, was $5,850. Two machine hours are used for each direct labor hour. Overhead is applied at a rate of $4 per machine hour. The actual overhead cost for the month was $6,320. Jobs 686, 687, and 688 were completed during the month. Questions: 1. 2. 3. 4. Compute the costs for Jobs 686, 687, and 688. Show costs by cost element. Determine the amount of overhead applied to all orders during the month. What was the amount of the underapplied or overapplied overhead? You have received a telephone call from the general manager requesting the total cost per unit on Job 686. There were 50 units (books) on this order. What is the total cost per unit? Solution: (1) Costs of job by cost elements: Jobs 686 Direct materials 687 688 Other Total $528 $715 $850* $4,820 $6,913 Direct Iabor 820 500** 430 5,850 7,600 Applied overhead 656 400 344 4,680 6,080 $2,004 $1,615 $1,624 $15,350 $20,593 Total costs sch80342_03_c03_099-142.indd 126 12/20/12 11:52 AM CHAPTER 3 Key T