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									Lesson 13
Process Costing in a Manufacturing Business
Job order costing is a system of accounting used by manufacturing companies producing a variety of different products from a common manufacturing facility or process. Process costing is a system of accounting used by companies that operate factories or manufacturing processes that produce the same product over and over on a continuous basis. The two key characteristics that call for the use of process costing as opposed to job order costing are:
1. The company's manufacturing procedures are essentially the same for every unit produced, and 2. The final completed units are all basically the same.

Lesson 13
Product Costing Continued…

Companies that use process costing are typically businesses that massproduce their products through some kind of a production line or standardized manufacturing process. Businesses that make their products using an assembly line, including automobile manufacturers, or makers of appliances like washing machines or television sets, will typically use process costing, at least to some extent, to determine the cost of each unit produced. Oil refineries, mining companies, food processors, pharmaceutical companies and other businesses involved in the mass production of standardized products will all typically use process costing.

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Direct labor costs incurred:

Completion of production:*

WIP Inventory Cash or Wages Payable
Indirect labor costs incurred:

XXX

XXX

Finished Goods Inventory WIP Inventory
Sale of finished units:

XXX

XXX

Manufacturing Overhead Cash or Salaries/Wages Payable

XXX

XXX

Cost of Goods Sold Finished Goods Inventory

XXX

XXX

Other indirect costs, including factory rent, utilities, depreciation, and other overhead costs incurred:

Manufacturing Overhead Cash Utilities or Other Payables Accumulated Depreciation

XXX

* In a job order cost system this entry is made as each separate job is completed with the amount transferred to finished goods taken from the job cost record maintained for each completed job. In a process cost system, because production is continuous, this entry is made once at the end of each accounting period, and assuming all units in production are completed at the end of the period, the full amount included in the WIP account is credited out and transferred to finished goods. Cost Per Unit = of Production Total cost transferred to finished goods Total number of units completed during the period

XXX XXX XXX

Manufacturing overhead costs applied (predetermined overhead rate):

WIP Inventory Manufacturing Overhead

XXX

XXX

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If there are unfinished units in ending WIP, this process costing approach becomes a lot more complicated. In that case, a portion of the production costs added to WIP must be left in the WIP inventory account at the end of the period to reflect the costs incurred to date on unfinished units. In other words, when there's ending WIP inventory, a company's total production costs must be allocated between the finished and unfinished units to determine the cost of units transferred to finished goods and the costs of units in ending WIP.

Allocation of direct material costs: First determineCost per finished = equivalent Then allocateTo the 98,000 units transferred to finished goods98,000 units x $1.20 per unit = $117,600 To the 2,000 units in ending WIP1,600 units x $1.20 per unit = $1,920 $119,520 = $1.20 cost per unit 99,600 units (98,000 + 1,600)

How should a company's product costs, including its direct materials, direct labor and applied manufacturing overhead costs, be allocated between its finished and unfinished units at the end of the period?

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13-1

Direct Labor and Applied Manufacturing Overhead Costs ("Conversion Costs"): Assume Kreamy Peanut Butter's total conversion costs for the month of June amounted to $49,400 and the 2,000 units in ending WIP are only 40% complete in terms of those conversion costs. That means the allocation of a portion of the $49,400 to those 2,000 units will be based on 2,000 units x 40% = 800 finished equivalent units
Allocate the $49,400 of conversion costs between finished goods and WIP:
Direct material costs Conversion costs Total

Finished Goods Inventory Costs $117,600 $ 49,000 $166,600 # Units 98,000 98,000 Cost/ Unit $1.20 $ .50 $1.70

WIP Inventory Costs $1,920 $ 400 $2,320 # FE Units 1,600 800 Cost/ Unit $1.20 $ .50 $1.70

First determineCost per finished equivalent Then allocate= $49,400 98,800 units (98,000 + 800) = $ .50 cost per unit

Journal entry to record the completed production for the month: Finished Goods Inventory 166,600 WIP Inventory 166,600

To the 98,000 units transferred to finished goods98,000 units x $ .50 per unit = $49,000 To the 2,000 units in ending WIP800 units x $ .50 per unit = $400

Journal entry to record any subsequent sale of the finished units: XXX Cost of Goods Sold (# units sold x $1.70) XXX Finished Goods Inventory

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A final complicating factor:
In this case, we'll assume that in addition to the 98,000 units of production started and completed in the month of June, and 2,000 partially completed units in process at the end of the month, an additional 3,000 unfinished units were carried over from the prior month's production and finished in the current period. In other words, we'll assume the company had 3,000 units in beginning WIP that were then completed in the current period and transferred to finished goods. We'll also assume that at the beginning of the period, those 3,000 units were 80% complete as to direct materials at a cost of $2,832, and 70% complete as to conversion, at a cost of $987. In addition, we'll assume the total costs of production for the month increased from $119,520 to $120,240 for direct materials and from $49,400 to $49,850 for conversion costs given the additional costs required to complete the 3,000 units of beginning inventory. Direct Materials Conversion # of % % Units Completed Completed Costs Costs
Beginning WIP inventory Units started and completed Costs added during the month Ending WIP inventory 3,000 98,000 2,000 80% 80% $2,832 $120,240 40% 70% $987 $49,850

Production Cost Report (June, 20X5)

Finished Equivalent Units of Production for the Month
Direct Material Costs
# of Units % Completed in Current Period Finished Equivalent Units

Conversion Costs
% Completed in Current Period Finished Equivalent Units

Beginning WIP Started and completed Ending WIP

3,000 98,000 2,000

20% 100% 80%

600 98,000 1,600 100,200

30% 100% 40%

900 98,000 800 99,700

Cost Per Unit of Production
Current Period: Direct material costs Conversion costs
Total Costs Equivalent Units Cost per Unit

$120,240 $ 49,850 $170,090

100,200 99,700

= =

$1.20 $ .50 $1.70 $1.18 $ .47 $1.65

Begin by calculating Kreamy Peanut Butter's current cost per unit of production.

Beginning WIP (3,000 units) Direct material costs $ 2,832 Conversion costs $ 987 $ 3,819 $173,909

2,400 (80%) 2,100 (70%)

= =

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Production Cost Report (continued)

WIP Inventory - Mixing Department
Beginning inventory Cost added during the month: Direct material costs Conversion costs Ending inventory XXX XXX XXX XXX XXX Completed production

Allocation of Costs to Finished Goods
Beginning WIP (3,000 units): Costs from prior period Direct material costs Conversion costs Costs from current period: Direct material costs Conversion costs Started and completed (98,000 units) Total allocation
Cost per Unit Equivalent Units Allocated Cost

$ $1.20 $ .50 $1.70 x x x 600 (20%) 900 (30%) 98,000 = = =

2,832 987

WIP Inventory - Baking Department
Beginning inventory Production from mixing dept. Cost added during the month: Direct material costs Conversion costs Ending inventory XXX XXX XXX XXX XXX XXX Completed production

720 450 166,600 $ 171,589
Allocated Cost

Allocation of Costs to Ending WIP
Ending WIP (2,000 units): Direct material costs Conversion costs Total allocation Grand total
Cost per Unit Equivalent Units

WIP Inventory - Packaging Department
Beginning inventory Production from baking dept. Cost added during the month: Direct material costs Conversion costs Ending inventory XXX XXX XXX XXX XXX XXX Completed production

$1.20 $ .50

x x

1,600 (80%) 800 (40%)

= =

$ $

1,920 400 2,320

$ 173,909

Journal entry to record the completed production for the month: Finished Goods Inventory 171,589 WIP Inventory 171,589

Finished Goods Inventory
Beginning inventory Production from packaging dept. Ending inventory XXX XXX XXX XXX Cost of goods sold

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Manufacturing Overhead
Actual costs: Utilities Rent Indirect Labor Indirect materials Depreciation Etc. Balance before adjustment (under-applied) XXX XXX XXX XXX XXX XXX XXX XXX Applications to WIP

Summary
The primary purpose behind both job order and process costing is the determination of a company's cost per unit of production. That's crucial information from both a managerial as well as a financial accounting perspective. Without an accurate knowledge of a company's cost per unit of production successful management of a company's operations is virtually impossible. From a financial reporting standpoint, a company's costs of goods transferred to finished goods and resulting balances in ending WIP, finished goods and cost of goods sold are ultimately based on a company's costs per unit of production. In a job order cost system used by companies that manufacture a variety of products from a common factory or process, this per unit cost is determined through job cost records maintained for each separate batch of units produced. In a process cost system used by companies that continuously produce the same product, the cost per unit of production is determined through production cost reports prepared for each of product's manufacturing processes.

Adjusting entry:

Cost of Goods Sold Manufacturing Overhead

XXX

XXX

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The basic steps reflected in those production cost reports include:
1. The determination of the number of units produced during the period. (If there are partially completed units in beginning and ending WIP inventory then the number of units produced for the period must be stated in terms of finished equivalent units of production as to both direct materials and conversion costs. 2. The company's actual direct material and conversion costs added to production during the period are then divided by those finished equivalent units to determine the company's cost per unit of production. 3. For managerial purposes, that cost per unit of production is then usually compared to the prior period cost per unit for purposes of evaluation. 4. For financial reporting purposes, the cost of units completed and transferred to finished goods during the period is determined by adding any costs of beginning WIP, the costs incurred in completing those units and costs incurred on new units started and completed during the current period at the current period's cost per unit of production. The cost of ending WIP inventory can also be determined by using that same cost per unit times the finished equivalent units in WIP at the end of the period.

Problem 13-1

Production Cost Report
After reviewing the production cost report provided below, respond to the requirements that follow: Excel Industries Production Cost Report (April, 20X9) Direct Material Costs
# of Units 500 8,000 600 % Completed in Current Period 30% 100% 80% Finished Equivalent Units 150 8,000 480 8,630

Finished Equivalent Units of Production for the Period
Conversion Costs
% Completed in Current Period 40% 100% 50% Finished Equivalent Units 200 8,000 300 8,500

Beginning WIP Started and completed Ending WIP

Cost Per Unit of Production
Current Period: Direct material costs Conversion costs Beginning WIP (500 units) Direct material costs Conversion costs
Total Costs $ 72,492 $ 44,200 $116,692 Equivalent Units 8,630 8,500

= =

Cost per Unit $ 8.40 $ 5.20 $13.60

$ 2,940 $ 1,530 $ 4,470 $121,162

350 (70%) 300 (60%)

= =

$ 8.40 $ 5.10 $13.50

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Problem 13-1 Production Cost Report (continued)

Problem 13-1

Requirements: A. Identify the following for Excel Industries for the month of April, 20X9:
1. Percentages of completion in beginning WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. 2. Percentages of completion in ending WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. 3. Finished equivalents units of production in the current period to complete the beginning WIP inventory in terms of both direct materials and conversion costs. 4. Total finished equivalent units of production for the month in terms of both direct materials and conversion costs. 5. Direct material cost per unit of production during the month. 6. Conversion cost per unit of production during the month. 7. Total cost of beginning WIP inventory. 8. Total costs added to WIP during the month. 9. Total cost of units completed during the month. 10. Total cost of ending WIP inventory.

Allocation of Costs to Finished Goods
Beginning WIP (500 units): Costs from prior period Direct material costs Conversion costs Costs from current period: Direct material costs Conversion costs Started and completed (8,000 units) Total allocation
Cost per Unit Equivalent Units Allocated Cost

$ $8.40 $5.20 $13.60 x x x 150 (30%) 200 (40%) 8,000 = = =

2,940 1,530

1,260 1,040 108,800 $ 115,570
Allocated Cost

Allocation of Costs to Ending WIP
Ending WIP (600 units): Direct material costs Conversion costs Total allocation Grand total
Cost per Unit Equivalent Units

$8.40 $5.20

x x

480 (80%) 300 (50%)

= =

$ $

4,032 1,560 5,592

B. What is the combined cost of beginning WIP inventory and costs added to WIP during the period and does that amount equal the combined cost of units completed during the period and ending WIP inventory? Will those amounts always be same and why? C. What journal entry would be made to record the company's completed production for the month? D. How did the company's April production costs per unit compare to the same costs in March?

$ 121,162

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Problem 13-1 - Answer

Problem 13-1 - Answer

Production Cost Report
A. Identify the following for Excel Industries for the month of April, 20X9:
1. Percentages of completion in beginning WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. Direct material cost: 70% Conversion costs (including direct labor and manufacturing overhead): 60% 2. Percentages of completion in ending WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. Direct material cost: 80% Conversion costs (including direct labor and manufacturing overhead): 50% 3. Finished equivalents units of production in the current period to complete the beginning WIP inventory in terms of both direct materials and conversion costs. Direct material cost: 150 units Conversion costs : 200 units 4. Total finished equivalent units of production for the month in terms of both direct materials and conversion costs. Direct material cost: 8,630 units Conversion costs : 8,500 units

5. Direct material cost per unit of production during the month. $8.40 6. Conversion cost per unit of production during the month. $5.20 7. Total cost of beginning WIP inventory. $4,470 8. Total costs added to WIP during the month. $116,692 9. Total cost of units completed during the month. $115,570 10. Total cost of ending WIP inventory. $5,592 B. What is the combined cost of beginning WIP inventory and costs added to WIP during the period and does that amount equal the combined cost of units completed during the period and ending WIP inventory? $121,162 Will those amounts always be same and why? Answer: Yes, assuming the production cost report is accurately prepared. The total cost of beginning WIP inventory plus costs added during the period must be equal to the costs transferred out of WIP (cost of completed production) and costs left in ending inventory.

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Problem 13-1 - Answer

Problem 13-2

C. What journal entry would be made to record the company's completed production for the month?

Process Costing
Adams, Inc. utilizes two process centers (processing and packaging) to manufacture boxes of laundry detergent. Assuming all direct materials used in the processing department are added at the beginning of the production process, and given the following information for the center's September, 20X8 activities:
Direct Material Costs $18,600 $894,900 5,000 70%

Finished Goods Inventory WIP Inventory

115,570

115,570

D. How did the company's April production costs per unit compare to the same costs in March? Answer: The same for direct material costs and higher for conversion costs. Costs Per Unit of Production
March April

Conversion
% Completed 60% Costs $5,400 $434,568

# of Units Beginning WIP inventory Units started and completed Costs added during the month Ending WIP inventory 6,000 280,000

Direct material costs Conversion costs Total

$8.40 5.10 $13.50

$8.40 5.20 $13.60

A. Prepare the company's journal entry to record the processing center's completed production for the month of September. B. Compare the processing center's September costs per unit of production with the costs from the prior month and explain what could give rise to the increase or decrease.

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Problem 13-2 - Answer

Problem 13-2 - Answer Production Cost Report - Processing Center (September, 20X8)

Process Costing
A. Prepare the company's journal entry to record the processing center's completed production for the month of September.

Finished Equivalent Units of Production for the Period
Direct Material Costs Conversion Costs
% Completed in Current Period 40% 100% 70% Finished Equivalent Units 2,400 280,000 3,500 285,900 % Completed in Current Period 0% 100% 100% Finished Equivalent Units 0 280,000 5,000 285,000

WIP Inventory - Packaging Center WIP Inventory - Processing Center

1,332,448

1,332,448
Beginning WIP Started and completed Ending WIP

B. Compare the processing center's September costs per unit of production with the costs from the prior month and explain what could give rise to the increase or decrease. Costs Per Unit of Production
August September

# of Units 6,000 280,000 5,000

Direct material costs Conversion costs Total

$3.10 1.50 $4.60

$3.14 1.52 $4.66

Cost Per Unit of Production
Current Period: Direct material costs Conversion costs Beginning WIP (500 units) Direct material costs Conversion costs
Total Costs $ 894,900 $ 434,568 $1,329,468 Equivalent Units 285,000 285,900

Answer: The increasing cost of direct materials could be the result of increasing material prices or less efficient use of the materials in the production process as a result of increased waste or other factors. The increasing conversion costs could be the result of increasing wage rates, increasing overhead costs or less efficiency in the production process.

= =

Cost per Unit $3.14 $1.52 $4.66

$

18,600 5,400 $ 24,000 $1,353,468

6,000 (100%) 3,600 (60%)

= =

$3.10 $1.50 $4.60

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Problem 13-2 - Answer Production Cost Report - Processing Center (continued)

Allocation of Costs to Completed Units Transferred to Packaging Center
Beginning WIP (6,000 units): Costs from prior period Direct material costs Conversion costs Costs from current period: Direct material costs Conversion costs Started and completed (280,000 units) Total allocation
Cost per Unit Equivalent Units Allocated Cost

$ $3.14 $1.52 $4.66 x x x 0 2,400 (40%) 280,000 = = =

18,600 5,400

3,648 1,304,800 $1,332,448

All of the process costing examples and problems we've used in this lesson up to this point in time have assumed a first-in first-out, or FIFO, inventory cost flow. That means we've assumed all units in beginning WIP were completed first in the current period before any new units were started in the production process. As a result, all costs in beginning WIP inventory were allocated to units completed during the period. No beginning WIP costs were carried over to ending WIP inventory.

Allocation of Costs to Ending WIP - Processing Center
Ending WIP (5,000 units): Direct material costs Conversion costs Total allocation Grand total
Cost per Unit Equivalent Units Allocated Cost

$3.14 $1.52

x x

5,000 (100%) = 3,500 (70%) =

$ $

15,700 5,320 21,020

$1,353,468

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Production Cost Report - Processing Center

Allocation of Costs to Completed Units Transferred to Packaging Center
Beginning WIP (6,000 units): Costs from prior period Direct material costs Conversion costs Costs to complete in current period: Direct material costs Conversion costs Started and completed (280,000 units) Total allocation
Cost per Unit Equivalent Units Allocated Cost

$ $3.14 $1.52 $4.66 x x x 0 2,400 (40%) 280,000 = = =

18,600 5,400

3,648 1,304,800 $1,332,448

Allocation of Costs to Ending WIP - Processing Center
Ending WIP (5,000 units): Direct material costs Conversion costs Total allocation Grand total
Cost per Unit Equivalent Units Allocated Cost

An alternative to this FIFO process costing assumption is a weighted average approach which assumes that all beginning WIP units and costs are simply mixed in with the new units started in the current period, such that the beginning costs are spread out evenly over both finished and unfinished units at the end of the period. Although this approach is sometimes used for financial reporting purposes to smooth out the effect of changing costs over time, from a managerial perspective this weighted average approach really doesn't make much sense. It ignores the actual physical flow of goods and fails to reflect the true cost per unit of production from one period to the next.

$3.14 $1.52

x x

5,000 (100%) = 3,500 (70%) =

$ $

15,700 5,320 21,020

$1,353,468

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In some cases, companies will actually use a combination of both process and job order costing to determine their costs per unit of production. When companies manufacture a variety of similar products in batches or jobs that undergo a number of common manufacturing processes, then both job order and process costing methods will be used to determine the cost of each unit produced.
For example, a clothing manufacturer making the same shirt in a variety of different fabrics will use a combination of both process and job order costing to determine their total production cost per shirt. If the cutting and sewing of each shirt is exactly the same regardless of the fabric used, then process costing will be used to determine the company's cutting and sewing, or conversion costs per unit. On the other hand, direct material costs will depend on the specific fabric used to make each shirt. Assuming batches of shirts are produced according to the fabric used, then job order costing will be used to determine the direct material cost per unit. The combined total of both the direct material costs and conversion costs per unit will then be added together to determine each shirt's total cost.

Merchandising Businesses
Serve as channels of distribution in getting a manufacturer's finished product to its final end user or consumer.
Wholesale distributors are in the business of buying finished products from manufacturers and then selling those products to a large number of different retail merchandisers. Most wholesalers focus on products in a particular industry. To operate effectively, wholesalers typically enter into distribution contracts with key manufacturers that provide favorable pricing on large volume purchases. The wholesaler then makes a profit if they're able to sell the products to retailers at a price that covers not only the cost of the merchandise purchased but also all of the company's other operating costs, including costs incurred in the handling and shipping of merchandise. Handling refers to the process of breaking down large shipments from manufacturers and then picking and re-packaging those goods for smaller deliveries to specific retail customers. A wholesaler's ability to perform this function efficiently and then ship the goods at the lowest possible cost is crucial to the company's ultimate success. That's why most wholesale distributors operate from large warehouses located near airports, train yards, shipping docks or major freeways. Retail distributors operate stores and shops that typically buy goods from a large number of different wholesale distributors or purchase goods directly from manufacturers and then sell those goods to final customers.

The point here is that both process and job order costing can be used on a combined basis in a company's product cost system. The determination of which method should be used for each of a company's specific costs will depend entirely on the nature of the company's products and production processes.

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The Flow of Product Costs in a Merchandising Business
Inventory
Beginning balance Cost of merchandise purchased* Ending balance XXX XXX Cost of merchandise sold

Example: A wholesaler of landscape maintenance equipment and garden tools purchased 1,000 lawn mowers from a Chinese manufacturer at a price of $75 dollars per unit.
Purchase price Freight costs Import fees and duties In-transit insurance Total Total cost per unit $75,000 5,000 2,000 500 $82,500 1,000 units $ 82.50

Cost of Goods Sold
Cost of merchandise sold XXX

* Includes the net price paid to suppliers plus any freight costs, import fees, insurance premiums paid to cover the risk of lost or damaged goods in transit from the supplier, and any other direct costs incurred in the acquisition and receipt of the purchased goods.

A merchandising company should probably also include in this cost some allocation of costs associated with the company's purchasing department, plus other costs incurred in the handling and storing of purchased goods. Those are certainly costs incurred to acquire the merchandise and get it ready for its intended use…. to be shipped or provided for sale to customers. Although that makes sense in theory, in actual practice most companies simply expense those costs when incurred as part of the company's general and administrative expenses. Meaningful allocations of those costs to specific products are difficult and efforts to understand and control those costs can be more effectively accomplished through a method referred to as activity based costing, which will be discussing in a subsequent lesson.

Total Cost Per Unit =

Total Capitalized Costs Total Number of Units Purchased

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Problem 13-3

Problem 13-3 - Answer

Merchandising Questions
1. Some manufacturers successfully sell their products direct to final end users or consumers. For example, Dell is a personal computer manufacturer that uses no wholesalers or retailers in the distribution of its products. All sales are made direct to hundreds of thousands of individual customers. Why do you suppose, most manufacturers limit their channels of distribution to wholesale and/or retail distributors, when higher prices could be charged on direct sales to end users and consumers? 2. Why do you think a retail business might choose to buy products from a wholesaler, when the same product could be purchased direct from the manufacturer at a lower price?

Merchandising Questions
1. Some manufacturers successfully sell their products direct to final end users or consumers. For example, Dell is a personal computer manufacturer that uses no wholesalers or retailers in the distribution of its products. All sales are made direct to hundreds of thousands of individual customers. Why do you suppose, most manufacturers limit their channels of distribution to wholesale and/or retail distributors, when higher prices could be charged on direct sales to end users and consumers?
Answer: Direct sales to end users and consumers usually takes a significant investment of resources and requires management expertise that may be very different from that typically found in a manufacturing business. In short, the costs incurred in a successful direct sales effort could easily exceed any additional revenues earned on higher prices. The fact is Dell is an unusual company. In fact, its really two companies in one. It's combines both manufacturing and merchandising and is totally committed in terms of management effort and resources to both phases of the business. In today's world most manufacturers have chosen to focus their efforts and limited resources on what they do best… manufacture quality products at the lowest possible cost. In effect, they've decided to leave the merchandising to other company's that specialize in the distribution process. In most cases that's not a bad decision, and in many ways that makes a lot of sense in terms of a more efficient and cost effective economy. The effective distribution of goods can be an expensive and complicated logistical process, and the development of companies that specialize in that process is a big reason why the US economy is as prosperous as it is.

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Problem 13-3 - Answer

2. Why do you think a retail business might choose to buy products from a wholesaler, when the same product could be purchased direct from the manufacturer at a lower price?
Answer: Wholesalers may provide a variety of services that can more than compensate for their product's higher price. For one, wholesalers usually offer a wide variety of merchandise that can greatly simplify a retailer's purchasing process. The savings in terms of time and effort in dealing with a few wholesalers as opposed to numerous manufacturers can be significant. In addition, wholesalers are usually set up to make smaller more frequent shipments of merchandise. This allows retailers to reduce the amount of inventory that must be maintained at any point in time to meet continuing customer demand. The maintenance of excess inventory can be extremely expensive; it eats up valuable floor space, increases handling and financing costs and can sometimes result in increased write-downs due to product obsolescence. The use of wholesalers to reduce a company's inventory levels and related costs might more than offset a wholesaler's higher product prices.

Service Businesses
A service business is any company that doesn't manufacture or distribute a physical product, or at least that's not its primary purpose.

Common service businesses include:
CPA firms Law firms Hospitals and other medical service providers Banks Real estate brokerage firms Insurance companies Consulting firms Software programming companies Airlines Trucking and delivery companies Educational institutions Etc.

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13-6

Effective management of a service company requires a knowledge and understanding of the company's product costs, just as it does for a manufacturing or merchandising business. However, in this case, product costs refer to the costs incurred in providing the company's services rather than the costs associated with the manufacture or purchase of a physical product. Example: A hospital's product costs will include all of the costs incurred in providing patient services, including:
Direct labor costs - Salaries and wages of any doctors, nurses or other employees of the hospital involved in the direct care of patients. Overhead costs* - Any salaries and wages of indirect support personnel, depreciation of buildings, equipment rent, utilities, insurance, and all of the other costs associated with the operation of the hospital.

For most service companies, direct material costs are relatively insignificant, if they exist at all. For example, a law firm may use miscellaneous office supplies in the performance of its services but those costs aren't significant enough to account for them separately as raw materials inventory or even as an asset ("Supplies"). Instead those costs are simply included as part of the company's overhead costs. For some service businesses, like a hospital, certain supplies including drugs, syringes, bandages and other items may be accounted for separately as materials inventory or supplies due to their considerable cost. When those items are then requisitioned and used in a patient's care, those costs become a direct material cost of the service provided. In fact, those costs are usually reflected in a patient's billing as a separately recorded charge.

* In many cases, service companies will also include any general and administrative costs as part of their product overhead costs. For example, a hospital may include the costs of its accounting department and other administrative personnel as part of the product overhead costs allocated to its various services. That way billing rates for those services or procedures can be set in a way that's designed to cover all of the hospital's anticipated costs. For example, the billing rate for an X-ray may be set at an amount to cover not only the direct costs associated with the X-ray but also a portion of all of the other costs of the hospital.

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Flow of Product Costs In A Service Business
Supplies
Supplies Purchased XXX XXX XXX Supplies Used Direct Labor Applied Overhead

WIP - Services
XXX XXX XXX Completed Services XXX

XXX

Overhead
Actual Overhead Under-Applied XXX XXX Applied Overhead XXX XXX Over-Applied Under-Applied Overhead

Cost of Services
Completed Services XXX XXX XXX XXX Over-Applied Overhead

Close Over-Applied XXX XXX Close Under-Applied

Any balance in the WIP - Services Account represents the company's investment in partially completed services that will ultimately produce future economic benefit when those services are completed and provided to customers. That sounds like an asset to me, and the expensing of those costs when services are finally complete and revenues are recognized from customers is consistent with the requirements of the matching principle.

0

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Product Costing Example for a Service Business
Our ultimate goal from a managerial standpoint is the determination of a company's cost per service provided. That's important information in determining the price of services to customers, as well as efforts to monitor and control costs, evaluate performance and prepare budgets for the future. Similar to a manufacturing company, the actual accounting used to determine the cost of services provided will naturally require the use of either a process or job ordercosting approach, or some combination of the two depending on the nature of the services provided. For example, a bank's determination of the costs incurred in processing each of its customer checks will naturally use a process costing approach where all of the direct and indirect costs associated with the operation of the bank's check processing department are accumulated and then divided by the number of checks processed during the period. On the other hand, the determination of a CPA firm's costs associated with the performance of a financial statement audit will require the use of a job order cost system. The costs of auditing the financial statements of General Motors will be different from the costs incurred in the performance of an audit of a small start-up company. There is no standardization of procedures in the performance of audits, and in that case, a separate job cost record will be maintained for each of the firm's various jobs. In reality, most service companies use job order costing because most services are tailored to meet the individual and unique needs of each customer.

Example: Use job order costing to do the accounting for the Jones & Company, CPA firm and determine the costs incurred in their performance of a financial statement audit for the Jordan Company for a fee of $25,000. Job Cost Record
Job Description: Jordan Company Audit Date Started: 1/5/X6 Amount of Fee: $25,000 Date Completed: Direct Labor:
Date Name Time Sheets Employee Hours

Rate

Amount

Applied Overhead:
Date Rate

Direct Labor Costs

Amount

Total Cost

$

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13-7

Accounting given the following transactions and events:
Salaries paid by the firm to its professional employees totaled $50,000 for the month. Based on time sheets, the portion of that total associated with the Jordan Company audit amounted to $14,000.
Work-in Process - Services* Cash 50,000 50,000

Job Cost Record
Date Started: 1/5/X6 Job Description: Jordan Company Audit Amount of Fee: $25,000 Date Completed: Direct Labor:
Date Name Time Sheets Employee Hours

Rate

Amount

* Sometimes referred to as "Unbilled Service Costs."

$14,000 Applied Overhead:
Date Rate Direct Labor Costs

In addition to this entry, the company's individual job cost records maintained for each of its various jobs will be updated for each job's respective share of the $50,000 total.

Amount

Total Cost

$

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Total budgeted overhead costs for the upcoming period Predetermined = Overhead Rate Total budget for the measurable activity or cost that correlates with or drives overhead costs over the same period

Assume that the Jones & Company CPA firm allocates its overhead on the basis of direct labor costs, and the firm's budgeted overhead costs for the year amounted to $350,000 with direct labor costs budgeted at $620,000.
$350,000 Predetermined = = $ .56 per direct labor dollar Overhead Rate $620,000 In the current month, the firm's total overhead application: $50,000 direct labor costs (x) $ .56 = $28,000
Work-in Process - Services Overhead 28,000 28,000

For many service companies the measurable activity or cost used in determining its overhead rate also serves as the basis for billing customers or establishing the price of its services. Such an approach makes sense given that profitable companies must charge a price for each service that covers all of its direct costs and all of its overhead costs allocated on a job-by-job basis. If the same basis used for allocating overhead is also used to establish billing rates and prices, then coverage of those costs can be reasonably assured.

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Job Cost Record
Date Started: 1/5/X6 Job Description: Jordan Company Audit Amount of Fee: $25,000 Date Completed: Direct Labor:
Date Name Time Sheets Employee Hours

Assume the firm's audit of the Jordan Company financial statement is completed at the end of the month at which time a bill is sent out for the firm's $25,000 fee.
Accounts Receivable Fee Revenues Cost of Services Work-in Process - Services 25,000 25,000 21,840 21,840

Rate

Amount

$14,000 Applied Overhead:
Date Rate Direct Labor Costs

Amount

$ .56

$14,000 Total Cost $

$ 7,840

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13-8

Job Cost Record
Date Started: 1/5/X6 Job Description: Jordan Company Audit Amount of Fee: $25,000 Date Completed: Direct Labor:
Date Name Time Sheets Employee Hours

Assume the firm's audit of the Jordan Company financial statement is completed at the end of the month at which time a bill is sent out for the firm's $25,000 fee.
Accounts Receivable Fee Revenues 25,000 25,000 21,840 21,840

Rate

Amount

$14,000 Applied Overhead:
Date Rate Direct Labor Costs

Cost of Services Work-in Process - Services

Amount

Gross profit earned = $3,160

$ .56

$14,000 Total Cost

$ 7,840 $ 21,840

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Problem 13-4

At the end of firm's accounting period, the temporary overhead account should be closed out for any over or under-application of overhead made during the period.
Overhead
Actual costs 25,800 28,000 2,200 Applied overhead ($50,000 x $ .56) Over-applied

Job Order Costing in a Service Company
Custom Software, Inc. provides software programming services to customers and bills those customers based on hourly rates associated with each of its three programmers. The hourly billing rate for each programmer is equal to 200% of the combined amount of the programmer's hourly wage rate plus allocated overhead costs. Allocations of overhead are made based on the company's total budgeted overhead costs for the year as a percentage of total anticipated programmer wages (direct labor costs). A. Given the following information, determine the hourly billing rate to be charged to customers for each programmer's services during the current year.
Programmer Budget for the Year Overhead Budget for the Year
Building rent Utilities Office salaries Office supplies Office equipment depreciation Taxes and insurance Other costs Total $ 12,000 4,200 28,000 8,800 2,400 6,600 7,600 $ 69,600

Closing entry: Overhead Cost of Services 2,200 2,200

Programmer

Wage Rate

Anticipated Hours

Mary Hart Bob Smith Eric Smart

$40/hr. $30/hr. $25/hr.

2,000 1,800 1,600

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Problem 13-4

Problem 13-4 - Answer

B. Prepare journal entries for the following during the month of January:
1. Purchased $1,000 of supplies on account. (Assume a separate asset account "Supplies" is used to account for supplies on hand.) 2. Paid programmer wages totaling $14,000. 3. Paid various overhead costs including, rent, utilities, office salaries, etc. totaling $4,800. 4. Recorded $200 of depreciation on office equipment. 5. The cost of supplies used up totaled $700. 6. Applied overhead to customer projects. 7. Billed customer (Axim Enterprises) for project started and completed during the month. (Total programmer hours incurred: Mary Hart - 120 hrs., Eric Smart - 30 hrs.)

Job Order Costing in a Service Company
A. Given the following information, determine the hourly billing rate to be charged to customers for each programmer's services during the current year.
Billing Rates for the Year
Programmer Wage Rate Overhead at 40%* of Wage Rate Wage and Overhead Rate Billing Rate

Mary Hart Bob Smith Eric Smart

$40/hr. $30/hr. $25/hr.

+ + +

$16/hr. $12/hr. $10/hr.

= = =

$56/hr. $42/hr. $35/hr.

x x x

200% 200% 200%

= $112/hr. = $84/ hr. = $70/hr.

* Overhead Rate =

Total Budgeted Overhead Costs Total Anticipated Programmer Wages

C. What was the company's markup on cost used in establishing billing rates and determine the gross margin percentage earned on the Axim Enterprises project. D. Prepare the closing entry at the end of the year if total actual overhead costs incurred during the year amounted to $70,750 and total wages paid to programmers came to $180,000.

$69,600 = 40 % of wages $174,000** **
Programmer Wage Rate Anticipated Hours Total Anticipated Wages

Mary Hart Bob Smith Eric Smart

$40/hr. $30/hr. $25/hr.

x x x

2,000 1,800 1,600

= = =

$ 80,000 $ 54,000 $ 40,000 $174,000

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13-9

Problem 13-4 - Answer

Problem 13-4 - Answer

B. Prepare journal entries for the following during the month of January:
1. Purchased $1,000 of supplies on account. (Assume a separate asset account "Supplies" is used to account for supplies on hand.) Supplies Accounts Payable 2. Paid programmer wages totaling $14,000. Work-in-Process Services Cash 14,000 14,000 1,000 1,000

6. Applied overhead to customer projects. Work-in-Process Services Overhead 5,600* 5,600

* $14,000 (programmer wages) x 40% = $5,600

7. Billed customer (Axim Enterprises) for project started and completed during the month. (Total programmer hours incurred: Mary Hart - 120 hrs., Eric Smart - 30 hrs.) Accounts Receivable* Fee Revenues
*Axim Enterprises Billing
Mary Hart Eric Smart 120 hrs. 30 hrs. x x $112/hr. $70/hr. = = $13,440 $ 2,100 $15,540

15,540 15,540

3. Paid various overhead costs including, rent, utilities, office salaries, etc. totaling $4,800. Overhead Cash Overhead Accumulated Depreciation 5. The cost of supplies used up totaled $700. Overhead Supplies 700 700 4,800 4,800 200 200

4. Recorded $200 of depreciation on office equipment.

Cost of Services** Work-in-Process Services
Direct Labor: Mary Hart Eric Smart Overhead Applied Total Cost

7,770 7,770

**Axim Enterprises Job Cost Record
120 hrs 30 hrs. $5,550 x x x $40/hr. $25/hr. 40% = = = $4,800 750 5,550 2,220 $7,770

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Problem 13-4 - Answer

Problem 13-4 - Answer

C. What was the company's markup on cost used in establishing billing rates and determine the gross margin percentage earned on the Axim Enterprises project. Fee revenues Less: Cost of services Gross margin or profit $15,540 7,770 $ 7,770

D. Prepare the closing entry at the end of the year if total actual overhead costs incurred during the year amounted to $70,750 and total wages paid to programmers came to $180,000.
Closing entry:

50% gross margin/profit $7,770 = 100% $7,770
Actual costs

Overhead Cost of Services Overhead
70,750 1,250 0

1,250 1,250

Markup Markup on Cost = = Cost

72,000 Applied overhead ($180,000 x 40%) 1,250 Over-applied

Answer: Billing rates based on 200% of cost produce a 100% markup and a 50% gross margin.

Closing entry

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