Ch. 5 Cost Components and Cost-Volume-Profit
5.2 Flow of Product Costs
Learning Objectives
After finishing this section, students will be able to:
- Identify direct materials and create a bill of materials.
- Calculate the cost of direct labor.
- Allocate overhead using the predetermined method.
- Process the sale of product.
When you make a new recipe, you need the correct ingredients or direct materials. The ingredients are used to make the recipe. The recipe is the bill of materials. The time you spend making the recipe is direct labor. You then need to think about the utilities, cost of kitchen supplies, etc. These are called overhead items because you will use them for many recipes. Every time you cook, you are making a product!
The three general categories of costs included in manufacturing processes are direct materials, direct labor, and overhead. A benefit of knowing the production costs for each product is the ability to set appropriate sales prices. For each product, management typically wants to set the price higher than its production cost. Even if management is willing to price the product as a loss leader, they still need to know how much money will be lost on each product. To achieve this, management needs an accounting system that can accurately assign and document the costs for each product.
Direct Materials
Direct materials (DM) are those materials that can be directly traced to the manufacturing of the product. Some examples of direct materials for different industries are:
- Automotive
- iron, aluminum, glass, rubber
- Cell Phones
- glass, various metals, plastic
- Furniture
- wood, leather, vinyl
- Jewelry
- gold, silver, diamonds, rubies
In order to respond quickly to production needs, companies need raw materials inventory on hand. While production volume might change, management does not want to stop production to wait for raw materials to be delivered. Further, a company needs raw materials on hand for future jobs as well as for the current job. The materials are sent to the production department as it is needed for production of the products.
Each job begins when raw materials are put into the work in process inventory. When the materials are requested for production, a materials requisition slip is completed and shows the exact items and quantity requested, along with the associated cost. The completed form is signed by the requestor and approved by the manager responsible for the budget.
Traditional billboards with the design printed on vinyl include direct materials of vinyl and printing ink, plus the framing materials, which consist of wood and grommets. The typical billboard sign is 14 feet high by 48 feet wide, and Dinosaur Vinyl incurs a vinyl cost of $300 per billboard. The price for the ink varies by color. For this job, Dinosaur Vinyl needs two units of black ink at a cost of $50 each, one unit of red ink and one unit of gold ink at a cost of $60 each, twelve grommets at a cost of $10 each, and forty units of wood at a cost of $1.50 per unit. The total cost of direct materials is $700.
Bill of Materials
Another name for a list of direct materials is bill of materials. A bill of materials (BOM) is a source of information containing a list of items to design or manufacture a product. A BOM is often the step a company skips and then does not charge the customers enough for the product leading to money problems. A good BOM will help the production process as plans are made for purchasing of inventory, maintaining inventory levels, staying on schedule, and reducing waste.
| Item | Units | $ per unit | Item Cost | Total Cost |
|---|---|---|---|---|
| Production Department | – | – | – | – |
| Vinyl | 1 | $300 | $300 | – |
| Black ink | 2 | 50 | 100 | – |
| Red ink | 1 | 60 | 60 | – |
| Gold ink | 1 | 60 | 60 | $520 |
| Finishing Department | – | – | – | – |
| Grommets | 12 | $10 | $120 | – |
| Framing wood | 40 | 1.50 | 60 | 180 |
| Total Direct Materials | – | – | – | $700 |
| Balance Sheet | Income Statement | ||||||||||||||||||
| Cash | + | Raw Materials | + | Work in Process | + | Finished Goods | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Description | |
| 13,000 | = | 13,000 | Beg. Bal | ||||||||||||||||
| -700 | 700 | = | Use Raw Materials | ||||||||||||||||
Some items are more difficult to measure per unit, such as adhesives and other materials not directly traceable to the final product. Their costs are assigned to the product as part of manufacturing overhead as indirect materials. We will evaluate indirect materials in the manufacturing overhead section later in this section.
Direct Labor
Direct labor (DL) is the total cost of wages, payroll taxes, payroll benefits, and similar expenses for the individuals who work directly on manufacturing a particular product. The biggest mistake a company makes is just using the hourly wage and forgetting to include the taxes and benefits. Once again, miscalculation cause the customer to not be charged enough for the product leading to money problems.
The direct labor costs for Dinosaur Vinyl to complete the billboard occur in the production and finishing departments. In the production department, two individuals each work one hour at a rate of $15 per hour, including taxes and benefits. The finishing department’s direct labor involves two individuals working one hour each at a rate of $18 per hour. The hours worked will be found in the companies payroll records.
| Item | Units | $ per unit | Item Cost | Total Cost |
|---|---|---|---|---|
| Production Department | – | – | – | – |
| Material Handler | 1 | $15 | $15 | – |
| Black ink | 1 | 15 | 15 | $30 |
| Finishing Department | – | – | – | – |
| Grommets | 1 | $18 | $18 | – |
| Framing wood | 1 | 18 | 18 | 36 |
| Total Direct Materials | – | – | – | $66 |
| Balance Sheet | Income Statement | |||||||||||||||||
| Cash | + | Raw Materials | + | Work in Process | + | Finished Goods | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Description |
| 13,000 | = | 13,000 | Beg. Bal | |||||||||||||||
| -700 | 700 | = | Use RM | |||||||||||||||
| -66 | 66 | = | DL | |||||||||||||||
Manufacturing Overhead
Recall that the costs of a manufactured item are direct materials, direct labor, and manufacturing overhead. Costs that support production but are not direct materials or direct labor are considered overhead. Manufacturing overhead has three components: indirect materials, indirect labor, and overhead.
Indirect Materials
Indirect material costs are derived from the goods not directly traced to the finished product, like the sign adhesive in the Dinosaur Vinyl example. Tracking the exact amount of adhesive used would be difficult, time consuming, and expensive, so it makes more sense to classify this cost as an indirect material. Another example, a furniture factory classifies the cost of glue, stain, and nails as indirect materials. Nails are often used in furniture production; however, one chair may need 15 nails, whereas another may need 18 nails. At a cost of less than one cent per nail, it is not worth keeping track of each nail per product. It is much more practical to track how many pounds of nails were used for the period and allocate this cost (along with other costs) to the overhead costs of the finished products.
Indirect Labor
Indirect labor represents the labor costs of those employees associated with the manufacturing process, but whose contributions are not directly traceable to the final product. These would include the costs of the factory floor supervisor, the factory housekeeping staff, and factory maintenance workers. For Dinosaur Vinyl, for example, labor costs for the technician who maintains the printers would be indirect labor. It would be too time consuming to determine how much of the technician’s time is attributable to each sign being produced. It makes much more sense to classify that labor expense as indirect labor.
It is important to understand that the allocation of costs may vary from company to company. What may be a direct labor cost for one company may be an indirect labor cost for another company or even for another department within the same company. Deciding whether the expense is direct or indirect depends on its task. If the employee’s work can be directly tied to the product, it is direct labor. If it is tied to the factory but not to the product, it is indirect labor. If it is tied to the marketing department, it is a sales and administrative expense, and not included in the cost of the product. For example, salaries of factory employees assembling parts are direct labor, salaries of factory employees performing maintenance are indirect labor, and salaries of employees in the marketing department are sales and administration expenses.
Overhead
The last category of manufacturing overhead is the overhead itself. These costs are necessary for production but not efficient to assign to individual product production. Examples of typical overhead costs are production facility electricity, warehouse rent, and depreciation of equipment.
But note that while production facility electricity costs are treated as overhead, the organization’s administrative facility electrical costs are not included as overhead costs. Instead, they are treated as period costs, as office rent or insurance would be.
When both administrative and production activities occur in a common building, the production and period costs would be allocated in some predetermined manner. For example, if a 10,000 square foot building were physically allocated at 4,000 square feet for administrative purposes and 6,000 square feet for production, a company might allocate its annual $30,000 property tax expense on a 40%/60% basis, or $12,000 as a period cost for the administrative offices and a production (overhead) cost of $18,000.
Dinosaur Vinyl’s records indicates that $25,000 of expenses where paid for manufacturing overhead for the month.
- $4,000 in manufacturing supervisor’s wages
- $1,500 in raw materials that is untraceable to the product
- $7,000 in utilities expense
- $7,500 in factory equipment depreciation
- $2,917 in insurance expense
- $2,083 in interest expense
| Balance Sheet | Income Statement | ||||||||||||||||||||
| Cash | + | Raw Materials | + | Manuf. Overhead | + | Work in Process | + | Finished Goods | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Description | |
| 13,000 | = | 13,000 | Beg. Bal | ||||||||||||||||||
| -700 | 700 | = | Use RM | ||||||||||||||||||
| -66 | 66 | = | DL | ||||||||||||||||||
| -23,500 | -1,500 | 25,000 | = | Actual OH | |||||||||||||||||
Predetermined Overhead
Cost systems maintain the actual direct materials and direct labor for each individual job. Since production consists of overhead—indirect materials, indirect labor, and other overhead—we need a methodology for applying that overhead. Unfortunately, the nature of indirect material, indirect labor, and other overhead expenses makes it impossible to determine the exact amount of overhead for each specific job.
The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The expected overhead is estimated, and an allocation system is determined. The actual costs are accumulated in a manufacturing overhead account. The overhead is then applied to the cost of the product from the manufacturing overhead account. The overhead used in the allocation is an estimate due to the timing considerations already discussed.
The application rate that will be used in a coming period, such as the next year, is often estimated months before the actual overhead costs are experienced. Often, the actual overhead costs experienced in the coming period are higher or lower than those budgeted when the estimated overhead rate or rates were determined. The predetermined rate is calculated as shown and is used to apply overhead costs to work in process:
Predetermined Overhead Rate (PDOR) = Estimated Overhead Cost / Expected Level of Activity
| Overhead Expense | Annual Estimate |
|---|---|
| Indirect labor | $5,000 |
| Indirect materials | 20,000 |
| Utilities | 75,000 |
| Depreciation | 90,000 |
| Insurance | 35,000 |
| Interest Expense | 25,000 |
| Total overhead expense | $250,000 |
Dinosaur Vinyl also used its payroll records to estimate that it will spend $100,000 on direct labor. Using the predetermined overhead rate calculation, the overhead rate is $2.50 per direct labor dollar:
PDOR ($2.50) = Estimated Overhead Cost ($250,000) / Expected Direct Labor Cost ($100,000)
Over the fiscal year, the actual costs are recorded into the account called manufacturing overhead. When the overhead is applied to the jobs, the amount is first calculated using the application rate. If the total labor paid for the job is $66, the overhead applied to the job is $2.50 times that amount, or $165.
| Balance Sheet | Income Statement | |||||||||||||||||||
| Cash | + | Raw Materials | + | Manuf. Overhead | + | Work in Process | + | Finished Goods | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Description |
| 13,000 | = | 13,000 | Beg. Bal | |||||||||||||||||
| -700 | 700 | = | Use RM | |||||||||||||||||
| -66 | 66 | = | DL | |||||||||||||||||
| -23,500 | -1,500 | 25,000 | = | Actual OH | ||||||||||||||||
| -165 | 165 | = | Applied OH | |||||||||||||||||
Processing the Sale of Product
| Balance Sheet | Income Statement | |||||||||||||||||||
| Cash | + | Raw Materials | + | Manuf. Overhead | + | Work in Process | + | Finished Goods | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Description |
| 13,000 | = | 13,000 | Beg. Bal | |||||||||||||||||
| -700 | 700 | = | Use RM | |||||||||||||||||
| -66 | 66 | = | DL | |||||||||||||||||
| -23,500 | -1,500 | 25,000 | = | Actual OH | ||||||||||||||||
| -165 | 165 | = | Applied OH | |||||||||||||||||
| -931 | 931 | = | Finished | |||||||||||||||||
| Balance Sheet | Income Statement | |||||||||||||||||||
| Cash | + | Raw Materials | + | Manuf. Overhead | + | Work in Process | + | Finished Goods | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | COGS | = | Net Income | Description |
| 13,000 | = | 13,000 | Beg. Bal | |||||||||||||||||
| -700 | 700 | = | Use RM | |||||||||||||||||
| -66 | 66 | = | DL | |||||||||||||||||
| -23,500 | -1,500 | 25,000 | = | Actual OH | ||||||||||||||||
| -165 | 165 | = | Applied OH | |||||||||||||||||
| -931 | 931 | = | Finished | |||||||||||||||||
| 2,000 | = | 2,000 | 2,000 | – | = | 2,000 | Revenue | |||||||||||||
| -931 | = | -931 | – | 931 | = | 931 | COGS | |||||||||||||
The process for tracking a product being made is complex and we have only looked at one vinyl sign. The visual of tracking costs should help you understand the complexity of costs and why miscalculation causes the customer to not be charged enough for the product. It is encouraged that management should understand all costs so the sales price of a product is determined correctly.
An Income Statement is created to finish the process.
| Dinosaur Vinyl | ||
| Income Statement | ||
| Revenue | $2,000 | |
|---|---|---|
| COGS | 931 | |
| Gross Profit | $1,069 | |
5.2a Example
The following transactions for Hurley’s Haberdashery occurred.
| Date | Transaction Detail |
|---|---|
| 1 | Purchased $2,400 of raw materials on account. |
| 2 | The factory requisitioned $2,200 in raw materials of which $2,000 are direct materials and $200 are indirect materials. |
| 3 | Wages of $2,500 were paid, of which $600 was for the part time maintenance man/janitor and the rest was for the employees who physically create the hats. |
| 4 | Other actual manufacturing overhead costs of $400 were incurred and paid. |
| 5 | Manufacturing overhead of $1,100 was applied. |
| 6 | Hats costing $5,600 were finished. |
| 7 | Hats costing $5,350 were sold for cash of $8,600. |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- Prepare an Income Statement for February 28, 20X2. DO NOT calculate income tax.
- If Hurley’s sold 28 hates during the period, what was the cost of each hat?
- How much is the gross profit (aka gross margin) for each hat?
5.2a Homework
The company applies overhead based on a predetermined overhead rate based on machine-hours. The following transactions for Widgets R US occurred.
| Date | Transaction Detail | |
|---|---|---|
| 1 | $450,500 in raw materials were purchased on account. | |
| 2 | $418,500 in raw materials were requisitioned for use in production, of that amount $390,500 were for direct materials, the remainder was for indirect materials. | |
| 3 | The following employee wages incurred and were paid: Direct labor, $157,500; Indirect labor, $70,500; and administrative salaries, $207,500. | |
| 4 | $79,500 of selling costs were incurred on account. | |
| 5 | $13,500 in factory utility costs were paid. | |
| 6 | Depreciation for the year was $104,000, of which $95,500 is related to factory operations and $8,500 is related to selling and administrative activities. (Hint: How are factory expenses different from selling and administrative expenses?) | |
| 7 | $204,500 of manufacturing overhead was applied. | |
| 8 | Product finished during the year was $747,000. | |
| 9 | Cash sales for the year totaled $1,098,000. The cost of goods sold was $732,000. | |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- Prepare an Income Statement for April 30, 20X3. DO NOT calculate income tax.
- What is Net Income?
- If 2,000 widgets were sold, what was the cost of each widget?
- How much is the gross profit (aka gross margin) for each widget?
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 2: Managerial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
are those materials that can be directly traced to the manufacturing of the product.
is a source of information containing a list of items to design or manufacturing a product.
is the total cost of wages, payroll taxes, payroll benefits, and similar expenses for the individuals who work directly on manufacturing a particular product.
