Absorption costing

Absorption costing

We allocate costs for several reasons:

If you take one thing from this course it is the following:

Absorption costing: key features

While absorption costing (the allocation of all costs) is useful for financial reporting, it is often misleading for internal decision making. The following problems should highlight which costs should not be allocated as much as which costs should be allocated.

Brief review of cost concepts

Brief review: Topics

  1. Direct vs. Indirect Costs.
  2. Fixed vs. Variable Costs.
  3. The managerial use of accounting information.

Brief Review: Direct vs. Indirect Costs

The easiest way to think about the difference between direct and indirect costs is to think about whether it makes sense (i.e. is easy/cost effective) to track the consumption of costs for each unit of output (each unit of the final product, or any particular production step–i.e. any ‘activity’).

Direct costs are usually the components of the final product (direct materials) and the labor to produce the final product (direct labor). The physical things in the product and the time of the people who touch them.

Indirect costs are most often things that support the direct activities. All costs in support departments, and any costs that don’t neatly track to individual units of output or activities. For example: line workers’ clean room suits, clean room maintenance, cleaning supplies. Anything else that we decide not to directly track.

Brief Review: Direct vs. Indirect Costs

Example: Laptop computer.

Brief Review: Direct vs. Indirect Costs

The distinction is whether it makes sense to track the actual consumption of the cost for each unit of output (or activity). If it does, then the cost is direct, if not the cost is indirect.

Cost Type Easy to track?
Direct Yes
Indirect No

Brief Review: Fixed vs. Variable Costs

Cost Type Changes with Output/Activity
Fixed No
Variable Yes

Brief Review: The managerial use of accounting information

You might have some questions at this point in the course:

  1. Why don’t we do journal entries?
  2. Why are we allowed to just not allocate some costs?
  3. Don’t we have to keep track of everything?

Brief Review: The managerial use of accounting information

Absorption costing (and financial accounting) is about tracking the flow of value through a firm. In managerial accounting we are interested in (1) aligning incentives, (2) making decisions, and (3) controlling costs. In each case, we are interested in understanding the impact of our choices on costs. This means that we will often ignore costs that are irrelevant to the decision we are considering.

Note that all three uses of managerial accounting have implicit or explicit decisions.

DeJure Scents

Problem details

DeJure Scents manufactures an aftershave and uses process costing. All materials are added at the beginning of the process, and conversion costs are incurred uniformly over time. In May, DeJure started 15,000 gallons. There was no beginning inventory. May’s ending inventory of work-in-process was 2,000 gallons, which were 50 percent complete with respect to conversion costs. In May, conversion costs were $28,000 and materials costs were $45,000.

Questions

  1. Calculate the equivalent units of conversion and materials.
  2. Calculate the cost per equivalent unit of conversion and materials.
  3. Calculate the cost of the ending inventory and the cost transferred to finished goods inventory.

Concepts

  1. Process costing
  2. Conversion costs
  3. Equivalent units

Process costing

In process costing no costs are direct, we allocate all costs based on cost drivers (allocation bases). The choice to use process costing implies that it is not feasible to track the consumption of costs for each unit of output, or it’s simply not worth the time.

Process costing

  1. beginning work-in-process inventory,
  2. units started and finished this period, and
  3. ending work-in-process inventory.

Conversion costs

Equivalent units

Setup

Physical flow: Gallons E.U Conversion E.U. Materials
WIP, begin. 0 0 0
Units started 15,000    
Units to account for 15,000    

Note: E.U. is ‘equivalent units.’

WIP-Effective Units

  Gallons E.U Conversion E.U. Materials
Work-In-Process, ending (50%) 2,000 ? ?

What information do we have to help us fill in this table?

WIP-Effective Units

  Gallons E.U Conversion E.U. Materials
Work-In-Process, ending (50%) 2,000 ? 2,000

All materials are added at the beginning of the process.

WIP-Effective Units

  Gallons E.U Conversion E.U. Materials
Work-In-Process, ending (50%) 2,000 .5 $\times$ 2,000 2,000

Conversion costs are incurred uniformly over time.

Units accounted for

  Gallons E.U Conversion E.U. Materials
Work-In-Process, ending (50%) 2,000 1,000 2,000
Completed 13,000 13,000 13,000
Units accounted for 15,000 14,000 15,000

Cost per equivalent unit

  Total E.U. Conversion E.U. Materials
Units 15,000 14,000 15,000
Costs $73,000 $28,000 $45,000
per equi. unit   $2.00 $3.00

Overhead rate

Cost of inventory and transfer to finished goods

  Gallons E.U Conversion E.U. Materials
Work-In-Process, ending $ 8,000 $2,000 $6,000
    $($2\times1000)$ $($3\times2000)$
Finished goods inventory $65,000 $26,000 $39,000
    $($2\times13,000)$ $($3\times13,000)$
Total costs $73,000 $28,000 $45,000

Did we learn anything interesting here?

But what are the $2.00 and $3.00 amounts doing?

Kitchen Rite: Outsourcing and job order costing

Job order costing

Kitchen Rite

Kitchen Rite is considering outsourcing the production of a steel chassis that is used in a kitchen appliance. Two thousand chassis are produced per month. An outside vendor will supply an identical chassis for $9.90. The chassis is manufactured in two steps. A stamping press punches out the part from sheet metal, bends the sides, and cuts holes in it, all in one operation. Then a welding machine welds the corners. Both the welding and stamping machines are used to produce only this one chassis model.

Job cost sheet

The following job order cost sheet summarizes the costs of producing a single chassis.

  Cost per Unit
Steel Plate $4.75
Direct Labor:  
- Stamping ($20/hr) 1.60
- Welding ($30/hr) 2.50
Overhead:  
- Stamping (depreciation) 3.60
- Welding (lease payment) 2.15
General plant 5.90
  $ 20.50

Machine details

The stamping machine is old and has little economic value. A used equipment dealer is willing to remove the machine and haul it away at no cost. The stamping machine was purchased 13 years ago for $1,728,000. For both tax and reporting purposes, it is being depreciated using a 20-year life, straight-line method, and it has zero salvage value. The welding machine is leased for $4,300 per month, and the lease can be canceled at any time and the machine returned. However, an early termination penalty of $1,800 per month for the next 42 months must be paid.

Plant overhead

General plant overhead consists primarily of the allocated cost of depreciation on the plant, property taxes, and fire insurance on the plant. Kitchen Rite currently has excess plant space. The manufacturing space freed up if the chassis is outsourced has no other use.

Labor

Employees are unionized and have a clause in their contract that prevents the firm from firing them if their jobs are eliminated due to outsourcing. The employees working on the stamping machine will be placed on indefinite furlough at 75 percent of their current pay. The employees operating the welding machine can be reassigned to other positions in the firm as job openings occur. Given the high demand for welders, these reassignments will occur within a few weeks of outsourcing the chassis.

Taxes

Kitchen Rite has a tax loss for the current and the previous two years.

Questions

Should Kitchen Rite outsource the chassis? Support your recommendation with a clear financial analysis of the facts.

Consider

This problem illustrates that not all direct labor costs are incremental and not all fixed overhead costs are sunk.

Current cash flows

The current cash outflows of manufacturing the chassis per unit are:

   
Direct material $ 4.75
Direct labor:  
Stamping 1.60
Welding 2.50
Overhead:  
Stamping 0
Welding ($4,300 ÷ 2,000) 2.15
Total $11.00

Cash outflows if we outsource

   
Purchased chassis $ 9.90
Stamping labor (75% × 1.60) 1.20
Welding lease early termination ($1,800 ÷ 2,000) .90
Total $12.00

Recommendation

Do not outsource because the net cash flows of outsourcing are lower than continuing to manufacture the chassis internally.

Are these numbers that we can use?