In Stage 1 of a cost accounting system, some basic decisions that get made. These include defining a cost object, determining cost centers, distinguishing between direct and indirect costs, choosing allocation bases for service center costs, selecting an allocation method, and choosing between process and job order cost systems. Upon completion of this stage, costs have been allocated from service centers to production centers.
During Stage 2, production center costs must be “attached” to the products (or services) that are worked on (or delivered by) the organization. In many organizations, but especially in manufacturing ones, attaching costs to products can be especially tricky. Indeed, some organizations spend considerable effort determining precise allocation bases to allocate service center costs to production centers, but then use a highly simplistic approach to attach production center costs to products. As a result, they may be deceived about the accuracy of their product’s costs. 1
This Note addresses Stage 2 of a cost accounting system. In particular, it focuses on some complexities in cost accounting that arise in manufacturing companies, and introduces some concepts that are useful in both manufacturing and service organizations, such as standard costs and overhead variance analysis. Both are relatively old but powerful ideas. It also discusses the concept of variable costing, which is a technique that some organizations use to avoid the complexities associated with manufacturing overhead.
ORGANIZATION OF THE NOTE
The note begins with some terminology that is especially important in manufacturing organizations, and shows the financial statements that report the results of manufacturing activities. Next, we turn to the computation of costs in a manufacturing context. This requires understanding the various manufacturing inventories, and bringing them into the cost accounting context. We look at these ideas in both job order and process systems of accounting.
We next address the question of overhead, relating it to the allocation bases used in Stage 1. This leads to the idea of standard costs, which is an important aspect of both cost measurement and control. Next, we take up absorption costing (sometimes called full costing), a technique used by manufacturing organizations to account for costs as raw materials move through the production effort to become finished goods. In most situations, absorption costing requires the use of standard costs, which creates the need to look at the variances between them and actual production costs. We examine three important variances in overhead costs: volume, efficiency, and spending.
The note then turns to the topic of variable costing, a technique that removes fixed manufacturing overhead from the absorption process, treating it as a period cost rather than a product cost. In so doing, it relies on the distinction between fixed and variable costs. While not permitted by GAAP for external reporting purposes, this technique frequently is used internally by managers to help them better understand how manufacturing costs are being incurred. The note compares absorption costing with variable costing, identifies the differences between the approaches, and discusses the advantages and disadvantages of each. The note’s learning objectives are contained in Exhibit 1.
Exhibit 1. LEARNING OBJECTIVES
Upon completing this note, you should know about:
- The various types of costs that exist in manufacturing settings
- Computing cost of goods manufactured and cost of goods sold with job order and process systems
- Overhead rates, including predetermined overhead rates
- Flexible overhead budgets and the computation of overhead variances
- The managerial uses of overhead variances
- The distinction between absorption costing and variable costing, and the advantages and disadvantages of each
- The cause of a difference between income under absorption costing and variable costing under the same set of manufacturing and selling circumstances
- The reason why there can be an overhead volume variance under absorption costing, but not under variable costing.
- The impact of just-in-time (JIT) manufacturing operations on the differences between absorption and variable costing.
1 A great deal has been written about this problem. These issues are explored more fully in David W. Young, Note on Activity-Based Costing, Cambridge, The Crimson Press Curriculum Center. That note contains references to the accounting literature on the topic.