Functional Based Product Costing 582dy

FUNCTIONAL BASED PRODUCT COSTING Exhibit 4-1 shows a general functional-based product costing model. Asg the cost of direct materials and direct labor to products proses little challenge. The costs can be assigned to products using direct tracing, and most functional-based costing system are designed to ensure that this tracing takes place. Overhead costs, on the other hand, pose a different problem. The physically observable input-output relationship that exists between direct labor, direct materials, and products is simply not available for overhead. Thus, assignment of overhead must rely on driver tracing and perhaps on allocation. Functional-based costing first assign overhead coast to a functional unit, creating either plantwide or departmental cost pools. These pooled costs are then assigned to products using predetermined overhead rates based on unit level drivers. A predetermined overhead rate is calculated at the beginning of the year using the following formula. Overhead rate = budgeted annual overhead/budgeted annual driver level. Predetermined rates are used because overhead and production often are incurred non uniformly throughout the year, and it is not possible to wait until the end of the year to calculate the actual overhead cost assignments (managers need unit product cost information throughout the year). A cost system that uses predetermined overhead rates and actual costs for direct materials and direct labor is referred to as normal costing system. Budgeted overhead is usually the tirm’s best estimate of the amount or overhead (utilities, indirect labor, depreciation, etc.) to be incurred in the coming year. The estimate is often based on last year’s figures, adjusted for anticipated changes in the coming year. The second input requires that the predicted level for an activity driver be specified. Assignment of overhead costs should follow, as nearly as possible, a cause and-effect relationship. Drivers are the causal factors that measure the consumption of overhead by product. In functional-based costing, only unit-level drivers are used to calculate overhead rates. Unit-level driver are factors that measure the demand placed on unit-level activities by product. Unit-level activities are activities performed each and every time a unit of a product is produced. The five most commonly used unit-level drivers are : 1. Units produced 2. Direct labor hours 3. Direct labor dollars 4. Machine hours

5. Direct material dollars Unit-level drivers increase as units produced increase. Thus, the use of only unit-based drivers to assign overhead costs to products assumes that all overhead consumed by products is proportional to the number of units produced. To the extent that this assumption is valid, functional-based costing system can produce accurate product cost information. Plant wide or departmental predetermined overhead rates are used to assign or apply overhead costs to production as the actual production activity unfold. The total overhead assigned to actual production at any point in time is called applied overhead. Applied overhead is computed using the following formula : Applies overhead = overhead rate x actual driver usage OVERHEAD APPLICATION: PLANTWIDE RATE In the plant wide rate approach, all budgeted costs are accumulated to a single planwide cost pool (first-stage cost assignment). A plan wide rate is then calculated using a single unit-level driver, such as direct labor hours. Finally, overhead costs are assigned to products by multiplying the rate by the actual direct labor hours used by each product (second-stage assignment). These steps are best illustrated with an example. Suncale, Inc.., produces two unique, solarpowered products: a pocket calculator and a currency translator used to convert foreign currency into U.S. dollars and vice versa. Suncale uses a plandwide rate based on direct labor hours to assign its overhead costs. The company has the following estimated and actual data for the coming year : Budgeted overhead Expected activity (in direct labor hours) Actual activity (in direct labor hours) : Pocket calculator Currency translator Actual overhead Units produced Pocket calculator Currency translator

$360,000 120,000 40,000 60,000 100,000 $320,000 80,000 90,000

UNDERAPPLIED AND OVERAPPLIED OVERHEAD Notice that the amount of overhead applied to production ($300,000) differs from the actual overhead incurred ($320,000). Since the predetermined overhead rate is based on estimated data, applied overhead will rarely equal overhead. Since only ($300,000) was applied in our example, the firm has underpplied overhead by $20,000. If applied overhead had been $330,000, too much overhead would have been applied to production. The firm would have overhead by $10,000. The difference between actual overhead and applied overhead is an overhead variance. If actual overhead is greater than applied overhead, then the variance is called under applied overhead if applied overhead is greater than actual overhead, then the variance is called over applied overhead. Overhead variances occur because it is impossible to perfectly estimate future overhead costs and production activity. Costs reported on the financial statements must be actual-not estimated amounts. Accordingly, at the end of a financial reporting period procedures must exist to dispose of any overhead variance. DISPOSITION OF OVERHEAD VARIANCES An overhead variance is disposed of in one two ways: 1. If immaterial, it is assigned to cost of goods sold 2. If material, it is allocated among work-in-process inventory, Finished goods inventory, and cost of goods sold. ASSIGNED TO COST OF GOODS SOLD The most common practice is simply to assign the entire overhead variance to costs of goods sold. The practice is justified on the basis of materiality, the same principle used to justify expensing the entire cost of a pencil sharpener in the period acquired rather than allocating (through depreciation) its cost over the life of the sharpener. Thus the overhead variance is added to cost of goods sold if under applied and subtracted from cost of goods sold if over applied. For example, assume that Suncalc has an ending balance in its cost of goods sold equal to $500,000. The underpplied variance of $20,000 would be added to produce a new, adjusted balance of $520,000. Assuming that both actual and applied overhead are accumulated in the overhead control , the journal entry associated with this adjustment would be :

Cost of goods sold

20,000

Overhead control

20,000

ALLOCATED TO PRODUCTION S If the overhead variance is material, it should be allocated to the period’s production. Conceptually, the overhead costs of a period belong to goods started but not complemented (work-in-process inventory), goods finished but not sold (finished goods inventory), and goods finished and sold (cost of goods sold). The recommended way to achieve this allocation is to prorate the overhead variance based on the ending applied overhead balances in each . Using applied overhead captures the original cause-and-effect relationships used to assign overhead. using another balances, such as total manufacturing coasts, may result in an unfair assignment of the additional overhead. for example, two products identical on all dimensions except for the coast of direct material inputs should receive the same overhead assignment. Yes if total manufacturing coasts were used to allocate overhead variance, then the product with the more expensive direct materials would receive a higher overhead assignment. To illustrate the disposition of the overhead variance using the recommended approach, assume that Suncalc’s s had the following applied overhead balances at the end of the year: Work-in-process inventory

$60,000

Finished goods inventory

90,000

Coast of goods sold

150,000

Total

$300,000

OVERHEAD APPLICATION: DEPARTMENTAL RATES For departmental rates, overhead coast are first assigned to individual departments, creating departmental overhead coast pools. In this stage, producing departments are coast objects and budgeted overhead coasts are assigned using direct tracing, driver tracing, or allocation. Once coasts are assigned to individual production departments. Then unit-level drivers such as direct labor hours (for labor-intensive departments) and machine hours (for machine-intensive departments) are used to compute predetermined overhead rates for each departments. Products ing through the departments are assumed to consume overhead resources in proportion to

the departments’ unit-level drivers (machine hours or direct labor hours used). Thus, in the second stage, overhead is assigned to products by multiplying the departmental rates by the amount of the driver the products use in the respective departments. The total overhead assigned to products is simply the sum of the amounts received in each department. Increased accuracy is the usual justification offered for the use of departmental rates. The Suncalc example will again be used to illustrate the use of departmental rates. Assume that Suncalc has two producing departments: fabrication and assembly. Machine hours are used to assign the overhead of fabrication and direct labor hours are used to assign the overhead of Assembly. The following data are provided. LIMITATIONS OF PLANTWIDE AND DEPARTMENTAL RATES Plant wide and departmental rates that characterize functional-based costing system have been used for decades. In the early 1900s the majority of manufacturing costs were labor related. Therefore, it was logical to use only unit-level drivers, such as direct labor hours as the basis for asg overhead costs to products. When labor coast made up a smaller portion of total product coast and companies became more diversified with with more complex manufacturing processes, using direct labor hours as a basis for asg overhead coast resulted in inaccurate product coast information and less than optimal product mix. At least two major factors can impair the ability of the unit-based plant wide and departmental rates to assign overhead coasts accurately: (1) the proportion of non-unit related overhead costs to total overhead costs is large, and (2) the degree of product diversity is large. NON-UNIT RELATED OVERHEAD COSTS The use of either plant wide rates or departmental rates assumes that a product’s consumption of overhead resources is related strictly to and proportional to the units produced this assumption, however, does not take economies of scale into . Products manufactured in large production runs are assigned the same cost per unit as those manufactured in small production runs. Unfortunately, some costs do not change as a function of the batch size. For example, setup costs are incurred each time a batch of products is produced. A batch may consist of 1,000 or 10,000 units, but the cost of setup is the same. Logically, if setup costs for each is the same, the applied setup cost per unit. In a smaller batch should be higher than that in a larger batch. Since

functional-based costing system spread the setup costs equally among all units produced without regard. To the batch in which they are produced, large batch production is often “penalized.” In the case of setup costs, the number of setups, instead of the number of units produced or direct labor hours consumed, should be the cause of setup costs. As another example, product engineering costs may depend on the number of different engineering work order rather than the units produced of any given product. Both these examples illustrate the existence of non-unit based drivers. Non-unit-based drivers are factors, other than the numbers of units produced, that casually measure the demand that product place on activities. If the proportion of total overhead costs these non-unit related costs represent is large, using unit level drivers to assign these nonunit-related overhead costs can generate distorted product costs. PRODUCT DIVERSITY Plant wide rate or departmental rates will not cause product cost distortion if products consume the non-unit-level overhead activities in the same proportion as the unit-level overhead activities. Product diversity, on the other hand