This chapter describes the kinds of operations that call for a process cost system and distinguishes it from job costing. It explains the concept of equivalent units, computing equivalent units and unit costs under the average cost procedure, preparing a production cost report, and distinguishing normal spoilage from abnormal spoilage.
When process costing applies
Process costing suits companies that produce large quantities of similar or identical units through a continuous, standardized process, such as a food or chemical manufacturer, in contrast to job costing, which accumulates costs by individual job or batch for companies producing distinct, custom units. Under process costing, costs are accumulated by department or process for a period and then spread evenly over all the units that passed through it.
Equivalent units and unit costs
Because a department typically has partially completed units in process at both the beginning and end of a period, process costing converts those partial units into equivalent whole units to make cost averaging possible; a unit that is 40 percent complete counts as 0.4 of an equivalent unit for that cost element. Dividing total costs by total equivalent units, under the average cost procedure, produces the unit cost used to value both units transferred out and the ending work in process.
The production cost report and spoilage
A production cost report ties directly to the Work in Process Inventory account, showing the physical units and costs a department is accountable for and how those costs are assigned to units completed and to ending inventory. Some spoilage is normal, an expected byproduct of the production process absorbed into the cost of good units, while abnormal spoilage, arising from unusual circumstances, is instead treated as a loss of the period in which it occurs.
This chapter shows how to calculate and record the sale, retirement, and destruction of plant assets, and how to account for exchanges of nonmonetary assets. It covers determining the periodic depletion cost of a natural resource, depreciating plant assets on extractive industry property, recording the acquisition and amortization of intangible assets, and total assets turnover.
Disposing of plant assets
When a plant asset is sold, retired, or destroyed, its cost and accumulated depreciation must first be removed from the accounts, and any difference between the amount received, if any, and the asset’s remaining book value is recorded as a gain or a loss. Exchanges of one nonmonetary asset for another follow a related but distinct set of rules for measuring the new asset’s cost and recognizing any gain or loss on the transaction.
Depletion of natural resources
A natural resource such as timber, oil, or a mineral deposit is gradually consumed as it is extracted, and its cost is allocated to the units removed through depletion, calculated per unit and then applied to the quantity extracted during the period. Plant assets located on extractive industry property, such as roads or equipment built to support extraction, are depreciated in a manner that reflects the resource’s own extraction pattern rather than a simple straight-line schedule.
Intangible assets
Intangible assets, such as patents, copyrights, trademarks, and goodwill, lack physical substance but still provide future economic benefit, and their acquisition cost is recorded and then amortized over their useful or legal life, whichever is shorter. The chapter closes by using total assets turnover, which relates net sales to average total assets, to analyze how effectively a company is using its full base of assets, tangible and intangible, to generate revenue.
This chapter compares managerial accounting with financial accounting and identifies the basic components of a product’s cost, distinguishing product costs from period costs. It compares financial reporting by a merchandiser with that of a manufacturer, traces cost flows through a job costing system, and explains predetermined overhead rates.
Managerial versus financial accounting, and product cost
Managerial accounting serves internal decision makers with detailed, forward-looking information prepared as needed, while financial accounting serves external users through general-purpose statements prepared under set standards; the two draw on much of the same underlying data but for different audiences. A manufactured product’s cost consists of direct materials, direct labor, and manufacturing overhead, and only these product costs attach to inventory, while period costs, such as selling and administrative expenses, are expensed as incurred regardless of production volume.
Reporting for a manufacturer
A manufacturer’s financial statements differ from a merchandiser’s mainly in the cost of goods sold section: rather than simply purchasing finished goods for resale, a manufacturer prepares a statement of cost of goods manufactured that tracks materials, labor, and overhead through work in process into finished goods. The resulting cost of goods manufactured then flows into the income statement, and unsold inventory at each stage of production appears among the assets on the balance sheet.
Job costing and overhead rates
A job cost system accumulates the materials, labor, and overhead costs of production according to individual jobs, which suits companies that produce distinct, identifiable units or batches, such as a construction project or a custom order. Because actual overhead costs are not known until a period ends, companies apply overhead to jobs using a predetermined overhead rate, calculated in advance by dividing estimated overhead by an estimated activity base, so job costs can be determined as work is completed.
This chapter describes the features of bonds and how they differ from stock, and the advantages and disadvantages of financing with long-term debt, including financial leverage. It covers pricing a bond using present value, recording bonds issued at face value, at a discount, or at a premium, bond redemptions and conversions, and bond ratings.
Bonds compared with stock
A bond is a formal promise to pay a stated amount at a future maturity date plus periodic interest, which makes it fundamentally different from stock: interest is a fixed, tax-deductible obligation regardless of company earnings, while dividends are discretionary and paid only after taxes. Financing with long-term debt can amplify returns to shareholders through financial leverage when the return earned on borrowed funds exceeds their interest cost, but it also raises fixed obligations the company must meet even in a poor year.
Pricing and recording bonds
A bond’s issue price is found by applying the concept of present value to its future interest payments and maturity amount, discounted at the market rate of interest; when the market rate differs from the bond’s stated rate, the bond sells at a discount or a premium rather than at face value. The chapter shows the journal entries required in each case, at issuance and as interest is recorded, as well as the entries for bonds issued exactly at face value.
Redemptions, conversions, and ratings
Bonds can be redeemed before maturity or converted into shares of stock under terms set when they were issued, each requiring its own set of journal entries to remove the bond liability and recognize any resulting gain or loss. Independent rating agencies assign bond ratings that signal a company’s creditworthiness to investors, and the times interest earned ratio, which relates income before interest and taxes to interest expense, measures how comfortably a company can meet its interest obligations.
This chapter explains cost behavior patterns and how to separate mixed costs into fixed and variable components using the scatter diagram and high-low method. It covers the relationship among costs, volume, revenue, and profits, finding the break-even point and margin of safety, applying cost-volume-profit analysis, and the assumptions and limitations that underlie it.
Cost behavior and separating mixed costs
Costs behave differently as volume changes: fixed costs stay constant in total regardless of activity level, while variable costs change in direct proportion to it, and many real costs are mixed, containing both a fixed and a variable element. The scatter diagram plots cost against activity to visualize this relationship, while the high-low method uses the highest and lowest activity levels observed to estimate the fixed and variable components mathematically.
Break-even point and margin of safety
The break-even point is the sales volume, in units or dollars, at which total revenue exactly equals total costs and profit is zero, found by relating the contribution margin, the amount each unit contributes toward fixed costs after covering its variable cost, to total fixed costs. The margin of safety measures how far actual or expected sales can fall before the company reaches that break-even point, giving managers a sense of how much cushion exists against a downturn.
Applying and questioning the analysis
Cost-volume-profit analysis can be applied to decisions such as setting sales targets for a desired profit or evaluating the effect of a change in price or cost structure, and computer spreadsheets make it practical to test many such scenarios quickly. The analysis rests on assumptions, including that costs and revenues behave in a straight-line manner within a relevant range and that sales mix stays constant, and automation’s tendency to convert variable costs into fixed costs is changing how these relationships play out in practice.
