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Assignment Content Competency Analyze cost behaviors and production costing methods. Student Success Criteria View the grading rubric for this deliverable by selecting the “This item is graded with a rubric” link, which is located in the Details & Information pane. Scenario Community Hospital is considering offering a new clinic for hospital employees and their dependents. The Accounting Manager would like you to assist with a review of cost assignments within the cost accounting system for a new service that is being considered. They review the following new service and cost with you. There will be a manager hired to oversee the operations of the new service at a salary of $6,000 per month. Technical staff will be scheduled on an as-needed basis, based on number of tests done, and will be paid $25.00 per hour. In addition, there will be one new full-time unit secretary at $15.00 per hour. A maintenance contract has been purchased to cover any needed repairs on the equipment at a cost of $10,000 for 12 months. Office supplies generally run about the same each month, and are roughly $100. Each test requires approximately the $75 of testing supplies. The office rent is $1,000 per month for the first year and then increases to $1,200 for the second year. Electricity to run all of the office equipment is expected to be $750 per month. Travel expenses for the manager will be $150. Instructions The Accounting Manager would like you to first create a Word document where you describe the characteristics of direct vs. indirect expenses and variable vs fixed expense. Following your discussion, you should create a table to classify each cost item (A–I) as: Direct or indirect (D or I) Variable or fixed (V or F) She has asked you to prepare a table in Word with the following information: You will have two answers (D or I; V or F) for each of the following items: Cost Item D or I V or F Department Manager Technical Staff Unit Secretary Maintenance Contract Office Supplies Testing Supplies Office Rent Electricity Travel Expenses Finally, in your document, the Accounting Manager would like to know if there are any other assumptions that you have made in making your selections in the table. Overview of Costing A company needs to know the total cost of a product in order to determine if the product is profitable. Product costing also allows management to accomplish this objective. Determining the total cost of a product may seem fairly straightforward, and to some extent it is. However, there are certain types of costs that can complicate matters. For this reason, a company needs to categorize costs to assist with getting costs down to the product level. The two main cost categories are direct and indirect costs. Direct costs are those costs that are directly associated with a product. They are costs than can be easily measured. Sub categories of direct costs are direct materials and direct labor. Direct materials are the raw materials used to produce a product. We can measure how much was used in producing the product. If we can measure how much was used, we can easily determine the cost of the direct materials that were used in production. Direct labor is the cost of the workers that directly worked on the product. We can also measure how much time they spent working on the product. If we can measure the time they spent, then we can easily calculate how much the direct labor costs were. Indirect cost represents costs that were incurred in the production process but are not easily traced to a specific product. With direct materials and direct labor, we can see a link between the cost and product. Indirect costs are not easily measured at the product level, but we can intuitively see that they are a necessary cost in the production. For example, a factory supervisor may oversee the production process of many products but they do not “touch” the individual product. We cannot measure their time spent on individual products, just their overall time on the process. However, these costs were necessary in the production of the product. Most companies use an allocation process to distribute the indirect costs, rather than an exact measurement as with direct costs. Most Common Production Costing Methods Now that we understand the importance of product costing and a few of the costing terms and categories, let’s look at two common production costing methods: Job Costing and Process Costing. Job Costing Job costing is most often used when the units of production are not identical or are commonly different from each other. Since the individual units of production are not same, we are required to accumulate the costs associated with each job. Companies that usually use job costing are custom home builders, automotive repair shops, accountants and lawyers. Process Costing Process costing, on the other hand, is used when the output consists of virtually identical items that are made in large quantities. Costs are accumulated in batches as the products are produced and then allocated to the individual products themselves. Process costing of most often used by soda makers, cookie bakers, aluminum foil manufacturers and oil refiners. Regardless of the whether a company uses job costing or process costing, the goal is still the same. “Push” all production costs down to the product level so that management can tell if a product is profitable or not. Other uses of product cost information include: setting a sales price, determining product mix and determining a transfer price to another division. Bottom of Form Why is Cost Accounting Important? Any company that is required to have their financial statements audited by an independent accountant must comply with Generally Accepted Accounting Principles (GAAP) (IFRS outside of the US). This means that that ALL product costs will appear on the inventory line on the balance sheet until the product is actually sold and then transferred to the income statement as cost of goods sold to match expenses with revenues. Overview of Product Costing Methods Companies will use one or more product costing method to assign the appropriate costs to a manufactured product. Regardless of the method that is used, the goal is the same: To assign the appropriate amount of cost to a product using the best product costing method for that particular production and decision-making environment. There can be a substantial difference in cost depending on the method used, so management must be careful when choosing a method and what its intended use is. For example, a costing method intended for incremental analysis may not be appropriate for long-term decision making. In addition, there are only certain methods that are approved to use in financial statement preparation. Deciding on the Method of Costing Choosing the best method really depends on the decision environment and whether the cost information is for external or internal reporting. External Reporting: · Absorption Costing: · GAAP · Variable Costing: · Not GAAP · Throughput Costing: · Not GAAP Internal Reporting · Absorption Costing · Used to save costs · Variable Costing · Used to evaluate performance and for decision making · Throughput Costing · Used for short-term capacity decisions Inventory Costs · Absorption Costing: · Direct materials · Direct labor · Variable overhead · Fixed overhead · Variable Costing: · Direct materials · Direct labor · Variable overhead · Variable SG&A expenses* · Throughput Costing · Direct materials Period Costs (expensed when occurred) · Absorption Costing: · SG&A expenses · Variable Costing: · Fixed overhead · Fixed SG&A expenses · Throughput Costing: · Direct labor · Variable overhead · Fixed overhead · SG&A expenses External reporting means that the costing information is going to be used external to the company. Anytime financial information is released to the public, it must comply with U. S. GAAP. For external reporting, the only GAAP approved costing method is called absorption costing. This costing method requires that the product cost include ALL manufacturing costs. This basically means that product costs may be incurred in one period (when goods are produced) and recognized in another (when goods are sold). All other costs (non-product) are recognized when incurred and called period costs. Internal reporting means that the costing information is only going to be used within the company for decision-making process. Internal reports do not have to comply with U. S. GAAP and can be designed by management to suit the needs of the organization. For internal reporting, absorption, variable and throughput costing methods are often used. Costing Methods Absorption costing is where the product “absorbs” all manufacturing costs, both fixed and variable. Manufacturing costs are assigned to one of three inventory accounts (raw materials, work in process, finished goods) prior to the sale, and then transferred to the income statement (cost of goods sold) upon sale to comply with the matching principle. All other costs, typically selling and administrative costs, are expensed in the period they are incurred and referred to as “period costs” since they do not benefit any future period. Absorption costing can be used for both internal and external reporting as it is the only method that is GAAP approved. Some companies use absorption costing for both internal and external reporting to save time and money by using just one method. Variable costing is where ALL costs are divided into fixed and variable categories and only variable costs are inventoried. Variable costing is often used by companies to hold production managers accountable for only the costs that they have some control over, applying the theory that a production manager cannot change or effect a fixed cost. Variable costing is typically used for short-term decision making. Keep in mind that a company still needs to cover their full costs to stay in business. Throughput costing is where only direct materials are inventoried. All other costs, direct labor, manufacturing overhead and period costs are expensed as incurred. Throughput costing is also used for short-term decisions. It can also be useful in making special order type decisions where there is extra factory capacity involved. Costing methodologies can produce significant variations in what we call total costs. Before a costing method is selected, we must fully understand what the information is going to be used for. Once we understand the use of the information, we can select a method that best fits our needs under that circumstance. Resource(s) Wiley GAAP 2019 : Interpretation and Application of Generally Accepted Accounting Principles Costing Methods Production costing methods not only impact the actual cost assigned to a product but can also have effects on how inventory is valued, how transfer pricing is determined as well as tax implications. Let’s examine these issues: Transfer Prices and Taxes PRICES AND TAXES Transfer price is simply what one related entity charges another for a product. In other words what on division of a company charges another division for a product. While these types of transactions are eliminated during the consolidation process in preparing the audited financial statements, so they have no impact, there can still be tax consequences particular in multinational companies. Tax rates can vary from Country to Country so that these multinational companies have an incentive to show their profits in the Country with the lowest tax rate. TAX RATE EXAMPLES For example, Corporation A has two divisions, Division B and Division C. The tax rate in the Country where Division B is located is 25\% and the tax rate where Division C is located is 50\%. For simplicity sake, lets assume Corporation A makes and sells widgets and there are no laws or restrictions on transfer pricing. The selling price is $1,000 and the cost to make a widget is $600. Therefore the company makes a profit of $400 per widget. Widgets are produced in Division B and in sold by Division C and sold in the Country that division C is located. PROFITS AND TAXES If Division C buys the widgets from Division B for $900. Division B then sells them for $1,000 and reports a profit of $100 ($1,000 - $900) and pays tax of $50 ($100 x 50\%). Division B reports a profit of $300 ($900 - $600) and pays tax of $75 ($300 x 25\%). So the total tax paid in this example is $125 ($50 + $75) which is well below the $200 ($400 x 50\%) they would have had to pay if the entire transaction would have taken place in Division Cs home Country. For the Corporation in total there is no difference in the total amount of profit, just the amount of tax paid. The above example is for illustrative purposes of how taxes could be manipulated by a multinational corporation and does not reflect reality. In the United States, the IRS takes a close look at transfer pricing policies in multinational corporations. Sec. 482 of the US Tax Code gives the IRS the authority to adjust taxable income between two related divisions to more accurately reflect the income earned by each division. The IRS will apply their standard to determine the true taxable income of a controlled division. Their standard basically tries to determine the transfer price of an open market transaction of unrelated companies. Inventory Costing The method in which inventory is costed affects how a production company’s inventoried is valued. Most companies use one of the following inventory costing methods: 1. First-In First-Out (FIFO) 2. Last-In First-Out (LIFO) 3. Weighted Average 4. Specific Identification These inventory costing methods determine the how the inventory is valued each time new inventory is added or taken out of the inventory pool. Production companies maintain three inventory accounts (pools): raw materials, work in process and finished goods. Costs will flow through these inventory accounts until the product is sold. The costs are then transferred from the balance sheet (credit to finished goods inventory) to the income statement (debit cost of goods sold) to match expenses with revenues (matching principle). First-In First-Out moves the oldest cost of inventory from one inventory account to the next or to cost of goods sold in the case of finished goods. This is the most common method used. Last-In First-Out moves the newest cost of inventory from one inventory account to the next or to cost of goods sold in the case of finished goods. Average or Weighted Average essentially establishes a new average cost after every purchase. It is this average cost that is used when items are removed from inventory. Specific Identification assigns each inventory item a specific cost and when it is sold or used in production, the specific cost of the item is moved to the next inventory account or cost of goods sold, as appropriate. This method is used if you are producing items that are individually produced and they are expensive.