COMPUTING STANDARD COSTS

A fully integrated standard costing system uses standard costs for all the elements of product cost: direct materials, direct labor, and overhead. Inventory accounts for materials, work in process, and finished goods, as well as the Cost of Goods Sold account, are maintained and reported in terms of standard costs, and standard unit costs are used to compute account balances. Actual costs are recorded separately so that managers can compare what should have been spent (the standard
costs) with the actual costs incurred in the cost center.A standard unit cost for a manufactured product has the following

six elements:
Price standard for direct materials
Quantity standard for direct materials
Standard for direct labor rate
Standard for direct labor time
Standard for variable overhead rate
Standard for fixed overhead rate
To compute a standard unit cost, it is necessary to identify and analyze each of these elements. (A standard unit cost for a service includes only the elements that relate to direct labor and overhead.)

Standard Direct Materials Cost

The standard direct materials cost is found by multiplying the price standard for direct materials by the quantity standard for direct materials. For example, if the price standard for a certain item is $2.75 and a specific job calls for a quantity standard of 8 of the items, the standard direct materials cost for that job is computed as follows:

Standard Direct    Direct Materials      Direct Materials
Materials Cost   = Price Standard    x   Quantity Standard

$22.00           =    $2.75                       x         8 

The direct materials price standard is a careful estimate of the cost of a specific direct material in the next accounting period. An organization’s purchasing agent or its purchasing department is responsible for developing price standardsfor all direct materials and for making the actual purchases. When estimating a direct materials price standard, the purchasing agent or department must take into account all possible price increases, changes in available quantities, and new sources of supply. The direct materials quantity standard is an estimate of the amount of direct materials, including scrap and waste, that will be used in an accounting period. It is influenced by product engineering specifications, the quality of direct materials, the age and productivity of machinery, and the quality and experience of the work force. Production managers or management accountants usually establish and monitor standards for direct materials quantity, but engineers, purchasing agents, and machine operators may also contribute to the development of these standards.

Standard Direct Labor Cost
The standard direct labor cost for a product, task, or job order is calculated by multiplying the standard wage for direct labor by the standard hours of direct labor. For example, if the standard direct labor rate is $8.40 per hour and a product  standard direct labor hours to produce, the product’s standard direct labor cost is computed as follows:

Standard Direct       Direct Labor   Direct Labor
Labor Cost Rate  =    Standard     x Time Standard
 
$12.60           =     $8.40                  x  1.5 hours


The direct labor rate standard is the hourly direct labor rate that is expected to prevail during the next accounting period for each function or job classification. Although rate ranges are established for each type of worker and rates vary within those ranges according to each worker’s experience and length of service, an average standard rate is developed for each task. Even if the person making the product is paid more or less than the standard rate, the standard rate is used to calculate the standard direct labor cost. Standard labor rates are fairly easy to develop because labor rates are either set by a labor union contract or defined by the company. The direct labor time standard is the expected labor time required for each department, machine, or process to complete the production of one unit or one batch of output. In many cases, standard time per unit is a small fraction of an hour. Current time and motion studies of workers and machines, as well as records of their past performance, provide the data for developing this standard. The direct labor time standard should be revised whenever a machine is replaced or the quality of the labor force changes.

Standard Overhead Cost
The standard overhead cost is the sum of the estimates of variable and fixed overhead costs in the next accounting period. It is based on standard overhead rates that are computed in much the same way as the predetermined overhead rate that Unlike that rate, however, the standard overhead rate has two parts, one for variable costs and one for fixed costs. The reason for computing the standard variable and fixed overhead rates separately is that their cost behavior differs. The standard variable overhead rate is computed by dividing the total budgeted variable overhead costs by an expression of capacity, such as the number of standard machine hours or standard direct labor hours. (Other bases may be used if machine hours or direct labor hours are not good predictors, or drivers, of variable overhead costs.) For example, using standard machine hours as the base, the formula is as follows:

 Variabl           =   Budgeted Variable Overhead Cost
 Overhead Rate    Number of Standard  Hours


The standard fixed overhead rate is computed by dividing the total budgeted fixed overhead costs by an expression of capacity, usually normal capacity in terms of standard hours or units. The denominator is expressed in the same terms as the variable overhead rate. For example, using normal capacity in terms of standard machine hours as the denominator, the formula is as follows:

 Fixed             =    Budgeted Fixed Overhead Costs_
 Overhead Rate  Normal Capacity of Standard Hours

Recall that normal capacity is the level of operating capacity needed to meet expected sales demand. Using it as the application base ensures that all fixed overhead costs have been applied to units produced by the time normal capacity is reached.

STANDARD COSTING

Standard costs are realistic estimates of costs based on analyses of both past and projected operating costs and conditions. They are usually stated in terms of cost per unit. They provide a standard, or predetermined, performance level for use in standard costing, a method of cost control that also includes a measure of actual performance and a measure of the difference, or variance, between standard and actual performance. This method of measuring and controlling costs differs from
the actual and normal costing methods in that it uses estimated costs exclusively to compute all three elements of product cost—direct materials, direct labor, and overhead. Standard costing is especially effective for managing cost centers. You may recall that a cost center is a responsibility center in which there are well-defined links between the cost of the resources (direct materials, direct labor, and overhead) and the resulting products or services. A disadvantage to using standard costing is that it can be expensive because the estimated costs are based not just on past costs, but also on engineering estimates, forecasted demand, worker input, time and motion studies, and type and quality of direct materials. However, this method can be used in any type of business. Both manufacturers and service businesses can use standard costing in conjunction with a job order costing, process costing, or activity-based costing system.

RECONCILIATION OF OVERHEAD COSTS

To prepare financial statements at the end of the accounting period, the Cost of Goods Sold account must reflect actual product costs, including actual overhead.Thus, the Overhead account must be reconciled every period. Under applied overhead: As you learned in a previous chapter, if at the end of the accounting period the actual overhead debit balance exceeds the applied overhead credit balance, then the Overhead account is said to be under applied and the debit balance must be closed to the Cost of Goods Sold account. Here is the entry in journal form:
                                                        Dr.          Cr.
Cost of Goods Sold                      XX
             Overhead                                       XX

Over applied overhead: If the actual overhead cost for the period is less than the estimated overhead that was applied during the period, then the Overhead account is over applied and the credit balance must be closed to the Cost of Goods Sold account. Here is the entry in journal form:
                                                  Dr.         Cr.
Overhead                                XX
     Cost of Goods Sold                          XX

JOB ORDER COSTING

A job order costing system is a system that traces the costs of a specific order or batch of products to provide timely, accurate cost information and to facilitate the smooth and continuous flow of that information. A basic part of a job order costing system is the set of procedures, electronic documents, and accounts that a company uses when it incurs costs for direct materials, direct labor, and overhead.
Job order cost cards and cost flows through the inventory accounts form the core of a job order costing system.

Materials
When Augusta receives or expects to receive a sales order, the purchasing process begins with a request for specific quantities of direct and indirect materials that are needed for the order but are not currently available in the materials storeroom. When the new materials arrive at Augusta, the Accounting Department records the materials purchased by making an entry in journal form that debits or increases the balance of the Materials Inventory account and credits either the Cash
or Accounts Payable account (depending on whether the purchase was for cash or  credit):                   
                                                          Dr.                 Cr.
Materials Inventory                      XX
        Cash or Accounts Payable                          XX
When golf carts are scheduled for production, requested materials are sent to the production area. To record the flow of direct materials requested from the Materials Inventory account into the Work in Process Inventory account, the entry in journal form is:
                                                                Dr.            Cr.
Work in Process Inventory                XX
           Materials Inventory                                XX
To record the flow of indirect materials requested from the Materials Inventory account into the Overhead account, the entry in journal form is:
                                                          Dr.             Cr.
Overhead                                       XX
    Materials Inventory                                   XX


Labor
Every pay period, the payroll costs are recorded. In general, the payroll costs include salaries and wages for direct and indirect labor as well as for non production-related employees. As noted earlier, Augusta’s two production employees assemble the golf carts. Several other employees support production by moving materials and inspecting the products. The following entry in journal form records the payroll:
                                                                   Dr.          Cr.
Work in Process Inventory                  XX
Overhead (indirect labor costs)          XX
Selling and Administrative Expenses  XX
salary and wage costs)
                         Payroll Payable                             XX

Overhead
Thus far, indirect materials and indirect labor have been the only costs debited to the Overhead account. Other actual indirect production costs, such as utilities,property taxes, insurance, and depreciation, are also charged to the Overhead account as they are incurred during the period. In general, the entry in journal form to incur actual overhead costs appears as:
                                                     Dr.             Cr.
Overhead                                 XX
     Cash or Accounts Payable                     XX
     Accumulated Depreciation                    XX
During the period, to recognize all product-related costs for a job, an overhead cost estimate is applied to a job using a predetermined rate. The entry in journal form to apply overhead using a predetermined rate is:
                                                         Dr.      Cr.
Work in Process Inventory         XX
                Overhead                                  XX
Based on its budget and past experience, Augusta currently uses a predetermined overhead rate of 85 percent of direct labor costs.

COST OF GOODS SOLD AND A MANUFACTURER'S INCOME STATEMENT

The income statement and its statement of cost of goods manufactured. The total amount of the cost of goods manufactured during the period is carried over to the income statement, where it is used to compute the cost of goods sold. The beginning balance of the Finished Goods Inventory account is added to the cost of goods manufactured to arrive at the total cost of goods available for sale during the period. The cost of goods sold is then computed by subtracting the ending balance in Finished Goods Inventory (what was not sold) from the total cost of goods available for sale (what was available for sale). The cost of goods sold is considered an expense in the period in which the goods are sold.

STATEMENT OF COST OF GOODS MANUFACTURED

The key to preparing an income statement for a manufacturing organization is computing its cost of goods sold, which means that you must first determine the cost of goods manufactured. This dollar amount is calculated on the statement of cost of goods manufactured, a special report based on an analysis of the Work in Process Inventory account. At the end of an accounting period, the flow of all manufacturing costs incurred during the period is summarized in this statement It is helpful to think of the statement of cost of goods manufactured as being developed in three steps:

Step 1. Compute the cost of direct materials used during the accounting period.As shown in add the beginning balance in the Materials Inventory account to the direct materials purchased. The subtotal the cost of direct materials available for use during the accounting period. Next, subtract the ending balance of the Materials Inventory account from the cost of direct materials available for use.The difference is the cost of direct materials used during the period.

Step 2. Calculate total manufacturing costs for the period. As shown in the costs of direct materials used and direct labor are added to total overhead costs incurred during the period to arrive at total manufacturing costs.

Step 3. Determine total cost of goods manufactured for the period. As shown in add the beginning balance in the Work in Process Inventory account to total manufacturing costs to arrive at the total cost of work in process during the period. From this amount, subtract the ending balance in the Work in Process Inventory account to arrive at the
cost of goods manufactured.

ELEMENTS OF MANUFACTURING COST

Manufacturing or production costs are classified into three basic elements:
(1) direct materials (2) direct labor  (3) factory overhead.

Direct Materials
The materials that become part of a certain manufactured product and can be readily identified with that product are classified as direct materials. Examples include lumber used in making furniture, fabric used in the production of clothing, iron ore used in the manufacture of steel products, and rubber used in the production of athletic shoes. Many types of materials and supplies necessary for the manufacturing process either cannot be readily identified with any particular manufactured item or have a relatively insignificant cost. Items such as sandpaper used in sanding furniture, lubricants used on machinery, and other items for general factory use are classified as indirect materials. Similarly classified are materials that actually become part of the finished product, such as thread, screws, rivets, nails, and glue, but whose costs are relatively insignificant, making it not cost effective to trace them to specific products.

Direct Labor
The labor of employees who work directly on the product manufactured, such as machine operators or assembly-line workers, is classified as direct labor The employees who are required for the manufacturing process but who do not work directly on the units being manufactured are considered indirect labor. This classification includes department heads, inspectors, materials handlers, and maintenance personnel. Payroll-related costs, such as payroll taxes, group insurance, sick pay, vacation and holiday pay, retirement program contributions, and other fringe benefits are usually treated as indirect costs. Some companies, however, more appropriately,treat the fringe benefits paid for direct laborers as additional direct labor cost for the purpose of more precisely determining how much each hour of direct labor really costs. As manufacturing processes have become increasingly automated, direct labor cost as a percentage of total product cost has decreased for many companies. Harley-Davidson, the motorcycle manufacturer, stopped tracking direct labor as a separate cost category because it was only 10% of total product cost but required an inordinate amount of time to trace directly to the individual products manufactured.


Factory Overhead
Factory overhead, also known as manufacturing overhead and factory burden, includes all costs related to the manufacture of a product except direct materials and direct labor. Thus, factory overhead includes the previously mentioned indirect materials and indirect labor, plus other Manufacturing expenses, such as depreciation on the factory building and the machinery and equipment, heat, light, power, maintenance, insurance, and taxes. As factories have become more automated, factory overhead as a percentage of total manufacturing cost has increased dramatically. The costs of direct materials and direct labor are sometimes combined and Described as the prime cost of manufacturing a product. Prime cost plus factory overhead equals the total manufacturing cost. Direct labor cost and factory overhead, which are necessary to convert the direct materials into finished goods, can be combined and described as conversion cost. These relationships are .Marketing expenses, general administrative costs, and other non-factory expenditures are not included in the costs of manufacturing. Some costs incurred by a manufacturer, however, may benefit both factory and non-factory operations. Examples include depreciation, insurance, and property taxes on a building that houses both the factory and the administrative offices. In this situation, an allocation of cost must be made to each business function.