Direct Costs:
Management accounting classifies product costs as either direct costs or overhead costs (indirect costs). This distinction is important because costing systems handle these two types of costs very differently. The distinction is sometimes subtle, because whether a cost is direct or overhead is a function of the cost object, and also partly a matter of choice on the part of managers and accountants.
Following are three definitions of direct costs from different accounting textbooks:
Direct costs of a cost object are costs that are related to the cost object and can be traced to it in an economically feasible way.
Direct costs are costs that can be directly attached to the unit under consideration.
Direct costs are costs that can be traced easily to specific products.
Direct costs are also called prime costs. For manufacturing companies, direct costs usually can be categorized as either materials or labor.
Direct materials: materials that become part of the finished product and that can be conveniently and economically traced to specific units (or batches) or product.
Example of direct materials for an apparel manufacturer: fabric. All other materials, such as thread and zippers, are probably indirect.
Direct labor: costs for labor that can be conveniently and economically traced to a unit (or batch) of product. The following examples show how the determination of whether a cost is direct or overhead depends on the identification of the cost object:
Examples of direct labor for an apparel manufacturer:
1) If the cost object is a single pair of pants, in a batch of several dozen pairs:
Probably no labor is direct.
2) If the cost object is a batch of several dozen pairs of pants:
Probably, sewing operators’ wages are direct.
3) If the cost object is a production line in the factory, add:
The line manager’s salary, and possibly wages incurred in the cutting room (where rolls of fabric are cut into panels and pieces that are then sewn together).
4) If the cost object is the entire factory, add:
The factory manager’s salary, wages of maintenance and janitorial workers, and salaries of front office personnel.
Even though probably no labor is direct with respect to a single pair of pants, if labor is direct with respect to a batch of 50 or 100 units, cost accountants would usually (and loosely) call labor a direct cost with respect to units of product, and divide the direct labor cost for the batch by the number of units per batch to derive the direct labor cost per unit.
Overhead Costs:
Overhead costs are costs that are related to the cost object, but cannot be traced to the cost object in an economically feasible way. Overhead costs are not directly traceable to specific units of production. Examples of overhead costs incurred at an apparel manufacturer, when the cost object is a batch of product, probably include the following:
- Electricity
- Factory office salaries
- Building and machine maintenance
- Factory depreciation
The distinction between direct costs and overhead costs relate, in some measure, to the way the accounting system treats the cost. For example, one apparel manufacturer might track thread using the same methods that are used to track fabric, thus treating thread as a direct material. Another apparel manufacturer might decide that the cost of thread is immaterial, and does not warrant the cost and effort to track it as a direct cost. For this company, thread is an overhead cost. Therefore, whether some costs are direct or overhead depend on a choice made by the manager and the cost accountant.
There are three ways overhead costs can be treated in any decision-making context: (1) they can be ignored, (2) they can be treated as a lump-sum, or (3) they can be allocated to the products and services (i.e., to the cost objects) to which they relate. Each of these three alternatives is appropriate, depending on the circumstances and the purpose for which the accounting is done. However, in this chapter and throughout much of this book, we are concerned with the third alternative: how to allocate overhead costs to products and services.
Cost Allocation Bases
The allocation base is the “link” that is used to attach overhead costs to the cost object. In a manufacturing setting, the simplest allocation base is the number of units produced. For example, if the factory makes 15,000 units, the accounting system can simply “spread” the overhead costs evenly over all 15,000 units. The problem with using units as an allocation base, however, is that if the factory makes a range of different products, those products might differ significantly in their resource utilization. A deluxe widget might require twice as much labor and 20% more materials than a standard widget, and one might infer that the deluxe widget also requires more resources that are represented by overhead costs.
Whatever cost allocation base is chosen, it must be a “common denominator” across all cost objects. For example, a furniture factory could allocate overhead costs across all products using direct labor hours, because direct labor is incurred by all products made at the factory. However, it would not seem appropriate to allocate factory overhead based on the quantity of wood used in each unit, if the factory makes both wood furniture and a line of plastic-molded, because no overhead would be allocated to the plastic chairs.
Overhead Rates:
The overhead rate is the ratio of cost pool overhead dollars in the numerator, and the total quantity of the allocation base in the denominator:
Overhead rate
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Overhead costs in the cost pool
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=
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Total quantity of the allocation base
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The result represents dollars of overhead per unit of the allocation base. For example, if an apparel factory allocates overhead based on direct labor hours, the overhead rate represents dollars of overhead per direct labor hour. Assume the overhead rate is $20 per direct labor hour. Then for every hour that a sewing operator spends working on product, $20 will be allocated to the products that the sewing operator assembles during that hour.
ZFN Apparel Company, Example of Actual Costing:
The ZFN apparel company in Albuquerque , New Mexico
The following journal entries and T-accounts illustrate how the accounting system records the manufacturing activities of the factory in order to derive product cost information for jeans and chinos. Journal entry (6) to debit overhead to work-in-process is based on an overhead rate calculated as follows.
$3,300,000 ÷ 500,000 direct labor hours = $6.60 per direct labor hour.
In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our example, we record only one journal entry for each type of transaction. We also make the unrealistic assumption that there is no work-in-process at the end of the period. To focus the presentation on inventory-related accounts, T-accounts for some non-inventory accounts, and the entry to debit accounts receivable and credit revenue, are omitted.
(1) Raw Materials: denim fabric $3,000,000
Raw Materials: cotton twill 2,250,000
Accounts Payable $5,250,000
(To record the purchase of 600,000 yards of denim fabric at $5.00 per yard, and 500,000 yards of cotton twill fabric at $4.50 per yard.)
(2) Work-in-process: Jeans $2,500,000
Raw Materials: denim fabric $2,500,000
(To record materials requisitions for 500,000 yards, for the movement of denim from the receiving department to the cutting room.)
(3) Work-in-process: Chinos $2,160,000
Raw Materials: cotton twill $2,160,000
(To record materials requisitions for 480,000 yards, for the movement of cotton twill from the receiving department to the cutting room.)
(4) Work-in-process: Jeans $2,800,000
Work-in-process: Chinos 4,200,000
Accrued Sewing Operator Wages $7,000,000
(To record sewing operator wages for the year: 200,000 hours for jeans, and 300,000 hours for chinos, at $14 per hour.)
(5) Factory Overhead $3,300,000
Accounts Payable $1,800,000
Accrued Wages for Indirect Labor 900,000
Accumulated Depreciation 600,000
(To record overhead costs incurred during the year, including utilities, depreciation, repairs and maintenance, and indirect wages and salaries.)
(6) Work-in-process: Jeans $1,320,000
Work-in-process: Chinos 1,980,000
Factory Overhead $3,300,000
(To allocate factory overhead to production, using an overhead rate of $6.60 per direct labor hour.)
(7) Finished Goods: Jeans $6,620,000
Work-in-process: Jeans $6,620,000
(To record the completion of all 500,000 jeans, at $13.24 per pair.)
(8) Finished Goods: Chinos $8,340,000
Work-in-process: Chinos $8,340,000
(To record the completion of all 400,000 chinos, at $20.85 per pair.)
(9) Cost of Goods Sold: Jeans $5,296,000
Cost of Goods Sold: Chinos $7,297,500
Finished Goods: Jeans $5,296,000
Finished Goods: Chinos $7,297,500
(To record the sale of 400,000 jeans and 350,000 chinos.)
Raw Materials:
Denim Fabric
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Raw Materials:
Cotton Twill
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(1)
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$3,000,000
$ 500,000
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$2,500,000
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(2)
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(1)
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$2,250,000
$ 90,000
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$2,160,000
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(3)
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Accrued Sewing
Operator Wages
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Factory Overhead
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$7,000,000
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(4)
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(5)
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$3,300,000
$0
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$3,300,000
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(6)
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Work-in-Process: Jeans
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Work-in-Process: Chinos
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(2)
(4)
(6)
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$2,500,000
2,800,000
1,320,000
$0
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$6,620,000
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(7)
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(3)
(4)
(6)
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$2,160,000
4,200,000
1,980,000
$0
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$8,340,000
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(8)
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Finished Goods: Jeans
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Finished Goods: Chinos
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(7)
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$6,620,000
$1,324,000
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$5,296,000
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(9)
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(8)
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$8,340,000
$1,042,500
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$7,297,500
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(9)
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Cost of Goods Sold: Jeans
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Cost of Goods Sold: Chinos
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(9)
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$5,296,000
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(9)
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$7,297,500
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Accounts Payable
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$5,250,000
1,800,000
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(1)
(5)
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The per-unit inventory cost is calculated as follows:
Jeans: $6,620,000 ÷ 500,000 pairs = $13.24 per pair
Chinos: $8,340,000 ÷ 400,000 pairs = $20.85 per pair
These amounts, which are used in journal entry (9), can be detailed as follows:
Input
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Jeans
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Chinos
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Fabric
Direct labor
Overhead
Total
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1 yard per jean x $5 per yard = $5.00
0.4 hours per jean x $14 per hour = $5.60
0.4 hours per jean x $6.60 per hour = $2.64
$13.24
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1.2 yards per chino x $4.50 per yard = $5.40
0.75 hours per chino x $14 per hour = $10.50
0.75 hours per chino x $6.60 per hour = $4.95
$20.85
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In the above table, the direct labor hours per jean and per chino appear in the lines for both the per-unit direct labor cost and the per-unit overhead cost, because overhead is allocated based on direct labor hours. If the allocation base had been something else, such as machine hours, the hours per unit would only appear in the calculation of the direct labor cost.
More overhead is allocated to each pair of chinos than to each pair of pants ($4.95 versus $2.64) because direct labor hours has been chosen as the allocation base, and each chino requires more direct labor time than each pair of jeans (0.75 hours versus 0.40 hours). Changing the allocation base cannot change the total amount of overhead incurred, but it will usually shift costs from some products to others. For example, if the allocation base were units of production instead of direct labor hours, the overhead rate would be:
$3,300,000 ÷ 900,000 units = $3.67 per unit.
In this case, the total cost per pair of jeans would increase from $13.24 to $14.27, and the total cost per pair of chinos would decrease from $20.85 to $19.57.
Because the choice of allocation base determines how overhead is allocated across products, product managers usually have preferences over this choice (because a lower reported product cost results in higher reported product profitability). However, the company’s choice of allocation base should be guided, if possible, by the cause-and-effect relationship between activity on the factory floor and the incurrence of overhead resources. For example, direct labor hours is a sensible allocation base if the significant components of overhead increase as direct labor hours increase. More direct labor implies more indirect labor by human resources and accounting personnel, janitorial staff and other support staff. Also, more direct labor implies more machine time, which implies more electricity usage, and more repairs and maintenance expense. For these reasons, direct labor hours is probably a better choice of allocation base than units of product.
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