Throughout the year they are transferred from the labor expense account to Work-in- process account (an asset). Page 6. Absorption Costing. 4. Overhead costs

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Absorption Costing -Overview˜ 1. Overview of Absorption costing and Variable Costing 2. Review how costs for Manufacturing are transferred to the product 3. Job Order Vs. Process Costing 4. Overhead Application -Under applied Overhead -Over applied overhead 5. Problems with Absorption Costing 6. Concluding Comments

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Absorption Costing˜The focus of this class is on how to allocate manufacturing costs to the product. -Direct Materials ˜ -Direct Labor ˜ -Overhead ˜ Absorption costing is a process of tracing the variable costs of production and the fixed costs of production to the product. Variable Costing traces only the variable costs of production to the product and the fixed costs of production are treated as period expenses.

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Absorption Costing˜There are three different types of Absorption Costing Systems: -Job Order Costing -Process Costing -ABC Costing In Job Order Costing costs are assigned to the product in Batches or lots. -Printing -Furniture manufacturing -Bicycle Manufacturing In Process Costing, costs are systematically assigned to the product, since there are no discreet batches to assign costs. -Oil Distilling -Soda Manufacturing ABC Costing assigns cost from cost centers to the product -Best in a multi product firm, where there are different volumes

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Absorption Costing˜A simplified view of Production:˜Introduce Raw Materials Manufacture Product Store finished goods Sell Finished Goods 1.˚Direct materials 1. Direct labor 1. Production process are purchased applied to completed 2.˚Direct materials product 2. Goods are shipped are placed into 2. Overhead costs for sale production are incurred

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Absorption Costing˜How do we account for the production process? 1. Direct materials are purchased and recorded as an asset. 2. As direct materials are placed into production, their cost is transferred from the raw materials account to the Work-in-Process account (an asset) 3. As direct labor costs are incurred they are recorded in a labor expense account. Throughout the year they are transferred from the labor expense account to Work-in-process account (an asset).

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Absorption Costing˜4. Overhead costs are initially accumulated in expense accounts (electricity, depreciation, etc..). Throughout the year they are transferred to Work-in-process. 5. When goods are completed, their costs (direct materials, direct labor and overhead) are transferred out of Work-in-process, and into Finished Goods. 6. When foods are sold, their costs are transferred out of finished goods inventory (an asset) and into Cost of goods sold (an expense).

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Absorption Costing˜Consider the following example: A company is formed to manufacture computers. It starts the year with $2000 in cash and equity. During the year the company incurs $500 in payroll costs, $500 in rent for the plant, and $500 in raw materials. During the year he makes 100 computers. What will his profits (or loss) be if he sells no computers? What will his profits be if he sells all 100 computers at $20 per computer?

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Job Order Costing˜Job Order Costing is one method of allocating the costs of manufacturing to the product. In Job order costing the manufacturing costs are allocated to the product by batch. Job order costing is appropriate when the firm makes products in small batches, and each batch consumes different amounts of direct labor, direct materials, and processing time/energy. A survey in fiCost and Management Accounting Practices..fl in the Management Accounting Research Centre indicate that job order costing is the primary method of costing in the following industries: -Electorics -Machinery -Computers -Furniture and fixtures

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Job Order Costing˜Consider a computer manufacturing company. They have a plant that receives an order for 50 computers. They need to determine how much it costs to manufacture these computers. The batch of 50 computers starts with the introduction of direct materials: -50 Computer Cases˜ -50 Motherboards˜ -50 CD drives, and floppy drives˜ Individuals mount equipment, add additional memory etc, to meet the specifications of the job. Special machines are also used to attach the disk drives.

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Job Order Costing˜In Job order costing the manufacturing costs are allocated to the product by batch. Thus the company allocates manufacturing costs to the 50 Computers ordered. The Job is assigned a Lot #. Lets call this Lot # 1118. When the Parts warehouse provides 50 motherboards, cd roms etc– to the manufacturing group, they allocate the costs of these raw Materials to LOT #1118. The individuals that assemble these computers record the time spent assembling Lot 1118 on their time sheets. The accounting system will allocate the payroll costs at the hourly wage rate to the job. Finally, the cost of the plant, the cost of the specialized machines, the utilities, the accounting system that tracks costs within the plant, the accountant running the system etc– must be allocated to the product. This is known as overhead allocation.

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