Manufacturers Produce Special Transactions
As you learned in Chapter 7, manufacturers have a lot more going on in the accounting department than do any other kinds of businesses. There are three different stages of inventory to deal with, and all sorts of extra things that go into figuring out product costs; in addition, the statement of profit and loss has a whole extra section to contend with. Although the rest of the transactions follow the standard flow, creating inventory triggers special accounting procedures.
Unlike companies that deal only with finished goods, manufacturers don't always know exactly what their product costs are. Instead of just pulling costs off a vendor invoice, manufacturers have to combine a variety of expenses to come up with their product costs: direct materials, direct labor, and overhead. How they combine those expenses and apply them to the three phases of inventory is the entire point of cost accounting.
Since figuring out product costs is such a big part of manufacturing companies, it has a whole special system of accounting, aptly named cost accounting. This extra system combines all the inventory-related information to come up with both total and individual unit product costs.
Two Distinct Cost Accounting Systems
Cost accounting, as the name suggests, deals with figuring out product costs. There are two different ways to do this, and each has its own system.c In a job order cost system, product costs are computed based on a specific job, such as creating 250 wedding invitations or producing a complete set of kitchen cabinets. The other option, a process cost system, is used when you produce a high volume of products that are all the same, such as bagels or napkin rings; here the focus is on different steps in the production process. Which system you use depends on what you're manufacturing. Custom-made products call for a job order system; products that are all the same call for process costing.
How to Allocate Overhead
When you make your own products, part of that product cost comes from overhead expenses. Unlike direct product costs, which you can easily link to a specific product, overhead is like a big cost pool that you have to split up among your inventory. That cost-splitting process is called allocation. With it, you figure out exactly how much of your total manufacturing overhead goes into each product.
Manufacturing overhead includes expenses necessary to the production process but not directly linked to any particular product. Examples of these expenses include things such as electricity in the production area and oil that keeps the machines running. You couldn't make your products without these expenses, so they are included in your product costs rather than with your general expenses.
To figure out the right allocations, you first have to come up with a basis for dividing up your overhead. Then you'll have an allocation rate that you can apply to products. Your allocation basis could be:
Direct labor hours
Direct labor dollars
Essentially, anything that's common to all your products and is also easy to measure can be used for your allocation basis. To compute the allocation rate, divide your total estimated overhead for the period by the total allocation basis. For example, assume that your total estimated overhead was $30,000. You decide to make your allocations based on labor dollars, and estimate $60,000 total labor costs for the period. To get your allocation rate, divide that $30,000 of overhead by $60,000 in labor costs; here, the allocation rate would be 50 percent, or fifty cents of overhead allocated for each direct labor dollar. If the direct labor for Product A costs $10, the overhead allocation for that product would be $5.