# Chapter 6 Determining full cost (chapters 3, 4, & 7) By the end of this chapter students will be

Chapter 6 Determining full cost (chapters 3, 4, & 7)
By the end of this chapter students will be able to
1. Define and calculate the full cost of a product
2. Explain the role of overhead cost allocation in determining full cost
3. Define the terms cost driver and cost pool and explain the characteristics of a good cost
driver
4. Use job order costing, process costing, and ABC costing to allocate overhead
5. Determine the full cost of a product or service using the three cost allocation methods
6. Explain when each of the three methods of overhead allocation should be used

An essential goal of all accounting systems is to determine the full cost of creating a product or
service. According to GAAP, Generally Accepted Accounting Principles, the cost of goods sold
reported on a traditional income statement needs to be based on the full cost of creating the good
so a method of determining the full cost of a product is required for reporting purposes. Beyond
reporting requirements, knowing the full cost of creating a good or service is useful in
determining pricing. From the very first chapter in the book we have been discussing whether a
business idea is viable. To determine the viability of a business idea we compared the direct cost
of creating a good or service with the revenue that could be generated by selling the good or
service. In the beginning we only considered whether revenue was adequate to cover the direct
cost of producing a good or service, but we have since learned that the full cost of a product is
composed not only of direct materials and direct labor but also manufacturing overhead which
includes indirect materials, indirect labor, and general overhead.
Full cost = direct materials + direct labor + a fair share of manufacturing overhead
For a company to make a profit from its sales, it needs to cover all of the costs of production
including the indirect costs of producing their products. To be able to do that, the price of the
good or service needs to be high enough to cover the full cost of production.
The key issue is then how a company should go about accounting for indirect production costs in
order to determine the full cost of a product. The general answer is that overhead costs will be
systematically allocated to products. The goal in allocating the costs, is to not only to do so
systematically, but also fairly. Products should bear an amount of overhead that fairly represents
their usage of indirect materials, indirect labor, and the remainder of general manufacturing
overhead. This is important because if companies do not fairly allocate overhead, they will not
be able to determine a reasonable price for their goods or services. If products have too much
overhead allocated to them they could be priced so high that potential customers will not
purchase the goods. Alternately, if they do not have enough overhead allocated to them they
could be priced so low that the company will lose money on each and every sale.
There are three commonly used methods to systematically allocate overhead: Job Order Costing,
Process Costing, and Activity Based Costing. All of the methods require estimating overhead
costs and choosing an appropriate basis for allocating costs to products. Choosing the method
that fits the production situation is essential to ensuring the fair allocation of overhead Likewise
choosing an appropriate basis for allocating costs and correctly estimating input values for the

various formulas are key to the process of fairly allocating overhead. The term cost driver is used
in the context of allocating overhead costs. Cost drivers are used as the basis for allocating
overhead costs. A cost driver is something that causes overhead costs to be incurred or drives
overhead costs. Common cost drivers ion manufacturing are the number of units produced, the
number of labor hours worked, or the number of machine hours used in production. The
underlying idea is that general overhead costs, including supervisors’ salaries, utilities, machine
maintenance and the like, increase when the cost driver increases. For example, if more labor
hours are used, more utilities will be used. A common cost driver in service firm is the number of
clients served. Here, like in manufacturing, the number of clients served will drive or help
determine the types and quantities of support services and costs.
Next we move to a detailed description of each allocation method. Specific criteria for using
each method along with the key concepts and formulas are summarized in the following graphic.

Comparison
when....

Job Order
Costing
Orders are different from
each other

Process Costing

Activity Based
Costing

Units produced are identical
to each other

Products lines use resources
differentially

Examples

Models of cars, motocycles.,

Gallons of milk, electical
wire, hoses, pvc pipes

Mix of regular high and
specialized low volume
models

Key Concept

rate (PDOR)

Equivalent units (EU)

Activity cost pools, activity
cost drivers, rates for each
activity

Relevant Formula

PDOR =
Total MOH /
Total quantity of cost driver

Unit Cost =
Total Costs /
Equivalent Units

Activity Rate =
Total cost of activity /
Total usage of each activity

Application

Rate x quantity of cost
driver

Unit cost attached to
finished units and
equivalent units of
inventory

Rate x usage of activity

Job Order Costing
Job order costing is used when a company makes a number of different products which use
differing amounts of overhead. A good manufacturing example of job order costing is the
production of air conditioners for different retailers. Best Buy, Home Depot, Costco, Walmart,
and other firms purchase air conditioners from Gold Star. Gold Star builds each order of air
conditioners to the specifications of each retailer. Because the specifications differ on each order,
Goldstar would probably use job order costing to keep track of the costs of each order. A good
service example would be a hospital that cares for patients with a variety of conditions. Each
condition requires different services. Clearly a broken bone would require a different treatment
plan than open heart surgery.

In job order costing, the costs for each job are tracked on a job costing sheet similar to the one
presented below. Direct materials and direct labor are posted to a job costing sheets based on
actual usage and overhead is allocated to a job when the job is complete or at the end of an
accounting period.
Job Number
Start Date

Customer
Date order was placed or started in
production

End Date

Shipment date or end of accounting
period

Description of Job

100 - Model XL5 Air conditioners

Direct Materials

Accumulated on the sheet based on actual use

Direct Labor

Accumulated on the job order sheet based on actual hours x labor rate per hour

Manufacturing

Allocated to the job order sheet based on predetermined overhead rate x quantity of
cost driver associated with each particular order

Total Cost

Sum of direct materials + direct labor + allocated overhead

Direct materials and direct labor are both traceable to specific jobs. As actual materials are
moved from the warehouse to the production floor the costs of those materials are transferred
from the warehouse to the job order sheet. As labor is used in converting the materials to the end
product, the cost of labor is tracked on the job order sheet as well. When the job is complete, in
this case the air conditioners are assembled and packed for shipment; overhead is allocated to the
job.
Allocating overhead in job order costing
In job order costing, overhead is allocated based on a predetermined overhead rate (PDOR). The
rate has two components: an estimate of expected overhead costs and a cost driver. As with
many things, it is good to think about the process systematically
Step 1: Choose a cost driver
The three typical cost drivers used in job order costing for manufacturing companies are machine
hours, direct labor hours, and direct labor cost. To be effective in terms of allocating overhead,
the specific cost driver that is chosen should be highly correlated with overhead costs. In other
words, overhead costs should increase when the quantity of the cost driver increases and
overhead should decrease when the quantity of the cost driver decreases. Therefore, the choice of
cost driver should be related to the type of production. Machine hours are generally an
appropriate choice when production is automated while direct labor hours or direct labor costs
are more appropriate cost drivers for products that are labor intensive.
Step 2: Estimate total manufacturing overhead and the total quantity of the cost driver
Overhead costs are typically estimated as part of the budget process. Much like developing your
own annual budget, companies also develop annual budgets. They estimate the level of sales
along with anticipated expenses. For manufacturing overhead, they develop estimates of the cost

of indirect materials and indirect labor along with the expected costs of general manufacturing
overhead. For the cost driver, they estimate the anticipated quantity of the driver; how many
machine hours will be used in production, how many direct labor hours will be worked, or how
much will be spent in direct labor costs.
Step 3: Calculate the predetermined overhead rate
Once the estimates are completed, a predetermine overhead rate or PDOR can be calculated by
dividing the estimated total overhead cost by the estimated quantity of the cost driver
PDOR= total overhead cost / total quantity of the cost driver
Step 4: Apply overhead to specific jobs
Overhead is then applied to specific jobs according to the actual use of the cost driver by each
job. To do this, the predetermined overhead rate is multiplied by the actual quantity of the cost
driver in a specific job or work order.
Applied overhead = PDOR x actual quantity of cost driver traced to specific job
Step 5: Determine the full cost of the product
To determine full cost simple add the direct materials, direct labor, and the applied overhead
costs. If the information is given on a per unit basis, adding the three cost components will
provide you with the full cost per unit. If costs are given in total, rather than per unit, you will
need to divide by the number of units to get the full cost per unit.
Total costs = direct material cost + direct labor cost + applied overhead cost
Step 6: Determine whether overhead was over or under applied
As noted above, overhead is applied job by job throughout each accounting period. At the end of
the accounting period, companies need to reconcile the amount of overhead applied to jobs with
the amount of overhead actually incurred. As long as the estimated overhead costs equals the
actual costs AND as long as the estimated quantity of the cost driver equals the actual quantity,
the amount of overhead applied to jobs will equal the actual overhead expenditures. But
estimates being what they are, it is unlikely that the amount applied and the actual amount will
be the same. Difference between applied overhead and actual may or may not have a bearing on
pricing jobs, but it will have an impact on financial reporting. Overhead is over-applied if the
amount applied is more than the actual overhead cost and is under-applied if the amount applied
is less than the actual overhead cost.
= (PDOR x total quantity of cost driver for the period) – Actual costs
= positive number
over-applied
= negative number under-applied
=0
perfectly applied
Step 7: Evaluate whether the job order cost system works
A final step is any system is to periodically evaluate whether or not the system works as planned.
The two issues are whether the system fairly allocated overhead and whether overhead is

systematically over or under applied. If a company seems to be losing bids for jobs or seems to
be getting jobs that are not profitable, there is a good chance that overhead is not being fairly
allocated. If too much overhead is allocated to a job, the price of the job will be higher than
competitors prices resulting in customers going elseware and if too little overhead is allocated to
jobs, the price to customers will be relatively low resulting in lower profits.
The solution to these types of problems may require changing from one plant-wide
predetermined overhead rate to predetermined overhead rates by department or may require
choosing a new cost driver or even different cost drivers for different products. If overhead is
always under- or over-applied, it may mean that either the estimates of overhead costs or the
estimates of the quantity of the cost driver are off. This may or may not cause a problem
depending on whether the difference between applied and actual is significant and whether it is
affecting profitability.
Now an example:
We will use the steps outlined above to work through a numerical example.
Simply Southern produces a line of gourmet food products using Georgia peanuts, pecans, and
peaches. They estimated their manufacturing overhead would be $210,000 in the coming year which will be applied based on 70,000 machine hours. During the year, they spent$300,000 on
direct materials, $225,000 on direct labor, and used 80,000 machine hours to make 200,000 units. Actual overhead was$220,000.
Step 1: Choose a cost driver
The cost driver is identified as machine hours
Step 2: Estimate total manufacturing overhead and the total quantity of the cost driver
Manufacturing Overhead costs are estimated to be $210,000 and machine hours, the cost driver, is estimated to be 70,000 hour. Step 3: Calculate the predetermined overhead rate PDOR = total overhead cost / total quantity of the cost driver =$210,000 / 70,000 machine hours
= $3.00 per machine hour Step 4: Apply overhead to specific jobs The PDOR is$3.00 per machine hour and 80,000 machine hours were actually worked during
the year. Overhead can be applied in aggregate, by individual job, or unit of production.
Regardless of how it is allocated, in the end we will need to determine the overhead cost of
producing each unit to get the full cost per unit. We will calculate applied overhead in aggregate
and to each unit. In aggregate, 80,000 hours were worked with a PDOR of $3 per machine hour. Applied overhead = PDOR x actual aggregate quantity of cost driver =$3.00 per machine hour x 80,000 machine hours
= $240,000 of total applied overhead To determine the amount allocated per unit, we need to divide the total machine hours by the number of units. In this case we will divide 80,000 actual machine hours by the 200,000 units that were made to get 0.40 machine hours per unit. Adding this to the formula give us,$1.20 of

= PDOR x actual quantity of cost driver traced to specific job
= $3.00 per machine hour x 0.40 machine hours per unit =$1.20 applied overhead per unit

Step 5: Determine the full cost of the product
Full cost can be determined on a per unit basis or in aggregate. The aggregate value is what
would be reported on a traditional income statement. To get the aggregate value, add together
direct material costs, direct labor costs, and applied manufacturing overhead. From the problem
and prior calculations we know that during the year, Simply Southern spent $300,000 on direct materials and$225,000 on direct labor. They used 80,000 machine hours to make 200,000 units
which resulted in $240,000 of applied overhead. The total is then divided by the number of units to get a full cost per unit. In this case$3.82.
Full cost

= direct material cost + direct labor cost + applied overhead cost
= $300,000 +$224,000 + $240,000 =$764,000 full cost in total

We can also determine the full cost on a per unit basis. To do this we must determine the unit
cost for direct materials and direct labor and add the applied overhead. To get unit costs, we
divide total costs by total units. This results in $1.50 direct materials per unit and$1.12 direct
labor per unit.
Per unit cost = Total Cost / Total Units
Direct material =
$300,000 / 200,000 units =$1.50 per unit
Direct Labor =
$224,000 / 200,000 units =$1.12 per unit
We already determined that applied overhead is $1.20 per unit. Adding the three together results in a full cost of$3.82 per unit.
Full cost

= direct material cost + direct labor cost + applied overhead cost
= $1.50 per unit +$1.12 per unit + 1.20 per unit
= $3.82 full cost per unit We can convert back and forth from cost per unit to aggregate cost by multiplying or dividing by total quantity: Per unit to aggregate = price per unit x total units =$3.82 x 200,000 units
= $764,000 full cost in total Aggregate to per unit = total price per unit / total units =$764,000 / 200,000 units
= $3.82 full cost per unit Step 6: Determine whether overhead was over or under applied As noted above,$240,000 overhead was applied to production while the actual overhead costs
were $220,000. In this case, since more overhead was applied to the products than the actual cost, overhead was over-applied. Under/Over-applied = Applied overhead – Actual overhead =$240,000 - $220,000 =$20,000 over-applied
Step 7: Evaluate whether the job order cost system works
It would be a good idea to check and see if machine hours is a good basis for allocating costs. It
may be that some products use relatively more machine hours than other products. This might
skew the results.

APPLY WHAT YOU HAVE LEARNED: Determine the full cost of the product described
below. Determine whether overhead was under- or over applied.
Venture Kayaks build custom kayaks. http://www.venturekayaks.com/aboutUs.php Since each job is unique, it
uses job order costing to track costs. Overhead, which is applied to jobs based on direct labor hours, is estimated
to be $250,000 for the year. The company plans to produce 3,125 kayaks each of which require 10 hours of labor. In terms of cost, each boat uses$175 of direct materials and $375 of direct labor. Calculate the predetermined overhead rate. Determine how much overhead will be applied to each kayak. Determine the full cost to produce each kayak. Will overhead be over- or under- applied if actual overhead costs are$240,000 and the company actually
produces 3,000 kayak?

Process Costing
Process costing is used when a company essentially makes the same product in a fairly
continuous manner: making and bottling juice, processing oil into gasoline, creating paint. In
these cases it does not make sense to accumulate cost by jobs or by individual product. Rather in
process costing, material, labor, and overhead costs are accumulated by department and allocated
to the number of units produced in each department. This makes sense. Since the company is
essentially making one product, the accountant simply adds the product costs together and
divides by the number of products made to get the full cost of production. In this way the costs
are spread equally over the number of units created.
Paint is one example of a product that could be
tracked using process costing. The steps for making
paint are outlined below. Each step occurs in a
different department. Each department tracks the cost
of materials, labor and overhead for its department.
Once the work is done in one department, the partially
completed paint and the costs associated with the
paint are passed to the next department. (picture from
http://www.artspectrum.com.au/)

Sequential steps in producing paint. Each step is completed in a separate department.

Making the pigment
•Minerals and chemicals are pulvarized and washed to create colored
powders

Making the paste
•Pigment is moistened with a wetting agent, solvents, and additive to
form a paste

Dispersing the pigment
•paste is agitated and sifted to blend ingredients and remove lumps

Thinning the paste
•Solvent is added to thin the paste to produce the final product

Canning the paint
•Finished paint to pumped into cans and sealed.

Since full cost is determined by dividing all the costs by the number of units created, the key
issue in process costing is determining how many units of production are completed. This would
not be an issue if all effort in any given accounting period went into creating only complete
products. But this is not always the case. With process costing, there are always some units of
production that are not complete by the end of the accounting period. In the case of paint, there
will always be some minerals and chemicals still being converted to pigment, some pigments
being converted to paste, some paste being thinned into paint, and some vats of paint still in the
process of being canned. As a result we will use a concept called equivalent units of production
to adjust partially completed units to the number of units that would have been completed if all
effort had resulted in complete units. This conversion is like converting the number of part-time
employees to a full time equivalent number of employees. For example, say a company has two
half time employees or four-quarter time employees. Combined, the two half time employees or
the 4-quarter time employees are equivalent to one full time employee. We will discuss the
process of converting partially completed units to equivalent units of production along with the
other steps in process costing below.
Allocating cost in process costing
In process costing, overhead is allocated based on equivalent units of production. This is
determined by adjusting partially completed units to the number of units that would have been
completed if all effort had resulted in complete units. This is usually done separately for
often combined and labeled conversion costs. Conversion costs are the costs of converting raw
materials to the finished good. As with job order costing, it is good to think about the process
systematically.

Step 1: Determine equivalent units (EU): To calculate total units to equivalent units of
production we will gather information about the number of units completed and the number of
units started into production, but not yet complete. Additionally, we will need information that
helps us determine how complete the in process units are. The table below can be used to gather
the information and calculate equivalent units.
Materials

Conversion

Units completed and transferred out
+ Units in process x percent complete
= Equivalent units of production
In the first row, enter the number of units completed and transferred out to a subsequent
department. In the second row enter the number of units in process adjusted for their degree of
completion. To adjust partially complete units multiply the number of units started but not yet
competed, by how complete they are. How complete they are is based on percentage complete.
For example, half complete would be 50% complete, a quarter complete would be 25%
complete. So if a company has 100 units that are each half complete, there would be 50
equivalent units (50% of 100 or 100 units x 0.50). If they had 100 units that were each 10%
complete, there would be 10 equivalent units (10% of 100 or 100 units x 0.10). Add the adjusted
the number of units left in a department and add those to the number of units completed and
transferred
Equivalent units are determined separately for materials and conversion because a product could
be in different stages in regards to each. For example, if Kraft Food Products is aging cheese, the
cheese might already have 100% of the materials (milk, enzymes, rennet) needed to make the
cheese, but still require additional conversion costs (labor and overhead) to finish the production
process.
We will use Art Spectrum as an example:
Art Spectrum produces paints which it distributed through retailers including Blink, A.C. Moore,
and Michael’s. During the month the pigment department transferred enough paint pigment for
4,000 cases to the paste department. At the end of the month 3,000 cases worth of pigment were
left. The product was 75% complete in terms of materials and 25% complete in regards to
conversion. At the beginning of the month, the pigment department had material costs of
$36,900 and conversion costs of$140,150. During the month $8,725 of materials were added, while$77,400 of conversion costs were added.
Step 1: Determine equivalent units (EU):
Materials
Units completed and transferred out
Units in process x percent complete
= Equivalent units of production

4,000
2,250 =(3,000 × .75)
6,250 EU

Conversion
4,000
750 =3,000 × . 25
4,750 EU

Step 2: Determine total costs to be allocated: To determine total cost we combine the costs
tracked to the department at the beginning of the period with the costs added during the current ## Plagiarism Checker

Submit your documents and get free Plagiarism report

Free Plagiarism Checker
{"ft_lang_label":"__label__en","ft_lang_prob":0.93934387,"math_prob":0.9091133,"size":25199,"snap":"2020-45-2020-50","text_gpt3_token_len":5043,"char_repetition_ratio":0.1800754,"word_repetition_ratio":0.08985301,"special_character_ratio":0.2110798,"punctuation_ratio":0.093023255,"nsfw_num_words":0,"has_unicode_error":false,"math_prob_llama3":0.97144556,"pos_list":[0,1,2],"im_url_duplicate_count":[null,null,null],"WARC_HEADER":"{\"WARC-Type\":\"response\",\"WARC-Date\":\"2020-11-24T18:14:10Z\",\"WARC-Record-ID\":\"<urn:uuid:a0be57b1-6899-457b-b2ef-c9edcf5d5fab>\",\"Content-Length\":\"126190\",\"Content-Type\":\"application/http; msgtype=response\",\"WARC-Warcinfo-ID\":\"<urn:uuid:830d4da3-fa18-4d30-b498-e78ade0a349c>\",\"WARC-Concurrent-To\":\"<urn:uuid:54249dab-0b28-4faf-a5ec-3dda1f4cafed>\",\"WARC-IP-Address\":\"34.224.249.39\",\"WARC-Target-URI\":\"https://www.transtutors.com/questions/chapter-6-determining-full-cost-chapters-3-4-amp-7-by-the-end-of-this-chapter-studen-3205949.htm\",\"WARC-Payload-Digest\":\"sha1:DT7G6V4FVT4XQGP22MSJVRDTTKXJN6FJ\",\"WARC-Block-Digest\":\"sha1:YZZEZZOJTZGRP27ZU3FRX4DS23JNRNVU\",\"WARC-Identified-Payload-Type\":\"application/xhtml+xml\",\"warc_filename\":\"/cc_download/warc_2020/CC-MAIN-2020-50/CC-MAIN-2020-50_segments_1606141176922.14_warc_CC-MAIN-20201124170142-20201124200142-00243.warc.gz\"}"}