Module No.

1 – Basic Concepts

Learning Outcome/s:
 Define and differentiate cost accounting versus any other branches of accounting
 Understand the scope of cost accounting
 Properly classify manufacturing costs
 Classify the inventories of a manufacturing entity
 Differentiate the different systems of cost accumulation

Core Values/Biblical Principles:

Competency is defined as the quality or state of having sufficient knowledge, skill or strength. A lack of
competency can cause problems within the work environment and can lead to poor quality work. This
could lead to fatalities or rework which may cost the company money and possibly their reputation.

Introduction:
Cost accounting is a system that records, summarizes, analyzes, and interprets the details of the costs of
materials, labor, and overhead necessary to produce and sell an article.

Body:
Purposes of Cost Accounting
1. Estimating and bidding
2. Planning, budgets, and control

Cost – a measurement, in monetary terms, of the amount of resources used for some purpose. When
notified by a term that defines the purpose, cost becomes operational, e.g., selling cost, acquisition cost,
variable cost, etc.

Cost pool – an account in which a variety of similar costs are accumulated prior to allocation to cost
objects. It is a group of costs associated with an activity, e.g., overhead account.

Cost object – the intermediate and final disposition of cost pools, e.g., product, job, process.

Cost driver – a factor that causes a change in the cost pool for a particular activity. It is used as a basis
for cost allocation; any factor or activity that has a direct cause-effect relationship.

Activity – any event, action, transaction or work sequence that incurs costs when producing a product or
providing a service.

Manufacturing is the process of converting materials into finished goods by using labor and incurring
other costs, generally called manufacturing overhead.

Three Manufacturing Cost Classifications

1. Direct materials – also called raw materials; these are used in the manufacturing process that
become a significant part of the finished goods.

2. Direct labor – this account is represented by employees who work directly with the raw
materials in converting them to finished goods.

3. Manufacturing overhead – also called factory overhead, manufacturing expenses, or factory

burden; these are costs incurred in the factory that cannot be considered direct materials or
direct labor.

a. Indirect materials – materials that are used in small amounts in the manufacturing process
or that cannot easily be traced to specific products.
 Factory supplies or operating supplies – another type of indirect material which consist of
items that are used in the manufacturing process but do not become a part of the finished
goods.

b. Indirect labor – salaries and wages of factory personnel who do not work directly on raw
materials.

c. Other manufacturing overhead – includes costs such as payroll taxes on factory wages;
rent, depreciation, taxes, and insurance on factory buildings and machinery; heat, light and
power; repairs and maintenance of machinery and equipment.

Prime and Conversion Costs

Prime cost – is the sum of direct materials and direct labor. It reflects the primary sources of costs for
units in production.

Conversion cost – is the total of direct labor and manufacturing overhead. It indicates the costs required
to convert the raw materials into finished products.

Inventory Accounts for a Manufacturing Company

1. Raw materials inventory – this account reflects the cost of raw materials and factory supplies
that will be used in the manufacturing process.

2. Work in process inventory – this account reflects the cost of raw materials, direct labor, and
manufacturing overhead of goods on which manufacturing has begun but has not been
completed at the end of the fiscal period.

3. Finished goods inventory – this account reflects the costs of goods that have been completed
and are ready for sale.

System of Cost Accumulation

1. Actual cost system (Historical) – direct materials, direct labor and factory overhead costs are
determined as they occur simultaneously with the manufacturing operation but the total of
these costs is known only after the operation has been completed.

2. Standard cost system (Predetermined) – costs are determined in advance from analysis and
forecasts made before the actual production begins.

3. Normal cost system – it is a combination of the actual cost system and standard cost system.
This system accumulates only the actual amounts of direct materials and direct labor costs.
Factory overhead costs are accumulated on the basis of a predetermined rate.

Summary:
Cost accounting is used in the determination or accumulation of a product’s cost for inventory valuation
and consequently income determination, hence, it is important to understand the cost of a product and
to have proper classification of these costs.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 2 – Job Order Cost Cycle

Learning Outcome/s:
 Understand the differences between a job order system and a process cost system
 Enumerate and understand the steps in a typical cycle of operation in a job order cost system
 Prepare journal entries necessary in a job order cost system

Core Values/Biblical Principles:

To have compassion is to empathize with and to endeavor to respond to the needs of the people around
us. We can create a meaningful difference in the world simply by performing one simple act of
compassion after another.

Introduction:
There are two types of cost systems, namely job order cost system and process cost system. Job order
cost system is used to accumulate costs of goods manufactured when products are produced in jobs or
lots of varying quantities and types. Process cost system, on the other hand, is used when there is a
continuous flow of goods of identical or similar characteristics throughout the manufacturing process.

Body:
Job Order Cost System
Job order cost system accumulates costs applicable to each specified job order or lot of similar goods
manufactured on a specific order for stock or for a customer. This system is often used by manufacturers
who produce a variety of products, because such producers need to keep track of each specific order to
ensure correct assignment of costs.

Process Cost System

Process cost system accumulates costs without attempting to allocate them during the accounting
period to specific units of goods being manufactured. At the end of the fiscal period, the average cost
per unit is determined by dividing the total number of units produced into the total cost accumulated,
hence, it is also referred to as average costing.

Dual Systems
A dual system is often used when a company makes standard parts or subassemblies continuously and
then incorporate them into finished goods built to customer specifications.

The steps in a typical cycle of operation of a company using a job order cost system are:
1. Procurement – materials and supplies needed for manufacturing are ordered, received, and
stored. Direct and indirect factory labor are obtained.

2. Production – materials are transferred from the storeroom to the factory. Labor tools,
machines, power, and other costs are applied to complete the product.

3. Warehousing – finished goods are moved from the factory to the warehouse to be held until
they are sold.

4. Selling – merchandise is shipped from the warehouse and sales to customers are recorded.
Cost Accounting Cycle for Materials

Cost Accounting Cycle for Labor

Gross Salaries xxx

Less: Mandatory Deductions
SSS/GSIS xxx
PhilHealth xxx
Pag-Ibig xxx
Net Pay xxx

Factory Overhead Applied

Work in process xxx
Factory overhead xxx

Debit balance means that less overhead was applied than the actual cost incurred. (under-applied)
Credit balance means that the applied overhead is greater than the actual cost incurred. (over-applied)

If the difference is immaterial, under-/over-applied overhead is closed to the Cost of Goods Sold.
Otherwise, it is pro-rated to Work in Process, Finished Goods, and Cost of Goods Sold.

Summary:
Under the job order cost system, costs are accumulated to specific goods or products with varying
quantities and types. This system usually involves the following stages: procurement, production,
warehousing and selling.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 3 – Purchasing Materials

Learning Outcome/s:
 Understand the different departments that deal with purchasing
 Understand and compute for the reorder point and safety stock
 Understand and compute for the economic order quantity
 Identify the significant documents that circulate during the purchasing process

Core Values/Biblical Principles:

Unity can nurture the spirit of harmony through mutual respect and understanding. We can see unity at
the workplace where team members work together in order to complete the goal and meet the
deadline. If any team member works alone, there can be chances that the person will not achieve the
goal, but if the people are united, the chances of success increases.

Introduction:
The detailed procedures and documents required to account for purchasing materials will be discussed
in this module.

Body:
In a manufacturing company, the cost of raw materials is a major part of the total manufacturing cost of
each product, hence, strict controls are necessary not only to guard against theft but also to minimize
waste and misuse from causes such as maintenance of excessive inventories, over-issuance,
deterioration, spoilage and obsolescence of materials. Below are some requirements to an effective
internal control system for materials:

1. Materials of the desired quality must be available when needed.

2. Correct quantities and types of materials must be on hand at the right time for production to
proceed on schedule.
3. Materials must be purchased at the most favorable prices.
4. Materials must be protected from loss or theft.
5. Risks of spoilage and obsolescence must be minimized.
6. Cost of materials handling and storage must be kept to a minimum.

Organization for Control

Control is achieved in part through an organizational structure that allows specialization at the same
time defines authority, fixes responsibility, and provides a system of checks and balances. The following
are the different departments usually related to the materials acquisition of a manufacturing company:

1. Purchasing department – it is charged with the responsibility of placing orders for materials
with reliable suppliers, at the right time and at the right price.

2. Receiving department – it is charged with the inspection of incoming shipments and verification
of the quantities received on order.

3. Storeroom (stockroom) – it is responsible for protecting the materials against physical

deterioration and ensuring that the stocks are properly issued.

4. Accounting department – it records all transactions in the accounts after documentary evidence
have been supplied by other departments.

5. Cash department – it pays all invoices after approval by the accounting department.
 Purchase order Ordering
specification

Receiving
Vendor

Accounting

Payment

What if there is a return:

Storeroom
Storeroom Cash/APxxx
Purchase returnsxxx

Production
Production Materialsxxx
Work in processxxx

Indirect Direct

Overhead Work in
process

COGM

COGS

Reorder Point
To determine when an item has reached a level at which it should be reordered, the following factors
should be considered:

1. The frequency at which the materials is used.

2. Lead time – the length of time it takes for the materials to be delivered from the supplier after
an order has been placed.
3. Safety stock – the minimum level of materials that should be maintained to ensure that the
company does not run out of materials.

Safety stock = (Maximum lead time – Normal lead time) x Average usage
Normal lead time usage = Normal lead time x Average daily usage
Maximum lead time usage = Maximum lead time x Average daily usage
Reorder point:
 Normal lead time usage; if there is no safety stock
 Maximum lead time usage; if there is safety stock
 Normal lead time usage + Safety stock; if there is safety stock

Illustration
ABC Company has a daily average usage of 20 cans for its production. It usually takes five days to receive
an order, however, if there is delay, it takes 8 days before the order arrives.

Normal lead time usage = 5 x 20 = 100

Maximum lead time usage = 8 x 20 = 160
Safety stock = (8 – 5) x 20 = 60
Reorder point = 100 + 60 = 160

Economic Order Quantity (EOQ)

It is the standard quantity to be ordered varies from item to item. It should reflect the quantity
necessary to get the best price while keeping inventory at an appropriate level to ensure uninterrupted
production.

2 x Annual requirements x Cost of an order

EOQ = √ carry a single item ¿
Cost ¿

Illustration
ABC Company’s cost to order is Php 108, the cost to carry an item in inventory is Php 75 and the
company’s annual demand is 5,000.

2 x 5,000 x 108
EOQ = √
75
1,080,000
=√
75
= √ 14 , 400
= 120

Purchase requisition – once the materials reach the reorder point, the storeroom supervisor completes
a purchase requisition requesting that materials be ordered. A purchase requisition is a properly
approved, written request for materials and is prepared in duplicate. The original copy is sent to the
purchasing department as a request for the materials.

Purchase order – written authorization to the supplier to ship the specified material.

Receiving report – shows all the details of the shipment, including comments on the condition of the
materials received.

Check voucher or disbursement voucher – if all documents are in order (e.g., purchase invoice,
receiving report, and purchase order), this voucher is then prepared and becomes the basis for the
preparation of journal entries to record the purchase and the payment of the invoice.

Bill of materials – this may be prepared when a sales order is received to avoid the problem of
insufficiency of materials needed. This document lists all materials needed on the job and the date they
will be needed.

Debit memorandum – is a notice to the vendor of a deduction from the invoice for the cost of the
returned materials.
Credit memorandum – this is prepared if the supplier ships more materials than were ordered and the
materials are retained for future use and have not been included in the supplier’s invoice.

Control Procedures
1. Order cycling – materials are reviewed on a regular cycle and orders are placed to maintain a
desired inventory level.
2. Min-max method – minimum and maximum inventory levels are determined. Reordering is
done when the minimum level is reached.
3. Two-bin method – this is used for inexpensive items. When the first bin is empty, an order is
placed. The second bin provides coverage until the order is received.
4. ABC plan – this is used with a wide variety of items having different values. The more expensive
items receive more frequent review and closer monitoring.
5. Automatic order system – an order is automatically placed when the inventory reaches a
predetermined level. This system works best when used with a computer.

Summary:
Materials must be carefully controlled to protect the company’s large investment in materials and to
maintain enough materials on hand to meet the production requirements. Further, materials should be
purchased in correct quantities, at the proper time and at the most economical cost to the company.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 4 – Storing and Issuing Materials

Learning Outcome/s:
 Enumerate and identify the different documents that circulate during material storage and
issuance
 Learn different methods of protecting materials during storage and issuance

Core Values/Biblical Principles:

Workplace spirituality includes many aspects like meaningful work, sense of community, and
organizational value. It is intended to interconnect past experiences and develop trust among
employees in a way that would lead the organization into a better and productive environment. If there
is no spirituality in the workplace, the organizational environment becomes challenging which would
create hurdles and issues.

Introduction:
Internal control procedures for purchasing must be accompanied by appropriate systems for storing and
issuing materials to ensure that the company’s investment in inventory is protected.

Body:
Storing Materials
The storeroom supervisor shall be responsible for the protection of materials in the storeroom and for
the identification of the materials.

Bin tag – informal record showing the quantities of the materials received, issued, and on hand at all
times.

Issuance of Materials
No materials are issued from the storeroom without a materials requisition. This document indicates
the quantity, material number, description, and job number to which the materials are to be charged.

Materials ledger card – serves as a perpetual inventory record. The materials ledger is a subsidiary
ledger which is verified against the Materials account in the general ledger. At the end of the accounting
period, the balance on the materials ledger card should equal the balance of the Materials account.

Materials requisition journal – after recording the requisition in the related materials ledger card, the
requisition is forwarded to the cost clerk who journalizes the transaction in the materials requisition
journal so that the effect of the issuance will be reflected in the general ledger.

Job cost sheet – the cost clerk’s next step is to post the information from the requisition to the
Materials section of the job cost sheet. Only the direct materials are posted in this document.

Departmental overhead analysis sheet – all indirect manufacturing expenses are posted from a
requisition to the Indirect Materials section of this document.

Materials Internal Control

The internal control procedures for storing and issuing materials should reflect the following:
1. Admittance to the storage area should be restricted.
2. Materials ledger cards, covering all receipts and issues should be maintained.
3. Each type of material should be clearly identified, stored and carefully protected while in
storage.
4. Materials should be issued only upon proper written authorization.
 5. The accounting system should permit a periodic check of the materials ledger against the
balance of the Materials account.
6. Different persons should be involved in storage and issuance operations.

Materials Returned to Storeroom

Returned materials report – this must accompany the materials returned to the storeroom as a result of
requisitioning too many materials, withdrawing wrong materials or any other reasons.

Materials Returned to the Supplier

Return shipping order – is made together with a debit memorandum authorizing the return of the
materials to the supplier.

Summary:
An effective control system for storing and issuing materials should be adopted by the company to
safeguard its investment in these items. Materials must also be carefully identified, stored, and recorded
by the storeroom staff and must only be issued upon receipt of the necessary documents.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 5 – Controlling and Costing Materials Inventory

Learning Outcome/s:
 Identify and apply different inventory costing methods
 Apply the LCNRV in its inventories at year-end
 Compute for the ending inventory

Core Values/Biblical Principles:

To be accountable means to be reliable and to be responsible for one’s decisions. Accountability
eliminates the time and effort one spends on distracting activities and unproductive behavior. When
people in the workplace are accountable for their actions, they value their work and productivity is
increased.

Introduction:
It is important to determine the valuation of the materials as this will have an effect on the company’s
profit of loss for the accounting period. Assuming the other factors remain the same, the higher the
ending inventory valuation, the lower the cost of goods sold resulting in greater profits or smaller losses.
On the other, the lower the ending inventory valuation, the higher the cost of goods sold resulting in a
smaller profit or greater losses.

Body:
Inventory Costing Methods
1. Specific identification – specific costs are attributed to identify items of inventory. This may be
used when the inventory items are few and are not ordinarily interchangeable.

2. Perpetual inventory system – unit costs and total costs should be computed each time
materials are received or issued. This is usually used when there are large numbers of inventory
items that are interchangeable.

a. First in, first out (FIFO) method – the first materials purchased are the first materials to be
used. The materials on hand are therefore assumed to be the last ones purchased.

Advantage/s:
 Easier and less costly to use
 Less recordkeeping than LIFO
 Reflects the actual physical flow of goods

Disadvantage/s:
 Does not match current costs against current sales revenue
 Can lead to distortions of net income in period of rising prices since the cost of
goods sold is understated

b. Last in, first out (LIFO) method – the last materials purchased are the first materials to be
used. The materials on hand are assumed to be the first one purchased.

Advantage/s:
 The current costs are matched against current revenue

Disadvantage/s:
 Unrealistic physical flow of goods
 c. Moving average method – all the costs are commingled and an average cost is computed
with each new purchase and assigned to materials issued and on hand.

Advantage/s:
 Simple to apply
 Produces inventory valuation that approximate current value if there is a rapid
turnover of inventory

Disadvantage/s:
 There may be a considerable lag between the current cost and inventory valuation
since the average unit cost involves early purchases

PAS 2 (Inventories) prescribes the use of the FIFO and moving average methods to compute the cost of
inventories. However, LIFO is no longer permitted.

Illustration
Assume the following transactions:
January 1 – the beginning balance of materials on hand is 150 units costing Php 150 each.
January 6 – 150 units are purchased at Php 155 each.
January 10 – 180 units are issued for production.
January 21 – 150 units are purchased at Php 156 each.
January 23 – 160 units are issued for production.
January 25 – 10 units are returned to the storeroom. These units had been issued on January 10 for use
in the production.

a. Under the FIFO method:

1. Compute the total cost of inventory issued to production.
January 10: (150x150) + (30x155) 27,150
January 23: (120x155) + (40x156) 24,840
January 25: (10x155) (1,550)
Total cost issued to production 50,440

2. Compute the cost of ending inventory.

January 21: (110x156) 17,160
January 25: (10x155) 1,550
Total cost of ending inventory 18,710

b. Under the LIFO method:

1. Compute the total cost of inventory issued to production.
January 10: (150x155) + (30x150) 27,750
January 23: (150x156) + (10x150) 24,900
January 25: (10x150) (1,500)
Total cost issued to production 51,150

2. Compute the cost of ending inventory.

January 21: (110x150) 16,500
January 25: (10x150) 1,500
Total cost of ending inventory 18,000
 c. Under the moving average method:
1. Compute the total cost of inventory issued to production.
Units Unit Price Total Cost
January 1 150 150 22,500
January 6 150 155 23,250
300 152.5 45,750
January 10 (180) 152.5 (27,450)
January 21 150 156 23,400
270 154.44 41,700
January 23 (160) 154.44 (24,710.4)
January 25 10 152.5 1,525
Total 120 154.28 18,514.6

Total cost of inventory issued to production = 27,450 + 24,710.4 – 1,525 = 50,635.4

2. Compute the cost of ending inventory.

Valuation at Cost or Net Realizable Value Whichever is Lower

Inventories shall be measured at the lower of cost and net realizable value.

Net realizable value = estimated selling price – estimated of cost completion and cost necessary to make
the sale

 LCNRV by item – the cost and the net realizable value of each item in inventory are determined.

 LCNRV by totality – the total cost and the total net realizable value is computed and compared.
If the price of some materials increased and the other decreased, this method gives a less
conservative valuation than by item method.

Illustration
Quantity Cost/u NRV/u LCNRV/item Total cost Total NRV
Item A 100 100 110 10,000 10,000 11,000
Item B 200 150 120 24,000 30,000 24,000
LCNRV by item 34,000 40,000 35,000
LCNRV by totality 35,000

To adjust inventory to lower value, the following may be used when perpetual inventory records are
kept:

 Each materials ledger card is adjusted to show the new unit values. This method results in an
increase on the cost of goods sold for the difference between the cost and the NRV and does
not show the inventory loss as a separate item on the income statement.

Loss on inventory write-down xxx

Materials xxx

 A valuation account is set up to reduce the total value of the inventory to net realizable value.
The individual materials ledger cards are not changed and continue to reflect cost.

Loss on inventory write-down xxx

 Allowance for inventory write-down xxx

Illustration
Assume the following information:
December 31, 2020 December 31, 2021
Inventory at cost 360,000 420,000
Inventory at NRV 348,000 416,000

December 31, 2020:

Loss on inventory write-down 12,000
Allowance for inventory write-down 12,000

December 31, 2021:

Allowance for inventory write-down 8,000
Gain on reversal/Recovery from inventory write-down 8,000

Finished goods, beginning xxx

Cost of goods manufactured (at cost) xxx
Total goods available for sale xxx
Finished goods, ending (xxx)
Cost of goods sold before write-down/recovery xxx
Loss on inventory write-down xxx
Recovery from write-down (xxx)
Cost goods sold after write-down/recovery xxx

Inventory at cost xxx

Less: Allowance for inventory write-down (xxx)
Inventory at LCNRV xxx

Physical Inventory
To detect errors and to correct the records, it is necessary to count the materials on hand periodically
and to compare the actual count with the records. Physical inventory can be performed either of the
following:

 At the end of a period, all production is halted and the employees count and tally the materials
on hand.

 Continuous or cycle inventory method is a less disruptive procedure. Only a few materials are
counted each day under this method.

Adjustment of Shortage and Overage

 Materials ledger cards are corrected. Shortage is recorded by an entry under the Issued column
while overage is entered under the Received column.

 Prepare the entry to adjust the accounts for the net shortage or overage.

Manufacturing overhead control xxx

Materials xxx

Some of the following reasons for inventory shortage or overage are:

 Failure to post receipts and/or issues
 Errors in posting
  Errors in recognizing the correct cutoff dates
 Spoilage as a result of poor storage conditions
 Losses due to theft of materials by employees
 Losses arising from theft by outsiders owing to inadequate plant protection

Just in time (JIT) inventory management – improvement that focuses on reducing the cost of inventory.
JIT manufacturing involves restructuring the production process so that every material arrives at the
right place on the production line just in time to be used.

Summary:
There are different costing methods that the company may use in order to value its inventories. Each
costing method has some advantages and disadvantages. The company shall use the method that best
fits its needs.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 6 – Labor Accounting (Control and Costing)

Learning Outcome/s:
 Familiarize with the common payroll procedures
 Familiarize with the documents that circulate in the entity’s payroll procedures

Core Values/Biblical Principles:

“I sought the Lord, and he answered me and delivered me from all my fears.” – Psalm 34:4 (ESV)

Introduction:
Labor cost is one of the major cost elements in a manufacturing operation. Accounting system for labor
costs includes keeping of records of time worked by employees, computing and recording their earnings,
and charging costs to production.

Body:
Timekeeping Procedures
Timekeeping function involves two major procedures in labor costing:
1. Accumulation of the total number of hours worked by each employee so that their earnings can
be computed
2. Determination how the labor hours were spent so that distribution can be made in the cost
records

Time records – serve as a basis for calculating gross wages of employees. It also serves as a basis to
compute the employer’s payroll taxes.

Time card – this is prepared to gather data on how many hours have been worked by each hourly rate
employee. This is the most common form of employee’s attendance record. This is sometimes called
clock card.

Payroll register – the number of hours worked each day of employees under the hourly rate is
transferred from the time card to this document. This is sometimes called payroll sheet.

Following are the usual payroll deductions as prescribed by the government:

1. Income taxes
2. Social Security System Contributions
3. Philippine Health Insurance Corporation (Phil. Health) Contributions
4. PAG-IBIG fund or Development Mutual Fund Contributions

Recording Payroll from the Payroll Register

Factory payroll (gross earnings) xxx
Withholding tax payable xxx
SSS contributions payable xxx
Phil. Health contributions payable xxx
PAG-IBIG contributions payable xxx
Payroll payable (net earnings) xxx

Payroll payable xxx

Vouchers payable xxx
Voucher payable xxx
Cash in bank xxx

Charging Labor Costs into Production

Labor costs are to be allocated between direct labor and indirect labor costs. Direct labor costs are
charged to Work in Process while indirect labor costs are charged to Manufacturing Overhead Control
account.

Work in progress xxx

Manufacturing overhead control xxx
Factory payroll xxx

Summary:
Labor cost is one of the major portions of the production cost of a company. As such, computing and
recording the employee’s wages shall be made accurately for the benefit of both the employer and its
employees.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 7 – Manufacturing Overhead Accounting (Actual and Applied)

Learning Outcome/s:
 Define and identify different examples of manufacturing overhead
 Properly classify manufacturing overhead costs
 Acquire skills to appropriately charge the overhead to production using different bases
 Determine the overapplied and underapplied overhead and prepare journal entries

Core Values/Biblical Principles:

“Have I not commanded you? Be strong and courageous. Do not be frightened, and do not be dismayed,
for the Lord your God is with you wherever you go.” – Joshua 1:9 (ESV)

Introduction:
The third type of production cost, the manufacturing overhead, will be discussed below. This module
will discuss the procedures in applying manufacturing overhead using a single predetermined overhead
rate and the procedures in recording manufacturing overhead.

Body:
Manufacturing overhead costs – costs that are not conveniently identified with particular units of
products. These include all factory costs other than direct materials and direct labor. These are
sometimes called manufacturing expenses, factory burden, factory overhead, factory expenses and
indirect manufacturing costs.

Types of Manufacturing Overhead Costs

1. Indirect materials – factory supplies, cleaning supplies, small tools, packaging materials, etc.
2. Indirect labor – receiving clerks, storeroom clerks, supervisors, etc.
3. Other manufacturing overhead – employee fringe benefits, factory utilities, rent of factory
building and warehouse, depreciation of factory building and equipment, property taxes, repairs
and maintenance, spoiled goods, shortage, etc.

Charging Manufacturing Overhead to Production

1. Actual costing – manufacturing overhead costs are charged to production at an arbitrary
manufacturing overhead costs using an arbitrary overhead application rate determined at the
end of the period.
2. Normal costing – uses predetermined overhead rate to allocate manufacturing overhead costs
to jobs.

Predetermined overhead rate – rate calculated at the beginning of a period. Its primary purpose is to
charge a fair share of overhead costs to each job. A number of bases for determining overhead rates
may be used to compute an overhead application rate:

1. Direct labor costs – this method is widely used because it is simple and easy to use.
Predetermined overhead rate is calculated by dividing the estimated manufacturing overhead
costs by the estimated direct labor costs.

Estimated manufacturing overhead costs

Percentage of direct labor costs =
Estimated direct labor costs
 2. Direct labor hours – this method assumes that overhead costs tend to vary with the number of
hours of direct labor used.

Estimated manufacturing overhead costs

Rate per direct labor hour =
Estimated direct labor hours

3. Direct material costs – the estimated manufacturing overhead costs are divided by the
estimated direct materials costs to compute the percentage of materials costs to be applied as
overhead.

Estimated manufacturing overhead costs

Percentage of materials costs =
Estimated direct materials costs

4. Machine hours – overhead may be applied as a rate for each machine hour when work is
performed principally by machines.

Estimated manufacturing overhead costs

Rate per machine hour =
Estimated machine hours

5. Units of production – this is used only if the manufacturing process is a simple one and only if
one type, or a few similar types, of products are produced.

Estimated manufacturing overhead costs

Overhead cost per unit of production =
Estimated units of production

Illustration
Assume the following budgeted data for the year:
Manufacturing overhead costs Php 96,000
Number of units of production 24,000 units
Direct material costs Php 480,000
Machine hours 12,000 hours
Direct labor hours 40,000 hours
Direct labor costs Php 200,000

1. Direct labor costs basis

96,000
= 48% of direct labor costs
200,000

2. Direct labor hour basis

96,000
= Php 2.4 per direct labor hour
40,000

3. Direct material costs basis

96,000
= 20% of materials costs
480,000

4. Machine hours basis

96,000
= Php 8 per machine hour
12,000

5. Units of production basis

96,000
= Php 4 per unit
24,000

Recording Applied Manufacturing Overhead Costs

Work in process xxx
 Manufacturing overhead control xxx

Recording Actual Manufacturing Overhead Costs

Manufacturing overhead control xxx
Accounts payable and other accounts xxx

Overapplied or Underapplied Overhead

1. Overapplied overhead – results when product costs are overstated because the actual overhead
costs were lower than expected (applied overhead). This will show as a credit balance in the
manufacturing overhead control account.

2. Underapplied overhead – results when product costs are understated because the actual
overhead costs were higher than expected (applied overhead). This will show as a debit balance
in the manufacturing overhead control account.

Illustration
Assume that the applied manufacturing overhead of ABC Company is Php 500,000. However, the actual
manufacturing overhead costs incurred totaled Php 600,000. Further, the year-end balances of the
company are as follows:
Work in process Php 40,000
Finished goods 80,000
Cost of goods sold 280,000

Work in process 500,000

Manufacturing overhead control 500,000

Manufacturing overhead control 600,000

Accounts payable and other accounts 600,000

a. Assuming the amount is material:

Account balances % Allocated amount
Work in process Php 40,000 10% Php 10,000
Finished goods 80,000 20% 20,000
Cost of goods sold 280,000 70% 70,000
Total Php 400,000 100% Php 100,000

Work in process 10,000

Finished goods 20,000
Cost of goods sold 70,000
Manufacturing overhead control 100,000

b. Assuming the amount is immaterial:

Cost of goods sold 100,000
Manufacturing overhead control 100,000

Summary:
There are different bases that the company may use for the computation of the predetermined
manufacturing overhead rate. Company shall select the base to used according to some factors such as
the type of goods produced, amount of machinery employed, type of labor used, wage rates paid, etc.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition
 Module No. 8 – Manufacturing Overhead (Departmentalization)

Learning Outcome/s:
 Define departmentalization and understand the need for it
 Classify direct and indirect costs
 Properly allocate departmental costs
 Understand the functions of different departments and determine their allocation bases
 Apply the step method and reciprocal method in problem solving

Core Values/Biblical Principles:

Commit your work to the Lord, and your plans will be established. – Proverbs 16:3 (ESV)

Introduction:
When a manufacturing firm has several departments that incur overhead costs, departmental overhead
application rates are preferable. The methods on applying the departmental rates to production are
discussed below.

Body:
Departmentalization – usually occurs in large businesses when factory operations are divided into
departments. Departments are classified into two categories:

1. Producing departments – directly engaged in the manufacturing activities. Examples include

assembly, finishing and packaging departments.

2. Service departments – assist indirectly by rendering services. Examples include purchasing and
maintenance departments.

Procedures in Departmentalizing Manufacturing Overhead

1. Calculate the departmental predetermined overhead application rates.
2. Apply the predetermined overhead rates to production on a department basis.
3. Record actual manufacturing overhead costs by departments in the Department Overhead
Analysis Sheet.

Direct departmental overhead costs – are costs that can easily be traced to specific departments.
Examples are as follows:
1. Repairs and maintenance
2. Indirect labor
3. Indirect materials
4. Depreciation of equipment

Indirect departmental overhead costs – examples are as follows:

1. Factory rent – distribution base is square footage
2. Depreciation of factory building – square footage
3. Fire insurance on building – square footage
4. Light – kilowatt hour

Service department costs – reallocated to the producing departments since these costs cannot be
directly identified to the products manufactured. Examples include the following departments below:
 1. Procurement – allocation base is the number of orders or cost of materials
2. Receiving – cost of materials, number of units or number of orders
3. Storeroom – cost of materials, number of requisitions filled or number of units handled
4. Factory office – number of employees, labor hours or labor costs
5. Personnel – number of employees, labor hours or labor costs
6. Building maintenance – floor space occupied
7. Power plant – kilowatt hours of power usage

Three Methods of Distributing or Reallocating Service Departments’ Costs

1. Direct method – the costs of each service department are allocated only to producing
departments. This method is the most often used in practice because it is simple to apply.

2. Step method – allocates service department costs to all service departments as well as
producing departments. The generally accepted procedures of allocation are:

a. Select the service department serving the most other service departments.
b. Allocate the costs of the service department selected in step 1 to the producing
departments and other service departments based on a relative level of the apportionment
base.
c. Allocate the costs of each remaining service department selected in the same manner as
described in step 1.
d. Costs of service departments are never allocated back to the departments whose costs have
already been allocated.

3. Reciprocal method – service department costs and service department reciprocal service
relationships are described by an algebraic equation.

Illustration
Assume the following data for January 2021:
Service Department Allocation Bases
Personnel Number of employees in each producing department
Building maintenance Floor space occupied by each producing department
Power plant Kilowatt hours of power usage in producing department

The following data for each department during January 2021 are obtained:
Department Costs No. of employees Floor space Kilowatt hours
Service department
Personnel Php 3,600 5 1,500 -
Building maintenance 2,000 4 2,500 -
Power plant 1,000 2 4,000 -

Producing department
Machining 11,800 10 10,000 7,000
Assembly 8,600 20 10,000 3,000

Compute the allocation of service department overhead costs under:

a. Direct method
Department Costs Proportion Machining Proportion Assembly
Personnel Php 3,600 10/30 Php 1,200 20/30 Php 2,400
Bldg maintenance 2,000 10,000/20,000 1,000 10,000/20,000 1,000
Power plant 1,000 7,000/10,000 700 3,000/10,000 300
Php 6,600 Php 2,900 Php 3,700

b. Step method
Department Cost Personne Bldg. Power Machining Assembly
 l Maintenance plant
Personnel 3,600 3,600 4/36: 400 2/36: 200 10/36: 1,000 20/36: 2,000
Bldg. 2,000 2,400 4/24: 400 10/24: 1,000 10/24: 1,000
maintenance
Power plant 1,000 1,600 7/10: 1,120 3/10: 480
Total 6,600 3,120 3,480

Illustration
Assume the following data for departments A, B, and C which provides services to each other and to
producing departments X and Y.
Percentage of Services
Total Cost A B C X Y
A – Php 200,000 - 15% 5% 55% 25%
B – 140,000 10% - 9% 18% 63%
C – 100,000 - - - 20% 80%

Based on the above data, the reciprocal method considers only services from A to B and B to A. If all
reciprocal services, are recognized, linear algebra may be used to reach a solution.

A = 200,000 + 0.10B
B = 140,000 + 0.15A
C = 100,000 + 0.05A + 0.09B

B = 140,000 + 0.15(200,000 + 0.10B)

B = 140,000 + 30,000 + 0.015B
0.98B = 170,000
B = 172,589

A = 200,000 + 0.10(172,589)
A = 217,259

C = 100,000 + 0.05(217,259) + 0.09(172,589)

C = 100,000 + 10,863 + 15,533
C = 126,396

Allocation of costs ca be made as follows:

A B C X Y
Cost prior to allocation 200,000 140,000 100,000 - -
Allocation of A (217,259) 32,589 10,863 119,492 54,325
Allocation of B 17,259 (172,589) 15,533 31,066 108,731
Allocation of C (126,396) 25,279 101,117
Total - - - 175,837 264,163

Summary:
There are several methods in applying the overhead costs to the different departments of a
manufacturing company. The company may use any method that is deemed fit for the necessity of the
business.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition