College of Business, Economics & Social Sciences

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UNITY UNIVERSITY

COLLEGE OF BUSINESS, ECONOMICS & SOCIAL SCIENCES

DEPARTMENT OF ACCOUNTING & FINANCE

MODULE FOR

COST & MANAGEMENT ACCOUNTING I (ACFN 211)

PRE- REQUISITE: FUNDAMENTALS OF ACCOUNTING II (ACFN 202)

Course Title: Cost & Management Accounting I Prepared By Asmamaw Kasahun

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CHAPTER I ............................................................................................................................................................ 10
OVERVIEW OF COST & MANAGEMENT ACCOUNTING.......................................................................................... 10
1.1 INTRODUCTION ....................................................................................................................................... 10
1.2. LEARNING OBJECTIVE.................................................................................................................................... 11
1.3. FUNDAMENTALS OF COST & MANAGEMENT ACCOUNTING (SESSION 1& 2) ................................................. 11
1.3.1 DEFINITION OF COST ACCOUNTING , MANAGEMENTS ACCOUNTING, & FINANCIAL ACCOUNTING ....................................... 11
1.3.1.1 Meaning of Cost accounting.............................................................................................................. 11
1.3.1.2 Definition of Management Accounting ................................................................................................. 12
 1.3.1.3 Definition of Financial Accounting.............................................................................................. 13
1.3.2 MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING ..................................................................................... 13
1.3.3. ACCOUNTING SYSTEMS AND THEIR PURPOSES......................................................................................... 19
1.4 IDINTIFYING WORK FLOW OF A MANUFACTURING FIRM (SESSIONS 3 & 4) ................................................... 23
1.4.1 MATCHING COST FLOW WITH WORK FLOW .............................................................................................. 24
1.4.2. RECORDING THE COST FLOW AT EACH STAGE OF WORK FLOW ................................................................. 26
1.4.3. PREPARINGCOST OF GOODS MANUFACTURED AND COST OF GOODS SOLD SCHEDULE.......................... 28
1.5. IDENTIFYING THE COST ACCOUNTING SYSTEM/METHOD ............................................................................ 33
1.5. COST CLASSIFICATIONS, CONCEPTS AND COST TERMINOLOGIES (SESSIONS 5 & 6) ....................................... 38
1.5.1 COST CONCEPTS: .......................................................................................................................................... 38
1.5.2. CLASSIFICATION OF COSTS ...................................................................................................................... 39
1.5.2.1 Classification of Cost According to Natural Characteristics: ............................................................. 40
1.5.2.2 Classification according to changes in the volume/levels of activity: .................................................. 41
1.5.2.3. Classification of cost based on degree of traceability to the product ................................................. 48
1.5.2.4 Classification as Product versus period costs ..................................................................................... 49
1.5.2.5 Classification according to the nature of functions: ........................................................................... 50
1.5.2.6 Classification according to the time of cost determination: ................................................................ 51
1.5.2.6 Classification according to the nature of production: ......................................................................... 52
1.5.2.7 Classification of costs according to its relevance for decision making and analysis: ............................ 52
1.6. THE CONCEPTS OF COST UNITS, COST CENTERS AND PROFIT CENTERS ......................................................... 56
CHAPTER TWO ..................................................................................................................................................... 60
COST DETERMINATION: THE COSTING OF RESOURCE INPUTS .............................................................................. 60
LEARNING OBJECTIVES......................................................................................................................................... 60
2.1 ACCOUNTING FOR MATERIALS: PURCHASE, STORAGE, PRICING AND CONTROL (SESSIONS 7 & 8)................. 61
2.1.2 MEANING OF MATERIALS ......................................................................................................................... 61
2.1.1 MATERIALS CONTROL: Concept and Objectives .................................................................................... 62
2.1.2. PROCEDURE FOR PURCHASING AND RECEIVING MATERIALS: ................................................................... 63
2.1.2.1 Purchase Requisition ......................................................................................................................... 63
2.1.2.2 Purchase order ................................................................................................................................. 59

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2.1.2.3 Receiving Materials .......................................................................................................................... 60
2.1.2.4. Preparing and Recoding the Voucher ............................................................................................... 62
2.1.2.5. Paying the voucher .......................................................................................................................... 64
2.1.3. ACCOUNTING FOR MATERIALS RETURNED ........................................................................................................... 64
2.1.4. STORING AND ISSUING MATERIALS................................................................................................................... 66
2.1.4.1 Storage of Materials ......................................................................................................................... 66
2.1.4. 2 Issuance of Materials ....................................................................................................................... 68
2.1.4.3 Bill of Materials ................................................................................................................................ 70
2.1.5. ACCOUNTING FOR MATERIALS TRANSFER .......................................................................................................... 70
2.1.6. CONTROLLING AND VALUING INVENTORY .......................................................................................................... 71
2.1.6.1. Inventory Control ............................................................................................................................. 71
2.1.6.2. Valuing inventory............................................................................................................................. 75
2.1.7. IDENTIFICATION & ACCOUNTING FOR MATERIAL STOCK LOSSES ............................................................................... 76
2.2 ACCOUNTING FOR LABOUR: (SESSIONS 9& 10) .............................................................................................. 80
SESSIONS LEARNING OBJECTIVES .............................................................................................................................. 80
2.2.1. INTRODUCTION ........................................................................................................................................... 81
2.2.2 TYPE OF LABOR COSTS .................................................................................................................................... 81
2.2.3 ACCOUNTING PROCEDURES FOR LABOR COSTS: ..................................................................................................... 82
2.2.3.1. Timekeeping procedures .................................................................................................................. 82
2.2.3.2. Payroll Procedures ........................................................................................................................... 85
2.2.3.3 Charging labor costs in to production ............................................................................................... 89
2.3. ACCOUNTING FOR OVERHEAD COSTS: (SESSIONS 11, 12, 13 & 14)................................................................ 96
2.3.1. INTRODUCTION ........................................................................................................................................... 96
2.3.2 LEARNING OBJECTIVE .................................................................................................................................... 96
2.3.3 MEANING& NATURE OF OVER HEAD .................................................................................................................. 97
2.3.4. DEPARTMENTALIZING OVERHEAD COSTS ............................................................................................................ 97
2.3.5 DISTRIBUTING SERVICE DEPARTMENT COSTS.......................................................................................... 105
2.3.5.1 Allocating Service Department Costs .............................................................................................. 105
2.3.6. SETTING OVERHEAD RATES ........................................................................................................................... 110
2.3.7. APPLYING MANUFACTURING OVERHEAD .......................................................................................................... 115
2.3.8. OVER APPLIED OR UNDER APPLIED OVERHEAD ................................................................................................... 117
CHAPTER THREE ................................................................................................................................................. 125
COST METHODS: THE COSTING OF RESOURCE OUT PUTS .................................................................................. 125
3.1. INTRODUCTION ....................................................................................................................................... 125
3.2. METHODS OF COSTING:........................................................................................................................... 126
3.3. TECHNIQUE OF COSTING .......................................................................................................................... 127
3.4. DETERMINING MANUFACTURING COSTS USING JOB ORDER COSTING SYSTEM ................................... 129
3.4.1. IDENTIFYING JOB ORDER COSTING ................................................................................................................. 130
3.4.2. SOME COMMON TERMS IN JOB COSTING SYSTEM ............................................................................................. 131
3.4.3. RECORDING COSTS IN JOB ORDER COSTING SYSTEM-ILLUSTRATIONS ...................................................................... 134

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3.4.4 ACCOUNTING FOR SPOILAGE, REWORK & SCRAP UNDER JOB COSTING ..................................................................... 141
3.4.4.1 Spoilage costs ................................................................................................................................. 141
3.4.4.2 Rework ........................................................................................................................................... 143
3.4.4.3. Accounting for Scrap ..................................................................................................................... 144
CHAPTER 4: ........................................................................................................................................................ 150
THE PROCESS AND OPERATION OR SERVICE COSTING METHODS: ..................................................................... 150
4.1. INTRODUCTION ....................................................................................................................................... 150
4.2. LEARNING OBJECTIVES ............................................................................................................................. 150
4.3 DESCRIBING THE NATURE OF PROCESS COSTING ....................................................................................... 151
4.3.1 CHARACTERISTICS OF PROCESS COSTING ........................................................................................... 151
4.3.2 DISTINCTION BETWEEN PROCESS COSTING AND JOB ORDER COSTING ............................................... 152
4.3.3 ADVANTAGE AND DISADVANTAGE OF PROCESS COSTING .................................................................. 152
4.3.4 Tracking the flow of costs under process costing system ..................................................................... 153
4.4 IDENTIFYING THE EQUIVALENT UNITS OF PRODUCTION ............................................................................. 155
4.5. IDENTIFYING BASIC STEPS IN PROCESS COSTING ....................................................................................... 156
4.6 COST OF PRODUCTION REPORT.................................................................................................................. 157
4.6.1 Weighted average method .................................................................................................................. 158
4.6.2. FIFO Method..................................................................................................................................... 160
4.7. ACCOUNTING FOR SPOILAGE COSTS-UNDER PROCESS COSTS .............................................................................. 167
CHAPTER FIVE .................................................................................................................................................... 178
ACCOUNTING FOR JOINT PRODUCTS, COST ALLOCATION AND BY PRODUCTS ................................................... 178
5.1. INTRODUCTION........................................................................................................................................... 178
5.2. LEARNING OBJECTIVES .......................................................................................................................... 179
5.3. JOINT PRODUCED .................................................................................................................................. 179
5.4. DEFINITION OF TERMINOLOGIES RELATED TO JOINT COSTS.................................................................. 179
5.5. JOINT COST ALLOCATIONS .................................................................................................................... 180
5.5.1. APPROACH-1 ALLOCATE COSTS USING MARKET BASED INFORMATION ........................................... 181
5.5.2. APPROACH II: ALLOCATING COSTS USING PHYSICAL MEASURED DATA SUCH AS WEIGHT OR VOLUME ........................ 191
5.6. ACCOUNTING FOR BY-PRODUCT ........................................................................................................... 195
CHAPTER 6: ........................................................................................................................................................ 201
ACTIVITY-BASED COSTING AND MANAGEMENT ................................................................................................ 201
6.0. LEARNING OBJECTIVES .......................................................................................................................... 201
6.1. INTRODUCTION........................................................................................................................................... 201
6.2. REASONS FOR THE DEVELOPMENT OF ABC ................................................................................................. 202
6.3. STEPS IN APPLICATION OF ABC SYSTEMS .................................................................................................... 203
6.4. TRADITIONAL ABSORPTION COSTING VS ABC SYSTEMS .............................................................................. 203

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6.5. WHEN USING ABC MIGHT BE MORE APPROPRIATE? ................................................................................... 207
6.6. ABC AND DECISION MAKING ....................................................................................................................... 207
6.7. ADVANTAGES AND DISADVANTAGES OF ABC ............................................................................................. 208
6.7.1. ADVANTAGES OF ABC: ............................................................................................................................... 208
6.7.2. DISADVANTAGES OF ABC ............................................................................................................................ 209

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Module Name Cost & Management Accounting I

Faculty College of Business, Economics & Social Studies
Department or equivalent Accounting & Finance
Credit Hour Allotted 3 credits
ECTS 5 hours

MODULE SUMMARY
Finance and Accounting have assumed much importance in today’s competitive world of
business wherein corporate organizations have to show the true and fair view of their financial
positions. Thus, the application of the accounting in the business sector is indispensible factor.
Finance/accounting personnel has to provide the complete and accurate information about the
financial operations of the company to the management for decision-making purpose.
The subject of “Cost & Management accounting is very important & useful for optimum
utilization of the existing resources. These are branches of accounting had been developed due
to the limitations of financial accounting. It is indispensible discipline for the corporate
management, as the information collected and presented to the management based on cost and
management accounting techniques helps management to solve not only specific problems but
also guides them in decision making process.
Keeping in view of the importance of this subject, various topics in cost and management
accounting have been prescribed in this module with the objective of acquainting the students
with the basic concepts used in cost and management accounting having a bearing on
managerial decision-making.
In this module, every effort has been made to give a comprehensive coverage of the topics
relevant to the subject. In all study lessons, the requisite theoretical framework for
understanding the practical problems in the subject has been explained and wherever necessary
practical illustrations have been given to facilitate a better understanding. At the end of each
sessions, a brief summary have been given under the caption “Lecture Synopsis” as well as a
good blend of theoretical and practical questions have been given under the caption ‘Wrap-up
questions’ for the practice of students to test their knowledge.
Although due care has been taken in preparing this module yet the possibility of errors,
omissions, and/or discrepancies cannot be ruled out. This module is released with the
understanding the department/university shall not be responsible for any errors, omissions,
and/or discrepancies or any action taken in that behalf.

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HOW WILL I LEARN?

Lectures and class based discussions. You will also be exposed to situations in the class exercises
that will help in the use of argument and evidence.
Problem solving tutorials. You will be guided on how to approach and solve costing problems.
Case study discussion and presentation. You will work in group to analyze cost & management
accounting cases, write reports, and deliver presentations during class.

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WHAT TYPES OF ASSESSMENT AND FEEDBACK CAN I EXPECT?

Assessments
Assessment will be a combination of an individual and group coursework/assignment, tests and
final exam. When a coursework includes group assignments, marks will be adjusted using peer
assessment.
Assessment pattern:
Assessment component Assessment type Weighting
Individual Assignment I 5%
Assignments: Individual Assignment II 5%
Group Assignment 5%

Class activity/participation/attend. N/A 5%

Tests (Two Tests) Written Exams 30%

Final Exam Written Exam 50%

Total 100%

Assessment criteria
As a student of this course and user of the cost & management accounting module, you need to
have a clear understanding between the assessment criteria and grade related criteria.
Assessment Criteria are descriptions of the skills, knowledge or attributes students need to
demonstrate in order to complete an assessment successfully whereas Grade-Related Criteria
are descriptions of the skills, knowledge or attributes students need to demonstrate to achieve a
certain grade or mark in an assessment. Assessment Criteria and Grade-Related Criteria for
module assessments will be made available to students prior to an assessment taking place.
Feedback on assessment
The feedbacks for individual/group works and tests will be returned to the students in class. For
other types of assessment (final exam and class activity), students will be given their marks and
feedback within 4 days after the date of their final exam and in line with the Assessment
Regulations and Policy of the university.

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INDICATIVE READING LIST
Main textbook:
 Charles T Horngren, Cost Accounting: A Managerial Emphasis, 9th Edition, Prentice
Hall In
 Cost Accounting: A Managerial Emphasis 11th ed Prentice Hall, Inc. New Jersey Charles
T.Horgren
Additional references:
 Introduction to Management Accounting: Prentice Hall New Jersey Charles T. Horngren
Principles & practice of cost accounting 2nd ed. Wheeler & Co. Ltd. New Delhi
Cost Accounting 3rd ed. John Wiley & Sons, Enc. New York 1991

 Principles of Cost Accounting 10th ed. Soult Western College Publishing Company, Ohio
1979.
 Horngren, Datar & Rajan. Cost Accounting: A Managerial Emphasis, th 14 Ed. 2012

 Garison. Noreen and Brewer, Managerial Accounting, 13th Ed

 Jain and Narang, Cost and Management Accounting, Kalyani Publisher, 2001 Edition
 Charles T Horngren, Cost Accounting, 8th Edition, Prentice Hall Inc.
 CharlesT Horngren, Introduction to Management Accounting Prentice Hall Inc

Module Introduction
Accounting information is important for every business which will serve the needs of a variety of
interested parties. To satisfy the needs of all interested parties, a sound accounting system is very
essential. Accounting as a discipline is generally divided into three main parts: (i) Financial
accounting; (ii) Cost accounting; and (iii) Management Accounting.

Financial Accounting is mostly concerned to record the business transaction in books of

accounts so that the financial statements can be prepared. Cost accounting is developed to help

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the internal management in decision making. The information provided by cost accounting acts
as a managerial tool so that businesses can utilize the available resources at optimum level.
Management accounting is an extension of management aspects of cost accounting. It provides
the information to management so that the managerial functions (planning, organizing, directing,
and controlling) of business operations can be done in an orderly manner.

Cost and Management Accounting is taken as one of the best business investment a student
could make. This is simply because success in any organization, whether it is a small corner store
or a large multinational corporation requires the use of cost and management accounting
concepts, techniques and practices.

Cost and management accounting provides key data to managers for planning and controlling of
future activities in which the company engages.

Cost management accounting prepares students for the rewards and challenges they face in the
competitive world of today and tomorrow. The course emphasize both the development of
analytical skills such as excel to leverage available information technology and the values and
behaviors that make students effective in their future career.

This module can be used in the way in which it is organized from simple to complex. The topics
in the course covered all the major purposes of accounting basic cost concepts and classification,
cost determination, cost accumulation & allocation through job-order and process costing,
accounting for spoilage, rework and defective goods, accounting for joint & by product costs and
finally the ABC costing systems will be discussed.

The students are required to prepare and present a summary note on the discussion. They are also
encouraged to participate in questioning-answering session in order to develop confidence &
problem solving skills.

The instructor is highly required to come up with full knowledge of the topic and has to test
whether the ideas in this topic are sutured using his own mechanism.

Course objective

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After completion of the course, the students be able to:

 Distinguish the similarity & distinction between Cost accounting, Management

Accounting & Financial Accounting.
 Describe a framework for Cost Accounting and Management Accounting
 Explain the concept of cost and its application in the three business organizations:
service, merchandising & manufacturing.
 Describe the approaches to evaluating and implementing job-order and process
costing systems
 Describe how cost Accounting supports management Accounting & Financial
Accounting

Chapter I
Overview of Cost & Management Accounting
1.1 Introduction
Modern accounting system provides key information to managers for their decision making
process. The study of cost and management accounting outlines into both manager’s role and the
accountants’ role in an organization. This unit is an introduction to cost and management
accounting that identifies the need for general accounting system and purpose of accounting,

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compares management accounting, cost accounting, and financial accounting and described
elements of management control and cost management.

1.2. Learning Objective

After the successful completion of this unit, students will be able to:
 Identify and understand the major purpose of accounting as an information system
 understand the meaning and purpose of cost accounting
 Compare and contrast management accounting, cost accounting, and financial
accounting.
 Understand how accounting can facilitate planning, and decision making.
 Distinguish among the problem-solving, scorekeeping and attention directing roles of a
management accountant

1.3. Fundamentals of Cost & Management Accounting (Session 1& 2)

Session Objective:
After the successful completion of this session, students are expected to:
 Know why they study accounting in general
 Identify the broad purposes of accounting
 Understand the meaning and purpose of cost accounting
 Compare and contrast management accounting, cost accounting, and financial accounting
 Understand primary objective of accounting systems in general

1.3.1 Definition of Cost accounting, Managements accounting, & Financial Accounting

1.3.1.1 Meaning of Cost accounting
There are different ways of defining “cost accounting” and “cost accountancy.” One of the most
comprehensive definitions provided by different scholars is provided as follows:-

Cost Accounting is a branch of accounting dealing with the classification, recording, allocation,
summarization and reporting of current and prospective costs and analyzing their behaviors. Cost
accounting is frequently used to facilitate internal decision making and provides tools with which
management can appraise performance and control costs of doing business.

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Cost accounting is the process of classifying, recording, and appropriate allocation of
expenditure for determining the cost of product or service, and for the presentation of suitably
arranged data for the purpose of controlling and guidance of the management. It includes the
ascertainment of cost of every order, job, contract, process, service or units as may be
appropriate.

Or cost accounting can be defined as, the process of determining and accumulating the cost of
some particular product or activity. In other words, cost accounting provides the management
with detailed records of cost related to product, operations or functions.

Cost accountancy is the application of cost accounting principles, methods and techniques to the
science, art and practice of cost control and ascertainment of profitability.

It is a science because it is the body of systematic knowledge having certain principles which a
cost accountant possesses for a proper discharge of their responsibility.

It is an art as it requires the ability and skill with which a cost accountant is able to apply the
principles of cost accountancy to various managerial problems.

1.3.1.2 Definition of Management Accounting

Management accounting, also called managerial accounting, is the process of analyzing business
costs and operations to prepare internal financial report, records, and account to aid managers’
decision making process in achieving business goals. In other words, it is the act of making sense
of financial and costing data and translating that data into useful information for management
and officers within an organization.

Management Accounting: means analysing and recording business activities for internal company
use in an effect to increase efficiency and productivity.

More specifically, management Accounting:

 Measures and reports financial and non-financial information that helps managers to fulfil
the goals of the organization.

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 Concerned with providing information to mangers, i.e. people inside the organization who
direct and control its operations.
 Focuses on internal reporting.
 1.3.1.3 Definition of Financial Accounting

Financial accounting is the field of accounting concerned with the summary, analysis and
reporting of financial transactions related to a business. This involves the preparation of financial
statements available for public/external use

Financial Accounting is

 Concerned with providing information to stockholders, creditors and others who are outside
the organization.
 Focuses on reporting to external parties.
 It measures and records business transactions and provides financial statements that are
based on GAAPs.
Managers are responsible for the financial statements issued to investors, government regulators,
and other outside parties. Therefore, managers are interested in both management accounting and
financial accounting.

1.3.2 Management Accounting Vs Financial Accounting

There are several major differences between financial accounting and management accounting.
They differ in primary users, in orientation of reports, in point of emphasis between the past and
the future, in the type of data provided to users, and in several ways. These differences are
described here below.

Primary Users: One important difference between management and financial accounting
information is the intended users. Financial accounting reports are prepared for the use of
external parties such as shareholders and creditors, whereas management accounting reports are
intended to be used by managers inside the organization. However, this does not mean that
financial accounting is not useful to management.

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Emphasis on the Future/Time Orientation: Since planning is such an important part of the
manager’s job, management accounting has a strong future orientation. In contrast, financial
accounting primarily provides summaries of past financial transactions. The difficulty with
summaries of the past is that the future is not simply a reflection of what has happened in the
past. Changes are constantly taking place in economic conditions; customer needs and desires,
competitive conditions, and so on. All of these changes demand that manager’s planning be
based in large part on estimates of what will happen rather than on summaries of what has
already happened.

Emphasis on Precision: Management accounting information is usually less precise than

financial accounting information. The latter reports on events that have already been occurred,
and are governed by structured reporting rules. Therefore, financial accounting is composed of
measurements that are often very precise. Management accounting information, which focuses
on future actions, is composed of estimates and forecasts. It is not possible for estimates and
forecasts to be as precise as measurements of past activities.

Reporting Flexibility /Freedom of Choice: Financial accounting statements prepared for

external users must be prepared in accordance with generally accepted accounting principles
(GAAP). External users must have some assurance that the reports have been prepared in
accordance with some common set of ground rules. These common ground rules enhance
comparability and reduce fraud and misrepresentation, but they do not necessarily lead to the
type of reports that would be most useful in internal decision-making.

Management accounting is not bound by generally accepted accounting principles. Managers set

their own ground rules concerning the content and form of internal reports. The only constraint

is that the expected benefits from using the information should outweigh the costs of collecting,

analyzing, and summarizing the data.

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Reporting Entity: Financial accounting information tends to report the activities of the
organization as a whole. This is because creditors and stockholders are usually concerned with
performance of the whole organization. If a bank loans money to a business, the loan is not to the
manager of a product line, but instead to the company as a whole. Likewise, a stockholder
purchases stock in the company as a whole, not in a specific product of the company.
Management accounting tends to focus on segments of the organization because most managers
are responsible for the operations of only a segment of the organization, not the whole
organization. Therefore, the managers are interested in operations of their specific segments.
These managers may wish to know about specific products, particular groups of customers, or
employees in a particular department of the organization. If the manager is making decisions
about products, the accountant will organize the data by product. If the decision compares
different sales territories, the data will be organized by sales territory.

Compulsion: Financial accounting is mandatory; that is, the preparation of financial accounting
reports and statements is must in certain undertakings (in case of a company form of
organization) where these are a necessity in others. Various outside parties such as regulatory
bodies and the tax authorities require periodic financial statements. Management accounting, on
the other hand, is not mandatory. A company is completely free to use or not to use management
accounting. There are no regulatory bodies or other outside agencies that specify what is to be
done, or, for that matter, whether anything is to be done at all. Since management accounting is
optional, the important question is always, “Is the information useful?” rather than,” Is the
information required?”

Description /Nature of Data Reported: Since many of the decisions that managers make require
non-financial information, management accounting information includes quantitative data that is
not financial. For example, accountants often report production quantities, capacity utilization
estimates, material scrap rates, quality control measures, employee turnover statistics, and
market share estimates. In addition to non-financial quantitative data, management accounting
reports non-monetary events, like technical changes, political changes, market competition and
so on. However, almost exclusively monetary transactions are recorded in financial accounting.
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Publication: Management accounting statements are prepared for the benefit of management
only and these are not published. Furthermore, they are confidential. In contrast, financial
accounting statements like income statement, balance sheet and others are published for the
benefit of the public.

Source of Data: In financial accounting, the sources of information are journal and ledger
accounts that form the basis for drawing income statement and balance sheets. Thus, the source
of information is almost exclusively drawn from the organization’s basic accounting system,
which accumulates financial information. But management accounting draws information both
from internal as well as external sources. The external sources of information may be the
magazines, newspapers and other publications. Delineation of Activities: Management
accounting is less sharply defined. That is, there is heavier use of related disciplines such as
economics, statistics, decision science and behavioral sciences. Financial accounting, however,
is more sharply defined because there is lighter use of related disciplines.

Time Span: Financial accounting presents 1 year or 1-quarter reports whereas management
accounting presents reports covering shorter or longer periods, varying from hourly to 10 to 15
years.

Items of Financial Accounting Management Accounting

Difference
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Primary Users External decision makers, Internal decision makers-managers at
such as creditors, various levels.

stockholders, tax authorities

and regulators

Time orientation Past Oriented Future oriented

Precision Precision of information is No emphasis is given to actual

required figures. Approximate figures are

considered more useful than exact

figures.

Freedom of choice Must follow IFRS Need not follow IFRS

Reporting entity Organization as a whole. Detailed segment reports about

That is, only summarized departments, divisions, products,

data for the entire customers and employees are

organization are presented. prepared.

Compulsion Mandatory for external Not mandatory

reports

Description Monetary Monetary and non-monetary

Publication Financial accounting Management accounting statements

statements are published are not published

Source of data Internal sources Both internal and external sources

Delineation of More sharply defined Less sharply defined

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activities

Time span Less flexible, usually 1 year Flexible, varying from hourly to 10 to

or 1 quarter 15 years.

Exhibit 1-1 Summary of the Differences between Financial and Management Accounting
From the above exhibit, the distinction between financial accounting and management
accounting becomes quite clear. Although many differences exist between them, they are similar
in at least two ways.

i. Both rely on the same accounting information system. It would be a waste of money to
have two different data collecting systems existing side by side. One part of the overall
accounting system is the cost accounting system, which accumulates cost data for use in
both management and financial accounting. For example, production cost data typically
are used in helping managers set prices, which is a management accounting use.
However, production cost data also are used to value inventory on a manufacturer’s
balance sheet, which is a financial accounting use.
ii. Both rely heavily on the concept of responsibility, or stewardship. Financial accounting is
concerned with stewardship over the company as a whole; management accounting is
concerned with stewardship over its parts, and this concern extends to the last person in
an organization who has any responsibility over cost.

Cost Accountancy is an essential part of accountancy, which has been developed to meet the
managerial needs of business. Starting off as a branch of financial accounting, cost accountancy has
developed so fast in the last few decades that it is difficult to give suitable definition, which fully
covers its scope.

Further cost accountancy is regarded as the science, art and practice of s cost accountant.

 It is a science in the sense it is body of systematic knowledge having certain principles,

which a cost accountant should follow for the proper discharge of his duties.

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 It is an art, as it requires the ability and skill on the part of a cost accountant in applying
the principles of cost accountancy to various managerial problems.

 Cost Accounting primarily deals with collection, analysis of relevant cost data for
interpretation and presentation for various problems of management.
 Cost accounting is a management information system, which analyses past, present, and
future data to provide the basis for managerial decision making.
 According to Charles T. Horngren Cost Accounting is “a Quantitative method that
accumulates, classifies, summarizes, and interprets information for three major purposes: (i)
Operational planning and control (ii) Special decisions and (iii) product decisions.
 In general, cost accounting is thus concerned with recording, classifying and summarizing
costs for determination of costs of products or services, planning, controlling and reducing
such costs and furnishing of information to management for decision making.
Cost Accounting

 Provides information for both management accounting and financial accounting.

 It measures and reports financial and nonfinancial information that relates to the cost of
acquiring or consuming resources by an organization.
Includes those parts of both management accounting and financial accounting where cost
information is collected or analyzed.

1.3.3. ACCOUNTING SYSTEMS AND THEIR PURPOSES

All accounting information is accumulated to help someone (may be a company president, a

production manager, a sales manager, a shareholder, a small business owner, a politician and
others) to make economic decisions. In general, users of accounting information fall into three
categories:
i) Internal managers who use the information for short-term planning and controlling routine
operations.

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ii) Internal managers who use the information for making non-routine decisions and
formulating overall policies and long-range plans. Examples of these non routine decisions
include:
 Investment in equipment.
 Pricing products and services.
 Choosing which products to emphasize or de-emphasize.
iii) External parties, such as investors, creditors and government authorities, who use the
information for making decisions about the company.

Each of the above purpose of an accounting system may require different ways of aggregating or
reporting data. Despite these differences, most organizations prefer a general-purpose
accounting system that can supply appropriate information for all three types of users.

An accounting system is a formal mechanism for gathering, organizing, and communicating

information about an organization’s activities. A good accounting system helps an organization
achieve its goals and objectives by helping to answer the following three types of questions:
I. Scorecard questions. Am I doing well or poorly?
II. Attention-directing questions. Which problems should I look into?
III. Problem solving questions. Of the several ways of doing the job, which is the best?

To answer each of the above questions, one can classify accounting data as scorekeeping data,
attention-directing data and problem solving data, respectively. Furthermore, depending upon
the classification of accounting information, the accountant’s task of supplying information can
be identified as scorekeeping task, attention-directing task and problem solving task.
Scorekeeping task: This is an accumulation and classification of data. This aspect of accounting
enables both internal and external parties to evaluate organizational performance. The
collection, classification and reporting of scorekeeping information is the task that dominates
day-to-day accounting. Examples of scorekeeping (scorecard) task include:
 Posting daily cash collections to customers’ accounts.
 Preparing journal entries for depreciation of equipment.

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 Processing monthly payroll.

Attention-directing task: It is the task of reporting and interpreting information that helps
managers to focus on operating problems, imperfections, inefficiencies, and opportunities. This
aspect of accounting helps managers to concentrate on important areas of operations promptly
enough for effective action. Attention directing is commonly associated with current planning
and control, and with the analysis and investigation of recurring routine internal accounting
reports. The following activities fall under attention directing based on the function that the
accountant is performing.
 Interpreting why a branch did not meet its sales quota.
 Interpreting variances on a post office supervisor’s performance report.
 Analyzing for the president the impact of net income of a contemplated new product.

Problem solving task: This task of the accountant involves quantification of the likely results of
possible courses of actions and often recommends the best course to follow. Problem solving is
commonly associated with nonrecurring decisions, situations that require special accounting
analyses or reports. Examples of activities performed by an accountant that could be classified
as problem-solving task include:
 Preparing, for production manager, a cost comparison for two computerized
manufacturing control systems.
 Analyzing the cost of several different ways to blend raw materials in the foundry.

Sometimes this classification of accounting information may overlap. A single data may serve to
answer one or more of the questions to be dealt with a good accounting system. For example, the
scorecard and attention-directing data are closely related. The same information may serve as a
scorecard function for a manager and an attention-directing function for the manager’s superior.
Consider a performance reports in which actual results of decisions and activities are compared
with previously determined plans. By pinpointing where actual results differ from plans, such
performance reports can show managers how they are doing and show the managers’ superiors
where to take action. In addition the actual results help answer scorecard questions of financial
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accounting, which is concerned with reporting the results of the organization’s activities to
external parties.

In contrast, problem-solving information may be used in long-range planning and in making

special, nonrecurring decisions, such as whether to make or buy parts, replace equipment, or add
or drop a product. These decisions often require expert advice from specialists such as industrial
engineers, budgetary accountants, and statisticians.

Exhibit 1-2 Users of Accounting Information

Major Means Major Ends
(Types of Accounting Information) (Helping Decisions)

Problem solving information Managers for long-range planning and special

decisions.

Scorekeeping information Managers for planning and controlling routine

operations.
Attention-directing information

Outsiders- investors, tax collectors, regulators,

Scorekeeping information and others.

 Synopsis
 Accounting systems exists to help decision making in a way that achieves the goal of the
organization. This assistance occurs by providing information for three major purposes:
(a) routine internal reporting to managers, (b) non-routine internal reporting to managers,
and (c) external reporting to investors, government authorities, and other outside parties.
 Cost accounting measures and reports financial and other information related to the
acquisition or consumption of an organization’s resources.
 Cost accounting provides information to both management accounting and financial
accounting.

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 Management accounting measures and reports financial and non-financial information
that helps managers make decisions to fulfill the goals of an organization.
 Management accounting focuses on internal reporting whereas financial Accounting
focuses on reporting to external parties.
 Financial Accounting measures and records business transactions and provide financial
information that are based on International Financial Reporting Standards (IFRS)
 Roles of Management Accountant include:
o Scorekeeping
o Attention directing
o Problem solving

 Wrap-up Discussion Questions

1. Describe the major purposes of accounting systems

2. How management accounting does differ from financial accounting?
3. Describe how cost accounting supports management accounting and financial
accounting?
4. How is cost accounting related to financial accounting?
5. Distinguish among the problem-solving, scorekeeping, and attention-directing roles of
management accounting
1.4 IDINTIFYING WORK FLOW OF A MANUFACTURING FIRM (SESSIONS 3 & 4)
Session Objective:

 Understand the work flow of Manufacturing organizations

 Understand how the manufacturing firms work flows are matched with the cost flows
 Know the accounting treatment and recording the cost flows at each stages of the work
flows
 Prepare the cost of goods manufactured & Cost of Goods Sold schedule for
Manufacturing firms

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The firm’s cost accounting system is parallels to the flow of operations. The steps in a typical
cycle of operations of a firm that makes and sells products are outlined as follows:-

1. Procurement
 Raw materials and supplies needed for manufacturing are ordered, received, and
stored. Factory labor and services are also obtained.
2. production
 Raw materials are transferred from the store room 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 ware- house to be held until they
are sold.
4. Selling
 Customers are found. Products will be shipped from the ware house and sales to
customers are recorded.

1.4.1 MATCHING COST FLOW WITH WORK FLOW

After identifying the different workflows of manufacturing firm, efforts will be made to match
cost incurred in each of the respective workflows.

1. Procurement
 Accounts must be provided to record the purchase of materials labor and overheads.
These costs will later be charged to production.
 Typical general ledger account titles used for this purpose are raw materials,
factory payroll clearing, and manufacturing overhead control respectively.

2. Production
 An account is required to gather procurement costs as they become chargeable to
manufacturing operations. This account is known as work in process.
3. Ware housing

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 An account must be set up to record the cost of goods that have been completely
manufactured. This account is referred as finished goods.
4. Selling
 The cost of completed goods that have been sold must be recorded. An account
termed as cost of goods sold is provided in the general ledger for this purpose.
Other general ledger accounts such as Accounts receivable and sales are used for recording the
sale to the customer and the credit to income at selling price.

Procurement ------------production-------------ware housing--------------selling

-Raw materials -work process -finished goods -CGS
-Factor payroll clearing
-Manufacturing overhead control
1.Procurement
 Purchase of materials, labor and overheads are recorded as debits to raw materials,
factory payroll clearing, and manufacturing overhead control. As this cost are used
or applies in factory operations, they are credited to these accounts and transferred to
production.

2. Production
 Costs of materials, labor and overhead transferred in to production are debited to work in
process. As goods are finished and moved from the factory, their total costs is moved
from or debited to finished goods.
3. Ware housing
 The cost of finished goods transferred from work in process is recorded as a debit to
finished goods. The costs of finished goods shipped from the warehouse to customers is
credited to finished goods and charged (debited) to cost goods sold.
4. Selling

As finished goods are sold and shipped from the warehouse, their cost is debited to cost of
goods sold. At the end of the accounting period, this account is closed by crediting cost of
goods sold and debiting incomes summary.

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1.4.2. RECORDING THE COST FLOW AT EACH STAGE OF WORK FLOW

Assume that on October 1,19x4 these balances in the following accounts were available:-

Raw materials 40,000 Br

Work; in process 30,000

Finished goods 24,000

1. Additional raw materials were purchased during the month of October at a cost of 60,000
Birr.
Raw materials 60,000

Vouchers payable (accounts payable) 60,000

2. During the month raw material costing 70,000 Birr were used as follows:-
Direct materials charged to the work in process Br.68, 000

Indirect materials charged to the manufacturing overhead control was Br.2, 000

Work in process 68,000

Manufacturing overhead control 2,000

Raw materials 70,000

3. During the month wages and salaries totaling 84,000 Birr were earned by the factory
employees and charged from the factory payroll register.
Factory payroll clearing 84,000

Salaries and wages payable 84,000

4. An analysis of records indicates that labor costs of 84,000 Birr is allocated as follows:-
Direct labor chargeable to the work in process 60,000

Indirect labor chargeable to man overhead control 24,000

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Work in process 60,000

Manufacturing overhead control 24,000

Factory payroll clearing 84,000

5. In addition to indirect materials and indirect labors other manufacturing overhead costs
totaling 14,000 Birr incurred during the month were charged form various journals.
Manufacturing overhead control 14,000

Vouchers payable (accounts payable) 14,000

6. It is estimated that overhead costs totaling 38,000 Birr are applied or charged to jobs
worked on during the month
Work in process 38,000

Manufacturing overhead control 38,000

7. During the month, some jobs were completed and transferred to the finished goods ware
house. The jobs cost were Br.180, 000
Finished goods 180,000

Work in process 180,000

8. During the month, finished goods costing Br.170, 000 were sold to various customers.
Cost of goods sold 170,000

Finished goods 170,000

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1.4.3. PREPARINGCOST OF GOODS MANUFACTURED AND COST OF GOODS

SOLD SCHEDULE

COST OF GOODS MANUFACTURED SCHEDULE

Raw materials
Raw material inventory, beginning xxx
Materials purchased xx
Freight in xx
Less:-Purchase return and allowance (xx)
Purchase discount ( xx)
Net purchase xxx
Total materials available xxx
Less: - Raw materials inventory, ending xxx
Raw materials used xxx
Direct labor xxx
Manufacturing over head
Indirect materials and supplies xx
Indirect labor xx
Payroll taxes expense-factory xx
Utilizes expense xx
Repair and maintenance xx
Depreciation -factory equipment xx
Insurance expense xx
Property taxes- factory equipment xx
Total manufacturing overhead xxx
Total current manufacturing cost xxx
Add: - work in process inventory, beginning
Less: - work in process inventory, ending (xx)

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Cost of goods manufactured xxx

COST OF GOOD SOLD SCHEDULE

Finished goods inventory, beginning xx
Add: - Cost of goods manufactured xx
Total goods available for sale xx
Less: - finished goods inventory, ending xx
Cost goods sold xx

Illustration-1
The following data is related to the operations of ABC Manufacturing Company
Jan 1, 2018 Dec 31,208
Inventories
Finished goods 43,000Br 52,000Br
Raw materials 12,000 10,000
Work in process 16,000 14,000
Direct labor 85,000
Freight in 4,000
Administrative expense 30,000
Indirect labor 18,000
Indirect materials and supplies 3,000
Insurance expense factory 1,500
Depreciation- factory plans 7,500
Raw materials purchases 170,000
Payroll taxes expense- factory 4,000
Utilities-factory 7,500
Property taxes -factory 3,000
Raw materials purchase returns and allowance 4,000
Repair and maintenance- factory 4,000

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Sales 500,000
Selling expense 85,000
Sales return and allowance 2,500
Instructions:-
1. Prepare statement of cost of goods manufactured and cost goods sold for the year ended
December 31,2018
2. Prepare the income statement for the year ended December 31,2018

Solution
1. Statement of Cost of Goods Manufactured (SCGM)

ABC Manufacturing Company

Statement of cost of goods manufactured
For the year ended December 31,2018
Raw materials
Raw materials, beginning 12,000
Purchase 170,000
Freight in 4,000
Less: - purchase return and allowance 2,500
Net purchase 171,500
Total materials available 183,500
Less: - raw material, ending 10,000
Raw materials used 173,500
Direct labor 85,000
Manufacturing over head
Indirect labor 18,000
Indirect material and supplies 3,000
Depreciation-factory plant and equipment 7,500
Insurance expense-factory 1,500
Payroll taxes expense-factory 4,000
Utilities factory 7,500
Property taxes-factory 3,000
Repair and maintenance-factory -------------------- 4,000
Total manufacturing Overhead 48,500

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Total current manufacturing cost 307,000
Add: - work in process beginning 16,000
Less: - work in process ending (14,000)
Cost of goods manufactured 309,000

Cost of Goods Sold- schedule

Finished goods, beginning 43,000
Add: cost of goods manufactured 309,000
Total cost of goods available for sale 352,000
Less: - finished goods, ending 52,000
Cost of goods sold 300,000

ABC Manufacturing Company

Income statement
For the year ended Dec 31, 2018

Sales 500,000
Less: - sales return and allowance 2,500
Net sales 497,500
Less: - Cost of goods sold 300,000
Gross profit 197,500
Less: -Administrative expense 30,000
Selling expense 85,000
Income before tax 82,500

Illustration -2

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Sunny company’s July 1995 cost of goods sold was 700,000 Birr, July 31 work in process
was 80% of July 1 work in process. Direct labor cost was 90% of manufacturing overhead
costs. During July 220,000 Birr of direct materials were purchased. Other July information’s
are as follows:-

Inventories July 1 July 31

Direct materials 54,600 50,000
Work in prices 80,000 ?
Finished goods 219,000 211,800
Required:-
1. Prepare a schedule of cost of goods sold for July
2. Prepare the July’s cost of cost of goods manufactured schedule
3. What was the amount of prime and conversion costs incurred in July?
Solution
1. Cost of goods sold schedule
Fished goods, beginning 219,000
Add: - cost of goods manufacturing (CGM) X
Less: - finished goods ending 211,800
Cost of goods sold (CGS) 700,000
CGS =Finished goods, big + CGM – Finished goods, ending
700,000 = 219,000 + X - 211,800
CGM(X) = 700,000 + 211,800 – 219,000
CGM(X) = 692,800 Br.
Cost of manufactured = 692,800
2. Cost of goods manufactured schedule
Direct material, beginning 54,600
Add:-direct material purchased 220,000
Less: - direct material ending 50,000
Direct materials used 224,600

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Direct labor 0.9 MOH
Manufacturing overhead (MOH) 1MOH
Add: - work in process, beginning 80,000
Less: - work in process, ending (80,000x0.8.) 64,000
Cost of goods manufactured. 692,800

224,600+0.9MOH+MOH+80,000-64,000=692,800
224,600+1.9MOH+80,000-64,000 = 692,800
1.9MOH = 692,800-240,600
MOH= 238,000 Birr
Direct labor = 238,000x0.9
=214,200 Birr
3. Prime cost = Direct material + Direct labor
= 224,600+214,200
= 438,800 Birr
Conversion cost = Direct labor + Manufacturing over head
= 214,200+238,000
= 452,200 Birr

1.5. IDENTIFYING THE COST ACCOUNTING SYSTEM/METHOD

Compared to financial accounting, cost accounting is relatively a recent development. The vital
importance of cost accounting has emerged because of the growth and complexity of the modern
industry. Financial information supplied by financial accounting in the form of financial
statement relates to past activity. Whereas, cost accounting is not so restricted and is concerned
with the ascertainment of past, present, and expected future costs of the products manufactured
and services supplied.
Therefore, the primary objectives of cost accounting system are ascertainment of cost, fixation of
price, proper recording and presentation of cost data to the management for measuring efficiency

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and for cost control. In cost accounting system terms such as cost, costing, cost accounting,
expenses, losses has to be clarified clearly.

Some of the definitions of cost are presented below.

1. A cost is the value of economic resources used as a result of producing or doing

the thing. In other words, cost is the amount of expenditure related to a specific
thing or activity.
2. A cost is the amount of resources given up in exchange for some goods or
services. Cost is an exchange price or a sacrifice made to secure benefit.

Basically, when cost is incurred, it could be in the form of deferred costs (asset) or expired costs
(expense).Deferred costs are unexpired costs which provide benefits in the future periods and are
known as assets. For example: equipment, building, machinery and so on.

When the deferred cost (assets) are used up, to the extent used they will become an expense. In
other words, expenses are expired costs incurred and used up in the process of generating
revenue. These expenses are then matched against the revenue that they helped to generate.
Examples of expenses include depreciation expense, selling expense, office salaries etc.
In contrast, losses are reduction in the firm’s equity for which no compensating value has been
received. A loss is an expired cost resulting from the decline in the service potential of an asset
that generates no benefit to the firm. Obsolescence or destruction of stock by fire is an example
of loss.
Costing simply means ascertainment of costs. It includes the techniques and process of
ascertaining and determining costs. The technique consists of principles and rules which are
applied for ascertaining costs of products manufactured and services rendered.

The process includes the day to day routine activity of determining costs within the method of
costing adopted by a business enterprise. Generally, costing refers to the technique and process
of determining costs of product manufactured or services rendered.

METHODS OF COSTING
There are two major types of costing a product or service:-
1. Job order costing system

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2. Process costing system
1. Job order costing system
Job order costing is used in those business concerns where production is carried
out as per the customer’s order and specifications. That means, each job or
product is considered to be separate and distinct from the other jobs or products.
Therefore, under this method costs are collected and accumulated for each job,
work order, or project separately.
This method is adopted in furniture manufacturers, construction companies,
printing (publishing) companies, accounting firms, research firms etc

2. Process costing system

This costing system is used in those industries where manufacturing is done
continuously through different processing cycles. Companies which are using this
method produce homogeneous or similar products in a repetitive manner through
different process. The finished product for one process becomes the raw material
for the subsequent process.
This method of costing is suitable for textile industries, chemical industries, paper
manufacturers, cement factories etc.
 Synopsis
 Procurement, production, & selling are typical operating cycles of a manufacturing
concern at which stages the cost accounting will be necessarily be applicable.
 Prime cost is the sum of direct material and direct labor whereas conversion costs is the
sum of direct labor and manufacturing overhead.
 The two commonly used costing methods/systems are job order costing & Process
costing systems depending on the nature of products being produced from a given
business concerns.
 Job order costing is used in those business concerns where production is carried out as
per the customer’s order and specifications whereas process costing system is used in

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those industries where manufacturing is done continuously through different processing
cycles.

 Wrap-up Exercise Questions

1. Calculating manufacturing costs and cost of goods manufactured.

The costs for Simon Inc. for the year ended June 30, 19X3, are given below.

Direct Materials $50,370

Direct Labor 73,825

Manufacturing Overhead 26,310

Work in Process Inventory, July 1, 19X2 28,830

Work in Process Inventory, June 30, 19X3 24,500

a. What is the current manufacturing cost for the year?
b. What is the cost of goods manufactured for the year?
2. Calculating prime costs and conversion costs.
The following costs were incurred by Texas Manufacturers:

Direct Material $206,180

Direct Labor 341,220

Manufacturing Overhead 172,382

a. What were the prime costs for the company?
b. What were the conversion costs?
3. Calculating Cost of goods sold and gross profit.
The following amounts relate to the Bio-Tech Corporation:
Finished Goods Inventory, April 1, 19X2 $58,480
Finished Goods Inventory, April 30, 19X2 52,219

Costs of Goods Manufactured 81, 507

Net Sales 127,493

a. Calculate the cost of goods sold

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b. Calculate the gross profit on sales.
4. Calculating cost of goods manufactured, cost of goods sold, and gross profit. The New
Bedford Plumbing Company manufactures water pumps and filters and uses a job cost order
accounting system. Cost data for 19X2 are given below.
Raw Materials, January 1, 19X2 $348,542
Raw Materials, December 31, 19X2 361,417

Work in Process, January 1, 19X2 283,463

Work in Process, December 31, 19X2 308,182

Finished Goods, January 1, 19X2 221,932

Finished Goods, December 31, 19X2 201,647

Raw Materials Purchases 631,917

Direct Labor 1,082,680

Manufacturing Overhead 714,530

Net Sales 4,608,917

a. Calculate cost of goods manufactured.

b. Calculate cost of goods sold.
c. Calculate gross profit on sales.

5. Calculating direct materials cost.

The Agricultural Products Company maintains a raw material inventory account for all
materials used in its factory operations. Purchases of both direct and indirect materials are
debited to this account. The balance on January 1, 19X4, for the raw materials account was
$250,738. Purchases of raw materials for the year were $762,910 and purchase returns
totaled $23,853. The ending inventory on December 31, 19X4, was $238,649. Calculate the
following:

a. What was the total amount of the raw materials available for use?
b. What was the cost of raw materials used in factory operations?
c. Materials requisitions show that of the total raw materials used during the year,
indirect materials amounted to $63,071. What was the amount of direct materials
used during the year?

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1.5. Cost Classifications, Concepts and Cost Terminologies (SESSIONS 5 & 6)

Session Objective
After completing this lesson, you are expected to be able to:
 Understand different cost concepts & terminologies
 Identify and understand different types of cost classifications and their purposes

1.5.1 Cost Concepts:

It is important to distinguish costs, expenses and losses.

Costs: Cost reflects a monetary measure of the resources given up to attain some objectives such
as acquiring a good or service. Cost is a monetary measure of the amount of resources used for a
cost object. Normally, a cost is viewed as an asset if it can be shown that it has future service
potential that can be identified. For example, prepayment of insurance premium for future period
can be considered as a best example. Now as we have already understood a cost is the value of
assets given up, or to be given up, to acquire other assets, i.e. cost is a sacrifice of resources.
Expenses are costs that are applicable to the current accounting period. Expenses in its broadest
sense include all expired costs, i.e. costs which do not have any potential future economic
benefit. The term expense is the cost of services or benefits received, or resources consumed
during an accounting period. The term, "cost is not synonymous with expense".
Expense means a decrease in owners’ equity that arises from the operation of a business during a
specified accounting period, whereas cost means any monetary sacrifice whether or not the
sacrifice affects the owners’ equity during a given accounting period. Example cost of goods
sold and selling and distribution expenses.
A loss is unplanned cost expiration and for these reasons is often included in the broad definition
of expense. When assets are given up for nothing in return, the value of the assets given up
becomes a loss. A more precise definition restricts the use of the term loss, stating that the cost
expiration which does not benefit the revenue producing activities of a firm. Examples,

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unrecovered book value on the sale of fixed assets, the write-off goodwill, carelessly destroyed
supplies etc.

1.5.2. CLASSIFICATION OF COSTS

After completing this lesson, you are expected to be able to:

 State the importance of cost classification.
 Cost classify according to natural characteristics.
 Make the cost classification according to changes in the volume of activity.
 Explain the classification of costs according to traceability to the product
 Distinguish between period costs and product costs
 Describe and give examples of manufacturing costs, administrative costs, marketing costs
and research and development costs.
 Classify cost according to relation with accounting period.
 Distinguish between cost classifications according to the time of incurrence and nature of
data.
 Explain cost classification according to the nature of production.
 Describe the role of various costs to the management policies.
 Make cost classification according to relevancy of decision making and analysis.
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Classification of costs is the process by which costs are grouped according to some common
characteristics. Classification is the arrangement of cost items in logical groups having regard to
their nature (subjective classification) or purpose (objective classification) to be achieved and
requirement of an organization. Subjective classification is used to indicate the nature of the
expenditure, for example, material, labor; whereas objective classification indicates the cost
center or cost unit where the costs are to be charged. Cost classifications are needed for the
development of cost data and each classification throws light on the different aspects of the
decision making process.
In general costs can be classified in the following ways:
 Based on natural characteristics.
 Based on changes in the volume/levels of activity.
 Based on tractability of the product.
 Based on association with product or period.
 Based on the nature of functions.
 Based on relation with accounting period.
 Based on the time of cost determination.
 Based on the management policies.
 Based on relevance for decision making and analysis.

1.5.2.1 Classification of Cost According to Natural Characteristics:

According to this classification, costs are divided into three categories; i.e. Material, labour and
other costs.
 Material: Material is rated as the first element of cost because without material to work
upon nothing can be manufactured. Conversion of material in the production process
increases the utility of the finished product. Material can be divided as (a) direct material
and (b) indirect material
Industry/Product Direct material Indirect material
Garments industry-Shirt Cloths Thread, Button

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Cloth Industry-Cloth Yarn, Cotton Color, Starch
Jute industry-Sack cloth Jute Baching oil
 Labor: Labor is considered as the second element of cost because without labor the
form, shape or nature of material cannot be changed to increase its usefulness. This cost
can also be of two types, (a) direct labor and (b) indirect labor. Wage which can be
economically traced to the output is known as direct labor and on the other hand, salaries
paid to supervisor, cleaner, guard and production manager are treated as indirect
labor/wages.
 Other Costs: All other manufacturing costs are classified as the third elements i.e. other
costs, because, unless certain other costs are incurred, material cannot be worked upon by
labor. Examples of this types of costs include tools must be supplied, supervision must be
exercised, machinery must be maintained, a place of work must be furnished to make
possible labors work upon the raw material furnished. Classification of costs according to
natural characteristics is important because it is necessary to know the cost of each
element that enters into a product to answer to the questions relating to stock valuation,
decision making, and controlling the organisation’s activities.
1.5.2.2 Classification according to changes in the volume/levels of activity:
Within a period, a particular cost may be observed changing with corresponding changes in some
measures of activity. Hence, costs are classified according to their behavior in relation to changes
in the volume of output (production), which others, as they are incurred in relation to time,
remain more less fixed in amount. Accountants describe a given cost behavior pattern according
to the way its total cost (rather than its unit cost) reacts to changes in a related measure of
activity. On this basis, costs can be classified into four categories, viz., fixed, variable, mixed,
and Step costs

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 Fixed Costs: A cost that is not immediately affected by
A fixed cost is a cost changes in the cost driver. Activities that affect costs are often called
which tends to
remain unchanged cost driver. A fixed cost is that which tends to remain unchanged
despite often wide
changes in output or despite often wide changes in output or activity. On a per unit basis,
activity.
a fixed cost varies inversely with changes in the level of activity.
This means that the per unit fixed cost decreases with increase in the
activity level, and increases with decrease in the activity level. The
rent of buildings of an organization, supervisor’s salaries, taxes on
real estate, maintenance and repairs of buildings and grounds, depreciation (other than
that computed under the units of production method), insurance are good examples of
fixed costs. Fixed costs are sometimes termed as "capacity cost" because fixed costs are
generally incurred to create facilities.
Some costs that are usually fixed include:
 Some manufacturing overhead costs, like
 Rent or depreciation expenses for factory building.
 Depreciation on factory machinery and equipment.
 Insurance and property taxes on manufacturing facilities and
 Production supervisory salaries.
 Some non-manufacturing costs, such as
 Office property taxes.
 Office fire insurances.
 Advertising and promotion and
 Supervisory salaries (related to administrative functions)
Fixed Costs remain fixed only over a given period of time usually the budget period. It may
change form budget-to-budget year solely because of changes in insurance, property taxes rates,
executive salary levels, or rent levels.
The graph below illustrates that total fixed cost remains unchanged irrespective of whether
activity changes. When activity doubles or triples, from 10 to 20 to 30, total fixed cost remains
constant at $1,500. However, the fixed cost per unit does change as activity level changes. If the
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activity level is only 1 unit, then the fixed cost per unit is Br.1, 500(Br.1, 500 1). If the activity
level is 10 units, then the total fixed cost per unit declines to Br.150 per unit (Br.1, 50010). The
table shown in exhibit depicted here below illustrates the behavior of total fixed cost and unit
fixed cost.

Exhibit 1.3 Fixed Cost Behaviors

A. Graph of Total Fixed Cost B. Graph of Unit Fixed Cost

Total fixed cost Unit fixed cost

Br. 1,500

Br. 1,000

Br. 1,500 Br. 500

Activity (or cost Activity (or

driver) 10 20 30 cost driver)

C. Tabulation of Fixed Cost

Activity( or cost driver) Fixed Cost per Unit Total Fixed Cost
1 Br.1, 500 Br.1, 500
2 750 1, 500
5 300 1, 500

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10 150 1, 500
20 75 1, 500
30 50 1, 500

Fixed costs can be fixed only over a restricted range of possible levels of activity (which is
known as relevant range). For example, rent costs will rise if increased production requires a
larger or additional building. Conversely, rent costs may go down if decreased production
caused the company to move to a smaller plant.

The relevant range is the limits of cost drive activity with in which a specific relationship
between costs and the cost driver is valid. It refers to the range of activity in which management
expects the firm to be operating in the next planning period.
Example: Assume that Sara Electric plant has a relevant range of between 40,000 and 80,000
cases of light bulbs per month and that total monthly fixed costs within the relevant range is Br.
800,000. Within the relevant range of 40,000 to 80,000 cases a month, fixed costs will remain
the same. If production falls below 40,000 cases, changes in personnel and salaries would slash
fixed costs to an amount below Br. 800,000. If operations rise above 80,000 cases, increase in
personnel and salaries would boost fixed costs above Br. 800,000. Refer Exhibit 1-4.

Br. 1,200,000
Fixed costs

Br. 800,000

A cost that varies in total in a direct

Br. 400,000 proportion to changes in activity
levels is called a variable cost.

20 40 60 80 100
Number of cases (in 000’s)

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Exhibit 1-4 Fixed Costs and Relevant Range

 Variable Costs: A cost that changes in direct proportion to changes in the cost driver. A
cost that varies in total in a direct proportion to changes in activity levels, a variable cost
must be a constant amount per unit. The cost of raw materials, wages, sales commission,
use of machine on rental basis is the good examples of variable costs. Thus, as activity
changes, total variable cost increases or decreases proportionately with the activity
changes, but unit variable cost remains the same.
There are many examples of variable costs. In a manufacturing company, they would usually
include direct materials, direct labor, some items of manufacturing overhead (such as utilities,
supplies, and lubricants), and perhaps shipping costs and sales commissions. In a merchandising
company, they would include cost of goods sold, commissions to sales persons, and billing costs.

Exhibit 1.5 Variable Cost Behavior

A. Graph of total variable cost B. Graph of unit variable cost

Total variable cost Unit variable cost

Br. 3,000

Br. 2,000
Br. 100

Br. 1,000 10 20 30
Activity 10 20 30

(or cost Activity

driver)
(or cost driver)

C. Tabulation of Variable Cost

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Activity (or cost driver) Variable Cost Per unit Total Variable Cost
1 Br. 100 Br. 100
10 100 1,000
20 100 2,000
30 100 3,000

Total Variable Cost = Unit variable cost  Activity

Unit Variable Cost = Total Variable cost
Activity

Panel A of Exhibit 1-5 displays a graph of a variable cost. As this graph show, total variable cost
increases proportionately with activity. When activity doubles, form 10 to 20 units, total
variable cost doubles, from Br. 1,000 to Br. 2,000. In contrast, a variable cost is a cost that
remains constant on a per-unit basis no matter what our level of output. The variable cost
associated with each of activity is Br. 100, whether it is the first unit or the tenth. The table in
Panel C of Exhibit 1-5 illustrates this point.
In a nutshell, as activity changes, total variable cost increases or decreases proportionately with
the activity change, but unit variable cost remains the same.
 Mixed Costs/Semi-variable costs: A mixed cost is a semi-variable cost (sometimes
known as a semi-fixed cost) that has both a fixed and variable element to it. So a mixed
cost has both a variable and a fixed component. On a per unit basis, a mixed cost does not
fluctuate in direct proportion with changes in activity nor remains constant with changes
in activity.
Telephone cost is an example of a mixed or semi-variable cost. This is so because it has a fixed
rental charge and a variable cost per unit of telephone time used per call. This means that the
total telephone cost is a mixture of fixed and variable costs. Another good example of a mixed
cost is electricity that is computed as a flat charge (the fixed component) for basic service plus a
stated rate for each kilowatt-hour of electricity used (the variable component).

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To sum up, the fixed portion of a mixed cost represents the basic, minimum cost of just having a
service ready and available for use. The variable portion represents the cost incurred for actual
consumption of the service. The variable element varies in proportion to the amount of service
that is consumed. Mixed cost is represented by a straight line; the following equation for a
straight line can be used to express the relationship between mixed cost and the level of activity.
y=a+bx
In this equation,
y = the total mixed cost
a = the total fixed cost (the y-intercept of the line)
b = the variable cost per unit of activity (the slope of the line)
x = the level of activity.
The behavior of mixed cost is shown graphically in Exhibit 1.6

Exhibit 1-6 Mixed Cost Behaviors

The graph illustrates the electricity charge of a company, which consists of a flat rate of $500 per
month plus $0.010 per Kwh. If the company uses 80,000 Kwhs of electricity per month, its total
electricity bill is $1,300 [$500 + ($0.010 x 80,000]. If 90,000 Kwhs are used, the electricity bill

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is $1,400. The distance between the fixed cost line and the total cost line in Exhibit is the amount
of variable cost. The slope of the total cost line is the variable cost per unit of activity.

 Step Costs: Step costs, sometimes called semi-fixed costs, remain fixed over a range of
activity, but beyond some activity level they change usually by intermittent jumps rather
than continuously. Step costs are costs that change abruptly at intervals of activity
because the resources and their costs come in indivisible chunks. If the individual chunks
of step cost are relatively large and apply to broad range of activity the cost is considered
a fixed cost over the range of activity. (Refer diagram (a) in Exhibit 1-8). In contrast,
accountants often describe step costs as variable when the individual chunks of costs are
relatively small and apply to a narrow range. Panel B in Exhibit 1-8 shows that the steps
in a semi-fixed cost behavior pattern are small; here in this case, the semi-fixed cost
function may be approximated by a variable cost function without much loss in accuracy.

Exhibit 1-7 Step Cost

Br. 45,000

Br. 45,000 Br. 35,000

Br. 35,000 Br. 25,000

Br. 25,000
10,000 20,000 30,000
10,000 20,000 30,000
Activity
Activity
(a)
1.5.2.3. Classification of cost based on degree of traceability to the product (b)
Based on the degree of traceability to the product costs are classified as direct and indirect.
(
Direct Costs

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A direct cost is a cost that can be easily and conveniently traced to the particular cost objects
under consideration in an economically feasible way. "Traceability” refers to the existence of a
clear cause -and- effect relationship between the cost object and the incurrence of a cost.
“Economically feasible" means cost effective i.e. that managers do not want cost accounting to
be too expensive in relation to e
Direct costs are those which are incurred for a particular cost unit, and can be conveniently
linked with that particular cost unit. Direct costs are those incurred primarily for, and which can
be identified as part of the cost of a given product. So once the cost object is specified, any costs
that are distinctly traceable to it are called direct costs. Examples of direct costs include cost of
direct material, direct labor, direct charges (special tool used for product) etc.
Indirect Costs
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost
object under consideration. Indirect costs are those of a more general nature which cannot be
identified primarily as part of the cost of a given product but without which the product could not
be manufactured. So these costs that cannot be traced are called indirect or common costs and
are allocated or assigned to the cost object using one on more appropriate predictions or
arbitrarily chosen bases. Examples of indirect costs include supervisors' salary, rent, rates and
taxes,
1.5.2.4 Classification as Product versus period costs
An important issue in both managerial and financial accounting is the timing with which the
costs and services are recognized as expenses. Costs are also classified by time period to provide
some bases of comparison of the firm's financial position from period to period. Costs related to
time periods are either period costs or product costs.
Product Costs:
Product costs refer to those items of cost that are included in the costs of inventory and become
expenses when the product is sold subsequently. So product costs are those costs that are
assigned to inventory because they are closely associated with production activities rather than
with the passage of time. It should be remembered that product costs are considered assets when
incurred, because they are resources that are expected to provide future economic benefits to the

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organization. Product costs associated with making or acquiring inventory are also called
“inventoriable costs”, which means the amount of inventory remains unsold that is the portion of
product cost stored. During the time period of sale the product costs are recognized as an
expense called “cost of goods sold”. For examples, the cost of direct materials, direct labor, and
manufacturing overhead consist product costs for manufactured goods
Period costs
Period costs refer to those items of cost which are recognized as expenses for the period in which
they are incurred and are charged against the revenue for the period. So period costs are charged
in the profit and loss account in the period in which they are incurred because they relate to the
passage of time, rather than being associated closely with the manufacturing process. It should be
remembered that period costs are not assets, because they are not expected to provide any future
economic benefits to the organization. Examples of period costs are salaries of sales personnel,
sales representatives’ commission, administrative expenses, selling expenses, distribution
expenses, depreciation of the office equipment, and finance expenses etc.
1.5.2.5 Classification according to the nature of functions:
According to this classification costs are classified relating to the number of functions
performed by a business enterprise. It leads to grouping of costs according to the broad division
of activity i.e. functional costs may be classified into the following types.
 Manufacturing Costs: These refer to the costs of operating the manufacturing division
of an undertaking i.e. these costs include the transformation of material into finished
products through the use of labor and factory facilities. This cost is also termed as
“production cost” or “factory cost”, which is the sum of direct material, direct labour,
and factory overhead. The portion of manufacturing costs which represent work
completed is transferred to finished goods to offer for sale while incomplete works
remain in work-in-process.
 Administrative Costs: Administrative costs refer to all costs of running the organization
as a whole. So it includes all expenditure incurred in formulating the policy, directing the
organization and controlling its operations, which is not directly related to production,
selling, distribution, research and development costs. Examples of such costs include

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salaries of top management personnel, general accounting, secretarial, cost of legal and
public relation activities, general administration etc.
 Marketing Costs: Marketing costs also known as selling costs incurred at the point
where manufacturing costs end that is, when manufacturing process is completed and the
finished product is ready for sale. So the marketing costs include the cost of selling goods
or services and also the cost of distribution. This cost is often termed as “order-getting”
and “order-filling” cost. Order-getting costs also known as selling costs include salaries,
commissions, travel costs of sales representatives, and cost of advertising and promotion.
On the other hand, order filling costs also known as distribution costs include costs of
storing, handling and shipping finished products. Taking together, marketing cost is well
known as “selling and distribution cost.”
 Research and Development Costs: Research cost is the cost of researching for new or
improved products, new application of materials or new or improved methods, processes,
systems or services. Development cost is the cost of the process which begins with the
implementation of the decision to use scientific or technical knowledge to produce a new
or improved product or to employ a new or improved method, process, system, etc., and
ends with the commencement of commercial production of that product or by that
method.
1.5.2.6 Classification according to the time of cost determination:
Costs classified in relation to the time of incidence include historical costs, replacement costs
and budgeted costs.
 Historical Costs/Actual costs: Historical costs or actual costs refer to the costs actually
incurred and ascertained after they have been incurred. Historical costs were incurred in
the past and are normally used in financial accounting. These costs are objective and
verifiable in quantities for income statement and balance sheet valuations. It is a
postmortem of the costs. However, historical costs are frequently not so useful for
decision making because conditions may have changed since the costs were incurred.
 Replacement Costs: A replacement cost is an amount that a firm would currently have to
pay to replace an asset or to buy one that performs functions similar to an asset currently

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held. It is the cost of replacement at current market price. So replacement cost valuation
states the costs at prices that would have to be paid currently.
 Budgeted Costs: A budgeted cost is a planned future expenditure. A budgeted cost
could be, but is not necessarily, the same amount as the replacement cost.
 Standard Cost: An estimated or predetermined cost of performing an operation or
producing goods or services, under normal conditions. Standard costs are used as
target costs (or basis for comparison with the actual costs), and are developed from
historical data analysis or from time and motion studies.

1.5.2.6 Classification according to the nature of production:

Costs classified according to the nature of production include separable cost, joint cost, and
common cost.
 Separable Cost: A separable cost refers to any cost that can be attributed to exclusively
and wholly to a particular product, process, division or department.
 Joint Cost: In costing of joint products, difficulty arises in apportioning joint costs that is
the cost incurred up to the spilt-off point between individual joint products. So a joint
cost is the cost of a process which results in more than one main product. So, the costs
which are a sort of common costs exist when units of different goods are produced out of
one and the same material or process.
 Common Cost: Common cost refers to those costs which are incurred collectively for a
number of cost centers and are required to be suitable apportioned for determining the
cost of individual cost centers. Common costs are costs of maintaining common facilities.
1.5.2.7 Classification of costs according to its relevance for decision making and analysis:

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Although costs are accumulated for cost as curtailment and cost control, one of the main
purposes of cost accounting is to provide detailed information for managerial decision making.
In fact, the fixed-variable classification cannot deal with all cost relationships involved in
managerial decisions. So it is necessary at this stage to discuss a wider range of cost concepts.
Each classification throws light on manager’s relevancy of decision making and analysis.
 Opportunity Cost and Outlay Cost: The term opportunity cost, used by accountants is
borrowed from economists. We know that, in managerial decision making, a cost is not
really a cost unless it requires a sacrifice of alternatives, i.e., unless it is an opportunity
cost. Opportunity cost is the cost of selecting one course of action in terms of the
opportunities which are given up to carry out that course of action; that is, an opportunity
cost is the cost of an opportunity foregone. The concept recognizes that resources are
scarce and have alternative uses. For example, assume that a manufacturer can sell his
work-in-process to outside market for $10,000. The company’s management decided,
however, to keep it and finish it. The opportunity cost of the work-in process is $10,000
because this is the amount of economic resources foregone by the manufacturer to
complete the product. Further, if fixed deposits in the banks are proposed to be
withdrawn for financing a project, the opportunity cost would be the loss of interest on
the deposits. Since the opportunity cost represents only sacrificed alternatives, they are
never recorded as such in the financial accounts. On the contrary, the concept of cost
which normally enters into the accounts of a business is known as outlay cost. Outlay
costs refer to the actual expenditures incurred on raw materials and other productive
facilities.
 Relevant Costs and Irrelevant Costs: Any cost which is relevant in making a decision
is relevant cost. Costs or revenues are relevant when they are logically related to a
decision and vary from one decision alternative to another. Any cost which is relevant in
making a decision is relevant cost. Costs that will be incurred as a result of a decision and
thus appropriate to a specific managerial decision are known as relevant costs. These
costs are relevant for future decision making.

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On the contrary, costs which are not affected by a decision are irrelevant costs that are costs that
have already been incurred irrespective of what is being done by the enterprise at present are
irrelevant costs. Relevant costs for decision making reflect the following two important features:
 They must be expected future costs and
 They must differ among alternatives.
For example; when plant replacement is being considered, the present depreciated cost of the
plant to be replaced would be irrelevant but its sale value would be relevant since this will go to
reduce the cost of capital investment. Similarly, if a company wants to make components that
was purchased from outside market, the relevant cost will be the cost of material and direct labor
and fixed costs that will be required for creating new facilities to make the components.
 Incremental Cost and Differential Cost: For most practical decision problems, the two
terms incremental cost and differential cost are used synonymously. When the cost of an
option is shown as additional to that under another option it is called an incremental cost.
On the other hand, differential cost is the difference in the total cost of two options
compared. The option may involve change in production, introduction of new machinery
on new product, marketing on any other business activity. It is noteworthy here that,
although technically an incremental cost should refer only to an increase in cost from one
alternative to another; decrease in cost should be referred to as decrement cost.
Differential cost is a broader term, encompassing both cost increases (incremental costs)
and cost decreases (decremental costs) between alternatives.
For example; that a company is considering two competing sites for a new factory. If the
northern site is chosen, the annual cost of transporting raw materials to the site is
estimated $185,000. If the southern site is selected, annual transportation charge is
estimated to be $150,000. The annual differential cost of transporting raw material is
calculated as follows:
Annual cost of transporting raw materials to northern site -------$185,000
Annual cost of transporting raw materials to southern site----------150,000
Annual differential cost---------------------------------------------------35,000

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It may be noted that differential cost calculation is generally done for facilitating
managerial decisions and is not generally incorporated in accounting records.
 Sunk Cost: A sunk cost is a cost that has already been incurred at the time that a decision
is being considered and is therefore not of importance for the new decision under
consideration. So sunk costs are costs that have been incurred in the past and
consequently they do not affect future costs and cannot be changed by any current or
future action. Such costs are irrelevant in a decision-making situation because there is
nothing that can be done to undo the decision to invest in them. Some argue that the total
cost of a fixed asset is not a sunk cost, but sunk cost is the difference between the
purchase price of a fixed asset and the net amount that could be realized from its sale. For
example, if the book value of a machine is $1,000,000 and its estimated scrap value is
$75,000; the net book value of the machine i.e., $925,000 ($1000,000 - $75,000) should
be considered as sunk cost.
 Out of Pocket Costs and Book Costs: Out-of-pocket costs refer to costs that involve
current payments to outsiders as opposed to book cost (such as depreciation that do not
require current cost expenditures). Out of pocket costs could also be like sunk cost and
irrelevant if the firm is not in a position to save them; otherwise these costs are relevant
costs. Book costs can be converted into out-of-pocket costs by selling assets and leasing
them back from the buyer. For example, A firm can sell own factory building but can
continue to use it by paying rent to the new owner. The rental payment then replaces the
depreciation charge and interest cost of owned capital.
 Controllable Costs and Uncontrollable Costs: The controllability of a particular cost
depends upon the level of management, that is, it is related to a special center of
managerial responsibility. Controllable costs are those which can be influenced by the
decisions and actions of a specified member of an undertaking and uncontrollable costs
are those which cannot be influenced by a specified member of an undertaking. The
distinction is not absolute because many costs are not completely under the control of one
individual. In classifying costs as controllable or uncontrollable, managerial accountants
generally focus on a manager’s ability to influence costs. Examples of controllable costs

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are indirect labor, lubricants, and power costs while depreciation, rent, and property tax
are uncontrollable costs. The time period factor and the decision making authority can
make a cost controllable or uncontrollable. If the time period is long enough, all costs can
be controllable. Similarly, whether a cost is controllable or not should be decided by the
decision making authority.
 Avoidable costs vs Unavoidable costs: Whether certain costs are escapable/avoidable or
inescapable/unavoidable varies according to the decision. Avoidable costs refer to those
costs that may not only be postponed but can also be avoided entirely as a result of
contraction of business activity. For example; a portion of depreciation which varies with
the use of a machine can be avoided by reducing output. Therefore, the part that
continues regardless of output/production is escapable only if the machine or building is
sold.
On the contrary, inescapable or unavoidable costs are those that must be met even if there
is contraction of business activity. For example, manufacturing plants must incur
minimum power costs regardless of the volume of sales.
 Shut-down Costs and Abandonment Costs: Shutdown costs are those costs which have
to be incurred under all situations in the case of stopping manufacture of a product or
closing down a department or a division. Shut down costs are always fixed costs. For
example, in case of a manufacturing company, if a product manufacturing is stopped,
then a part of fixed costs associated with the product like rent, watchman’s salary, and
property taxes will be incurred. Such fixed costs are unavoidable. On the other hand,
abandonment costs are those that result from a permanent cessation of business activities.
In other words, when a fixed asset is retired from service and is to be disposed of, the
costs connected with disposal are known as abandonment costs.

1.6. The concepts of cost units, cost centers and profit centers
It is also necessary to understand the following three important terms that are widely used in cost
& management accounting.

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 Cost units: - In the context of cost accounting, cost units refer to the unit of products or
services for which cost is computed. Cost units are selected to allow for comparison
between actual cost and standard cost, or between different actual costs.
 Cost Centre: - Cost Centre is defined as, ‘a production or service, function, activity or
item of equipment whose costs may be attributed to cost units.
 A cost center is the smallest organizational sub unit for which separate cost
allocation is attempted’.
 To put in simple words, a cost center is nothing but a location, person or item of
equipment for which cost may be ascertained and used for the purpose of cost
control.
 In a particular manufacturing company, a production department, stores
department, sales department, IT department, Finance departments, etc. can be
cost centers. Similarly, an item of equipment like molding/forming equipment,
Mixer, fork-lift, truck or delivery vehicle can be cost center, or a person like sales
manager can also be a cost center.
 A cost center can be either personal or impersonal, similarly it can be a
production cost center or service cost center.
 Profit Center: Profit Center is defined as, ‘a segment of a company by which both
revenues are received and expenses are incurred or controlled’. As explained above, cost
center is an activity to which only costs are assigned but a profit center is one where costs
and revenues are assigned so that profit can be ascertained. In most cases both the
investment and profit center is assumed to be the company itself.
 Synopsis
 According to natural characteristics, costs are divided into three categories; i.e. Material,
labor and other costs.
 According to changes in the volume/levels of activity costs are classified as variable,
fixed and mixed & step costs
 Based on the degree of traceability to the product, costs are classified as direct and
indirect.

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 Direct costs are those which are incurred for a particular cost unit, and can be
conveniently linked with that particular cost unit.
 An indirect cost is a cost that cannot be easily and conveniently traced to the particular
 Sunk Cost: A sunk cost is a cost that has already been incurred at the time that a decision
is being considered and is therefore not of importance for the new decision under
consideration cost object under consideration.
 Product costs refer to those items of cost that are included in the costs of inventory and
become expenses when the product is sold subsequently
 Period costs refer to those items of cost which are recognized as expenses for the period
in which they are incurred and are charged against the revenue for the period.
 Common cost refers to those costs which are incurred collectively for a number of cost
centers and are required to be suitable apportioned for determining the cost of individual
cost centers.
 Avoidable costs refer to those costs that may not only be postponed but can also be
avoided entirely as a result of contraction of business activity.

Wrap-up Exercise Questions

Exercise 1: Classify the following as variable cost or fixed cost.
a. President’s salary
b. Direct labour
c. Straight-line depreciation on factory building
d. Commissions paid to sales persons.
e. Direct material
f. Advertising

Exercise2. : Guild Company manufactures and sells one product. The production can vary from
20,000 to 60,000 units. A partially schedule of the company’s total and per unit costs for the coming
year follows:
Units produced and sold

20,000 40,000 60,000

Total costs:
Variable costs $ 80,000 ? ?
Fixed costs 100,000 ? ?
Total costs $ 180,000 ? ?

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Cost per unit:
Variable cost ? ? ?
Fixed cost ? ? ?
Total cost per unit ? ? ?
Required:
1. Compute the schedule for Guild Company’s total and per unit costs.
2. Determine the cost formula in the format of Y=a + bx
Exercise 3

Sunny company’s July 1995 cost of goods sold was 700,000 Birr, July 31 work in process
was 80% of July 1 work in process. Direct labor cost was 90% of manufacturing overhead
costs. During July 220,000 Birr of direct materials were purchased. Other July information’s
are as follows:-

Inventories July 1July 31

Direct materials 54,600 50,000
Work in prices 80,000 ?
Finished goods 219,000 211,800
Required:-
1. Prepare a schedule of cost of goods sold for July
2. Prepare the July’s cost of cost of goods manufactured schedule
3. What was the amount of prime and conversion costs incurred in July?

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CHAPTER TWO
COST DETERMINATION: THE COSTING OF RESOURCE INPUTS

Learning Objectives
After completing this chapter you should be able to:
 Understand how the cost of material is accounted starting from procurement to allocation
to the units produced
 Know how the cost of labor is accounted starting from procurement to allocation to the
units produced
 Know how the cost of manufacturing overhead is accumulated and allocated to the cost
of finished products

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2.1 ACCOUNTING FOR MATERIALS: PURCHASE, STORAGE, PRICING AND
CONTROL (SESSIONS 7 & 8)

Session Learning Objectives

After completing this chapter you should be able to:
 Understand the meaning and types of material in the context of cost accounting
 Explain the control procedures to be applied on material inventory starting from its
acquisition to usage
 Understand the different techniques to be used for valuation of material inventory

2.1.2 MEANING OF MATERIALS

Materials constitute one of the important elements of production. Types of materials covered
under this session are raw materials, process materials, additives, manufactured / bought out
components, sub-assemblies, accessories, semi-finished goods, consumable stores, spares and
other indirect materials.

Raw Materials:
Raw material is a basic /main material used in the manufacture of product. For example
sugarcane is the raw material for production of sugar. Cotton is the raw material for production
of cotton yarn.

Process Materials:

Process materials/additives are materials used in the process of manufacture in addition to raw
material. It varies from industry to industry. Process material for sugar industry is lime, sulphur;
in cement industry and gypsum are additive materials; and in paper industry clay/china clay is
additive material.

Bought Out Components:

It means a manufactured (industrial) product, which form part of the finished product (for
example fastener, fan belt and the like) and is fitted to the product without any further

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processing. In other words, bought components are purchased items used in the assembly of
main product. These items are developed by the supplier as per specifications of manufacturer.
Bought out component when used in the main product are called “Original Equipment Supplies
(O.E.S)”. These items are also available in the market for replacement of worn out parts and is
called as spares /bought out parts.

Sub-assemblies:

“Sub-assembly” (also sometimes called as “aggregates”) means an assembly of various

components with a distinct identity, and forms part of the finished product, for example engine,
steering in an automobile. “Accessory” may be either a component or sub-assembly, which is not
essential for the basic functioning of the product, but supplied as an optional item (for example
Consumable Stores:

Consumable stores are items used in the maintenance of plant for example lubricant, cotton
waste, paint and the like. In other words, ‘Consumable’ stores are items used in production but
do not become a part of the finished product, such as oil, grease, sand paper, soap, and other
cleaning materials etc. Spares are purchased items used for replacement of worn out part of
machinery and the like.

Other indirect materials are items of small value such as bolt, nut nails, and the like which cannot
be directly identified economically with a product and are treated as indirect material.an air
conditioner or music system in an automobile).

2.1.1 MATERIALS CONTROL: Concept and Objectives

2.1.1.1 Concept of Materials in general
Materials form an important part of the cost of a product and, therefore, proper control over
materials is necessary. No cost accounting system can become effective without proper and
efficient control of materials. Materials control basically aims at efficient purchasing of
materials, their efficient storing and efficient use or consumption. Materials or inventory control
may be defined as “systematic control and regulation of purchase, storage and usage of materials
in such a way that maintain smooth flow of production and at the same time avoids excessive

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investments in inventories. Efficient material control cuts out losses and wastes of materials that
otherwise pass unnoticed”.

2.1.1.2 The broad objectives of material control are listed below:

1) It eliminates the problem of under-stocking and, therefore, materials of the desired

quality will be available when needed for efficient and interrupted production.
2) Material will be purchased only when need exists. Hence, it avoids the chances of over-
stocking.
3) By purchasing materials at the most favorable prices, the purchase is able to make a
valuable contribution to the reduction in cost.
4) Materials are protected against loss by fire, theft; handling with the help of proper
physical controls.
5) Issues of materials are properly authorized and properly accounted for.
6) Vouchers will be approved for payment only if the material has been received and is
available for issue.
7) Materials are, at all times, charged as the responsibility of some individual.

In short, control over materials enables us to achieve the five R's.

 Right quantity materials  At the right place

 Right Quality materials  From right suppliers
 At the right time
2.1.2. PROCEDURE FOR PURCHASING AND RECEIVING MATERIALS:

Purchasing procedure varies with different business firms, but all of them follow a general
pattern in the purchases and receipt of materials and payment obligations. The most important
steps in materials purchasing and receiving procedures are summarized below:
2.1.2.1 Purchase Requisition
The initiation of purchase begins with the receipt of a purchase requisition by the purchasing
department. The purchase requisition is prepared by the storekeeper for regular stock items and

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by the departmental head for special equipment or materials not stocked as regular items. The
requisition is approved by one or more executives in addition to one originating the requisition.
The requisition is prepared in triplicate, the original copy is sent to the purchasing department,
the second is retained by the storekeeper or executive initiating the purchase requisition and the
third copy is sent to the costing department. The requisition contains particulars regarding
quantity, the quality or material specifications, and the date by which purchase of materials is
required. The requisition may be in the following form:
Purchase Requisition
Purchase Requisition No. _________________ Date______________________
Department ___________________ Delivery Required_______________
Purchase order No. ______________________
Item No Quantity Description Grade or Remarks

Quality

Requested by Checked by Approved by

_______________ ______________ _______________

Purchasing requisition serves three general purposes:

 It automatically starts the purchasing process and informs the purchasing
department of the need for the purchase of materials.
 It fixes the responsibility of the department making the purchase requisition
 It can be used for future reference.
2.1.2.2 Purchase order
If the purchase requisition received by the purchasing department is in order, then it will call for
tenders and/or quotations from the suppliers of materials. It will send enquiries to prospective
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suppliers giving details of requirement and requesting details of available materials, prices, terms
and delivery etc. Quotations will then be compared and will place order with those suppliers who
will provide the necessary goods at competitive price.
The number of copies and routing of purchase orders depend on the procedure followed in the
organisation. Normally, the copies of the purchase order will be sent to the supplier, the
department originating purchase requisition, inspection department, and accounting department.

2.1.2.3 Receiving Materials

The receiving department performs the function of unloading and unpacking materials which are
received by an organization. Materials are inspected and inspection report is prepared, indicating
the items accepted and rejected, with reason. Receiving report is prepared by the receiving
department. Inspection report may be incorporated in the receiving report, or may be issued
separately.
a) Materials inspection note

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When materials are delivered, a supplier’s carrier will usually provide a document called
Delivery note or Delivery advice to confirm the details of materials delivered. When materials
are unloaded the warehouse staff checks the materials unloaded with the delivery note. Then the
warehouse staff prepares a Materials Receipt Note, a copy of which is given to the supplier’s
carrier as a proof of delivery. After receiving the materials the inspection department thoroughly
inspects whether the quality of material is in accordance with the purchase order and issue a
note, called Material Inspection Note, copies of which are sent to the supplier and stores
department. A specimen of Material Inspection Note is given below:

b) Goods Received Note (GRN)

Once the inspection is completed a GRN is prepared by the stores department, and copies of
GRN is sent to the Purchasing department, Costing department, Accounts department and
Production department, which initiated purchase requisition. A specimen of Goods Received
Note is shown below:

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After receipt of GRN from the stores department and invoice from the supplier the Accounts
department will check the purchase order and take necessary steps for making payment to the
supplier.
2.1.2.4. Preparing and Recoding the Voucher
The invoice received from the supplier is sent to the purchasing unit. The purchasing unit holds
the invoice and the purchase order in the open purchase order file until the receiving report is
received from store (receiving department). After the receiving report is received, the purchasing
unit compares the supplier's invoice with the purchase order and receiving report to make sure
that:
- Goods ordered have been received in good condition and those listed on the invoice.
- Terms, unit prices, shipping charges, and other details agree with order specifications.
- Computations are correct.
After comparisons, an employee of the purchasing unit staples together one copy of the invoice,
receiving report, and purchase order, and places them in a completed purchases file
alphabetically by supplier. Next a disbursement voucher is completed and a second set of
supporting documents is attached to it. Then the voucher is formally approved and sent to the
accounting unit for recording. A sample of disbursement voucher is shown below:

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Disbursement Voucher
Voucher No____________
Payee ________________________ Issued date_____________
______________________________ Discount date___________
______________________________ Due date_______________

Invoice date Terms Invoice No Amount

September 2/10.n/30 124586 $12000.00
5/02 Less Damaged items returned 1000.00
11,000.00

Price O.K_________________________
Materials Received ________________
Extensions Ok_____________________
Gross amount _____________________
Discount _________________________
Net paid__________________________
Approved for pay___________________
Paid by Check No.____________
Date______________

When the voucher, invoice, and attached papers reach the accounting unit, the voucher clerk
compared quantities, verifies indentions and footings, computes discounts, and checks all other
computations. The clerk also checks that all supporting documents are included in the file and
that they are properly approved and signed. Then the purchase of materials is recorded as
follows:

Raw materials-----------------------------------------------xxx
Vouchers payable ----------------------------------- xxx

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The above entry is recorded in a voucher register, and the voucher is sent to the treasurer’s
office, the voucher is filed in the unpaid vouchers file according to the last date on which the
discount may be taken.
2.1.2.5. Paying the voucher
Before the due date, the voucher is removed from the unpaid vouchers file. A check is prepared
for the net amount. The check is then recorded in the check register. The employee mark the
voucher “paid” by using a rubber stamp and enters the check is mailed to the supplier, and the
voucher is returned to the voucher clerk. The voucher clerk enters the check number and date of
payment in the voucher register. The voucher, with the invoice and supporting documents, is
then placed in the paid vouchers file.
2.1.3. Accounting for materials returned
Occasionally, damaged or defective materials may be received from the supplier. These items are
usually returned to the supplier immediately. A note of the return is made on the receiving clerk'
copy of the purchase order and on the receiving repot. The purchasing agent then prepares a
debit memorandum. A debit memorandum is a notice to the vendor (means suppler) of a
reduction from the invoice for the cost of the returned materials. Then the following entry is
recorded.

Vouchers payable --------------------------------------------xxx

Purchase returns and allowances ------------------ xxx
Example
A furniture manufacturer has issued a debit memorandum to a supplier for materials returned
costing $3000. The entry to record this transaction in the book of the buyer is

Vouchers payable --------------------------------------------3000

Purchase returns and allowances ------------------ 3000
A credit memorandum is a notice to the supplier of an addition to the invoice a supplier ships
more materials than were ordered. In this case, if the buyer needs the excess materials, they will
be kept by issuing credit memorandum for additional cost. The accounting entry is shown below:

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Raw materials ----------------------------xxx
Vouchers payable ----------------------------------xxx
If materials received from the stores are not of suitable quality or if there is surplus material
remaining with the department, they are returned to stores with a note called ‘Material Return
Note’ evidencing return of material from Production department to Stores. A copy of Material
Return Note is sent to the Costing department for making necessary adjustments in accounts.
Sometimes materials that have been issued are returned to the storeroom. This may be due to
requisitioning too many materials, withdrawing the wrong materials, or some other reasons. A
returned materials report has to be prepared. It is very similar to the materials requisition. The
bin tag is adjusted. Then the cost clerk will make the following entry and post to job cost sheet
and/or department overhead analysis sheet.
Raw materials --------------------------------------xxx
Work in process -----------------------------------------xxx
MOH-----------------------------------------------------xxx
Returned materials report is the basis to post the above transaction to job cost sheet and
departmental overhead analysis sheet. Note that individual amount is not posted to general ledger
(controlling) account) from materials requisition journal. Rather the totals of each column in the
materials requisitions journal (work in process, MOH control and Raw materials) are posted to
the appropriate controlling account.

Illustration
The following are transactions of XYZ manufacturing company for the month of June 2005.
Record in general journal form those transactions that require journal entries.
1. June 2: Purchase requisition 201 for 2000 units of materials k-70 is prepared by the
storeroom clerk. The material is to be ordered from Family International at a cost of
$8.00 per unit. Terms 2/10, n/60.
2. June 4: Purchase order 79 is completed for the materials specified on purchase
requisition 201

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3. June 16: Materials ordered on purchase order 79 are received. Of the 2000 units
received, 100 units are rejected because they have imperfections and are immediately
returned. Receiving report 95 is prepared. The purchase invoice is included in the
carton, dated May 16.
4. June 17 A debit memorandum to Family International for materials returned is
prepared
5. June 17 Materials received yesterday from Family International (except those
returned) are transferred to the storeroom and entered in the materials ledger.
6. June 26 Disbursement voucher 98 to Family International is prepared for the amount
owed on the firm's invoice.
7. June 25 A check to Family international for the amount due, after discount, is
prepared and mailed.
Solution
- June 2 No entry is made when materials requisition is issued (prepared). It initiates the
purchasing procedures.
- 4 No entry is made when purchase order is place with supplier.
- 16 16 Raw materials (2000 x 8) --------------------- 16,000
Vouchers payable (Family international) --------------------16,000
- 17 Vouchers payable (Family International) ------------------800
Purchase Returns & Allowances --------------------------------800
- 17 No journal entry is made when materials are received by the storekeeper. Rather
materials ledger card and other necessary documents are up dated.
- 25 Vouchers payable (Family International) ---------------------15,200
Purchase Discounts -----------------------------------------------104
Cash ------------------------------------------------------------- 15096
2.1.4. Storing and Issuing Materials
2.1.4.1 Storage of Materials
Two types of control are made in store, one is physical control of materials and the second is
accounting control.

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a) Physical control of materials involves restricting admission to the storeroom area only for
authorized personnel. If the store room is open to everybody, materials may be stolen.
b) Accounting control of materials involves maintaining the necessary records for the materials;
one important record is materials ledger. Materials ledger is used to protect materials in the
storeroom and to identify materials. Materials ledger is established for each type of materials
indicating material number, type of material and its location. Materials are stored in a
systematic manner on a bin, on racks, or on shelves. A bin tag may be attached to each bin.
The bin tag is an informal but carefully maintained record to show the quantities of the
materials received, issued and on hand at all times. The materials ledger and bin tag are
shown below.
Materials Ledger
Material ________________ Recorder point__________
Number _______________
Recorder Quantity_________

Received Issued Balance

Date Reference Units Price Units Price Unit Price

Bin tag
Materials No_______________ Location _________
Recorder Point______________
Description ________________

Quantity Received Quantity Issued Balance

Date

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2.1.4. 2 Issuance of Materials
Materials requisition is prepared by production (using) departments in order receive materials
from the store. No material is issued without a materials requisition. Materials requisition is
prepared by department head or job supervisor.
Materials requisition shows the quantity materials number, description, and job number to which
the materials are charged (for direct materials) or department (for indirect materials) Materials
requisition may look like the following:
Materials Requisition
Deliver to ___________________ Requisition No.__________
Acct._______________________ Date _______________
Charge -Job ________________
Dept.________________

Quantity Materials Neo Description Unit price Amount

Approved _______________ Delivered by_____________Received by ____________

Up on receipt of materials requisition, the storeroom supervisor issues the materials and makes
the necessary notations or the requisition. The storeroom clerk enters the unit price and
computers and enters the total amount. Then the storeroom clerk records the entry in the issued
section of the materials ledger, computes the new quantity on hand, and records it in the balance
section.
Note that the materials ledger is a subsidiary ledger that will be verified against the raw materials
control account. At the end of the accounting period, the sum of the dollar amount balances on
the materials ledger cards should equal the balance of the control account.
After the requisition has been recorded on the related materials ledger, card the requisition is
forwarded to the cost clerk. The cost clerk journalizes the transaction (issuance of materials)
requisition journal.

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The Journal entry is as follows:
Work in process -------------------------------------xxx
MOH control ---------------------------------------xxx
Raw materials ----------------------------------------------xxx
The above entry is recorded in the materials requisition journal. The format of this journal is
shown below:
Materials Requisition Journal

For months of _____________________ 19____ Page __________

Requisition Post Job Work in MOH MOH Raw

Date No. Ref. or Process Control Control Materials
Dept Dr Dr Dr Cr

Note that materials Requisition Journal is a special journal used in a job-cost system.
The next step is that the cost accountant will post the information from the requisition to the
materials section of the proper job cost sheet. Similarly, the direct materials cost is posted to
departmental overhead analysis sheet in the indirect materials section. Department overhead
analysis sheet is shown below:

Departmental Overhead Analysis Sheet

Department __________________ Month of ____________ 19_____

Date Ref. Total Indirect Indirect Payroll Depreciation Utilities Insurance

Materials Labor Taxes

The important principles of internal control for storing and issuing materials are:
 Admittance to the storage area is restricted.
 Materials ledger cards are maintained to record all receipts and issues.

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 Each type of materials is clearly identified, stored in a particular place, and carefully
protected while in storage.
 Materials are issued only upon proper written authorization
 The accounting system permits a periodic check of the materials ledger against the
balance of the Raw materials control account.
 Separation of duties in storage and issuance operations.
2.1.4.3 Bill of Materials
The bill of materials lists all materials required on the job and the date they will be needed.
The bill of materials serves as a requisition. The format of bill of materials is shown below:

Bill of Materials
Job________________________ Date ___________________
To be Started ________________ For____________________
Will require the following Materials:

Units Materials Description

Requisition Materials Issued
Unit Cost Total Cost

2.1.5. Accounting for Materials Transfer

If materials are transferred from one department or job to another within the organisation, then
Material Transfer Note should be raised. It is record of the transfer of materials between stores,
cost centers of cost units showing all data for making necessary accounting entries. A specimen
of Material Transfer Note is given below:

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2.1.6. Controlling and Valuing Inventory

2.1.6.1. Inventory Control
Inventory management refers to the planning, organizing, and controlling activities to ensure that
inventories are kept at levels which provide maximum services at minimum cost. The main
objective of inventory control is to ensure that stock outs do not occur and that surplus stocks are
not accumulated and carried. Inventory management includes management of finished goods,
work-in-process, and raw materials.
In controlling inventories or stock levels are established for standardized materials which are
regularly used by the firm so that inventory holding can be controlled.
Control of raw materials requires the purchasing department to determine the reorder point and
reorder quantity. Reorder quantity refers the quantity to be covered in a single purchase order.
Reorder point (or the level) is the level at which store-keeper initiates purchase requisitions for
new supplies of materials. Lead time is another factor that should be considered in determining
reorder quantity. Lead time refers to the amount of time it takes for the materials to be delivered
from the supplier. Usage is also used to determine the reorder quantity. Usage represents the
consumption patterns.
2.6.1.1 Determining the Reorder point
The point, at which an item should be ordered, called the reorder point, occurs when the
predetermined minimum level of inventory on hand is reached. Assuming a constant usage rate
of inventory, the reorder point can be determined by the following equation.

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Reorder Point = (Lead Time in Days X Daily Usage) + Safety stock

Calculating the reorder point is based on the following data:

 Usage-the anticipated rate at which the material will be used.
 Lead time-the estimated time interval between the placement of an order and receipt of
the material.
 Safety stock-the estimated minimum level of inventory needed to protect against stock
outs (running out of stock). Stock outs may occur due to inaccurate estimate of usage or
lead time or various other unforeseen events, such as the receipt of damaged or inferior
materials from the supplier.

Example 1: Addis Furniture Factory uses 45, 000 units of Material X102 every day in
production. It takes 10 days for an order to be delivered. The factory always wants to have a
four-day supply on hand (or safety stock); what is the point at which it should reorder Material
X102?
Solution:
Estimated usage during lead time
= daily usage X Lead Time
= 45, 000 x 10= 450, 000 units
Safety stock = 45, 000 x 4
= 180, 000 units
Order point = Expected usage during lead time + Safety stock
= 450, 000 units + 180, 000 units
= 630, 000 units
Example 2: Assume that XYZ manufacturing wants to have at least 180 units on hand at all
times. The factory uses 10 units every day. It takes fifteen days to receive an order. The reorder
point is
Lead time usage (10x 15 days) ------------------------- 150 units
Add, Safety Stock------------------------------------------180

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Reorder point ----------------------------------------------330 units

The reorder point (ROP) represents the inventory level at which a new purchase order must be
issued. According to the above example, a new purchase order is placed when the quantities of
raw materials on hand reached 330 units. If the new purchase order is processed as expected
within 15 days, the inventory reaches the safety stock of 180 units when the new units arrive at
the premise of the factory.
2.6.1.2 Determining Economic Order Quantity (EOQ)
Another problem in managing material inventory is determining how much to order at a time
(Economic order Quantity). To determine this quantity, it is necessary to consider the costs of
placing an order and the costs of carrying items in the store. If the frequency of ordering
materials is increasing, the cost of order will be higher and vice versa. Holding many items
involve higher holding costs.
Some examples of order costs are:
 the purchasing department
 Costs of operating the receiving department
 Clerical costs of processing an order.
The cost of holding items in the inventory includes:
 Costs of handling and storing materials
 Costs of operating the receiving department
 Clerical costs of processing an order
 Clerical costs of maintaining inventory records
In order to determine the quantity that should be ordered at a time, the following formula can be
used.

2C  D
EOQ =
H
Where
EOQ = Economic order quantity
D = Annual requirements (demand)

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C = Ordering cost per unit
H = Holding cost per unit

Example1.

ABC printing has determined that the cost to place an order for papers is Br. 10 and the cost to
carry this item in inventory is Br. 0.8 per dozen. 10,000 dozen of papers are required for
production each year, what is the economic order quantity?

Solution

2  10  10,000
EOQ = = 500dozen of papers
0.8
Example2. Nati Printing has determined that the cost to place an order for papers is Br.15 and
the cost to carry this item in inventory is Br.0.75 per unit.1,000 dozen of papers are required for
production each year.

Instruction:
a. What is the most economical order quantity (EOQ)?
b. Calculate the total cost of ordering and carrying at the EOQ point.
Method 1: EOQ Formula Method:
Using the data presented earlier with D= 1, 000, C=Br 15 and H= Br 0.75, the EOQ is
determined as 200 units below:
2  15  1,000
 200units
EOQ = 0.75
Method 2: Graphical Method
Rather than calculating the EOQ using a formula to determine the EOQ, a company can prepare
graphs. Figure 3-1 illustrates the graphic method of determining EOQ. The ordering cost curve
shows that total order costs decrease as the order size increases. Carrying costs move in the
opposite direction; they increase as the order size increase because there is more inventories on

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hand. The curve representing the total costs of carrying and ordering begins to flatten between
200 and 400 units. After this range is found, an order size is chosen in this area at the lowest
point. In Figure 4-1, the lowest point is 200 units, which is considered to be the EOQ.

Fig. 3.1: EOQ Graph

2.1.6.2. Valuing inventory

In the earlier part of this chapter, it was assumed that the prices of materials were constant.
However, prices vary from one purchase to the next, and it is often impossible to tell the specific
purchase from which an issue is made. This topic is intended to introduce how accountants price
issuance of materials. And the topic will introduce how to value the units on hand.
The primary basis of inventory valuation is cost. In the situation where the purchase prices of
materials vary, accountants must make an assumption about the flow of costs. The flow of costs
may not match the physical flow of goods; these cost flow assumptions are called inventory
costing methods. There are three basic inventory flow assumptions. These are:
1. Specific identification method
2. First-in-first -out ( FIFO)
3. Moving Average Method
Specific identification Method

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Some materials do not lose their identity when placed in the bin. These materials have unique
specification. Examples of these materials are electric motors for large pumps and compressors
where each motor is different from others. In this case, it is easy to identify the purchase price of
materials issued to production, and items remaining in store.
First-in, First-Out (FIFO) method
This method assumes that stocks (inventories) are issued in a strictly chronological order.
Materials issues are coasted at the unit cost of the oldest supply on hand. The ending inventory is
composed of the most recent costs of material or production of goods.
Moving Average method

This method allows the issuance to be coasted out currently at the average unit cos.
Cost of materials available for use
Average Unit Cost = Quantities of materials available for use

A new average unit cost is calculated after each purchase. Until another new purchase is made,
the current average cost is used to value the materials issued.

Valuation of inventory at Lower of Cost or Net realizable value (LCNRV)

The previous three methods have been on cost. When the net realizable value of the inventory
has been significantly declined, the most appropriate method is lower of cost or NRV. Under
lower of cost or NRV, the inventory is valued at either a cost, or NRV, whichever is lower.

2.1.7. Identification & Accounting for Material stock Losses

Sometimes materials are lost in transit or spoiled. Treatment of such a loss will depend upon the
terms and conditions of purchase order. If the purchase order does not specify any level of loss
and supplier is responsible to supply good quantity, in such cases, the loss is to be borne by the
supplier or the insurer as the case may be. The normal loss is to be absorbed by the good units.
Abnormal loss of material is charged to Profit and Loss Account and does not form part of the

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cost of material. In case of spoiled material if there is any significant realizable value , loss is to
be accounted net of such value. Generally, the following principles should be applied in
accounting for stock losses/gains:
1. Normal loss or spoilage of material prior to reaching the factory or at places where the
services are provided shall be absorbed in the cost of balance materials net of amounts
recoverable from suppliers, insurers, carriers or recoveries from disposal.
2. Losses due to shrinkage or evaporation and gain due to elongation or absorption of
moisture etc., before the material is received shall be absorbed in material cost to the
extent they are normal, with corresponding adjustment in the quantity.
In case of certain materials before its receipt, losses due to shrinkage /evaporation and
gain due to elongation or absorption of moisture arises. An anticipated level for such
losses or gains for each type of material is to be predetermined. Unit price of material is
reduced or inflated to cover the cost of the normal percentage of loss or gain. An
illustration is given below:
 1000 units of material X purchased @ $ 4/- per unit = $ 4000
 Anticipated loss on shrinkage: 4% i.e. 40 units
 Receipt will be 960 units and price inflated = $4000/(1000-40 Units) = $ 4.17 per
unit
 If there is gain in the quantity, issue rate will be reduced.
Certain materials contain moisture at the time of purchase which may evaporate during
summer, thereby losing some weight or moisture may be absorbed during monsoon
thereby gaining some weight. One of the methods of dealing with such material is to
record the material as dry weight after deducting the moisture percentage which is
considered normal. For any variation in moisture, suitable adjustment shall be made to
record weight in term of dry weight. Loss in quantity due to excess moisture over the
normal percentage will not form part of the material cost.
3. Any demurrage or detention charges, or penalty levied by transport or other authorities
shall not form part of the cost of materials.

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Demurrage and penalties are levied by the Transporters /Custom Authorities for delay in
clearance of wagon/vessel and the like.
Illustrations are:
 Demurrages levied by transporter for not removing goods,
 Penalties for keeping hazardous goods in unauthorized places in transit without
proper safeguards.
 Penalties levied by Customs Authorities for delayed clearance.
NB. Demurrage and penalties are abnormal cost and are not part of the material cost. It is
charged to Profit & Loss Account.
4. The material cost of normal scrap/ defectives which are rejects shall be included in the
material cost of goods manufactured. The material cost of actual scrap / defectives, not
exceeding the normal shall be adjusted in the material cost of good production. Material
Cost of abnormal scrap /defectives should not be included in material cost but treated as
loss after giving credit to the realizable value of such scrap/ defectives.
Scrap results from the processing of material. It is unavoidable residue material arising in
the process of manufacture. It may have some value. Example of scrap is border material
from stamping, shavings, filing, boring, and turning operations and the like. The scrap is
accumulated in storage yard so that it can be sold to scrap dealers.
In some cases scrap can be reprocessed into useful raw material for subsequent
production of basic products. For example the scrap material from sheets of metal from
which parts have been stamped, may be melted and again formed into sheets from which
more units may be stamped. Similarly scrap generated in steel foundry is put into furnace
to melt and form steel castings. Another example is runners and risers generated in the
course of dressing up of castings in foundry. Runners and risers are valued at weighted
average cost at pouring stage (i.e. raw material cost plus conversion cost of molten
metal). The material cost of abnormal scrap will not form part of the material cost.
Normal scrap generated during process of manufacture is to be treated as a part of
material cost. Scraps have generally low recovery value as in the case of steel but it may

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have significant value as in the case of gold. Thus its recovery value depends upon the
type of material. There are several methods of accounting of scrap as detailed below:
1. Scrap sales credited to revenue
2. Scrap sales credited to production overhead
3. Scrap identifiable with a job and its realizable value is credited to the job.
Defective /Spoiled material arises when the material does not meet the exact specification
of the material required. Normal Defective/spoilage of material is to be absorbed by good
production and abnormal spoilage is to be charged to Profit and Loss Account.
 Synopsis
 Material constitutes raw material, components, consumables, stores, semi-finished goods
and assemblies.
 There are two aspects of material control: Physical control and control of investment in
materials.
 Physical control/safeguarding of materials protects materials from misuse or
misappropriation.
 Control of investment in inventory strives to maintain appropriate quantity of inventory
that minimizes the level of investment tied-up on inventory.
 Documents common to the purchasing and receipt of material include:
o Purchase requisition
o Purchase order
o Vendor’s invoice
o Receiving report
o Debit/credit memorandum
 Controls & relevant documents during storage and issuance include:
o Material Requisition note
o Material Issue voucher
o Returned Material Reports
o Material transfer note

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 Accounting & internal control over material inventory should be properly implemented in
all the procedures that involves purchasing, receiving, storing and issuing.
 The point, at which an item should be ordered, called the reorder point, occurs when the
predetermined minimum level of inventory on hand is reached.
 Lead time-the estimated time interval between the placement of an order and receipt of
the material.
 Safety stock-the estimated minimum level of inventory needed to protect against stock
outs (running out of stock).
 The optimal level of inventory that should be ordered at a time is called Economic Order
Quantity (EOQ).

 Wrap-up Exercise Questions

1. What are some of the steps manufacturers can take to control inventory costs?
2. What are carrying costs? Ordering costs?
3. List the forms most frequently used in procurement and use of materials.
4. The demand for a commodity is 40,000 units a year, at a steady rate. It costs $20
to place an order, and 40 cents to hold a unit for a year. Find the order size (EOQ)
that minimize inventory costs, the number of orders placed each year, the length
of the inventory cycle and the total costs of holding inventory for the year.

 Next day’s Assignment

Refer to relevant cost accounting books under the reference lists and study the following:
 Procedures for controlling labor costs
 Functions of timekeeping and payroll departments
 Procedures involved in accounting for labor costs

2.2 ACCOUNTING FOR LABOUR: (SESSIONS 9& 10)

Sessions Learning Objectives

After studying this unit you should be able to:

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 Differentiate between direct and indirect labor
 Enumerate procedures for controlling labor costs
 Enumerate procedures involved in accounting for labor costs
 Know the general accounting control procedures for labor costs
 Describe the relevant documents and records used in labor costs control
 Present appropriate journal entries related to labor costs.

2.2.1. Introduction
Labor cost is an important element of manufacturing costs. It constitutes a significant portion of
total cost of production. Thus, it is important to establish an efficient system of labor control and
selecting the most appropriate method of remunerating them. The productivity of all other
resources is linked to the productivity of employees. Assets cannot operate by themselves.

2.2.2 Type of labor costs

Labor costs are composed of direct and indirect payments to workers and other personnel
engaged in manufacturing activities. In other words, labor costs represent the costs of purchasing
the labor hours and employee's services. Thus labor costs are classified as direct labor indirect
labor.

1. Direct labor is the personnel who work directly with the raw materials in converting them
to finished goods. In other words, direct labor is the time spent by a work, identifiable
with the particular job or a process.
2. Indirect labor is the wage of factory personnel who do not work directly on raw materials.
Indirect labor does not directly spend time on a particular job or product. The distinction
between direct labor and indirect labor is based on the convenience of linking the time
spent on a particular job or product. Although indirect workers spend time on work of
general nature, they also equally support production activities

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2.2.3 Accounting procedures for labor costs:
Accounting for labor cost requires
 Strict control on labor recruitment
 Correct time keeping
 Time booking i.e analysis of time in terms of departments, operations and production
orders or jobs.
 Generation of adequate and effective manpower performance reports indicating
productivity and efficiency of labor.
 Constant attempt to improve productivity and efficiency through improvement in the
remunerations, conversion of indirect labor into direct labor, etc.

In general, accounting for labor costs has three phases. These are:

 Timekeeping procedures
 payroll procedures
 Charging labor costs into production

2.2.3.1. Timekeeping procedures

Timekeeping is the procedure for keeping records of time worked by each employee. There are
various methods for recording the time spent by an employee in the factory. Some of them are
described below.
1) Clock cards (or time cards)

Clock cards are produced by mechanical devices. They provide evidence of the presence of a
worker inside the plant and the time of his entry of departure. Clock cards are used with time

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clocks. Time clock is installed at the entrance of the plant. Each employee has his or her own
time card which shows the dates worked and the time the employee entered and left each day. If
there is time Clock card is entered in to time clock. The time clock prints on the card the “in" and
“out" time. The clock card our time card may be filled out manually.

It is necessary that the timekeeping staffs are present at the time of filling the cards to supervise
and ensure smooth and rapid movement of workers and also to ensure that proper clock card
procedure is observed.
Time cards may be collected daily or at the end of the wage period. The format of clock card is
shown below:

Clerk ( Time ) card

Name _____________________
No._______________________
Week ending _______________
Date Regular Extra
In Out In Out Hours In Out hours

2) Time tickets (job tickets)

Time ticket show the time spent by each employee on individual job during the day. Time tickets
serve dual purposes:

 it provides instructions for operations to be performed

 It records time spent in performing the operations

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The worker normally collects the ticket form the foreman's office. On completion of the
operations, the worker records time of completion on the ticket, submits the same to the Forman
and collects a new ticket for the next job to be worked on. Time ticket is needed because time
card or clock card indicates only the total time worked on by an employee. Time card does not
show the number of hours worked on a specific job by an employee.

However, time ticket clearly shows the number of hours worked on by an employee on a specific
job. The format of time ticket is shown below:

Time Ticket
Date ___________ Employee name ( or No) _________
Time started _________________ Job. NO_______________
Time Stopped ________________ Department ____________________
Hours worked ________________ Operations ___________________
Rate ______________________
Amount __________________ Pieces completed ________________
Approved __________________________

3) Daily analysis of Data

At the end of the day all time tickets are collected by a time clerk. The time clerk will complete
the following procedures.

1. Compare the hours shown on each employee’s time tickets with the total time shown on
the employee's time card.
2. Investigate the differences between time tickets and time cards.
3. Enter the earnings (Amount) on the time tickets.
4. Enter the number of hours worked during the day by each worker, in the payroll register.
5. Separate individual parts of the time tickets to make it easier to sort by job or department.
4) Idle time

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Idle time is said to occur if time cards show more hours as compared to the time tickets. Idle time
may occur because of the following reasons:

 Hour lost waiting for materials

 Hour lost waiting for assignment to a new job
 Hour lost waiting for a machine to be repaired
 Strikers, fire floods etc.

Idle time costs are considered to be manufacturing overhead.

Note that the short time spent during the morning an afternoon rest periods is not considered idle
time. It is absorbed into whatever job the employee is working on at the time of the break.
At the end of each week, an analysis of idle time is made an idle time sheet is prepared. Then the
idle time sheet is attached to time ticket.
If the clock card hours are less than hours recorded on time ticket the difference is as a result of
error. The error has to be corrected in consolation with the Forman and the worker concerned.

2.2.3.2. Payroll Procedures

The payroll unit (or payroll department) is responsible for the following:

1. Maintain details of job classification cost center and wage rate of each employee
2. Maintain a list of mandatory deductions such as employee income taxes
3. Maintain a list of voluntary deductions, such as credit association contribution,

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4. Determine for each employee the amount of income tax to be deducted from each
employee's gross pay.
5. Determine the net amount payable to each employee.
6. Prepare wage sheets which form the basis for disbursement of wages
7. Summarize the cost by cost center including the gross amount earned deductions, net pay
hours, worked overtime premium incurred, incentive earned by each employee etc.
The time keeping procedures provide the data needed by the payroll department for computing
earnings and completing labor cost records. Factory payroll register may be prepared weekly,
and monthly (or semi-monthly)

i. Weekly factory payroll Register

Information about hours worked and wages rate is transferred to weekly factory payroll register
from time daily. In other words, time tickets are the source of information for preparing weekly
factory payroll register. Weekly factory payroll register is usually prepared for wage workers.
The term “Wages” designates hourly or piece rate payment thus, wage workers are those who are
paid on an hourly rate basis.

After all hours worked by each employee during the week have been entered in the payroll
register, regular earnings, overtime, earnings and total earnings are computed. Besides,
appropriate. Thus, in order to prepare a factory payroll department should make a distinction
among the following.

a) Normal hours worked and normal rate

b) Overtime hours worked
c) Overtime premium

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Overtime premium varies from country to country. For example, in Ethiopia the overtime
premium is as follows:

From to 6:00 pm -10.00 PM ------ 125% of Regular rate

10:00 PM -6:00 AM ---------------------- 150% of Regular rate
Rest days ----------------------------------- 200% of Regular rate
Holidays ----------------------------------- 250% of Regular rate

Example

The regular hourly rate of Ato Abebe is 20 birr per hour. Ato Abebe has worked for 10 hours
during the week on his rest days. What is Ato Abebe's overtime pay?

Solution

OT = Regular rate x the premium x overtime hours

= 20 x 200% 10 = 40 birr hour x 10 = Br 400

ii. Semi Monthly (or factory payroll register)

A separate monthly or semi-monthly factory payroll is prepared for workers who are paid fixed
periodic (or salaried employees). Salaried employees are those who are paid fixed periodic
payment, usually semi-monthly (every two weeks) monthly or yearly. Examples of these
workers are factory supervisor, managers, accountants etc.

Posting from the payroll register

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At the end of the payroll, the total gross earnings and the totals for each of the various
liabilities are posted directly from the payroll register to the general ledger accounts. The total
gross earnings are debited to “Factory payroll clearing “Account. Deductions are credited.
Salaries and wages, payable account is credited for the net pay. The general journal entry is
shown below:

Factory payroll clearing ----------------------------------xxx

Employee Income taxes payable --------------------------------xxx
Pension contribution -----------------------------------------------xxx
Salaries & wages payable -----------------------------------------xxx
Note that above general journal entry is made on any payroll date ( or at the end of each pay day)

Paying the payroll

After the payroll register is completed and posted to general ledger accounts, the payroll clerk
prepares a voucher for the net amount of the payroll. The voucher is forwarded to the voucher
clerk completes the voucher and records in the payroll register. The accounting entry is a debit to
salaries and wages payable and a credit to vouchers payable.

Salaries and wages payable -------------------------------------xxx

Vouchers payable ----------------------------------------------------------xxx
Then the voucher goes to the treasure, who preparers a check and record it in the check
register. If employees are paid by check it is prepared for each employee and the check will be
cashed. When the check is prepared the required entry is:

Vouchers payable -------------------------------xxx

Cash in bank -------------------------------------------------xxx

Individual Earrings Records

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An employer should keep an individual record of the earnings of each employee and
deductions. The source of information for individual earnings record is the payroll register
prepared at the end each pay period. The format of this record is shown below:

Name________________________ Marital Status___________

Address ______________________ Date of Birth ____________

Employee No __________________

Week Houre Rate per Earnings Deductions Net

worked hour
Period Ended Pay
Regular OT Regular OT Regular OT Total Tax Pension Total

*OT = over time

2.2.3.3 Charging labor costs in to production

In the preceding section, the various recording phases of accounting for labor costs have been
discussed. In that section, it was introduced that labor costs are classified in to direct labor and
indirect labor. Direct labor costs are charged to work in process account and indirect labor costs
are charged to manufacturing overhead control account. The direct labor costs are transferred to
job cost sheet. The indirect labor costs are posted to departmental overhead analysis sheet.

However, an analysis should be each week (for wage workers) before posting has been made.
The main purposes of the analysis are summarized as follows:

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a) The analysis divides total gross earnings (or total labor costs) in to direct labor and
indirect labor. The basis of information is the time tickets.
b) The analysis shows the direct labor costs incurred on each job by each department and
the total direct labor costs for each department.
c) The analysis indicates the indirect labor costs for each department.

Once the analysis is made, the next step is to direct labor costs to job cost sheet and indirect labor
costs to the departmental overhead analysis sheet.

An example of this analysis is shown below

Departmental analysis sheet

Milling Assembly Finishing

Job Hours Amount Hours Amount Hours Amount Total

Indirect Labor
Department Regular
Earnings overtime Total
Milling xx xx xx
Assembly xx xx xx
Finishing xx xx xx
Building service xx xx xx
General Factory xx xx xx
Total xxx xxx xxx
Summary
Direct labor ------------------------ 62,200
Indirect Labour --------------------38,000
Total ----------------------------100,000

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In the above analysis sheet, five departments are involved. The first three departments are
production departments, and Building service and General factory are service department.

Job No. 11 has been worked in all of the three departments. It took 10 hours in milling
department 5 hours in Assembly department and 6 hours in finishing department. This job took
21 hours in total.

Indirect labor costs may be incurred both in production departments and service departments.
The total direct labor and indirect labor costs should equal to the total labor costs incurred during
the week. It is from this analysis that posting is made to job cost sheet and departmental
overhead analysis sheet.

The semi-monthly or monthly payroll is also analyzed. As mentioned earlier, the semi-monthly
or monthly payroll represents the salaries earned by employees who are on a fixed monthly
salary. The earnings of these employees are classified as indirect labor. They are directly posted
to the departmental overhead analysis sheet. The purpose of the analysis is to divide indirect
semi-monthly or monthly labor costs by departments.

A.A Furniture Factory

Semi-monthly ( monthly) Factory Payroll Analysis
Period ended ____________
Department indirect Labor
Milling xx
Assembly xx
Finishing xx
Building Services xx
General Factory xx
Total xx

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Analysis of unpaid wages

If the last day weekly pay period is different from the last day of the fiscal period, it is necessary
to prepare an analysis of time tickets at the end of the month. This is to identify the labor costs
that have been incurred since the last weekly payroll date but have not yet.

The main objectives are to charge production with all labor costs in the month in which they are
incurred. The analysis is in the same manner as the previous analysis, classifying labor indirect
labor is posted to job cost sheet and the indirect labor is posted to department overhead analysis
sheet.

For example, assume that weekly pay day is Saturday for the work week from Monday to
Saturday. Assume further that the fiscal period ends on Wednesday. In this case, there is accrued
payroll for three days (i.e. Monday, Tuesday and Wednesday). Thus the salaries and wages
earned for the days have to be determined and divided between direct and indirect labor.

Transferring labor costs to production

Labor costs are transferred to production by means of journal entries. The journal entry is based
on the analysis made above. After the analysis, the “work in process" account is debited for total
direct labor and “MOH control" account is debited for the total indirect labor costs. The
corresponding credit account if Factory payroll clearing account. This account is credited for the
total labor costs (i.e. direct labor +indirect labor). The general journal entry is summarized
below:

Work in process ---------------------------xxx

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Manufacturing overhead control ---------xxx
Factory payroll clearing ----------------------------xxx

Balance of Factory payroll clearing

The factory payroll clearing account has been debited for he gross amount of factory wages and
salaries paid during the period. It is credited for the total amount of wages and salaries charged to
production during the period. If they are unpaid wagers at the end of the period, Factory payroll
clearing account has a credit balance. This credit balance represents the amount of factory wages
and salaries earned and charged to production but unpaid at the end of the period. This balance
will be shown on the balance sheet as a current liability called Accrued wages payable or salaries
and wages payable. The balance of factory payroll clearing account may be shown in the name
of either.

1) Factory payroll clearing

2) Salaries and wages payable, or Accrued wages payable. If this alternative is chosen,
the adjusting entry is made at the end of the period as follows:

Factory payroll Clearing ------------------------xxx

Salaries and wages payable --------------------------xxx

Employer's payroll taxes

Employer's payroll taxes represent the amount of pension contributed to the employee's pension
plan by the employer. Payroll taxes are usually part of the manufacturing overhead. They are
recorded as follows:

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Manufacturing overhead control ---------------------xxx

Cash (or other account) -----------------------------------xxx

Fringe Benefit Costs

Fringe benefits are costs related to salaries and wages. These include vacation and holiday pay,
compensation/insurance of workers, hospitalization, insurance, life insurance e.t.c. Fringe benefit
costs are usually charged to manufacturing overhead. In this case manufacturing overhead
control account is debited for the fringe benefit costs and posted to departmental overhead
control account is debited for the fringe benefit costs and posted to departmental overhead
analysis sheet. Alternatively, fringe benefits associated with direct labor may be classified as part
of the direct labor cost rather than as manufacturing overhead.

 Synopsis
 Labor costs are the second major cost element in modern manufacturing operations.
These costs must be carefully controlled for good management.
 Factory payroll costs are divided into two categories: Direct labor and indirect labor
costs.
o Direct labor costs: represents payroll costs traced directly to the product.
o Indirect labor costs consist of labor costs incurred to a variety of jobs related to
the production process but not readily identifiable with the individual jobs worked
during the period.
 Accounting for labor costs has three phases:
o Keeping track of time worked
o Computing and recording earnings, and
o Charging costs of production

 Wrap-up Exercise Questions

1. How do the clock cards and time tickets complement each other?
2. In accounting for labor cost what is the distinction between regular pay and
overtime pay?
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3. Assume that the total labor costs paid during the month is Br 200,000. The
analysis of time tickets that labor costs amounted Br 40,000 were not paid at the
end of the month.
Required

a) What is the amount by which factory payroll clearing account has been debited
during the month?
b) What is the amount by which factory payroll clearing account has been credited
for the month?
c) Determine the balance of factory payroll clearing account at the end of the month.
d) How much should be shown as a current liability in the balance sheet at the end of
the month?
4. At the end of the month, after posting, the Factory payroll clearing account has a
$10,000 credit balance. What does this credit balance represent, and where is it
shown on t financial statements?
 Next day’s Assignment
Refer to relevant cost accounting books under the reference lists and study the following:
 The meaning of overhead costs in general
 Accounting for actual & applied overhead costs
 The meaning of overhead allocation bases
 The common types of overhead allocation basis

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2.3. ACCOUNTING FOR OVERHEAD COSTS: (SESSIONS 11, 12, 13 & 14)

2.3.1. Introduction

In this session, you will learn about what are the overhead costs in manufacturing activities, how
they are recorded and classified, summarized and at last distributed to units of production. The
first part of the session discusses about departmentalization of overhead costs, distribution of
support department costs and some documents involved in such activities. The distribution of
overhead costs to each unit of production is discussed in the second part of the unit.

2.3.2 Learning Objective

After completing this session you should be able to

 Define overhead items

 Describe possible methods of departmentalizing overhead costs
 Distribute service department costs to production departments
 Define predetermined overhead rate
 Distinguish between actual and applied overhead
 Define under or over applied overhead
 Present appropriate journal entries to record overhead costs.

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2.3.3 Meaning& nature of over head

Overhead refers to any cost which is not directly attributable to a particular unit. In other words,
overheads are real costs and represent spending on resources or services which benefit all units
of products and services. Overhead costs are costs common to more than one unit cannot be
linked to a particular unit.

2.3.4. Departmentalizing overhead costs

Classification of overhead costs

a) Factory overhead

Factory overhead is the aggregate of indirect costs associated with manufacturing activities,
Factory overhead is also called factory burden, manufacturing overhead, manufacturing
expresses, or indirect manufacturing costs.

Factory overhead includes:

 Factory rent, lighting an heating

 Depreciation repairs and maintenance and insurance of factory building, plant and
machinery & other facilities.
 Power and fuel
 Salaries and related costs of production management
 Wages of indirect costs of production management
 Indirect materials
 Direct materials of small individual value that cannot be economically feasible to allocate
to individual unit

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 Expenses connected with administration of factory
 Fringe benefits etc
In general, factory overhead costs are classified into three. There are:

 Indirect labor
 Indirect materials
 Other factory overhead

b) Administration overhead

Administration overhead is the aggregate of the costs of formulating the policy, directing the
organization and controlling the operations of an undertaking which is not directly related to
production, selling and distribution. Administration is a distinct function of an organization
which supports the other main functions.

Examples of administration are:

 Office rents
 Office lighting, heating and cleaning
 Depreciation, repairs and maintenance, and insurance of office buildings, office
equipment office furniture and other office machines.
 Salaries of office staff
 Director's remuneration
 Office supplies and other expenses
 Postage and telephone
 Printing and stationery
 Audit fees
 Legal expense
 Bank charges
Administration overhead costs are not product costs, rather directly recorded as expense when
incurred.

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c) Selling overhead

Selling overhead costs refers to those indirect costs which are associated with marketing and
selling (excluding distribution) activities. Examples are:

 Salaries commissions and traveling expenses of salesmen and technical representatives.

 Sales office expense
 Bad -debits expense ( or uncollectible accounts)
 Brokerage or third party commissions
 Costs of marketing information system including market research
 Advertisement and publicity expenses
 Costs of catalogues and price -levels
 Expenses incurred in maintenance of show rooms.

Selling overhead costs are not part of product costs. They are period costs

d) Distribution overhead

Distribution overhead costs are the aggregate of indirect costs associated with the distribution of
finished goods. Distribution includes such activities as moving articles to central or local storage,
moving articles to and from prospective customers. In gas, electricity, and water industries
“Distribution" means pipes, mains and services which may be regarded as equivalent to packing
and transportation. Some examples of distribution overhead are:

 Packing charges

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 Warehousing expenses
 Insurance of finished goods
 Wastages of finished goods
 Deprecation, repairs and maintenance, insurance, and cost of operating the distribution
vehicles.

Behavioral classification of factory overhead

Factory overhead costs are also classified in to three behavioral classifications (categories)

 Fixed overheads
 Variable overheads
 Semi variable overheads

Fixed overheads are indirect costs which conform to the definition of fixed costs. If there are
many different types of overhead costs, factory overhead analysis sheets are used as a subsidiary
ledger. The controlling account of the analysis sheet is manufacturing overhead control account.
This summarizes the data in the analysis sheets. The format of the factory overhead analysis
sheet is shown below:

Departmental overhead Analysis Sheet

Department _________________ Month of ________ 19________

Date Ref Total Indirect Indirect Payroll Depreciation Utilities Others

Materials labor taxes

Sep. R42 2500.00 2500.00

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Usually large businesses divide factory operations into departments so that costs can be
effectively controlled. There are two methods of achieving cost departmentalization.

1. Maintain separate control accounts

Under this method, a control account is maintained for each different manufacturing overhead
cost. An analysis sheets are used to show the amount chargeable to each department in a
subsidiary ledge. For example, a control account for indirect materials through the factory may
be set up in the following manner.

Indirect materials No_______________________

Departmental Analysis

Date Explanation Post Ref Dep 1 Dept 2 Dept 3 Dept 4 Total

2. Maintain single control accounts

Under this method a single control accounts is maintained for all manufacturing overhead costs.
The subsidiary ledger may organize costs two ways.

a) Subsidiary ledger by type of cost

For each manufacturing overhead cost a subsidiary ledger account is maintained (or kept)
for example, a separate account 'is established for indirect labor. Another account is
maintained for utilities. This method enables to accumulate costs by type.

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b) Subsidiary ledger by department

Under this method, the departmental overhead analysis sheet is used as a subsidiary
ledger account (refer the format presented in this chapter)

Recording overhead costs

You recall that manufacturing overhead costs are classified into indirect materials; indirect,
manufacturing overhead control account is debited. The credit may be cash vouchers payable or
other appropriate account. Certain factory overhead costs, such as electricity, fuel, and water are
paid at end of month. Thus, these costs are recorded when paid or bills are received. Other
manufacturing overhead costs, such as insurance vacations, and holidays, is accrued and arises
from adjusting entries made at the end of the relevant period.

The source documents for recording manufacturing overhead are generated internally and/or
extremely/ outside the company. For example, source documents for indirect materials and
indirect labor are materials requisitions and time tickets respectively. They are internally
generated documents. The source documents for fire insurance property taxes and utilities are
vendor invoices, which originate form external sources.

Once we obtain the necessary source documents, the necessary entries are made in the voucher
register. In order to record in a voucher register, a voucher must be prepared first using the
following steps.

Compare the invoice with purchase order and receiving report and all computations are checked.

Prepare a voucher, including a notation of the department to be changed

Record the voucher in the voucher register. The entry is:

Manufacturing overhead control -----------------------------xxx

Vouchers payable -----------------------------------------------xxx

The cost clerk will post the cost to the appropriate departmental overhead analysis sheet.

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The format of the voucher register is shown below:

Voucher Register for Month of ___________________

Paid Vouchers MOH control

Payable Cr Dr
Date Voucher Payable to
No Date Check
No

Note that the above four steps do not apply to the manner of recording indirect materials and
indirect labor. Indirect materials are directly entered into departmental overhead analysis sheet
from materials requisition. Indirect labor is directly transferred from the time ticket analysis to
departmental overhead analysis sheet.

Manufacturing overhead costs that occur at the end of the period are recorded by means of
adjusting entries. These costs usually do not vary from month. Examples are depreciation, taxes,
and property insurance. These costs are recorded in the general journal voucher and then posted
to departmental overhead analysis sheet.

Illustration

Indirect materials costing Br 75,000 were issued to different departments. Prepare the entry to
record the issuance.

Entry

MOH control - Indirect materials ------------------------------75,000

Raw materials ---------------------------------------------------------------75,000

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Analysis of time ticket indicates that indirect labor costs amounted to Br. 160,000 prepare the
entry to record the costs.

Journal Entry

MOH control - Indirect labor ---------------------160,000

Factory payroll clearing ------------------------------------160,000

Assume that depreciation for the period amounts to Br. 120,000 on the factory building and to
Br. 95, 000 on the factory equipment. Prepare the entry to record depreciation.

Entry

MOH control - Depreciation --------------------------215,000

Accumulated depreciation -Factory Building ---------------120,000

Accumulated depreciation - Factory Equipment---------- 95,000

Insurance of factory building amounting Br. 5000 has been expired during the period.
Prepayment for insurance was initially debited to asset account. Prepare the entry to record the
expired insurance.

Entry

MOH control property taxes -------------5000

Property taxes payable ---------------------------5000

Property taxes on factory facilities are estimated to be Br. 49000. Prepare the entry to record
property taxes.

Entry

MOH control property taxes ----------------------49000

Property taxes payable -----------------------------------49000

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Factory utilities have been paid in cash of Br. 140,000

Entry

MOH control - Utilities ----------------------140,000

Cash -------------------------------------------------------140,000

2.3.5 DISTRIBUTING SERVICE DEPARTMENT COSTS

By the end of the period, the Production departments and other service departments are expected
to operate efficiently. Bur service departments do not produce goods themselves. The
manufacturing overhead costs charged to service departments operations must be redistributed to
where goods are produced.

2.3.5.1 Allocating Service Department Costs

Service departments help producing departments and other service departments to operate
efficiently. But service departments do not produce goods themselves. The manufacturing
overhead costs charged to service departments operations must be redistributed to where goods
are produced.

It must be noted that relationships exist not only between service departments and production
departments but also among individual service departments. One service department receives
service from other service departments, or gives service to other service departments. Costs are
primarily accumulated at each department for planning and controlling purposes. For inventory
costing purposes, however, the factory service department costs must be allocated to the
production departments.

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2.3.5.1.1 Basis of allocation

Allocations of service department costs require a proper assessment of the benefits received
provide the most equitable basis of allocation. The following are some of common bases usually
adopted for measurement of benefits.

Basis for allocation Cost Item

Floor Area Rent, depreciation, maintenance of building

lighting heating ,fire precaution service

Number of workers employee Any expense associated with workers such

as recreation costs, time keeping supervision
costs etc.

Value of materials passing through the Costs associated with material such as
department materials handling expenses

Capital value Depreciation, insurance and maintenance of

production facilities

Direct labor hours and/ Machine hours or Majority of general overhead items

Technical estimates, or watts  Lighting: capacity of lighting or

number of Used lights
 Electric power, Horse power of
machines coupled with operating time
 Steam
 Water

2.3.5.1.2 Methods of Allocation

There are three methods of allocating the costs of service departments to production departments.
These are:

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 Direct allocation method
 Step down allocating method
 Reciprocal allocation method
1) Direct Allocation Method

This method ignores any service rendered by one service department to another. It allocates each
service department costs directly to the production departments in the ratio of the benefits
received by them. The direct allocation method is also called method. This method is simple to
use but inaccurate method. Under this method, there is no need to predict (or budget) the usage
of service department resources by other services departments.

Example
Consider a company with two service departments (plant maintenance and information system)
and two production departments (machining and assembly). The budgeted factory overhead costs
before any interdepartmental costs allocations are shown below:

 Plant maintenance ------------------------------- Br. 100,000

 Information systems---------------------------- 70,000
 Machining -------------------------------------- 180, 000
 Assembly --------------------------------------- 160,000
Budgeted labor hours by plant maintenance to:
 Information systems ----------------------------- 2000 hours
 Machining ----------------------------------------- 5000
 Assembly ----------------------------------------- 3000
Budgeted computer time by information systems to:
 Plant maintenance ------------------------------- 1000 hours
 Machining ---------------------------------------- 5000
 Assembly ---------------------------------------- 4000
Plant maintenance costs are allocated on the basis of labor hours and that of information systems
are allocated on the basis of computer time.

Based on the above data, the costs of service departments are allocated to the two production
departments under direct method as follow:

2) Step -down allocation method

Step down allocation method for partial recognition of service rendered by service departments
to other service departments. A popular step -down sequence begins with the departments that
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render the highest percentage of its total service to other service departments. The sequence
continues with the department that gives the next highest percentage of its total services to other
service departments, and so on, ending with the service department that renders the lowest
percentage of service to other service departments. An alternative approach to selecting the
sequence of allocations is to begin with the department that renders the highest dollar (birr)
amount of services to other service departments. In the example under consideration, plant
maintenance renders the highest service (20%=2000/10,000) to information systems department.
Thus allocation starts with plant maintenance department. Using the preceding example, the
costs of the two service departments are allocated to production departments as follow:

Step -down allocation method

Factory service depts.. Factory production depts.

Plant Information Machining Assembly Total

maintenance systems

Budgeted MOH 100,000 70,000 180,000 160,000 510,00

costs 0

Allocation plant

Maintenance ( ( 100,000) 20,000 50,000 30,000

2/10/5/10)

Allocation of (90,000) ( 50,000) (40,000)

information systems
( 5/9, 4/9)

Total budgeted
MOH costs of
280,000 230,000 510,00
production
0
departments

a) 2000 5000 3000

10,000 10,000 10,000
b) 5000 4000
9000 9000

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Note that alternative term for step -down allocation method is sequential allocation method.

3) Reciprocal allocation method

The reciprocal allocation method allocates costs explicitly including the mutual services
rendered among all service departments. This method enables us to incorporate fully inter
departmental relationship in to the service cost allocations the reciprocal allocation method is
also called allocation method m matrix allocation method, and double distribution allocation
method. Allocation of service department costs under reciprocal allocation method requires three
steps as discussed below.

Step 1: Express service department costs and service department reciprocal relationship in linear
equation form.

Let:
PM: the complete reciprocated costs of plant maintenance department
IS: the complete reciprocated costs of information systems department
PM: 100,000 + 0.10 IS
IS: 70,000 + 0.20 PM

Step 2: Solve the above equations using simultaneous equation to obtain the complete
reciprocated cost of each service department

PM= 100,000 + 0.10 (70,000 + 0.20 PM)

PM = 100,000 + 7000 + 0.02 PM
PM = 107,000 - 0.02 PM
PM = 0.02 PM = 107,000
0.98 PM = 107,000
PM = 107,000.98 = Br 109,183.67
The Br. 109,183.67 represents the total reciprocated (artificial)cost of plant maintenance
department.

IS= 70,000 + 0.20 PM

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= 70,000 + 0.20 (109,183.67)
= Br. 9,836.67 - Total reciprocated cost (artificial) cost of information systems
department
Step 3: Allocate the complete reciprocated cost of each service department to all other
departments (both production and service departments) using the usage proportions:

Factory service departments Production departments

Plant Informatio Machining Assembly Total
maintenance n system
Budgeted MOH 100,000 70,000 180,000 160,00 510,000.00
costs
Allocation of
plant maintenance
( 2/10,5/10,3/10) 109,183.67 21,836.73 54591.84 32.755.10

Allocation of
information
system 9183.67 91,836.73 36.734.69 36,734.69

( 1/10, 5/10, 4/10)

Total budgeted
MOH costs of
production 0 0 280,489.79 510,000.00
departments

2.3.6. Setting overhead rates

Manufacturing overhead costs are not directly traceable to a unit of output. Instead, these costs
are accumulated during the year and charged to jobs or products at the end of the year. However,
management cannot wait until the end of the year, or month to find out how much particular job
costs. Cost date are most useful when they are immediately available then they can be used to
evaluate efficiency, to suggest changes in procedures, and to help setting profitable selling
prices. The cost accountant is usually expected to report the total setting profitable selling prices.
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The cost accountant is usually expected to report the total cost of a job as soon as it s finished. At
this time the actual total overhead costs are available, as they would be t the end of a fiscal
period. Thus, the accountant has to devise a method of estimating overhead costs applicable of
the completed jobs. This is achieve by establishing a predetermined overhead rates, or
predetermined overhead application rate.

Predetermined overhead application rate refers to the rate determined before the
commencement of the period during which the same would be used.

2.3.6.1 Factors Affecting Rate Setting

Several factors affect the setting overhead rate. Among these are:

1. Length of the Period

This refers to the length of the period over which the rate is to be used. Selection of the length of
the period determines the questions as to how frequently the rate should be revised. The period
varies from organization to organization. Rate may be revised every year, six months, quarter, or
even every month.

The general principle governing the selection of the period is that the period should be long
enough to normalize the rate. A shorter period for averaging costs is not satisfactory because
wide variation can occur from to period. These variations are due to changes is seasons, calendar,
and volume. Fluctuating costs also complicate any attempt to use shorter period such as a month.

2. Departmental and factory rates

The second factor is whether a single factory wide rate is used for all factory overhead or
whether separate rates are used for each producing departments. If the company is small, has a
few manufacturing departments, produces very few types of goods, it may successfully use a
single overhead application rate. However, a single overhead rate is not appropriate if different
types of products are manufactured, of if all products do not go through all departments. If one
department uses largely machine operations, and another department uses primarily hand labor, a

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single rate is not suitable. Note that when a single rate is used for the entire, it is called blanket
rate.

2.3.6.2. Types of overhead rate bases

The overhead rate is calculated with reference to the amount of overhead provided in the budget
and a predetermined volume of production in terms of the base which will be used as
denominator. The base should be the best available of the cause and effect relationships between
overhead costs and cost drivers.

Overhead rate = Estimated manufacturing overhead

Estimated activity base

A number of bases may be used in computing overhead application rate. The most commonly
used bases are:

1. Units of production 4. Prime cost

2. Direct material cost 5. Direct labor hours

3. Direct labor cost 6. Machine hours

Illustration

A summary of the budget data for Abdi manufacturer for the year ended December 31, 1998 is
given below:
Budgeted Manufacturing overhead costs = $ 600,000

" Units of production = 30,000 units

" Direct labor costs = $400,000

" Direct labor hours = 240,000 hours

" Direct material costs = $ 360,000
" Machine hours = 350,000 hours

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Required: Determine overhead application rate under each of the following bases:
 Units of production
 Direct material cost
 Direct labor cost
 Prime cost
 Direct labor hours
 Machine hours

a) Units of production

Units of production result in a meaningful rate only if the manufacturing process is simple and
only if one type or a few very similar types of goods are produced.

Rate = Estimated Manufacturing Overhead

Estimated units of production

= 600,000 = $ 20 unit

30,000

The rate implies that if one units is produced, the overhead applied ( charged) to this unit is $20.
If a job of 100 units is produced, the overhead applied to the job would be $2000 (i.e. $20 x 100
units= $2000)

b) Direct Material cost

Under this method, the overhead application rate is expressed as a percentage of direct material
costs.

Rate = Estimated Manufacturing Overhead

Estimated Direct material costs

= 600,000

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360,000

= 1.67 or 167% of direct maternal costs

If direct materials consumed of job No. 15 totaled $22,000, the overhead applied to this job
would be $36,740 (i.e 167%22000: 36,740)

Direct material cost is more appropriate when each article manufactured must require
approximately the same amount of materials, or usage must be distributed uniformly throughout
the manufacturing process.

However, in practice, most overhead costs have little relationship to materials used. As a result,
it is likely to give totally inaccurate results.

C) Direct labor cost

Rate = estimated manufacturing overhead

Estimated direct labor costs

= 600,000
400,000
The rate implies that the amount of overhead applied to a job or product is 150% of actual direct
labor cost incurred on that job. For instance, if actual direct labor costs incurred on job No. 15
totaled $ 20,000, the overhead applied to this job would be $ 30,000 (i.e 150% x20, 000 =
30,000)

This method is the most widely used overhead application basis because it is simple and easy to
use. However, the direct labor costs basis is not generally used in all cases where a large
proportion of overhead costs relate to the use of machinery. Also if hourly wage rates vary
widely between different workers on the same job or in the same department, the direct labor
cost is not appropriate.

d) Prime cost method: under this method overhead rate is expressed as a percentage of prime
costs (i.e. direct materials plus direct labor)

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Rate = Estimated Manufacturing Overhead

Estimated prime cost

= 600,000 = 0.79 or 79% of prime cost

400,000 + 360,000

This method takes in to account both direct materials and direct labor. However, it would
produce inaccurate results due to the following reasons:

If material cost is predominant in prime cost, the method would completely ignore the time
element.

If ignores the fact that use of expensive machinery gives rise to additional overheads ( i.e. higher
depreciation higher insurance, higher repair and maintenance etc)

It combines the disadvantages associated with the rates based on the direct material costs and
those based on the direct labor costs.

e) Direct labor hours:

This method assumes that overhead costs tend to vary with the number of hours of direct labor
used:

Rate= Estimated Manufacturing Overhead

Estimated Direct labor hours

= 600,000

240,000

= 250% of direct labor hours, or

= $2.50 direct labor hour.

If a job required 100 direct labor hours is completed, the overhead applied to job would be
$25000 (i.e $2.50 x 100 hours = $2500)

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The direct labor hour basis is more appropriate if labor operations are the major part of the
production process.

f) Machine Hours

This method is used when machine operations are the major part of the production process.
When work is performed primarily by machines, a large part of factory overhead consists of
depreciation, power repairs and other costs associated with machinery. Thus, a logical
relationship exists between the use of the machinery and the amount of overhead costs incurred.

Rate = Estimated Manufacturing Overhead

Estimated Machine Hours

= 600,000

350,000

= $1.71 per machine hour

If job 15 used hours basis is not accurate if different kinds of machines are used for various
products. In such a case, variations in original cost, operating costs, machine speed, and labor
costs would make this rate in appropriate as an overall formula.

2.3.6.3. Setting Departmental overhead rates

As described earlier, if a single factory -wide overhead rate is not appropriate, multiple overhead
rates are calculated for each production departments. Note that the rate is now computed for
service departments. In order to compute departmental overhead rates, the following may be
used:

Step 1: Allocate service department costs to production departments using the methods
introduced earlier (i.e. direct allocation method, step -down allocation method, or reciprocal
allocation method)

Step 2: Determine the overhead application rate using any one of the appropriate base described
earlier in this chapter. It is determined in the same way as single overhead application rate.

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2.3.7. Applying manufacturing overhead

In the preceding discussion, the methods of determining overhead application rate were
introduced. However, accounting for applied overhead was not introduced. Thus, this topic is
intended to introduce how manufacturing overhead is applied to jobs or products, how to record
in the accounting records, and how to treat the difference between actual manufacturing
overhead and applied manufacturing overhead.

In general the following procedures are used to apply manufacturing overhead to jobs or
products.

 Step 1: Select the application base (bases described earlier)

 Step 2: Prepare a factory overhead budget for the planning period. The two key
Items are
o Budgeted total overhead and
o Budgeted total volume of the application base.
 Step 3: Compute the overhead application rate by dividing the budgeted total overhead
by the budgeted total volume of the application base.
 Step 4: Obtain the actual application base date (such as machine hours) for the period.
 Step 5: Apply the overhead to the jobs by multiplying the overhead application rate by
the actual application base data.

 Step 6: prepare the necessary entry to the applied factory overhead by the following
entry
Work in process---------------------------xxx

Manufacturing -----------------------------xxx

 Step 7: At the end of the period, account for any difference between the amount of
overhead actually incurred and overhead applied to products.

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Example

Suppose that the company budgeted its factory overhead for the fourth coming year as
$900,000. Assume that manufacturing overhead is applied to products on the basis of machine
hours of 600,000 hours. Assume further that a job cost sheet for job 243 included the following
information:

 Actual direct materials cost ----------------------------$ 2500

 Actual direct labor cost --------------------------------- 3000
 Actual machine hours ----------------------------------- 2000 hours
Required

A. Determine the overhead application rate

B. Compute the applied overhead to job 243
C. Prepare the entry to record applied overhead to job 243
D. Determine the total manufacturing costs of job 243.
Solution

a. Overhead application rate = Estimated Manufacturing Overhead

Budgeted machine hours

= 900,000

600,000

= $ 1.51 machine hour

b. Applied overhead = overhead rate x Actual activity base

= 1.50 x 2000

= $ 3000

c. Journal Entry
Work in process -----------------------------------------3000
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Manufacturing --------------------------------------------------------3000

d. Determining the total Manufacturing cost

Actual direct material cost ……………….. $ 2,500

Actual direct labor cost …………………… 3,000

Applied manufacturing overhead ………… 3,000

Total manufacturing costs (Job 243) …….. $ 8,500

Note that the applied manufacturing overhead is posted to job cost sheet.

Some accountants prefer to credit special departmental overhead applied account, instead of
directly crediting manufacturing overhead control account. i.e.

Work in process ………………………. 3000

Manufacturing overhead applied ………………. 3000

Then manufacturing overhead applied account is closed to manufacturing overhead control

account as follows:

Manufacturing overhead applied ………… 3000

Manufacturing overhead control ……………………. 3000

2.3.8. Over applied or under applied overhead

Actual manufacturing overhead costs have been debited to MOH control account, and the same
account has been credited fro the manufacturing overhead applied to jobs or products. At the
end of the period, MOH control account may have debit or credit balance. A credit balance in
the account implies over applied manufacturing overhead. In other words, over applied overhead
occurs when applied overhead is greater than actual manufacturing overhead. If actual
manufacturing overhead, on the other hand, exceeds applied overhead, the difference is called
under applied overhead. In other words, under applied overhead is said to exist if MOH control
account has debit balance.
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The next question is how to treat under applied or over applied overhead. The treatment depends
on whether the objective is to prepare interim or annual financial statements. The manner of
treating under applied or over applied overhead varies, depending on whether the intention is for
interim or annual report

Monthly procedures (Interim Reporting)

The balance of MOH control account is closed to over “applied or under applied manufacturing
overhead” account at the end of the month. Under applied overhead is closed as follows:

Under applied manufacturing overhead ……………….. Xxx

Manufacturing overhead control ……………………….. Xxx

Over applied overhead is closed as follows:

Manufacturing overhead control ………………… xxx

Over applied manufacturing overhead …………………… xxx

The under applied or over applied manufacturing overhead is not closed monthly. The amount
of under applied is considered a deferred charge and is shown under prepaid expenses on the
interim balance sheet as a deferred credits.

Note that the amount of under applied or over applied overhead does not appear in the interim
income statement. The statement of cost of goods manufactured shows direct materials used,
direct labor, and manufacturing overhead applied.

End-of-year procedures

The balance of under applied or over applied manufacturing overhead represents a difference
between overhead costs applied to goods worked on during the year and the actual overhead
costs that were incurred in producing these goods. There are two ways of treating under applied
or over applied overhead at the end of the year.

Immediate write off method

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If the amount of under applied or over applied overhead is small, it is regarded as an adjustment
to Cost of Goods sold (i.e. written-off against cost of goods sold account).

Example

Assume that factory overhead incurred is $800.000 and that factory overhead applied is
$750.000. The difference is under applied of $50.000. The closing entry is:

Cost of Goods sold ……………………. 50.000

Manufacturing overhead control ……………………50.000

If the difference were over applied, the closing entry would be:

Manufacturing overhead control ………………… 50.000

Cost of Goods sold …………………………………………50.000

Perorations Method

If the amount of under applied or over applied overhead is considered to be material, it is divided
among Cost of Goods Sold. Work in Process, and Finished Goods Inventory.

Example

Assume that factory overhead incurred is $900.000 and that factory overhead applied is
$1,200,000. The difference is considered to the material. Assume further that the ending
balances (before prorating) were as follows:

Cost of goods sold ………………….. $1,000,000

Work in Process …………………….. 400,000

Finished goods ……………………… 600,000

Required

Compute under applied or over applied overhead at year end.

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Prorate under applied or over applied overhead among the three balances.

Prepare the closing entry to record the prorated amount assuming that applied overhead was
recorded in manufacturing overhead control account.

Compute the new balances of the account after proration.

Solution

Over applied overhead:

Factory overhead applied …………………………….. $1,200,000

Less Factory overhead incurred ………………………. 900.000

Over applied overhead ………………………………… $ 300.000

Proration of over applied overhead is shown below:

1,000.000
x300.000
 Cost of Goods Sold = 2.000.000 = $ 150.000
400.000
x300.000
 Work in Process = 2,000.000 = 60,000
600,000
x300,000
 Finished Goods = 2,000,000 = 90,000

 Manufacturing overhead control ……………… 300,000

 Cost of Goods sold ……………………………… 150,000
 Work in Process ………………………………… 60,000
 Finished Goods …………………………………. 90,000
The balance of the three accounts after proration are computed below.

 Cost of Goods sold = 1,000,000 - $150,000 = $850,000

 Work in Process = 400,000 - 60,000 = 340,000
 Finished Goods = 600,000 - 90,000 = 510,000
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 Synopsis

 Factory Overhead (FOH) is generally defined as indirect materials, indirect labor, and all
other factory expenses that cannot conveniently be identified with nor charged directly to
specific jobs or products
 Other terms used for FOH are factory burden, manufacturing expenses, manufacturing
overhead, factory expenses, and indirect manufacturing costs.
 FOH costs cannot be separated and assigned directly to a specific unit or product in an
easy and cost-effective manner. Some of FOH costs include: Indirect materials, indirect
labor, depreciation, utilities, insurance and property taxes on the factory.
 There are two main reasons for the question why it is impossible to determine the actual
FOH to a specific job or product. These are:
o FOH is incurred for general factory use but not for a specific job or product
o Some actual FOH costs are determined at the end of the fiscal period, e.g.
depreciation.
 Overhead costs are applied by using a predetermined overhead rate, which are
determined by dividing the total estimated overhead costs for the year by the estimated
allocation base.
 An allocation base is a common denominator that links indirect costs to cost objects
(products). Stated differently, it is a measure such as direct labor-hours or machine-hours
that is used to assign overhead costs to products or services. The most commonly used
bases of computing predetermined FOH rate are:
o Physical output (Units of Production)
o Direct material cost
o Direct Labor cost
o Direct Labor hours
o Machine hours
 There are three ways to dispose over or under applied overhead costs:
o Immediate write-off to CGS approach
o Proration approach
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o Adjusted allocation rate approach
 There are three methods of allocating the costs of service departments to production
departments. These are:
o Direct allocation method
o Step down allocating method
o Reciprocal allocation method

 Wrap-up Exercise Questions

5. What are the two types of budget data needed to compute predetermined overhead
rates?
6. Describe the role of a manufacturing overhead allocation base in job costing
7. What are the most frequently used allocation bases for manufacturing overhead
costs
8. Describe three alternative ways to prorate end-of-period adjustments for under or
over allocated indirect costs
9. Why might a company prefer the adjusted allocation rate over a proration rate
approach to under or over allocated indirect costs?
10. A company manufactures four products A, B, C and D products are assigned
5,10,8 and 4 points respectively, to compensate the basic difference in the
products. The normal capacity is as follows:

 A-------------------------------2000 units
 B-------------------------------5000 units
 C-------------------------------3000 units
 D-------------------------------4000 units
Total factory overhead costs for the budget year are estimated at $700,000.
Required: Determine overhead application rate if units of production basis is
used.

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11. The UNITED Company uses a budgeted overhead rate for applying overhead to
job orders on a machine hour basis for the machining department and on a direct
labor cost basis for the finishing department. The company budgeted the
following for 1999
Machining Finishing

Factory overhead …………………. $10,000,000 $8,000,000

Machine hours ……………………. 200,000 33,000
Direct labor hours ………………… 30,000 160,000
Direct labor cost …………………... $ 900,000 $4,000,000
Required
i. What is the budgeted overhead rate that should be used in the machining
department? In the finishing department?
ii. During the month of January, the cost record for job No. 431 shows the following:
Machining Finishing
Direct materials requisitioned …………….. $ 14,000 $ 3,000
Direct labor cost …………………………... 600 1,250
Direct labor hours ………………………… 30 50
Machine hours ……………………………. 130 10
What is the total overhead applied to job 431?
 Assuming that job 431 consists of 200 units of product, what is the total
costs and unit cost of job 431?
 Balances at the end of 1999:
Machining Finishing
‘Factory overhead Incurred ………… $11,200,000 $7,900,000
Direct labor cost …………………… 950,000 4,100,000
Machine hours ……………………… 220,000 32,000
Compute the under applied or over applied overhead for each department and for the
factory as a whole.

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12. GH manufacturing company applies overhead to jobs on the basis of machine
hours. The following data is extracted from the record or the company for 1996.
 Budgeted factory overhead costs ………………….. $ 7,000,000
 Budgeted machine hours …………………………… 200,000 hours
 Actual factory overhead costs ………………………$ 6,800,000
 Actual machine hours ………………………………. 195,000
Required
a) Compute the factory overhead application rate.
b) Journalize the application of factory overhead.
c) Compute the amount of under applied or over applied factory overhead.
Journalize the disposition of the ending balance in manufacturing overhead
control account to Cost of Goods Sold.
13. For the current year, 1999, the estimated manufacturing overhead for the cutting
department is $256,000. The estimated number of units of production is 204-800.
The company uses the units of production base for overhead rates. How much
overhead should be applied to:
a) job 15 for 1200 units
b) job 22 for 980 units

14. The D and L Company use the direct labor cost base in establishing overhead
rates for its production departments. Fro the year 1999,the company estimates the
following overhead budgets:
Building services ………………………… $ 42,000
Department 1 ……………………………. 60,000
Department 2 ……………………………. 80,000
Department 3 ……………………………. 70,000
Building services is a service department that assists the production departments on the
basis of floor space occupied. The floor space occupied is given below:

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Floor space
Department 1 ………………………….. 2,000 sq.ft.
Department 2 ………………………….. 3,000 sq.ft.
Department 3 ………………………….. 5,000 sq.ft.
Required: Determine the factory overhead application rates for each department, assuming that
the estimated direct labor costs for each department are $136,800, $ 236,500, and $910,000
respectively.

CHAPTER THREE
COST METHODS: THE COSTING OF RESOURCE OUT PUTS

3.1. Introduction

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It is necessary to understand the difference between the costing methods and techniques. Costing
methods are those which help a firm to compute the cost of production or services offered by it.
On the other hand, costing techniques are those which help a firm to present the data in a
particular manner so as to facilitate the decision making as well as cost control and cost
reduction.

LEARNING OBJECTIVES
After studying this chapter, you will be able to:
 Understand various costing methods & techniques to be used in both manufacturing
& non-manufacturing concerns
 Differentiate between job order and process costing systems.
 Account for materials in job order costing system.
 Account for labor in job order costing system.
 Account for manufacturing overhead costs in job order costing.

3.2. Methods of Costing:

The following are the commonly used methods of costing.
I. Job order costing system: It refers to a system of costing in which costs are ascertained
in terms of specific jobs or orders, which are not comparable with each other, i.e., is a
costing method applied to determine the costs of specific jobs generally manufactured
according to customer’s specification. The main feature of these organizations is that they
produce according to the requirements and specifications of the consumers. Each job may
be different from the other one. Production is only on specific order and there is no pre
demand production.
II. Batch Costing: - This method of costing is used in those firms where production is made
on continuous basis. Each unit coming out is uniform in all respects and production is
made prior to the demand, i.e. in anticipation of demand. One batch of production
consists of the units produced from the time machinery is set to the time when it will be
shut down for maintenance.

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III. Process Costing:- Process costing system: This costing system is used in those
industries where manufacturing is done continuously through different processing cycles,
where a product passes through distinct stages or processes in which the output of one
process being the input of the subsequent process. This method of costing is suitable for
textile industries, chemical industries, paper manufacturers, cement factories, oil
refineries, soap manufacturing companies, tanners, consumer product factories etc.
IV. Operation Costing: - This type of costing method is used in service sector to work out
the cost of services offered to the consumers. For example, operating costing method is
used in hospitals, power generating units, transportation sector etc. A cost sheet is
prepared to compute the total cost and it is divided by total units for working out the cost
per unit.
V. Contract Costing: - This method of costing is used in construction industry to work out
the cost of contract undertaken. This type of costing is actually similar to job costing, the
only difference being that in contract costing; one construction job may take several
months or even years before they are complete while in job costing, each job may be of a
short duration.

3.3. Technique of Costing

As mentioned above, costing methods are for computation of the total cost of
production/services offered by a firm. On the other hand, the purpose of costing technique is to
help in presenting the data in a particular format so that decision making becomes easy. The
following are the common techniques of costing.
1. Marginal Costing: - This technique is based on the assumption that the total cost of
production can be divided into fixed and variable. Fixed costs remain same irrespective
of the changes in the volume of production while the variable costs vary with the level of
production, i.e. they will increase if the production increases and decrease if the
production decreases. In this technique, only variable costs are taken into account while
calculating production cost. This technique is effectively used for decision making in the

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areas like make or buys decisions, optimizing of product mix, key factor analysis,
fixation of selling price, accepting or rejecting an export offer, and several other areas.
2. Standard Costing: - refers to the preparation of standard costs and applying them to
measure the variations from standard costs and analysing the variations with a view to
maintain maximum efficiency in production. Standard costs are predetermined costs
relating to material, labor and overheads. Though they are predetermined, they are
worked out on scientific basis by conducting technical analysis. They are computed for
all elements of costs such as material, labor and overheads. The main objective of
fixation of standard cost is to have benchmark against which the actual performance can
be compared. This means that the actual costs are compared with the standards. The
difference is called as ‘variance’. If actual costs are more than the standard, the variance
is ‘adverse’ while if actual costs are less than the standard, the variance is ‘favorable’.
Both the adverse & Favorable variances are analyzed and reasons for the same are found
out.
3. Actual cost system: When a company uses the actual cost of direct materials, direct
labor, and overhead to determine costs of work in process inventory, that company is
employing an actual cost system.
4. Normal costs system: - The combination of actual direct materials and direct labor costs
with the predetermined overhead rates are called normal cost system.
5. Activity Base Costing (ABC): it is a technique of cost attribution to cost units on the
basis of the benefits received from indirect activities; e.g. setting up, assuring quality,
purchase orders issued, maintenance requests, material receipts, inventory movements,
power consumed, machine time etc. ABC involves identification of costs with each cost
deriving activities (the cause for incurrence of overhead costs) and making it as the basis
of apportionment of costs over different products or jobs on the basis of the number of
activities required for their completion. It is basically used for apportionment of overhead
costs in an organization having products that differ in volume and complexity of
production.

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3.4. DETERMINING MANUFACTURING COSTS USING JOB ORDER COSTING SYSTEM
Introduction
In this sub-section, we will see how production costs are determined based on job order costing
system.
It is known that the primary objective of cost accounting is to determine the cost of an
organization’s products or services. Just as a variety of methods (FIFO, Weighted average, and
specific identification) exist to determine inventory valuation and cost of goods sold for a
retailer, different methods are available to value inventory and calculate product cost in a
manufacturing or service environment. The method chosen depends on the nature of the product
or service and the company’s conversion process.
Generally, before product costs can be can be determined, a clear understanding must be made
about:
1. The product costing system
2. The valuation method to be used
There are two basic systems of costing a product:
1. Job Order Costing System
 Job order costing system is used in those business concerns where production is carried
out as per specific orders and customer’s specifications. That means each job or product
is separate and distinct from the other product. In other words, each job is treated as a
unique cost entity or cost object.
 Therefore, under this method, costs are collected and accumulated for each job, work
order or project separately.
 Each job will be separately identified with a job number, so that it becomes essential to
analyze the cost of each job.
 Different jobs can vary considerably in terms of materials, labor and overhead costs; so
job-costing system accumulates costs separately for each job preparing a job card.
 This type of costing system is applied by furniture manufacturers, construction
companies (house builders), publishing companies, accounting firms, research firms, etc.
2. Process Costing System

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 Process costing system is used by entities that produce large quantities of homogenous
goods/products.
 This costing system is used in those industries where manufacturing is done continuously
through different processing cycle stages. In this way the finished product of one process
usually becomes a raw material for the subsequent process.
 This method of costing is suitable for textile industries, chemical industries, paper
manufactures, cement factories, etc…

3.4.1. Identifying Job Order Costing

Job order costing is costing method applied to determine the costs of specific job generally
manufactured according to customer’s specification.
Job order costing system provides for separate records of the cost of each particular quantity of
product manufactured.
 The main feature of the job order costing system is that no two orders are necessarily the
same.
 Under this method costs are collected and accumulated for each job—work order—
separately.
 Each job will be specifically identified with a job number.
 Different jobs can vary considerably in terms of materials, labor, and overhead costs.
Therefore, job costing accumulates costs separately for each individual job.

Advantages of Job Order Costing System

Job order costing system has the following advantages

 The cost of material, labor and overhead for every job is readily available and
management is able to control the efficiency of operations.
 It is simple as the recording of direct materials, direct labor, and overhead is done for
each job.

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 Spoilage and defective works can be easily identified with specific jobs so that
responsibility can be fixed.
 It provides basis for comparison between job costs or through periods.
Disadvantages of Job Costing System

Job order costing system has the following limitations:

 Job costing is very expensive as more clerical work is involved in identifying each
element of cost with specific jobs.
 With the increase in clerical processes, chances of errors are enhanced.
 In case of inflation, comparison of cost of a job for one period with that of another
becomes meaningless.

Characteristics of Job Costing System

The major objective of job order costing is to find out the profit or loss on each job. When
distinct products are produced, there is a need that costs be identified with specific orders. Some
of the common features of this method of costing are given below:
 The distinction between direct and indirect costs is more important in job order costing
than in process costing.
 Orders are issued, and costs are kept for each lot of products manufactured.
 Direct costs are charged to the work in process account and are entered in job sheets.
 This method is used for estimating the amount of applied indirect costs, also known as
applied manufacturing expenses in respect of each order. Such amounts are entered in
cost sheets and charged to the work in process account.
 This method is relatively more labor intensive. That means majority of the expenses are
related to labor or payroll.

3.4.2. Some Common Terms in Job Costing System

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1. Production order
The central point of job order costing system is the production order. Once an order has been
accepted and the time has come to start manufacturing, the production control department will
make the production order. It serves as authorization to manufacture or to execute the order and
control its physical progress. Each production order bears a serial number and several copies are
prepared. These copies are then passed on to the concerned departments. However, there is no
standard format for the production order and its details differ according to the nature of
production.
FORMAT OF PRODUCTION ORDER
ABC Company
Production order --------------------------- Job number----------
Name of the customer ------------------- Date -----------
Date of starting manufacturing ---------
Date of completion of manufacturing------
Special instruction --------------------

Quantity Description Machine to be used Tools required

Bills of materials No--------

Production authorization (signature) -----------------------

2. Job Cost sheet (Job Cost card)

Production order is the starting point for the cost accountant to prepare a job cost sheet. It is also
termed as job cost card. It is the basic record form or document in a job order costing system. It
is a cost sheet on which the cost accountant records the costs incurred as the job passes through
the factory. The job cost card, at time of completion of a product, shows the total cost of the

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completed jobs. The job cost sheet can differ in form, content and arrangement in each business.
But the common items to be included are stated in the following format.

FORMAT OF JOB COST SHEET

ABC Company
Customer name -------------- Date------------
Product description --------- Job order no------
Quantity ------------------- Date started -------
Selling price ------------- Date completed -------
Total cost ----------------
Department 1 Department 2 Department 3
Materials
Date
Requisition No
Amount
Labor
Date
Job time card No
Amount
Over head
Rate /basis
Amount

Cost summary
Depatment1 Department 2 Department3
Material
Labor
Overhead ________________________________________________________
Total

3. Work in progress account (work in process account)

When job costing is used, the work in progress account serves as a control account for a job cost
card. As jobs are finished and passed from the factory floor to the finished goods warehouse for
dispatch, the job cost cards are totaled and removed from their collection as work in progress.
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The corresponding entry is made in the cost ledger by crediting the work in progress account and
debiting finished goods account.

4. Job ticket
In job costing it is an advantage to use job tickets. Because their use provides information about
the progress of the job as it passes from one operation to the next. The production department
upon receiving the job ticket will be able to check actual production against the plan and take
action to investigate delays in production.

5. Profit/loss on job

This is determined by comparing the total cost incurred with the selling price obtained for each
job. That means, each job’s required resources will be separately indicated in the job cost sheet
by that specific job number. The sum of costs indicated in the job cost sheet reflects total cost of
completing the job. Finally, this cost will be compared with the selling price to arrive at profit or
loss on the job.

3.4.3. Recording Costs in Job Order Costing System-Illustrations

Illustration-1
Addis manufacturing company follows job order costing and has the following information and
transactions related to the month of March 2010.
1. The beginning inventory of direct materials consists of:
Material X……………………………… Br. 7,000
Material Y……………………………… Br. 6,500
Material Z………………………………. Br. 9,000
Total 22,500
2. Purchase of direct materials on account consists of:
Material X…………………………….... Br. 25,000

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Material Y……………………………… Br. 30,000
Material Z………………………………. Br. 50,000
Total 105,000
3. Issuance of direct material consists of:
Material X………………………………. Br. 22,000
Material Y………………………………. Br. 28,000
Material Z………………………………. Br. 45,000
Total 95,000
The materials are charged as follows:
Job 10 25,000
Job 11 30,000
Job 12 40,000
Total 95,000
4. The beginning work in process inventory consists of:
Job 10 15,000
Job 11 18,000
Job 12 16,000
Total 49,000

5. The beginning finished goods inventory consists of:

Job 10 360 units @ 50 Br each 18,000
Job 11 100 units @125 Br each 12,500
Job 12 150 units @120 Br each 18,000
Total 48,500
6. The direct labor cost for the month was 80,000 Birr of which 30% is charged to job 10, 30%
to Job 11, and 40% to Job 12.
7. Manufacturing overheads is applied to the production at 75% of direct labor cost.
8. All the jobs are completed.
9. Job 10 was for 1,500 units, job 11 was for 600 units and job 12 was for 700 units.

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10. Sales for the month were as follows:
 1,200 units of Job 10 at Br. 60 each
 560 units of Job 11 at Br.170 each
 650 units of Job 12 at Br. 150 each
Note that, the company uses FIFO method to account for all inventories.
Required
A. Prepare all the necessary journal entries for the above transactions.
B. Prepare the job cost sheet for each job.
C. Compute unit costs for each job
D. Compute the direct material, work in process, and finished goods at March 31,
2010.

SOLUTION FOR ILLUSTRATION-1

A. preparing the journal entry
1. Material X 25,000
Material Y 30,000
Material Z 50,000
Accounts payable 105,000
To record the cost of materials purchased

2. Work in process (Job 10) 25,000

Work in process (Job 11) 30,000
Work in process (Job 12) 40,000
Material X 22,000
Material Y 28,000
Material Z 45,000
To record the cost of materials used by each job
3. Work in process (Job 10) 24,000
Work in process (Job 11) 24,000
Work in process (Job 12) 32,000
Factory payroll clearing 80,000
To record the cost of labor incurred for each job.
4. Work in process (Job 10) 18,000

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Work in process (Job 11) 18,000
Work in process (Job 12) 24,000
Manufacturing overhead applied 60,000
To record the cost manufacturing overhead cost applied to each job.

5. Work in process (Job 10) = 15,000+25,000+24,000+18,000

= 82,000 Br
Work in process (Job 11) =18,000+30,000+24,000+18,000
= 90,000 Br
Work in process (Job 12) =16,000+40,000+32,000+24,000
= 112,000 Br
Finished goods (Job 10) 82,000
Finished goods (Job 11) 90,000
Finished goods (Job 12) 112,000
Work in process (Job 10) 82,000
Work in process (Job 11) 90,000
Work in process (Job 12) 112,000
To record the cost of goods completed and transferred to the finished goods warehouse.
Unit cost = Total cost
Total quantity
Unit cost of Job 10 = 82,000 Br = 54.667 Br/unit
1,500 units
Unit cost of Job 11 = 90,000 Br = 150 Br/unit
600 units
Unit cost of Job 12 = 112,000 Br = 160 Br/unit
700 units
6. A. Cash (Accounts Receivable) 72,000
Sales 72,000
Cost of goods sold 63,920
Finished goods(Job 10) 63,920
Finished goods sold (Job 10) = (360*50) + (840*54.667)
= 63,920 Br
B. Cash (Accounts Receivable) 95,200
Sales 95,200
Cost of goods sold 81,500
Finished goods job 11 81,500
Finished goods sold (Job 11) = (100*125) + (460*150)
=81,500 Br
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C. Cash (Accounts Receivable) 97,500
Sales 97,500
Cost of goods sold 98,000
Finished goods job 12 98,000
Finished goods sold (job12) = (150*120) + (500*160)
=98,000 Br
To record the cost of jobs sold to the customers

B. preparing the job cost sheet

Job 10 Job 11 Job 12
Beginning work in process 15,000 18,000 16,000
Direct material 25,000 30,000 40,000
Direct labor 24,000 24,000 32,000
Manufacturing overhead 18,000 18,000 24,000
Total 82,000 Br 90,000 Br 112,000 Br

C. Computing ending inventories

Ending Material =Beginning Materials + Purchases of Materials - Materials Used
Ending material X=7,000 + 25,000 - 22,000
= 10,000 Br
Ending material Y=6,500 + 30,000 - 28,000
= 8,500 Br
Ending material Z=9,000 + 50,000 – 45,000
= 14,000 Br
 There are no Ending Work in Process Inventories because all of the jobs started are
completed currently. Therefore, there is no job which could be referred to as work still in
process.
Finished goods ending (Job 10) = (1,500-840)*54.667
= 36,080 Br
Finished goods ending (Job 11) = (600-460)*150
= 21,000 Br
Finished goods ending (Job 12) = (700-500)*160
= 32,000 Br

Illustration-2
3F company uses a job order costing system, the factory overhead rate estimated for the year
2002 is birr 6 per direct labor hour. The inventory account has the following balance on January
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Materials 8,000
Work in process (Job b 410) 7,500
Finished goods (Job 409) 7,800
During January the following events have occurred
1. Material purchased on account 170,000
2. Materials and supplies were issued as follows:
Job (411) 5,000
Job (412) 6,400
Job (413) 7,500
Supplies 2,000
3. The January direct labor cost were
Job (410) 200 hours @7 Br/hour
Job (411) 450 hours @7 Br/hour
Job (412) 400 hours @7 Br/hour
Job (413) 150 hours @ 7 Br/hour
4. Factory indirect labor for January was 3,600 birr
5. Other over head cost incurred during January
Utilities 3,500 Br
Depreciation 1,500 Br
Repairs and maintenance 1,000 Br
6. Job 410, 411,412 were completed and transferred to finished goods.
7. Job 409 and 410 were sold on account for 150% of the cost.

Required
1. Prepare the journal entries for the above transaction
2. Determine the ending inventory
3. Calculate the MOH over or under applied
SOLUTION FOR ILLUSTRATION-2
Journal entry

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1. Materials 170,000
Vouchers payable 170,000
To record purchase of materials

2. Work in process (411) 5,000

Work in process (412) 6,400
Work in process (413) 7,500
MOH Control 2,000
Material 20,900
To record the cost of materials issued to the production process.
3. Work in process (410) (200hrs*7Br) 1,400
Work in process (411) (450hrs*7Br) 3,150
Work in process (412) (400hrs*7Br) 2,800
Work in process (413) (150hrs*7Br) 1,050

Factory payroll clearing 8,400

To record the cost of labor incurred in the production process
4-MOH control 3,600
Factory payroll clearing 3,600
To record the cost of indirect labor identified
5- MOH Control 6,000
Utilities payable 3,500
Accumulated depreciation 1,500
Repair and maintenance payable 1,000
To record other manufacturing overhead costs
6. Work in process (410) 1,200
Work in process (411) 2,700
Work in process (412) 2,400
Work in process (413) 900
MOH control applied 7,200
To record the manufacturing overhead cost applied to the production process
7. Finished goods (410) 10,100
Work in process (410) 10,100
Finished goods (411) 10,850
Work in process (411) 10,850
Finished goods (412) 11,600
Work in process (412) 11,600
To record the cost of finished goods completed and transferred to warehouse.
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8. Job (409)
Cost of goods sold 7,800
Finished goods 7,800
Sales = 7,800 x150%
= 11,700 Br

Accounts receivable 11,700

Sales 11,700
Job (410)
Cost of goods sold 10,100
Finished goods 10,100
Sales= 10,100 x150%
= 15,150 Br

Account receivable 15,150

Sales 15,150
To record the cost of goods sold and sales
2. Ending inventory
Ending inventory of Material = 7,000+170,000- 20,900
= 156,100 Br
Ending work in process = 7,500+1,050
= 8,550 Br
3. Determining over or under applied over head
MOH Control 11,600
MOH applied 7,200
MOH under applied 4,400
MOH applied 7,200
Under applied MOH 4,400
MOH control 11,600

3.4.4 Accounting for Spoilage, Rework & Scrap under Job Costing

3.4.4.1 Spoilage costs

Spoilage is unacceptable units of production that are discarded or are sold for reduced prices.
Spoilage is of two types: Normal & Abnormal spoilages. Abnormal spoilage is usually regarded
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as controllable by the manager. Costs of abnormal spoilage are not considered as inventoriable
costs and are written off as costs of the period in which detection occurs.

Normal Spoilage costs in job-costing systems just as in process costing systems are inventoriable
costs, although managements are tolerating only small amounts of spoilage as normal. When
assigning costs, job-costing systems generally distinguish between normal spoilage attributable
to a specific job and normal spoilage common to all jobs. Normal spoilage attributable to a
specific job is assigned to that job, a step unnecessary in process costing since masses of
identical or similar units are manufactured.

Example: In a Machine Shop 5 aircraft parts out of a job lot of 50 aircrafts parts are spoiled.
Costs assigned prior to inspection point are $2,000 per part. The current disposal price of the
spoiled parts is estimated to be $600 per part. When the spoilage is detected, the spoiled goods
are inventoried at $600 per part.

Normal Spoilage attributable to a specific job: When normal spoilage occurs because of the
specifications of a particular job, that job bears the cost of the spoilage reduced by the current
disposal value of the normal spoilage is:

Materials Control (5*$600) 30001

Work-in Process Control (specific job) (5*$600) 3000

Note that the Work-in Process Control (specific job) has already been debited $10,000 for the
spoiled parts (5 spoiled parts * $2,000 per part). The effect of the $3,000 entry is that the net
cost of the normal spoilage, $7,000 ($10,000-$3,000) becomes an additional cost of the 45(50-5)
good units produced. The total cost of the 45 good units is $97,000. $90,000 (45units*$2,000 per
unit) incurred to produce the good units plus the $7,000 net cost of normal spoilage.

Normal Spoilage common to all jobs: In some cases, spoilage may be considered a normal
characteristics of a given production cycle. The spoilage inherent in production only coincidently
occurs when a specific job is being worked on. The spoilage is not then attributable, and hence is

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not charged, to the specific job. Instead it is considered as manufacturing overhead. The journal
entry is:

Materials Control (spoiled goods at disposal value 5*$600) 3000

MOH Control (normal spoilage $10,000-$3,000) 7000

Work-in Process Control (specific job 5*$2,000) 10000

When normal spoilage is common to all jobs, the budgeted MOH rate includes a provision for
normal spoilage cost. Therefore, normal spoilage cost is spread, through overhead allocation,
over all jobs rather than loaded on particular jobs only. The total cost of the 45 good units is
$90,000 (45 units*$2,000 per unit) plus a prorated share of the $7,000 of normal spoilage
overhead costs.

Abnormal Spoilage: if the spoilage is abnormal, the net loss highlighted and always charged to
an abnormal loss account. Unlike normal spoilage costs, abnormal spoilage costs are not
included as part of the cost of goods unit produced. The total cost of the 45 good units is $90,000
(45 units*$2,000 per unit).

Materials Control (spoiled goods at current disposal value: 3000

Loss from Abnormal Spoilage 7000

Work-in Process Control (specific job) 10000

3.4.4.2 Rework
Rework is unacceptable units of production that are subsequently repaired and sold as acceptable
finished goods.

Example: Consider Hull Machine Shop; assume that the 5 spoiled parts used in the illustration
are reworked. The journal entry for the $10,000 of total cost assigned to the 5 spoiled units
before considering rework costs are as follows:

Work-in Process Control (Specific Job) 10000

Materials Control 4000

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Wage payable Control 4000

MOH Allocated 2000

Normal Rework common to all jobs: When rework is normal and not attributable to any
specific job, the costs of rework are charged to MOH and spread through overhead allocation,
over all jobs.

MOH Control (rework costs) 3800

Materials Control 800

Wage payable control 2000

MOH Allocated 1000

Abnormal rework: if the work is abnormal, it is recorded by charging abnormal rework to a

separate loss account.

Loss from Abnormal Rework 3800

Materials Control 800

Wage Payable Control 2000

MOH Allocated 1000

Accounting for rework in a process costing system also requires abnormal rework to be
distinguished from normal rework. A process costing system accounts for abnormal rework in
the same way as a job-costing system. Accounting for normal rework follows the accounting
described for normal rework common to all jobs because masses of identical or similar units are
manufactured in process costing systems.

3.4.4.3. Accounting for Scrap

Scrap is a material left over when making a product(s); it has low sales value compared with the
sales value of the product(s). There are no distinctions of normal and abnormal scrap, but scrap
attributable to a specific job is distinguished from scrap common to all jobs.

There are two major aspects of accounting for scrap:

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1. Planning and control, including physical tracking.

2. Inventory costing, including when and how to affect operating income

The question here is:

 When should the value of scrap be recognized in the accounting records at the time scrap
is produced or at the time scrap is sold?

 How should revenue from scrap be accounted for?

To illustrate: In Hull co. assuming that the manufacturer of aircraft parts generates scrap. We
further assume that the scrap from a job has a total sales value $900.

1. Recognizing Scrap at the Time of its Sale: When the dollar amount of scrap is
immaterial, the simplest accounting is to make a memo of the quantity of scrap
returned to the storeroom and to regard scrap sales as a separate line item of other
revenues. The only journal entry is:

Cash or A/R 900

Sales of Scrap 900

(Sale of Scrap)

When the dollar amount of scrap is material and the scrap is sold quickly after it is produced, the
accounting depends on whether the scrap is attributable to a specific job or common to all jobs.

 Scrap attributable to a specific job: Job costing system sometimes trace the sales of
scrap to the jobs that yielded the scrap. This method is used only when the tracing can be
done in an economical feasible way. The journal entry is:

For scrap returned to storeroom: No journal entry2

Sale of Scrap: Cash or A/R 900

Work-in Process Control 900

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Unlike spoilage and rework, there is no cost attached to the scrap, and hence no distinction is
made between normal and abnormal scrap. All scarp sales, whatever the amount, are credited to
the specific job. Scrap sales reduce the costs of the job.
 Scrap common to all jobs: The journal entry in this case is:
Scrap returned to storeroom: No journal entry.
Sale of scrap: Cash or A/R 900
MOH Control 900
This method does not link scrap with any particular job or product. Instead, all products
bear regular production costs without any credit for scrap sales except in an indirect
manner. The expected sales are considered when setting he budgeted MOH rate. Thus,
the budgeted OH rate is lower than it would be if the OH budget had not been reduced by
the expected sales of scrap. This accounting for scrap is both in process costing and job
costing systems.

2. Recognizing Scrap at the Time of its Production

In the preceding illustration the assumption is that scrap returned to the storeroom is sold quickly
and hence not assigned an inventory cost figure. Sometimes however, the value of scrap is not
immaterial, and the time between storing it and selling or reusing it can be quite long.
Under conditions, the company is justified in inventory scrap at a conservative estimate
conditions of net realizable value so that production costs and related scrap recovery are
recognized in the same accounting period. Some companies tend to delay sales of scrap until the
market price is most attractive.
 Scrap attributable to a specific job: The journal entry in the example is:
Scrap returned to storeroom: Materials Control 900
Work-in Process Control 900
 Scrap common to all jobs: The journal entry in this case is
Scrap returned to storeroom: Materials Control 900
MOH Control 900
Observe that Materials Control account is debited in place of Cash/A/R. When the scarp
is sold, the journal entry is:
Sale of Scrap: Cash or A/R 900
Materials Control 900

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Scrap is sometimes reused as direct materials rather than sold as scrap. In this case, it
should be debited to Materials Control as a type of direct materials and carried at its
estimated net realizable value. For example, the entries when the scarp generated is
common to all jobs are:
Scrap returned to storeroom: Materials Control 900
MOH Control 900
Reuse of Scrap: Work-in Process Control 900
Materials Control 900
The accounting for scrap under process costing is like the accounting under jobs costing
when scrap is common to all jobs because process costing applies to the manufacture of
masses of identical or similar units. The high cost of scrap focuses manager’s attention on
ways to reduce scrap and to use it more profitably.
 Synopsis

 Job-order costing refers to a system of costing in which costs are ascertained in terms of
specific jobs or orders, which are not comparable with each other, i.e., is a costing
method applied to determine the costs of specific jobs generally manufactured according
to customer’s specification.
 Under Job-order costing method, costs are collected and accumulated for each job, work
order or project separately.
 The process costing system is used in those industries where manufacturing is done
continuously through different processing cycles, where a product passes through distinct
stages or processes in which the output of one process being the input of the subsequent
process.
 Process costing as a costing method is suitable for textile industries, chemical industries,
paper manufacturers, cement factories, oil refineries, soap manufacturing companies,
tanners, consumer product factories etc
 Spoilage is unacceptable units of production that are discarded or are sold for reduced
prices.
 Rework is unacceptable units of production that are subsequently repaired and sold as
acceptable finished goods.

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 Scrap is a material left over when making a product(s); it has low sales value compared
with the sales value of the product(s).

 Wrap-up Exercise Questions

1. Compare and contrast job order and process costing systems. What factors dictate
whether a job order or process cost system is more appropriate?
2. Differentiate between costing methods and techniques.
3. What is a production order? Cost sheet?
4. What is meant by standard costing and how it is applied in manufacturing concerns?
5. Discuss the accounting treatment for spoilage, rework and scrap costs under job-order
costing.
6. Define/explain the following costing methods/techniques:
 Batch costing
 Contract costing
 Normal costing
 ABC costing
 Marginal costing
a. Actual costing
7. Sharp company uses job order costing system and the following information are
provided during March
1. beginning inventory of direct material
Material x 600 units @ 55 birr
Material y 5000 units @ 65 birr
Material z 3000 units @ 60 birr
2. purchase of material on account during months is as follows
Material x 3000 units @ 60 birr
Material y 2500 units @ 70 birr
Material z 2500 units @ 50 birr
3. Issued materials as follows. Which are changeable to difference jobs

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Job 1. 2500 units of material x, 200 unit of material y, 2000 units of material z.
Job 2 .1000 units of material x, 1500 units of material y, 500 units of material z,
4. The direct labor cost chargeable to each job is
Job 1 70,000 birr
Job 2 50,000 birr
5. The manufacturing over head cost applied in the production process is 50% of the
total direct labor cost which is chargeable to job 60% to job 2 40%
6. Beginning work in process account consists of
Job 1 20,000 birr
Job 2 30,000 birr
7. Beginning finished goods inventory consists of
60 units job 1 @ 500 birr
50 units job 2 @ 490 birr
8. During March all the jobs are completed.
9. During this month 1000 units of job 1. And 500 units job 2 were completed
10. The company sold 1,050 units of job 1, and 540 units of job 2 on account at a
selling price of 600 birr and 550 birr respectively.
* Assume that the company use LIFO method account for its inventories
Required
1. Prepare all the necessary journal entries
2. Prepare the job cost sheet for each job
3. Compute the unit cost for job 1 and job 2
4. Compute the ending inventory of
 Direct material
 Work in process
 Finished goods

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CHAPTER 4:

The Process and Operation or service costing methods:

4.1. INTRODUCTION

In process costing system, as in job order costing system, costs are accumulated by cost
component in each production department. In job order costing system, the accumulated
departmental costs are assigned to a specific job. In contrast, a process costing system assigns
accumulated departmental costs to all the units produced in that department during the period.
Thus, the fundamental characteristic of process costing is the use of an averaging technique
when assigning costs to the units produced. As units are transferred from one department to the
next, unit costs in both job order and process costing are also transferred to accumulate a total
production cost.

This chapter presents basic process costing procedures and illustrates the two methods (weighted
average and FIFO) of calculating unit cost in a process costing system. Once unit cost is
determined, total costs are assigned to the units transferred out of a department and to that
department’s ending inventory.

4.2. LEARNING OBJECTIVES

After studying this chapter, you will be able to

 Identify the nature of process costing by applying the distinguished

accounting principles.
 Identify equivalent units of production by relating it with physical units.
 Identify the basic steps in process costing properly
 Apply costs to units completed and to units in ending work in process
inventory
 Prepare cost of production report

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4.3 DESCRIBING THE NATURE OF PROCESS COSTING

Process costing is a system used to assign costs to goods that are mass produced in a continuous
sequence of steps called processes. The output consists of similar units, with each unit being
processed in the same repetitive condition. Products are homogenous and each unit is exactly the
same. The products are similar means, each unit of finished goods require the same amount of
direct material, direct labor, and manufacturing overhead costs. Most continuous process
manufacturing companies are organized into two or more production departments each of them
performs a specialized function or a series of production operations in the sequence of
manufacturing the products. The industries adopting this method of costing are chemicals, soap,
oil and petroleum refineries, textile, glass, mining, cement, steel, breweries, electricity, and gas.
Process costing is also used in the assembly type industry which manufactures automobiles, aero
planes, refrigerators, radios, TV etc.

4.3.1 CHARACTERISTICS OF PROCESS COSTING

The major characteristics of process costing system are:-

1. The manufacturing costs are accumulated for each production department or

process.
2. Each process or department has its own account and records the processing
costs incurred by the department.
3. Under processing industries, the production is continuous and the emphasis is
on uniform or standardized product.
4. Completed units and their associated costs are transferred to the next process,
if something is still to be done on those units. Completed units are transferred
to finished goods, if nothing is to be done.
5. A cost of production report s used to collect, summarize and compute the total
and unit cost.
6. Production in process at the end of a period is restated In terms of equivalent
units.

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4.3.2 DISTINCTION BETWEEN PROCESS COSTING AND JOB ORDER COSTING
Process costing and job order costing can differ in the following points:-

1. Job costing is applicable in situations where the objective is to identify costs

with specific products or jobs. Process costing on the other hand, is used in
cases of mass production of similar units that continuously pass through
different departments or processes.
2. In job costing manufacturing costs are accumulated for particular jobs. In
process costing manufacturing costs are accumulated for the entire
departments
3. In job costing production is generally dependant on customer orders and
specifications. Under process costing, production is done for building stock of
goods and for future sale.
4. Process costing is considered as a capital intensive; whereas job order is
characterized as a labor intensive process.
5. Exercise of control over jobs is relatively difficult as each job in separate and
unique. However, in process costing the exercise of control is easier, since the
processes are repetitive and more or less identical from period to period.
4.3.3 ADVANTAGE AND DISADVANTAGE OF PROCESS COSTING
ADVANTAGES

1. In process costing, the product is uniform type, so the computation of

average costs is easier.
2. The cost is calculated periodically and not at the completion of each job as is
done in the case of job costing.
3. The clerical efforts and costs are less as compared to job costing.
4. Effective control over production can easily be exercised.

DISADVANTAGES

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1. Since the process costs are average costs they are not always accurate. The
chances of errors are more. Moreover, once an error is committed in one
process it is carried over to the subsequent processes.
2. Since the process costs are collected at the end of the period, they are in the
nature of historical costs there may be use of excessive materials and labor but
they are not revealed until the end of the period.
3. Computation of average cost becomes more difficult when more than one type
of product is manufactured.
4.3.4 Tracking the flow of costs under process costing system
In process costing the accounting task is to track the flow of costs through the production
process. This task has two parts:-

1. Account for the cost of goods that have been completed in one department and
transferred to the next department.
2. Account for the cost of incomplete units that remains as a department’s ending
work in process inventory.
In process costing there can be different types of product flows

1. Sequential flow
 In this flow, all units produced go through the same process in the same sequence.
Department A Department B Department C

M, L, MOH ------------L, MOH-------------L, MOH-------------FINSHED GOODS

2. Parallel product flow

 Under this flow certain portion of the process are done simultaneously and they
then will be brought together. This means units are started in different department
and continued in one department to be produced as finished goods.

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Department A Department C

M, L, MOH----------L, MOH

Department E

L, MOH----------Finished goods

Department B Department D

M, L, MOH---------- L, MOH

3. Selective product flow

 In this flow the products will move to different departments with in the factory
depending up on the desired finished product.

Department B

L, MOH

Department A Department C

M,L, MOH L, MOH finished goods

Department D

L, MOH

Generally, under process costing system during the period some units can be started but will not
be completed by the end of the period. Therefore, the process costing helps to determine the
costs incurred in each department that are attributable to the units completed and the remaining

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still in process for that period. Units completed in one department are considered as output for
that departments were as in puts for the subsequent department.

4.4 IDENTIFYING THE EQUIVALENT UNITS OF PRODUCTION

Departmental supervisors are responsible for achieving the production goals assigned to their
departments. They direct and control the performance of the workers so that the desired output is
achieved on schedule and according to specifications.

Therefore, production report will be prepared for this purpose. Production report may include:-

1. The number of units started in production

2. The number of units completed and transferred out of the department
3. The number of units remaining in process.
4. Stage of completion of the ending work in process.
It is common to find that in a process some of the units are incomplete. The question arises on
how to properly account for these uncompleted units. These units have to be treated as equivalent
units of production. Equivalent units of production is a measure of the amount a work done
during a period expressed in terms of fully completed units of output. Units of incomplete goods
are converted to equivalent units of production by multiplying the number of units by the
percentage of completion.

The equivalent production for materials is the sum of the number of units completed and
transferred to the next department and the number of units remaining in process. The equivalent
production for labor and manufacturing overhead involves two important factors. The first factor
is the units transferred to the next department which are 100% completed in terms of labor and
manufacturing overhead. The second factor is the work still in process, which has been charged
both to labor and manufacturing overhead.

Example

The production data of process A for the month of March is given as follows:-

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Units placed in process……………………………………. 50,000

Units completed…………………………………………… 44,000

Units in process at the end of March (25% completed)……. 6,000

Total cost ………………………………………………….. 91,000 Br

Calculate the total equivalent units of production and the unit cost of equivalent units of
production.

Units completed……………………………………………….. 44,000

Ending in process X percentage of completion (6,000*25%)… 1,500

Total equivalent units completed 45,500

Unit cost of equivalent unit = 91,000 Br

45,500 units

= 2 Br/unit

Cost attached to finished units (44,000 units X 2 Br) = 88,000 Br

Cost attached to work in process (1,500 units X 2 Br) = 3,000

Total cost 91,000

4.5. IDENTIFYING BASIC STEPS IN PROCESS COSTING

The steps in process costing system may include

1. To calculate the total physical units for which the department is responsible or the total
units to be accounted for. This amount is equal to the total number of units worked on in
the department during the current period. That is beginning inventory plus units started.
2. Determine what happened to the units to be accounted for during the period. This step
also requires the use of physical units. These units may fit into one or two of the
following categories.

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 Completed and transferred
 Partially completed and remaining in the ending work in process inventory.
At this point, you should verify that the total units to be accounted for is equal the units that are
accounted for.

3. Use either the weighted average or FIFO method to determine the equivalent units of
production for each component.
4. Find the total cost to be accounted for, which includes the balance in work in process
inventory at the beginning of the period plus all current costs for direct materials, direct
labor and overhead.
5. Compute the cost per equivalent units for each cost component using either the weighted
average or FIFO equivalent units of production in step 3.
6. Use the cots computed in step 5 to assign costs to units completed and transferred from
the production process and to the units remaining in ending work in process inventory.
4.6 COST of PRODUCTION REPORT
The steps discussed previously can be combined in a cost production report. This process costing
document details all manufacturing quantities and costs, shows the computation of cost per
equivalent units of production, and indicates the cost assignment to goods produced during the
period. The cost of production report contains two sections:-

1. Quantity schedule
2. Cost schedule
The quantity schedule contains two parts:-

A. Quantity to be accounted for

 It shows the number and source of the units handled during the month
B. Quantity accounted for
 shows what happened to units reported in the first half of the quantity schedule
Note that, the total units to be accounted for must be equal to the total units accounted
for. The cost schedule contains two parts:-

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A. Cost to be accounted for
 Shows which costs are charged to or accumulated by the department. Unit costs
broken down by the cost elements are also presented in this section.
B. cost accounted for:-
 Shows the distribution of accumulated cost to units completed and transferred,
and units still in process.
The total cost to be accounted for must equal the total cost to account for.

There are two alternative methods of accounting for cost flows in process costing.

1. Weighted average method

2. FIFO method
In retail business, the weighted average method is used to determine an average cost per unit of
inventory. This cost is computed by dividing the total cost of goods available by total units
available. Total cost and total units are found by adding purchases and beginning inventory.

In the FIFO method of accounting, the cost of beginning inventory is the first cost sent to cost of
goods sold, units remaining in the ending inventory are costed at the most recent purchase prices.

4.6.1 Weighted average method

To determine production quantity for the period, the weighted average method of computing
equivalent units of production adds the beginning work in process units, the units started and
completed during the current period, and the equivalent units of production in ending inventory.
The number of units started and completed equals the total units completed during the current
period minus the units in beginning inventory.

Example: - Quincy manufacturing company operating and cost information for May 1997 is
provided as follows:-

Beginning work in process[60% complete] 5,000 physical units

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Units started in may 105,800 units

Units completed and transferred in may 110,000 units

Ending work in process [30% complete] 800 units

Cost of beginning inventory 30,051.20

Cost of current period 561,937.60

The weighted average equivalent units of production will be:-

Beginning inventory units 5,000

Units started and completed in May [110,000-5,000] x100% 105,000

Work performed on ending inventory during May [800x30%] 240

Weighted average equivalent units of production 110,240

The weighted average method is not concerned about the quantity of work that was performed in
the prior period on the units in beginning inventory. This method focus only on the units that are
completed in the current period and the units that remains in the ending inventory. Because this
method does not distinguish between units in the beginning inventory and units worked on only
during the current period, the weighted average method also does not differentiate between
beginning inventory and the current period costs.

The numerator of the per unit cost formula for the weighted average method is composed of the
cost of beginning inventory plus the cost incurred in the current period.

Beginning inventory cost 30, 051. 20

Current period cost 561, 937.60

Total cost be accounted for 591, 988.80

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The sum of beginning inventory and current period production cost is called total cost to account
for. Average unit cost is found by dividing the total cost to be accounted for by the total
equivalent units of production.

Weighted average units cost= Beginning work in process cost + current period cost

Total weighted average equivalent units of production

=591, 988, 80

= 110,240

=5. 37 Birr/unit

 Note that, under weighted average method, costs and units (respectively) from two
different periods are totaled to form the numerator and denominator used to calculates the
average unit cost.
4.6.2. FIFO Method.
The FIFO method of determine equivalent units of production more realistically reflects the way
in which goods actually flow through the production system. The FIFO method computation of
equivalent units of production adds the equivalent units of work performed on beginning
inventory units in the current period, the units started and completed during the current period,
and the equivalent units in ending inventory. FIFO method computes equivalent units of
production as follows:-

Equivalent units of work performed on:-

Beginning inventory during May [5,000 x40%] 2,000

Units started and completed in May [110,000 - 5,000] x100% 105,000

Work performed on ending inventory during May [800x30%] 240

FIFO equivalent units of production 107,240

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By ignoring the work performed on the beginning inventory units in the prior period, FIFO
focuses specifically on the work performed during the current period. The FIFO equivalent units
of production can now be used to compute a per unit cost, however, because the denominator for
the FIFO method includes only current period cost information, the numerator must also reflect
only current period cost information. The FIFO average cost per equivalent unit is calculated as
follows:-

Average FIFO unit cost = current period costs

Total FIFO equivalent units of production

 There is only one difference between weighted average and FIFO process costing, and
that difference lies in the treatment of beginning inventory for equivalent units of
production calculation.
Illustration-2

Faire more steel production and cost information for November 19x7are as follows:-
Beginning inventory (40% complete as to conversion cost) 15,000 units

Units started during current period 977,800

Units completed and transferred to finished goods 980,000

Ending inventory (80% complete as to conversion cost) 12,800

Cost of beginning inventory
Direct material 988,880Br
Direct labor 459,024
Overhead 435,912 1,883,816 Br
Current period cost
Direct material 90,348,720 Br
Direct labor 59,054,400
Overhead 63,385,056 212,788,176 Br
Required:-

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Prepare the cost of production report using:
1. Weighted average method
2. FIFO method

Solution

A. Weighted average method

Step 1. Calculate the total units to account for

Beginning inventory 15,000

Units started during the current period 977,800

Units to be account for 992,800

Step 2. Calculate the total units accounted for

Units completed and transferred 980,000

Units in ending work in process inventory 12,800

Units accounted for 992,800

Step 3. Determine the equivalent units of production

Units started and completed during November = 980,000-15,000

= 965,000 units

Note that, ending inventory is 100% complete as to material and 80% complete as to conversion
costs (labor and overheads).

Direct materials Conversion cost

Beginning inventory (whole units) 15,000 15,000

Units started and completed 965,000 965,000
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Ending inventory (whole units X %complete) 12,800 10,240
Equivalent units of production 992,800 990,240

Step 4. Determine the total cost to be accounted for

The total cost to be account for equals the costs included in beginning inventory plus current
period costs.

Direct material Direct labor Overhead Total

Beginning inventory 988,880 Br 459,024 435,912 1,883,816

Current period costs 90,348,720 59,054,400 63,385,056 212,188,176

Cost to be account for 91,337,600 59,513,424 63,620,968 214,671,992

Step 5. Determine the cost per equivalent unit of production

Unit cost = Beginning inventory cost + current period cost

Weighted average equivalent units of production

= Total cost incurred

Total equivalent units of production

Direct material Direct labor Overhead

Beginning inventory cost 988,880 Br 459,024 Br 435,912 Br
Current period costs 90,348,720 59,054,400 63,385,056
Total cost incurred 91,337,600 59,513,424 63,820,968
Equivalent units of production 992,800 990,240 990,240

Unit cost =91,337,600 = 92 Br 59,513,424 =60.1Br 63,820,968 = 64.45

992,880 990,240 990,240
Step 6. Assign costs to inventories, that is:-

1. The goods completed and transferred

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2. The ending work in process inventory
Ending inventory

Direct material [12,800x 92 Birr] 1,177,600

Direct labor [10,240x 60.1 Birr] 615,424

Overhead [10,240x 64, 45Birr] 659,968

Total cost of ending inventory 2,452,992

Cost assigned to goods completed and transferred [216.55 Br* X 980,000] 212,219,000

Plus:-Total cost of ending inventory 2,452,992

Total cost to be accounted for 214,677,992

* 92 Br + 60.1 Br + 64.45 Br = 216.55 Br

Therefore, the steps and concepts discussed above should be considered when determining the
equivalent units of production, which in turn leads to the cost of units still in process and units
completed and transferred to the next department.

B. FIFO method
Step 1 and step 2 are the same for FIFO method as the weighted average method.

Step 3. Determine the equivalent units of production.

Direct material Direct labor

Beginning inventory -0- 9,000

Tons started and completed 965,000 965,000

Ending inventory (whole units x % complete) 12,800 10,240

Equivalent units of production 977,800 984,240

Step 4. Determine the total cost to be accounted for

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This step is the same as it was under the weighted average weighted method. That is
214,671,992 Birr.

Step 5. Calculate the cost per equivalent units of production (unit cost)

Direct material Direct labor Overhead

Current period costs (A) 90,348,720 59,054,400 63,385,056

Equivalent unit of prod (B) 977,800 984,240 984,240

Unit cost (A/B) 92.4 Br 60 Br 64. 4 Br

Step 6. Assign costs to inventories

Transferred

Beginning inventory [prior period costs] 1,883,816

Completion of beginning inventory

Direct material [0 x 92. 4Br] 540,000

Direct labor [9,000x 60Br] 579,600

Overhead [9,000 x 64. 4Br] 3,003,416

Units started and completed [965,000 x 216.80Br*] 209,212,000

Total cost transferred 212,215,416

* 92.4Br + 60Br + 64.4 Br =216.8Br

Ending inventory

Direct material (12,800x92.4Br) 1,182,720

Direct labor (10,240x60Br) 614,400

Overhead (10,240x64.4Br) 659,456

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Total cost of ending inventory 2,456,576

Total cost to be accounted for = 212,215,416 + 2,456,576

=214,671,992 Br

Journal entry in process costing

1. Work in process inventory 90,348,720

Raw materials inventory 90,348,720

2. Work in process inventory 59,054,400

Factory payroll clearing 59,054,400

3. Manufacturing overhead 63,385,056

Various accounts 63,385,056

4. Work in process inventory 63,385,056

Manufacturing overhead 63,385,056

Note that, the above journal entries are the same for both weighted average and FIFO method.
But, the difference is on the next journal entry.

5. For FIFO method:-

Finished goods inventory 212,215,416

Work in process inventory 212,215,416

For Weighted average method:-

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Finished goods inventory 212,219,000

Work in process inventory 212,219,000

4.7. Accounting for Spoilage costs-under process costs

Spoilage is unacceptable units of production that are discarded or are sold for reduced prices.
The accounting procedures in this section highlight spoilage costs so that they are not ignored or
buried as an unidentified part of the costs of good units manufactures. Spoilage is divided into
two: normal and abnormal.

Normal spoilage is spoilage that arises under efficient operating conditions; it is an inherent
result of the particular production process. For a given production process, management must
decide the rate of spoilage it is willing to accept as normal. Costs of normal spoilage are typically
viewed as a part of the costs of good units manufactured, when good units cannot be made
without the simultaneous appearance of spoiled units.

Normal spoilage rates should be computed using the total good units completed as the based, not
the total actual units started. Why? Because total actual units stated also include any abnormal
spoilage in addition to normal spoilage. Normal spoilage is considered by business as something
that can not be avoided or controlled in the production process.

Abnormal spoilage is spoilage that is not expected to arise under efficient operating conditions;
it is not an inherent part of the chosen production process. Most abnormal spoilage is usually
regarded as avoidable and controllable. Line operators and other plant personnel can generally
decrease abnormal spoilage by minimizing machine breakdowns, accidents, and the like.
Abnormal spoilage costs are written off as losses of the accounting period in which detection of
the spoiled units occurs. For the most informative feedback, the Loss from Abnormal Spoilage
account should appear in a detailed income statement as a separate line item and not be buried as
an indistinguishable part of the cost of goods manufactured.
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Many companies adhere to a perfection standard as a part of their emphasis on total quality
control. Their ideal goal is zero defects. Hence, all spoilage would be treated as abnormal.

Process Costing and Spoilage

A key issue in accounting for spoilage in process-costing systems is how to count spoiled units.
Units of abnormal spoilage should be counted and recorded separately. But what units of
abnormal spoilage should be counted and recoded? These units can either be counted (Approach
A) or not counted (Approach B).

Approach A leads to more accurate product costs because it makes visible the costs associated
with normal spoilage and spreads it over good units.

Approach B is less accurate because it spreads the costs of normal spoilage over all units.

Example: Anzio Co. manufactures a wooden recycling container in its Forming Department.
Direct materials for this product are introduced at the beginning of the production cycle. At the
start of production, all direct materials required to make one output unit are bundled in a single
kit. Conversion costs are added evenly during the cycle. Some units of this product are spoiled as
a result defects only detectable at inspection of finished units. Normally spoiled units are 10% of
the goods output. Summary of data for July 2004 are:

Physical Units for July 2004

Work in Process, beginning inventory (July 1) 1,500 units
Direct Materials (100% complete)
Conversion costs (60% complete)
Started during July 8,500 units
Completed and transferred out during July 7,000 good units
Work in Process, ending inventory (July 31) 2,000 units
Direct Materials (100% complete)
Conversion costs (50% complete)
Total Costs for July 2004

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Work in process, beginning inventory
Direct materials (1,500 equivalent units * Br. 8) Br. 12,000
Conversion costs (900 equivalent units * Br.10) 9,000 Br. 21,000
Direct materials costs added during July 76,500
Conversion costs added during July 89,100
Total costs to account for Br.186, 600

Step 1: Summarize the Flow of Physical Units of Output. Identify units of both normal and
abnormal spoilage.

Spoiled Units= (Beginning units + Units started)-(Goods units transferred out + ending units)

= (1,500+8,500) – (7,000 + 2,000)

= 1,000 units
Normal Spoilage is 10% of the 7,000 units of good output, or 700 units. Thus,
Abnormal Spoilage = Total Spoilage – Normal Spoilage
= 1,000-700
= 300units
Step 2: Compute output in terms of Equivalent Units.
Step 3: Compute Equivalent unit costs.
Step 4: Summarize Total Costs to Account for.
Step 5: Assign Total Costs to units completed, to spoiled units, and to units in ending work-in
process.

A. Weighted Average
Physical units and Equivalent units (Step 1&2)
Equivalent Units
Flow of Production Physical Direct Conversion
Units Materials costs

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Work in process, beginning 1,500
Started during current period 8,500
To account for 10,000
Goods units completed and transferred out
during current period:
7,000 7,000 7,000
Normal Spoilage
700 700 700
700*100%; 700*100%
Abnormal Spoilage
300 300 300
300*100%; 300*100%
Work in process, ending
2,000 2,000 1,000
2,000*100%; 2,000*50%
Accounted for
10,000
Work done in current period
10,000 9,000

Calculation of Product Costs (Steps 3, 4, and 5)

Total Direct Conversion
Production Materials costs
Costs
(Step 3) Work in process, beginning Br.21,000 Br.12,000 Br.9,000
Costs added during the current period 165,600 76,500 89,100
Costs incurred to date divided by Br. 88,500/ Br. 98,100/
Equivalent units of work done to date 10000 9000
Cost per equivalent unit of work done Br.8.85 Br.10.90
(Step 4) Total costs to account for
(Step 5) Assignment of Costs Br.186,600
Goods units completed and transferred
out (7,000 units)

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Costs before adding normal spoilage
Normal Spoilage (700 units) 138,250 (7,000*8.85) (7,000*10.9)
Total cost of goods completed and transferred 13,825 700*8.85 700*10.9
out
152, 075
Abnormal Spoilage(300 units)

5,925 300*8.85 300*10.90

Work in process, ending (2,000 units)
Direct Materials
17,700 2,000*8.85
Conversion costs
10,900 1,000*10.90
Total work in process
28,600
Total costs accounted for
Br186,600

B. FIFO Method
Equivalent Units
Flow of Production Physical Direct Conversion
Units Materials costs
Work in process, beginning 1,500
Started during current period 8,500
To account for 10,000
Good units completed and transferred out
during current period
From beginning work in process
1,500
1,500*(100%-100%); 1,500*(100%-60%)
0 600
Started and Completed
5,500
5,500*100%, 5,500*100%
5,500 5,500
Normal Spoilage
700

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700*100%;700*100% 700 700
Abnormal Spoilage 300
300*100%; 300*100% 300 300
Work in process, ending 2,000
2,000*100%; 2,000*50% 10,000 2,000 1,000
Accounted for 8,500 8,100
Work done in current period

Calculation of Product Costs (Steps 3, 4, and 5)

Total Direct Conversion
Production Materials costs
Costs
(Step 3) Work in process, beginning Br.21,000
Costs added current period 165,600 76,500/ 89,100/
Divided by equivalent units of work 8,500 8,100
done in current period
Costs per equivalent unit of work done in the
current period Br. 9 Br. 11

(Step 4) Total costs to account for

(Step 5) Assignment of Costs Br.186,600

Good units completed and transferred out

(7,000 units)
Work in process, beginning (1,500 units)
Direct Materials added in current period Br. 21,000
Conversion costs added in current period 0 0*9
Total from beginning inventory before 6,600 600*11
spoilage
27,600

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Started and completed BNS(5,500units)
Normal Spoilage (700 units) 110,000 5,500*9 5,500*11
Total costs of goods units transferred out 14,000 700*9 700*11
Abnormal Spoilage (300 units) 151,600
Work in process, ending (2000 units) 6,000 300*9 300*11
Direct Materials
Conversion costs 18,000 2000*9
Total work in process, ending 11,000 1,000*11
Total costs accounted for 29,000
Br.186,600

Journal Entries
Weighted Average FIFO
Finished Goods 152,075 151,600
Work-in Process-Forming 152,075 151,600
(To transfer good units completed in July)
Loss from Abnormal Spoilage 5,925 6,000
Work-in Process-Forming 5,925 6,000
(To recognize abnormal spoilage detected in July)

 Synopsis

 In process costing the accounting task is to track the flow of costs through the production
process. This task has two parts:-
3. Account for the cost of goods that have been completed in one department and
transferred to the next department.
4. Account for the cost of incomplete units that remains as a department’s ending
work in process inventory.

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 In process costing there can be different types of product flows
o Sequential flow
o Selective product flow
o Parallel product flow
 Equivalent units of production is a measure of the amount a work done during a period
expressed in terms of fully completed units of output
 . Production report may include:-
 The number of units started in production
 The number of units completed and transferred out of the department
 The number of units remaining in process.
 Stage of completion of the ending work in process.
 The steps in process costing system may include
7. To calculate the total physical units for which the department is responsible or the
total units to be accounted for. This amount is equal to the total number of units
worked on in the department during the current period. That is beginning inventory
plus units started.
8. Determine what happened to the units to be accounted for during the period. This step
also requires the use of physical units. These units may fit into one or two of the
following categories.
 Completed and transferred
 Partially completed and remaining in the ending work in process
inventory.
9. Use either the weighted average or FIFO method to determine the equivalent units of
production for each component.
10. Find the total cost to be accounted for, which includes the balance in work in process
inventory at the beginning of the period plus all current costs for direct materials,
direct labor and overhead.
11. Compute the cost per equivalent units for each cost component using either the
weighted average or FIFO equivalent units of production in step 3.
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12. Use the cots computed in step 5 to assign costs to units completed and transferred
from the production process and to the units remaining in ending work in process
inventory
 The cost of production report contains two sections:-
 Quantity schedule: It shows the number and source of the units handled during
the month
 Cost schedule: shows what happened to units reported in the first half of the
quantity schedule
 The cost schedule contains two parts:-
 Cost to be accounted for: Shows which costs are charged to or accumulated by the
department. Unit costs broken down by the cost elements are also presented in
this section.
 Cost accounted for: Shows the distribution of accumulated cost to units completed
and transferred, and units still in process.
 There are two alternative methods of accounting for cost flows in process costing.
o Weighted average method
o FIFO method
 There is only one difference between weighted average and FIFO process costing, and
that difference lies in the treatment of beginning inventory for equivalent units of
production calculation.

 Wrap-up Discussion & Exercise Questions

8. What is meant by the term equivalent units of production when the weighted-average
method is used?
9. Clonex Labs Company uses a process costing system. The following data are available
for one department for October:
o Work in process, Oct.1 30,000 (materials, 60% completion; conversion costs,
30% completion)

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o Work in process, Oct. 31 15,000 (materials, 80% completion; conversion costs,
40%completion )
The department started 175,000 units and completed 190,000 during October. Calculate
the equivalent units of production using FIFO method.
10. Pure Form Corporation manufactures a product that passes through two departments.
Data for a recent month for the first department as follows:
Units Materials Labor Overhead
Work in process, beginning 5,000 Br. 45,000 Br.12,500 Br.18,750
Units Stated in process 45,000
Units transferred out 42,000
Work in process, ending 8,000
Costs added during the month 528,000 215,000 322,500

The beginning work in process inventory was 80% complete as to materials and 60%
complete as to processing. The ending work in process inventory was 75% complete as to
materials and 50% complete as to processing.
Instructions
a. Assume that the company uses the weighted-average method of accounting for
units and unit costs, prepare a cost of production report for this month.
b. Prepare a cost of production report for the month using FIFO method.
11. CHAW Plastics makes plastics real lamps for cars using an injection molding process.
The following information actual cost of direct material and direct labor for April 2006 is
available.
Direct Materials Direct Labor
Equivalent Total Equivalent Total
Units Costs Units Costs
Work in process, April1* 15,000 Br. 60,000 ? Br. 50,000
Work done during April 1 25,000 105,000 ? 110,000
To account for 40,000 Br. 165,000 ? Br. 160,000

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Units completed and
Transferred in April 24,000 ? 24,000 ?
Work in process, April 30** 16,000 ? ? ?
 Degree of completion: direct materials, 100%;
Conversion costs, 80%,
 Degree of completion: direct materials, 100%;
Conversion costs, 60%
Manufacturing overhead costs are 40% of direct labor costs.
Required:
A. Prepare a cost of production report for the month of April 2006 using weighted-average
method.
B. Prepare a cost of production report for the month of April 2006 using FIFO method.
C. Prepare journal entries to record the following transaction using weighted-average
method.
(1) Issuance of direct materials
(2) Direct labor costs
(3) Manufacturing overhead costs applied
(4) The transfer of completed units to finished goods
D. Using FIFO method, prepare journal entry to record transfer of completed units
to finished goods.
12. Shemsu Company makes super-premium cake mixes that go through two processes,
blending and packaging. The following activity was recorded in the Blending Department
during July:
Production data
Units in process, July 1: 30% complete
As to conversion costs 10,000
Units started in to production 170,000
Units completed and transferred to packaging ?
Units in process, July 31: 40% complete
as to conversion costs 20,000
Cost data:
Work in process inventory, July 1:
Materials cost Br. 8,500
Conversion cost 4,900 13,400
Costs added during the month:
Materials cost 139,400
Conversion cost 244,200 383,600

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Total cost Br. 397,000

All materials are added at the beginning of work in the Blending Department conversion costs
are added uniformly during processing.
Required:
1. If the company uses FIFO method, prepare a cost of production report.
2. If the company uses weighted-average method, prepare a cost of production report.

Chapter Five
Accounting for Joint Products, Cost Allocation and by Products
5.1. Introduction
Joint production occurs whenever two or more products must result from the same production
process. The key word in this definition is “must”. The crucial characteristics of joint products
are that the production of one automatically results in the production of the other. It is often
possible, of course, to eliminate one of the joint products; it is not economic to do so if the
product has a sales value greater than the unique costs of completing and marketing. For
example, in marble quarrying, it is possible to leave all the marble except the best grade at the
quarry site. If other grades must be quarried to obtain the best grade, it is not economic to leave
the other grades at the quarry so long as their sales value exceeds the unique costs of finishing
and selling. In this case, the quarrying of marble is a joint-production process because, in
quarrying pure white marble, it is necessary (from an economic point of view) to quarry other
grades.
The fact that joint products must be produced together is of the major importance to the cost
accountant because it means that all cost allocations among joint products are entirely arbitrary.
If two products must result from a single productive process, one product without both, the cost
of producing only one cannot be isolated. The facts are that it costs a certain sum of money to
produce a certain amount of each of two products. If part of the joint production cost is assigned

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to one of the products, it is a meaningless allocation. This is the most important point to
remember about joint cost accounting because it is this characteristics that makes it necessary
traditional cost accounting techniques.
5.2. Learning Objectives
After studying this chapter, students should be able for
 Identify split off point in a joint cost situation
 Distinguish between joint products and by products
 provide several reasons for allocating joint costs to individual products
 Distinguish alternative methods of allocating joint costs
 Describe why we sales value at split off method is widely used
 Describe the irrelevance of joint costs in to sell or process further
 Distinguish alternative methods of accounting for by products
5.3. Joint produced
Joint products are two or more manufactured products (1) that have relatively significant sales
values and (2) that are not separately identifiable as individual products until their split of point.
The split-off point is that juncture of manufacturing were the joint products become individually
identifiable. Any cost beyond that stage are called separable cost because they are part of joint
process and can be exclusively identified with individual products. Examples, of joint products
include chemicals, petroleum refining, and meat packing.
5.4. Definition of terminologies related to joint costs

1. Joint Costs--joint costs are the costs of the common manufacturing process
2. Joint Products--joint products are the products produced from a common input and a
common manufacturing process
3. By-products-- are joint products that are relatively minor in quantity and/or value
4. Split-off Point--the split-off point is the stage of the common manufacturing process
where the joint products are separated

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5.5. Joint Cost Allocations
The accounting for joint products is essentially a problem of apportioning the joint costs, which
are incurred on behalf of two or more products. Such apportionment serves the following
objectives.
a) To determine the unit costs of products.
b) To help in inventory valuation
c) To determine the profit or loss on each line of product.

The various method of apportionment of joint costs discussed below are based mainly on
individual opinion and tend to produce only approximate results. This is because no perfectly
logical basis exists for the apportionment of joint cost to products and most of the methods are
arbitrary. Therefore, while selecting a particular method it should be kept in mind that the
method should be logical, appropriate and reliable and should be consistently followed.

The following are the main methods of making the apportionments of joint costs.

Approach-1 Allocate cost using Market based – information

A. The sales value at split of method

1. On the basis of unit price
2. On the basis of sales value.
B. The estimated net realizable value (NRV) method
C. The constant gross margin percentage NRV method
Approach-2 Allocate costs using physical measure based data such as weight or value.

A. Physical measure method

B. The average unit cost method

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5.5.1. APPROACH-1 ALLOCATE COSTS USING MARKET BASED
INFORMATION
Under this method, joint costs are apportioned between various joint products according to the
market value of each product. This is based on the argument that the market value of any product
is a manifestation of the cost incurred in it’s production-means, if product is sold at a higher
price, it is because more costs was expended to produce it.

A. The sales value at split off method

 The sales value at split off point method exemplifies the benefit received criteria to
allocate the joint cost incurred or it can be said that costs are allocated based on their
ability to contribute revenue.
 The sales value at split-off method allocate joint cost on the basis of the relative sales
value at the split off point of the total production in the accounting period of each
product. It has the following variant.
1. On the basis of unit price
In this method, the selling price per unit of the various joint products is taken as the basis for
apportionment of joint cost or joint cost is apportioned to various joint products in the ratio of
selling prices of individual joint product with out any regard to the quantities.

Example: - Joint cost for product A, B & C is 9000 Birr. The selling price of A, B & C is 12,
8 and 4 respectively

Required - Allocate the joint cost using unit selling price method

Solution:-

Product Selling Price/Unit Weight Joint cost allocated

A 12 12/24 12/24 * 9000 = 4500

B 8 8/24 8/24 * 9000 = 3000

C 4 4/24 4/24 * 9000 = 1500

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Total 24 9000

 This method is suitable when the number units product are equal

2. On the basis of sales value

In this method the apportionment is done on the basis of weighted sales value.

i.e. = Number of unit produced and sold * Selling price per unit

This method gives due consideration to the quantities of the various joint product produced.

Illustration-1: Joint cost of product A, B and C is 9000 Birr. The following information is given
related to the number of unit produced and unit selling price.

Number of unit produced Selling price

A – 200 12

B – 600 8

C – 700 4

Required: – Allocate joint costs using the sales value method

Solution:-

Product Selling price Units Sales Weight Allocation of Cost per unit
per unit(A) value joint cost
(B) E=D/10000 F/B
D=(A*B)
F=9000*E
A 12 200 2400 2400/10000 2160 10.80

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B 8 600 4800 4800/10000 4320 7.20

C 4 700 2800 2800/10000 2520 3.6

10000 9000

 This method will give satisfactory results even when numbers of units of different joint
products are widely different.
An illustration -2 Farmer’s Dairy purchase raw milk from individual farms and processes it

up to the split off point, where two products (cream and liquid skim) are obtained. These two

products are sold to an independent company which markets and distributes them to

supermarkets and other retail outlets.

Row milks processed: 110 gallon (110 gallons of raw milk yield 100 gallons of good product

with 10gallon shrinkages)

Production Sales

Cream 25 gallons 20 gallons at 8 birr per gallon

Liquid skim 75 gallons 30 gallons at 4 birr per gallon

Beginning Inventory Ending Inventory

Raw milk 0 gallons 0 gallons

Cream 0 gallons 5 gallons

Liquid Skin 0 gallons 45 gallons

Additional Information

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 Cost of purchasing 110 gallons of raw milk and processing it up to the split off point to
yield 25 gallons of cream and 75 gallons of liquid skim is 400 birr.

Required: - 1. Allocate the joint cost using sales value method

2. Prepare income statement for individual product

Solution:-

R-1 joint cost allocation

Items Liquid
Cream skim Total

1.Sales value at split off point

(Cream 25 gall. * 8, liquid skim 75 gall * 4) 200 300 500

2. Weight (200 500, 300 500) 0.4 0.6

3. Joint cost allocated

(Cream 400 * 0.4, liquid skim 400 * 0.6) 160 240 400

4. Joint production cost per gallon

(cream 160 25 gallon, liquid skim 240  75

gallon) 6.4 3.2

Sales (Cream 20g * 8, 30g * 4 160 120 280

R-2 Income statement

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Items Liquid
Cream skim Total

Sales (Cream 20g * 8, 30g * 4) 160 120 280

Joint cost
Production cost (cream 0.4 * 400,Liquid skim 0.6 * 400) 160 240 400

Deduct ending Inv (Cream 5g * 6.4, 45g * 3.2) 32 144 176

Cost of good sold 128 96 224

Gross margin 32 24 56

B: The Estimated Net Realizable value (NRV) Method

 This method is used where products are not saleable in their stage at the split off point
and required further processing to place them in a marketable state. This product is sold
when this stage is complete, and there is no selling price available for apportionment at
the split off point.
 In such a case, there fore the basis of apportionment of joint cost is a hypothetical sales
value at the split off point
 In order to arrive in this hypothetical sales value at split-off point, we have to subtract
separable/ subsequent and marketing costs from the expected final sales value.
Illustration-1:-Assume the same situation of farmer’s Dairy example above, except that both
cream and liquid skim can be processed further.
Additional Information
 Cream Butter cream: 25 gallons of cream are further processed to yield 20 gallons of
butter cream at additional processing (separable) costs of 280 Birr. Better cream is sold
for 25 Birr per gallon.

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 Liquid skim condensed Milk: 75 gallons of liquid skim are further processed to yield
50 gallons of condensed milk at additional processing cost of 520 Birr. Condensed milk
is sold for 22 Birr per gallon.

Beginning Inv. Ending Inv.

Better cream 0 gallons 8 gallons
Condensed milk 0 gallons 5 gallons
Required:-
1. Allocate the joint cost using not realizable value.
2. Prepare an income statement for each product
Solution:-
R-1 joint cost allocation
Better Condensed
Cream(B.C) Milk(C.M) Total
1. Expected final sales value of production
(BC 20g x 25, CM 50g x 22) 500 1,100 1,600
2. Deduct expected subsequent cost 280 520 800
3. Estimated net realizable value at split off
point 220 580 800
4. Weight (220  800, 580  800) 0.275 0.725
5. Joint cost allocated
(B.C= 0.275 x 400, CM=0.725 x 400) 110 290 400
6. Production cost per gallon
B.C= (110 + 280)  20 gall. 19.50
C.M= (290 + 520) 50 galls. 16.20

R-2 Income statement

Better Condensed
Total
Cream(B.C) Milk(C.M)
Sales (B.C. 12gall x 25, CM 45gall x 22) 300 990 1290
Cost of good sold
Joint cost 110 290 400

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(B.C. 400 x 0.275, CM 400 x 0.725)
Separable processing costs 280 520 800
Cost of goods available for sale 390 810 1200
Deduct Ending Inventory
BC = 8gall x 19.50, CM 5 gall x 16.2) 156 81 237
Cost of good sold 234 729 963
Gross margin 66 261 327

Illustration–2:- XYZ Company incurred a joint cost of 9000 Birr and produces three products
A, B and C that have a selling price of 12, 8 and 4 respectively.
Additional information
Cost after split Product
Unit produced off point
A 200 400
B 600 800
C 700 800
2000
Required
1. Allocate joint cost
2. Determine the unit cost of each product

Solution:-
Items A B C Total
1. Sales (A-12 x 200, B-8 x 200 C-4 x 700) 2,400 4,800 2,800 10,000
2. Deduct subsequent cost 400 800 800 2,000
3. Estimated net realizable value 2000 4000 2000 8000
4. Weight (2000  8000, 4000  8000, 2000  8000) 0.25 0.5 0.25
5. Joint cost allocated
(A-9000 x 0.25, B- 9000 x 0.5, C- 9000 x 0.25) 2250 4500 2250 9000
6. Production cost per unit

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A = (2250 + 400)  200 13.25
B = (4500 + 800)  600 8.83
C = (2250 + 800)  700 4.36

C. Constant Gross-Margin percentage NRV Method

The constant gross-margin percentage NRV method allocates joint costs in such away that the
overall gross-margin percentage is identical for all the individual products. This method uses the
following three steps:
Step –1 Compute the overall gross-margin percentage
Step –2 Uses the overall gross-margin percentage and deduct the gross margin from the final
sales values to obtain the total costs that each product should bear.
Step –3 Deduct the expected separable costs from the total costs to obtain the joint-cost
allocation.
Generally in order to arrive at the net value the following are deducted from the sales value
a) Estimated Gross profit margin
b) Selling and distribution costs
c) After split of processing costs.
Illustration: - Assume the farmer’s Dairy example that further process and produce
- Condensed milk
- Better cream

Required:–
1 allocate the joint cost using constant gross profit margin
2. Prepare the income statement.

Solution:-
R-1 allocate the joint cost
Better Condensed Total

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cream(B.C) milk(C.M)
Step – 1
Expected final sales value of production
[(20gall x 25) + (50gall x 22)] 1600
Deduct joint and & separable cost
( 400 + 280 + 520) 1200
Gross margin 400
Gross margin percentage (400  1600) 25%
Step – 2
Expected final sales value of production
(BC – 20gall x 25, CM 50gall x 22) 500 1100 1600
Deduct, gross profit margin, using overall
Gross-margin percentage (25%) 125 275 400
Cost of good sold 375 825 1200
Step – 3
Deduct, separable cost to complete & sell 280 520 800
Joint cost allocated 95 305 400
R-2 income statement
Better Condensed Total
cream milk
Sales (B.C 12gall x 25, CM 48gall x 22) 300 990 1290
Cost of good sold
Joint cost 95 305 400
Separable cost to compete & sell 280 520 800
Cost of goods available for sale 375 825 1200
Deduct Ending Inventory
(BC. 8 x 18.75* , CM 5 x 16.50) 150 82.5 232.5
Cost of good sold 225 742.5 967.5
Gross margin 75 247.5 322.5
Gross margin percentage 25% 25% 25%
Production cost per unit
 B.C = 375  20 gallons = 18.75 per gallon
 C.M = 825  50 gallons = 16.50 per gallon
Illustration–2:- XYZ company incurred 9000 Birr of joint cost in the production process to
produce three products A, B and C and the selling price of product A, B and C is
12, 8, 4 respectively. The company further assumes that the estimated gross profit
margin is 25%.
Additional information

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Product Units Selling & dist. Cost Cost after split of
point
A 200 100 400
B 600 200 800
C 700 200 800
500

Required:-1. Computer the cost to be allocated to product A, B and C respectively

2. Compute the unit cost of product A, B and C respectively
Solution:-
R-1cost to be allocated to product A, B and C
A B C Total
1. Expected final sales value of production.
(200 x 12-A, B. 600 x 8 C-700 x 4)
2400 4800 2800 10,000
2. Deduct gross, margin, using overall gross-
margin percentage 25%
600 1200 700 2500
3. Cost of good sold 1800 3600 2100 7500
4. Deduct
 Selling & distribution- cost
 Separable cost 100 200 200 500
400 800 800 800
Net value 1300 2600 1100 5000
5. Weight (A=1300  5000, B=2600  5000,
C=1100  5000) 0.26 0.52 0.22
6. Joint cost allocated (9000 x 0.26, 9000 x
0.52, 9000 x 0.22)

2340 4680 1980 9000

Unit cost of production
A = 1800  200 9
B = 3600  600 6

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C = 2100  700 3

Illustration -2:- ABC Ltd manufactures three joint products A, B and C. In a period, the amount
spent up to the point of separation was Birr 20,600

Subsequent expenses were:

A B C
Material 300 200 150
Direct wages 400 300 200
Overheads 300 270 280
1000 770 630
Gross sales value of product A, B and C is Birr 15,000, 10,000 and 5,000 respectively. It was
estimated that the net profit percentage of sales would be 30%, 25% and 20% for A, B and C
respectively.
Required: Apportion the joint costs.
Solution
A B C Total
1. Sales value 15000 10000 5000 30000
2. Less estimated profit (30%, 25% & 20 resp.) 4500 2500 1000 8000
3. Cost of sale 10500 7500 4000 20000
4. Less subsequent costs 1000 770 630 2400
5. Basis of apportionment of joint cost 9500 6730 3370 19600
6. Weight (9500/19600,6730/19600, 3370/19600 0.49 0.34 0.17
7. Joint cost allocated (20,600) 10094 7004 3502 20600

5.5.2. Approach II: Allocating costs using physical measured data such as weight or
volume
A. Physical unit method /Physical measure method/

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Under this method the joint cost is apportioned/allocated/ on the basis of the relative weight,
volume or quantity --- etc of each product obtained at the point where the split off occurs. This
method is applicable when the unit of measurement is similar for all products.

Illustration -1:-Assume the farmers dairy example before requiring further processing.
Required: 1) Allocate the joint cost
2) Prepare income statement for each production
Solution
R-1 allocating joint cost
Cream Liquid Total
(C) skim(L.S)
1. Physical measure of production (gallon) 25 75 100
2. Weight (25  100, 75  100) 0.25 0.75
3. Joint cost allocation. (C-0.25 x 400, L 0.75 x 400) 100 300 400
4. Joint production cost per gallon
(cream 100  25, L.S – 300  75) 4 Birr 4 Birr

R-2 income statement

Cream(C) Liquid Total
skim(L.S)
1. Sales cream 20 gallon x 8, 15-30 x 4) 160 120 280
2. Joint cost
Production costs
(C – 0.25 x 400, LS 0.75 x 400) 100 300 400
Deduct ending inventory
Cream (5 x 4), L.S (45 x 4) 20 180 200
Cost of good sold 80 120 200
Gross profit 80 0 80

Illustration-2:- The following data have been extracted from the books of coke Co. Ltd
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Joint products Yield (in kg) of recovered products

per tone of coal

Coke 1,420

Coal tar 120

Benzol 22

Sulphate of Ammonia 26

Gas 412

2000

The price of coal is 80 Birr per tone. The direct labor and overhead costs to the point of split-off
are 40 Birr and 60 Birr respectively per tone of coal.

Requires – Calculate the material, labor, overhead costs of each product on the basis of weight

Yield in (weight Coal Apportioned cost

kg total)%
Direct labor MOH Total

Coke 1420 71 56.80 20.4 42.6 127.8

Coal tar 120 6 4.8 2.4 3.6 10.8

Benzol 22 1.1 0.88 0.44 0.66 1.98

Sulphate of Ammonia 26 1.3 1.04 0.52 0.78 2.34

Gas 412 20.6 16.48 8.24 12.36 37.08

Total 2000 100% 80 40 60 180

B. The Average Unit Cost Method

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- In this method, the joint cost is apportioned by using the average unit cost which is
obtained by dividing the total joint cost with the number of units produced.
- This is with the assumption that the average cost per unit of each product is the same.
Illustration: - From the following information, find out the cost of each product A, B and C
under the average unit cost method.

Information

- Pre-separation point cost 30000 Birr

- Other production Data
Product Units produced
A 1000
B 400
C 600
2000
Solution:

Average Unit costs = Total joint cost = 30000 Birr

No of unit produced 2000 unit

= 15 Birr per unit

Product Units produced Average unit cost Apportioned cost

A 1000 15 15000
B 400 15 6000
C 600 15 9000
2000 30000
N.B:- The average unit cost method cannot be applied where joint products cannot be expressed
in the same physical unit.

These methods also have a drawback because it assigns identical costs to joint products
when they are of different grades of qualities.

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5.6. ACCOUNTING FOR BY-PRODUCT

Processes that yield joint product often also yield what are frequently referred to as by-product-
product that have a relatively law sales value compared with the sales value of the main or joint
product (s)

The accounting, for by-products fall in two broad categories.

A. NON-COST METHOD (SALES VALUE METHOD)

- Under these method costs are not assigned to the by-product for costing purposes. Instead
any income resulting from the sale of the by-product is credited either to other income or
the main product
- Non-cost method has the following variants:
I) OTHER INCOME METHOD
- In this method any amount realized from the sale of the by-product is transferred to profit
and loss account as sundry income.
- It is suitable when the value of the by product is quite small in relation to the main
product.
- This method of accounting for by-products is simple, practical and requires no
computation of cost for the by product.
II) BY PRODUCT SALES ADDED TO THE MAIN PRODUCT SALES

- In this method, the combined sales figure of the entire main and by product is computed
and the total cost is deducted to arrive at the profit or loss figure.
- This method is based on the view that since it is physically impossible to produce one
product with out the other, then the accounting statement must reflect this by providing
combined figures.
III) BY-PRODUCT SALES VALUE DEDUCTED FROM TOTAL COST

- In this method, the sales value of the by-product is deducted from the total cost. Thus the
value of the by product reduces the cost of the main product.

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Illustration Dollar/Birr amount

Joint cost 5000

Add Subsequent cost on main product 1500
6500
Less sale of by-product 400
Less subsequent cost of by-product 100
300
Less selling & distribution cost 50 250
Net cost of the main product 6250
Add Selling and distribution cost of the main product 500
Total cost of the main product 6750
Net profit 750
Selling price of the main product 7500
IV) REVERSE COST METHOD

- In this method, the cost of the by-product is obtained by deducting the following from the
sales value of the by-product.
a) estimated profit margin
b) Selling and distribution expenses
c) After split off costs.
- This method is called a reverse method because the cost of the by product is arrived from
the sales value by working back.
- The cost of the by-product so arrived at is deducted from the joint cost and the final
figure is the cost of the main product.
Illustration: in manufacturing the main product, a company processes the incidental waste into
two by-products A and B. From the following data relating to the product you are
required to prepare a comparative profit and loss statement showing the individual
costs and other detail. The total costs up to separation point were 310,400 Birr.

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Main Product By product

A B

Sales 800,000 64,000 96,000

Cost after separation 80,000 12,800 14,400

Estimated net profit % age to sales value 20% 20%

Estimated selling expense as % of sales value 20% 10% 15%

- Use the reverse method for separation of joint cost

Solution:-

Cost allocated to by-product

A B Total

Sales 64,000 96,000

Less estimated net profit 12,800 19,200

Estimated selling exp. 6,400 14,400

Cost after separation 12,800 32,000 14,400 48,000 -

Cost included in a joint cost 32,000 48,000 80,000

Comparative profit and loss statement

Main product By product

A B
Joint cost up to separation point 310,400
Less cost allocated to By-product 80,000 32,000 48,000
230,400

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Cost after separation 80,000 12,800 14,400
Selling expense 160,000 6,400 14,400
Total cost 470,400 51,200 76,800
Net profit 329,600 12,800 19,200
Sales 800,000 64,000 96,000

 Synopsis

 Basics
 Joint costs: costs of production process that yields multiple products simultaneously
 Split off point: juncture in joint production process when two or more products
become separately identifiable
 Separable costs: all costs (manufacturing, marketing, distribution, etc.) incurred
beyond the split off point that are assignable to each of the specific products
identified at split off point
 Focus of joint costing
 Assigning costs to individual products at split off point
 Classifying outputs by sales value
 Changing values of products over time and distinctions of terms in organizations
 Purposes for allocating joint costs
 Computation of inventoriable costs and cost of goods sold for financial accounting
purposes and reports for income tax authorities
 Computation of inventoriable costs and cost of goods sold for internal reporting
purposes, used in division profitability analysis and affect evaluation of division
managers’ performance
 Cost reimbursement under contracts for companies that have few, but not all, of
products or services reimbursed under cost-plus contracts
 Insurance-settlement computations for damage claims made on basis of cost
information by company having joint products, main products, or byproducts

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 Rate regulation for one or more of the jointly produced products or services are
subject to price regulation
 Litigation in which costs of joint products are key inputs
 Approaches to allocating joint costs
o Market-based data, such as revenues, used as basis of allocation
o Physical measures data, such as weight or volume, of joint products
 Criterion to support use of market-based data as basis of joint cost allocation
 Cause-and-effect criterion not applicable by definition at individual product level
 Benefits-received criterion: revenues better indicator of benefits received than
physical measures
 Presence of byproducts can affect allocation of joint costs although byproducts have
much lower sales value than joint or main products
 Two methods of accounting for byproducts
o Method A: production method—byproducts recognized at time production is
completed
o Method B: sale method—byproducts recognized at time of sale

 Wrap-up Discussion & Exercise Questions

1. Why joint cost need to be allocated?

2. List and discuss the basic joint cost allocation methods.
3. Define by products
4. What is the need for accounting for by products?
5. Daily company produce a product used in preserving grain and other food products many
of the firms product are made in joint production progress one of such group is called
phenol group which resulted in a joint cost of Br. 240.000 and the following production
quantities and cost after split off in the month of June.

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Product Output in kg Selling Cost after split NRV at split off
price/kg off
PH 01 60,000 Br. 4 Br. 60,000 120,000
PH 02 30,000 8 120,000 100,000
PH 03 10,000 12 30,000 80,000
Total 100,000 210,000 300,000

Required
Allocate the joint cost for joint products in each of the following allocation bases
a) Physical units allocation method
b) Sales value allocation method
c) NRV joint cost allocation method
d) Gross profit percentage method
6. In Shaping Department of Royal Company, a byproduct is removed. The material is
further processed and then sold. The company uses the reversal cost method to account
for the by product. Data for December 20x3 follow:
Byproduct removed, 8, 200 kilograms.
o Estimated sales price of the by-product after further process, Br.1 per K.G.
o Estimated manufacturing cost after separation, Br.0.30 per K.G.
o Estimated selling and Administrative costs, 20% of sales price.
o Estimated normal net profit, 6% of sales price.
Instruction:
a) Compute the value to be assigned to the by product and removed from WIP at the point
of separation.
b) Make the necessary journal entries to:
I. Record the transfer of estimated costs incurred before separation to the by
product.
II. Record the additional processing costs after separation. Assume that costs to
further process the byproduct follows:
Materials……………………………………… Br. 1, 000
Labor…………………………………………. 1,200
Overhead…………………………………..…. 260

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CHAPTER 6:
Activity-Based Costing and Management

6.0. Learning Objectives

After completing this chapter, students will be able to:
 Explain the ABC concept and the reasons for development of ABC.
 Identify appropriate cost drivers under ABC.
 Calculate costs per driver and per unit using ABC.
 Compare ABC and traditional methods of overhead absorption based on production
units, labour hours or machine hours.
 Explain when to use ABC is more appropriate.
 Explain how ABC can assist the decision making for management.
 Describe the advantages and disadvantages of ABC.

6.1. Introduction
Activity-based costing (ABC) is a methodology for more precisely allocating overhead to those
items that actually use it. The system can be used for the targeted reduction of overhead costs.
ABC works best in complex environments, where there are many machines and products, and
tangled processes that are not easy to sort out. Conversely, it is of less use in a streamlined
environment where production processes are abbreviated.

Activity Based Costing

(a) Activity based costing (ABC) is a form of absorption costing. However, it

differs from traditional absorption costing, because it takes a different
approach to the apportionment and absorption of production overhead
costs.
(b) ABC involves the identification of the factors (cost drivers) which cause the
costs of an organization’s major activities. Support overheads are charged to

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products on the basis of their usage of an activity.
(i) For costs that vary with production level in the short term, the cost
driver will be volume related (labour or machine hours).
(ii) Overheads that vary with some other activity (and not volume of
production) should be traced to products using transaction-based cost
drivers such as production runs or number of orders received.

6.2. Reasons for the development of ABC

In recent years, there has been dramatic fall in the costs of processing information. And, with
the advent of advanced manufacturing technology (AMT), overheads are likely to be far more
important and in fact direct labour may account for as little as 5% of a product’s cost. It
therefore now appears difficult to justify the use of direct labour or direct material as the basis fro
absorbing overheads or to believe that errors made in attributing overheads will not be
significant.
Many resources are used in non-volume related support activities, such as setting-up,
production scheduling, inspection and data processing. These support activities assist the
efficient manufacture of a wide range of products and are not, in general, affected by changes
in production volume. They tend to vary in the long term according to the range and
complexity of the products manufactured rather than the volume of output.
Example 1

The wider the range and the more complex the products, the more support activities
will be required. Consider, for example, factory X which produces 10,000 units of
one product, the Alpha, and factory Y which produces 1,000 units each of ten
slightly different versions of the Alpha. Support activities costs in the factory Y are
likely to be a lot higher than in factory X but the factories produce an identical
number of units. For example, factory X will only need to set-up once whereas
factory Y will have to set-up the production run at least ten times for the ten different
products. Factory Y will therefore incur more set-up costs for the same volume of

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production.

6.3. Steps in application of ABC systems

An ABC system operates as follows:
Step 1: Identify an organization’s major activities.
Step 2: Identify the factors which determine the size of the costs of an activity/cause the
costs of an activity. These are known as cost drivers.
Step 3: Collect the costs associated with each cost driver into what are known as cost
pools.
Step 4: Charge costs to products on the basis of their usage of the activity. A product’s
usage of an activity is measured by the number of the activity’s cost driver it
generates.
It is not always obvious what the cost driver for an activity might be. A cost driver might be
unique to the activity. Here are some examples.

Activity Possible cost driver

Materials handling and storage Raw materials: purchases of materials

Finished goods: volume of products made

Customer order processing No. of customer orders

Materials purchasing No. of purchase orders

Quality control and inspection No. of inspections

Production planning No. of production runs or batches

Repairs and maintenance No. of machines, or machine hours operated

6.4. Traditional Absorption Costing Vs ABC systems

Traditional costing systems, which assume that all products consume all resources in
proportion to their production volumes, tend to allocate too great a proportion of overheads to

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high volume products and too small a proportion of overheads to low volume products.
ABC attempts to overcome this problem. The difference between traditional absorption costing
and ABC is shown by the following diagrams:

Although ABC is a form of absorption costing, the effect of ABC could be to allocate overheads
in a completely different way between products. Product costs and product profitability will
therefore be very different with ABC compared with traditional absorption costing.

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Example 2

Entity Blue makes and sells two products, X and Y. Data for production and sales
each month are as follows:

Product X Product Y
Sales demand 4,000 units 8,000 units
Direct material cost/unit $20 $10
Direct labour hours/unit 0.1 hour 0.2 hours
Direct labour cost/unit $2 $4

Production overheads are $500,000 each month. These are absorbed on a direct
labour hour basis.

An analysis of overhead costs suggests that there are four main activities that cause
overhead expenditure.

Activity Total cost Cost driver Total Product Product

number X Y
$
Batch setup 100,000 No. of set-ups 20 10 10
Order handling 200,000 No. of orders 40 24 16
Machining 120,000 Machine hours 15,000 6,000 9,000
Quality control 80,000 No. of checks 32 18 14
500,000

Required:

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Calculate the full production costs for Product X and Product Y, using:
(a) Traditional absorption costing
(b) Activity based costing.

Solution:
Traditional absorption costing
The overhead absorption rate = $500,000/ (4,000 × 0.1 + 8,000 × 0.2) = $250

Product X Product Y Total

$ $
Direct materials 20 10
Direct labour 2 4
Overhead (at $250 per hour) 25 50
Cost per unit 47 64

No. of units 4,000 8,000

Total cost $188,000 $512,000 $700.000

Activity based costing

Activity Total cost Cost driver Product Product
X Y
$ $ $ $
Batch setup 100,000 Cost/setup 5,000 50,000 50,000
Order handling 200,000 Cost/order 5,000 120,000 80,000
Machining 120,000 Cost/machine hour 8 48,000 72,000
Quality control 80,000 Cost/check 2,500 45,000 35,000
500,000 263,000 237,000

Product X Product Y Total

$ $ $
Direct materials 80,000 80,000
Direct labour 8,000 32,000
Overhead 263,000 237,000
Total cost 351,000 349,000 700,000

No. of units 4,000 8,000

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Cost per unit $87.75 $43.625

Using ABC in this situation, the cost per unit of Product X is much higher than with
traditional absorption costing and for Product Y the unit cost is much less.

The difference is caused by the fact that Product X use only 20% of total direct
labor hours worked, but much larger proportions of set-up resources, order
handling resources, machining time and quality control resources. As a result, the
overheads charged to each product are substantially different.

This is an important feature of activity-based costing. The overheads charged to

products, and so the overhead cost per unit of product, can be significantly different
from the overhead cost per unit that would be obtained from traditional absorption
costing.

6.5. When Using ABC might be more appropriate?

Activity based costing could be suitable as a method of costing in the following circumstances:
(a) In a manufacturing environment, where absorption costing is required for
inventory valuations.
(b) Where a large proportion of production costs are overhead costs, and direct labour
costs are relatively small.
(c) Where products are complex.
(d) Where products are provided to customer specifications.
(e) Where order sizes differ substantially, and order handling and despatch activity
costs are significant.

6.6. ABC and Decision Making

 The traditional cost behaviour patterns of fixed cost and variable cost are felt by
advocates of ABC to be unsuitable for longer-term decisions, when resources are not
fixed and changes in the volume or mix of business can be expected to have an impact on
the cost of all resources used, not just short-term variable costs.
 ABC attempts to relate the incidence of costs to the level of activities undertaken. A
hierarchy of activities has been suggested.

Classification Cause of cost Types of cost Cost driver

level

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Unit level Production / acquisition Direct materials Units produced
of a single unit of Direct labour
product or delivery of
single unit of service
Batch level A group of things being Purchase orders Batches produced
made, handled or Set-ups
processed Inspection
Product level Development, production Equipment Product lines
or acquisition of different maintenance produced
items Product development
Facility Some costs cannot be Building depreciation None – supports the
sustaining level related to a particular Organizational overall production or
line, instead they are advertising service process
related to maintaining the
buildings and facilities.
These costs cannot be
related to cost objects
with any degree of
accuracy and are often
excluded from ABC
calculations for this
reason.

6.7. Advantages and Disadvantages of ABC

6.7.1. Advantages of ABC:

The fundamental advantage of using an ABC system is to more precisely determine how
overhead is used. Once you have an ABC system, you can obtain better information about the
following issues:
 Activity costs. ABC is designed to track the cost of activities, so you can use it to see if
activity costs are in line with industry standards. If not, ABC is an excellent feedback tool
for measuring the ongoing cost of specific services as management focuses on cost
reduction.
 Customer profitability. Though most of the costs incurred for individual customers are
simply product costs, there is also an overhead component, such as unusually high
customer service levels, product return handling, and cooperative marketing agreements.
An ABC system can sort through these additional overhead costs and help you determine
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which customers are actually earning you a reasonable profit. This analysis may result in
some unprofitable customers being turned away, or more emphasis being placed on those
customers who are earning the company its largest profits.
 Distribution cost. The typical company uses a variety of distribution channels to sell its
products, such as retail, Internet, distributors, and mail order catalogs. Most of the
structural cost of maintaining a distribution channel is overhead, so if you can make a
reasonable determination of which distribution channels are using overhead, you can
make decisions to alter how distribution channels are used, or even to drop unprofitable
channels.
 Make or buy. ABC provides a comprehensive view of every cost associated with the in-
house manufacture of a product, so that you can see precisely which costs will be
eliminated if an item is outsourced, versus which costs will remain.
 Margins. With proper overhead allocation from an ABC system, you can determine the
margins of various products, product lines, and entire subsidiaries. This can be quite
useful for determining where to position company resources to earn the largest margins.
 Minimum price. Product pricing is really based on the price that the market will bear,
but the marketing manager should know what the cost of the product is, in order to avoid
selling a product that will lose a company money on every sale. ABC is very good for
determining which overhead costs should be included in this minimum cost, depending
upon the circumstances under which products are being sold.
 Production facility cost. It is usually quite easy to segregate overhead costs at the plant-
wide level, so you can compare the costs of production between different facilities.

6.7.2. Disadvantages of ABC

Many companies initiate ABC projects with the best of intentions, only to see a very high
proportion of the projects either fail or eventually lapse into disuse. There are several
reasons for these issues, which are:

 Cost pool volume. The advantage of an ABC system is the high quality of information

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that it produces, but this comes at the cost of using a large number of cost pools – and the
more cost pools there are, the greater the cost of managing the system. To reduce this
cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the
utility of the resulting information. Doing so should keep the number of cost pools down
to manageable proportions.
 Installation time. ABC systems are notoriously difficult to install, with multi-year
installations being the norm when a company attempts to install it across all product lines
and facilities. For such comprehensive installations, it is difficult to maintain a high level
of management and budgetary support as the months roll by without installation being
completed. Success rates are much higher for smaller, more targeted ABC installations.
 Multi-department data sources. An ABC system may require data input from multiple
departments and each of those departments may have greater priorities than the ABC
system. Thus, the larger the number of departments involved in the system, the greater
the risk that data inputs will fail over time. This problem can be avoided by designing the
system to only need information from the most supportive managers.
 Project basis. Many ABC projects are authorized on a project basis, so that information
is only collected once; the information is useful for a company’s current operational
situation, and it gradually declines in usefulness as the operational structure changes over
time. Management may not authorize funding for additional ABC projects later on, so
ABC tends to be “done” once and then discarded. To mitigate this issue, build as much of
the ABC data collection structure into the existing accounting system, so that the cost of
these projects is reduced; at a lower cost, it is more likely that additional ABC projects
will be authorized in the future.
 Reporting of unused time. When a company asks its employees to report on the time
spent on various activities, they have a strong tendency to make sure that the reported
amounts equal 100% of their time. However, there is a large amount of slack time in
anyone’s work day that may involve breaks, administrative meetings, playing games on
the Internet, and so forth. Employees usually mask these activities by apportioning more
time to other activities. These inflated numbers represent misallocations of costs in the

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ABC system, sometimes by quite substantial amounts.
 Separate data set. An ABC system rarely can be constructed to pull all of the
information it needs directly from the general ledger. Instead, it requires a separate
database that pulls in information from several sources, only one of which is existing
general ledger accounts. It can be quite difficult to maintain this extra database, since it
calls for significant extra staff time for which there may not be an adequate budget. The
best work-around is to design the system to require the minimum amount of additional
information other than that which is already available in the general ledger.
 Targeted usage. The benefits of ABC are most apparent when cost accounting
information is difficult to discern, due to the presence of multiple product lines, machines
being used for the production of many products, numerous machine setups, and so forth –
in other words, in complex production environments. If a company does not operate in
such an environment, then it may spend a great deal of money on an ABC installation,
only to find that the resulting information is not overly valuable.

6.8. Activity Based Management

Although specifically designated as an accounting function, determination of product cost is

amajor concern for all managers. The profitability of a particular product or market, product
pricing policies, and investments to support production are issues that extend beyond accounting
tothe areas of corporate strategy, marketing, and finance. In theory, the cost to produce a
productor to perform a service would not matter if enough customers were willing to buy that
product orservice at a price high enough to cover its cost and provide a reasonable profit margin.
In reality, customers purchase a product or service only if they perceive an acceptable value for
the price.
Management, then, should be concerned about an equitable relationship between selling price
and value. Activity-based management (ABM) is a business process model that focuses on
controlling production or performance activities to improve customer value andenhance
profitability. ABM includes a variety of concepts that help companies to

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• produce more efficiently,
• determine costs more accurately, and
• control and evaluate performance more effectively.
A primary component of activity-based management is activity analysis, which is the process of
studying activities both to classify them and to devise ways of minimizing or eliminatingthe
activities that increase costs but provide little or no customer value. In a business context, an
activity is any repetitive action that is performed in fulfillment of a business function.

 Synopsis

 Activity based costing (ABC) is a form of absorption costing that differs from traditional
absorption costing, because it takes a different approach to the apportionment and
absorption of production overhead costs.
 The following steps are applied in ABC costing systems:
Step 1: Identify an organization’s major activities.

Step 2: Identify the factors which determine the size of the costs of an activity/cause the
costs of an activity. These are known as cost drivers.
Step 3: Collect the costs associated with each cost driver into what are known as cost
pools.
Step 4: Charge costs to products on the basis of their usage of the activity. A product’s
usage of an activity is measured by the number of the activity’s cost driver it
generates.

 Traditional costing systems, which assume that all products consume all resources in
proportion to their production volumes, tend to allocate too great a proportion of
overheads to high volume products and too small a proportion of overheads to low
volume products.
 Activity based costing could be suitable as a method of costing in the following
circumstances:
o In a manufacturing environment, where absorption costing is required for
inventory valuations.
o Where a large proportion of production costs are overhead costs, and direct labour
costs are relatively small.
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o Where products are complex.
o Where products are provided to customer specifications.
o Where order sizes differ substantially, and order handling and dispatch activity
costs are significant.

 Wrap-up Discussion & Exercise Questions

1. What is the key difference between Activity based costing and Traditional absorption
costing systems?
2. At what situation(s) companies is use of ABC costing systems is more appropriate?
Why?
3. What are the advantages and disadvantages of ABC costing systems?
4. Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the
Poser (P). A traditional product costing system is used at present; although an activity
based costing (ABC) system is being considered. Details of the three products for a
typical period are:

Hours per unit Materials Production

Labour hours Machine hours Cost per unit ($) Units
Product D 0.5 1.5 20 750
Product C 1.5 1 12 1,250
Product P 1 3 25 7,000

Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis.
The overhead absorption rate for the period is $28 per machine hour.
Required:
(a) Calculate the cost per unit for each product using traditional methods, absorbing overheads
on the basis of machine hours.
Total production overheads are $654,500 and further analysis shows that the total production
overheads can be divided as follows:
%
Costs relating to set-ups 35

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Costs relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30
Total production overhead 100

The following total activity volumes are associated with each product line for the period as a
whole:

Number of set Number of movements Number of

ups of materials inspections
Product D 75 12 150
Product C 115 21 180
Product P 480 87 670
670 120 1,000

Required:
(b) Calculate the cost per unit for each product using ABC principles (work to two decimal
places).
(c) Explain why costs per unit calculated under ABC are often very different to costs per unit
calculated under more traditional methods. Use the information from Triple Limited to
illustrate.
(d) Discuss the implications of a switch to ABC on pricing and profitability.

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