Cost and Management Accounting I For 3rd Year Business Education Students

Woldia University Faculty of Business & Economics Department of Accounting & Finance
WOLDIA UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ACCOUNTING AND FINANCE

COST AND MANAGEMENT ACCOUNTING I
(ACFN2141)
FOR MANAGEMENT SECOND YEAR REGULAR
Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 1

Chapter One: introduction to cost and management accounting
1.1 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 two categories:
Internal parties, internal managers use the information for short-term planning and controlling
routine operations as well as use 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.
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 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:
1. Scorecard questions. Am I doing well or poorly?
2. Attention-directing questions. Which problems should I look into?
3. 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.
 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.
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 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.
1.2 The management process and Accounting
The management process summarizes the major activities performed by management in leading an
organization. A manager‘s work generally involves a cycle:
(a) Setting organizational objectives,
(b) Formulating an operating plan,
(c) Implementing the plan,
(d) Measuring the results,
(e) Evaluating the results to see if the plan was properly implemented and the objectives of the
organization are being accomplished.
Organizational objectives are not changed frequently, although slight modifications may be made
annually to keep them current and at a realistic level of aspiration.
The operating plan is formulated for a specific period of time, such as one year, and is prepared in
detail. Central to each of the planning activities, there is the accounting system. Financial resources
available in the business, as indicated in accounting reports, are frequently a limiting factor in the
development of organizational objectives. The planning process results in a budget representing the formal
plan of operations for the coming year.

The accounting function measures the results of operations and compares them with the planned level
of operations. Differences between the actual results and planned results help management to evaluate
each area of the business and to identify areas in which corrective action is required.
1.3 Financial Accounting, Management Accounting, and Cost Accounting
Accounting systems take economic events and transactions, such as sales and materials purchases, and
process the data into information helpful to managers, sales representatives, production supervisors, and
others. Processing any economic transaction means collecting, categorizing, summarizing, and analyzing.
For example, costs are collected by category, such as materials, labor, and shipping. These costs are then
summarized to determine total costs by month, quarter, or year. The results are analyzed to evaluate, say,
how costs have changed relative to revenues from one period to the next. Accounting systems provide the
information found in the income statement, the balance sheet, the statement of cash flow, and in
performance reports, such as the cost of serving customers or running an advertising campaign. Managers
use accounting information to administer the activities, businesses, or functional areas they oversee and to
coordinate those activities, businesses, or functions within the framework of the organization.
Understanding this information is essential for managers to do their jobs.
Individual managers often require the information in an accounting system to be presented or reported
differently. Consider, for example, sales order information. A sales manager may be interested in the total
dollar amount of sales to determine the commissions to be paid. A distribution manager may be interested
in the sales order quantities by geographic region and by customer-requested delivery dates to ensure
timely deliveries. A manufacturing manager may be interested in the quantities of various products and
their desired delivery dates, so that he or she can develop an effective production schedule. To
simultaneously serve the needs of all three managers, companies create a database—sometimes called a
data warehouse consisting of small, detailed bits of information that can be used for multiple purposes.
For instance, the sales order database will contain detailed information about product, quantity ordered,
selling price, and delivery details (place and date) for each sales order. The database stores information in
a way that allows different managers to access the information they need. Many companies are building
their own Enterprise Resource Planning (ERP) systems, single databases that collect data and feed it into
applications that support the company‘s business activities, such as purchasing, production, distribution,
and sales.
Financial accounting and management accounting have different goals. Financial accounting focuses
on reporting to external parties such as investors, government agencies, banks, and suppliers. It measures
and records business transactions and provides financial statements that are based on generally accepted
accounting principles (GAAP). The most important way that financial accounting information affects
managers‘ decisions and actions is through compensation, which is often, in part, based on numbers in
financial statements.
Management accounting measures analyzes, and reports financial and nonfinancial information that
helps managers make decisions to fulfill the goals of an organization. Managers use management
accounting information to develop, communicate, and implement strategy. They also use management
accounting information to coordinate product design, production, and marketing decisions and to evaluate
performance. Management accounting information and reports do not have to follow set principles or
rules. The key questions are always (1) how will this information help managers do their jobs better, and

(2) do the benefits of producing this information exceed the costs? Table 1 summarizes the major
differences between management accounting and financial accounting. Note, however, that reports such as
balance sheets, income statements, and statements of cash flows are common to both management
accounting and financial accounting.
Cost accounting provides information for management accounting and financial accounting. Cost
accounting measures, analyzes, and reports financial and nonfinancial information relating to the costs of
acquiring or using resources in an organization. For example, calculating the cost of a product is a cost
accounting function that answers financial accounting‘s inventory-valuation needs and management
accounting‘s decision-making needs (such as deciding how to price products and choosing which products
to promote).
Table 1: Major distinctions between management accounting and financial accounting
Areas of comparison Management Accounting Financial Accounting
Purpose Help managers make decisions to Communicate organization‘s financial

of information fulfill an organization‘s goals position to investors, banks, regulators,
and other outside parties
Primary users Managers of the organization External users such as investors, banks,
regulators, and suppliers
Focus& emphasis Future-oriented (budget for 2011 Past-oriented (reports on 2010
prepared in 2010) performance prepared in 2011
Rules of measurement Internal measures and reports do Financial statements must be prepared
and reporting not have to follow GAAP but are in accordance with GAAP and be
based on cost-benefit analysis certified by external, independent
auditors
Frequency of reporting When ever needed; may not be on Periodical on a regular basis
a regular basis
Focal point for analysis Various segments of the business Business entity as a whole
entity.
Behavioral Designed to influence the behavior Primarily reports economic events but
implications of managers and other employees also influences behavior because
manager‘s compensation is often based
on reported financial results
1.4 Cost terms and cost classifications
Many accounting reports contain several cost terminologies. A good understanding of the different
cost terminology is essential at least for the following two reasons.
 It enables accounting information users to best use the information provided.
 Use of common terminology avoids confusion and misunderstanding among the users
The following are some of the terms and concepts used in cost accounting
Cost, Expense and loss
One of the common confusion in accounting is the distinction between cost and expense. Many people
use cost and expense interchangeably. Thus, we start with the definition of these terms.

Accountants usually define cost as resource sacrificed or forgone to achieve a specific objective. It
refers to an outlay or expenditure of money to acquire goods and services in the course of generating
revenue. For instance purchase of raw material represent a cost as the raw material is used to produce
finished goods that generate revenue when sold. However some disbursements are not costs. For example,
payment of dividend is disbursement but it does not help to generate revenue, hence it is not a cost.
All costs initially represent an asset. As the asset is used in generating revenue, the amount consumed
becomes an expense. The cost of the asset used should then be recognized as an expense to properly match
revenues and expenses in the process of determining the income of the organization over a given period.
For instance, insurance premium paid in advance to serve the coming period are initially recognized as an
asset (prepaid insurance), but as time passes on, the asset is continually converted in to an expense
(Insurance expanse). Another example may be a motor vehicle bought for use for the coming five years is
an asset when initially purchased. However, as the asset is used up in the process of generating revenue,
the cost gradually becomes an expense. Thus, expenses are expired costs or costs used up in the course of
generating revenue.
The distinction between cost and expenses is important for the preparation of financial statement for
service, merchandising and manufacturing firms. In fact, it has more importance relatively for
manufacturing enterprise. This is because, costs incurred in the manufacturing process don‘t become
expense until the product is sold and thus, items that are fully or partially manufactured represent costs
and should be recognized as assets on the balance sheet. Therefore, financial reporting in manufacturing
firms has some complication as compared to financial reporting in the service and merchandising
business.
Sometimes, a firm may incur a cost that produces neither immediate nor future benefit. This is called a
loss. For example damage caused by fire or flood on property held is a loss.
Cost object: is defined as ‗any activity for which a separate measurement of cost is desired‘. It may be
an activity, or operation in which resources, like materials, labor, etc. are consumed. The cost object may
be a product or service, a project or a department, or even a program like eradication of illiteracy. Again,
the same cost may pertain to more than one cost objects simultaneously. For example, material cost may
be a part of product cost as well as production department cost.
Cost accumulation and cost Assignment: A costing system typically account for costs in two basic
stages, accumulation followed by assignment. Cost accumulation is the collection of cost data in some
organized means of accounting system and cost assignment is a general term that encompass both (1)
tracing accumulated cost that have direct relationship to the cost object and (2) allocating accumulated
costs that have an indirect relationship to the cost object. For example, a publisher that purchase paper
rolls for printing magazines collect the cost of paper bought and used in any one month to obtain the total
monthly cost of paper used. Beyond accumulating costs, the cost accountant assign cost to the different
magazines the publisher publish to help decision making
o Cost tracing: - is the assigning of direct costs to the chosen cost object.
o Cost allocation: - is the assigning of indirect costs to the chosen cost object.
o Direct costs are costs that are related to the particular cost object where as indirect costs are
costs that are common to two or more cost objects.
 Direct costs are traced to the cost object where as indirect costs are allocated to the cost object.

Cost tracing
Direct
cost
Cost
Accumulat Cost object
ed costs assignment Indirect Cost allocation
cost
Cost driver: - is a variable, such as the level of activity or volume, that causes costs to increase or
decrease over a given time period. In other words, a cause-and-effect relationship exists between a change
in the level of activity or volume and a change in the level of total costs i.e. any factor that affects costs.
For example, the number of trucks assembled is a cost driver of the cost of steering wheels for the trucks,
Mile driven for transport cost, Length of time of call for telephone cost, Metric cube of water consumed
for water cost, Unit sold for cost of goods sold
Cost management: cost management is the essence of cost accounting. Cost management refers to the
planning and execution of activities both in the short run and long run to control costs. Profoundly, cost
management is about cost reduction but it is not confined to it alone. Sometimes managers may incur
additional costs in order to increase their future sales. This activity is also a cost management. It is the set
of actions that a manager takes to satisfy customers while continuously reducing and controlling cost. Cost
reduction efforts frequently focus on two key areas:
 Doing only value adding activities, that is, those activities that customers perceive as adding
value to the product or service they purchase
 Efficiently managing the use of the cost drivers in the value adding activities.
Classification of costs
Classification is the process of grouping of costs according to their common characteristics. Therefore
costs can be classified in different ways from different point of view.
I. General Cost Classifications – Manufacturing Companies
 Manufacturing Costs – Most manufacturing companies separate manufacturing costs into
three broad categories: direct materials, direct labor, and manufacturing overhead.
1. Direct Materials-are the acquisition costs of all materials that eventually become part of the
cost object (WIP and then finished goods) and can be traced to cost object in an economically feasible
way. Acquisition costs of direct materials include freight in (inward deliver) charge, sales tax and custom
duties. For example, paper used in a printing shop would be classified as direct material because the paper
is a significant part of each printing job and can easily be identified with the finished product.
2. Direct Labor (Touch Labor) – include the compensation of all manufacturing labor that can
be traced to the cost object (work in process and then finished goods) in an economically feasible way.
Examples include wages and fringe benefits paid to machine operators and assembly-line workers who
convert direct materials purchased to finished goods.
3. Manufacturing Overhead – the third element of manufacturing cost includes all
manufacturing costs that are related to the cost object (work in process and then finished goods) but

cannot be traced to that cost object in an economically feasible way. Example: plant maintenance and
cleaning labor, heat, light, property taxes, plant rent, plant insurance, plant depreciation, and the
compensation of plant managers and etc.
 Only those costs associated with operating the factory are included in manufacturing overhead
 Various names are used for manufacturing overhead, such as indirect manufacturing cost,
factory overhead, and factory burden
 Non manufacturing costs- non manufacturing costs are often divided in to two categories:
1. Selling and Distribution Costs: - All costs incurred for procuring an order are called as selling
costs while all costs incurred for execution of order are distribution costs. Market research expenses,
advertising, sales staff salary, sales promotion expenses are some of the examples of selling costs.
Transportation expenses incurred on sales, warehouse rent etc are examples of distribution costs.
2. Administrative Costs: - Costs incurred for administration are known as administrative costs.
Examples of these costs are office salaries, printing and stationery, office telephone, office rent, office
insurance etc.
II. Classification According to the Period to Which the Cost Is Charged to Income
Costs may also be classified on the basis of the time or accounting period they are to be charged
against revenue. Some costs first recorded as assets and then expensed as they are used or expired. Other
costs are immediately expensed in the year of incurrence.
a. Product Costs (Inventoriable Costs) – include all costs involved in acquiring or making a
product (direct materials, direct labor, and manufacturing overhead). Product costs are initially assigned to
an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory
as expenses (typically called costs of goods sold) and matched against sales revenue.
b. Period Costs –are all costs in the income statement other than cost of goods sold. Period costs
are treated as expenses of the accounting period in which they are incurred because they are expected to
benefit revenues in that period and are not expected to benefit revenues in the future periods (because
there is no sufficient evidence to conclude that such future benefit exist). Expensing these costs in the
period they are incurred matches expense to revenue
Example:
 For manufacturing sector companies, period costs in the income statement are all non manufacturing
costs such as selling and administrative costs, design costs etc.
 For merchandising sector companies period costs in the income statements are all costs not related to
the cost of goods purchased for resale. Advertising cost, freight out cost, salary for sales person etc.
 Service sector companies all costs in the income statement are period costs because there are no
Inventoriable costs.
III. Cost Classifications for Predicting Cost Behavior
Cost Behavior – refers to how a cost reacts to changes in the level of activity. As the activity
level rises and falls, a particular cost may rise and fall as well—or it may remain constant
A. Variable Cost – a cost that varies, in total, in direct proportion to changes in the level of
activity (direct materials)
In a manufacturing company, variable costs include items such as direct materials, shipping costs,
and sales commissions and some elements of manufacturing overhead such as lubricants.

In a merchandising company, the variable costs of carrying and selling products include all items
such as cost of goods sold, sales commissions, and billing costs.
In a hospital, the variable costs of providing health care services to patients would include the costs
of the supplies, drugs, meals, and perhaps nursing services.
When we say that a cost is variable, we ordinarily mean it is variable with respect to the amount of
goods and services produced.
B. Fixed Cost – a cost that remains constant, in total, regardless of changes in the level of
activity (rent, straight-line depreciation, insurance, property taxes, supervisor salaries, and advertising)
When we say a cost is fixed, we mean it is fixed within some relevant range – the range of activity
within which the assumptions about variable and fixed costs are valid (the assumption that the rent
for diagnostic machines is Birr.8,000 a month is valid within the relevant range of 0 to 2,000 tests
per month)
Fixed costs can create confusion if they are expressed on a per unit basis. This is because the
average fixed cost per unit increase and decreases inversely with changes in activity (The average
cost per test will fall as the number of tests performed increases because the Birr.8,000 rental cost
will be spread over more tests)
The feature of these costs is that the total costs remain same while per unit fixed cost is always
variable. Examples of these costs are salaries, insurance, rent, etc.
C. Semi-fixed/semi-variable cost is partly fixed and partly variable, such as telephone expense,
electricity charges, etc.
IV. Cost Classifications for Assigning Costs to Cost Objects
Cost Object – anything for which cost data are desired—including products, customers, jobs,
and organization subunits.
i. Direct Cost – a cost that can be easily and conveniently traced to a specified cost object. For
example; direct material & direct labor are direct costs.
ii. Indirect Cost – a cost that cannot be easily and conveniently traced to a specified cost object.
It is associated with the manufacture of two or more units of finished product, or is an immaterial cost that
cannot be economically traced to single units of finished product. For example: Cost of electricity,
Depreciation of equipment, indirect labor, indirect material, Cost of different utilities, Cost of repair and
maintenance, Insurance for the factory are indirect costs.
V. Cost Classifications for Decision Making
a. Differential Cost – Differential Cost (Incremental Cost) – a difference in costs between any two
alternatives (can be fixed or variable)
b. Opportunity Cost – the potential benefit that is given up when one alternative is selected over
another
c. Sunk Cost – a cost that has already been incurred and that cannot be changed by any decision
made now or in the future. Because sunk costs cannot be changed by any decision, they are not
differential costs because only differential costs are relevant for decision making.
VI. Classification based on relationship of the Cost to the Production Process
Based on the relationship of the cost to the production process, we can classify costs in to prime costs
and conversion costs.

1. Prime cost: are costs which are directly related to the production of a product. Prime cost is the
sum of direct material costs and direct labor costs
2. Conversion costs: called processing costs, are costs concerned with transforming direct materials
in to finished products. They are the sum of direct labor and manufacturing overhead costs.
Therefore the following equations hold true:
Prime cost= DM + DL
Prime cost (PC) = DM + DL
Conversion cost (CC) = DL + MOH
Manufacturing cost = DM + DL + MOH or PC + CC - DL
1.5 Flow of Inventory Costs

When raw materials are used in production, their costs are transferred to the Work in Process
inventory account as direct materials. Direct labor cost and manufacturing overhead cost are added
directly to Work in Process. Work in Process can be viewed most simply as products. Direct materials,
direct labor, and manufacturing overhead costs added to Work in Process are the costs needed to complete
these products as they move along this line.
Merchandiser
Inventory cost of goods sold
Purchase of goods sales of goods
Manufacturer
Raw materials inv. WIP inventory Finished goods inv. CGS
Purchase of goods Use in production production complete sales of goods
Other production costs*

Use in production
*Work-In-Process Inventory consists of raw materials used in production (also known as direct
materials) as well as other production costs. These other production costs are called direct labor and
factory overhead. The process by which these costs are converted to a final cost of a product is covered in
managerial accounting
Flow of product & period costs in manufacturing enterprise

1.6 Financial Statement for a Manufacturing Organization

Financial statement of a manufacturing company is more complex as compared to financial statement
of merchandising and service giving companies. Particularly, the balance sheet and income statement of a
manufacturing enterprise are somewhat different from their merchandising and service counterpart. All
costs mentioned above should be properly accounted for and reported in the financial statement of a
manufacturing firm.
Manufacturing organizations perform selling and administrative functions similar to merchandising
firms. However, instead of purchasing goods that are ready for resale, a manufacturing firm buys raw
materials, labor, and other components needed to perform the manufacturing function of converting the
raw materials into finished products. This difference is shown in the cost-of –goods –sold statements. In
addition, the balance sheet at the end of the period will show ending inventories for raw materials, work in
process, and finished goods. Our objective here is to explain the computation of cost of goods
manufactured and to illustrate the development of external financial statements for a manufacturing
organization.
I. Balance Sheet of a Manufacturing Firm
The balance sheet of a manufacturing firm differs from the balance sheet of a merchandising firm
principally by the type of inventories reported. A manufacturing firm carries three types of inventory.
Namely, Raw material inventory, Work in Process inventory and Finished Goods inventory
 Raw Material Inventories: are raw materials in stock and waiting to be used in manufacturing
process.
 Work in Process Inventories: are goods partially processed but not yet completed. They are also
called Work In Progress (WIP).
 Finished Goods Inventories: are goods fully completed but not yet sold.
The balance sheet presented below for a XYZ manufacturing company shows how the three types of
inventories are presented.
XYZ Furniture Factory
Balance Sheet
June 30, 2009

Current assets:
Cash ………………………….. Br.250, 000
Accounts receivable …………….315, 000
Allowance for uncollectible……. (15,000) 300,000
Inventories:
Raw material …………………..Br.150, 000
Work in process ……….…………75,000
Finished goods………………….. 225,000 450,000
II. Income Statement of a Manufacturing Firm
Income statement of a manufacturing firm differs from income statement of a merchandising firm by
the cost of goods manufactured section. A merchandising firm sells goods that are bought from another
merchandising firm or from a manufacturing firm. But a manufacturing company sells goods that are
internally produced. Hence, the cost of goods sold section contains cost of goods manufactured instead of
purchase. Cost of goods manufactured must first be computed before the income statement is prepared.
The cost of goods manufactured by itself need a computation that presents the cost of direct material used,
cost of labor incurred, and factory overhead costs. The direct material used is a separate schedule that
shows the direct material placed in to the production process in that period. In general, the following four
steps are required to prepare income statement of a manufacturing firm.
Step 1: The Schedule of Direct Materials Used in Production
The cost of direct material used is equivalent to the beginning inventory of direct material plus
purchase made during that period less the direct material left at the end of the period.
Schedule 1: Cost of Direct Material Used
Beginning direct material inventory XX
Add: Purchase in the period XX
Direct material available for use XX
Less: Ending direct material inventory (XX)
Cost of direct material used XX
Illustration: Assume that the direct material inventory of Gibe furniture factory amounts to Br. 248,
000 at the beginning of the year i.e., as of July 1, 2008. Purchase of direct material amounting Br. 440,000
was made and freight cost of Br.3, 200 is incurred during the year, and the amount of direct materials
inventory at the end of the year is Br. 234, 900. The direct material used is therefore determined as follows
using schedule 1 above.
Schedule of Direct Material Used
Beginning direct materials Inventory Br.248,000
Add: Total cost of direct material purchased
Direct Materials purchased Br.440,000
Freight in 3,200 443,200
Direct material available for use Br.691,200
Deduct: Ending direct material inventory 234,900
Cost of Direct materials used Br.456,300

Step 2: The Schedule of Cost Goods Manufactured

Cost of goods manufactured refers to the cost of goods brought to completion whether they were
started before or during the accounting period. To determine the cost of goods manufactured, three factors
are necessary; cost of direct materials used, cost of direct labor and manufacturing overhead. In addition,
work in process at the beginning and at the end should be incorporated in the calculation. The following is
the schedule used to calculate the cost of goods manufactured.
Cost of Goods Manufactured
Work in process at the beginning…………………………………XX
Add: Cost of direct material used………………XX
Direct labor cost……….………………….XX
Manufacturing over head cost……………..XX
Cost incurred in current period…………………………………... (XX)
Total cost incurred to date………………………………………… XX
Less: Work in process ending ……………………………………..XX
Cost of goods manufactured………………………………………..XX
Assume Gibe furniture factory has beginning work in process of Br. 220,000 and ending work in
process of Br. 263,200. The direct labor cost incurred in the year is Br.875, 000 and the different
manufacturing over head costs incurred during the year are given below:
Indirect labor Br.98, 600
Depreciation on factory equipment 44,600
Light and power 43,600
Depreciation of factory building 12,000
Insurance expense on factory properties 9,500
Property tax 19,500
Factory supplies 9,900
Total Manufacturing over head cost Br.237, 700
The cost of goods manufactured for Gibe Furniture factory will be computed as follows using
schedule 2:
Schedule of Cost of Goods Manufactured
Beginning Work in process Br.220,000
Br.456,30
Add: Cost of direct material used 0
Direct labor cost 875, 000
Manufacturing over head cost 237, 700
Cost incurred in current period Br.1,569,000
Total cost incurred to date Br.1,789,000
Ending work in process (263,200)
Cost of goods manufactured Br. 1,525,800
Step 3: The Schedule of Cost of Goods Sold

The cost of goods sold represents the cost of goods that are sold during a given period. In computing
cost of goods sold amount, cost of finished goods at the beginning, cost of goods manufactured in the
period and cost of finished goods at the end will be taken in to account. The following is the schedule used
to compute cost of goods sold.
Cost of Goods Sold:
Finished goods beginning……………………………… XX
Add: Cost of goods manufactured………………………XX
Cost of goods available for sale………………………... XX
Less: Finished goods ending………………………….. (XX)
Cost of Goods Sold………………………………………XX
Assume that the finished goods inventory at the beginning of the year was Br. 314,000 and the ending
inventory of finished goods is Br.364, 000 for Gibe furniture factory. The cost of goods sold is then
calculated as follows.
Schedule of Cost of Goods Sold
Finished Goods Beginning Br.314,000
Add: Cost of goods manufactured 1,525,800
Cost of goods available for sale 1,839,800
Finished Goods Ending 364, 000
Cost of Goods sold Br. 1,475,800
Step 4: Income Statement
All of the above schedules are inputs one to the other. The ultimate goal of making all the schedules is
to prepare the income statement. The income statement contains three main elements. These are sales, cost
of goods sold and operational expense. The cost of goods sold is deducted from sales to arrive at gross
profit. From gross profit, operational expense is deducted to arrive at operating income. The following is
the schedule used to calculate operating income.
Schedule 4: Income Statement
Revenues XX
Cost of goods sold XX
Gross profit XX
Operating expenses (XX)
Operating income XX
Assume that the sales amount for the year for Gibe Furniture factory is Br.3,663,200 and the operating
expense for the year is Br.1,498,850, the income statement for Gibe Furniture factory can be prepared as
follows.
Gibe Furniture Factory
Income Statement
For the year ended June 30, 2008
Sales revenue Br.3,663,200
Cost of Goods sold ( 1,475,800)
Gross profit 2,187400

Operating expenses (1, 498,850)

Operating Income Br.688,550
The above income statement is called a single step or condensed income statement, as it does not show
how each element is constructed. The separate schedules are inputs to the income statement. It is also
possible to include all the schedules at a time to prepare the income statement. Such statement contains
detailed information about each item and is called Multiple Step Income Statement.
Example
 Income statement
Cellular Products
Income Statement
For the Year Ended December 31, 2011 (in thousands)
Revenues Birr.210,000
Cost of goods sold:
Beginning finished goods inventory, January 1, 2009 Birr. 22,000
Cost of goods manufactured 104,000
Cost of goods available for sale 126,000
Ending finished goods inventory, December 31, 2009 18,000
Cost of goods sold 108,000
Gross margin (or gross profit) 102,000
Operating costs:
R&D, design, mktg., dist., and cust.-service cost 70,000
Total operating costs 70,000
Operating income Birr.32,000
 Cost of goods manufactured
Cellular Products
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2009 (in thousands)
Direct materials:
Beginning inventory, January 1, 2009 Birr.11,000
Purchases of direct materials 73,000
Cost of direct materials available for use 84,000

Ending inventory, December 31, 2009 8,000
Direct materials used Birr. 76,000

Direct manufacturing labor 9,000
Manufacturing overhead costs:
Indirect manufacturing labor Birr. 7,000

Supplies 2,000
Heat, light, and power 5,000
Depreciation—plant building 2,000
Depreciation—plant equipment 3,000
Miscellaneous 1,000
Total manufacturing overhead costs 20,000
Manufacturing costs incurred during 2009 105,000
Beginning work-in-process inventory, January 1, 2009 6,000
Total manufacturing costs to account for 111,000
Ending work-in-process inventory, December 31, 2009 7,000
Cost of goods manufactured (to income statement) Birr.104,000
Chapter 2: job and process costing

1. Building-Block Concepts of Costing Systems
Before we begin our discussion of costing systems, let’s review Chapter 1’s cost-related terms and introduce
the new terms that we will need for our primary discussion.
1. Cost object—anything for which a measurement of costs is desired.
2. Direct costs of a cost object—costs related to a particular cost object that can be traced to that
cost object in an economically feasible (cost-effective) way.
3. Indirect costs of a cost object—costs related to a particular cost object that cannot be traced to
that cost object in an economically feasible (cost-effective) way. Indirect costs are allocated to
the cost object using a cost allocation method. Recall that cost assignment is a general term for
assigning costs, whether direct or indirect, to a cost object. Cost tracing is a specific term for
assigning direct costs; cost allocation refers to assigning indirect costs.
4. Cost pool. A cost pool is a grouping of individual indirect cost items. Cost pools can range
from broad, such as all manufacturing-plant costs, to narrow, such as the costs of operating
metal-cutting machines. Cost pools are often organized in conjunction with cost-allocation
bases.
5. Cost-allocation base. How should a company allocate costs to operate metal-cutting machines
among different products? One way to allocate costs is based on the number of machine-hours
used to produce different products. The cost-allocation base (number of machine-hours) is a
systematic way to link an indirect cost or group of indirect costs (operating costs of all metal-
cutting machines) to cost objects (different products).
2. Methods of costing/or cost accumulation:
 Job-Costing and Process-Costing Systems
Companies frequently adopt one of the two costing systems to assign costs to products or services.
1. Job order costing system: is a type of cost system that provides for a separate record of the
cost of each particular quantity of product that passes through the factory. Job order costing

system is commonly used by companies with products that are unique and divisible. In this
system, costs are assigned to a distinct unit, batch or lot of product or service. Job is a task for
which resources are expended in bringing a distinct product or service to market
Examples of business that use job order costing includes:
 construction companies  Repair shops
 Furniture manufacturers  Service giving organization.
 printing firms  Garages etc
2. Process costing system: is used for manufacturing processes which produce a single product
or single mix of products continuously for an extended period of time. In this system, the cost
of a product or service is obtained by using broad averages to assign costs to mass of similar
units produced for general sale and not for any specific customers
Companies that use process costing system are:
 Cement factories  Beer factories
 Petroleum refineries  Textile factories
 Flour companies  Beverage companies
Most companies have costing system that are neither pure job costing nor pure process costing, rather they
combine elements of both job costing and process costing.
3. Input Measurement Methods:
 Actual Costing and Normal Costing
Actual Costing is a job-costing system that uses actual costs to determine the cost of individual
jobs. Actual costing is a method of job costing that traces direct costs to a cost object by the
actual direct-cost rate(s) times the actual quantity of the direct cost input(s) and allocates
indirect costs using indirect costs to a cost object by using the actual indirect-cost rate(s) times
the actual quantity of the cost allocation base.
Normal Costing allocates indirect costs based on the budgeted indirect-cost rate(s) times the
actual quantity of the cost allocation base(s).
Actual Costing Normal Costing
Direct Costs Actual direct-cost rates x actual Actual direct-cost rates x actual
quantities of direct-cost inputs quantities of direct-cost inputs
Indirect Costs Actual indirect-cost rates x actual Budgeted indirect-cost rates x actual
quantities of cost-allocation bases quantities of cost-allocation bases

Normal Costing: Assume that S&S budgets Birr.60, 000 for total manufacturing overhead costs and 2,400
machine hours. What is the budgeted indirect-cost rate? Birr.60, 000 ÷ 2,400 = Birr.25 per hour. How much
indirect cost was allocated to Job? Assume that job used 500 machine hours. 500 machine hours × Birr.25 =
Birr.12, 500.
I. Job Order Costing System
4. Source Documents in Job order Costing System
I. Measuring Direct Materials Cost in Job Order Costing System:
At the beginning of production process, a document known as bill of materials is used for standard products.
"A bill of materials is a document that lists the type and quantity of each item of materials needed to complete
a unit of standard product". In case where it is not possible to use a bill of materials, the production staff
determines the material requirements from the blueprints submitted by the customer.
When an agreement is reached with the customer concerning the quantities, price and shipment date
for the order, a production order is issued. The production department then prepares a materials
requisition form. Materials requisition form is a detailed source document that specifies the type and
quantity of materials to be drawn from the storeroom, and identifies the job to which the costs of the
materials are to be charged. The form is used to control the flow of materials into production and also
for making entries in the accounting records. The completed form is presented to the storeroom clerk
who then issues the necessary raw materials. The storeroom clerk is not allowed to release materials
without such a form bearing an authorized signature. The following is a sample material requisition
form for job 2B47.
Sample Materials Requisition Form:
Materials Requisition Number14873 Date March 2 ,2009
Job Number to Be Charged 2B47
Department Milling
Description Quantity Unit Cost Total Cost
M46 Housing 2 Br.124 Br.248
G7 Connector 4 103 412
Br.660
Authorized Signature __________________
After being notified that the production order has been issued, the accounting department prepares a
job cost sheet. A job cost sheet is a form prepared for each separate job that records the materials,
labor and overhead costs charged to the job. After direct materials are issued, the accounting
department records their costs directly on the job cost sheet. In addition to serving as a means for
charging costs to jobs, the job cost sheet also serves as a key part of a firm's accounting records. The
job cost sheets form a subsidiary ledger to the work in process (WIP) account. They are detailed
records for the jobs in process that add up to the balance in the work in process (WIP). The raw
material cost Br.660 for job 2B47 is accumulated on a job cost sheet as follows:
JOB COST SHEET
Job Number 2B47 Date Initiated March 2 ,2009
Department Milling Date Completed

Item Units Completed

For Stock
Direct Materials Direct Labor Manufacturing Overhead

Req. No. Amount Ticket Hours Amount Hours Rate Amount
14873 Br.660
II. Measuring Direct Labor Cost under Job Order Costing System:
Direct labor cost is handled in much the same way as direct materials cost. Direct labor consists of
labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced
directly to any job are treated as part of manufacturing overhead. The later category of labor cost is
known as indirect labor and includes tasks such as maintenance, supervision, and cleanup. Workers
use time tickets to record the time they spend on each job and task. A completed labor time ticket is an
hour by hour summary of the employees activities throughout a specific job, the employee enters the
job number on the time ticket and notes the amount of time spent on that job. When not assigned to a
particular job, the employee records the nature of the indirect labor task (such as cleanup and
maintenance) and the amount of time spent on the task. The daily time tickets are also used as the
basis for labor cost entries into the accounting records. Following is an example of employees‘ time
ticket.
Time Ticket No. 843 Date March 3 ,2009
Employee : Jaleta Bulli Station 4
Started Ended Time Completed Rate Amount Job Number

7:00 12:00 5.0 Br.9 Br.45 2B47
12:30 2:30 2.0 9 18 2B50
2:30 3:30 1.0 9 9 Maintenance
At the end of the day, the time tickets are gathered and accounting department enters the direct labor
hours and costs on individual job cost sheets. The following is how to do that for job 2B47.
JOB COST SHEET
Department Milling Date Completed
Item Units Completed
For Stock

14873 Br.660 843 5 Br.45

III. Application of Manufacturing Overhead Cost in Job Order Costing:

Manufacturing overhead must be included with direct labor on the job cost sheet since manufacturing
overhead is also a product cost. However, assigning manufacturing overhead to units of products can
be a difficult task. There are two reasons for this:
1. Manufacturing overhead is an indirect cost. This means that it is either impossible or difficult
to trace these costs to a particular product or job.
2. Manufacturing overhead consists of many different items ranging from the grease used in
machines to the annual salary of production manager.
Given these problems, the only way to assign overhead costs to production is to use an allocation
process. This allocation of overhead cost is accomplished by selecting an allocation base that is
common to all of the company's products and services. An allocation base is a measure such as direct
labor hours or machine hours that is used to assign overhead costs to products and services. The most
widely used allocation bases are direct labor hours, direct labor cost, machine hours and even units of
product can also be used to some extent. The allocation base is used to compute "predetermined
overhead rate" in the following formula or equation.
Predetermined Overhead Rate = Estimated total MOH cost
Estimated total allocation base
For example, if a company has estimated that its total manufacturing overhead cost will be Br.320, 000
for the year and its total direct labor hour will be Br.40, 000, its predetermined overhead rate (POR)
for the year will be Br.8 per direct labor hour, calculated as follows:
Br. 320,000 / 40,000 = Br.8 per direct labor hour
Predetermined overhead rate is based on estimates rather than actual result. This is because the
predetermined overhead rate is computed before the period begins and is used to apply overhead cost
throughout the period. The process of assigning overhead costs to jobs is called overhead application.
The formula for determining the amount of overhead cost to apply to a particular job is:
Overhead applied to a particular job = POR × Amount of allocation base
Note that the job cost sheet in the example below indicates that 27 labor hours have been worked.
Therefore a total of Br.216 of manufacturing overhead cost would be applied to the job.
Overhead applied to Job 2B47 = Predetermined overhead rate × Actual direct labor hours
= Br.8 per DLH × 27 DLHrs
= Br.216
In addition to direct material and direct labor cost, the applied manufacturing overhead cost will be
entered in the job cost sheet and the total estimated cost to complete the job will be summarized as
shown below.
JOB COST SHEET

Department Milling Date Completed March 8 ,2009


14873 Br.660 843 5 Br.45 27 Br.8/DLH Br.216
14875 506 846 8 60
14912 238 850 4 21
--------- 851 10 54
Br.1,404 -------- --------
===== 27 Br.180
===== =====
Cost Summary Units Shipped
Direct Materials Br.1,404 Date Number Balance
Direct Labor 180 March 8 -- 2
Manufacturing Overhead 216
Total Cost Br.1800
Unit Product Cost 900
The amount of overhead cost entered in the job cost sheet is not the actual amount of overhead caused
by the job. There is no attempt to trace actual overhead costs to jobs. If that could be done, the costs
would be direct costs, not overhead costs. Overhead assigned to the job is simply a share of the total
overhead that was estimated at the beginning of the year. When a company applies overhead cost to
jobs as we have done, it is called normal costing system. The overhead may be applied as direct labor-
hours are charged to jobs, or all of the overhead can be applied at once when the job is completed. The
choice is up to the company. If a job is not completed at the year-end, however, overhead should be
applied to value the work in process inventory.
Instead of using a predetermined overhead rate, a company could wait until the end of the accounting
period to compute an actual overhead rate based on actual total manufacturing costs and the actual
total units in the allocation base for the period. However, managers cite the following 3 reasons for
using predetermined over head rates instead of actual overhead rates:
I. Managers would like to know the accounting system's valuation of completed jobs before the
end of the accounting period. Suppose, for example a company waits until the end of the year
to compute its overhead rate. Then there would be no way for managers to know the cost of
goods sold for a job until the close of the year. The job may be completed and shipped before
the end of the year. The seriousness of this problem can be reduced to some extent by
computing the actual overhead more frequently, but that immediately leads to another problem
as discussed below.
II. If actual overhead rats are computed frequently, seasonal factors in overhead costs or in the
allocation base can produce fluctuations in overhead rates.
III. The use of predetermined overhead rate simplifies the record keeping. To determine the
overhead cost to apply to a job, the accounting staff simply multiplies the direct labor hours
recorded for the job by the predetermined overhead rate.

5. General Approach to Job Costing

The following seven-step approach is used to assign costs to individual jobs:
1. Identify the chosen cost object(s).
2. Identify the direct costs of the cost object.
3. Select the cost-allocation base(s).
4. Identify the indirect costs associated with each cost-allocation base
5. Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the
job.
6. Compute the indirect costs allocated to the job.
7. Compute the cost of the job by adding all direct and indirect costs assigned to it.
Example
ABC Company uses job-order costing. It incurred the following costs for job M301: 20 pounds of raw materials
(all direct) were issued to be used for job M301 at a cost of Birr.7 per pound. Three people were assigned to
work on Job M301 at a rate of Birr.12 per hour. Records show that a total of 25 direct labor-hours were
worked on Job M301. Manufacturing overhead is applied based on direct labor-hours. At the beginning of the
year, estimated total manufacturing overhead was Birr.450, 000 and the total direct labor hours incurred
would be 50,000.
Required: Determine the cost assigned to the Job.
Solution
 The 7 steps:
Step 1: The cost object is Job M301.
Step 2: Identify the direct costs of Job M301.
 Direct material = (20×Birr.7) = Birr.140
 Direct manufacturing labor = 25×12 = Birr.300
Step 3: Select the cost-allocation base.
 ABC chose direct labor hours as the only allocation base for linking all indirect
manufacturing costs to jobs.
 Job M301 used 25 labor hours.
 50,000 direct hours were used by all jobs.
Step 4: Identify the indirect costs.
 Estimated manufacturing overhead costs were Birr.450, 000.
Step 5: Compute the rate per unit.
 Predetermined indirect cost rate is Birr.450, 000 ÷ 50,000 = Birr.9 per labor
hour.
Step 6: Compute the indirect costs allocated to the job.
 Birr.9 per direct labor hour × 25 hours = Birr.225
Step 7: Compute the cost of Job
Direct materials……………………………………………… Birr.140
Direct labor ………………………………………………….. 300
Factory overhead…………………………………………….. 225
Total……………………………………………………... Birr.665

6. Accounting Procedures for Job order Costing

Job order costing system requires a subsidiary ledger for each job order and general ledger (controlling
account) for the total amount. Entries in subsidiary ledger will be made frequently and summarized in
control account in weekly or monthly interval.
Major Accounting procedures in job order costing system
 Receiving job order and purchase of raw materials
 Transferring raw material to work in process
 Recording labor to work in process.
 Recording actual manufacturing over head cost incurred
 Allocating manufacturing over head cost to work in process
 Transferring finished goods to work in process
 Transferring finished goods to customers.
 Flow of costs in job order costing

Working in
DM cost of goods Finished Cost of
Materials process
Manufactured goods goods sold
Inventory inventory
Indirect material DL
Factory
Manufacturing Labor
overhead
Indirect labor
Explanations of transactions
Raw Material Inventory ………………………………….………XXX
Accounts Payable ……………………………………………………XXX
To record the purchase of raw materials on account.
Work in Process Inventory—Dept. (Job #) ………………………XXX
Manufacturing Overhead …………………………………………XXX
Raw Material Inventory ……………………………………………XXX
To record the issuance of direct and indirect materials requisitioned for a specific job.
Work in Process Inventory—Dept. (Job #) …………………….…..XXX
Manufacturing Overhead ……………………………………..…….XXX
Wages Payable ……………………………………………………………XXX
To record direct and indirect labor payroll for production employees.
Manufacturing Overhead ………………………………………XXX
Various accounts ………………………………………………………. XXX
To record the incurrence of actual overhead costs. (Account titles to be credited must be
specified in an actual journal entry.)
Work in Process Inventory—Dept. (Job #)………………….. XXX
Manufacturing Overhead ……………………………………………… XXX
To apply overhead to a specific job. (This may be actual OH or OH applied using a
predetermined rate. Predetermined OH is applied at job completion or end of period,
whichever is earlier.)
Finished Goods Inventory (Job #) ………………………….XXX
Work in Process Inventory …………………………………………XXX
To record the transfer of completed goods from WIP to FG.
Accounts Receivable ……………………………………….XXX
Sales ………………………………………………………………………XXX
To record the sale of goods on account.
Cost of Goods Sold ……………………………………….XXX
Finished Goods Inventory ……………………………………… XXX
To record the cost of the goods sold.
Illustration

To understand the flow of costs in job order costing system, we shall consider a single month's activity
for Gibe Furniture Company, a producer of product A and product B. The company has two jobs in
process during April, the first month of its fiscal year. Job 1 (1000 units of product A) was started in
March. By the end of March, Br. 30,000 in manufacturing costs had been recorded for job 1. Job 2, an
order for 10,000 units of product B was started in April.
1. The Purchase and Issue of Materials:
On April 1, the company had Br.7,000 in raw materials on hand. During the month, the company
purchased an additional Br.60,000 in raw materials. The purchase is recorded in journal entry (1)
below:
(1)
A raw material is an asset account. Thus, when raw materials are purchased, they are initially recorded
as an asset--not as an expense.
Raw Materials 60,000
Accounts Payable 60,000
2. Issue of Direct and Indirect Materials:

During April, Br.52,000 in raw materials was requisitioned from the storeroom for use in production.
These raw materials include Br. 2,000 indirect materials. Entry (2) records issuing the materials to the
production department.
(2)
Work in Process 50,000
Manufacturing Overhead 2,000
The materials charged to work in process (WIP) represent direct materials for specific jobs. As these
materials are entered into the work in process account, they are also recorded on the appropriate job
cost sheets. From the above Br. 50,000 costs of direct materials, where Br. 28,000 of direct material is
charged to job A‘s cost sheet and the remaining Br. 22,000 is charged to job B‘s cost sheet. The Br.2,
000 charged to manufacturing overhead in entry (2) represents indirect materials used in production
during April. Observe that the manufacturing overhead account is separate from work in process
account. The purpose of the manufacturing overhead account is to accumulate all manufacturing
overhead costs as they are incurred during a period. Work in process account contains a summarized
total of all costs appearing on the individual job cost sheet for all jobs in process at any given point in
time.
3. Labor Cost:
As work is performed each day in various departments of the company, employee time tickets are
filled out by workers, collected, and forwarded to the accounting department. In the accounting
department, wages are computed and the resulting costs are classified as either direct or indirect labor.
This costing and classification for April resulted in a total labor cost Br.75, 000 of which Br.15, 000 is
indirect labor. The journal entry to record this is given as follows
(3)
Work in process 60,000
Manufacturing overhead 15,000
Salaries and wages payable 75,000

Only direct labor is added to the work in process account. At the same time the direct labor costs are
added to work in process, they are also added to the individual job cost sheets. During April, Br.40,
000 of direct labor cost was charged to job 1 and the remaining Br.20, 000 was charged to job 2. The
labor cost charged to manufacturing overhead represent the indirect costs of the period, such as
supervision, janitorial work, and maintenance for the two jobs in common.
4. Manufacturing Overhead Costs:
All costs of operating the factory other than direct materials and direct labor are classified as
manufacturing overhead costs. These costs are entered directly into the manufacturing overhead
account as they are incurred. To illustrate, assume that the company incurred the following general
factory costs during April:
Utilities (heat, water, and power) Br.21,000
Rent on factory equipment 16,000
Miscellaneous factory costs 3,000
Total Br.40,000
The following entry records the incurrence of these costs:
(4a)
In addition, let us assume that during April, the company recognized Br.13, 000 in accrued property
taxes and that Br.7,000 in prepaid insurance expired on factory buildings and equipment. The
following entry records these items:
(4b)
Property taxes payable 13,000
Prepaid insurance 7,000
Finally let us assume that the company recognizes Br.18, 000 in depreciation on factory equipment
during April. The following entry records the accrual of this depreciation:
(4c)
Accumulated Depreciation 18,000
In short, all manufacturing overhead costs are recorded directly into the manufacturing overhead
account as they are incurred day by day through a period. It is important to understand that
manufacturing overhead is a control account for many--perhaps thousands--of subsidiary accounts
such as indirect materials, indirect labor, factory utilities, and so forth. As the manufacturing overhead
account is debited for costs during a period, the various subsidiary accounts are also debited. In this
example, we omit the entries to the subsidiary accounts for the sake of brevity.
5. Calculation of Predetermined Overhead Rate and Application of Manufacturing Overhead to
Work in Process (WIP):
Since actual manufacturing costs are charged to the manufacturing overhead control account rather
than work in process account. How are manufacturing costs assigned to work in process? The answer
is, by means of the predetermined overhead rate. A predetermined overhead rate is established at the

beginning of each year. The predetermined overhead rate is calculated by dividing the estimated total
manufacturing overhead cost for the year by the estimated total units in the allocation base (measured
in machine hours, direct labor hours, or some other base). This rate is then used to apply overhead
costs to jobs.
To illustrate, assume that the company has used machine hours to compute predetermined
overhead rate and that this rate is Br.6 per machine hour. Also assume that during April, 10,000
machine hours were worked on Job 1 and 5,000 machine hours were worked on Job 2 (a total of
15,000 machine hours). Thus, Br.90, 000 in overhead cost (15,000 machine hours times Br.6 per
machine hour = Br.90, 000) would be applied to work in process. The following entry records the
application of manufacturing overhead to work in process:
(5)
The manufacturing overhead account operates as a clearing account. As we have noted, actual factory
overhead costs are debited to the accounts as they are incurred day by day through the year. A certain
intervals during the year, usually when a job is completed, overhead cost is applied to the job by
means of the predetermined overhead rate, and work in process is debited and manufacturing overhead
is credited.
 As we emphasized earlier, the predetermined overhead rate is based on estimates of what
overhead costs are expected to be, and it is established before the year begins. As a result, the
overhead cost applied during a year will almost certainly turn out to be more or less than the
overhead cost that is actually incurred. For example, the company's actual overhead costs for
the period in the above example are Br.5,000 greater than the overhead cost that has been
applied to work in process (WIP), resulting in a Br.5,000 debit balance in the manufacturing
overhead account. This debit balance in manufacturing overhead account is called under-
applied overhead. Any credit balance in manufacturing overhead account is called over-
applied overhead.
 The accounting for MOH over/under applied is discussed in the next section. For the moment,
we can conclude that the cost of a completed job consists of the actual material cost of the job,
the actual labor cost of the job, and the overhead cost applied to the job. This is called Normal
costing. Pay particular attention to the following important point: Actual overhead costs are not
charged to jobs; actual overhead costs do not appear on the job cost sheet nor do they appear in
the work in process account. Only the applied overhead cost, based on the predetermined
overhead rate, appear on the job cost sheet and in the work in process account.
6. Non-Manufacturing Costs:
In addition to manufacturing costs, companies also incur marketing and selling costs. These costs
should be treated as periodic expenses and charged directly to the income statement and therefore
should not go into the manufacturing overhead account. To illustrate the correct treatment of non-
manufacturing costs, assume that the company (in this example) incurred Br.30, 000 in selling and
administrative salary costs during a months, the following entry records these salaries.
(6a)
Salaries expense 30,000

Depreciation on factory equipment is debited to manufacturing overhead account but depreciation on

office equipment is considered a period expense and is not included in manufacturing overhead.
Assume that depreciation of office equipment during the month was Br.7, 000. The entry is as follows.
(6b)
Depreciation expense 7,000
Accumulated depreciation 7,000
Finally, assume that advertising was Br.42, 000 and that other selling and administrative expenses
during the month were Br.8, 000. The following journal entry records these items:
(6c) Advertising expenses 42,000
Other selling and admin. Expense 8,000
Accounts payable 50,000
Since the amounts in entries above all go directly into expense accounts, they will have no effect on
the costing of the company's production for the month. The same will be true of any other selling and
administrative expenses incurred during the month including sales commission, depreciation on sales
equipment, rent on office facilities, insurance on office facilities, and related costs.
7. Cost of Goods Manufactured (COGM):
When a job has been completed, the finished output is transferred from the production department to
the finished goods warehouse. By this time, the accounting department will have charged the job with
direct materials and direct labor cost and manufacturing overhead will have been applied using the
predetermined overhead rate. A transfer of costs is made within the costing system that parallels the
physical transfer of the goods to the finished goods warehouse. The costs of the completed jobs are
transferred out of the work in process (WIP) account and into the finished goods account. The sum of
all amounts transferred between these two accounts represents the cost of goods manufactured for the
period. Let us assume that job 1 was completed at a total cost of Br.158, 000 during the period. The
following entry transfers the cost of job 1 from work in process (WIP) to finished goods.
(7)
Finished goods 158,000
Since Job 1 was the only Job completed during April, the Br.158,000 also represents the cost of goods
manufactured for the month. Job 2 was not completed by month-end, so its cost will remain in the
work in process (WIP) account and carry over to the next month. If a balance sheet is prepared at the
end of April, the cost accumulated thus far on the job 2 will appear as "work in process inventory" in
the assets section.
8. Cost of Goods Sold (COGS):
As units in the finished goods are shipped to the customers, their costs are transferred from the
finished goods account into the cost of goods sold account. If complete job is shipped, as in the case
where a job has been done to a customer's specification, then it is a simple matter to transfer the entire
cost appearing on the job cost sheet into the cost of goods sold account. In most cases, only a portion
of the units involved in a particular job will be immediately sold. In these situations, the unit cost must
be used to determine how much product cost should be removed from finished goods and charged to
cost of goods sold. Assume that the company has completed 1000 units and 750 out of 1000 units

have been shipped to customers for a price of Br.225,000. The unit product cost is Br.158. The
Following journal entries would record the sales (all sales are on account).
(8a)
(8b) Accounts receivable 225,000
Sales 225,000
118,5000
Cost of goods sold
(Br.158 × 750units = Br.118, 500)

With entry (8), the flow of cost through our job order costing system is completed. To pull the entire
example together, journal entries (1) through (8), T-accounts, and schedules of cost of goods
manufactured and cost of goods sold are presented below:
(1)
(2)
Raw materials 52,000
(3)
(4a)
(4b)
Property taxes payable 13,000
Prepaid insurance 7,000
(4c)
(5)
(6a)
Salaries expenses 30,000
(6b)

Depreciation expense 7,000 .

(6c)
Advertising expense 42,000
Other selling and administrative expense 8,000
(7)
(8a)
Accounts receivable 225,000
Sales 225,000
(8b)
The above journal entries can be summarized using T-account as follows
Accounts Receivable Accounts Payable Capital Stock
xx xx xx
(12) 225,000 (1) 60,000
(4) 40,000
(10) 50,000
Prepaid Insurance Salaries and Wages Payable Retained Earnings

Xx xx xx
(3) 75,000
(4b) 7,000 (6a) 30,000
Raw Materials Property Taxes Payable Sales
Bal. 7,000 (2) 52,000 xx (12) 225,000
(1) 60,000 (4b) 13,000
Bal. 15,000
Cost of Goods Sold
Work in Process Salaries expenses (8b)118500

Bal. 30,000 (7 158,000 (6a)30,000
(2) 50,000 Depreciation expenses
(3) 60,000 (6b) 7,000
(5 90,000
Bal. 72,000

Finished Goods Advertising Expenses

Bal. 10,000 (8b)118,500 (6c)42,000
(7) 158,000
Bal. 49,500
Accumulated Depreciation Other Selling and Administrative
expenses
xx (6c) 8,000
(4c) 18,000
(6b) 7,000
Manufacturing Overhead
(2) 2000 (5) 90,000
(3) 15,000
(4a) 40,000
(4b) 20,000
(4c) 18,000
Bal. 5,000
After accounts are summarized in a T-account, cost of goods manufactured, cost of goods sold and
Income statement for the job completed (Job1) is presented as follows.
1. Cost of Goods Manufactured:
Direct materials Br.50,000
Direct labor 60,000
Manufacturing overhead applied to work in process 90,000
Total Manufacturing cost Br.200,000
Add: Beginning work in process 30,000
Total cost incurred to date Br.230,000
Deduct: Ending work in process inventory (Job-2) 72,000
Cost of goods manufactured Br.158,000
2. Cost of Goods Sold:
Finished goods inventory beginning Br.10,000
Add: cost of Goods manufactured 158,000
Goods available for sale Br.168,000
Deduct: Finished goods inventory ending 49,500
Unadjusted cost of goods sold Br.118,500
Add: Under applied overhead 5,000
Adjusted cost of goods sold Br.123,500
3. Income Statement:
Sales Br.225,000
Less cost of goods sold (Br. 118,500 + Br.5,000) 123,500
Gross margin Br.101,500

Less selling and administrative expenses:

Salaries Br.30,000
Depreciation 7,000
Advertising expenses 42,000
Other expense 8,000 87,000
Net operating income Br.14,500
7. Accounting for Under/Over-Applied MOH cost
Since predetermined overhead rate is established before a period begins and is based entirely on estimated
data, the overhead cost applied to work in process (WIP) will generally differ from the amount of overhead
cost actually incurred during a period. The difference between the overhead cost applied to work in process
(WIP) and the actual overhead costs of a period is termed as either under applied overhead or over applied
overhead. For example if a company calculates it’s predetermined overhead rate Br.6 per machine hour.
15,000 machine hours are actually worked and overhead applied to production is therefore Br.90, 000 (15,000
hours × Br.6). If actual factory overhead is Br.95, 000 then under applied overhead is Br.5, 000 (Br.95, 000 –
Br.90, 000). If the situation is reversed and the company applies Br.95, 000 and actual overhead is Br.90, 000,
the over applied overhead would be Br.5, 000.
The causes / reasons of under or over-applied overhead can be complex. Nevertheless the basic
problem is that, the method of applying overhead to jobs using a predetermined overhead rate assumes
that actual overhead costs will be proportional to the actual amount of the allocation base incurred
during the period. If, for example, the predetermined overhead rate is Br.6 per machine hour, then it is
assumed that actual overhead cost incurred will be Br.6 for every machine hour that is actually
worked. There are actually two reasons why this may not be true. First, much of the overhead often
consists of fixed costs that do not grow as the number of machine hours incurred increases. Second,
spending on overhead items may or may not be under control. If individuals who are responsible for
overhead costs do a good job, those costs should be less than were expected at the beginning of the
period. If they do a poor job, those costs will be more than expected. For example, suppose that two
companies A and B have prepared the following estimated data for the coming year:
Company
A B
Predetermined overhead rate based on Machine-hours Direct materials cost
Estimated manufacturing overhead Br.300,000 Br.120,000
Estimated machine-hours 75,000 --
Estimated direct materials cost Br.80,000
Predetermined overhead rate, Br.4 per machine hour 150% of direct materials cost
Now assume that because of unexpected changes in overhead spending and changes in demand for the
companies' products, the actual overhead cost and the actual activity recorded during the year in each
company are as follows:
Company
A B
Actual manufacturing overhead costs Br.290,000 Br.130,000

Actual machine-hours 68,000 --

Actual direct materials costs -- Br.90,000
For each company, note that the actual data for both cost and activity differ from the estimates used in
computing the predetermined overhead rate. This results in under applied overhead and over applied
overhead as follows:
Company
A B
Actual Manufacturing overhead costs Br.290,000 Br.130,000
Manufacturing overhead cost applied to work in process during
the year:
68,000 actual machine hours × Br.4 per machine hour 272,000
Br.90,000 actual direct materials cost × 150% of direct materials 135,000
cost
Under applied (over applied) overhead Br. 18,000 Br. (5,000)
For company A, notice that the amount of overhead cost that has been applied to work in process (Br.272,
000) is less than the actual overhead cost for the year (Br.290, 000). Therefore the overhead is under applied.
Also notice that original estimate of overhead in company A (Br.300, 000) is not directly involved in this
computation. Its impact is felt only through the Br.4 predetermined overhead rate that is used. For B company
the amount of overhead cost that has been applied to work in process (WIP) (Br.135, 000) is greater than the
actual overhead cost for the year (Br.130, 000), and so overhead is over applied.
There are three main approaches to accounting for the under/over applied manufacturing overhead.
A. Adjusted Allocation Rate Approach: The adjusted allocation rate approach restates all
overhead entries in the general ledger and subsidiary ledger using actual cost rates than budget
cost rates. First, the actual manufacturing overhead rate is computed at the end of the fiscal
year. Then, the manufacturing overhead costs allocated to every job during the year are
recomputed using the actual manufacturing overhead rate rather than the budgeted
manufacturing overhead rate. The result is that at year end, every job cost record and finished
goods record accurately represent actual manufacturing overhead costs incurred.
B. Closed Out to Cost of Goods Sold: Closing out the balance in manufacturing overhead
account to cost of goods sold is simpler than the adjusted allocation rate approach. Where the
overhead is under applied, the following journal entry is made:
Cost of goods sold Manufacturing XX
overhead XX
Where the overhead is over applied, the following journal entry is made:
Manufacturing Overhead XX
Cost of goods sold XX
After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of goods
sold is increased by the amount of under applied and decreased by the amount of over applied
overhead. For Gibe furniture factory, the under applied amount is Br.5, 000 and is closed to cost of
goods sold as follows
Cost of goods 5,000
sold Manufacturing overhead 5,000

This is the reason why we have added the under applied manufacturing overhead to the unadjusted
cost of goods sold amount and arrive at the adjusted amount of Br.123, 500
C. Proration Approach: Allocation of under or over applied overhead between work in process
(WIP), finished goods and cost of goods sold (COGS) is more accurate than closing the entire
balance into cost of goods sold. The reason is that allocation assigns overhead costs to where
they would have gone in the first place had it not been for the errors in the estimates going into
the predetermined overhead rate.
Accounts End balance Percentage

Work In process 72,000 30%
Cost of Goods Sold 118,500 50%
Finished Goods 49,500 20%
Total 240,000
The followings are end balance of the three accounts for Gibe Furniture Company
The under applied manufacturing overhead can be prorated based on the end balance percentage
computed above as follows
Accounts Percentage Prorated amount
Work In process 30% 30%×5000 = 1,500
Cost of Goods Sold 50% 50%×5000 = 2,500
Finished Goods 20% 20%×5000 = 1,000
Total 5,000
After peroration the under applied amount will be closed to the three accounts as shown below
Work in Process 1,500
Finished Goods 1,000 5,000
Manufacturing overhead
II. Process costing systems
1. Features of Process Costing:
The objective of process costing is to find out the cost of each process by identifying the direct costs with the
particular process and apportioning the indirect costs i.e. overheads to each process on some suitable basis.
The important features of process costing are:
i. The production is continuous and mass production and the final product is the result of a
sequence of processes or departments.
ii. Costs are accumulated by processes or operations or department.
iii. The products are standardized and homogeneous.
iv. The cost per unit produced is the average cost which is calculated by dividing the total
process cost by the number of units produced
v. The finished product of each but last process becomes the row material for the next
process.

2. Similarities and Difference between Process and Job order Costing

Base of comparison Job order costing Process costing
Type of product Diversified, heterogeneous and Homogeneous products produced continuously
unique products
Cost accumulation By job for a specified number of By department or cost center for a specified
units period of time
Work in process One for each job One for each department
Basic document Job cost sheet for each job Cost of production report for each department or
cost centers
Cost per unit Cost accumulated by job divided Cost accumulated by cost centers divided by
by units in job equivalent unit of production during a period of
time
Reporting By job By cost center or department
Nature of costs for Each job may use different Each units produced uses the same standard
each cost object amount of material, labor and amount of materials, labor and overhead cost
overhead cost
It is important to recognize that much of what was learned in the preceding section about costing and about
cost flows equally applies well to process costing in this section. That is, we are not throwing out all that we
have learned about costing and starting from scratch with a whole new system. The similarities that exist
between job orders costing and process costing can be summarized as follows:
 The same basic purposes exist in both systems, which are to assign material, Labor, and overhead cost
to products and to provide a mechanism for computing unit cost.
 Both systems maintain and use the same basic manufacturing account including manufacturing
overhead, raw material, work in process and finished goods.
 The flow of costs through the manufacturing accounts is basically the same in both systems. As can be
seen from these comparisons, much of the knowledge that we have already acquired about costing is
applicable to process costing system. our task is simply to refine and extend this knowledge to process
costing
In process costing system, direct material, labor, and manufacturing overhead costs are accumulated in the
same way as job order costing system. However, the costs are accumulated by department over some period
of time than by individual jobs. The time period over which the cost is to be accumulated depends on the
information needs of the company. It can be a week, two weeks, but no longer than a month most often. Cost
accumulation is much simpler in process costing system than in job order costing.
3. Preparing cost of production report
The cost of production report is an analysis of the activity of a department for a given period. The cost of
production report for each department may be prepared following the five-step approach. Each step presents
a separate schedule. These schedules are:
Step 1: Summarize the flow of physical units of output.
Step 2: Compute output in terms of equivalent units.
Step 3: Summarize total costs to account for.
Step 4: Compute cost per equivalent unit.
Step 5: Assign total costs to units completed and to units in ending work in process.
A. Flow of physical units (quantity schedule)

This schedule shows the physical flow of units into and out of departments. The total units to
account for must be equal to the total units accounted for.
B. Equivalent units (EU) schedule
Equivalent Units
 A derived amount of output units that:
Equals the total units completed plus incomplete units (WIP) restated/or expressed in terms of
completed units.
 Are calculated separately for each input (direct materials and conversion cost)
Materials + Labor
Labor++Overhead
overhead
Conversion Costs
C. Cost to account for schedule
This schedule shows the costs which are charged to or accumulated by the department.
Costs to be account for in each processing department consist of:
1. Costs of the beginning work in process inventory in the department.
2. Costs added during the period.
a. Costs of units transferred in from a preceding department.
b. Costs added in the department itself.
D. Cost per equivalent unit schedule
This schedule shows us cost per equivalent unit for each cost categories i.e. cost for direct
material and conversion cost.
E. Assignment of costs to units completed and to ending WIP inventories.
This schedule shows the distribution of accumulated costs to units completed and transferred
and to units still in process. The total cost to account for must be equal to the total costs
accounted for.
These total cost accounted for will assign to:
1. Ending work in process inventory in the department.
2. Units completed and transferred out to the next department (or to finished goods).
 Illustrating Process Costing
Case one: process costing with no beginning or ending WIP inventory.
This means all units are started and fully completed by the end of the accounting period. This case
illustrates the basic averaging of costs- a key feature of process costing system.
Case two: process costing with no beginning WIP inventory but with ending WIP inventory.
This is some units started during the accounting period are incomplete at the end of the period. This
case introduces the concept of equivalent units.
Case three: process costing with both beginning and ending WIP inventory.
This case describes the effect of weighted average and first-in-first-out (FIFO) cost flow assumptions
on cost of units completed and cost of WIP inventory.
Case one: process costing with no beginning or ending WIP inventory.
The simplest case for assigning costs using a process costing approach assumes all products are started
and completed within a single accounting period. This assumption makes it easier to see how materials
and conversion costs are used and applied to units of product. If all units of products are completed in

one month, there is no WIP inventory. It is the presence of WIP inventory that makes process costing
complex.
Example 1
XYZ Company manufactures its products in two departments: Dep‘t A and Dep‘t B. the company
started operation at the beginning of January, 2004 E.C. the following information belongs to Dep‘t A
for January 2004 is:
Physical units for January 2004
WIP beginning inventory (January 1)………………..….. 0 units
Started during January ………………………………….. 60,000 units
Completed and transfer out during January ……..………. 60,000 units
WIP ending inventory (January 31) ………………….…… 0 units
Total cost for January
Direct material cost added during January …………… Birr 30,000
Conversion costs added during January ……………... birr 60,000
Required: prepare a cost of production report to department A of XYZ Company for January and
necessary journal entries.
XYZ Company records direct material costs and conversion costs in the Dep‘t A as these costs are
incurred. By averaging, Dep‘t A cost of products is Birr 90,000 ’ 60,000 units= Birr 1.5 per unit,
itemized as follows:
Direct material cost per unit (Birr 30,000 ’ 60,000 units) ………………….. 0.5
Conversion cost per unit (Birr 60,000 ’ 60,000 units) ……………………… Birr 1
Department A cost per unit………………………………………………….. Birr 1.5
Journal entries
1. Work-in-process-Dep’t A ………………….Birr 30,000
Raw materials inventory ……………………….. Birr 30,000
(To record direct materials purchase and used in production during January)
2. Work-in-process-Dep’t A ………………… Birr 60,000
Various accounts…………………………………. Birr 60,000
(To record conversion costs for January; example includes energy, manufacturing supplies, all
manufacturing labor, and plant depreciation.)
3. Work-in-process-Dep’t B………………….. Birr 90,000
Work-in-process-Dep’t A ……………………………… Birr 90,000
(To record cost of goods completed and transferred from Dep‘t A to Dep‘t B during Jan)
Case-1 shows that in a process costing system, average unit costs are calculated by dividing total costs
in a given accounting period by total units produced in the period. Because each unit is identical, we
assume all units receive the same amount of direct material costs and conversion costs. Case-1 applies
whenever a company produces a homogeneous product or service but has no incomplete units when
each accounting period ends, which is a common situation in service organizations.
Case two: process costing with no beginning WIP inventory but with ending WIP inventory.
A slightly more complex case for process costing occurs when there is production that is not
completed at the end of accounting period. In another word, there is no beginning WIP inventory, but
there is some ending WIP inventory.
Example 2

In February, 2004 E.C. XYZ Company places 60,000 units of products in to production. Because all
units placed in to production in January were completely finished, there is no beginning inventory of
partially completed units in Dep‘t A on February 1. Prepare cost of production report for Dep‘t A for
February based on the following information that pertains to Dep‘t A for February.
Units of data for the month of February:
WIP at the beginning …………………………………………. 0 units
Started during February ……………………………………… 60,000 units
Completed and transfer out during February ………….…….. 40,000 units
Units still in process at the end ………………………….…... 20,000units
Degree of completion of ending WIP inventory, DM 100%, CC 40%
Total costs added during February
Direct material ………………………….. Birr 42,000
Conversion cost ………………………… Birr 43,200
XYZ Company
Cost of production report- Dep’t A
For the month ended February 28, 2004
Step-1 Step-2
Equivalent Units (EU)
Physical units Materials Conversion
Flow of production
WIP inventory beginning 0
Started during current period 60,000
To account for 60,000
Completed and transferred out 40,000 40,000 40,000
WIP ending (20,000*100%, 20,000*40%) 20,000 20,000 8,000
Account for 60,000
Work done in current period only 60,000 48,000
Total Direct Conversion
Step-3 production cost materials cost
Cost added during February 85,200 42,000 43,200
Total cost to account for 85,200 42,000 43,200
Step-4
Cost added in current period 85,200 42,000 43,200
Divided by equivalent units of work done in
current period 60,000 48,000
Cost per equivalent unit 0.7 0.9
Step-5 : assignment of costs
Completed and transfer out(40,000 units) Birr 64,000 40,000*0.7 40,000*0.9
Work-in-process ending (20,000 units) Birr 21,200 20,000*0.7 8,000*0.9
Total cost accounted for Birr 85,200
Journal entries
i. Work-in-process-Dep’t A ………………….Birr 42,000

Raw materials inventory ……………………….. Birr 42,000

(To record direct materials purchase and used in production during February)
ii. Work-in-process-Dep’t A ………………… Birr 43,200
Various accounts …………………………………. Birr 43,200
(To record conversion costs for January; example includes energy, manufacturing supplies, all
manufacturing labor, and plant depreciation.)
iii. Work-in-process-Dep’t B………………….. Birr 64,000
Work-in-process-Dep’t A ………..………………………… Birr 64,000
(To record cost of goods completed and transferred from Dep‘t A to Dep‘t B during Feb)
Case three: process costing with both beginning and ending WIP inventory.
Since production is usually continuous and some units still being in process at the end of a period,
ending WIP inventory of the last period becomes beginning inventory of WIP in this period.
The existence of beginning WIP inventory creates a problem in process costing because the following
questions must be considered.
a) Should a distinction be made between completed units from beginning WIP inventory& from
current period?
b) Should cost of beginning WIP inventory be added to costs of the current period?
c) Should all units completed during the current period be included 100% in equivalent
production regardless of the stage of completion?
The answer to the above questions will depend on the method chosen to account for beginning WIP
inventory. There are two common methods of computing average costs per unit are the weighted
average method and the FIFO method.
I. Weighted-Average Method
 Calculates cost per equivalent unit of all work done to date (regardless of the accounting period in
which it was done)
 Assigns this cost to equivalent units completed & transferred out of the process, and to incomplete
units in still in-process
 Weighted-average costs is the total of all costs in the Work-in-Process Account divided by the total
equivalent units of work done to date
 The beginning balance of the Work-in-Process account (work done in a prior period) is blended in with
current period costs
 For each category of cost in each processing department the following calculations are made:
Costs to be Accounted for = costs of beginning WIP inventory + costs added during current period
Equivalent unit = Physical unit x Percentage of completion
Equivalent units of production = units transferred out + Equivalent units of ending WIP inventory
 Units transferred out of the department are 100% complete with respect to the work done in the
department.
Cost per EU = costs to be accounted for
Equivalent units of production
Costs of units Transferred out = units transferred out X cost per EU
Costs of units in ending WIP inventory = EUs of ending WIP inventory X cost per EU

Example 3: The following data are for the first processing department at Midwest Refining, a
company that reclaims petroleum products from used motor oil.
Units Materials Conversion
Work in process, beginning:
Units in process ............................................. 10,000
Percentage completion .................................. 60% 50%
Cost of beginning inventory .......................... $4,300 $7,600
Units started into production ............................. 190,000
Costs added in the department during the $74,100 $140,400
current period ................................................
Units completed and transferred ....................... 180,000
Work in process, ending:
Units in process ............................................. 20,000
Percentage completion .................................. 80% 25%
Required:
Prepare a cost of production report to department A of XYZ using weighted average and FIFO method.
XYZ Company
Cost of production report- Dep’t A (weighted average)
Step-1 Step-2
Flow of production
WIP inventory beginning 10,000
Completed and transferred out 180,000 180,000 180,000
WIP ending (20,000*80%, 20,000*25%) 20,000 16,000 5,000
Accounted for 200,000
Work done to date 196,000 185,000
Work-in-process beginning 11,900 4,300 7,600
Step-4
Cost incurred to date 78,400 148,000
Divided by equivalent units of work done
in current period 196,000 185,000
Completed and transfer out(180,000 Birr216,000 180,000*0.4 180,000*0.8

units)
Work-in-process ending (20,000 units) Birr 10,400 16,000*0.4 5,000*0.8
Total cost accounted for Birr 226,400
Note: The quantity schedule is based on the following equation:
Units in beginning work in process Units transferred out
+ = +
Units started into production Units in ending work in process
II. FIFO Method

 The FIFO method separates the costs of beginning inventory from the costs incurred during the
current period. (The weighted-average method combines them.)
 The beginning balance of the Work-in-Process account (work done in a prior period) is kept separate
from current period costs.
 FIFO assumes the beginning inventory is completed before any new units are started.
 Assigns the cost of the previous accounting period’s equivalent units in beginning work-in-process
inventory to the first units completed and transferred out of the process.
 Assigns the cost of equivalent units worked on during the current period first to complete beginning
inventory, next to start and complete new units, and lastly to units in ending work-in-process
inventory.
Formulas for to compute equivalent units of production in FIFO method
A separate calculation is made for each cost category in each process department.
Costs to be Costs of Costs added
accounted = beginning WIP + during the
for inventory current period
Equivalent units of production = equivalent units to complete beg. WIP Inventory*
+
Units started & completed during the period
+
Equivalent units in ending WIP inventory.
Equivalent Units Equivalent units
units of = transferred + of ending WIP
production out inventory
*Equivalent units to complete beg. WIP inv = WIP in beg. Inv. × (100 – percentage
completion of beg. WIP inventory.
Or, the equivalent units of production can also be determined as follows:
Equivalent units of production = Units started & completed during the period
+
Equivalent units in ending WIP inventory
-
Equivalent units in beg. WIP Inventory
Cost per EU = cost added during current period only

EU of Work done in current period only

Costs of units = Units × Cost
transferred out transferred out per EU
Costs of units in = Equivalent units of × Cost
ending WIP inventory ending WIP inventory per EU
Costs added to complete EU of beg. = EU of beg WIP inventory× cost per EU

XYZ Company
Cost of production report- Dep’t A (FIFO method)
Step-1 Step-2
Flow of production
WIP inventory beginning 10,000
Completed and transferred out
From beginning WIP inventory* 10,000 4,000 5,000
Started and completed† 170,000 170,000 170,000
Work-in-process ending 20,000 16,000 5,000
accounted for 200,000
Work done in current period only 190,000 180,000
Work-in-process beginning 11,900 Work done in previous
period
Step-4
Cost added in current period only 214,500 74,100 140,400
Divided by equivalent units of work done in 190,000 180,000
current period
Completed& transferred out(180,000)
WIP beginning inventory(10,000 units) 11,900 4,300 7,600
Cost added to beginning WIP inv. In 5,460 4,000*0.39 5,000*0.78
current period
Total cost from beginning WIP inventory 17,360
Started and completed (170,000 units) 198,900 170,000*0.39 170,000*0.78
Total cost of units completed & 216,260

transferred out
WIP ending (20,000 units 10,140 16,000*0.39 5,000*0.78
Total cost accounted for 214,500
* Materials: 10,000 × (100% – 60%) = 4,000 EUs
Conversion: 10,000 × (100% – 50%) = 5,000 EUs
†
190,000 units started – 20,000 units in ending WIP = 170,000 units
 Transferred in Cost
Many process-costing systems have two or more departments or processes in the production cycle. As units
move from department to department, the related cost is also transferred by monthly journal entries. If
standard costs are used, accounting for such transfers is simple. However, if the weighted-average or FIFO
method is used, the accounting can become more complex. Conversion cost
added
evenly during the process
WIP
Assembly Finishing
Transfer
Department Department
Direct material
added at the end
Transferred-in costs (also called previous departments’ cost) are the cost incurred in the previous process in
the production cycle. That is, as the units move from one department to the next, their costs are transferred
with them. Computations of finishing department costs consist of transferred-in costs as well as the direct
materials and conversion costs added in finishing department. Transferred-in cost is treated as if it is a
separate type of direct material added at the beginning of the process. When successive departments are
involved, transferred units from one department become all or part of the direct materials of the next
department; however, they are called transferred-in costs not direct materials costs.
Transferred-In costs and the Weighted-Average Method
To examine the weighted-average process-costing method with transferred-in costs, we use the five-step
procedure described earlier to assign costs of the finishing department to units completed and transferred out
and to units in ending work in process. Let us assume the following data for SNAP computer for the month of
April, 2008.
Illustration 4: The assembly department of SNAP computer transfers assembled units to its finishing
department. Here, the units receive additional direct material such as crating and other packing material to
prepare the units for sell at the end of the process. Conversion costs are added evenly during the process. As
units are completed in finishing department, they are immediately transferred to finished goods.
Physical units
WIP beginning ----------------------------- 240 units
Transferred in Cost (100% complete)
Direct material (0% complete)
Conversion cost (62.5% complete)
Transferred in during April -------------- 400 unit
Completed during April ------------------------- 440 unit
WIP ending ---------------------------------------200 units
Transferred in Cost (100% complete)

Direct material (0% complete)

Conversion cost (80% complete
Cost for finishing department in April:
WIP beginning
Transferred In cost --------------------------Br.672, 000
Direct materials ---------------------------------- 0
Conversion cost ---------------------------- 360,000
Transferred in during April:
Under WA method -------------------------------Br.1, 040,000
Under FIFO method ----------------------------- 1, 049,600
Direct material cost added during April --------- -- -- 13,200
Conversion cost during April ----------------------- --- 48,600
The production report for the month of April for finishing department can be prepared under weighted
average method as follow:
(Step 1)
Flow of production Physical flow
Work in process beginning 240
(Step 2)
Units started in current period 400 Equivalent Units
Transferred in Direct Conversion
Units to account for 640 cost material costs
Units completed and transferred
out: 440 440 440 440
Work in process ending 200 200 0 160
Units accounted for 640 - - -
Work done in current period only 640 440 600
(Step 3): Cost summary
Work in process beginning Br. 1,032,000 Br. 672,000 0 Br. 360,000
Costs added during March 1,101,800 1, 040,000 13,200 48,600
Total cost Br. 1,712,000 Br. 13,200 408,600
Divide by equivalent units ÷ 640 ÷ 440 ÷ 600
Cost per equivalent units Br. 2,675 Br. 30 Br. 681
(Step 4)
Total cost to account for Br.2,133,800
(Step 5) Assignment of cost:
To completed units (440 units) Br.1,489,840 (440×2,675) + (440×30) + (440×681)
To work in process ending (200
units) 643,960 (200×2675) + (0×30) + (160×681)
Total cost accounted for Br. 2,133,800

The computations are the same as the calculations of equivalent units under the weighted-average method
for the assembly department, but here we also have transferred-in costs as another input. The units, of course
are fully completed as to transferred-in costs carried forward from the previous process. Direct material costs
have a zero degree of completion in both the beginning and ending work-in process inventories because, in
finishing department direct materials are introduced at the end of the process. Beginning work in process and
work done in the current period are combined for purposes of computing equivalent-unit costs for
transferred-in costs, direct material costs and conversion costs. The necessary journal entries for the month
of April in the finishing department are given as follows:
Work In process – Finishing 13,200
Raw material control 13,200
(To record the use of direct materials in the production process)
Various accounts 48,600
To record the use of conversion cost in the production process)
Finished Goods 1,489,840
Work in process – Assembly 1,489,840
(To record the transfer of completed products from finishing department to warehouse)
2. Transferred-In Costs and the FIFO Method:
The cost of production report for finishing department for the month of April can be prepared using FIFO
method as follows:
(Step 2) Equivalent Units
Flow of production (Step 1)Physical flow
Work in process beginning 240
Units started in current period 400
Transferred in Direct Conversion
Units to account for 640 cost material costs
Units completed
From WIP Beginning 240 0 240 90
Started and completed 200 200 200 200
WIP Ending 200 200 0 160
Units accounted for 640 - - -
Work done in current period only 400 440 450
(Step 3): Cost summary
Work in process beginning Br. 1,032,000 Incurred last month
Costs added during March 1,111,400 Br.1, 049,600 Br. 13,200 48,600
Divide by equivalent units ÷ 400 ÷ 440 ÷ 450
Cost per equivalent units Br. 2,624 Br. 30 Br. 108
(Step 4)
Total cost to account for 2,143,400
To completed units (440 units)
From WIP Beginning (240 units) Br.1,032,000

Cost added to WIP Beginning 16,920 (0×2,624) + (240×30) + (90×108)

Total from beginning Inventory Br. 1,048,920
Started and completed 552,400 (200×2,624)+(200×30)+ (200×108)
Total cost of units completed Br. 1,601,320
To WIP ending (200 units) 542,080 (200×2,624) + (0×30) + (160×108)
Total cost accounted for Br.2,143,400
To examine the FIFO process-costing method with transferred-in costs, we again use the five step procedure.
Other than considering transferred-in costs in the computations of equivalent units, the remaining are the
same as under the weighted average method for the assembly department. The necessary journal entries for
the month of April in the finishing department are given as follows:
Finished Goods 1,601,320
Work in process – Assembly 1,601,320
Chapter three: spoilage, reworked units and scrap

4.1 Spoilage, rework and scrap in general
While the terms used in this chapter may seem familiar, be sure you understand them in the context of
management accounting.
 Spoilage: - Are completed or semi-completed products that do not meet the standard or
specification and that are discarded or are sold for a disposal value. Accounting for spoilage
aims to determine the magnitude of spoilage costs and to distinguish between costs of normal
and abnormal spoilage
 Normal spoilage is spoilage inherent in a particular production process that arises even under
efficient operating conditions. Management decides the spoilage rate it considers normal
depending on the production process. Costs of normal spoilage are typically included as a
component of the costs of good units manufactured because good units cannot be made without
also making some units that are spoiled.
 Abnormal spoilage is spoilage that is not inherent in a particular production process and would
not arise under efficient operating conditions. Abnormal spoilage is usually regarded as
avoidable and controllable. Line operators and other plant personnel generally can decrease or
eliminate abnormal spoilage by identifying the reasons for machine breakdowns, operator errors,
and the like, and by taking steps to prevent their recurrence. To highlight the effect of abnormal
spoilage costs, companies calculate the units of abnormal spoilage and record the cost in the loss
from abnormal spoilage account, which appears as a separate line time in the income statement.
Issues about accounting for spoilage arise in both process – costing and job – costing systems.
 Reworks (defective) are completed units that do not meet the production standard or the
specification but while can subsequently repaired and sold as acceptable finished goods with

incurrence of additional costs which are called Rectifying or rework costs. These units are
salable as second or first depending on the market condition. The accounting issue related to
rework is how to accumulate and record the rework costs.
 Scrap Material: are raw materials left over from the production process that cannot be put back
into the production for the same purpose. However, they may be useful for other purpose or in
other production processes.
 Waste materials: are parts of raw materials left over after production that has no further use or
resale value. Sometimes cost be incurred to dispose waste materials.
Note: scrap is the byproduct of the production of the primary product whereas spoilage and
defective goods are not byproducts but imperfect primary products.
3.2 Process costing and spoilage
How do process-costing systems account for spoiled units? We have already said that units of
abnormal spoilage should be counted and recorded separately in a Loss from Abnormal Spoilage
account, but what about units of normal spoilage? The correct method is to count these units when
computing output units—physical or equivalent—in a process-costing system. The following example
and discussion illustrate this approach.
Illustration 1: ABC Company manufactures a recycling container in its forming department. Direct
materials are added at the beginning of the production process. Some units of this product are spoiled
as a result of defects, which are detectable only upon inspection of finished units. Normally, spoiled
units are 10% of the finished output of good units. That is, for every 10 good units produced, there is
1 unit of normal spoilage. Summary data for July 2009 are:
Physical Direct Conversion Costs Total Costs
Units (1) Materials (3)
Work in process, beginning inventory 1,500 Br.12,000 Br.9,000 Br.21,000
(July 1)
Degree of completion of beginning 100% 60%
work in process
Started during July 8,500
Good units completed and transferred 7,000
out in July
Work in process, ending inventory (July 2,000
31)
Degree of completion of ending work in 100% 50%
process
Total costs added during July Br.76,500 Br.89,100 Br.165,600
Normal spoilage as a percentage of good 10%

units
Degree of completion of normal 100% 100%
spoilage
Degree of completion of abnormal 100% 100%
spoilage

The five – step procedure for process costing used in the previous sub section need only slight
modification to accommodate spoilage.
Step 1: Summarize the flow of Physical units of Output. Identify units of both normal and abnormal
spoilage.
Total spoilage = (WIP Beginning + Units started) _ (Good units completed + WIP End)
= (1,500 + 8,500) – (7, 000 + 2,000)
= 10,000 – 9,000
= 1,000 units
Recall that normal spoilage is 10% of good output at ABC Corporation. Therefore, normal spoilage =
10% of the 7,000 units of good output = 700 units.
Abnormal Spoilage = Total spoilage – Normal spoilage
= 1,000 units – 700 units
= 300 units
Step 2: Compute output in terms of equivalent units. Compute equivalent unit for spoilage in the
same way we compute equivalent units for good units. All spoiled units are included in the
computation of output units. Because ABC‘s inspection point is at the completion of production, the
same amount of work will have been done on each spoiled and each completed good unit.
Step 3: Summarize Total costs to Account for. The total costs to account for are all the costs debited
to work in process.
Step 4: Compute cost per Equivalent unit.
Step 5: Assign total Costs to units Completed, to Spoiled Units, and to units in ending work in
process. This step now includes computation of the cost of spoiled units and the cost of good units.
We will illustrate these five steps of process costing for the weighted – average and FIFO methods
using the example of ABC corporation.
1. Weighted – Average Method and Spoilage
(Step 1)
Flow of production Physical flow
Work in process beginning 1,500 (Step 2)
Units started in current period 8,500 Equivalent Units
Direct Conversion
Units to account for 10,000 materials costs
Good units completed 7,000 7000 7000
Normal spoilage 700 700 700
Abnormal spoilage 300 300 300
Work in process ending 2,000 2,000 1,000
Units accounted for 10,000
Work done to date (Equivalent
units) 10,000 9,000
(Step 3) ; Cost summary
Work in process beginning Br.21,000 Br.12,000 Br. 9,000
Costs added during February 165,600 76,500 89,100
Total cost incurred to date Br.88,500 Br.98,100

(Step 4); Cost per EU

Total cost incurred to date Br.88,500 Br.98,100
Divide by equivalent units ÷ 10,000 ÷ 9,000
Cost per equivalent units Br. 8.85 Br. 10.90
Total cost to account for Br. 186,600
To Good units completed (7000
units) Br. 138,250 Br 8.85×7000 + Br 10.90×7000
Normal spoilage 13,825 Br 8.85×700 + Br 10.90×700
Total cost of good units Br. 152,075
Abnormal spoilage 5,925 Br 8.85×300 + Br 10.90×300
To work in process ending
(2,000 units) 28,600 Br 8.85×2000 + Br 10.90×1000
Total cost accounted for Br. 186,600
The journal entries to be recorded are given below:
Work In process – Forming 76,500
Work In process – Forming 89,100
Finished Goods 152,075
Work in process – forming 152,075
Loss from abnormal spoilage 5,925
(To record the loss from abnormal spoilage)
2. FIFO Method & Spoilage
Flow of production (Step 1) Physical flow

Work in process beginning 1,500
(Step 2)
Units started in current period 8,500 Equivalent Units
Direct Conversion
Units to account for 10,000 materials costs
Good units completed :
From WIP Beg. 1,500 0 600
Started and completed 5,500 5,500 5,500
Normal spoilage 700 700 700

Abnormal spoilage 300 300 300

Work in process ending 2,000 2,000 1,000
Units accounted for 10,000
Work done in the current period 8,500 8,100
(Step 3) ; Cost summary
Work in process beginning Br.21,000 ----------------- --------------------
Costs added during February 165,600 76,500 89,100
Divide by equivalent units ÷ 8,500 ÷ 8,100
Cost per equivalent units Br. 9 Br. 11
(Step 4)
Total cost to account for Br.186,600
Good units completed (7000 units)
WIP Beginning (1,500 units) 21,000
Cost added during the period 6,600 Br. 9×0+ Br. 11×600
Total from beginning inventory 27,600
Started and completed (5,500 units) 110,000 Br. 9×5,500+ Br. 11×5,500
+Normal spoilage (700 units) 14,000 Br. 9×700+ Br. 11×700
Total cost of good units completed Br.151,600
Abnormal spoilage 6,000 Br. 9×300 + Br. 11×300
To work in process ending (2000 units) 29,000 Br. 9×2000 + Br. 11×1000
Total cost accounted for Br.186,600
The journal entry for recording consumption of raw material and conversion cost is the same as in the
weighted average method but the remaining journal entries are slightly different & are given as
follows:
Finished Goods 151,160
Loss from abnormal spoilage 6,000
(To record the loss from abnormal spoilage)

Note that Costs of abnormal spoilage are separately accounted for as losses of the accounting period in
which they are detected. However, the cost of normal spoilage is added to the costs of good units
completed in the period.
3.3 Job order costing and spoilage
The concepts of normal and abnormal spoilage can also apply to job order costing systems. Abnormal
spoilage is separately identified so companies can work to eliminate it altogether. Costs of abnormal
spoilage are not considered to be inventorable cost and are written off as costs of the accounting period
in which the abnormal spoilage is detected. Normal spoilage costs in job – costing systems – as in
process – costing systems – are inventorable costs, although increasingly companies are tolerating
only small amounts of spoilage as normal. When assigning costs, job costing systems generally
distinguish normal spoilage attributable to a specific job from normal spoilage common to all jobs. We
describe accounting for spoilage in job costing using the following example.
Illustration 2: In the BOING Machine Shop, 5 aircraft parts out of a job lot of 50 aircraft parts are
spoiled. Costs assigned prior to the inspection point are Br. 2, 000 per part. Our presentation here and
in subsequent sections focuses on how the Br. 2, 000 cost per part is accounted for. When the spoilage
is detected, the spoiled goods are inventoried at Br. 600 per part which is the net disposal value.
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 minus the disposal value of the
spoilage. The journal entry to recognize disposal value is:
Materials Control - spoiled goods (5  Br. 600) 3,000
Work-in-Process Control (specific job) 3,000
Note, the Work – in – process Control (specific job) has already been debited (charged) Br.10, 000 for
the spoiled parts (5 spoiled parts  Br.2, 000 per part). The net cost of normal spoilage = Br. 7, 000
(Br.10, 000 - Br.3, 000), which is an additional cost of the 45(50 – 5) good units produced. Therefore,
total cost of the 45 good units is Br.97, 000: Br.90, 000 (45 units  Br.2, 000 per unit) incurred to
produce the good units plus the Br.7, 000 net cost of normal spoilage. Cost per good unit is Br.2,
155.56 (97,000  45 good units).
Normal spoilage common to all jobs: In some cases, spoilage may be considered a normal
characteristic of the production process. The spoilage inherent in production will of course, occur
when a specific job is being worked on. But the spoilage is not attributable to, and hence is not
charged directly to, the specific job. Instead, the spoilage is allocated indirectly to the job as
manufacturing overhead because the spoilage is common to all jobs. The journal entry is:
Materials Control -spoiled goods (5 Br. 600) 3,000
MOH control - normal spoilage (Br.10, 000 - Br. 3, 000) 7,000
Work-in-Process control: 5 unit  Br.2, 000 10,000
When normal spoilage is common to all jobs, the budgeted manufacturing overhead rate includes a
provision for normal spoilage cost. Normal spoilage cost is spread, through overhead allocation, over
all jobs rather than allocated to a specific job.
Abnormal Spoilage: If the spoilage is abnormal, the net loss is charged to the loss from abnormal
spoilage account. Unlike normal spoilage costs, abnormal spoilage costs are not included as a part of
the cost of good units produced. Total cost of the 45 good units is Br.90, 000 (45 units  Br.2, 000
per unit). Cost per good unit is Br.2, 000 (Br.90, 000  45 good units).

Materials Control - spoiled goods (5  Br.600) 3,000

Loss from Abnormal Spoilage: (Br.10, 000 - Br.3, 000) 7,000
Work – in- process control (specific job): 5 units  Br.2, 000 10,000
3.4 Reworked units
Rework is units of production that are inspected, determined to be unacceptable, repaired, and sold as
acceptable finished goods. We again distinguish (1) normal rework attributable to a specific job, (2)
normal rework common to all jobs, and (3) abnormal rework.
Consider the BOING Machine shop data in illustration above; assume the five spoiled parts are
reworked. The journal entry for the Br.10,000 of total costs (the details of these costs are assumed)
assigned to the five spoiled units before considering rework costs is:
Materials Control 4,000
Wages payable control 4,000
Manufacturing Overhead Allocated 2,000
Assume the rework costs equal $3,800 (comprising $800 direct materials, $2,000 direct manufacturing
labor, and $1,000 manufacturing overhead).
1. Normal Rework attributable to specific job: If the rework is normal but occurs because of the
requirements of a specific job, the rework costs are charged to that job. The journal entry is as
follows:
Materials Control 800
Wages Payable Control 2,000
2. Normal rework common to all jobs: When rework is normal and not attributable to a specific
job, the costs of rework are charged to manufacturing overhead and are spread, through overhead
allocation, over all jobs.
Manufacturing Overhead Control (rework costs) 3,800
3. Abnormal rework: If the rework is abnormal, it is recorded by charging abnormal rework to a
loss account.
Loss from Abnormal Rework 3,800
Accounting for rework in a process – costing system also requires abnormal rework to be
distinguished from normal rework. Process costing system accounts for abnormal rework in the same
way as job order costing. Accounting for normal rework follows the accounting described for normal
rework common to all jobs (units) because masses of identical or similar units are being manufactured.
3.5 Accounting for scrap

Scrap is residual material that results from manufacturing a product; it has low total sales value
compared with the total sales value of the product. No distinction is made between normal and
abnormal scrap because no cost is assigned to scrap. The only distinction made is between scrap
attributable to a specific job and scrap common to all jobs.
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 revenues from scrap be accounted for? To illustrate
this, we extend the case of BOING machine shop. Assume the manufacture of aircraft parts generates
scrap and that the scrap from a job has a net sales value of Br.900.
1. Recognizing Scrap at the Time of Its Sale
When the Birr amount of the scrap is immaterial, the simplest accounting is to record the physical
quantity of scrap returned to the storeroom and to record scrap sales as a separate line item in the
income statement. In this case, the only journal entry is:
Sales of Scrap: Cash or Accounts Receivable 900
Scrap Revenues 900
When the Birr 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 is common to all jobs.
Scrap Attributable to a Specific Job: Job-costing systems sometimes trace scrap revenues to the jobs
that yielded the scrap. This method is used only when the tracing can be done in an economically
feasible way. For example, BOING Machine Shop and its customers may reach an agreement that
provides for charging specific jobs with all rework or spoilage costs and then crediting these jobs with
all scrap revenues that arise from the jobs. The journal entry is:
Scrap returned to storeroom: No journal entry.
Sale of scrap: Cash or Accounts Receivable 900
Work-in-Process Control 900
Unlike spoilage and rework, there is not cost assigned to the scrap, so no distinction is made between
normal and abnormal scrap. All scrap revenues, whatever the amount, are credited to the specific job.
Scrap revenues reduce the costs of the job. The journal entry for Scrap common to all jobs is given as
follows
Scrap returned to storeroom: No journal entry.
Sale of Scrap: Cash or accounts receivable 900
MOH control 900
2. Recognizing Scrap at the Time of its Production
Our Preceding illustrations assume that scrap returned to the storeroom is sold quickly, is not assigned
an inventory cost figure. Sometimes, as in the case with edges of molded plastic parts, the value of
scrap is not immaterial, and the time between storing it and selling reusing it can be long. In these
situations, the company assigns an inventory cost to scrap at a conservative estimate of its net
realizable value so that production costs and related scrap revenues are recognized in the same
accounting period. Some companies tend to delay sales scrap until its market price is considered
attractive. Volatile price fluctuations are typical for scrap metal. In these cases, it‘s not easy to
determine some ―reasonable inventory value.‖
Scrap attributable to a specific job: The journal entry in the BOING example is:
Scrap retuned 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
Manufacturing Overhead Control 900
Observe that the materials control account is debited in place of cash or account receivable. When the
scrap is sold, the journal entry is:
Sale of Scrap: Cash or Accounts Receivable 900
Scrap is sometimes reused as direct material rather than sold as scrap. In this case, materials control is
debited at its estimated net realizable value when the scrap is reused. For example, the entries when
the scrap is common to all jobs are:
Scrap returned to storeroom: Materials Control 900
Manufacturing overhead control 900
Reuse of scrap: Work-in-process control 900
Accounting for scrap under process costing is like the accounting under job costing when scrap is
common to all jobs. That is because; the scrap in process costing is common to the manufacture of
mass of identical or similar units.
Note
1. Sometimes scrap may be sold for more or less than the value at which it is recorded. Any
difference between the sales price and the recorded value is treated as an adjustment to the account
that was originally credited. (i.e.,WIP, FOH-control, scrap revenue, Miscellaneous income, etc.)
2. If the market value of the scrap is not known, no journal entry is made until the scrap is sold. At
the time of sale, the following entry is made:
Cash ………………………… xxx
Scrap revenue (WIP or FOH-control)………………… xxx
Example
Bisrat Teshome Company maintains a scrap inventory account for metal scrap recovered from
operations in the cutting department. On sene 8, 1995 5,300 pounds of scrap with an estimated market
value of 2,385 are transferred from the factory to the storeroom.
Required:
1. The storage of the metal scrap. ( credit WIP account)
2. The cash sales of 1,900 pounds of scrap at recorded value
3. The sales of 2,100 pounds of scrap at 0.52 per pound on credit.
4. The sales of 1,300 pounds of scrap at 0.39 per pound on credit.
Solution
1. Scrap material……………..2,385
WIP inventory………………………… 2,385
2. Cash …………………………….. 855
Scrap material……………………………… 855
3. A/R ……………………….. 1,092
Scrap material ………………………..945
WIP inventory………………………..147
4. A/R………………………….. 507

WIP inventory ……………. 78

Scrap material …………………….585
CHAPTER four
INCOME EFFECT OF ALTERNATIVE PRODUCT COSTING METHODS
I. Inventory Costing Approaches

After a product is manufactured in a manufacturing process, the cost of the product should be determined.
The purposes of determining cost of a product are many. Therefore, a single cost cannot satisfy all purposes of
product costing. Because of this, accountant will calculate different cost for different purpose. For example,
for pricing decision, each and every cost should be added and considered as cost of production but for
financial reporting purpose, Generally Accepted Accounting Principles states that only manufacturing cost
should be considered as a product cost. In a manufacturing company, the three main manufacturing costs are
direct material cost, direct labor cost and manufacturing overhead costs. Direct material and direct labor costs
are usually variable in nature where as part of MOH cost is variable and the remaining is fixed. Based on this,
there are three known inventory costing methods. The following is a discussion of the three inventory costing
methods.
1. Absorption (Full costing): is the traditional method of inventory costing where all production costs i.e. both
variable and fixed costs are assigned to inventory cost.
2. Variable or marginal costing: is a method of inventory costing in which all variable production costs are
included as inventor able costs. All fixed manufacturing costs are excluded from inventor able cost.
3. Through put (Super variable) costing: is a costing method that treats all costs except those related to
variable direct material as expense. The only inventor able cost is direct material cost.
Income statement under alternative costing system
The measurement of net income under the three costing method differs. The difference result from the
amount of fixed manufactured over head cost. In general, the income measurements under the three
methods will differ when production and sales amount differs.
 If production is equal to sales, the operating income under absorption costing is the same as operating
income under direct costing
 If production is greater than sales, the operating income under absorption costing is greater than
operating income under direct costing
 If production is less than sales, the operating income under absorption costing is less than operating
income under direct costing
1. Format of Absorption Costing Income Statement
Sales ------------------------------- XX
Cost of goods sold:

Direct material ---------- xx

Direct labor ------------ xx
Variable MOH ---------- xx
Fixed MOH -------------- xx XX
Gross profit ----------------------- XX
Variable operating expense --------xx
Fixed operating expense ----------- xx
Operating income ------------------- XX
2. Format of Direct costing Income Statement
Sales revenue --------------------------XX
Variable costs & Expense:
Direct material -------------- xx
Direct labor ---------------- xx
Variable MOH ---------------xx
Variable expense ------------ xx XX
Contribution margin ------------------ XX
Fixed MOH cost ---------------------- XX
Fixed operating expense ---------------XX
Operating income ----------------------- XX
3. Format of Throughput Costing Income Statement
Sales revenue ------------------------ XX
Direct material cost ------------------XX
Throughput contribution ---------- XX
Direct labor cost ----------- xx
Variable MOH cost -------- xx
Fixed MOH cost ------------ xx
Variable operating expense --xx
Fixed operating expense ------xx XX
Operating income -----------------------XX
Illustration 1: To evaluate the performance of a given product line, ABC Company’s management wants to
prepare an income statement for the year 2008. The operating information for the year are given below
Beginning inventory 0
Production 800 units
Sales 600units
Ending Inventory 200 units
Selling price Br.100
Variable manufacturing cost per unit:
 Direct material cost per unit 11
 Direct manufacturing labor cost per unit 4
 Manufacturing overhead cost per unit 5
Total variable manufacturing cost per unit 20
Variable marketing cost per unit 19
Total Fixed manufacturing costs (all indirect) 12,000

Total Fixed marketing costs 10,800

For simplicity and to focus on the main idea, we assume the following about ABC Company:
 ABC incurs manufacturing and marketing cost only.
 The cost driver for all variable manufacturing costs is units produced.
 The cost driver for variable marketing costs is units sold.
 Work in process inventory is assumed to be zero
 The budgeted level of production for 2008 is 800 units which are used to calculate the budgeted fixed
manufacturing cost per unit. Fixed MOH cost per unit is Br.15 ( Br.12,000 / 800 units)
For ABC Company, Inventor able cost per unit in 2008 under the two methods is calculated as follows:
Variable
costing Absorption costing
Variable Manufacturing cost per unit produced
 Direct material cost per unit Br. 11 Br. 11
 Direct manufacturing labor cost per unit 4 4
 Manufacturing overhead cost per unit 5 5
Fixed manufacturing cost per unit produced - 15
Total inventor able cost per unit Br.20 Br. 35
 The basis of the difference between variable costing and absorption costing is how fixed manufacturing
costs are accounted for. As you see in the above table, fixed manufacturing cost is added under
absorption costing but is not included under variable costing.
If inventory level changes operating income will differ between the two methods because, of the difference in
accounting for fixed manufacturing costs.
For ABC Company above, income statement under the three approaches can be prepared as follows for the
year ended December 3, 2008:
ABC Company
Absorption Costing Income Statement
For the year ended December 31, 2008
Sales (600xBr.100) Br.60,000
Cost of goods sold
Direct material cost (600xBr. 11) Br. 6,600
Direct labor cost (600xBr.4) 2,400
Variable overhead cost ( 600xBr.5) 3,000
Fixed overhead cost ( 600x Br.15) 9,000
Gross profit 39,000
Variable marketing expense (600xBr.19) 11,400
Fixed marketing expense 10,800
Operating Income Br. 16,800

ABC Company
Variable Costing Income Statement
Sales (600xBr.100) Br.60,000
Variable cost and expenses:
Variable marketing expense ( 600xBr.19) 11,400
Total variable costs and expenses 23,400
Contribution margin Br.36,600
Fixed overhead cost 12,000
ABC Company
Throughput Costing Income Statement
Sales (600xBr.100) Br.60,000
Direct material Cost of goods sold 6,600
Throughput contribution Br.53,400
Other costs and expenses
Total other costs and expenses 41,400
In the above three income statement, we can see how the fixed manufacturing cost of Br.12, 000 are
accounted for under the three methods. The income statement under variable costing deducts the lump sum
Br. 12, 000 as an expense for the year. In contrast, the income statement under absorption costing regards
each finished good units as absorbing Br15 of fixed manufacturing costs. Under absorption costing, the Br
12,000 is initially treated as an inventor able cost of the year. If this Br. 9000 (Br.15x600) subsequently
becomes a part of goods sold in the year and Br. 3000 (Br.15x200) remains an asset part of ending finished
goods inventory on December 31, 2006. Operating income is Br. 3, 000 higher under absorption costing
compared to variable costing. The variable manufacturing costs are accounted the same way under both
methods.
The net income under throughput costing is less than that under absorption costing and variable costing. This
is because; all costs except direct material cost is considered as periodic expense under throughput costing.

That is all direct labor cost, variable manufacturing cost and all fixed manufacturing costs are considered as
expense under throughput costing approaches.
 If inventory level changes from one year to another, operating income will differ among the three
methods, because of the difference in the treatment of fixed MOH cost. Assume ABC Company
above, if the production and sales amount for the year 2009 are 800 units and 950 units
respectively and all the remaining data are the same as in 2008. Prepare the income statement
under the three inventory costing approaches
ABC Company
Absorption Costing Income Statement
Sales (950xBr.100) Br.95,000
Cost of goods sold:
Gross profit 61,750
ABC Company
Variable Costing Income Statement
Sales (950xBr.100) Br. 95,000
Variable cost and expenses:
Variable marketing expense ( 950xBr.19) 18,050
Total variable costs and expenses 37,050
Gross profit Br.57,950
Fixed overhead cost 12,000
ABC Company
Throughput Costing Income Statement
Sales (950xBr.100) Br. 95,000
Direct material Cost of goods sold Br. 10,450
Throughput contribution Br. 84,550

Other costs and expenses:

Total other costs and expenses 48,050
Why do variable costing and absorption costing usually report different income? The difference in reported
operating income is due solely to;
 Moving fixed manufacturing costs in to inventories as inventories increase and
 Moving fixed manufacturing costs out of inventories as inventory decreases
The difference between operating income under absorption costing and variable costing can be computed by
the following formula which focuses on fixed manufacturing cost in beginning inventory and ending inventory.
Absorption costing - Variable costing = FMOH cost - FMOH cost
Operating income Operating income in end. Inventory in beg. Inventory
2008: 16,800 – 13,800 = 200x15 -15x0

3000 = 3000
2009: 32,900 – 35,150 = 15x50 – 15x200
-2250 = -2250
 Comparison among the Three Costing Systems
Items of comparison Absorption costing Direct costing Through put costing
Direct material Product cost Product cost Product cost
Direct labor Product cost Product cost periodic cost
Variable MOH Product cost Product cost periodic cost
Fixed MOH Product cost periodic cost periodic cost
Variable Op.Exp. periodic cost periodic cost periodic cost
Fixed Op. Exp. periodic cost periodic cost periodic cost
GAAP Acceptable Not Acceptable Not Acceptable
Usefulness For external reporting For internal reporting For internal reporting
Performance eval. Not useful Useful useful
Terms used Gross profit Contribution margin Throughput cont.
If Sales= prod. ,NI Equal Equal Equal
If Sales < prod., NI Higher Medium lower
If Sales >prod., NI Lower Medium Higher
II. Denominator-Level Capacity Concepts and Fixed-Cost Capacity Analysis

We have seen that the difference between variable and absorption costing methods arises solely from the
treatment of fixed manufacturing costs. Spending on fixed manufacturing costs enables firms to obtain the
scale or capacity needed to satisfy the expected demand from customers. Determining the “right” amount of
spending, or the appropriate level of capacity, is one of the most strategic and most difficult decisions
managers face. Having too much capacity to produce relative to that needed to meet market demand means
incurring some costs of unused capacity. Having too little capacity to produce means that demand from some
customers may be unfilled. These customers may go to other sources of supply and never return. Therefore,
both managers and accountants should have a clear understanding of the issues that arise with capacity costs.
We start by analyzing a key question in absorption costing: Given a level of spending on fixed manufacturing
costs, what capacity level should be used to compute the fixed manufacturing cost per unit produced?
Absorption Costing and Alternative Denominator-Level Capacity Concepts
The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly
affect the operating income reported under normal costing or standard costing and the product-cost
information available to managers.
Consider the XYZ Company. The annual fixed manufacturing costs of the production facility are $1,080,000.
XYZ currently uses absorption costing with standard costs for external reporting purposes, and it calculates its
budgeted fixed manufacturing rate on a per unit basis. We will now examine four different capacity levels
used as the denominator to compute the budgeted fixed manufacturing cost rate: theoretical capacity,
practical capacity, normal capacity utilization, and master-budget capacity utilization.
Theoretical Capacity and Practical Capacity

In business and accounting, capacity ordinarily means a “constraint,” an “upper limit.”Theoretical capacity is
the level of capacity based on producing at full efficiency all the time. XYZ can produce 25 units per shift when
the production lines are operating at maximum speed. If we assume 360 days per year, the theoretical annual
capacity for 2 shifts per day is as follows:
25 units per shift * 2 shifts per day * 360 days = 18,000 units
Theoretical capacity is theoretical in the sense that it does not allow for any plant maintenance, shutdown
periods, interruptions because of downtime on the assembly lines, or any other factors. Theoretical capacity
represents an ideal goal of capacity utilization. Theoretical capacity levels are unattainable in the real world
but they provide a target to which a company can aspire.
Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable
operating interruptions, such as scheduled maintenance time, shutdowns for holidays, and so on. Assume that

practical capacity is the practical production rate of 20 units per shift (as opposed to 25 units per shift under
theoretical capacity) for 2 shifts per day for 300 days a year (as distinguished from 360 days a year under
theoretical capacity). The practical annual capacity is as follows: Engineering and human resource factors are
both important when estimating theoretical or practical capacity. Engineers at the XYZ facility can provide
input on the technical capabilities of machines for cutting and polishing lenses. Human-safety factors, such as
increased injury risk when the line operates at faster speeds, are also necessary considerations in estimating
practical capacity. With difficulty, practical capacity is attainable.
Normal Capacity Utilization and Master-Budget Capacity Utilization

Both theoretical capacity and practical capacity measure capacity levels in terms of what a plant can supply—
available capacity. In contrast, normal capacity utilization and master-budget capacity utilization measure
capacity levels in terms of demand for the output of the plant, that is, the amount of available capacity the
plant expects to use based on the demand for its products. In many cases, budgeted demand is well below
production capacity available.
Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a
period (say, two to three years) that includes seasonal, cyclical, and trend factors. Master-budget capacity
utilization is the level of capacity utilization that managers expect for the current budget period, which is
typically one year. These two capacity utilization levels can differ—for example, when an industry, such as
automobiles or semiconductors, has cyclical periods of high and low demand or when management believes
that budgeted production for the coming period is not representative of long-run demand.
Consider XYZ’s master budget for 2012, based on production of 8,000 telescopes per year. Despite using this
master-budget capacity-utilization level of 8,000 telescopes for 2012, top management believes that over the
next three years the normal (average) annual production level will be 10,000 telescopes. It views 2012’s
budgeted production level of 8,000 telescopes to be “abnormally” low because a major competitor has been
sharply reducing its selling price and spending large amounts on advertising. XYZ expects that the
competitor’s lower price and advertising attack will not be a long-run phenomenon and that, by 2014 and
beyond, XYZ ’s production and sales will be higher.
Effect on Budgeted Fixed Manufacturing Cost Rate

We now illustrate how each of these four denominator levels affects the budgeted fixed manufacturing cost
rate. XYZ has budgeted (standard) fixed manufacturing overhead costs of $1,080,000 for 2012. This lump-sum
is incurred to provide the capacity to produce telescopes. The amount includes, among other costs, leasing

costs for the facility and the compensation of the facility managers. The budgeted fixed manufacturing cost
rates for 2012 for each of the four capacity-level concepts are as follows:
Denominator-Level Budgeted Fixed Budget Capacity Budgeted Fixed
Capacity Concept Manufacturing Costs Level (in units) Manufacturing Cost
per Year per Unit
(1) (2) (3) (4) = (2) / (3)
Theoretical capacity $1,080,000 18,000 $ 60
Practical capacity $1,080,000 12,000 $ 90
Normal capacity $1,080,000 10,000 $108
utilization
Master-budget $1,080,000 8,000 $135
capacity utilization
The significant difference in cost rates (from $60 to $135) arises because of large differences in budgeted
capacity levels under the different capacity concepts. Budgeted (standard) variable manufacturing cost is $200
per unit. The total budgeted (standard) manufacturing cost per unit for alternative capacity-level concepts is
as follows:
Denominator-Level Budgeted variable Budgeted Fixed Budgeted Total
Capacity Concept Manufacturing Costs Manufacturing Cost Manufacturing Cost
per unit per Unit per Unit
(1) (2) (3) (4) = (2) + (3)
Theoretical capacity $200 $ 60 $260
Practical capacity $200 $ 90 $290
Normal capacity $200 $108 $308
utilization
Master-budget $200 $135 $335
capacity utilization
Because different denominator-level capacity concepts yield different budgeted fixed manufacturing costs per
unit, XYZ must decide which capacity level to use. XYZ is not required to use the same capacity-level concept,
say, for management planning and control, external reporting to shareholders, and income tax purposes.

The major factors managers consider in choosing the capacity level to compute the budgeted fixed
manufacturing cost rate are
 Product Costing and Capacity Management,
 Pricing Decisions
 External Reporting
 Performance evaluation
 Tax requirements
III. External Reporting

The magnitude of the favorable/unfavorable production-volume variance under absorption costing is affected
by the choice of the denominator level used to calculate the budgeted fixed manufacturing cost per unit.
Assume the following actual operating information for XYZ in 2012:
Beginning inventory 0
Production 8,000 units
Sales 6,000 units
Ending inventory 2,000 units
Selling price $ 1,000 per unit
Variable manufacturing cost $ 200 per unit
Fixed manufacturing costs $ 1,080,000
Variable marketing cost $ 185 per unit sold
Fixed marketing costs $ 1,380,000
Assume that there is no price, spending, or efficiency variances in manufacturing costs. Equation used to
calculate the production-volume variance:
Production volume variance = (Budgeted fixed manufacturing overhead) - (Fixed manufacturing overhead
allocated using budgeted cost per output unit allowed for actual output produced)
The four different capacity-level concepts result in four different budgeted fixed manufacturing overhead cost
rates per unit. The different rates will result in different amounts of fixed manufacturing overhead costs
allocated to the 8,000 units actually produced and different amounts of production-volume variance. Using
the budgeted fixed manufacturing costs of $1,080,000 (equal to actual fixed manufacturing costs) and the
rates calculated so far for different denominator levels, the production-volume variance computations are as
follows:
Production-volume variance (theoretical capacity)

$1,080,000 – (8,000 units * $60 per unit)

= $1,080,000 - 480,000
= 600,000 Unfavorable
Production-volume variance (practical capacity)
= $1,080,000 - (8,000 units * $90 per unit)
= $1,080,000 - 720,000
Production-volume variance (normal capacity utilization)
= $1,080,000 - (8,000 units * $108 per unit)
= $1,080,000 - 864,000
Production-volume variance (master-budget capacity utilization) = $1,080,000 - (8,000 units * $135
per unit)
= $1,080,000 - 1,080,000
=0
How XYZ disposes of its production-volume variance at the end of the fiscal year will determine the effect this
variance has on the company’s operating income. We now discuss the three alternative approaches XYZ can
use to dispose of the production-volume variance.
1. Adjusted allocation-rate approach. This approach restates all amounts in the general and subsidiary ledgers
by using actual rather than budgeted cost rates. Given that actual fixed manufacturing costs are $1,080,000
and actual production is 8,000 units, the recalculated fixed manufacturing cost is $135 per unit ($1,080,000 ÷
8,000 actual units). Under the adjusted allocation-rate approach, the choice of the capacity level used to
calculate the budgeted fixed manufacturing cost per unit has no effect on yearend financial statements. In
effect, actual costing is adopted at the end of the fiscal year.
2. Proration approach. The under allocated or over allocated overhead is spread among ending balances in
Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold. The proration restates the ending
balances in these accounts to what they would have been if actual cost rates had been used rather than
budgeted cost rates. The proration approach also results in the choice of the capacity level used to calculate
the budgeted fixed manufacturing cost per unit having no effect on year-end financial statements.
3. Write-off variances to cost of goods sold approach. Example below shows how use of this approach affects
XYZ’s operating income for 2012. Recall that XYZ had no beginning inventory, and it had production of 8,000
units and sales of 6,000 units. Therefore, the ending inventory on December 31, 2012, is 2,000 units. Using
master budget capacity utilization as the denominator-level results in assigning the highest amount of fixed
manufacturing cost per unit to the 2,000 units in ending inventory (see the line item “deduct ending

inventory” in Example below). Accordingly, operating income is highest using master-budget capacity
utilization. The differences in operating income for the four denominator-level concepts in Example are due to
different amounts of fixed manufacturing overhead being inventoried at the end of 2012:
Fixed Manufacturing Overhead
In December 31, 2012, Inventory
Theoretical capacity 2,000 units * $60 per unit = $120,000
Practical capacity 2,000 units * $90 per unit = $180,000
Normal capacity utilization 2,000 units * $108 per unit = $216,000
Master-budget capacity utilization 2,000 units * $135 per unit = $270,000
In Example below, for example, the $54,000 difference ($1,500,000 – $1,446,000) in operating income
between master-budget capacity utilization and normal capacity utilization is due to the difference in fixed
manufacturing overhead inventoried ($270,000 – $216,000).
When the amount of fixed manufacturing costs incurred that is included in ending inventory at the end of the
year increases, so does operating income. The amount of fixed manufacturing costs inventoried depends on
two factors:
1. the number of units in ending inventory and
2. the rate at which fixed manufacturing costs are allocated to each unit

CHAPTER SIX: COST ALLOCATION
1. Introduction
Most large organizations have both operating departments and service departments. The main activities of an
organization are carried out in the operating departments. In contrast, service departments do not directly
engaged or involved in producing the organization's goods or services. Instead, they provide service or
assistance that enables the organization's production process to take place. For example, the Maintenance
Department in an automobile plant does not make automobiles, but if it did not exist, the production process
would stop when the manufacturing machines broke down. Thus, the Maintenance Department is crucial to the
production operation even though the repair personnel do not work directly on the plant's products.
Service departments are important in nonmanufacturing organizations also. For example, a hospital's Personnel
Department is responsible for staffing the hospital with physicians, nurses, lab technicians, and other
employees. The Personnel Department never serves the patients, yet without it the hospital would have no staff
to provide medical care.
A service department such as the Maintenance Department or the Personnel Department must exist in order to
carry out its primary function of an organization‘s producing department. Therefore, the cost of running a

service department is part of the cost incurred by the organization in producing goods or services. In order to
determine the cost of those goods or services, all service department costs must be allocated to the production
departments in which the goods or services are produced. For this reason, the costs incurred in an automobile
plant's Maintenance Department are allocated to all of the production departments that have machinery. The
costs incurred in a hospital's Personnel Department are allocated to all of the departments that have personnel.
Direct-patient-care departments, such as Surgery and Physical Therapy, are allocated their share of the
Personnel Department's costs.
Costs that are related to particular cost object but cannot be traced to it in economically feasible way are called
manufacturing overhead or indirect costs. The term cost allocation describes assigning of indirect costs to the
chosen cost object.
2. Types of Departments
If departments are the cost objects, departments are classified as either producing departments or support
departments.
Definition: responsible for creating the products Provide essential support services for
or services sold to customers producing departments
Examples: assembly department, finishing department maintenance, personnel, security
Even if, support departments do not work directly on the products of an organization, the costs of providing
these support services are part of the product cost.
3. The main objectives (purposes) of cost allocation are:

Costs that are related to a particular cost object but cannot be traced to it in an economically feasible way are
called manufacturing overhead cost or indirect cost. The term cost allocation describes assigning indirect cost
to the chosen cost object. Cost allocation can also be assigning cost from one or more service giving
departments to operating departments. The followings are some of the purposes of cost allocation.
 To provide information for economic decision
 To justify cost or compute reimbursement
 To measure income and asset for reporting
 To encourage managers of operating departments to make wise use of services provided by service
departments.
 To provide more complete cost data for making decisions in operating departments
 To help measure profitability in the operating departments
 To put pressure on the service departments to operate efficiently
 To develop overhead rates in the operating departments.
There is no one best way of allocating cost to cost objects. However, the followings are the Criteria for guiding
cost allocation decisions usually used by cost accountants.
1. Cause and Effect Criteria: Using this criterion, a manager identifies the variables that cause a resource to be
consumed. For example, managers may use hours of testing as a variable when allocating the cost of quality
test area to products. Cost allocation based on cause and effect criteria are likely to be the most credible to
operating personnel

2. Benefit Received Criteria: using these criteria managers identifies the beneficiary of the output of the cost
object. The cost of the cost object is allocated among the beneficiaries in proportion to the benefit each
received. Consider corporate wide advertising program that promote the general image of the corporation
rather than any individual product. The cost of this program may be allocated on the basis of individual
revenue; the higher the revenue, the higher the divisions allocated cost of the advertising program. The
rationale behind this allocation is that division with higher revenue has apparently benefited from the
advertising more than division with lower revenue and, therefore ought to be allocated more of the
advertising cost.
3. Fairness or Equity: This criterion is often cited in government contracts when cost allocations are the basis
of establishing a price satisfactory to the government and its suppliers. Cost allocation here is viewed as a
reasonable or fair means of establishing a selling price in the mind of the contracting parties.
4. Ability to Bear: This criteria advocates allocating costs in proportion to the cost objects ability to bear cost
allocated to income. An example is the allocation of corporate executive salaries on the basis of division
operating income. The presumption is that the more profitable division have a greater ability to absorb
corporate headquarters cost.
4. Allocating One Department’s Costs to another Department

Support department costs are allocated through the use of a charging rate. Considerations that go into
determining an appropriate charging rate include
1) The choice of a single or a dual rate and
2) The use of budgeted versus actual support department costs.
Approaches to allocating support-department costs:
i. Single-rate cost-allocation method and
ii. Dual-rate cost-allocation method.
A. Single rate method
1. Both fixed and variable costs are combined into a single rate. The amount of service cost allocated
is solely a function of usage/volume.
2. The use of a single rate treats the fixed cost as it was variable. It ignores the differential impact of
changes in usage on costs. Fixed costs do not vary with the level of services.
B. Dual rate method
Dual rate method partitions the cost of each support department into two pools, a variable cost pool and
a fixed-cost pool, and allocates each pool using a different cost-allocation base. These are used to avoid
the treatment of fixed costs as variable.
NB: When using either the single-rate method or the dual-rate method, managers
can allocate support-department costs to operating divisions based on either a
budgeted rate or the eventual actual cost rate.
Example
The central computer department of Sand Hill Company (SHC) has two users, both operating divisions: the
microcomputer division and the peripheral equipment division. The following data relate to the 2012 budget:
Practical capacity 18,750 hours

Fixed costs of operating the computer facility in the

6,000-hour to 18,750-hour relevant range $3,000,000
Budgeted long-run usage (quantity) in hours:
Microcomputer division 8,000 hours
Peripheral equipment division 4, 000 hours
Total 12,000 hours
Budgeted variable cost per hour in the 6,000-hour to
18,750-hour relevant range $200per hour used
Actual usage in 2012 in hours:
Microcomputer division 9,000 hours
Peripheral equipment division 3,000 hours
Total 12,000 hours
Required:
1. Compute the charging /allocation rate to allocate the central computer department costs based on
a. The demand for (or usage of) computer services
b. Based on the supply of computer services or practical capacity and
2. Allocate the central computer department cost to the two producing departments using single and dual
rate method.
1. Allocation Based on the demand or usage of computer service
Single-Rate Method
In this method, a combined budgeted rate is used for fixed and variable costs. The rate is calculated as follows:
Budgeted usage 12,000 hours
Budgeted total cost pool: $3,000,000 + (12,000 hours * $200/hour) $5,400,000
Budgeted total rate per hour: $5,400,000 ÷ 12,000 hours $450 per hour used
Allocation rate for microcomputer division $450 per hour used
Allocation rate for peripheral equipment division $450 per hour used
Under the single-rate method, divisions are charged the budgeted rate for each hour of actual use of the central
facility. Applying this to our example, SHC allocates central computer department costs based on the $450 per
hour budgeted rate and actual hours used by the operating divisions. The support costs allocated to the two
divisions under this method are as follows:
Microcomputer division: 9,000 hours * $450 per hour $4,050,000
Peripheral equipment division: 3,000 hours * $450 per hour $1,350,000
Dual-rate method
The costs allocated to the microcomputer division in 2012 under the dual-rate method would be as follows:
Fixed costs: $250 per hour * 8,000 (budgeted) hours $2,000,000
Variable costs: $200 per hour * 9,000 (actual) hours 1,800,000
Total costs $3,800,000
The costs allocated to the peripheral equipment division in 2012 would be as follows:
Variable costs: $200 per hour * 3,000 (actual) hours 600,000
Note that each operating division is charged the same amount for variable costs under the single-rate and dual-
rate methods ($200 per hour multiplied by the actual hours of use). However, the overall assignment of costs
differs under the two methods because the single-rate method allocates fixed costs of the support department
based on actual usage of computer resources by the operating divisions, whereas the dual-rate method allocates
fixed costs based on budgeted usage.
2. Allocation Based on the Supply of Capacity

We illustrate this approach using the 18,750 hours of practical capacity of the central computer department. The
budgeted rate is then determined as follows:
Budgeted fixed-cost rate per hour, $3,000,000 ÷ 18,750 hours $160 per hour
Budgeted variable-cost rate per hour $200 per hour
Budgeted total-cost rate per hour $360 per hour
Using the same procedures for the single-rate and dual-rate methods as in the previous section, the support cost
allocations to the operating divisions are as follows:
Single-Rate Method
Microcomputer division: $360 per hour * 9,000 (actual) hours $3,240,000
Peripheral equipment division: $360 per hour * 3,000 (actual) hours 1,080,000
Fixed costs of unused computer capacity: $160 per hour * 6,750 hours a 1,080,000
a
6,750 hours = Practical capacity of 18,750 – (9,000 hours used by microcomputer division + 3,000 hours used
by peripheral equipment division).
Dual-Rate Method
Microcomputer division
Variable costs: $200 per hour * 9,000 (actual) hours 1,800,000
Peripheral equipment division
Fixed costs: $160 per hour * 4,000 (budgeted) hours $ 640,000
Variable costs: $200 per hour * 3,000 (actual) hours 600,000
Fixed costs of unused computer capacity: $160 per hour * 6,750 hours b $1,080,000
b
6, 750 hours = Practical capacity of 18,750 hours – (8,000 hours budgeted to be used by microcomputer
division + 4,000 hours budgeted to be used by peripheral equipment division).
When practical capacity is used to allocate costs, the single-rate method allocates only the actual fixed-cost
resources used by the microcomputer and peripheral equipment divisions, while the dual-rate method allocates
the budgeted fixed-cost resources to be used by the operating divisions. Unused central computer department
resources are highlighted but usually not allocated to the divisions.*
*
In this example, the cost of unused capacity under the single-rate and the dual-rate methods
coincide (each equals $1,080,000). This occurs because the total actual usage of the facility matches
the total expected usage of 12,000 hours. The budgeted cost of unused capacity (in the dual-rate
method) can be either greater or lower than the actual cost (in the single rate method), depending on
whether the total actual usage is lower or higher than the budgeted usage.
Benefit of the single-rate method
 Is the low cost to implement
 Avoids expensive analysis necessary to classify the individual cost items of a department into fixed
and variable categories.
Disadvantage of single-rate method
 It makes the allocated fixed costs of the support department appear as variable costs to the
operating divisions. Consequently, the single-rate method may lead division managers to make
outsourcing decisions that are in their own best interest but that may be inefficient from the

standpoint of the organization as a whole.

Benefit of the dual-rate method
 It signals to division managers how variable costs and fixed costs behave differently. This
information guides division managers to make decisions that benefit the organization as a whole, as
well as each division.
Disadvantage of dual-rate method
 Requires expensive analysis necessary to classify the individual cost items of a department into
fixed and variable categories.
The advantage of using practical capacity to allocate costs is
 It focuses management‘s attention on managing unused capacity.
 Using practical capacity also avoids burdening the user divisions with the cost of unused capacity
of the central computer department.
 In contrast, when costs are allocated on the basis of the demand for computer services, all
$3,000,000 of budgeted fixed costs, including the cost of unused capacity, are allocated to user
divisions. So, if costs are used as a basis for pricing, then charging user divisions for unused
capacity could result in the downward demand spiral.
Budgeted versus Actual Usage
In both the single-rate and dual-rate methods, we use budgeted rates to assign support department costs (fixed as
well as variable costs). An alternative approach would involve using the actual rates based on the support costs
realized during the period. This method is much less common because of the level of uncertainty it imposes on
user divisions. When allocations are made using budgeted rates, managers of divisions to which costs are
allocated know with certainty the rates to be used in that budget period. Users can then determine the amount of
the service to request and if company policy allows whether to use the internal source or an external vendor. In
contrast, when actual rates are used for cost allocation, user divisions are kept unaware of their charges until the
end of the budget period.
Budgeted rates also help motivate the manager of the support (or supplier) department (for example, the central
computer department) to improve efficiency. During the budget period, the support department, not the user
divisions, bears the risk of any unfavorable cost variances. That‘s because user divisions do not pay for any
costs or inefficiencies of the supplier department that cause actual rates to exceed budgeted rates. The manager
of the supplier department would likely view the budgeted rates negatively if unfavorable cost variances occur
due to price increases outside of his or her control.
Some organizations try to identify these uncontrollable factors and relieve the support department manager of
responsibility for these variances. In other organizations, the supplier department and the user division agree to
share the risk (through an explicit formula) of a large, uncontrollable increase in the prices of inputs used by the
supplier department. This procedure avoids imposing the risk completely on either the supplier department (as
when budgeted rates are used) or the user division (as in the case of actual rates).
5. Allocating Costs of Multiple Support Departments

Many companies have multiple support departments, and they frequently interact. These interactions among
support departments need to be considered to produce accurate cost assignments. Three methods can be used to
allocate support department costs:
1. The direct allocation method
2. The step-down /sequential method
3. The reciprocal method
In determining which support department cost allocation method to use, companies must:

 Determine the extent of support department interaction.

 Weigh the costs and benefits associated with each method.
i. Direct method: - This is the most simple and straightforward of the three allocation methods. Under
this method,
 No support department costs are allocated to any other support department.
 All interactions between the support departments are ignored.
Example: Machining and Assembly are the only production departments that used the services of the
Human Resources Department in March. Costs from Human Resources are allocated based on the
number of new hires. Machining hired seven employees in March and Assembly hired three
employees. Human Resources incurred total costs of $93,000 in March.
Allocation of H.R. Department costs to Machining: 70% of $93,000 = $65,100
Allocation of H.R. Department costs to Assembly: 30% of $93,000 = $27,900
The main feature of the direct method is that no information is necessary about whether any service
departments utilized services of the Human Resources Department. It does not matter whether no
other service department hired anybody, or whether three other service departments each hired five
employees (implying that more than 50% of the hiring occurred in the service departments). Under
the direct method, service department to service department services are ignored, and no costs are
allocated from one service department to another.
ii. Step-down/sequential method, also widely used, allocates costs of service departments to both
production and service departments. The sequence of allocation usually begins either with the
department rendering greatest number of service to the other service departments (or, alternatively, the
most costly service department) and progresses all the way to the one rendering the smallest number of
service to other departments (or to the least costly department). Once a service department's costs have
been allocated, no subsequent service department costs are allocated back to it.
Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to
the Machining and Assembly production departments, and in some cases, the service departments also
provide services to each other:
Total Cost Service % of services provided by the service department listed at left to:
Dept H.R. D.P. R.M. Machining Assembly
$ 80,000 H.R. -- 20% 10% 40% 30%
120,000 D.P. 8% -- 7% 30% 55%
40,000 R.M. -- -- -- 50% 50%
$240,000
The amounts in the far left column are the costs incurred by each service department. Any services that a
department provides to itself are ignored, so the intersection of the row and column for each service
department shows zero. The rows sum to 100%, so that all services provided by each service department are
charged out.
The company decides to allocate the costs of Human Resources first, because it provides services to two other
service departments, and provides a greater percentage of its services to other service departments. However,
a case could be made to allocate Data Processing first, because it has greater total costs than either of the
other two service departments. In any case, the company decides to allocate Data Processing second.
In the table below, the row for each service department allocates the total costs in that department (the
original costs incurred by the department plus any costs allocated to it from the previous allocation of other

service departments) to the production departments as well as to any service departments that have not yet
been allocated.
H.R. D.P. R.M. Machining Assembly
Costs prior to allocation $ 80,000 $120,000 $40,000 -- --
Allocation of H.R. ($ 80,000) 16,000 8,000 $32,000 $24,000
Allocation of D.P. (136,000) 10,348 44,348 81,304
Allocation of R.M. (58,348) 29,174 29,174
0 0 0 $105,522 $134,478
After the first service department has been allocated, in order to derive the percentages to apply to the
production departments and any remaining service departments, it is necessary to “normalize” these
percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P. can be
allocated back to H.R. The percentages for the remaining service and production departments sum to 92% (7%
+ 30% + 55%), not 100%. Therefore, these percentages are normalized as follows:
Risk Management: 7% ÷ 92% = 7.61%
Machining: 30% ÷ 92% = 32.61%
Assembly: 55% ÷ 92% = 59.78%
Total: 100.00%
For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to Assembly, not 55%.
The main feature of the step-down method is that once the costs of a service department have been
allocated, no costs are allocated back to that service department. As can be seen by adding $105,522 and
$134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production
departments. The intermediate allocations from service department to service department improve the
accuracy of those final allocations.
iii. Reciprocal method: - is the most accurate of the three methods for allocating service department costs,
because it recognizes reciprocal services among service departments. It is also the most complicated
method, because it requires solving a set of simultaneous linear equations.
Using the data from the step-down method example, the simultaneous equations are:
H.R. = $ 80,000 + (0.08 x D.P.)
D.P. = $120,000 + (0.20 x H.R.)
R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.)
Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of these service
departments. For example, Human Resources receive services from Data Processing, but not from Risk
Management. 8% of the services that Data Processing provides, it provides to Human Resources. Therefore,
the total costs allocated from Human Resources should include not only the $80,000 incurred in that
department, but also 8% of the costs incurred by Data Processing. Solving for the three unknowns:
H. R. = $ 91,057
D.P. = $138,211
R.M. = $ 58,781
Hence, costs are allocated as follows:
H.R. D.P. R.M. Machining Assembly
Costs prior to allocation $80,000 $120,000 $40,000 -- --
Allocation of H.R. ($91,057) 18,211 9,106 $36,423 $ 27,317
Allocation of D.P. 11,057 (138,211) 9,675 41,463 76,016
Allocation of R.M. (58,781) 29,390 29,390

$ 0 $ 0 $ 0 $107,276 $132,723
To illustrate the derivation of the amounts in this table, the $36,423 that is allocated from Human Resources
to Machining is 40% of H.R.’s total cost of $91,057.
Example 2: Evergreen Producers
Evergreen has two production departments, fabrication and assembly, and two major service departments,
material handling and power generation. The following table shows the costs incurred by each service
departments as well as the distribution of output among the other departments.
Material Power
Handling Generation Fabrication Assembly
Traceable costs $10,000 $4,000 -
Pounds of material used (%) 20 50 30
Power used, kWhr (%) 50 40 10
Required: allocate the costs of service department using:-
a. Direct method
b. Step down(assign material handling cost first)
c. Reciprocal method.
Direct Allocation Method
Fabrication: (5/8) (10,000) + (4/5) (4,000) = $ 9,450
Assembly: (3/8) (10.000) + (1/5) (4,000) = $ 4,550
$ 14,000
Note that the Direct Method simply ignores interdependencies among the service departments, i.e. the
method ignores that material handling consumes 50% of the total power generated.
Step Down Method
Each of the two service departments provides some service to the other service department.
Material Power
Handling Generation Fabrication Assembly
A. Allocate material
handling first
Overhead costs before $10,000 $4,000
allocation
Material handling (10,000) 2,000 $5,000 $3,000
(0.2, 0.5, 0.3)
Power generation (6,000) 4,800 1,200
(0.8, 0.2)
Reallocated Costs $9,800 $4,200
---------------------------------------------------------------------------------------------------------------------
B. Allocate power generation first
Overhead Costs $10,000 $4,000
Power generation 2,000 (4,000) $1,600 $ 400
(0.5, 0.4, 0.1)
Material handling (12,000) 7,500 4,500
(0.625, 0.375)
Reallocated Costs $9,100 $4,900
Reciprocal Method

Define x1 : Reallocated cost of the Mat. Handling Dept.

x2 : Reallocated cost of the Power Generation Dept.
The reallocated costs of each service department are its basic cost plus its share of the reallocated cost of the
other service department:
Material x1 = 10,000 + 0.5x2
Power x2 = 4,000 + 0.2x1
Solving these two simultaneous equations yields
x1 = (120,000 / 9) = 13,333,
x2 = (60,000 / 9) = 6,667.
We then allocate these costs to the two production departments using the appropriate coefficients in the
original table. For the fabrication department this results in:
z1 = 0.5(13,333) + 0.4(6,667) = 9,333
And for assembly
z2 = 0.3(13,333) + 0.1(6,667) = 4,667.
Note that z1 + z2 = $14,000. Note also that this allocation is different from the three allocations obtained using
the direct apportionment and step-down methods:
Fabrication Assembly
Direct apportionment $9,450 $4,550
Step Down: material handling first 9,800 4,200
Step Down: power generation first 9,100 4,900
Reciprocal 9,333 4,667
CHAPTER SEVEN: COST ALLOCATION-JOINT PRODUCTS AND BY PRODUCTS

Joint Products
In some manufacturing processes, multiple products emerge from the same material and the same production
process. For instance, edible oil and animal feed emerge from the same material and production process. Joint
products are products that simultaneously emerge from the same material and manufacturing process. The
cost of the material and production process is called joint production cost or simply joint cost. The followings
are some examples of industries that simultaneously yield two or more products from the same production
process.
Examples of Joint Cost Situations
Industry separable products at the split-off point
Agriculture and food process industries
Cocoa beans cocoa butter, cocoa powder, cocoa drink mix
Raw milk cream, liquid skim
Extractive industries
Coal coke, gas, benzol, tar, ammonia
Copper ore copper, silver, lead, zinc
Petroleum crude oil, natural gas
Salt hydrogen, chlorine, caustic soda
Chemical industries
Raw LPG (liquefied petroleum gas butane, ethane, and propane
Crude oil gasoline, kerosene, benzene, naphtha
Terminologies

 Joint Costs – costs of a single production process that yields multiple products simultaneously i.e.
Material, labor, and overhead incurred during a joint process.
 Split off Point – the place in a joint production process where two or more products become separately
identifiable
 Separable Costs – all costs incurred beyond the split off point that are assignable to each of the now-
identifiable specific products
 Main Product – output of a joint production process that yields one product with a high sales value
compared to the sales values of the other outputs
 Joint Products – outputs of a joint production process that yields two or more products with a high
sales value compared to the sales values of any other outputs
 Byproducts – outputs of a joint production process that have low sales values compare to the sales
values of the other outputs
I. Approaches to Joint Cost Allocation

As mentioned earlier, a joint production process results in multiple products. Normally, the different outputs
produced are not sold uniformly altogether and may not have the same sales value. Thus, it is essential to
allocate the join cost among the products. Here, one thing you need to be sure is that it is impossible to know
the cost of each output, as the products themselves are not even separate till the split off point. The following
are some of the reasons for the allocation of joint costs:
 Without joint cost allocation, it is impossible to prepare external purpose financial reports. What is the
value of units in the ending inventory?
 Without cost, it is impossible to price units. Further, management information for internal reporting
purposes is impossible.
 Sometimes, an organization may enter into a contract that works on the basis of commission and cost
reimbursement. When such is the case, to determine the amount of reimbursement, cost information
on the units is essential.
 In the event of possible loss of a main or joint product, insurance claims would be raised based on cost
information.
 When rate regulation exists, it is important to determine the cost of the product that is under the
price regulation.
Cost allocation is the process of apportioning costs among cost objects. Allocation is made in areas where cost
tracing is impossible. Nonetheless, the allocation process should not be arbitrary. It should follow some
reason. There are common ways of allocating cost to cost objects. The most common of which are allocating
costs to cost objects through cause and effect consideration, and allocating costs based on benefits received
criteria. Costs also be allocated based on some form of physical measure. Joint cost allocation could not follow
the cause and effect consideration. Joint costs are allocated based on benefits received criteria and through
physical measures. The following are the most common method of allocating joint cost to the products;
1. Allocating costs using physical measure methods
2. Allocating costs using revenue method
A. Sales value at split off point method
B. Estimated net realizable value method
C. Constant gross profit NRV method

The physical measure method uses physical measures like weight and volume as a base to allocate joint costs.
Sometimes the metric of the joint products may not be identical. When such happens, a common
measurement would be used to allocate the joint cost.
In the second method, revenue data are used as a means to allocate joint costs. The sales value at split off
point method uses the revenue of the joint products at the split off point to allocate the joint cost. The items
that generate the highest revenue would take the highest cost and the item with the lowest revenue would
share a proportionately lower cost. The other two methods work when the products at the split off point are
further processed and sold at a higher sales value. The estimated net realizable value method deducts the
separable costs from the value of the final product to arrive at the product at the split off point. The net value
will then be used to allocate the joint cost to the joint products. The constant gross profit margin keeps the
gross margin percentage of all the products constant. And the joint cost is allocated in such a way that the
gross margin percentage of all products becomes equal.
In the simplest joint production process, the joint products are sold at split off point without further
processing. The above joint cost allocation methods will be clear when we see their applications using
illustrative examples. To illustrate the four joint cost allocation approaches, we use the case of Sheno Lega
farmer’s cooperative.
Illustration 1: Sheno Lega Farmer’s cooperative purchase raw milk from individual farmers and process it until
the split of point, where two products – cream and liquid skim emerges. These two products are sold to an
independent company, which markets and distributes them to super-markets and other retail outlets in Addis
Ababa. In the year 2008, 110,000 gallon of raw milk was purchased and processed. Of this, 10,000 gallon was
lost in the production process due to evaporation, spoilage and the like, yielding 25,000 gallons of cream and
75,000 gallons of liquid skim. Cost of purchasing 110,000 gallon of raw milk and processing it until the split of
point to yield cream and liquid skim is Br.400, 000. The following table shows production and sales data for
the year ended December 31, 2008
Products Production Sales
Cream 25,000 gallons 20,000 gallons at Br.8 per gallon
Liquid skim 75,000 gallons 30,000 gallons at Br.4 per gallon
The following diagram depicts the basic relationship in this example
Cream
Raw milk Processing 25,000 gallon

110,000 gallon
Br.400, 000
Liquid skim
Split off point
Required: Allocate the joint cost using 75,000 gallon
1. Physical measure method
2. Sales value at split off method
1. Physical-measure method
The physical- measure method allocates joint costs to products on the basis of the relative weight, volume, or
other physical measures at the split off point of the total production of these products during the accounting
period. In the illustration above, the Br.400, 000 joint costs produces 25,000 gallons of cream and 75,000

gallons of liquid skim. Using the number of gallons produced as the physical measure, joint costs are allocated
as follows.
Cream Liquid Skim Total

Physical measure of total production(gallons) 25,000 75,000 100,000
weighting (cream: 25,000/100,000, liquid skim: 0.25 0.75
75,000/100,000)
Joint costs allocated (cream: 0.25xBr. 400,000, liquid skim
0.75xBr. 400,000) Br100,000 Br300,000 Br.400,000
Joint production cost per gallon (cream: Br. Br4/gal Br4/gal
100,000/25,000 gal, liquid skim, Br. 300,000/75, 000 gal)
The table below presents the product-line income statement using the physical –measure method:
Cream Liquid skim Total

Revenues (Cream, 20,000 gal x Br. 8/gal, Liquid skim, Br. 160,000 Br. 120,000 Br.280,000
30,000 gal x Br. 4/gal )
Costs of goods sold ( 20,000 gal x Br 4; 30,000 gal x Br. 80,000 120,000 200,000
4)
Gross margin Br. 80,000 0 Br. 80,000
Gross margin percentage 50% 0% 28.8%
Under the benefits- received criterion, the physical –measure method is less preferred than the sales value at
split off method. Why? Because it has no relationship to the revenue producing power of the individual
products. Consider a gold mine that extracts ore containing gold, silver and lead. Use of a common physical
measure (tons) would result in almost all costs being allocated to the products that weighs the most but has
the lowest revenue-producing power. In this case, the method of cost allocation is inconsistent with the
reason for the mine owner incurring mining costs- to find gold and silver, not lead.
In order to use physical measure method for joint cost allocation, the joint products should be expressed in
the same measuring unit. Determining which products of a joint process to include in a physical measure
computation can greatly affect the allocations between or among those products. Outputs with no sales value
(such as dirt in gold mining) are always excluded. Although many more tons of dirt than gold is produced costs
are not incurred to produce outputs that have zero sales vales. Byproducts with low sales values relative to
the joint products or the main product also are often excluded from the denominator used in the physical
measure method. The general guideline for the physical measure method is to include only the joint product
outputs in the weighting computations.
2. Sales Value at Split off Point Method

The sales value at split of point method allocates joint costs to joint products on the bases of the relative sales
value at the split off point of the total production of these products during the accounting period. For Sheno
Lega farmer’s cooperative, the joint cost will be allocated using sales value at the split off point method as
follows:


Sales value of total production at split off point (in Br.)
(Cream;25,000 gal x 8/gal; Liquid skim; 75,000 gal x 4/gal) 200,000 300,000 500,000
Weighting(200,000/500,000; 300,000/500,000) 0.40 0.60
Joint cost allocated (In Br.) (Cream,0.4 x Br. 400,000;
Liquidskim,0.60 x Br. 400,000) 160,000 240,000 400,000
Joint cost per gallon(Cream,160,000/25,000 gal; liquid
skim,240,000/75,000 gal) Br. 6.4/gal Br. 3.2/gal
This method uses sales value of the entire production of the accounting period. The reason is that, the joint
costs were incurred on all units produced not just the portion sold during the current period. The table below
presents the product-line income statement using the sales value at split off point method. Both cream and
liquid skims have gross- margin percentages of 20%.

Revenues (Cream, 20,000 gal x Br. 8/gal; Liquid Br. 160,000 Br. 120,000 Br. 280,000
skim, 30,000 gal x Br. 4/gal )
Costs of goods sold ( 20,000 gal x Br. 6.4; 30,000 gal 128,000 96,0000 224,000
x Br. 3.2)
Gross margin Br. 32,000 Br. 24,000 Br. 56,000
Gross margin percentage 20% 20% 20%
You can now see why the sales values at split off method follow the benefits-received criterion of cost
allocation. Costs are allocated to products in proportion to their expected revenues. This method is both
straightforward and intuitive. The cost allocation base is total sales value at split off point that is systematically
recorded in the accounting system. To use this method, a company needs the market selling price for all
products at the split off point.
3. Net Realizable Value (NRV) Method

In many cases, products are processed beyond the split off point to bring them to a marketable form or to
increase their value above their selling price at the split off point. To illustrate the cost allocation in this case,
let’s extend the case of Sheno Lega farmers cooperative.
Illustration 2: Assume the same data as in illustration 1, except that, here both cream and liquid skim can be
processed further. 25,000 gallons of cream are further processed to yield 20,000 gallons of butter cream at
additional processing costs of Br. 280, 000. Butter cream, which sells for Br. 25 per gallon, is used in the
manufacture of butter-based products. 75, 000 gallons of liquid skim are further processed to yield 50,000
gallons of condensed milk at additional processing costs of Br. 520, 000. Condensed milk sells for Br. 22 per
gallon. The following diagram depicts how raw milk is converted into cream and liquid skim in a joint
production process and how the cream is separately processed into butter cream and liquid skim is separately
processed into condensed milk.
Br.280, 000
Cream B. Cream
25,000 20,000gal
gallon
Raw milk Processing

110,000 gallon
Br.400, 000 Liquid skim Br.520, 000 C. Milk
75,000 gal 50,000gal
Split off point
Sales during the accounting period were 12,000 gallons of butter cream and 45,000 gallons of condensed milk
leaving 8,000 gallons of better cream and 5,000 gallons of condensed milk as end inventory. There is no other
beginning or end inventory than these two.
The net realizable value (NRV) method allocates joint cost to joint products on the basis of the relative NRV.
NRV is final sales value minus the separable costs of the total production of the joint products during the
accounting period. The NRV method is typically used in preference to the sales value at split off method only
when we don’t know the market selling prices for one or more products at split off point. Joint costs in this
example are allocated as follows:
Butter Condensed Total

Cream Milk
Final sales value (Butter cream: 20,000 gal x Br. Br. 500,000 Br. 1,100,000 Br1,600,000
25/gal, condensed milk 50,000 gal xBr.22/gal)
Deduct: Separable costs to complete and sell 280,000 520,000 800,000
Net realizable value at split off point Br. 220,000 Br. 580,000 Br. 800,000
Weighting (220,000/800,000;580,000/800,00) 0.275 0,725
Joint costs allocated (Butter cream 0.275x Br.110,000 Br.290,000 Br.400,000
400,000; condensed milk 0.725 x 400,000)
Production cost per gallon(Butter cream: Br.19.50/gal Br.16.20/gal.
{Br.110,000+Br.280,000}/20,000gal;condensed
milk {Br.290,000+Br.520,000}/50,000 gal)
The product line Income statement using the estimated NRV method can be prepared as follows
Butter
Cream Condensed Milk
Revenues (Butter cream, 12,000gal x Br.25/gal; Condensed milk
45,000 gal x Br.22/gal) Br. 300,000 Br. 990,000
Cost of goods sold :(Butter cream ,12,000gal x Br.19.50/gal;
Condensed Milk, 45,000 gal x Br.16.20/gal) 234,000 729,000
Gross Margin Br. 66,000 Br. 261,000
Gross Margin percentage 22% 26.4%
Because the sales value at split off method does not require knowledge of the processing steps beyond the
split off point, it is less complex than the NRV method. However using the sales value at split off method is not
always feasible. That is because; there may not be market prices for at least one of the products at the split off

point. Market prices may only be available after processing occurs beyond the split off point. In this case, we
have to use NRV method.
4. Constant Gross Margin Percentage NRV Method

The constant gross margin percentage NRV method allocates joint cost to joint products in such a way that the
overall gross margin percentage is identical for the individual products. This method entails three steps:
Step 1: Compute the overall gross margin percentage for all joint products together.
Step 2: Multiply the overall gross margin percentage and the final sales values of each product to calculate the
gross margin for each product. Subtract the gross margin for each product from the final sales value of each
product to obtain the costs that each product will bear.
Step 3: Deduct the separable costs from the total costs that each product will bear to obtain the joint cost
allocated.
The joint costs allocated to a product can be negative under this method. Some products may receive negative
allocation of joint costs to bring gross margin percentages up to the overall average. The following table
presents the overall income statement for the constant gross margin percentage NRV method.
Step 1 Total
Final sales value of total production ( 20,000 gal x Br. 25/gal + 50,000
gal x Br. 22/gal Br. 1,600,000
Less; Total cost (Br. 400,000 + Br. 800,000) 1,200,000
Gross Margin Br. 400,000
Gross Margin percentage(Br. 400,000/Br.1,600,000) 25%
Step 2 & 3 Butter Cream Condensed Milk

Final sales value of total production (Butter cream, 20,000 x
Br.25/gal; con. Milk , 50,000 gal x Br.22/gal) Br. 500,000 Br.1,100,000
Less : Gross margin (25% x Br.500,000, 25% x Br.1,100,000) 125,000 275,000
Cost of Goods available for sale Br. 375,000 Br. 825,000
Less: Separable cost to complete and sell 280,000 520,000
Joint costs Allocated Br.95,000 Br.305,000
Total cost per gallon ( Br. 375,000/20,000gal, Br.
825,000/50,000 gal Br.18.75/gal Br.16.5/gal
The constant gross margin percentage NRV method is different in one fundamental way from the two other
market based joint cost allocation methods described earlier. The sales value at split off method and the NRV
method allocate only the joint costs to the joint products. Neither method takes account of profits earned
either before or after the split off point when allocating the joint cost. In contrast, the constant gross margin
percentage NRV method is both a joint cost method and a profit allocation method. The total difference
between the sales value of production of all products and the separable cost of all products includes both (a)
the joint costs and (b) the total gross margin. Gross margin is allocated to the joint products under the
constant gross margin method to determine the joint cost allocation so that each product has the same gross
margin percentage. The following table presents the product line income statement under constant gross
margin NRV method.

Butter Cream Condensed Milk

Revenues (butter cream, 12,000 gal x Br.25/gal; condensed
milk 45,000 gal x Br. 22/gal) Br. 300,000 Br. 990,000
Cost of goods sold:(Butter cream ,12,000gal x Br. 18.75/gal;
Condensed Milk, 45,000 gal x Br. 16.50/gal) 225,000 742,500
Gross Margin percentage 25% 25%
 Which method of allocating joint costs should be used?

Use the sales value at split off method when selling price data are available (even if further processing is
done). Reasons for using the sales value at split off method include:
It measures the value of the joint product immediately at the end of the joint process.
The sales value at split off is the best measure of the benefits received as a result of joint processing
relative to all the other method of allocating joint costs.
The sales value at split off method does not require information on the processing steps after split off,
if there is further processing. In contrast, the NRV method and constant gross margin percentage NRV
method require information on (a) the specific sequence of further processing decisions (b) the
separable costs of further processing and (c) the point at which individual products are sold.
The sales value at Split off method and the other market-based methods have a meaningful basis to
allocate joint costs to products. In contrast the physical measure method may lack a meaningful basis
that can be used to allocate joint costs to individual products.
The sales value at split off method is simple. In contrast, the NRV and constant gross margin
percentage NRV method can be complex for processing operations having multiple products and
multiple split off points. This complexity is increased when management makes frequent changes in
the specific sequence of post split off processing decisions or in the point at which individual products
are sold.
When selling prices of all products at the split off point are not available, other joint cost allocation methods
are used. The NRV method attempts to approximate the sales value at split off by subtracting separable costs
incurred after the split off point on each product from selling prices. The NRV method assumes that the
markup or profit margin is attributable to the joint process and none of the markup is attributable to the
separable costs. Profit however, is attributable to all phase of production and marketing not just the joint
process. Despite its complexities, the NRV method is used when selling prices at split off are not available. It is
a better measure of benefits received compared with the constant gross margin percentage NRV method and
the physical measure method.
The main advantage of the constant gross margin percentage NRV method is that, it is easy to implement. This
method treats the joint products as though they comprise a single gross margin percentage to each products
and back into the joint costs allocated to each products. This method avoids the complexities inherent in the
NRV method to measure the benefits received by each of the joint products at the split off point. The main
issue with the constant gross margin percentage NRV method is the assumption that all the products have the
same ratio of cost to sales value across products is very uncommon in companies that produce multiple
products that do not involve joint cost.

Although there are difficulties in using the physical measure method, the lack of congruence with the benefits
received criterion and the possible lack of a meaningful common denominator for allocating the joint costs,
there are instances when it may be preferred, consider rate regulation. Market based measures are difficult to
use in the context of rate or price regulation. It is circular reasoning to use selling prices as a basis for setting
prices (rates) and at the same time use selling prices to allocate the costs on which prices (rates) are based. To
avoid this circular reasoning the physical measure method may be used in rate regulation.
II. Further Processing Decision
Many manufacturing companies constantly face the decision of whether to further process a joint product. For
example, Sheno Lega can sell the joint products: cream and liquid skim at the split off point or further process
them into butter cream and condensed milk. In the petroleum refining industry, the refiner must decide
whether to see raw liquefied petroleum gas as a product or process it further into butane, ethane and
propane.
Should the joint costs allocated to the joint products be used in making pricing decisions for each joint
product? No. why not? Because all joint cost allocations to products are somewhat arbitrary. There is no cause
and effect relationship that identifies the resources demanded by each joint product that can be used as a
basis for pricing.
Relevant revenues are expected future revenues that differ among alternative courses of action. These
concepts have important implications for decisions on whether a joint product should be sold at the split off
point or processed further. Joint costs incurred up to the split off point are irrelevant because these costs will
be incurred whether the product is sold at the split off point or processed further. Therefore, the decision
whether to process further should not be influenced by the total amount of the joint costs. The decision to
incur additional costs for further processing should be based on the incremental operating income attainable
beyond the split off point. The incremental analysis for these decisions to process further is given below
Butter Cream Condensed Milk
Incremental revenue (Butter cream, 20,000gal x Br. 25/gal-
25,000 gal x Br. 8/gal ; Condensed milk 50,000 gal x Br. 22/gal –
75,000 gal x Br. 4/gal) Br. 300,000 Br.800,000
Less: Incremental cost 280,000 520,000
Incremental income from further processing Br.20,000 Br.280,000
In this example, operating income increases for both products so the manager should process cream into
butter cream and liquid skim in to condensed milk. The Br. 400,000 joint costs incurred up to split off and how
they are allocated are irrelevant in deciding whether to process further. Why irrelevant? Because the joint
costs of Br. 400, 000 are the same whether or not further processing occurs.
Incremental costs are the additional costs incurred for an activity such as process further. Do not assume all
separable costs in joint cost allocation are always incremental costs. Some separable costs may be fixed costs
such as lease costs on building where the further processing is done: some costs may be sunk costs such as
depreciation on the equipment that converts cream into butter cream. Some separable costs may be
allocated costs such as corporate costs allocated to the condensed milk operations. None of these costs will
differ between the automotives of selling products at the split off point or processing further.

III. Accounting for Byproducts

Joint production processes may yield not only join products and main products but byproducts as well.
Although byproducts have much lower sales values than the sales values of joint or main products, the
presence of byproducts in a joint production process can affect the allocation of joint costs. Let’s consider a
two product example consisting of a main product and a byproduct.
Illustration 3: Kierra meat processing company processes meat from slaughterhouses. One of its
departments cuts lamb shoulders and generates two products: Shoulder meat (the main product) sold for Br.
60 per pack. Hock meat (the byproduct)-sold for Br.4 per pack (net of any selling costs). The data below
indicates the number of packs produced and packed in this department in July 2009:
Production Sales Ending inventory
Shoulder meat 5,000 4,000 1,000
Hock meat 1,000 300 700
The joint manufacturing costs of these products in July 2009 were Br. 250,000 comprising Br. 150, 000 for
direct materials and Br.100, 000 for conversion costs. Both products are sold at the split off point without
further processing. There are two byproduct accounting methods:
 Method A: Byproducts Recognized at Time Production is Completed

The production method - recognizes byproducts in the financial statements at the time production is
completed. This method recognizes the byproduct in the financial statements - the 1,000 packs of hock meat -
in the month it is produced, July 2009. The NRV form the byproduct produced is offset against the costs of the
main product
1. Work in process--------------------150,000
Accounts payable------------------------- 150,000
(To record direct materials of Br 150,000 used in production during July)
2. Work in process-------------------100,000
Various accounts -------------------100,000
(To record the consumption of conversion costs of Br. 100,000 in July)
3. Byproduct inventory—hock meat (1,000 packs x Br. 4/pack) -- 4,000
Finished goods—shoulder meat (Br.250, 000-Br.4, 000) ------- 246,000
Work in process (Br.150, 000+Br.100, 000) ---------- --------250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000 packs /5,000 packs) x Br. 246, 000--196,800
Finished goods –shoulder meat----------------------------------196,800
(To record the cost of the main product sold during July)
4b) Cash or Accounts receivable (4,000 packs x Br.60/pack) ---240,000
Revenues----shoulder meat----------------------------240,000
(To record the sales of the main product during July)
5) Cash or Accounts receivable (300 packs x Br. 4/pack) -----1,200
Byproducts inventory---hock meant------ ------1,200
(To record the sales of the byproduct during July)
This method reports the byproduct inventory of hock meat in the balance sheet prepared on July 31,2009 at
its Br. 4 per pack selling price [(1,000 packs-300 packs) x Br. 4/pack = Br. 2, 800]

 Method B: Byproducts Recognized at Time of Sale

The sales method delays recognition of byproducts until the time of sale. Recognition of byproducts at the
time of production is conceptually correct recognition than at the time of sales. However, sales method is
often used in practice when the birr amounts of the byproduct are immaterial. This method makes no journal
entries until sales of the byproduct occur. Revenues of the byproduct are reported as a revenue item in the
income statement at the time of sales. These revenues are grouped with other sales, included as other income
or deducted from cost of goods sold. In the above example, byproduct revenues in July 2004 are Br. 1, 200
(300 packs x Br. 4/pack) because only 300 packs of the hock meat are sold in July (of the 1,000 packs
produced). The journal entices are presented below:
Journal entries 1 and 2 are the same as for method A.
3. Finished goods---- shoulder meat 250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000 packs/ 5, 000packs) x Br.250, 000] 200,000
Finished goods-------------- ------------------------------200, 000
4b) The same as for method A.
5. Cash or account receivable------------ 1,200
Revenues----shoulder meat ----------- 1,200
(To record the sales of the byproduct during July)
Method B is used in practice primarily on the ground that the birr amounts of byproducts are immaterial.
However, this method permits managers to report earnings by timing when they sell byproducts. Managers
may store byproducts for several periods and give revenues and income a “small boost” by selling byproducts
accumulated over several periods when revenues and profits from the main product or joint products are low.
The following table presents the income statement and balance sheet under both methods:
Production method Sales method
Income statement
Revenue:
Main product 4,000 pack x Br. 60/pack Br. 240,000 Br. 240,000
By product 300 packs x Br 4/pack - 1,200
Total Revenue Br. 240,000 Br. 241,200
Cost of goods sold 196,800 200,000
Gross Margin Percentage 18% 17%
Balance sheet
End of period Inventory:
 Main product Br. 49,200 Br. 50,000
 Byproduct 2,800 0
Total Inventory Br. 52,000 Br. 50,000

Cost and Management Accounting I For 3rd Year Business Education Students

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Woldia University Faculty of Business & Economics Department of Accounting & Finance

DEPARTMENT OF ACCOUNTING AND FINANCE

FOR MANAGEMENT SECOND YEAR REGULAR

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 1

Chapter One: introduction to cost and management accounting

1.1 Accounting systems and their purposes

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 2

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 3

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 4

Purpose Help managers make decisions to Communicate organization‘s financial

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 5

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 6

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 7

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 8

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 9

1.5 Flow of Inventory Costs

Purchase of goods sales of goods

Other production costs*

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 10

1.6 Financial Statement for a Manufacturing Organization

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 11

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 12

Step 2: The Schedule of Cost Goods Manufactured

Step 3: The Schedule of Cost of Goods Sold

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 13

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 14

Operating expenses (1, 498,850)

Purchases of direct materials 73,000

Cost of direct materials available for use 84,000

Direct materials used Birr. 76,000

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 15

Chapter 2: job and process costing

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 16

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Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 18

Item Units Completed

Direct Materials Direct Labor Manufacturing Overhead

Started Ended Time Completed Rate Amount Job Number

Direct Materials Direct Labor Manufacturing Overhead

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 19

III. Application of Manufacturing Overhead Cost in Job Order Costing:

Job Number 2B47 Date Initiated March 2 ,2009

Direct Materials Direct Labor Manufacturing Overhead

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 20

Req. No. Amount Ticket Hours Amount Hours Rate Amount

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 21

5. General Approach to Job Costing

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 22

6. Accounting Procedures for Job order Costing

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 23

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 24

2. Issue of Direct and Indirect Materials:

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 25

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 26

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 27

Depreciation on factory equipment is debited to manufacturing overhead account but depreciation on

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 28

(Br.158 × 750units = Br.118, 500)

Cost and Management Accounting I (AcFn2141)-Handout-2012 EC. Page 29

Depreciation expense 7,000 .

Prepaid Insurance Salaries and Wages Payable Retained Earnings

Cost of Goods Sold

Work in Process Salaries expenses (8b)118500