Competence

INTRODUCION TO COST TERMINOLOGY AND COST CLASSIFICATION

2.1. Cost in General

1. Definition of Cost
Cost is an expenditure that has actually been incurred or that can be notionally attributed to a
specified thing or activity.
2. Cost Object:
Cost object is anything for which measurement of cost is desired. Managers for their decision making
often want to know how much a certain thing (such as a product, a machine, a service, or a job, or a
process) costs. We call this thing a "Cost object". Examples of cost object: product, service,
programmed, activity, etc.

3. Cost Driver:

A cost driver is any factor that affects total costs. That is a change in the level of the cost driver will
cause a change in the level of the total costs of related cost object. Any change made in any of the
cost drivers will cause a change in the total cost.

Examples of cost drivers: number of units produced, number of items distributed, number of
advertisements, number of customers, etc.

2.2. Cost Classification

 Based on traceability Costs can be divided in to:

1. Direct costs
2. Indirect costs
1. Direct Costs:
Direct costs are those costs which are related to the particular cost object and that can be easily and
conveniently traced to it. Direct materials and direct labor employed in producing an article are the
examples of direct costs.

2. Indirect Costs:

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Indirect costs are those costs which are related to the particular cost object but cannot be easily and
conveniently traced to it.

That is indirect costs cannot be conveniently identified. Examples of indirect costs: rent of factory
Building, managerial salaries, depreciation on machinery etc., indirect costs are also termed as factory
overheads.

 Base on behavior costs can be classified:

1. Fixed Costs

Fixed costs are those costs which remain fixed in total amount with increase or decrease in the volume
of output for a given period of time. Fixed cost per unit decreases as production increases, and fixed
cost per unit increases as production decreases. For example ATEX, rents a factory building for, Br.
50,000 per year. The total amount of rent paid will not change regardless of the number of clothes
produced in a year.

2. Variable Costs

Variable cost is so named because it varies in direct proportion to changes in activity or volume level.
If the activity level doubles the variable costs also double.
Variable cost remains constant, if it is expressed on per unit basis. For example premier motor Co
produces trucks, each truck has one radiator and the radiator cost is Br.30 each. If we look at the cost
of radiator on a per truck basis the cost remains constant at Br.30 per truck. The Br.30 figure will not
change regardless of how many trucks are produced during a period.
The principle of variable cost is constant per unit but varies in total with activity level is illustrated
below.
No. of Trucks Radiator cost Total radiator
Produced per truck (Br.) cost (Br.)
250 30 7500
500 30 15000
750 30 22500
1000 30 30000

3. Semi – variable costs:

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Semi –variable or semi-fixed costs are those which contain the elements of both fixed and variable
costs, i.e., they are partly affected by the fluctuations in the volume of output. Such costs do not vary
proportionately but simultaneously cannot remain same at all the times.
For example: telephone consists of charges as well as the call expenses. Charges part is fixed while fee
for calls is variable. The total of two becomes semi-variable. Other examples of semi – variable costs
are depreciation, repairs etc
Cost can expressed as Total Costs and Unit Costs
A unit cost also called as average cost. It is computed by dividing total costs by number of units.
Suppose Br. 980,000 of manufacturing costs were incurred to produce 10,000 units of finished goods.
Then the unit cost would be Br. 98.
Unit cost = Total manufacturing costs
Number of units manufactured
= Br. 980,000 = Br. 98 per unit.
10,000
Based on functions costs can categorized into two
1. Product Costs:
Product costs are those costs which are traceable to the product and each are included in inventory.
Product costs are inventorial costs and they become basis for product pricing.

They comprise direct materials, direct labor, and manufacturing over heads. A product cost is the total
of the costs assigned to a product (manufacturing cost).

2. Period Costs:

Period costs are incurred on the basis of time, such as rent, salaries etc. These are also known as
operating costs and sometimes called nonmanufacturing costs. These are all costs associated with
generating revenues other than cost of goods sold such as Selling, and Administrative expenses.

The net income of a company is influenced by both product and period costs. Product costs are
included in the cost of production, period costs are not at all related to production, but charged to the
period in which these are incurred.

Manufacturing costs:
The language of cost accounting has specific terms for manufacturing costs. They are
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1. Direct material costs.
2. Direct labor costs
3. Indirect manufacturing costs
1 Direct material costs:
Those materials which can be identified with the product and can be conveniently measured and
directly charged to the product. Examples of Direct materials: wood in furniture making, cloth in dress
making, etc.
Acquisition costs of direct materials include freight in charges, sales taxes and customs duties.
2. Direct labor costs:

Direct labor is that labor which can be conveniently identified with the product wages and such labor
costs are known as direct manufacturing labor costs. For example wages paid to carpenter to make
furniture, wages paid to tailor to make garments, etc.
3. Indirect manufacturing costs:
Indirect manufacturing costs are also termed as factory over head costs.
Indirect manufacturing costs considered to be part of the product cost but cannot be individually traced
to the product.
Examples: power, indirect material, indirect labor, plant rent, plant insurance, plant depreciation.

Prime costs and conversion costs:

The combinations of different production costs also produce the concepts of prime costs and
conversion costs.

1. Prime costs: Prime costs are all direct manufacturing costs. In the three part classification, prime
costs would comprise direct material costs, and direct manufacturing labor costs

2. Conversion costs: Conversion costs are all manufacturing costs other than direct material costs.
Conversion costs are those costs for transferring direct materials into finished goods

2.3. Flow of inventory cost in three different sectors are.

I. Manufacturing sector companies Purchase materials and components and convert them into
finished goods. Examples are automotive companies, food processing companies and textile
companies.
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 II. Merchandising sector companies Purchase and then sell tangible products without changing
their basic forms.
III. Service sector companies Provides services. Examples are law firms, accounting firms, banks,
insurance, transportation companies, advertising agencies, radio and television stations, etc.
Types of inventory maintained by manufacturing companies

Manufacturing companies purchase materials and components and convert them into finished goods.
These companies typically have one or more of the following 3 types of inventory.
 Direct materials inventory--- Direct materials use in the manufacturing process (for example
components needed to manufacture cellular phones).
 Work in process inventory---goods partially worked on but not yet completed. For example
cellular phones at various stages of completion in the manufacturing process also called work in
progress.
 Finished goods inventory--- includes products which are complete, in inventory and ready for
sale.
Income statement for manufacturing companies
Sales revenues xxx
Less :- Cost of goods sold
Beginning finished goods xxx
Add :- cost of goods manufactured xxx
Less :- ending finished goods xxx
Cost of goods sold xxx
Gross margin xxx
Less :- operating costs
Marketing, distribution and
Customer service costs xxx
Operating income xxx

Illustration:-1
The following data are presented by cellular production company for the year2007.
Beginning inventory of direct materials (Jan1, 2007) Br. 11,000
Ending inventory of direct materials (Dec31, 2007) Br. 8,000
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Beginning work-in-process (Jan1, 2007) Br. 6,000
Ending work-in-process (Dec31, 2007) Br. 7,000
Beginning finished goods (Jan1, 2007) Br. 22,000
Ending finished goods (Dec31, 2007) Br. 18,000
Purchase of direct materials during the year 2007 Br. 73,000
Direct manufacturing labor Br. 9,000
Indirect manufacturing labor Br. 7,000
Supplies Br. 2,000
Heat, light and power Br. 5,000
Plant building depreciation Br. 2,000
Plant equipment depreciation Br. 3,000
Miscellaneous factory over head Br. 1,000
Marketing, distribution and customer service costs Br. 70,000
Sales revenues Br. 210,000

Required:
i. Prepare a cost of goods manufactured schedule for cellular products for 2007.
ii. Prepare an income statement for cellular products for 2007.

Solution:-

Cost of goods manufactured is computed in three steps.

Step1: Cost of direct materials used.
Beginning inventory of direct materials (Jan1, 2007) Br.11,000
Add: purchase of direct materials during the year Br.73,000

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 Direct materials available for use Br.84,000
Less:- ending inventory of direct materials ( Dec31, 2007) Br.8,000
Direct materials used in 2007 Br.76,000
Step2 total manufacturing costs incurred in 2007.
1. Direct materials used in 2007 Br.76,000
2. Direct manufacturing labor Br. 9,000
3. Manufacturing over head costs
Indirect manufacturing labor 7,000
Supplies 2,000
Heat, light and power 5,000
Plant depreciation 2,000
Plant equipment--- depreciation 3,000
Misc. factory over head 1,000
Br.20,000
Total manufacturing costs in 2007 Br.105,000
Step3. Cost of goods manufactured in 2007.
Beginning WIP inventory (Jan1, 2007) Br. 6,000
Add:- total manufacturing costs during 2007 Br.105,000
Total manufacturing costs to account for Br.111,000
Less:- ending WIP inventory (Dec31, 2007) Br. 7,000
Cost of goods manufactured in 2007 Br.104,000

Income statement for cellular products for the year 2007

Sales revenues Br.210,000

Less:- cost of goods sold
Beginning finished goods (Jan1, 2007) Br.22,000
Add:- cost of goods manufactured Br.104,000
Cost of goods available for used Br.126,000

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Less: - Ending finished goods(Dec31, 2007) Br.18,000
Cost of goods sold Br.108,000
Gross margin Br.102,000
Less:- operating costs
Marketing, distribution and customer service costs Br.70,000
Operating income Br.32,000

Income statement for merchandising companies

Sales revenues xxx
Less :- cost of goods sold
Beginning merchandise inventory xxx
Add :- purchase of merchandise xxx
Cost of goods available for sale xxx
Less :- ending merchandise inventory xxx
Cost of goods sold xxx
Gross margin xxx
Less :- operating costs xxx
Operating income xxx

Practice Problem
Prestige bath rooms, sells bath room fixtures and furnishings (showers, sinks, hand towels and so on).
The following data pertains to prestige bathrooms.
Revenues Br. 1,500,000
Beginning merchandise inventory Jan1, 2002 Br. 95,000
Purchase of merchandise Br. 1,100,000

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Ending merchandise inventory Dec 31, 2002 Br. 130,000
Operating costs of adjusting the show room,
Sales personal and advertising Br. 315,000
Required: - prepare income statement for merchandising company
Solution:-
Income statement for merchandising companies
Revenues Br. 1,500,000
Less:- Cost of goods sold
Beginning merchandise inventory Br. 95,000
Add:- purchase of merchandise Br.1,100,000
Cost of goods available for sale Br. 1,195,000
Less:- ending merchandise inventory Br. 130,000
Cost of goods sold 1,065,000
Gross margin Br. 435,000
Less:- operating costs 315,000
Operating income Br. 120,000
Exercises Practice
1. The following data relates to Elliott & partners, a law firm specializing in personnel – injury
litigation.
Revenues Br.1, 500,000
Salaries & wages Br. 970,000
Rent Br. 180,000
Depreciation Br. 105,000
Other costs Br. 187,000
Required: - Prepare income statement

2. Superior manufacturing company has the following cost and expenses data for the year ending
Dec 31, 2005.
Raw materials 1/1/2005 Br. 30,000
Raw materials 31/12/2005 Br. 20,000
Raw materials purchased Br.205,000
Indirect materials Br. 15,000
Work-in-process 1/1/2005 Br. 80,000
Work-in-process 31/12/2005 Br. 50,000

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 Finished goods 1/1/2005 Br.110,000
Finished goods 31/12/2005 Br.120,000
Direct labor Br.350,000
Factory managers salary Br. 35,000
Insurance factory Br. 14,000
Property taxes factory building Br. 6,000
Sales Br.1,500,000
Delivery expenses Br.100,000
Sales commission Br.150,000
Indirect labor Br. 90,000
Factory & manufacturing expense Br. 40,000
Factory utilities Br. 65,000
Depreciation factory building Br.24,000
Administration expense Br.300,000
Required:- Prepare
a) The cost of goods manufactured schedule for superior company for 2005.
b) Income statement for superior company for 2005.

JOB ORDER COSTING

Objectives: At the end of this chapter would be able to:
 Describe features of job order costing
 Identify source documents for job order costing
 Calculate job order costing computation
Introduction

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In practice, assigning costs to products and services involves averaging across time and across
products. The way in which this averaging is carried out depends heavily on the type of production
process.
Two costing systems are commonly used in manufacturing and in many service companies;
1. Job order costing system
2. Process costing system

1. Job Order Costing system

JOC is a system for assigning manufacturing costs to an individual product or batches of products.

In this system, costs are assigned to a distinct job, or batch of product or service. A job is a task for
which resources are expended in bringing a product or service. Companies use job-order costing
systems when they need to know the costs of individual products or batches of products. Some of the
organization used it are:
4. Accounting firms doing individual audit.
5. Workshops undertaking a particular repair work
6. House construction
7. Advertising agency companies – undertaking a particular advertisement for a specific customer.

2. Process costing system:

A process-costing system is a costing system in which the cost of a product or service is obtained by
assigning costs to masses of like or similar units. It is used in situations where the company produces
many units of a single product for long periods such as oil refining, chemical processing, sugar
industries, steel manufacturing, etc.
Features of Job order costing System

The key feature of job-order costing is that the cost of one job differs from that of another job and
must be monitored separately.

 A job consists of a single order or contract.

 It is a cost unit by itself.
 Each job is unique in nature.
 Products are not manufactured for stock.

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 Each order is given a job number.
 Costs are accumulated with reference to this number.
 Costs are ascertained for each order.
 It is possible to identify a job at each stage of its manufacturing process.
 The purpose of job costing is to bring together all the costs incurred for completing a job.
 On the completion of the job, the job account as kept in Work-In-Progress ledger is closed by
transfer to the finished goods ledger.
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 job.
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: S&S manufacturer is planning to sell a batch of 25 special machines (Job 100) to S&G
Gym for Br.104, 800.
The 7 steps are:
Step 1: The cost object is Job 100.
Step 2: Identify the direct costs of Job 100.
 Direct material = Br.45,000
 Direct manufacturing labor = Br.14,000
Step 3: Select the cost-allocation base.
 S&S chose machines hours as the only allocation base for linking all indirect
manufacturing costs to jobs.
 Job 100 used 500 machine hours and 2,480 machine hours were used by all jobs.
Step 4: Identify the indirect costs associated with each cost-allocation base
 Budgeted manufacturing overhead costs were Br. 65,100.
Step 5: Compute the rate per unit.
Budgeted manufacturing overhead rate = Budgeted manufacturing overhead costs
Budgeted total quantity of cost-allocation base

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 = Br.65, 100 ÷ 2,480
= Br.26.25 per machine hour.
Step 6: Compute the manufacturing overhead costs allocated to the job.
 Br.26.25 per machine hour × 500 hours = Br.13,125
Step 7: Compute the cost of Job
Direct materials Br. 45,000
Direct labor 14,000
Factory overhead 13,125
Total Br. 72,125

Source of Documents for Job Order Costing

The key source document in job order costing system is job cost sheet (job cost record). This
document records and accumulates all the costs (direct material, direct labour, and MOH cost)
assigned to a specific job. Two primary source documents, materials requisition forms and work
tickets, provide the information recorded on the job cost sheet.

For example, see the following Almeda Textile industry data of processing job (T-shirt) ordered by
AKU graduate students:

Table1: Job Cost Sheet

Almeda Textile Industry

Job Cost Sheet
Customer Name: AKU Graduate Students Job Number: 202
Item Identification: T- shirt Date started: 12/2/2006
Quantity : 600 units Date completed: 12/3/2006
Direct material Direct labor Factory overhead
Req. No Type Amount Ticket No. Hours Amount Hours Rate Amount
46 XX1 Br. 400 16 2 Br. 140 2 Br.10 Br. 20
46 ZZ4 200 17 4 220 4 10 40
Total Br. 600 Total Br.360 Total Br. 60
Source document may also exist for individual items in a job.

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Table 2: Material Requisition

The form is used to control the flow of materials into production and also for making
entries in the accounting records.

Almeda Textile Industry

Material Requisition Record
Material Requisition No: 46
Job No to be charged: 202
Date: 13/2/2006
Description Quantity Unit Cost Total Cost
XX1 100 Br. 4 Br. 400
ZZ4 20 10 200
Total Br.600
Authorized Signature: __________________

Labor Time Record (Employees time ticket or time card)

Direct laborers use time tickets to record the time spent on each job. When an employee works on a
particular job, she/he fills out a time ticket that identifies her/his name, wage rate, hours worked, and
job number. These time tickets are collected daily and transferred to the cost accounting department,
where the information is used to post the cost of direct labor to individual jobs. The daily time tickets
are source documents that are used as the basis for labor cost entries into the accounting records.
Table3: Time Ticket for Zebib

Almeda Textile Industry

Labour Time Record (Time Tickets)
Employee No : 32 Time Ticket No: 16
Name: Zebib Date: 23/2/2006
Job Number Start Time Stop Time Total Time Hourly Rate Total Cost
201 8:00 10:00 2 Br. 50 Br. 100
202 10:00 12:00 2 70 140
Approved by: Bukela Sh.

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 Department Supervisor

Table4: Time Ticket for Abu

Almeda Textile Industry
Labour Time Record (Time Tickets)
Employee No : 33 Time Ticket No: 17
Name: Abu Date: 23/2/2006
Job Number Start Time Stop Time Total Time Hourly Rate Total Cost
201 12:00 2:00 2 Br. 50 Br. 100
202 8:00 12:00 4 55 220
Approved by: Bukela Sh.
Department Supervisor

Overhead Application

Overhead costs are assigned to Jobs with the predetermined overhead rate. Typically, direct labor
hours are the measure (allocation base) used to calculate overhead. For example, Assume Almeda
Textile industry has estimated overhead costs for the coming year of Br.900, 000 and expected activity
is 90,000 direct labor hours. The predetermined overhead rate is Br.900, 000/90,000 direct labor hours
= Br.10 per direct labor hour.

Therefore, overhead cost applied to job202 would be:

Overhead applied = actual direct labor hours incurred x predetermined overhead rate
= 6 hrs. X Br. 10
= Br.60

ACCOUNTING PROCEDURES FOR JOB ORDER COSTING

Major accounting procedures in job order costing system are:
 Receive job order & purchase of raw materials
 Transfer raw materials to WIP
 Recording labour to WIP
 Recording actual MOH cost incurred
 Allocating MOH cost to WIP

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  Transferring WIP to Finished Goods
 Transferring Finished Goods to Customers.
 Journal Entries in Job Costing (The Flow of Costs in Job Costing)

 Recall that cost flow is how we account for costs from the point at which they are incurred to the
point at which they are recognized as an expense on the income statement. Of principal interest in
a job-order costing system is the flow of manufacturing costs.

1. Purchase of materials on Account (both direct and indirect)

Material ……………………………. xx
Accounts payable ………….. xx
(To record purchase of materials on account)

2. Direct materials used in production

Work in process …………………… xx
Material ……………………. xx
(To record direct materials used in production)
3. In direct materials used in production
Manufacturing OH control ………… xx
Material ……………………. xx
(To record indirect materials used in production)
4. Direct Labor used in production
Work in process …………………. xx
Wage payable …………… xx
(To record direct wages liability)
5. Indirect Labor used in production
Manufacturing OH control ………… xx
Wages payable …………….. xx
(To record indirect wages liability)
6. Payment of wages
Wages payable …………………. xx
Cash ……………………. xx

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 (To record payment of wages)
7. Additional manufacturing OH incurred (utilities and repairs)
Manufacturing OH control ………………. xx
Account payable …………………. xx
(To record manufacturing OH cost incurred)

8. Additional manufacturing OH incurred( accumulated depreciation)

Manufacturing OH control ……………… xx
Accumulated depreciation ………. xx
(To record additional manufacturing OH cost incurred)

9. Allocation of manufacturing OH
Work in Process ……………………….. xx
Manufacturing OH allocated ….. xx
(To record allocation of manufacturing OH)
10. Cost of goods manufactured
Finished goods ………………………. xx
Work in process ……………… xx
(To record cost of gods manufactured)
11. Cost of goods sold
Cost of goods sold …………………. xx
Finished goods ……………… xx
(To record cost of goods sold)
12. Goods sold on account
Accounts receivable ………………. xx
Sales ……………………. xx
(To record goods sold on account)

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Practical Problem
Prepare the necessary Journal entries from the following data for ABC Co.,
1. Purchased raw materials on account Br. 56,700
2. Materials sent to production as follows.
Direct materials 80% of purchase
Indirect materials 15% of purchase
3. Direct Labor cost for production Br. 33,100 and indirect Labor is Br. 12,500
4. Over head costs incurred and paid Br. 66,900
5. Over head costs applied to production based on Direct Labor cost at the rate of 110%
6. Goods costing Br. 97,600 were completed during the period
7. Goods costing Br. 51,320 were sold on account for Br. 77,600.

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Solution:
1. Raw materials a/c 56,700
Accounts payable 56,700
(To record purchase of materials on account)
2. Work in process a/c 45,360 i.e 80%
Manufacturing OH a/c 8,505 i.e 15%
Raw materials a/c 53,865
(To record materials sent to production)
3. Work in process a/c 33,100
Manufacturing OH a/c 12,500
Wages payable a/c 45,600
(To record direct and indirect labor)
4. Manufacturing OH a/c 66,900
Cash a/c 66,900
(To record OH cost incurred and paid)
5. Work in process a/c 36,410 (33,100*110%)
Manufacturing OH a/c 36,410
(To record OH costs applied to production)
6. Finished goods a/c 97,600
Work in process a/c 97,600
(To record goods manufactured)
7. Cost of goods sold a/c 51,320
Finished goods a/c 51,320
(To record cost of goods sold)
Accounts receivable a/c 77,600

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 Sales a/c 77,600
(To record goods sold on account)

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