Cost Accounting

Adaptive Community for the Continuity of Education and Student Services
National Teachers College
Cost Accounting and Control/Cost Accounting and Cost Management
Student Name: Degree Program:

Section: Module Number:
Professor Name: Email Address:
YOUR GOALS
This module allows you to explore the fundamental in cost accounting At the end
of this learning module, you are expected to demonstrate the following competencies:
1. Differentiate the costs that are considered as part of product or period costs;
master the process on how to arrive at certain costs; and explain the reasons why
there are variances in the cost of products.
2. Allocate accurately overhead costs to jobs or functions; and determine the cost
of materials, labor, and factory overhead used to produce a specific order or job
and the method of allocation of manufacturing costs incurred during a given
period.
3. Analyze cost variances and attribute them properly to a specific reason and the
efficient management of costs thru Cost/Volume Profit Analysis.
4. Correctly allocate joint costs accounting for by-products/scrap.
YOUR PROJECT
When you have finished going through the experiences and reading resources
contained in this module, you will prepare an analysis based on the cases that are
provided. Please take note of the writing conditions and expectations that follow.
CHOOSE YOUR ADVENTURE! CHOOSE TO SOLVE WELL!
Level 1 – Solve Task 1 with 3 problems. Total points The following will be the rubrics for assessing your calculations:
is 75.
75/55/85 points: The calculations arrived at the correct answers for all
Level 2 – Solve Task 2 with 3 problems. Total points the requirements on the problems for Task 1, 2 and 3 respectively.
is 55.
38/28/43 points: The calculations arrived at the correct answer for the
Level 3 – Solve Task 3 with 3 problems. Total points majority of the requirements of the problems for Task 1, 2 and 3
is 85. respectively.
In addition to the tasks, to assess learning, weekly 20/17/27 points: The calculations arrived at the correct answer for few
assessments shall be conducted. Results shall be of the requirements in the 3 problem each for Task 1, 2 & 3.
included in the grade computation.
Course Code – Cost Accounting 1

School of Business, Summer, SY 2020-2021
YOUR EXPERIENCE
Be guided by the following schedule that you can follow in order to manage your
learning experience well:
WEEK TASK OUTPUT

1 Cost terminology and cost behaviors
1 Predetermined overhead rates, flexible budgets, and absorption
2
and variable costing
3 Activity-Based Costing and Job Order Costing
2
4 Process Costing
Standard Costing and Variance Analysis; and Cost / Volume Profit
5 3
Analysis
6 Allocation of Joint Cost and Accounting for by-product/scrap
There are four required reading resources for this module. You are allowed to look
for other related resources if you have the means to do so. Note that our school library
has online resources that you can access.
Read the summary of cost terminologies and cost behavior derived from the book Cost
Accounting: Foundations and Evolutions; Kinney and Raiborn Seventh Edition.
1. Familiarize yourself with the cost terminologies as these terms will be used
randomly in the discussions.
2. These readings will allow you to differentiate the different costs that comprises a
product as well as costs that are not attributable to the product.
3. This will also give you a way to visualize how cost move in the production of
product or services.
PRELIM READING MATERIAL NO. 1
COST TERMINOLOGY AND COST BEHAVIORS

Association of Cost to a Cost Object
A. Introduction
1. To effectively communicate information, accountants must clearly understand

the differences among the various types of costs, their computations, and their
usage.

2. Cost reflects the monetary measure of resources given up to attain an objective

such as making a good or delivering a service.
a. Unexpired cost: The portion of an asset’s value that has not yet been
consumed or sacrificed and which is reported on the balance sheet.
b. Expired cost: The portion of an asset’s value that has been consumed or
sacrificed during the period and which is reported as an expense or loss on the
income statement.
B. Cost Terminology
1. A cost management system is a set of formal methods developed for planning,
controlling, and reporting on an organization’s cost-generating activities relative to its
strategy, goals, and objectives.
2. Some important types of costs are summarized in in the exhibit below:
C. Association with Cost Object
1. To be useful, the term cost must be defined more specifically before “the cost” of
a product or service can be determined and communicated to others.
2. A cost object is anything (e.g., a product, a product line, a customer) for which
management wants to collect or accumulate costs.
3. Costs may be direct or indirect depending upon the cost object.
a. Direct costs are costs that can be easily traced to the cost object. As the name
implies it is something that has a direct association to the product.
i. For example, the cost of flour in making pizza.
b. Indirect costs are costs that you cannot conveniently trace to the cost object
but instead must be allocated to the cost object .
i. For example, the cost of salt in the pizza crust.
Assumptions about cost behavior
Reaction to Changes in Activity
1. General
a. A cost’s behavior pattern is described according to the way its total cost
(rather than its unit cost) reacts to changes in a related activity measure over
the relevant range.
b. Common activity measures include production volume, service and sales

volumes, hours of machine time used, pounds of material moved, and number
of purchase orders processed.
c. The relevant range is the assumed range of activity that reflects the company’s
normal operating range.
d. Accountants assume that there are three cost behavior patterns: variable,
fixed, and mixed.
i. A variable cost is a cost that varies in total in direct proportion to changes in

activity but is constant on a unit basis. For example, each slice of pepperoni
in a pizza cost P1, if there are 20 slices of pepperoni there, then the total cost
of pepperoni is P20.
ii. A fixed cost is a cost that remains constant in total within the relevant range
of activity but varies inversely with changes in the level of activity on a per
unit basis. For example the depreciation expense of the oven used in baking
pizza remains the same on a monthly basis no matter how many pizza crusts
were baked.
iii. A mixed cost has both a variable and a fixed component. Mixed costs must
be separated into their variable and fixed components in order to make
valid estimates of total costs at various activity levels.
e. A step cost is a cost that shifts upward or downward when activity changes by
a certain interval or “step.” Step costs can be variable or fixed; step variable
costs have small steps while step fixed costs have large steps. A most common
example for step cost are utility bills such as electricity. Within a certain range

the electricity cost is fixed however if you already have gone beyond that
certain range then a new rate is used.
f. Assuming a variable cost is constant per unit and a fixed cost is constant in
total within the relevant range can be justified for two reasons:
i. If the company operates only within the relevant range of activity, the
assumed conditions approximate reality and, thus, the cost behaviors are
appropriate.
ii. Second, selection of a constant per-unit variable cost and a constant total
fixed cost provides a convenient, stable measurement for use in planning,
controlling, and decision making activities.
g. Selection of an appropriate activity measure is important.
i. A predictor is an activity measure that, when changed, is accompanied by

consistent, observable changes in a cost item. It may predict the cost but
may not be cause the cost to change.
ii. A cost driver is a predictor that has an absolute cause-and-effect
relationship with the cost in question. It directly caused the cost to change.
iii. Traditionally, a single predictor has often been used to predict costs but
accountants and managers are realizing that single predictors do not
necessarily provide the most reliable forecasts, thus causing a movement
toward activity-based costing, which uses multiple cost drivers to predict
different costs.
Classification of costs on the financial statements

2. Classification on the Financial Statements
a. The balance sheet is a statement of unexpired costs (assets) and liabilities and
owners’ capital whereas the income statement is a statement of revenues and
expired costs (expenses and losses).
b. The matching concept provides a basis for deciding when an unexpired cost
becomes an expired cost and is moved from an asset category to an expense
or loss category.
c. When the product is specified as the cost object, all costs can be classified as
either product or period costs.
d. Product costs, also called inventoriable costs, are related to making or

acquiring the products or providing the services that directly generate the
revenues of an entity. This cost may first appear in Inventory of the balance
sheet, and subsequently transferred to Cost of Goods Sold in the Income
Statement.
i. Direct material is any material that can be easily and economically traced
to a product.

ii. Direct labor refers to the time spent by individuals who work specifically on
manufacturing a product or performing a service.
iii.Overhead is any factory or production cost that is indirect (i.e., not direct
material or direct labor) to the product or service.
e. The sum of direct labor and overhead costs is referred to as conversion cost as
those are the costs incurred to convert materials into products. To illustrate,
assume that to make a product you 2 hours of labor at P100/hr. The work area
is assigned electricity rate of P20/kwh. Using labor hours as basis our conversion
cost would be P240.
f. The sum of direct material and direct labor cost is referred to as prime cost as
those are the primary costs in making most products. To illustrate, assume that
a product requires a kilogram of flour @ P200/kg, 2 eggs at P10/each, and 2
hours of labor to make them @ P100 hr. Hence, the conversion cost would be
P420.
g. Period costs are related to business functions other than production, such as
selling and administration.
i. Period costs are generally more closely associated with a particular time
period than with making or acquiring a product or performing a service.
ii. Period costs that have future benefit are classified as assets, whereas those
having no future benefit are expenses. For example, prepaid insurance
(asset) becomes insurance expense.
iii. Distribution costs are period costs incurred to warehouse, transport, or

deliver a product or service.
Conversion process that occur in manufacturing and service companies
D. The Conversion Process
1. General
a. In general, product costs are incurred in the production (or conversion) area
and period costs are incurred in all nonproduction (or nonconversion) areas.
b. Conversion process outputs are usually either products or services.
c. Firms that engage in only low or moderate degrees of conversion (such as

retailers) can conveniently expense insignificant costs of labor and overhead
related to conversion.
d. In high-conversion firms, the informational benefits gained from accumulating

the material, labor, and overhead costs incurred to produce output
significantly exceed clerical accumulation costs.

e. A manufacturer is defined as any company engaged in a high degree of

conversion of raw material input into a tangible output using people and
machines.
f. A service company refers to a firm engaged in a high or moderate degree of

conversion using a significant amount of labor producing either tangible (an
architectural drawing) or intangible (insurance protection) outputs.
E. Stages of Production
1. The production or conversion process occurs in three stages: (1) work not started
(raw material), (2) work started but not completed (work in process), and (3) work
completed (finished goods).
a. Cost accounting uses Raw Material, Work in Process, and Finished Goods
Inventory accounts to accumulate processing costs and assign them to the
goods produced.
2. In the first stage of processing, the costs incurred reflect the prices paid for raw
materials and/or supplies.
3. As work progresses through the second stage, accrual-based accounting

requires that labor and overhead costs related to the conversion of raw materials
or supplies be accumulated and attached to the goods.
4. The total costs incurred in stages 1 and 2 equal the total production cost of
finished goods in stage 3.
5. In a service firm, the work not started stage of processing normally consists of the
cost of supplies needed to perform the services (Supplies Inventory). When
supplies are placed into work in process, labor and overhead are added to
achieve finished results.
Product cost categories, and items that comprise those categories
F. Components of Product Cost
1. Direct Material
a. Direct material cost includes the cost of all materials used to manufacture a
product or perform a service.
b. Material costs that are not conveniently or directly traceable are classified as
indirect costs and included in overhead. Examples are spare parts of cars such
bolts.
2. Direct labor
a. Direct labor refers to the value-adding effort of individuals who manufacture

a product or perform a service.

b. Direct labor cost consists of the wages or salaries paid to direct labor personnel
conveniently traceable to the product or service. For example, the wage
given to the car mechanic who assembled the parts of a car.
c. Labor costs that cannot be reasonably or directly traceable to the product

are classified as indirect costs and included in overhead. Example of this are
cost of supervision.
d. Costs for overtime or shift premiums are usually considered overhead rather
than direct labor cost and are allocated among all units unless the overtime
costs resulted from expediting a customer’s request.
3. Overhead
a. Overhead is any factory or production cost that is indirect to manufacturing a

product or providing a service.
b. Overhead includes indirect material, indirect labor and other production-

related costs such as factory depreciation, factory utilities, factory insurance,
etc.
c. Variable overhead includes the costs of indirect material, indirect labor paid
on an hourly basis lubricants used for machine maintenance, and the variable
portion of factory utility charges.
d. Fixed overhead includes costs such as straight-line depreciation on factory

assets, factory license fees, factory insurance and property taxes, and fixed
indirect labor costs such as salaries for production supervisors, shift
superintendents, and plant managers.
e. Quality costs are an important component of overhead cost since high-quality

products or services enhance a company’s ability to generate revenues and
produce profits and managers are concerned about production process
quality because higher process quality leads to shorter production time and
reduced costs for spoilage and rework.
i. Prevention costs are incurred to improve quality by precluding product
defects and improper processing from occurring.
ii. Appraisal costs are costs incurred for monitoring or inspecting products in
order to find mistakes not eliminated through prevention.
iii. Internal Failure costs are costs such as scrap and rework that results when
quality problems are detected before the product reaches the final
customer.
iv. External Failure costs are incurred when quality problems are not
discovered until after the product has been delivered to the final customer
and includes costs such as product returns and warranty claims.
f. Some quality costs are variable in relation to the quantity of defective output,
some are step fixed with increases at specific levels of defective output, and
some are fixed for a specific time.
G. Accumulation and Allocation of Overhead
1. General
a. To satisfy the historical cost and matching principles, which require that all
production or acquisition costs attach to the units produced or purchased,
overhead must be accumulated over a period and allocated to the
products manufactured or services rendered during that period.
b. Cost allocation refers to the assignment of an indirect cost to one or more

cost objects using some reasonable allocation base or driver.
c. Overhead costs are allocated to cost objects for three reasons: (1) to
determine the full cost of the cost object, (2) to motivate the manager in
charge of the cost object to manage it efficiently, and (3) to compare
alternative courses of action for management planning, controlling, and
decision making.
2. Actual Cost System

a. In an actual cost system, actual direct material and direct labor costs are
accumulated in Work in Process (WIP) Inventory as the costs are incurred.
Actual production overhead costs are accumulated separately in an
Overhead Control account and are assigned to WIP Inventory at the end of a
period or at completion of production.
i. Use of an actual cost system is generally considered to be difficult because

all production overhead information must be available before any cost
allocation can be made to products or services.
ii. Here’s an illusatration on the flow of costs in a Perpetual Inventory

Accounting System:

ii. The following entries are used in accounting for the flow of product
costs:
a. To record purchase of raw materials on account

Raw Materials Inventory xxx
Accounts Payable xxx
b. To record transfer of raw materials to processing department

Work in Process Inventory xxx
Raw Materials Inventory xxx
c. To record salary or wages payable for the period

Variable Overhead Control xxx
Fixed Overhead Control xxx
Salaries/Wages Payable xxx
d. To record various overhead for the period

Utilities Payable xxx
Supplies Inventory xxx
Accumulated Depreciation – equipment xxx
Other accounts xxx
e. To record application of overhead to work in progress

f. To record transfer of work in process to finished goods inventory

Finished Goods Inventory xxx
a. In a normal cost system, actual direct material and direct labor costs and an
estimated amount of overhead (assigned using a predetermined overhead
rate or rates) are accumulated in WIP.
i. A predetermined overhead rate (or overhead application rate) is a

charge per unit of activity that is used to allocate (or apply) overhead
cost from the Overhead Control account to WIP Inventory for the period’s
production or services
Calculation of cost of goods manufactured

COST OF GOODS MANUFACTURED AND SOLD
b. The Cost of goods manufactured (CGM) is the total production cost of the
goods that were completed and transferred to Finished Goods Inventory
during the period.
c. Information needed for computing CGM is found in the Raw Materials

Inventory, Work in Process Inventory, and Overhead Control accounts:
Beginning WIP
+ Cost of Direct Materials Added (See Note 1)
+ Cost of Direct Labor Added
+ Cost of Overhead
= Total Cost to Account For
- Ending WIP
= Cost of Goods Manufactured (CGM)
Note 1: Direct material added = Beginning Raw Materials + Raw Materials

Purchased – Ending Raw Materials

d. Cost of Goods Sold (CGS)
i. The Cost of goods sold is computed as beginning Finished Goods plus the
cost of goods manufactured less the ending Finished Goods.
Here’s the Proforma Statement of Cost of Goods Manufactured
Statement of Cost of Goods Manufactured
Raw Materials Used

Beginning balance xxx
Add: Purchase of materials xxx
Raw materials available xxx
Less: Ending balance xxx
Total raw materials used xxx
Add: Direct labor xxx
Variable overhead xxx
Fixed overhead xxx xxx
Current Period Manufacturing Cost xxx
Add: Beginning work in process xxx
Total costs to account for xxx
Less: Ending work in process xxx
Cost of goods manufactured xxx
Here’s a proforma Schedule of Cost of Goods Sold (a portion of the Income

Statement)
Beginning Finished Goods xxx

Add: Cost of Goods Manufactured xxx
Cost of Goods Available for Sale xxx
Less: Ending Finished Goods Inventory xxx
Cost of Goods Sold xxx

Illustration
Assume that Mark Company has beginning inventory worth P100,000. During the year,
the company purchased inventory of P100,000 monthly. On the average, Mark
Company uses 90% of the previous months inventory and 80% of the current purchases.
There was no work in process inventory in the beginning, but on the average 95% of
those in production are made into finished goods. There was a P40,000 worth of
inventory left in the warehouse from the previous year. On the average, 85% of the
finished goods produced are sold. Direct Labor is 50% of Materials and Overhead is 75%
of Direct Labor. Depreciation expense related to the manufacturing plant is P50,000.
Prepare the Schedule of Cost of Goods Manufactured as well as the Cost of Goods Sold
portion of the Income Statement.
Solution:
Statement of Cost of Goods Manufactured
Raw Materials Used

Beginning Inventory P 100,000
Add: Purchases (P100,000 x 12) 1,200,000
Raw Materials Available 1,200,000
Less: Ending Inventory (10% x 100,000 + 20% x 1,200,000) 250,000
Total raw materials used 950,000
Add: Direct Labor 475,000
Variable Overhead 356,250
Fixed Overhead 50,000
Current period manufacturing cost 1,831,250
Add: Ending Work in Process inventory 0
Total cost to account for 1,831,250
Less: Ending work in process (rounded off) 91,563
Cost of goods manufactured (rounded off) P1,739,687
Schedule of Cost of Goods Sold
Beginning Finished Goods P 40,000

Add: Cost of Goods Manufactured 1,739,687
Cost of Goods Available for Sale 1,779,687
Less: Ending Inventory 266,953
Cost of Goods Sold P1,512,734
Reference
Kinney and Raiborn. 2009. Cost Accounting Foundations and Evolutions 7 th edition.
Southwestern. USA

Read the summary of predeterminded overhead rates, flexible budgets, and

absorption variable costing derived from the book Cost Accounting: Foundations and
Evolutions Kinney and Raiborn Seventh Edition.
1. Understand the formula in computing the predetermined rate. Memorizing the

formula will not help you master the formula. You must know why such data were
used and how it is being used.
2. In this readings, you will also be led to somehow understand the connection of
cost accounting to financial accounting.
PRELIM READING MATERIAL NO. 2
Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
Allocation of costs to products and services
A. Introduction
1. Overhead consists of all non-direct material and non-direct labor costs incurred
in the production area and in selling and administrative departments.
2. Historically, direct material and direct labor were the manufacturer’s primary
costs while inventory and sales salaries were the retailer’s primary costs.
3. Overhead presents a costing problem since it cannot be traced directly to

distinguishable outputs.
B. Normal Costing and Predetermined Overhead
1. General
a. Normal costing is an alternative costing system to actual costing.
b. Normal costing assigns actual direct material and direct labor to products but
allocates production overhead to products using a predetermined overhead
rate.
c. There are four primary reasons for using predetermined overhead rates in
product costing:
1. A predetermined overhead rate allows overhead to be assigned during the

period to the goods produced or sold and to the services rendered rather
than having to wait until the end of the period for cost information;

2. Predetermined overhead rates adjust for variations in actual overhead

costs that are unrelated to activity. For example, electricity costs run higher
in the summer because of the costs of air conditioning;
3. Predetermined overhead rates overcome the problem of fluctuations in

activity levels that have no impact on actual fixed overhead costs. Since
unit fixed costs vary with activity level changes, a uniform annual
predetermined overhead rate for all units produced during the year is
needed to avoid significant variations in unit costs during the period; and
4. Using predetermined overhead rates allows managers to be more aware

of individual product or product line profitability as well as the profitability
of doing business with a particular customer or vendor.
2. Formula for Predetermined Overhead Rate
a. Overhead is assigned to production (i.e., charged or debited to Work in

Process) using a predetermined rate computed as follows:
Predetermined OH rate = Total Budgeted OH Cost at a Specified Activity Level

Volume of Specified Activity Level
Let say for example that budgeted overhead for the year is
P1,000,000, and that the average volume of work annually is 10,000 direct
labor hours. Using the formula above we will have a predetermined rate of
P100 per hour (1,000,000/10,000).
b. Overhead is typically budgeted for one year although a longer period may
be used by some companies (e.g., ship builder).
c. To allocate overhead effectively to heterogeneous products or services, a

measure of activity that is common to all output must be selected.
d. The activity base should be a cost driver that directly causes the incurrence of
overhead costs. Common activity bases include:
1. Direct labor hours;
2. Direct labor dollars; and
3. Machine hours.
e. Other activity bases could include:
1. Number of purchase orders;

2. Physical characteristics such as tons or gallons;
3. Number of machine setups;
4. Number of parts; and
5. Material handling time.
3. Applying Overhead to Production
a. The journal entries required under normal costing are identical to those made
in an actual cost system with one exception: the amount of overhead applied
to production.
b. Applied overhead is the amount of overhead assigned (charged, debited) to

Work in Process Inventory using the activity that was employed to develop the
application rate. For convenience, both actual and applied overhead are
recorded in a single general ledger control account.
c. The amount of applied overhead is determined as follows:
OH Applied = Actual Volume of Activity Level x the Predetermined OH Rate
Let us assume that during the period that factory workers worked a total of
12,500 direct labor hours. Using the predetermined rate in the previous
illustration, the amount to be applied for overhead is P1,250,000 (12,500 x P100).
d. Actual overhead costs are charged (debited) to the overhead control

account.
1. Accounts are credited as appropriate (e.g., Cash, Accounts Payable,

Accumulated Depreciation, Pre-paid Insurance, etc.)
2. The general ledger may contain a single overhead control account or

separate accounts for variable and fixed overhead.
Causes of underapplied or overapplied overhead and its treatment at the end of a

period
e. Actual overhead incurred during a period will rarely equal applied overhead.
1. Underapplied overhead is the debit balance in the overhead control

account that remains at the end of the period when the applied overhead
is less than the actual overhead.

2. Overapplied overhead is the credit balance in the overhead control

account that remains at the end of the period when the applied overhead
is greater than the actual overhead.
3. If two overhead control accounts are maintained, a separate under-or-

over applied amount will be computed for variable overhead and fixed
overhead.
f. There are two factors that cause underapplied or overapplied overhead:
1. A difference between actual and budgeted overhead costs (numerator

differences); and
2. A difference between actual and budget activity levels (denominator

differences).
4. Disposition of underapplied or overapplied overhead
a. Since overhead accounts are temporary accounts, their ending balances

must be closed at the end of the accounting period.
b. The method of disposition of underapplied or overapplied overhead depends

upon the materiality of the amount involved.
1. If immaterial, the ending balances in the overhead control accounts are

closed entirely to Cost of Goods Sold.
2. If material, the ending balances in the overhead control accounts should

be allocated among all the accounts containing applied overhead: Work
in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.
Impact of different capacity measures on setting predetermined overhead rates
5. Alternative Capacity Measures
a. The choice of activity level (i.e., the denominator in the predetermined OH

rate equation) impacts the amount of underapplied and overapplied
overhead.
1. Theoretical capacity is the estimated maximum production or service

volume that a firm could achieve during a period, disregarding realities
such as machine breakdowns and reduced or stopped plant operations
on holidays.

2. Practical capacity is the physical production or service volume that a firm

could achieve during normal working hours with consideration given to
ongoing, expected operating interruptions.
3. Normal capacity is the long-run (5–10 years) average production or service

volume of a firm that takes into consideration cyclical and seasonal
fluctuations.
4. Expected capacity is a short-run concept that represents the anticipated

level of capacity to be used by a firm in the upcoming period, based on
projected product demand.
b. If actual results are close to budgeted results (in both dollars and volume),
expected capacity should result in product costs that most closely reflect
actual costs and thus result in immaterial amounts of underapplied and
overapplied overhead.
Using high-low method and least squares regression analysis in analyzing mixed costs
C. Separating Mixed Costs
1. General
a. Accountants describe a given cost’s behavior pattern according to the way

its total cost (rather than its unit cost) reacts to changes in a related activity
measure.
b. Accountants assume that costs are linear rather than curvilinear.
1. Therefore, the general formula for a straight line can be used to describe
any cost within a relevant range of activity:
y = a + bx
Where:
y = total cost (dependent variable)
a = fixed portion of total cost
b = unit change of variable cost relative to unit changes in activity

(slope)
x = activity base to which y is being related (the predictor, cost driver,

or independent variable)

c. A fixed cost remains fixed in total within the relevant range of activity under
consideration.
1. The linear formula for a fixed cost is y = a.
d. A variable cost varies in total as production changes, but the cost per unit
remains the same.
1. The linear formula for a variable cost is y = bx.
e. Mixed costs contain both a variable and a fixed cost element.
1. The linear formula for a mixed cost is y = a + bx
2. The High-Low Method
a. The high-low method is a technique for determining the fixed and variable
portions of a mixed cost by using only the highest and lowest levels of activity
and related costs within the relevant range.
b. The method determines the variable cost per unit b as follows:
(Cost at High Activity Level) – (Cost at Low Activity Level)

b=
(High Activity Level) – (Low Activity Level)
Change in Total Cost

b=
Change in Activity Level
Let us consider this data to illustrate this formula:
Machine Hours Cost
High 9,000 P 15,000
Low 4,600 9,350
Difference 4,400 5,650
Using the above formula:
b = P 5,650 / 4,400 = P 1.28/unit (This is the variable cost per unit)
c. The fixed portion of a mixed cost a is found by subtracting total variable cost
from total cost at either the high or low activity level:
a = y – bx

where: y = total cost for either one of the observations used to determine b
b = variable cost per unit (determined in the previous step)
x = activity volume of the observation used to determine y
Substituting the values using the values above. For this matter the Low scenario
a = P9,350 – (P1.28 x 4600)
= P3,462 (the fixed cost)
d. Outliers are abnormal or nonrepresentative observations within a data set that

should be discarded when applying the high-low method.
e. Two potential weaknesses of the high-low method are that outliers can
inadvertently be used and the method uses only two data points
(observations) to determine the cost equation.
3. Least Squares Regression Analysis
a. Ordinary Least Squares (OLS) regression is a statistical technique that analyzes

the association between dependent and independent variables.
1. A dependent variable (cost) is an unknown variable that is to be predicted

using one or more independent variables.
2. An independent variable (activity) is a variable that, when changed, will

cause consistent, observable changes in another variable; a variable used
as the basis of predicting the value of a dependent variable.
b. OLS determines the line of “best fit” for a set of observations by minimizing the
sum of the squares of the vertical deviations between actual points and the
regression line.
c. When multiple independent variables exist, the least squares method can be
used to select the best predictor of the dependent variable based on which
independent variable has the highest correlation with the dependent
variable.
d. Simple regression is a statistical technique that uses only one independent

variable to predict a dependent variable while multiple regression uses two or
more independent variables to predict a dependent variable.
e. A regression line is any line that goes through the means (or averages) of the
set of observations for an independent variable and its dependent variables.

Mathematically, there is a line of “best fit” which is the least squares regression
line
f. OLS can be used to determine the fixed and variable portions of a mixed cost.
1. The equations needed to compute the variable cost per unit (b) and total
fixed cost (a) are provided and illustrated in the text.
g. The following considerations are important when using the OLS model:
1. For regression analysis to be useful, the independent variable must be a

valid predictor of the dependent variable; this relationship can be tested
by computing the coefficient of correlation;
2. OLS should only be used within a relevant range of activity; and
3. The OLS model is useful only as long as the circumstances existing at the
time of its development remain constant.
Using flexible budgets to set predetermined overhead rates
4. Flexible Budgets
a. A flexible budget is a series of individual budgets that presents costs according

to their behavior at different levels of activity.
b. A flexible budget presents variable and fixed costs separately at various levels
of activity within a relevant range of activity.
1. Estimated variable costs at a given activity level may be computed by

multiplying the variable cost per unit by the activity level volume.
c. Flexible budgets are prepared for both product and period costs.
d. How to prepare a Flexible Budget
1. Separate mixed costs into variable and fixed elements
2. Determine the a+bX cost formula
3. Select several potential levels of activity within the relevant range
4. Determine total cost expected at each of the activity levels

Absorption costing vs Variable costing Overview of Absorption and Variable Costing
5. General
a. Cost accumulation involves determining which manufacturing costs are

recorded as part of product cost and which are recorded as part of period
costs.
b. Cost presentation involves determining how costs are shown on external

financial statements or internal management reports.
c. The two methods of cost accumulation and presentation are absorption

costing and variable costing.
6. Absorption costing, also known as full costing, is a cost accumulation and

reporting method that treats the costs of all manufacturing components (direct
material, direct labor, variable overhead, and fixed overhead) as inventoriable
or product costs. The types of costs included are shown on the left panel of text
Exhibit 3-10.
a. Absorption costing is the traditional approach to product costing and must be

used for external financial statements and tax returns.
1. Authoritative accounting bodies such as the FASB and the SEC believe
absorption costing furnishes external parties with a more informative picture
of earnings, as compared to variable costing.
b. Absorption costing presents expenses on an income statement according to

their functional classifications.
1. A functional classification is a group of costs that were all incurred for the
same principle purpose. Examples include cost of goods sold, selling
expenses, and administrative expenses.
2. The absorption costing income statement format is as follows:
Revenue – Cost of Goods Sold – Selling & Administrative Expenses = Income

before Tax
Income Statement Format
Sales xxx
Less: Cost of Goods Sold xxx
Gross Profit xxx

Less: Operating Expenses xxx
Net Income xxx
3. As seen in the format, absorption costing is the one that is used in the
presentation of financial statements in accordance with GAAP.
c. Both variable and fixed overhead is considered to be a product cost.
1. Since total variable product costs increase with each additional product
made or each additional service rendered, these costs should be
considered product costs and inventoried until the product or service is
sold.
2. Fixed overhead costs should be considered product costs since production

could not take place without the incurrence of fixed overhead.
7. Variable costing, also known as direct costing, is a cost accumulation and

reporting method that includes only variable production costs (direct material,
direct labor, and variable overhead) as inventoriable or product costs.
a. Variable costing is not acceptable for external reporting and tax returns.
b. Only variable overhead is considered to be a product cost; fixed overhead is

treated as a period cost.
c. The variable costing income statement presents expenses according to cost

behavior (variable and fixed):
Revenue – Variable CGS = Product CM – Variable S&A Expenses = Total CM –

Fixed OH and S&A Expenses = Income before Tax
Income Statement Format
Sales xxx
Less: Variable Cost of Goods Sold xxx
Product Contribution Margin xxx
Less: Variable Operating Expenses xxx
Contribution Margin xxx

Less: Fixed Mfg. Overhead xxx
Less: Fixed Operating Expenses xxx
Net Income xxx
1. Cost of goods sold is more appropriately called variable cost of goods sold
since it is composed of only the variable production costs (DM, DL, VOH)
related to the units sold.
d. Product contribution margin is the difference between selling price and

variable cost of goods sold and indicates how much revenue is available to
cover all period costs and to potentially provide net income. Product
contribution margin is commonly called manufacturing margin.
e. Total contribution margin is the difference between revenue and all variable
costs regardless of the area of incurrence (production or nonproduction).
Difference in Income (Absorption vs. Variable)
D. Absorption and Variable Costing Illustrations
1. General
a. The Fixed Over Head ( FOH) rate is calculated as follows:
FOH Rate = Budgeted annual FOH / Budgeted Annual Capacity in Units
b. Case assumptions:
i. All costs are assumed to remain constant over the three years in question;
ii. All units started were completed and thus there are no WIP inventories at
the end of the period;
iii. All actual costs are assumed to be equal to standard and budgeted costs
for the years presented; and
iv. Changes in inventory levels are provided at the bottom of text Exhibit 3-13.
2.
a. The volume variance is the monetary impact of a difference between the

budgeted capacity used to determine the fixed overhead application rate
and the actual capacity at which the company operates:

Volume Variance = Fixed OH Rate x Unit Change in Inventory
b. If inventory levels increase, absorption costing will show higher income

because more fixed costs are trapped in ending inventory on the balance
sheet.
c. If inventory levels decrease, absorption costing will show lower income

because more fixed costs are passed through to the income statement as cost
of goods sold.
d. The differences in income between the two methods are only timing
differences based on when fixed overhead costs flow through to the income
statement as part of cost of goods sold under absorption costing.
3. Phantom profits are the difference between absorption costing and variable
costing profits caused by fixed manufacturing overhead added to absorption
costing inventory and therefore not expensed during a period.
a. Absorption costing creates phantom profits when more inventory is produced

than is sold because fixed overhead costs are deferred in the ending inventory
whereas all fixed costs are expensed under variable costing in the period
incurred.
E. Comparison of the Two Approaches
1. Absorption costing income will equal variable costing income if production is

equal to sales
a. Absorption costing income will be greater than variable costing income if

production is greater than sales as some fixed overhead cost is deferred as
part of inventory cost on the balance sheet under absorption costing.
b. The total amount of fixed overhead cost is expensed as a period cost under
variable costing.
2. Absorption costing income will be less than variable costing income if production
is less than sales.
a. Absorption costing expenses all of the current period fixed overhead cost as
well as releasing some fixed overhead cost from beginning inventory where it
had been deferred from a prior period.
b. Variable costing shows on the income statement only current period fixed
overhead, so that the additional fixed overhead released from beginning
inventory makes absorption costing income lower.

c. The process of deferring and releasing fixed overhead costs into and from
inventory makes it possible to manipulate income under absorption costing by
adjusting levels of production relative to sales. This leads some to believe that
variable costing might be more useful for external reporting purposes than
absorption costing.
d. For internal reporting purposes, variable costing provides managers

information about the behavior of the various product and period costs.
Reference
Southwestern. USA
PRELIM TASK
Case 1
The Jessica Co. has the following information available regarding costs and revenues
for two recent months. Selling price is P 1,000.
March April
Sales revenue P 3,000,000 P 5,000,000
Cost of goods sold -1,800,000 - 3,000,000
Gross profit P 1,200,000 P 2,000,000
Less other expenses:
Advertising P 30,000 P 30,000
Utilities 210,000 280,000
Salaries and commissions 160,000 200,000
Supplies (bags, cleaning supplies etc.) 16,000 20,000
Depreciation 115,000 115,000
Administrative costs 95,000 95,000
Total -626,000 -740,000
Net income P 574,000 P1,260,000
Required:
a. Identify each of the company's expenses (including cost of goods sold) as being
either variable, fixed, or mixed.
b. By the use of the high-low method, separate each mixed expense into variable
and fixed elements. State the cost formula for each mixed expense.
c. What is the total cost equation?

d. Estimate total cost if sales = P3,750,000.
Case 2
Sports Innovators has developed a new design to produce hurdles that are used in track
and field competition. The company's hurdle design is innovative in that the hurdle yields
when hit by a runner and its height is extraordinarily easy to adjust. Management
estimates expected annual capacity to be 90,000 units; overhead is applied using
expected annual capacity. The company's cost accountant predicts the following
current year activities and related costs:
Standard unit variable manufacturing costs $12

Variable unit selling expense $5
Fixed manufacturing overhead $480,000
Fixed selling and administrative expenses $136,000
Selling price per unit $35
Units of sales 80,000
Units of production 85,000
Units in beginning inventory 10,000
Other than any possible under or overapplied fixed overhead, management expects
no variances from the previous manufacturing costs. Under or overapplied fixed
overhead is to be written off to Cost of Goods Sold.
Required:
1. Determine the amount of under- or overapplied fixed overhead using (a) variable
costing and (b) absorption costing.
2. Prepare projected income statements using (a) variable costing and (b)
absorption costing.
3. Reconcile the incomes derived in part 2.
Case 3
On December 30, a fire destroyed most of the accounting records of the Adams
Division, a small one-product manufacturing division that uses standard costs and
flexible budgets. All variances are written off as additions to (or deductions from)
income; none are pro-rated to inventories. You have the task of reconstructing the
records for the year. The general manager informs you that the accountant has been
experimenting with both absorption costing and variable costing.
The following information is available for the current year:

a. Cash on hand, December 31 $10

b. Sales $128,000
c. Actual fixed indirect manufacturing costs 21,000
d. Accounts receivable, December 31 20,000
e. Standard variable manufacturing costs per unit 1
f. Variances from standard of all variable manufacturing costs $5,000 U
g. Operating income, absorption-costing basis $14,400
h. Accounts payable, December 31 18,000
i. Gross profit, absorption costing at standard (before deducting variances)
22,400
j. Total liabilities 100,000
k. Unfavorable budget variance, fixed manufacturing costs 1,000 U
l. Notes receivable from chief accountant 4,000
m. Contribution margin, at standard (before deducting variances) 48,000
n. Direct-material purchases, at standard prices 50,000
o. Actual selling and administrative costs (all fixed) 6,000
Required:
Compute the following items (ignore income tax effects).
1. Operating income on a variable-costing basis.

2. Number of units sold.
3. Number of units produced.
4. Number of units used as the denominator to obtain fixed indirect cost application
rate per unit on absorption-costing basis.
5. Did inventory (in units) increase or decrease? Explain.
6. By how much in dollars did the inventory level change (a) under absorption
costing, (b) under variable costing?
7. Variable manufacturing cost of goods sold, at standard prices.
8. Manufacturing cost of goods sold at standard prices, absorption costing.
Read the concise explanation about activity based costing from www.cliffnotes.com.
1. Activity Based Costing, commonly referred to as ABC, is discussed briefly below.

In order to digest the contents of this article, make sure to take into consideration
how terms are defined.

MIDTERM READING MATERIAL NO. 1
Activity-Based Costing Activities
Traditionally, in a job order cost system and process cost system, overhead is allocated
to a job or function based on direct labor hours, machine hours, or direct labor dollars.
However, in some companies, new technologies have changed the manufacturing
environment such that the number of hours worked or dollars earned by employees are
no longer good indicators of how much overhead will be needed to complete a job or
process products through a particular function. In such companies, activity‐based
costing (ABC) is used to allocate overhead costs to jobs or functions.
Activity‐based costing assumes that the steps or activities that must be followed to
manufacture a product are what determine the overhead costs incurred. Each
overhead cost, whether variable or fixed, is assigned to a category of costs. These cost
categories are called activity cost pools. Cost drivers are the actual activities that cause
the total cost in an activity cost pool to increase. The number of times materials are
ordered, the number of production lines in a factory, and the number of shipments
made to customers are all examples of activities that impact the costs a company
incurs. When using ABC, the total cost of each activity pool is divided by the total
number of units of the activity to determine the cost per unit.
The number of activities a company has may be small, say five or six, or number in the
hundreds. Computers make using ABC easier. Assume Lady Trekkers, Inc., has identified
its activity cost pools and cost drivers (see the following table).

A per unit cost is calculated by dividing the total dollars in each activity cost pool by
the number of units of the activity cost drivers. As an example to calculate the per unit
cost for the purchasing department, the total costs of the purchasing department are
divided by the number of purchase orders. Lady Trekkers, Inc., has determined that both
the purchasing and receiving departments' costs are based on the number of purchase
orders; therefore, the two departments' costs may be added together so that one per
unit cost is calculated for these departments. Once the per unit costs are all calculated,
they are added together, and the total cost per unit is multiplied by the number of units
to assign the overhead costs to the units.

Activity categories
While using cost drivers to assign overhead costs to individual units works well for some
activities, for some activities such as setup costs, the costs are not incurred to produce
an individual unit but rather to produce a batch of the same units. For other costs, the
costs incurred might be based on the number of product lines or simply because there
is a manufacturing facility. To assign overhead costs more accurately, activity‐based
costing assigns activities to one of four categories:
• Unit‐level activities occur every time a service is performed or a product is made.

The costs of direct materials, direct labor, and machine maintenance are
examples of unit‐level activities.
• Batch‐level activities are costs incurred every time a group (batch) of units is
produced or a series of steps is performed. Purchase orders, machine setup, and
quality tests are examples of batch‐level activities.
• Product‐line activities are those activities that support an entire product line but
not necessarily each individual unit. Examples of product‐line activities are
engineering changes made in the assembly line, product design changes, and
warehousing and storage costs for each product line.
• Facility support activities are necessary for development and production to take
place. These costs are administrative in nature and include building depreciation,
property taxes, plant security, insurance, accounting, outside landscape and
maintenance, and plant management's and support staff's salaries.
The costs of unit‐level, batch‐level, and product‐line activities are easily allocated to a
specific product, either directly as a unit‐level activity or through allocation of a pooled
cost for batch‐level and product‐line activities. In contrast, the facility‐level costs are
kept separate from product costs and are not allocated to individual units because the
allocation would have to be made on an arbitrary basis such as square feet, number of
divisions or products, and so on.
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/activity-based-
costing/activity-based-costing-activities

Read a concise explanation of how job order costing is being used from
www.cliffnotes.com.
1. Job order costing is commonly used for custom made products.
2. Take into consideration the forms that are being used in this article. However,
this should not limit your imagination to use other forms in the future.
3. As technological evolution has brought forth a lot of change, the explanations
below are very useful to understand the logic behind how a product cost was
computed.
Job Order Cost System
The job order cost system is used when products are made based on specific customer
orders. Each product produced is considered a job. Costs are tracked by job. Services
rendered can also be considered a job. For example, service companies consider the
creation of a financial plan by a certified financial planner, or of an estate plan by an
attorney, unique jobs. The job order cost system must capture and track by job the costs
of producing each job, which includes materials, labor, and overhead in a
manufacturing environment. To track data, the following documents are used:
Job cost sheet. This is used to track the job number; customer information; job
information (date started, completed, and shipped); individual cost information for
materials used, labor, and overhead; and a total job cost summary. See Figure 1.


Materials requisition form. To assure that materials costs are properly allocated to jobs in
process, a materials requisition form (see Figure 2) is usually completed as materials are
taken from the raw materials inventory and added to work‐in‐process.
Time ticket. Labor costs are allocated to work‐in‐process inventory based on the
completion of time tickets (see Figure 3) identifying what job a worker spent time on.

Predetermined overhead rate
Factory overhead costs are allocated to jobs in process using a predetermined

overhead rate. The predetermined overhead rate is determined by estimating (during
the budget process) total factory overhead costs and dividing these total costs by
direct labor hours or direct labor dollars. For example, assume a company using direct
labor dollars for the allocation of overhead estimated its total overhead costs to be
$300,000 and total direct labor dollars to be $250,000. The company's predetermined
overhead rate for allocating overhead to jobs in process is 120% of direct labor dollars,
and is calculated as follows:

If direct labor costs are $20,000 for the month, overhead of $24,000 ($20,000 × 120%)
would be allocated to work‐in‐process inventory. Factory overhead would be allocated
to individual jobs based on the portion of the $20,000 direct labor cost that is assigned
to each job. If job number 45 had $9,000 in direct labor cost for the month, factory
overhead of $10,800 ($9,000 × 120%) would also be allocated to the job.
Once a job is completed, the total costs assigned to the job are transferred from work‐
in‐process inventory to finished goods inventory. Once the job is sold and delivered, the
job costs are transferred from finished goods inventory to cost of goods sold. Figure 4
summarizes the flow of costs in a job order cost system and Figure 5 summarizes the
journal entries required given the flow of costs in Figure 4. The ending balances in the
three inventory accounts would be reported as inventories on the balance sheet and
cost of goods sold would be reported on the income statement.


The factory overhead account (see Figure 5) has a balance which indicates the
amount of overhead applied to work‐in‐process inventory is different from the actual
overhead incurred. When there is a debit balance in the factory overhead account, it
is called under‐applied overhead meaning not enough overhead was allocated to
jobs. If the balance in the factory overhead account was a credit, the overhead would
be over‐applied, meaning too much overhead was allocated to jobs. Factory
overhead must be zero at the end of the year. Most companies transfer the balance in
factory overhead to cost of goods sold. An alternative method, although more
complex, is to allocate the under‐ or over‐applied balance among the work‐in‐process
inventory, finished goods inventory, and cost of goods sold accounts. The $2,600
account balance in factory overhead in Figure 5 is relatively small. To zero out the
account balance and transfer it to cost of goods sold, the entry would be:
Key:
• A Purchased raw materials

• B Direct material requisition to be used on jobs
• C Direct labor payroll based on time ticket
• D Indirect materials used
• E Indirect labor payroll
• F Other overhead costs incurred
• G Overhead applied to jobs (direct labor dollars ¥ 80% predetermined
overhead rate)

• H Transfer completed jobs to finished goods inventory

• I Transferred sold jobs to cost of goods sold
• J Paid wages
The journal entries that follow support the transactions in Figure 5.


https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/traditional-cost-
systems/job-order-cost-system
Read a concise explanation of how process costing is being used from

www.cliffnotes.com.
1. Process Cost System is very commonly used in manufacturing of large volumes
of homogenous items.
2. Process costing is more complicated as compared to the other cost system as
this most often is comprised of more than one process or work areas.
Process Cost System
Some companies have homogeneous or very similar products that are not made to
order and are produced in large volumes. They continually process their product,
moving it from one function to the next until it is completed. In these companies, the
manufacturing costs incurred are allocated to the proper functions or departments
within the factory process rather than to specific products. Examples of products that
companies produce continuously are cereal, bread, candy, steel, automotive parts,
chips, and computers. Companies that refine oil or bottle drinks and companies that
provide services such as mail sorting and catalog order are also examples of continuous,
homogeneous processing.
To illustrate, assume the Best Chips company manufactures potato chips. The company
has three work areas they call preparation, baking, and packaging. The preparation
area includes cutting potatoes and adding flavorings. Conveyor belts are used to move
the product from one function to the next. In this company, raw materials are added in
two of the functions: the preparation function and the packaging function. Labor and
overhead are incurred in each function. Figure shows the process flow and costs
associated with Best Chip's process cost system.

The cost report for Best Chips summarizes how manufacturing costs (direct materials,
direct labor, and manufacturing overhead) are assigned to the three departments.
The report for June is as follows:

The raw materials are assigned based on material requisition forms, the labor based on
time tickets, and the overhead based on predetermined overhead rates based on
direct labor dollars. The journal entries to record these transactions are made prior to
the period end entries that transfer the amounts from one work‐in‐process inventory
account to another, from work‐in‐process inventory to finished goods inventory, and

from finished goods inventory to cost of goods sold. The letters of the journal entries used
to illustrate the accounting for process cost systems correspond to the letters in Figure.
Raw materials requisitioned
Best Chips started the month of June with $5,200 in raw materials inventory. Best Chips
uses the perpetual inventory method, so raw materials purchased are added to the raw
material inventory account when they are received. Raw materials requisitioned that
become part of the final product or are used by a specific function are considered
direct materials used. The costs of direct materials are added to the proper
department's work‐in‐process inventory account. Raw materials requisitioned that are
used for general production purposes are added to factory overhead. The journal
entries related to raw material activity for June are:

At the end of the month, $2,000 of materials remained in raw materials inventory.

Factory labor
As the factory labor payroll is prepared and recorded, the payroll costs are split
between those employees who work in specific functions (departments) and those
involved in the general functions of the factory. The specific function costs are called
direct labor and are assigned to work‐in‐process inventory. The general factory labor
costs are indirect labor costs that are added to factory overhead. Unlike the accounting
for payroll under the job order cost system, the employee does not have to be physically
involved in making a product to be assigned to a specific function. If a specific
maintenance worker or supervisor is assigned to the preparation function, their wages
are allocated to that function even though these workers are not directly involved in
preparing the chips to be baked. The accounting for the labor costs for June includes
the following journal entries, shown in the following table.


The balance in the factory labor account should be zero at the end of each period.
Factory overhead
In a process company, factory overhead represents those costs not directly assigned to
one function. For example, the depreciation expense of a machine used solely by the
preparation function would be assigned to work‐in‐process inventory for the
preparation department while depreciation expense for the plant (the factory building)
would be assigned to factory overhead as all functions occupy the plant. The journal
entries that follow illustrate the accounting for general overhead costs.

At the end of the period, the factory overhead account has a credit balance of ($125).
This is called overapplied overhead and an entry would be made at the end of the
period to move it to cost of goods sold, or alternatively, to allocate the difference to
work‐in‐process inventories, finished goods inventory, and cost of goods sold. After
recording this entry, the balance in the factory overhead account is zero.

At the end of the period, entries are needed to record the cost of the products moved
from one function (department) to another. In this example, costs are moved from work‐
in‐process inventory‐preparation to work‐in‐process inventory‐baking and from work‐in‐
process inventory‐baking to work‐in‐process inventory‐packaging. This is how the entries
would look:

When the packaging function (department) completes its work, the product is ready to
be sold. The costs of the completed products are then transferred from work‐in‐process
inventory‐packaging to finished goods inventory. This transfer also requires a journal
entry.
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/traditional-cost-systems/process-cost-system
MIDTERM TASK
Case 1
McMahon Company would like to institute an activity-based costing system to price

products. The company's Purchasing Department incurs costs of $550,000 per year and
has six employees. Purchasing has determined the three major activities that occur
during the year.

Allocation # of Total
Activity Measure People Cost
Issuing purchase orders # of purchase 1 $150,000
orders
Reviewing receiving # of receiving 2 $175,000
reports reports
Making phone calls # of phone calls 3 $225,000
During the year, 50,000 phone calls were made in the department; 15,000 purchase
orders were issued; and 10,000 shipments were received. Product A required 200 phone
calls, 150 receiving reports, and 50 purchase orders. Product B required 350 phone calls,
400 receiving reports, and 100 purchase orders.
a. Determine the amount of purchasing department cost that should be assigned to

each of these products.
b. Determine purchasing department cost per unit if 1,500 units of Product A and 3,000
units of Product B were manufactured during the year.
Case 2
Grace Company manufactures picture frames of all sizes and shapes and uses a job-
order costing system. There is always some spoilage in each production run. The
following costs relate to the current run:
Estimated overhead (exclusive of spoilage) $160,000

Spoilage (estimated) $ 25,000
Sales value of spoiled frames $ 11,500
Labor hours 100,000
The actual cost of a spoiled picture frame is $7.00. During the year 170 frames are
considered spoiled. Each spoiled frame can be sold for $4. The spoilage is considered a
part of all jobs.
a. Labor hours are used to determine the predetermined overhead rate.

What is the predetermined overhead rate per direct labor hour?
b. Prepare the journal entry needed to record the spoilage.
c. Prepare the journal entry if the spoilage relates only to Job #12 rather than
being a part of all production runs.
Case 3
Keener Company manufactures a specialized product. Department 2 adds new
material to the units received from Department 1 at the end of process. A normal loss

occurs early in processing. Production and cost data for Department 2 for the month of
September are as follows:
Production record (in units):

In process, September 1-75% complete for 4,000
processing cost
Received from Department 1 20,000
Completed and transferred to finished goods 16,000
Lost in processing (normal) 2,000
In process, September 30-2/3 complete for 6,000
process cost
Cost Record:
Work in process inventory, September 1:
Preceding department cost $ 620
Processing cost 2,000 $2,620
Cost from preceding department in September 1,800
Material cost for September 4,800
Processing cost for September 10,200
Required: Determine the following for Department 2 under (a) weighted average the
method of costing and (b) the FIFO method of costing: (1) unit costs for each cost
component, (2) cost of production transferred to finished goods, (3) cost of work in
process inventory of September 30.
Read the summarized outline of Chapter 7 on Standard Costing and Variance Analysis.
FINAL READING MATERIAL NO. 1
STANDARD COSTING AND VARIANCE ANALYSIS
Standards for material, labor, and overhead set?
A. Development of a Standard Cost System
1. General
a. A standard is a performance benchmark or norm used for planning and

control purposes. Standards specify the expected costs and quantities
needed to manufacture a single unit of product or perform a single service.

b. A standard cost system is a product costing system that determines product

cost by using standards or norms for quantities and/or prices of component
elements; it allows actual costs to be compared against norms for cost control
purposes.
i. Developing a standard cost involves judgment and practicality in

identifying the material and labor types, quantities, and prices as well as
understanding the types of organizational overhead and how they
behave.
ii. A primary objective in manufacturing a product is to minimize unit cost

while achieving certain quality specifications.
iii. After management has determined the input resources needed to achieve
desired output quality at reasonable cost, it can develop quantity and
price standards.
c. Standards should be developed by a group, composed of representatives

from the following areas: cost accounting, industrial engineering, personnel,
data processing, purchasing, and management.
d. To ensure credibility of the standards and to motivate people to operate as

close to the standards as possible, standard-setting involvement of managers
and workers whose performance will be compared to standards is vital.
2. Material standards
a. The first step in developing material standards is to identify and list the specific
direct material components used to manufacture the product. Four things
must be known about the materials inputs:
i. types of inputs;
ii. quantity of inputs;
iii. quality of inputs; and
iv. price of inputs.
b. Managers should seek the advice of materials experts, engineers, cost

accountants, marketing personnel, and possibly suppliers in making quality
decisions. Quantity and cost estimates become direct functions of quality
decisions.

Documents associated with standard cost systems

The bill of materials is a document that contains specifications for materials, including
quality and quantity
i. Companies often make allowances for normal waste of components.
ii. Component should also reflect quantity discounts allowed and

freight/receiving costs.
iii. Purchasing agents should be aware of company purchasing habits and of

alternative suppliers and such information should be incorporated into
price standards.
c. The standard direct material cost per unit is found by multiplying the standard
quantity of material required per unit of output by the standard price per
material input.
3. Labor Standards
a. The development of labor standards requires the same basic procedures as

those used for materials.
b. Each production operation performed by workers or by machinery should be

identified.
i. All unnecessary movements of workers and of material should be

disregarded when time standards are set.
c. To develop effective standards, a company must obtain quantitative

information for each production operation. Methods-time measurement is an
industrial engineering process that analyzes work tasks to determine the time
a trained worker requires to perform a given operation at a rate that can be
sustained for an eight-hour day.
d. After an analysis of labor tasks is completed, an operations flow document can

be prepared which lists all operations necessary to make one unit of product
(or perform a specific service) and the corresponding time allowed for each
operation.
e. Labor rate standards should reflect the wages paid to employees who perform
the various production tasks as well as the related employer costs such as
fringe benefits, FICA, and unemployment taxes.
i. A weighted average rate, computed as the total wage cost per hour
divided by the number of workers, should be used if employees are paid
different wage rates.

f. The standard direct labor cost per unit is found by multiplying the standard
quantity of labor required per unit of output by the standard price per labor
input.
4. Overhead standards
a. Overhead should be assigned to separate cost pools based on the cost

drivers, and allocations to products are made using various activity drivers in
order to provide the most appropriate costing information.
b. The development of the bill of materials, operations flow document, and

predetermined overhead rates is followed by the preparation of a standard
cost card, which summarizes all standard quantities and costs needed to
complete one unit of product.
c. Both actual and standard costs are recorded in a standard cost system. But
standard costs, rather than actual costs, are charged to the Raw (Direct)
Material, Work in Process, and Finished Goods Inventory accounts with any
differences between actual and standard costs reported as variances
Calculating and recording material, labor, and overhead variances
B. General Variance Analysis Model
1. General
a. A variance is any difference between an actual cost and a standard or

budgeted cost.
i. Such a difference is favorable if actual cost is less than standard cost and
unfavorable if actual cost is greater than standard cost.
b. A total variance is the difference between total actual cost for the production
inputs and the total standard cost applied to the production output:
Actual cost of actual input – Standard cost of actual output
c. A total variance can be computed for each production cost element.
d. Total variances indicate differences between actual and expected

production costs, but they do not provide useful information for determining
why such differences occurred. Thus total variances are subdivided into price
and usage variances in order to help managers in their control objectives:

i. A price/rate variance reflects the difference between the actual price (AP)
paid for inputs and the standard input price (SP) for the actual quantity
(AQ) of inputs used during the period:
• Price/Rate Variance = (AP – SP)(AQ)
ii. A usage (quantity/efficiency) variance shows the difference between the

actual quantity (AQ) of inputs used and the standard quantity (SQ) of inputs
allowed for the actual output achieved during the period. Usage variances
focus on the efficiency of results—the relationship of inputs to outputs:
• Quantity/Efficiency Variance = (AQ – SQ) (SP)
e. The standard quantity (SQ) is the quantity of input (in hours or some other cost
driver measurement) required at standard for the output actually achieved for
the period.
C. Material and Labor Variance Computations
1. Material Variances
a. Text Exhibit 7-4 presents the standard cost card for a mountain bike made by
Harris Corporation as well as actual costs and quantities used. This information
is used in the text narrative to illustrate variance analysis.

b. The total material variance can be subdivided into the material price variance
and the material quantity variance:
AP × AQ SP × AQ SP × SQ
Material Material
Price Variance Quantity Variance
Total Material Variance
c. Variances are labeled “unfavorable” if the actual price or quantity amounts

are higher than the standard price or quantity amounts; variances are labeled
“favorable” when the actual price or quantity amounts are lower than the
standard amounts.
i. The terms favorable and unfavorable do not necessarily equate to good

and bad performance, respectively.
d. The material price variance (MPV) indicates whether the amount paid for
material was less than or more than standard price.
i. This variance is usually the responsibility of the purchasing manager.
e. The material quantity variance (MQV) indicates whether the actual quantity
used was less than or more than the standard quantity for the actual output
achieved.
i. This variance is usually the responsibility of the production manager.
2. Point of Purchase Material Variance Model
a. When the quantity of material purchased is not the same as the quantity of
material placed into production, the general variance model can be easily
modified to isolate material price variances as early as possible to provide
more rapid information for management control purposes.
i. Because the material price variance relates to the purchasing (rather than
the production) function, the point of purchase model calculates the
material price variance using the quantity of materials purchased (Qp)
rather than the quantity of materials used (Qu).
b. The total material variance can be subdivided into the material purchase
price variance and the material price usage variance:

AP × AQP SP × AQP
Material Price Variance
SP × AQU SP × SQ
Material Quantity Variance
c. The material purchase price variance is the materials price variance when
computed based on the quantity of materials purchased during the period
rather than the quantity of materials used.
d. The material quantity variance is the material usage variance when computed
based on the quantity of materials used during the period.
3. Labor Variances
a. The total labor variance can be subdivided into the labor rate variance and
the labor efficiency variance.
Labor Labor
Rate Variance Efficiency Variance
Total Labor Variance
b. The labor rate variance (LRV) is the difference between the actual wages paid
to labor for the period and the standard cost of actual hours worked.
c. The labor efficiency variance (LEV) indicates whether the amount of time
worked was less than or more than the standard quantity for the actual output.
D. Overhead Variances
1. Overhead Variances
a. Because total variable overhead changes in direct relationship with changes

in activity and fixed overhead per unit changes inversely with changes in
activity, a specific capacity level must be selected to compute budgeted
overhead costs and to develop a predetermined overhead (OH) rate.
i. Capacity refers to any measure of activity. The most common capacity

measures are theoretical capacity, practical capacity, normal capacity,
and expected capacity.

b. If the company uses separate variable and fixed overhead application rates,
separate price and usage components are calculated for each type of
overhead. This four-variance approach provides managers the greatest detail
and, thus, the greatest flexibility for control and performance evaluation.
2. Variable Overhead
a. The total variable overhead variance is the difference between actual

variable overhead costs incurred for the period and standard variable
overhead cost applied to the period’s actual production or service output.
Actual VOH Budgeted VOH Applied VOH

(for actual activity) (for standard quantity allowed)
VOH VOH
Spending Variance Efficiency Variance
Total Variable Overhead Variance

(Underapplied or Overapplied Variable Overhead)
b. The variable overhead spending variance is the difference between total

actual variable overhead and the budgeted amount of variable overhead
based on actual hours; it is computed as part of the four-variance analysis.
i. Variable overhead spending variances associated with quantity

differences can be caused by waste or shrinkage of production inputs
(such as indirect material).
c. The variable overhead efficiency variance is the difference between

budgeted variable overhead based on actual hours and variable overhead
applied based on standard hours allowed for the production achieved; it is
computed as part of the four-variance analysis.
i. This variance quantifies the effect of using more or less of the activity or
resource which is the base for variable overhead application. When actual
input exceeds standard input allowed, production operations are
considered to be inefficient. Excess input also indicates that an increased
VOH budget is needed to support the additional activity base being used.
3. Fixed Overhead
a. The total fixed overhead variance is the difference between actual fixed
overhead costs incurred and standard fixed overhead cost applied to the
period’s actual production.

Actual FOHBudgeted FOH Applied FOH

(for standard quantity allowed)
SP × SQ
FOH
Spending Variance Volume Variance
Total Fixed Overhead Variance

(Underapplied or Overapplied Fixed Overhead)
b. The left column is simply the total actual fixed overhead incurred. The middle
column, budgeted FOH, is a constant amount throughout the relevant range
of activity and was the amount used to developed the predetermined FOH
rate; thus, this amount is a constant figure regardless of the actual quantity of
input or the standard quantity of input allowed. The right column is the amount
of fixed overhead applied to production based on the standard fixed
overhead rate and standard quantity allowed.
c. The fixed overhead spending variance is the difference between the total
actual fixed overhead and budgeted fixed overhead.
i. This variance amount normally represents the differences between

budgeted and actual costs for the numerous FOH components, although
it can also reflect resource mismanagement.
d. The fixed overhead volume variance is the difference between budgeted and
applied fixed overhead.
i. Although capacity utilization is controllable to some degree, the volume

variance is the one over which managers have the least influence and
control, especially in the short run and for that reason the volume variance
is also called the noncontrollable variance.
ii. The volume variance merely translates under-or-over-utilization into a dollar

amount. An unfavorable volume variance indicates less-than-expected
utilization of capacity. If available capacity is commonly being used at a
level higher (or lower) than that which was anticipated or is available,
managers should investigate and initiate appropriate action.
4. Alternative Overhead Variance Approaches
a. A four-variance approach is unworkable if the accounting system does not

distinguish between variable and fixed costs.

b. The total overhead variance is the difference between total actual overhead
and total applied overhead, and is the only variance computed under the
one-variance approach:
Total Applied Overhead
(Combined OH Rate × Standard
Input Allowed for Actual
Total Actual Overhead Production)
(Variable OH + Fixed OH) (SP × SQ)
Total Overhead Variance
c. A middle column representing budgeted overhead based on standard

quantity is inserted between total actual overhead and total applied
overhead under the two-variance approach:
Total Actual OH Budgeted OH

(Variable OH (for standard Total Applied OH
+ Fixed OH) quantity) SP × SQ
Budget Variance Volume Variance

(Controllable (Noncontrollable
Variance) Variance)
i. The budget variance is the difference between total actual overhead and
budgeted overhead based on standard hours allowed for the production
achieved; it is computed as part of the two-variance analysis; it is also
referred to as the controllable variance.
ii. The volume variance can be computed under the four-variance, three-
variance, or two-variance analysis.
d. A column representing budgeted overhead based on actual hours is inserted
immediately to the right of total actual overhead under the three-variance
approach:
Budgeted Budgeted
Total Actual Overhead Overhead Total Applied
Overhead (for actual (for actual Overhead
(VOH + FOH) input used) output) (SP × SQ)
Overhead Overhead Overhead

Spending Efficiency Volume
Variance Variance Variance

i. The overhead spending variance is the difference between total actual

overhead and total budgeted overhead at actual input activity; thus, a
flexible budget is required. It is computed as part of the three-variance
analysis; it is equal to the sum of the variable and fixed overhead spending
variances.
ii. The overhead efficiency variance is the difference between total

budgeted overhead at actual input activity and total budgeted overhead
at standard input allowed (output activity); it is computed as part of the
three-variance analysis; it is the same as variable overhead efficiency
variance.
E. Standard Cost System Journal Entries
1. Note that unfavorable variances have debit balances while favorable variances
have credit balances.
2. Although standard costs are useful for internal reporting, they can be used in
financial statements only if the amounts are substantially equivalent to those that
would have resulted from using an actual cost system.
3. At year-end, adjusting entries are made to eliminate standard cost variances. The
entries depend on whether the variances are, in total, insignificant or significant.
a. If insignificant, unfavorable variances are closed as debits to Cost of Goods

Sold; favorable variances are credited to Cost of Goods Sold.
b. If significant, variances are prorated at year-end among ending inventories

and Cost of Goods Sold so that the balances in those accounts approximate
actual costs.
i. Proration is based on the relative size of the account balances as illustrated

in the example provided in the text narrative.
F. Why Standard Cost Systems are Used
1. Clerical efficiency—a company that uses standard costs to trace the flow of costs
through its accounting system usually discovers that less clerical time and effort
are required than in an actual cost system.
2. Motivation—standards represent a technique of communicating management’s

expectations of efficiency to workers.
3. Planning—managers can use currently available standard costs to estimate

future quantities and costs.

4. Controlling—the control process begins with the establishment of standards which

provide a basis against which actual costs can be measured so variances may
be computed.
a. Variance analysis is the process of categorizing the nature (favorable or

unfavorable) of the differences between standard and actual costs and
determining the reasons for those differences.
b. The setting of upper and lower tolerance limits for deviations allows managers
to implement the management by exception concept.
5. Decision making—standard cost information availability facilitates many

decisions.
6. Performance evaluation—summary variance reports focus attention on the

operating performance of subordinate managers, allowing top managers to
determine when costs were and were not controlled by which managers. Top
management can then provide vital feedback to the subordinate managers.
G. Considerations in Establishing Standards
1. Appropriateness
a. Appropriateness and attainability need to be considered when standards are

established.
i. Appropriateness, in relation to a standard, refers to the basis on which the

standards are developed and how long they are expected to last.
b. Standards are developed from past and current information, and they should
reflect technical and environmental factors expected during the period in
which the standards are to be applied.
c. Factors such as the materials quality, normal ordering quantities of materials,

expected employee wage rates, degree of plant automation, facility layout,
and mix of employee skills should be considered.
d. Standards must evolve over the organization’s life to reflect its changing
methods and processes.
2. Attainability
a. Attainability refers to management’s belief about the degree of difficulty or

rigor that should be incurred in achieving the standard. Standards can be
classified by their degree of rigor and, thus, their motivational value from easy
to difficult as follows: expected, practical, and ideal.

b. Expected standards are standards set at a level that reflects what is actually
expected to occur in the future period; these standards anticipate future
waste and inefficiencies and allow for them; they are not of significant value
for control and performance evaluation purposes.
c. Practical standards are standards that can be reached or slightly exceeded

approximately 60 to 70 percent of the time with reasonable effort by workers;
d. they allow for normal, unavoidable time problems or delays and for worker
breaks; they are believed to be most effective in inducing the best
performance from workers, since such standards represent an attainable
challenge.
e. Ideal standards are standards that provide for no inefficiencies of any type,
are impossible to attain, and are sometimes called theoretical standards.
H. Changes in Standards Usage
1. Use of Ideal Standards and Theoretical Capacity
a. Many accountants and business people believe that incorrect measurements

are sometimes employed in utilizing variances for control and performance
evaluation purposes.
b. The Japanese philosophy is a notable exception to the disbelief in the use of

ideal or theoretical standards for performance evaluation.
i. The just-in-time (JIT) production system and total quality management

(TQM) concepts both have goals of zero defects, zero inefficiency, and
zero downtime.
c. Ideal standards become expected standards under such a system, and there
is no (or only minimal) level of acceptable deviation from standard.
d. Implementing ideal standards requires that employees communicate and

work together to improve performance:
i. Management must be willing to invest in those plant and equipment items,

equipment rearrangements, worker training and/or pay increases, vendor
changes, and so on that will make it possible to achieve ideal standards.
ii. Current problems must be identified and their causes must be pinpointed.
iii. Management must empower workers with the authority to react effectively
to problems since management has delegated the responsibility for quality
to the workers.

iv. Management must provide rewards for achievement since people are
required to work at their maximum potential.
e. Standards will move away from the practical and closer to the ideal in order
for American companies to compete in global markets.
2. Adjusting Standards
a. Standards were traditionally set and retained for at least one year.
b. The current business environment changes so swiftly that a standard might not
be useful for management control purposes during the entire year.
c. Management can either decide to ignore such changes or to incorporate the

changes in the standard. Changing the standards to reflect the changes in
prices or quantities would make some aspects of management control and
performance evaluation more effective and others more difficult.
d. Management may also consider the original standards to be “frozen” for

budget purposes and prepare a revised budget using the new current
standards.
3. Material Price Variance Based on Purchases Rather than Usage
a. The material price variance calculation has usually been based on purchases
rather than on usage.
b. The variance is computed as quickly as possible relative to the incurrence of

cost.
c. Such variance calculation at the point of purchase does allow the manager
to measure the impact of buying decisions more rapidly, but may not be
relevant in a JIT environment.
d. A material price variance computation based on purchases may lessen the

probability of recognizing a relationship between a favorable material price
variance and an unfavorable material quantity variance.
4. Decline in Direct Labor
a. The necessity for direct labor variance calculations will be minimized as the
percentage of total product cost represented by direct labor cost declines.
b. Direct labor cost may become a small part of a conversion cost category.

c. An increase in automation often relegates labor to an indirect category since

workers become machine overseers rather than product producers.
I. Conversion Cost as an Element in Standard Costing
1. Direct labor cost usually represents an extremely small part of total product cost
in highly automated factories.
a. One worker may oversee a large number of machines and deal mainly with
trouble-shooting machinery malfunctions.
b. The worker’s wages may be more closely related to indirect labor rather than
to direct labor.
2. Many companies have responded to overhead costs being so much larger than
direct labor costs by adapting their standard cost systems to provide for only two
elements of product cost: direct material and conversion.
a. Conversion costs are likely to be separated into their variable and fixed
components.
b. Conversion costs are also likely to be separated into direct and indirect
categories based on their ability to be traced to a machine rather than to a
product.
3. Variance analysis for conversion cost in automated plants usually focuses on:
a. Spending variances for overhead costs;
b. Efficiency variances for machinery and production costs rather than labor
costs; and
c. Volume variance for production.
J. Mix and Yield Variances
1. Mix and Yield Variances
a. A mix is any possible combination of materials or labor inputs.
b. A yield is the quantity of output that results from a specified input.
2. Material Price, Mix, and Yield Variances
a. A material price variance shows the dollar effect of paying prices that differ
from the raw material standard.

b. The material mix variance measures the monetary effect of substituting a

nonstandard mix of materials; (actual mix × actual quantity × standard price)
minus (standard mix × actual quantity × standard price).
c. The material yield variance is the difference between the actual total quantity
of input and the standard total quantity allowed based on output and uses
standard mix and standard prices to determine variance; (standard mix ×
actual quantity × standard price) minus (standard mix × standard quantity ×
standard price).
3. Labor Rate, Mix, And Yield Variances
a. The labor mix variance presents the financial effect associated with changing
the proportionate amount of higher or lower paid workers in production;
(actual mix × actual hours × standard rate) minus (standard mix × actual hours
× standard rate).
b. The labor yield variance shows the monetary impact of using more or fewer
total hours than the standard allowed; (standard mix × actual hours × standard
rate) minus (standard mix × standard hours × standard rate).
Reference:
Kinney and Raiborn. 2009. Cost Accounting Foundations and Evolutions 7th edition.
Southwestern. USA
Read a concise explanation on Cost-Volume-Profit analysis from www.cliffnotes.com.
Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and

volume affect a company's operating income and net income. In performing this
analysis, there are several assumptions made, including:
• Sales price per unit is constant.

• Variable costs per unit are constant.
• Total fixed costs are constant.
• Everything produced is sold.
• Costs are only affected because activity changes.
• If a company sells more than one product, they are sold in the same mix.

CVP analysis requires that all the company's costs, including manufacturing,
selling, and administrative costs, be identified as variable or fixed.
Contribution margin and contribution margin ratio
Key calculations when using CVP analysis are the contribution margin and
the contribution margin ratio. The contribution margin represents the amount of
income or profit the company made before deducting its fixed costs. Said
another way, it is the amount of sales dollars available to cover (or contribute to)
fixed costs. When calculated as a ratio, it is the percent of sales dollars available
to cover fixed costs. Once fixed costs are covered, the next dollar of sales results
in the company having income.
The contribution margin is sales revenue minus all variable costs. It may be
calculated using dollars or on a per unit basis. If The Three M's, Inc., has sales of
$750,000 and total variable costs of $450,000, its contribution margin is $300,000.
Assuming the company sold 250,000 units during the year, the per unit sales price
is $3 and the total variable cost per unit is $1.80. The contribution margin per unit
is $1.20. The contribution margin ratio is 40%. It can be calculated using either the
contribution margin in dollars or the contribution margin per unit. To calculate the
contribution margin ratio, the contribution margin is divided by the sales or
revenues amount.
Break-even point
The break‐even point represents the level of sales where net income equals zero.
In other words, the point where sales revenue equals total variable costs plus total
fixed costs, and contribution margin equals fixed costs. Using the previous
information and given that the company has fixed costs of $300,000, the break‐
even income statement shows zero net income.

This income statement format is known as the contribution margin income

statement and is used for internal reporting only.
The $1.80 per unit or $450,000 of variable costs represent all variable costs
including costs classified as manufacturing costs, selling expenses, and
administrative expenses. Similarly, the fixed costs represent total manufacturing,
selling, and administrative fixed costs.
Break‐even point in dollars. The break‐even point in sales dollars of $750,000 is

calculated by dividing total fixed costs of $300,000 by the contribution margin
ratio of 40%.
Another way to calculate break‐even sales dollars is to use the mathematical

equation.
In this equation, the variable costs are stated as a percent of sales. If a unit has a
$3.00 selling price and variable costs of $1.80, variable costs as a percent of sales
is 60% ($1.80 ÷ $3.00). Using fixed costs of $300,000, the break‐even equation is
shown below.

The last calculation using the mathematical equation is the same as the break‐
even sales formula using the fixed costs and the contribution margin ratio
previously discussed in this chapter.
Break‐even point in units. The break‐even point in units of 250,000 is calculated by

dividing fixed costs of $300,000 by contribution margin per unit of $1.20.
The break‐even point in units may also be calculated using the mathematical
equation where “X” equals break‐even units.
Again it should be noted that the last portion of the calculation using the
mathematical equation is the same as the first calculation of break‐even units
that used the contribution margin per unit. Once the break‐even point in units has
been calculated, the break‐even point in sales dollars may be calculated by
multiplying the number of break‐even units by the selling price per unit. This also
works in reverse. If the break‐even point in sales dollars is known, it can be divided
by the selling price per unit to determine the break‐even point in units.

Targeted income
CVP analysis is also used when a company is trying to determine what level of
sales is necessary to reach a specific level of income, also called targeted
income. To calculate the required sales level, the targeted income is added to
fixed costs, and the total is divided by the contribution margin ratio to determine
required sales dollars, or the total is divided by contribution margin per unit to
determine the required sales level in units.
Using the data from the previous example, what level of sales would be required
if the company wanted $60,000 of income? The $60,000 of income required is
called the targeted income. The required sales level is $900,000 and the required
number of units is 300,000. Why is the answer $900,000 instead of $810,000
($750,000 [break‐even sales] plus $60,000)? Remember that there are additional
variable costs incurred every time an additional unit is sold, and these costs
reduce the extra revenues when calculating income.
This calculation of targeted income assumes it is being calculated for a division

as it ignores income taxes. If a targeted net income (income after taxes) is being

calculated, then income taxes would also be added to fixed costs along with
targeted net income.
Assuming the company has a 40% income tax rate, its break‐even point in sales is
$1,000,000 and break‐even point in units is 333,333. The amount of income taxes
used in the calculation is $40,000 ([$60,000 net income ÷ (1 – .40 tax rate)] –
$60,000).
A summarized contribution margin income statement can be used to prove these

calculations.
Margin of Safety
The margin of safety is a tool to help management understand how far sales
could change before the company would have a net loss. It is computed by
subtracting break‐even sales from budgeted or forecasted sales. To state the
margin of safety as a percent, the difference is divided by budgeted sales. If the
Three M's, Inc., has budgeted sales of $800,000, its margin of safety is $50,000
($800,000 budgeted sales – $750,000 break‐even sales) or 6.7% ($50,000 ÷
$750,000), a rather low margin of safety. If, however, its budgeted sales are

$900,000, its margin of safety is $150,000 ($900,000 budgeted sales – $750,000

break‐even sales) or 20% ($150,000 ÷ $750,000). The competition, economy, and
assumptions in the sales budget must be reviewed by management to assess
whether 20% is a comfortable margin of safety.
Reference
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-
ii/cost-volume-profit-relationships/cost-volume-profit-analysis
Read a summarized outline of Chapter 11 of Raiborn’s Cost Accounting on the

allocation of Joint-costs and accounting for scraps or by-products.
ALLOCATION OF JOINT COSTS AND ACCOUNTING FOR BY-PRODUCT/SCRAP
A. Outputs of a Joint Process
1. This chapter discusses joint manufacturing processes, their related product

outputs, and the accounting treatment of the costs of those processes.
2. A joint process is a manufacturing process that simultaneously produces more

than one product line. The product lines resulting from a joint process and having
a sales value are referred to as (1) joint products, (2) by-products, and (3) scrap.
a. Classification of joint process output is based on management judgment

about the relative sales value of the outputs and can vary from company to
company.
3. Joint cost refers to the costs incurred for material, labor, and overhead during a
joint process up to the split-off point.
a. Although joint costs must be allocated to the primary products to determine

financial statement valuations, such allocations should not be used in making
internal decisions
4. Separate costs can be incurred in later stages of production that are assignable
to specific primary products

5. Joint products are the primary outputs of a joint process, each of which has
substantial revenue-generating ability.
a. Joint products are also called primary products, main products, and co-
products.
6. By-products are incidental outputs of a joint process; they are salable, but the
sales value of by-products is not substantial enough for management to justify
undertaking the joint process; they are viewed as having a higher sales value than
scrap.
7. Scrap is an incidental output of a joint process; it is salable, but the sales value
from scrap is not enough for management to justify undertaking the joint process;
it is viewed as having a lower sales value than a by-product; leftover material that
has a minimal but distinguishable disposal value.
8. Waste is a residual output of a production process that must be disposed of

because it has no sales value.
B. The Joint Process
1. Joint products are typically manufactured in companies using mass production

processes and a process costing accounting method.
a. Text Exhibit 11-1 describes the outputs produced from steer processing.
2. The split-off point is the point at which the outputs of a joint process are first
identifiable or can be separated as individual products.
3. A joint cost includes the costs incurred up to the split-off point for material, labor,
and overhead during a joint process.

a. Joint costs must be allocated to the primary outputs of the production process
for inventory valuation purposes.
4. Costs incurred after split-off are assigned to the separate products for which those
costs are incurred.
5. Allocated joint costs should not be used in making decisions about further
processing of joint products.
C. The Joint Process Decision
1. Management decision points in a joint production process:
a. Management must decide whether the total expected revenues from the sale
of the joint process output are likely to exceed the total expected processing
costs of the output. Other potential costs must be considered in determining if
the revenues are expected to exceed the costs;
b. Managers must compare the net income from this use of resources to the net
income that would be provided by all other alternative uses of company
resources if total anticipated revenues from the “basket” of products exceed
the anticipated joint and separate costs. Management would then decide
that this joint production process is the best use of capacity and would begin
production if joint process net income is greater than the net income that
would be provided by other uses;
c. Management must decide how to classify joint process outputs; and
i. Some will be primary; others will be by-product, scrap, or waste.
d. Management must then decide whether any (or all) of the joint process output
will be sold (if marketable) at split-off or whether it will be processed further.
i. Such decisions should be made only after considering whether the

expected additional revenues from further processing are higher than the
expected additional costs of further processing.
2. Managers must have a sound estimate of the selling price for each type of joint
process output in order to make decisions at any potential point of sale. Expected
selling prices should be based on both cost and market factors
D. Allocation of Joint Cost
1. Physical measurement allocation

a. Physical measurement allocation is a method of allocating common costs to

products that uses a common physical characteristic as the proration base.
i. This illustrates the method of allocation.
b. The physical measurement allocation method treats each unit of measure as

equally desirable and assigns the same per unit cost to each.
c. Physical measurement allocation, unlike monetary measure allocation,

provides an unchanging yardstick of output.
d. A primary disadvantage of the method is that it ignores the revenue-

generating ability of individual joint products.
2. Monetary measure allocation
a. General
i. Monetary measure allocation uses the following steps to prorate joint costs
to joint products:
• Step 1: choose a monetary allocation base;
• Step 2: list the values that compose the base for each joint product;
• Step 3: sum the values in step 2 to obtain a total value for the list;
• Step 4: divide each individual value in step 2 by the total in step 3 to

obtain a numerical proportion for each value. (The sum of these
proportions should total 100 percent);
• Step 5: multiply the joint cost by each proportion to obtain the amount
to be allocated to each product; and
• Step 6: divide the prorated joint cost for each product by the number of
equivalent units of production for each product to obtain a cost per EUP

for valuation purposes.
ii. Benefits and problems with monetary measure allocations:
• The primary benefit of monetary over physical measure allocations is

that the former recognizes the relative ability of each product to
generate a profit at sale; and
• A problem with monetary measure allocations is that the basis used is

dynamic.
b. Sales value at split-off
i. The sales value at split-off allocation is a method of assigning joint cost to

joint products that uses the relative sales values of the products at the split-
off point as the proration base; use of this method requires that all joint
products are marketable at split-off.
c. Net realizable value at split-off
i. The net realizable value at split-off allocation is a method of allocating joint

cost to joint products that uses as the proration base sales value at split-off
minus all costs necessary to prepare and dispose of the products; it requires
that all joint products be salable at split-off.

3. Approximated net realizable value at split-off
a. The approximated net realizable value at split-off allocation is a method of

allocating joint cost to joint products that uses a simulated net realizable value
at the split-off point; approximated value is computed as final sales price minus
incremental separate costs.
b. This further processing does not change the allocation of joint cost previously
made to the joint products.
4. In summary:
a. Each method discussed allocates a different amount of joint cost to the joint
products and results in a different per-unit cost for each product and,
accordingly, has its own advantages and disadvantages; and
b. For most companies, approximated NRV at split-off provides the most logical
joint cost assignment.
i. This is because, for each joint product, approximated NRV captures the
intended level of separate processing, costs of separate processing,
expected selling costs of each joint product, and the expected selling price
of each joint product. Thus, approximated NRV is the best measure of the
expected contribution of each product line to the coverage of joint costs.
ii. The method is, however, more complex than the other methods because
estimations must be made about additional processing costs and potential
future sales values.
E. Accounting for By-Products and Scrap

1. General
a. Because the distinction between by-product and scrap is one of degree,

these categories are discussed together by presenting several of the
treatments found in practice.
b. The appropriate choice of method depends on the magnitude of the net

realizable value of the item and the need for additional processing beyond
split-off.
2. Net realizable value (NRV) approach
a. The net realizable value (or offset) approach is a method of accounting for by-
products or scrap that requires the net realizable value of such products to be
treated as a reduction in the cost of the primary products.
b. The NRV is debited to inventory and one of two accounts may be credited:
i. WIP Inventory – Joint Products
ii. Cost of Goods Sold for the joint products.
c. Although reducing joint cost by the NRV of the by-products/scrap is the

traditional method used to account for such goods, it is not necessarily the
best method for internal decision making or the management of by-
products/scrap.
i. When management considers by-product/scrap to be a moderate source

of income, the accounting and reporting methods used should help
managers monitor production and further processing of the by-
product/scrap.
3. Realized value approach
a. The realized value (or other income) approach is a method of accounting for
by-products or scrap that does not recognize any value for these products until
they are sold; the value recognized at the time of sale can be treated as other
revenue or as other income.
b. The total sales price of the by-product/scrap is shown on the income

statement as other revenue under the “other revenue” method. Additional
processing or disposal costs of the by-product/scrap are included with the cost
of producing the primary products, so little useful information is provided to
management since the cost of producing the by-product/scrap is not
matched with the revenues generated by those items.

c. The net by-product revenue is presented as an enhancement of net income

in the period of sale as “other income” under the “other income” method. By-
product/scrap revenue is matched with related storage, further processing,
transportation, and disposal costs. Detailed information on financial
responsibility and accountability is provided, and control and performance
may be improved.
d. Alternative presentations include depicting the realized value from the sale of
the by-product or scrap as:
i. an addition to gross margin;
ii. a reduction of the cost of goods manufactured; or
iii. a reduction of the cost of goods sold.
F. By-Products or Scrap in Job Order Costing
1. Job order costing systems can have by-products or scrap even though joint
products are not normally associated with such systems.
2. The value of by-products/scrap in a job order costing system should be credited

to manufacturing overhead if the by-products/scrap value is created by a
significant proportion of all jobs undertaken.
3. The by-products/scrap value, in contrast, can be credited to the specific jobs in

process if only a few specific jobs generate a disproportionate share of the by-
products/scrap.
G. Joint Costs in Service and Not-for-Profit Organizations
1. Joint costs in service businesses and not-for-profit (NFP) organizations often do not
relate to production processes but to marketing and promotion activities such as:
a. advertising multiple products;
b. printing multipurpose documents; or
c. holding multipurpose events.
2. Service businesses may allocate joint costs using either a physical or monetary
base.
a. Joint costs for service businesses usually relate to advertisements rather than to
a process.

b. Service businesses may decide it is not necessary to allocate joint costs.
3. Although service businesses may decide that allocating joint cost is not necessary,
financial accounting requires that not-for-profit organizations allocate joint costs
among the activities of fund-raising, offering an organizational program (program
activities), or conducting an administrative function (management and general
activities).
4. No specific allocation method is prescribed; only that the method used must be
rational and systematic, result in reasonable allocations, and be applied in the
same manner under similar situations.
a. A major purpose of this allocation process is to ensure that external users of

financial statements are able to clearly determine amounts spent by the
organization for various activities—especially fundraising.
5. There are three tests that must be met for allocation; if all the tests are not met, all
the costs associated with the joint activity must be charged to fundraising:
a. The purpose test must demonstrate that the activity’s purpose includes
accomplishing some program or management/general function.
i. A critical element under the purpose test is the compensation test. If a

majority of compensation or fees for anyone performing a part of the
activity is tied to contributions raised, the activity automatically fails the
purpose criterion and all costs of the activity must be charged to
fundraising.
b. The audience test must demonstrate that the NFP chose the audience
because it is suitable for accomplishing the activity’s program or
management/general functions.
c. The content test must demonstrate that the activity’s content supports
program or management/general functions.
Reference:
Southwestern. USA
FINAL TASK
Case 1

Snider Company produces and sells two products: A and B in the ratio of 3A to 5B. Selling
prices for A and B are, respectively, $1,200 and $240; respective variable costs are $480
and $160. The company's fixed costs are $1,800,000 per year.
Compute the volume of sales in units of each product needed to:
Required:
a. break even.
b. earn $800,000 of income before income taxes.
c. earn $800,000 of income after income taxes, assuming a 30 percent tax rate.
d. earn 12 percent on sales revenue in before-tax income.
e. earn 12 percent on sales revenue in after-tax income, assuming a 30 percent tax

rate.
Case 2
Pest Away Company manufactures a product effective in controlling beetles. The

company uses a standard cost system and a flexible budget. Standard cost of a gallon
is as follows:
Direct material:
2 quarts of A $14
4 quarts of B 16
Total direct material $30
Direct labor:
2 hours 16
Manufacturing overhead 12
Total $58
The flexible budget system provides for $50,000 of fixed overhead at normal capacity of
10,000 direct labor hours. Variable overhead is projected at $1 per direct labor hour.
Actual results for the period indicated the following:
Production: 5,000 gallons

Direct
material:

A 12,000 quarts purchased at a cost of $7.20/quart; 10,500

quarts used
B 20,000 quarts purchased at a cost of $3.90/quart; 19,800
quarts used
Direct labor: 9,800 hours worked at a cost of $79,380
Overhead: Fixed $48,100
Variable 21,000
Total overhead $69,100
Required:
1. What is the application rate per direct labor hour, the total overhead cost
equation, the standard quantity for each material, and the standard hours?
2. Compute the following variances:
a. Total material price variance

b. Total material quantity variance
c. Labor rate variance
d. Labor efficiency variance
e. MOH volume variance
f. MOH efficiency variance
g. MOH spending variance, both fixed and variable
Case 3
Leigh Manufacturers produces three products from a common manufacturing process.
The total joint cost of producing 2,000 pounds of Product A; 1,000 pounds of Product B;
and 1,000 pounds of Product C is $7,500. Selling price per pound of the three products
are $15 for Product A; $10 for Product B; and $5 for Product C. Joint cost is allocated
using the sales value method.
Required:
a. Compute the unit cost of Product A if all three products are main products.
b. Compute the unit cost of Product A if Products A and B are main products and
Product C is a by-product for which the cost reduction method is used.


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Adaptive Community for the Continuity of Education and Student Services

National Teachers College

Cost Accounting and Control/Cost Accounting and Cost Management

Student Name: Degree Program:

CHOOSE YOUR ADVENTURE! CHOOSE TO SOLVE WELL!

Course Code – Cost Accounting 1

WEEK TASK OUTPUT

PRELIM READING MATERIAL NO. 1

COST TERMINOLOGY AND COST BEHAVIORS

1. To effectively communicate information, accountants must clearly understand

Course Code – Cost Accounting 2

2. Cost reflects the monetary measure of resources given up to attain an objective

strategy, goals, and objectives.

2. Some important types of costs are summarized in in the exhibit below:

C. Association with Cost Object

3. Costs may be direct or indirect depending upon the cost object.

i. For example, the cost of flour in making pizza.

i. For example, the cost of salt in the pizza crust.

Assumptions about cost behavior

Reaction to Changes in Activity

b. Common activity measures include production volume, service and sales

i. A variable cost is a cost that varies in total in direct proportion to changes in

Course Code – Cost Accounting 4

g. Selection of an appropriate activity measure is important.

i. A predictor is an activity measure that, when changed, is accompanied by

Classification of costs on the financial statements

d. Product costs, also called inventoriable costs, are related to making or

Course Code – Cost Accounting 5

iii. Distribution costs are period costs incurred to warehouse, transport, or

Conversion process that occur in manufacturing and service companies

D. The Conversion Process

b. Conversion process outputs are usually either products or services.

c. Firms that engage in only low or moderate degrees of conversion (such as

d. In high-conversion firms, the informational benefits gained from accumulating

Course Code – Cost Accounting 6

e. A manufacturer is defined as any company engaged in a high degree of

f. A service company refers to a firm engaged in a high or moderate degree of

3. As work progresses through the second stage, accrual-based accounting

Product cost categories, and items that comprise those categories

F. Components of Product Cost

a. Direct labor refers to the value-adding effort of individuals who manufacture

Course Code – Cost Accounting 7

c. Labor costs that cannot be reasonably or directly traceable to the product

a. Overhead is any factory or production cost that is indirect to manufacturing a

b. Overhead includes indirect material, indirect labor and other production-

d. Fixed overhead includes costs such as straight-line depreciation on factory

e. Quality costs are an important component of overhead cost since high-quality

G. Accumulation and Allocation of Overhead

b. Cost allocation refers to the assignment of an indirect cost to one or more

2. Actual Cost System

i. Use of an actual cost system is generally considered to be difficult because

ii. Here’s an illusatration on the flow of costs in a Perpetual Inventory

Course Code – Cost Accounting 9

a. To record purchase of raw materials on account

b. To record transfer of raw materials to processing department

c. To record salary or wages payable for the period

d. To record various overhead for the period

e. To record application of overhead to work in progress

f. To record transfer of work in process to finished goods inventory

i. A predetermined overhead rate (or overhead application rate) is a

Calculation of cost of goods manufactured

c. Information needed for computing CGM is found in the Raw Materials