BBMA3103

OUM Business School
BBMA3103
Management Accounting I
Copyright © Open University Malaysia (OUM)

BBMA3103
MANAGEMENT
ACCOUNTING I
Noor Asma Jamaludin
Nor Asma Lode
Junaidah Hanim Ahmad
Azlan Zainol Abidin
Amin Ali
Norazita Marina Abd Aziz
Ropiah Mohamed
Azlina Abdul Aziz
Nur Azlin Omar
Rosila Abu Zarin

Project Directors: Prof Dato’ Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia
Module Writers: Noor Asma Jamaludin (Leader)

Nor Asma Lode
Junaidah Hanim Ahmad
Azlan Zainol Abidin
Amin Ali
Norazita Marina Abd Aziz
Rapiah Mohamed
Universiti Utara Malaysia
Azlina Abdul Aziz

Nur Azlin Omar
Rosila Abu Zarin
Moderators: Assoc Prof Dr Arfah Salleh

Assoc Prof Hashanah Ismail
Lilian Kek Siew Yick

Developed by: Centre for Instructional Design and Technology

First Edition, February 2008

Second Edition, December 2014
Copyright © Open University Malaysia (OUM), December 2014, BBMA3103

All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide xiăxv
Topic 1 Introduction to Management Accounting 1

1.1 The Definition of Management Accounting 2
1.2 Functions of Management Accounting 4
1.3 Comparison between Management Accounting and
Financial Accounting 4
1.4 The Characteristics of Management Accounting
Information 6
1.4.1 Relevance 6
1.4.2 Comprehensible 8
1.4.3 Timeliness 8
1.4.4 Comparable 8
1.4.5 Reliable and Complete 9
1.4.6 Cost Beneficial 9
1.5 The Importance of Management Accounting Information 10
1.5.1 Determining the Cost of Each Product or Service
Offered 10
1.5.2 Implementing the Planning, Directing, Controlling
and Performance Evaluating Functions 10
1.6 Role and Importance of Information Technology 10
1.6.1 What are Meant by Information Technology and
Information System? 11
1.6.2 The Importance of Information Technology and
Information System in TodayÊs Business
Organisation 12
1.7 Management Accounting and Its Ethics 14
Summary 16
Self-Test 1 16
Self-Test 2 17
Key Terms 17

iv  TABLE OF CONTENTS
Topic 2 The Concepts and Classifications of Costs 18

2.1 Cost Concepts 19
2.1.1 Cost Object 21
2.1.2 Cost Driver 21
2.2 Cost Accounting System 22
2.2.1 Cost Classification by Behaviour 23
2.2.2 Cost Classification by Business Function 29
2.2.3 Cost Classification by Period 32
2.2.4 Cost Classification by Business Category 34
2.3 Mathematical Approach for Estimating Costs 40
2.3.1 Non-Mathematical Technique: Account Review 42
2.3.2 Mathematical Technique 44
Summary 52
Self-Test 1 53
Self-Test 2 56
Key Terms 59
Topic 3 Materials and Labour Accounting 60

3.1 The Importance of Materials in Production 61
3.2 Procedure for Materials Controls 64
3.3 Application of Accounting Equations in Operations
Involving Materials 68
3.3.1 Purchase of Materials: Direct Materials and
Indirect Materials 68
3.3.2 Usage of Materials: Direct Materials and Indirect
Materials 70
3.4 Determining the Price of Production Materials 72
3.4.1 First-In, First-Out (FIFO) 73
3.4.2 Last-In, First-Out (LIFO) 73
3.4.3 Weighted-Average 74
3.5 Materials and Storage Losses 74
3.6 Costs of Handling and Transporting Materials 75
3.7 Just-In-Time (JIT) Purchasing 76
3.7.1 Key Features of JIT Purchasing System 76
3.7.2 Advantages and Disadvantages of a JIT
Purchasing System 78
3.8 Labour Accounting 78
3.8.1 Labour Payroll System 80
Summary 83
Self-Test 1 84
Self-Test 2 84
Key Terms 85

TABLE OF CONTENTS  v
Topic 4 Overhead Cost Accounting 86

4.1 Manufacturing Overhead Cost 87
4.2 Comparison between Support Service Departments
and Production Departments 89
4.3 Calculation of the Predetermined Overhead Rate 90
4.4 Manufacturing Overhead Accounting 93
4.4.1 Recording the Use of Indirect Materials 93
4.4.2 Recording Indirect Labour 95
4.4.3 Allocating Overhead Cost to Cost Object 96
4.5 Allocating the Costs of a Department to Another
Department 97
4.5.1 Steps for Allocating Costs of Support
Departments to Other Departments 99
4.5.2 Method of Allocation 101
4.6 Actual and Normal Costing 106
4.6.1 Actual Costing 106
4.6.2 Normal Costing 106
4.7 Allocation for Underapplied and Overapplied
Overhead 108
Summary 109
Self-Test 1 110
Self-Test 2 111
Key Terms 113
Topic 5 Activity-Based Costing (ABC) 114

5.1 Activity-Based Costing (ABC) 116
5.2 Comparison between Traditional Costing System
and Activity-Based (ABC) System 118
5.3 Disadvantages of Traditional Costing Systems 120
5.4 Implementation of Activity-Based Costing 121
5.4.1 Identifying the Core Activities in the
Organisation 121
5.4.2 Identifying the Activity Costs and Combining
the Costs in a Pool (Cost Centre) 122
5.4.3 Determining the Cost Driver for Each Core
Activity and Computing the Rate of Activity
Cost Driver 123
5.4.4 Allocating the Costs of Each Activity to
the Object Cost Based on the Cost Driver
Activity of the Product 124
5.5 Calculations for Traditional Costing Systems and
Activity-Based Costing Systems 125

vi  TABLE OF CONTENTS
5.6 Advantages and Disadvantages of the ABC System 134

Summary 135
Self-Test 1 135
Self-Test 2 136
Key Terms 137
Topic 6 Job Order Costing 139

6.1 Preface 140
6.2 Product Costing 141
6.3 Job Order Costing 143
6.4 Application of Documents in the Job Order Costing
System 144
6.4.1 Job-Cost Sheet 145
6.4.2 Materials Requisition Form 146
6.4.3 Time Ticket 148
6.5 Application of Manufacturing Overhead Cost 150
6.6 The Flow of Activities and Costs in the Job Order
Costing System 152
6.6.1 Purchasing and Requisition of Materials 154
6.6.2 Labour Use 157
6.6.3 Using Manufacturing Overhead 157
6.6.4 Problems Involving Over and Under-absorbed
Overhead 160
6.6.5 Cost of Goods Manufactured 162
6.6.6 Cost of Goods Sold 164
6.6.7 Reporting of Financial Statements 164
6.7 Job Order Costing for Service Providers Firms 165
Summary 166
Self-Test 1 167
Self-Test 2 168
Key Terms 169
Topic 7 Process Costing System 170

7.1 Preface 171
7.2 The Environment of Process Costing 171
7.2.1 Production Process 172
7.3 Differences between Process Costing and Job Order
Costing 174
7.4 The Flow of Manufacturing Costs in Process Costing 175
7.5 Work in Process Account for Each Process 176
7.6 Journal Entries to Record the Cost Flow in Process
Costing 177

TABLE OF CONTENTS  vii
7.7 The Concept of Equivalent Units 178

7.8 Techniques of Treating Beginning Work in Process
Inventory 181
7.8.1 Weighted-Average Method 181
7.8.2 First-In, First-Out (FIFO) Method 185
7.9 Transferred-in Cost 189
7.10 Journal Entry 192
Summary 193
Self-Test 1 193
Self-Test 2 196
Key Terms 198
Topic 8 Marginal Costing and Absorption Costing 199

8.1 Preface 200
8.2 Absorption Costing 200
8.2.1 Applications of Absorption Costing 201
8.3 Marginal Costing 201
8.4 Applications of Marginal Costing 202
8.5 Differences between Absorption Costing and Marginal
Costing 202
8.6 Calculation of Product Cost Per Unit 205
8.7 Calculation of Inventory Cost 208
8.8 Income Statements Under Absorption Costing and
Marginal Costing 210
8.8.1 Income Statements Under Marginal Costing 211
8.8.2 Income Statements Under Arbsoption Costing 212
8.8.3 The Cause of Difference in Net Income between
Marginal and Absorption Costing 213
8.9 Adjusting Incomes Under the Two Methods 216
8.10 Relationship between Production Unit, Sales Unit,
Inventory Value and Net Income 218
8.11 Summary of Effects on Net Incomes Under Absorption
Costing and Marginal Costing 221
8.12 Evaluation of Methods 221
Summary 223
Self-Test 1 224
Self-Test 2 226
Key Terms 228

viii  TABLE OF CONTENTS
Topic 9 Modern Business Environment and Management Accounting 229

9.1 Drivers of Change to Business Environment 230
9.1.1 Characteristics of Modern Business Environment 231
9.2 Impact of Modern Business Environment on
Management Accounting 233
9.2.1 Factors that Drive Changes in Management
Accounting 234
9.2.2 Changes in Management Accounting 235
9.2.3 Impact on Management Accounting Practices 236
9.2.4 Impact on Management AccountantÊs Role 237
9.2.5 Impact on Management AccountantÊs Skills 237
9.3 Modern vs Traditional Business Environment 238
9.3.1 Change in Focus Towards Customers, Quality
and Value 239
9.4 Traditional Production vs Flexible Production 247
9.5 Inventory Management 250
9.5.1 What is Inventory Management? 251
9.6 Cost Reduction Programmes 258
Summary 260
Self-Test 1 260
Self-Test 2 261
Key Terms 261
Answers 262

COURSE GUIDE

COURSE GUIDE  xi
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBMA3103 Management Accounting I is one of the courses offered by the OUM
Business School at Open University Malaysia (OUM). This course is worth 3
credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all students taking the Bachelor of Accounting
programme. This module aims to impart fundamental concepts of the accounting
discipline, which is Management Accounting. The course will elaborate on the
roles, significance and fundamental concepts of management accounting.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please ensure that you have the right course materials, understand
the course requirements, as well as know how the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

xii  COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussion 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS 120
COURSE OUTCOMES
By the end of this course, you should be able to:
1. Appraise the fundamentals of management and financial accounting;
2. Explain cost concepts and cost classifications and construct a schedule for a
cost and income statement;
3. Apply accounting equations in purchasing of materials and explore the

function of labour accounting in operating a business;
4. Examine methods for allocating cost and administer entries in journals and
ledgers for manufacturing overheads;
5. Differentiate traditional costing system and activity based costing;
6. Calculate break-even point and prepare an income statement using the

marginal and absorption costing method; and
7. Apply management accounting techniques and analyses to facilitate

decision-making by management.

COURSE GUIDE  xiii
COURSE SYNOPSIS
This course is divided into 9 topics. The synopsis for each topic can be listed as
follows:
Topic 1 introduces the environment of management accounting which

emphasises on management accounting information employed by internal users
in decision making.
Topic 2 discusses the costs and its classifications based on behaviour, business
function, time period and business type.
Topic 3 elaborates on the significance of materials and labour in manufacturing

industries.
Topic 4 elaborates on manufacturing costs. You will be exposed to the differences

between support departments and production departments.
Topic 5 explains Activity-Based Costing (ABC) System which is supposed to

overcome the weaknesses of traditional costing system, where overhead costs are
allocated by using only a single base.
Topic 6 discusses job order costing. In this topic, you will study the
characteristics, as well as the flow of the documents involved in job order costing.
Topic 7 analyses the costing process. You will study the differences between
process costing and job order costing, the flow of manufacturing costs and work
in process account for each of the processes involved.
Topic 8 will discuss two traditional systems of product costing, namely marginal
costing and absorption costing. Students will be exposed to the techniques of
calculating product cost under both costing methods above.
Topic 9 discuss about the impact of modern business environment on

management accounting. It further compares the business focus and practices
between traditional and modern business environments.

xiv  COURSE GUIDE
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one sub-section or a few sub-
sections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.

COURSE GUIDE  xv
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
ASSESSMENT METHOD
Please refer to myINSPIRE.
REFERENCES
Horngren, C. T., Harrison W. T. Jr., & Bamber, L. S. (2004). Accounting (6th ed.).
New Jersey, NJ: Prentice Hall.
Wild, J. J., Larson, K. D., & Chiappetta, B. (2006). Fundamental accounting

principles (18th ed.). New York, NY: McGraw-Hill.
Roger, H. H. et al. (1997). Accounting: A business perspective (7th ed.). New

York, NY: Irwin.
Warren, C. S., Reeve J. M., & Fess, P. E. (2004). Accounting (21st ed.). Ohio, OH:
International Thompson.
Weygandth, J. J., Keison, D. E., Kimmel, P. D. (2008). Accounting principles (9th

ed.). New Jersey, NJ: John Wiley and Sons.
TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books24 7, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.

xvi  COURSE GUIDE

Topic  Introduction to
1 Management
Accounting
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define the meaning of management accounting;
2. Distinguish between management accounting and financial
accounting;
3. Analyse the characteristics of management accounting information;
4. Examine the purpose and importance of management accounting
information in decision-making; and
5. Apply the standards of ethical conduct for accounting management
practitioners.
 INTRODUCTION
This topic discusses the environment of management accounting which covers
different levels of managers, roles of the managerial accountant, the differences
between cost, management and financial accounting as well as the characteristics
and types of useful accounting information. Aside from the above, this topic also
touches on the aspects of ethical behaviour which must be demonstrated by
management accounting practitioners.

2  TOPIC 1 INTRODUCTION TO MANAGEMENT ACCOUNTING
1.1 THE DEFINITION OF MANAGEMENT

ACCOUNTING
Managers of any organisation require information in order to ensure that the
limited sources within the organisation can be effectively and efficiently utilised.
Management accounting is a field that involves providing accounting
information to assist managers in their management and decision-making. In
definition, management accounting is the process of preparing management
reports and accounts that provide financial and statistical information required
by managers to make decisions within an organisation.
Management accounting is a field of accounting which provides economic

and financial information for managers and other internal users.
In any organisation, the position of its management accounting can be seen

through the roles played by the management accountant. We need to study how
the management accounting information is used by the management accountant
to assist and direct the management in ensuring the effectiveness of its policy
implementation.
Apart from the management accountant, an organisation also comprises of other

managerial roles such as line managers and staff managers, who help to run the
organisation efficiently. You should know about these managersÊ roles and
function to be able to understand the management accountant roles in the
organisation:
(a) The staff managers are responsible for preparing the reports to be used by
both production and factory managers. They also provide services and
assistance to the production department although they do not have direct
authority over the production;
(b) The line managers are directly responsible for the production, such as to
supervise the production line, to assist in developing the production plan
and to ensure that the production target is achieved. They are also
responsible for monitoring the production cost; and

TOPIC 1 INTRODUCTION TO MANAGEMENT ACCOUNTING  3
(c) The management accountants play two important roles. They must act as
an advisor to the organisation and, at the same time as the operational
officer. This is not surprising, since they understand and know the
organisational profile at all phases of operations.
A common assumption is that we perceive an accountant as someone who only

plays with numbers without actually thinking of the meaning or consequences of
the numbers obtained. However nowadays, it is they who make the decisions
concerning product pricing, market penetration, product manufacturing and
requisition or any other financial decisions (funding) which require the skills and
experience of a management accountant. Figure 1.1 illustrates some decision-
making examples that require the skills and experience of a management
accountant.
Figure 1.1: Decision-making examples that require the skills and experience of a
management accountant
ACTIVITY 1.1
Discuss the status and functions of the management accountant in a

business organisation.

1.2 FUNCTIONS OF MANAGEMENT

ACCOUNTING
As we have discussed earlier, management accounting in an organisation
involves a lot of decision making and understanding of the organisational profile
at all phases of operations.
In general, the roles of management accounting are as follow:
(a) Preparing the information to be used by managers in planning and

decision-making;
(b) Assisting managers in operating and directing the organisation;
(c) Motivating managers and staff in order to enhance work performance and
achieve the objectives of the organisation; and
(d) Evaluating the performance of the organisation as well as its divisions.
1.3 COMPARISON BETWEEN MANAGEMENT

ACCOUNTING AND FINANCIAL
ACCOUNTING
ACTIVITY 1.2
What are the differences between management accounting and financial

accounting in terms of the purpose of its reporting and the focus of the
information contained in the reports?
Financial accounting provides financial information reports for the use of

external parties such as shareholders and investors. Management accounting
prepares reports for internal use, for instance, for the managers to make
organisational decision-making.
Although both areas of accounting have their differences, they also share
similarities, for example, the common practice of book-keeping and the recording
aspect of its monetary information.

Example 1.1
To determine the manufacturing cost per unit, a product is considered part of
management accounting. On the other hand, the reports of cost of products
manufactured and cost of products sold are considered under financial
accounting. However, both management and financial accounting rely on the
same results from the historical economic information which are then assessed
and communicated to the interested parties. In a nutshell, both areas of
accounting have their own significance which overlaps each other.
The principal differences between these two accounting areas are prevalent in
terms of the purpose of its reporting and the focus of the information contained
in the reports. Please refer to Table 1.1 to compare and better understand the
differences between Management Accounting and Financial Accounting.
Table 1.1: Key Differences between Financial Accounting and Management Accounting
Key
Financial Accounting Management Accounting
Difference
Users External users. Internal users.
Focus A summary of past activity, Emphasis on future oriented
based on historical costs. activities.
Information More objective and diverse. More flexible and relevant.
Nature of Only accurate (often audited) Data are presented as a whole or a
Information data are reported in annual segment of an entity, e.g. a division,
reports. products, customers and process.
Compliance Must comply with Generally Need not comply with GAAP
Accepted Accounting Principles (Generally Accepted Accounting
(GAAP). Principles).
ACTIVITY 1.3
After looking at the differences between management and financial

accounting, can you explain the importance of each of them to an
organisation?

1.4 THE CHARACTERISTICS OF MANAGEMENT

ACCOUNTING INFORMATION
As you are aware, the purpose of management accounting is to assist the
management of the organisation to plan, control and make business decisions
regarding the organisational activities. Most of us assume that accounting data
and information are the same. However, they are not only different but can only
be useful if they are of certain characteristics. For that reason, it is crucial for
accounting information to have the characteristics which will assist in making the
right decisions.
The following are the required characteristics to ensure the usefulness of the
management accounting information:
(a) Relevance;
(b) Comprehensible;
(c) Timeliness;
(d) Comparable;
(e) Reliable and complete; and
(f) Cost beneficial.
1.4.1 Relevance
An accounting information system generates a lot of information. However, not
all information is fit for use in the decision-making process. The management
needs to take into account only the relevant accounting information. Relevant
information is vital for decision-making.
Relevance means that for a particular activity, different choices of information

will result in different outcomes. The information should also affect the
decision to be made.

Example 1.2
Assuming that a company has to decide whether to repair an old machine or
acquire a new machine in order to process and manufacture its products. The
relevant information required for analysis, in this case, the cost of repairing the
old machine and the cost of acquiring the new machine. However, the above
information is said to be irrelevant for deciding on reduction of expenses if
both costs are the same and will only be relevant if the two costs are different.
Information related to a machine operator who manages the machines is not
relevant for the above decision-making.
Figure 1.2 illustrates the relevant information required for analysis.
Figure 1.2: Relevant information required for analysis
Nevertheless, irrelevant information for a given situation can be relevant in

another situation. For instance, the salary of a machine operator will be relevant
in the decision-making process by the personnel division or administration
managers.

1.4.2 Comprehensible
The second characteristic of management accounting information is that it is
easily understood by the information user. The information has to be concise and
comprehensible for managers to use. This is because most of the managers do not
have the background knowledge in accounting or finance. Hence, it is essential
for the management accountant to use terms which are understandable to ensure
that the information reported to the management can be used in making accurate
management decisions. Long-winded and incomprehensible information could
lead to making inaccurate management decisions.
1.4.3 Timeliness
The information is only useful if it is reported to the management on time. Late
reporting of the management accounting information may result in an inability to
make accurate decisions or in an irrelevant business decision.
Example 1.3
For example, the information for the year 2004 budget must be attained before
the year 2004 begins. This is to ensure that all actions to be taken in the year
2004, such as increasing sales or reducing expenses, are not behind schedule.
Similarly, if managers need to conduct a performance evaluation on its staff or

departments for a particular year, say 2003, the actual results (historical data)
must be obtained before the end of year 2003 so that it could be compared with
the last yearÊs proposal (estimated data). Any corrective actions will be
highlighted in the performance evaluation report.
1.4.4 Comparable
The next characteristic of management accounting information is that it is
comparable. The information is often used by the management for the purpose of
comparison.
Example 1.4
For example, comparing the performance of a department with another in the
same period, or comparing the performance of a particular department over
several periods of time.

When performance level deteriorates rapidly, such as when the quality of a

product is not satisfactory, remedial actions must be taken immediately.
However, the managers would be less able to compare the management reports
between the years or departments if they are inconsistent.
1.4.5 Reliable and Complete

Management accounting information is always associated with the future
(estimates). However, the estimates are not necessarily 100% accurate. They are
only accurate for a decision made within a given applicable range of time.
Therefore, significant and useful information within a given range of time must
be taken into consideration to ensure that the information is reliable and
complete.
1.4.6 Cost Beneficial

Preparing management information involves costs, such as the cost of collecting,
analysing and interpreting the data obtained before transforming it into the
required information format. Hence it is important for the information to
produce outcomes which can pay off the cost concerning it. In other words, the
value of the information produced (benefits) must be higher than the cost of
obtaining such information. Moreover, the information has to be useful before it
can produce an outcome.
ACTIVITY 1.4
From your knowledge of the definition of management accounting

given in the beginning of this topic, in your opinion, how does the
management accounting information play its role in an organisation?

1.5 THE IMPORTANCE OF MANAGEMENT

ACCOUNTING INFORMATION
As discussed earlier, accounting information is said to be useful if it satisfies the
six characteristics mentioned in the previous subtopic. The management will
employ the information for several underlying purposes. Among others:
(a) To determine the cost of each of the products and services offered; and
(b) To implement the planning, directing, controlling and performance

evaluating functions.
1.5.1 Determining the Cost of Each Product or Service

Offered
The price of the products and services offered must be determined to guarantee
the expected returns. Consequently, the management must determine the cost of
each of the products and services offered to ensure that the returns exceed the
costs. Hence, the management is responsible for implementing the planning and
controlling processes.
1.5.2 Implementing the Planning, Directing,

Controlling and Performance Evaluating
Functions
Next, the management must plan and control all its operations. These functions
require the management to make business assessments or evaluations by
comparing the expected and actual returns. If the differences are significant, then
corrective actions must be taken.
1.6 ROLE AND IMPORTANCE OF

INFORMATION TECHNOLOGY
If you realise, the world we are living today has changed in many ways.
Similarly, the ways how we manage business information or accounting
information have been changed and improved substantially. One of the main
drivers or causes of the change is the information technology.
In general, information technology continually changes the face of business,

affecting how companies produce and market their products, influencing how
people communicate and accomplish their jobs. Specifically, rapid development
of technology today has great impact on how we collect process, store, maintain
and deliver business information. Therefore, it is very crucial for you to be aware
of the role of information technology and its importance in managing
information.
Figure 1.3: An example of the evolution of technology: mobile phone

Source: http://nizam39.blogspot.com
1.6.1 What are Meant by Information Technology

and Information System?
Information Technology (IT) refers to the usage of computers, and any
telecommunication and electronic tool (e.g. satellite communications, robotics,
mobile, wireless devices, videotext, cable television, etc.) in managing data and
creating information. The technology could be of any type relating to computing
technology such as development, maintenance, and application of computer
systems, software and networks for managing data.
Whereas, Information System (IS) is a combination of components including the

hardware, software, infrastructure and the trained human resource who work
with these technologies that enable storing, processing, communicating business
information to be performed. IS uses IT to provide structured and relevant
information to facilitate various decision makings in planning, controlling, and
coordinating in an organisation. Examples of IS are structural databases and
specialised IS softwares like Management Information System (MIS) and
Enterprise Resource Planning (ERP).
In view of that, we may assume IT is a tool or a medium for us to effectively and

efficiently manage information. Simply put, the role of IT is similar to a
facilitator; IT facilitates information management by providing work systems or
information systems (IS) to support activities like data processing, retrieval and
maintenance. Some information systems are very specialised and customised to

generate relevant information and on real time for assisting accountants and
managers in making a variety of decisions. Some companies perceive IT as a
partner in business management and some even recognise IT as a strategic
business enabler.
1.6.2 The Importance of Information Technology and

Information System in Today’s Business
Organisation
Today we are living in the information age, in which IT has significant impact in
our daily lives. Nobody can deny the importance of IT in managing information,
as we fully acknowledge and agree with the saying that information is now at
our fingertips. Having an IT department or unit in an organisation has become a
necessity. The following points explain why IT is important:
(a) Bridging the Gap

IT can reduce the gap in language differences and geographical boundaries.
This is what is known as globalisation, in which the world has becoming
borderless and closer with respect to the communication aspect. With the
help of IT, information sharing and communications amongst accountants
and managers could be performed more efficiently, faster across the
borders, and using understandable IT languages.
(b) Timely and Real-time

IT has streamlined and computerised most of business processes. In
addition, IT supports online business and transactions 24/7 globally,
meaning that data processing can be performed conveniently at anytime
and anywhere. Another amazing feature of IT is that it is not only online
but on real-time. All these enable information to be supplied at the right
time and place for decision-making purposes.
(c) Storage Capacity

IT helps to convert manual systems and large filing cabinets into digital
versions of documents. Documents in digital format are stored on servers
and storage devices with huge capacities but with less square footage.
Those documents are readily accessible by anyone in the company, from
any location. For instance, accounting software keeps a companyÊs
inventory, sales, payroll information, tax records and many other data.
These current and historical data can be retrieved and processed
economically for tactical and operational decision making purposes or even
for strategic planning process.

(d) Media of Communication

IT provides a new range of communication media. For instance, Internet
communications have introduced face to face communication and
interaction and live update streaming in computer, mobile phones and
various gadgets. For instance, members of organisations can communicate
using live chat systems, online meeting tools and video-conferencing
systems. Many hi-tech applications are now available using smart phones.
Thus, communications inter and intra companies are becoming easier and
more efficient. On top of that, considerable growth in IT enables us to enjoy
more user-friendly, cheaper, faster and very efficient communication.
(e) Media of Doing Business

Business transactions and data processing have been computerised and
streamlined with the help of IT. As a result, IT has indeed improved
productivity and promoted better working conditions, which lead to cost
effectiveness and increase in profits. IT has a lot more to offer. Through IT,
organisations are able to connect with and manage their suppliers and
customers efficiently. IT can be an effective medium for organisations to
reach new customers and retain their existing customers, by applying web-
based customer relationship management system. In a similar way,
companies can manage their supply-chain effectively using appropriate IS.
Social networks and media via internet are examples of excellent media for
marketing and networking. In addition, with Web presence you can take
orders, sell and purchase products and services, or even conduct some
businesses entirely online. Virtual businesses such as e-commerce and
Internet or online business are common nowadays, and their numbers are
expected to increase rapidly.
Every invention has two sides, benefits and drawbacks. IT is not exceptional; we
should also know its potential risks and drawbacks. We need to place greater
attention on data and communication security and privacy. Invasion of privacy
could happen when phone signal and Internet connections are hacked and
intercepted, which may result in communication interference, leaks, and
information misuse or abuse by others. Private and confidential data of an
organisation may become public to our surprise. Sufficient and updated security
measures have to be in placed in order to protect organisational confidential
information. Despite those potential risks, IT has successfully improved the
efficiency and effectiveness of business operations and communications as well
as information management. Furthermore, IT also has been a source of
differentiation for companies to gain competitive advantage in the competitive
business environment. For that reason, its role remains important in managing
businesses in the future.

ACTIVITY 1.5
Write about why IT and IS are important with regard to managing

business information.
Post your answer to the above assignment in the myLMS forum and
respond to some of the postings by your coursemates.
1.7 MANAGEMENT ACCOUNTING AND ITS

ETHICS
As we are aware, accountants have an obligation to maintain the highest level of
ethical conduct in their work. But, what is meant by ethics?
Generally, ethics refers to doing the right thing that is supposed to be done.
Accountants, in both financial and management fields, have social obligations to

the public, accounting profession, organisations, shareholders, employees as well
as themselves to demonstrate ethical conduct.
The standard of ethical conduct for both management and financial accounting
practitioners consists of:
(a) Competency;
(b) Confidentiality;
(c) Integrity; and
(d) Objectivity.

These four ethical conduct standards are elaborated in Figure 1.4.
Figure 1.4: Standard of ethical conduct for management and financial accounting

 Management accounting is one of the accounting areas which must be

studied. For company managers, the data and information provided by
management accounting is crucial to ensure accuracy of the decisions made,
e.g. decisions on product pricing, manufacturing products, etc.
 The management accounting information system is suitable for internal use

within the company as the reports provided by the system are more internal
oriented. Hence, it is less suitable for external users, such as investors and
creditors.
 The internal users of a company require data and information from the
management accounting system for planning, controlling and decision-
making purposes.
 Information technology is a tool or a medium for us to effectively and

efficiently manage information.
 Information technology and information system is important in todayÊs

business to bridge the gap between business and consumers, in providing
timely and real time transaction, for its storage capacity and as a medium of
communication and doing business.
 Information technology also has its potential risks and drawbacks. Thus, we
need to place greater attention to data and communication security and
privacy.
 Practising good ethical conduct will enhance the level of integrity within the
organisation, enabling it to demonstrate a higher level of dedication and
responsibility on the micro and macro levels.
1. Provide five differences between financial accounting and management

accounting.
2. State five characteristics of good management accounting information.
3. Discuss two main purposes of the management accounting information to

an organisation.

1. Ramlee, who is the cost accounting manager, is responsible for calculating

and collecting all costs related to the garden product line. In addition, he is
also responsible for preparing periodic reports to be used for comparison
between the actual and estimated costs. The reports are prepared for the
production line and factory managers. He also assists in explaining and
interpreting the reports.
Amreel, the production manager, is responsible for producing high quality

garden equipment. He supervises the production line workers, assists in
developing the production plan and is also responsible for ensuring that
the production target is achieved. He is also responsible for monitoring
production cost.
You are required to identify and explain who the line manager and staff
manager is in the above mentioned case.
2. What is mean by an ethical conduct for management accounting

practitioners?
Discuss four types of ethical conduct.
Ethics Management accounting

Financial accounting Management accounting information

Topic  The Concepts
2 and
Classifications of
Costs
LEARNING OUTCOMES
1. Explain cost concepts and cost classifications according to
behaviour, function, period, and business type;
2. Prepare the schedule for cost of goods manufactured correctly;
3. Prepare the schedule for cost and income statement correctly; and
4. Estimate the relationship between costs and activities by means
of Account Review Method, High-Low Method, Scatter Graph
Method and The Least Squares Method.
 INTRODUCTION
Encik Abu Kassim has opened his own company, producing tyres. His company
began its operation three months ago. During this period, all costs involved in its
operations were identified and categorised accordingly. It is important for the
managers to identify all costs when making decisions regarding product pricing
in order to achieve the companyÊs objective, which is maximising its profits and
minimising its costs.

TOPIC 2 THE CONCEPTS AND CLASSIFICATIONS OF COSTS  19
A discussion session was held between Encik Abu Kassim and his financial
advisor to discuss the appropriate types of cost classification. There were various
questions concerning the costs involved which must be classified under the
following categories:
(a) Fixed cost and variable cost;
(b) Manufacturing cost and non-manufacturing cost;
(c) Direct cost and indirect cost; and
(d) Product cost and period cost.
The above questions will be resolved in this topic. Moreover, we will explore
how to obtain cost estimations by using the mathematical approach.
2.1 COST CONCEPTS

In general, we can see that every business entity performs management roles and
functions, such as the planning, directing and controlling of the business. All of
the aforesaid functions can be effectively implemented if the management
possesses accurate information. One of the fundamental information often used
in accounting is cost-related information.
ACTIVITY 2.1
In your opinion, why is it crucial for a manager to understand the cost

concepts in order to facilitate the decision-making process?
However, not all cost-related information will be used in making a decision.

Only relevant information on cost will be used depending on the situation. To
ensure that a cost related information is relevant, within a given applicable range
of time, managers have to understand the real meaning of the term cost.
According to a simpler definition:
Cost refers to the resources used or given up to obtain a product or service.

20  TOPIC 2 THE CONCEPTS AND CLASSIFICATIONS OF COSTS
The word „resource‰ here denotes cash or sources equivalent to cash, such as
assets. Goods and services which have not been used but have economic
potential which may be used in the future are called unexpired costs or assets.
Once the goods or services are utilised, the cost for the parts which are consumed
is called an expense.
Example 2.1
To distinguish between costs and expenses, we take ABC Firm as an example.
On 1 January 2004, the firm bought a building at the cost of RM35,000. The
lifespan of the building is 5 years, after which its value reduces to RM5,000. The
depreciation employed is a straight line method.
RM35,000  RM5,000
Depreciation Expense Per Year 
5 years
 RM6,000
Let us say, after the third year, the expired cost, i.e. the depreciation expense is
equivalent to RM18,000 (i.e. RM6,000  3 years). Therefore, the unexpired cost is
RM12,000. The relationship between costs, expenses and assets is illustrated in
Figure 2.1.
Figure 2.1: Relationship between costs, expenses and assets
It is evident that the RM6,000 is not a reduction in value but should be treated
as a usage charge being distributed and allocated for its yearly use.

In management accounting, the emphasis is on the costs, not expenses. On the

contrary, financial accounting calculates expenses to be presented in financial
statements based on the Generally Accepted Accounting Principles (GAAP) over
a certain period of time.
Before we go further into the types and classification of cost, we need to

understand several concepts related to costs, namely, cost object and cost driver.
2.1.1 Cost Object
Cost object is anything for which cost data is calculated, including items,
units, objects, etc.
Cost object includes products, departments or services. For instance, if a manager

has the cost for producing a book, then the book is the cost object.
Cost objects are „objects to‰ which costs are assigned.
2.1.2 Cost Driver

The cost of the cost object may vary, depending on certain factors. One of those
factors is called cost driver. It is a factor where the total cost, of a given cost
object, changes whenever it changes. In other word, the total cost of an object cost
changes if the cost driver changes.

2.2 COST ACCOUNTING SYSTEM

Different types of costs are then categorised into several classes, depended on the
context in which they are used. This is a cost accounting system or usually
referred to as cost classification. The purpose of a cost accounting system is to
ensure accurate decision-making process by taking into account the correct
classification of costs. A cost accounting system or cost classification is vital as
different objectives require different types or classes of costs. In general, costs can
be classified as shown in Figure 2.2.
Figure 2.2: Types of cost classifications

2.2.1 Cost Classification by Behaviour

Classification of costs by behaviour means the costs are classified based on how
its behaviour responds to production, or a single unit produced. A cost can be
classified as follows:
(a) Fixed cost;
(b) Variable cost; and
(c) Mixed cost.
Let us look into the details of these costs:
(a) Fixed Cost
Fixed cost is a cost for which its total remains unchanged with changes
in the volume of production. The total fixed cost will not be affected by
the changes in any activity.
Examples of fixed costs are factory rent, depreciation expense on the factory
building, or supervisorÊs salary. We know that these are the costs which
have to be borne whether or not we produce any products. The total
number of goods or products produced does not affect the fixed cost.
Figure 2.2 demonstrates the relationship between fixed cost and activity
level.
Figure 2.2: Relationship between fixed cost and activity level

The linear function for a fixed cost is given by:
y = a
Where:
y = total cost; and

a = total fixed cost
The circumstances are best described by the following example:
Example 2.2
Assuming that the total fixed cost which has to be borne by a company is
RM100,000 per annum. Production levels over the past 3 years are 50,000 units,
60,000 units and 40,000 units respectively. It is known that the fixed cost of the
company is RM100,000 per annum, regardless of the number of production units.
However, the fixed cost per unit changes with the changes in production
volumes. At the production level of 50,000, the fixed cost per unit is equivalent
to RM2 a unit [RM100,000/50,000] and at 60,000 units of production, the per
unit fixed cost is RM1.67 per unit [RM100,000/60,000]. The computation of
fixed cost per unit is shown in Table 2.1.
Table 2.1: Summary Computation of Fixed Cost Per Unit
Year Production (Units) Fixed Cost Per Unit (RM)

1 40,000 100,000/40,000 = 2.5
2 50,000 100,000/50,000 = 2
3 60,000 100,000/60,000 = 1.67

Relationship between the fixed cost per unit and activity level shown in
Figure 2.3.
Figure 2.3: Relationship between fixed cost per unit and activity level
We have to bear in mind that a cost will be considered a fixed cost only
within a certain production range. This range is known as relevant range, a
range of activity for which its relationship with costs is valid. In other
words, the total fixed cost, such as rent, depreciation of a building,
supervisorÊs salary, etc, does not change within a relevant range. However,
the fixed cost varies outside the relevant range. Thus, we need to determine
the relevant range during the planning process so as to arrive at an accurate
decision.
(b) Variable Cost
Variable cost is a cost where its total changes in proportion to changes

in the volume of production or the unit of activity.

Example 2.3
Examples of two variable costs are direct materials and direct labour costs. The
higher the number of production or activity units, the more cost is incurred.
The relationship between direct cost and activity can be demonstrated by
Figure 2.4.
Figure 2.4: Relationship between variable cost and activity level
The linear function for a variable cost is given by:
y = bx
Where:
y = total cost
b = variable cost per unit
x = activity level

Note that although the total variable costs vary in proportion to changes in the
volume of production, the variable cost per unit remains unchanged. This is
due to the fact that variable cost varies directly in proportion to the activity or
production unit. This condition or relationship is illustrated in Figure 2.5.
Figure 2.5: Relationship between variable cost per unit and activity level
(c) Mixed Cost
Mixed cost refers to a combination of fixed and variable costs.
In other words, in a given situation, the cost item will show the behaviours
of both variable and fixed costs.

A cost which has the characteristics of both fixed and variable costs is
known as mixed cost. The higher the activity level, the higher the cost
incurred. The following Figure 2.6 illustrates the relationship between
mixed cost and activity level.
Figure 2.6: Relationship between mixed cost and activity level
The equation for a mixed cost function is given by:
y = bx + a
Where:
y = total costs
b = variable cost per unit
a = fixed cost
x = activity level (units)
Examples of mixed cost are telephone, water and electricity bills.

2.2.2 Cost Classification by Business Function

Next, costs are categorised according to the functions of a business, which means
that they are classified based on the activity or operation carried out by an
individual business organisation. For the purpose of this topic, we can classify
costs according to two aspects of business functions (refer to Figure 2.7):
(a) Manufacturing Operational Function

Manufacturing operation is a function which processes and converts raw
materials into finished products.
(b) Non-Manufacturing Operational Function

Non-manufacturing operation can be divided into two categories:
(i) Trading or merchandising operation which runs its business by

purchasing and selling finished goods; and
(ii) Service operation which provides services to its customers.
Figure 2.7 shows the cost of classification based on business functions.
Figure 2.7: Cost classification based on business functions

To understand manufacturing and non-manufacturing operational function, you

should be familiar with two types of cost:
(a) Manufacturing costs; and
(b) Non-manufacturing costs.
Let us learn these costs in detail.
(a) Manufacturing Costs

Manufacturing costs or production costs are the costs involved in
making a product by converting raw materials into finished goods. The
manufacturing costs consist of direct raw materials cost, direct labour cost
and factory overhead (manufacturing overhead) cost. Please refer to
Figure 2.8.
Figure 2.8: Three types of manufacturing costs
The explanation on the three types of manufacturing costs is given in

Table 2.2.
Table 2.2: Three Types of Manufacturing Costs
Manufacturing Cost Explanation

Direct Materials Direct Materials Cost is the cost of any raw material used
Cost directly in producing a product, which is traceable directly
to the product or finished goods. This cost is known as
direct materials cost since they are directly allocated for
the making of the finished product.
Direct Labour Cost Direct Labour Cost such as salary, wages and benefits
given directly to the labour or workers who are directly
involved in the making of the finished product.
Factory Overhead Factory Overhead Cost is the combined costs, other than
Cost direct materials and direct labour costs incurred in the
manufacturing process. Overhead cost is the cost which is
not traceable directly to the product, such as electricity
and telephone expenses.

When we talk about manufacturing cost, we must consider how the

combination of the three costs mentioned add together to form the
manufacturing cost (refer to Figure 2.9). The terms prime costs and
conversion costs will often be used when discussing manufacturing cost.
(i) Prime Cost

Prime costs are the primary costs, which are the direct raw materials
and direct labour costs involved in producing the finished product.
They are called the prime costs because of their direct association with
the manufacturing of the finished product and without these two
elements, a product cannot be produced.
(ii) Conversion Cost

Conversion costs comprise direct labour cost and factory overhead
cost. They are referred to as conversion costs as they are the costs
incurred in converting raw materials into finished goods.
Figure 2.9: Prime cost and conversion cost in relation to manufacturing cost
All of the aforementioned costs can be summarised by the following

equations:
Prime Cost = Direct Materials Cost + Direct Labour Cost

Conversion Cost = Direct Labour Cost + Factory Overhead Cost
Manufacturing Cost = Prime Cost + Factory Overhead Cost

(b) Non-Manufacturing Costs

Non-manufacturing costs include cost of merchandised goods in a
merchandising company, marketing and administrative costs. Cost of
merchandised goods is the cost of acquiring the merchandised items for
resale. Marketing cost includes selling cost and administrative cost.
Administrative cost is the cost of managing the organisation.
2.2.3 Cost Classification by Period
ACTIVITY 2.2
In your opinion, is the salary of a production supervisor in a factory a

period cost or a manufacturing cost? Why do you think so?
The previously discussed costs can also be considered from another aspect, i.e.
the time period during which they are incurred. There are two types of costs
under this classification, which are:
(a) Product cost; and
(b) Period cost.
Let us learn these costs in detail.
(a) Product Cost
Product cost is the cost which a company assigns directly to production

units.
The product cost is an asset if the product is not sold. This is due to the fact
that it will remain in the inventory until the product is sold.
For manufacturing companies, product cost consists of direct raw materials

cost, direct labour cost and factory overhead cost. The product cost is
absorbed into the product unit and at the point of sale, it becomes an
expense known as cost of goods sold. In other words, it is not regarded as
expenses immediately. For a trading company, product cost is the cost of
goods purchased.

(b) Period Cost
Period cost refers to the cost deducted from revenues as expenses in the
period in which it is incurred. It is not an inventoriable cost.
Examples of the costs which can be identified as period cost are

administrative and selling expenses. To sum up, cost classification can be
concluded as shown in Figure 2.10 (a) and (b).
Figure 2.10(a): Summary of cost classification by period and their examples for
manufacturing cost

Figure 2.10(b): Summary of cost classification by period and its examples for
non-manufacturing cost
As discussed earlier, we noted that the term product cost is synonymous

with manufacturing (production) cost. Both terms are widely used in the
manufacturing business. To better understand the cost classification for
manufacturing companies, it is important to look at how the manufacturing
costs are used and interpreted in the statements of a manufacturing
company.
2.2.4 Cost Classification by Business Category

In previous courses, you have learnt how to prepare financial reports for external
parties. However, in management accounting, financial statements are prepared
for internal users, i.e. the management.
Internal reports emphasise on „operating profit‰. Operating profit refers to the

surplus of operating incomes over operating expenses. This is, however, different
from „net profit or net income‰.

Net profit is the operating profit after taking into account all the expenses, for
instance, interests, income tax, unexpected expenses and any other expenses
required by the Acts, such as Malaysian Accounting Standard Board (MASB) and
International Accounting Standard (IAS).
Operating Profit = Operating Income ă Operating Expense
As you are aware, there are many categories or types of business organisations.
The operations of a business organisation can be classified as service,
merchandising and manufacturing. Figure 2.11 presents the three business
categories. The ultimate product for each of these business categories is the
financial statements and reports prepared for the internal users of the
organisation. Thus, the management can take actions or make decisions on the
performance of its organisation based on the reports made in the financial
statements.
Figure 2.11: Three business categories
(a) Service Organisation
Service organisations run their businesses by providing services to

customers.
Service organisations also separate the direct costs from indirect costs when
preparing the financial statements. They usually offer their customers
intangible products, thus do not have physical inventories.

Example 2.4
A public accounting firm provides auditing and tax services, while other
service-based organisations include hospitals and schools. The key cost for a
service-based organisation is labour cost.
Table 2.3 illustrates an income statement prepared for a service-based

organisation called Pusat Pakar Kesihatan Timur (East Specialist Medical
Centre).
Table 2.3: Income Statement for a Service-based Organisation
Pusat Pakar Kesihatan Timur (East Specialist Medical Centre)

Income Statement
for the year ended 31 December 2013
Revenue (Income) (RM2,000,000
Service Cost (1,200,000)
Gross Margin (800,000
Marketing and Administrative Expenses (290,000)
Net Profit (510,000
Looking at the costs of services supplied by a service-based organisation,

they are normally charged according to the number of service hours
provided to the customers. Any other costs which are not related to
providing services to the customers will be categorised as marketing and
administrative expenses. Gross margin is the profit obtained after
deducting the service costs.
Nevertheless, for a health-based or medical firm, the cost of services

supplied may include direct raw materials costs (e.g. supply of medicines),
direct labour costs (e.g. salaries and benefits offered to the doctors and
nurses) and overhead costs (e.g. insurance costs).
(b) Trading Organisation
Trading organisations operate their business by purchasing and selling

finished goods.
The operations of trading organisations are mainly purchasing and selling

finished products. Some of the examples of trading organisations are
supermarkets, grocery stores, as well as furniture and motorcycle shops.
These companies provide their customers with tangible products.

The income statements for trading organisations consist of income and

costs items, similar to the service companies. However, the costs items are
presented in greater detail so as to identify the cost of purchased and sold
products.
Such information is known as Cost of Goods Sold. The cost of goods sold
for a trading organisation is computed by adding the opening inventory of
finished goods to the cost of goods purchased and subtracting the closing
inventory of the finished goods. Table 2.4 shows a sample of an income
statement for a trading organisation, Gong Bhd which operates a
merchandising business in musical instruments.
Closing
Inventory of
 Opening 
 Cost of  finished
Cost of Goods Sold  Inventory of   
goods goods
 finished 
purchased
goods
Gong Bhd
Income Statement
RM RM
Sales Revenue 2,000,000
Cost of Goods Sold:
Opening Inventory 200,000
Purchased Goods 630,000
Cost of Finished Goods 830,000
Closing Inventory (300,000) (530,000)
Gross Profit 1,470,000
Marketing Costs 200,000
Operating Profit 1,270,000
Table 2.4: Sample of income statement prepared for Gong Bhd which operates a
merchandising business in musical instruments

The term cost of goods sold refers to the actual cost of the product sold. The
cost of products sold does not include sales and administration costs, such
as marketing cost and advertising cost.
Based on the income statement mentioned, we can conclude that for a

trading organisation, inventory, purchases and sales of finished product
costs are recorded in detail. On the contrary, there is no inventory item for a
service company as the company does not „acquire‰ products to be kept as
inventory.
(c) Manufacturing Organisation
A manufacturing organisation is a company which converts raw

materials into finished products.
The income statement of a manufacturing organisation is more complicated

than that of service-based and trading organisations. To ensure good
decision-making, the management needs to know how much costs are
incurred in making finished goods as well as the type of costs which
constitute the total cost.
As we know, a manufacturing organisation is an organisation that

processes and converts raw materials into finished goods. The costs
involved include direct raw materials, direct labour and overhead costs.
Please refer to Table 2.5.
Table 2.5: The Three Product Costs Incurred in Producing Finished Goods
Costs Explanation
Direct Raw Materials Direct raw materials can be physically associated with the
finished product. In other words, there will not be any
finished goods without direct raw materials. For example,
flour for baking breads and syrup in making soft drinks.
Direct Labour Direct labour is the physical labour involved in
converting direct raw materials into finished goods. For
example, bread-makers of a bakery and carpenters of a
furniture factory.
Factory Overhead Factory overhead refers to all the costs, other than direct
raw materials and direct labour, involved in producing
finished goods. For instance, indirect raw materials,
indirect labour, depreciation of a factory building and
insurance on the building.

In manufacturing companies, the above three product costs are used in

producing finished goods. To obtain per unit product cost, we must first
look at the total production cost. Production cost, also known as
manufacturing cost, can be obtained by preparing the statement of cost of
goods manufactured. A sample format of the statement of cost of goods
manufactured is shown in Table 2.6
AlifÊs Manufacturing Company

Statement of Cost of Goods Manufactured
RM RM RM
Direct Raw Materials 1/1 400,000
+ Purchase of Direct Raw Materials 800,000
Ready-to-Use Raw Materials 1,200,000
ă Direct Raw Materials, 31/12 (150,000)
Used Raw Materials 1,050,000
+ Direct Labour 700,000
+ Factory Overhead 1,750,000
Incurred Manufacturing Cost 3,500,000
+ Work in Process 250,000
Total Work in Process During The Year 3,750,000
ă Work in Process (WIP) 31/12 (300,000)
Cost of Goods Manufactured 3,450,000
Table 2.6: Statement of cost of goods manufactured
After preparing the statement of cost of goods manufactured, we can then

proceed to prepare the income statement. The income statement for a
manufacturing company will classify the costs according to:
(i) Costs which are traceable directly to the product, i.e. the costs of
goods sold; and
(ii) Non-product costs, i.e. the administrative and selling costs.

From Table 2.7, we can see that a manufacturing organisation must first prepare
the statement of cost of goods manufactured before it can prepare the income
statement. The costs of goods sold can only be achieved after we obtain the total
manufacturing cost.
AlifÊs Manufacturing Company

Income Statement
RM RM
Sales Revenue 8,500,00
COST OF GOODS SOLD:

Opening Inventory of Finished Goods 920,000
+ Cost of Goods Manufactured 3,450,000
Cost of Goods Available for Sale 4,370,000
ă Closing Inventory of Finished Goods (1,460,000) (2,910,000)
Gross Margin 5,590,000

ă Marketing and Administrative Costs (1,440,000)
Operating Profit 4,150,000
Table 2.7: Income statement for a manufacturing organisation
2.3 MATHEMATICAL APPROACH FOR

ESTIMATING COSTS
At the beginning of this topic, we have learnt different types of cost classification
such as cost classification by behaviour. Subsequently, in this topic, we will
discuss how to estimate costs. We will also study how to distinguish between
fixed cost, variable cost and mixed cost. Basically, costs can be estimated using
various methods and one of the essential methods is by means of the
mathematical approach.

The mathematical approach is divided into two techniques (please refer to

Figure 2.12):
(a) Non-mathematical technique; and
(b) Mathematical technique.
The non-mathematical technique outlines the method of account review. On the

other hand, the mathematical technique comprises THREE methods, namely the
high-low method, the scatter graph method and the least squares method.
Figure 2.12: The techniques of mathematical approach

2.3.1 Non-Mathematical Technique: Account Review
Account review is the process of identifying the appropriate cost driver and
classifying each account by fixed cost or variable cost.
By this method, the cost function can be determined using the following
equation:
Y = a + bx
or
Total cost = Fixed cost + Variable cost
Where:
Y is the total cost

a is the total fixed cost
b is the variable cost per unit
x is the cost driver activity
It can be seen from the above equation that cost items have the features of a semi-
variable cost, known as mixed cost. To help you understand the method and its
application in estimating costs, we will explore the example.
Example 2.5
The management of LOTO Biscuit Factory assumes a monthly overhead cost of
RM6,000 that includes fixed and variable costs. The percentage split between
the fixed cost and variable cost is 60% and 40%, respectively. The cost driver is
machine hour. On average, 9,000 machine hours are used every month. Present
the above in terms of cost function.
The following are the steps to be taken to solve the above problem
Step 1: Verify every account involved

There are several types of accounts which comprise costs, namely,
materials costs, labour costs and overhead costs. Based on the
information given, we need to verify every account involved. You
should bear in mind that only overhead costs need to be considered
here.

Step 2: Identify and classify the incurred costs into fixed costs and variable
costs.
From the accounts which recorded overhead costs, we have to
separate the costs into fixed and variable costs. According to the
information given by LOTO Biscuit Factory, the costs can be divided
at the percentage of 60% for fixed cost and the remaining 40% for
variable cost.
Step 3: Identify a relationship between activity and cost by dividing the total
cost by the cost driver volumes.
Based on the information above, the total variable cost amounted to
40% of the total overhead cost while the cost driver is the machine
hours. The average of 9,000 machine hours is used per month.
In general, the cost function can be written as an equation of:
Total Cost = Fixed Cost + Variable Cost
Where:
 The value of fixed cost is RM3,600 that is 60% of RM6,000.
 The value of variable cost is:
Total Variable Cost/Cost driver Volumes
RM2,400/9,000 machine hours = RM0.27 for every machine hour.
To obtain the cost function, substitute the derived information into the
equation, as below:
Total Cost = RM3,600 + (RM0.27 per machine hour  total machine hours)

2.3.2 Mathematical Technique

Figure 2.13 shows three methods in mathematical technique:
Figure 2.13: Three methods in mathematical technique
The following methods in mathematical technique can be employed to estimate

the cost function:
(a) High-Low Method
High-Low Method is a method that breaks down mixed costs into fixed
cost and variable cost by analysing the changes in the total cost incurred
between its highest and lowest activity levels.
By this method, we need to choose two points, which are the highest and
lowest points of the activity or operation levels (i.e. the cost driver) together
with their corresponding cost amounts. The cost function can then be
derived by using the equation as follows:
Y = a + bx
Where:
Y is the total cost

a is the total fixed cost
b is the variable cost per unit
x is the cost driver activity
We will explore the following example for a better understanding of the

measurement of cost behaviour.
Example 2.6
Bulat Sdn Bhd is a factory manufacturing school uniforms in Ipoh, Perak. The
following are the machine hours for producing the uniforms and the electricity
costs for the corresponding months in year 2006:
Month Machine Hour (Hours) Electricity Cost (RM)

January 32,000 66,340
February 37,000 71,000
March 34,000 68,900
April 40,000 72,343
May 45,000 76,678
June 42,900 74,444
July 35,000 69,100
August 30,000 64,200
September 36,000 70,434
October 47,000 77,090
November 55,000 80,450
December 50,000 78,600
Based on the information above, calculate the variable electricity cost per unit
and fixed electricity cost for the factory, Bulat Sdn Bhd Subsequently,
determine its cost function.
The steps for solving the above problem are:
Step 1: Identify the period between the highest and lowest activity
(operation) levels.
From the information given, the lowest level of operation falls in
August with 30,000 machine hours used and RM64,200 electricity cost
incurred. Meanwhile, the highest operation level is in November
incurring 55,000 machine hours and RM80,450 of electricity bills.

Step 2: Analyse the differences in both operation levels to estimate the

variable cost.
To arrive at the variable cost per unit, the difference between the two
points in terms of the costs (in RM) is divided with the difference in
operation (in units).
The required formula is:
The difference in costs (RM)

Variable cost per unit 
The difference in activity or operation (unit)
RM80,450  RM64,200

55, 000  30, 000
RM16,250

25, 000
 RM0.65 per unit.
Step 3: Determine the fixed cost.

The fixed cost can be computed by selecting either the lowest or
highest point and deducting the variable cost from the total cost.
Suppose we choose the highest point, then:

RM80,450 = Fixed Cost + (55,000 machine hours  RM0.65)
Fixed Cost = RM80,450 ă RM35,750
= RM44,700
Similarly, if we choose the lowest point:

RM64,200 = Fixed Cost + (30,000 machine hours  RM0.65)
Fixed Cost = RM64,200 ă RM19,500
= RM44,700

Step 4: Derive the cost function.

The cost function for the electricity cost of Bulat Sdn Bhd is:
Y = RM44,700 + RM0.65x
Fixed Cost Variable Cost per unit
There are several factors to consider, i.e.:
 Y is a dependent variable and is usually plotted on the y-axis

which is vertical. It is called a dependent variable because the total
cost (electricity cost) depends on the activity level (number of
machine hours consumed). For instance, when the machine hour
increases, the electricity cost also increases.
 x is an independent variable and is plotted on the horizontal axis

known as the x-axis. It is this variable that causes change in the
total cost. If a graph is plotted using the high-low method, the two
points (highest and lowest points) will be connected by drawing a
straight line passing through them. The gradient of the straight
line is the variable cost per unit.
(b) Scatter Graph Method
The Scatter Graph Method applies a visual approach in estimating cost

correlations. This method uses past cost data from periodic reports (e.g.
monthly reports) to identify total variable cost due to change in activity
levels. The periodic cost data are then plotted on a graph to display a
visual correlation between cost and activity level.
To apply this method, you need to plot the cost data on a graph where the
x-axis represents the independent variable (volume or number) while the
y-axis represents the dependent variable (total cost). Draw a line through
the plotted points on the graph to obtain the behaviour of the cost/volume
relationship.

You can derive the fixed cost from the intersection between the cost line
and the y-axis. The variable cost per unit is reflected by the slope or the
gradient of the cost line. For better illustration of this method, let us study
the example:
Example 2.7
The following monthly data on Falcon Hotel, provides information on the
number of days of accommodation and the cost of laundry service for the past
seven months:
Month Accommodation (Days) Cost of Laundry Service (RM)

June 3,500 6,750
July 7,000 8,500
August 8,500 11,000
September 10,500 2,000
October 12,000 13,500
November 9,000 10,750
December 7,500 9,750
Based on the above data, prepare a scatter graph. Plot the number of days of
accommodation on the x-axis and the cost of laundry service on the y-axis.
Follow the steps given below to answer the question:
Step 1: Set up the x-axis, representing the number of days of accommodation

and the y-axis, representing the total cost of laundry service.
Step 2: Plot the data.
Step 3: Draw a line that best visually fits the points plotted.

Figure 2.14 shows a scatter graph plotted based on the information.
Figure 2.14: Scatter graph ă Falcon Hotel
SELF-CHECK 2.1
How do you identify the elements of fixed cost and variable cost
through the line provided on a scatter graph?

(c) The Least Squares Method
The Least Squares Method involves the process of assessing cost

function objectively by using a statistical method to match the cost
function with all the data.
This method is also known as a statistical method that calculates the

equation of a linear regression which is statistically closest to the points
monitored on the graph.
The formula used contains a statistical symbol called sigma (∑) which
means „the sum of‰.
Still using the linear equation of:
Y = a + bx
The value of b is calculated statistically according to the following formula:
n   xy     x   y 
b
n  x    x 
2 2
where n = the number of monitored points.
There are two statistical methods for calculating the value of a. The formula
required for each method are given as follows:
Method 1:
  y    x 2     x   xy 
a
n  x 2    x 
2
Where n = the number of monitored points.
OR

Method 2:
Alternatively, we can use the formula below to obtain the value for a. However,
this formula can only be applied if and only if the value of b is predetermined.
a = y ă bx
Where
y denotes the mean of y

x denotes the mean of x
To understand this method thoroughly, let us consider the example as follows:
Example 2.8
You are given the following information on overhead costs and machine hours
over a period of six months.
Month Overhead Cost in RM (y) Machine Hours (x)

January 1,500 100
February 2,000 150
March 2,180 160
April 3,000 250
May 2,500 178
June 2,800 200
By means of the least squares method, compute the estimate level of cost for
every machine hour used.

Solution:
The following is the solution to the previous problem:
Overhead Cost (y) Machine Hours (x) xy x2

1,500 100 150,000 10,000
2,000 150 300,000 22,500
2,180 160 348,800 25,600
3,000 250 750,000 62,500
2,500 178 445,000 31,684
2,800 200 560,000 40,000
Sum (∑y) = 13,980 (∑x) = 1,038 (∑xy) = 2,553,800 (∑x2) = 192,284
Mean (y) = 2,330 Mean (x) = 173
Now, substitute the derived values into the formula, as shown below:
6  2, 553, 800    1, 038  13, 980 

b  10.64
6  192, 284    1, 038 
2
a  2, 330   10.64  173   489
Thus, the cost function is: y = 489 + 10.64x
Therefore, the estimated fixed cost is RM489 while the variable cost is RM10.64
per machine hour.
 The purpose of cost classification is to assist the managers in making accurate

decisions by ensuring that they use the correct categorisation of cost. Costs
are categorised according to:
ă Behaviour ă Variable costs, fixed costs and mixed costs;
ă Business Function ă Manufacturing operations and non-manufacturing

operations;

ă Period ă Product costs and period costs; and
ă Business Category ă Service-based organisations, trading organisations

and manufacturing organisations.
 Estimating costs is a process of identifying the cost behaviour. Several

techniques, using the mathematical and non-mathematical approaches, can
be employed to estimate the relationship between cost and activity level.
 The following are two techniques which are used to breakdown a cost into its
fixed and variable cost elements:
ă Non-mathematical technique: Account Review Method
ă Mathematical technique: High-Low Method, Scatter Graph Method and

the Least Squares Method.
1. Distinguish the differences between the definitions of product cost, period

cost, prime cost and conversion cost.
2. This exercise is regarding the preparation of the spreadsheet for cost of

goods manufactured and income statement for a manufacturing company.
You are required to prepare a schedule of cost of goods manufactured
and an income statement for Rendasulam Sdn Bhd for the year ended
31 December 2013 based on the following information:
Rendasulam Sdn Bhd manufactures silk textiles for the local and
international markets. In September 2013, its factory was involved in a fire.
A large amount of its accounting records were destroyed in the fire.
Nonetheless, the companyÊs accountant attempted to complete the 2013
income statement. He managed to gather the information as follows from
various sources.
(a) Total sales in year 2013 amounted to RM300,000;
(b) Opening Inventory for 2013:

Work in Process RM20,000
Finished Goods RM45,000

(c) There is no raw materials inventory since the company only

purchased raw materials as and when needed in the manufacturing
process;
(d) Factory overhead cost is equivalent to six times of the amount of raw
materials consumed in production;
(e) Total raw materials consumed is equivalent to half of the total direct
labour cost;
(f) Gross margin of the company is 40% of the sales;
(g) Sales and administration expenses are RM80,000 yearly;
(h) During the year 2013, work in Process inventory increased by

RM5,000;
(i) Finished goods inventory in year 2013 reduced by an unknown

amount; and
(j) Direct labour cost recorded is RM40,000.
3. This exercise is also about the cost schedule of goods manufactured. You
have to prepare a cost schedule of Goods Manufactured for the year ended
2013 by taking into consideration the following costs and information
given:
Lis Company has the opening and closing inventories for year 2013 as:
Beginning (RM) Ended (RM)

Direct Raw Materials 48,000 70,000
Work in Process (WIP) 176,000 150,000
Finished Goods 128,000 104,000
During the year, the following costs were incurred:

Raw Materials Purchased RM240,000
Direct Labour Cost RM360,000
Factory Overhead RM640,000

4. The following information was obtained from the records of Russ Company
for the year ended December 2013:
RM
Advertising Expense 215,000
Insurance on Factory Equipment 8,000
Depreciation of Sales Equipment 40,000
Factory Rental 90,000
Factory Utilities 52,000
Sales Commissions 35,000
Factory Cleaning Supplies 6,000
Depreciation of Factory Equipment 110,000
Marketing and Administration Salaries 85,000
Factory Maintenance 74,000
Direct Labour ?
Purchase of Raw Materials 260,000
The balance of inventory at the beginning and ended of year 2013 are as
follows:
1 January 31 December
Raw Materials RM50,000 RM40,000
Work in Process RM ? RM33,000
Finished Goods RM30,000 RM ?
Total cost of goods manufactured for the year 2013 is RM675,000. Cost
of goods available for sale is RM720,000 while cost of goods sold is
RM635,000.
You are required to:
(a) Prepare a cost schedule of goods manufactured for Russ Company for
the year ended 2013.
(b) Assuming that the above information is valid for a production level of
30,000 units, calculate the cost per unit of raw materials consumed as
well as cost per unit of rental of factory building.

1. Hull Manufacturing Company produces plastic toys in Jitra, Kedah. The

company encountered a fire and most of its accounting records were ruined
by fire. The companyÊs managers, however, learnt that some of the records
were still available although incomplete. The information on the company
between the period of 1 August 2013 and 31 August 2013 are given as follows:
RM
Purchase of Direct Materials: Plastic 4,500,000
Purchase of Indirect Materials: Glue, Paint, Small Items 100,000
Purchases for Administrative Purposes: Office Supplies 210,000
Sales 18,000,000
Wages and Salaries:
Sales and Administration 2,000,000
Direct Labour 3,000,000
Rental 2,000,000
Utilities 600,000
Advertising 350,000
Prime Cost 8,900,000
Cost of Goods Sold 14,510,000
Inventory 1 August 31 August

Plastic A RM800,000
Glue, Paint, Small Items RM 250,000 RM300,000
Office Supplies RM 75,000 RM 90,000
Finished Goods RM12,000,000 B
Work in Process RM 1,000,000 RM500,000
Additional information: 60% of the rental and utility expenses is for

manufacturing purposes while the remaining 40% is for administrative
purposes.
You are Required to:

Prepare a cost statement of goods manufactured and income statement for
Hull Manufacturing Company for the month of August 2013. (Show your
calculations clearly).

2. The following are information on costs recorded by the Maintenance

Department of Bersamamu Sdn Bhd for the month of November:
Cost Item Total Cost (RM)

SupervisorÊs salary 4,700
WorkersÊ wages 16,700
Depreciation of machinery 6,000
Machine repairs cost 5,100
Total maintenance cost in November 32,500
The average machine hours consumed is 5,000 hours.

Analyse the costs incurred in the month of November by using the Account
Review Method.
3. Raihan, an accountant in Syarikat Fantasia Sdn Bhd is conducting an

analysis on the cost behaviour of the companyÊs machine repair costs. The
following is the information regarding the machine hours and the repair
costs for the past 12 months.
Month Machine Hours (Ê000) Repair Costs (RMÊ000)

January 90 185
February 110 220
March 100 200
April 120 240
May 85 170
June 105 215
July 95 195
August 115 235
September 95 190
October 115 225
November 105 180
December 125 250

Based on the previous information, you are required to:
(a) Estimate the cost function for the above data using the high-low
method; and
(b) Based on your answer in (a), compute the cost of repair for the
coming month if Raihan expects the company to use 90,000 machine
hours in the month for manufacturing purposes.
4. Give the definition of the Least Squares Method.
5. The following information concerns the relationship between

manufacturing volumes and costs for Yoyo Furniture Factory within a
given duration of 5 months:
Month Volume (Ê000 Units) (x) Cost (RMÊ000) (y)

January 20 82
February 16 70
March 24 90
April 22 85
May 18 73
Since volume and cost are closely interrelated, it is necessary for the
management of the company to obtain the fixed cost and the variable cost
per unit by using the Least Squares Method.

Calculate the estimated fixed cost and variable costs for each of the
production volumes of Yoyo Furniture Factory using the formula in the
Least Squares Method.

Conversion cost Mixed cost

Cost driver Non-manufacturing cost
Cost object Non-manufacturing operational
function
Cost of goods sold
Non-mathematical technique
Direct labour cost
Non-product costs
Direct raw materials cost
Operating profit
Factory overhead cost
Prime cost
Fixed cost
Scatter graph method
High-low method
Service organisation
Manufacturing costs
Manufacturing operational function The least squares method
Trading organisation
Manufacturing organisations
Variable cost
Mathematical approach
Mathematical technique

Topic  Materials and
3 Labour
Accounting
LEARNING OUTCOMES
1. Explain the significance of materials in the production process;
2. Distinguish the differences between direct and indirect materials
required in production;
3. Analyse the steps and the documents involved in the procedure of
purchasing materials;
4. Apply the accounting equations in businesses involving materials;
5. Evaluate the key characteristics, advantages and disadvantages of
just-in-time (JIT) materials acquisition (purchasing); and
6. Distinguish between the payroll payment system which is based on
time and which is based on performance, as well as the advantages
and disadvantages of such systems.
 INTRODUCTION
For factories involved in manufacturing, materials and labour are considered
important elements which are required in every production activity (refer to
Figure 3.1). Therefore, we must take materials, labour and factory overhead into
account when calculating the manufacturing cost.

TOPIC 3 MATERIALS AND LABOUR ACCOUNTING  61
Figure 3.1: Materials and labour in the manufacturing industry

Source: www.ocf.berkeley.edu
In this topic, we will discuss the significance of materials and labour in the
manufacturing industry. The procedures of purchasing materials and the process
of recording the materials involved in the production process are also
emphasised in this topic. Subsequently, we will discuss the method of payroll
payment for labour.
3.1 THE IMPORTANCE OF MATERIALS IN

PRODUCTION
Generally, materials are the supplies acquired by a factory from suppliers to be
used in making products for sale. Materials required in production must be
acquired before the production process commences. Therefore, the required
materials ought to be ordered first and kept in store to prevent problems, such as
shortage of materials.
It is important to have good materials management. The materials can be

categorised as direct material and indirect material.

62  TOPIC 3 MATERIALS AND LABOUR ACCOUNTING
ACTIVITY 3.1
In your opinion, should the flour, which is required in making bread

and cakes, be regarded as direct material or indirect material?
For a manufacturing company, raw material is the key component in the

production of goods. Apart from labour and factory overheads, materials are
crucial items in manufacturing cost accounting.
Materials can be classified as direct materials and indirect materials.
(a) Direct Materials
Direct materials are essential materials used in the manufacturing

process of a product. These materials are traceable directly to the
product, based on the physical feature of the product.
Let us take the production of rattan furniture as an example. Rattan is the

direct material required in the making of rattan furniture. Similarly, teak
is the direct material in the production of teak furniture (please refer to
Figure 3.2).

Figure 3.2: Direct materials in the manufacturing of products
(b) Indirect Materials
Indirect materials are other materials required to support the

manufacturing process but are not considered as essential materials for
the production.
Although indirect materials are not the key components in production, they
are considered important in manufacturing cost accounting.

Examples of indirect materials are nails and wood varnish (refer to

Figure 3.3). Although the cost involved may not be huge or expensive, for
costing purposes, it has to be accounted for.
Figure 3.3: Indirect materials
3.2 PROCEDURE FOR MATERIALS CONTROLS

After understanding the differences between direct materials and indirect
materials, we will proceed to the procedure for materials control. This procedure
covers the practice of efficient purchasing and good materials control to ensure
the availability and sufficiency of the materials required in the manufacturing
process. Furthermore, the quality aspects of the materials must be taken care of.
Materials control is crucial in ensuring and facilitating the flow of materials from
the store to the production department, so as to cater to the demands of the
manufacturing process. Moreover, a manufacturer must make sure that the
quality and quantity of the materials requested and received from suppliers are
accurate in terms of the price and timing.
There are several sequences of activities involved in materials control

procedures. The procedure begins with ordering the materials, receiving and
storing the materials and ends with payment being made to the suppliers.
Every document involved in the purchasing activity is an evidence of effective

and efficient operation. As a guideline, please refer to the summary of the
procedure of purchasing materials shown in Figure 3.4.

Figure 3.4: Procedure for purchasing materials

The purchasing process begins when the physical quantity of goods in the store
reaches the minimum level. The production manager is responsible for making a
decision on the minimum level of the inventories to be held. The storekeeper will
prepare purchasing claims which records the item of goods required. The claim
is then forwarded to the Purchasing Department to handle the purchasing of
such goods.
Subsequently, the Purchasing Department will select a supplier that can offer
quality goods at an agreed price, according to the specified item and quantity of
the goods required. After that, the Purchasing Department will prepare a
purchase order form in which the detailed information of the code, quantity and
price of the required goods for purchasing is recorded. The form is then extended
to the chosen supplier. The same form is also sent to the store, Receiving
Department and Accounts Department as a notice of acknowledgement on the
goods ordered.
The ordered goods will be delivered together with the supplierÊs invoice to the
Receiving Department. The goods received will be verified and inspected to
ensure that the items and quantity of the goods are consistent with the purchase
order. The findings of the inspection are documented in an inspection report.
At this point, the Receiving Department is required to prepare two copies of

memorandum of acknowledgement, containing information on the actual goods
received. A copy of the memo together with the goods are delivered to the store.
Another copy is sent to the Purchasing Department along with the supplierÊs
invoice and the inspection report.
In the store, the goods are inspected again according to the memo of
acknowledgement. Meanwhile, in the Purchasing Department, the supplierÊs
invoice will be verified based on the purchase order, memo of acknowledgement
and inspection report. If the goods received are consistent with the purchase
order, the Purchasing Department will sign and submit the supplierÊs invoice to
the Accounts Department.
Before any payment is made, the Accounts Department will verify the quantity of
goods received based on the memo of acknowledgement and the invoice price
based on the price list agreed by the Purchasing Department. Upon approval, the
Accounts Department will proceed with the payment to the supplier.

A summary of the documents involved in the purchasing process is illustrated in

Table 3.1.
Table 3.1: Documents Involved in the Purchasing Process
Document
Document Destination Purpose of Document
Prepared By
Purchasing Claim Storekeeper (a) Purchasing Records the goods required
Department for acquisition by the
Purchasing Department.
Purchase Order Purchasing (b) Supplier Records detailed information
Form Department (c) Store on the code, quantity and
price of goods to be
(d) Receiving
purchased. The form is sent to
Department
the selected supplier.
(e) Accounts
Department
Memo of Receiving (f) Receiving Records information on the
Acknowledgement Department Department actual goods received.
(g) Store
(h) Purchasing
Department
Inspection Report Receiving (i) Purchasing Records the condition of
Department Department goods received from the
supplier.
SupplierÊs Invoice Selected (j) Accounts Records the quantity of goods
supplier Department received and the price agreed
between the supplier and the

3.3 APPLICATION OF ACCOUNTING

EQUATIONS IN OPERATIONS INVOLVING
MATERIALS
After learning the procedures and documents involved in the process of
purchasing materials, we will now look at how to account for the materials
which are taken out from the store for the purpose of manufacturing by the
production department.
In management accounting, emphasis is given to the aspect of cost flow. In the

context of the materials being discussed, the cost flow begins as soon as the
materials, labour or any other resources are acquired, whether by cash or credit.
Every operation involving materials, whether direct or indirect materials, has to

be recorded for the purpose of preparing financial statements.
To better understand the accounting equation, we will explore the activities

involved in a printing factory called ABC Printing for the month of September
2013.
The activities involved will be discussed in terms of the accounting equations

concerning them.
3.3.1 Purchase of Materials: Direct Materials and

Indirect Materials
When purchasing materials, you should differentiate between:
(a) Purchase of direct materials; and
(b) Purchase of indirect materials.
Let us investigate further.
(a) Purchase of Direct Materials

On 1 September, ABC Printing purchased several rolls of paper amounting
to RM15,000 on credit basis for printing purposes. The rolls of paper, which
are direct costs to the company, are also the assets to the company. The
purchase of papers will, therefore increase the inventory account. The
purchase also increases the payable accounts, which is a liability to the
company as it is done on a credit basis. Thus, the purchasing activity
increases the asset as well as the liability of the company.

Assets = Liabilities + OwnerÊs Equity

Raw materials RM15,000 Accounts Payable RM15,000
The journal entries are as follows:
Raw Materials 15,000

Accounts Payable 15,000
Purchase of rolls of paper on credit
The journal entries are transferred to the general ledger:
Raw Materials
Accounts payable 15,000
Accounts Payable
Raw materials 15,000
(b) Purchase of Indirect Materials

On 4 September, the company purchased several bottles of glue, ink and a
few boxes of paper clips amounting to RM4,900 in cash. This activity
involved the purchasing of indirect materials which are also assets to the
company. Similar to the activity on 1 September, this purchase also
increases the inventory account. However, purchasing by cash will reduce
the companyÊs assets. This means that the purchase will increase the
inventory account but decrease the cash account and both are assets to the
company.

Raw materials RM4,900
Cash account RM4,900
Raw Materials 4,900

Cash 4,900
Purchase of indirect materials in cash

Raw Materials
Cash 4,900
Cash
Raw materials 4,900
3.3.2 Usage of Materials: Direct Materials and

Indirect Materials
The demand for raw materials from the store in the production process includes
both direct and indirect materials. Usage of direct materials will be recorded in
the Work in Process Account. On the other hand, usage of indirect materials will
be recorded in the Factory Overhead Account.
Usage of both materials is further discussed as follows:
(a) Usage of Direct Materials

Throughout September, the rolls of paper amounting to RM6,300 were
delivered by the store to the production department. Once the direct
materials are transferred out of the store to the production department, the
materials will be considered as work in process. Since the work in process is
perceived as benefitting the company in terms of cash flow from sales after
the product is ready and sold, it is therefore, treated as assets to the
company.
This implies that transferring direct materials to the production department

will reduce the inventory account and increase the work in Process account.
Both accounts are considered the companyÊs assets.


Work in Process 6,300

Raw Materials 6,300
Usage of direct materials in production
Raw Materials
Accounts payable 15,000 Work in Process 6,300
Cash 4,900
Cash
Raw materials 6,300
(b) Usage of Indirect Materials

Glue, ink and a few boxes of paper clips are indirect materials of the
company. The cost of indirect materials is an overhead cost which has to be
combined together with other overhead costs in the Manufacturing
Overheads Account.
A total of RM1,800 of indirect materials are received from the store to be

used by the production department. Based on this activity, the transfer of
indirect materials to the production department will reduce the inventory
account but at the same time will cause an increase in the manufacturing
overhead account. This will involve the companyÊs assets account.

Manufacturing Overheads RM1,800

Factory Overheads 1,800

Raw Materials 1,800
Usage of indirect materials in production
Raw Materials
Accounts payable 15,000 Work in Process 6,300
Cash 4,900 Manufacturing Overheads 1,800
Factory Overheads
Raw materials 1,800
3.4 DETERMINING THE PRICE OF

PRODUCTION MATERIALS
Now, we will discuss the methods to be used in determining the price of the
materials acquired (goods purchased) and materials produced (goods
manufactured) in the production process. When a material is transferred out
from the store to the production department, it has to be valued to determine its
price. This is necessary as the cost of the material will influence the
manufacturing cost of goods to be sold.
There are several methods which can be used to determine the price or cost of
materials produced. Some of the common methods used are given as follows:
(a) First-In, First-Out (FIFO);
(b) Last-In, First-Out (LIFO); and
(c) Weighted-Average.

3.4.1 First-In, First-Out (FIFO)

This method assumes that earlier purchased goods must be fully used and
produced first in the production process. Therefore, under this method, the first
goods to come into the store must be completely consumed before the later
purchased goods can be used. Thus, the goods are sold in the order acquired, i.e.
the first goods in are sold first and sequentially, last goods in will be left in ended
inventory (refer to Figure 3.5).
Figure 3.5: First-In, First-Out Method (FIFO)
Based on the FIFO method, goods will be valued at cost price. However, if the
cost of goods changes, the current (market) price and the cost price will be
different. This method appears to be more profitable during times of inflation
where the cost price is lower than the market price of the goods. In this way, the
manufacturing cost is reduced, thus increasing the companyÊs net income.
3.4.2 Last-In, First-Out (LIFO)

By this method, the latest purchased goods will be taken and used first in the
production process. This means, the latest goods in the store will be the first to be
transferred out and used by the production department (refer to Figure 3.6).
Figure 3.6: Last-In, First-Out Method (LIFO)

According to the LIFO method, the cost price of goods may be equal or similar to
the market price as it is priced at the latest (stock) cost price. In times of inflation,
this method appears to be less profitable as the cost price is almost similar to the
market price, thus reducing the net income of the company.
3.4.3 Weighted-Average
Based on this method, the cost price will be valued at an average price. The
average price can be determined by dividing the total cost of goods available for
sale, within a given period, by the quantity of available goods during the period.
The difference between the cost of goods purchased and the price of goods sold
will be small. This is due to the fact that the new average cost per unit will only
be calculated when new goods are acquired by the store. As a result, the same
average cost will be used for goods purchased and sent to the production
department provided that there are no new goods received.
This method can be interpreted as a combination of FIFO and LIFO methods

when there is a considerable change in the cycle of goods.
ACTIVITY 3.2
Do an Internet search and read about FIFO and LIFO accounting. Write
a short essay to summarise what you understand regarding the two.
3.5 MATERIALS AND STORAGE LOSSES

In an ideal situation, all goods received by the store will be sent and accepted by
the production department. In reality, deficiency on the goods may occur before
they are transferred to the production department for the purpose of processing.
The deficiency can be caused by defects or shortage in the goods and is
considered as a waste which will cause the company to incur losses.
Several factors can contribute to the losses of materials and storage. Examples of
the factors are given and elaborated in Table 3.2.

Table 3.2: Factors Contributing to Materials Loss
Loss Factor Description

Production Problems which may occur in production include inefficient
labour, insufficient equipment and defective or incorrect
materials used.
Rejection Problems occur when the materials delivered are inconsistent
with the specification. They may not be approved when the
inspection process is performed on them. This might happen
when materials are received or during the production process.
Obsolescence Problems arise when the new type of material required in
production differs from the purchased material. This normally
happens if there are changes in the specification or demand of
the materials.
Loss in Handling Problems occur during the handling of materials in the
production process and are caused by carelessness or theft.
Storage Procedure Problems caused by evaporation, corrosion and fading
(colour) processes.
Inefficient Procedure Problems may arise when the materials transferred to the
of Production production department are more than what is needed. This
may result in losses if the materials are damaged before they
are returned to the store.
Material Features Materials which are prone to damage by evaporation require
intensive care to avoid any losses.
3.6 COSTS OF HANDLING AND

TRANSPORTING MATERIALS
There are few other costs incurred in transporting materials from the store to the
production department. These costs include handling costs and costs of
transporting materials to the production department. Generally speaking, any
costs involved in the handling and transporting of materials are considered part
of the costs of goods purchased, e.g. the cost of renting a van to transport goods
from the warehouse to the factory.
Nevertheless, if the cost incurred is minimal, it can be regarded as factory

overhead cost.

3.7 JUST-IN-TIME (JIT) PURCHASING

JIT purchasing is a production system which provides products or services
upon the order or demand made by customers.
This means, materials are acquired just in time for the production process to
commence, processed materials are ready just in time for the materials to be
converted into products and complete finished products are ready just in time for
delivery to customers.
The JIT purchasing system requires a proper layout of the product to ensure that
the movement in the production line is smooth, eliminating any delays. A short
and systematic production line can reduce the level of inventory to be stored,
thus reducing the overall cost of the inventory.
The main purposes of the JIT purchasing system are to:
(a) Eliminate waste from production activities;
(b) Reduce the stock to nil;
(c) Achieve continuous production; and
(d) Minimise any activities with no value adding.
3.7.1 Key Features of JIT Purchasing System

To ensure the success of this system, several important features have to be
emphasised. Among these are:
(a) Suppliers
To ensure the success of the system, a company must have dependable
suppliers who are willing to deliver small quantities of materials at short
notice. This way, inventory can be kept at a minimum level. They must also
be willing to supply quality materials, so as to reduce the cost of returning
defective materials. In addition to the above, they must follow the
predetermined delivery schedule to minimise the delivery time spent.

(b) Factory Layout

To implement this system well, a factory must have a suitable layout.
Basically, the factory layout of a traditional company would be such that
machines are grouped and located in different areas according to their
types, i.e. only one type of machine is located in one area of the factory. On
the other hand, a company that follows JIT approach would arrange the
machines by grouping them according to production lines, e.g. the first area
of the factory will contain all the required machines for performing the first
line of production. This way, the production lines for a particular product
(or part of the product) can be formed into a straight line or a U-shape.
Production lines are the physical paths required in making a particular
product in the production process, which begin with acquiring the
materials and ends with delivering the finished goods.
(c) Inventory Level
A successful implementation of the system will ultimately reduce the
inventory level to zero. Subsequently, the costs of storing, handling and
transferring as well as the cost of damaged materials will be reduced.
(d) Quality
The quality aspects which are emphasised by this system include the
quality of materials, selected suppliers, layout of the factory, efficiency of
factory workers, machines employed as well as the finished goods. In other
words, a successful system will reflect a high quality in every aspect of the
production process.
(e) Flexible Workers
Workers in production lines must be multi-skilled and able to operate the
different machines used in their line of production. The workers should
also know how to perform small procedures of fixing and maintaining the
machines. This is vital to reduce idle time caused by a machine breakdown.

3.7.2 Advantages and Disadvantages of a JIT

Purchasing System
The benefits and drawbacks of a JIT system can be viewed in Table 3.3:
Table 3.3: Advantages and Disadvantages of a JIT System
Advantages Disadvantages
 Reduces production time.  Difficult to perform quickly.
 Increases productivity and working  Increases pressures among workers.
capital.  Bears high risks if suppliers fail to
 Reduces inventory cost and storing perform their job efficiently.
cost.  Failing to complete orders will
 Reduces defect items and waste. increase the risk of losing future sales.
You may read more about JIT in this website:

http://bus.sdsu.edu/home/BusOfficer-1.pdf
3.8 LABOUR ACCOUNTING

After studying and understanding the costs related to the accounting of
materials, we will explore another important element of manufacturing cost, i.e.
labour.
In this section, we will look at several significant aspects regarding labour, such
as the classification of labour which consists of direct labour and indirect labour,
payroll system and labour incentive scheme.
ACTIVITY 3.3
In your opinion, a security guard in a factory need to be considered as a

direct or indirect labour? Discuss.

Labour includes all employees responsible for operating a business. The

management of a company has to ensure that the welfare of its employees is well
taken care of to enhance their motivation, productivity and work satisfaction.
Labour can be divided into direct labour and indirect labour:
(a) Direct Labour
Direct labour refers to the employees who are directly involved in a

production process. Direct labour is easily and clearly traceable to the
product.
An example of direct labour is a production operator who is involved in the

making of a product (refer to Figure 3.7).
Figure 3.7: A production operator

Source: www.aviators.stark.k12.o.../.../MachineTrades/Machine.html

(b) Indirect Labour
Indirect labour refers to the employees who are involved in the process
of manufacturing but are not directly involved in the production
process.
An example of an indirect labour is a delivery van driver (Figure 3.8).

Although the driver is not directly associated with the production process,
he is still required for delivering the finished goods for sale. The total cost
incurred may not be huge, but must be accounted for costing purposes.
Figure 3.8: A van driver

Source: http://www.officearchieves.com
3.8.1 Labour Payroll System

In this section, we will discuss the costs related to employees, which are also
known as labour in some organisations. Labour-related costs include salaries or
payments to be paid to them.
There are two categories of labour payroll, which are time-based and
output/performance related (refer to Figure 3.9).

Figure 3.9: Labour payroll system
(a) Time-based Labour Payroll System

Based on this system, labour will be paid according to the number of hours
worked. The total number of hours worked will be paid at a predetermined
rate. Should an employee work longer than the agreed time (overtime), a
premium will be paid for the overtime.
This payroll system is fit for implementation under the following

circumstances:
(i) Works where an intensive scheme is difficult or impossible to

implement, such as in the case of shop assistants and clerks;
(ii) Works where the level of output is not under the labourÊs control, e.g.
at a power station; and
(iii) Works where the quality, security and health care are crucial, e.g.
nurses and traffic policemen.
This system is easy to implement and suitable for work that requires a high
level of quality. Still, it cannot assist the management in assessing the
efficiency of each of its employees.
The advantages and disadvantages of the system are given in Table 3.4:
Table 3.4: Advantages and Disadvantages of the Time-based Labour Payroll System
 Easy to understand and manage.  No incentive to enhance output
 Involves a single rate only, i.e. the level.
predetermined basic rate per hour.  All workers will be paid equally
regardless of their performance.
 Requires continuous supervision.

(b) Output/Performance-related Labour Payroll System

Based on this system, employees will be paid according to the volume of
output. The volume of output will determine the total pay or income
received. The greater the volume of output, the higher the income received.
Similarly, a lower volume of output implies a lower income received.
This payroll system is suitable for work where the output can be easily
measured and where a group of workers are involved in producing the
output, such as assembling cars (refer to Figure 3.10). This system
encourages employees to work more productively and strive to enhance
their output levels.
Figure 3.10: Workers at a car assembly plant

Source: www.rapcoonline.com
The advantages and disadvantages of this system are as follows:
Table 3.5: Advantages and Disadvantages of Output/

Performance-related Labour Payroll System
 Attracts workers with high  Encourage other employers to
efficiency. increase their rates in an attempt to
 Direct incentives with an easy-to- attract efficient workers.
compute system.  Risk of failure to achieve target
 Easy to understand and manage. output level.

 In the manufacturing industry, materials can be categorised as direct

materials and indirect materials.
 The procedures for controlling materials include efficient purchasing and

good management of materials to ensure the availability and adequacy of the
materials required in the production process.
 There are three main methods commonly used in determining the price or
cost of materials:
ă First-In, First-Out method;
ă Last-In, First-Out method; and
ă Weighted-Average method.
 Some of the factors contributing to storage loss are production, rejection,

obsolescence as well as storage procedure.
 JIT purchasing is a production system which only prepares products or

services upon receiving their order or demand from customers.
 There are two payment systems for labour payroll:
ă Time-based labour payroll system; and
ă Output/performance-related labour payroll system.

1. Assume you are working in a factory manufacturing cakes and breads.

Give three examples of direct materials and three examples of indirect
materials involved in the process of making cakes and breads.
2. For each of the documents below, provide the purpose and application of
materials purchasing procedures.
Document Purpose and Application

 SupplierÊs Invoice
 Purchasing Claim Form
 Memo of Acknowledgement
 Inspection Report
 Purchase Order
3. Describe the method of First-In, First-Out, (FIFO) which is used to

determine the price of goods. Is the method suitable for use in times of
inflation?
1. List down five factors which contribute to materials and storage losses.
2. (a) State two main purposes of JIT purchasing system.
(b) Provide three key features of the JIT system.
(c) List two advantages as well as two disadvantages of the JIT

purchasing system.
3. Assuming that you are working in a furniture factory, give three examples
of direct labour and three examples of indirect labour which can be
identified in a furniture factory.

Direct labour Output/performance-related

Direct materials Purchase of direct materials
First-in, first-out (FIFO) Purchase of indirect materials
Indirect labour Purchase order
Indirect materials Purchasing claims
Inspection report SupplierÊs invoice
Just-in-time (JIT) purchasing Time-based
Labour payroll system Usage of direct materials
Last-in, first-out (LIFO) Weighted-average
Memorandum of acknowledgement

Topic  Overhead Cost
4 Accounting
LEARNING OUTCOMES
1. Describe manufacturing overhead cost;
2. Compare between the characteristics of the support department
and the production department;
3. Calculate and apply predetermined overhead rate;
4. Prepare entries in journals and ledgers for manufacturing
overheads;
5. Examine the methods for allocating costs of the support
department to production department; and
6. Distinguish the different procedures in calculating overhead cost,
namely the direct method, step down method and reversal method.
 INTRODUCTION
Figure 4.1: Materials and labours needed for producing a unit of Game XX in Factory Z
Factory Z produces several types of toys. The materials and labours needed for
producing a unit of Game XX in Factory Z shows in Figure 4.1. The direct
materials cost to produce a unit of Game XX is ó kg of direct materials which

TOPIC 4 OVERHEAD COST ACCOUNTING  87
costs RM66 per kg. Meanwhile, two hours of labour is required to complete the
production of the game, which costs RM24 per hour. The direct cost of
manufacturing the game is RM114. Given that the selling price of the game is
RM130, is the game XX profitable to produce? Can you suggest a price for the
game, based on the above?
This is actually impossible as there are other costs involved in making the game
besides the direct costs. For example, the salary of a security guard who guards
the factory compound, utility expenses incurred for the air-conditioning units in
the factory and others. These indirect costs cannot be directly associated with the
product although they are involved in the process of manufacturing the product.
In this topic, we will discuss the meaning of indirect costs, also known as
overhead costs. The characteristics of overhead costs will be elaborated in this
topic. Then, we will study the accounting for overhead costs.
4.1 MANUFACTURING OVERHEAD COST

The costs involved in manufacturing a product are direct materials, direct labour
as well as manufacturing overhead costs. What is meant by manufacturing
overhead?
JIT purchasing is a production system which provides products or services

upon the order or demand made by customers.
Figure 4.2: Examples of indirect materials
Examples of indirect materials costs are the cost of nails in the furniture-making
business, cost of glue in the book binding business and cost of threads for sewing
clothes (refer to Figure 4.2). These costs cannot be traced directly to the final
(finished) products, or are too insignificant and thus will not be practical or
beneficial to trace.
88  TOPIC 4 OVERHEAD COST ACCOUNTING
Figure 4.3: Examples of indirect labour
Examples of indirect labour costs include salary of a factory supervisor who

supervises production and wages of a security guard who guards the factory
compound and a cleaner who cleans the factory (refer to Figure 4.3). Like indirect
materials cost, this cost also cannot be traced directly to the product. Yet, they are
both involved in the production process and contribute to the total cost of the
products manufactured.
Apart from indirect materials cost and indirect labour cost, there are also other
overhead costs, (refer to Figure 4.4) such as depreciation of factory building,
machineries, insurance cost and factoryÊs utility expenses.
Figure 4.4: The components of manufacturing overhead costs
Manufacturing overhead costs are normally incurred by the support service

department. The support departments, such as Security, Maintenance and
Cleaning Departments, provide their services to the production and operational
departments, e.g. Processing, Finishing, Assembling and Plating departments.
Next, we will study the differences between support departments and

production departments.

4.2 COMPARISON BETWEEN SUPPORT

SERVICE DEPARTMENTS AND
PRODUCTION DEPARTMENTS
Support service departments provide supporting services to other
departments within the company. However, the services provided by these
departments do not add value to the products.
Production or operational departments convert raw materials or direct

materials into finished goods.
Earlier on, the overhead costs have been separated from direct costs and are
combined into a pool of costs. Subsequently, the costs were classified into sub-
units. Generally speaking, support service departments and production
departments are the ones involved in allocating costs by identifying the cost
objects. Tables 4.1 and 4.2 show examples of overhead components incurred by
production departments and support service department for both manufacturing
and service-based organisations:
Table 4.1: Examples of Overhead Cost Components Incurred by the Production

Departments and Support Service Departments in the Manufacturing Industry
Production Departments Support Service Departments

Assembly Storeroom
 SupervisorÊs salary.  ClerkÊs salary.
 Small/miscellaneous items.  Depreciation of forklift truck.
 Indirect materials.
Cafeteria
 Depreciation of machinery.
 Food.
Finishing  CookÊs salary.
 Sand papers.  Depreciation of kitchen.
 Depreciation of finishing and
Maintenance
polishing machinery.
 Building caretakerÊs salary.
 Supply of cleaning equipment/materials.
 Machine oil and lubricator.
Factory
 Depreciation of building.
 Security.
 Utility.

Table 4.2: Examples of Overhead Cost Components Incurred by the Production

Departments and Support Service Departments in the Service Industry
Production Departments Support Service Departments

Automated Loans Drive-through Counter
 Salary of loan processing staff.  Salary of counter clerks.
 Office supplies and forms.  Depreciation of appliances.
Commercial Loans Data Processing
 Salary of loan officers.  PersonnelÊs salary.
 Depreciation of office appliances.  Software.
 Insolvency detection software.  Depreciation of hardware.
Personal Banking Administration
 Mailing costs and supplies.  Salary of chief executive officer (CEO).
 Salary of Receptionist.
 Telephone and fax costs.
4.3 CALCULATION OF THE PREDETERMINED

OVERHEAD RATE
In topic 2, we were exposed to the definition of cost driver. Cost driver describes
the behaviour of the indirect or overhead costs over a long duration. It is a factor
which causes the cost of a given cost object to change, when the cost driver
changes.
For example, part of the factory area is used by Maintenance (support service)
Department. In general, the factory area is a depreciation cost on the factory
(plant). The depreciation of factory cost is a direct cost of the product. However,
since part of the factory area is used by Maintenance Department, a new cost will
be allocated to the production department, which is called the manufacturing
overhead cost. In this example, the cost object is the production department itself.
The cost driver is necessary in allocating the cost of depreciation of factory to the
Maintenance Department.
There are several methods of allocating the overhead cost to cost object. Usually,
overhead costs are combined in a pool of costs and are then allocated by using a
predetermined rate. The rate is determined according to the most appropriate
form of the allocation base.

The general formula for calculating the predetermined overhead rate is as

follows:
Estimated Total Manufacturing Overhead

Cost (RM)
Predetermined Overhead Rate 
Overhead Cost
For example, it is assumed that Boo Lan Furniture Factory estimated its
operations and costs information for the beginning of next yearÊs quarter as
follows:
(a) Overhead cost is estimated to be RM100,000;
(b) The base of allocation is machine hours;
(c) Total machine hours are expected to be 8,000; and
(d) Total production units are 19,000.
The predetermined overhead rate = RM100,000/8,000 = RM12.50 per machine

hour.
The overhead cost can also be allocated to other cost objects, using different rates
for different departments. For instance, the overhead cost for the Maintenance
Department can be allocated based on direct labour hours while the cost for the
Plating Department is allocated based on direct machine hours.
SELF-CHECK 4.1
What is meant by cost driver?
The following are five different formulas for calculating the predetermined
overhead rate according to the respective absorption bases:
(a) Direct Labour Hours Base

Cost (RM)
Expected Total Direct Labour Hours

(b) Machine Hours Base

Cost (RM)
Expected Total Machine Hours
(c) Production Units Base

Cost (RM)
Expected Total Production Units
(d) Direct Materials Cost Base

Cost (RM)
Expected Total Direct Materials Cost
(e) Direct Labour Cost Base

Cost (RM)
Expected Total Direct Labour Cost
Manufacturing overhead cost can also be allocated based on percentages, such as

the percentage of direct labour cost, direct machine cost and direct materials cost.
To demonstrate this, let us assume that a single unit of a product requires direct
materials amounting to RM20. The overhead cost can be allocated to the product
based on a percentage predetermined by the management. For example, for a
rate of 150% of direct materials cost, the allocated overhead cost will be RM20 
150% = RM30.

4.4 MANUFACTURING OVERHEAD

ACCOUNTING
Previously, you have been exposed to the techniques of recording journal and
ledger entries for the purchase and use of both direct and indirect materials as
well as the use of direct and indirect labour.
You will now explore the techniques of recording journal and ledger entries
involving overhead cost. For better understanding, we will repeat and elaborate
one by one the process of purchasing indirect materials and using indirect
labour.
4.4.1 Recording the Use of Indirect Materials

In this subtopic, let us look step by step on the process of recording the use
of indirect materials starting from the recording of the purchase of the raw
materials followed by the recording of the usage of raw materials.
(a) Purchasing of raw materials (direct materials and indirect materials)

Purchasing of raw materials will be recorded in the raw materials
account upon acquisition. For example, on 1 February, 2006, Meena
Company purchased 220kg of glue at a price of RM5 per kilogramme and
some papers amounting to RM1,000 in cash.
The purchase of glue, that is an indirect raw material, increases the asset of
the company, i.e. raw materials with a total of RM1,100 and at the same
time reduces the companyÊs asset, i.e. cash, by RM1,100.

Raw Materials RM1,100
Cash RM1,100
Raw Materials 1,100

Cash 1,100
(Purchase of glue and paper in cash)

Raw Materials
(b) Use of Indirect Raw Materials

Assume that the Binding Department of Meena Company consumed 50kg
of glue in February for the purpose of binding magazines. Consuming
this indirect material implies that the companyÊs raw materials asset has
been reduced by RM250. Accordingly, the overhead cost of the Binding
Department has increased by RM250.
Assets = Liabilities + OwnerÊs Equity (OE)

Raw Materials RM250 Overhead Costs RM250
(OE)
The following journal entries are made:
Overhead Cost ă Binding Department 250

Raw Materials 250
(Using glue as an indirect raw material)
Raw Materials
Cash 1,100 Overhead Cost ă Binding 250
Department
Overhead Cost ă Binding Department

Raw Materials 250

4.4.2 Recording Indirect Labour

Throughout February 2013, Meena Company has employed the services of
10 employees to bind magazines. The employees are paid RM5 per hour. In the
said month, each employee worked 200 hours. The company also hired a security
guard to guard the factory area. His salary is RM500 per month.
ACTIVITY 4.1
Can you identify the direct labour cost and indirect labour cost in the
above example?
You should realise that the wages of the binding workers are direct labour costs
as they are directly involved in the production of the magazines. On the other
hand, the wage of the security guard is an indirect labour cost.
Wages are paid in the following month, resulting in an increase in the liabilities
of the company. In terms of indirect labour, the companyÊs liability for Payroll
Payable increased by RM500. In addition, overhead cost also increased by
RM500.
Assets = Liabilities + OwnerÊs Equity (OE)

Payroll payables RM500 Overhead Cost RM500
(OE)
The journal entries for the wages of a security guard for the month of February
are given as follows:

Payroll Payable 500
(Wages of a security guard of the company)

The mentioned journal entries are transferred to the general ledger:

Raw Materials 250
Payroll Payable 500
4.4.3 Allocating Overhead Cost to Cost Object

The accumulated overhead costs for each department will be allocated or
distributed to cost objects, such as products, other departments or services. The
overheads will be allocated to cost objects by using an appropriate allocating
base.
ACTIVITY 4.2
Do you recall the predetermined overhead rate which have just been
discussed and the multiple overhead rates?
Assuming that in February 2013, Meena Company managed to complete

2,000 magazines. Every magazine requires three minutes of the machine hours
and two minutes of the direct labour hours to be completed. The company
allocated its overhead costs based on the machine hours at a predetermined rate
of RM2 per machine hour.
You should know that when an overhead cost is allocated to a product, it will be
recorded in an account, called the Work in Process account. It is an account
where all costs of direct materials, direct labour and manufacturing overheads
incurred during the manufacturing of the product are recorded. Upon the
completion of the manufacturing process, the output is produced as finished
goods (product).
The journal entries for the allocated overhead costs in the month of February are
as follows:
Work in Process 200


Allocating the overhead cost of the Binding Department to the cost object
(magazines).
The above journal entries are entered to the general ledger:

Raw Materials 250 Work in Process 200
Payroll Payable 500
Work in Process
Overhead Cost ă Binding 200
Department
4.5 ALLOCATING THE COSTS OF A

DEPARTMENT TO ANOTHER
DEPARTMENT
So far, we have learnt how to allocate overhead cost to a product by collecting all
overhead costs of support departments and allocating the costs using a single
allocation base (such as direct labour hours, direct machine hours or units
produced) as shown in Figure 4.5.
Figure 4.5: Allocating overhead costs using a single rate

The overhead costs of a department can also be allocated using multiple rates
(refer to Figure 4.5). For example, costs of Department A can be allocated based
on direct labour hours while costs of Department B is allocated on direct machine
hours whereas Department C is based on number of units produced.
Figure 4.6: Allocating overhead using multiple rates
However, the methods above do not take into account the fact that a support
department also provides services to other support departments as well as
production departments. For instance, the Cleaning Department is a service
department which provides cleaning services to the Personnel (support)
Department, Assembly (production) Department and Packaging (production)
Department.
Therefore, to see the actual picture of the total costs involved in a particular
production department, the costs belonging to support departments must first be
allocated to all production departments.
The following are the rationales for allocating the costs of support departments to
production departments:
(a) To encourage production departments to economically consume the
services and resources provided by support departments;
(b) The costs of a production department which comprise costs of support
departments will give the actual picture of the costs involved in the
production, thus facilitating the decision- making process;
(c) The actual profits of a production department can be known more
accurately; and
(d) To encourage the support departments to work more efficiently.
4.5.1 Steps for Allocating Costs of Support

Departments to Other Departments
ACTIVITY 4.3
How can a cost of a support department which provides support

service to other support departments be allocated? Discuss your
opinion in myVLE.
In allocating costs of support departments to other departments. the following

steps must be taken:
Step 1: Identify the allocation base for each department; and
Step 2: Allocate the cost of each department to other departments.
Let us look at each step more thoroughly.
(a) Identify the Allocation Base for Each Department

The base of allocation for each service department has to be identified. The
costs of a service department can be allocated by using different bases of
allocation. For instance, the costs of the Human Resource Department
can be divided into two categories, namely training cost and other costs
(refer to Figure 4.7). Training cost is allocated to other departments by using
training hours provided, while other costs are allocated using the number
of staff within the department.
Figure 4.7: Costs of Human Resource Department

ACTIVITY 4.4
List the support service departments at your work place. Examples: The
canteen and the Security department.
Can you think of some examples of the allocation bases of the service
departments at your workplace?
The examples of allocation bases for support service departments shows in the
Table 4.3.
Table 4.3: Examples of Allocation Bases for Support Service Departments
Service Department Base of Allocation

Cafeteria Amount of food provided
Information Technology Number of computers in each department
Cleaning Area of the department, number of staff
Utility Area of the department, number of machines
Human Resource Number of staff, training hours
Maintenance Machine hours
Store Square feet of storage area
Factory Administration Total labour hours
(b) Allocate the Cost of Each Department to Other Departments

As you are aware, support departments provide interdepartmental and
reciprocal services. There are three methods for allocating costs to other
departments, which are:
(i) The Direct Method;
(ii) The Step Down Method; and
(iii) The Reversal Method.

4.5.2 Method of Allocation

As stated in the previous subtopic, there are three methods of allocation:
(a) Direct method;
(b) Step down method; and
(c) Reversal method.
Let us now demonstrate each method by looking at their calculative examples.

However, calculation using the reversal method will not be discussed here.
(a) Direct Method
The direct method is the easiest of all the three methods; it disregards
any interaction between a support department and other support
departments.
The cost of every support department will be allocated directly to

production departments (refer to Figure 4.8).
Figure 4.8: Allocation of support departmentsÊ costs using the direct method

Let us demonstrate it using the following example (Table 4.4):
Table 4.4: Information from Different Departments to be Used in Deciding Allocation
Support Service Department Production Department

Canteen Maintenance Processing Assembly
Total Costs of Department 500,000 200,000 400,000 900,000
Number of Employees 15 10 20 25
Square Feet Area 5,000 7,000 20,000 35,000
ACTIVITY 4.5
Can you suggest the most suitable allocation bases for the Canteen
Department and Maintenance Department?
It is appropriate for you to allocate the costs of the Canteen Department by

using the number of employees while the costs of the Maintenance
Department can be allocated using square feet area.
The costs of each support service department can be allocated to

production (or operational) departments based on the following
calculations (refer to Table 4.4):
(i) The cost of the Canteen Department is allocated to the Processing

Department on the basis of the number of employees, that is 20/45 
RM500,000 = RM222,222;
(ii) Whereas, the cost of the Canteen Department allocated to the

Assembly Department is 25/45  RM500,000 = RM277,778.
(iii) The cost of the Maintenance Department allocated to the Processing

Department, based on square feet area is 20,000/55,000  RM200,000 =
RM72,727; and
(iv) Finally, the cost of the Maintenance Department allocated to the

Assembly Department is 35,000/55,000  RM200,000 = RM127,273.

Table 4.5: Allocation to the Different Departments after Calculation with Direct Method

Canteen Allocation 500,000 ă 222,222 277,778
Maintenance Allocation ă 200,000 72,727 127,273
Total Costs After ă ă 694,949 1,305,051
Allocation
Subsequently, the new departmental costs of the Processing Department

and Assembly Department can be allocated to the products by using the
appropriate allocation bases for each department.
(b) Step Down Method
The step down method recognises the interdepartmental services

provided by the service departments to departments other than the
production departments.
It is a sequential (step down) method, where the sequence begins with the
service department that has the highest total of departmental cost. The cost
is then allocated to the other departments using the above predetermined
bases (refer to Figure 4.9). Note that, this is not a reciprocal method which
means that, after allocating the cost of a selected service department to the
other service departments, the new total costs of other service departments
will not be allocated back to the earlier service department.
Figure 4.9: Allocating costs of service departments by the step down method

Referring to information provided in Table 4.4, the calculation of the costs

allocated by step down method are as follows:
(i) The cost of the Canteen Department (highest departmental cost) is

allocated to the Maintenance Department based on the number of
employees, that is 10/55  RM500,000 = RM90,909;
(ii) Next, the cost of the Canteen Department allocated to the Processing
Department, based on the number of employees is 20/55  RM500,000 =
RM181,818;
(iii) Finally, the remaining cost of the Canteen Department is allocated to

the Assembly Department, that is 25/55  RM500,000 = RM227,273;
(iv) The new cost of the Maintenance Department is RM290,909 and is

allocated to the Processing Department based on square feet area, that
is 20,000/55,000  RM290,909 = RM105,785; and
(v) Similarly, the cost of the Maintenance Department allocated to the

Assembly Department is 35,000/55,000  RM290,909 = RM85,124.
Table 4.6: Allocation to the Different Departments after Calculation with

Step Down Method

Canteen Allocation 500,000 90,909 181,818 227,273
Maintenance Allocation ă 290,909 105,785 185,124
Total Costs After ă ă 687,603 1,312,397
Allocation
Subsequently, the costs of the Processing Department and Assembly

Department will be allocated to the products, based on the appropriate
bases of the departments.

(c) Reversal Method
The reversal method is a method that fully recognises the

interdepartmental services rendered by support departments.
Previously, the step down method is a one-sided allocation method, which

allocates the cost of a service department to another with no reciprocal
allocation. Reversal method, on the other hand, employs linear equations.
As a result, it is not commonly used due to its complexity and the fact that
it provides similar answers to the step down method (refer to Figure 4.10).
Although this linear equation reversal method will not be elaborated
further in this topic, it is important for you to know that such a method
exists and how to distinguish the differences between the three methods.
Figure 4.10: Allocating the costs of service departments using the reversal method

4.6 ACTUAL AND NORMAL COSTING

There are two types of costing that you should be familiar with:
(a) Actual costing; and
(b) Normal costing.
4.6.1 Actual Costing
Actual costing refers to a costing system where calculations of manufacturing

costs are performed after all the jobs are completed.
Actual costing consists of actual manufacturing overhead cost, which is divided

by its actual total activity or base of allocation. This system is employed for the
purpose of preparing interim financial reports (e.g. for a period of three months
or six months), determining the price of a product and prioritising the activities
or operations of a company.
Actual total indirect costs (RM)

Actual indirect cost rate 
Actual total activity or allocation base
4.6.2 Normal Costing
Normal costing is a costing system which assigns costs to activities or jobs.
According to this system, budgets or predetermined data will be estimated at the

beginning of a period (for instance, beginning of a year). Normal costing is
determined by dividing the estimated manufacturing overhead cost by its
expected total activity or allocation base.
To explain the above, we will study the following information/data of Jerat

Manufacturing Sdn Bhd:
(a) Actual overhead cost is RM1,000,000;
(b) Budgeted/Estimated overhead cost is RM900,000;

(c) Actual machine hours are 45,000;
(d) Expected machine hours are 35,000; and
(e) Cost of raw materials is RM6,000.
The calculation for Actual Costing is:
Actual Total Overhead Cost Rate = RM1,000,000/45,000 = RM22.22 for every

machine hour.
The calculation for Normal Costing is:
Estimated Total Overhead Cost = RM900,000/35,000 = RM25.71 per machine

hour.
Based on the above results, the overhead cost rate for normal costing is higher,
that is RM25.71 per machine hour or RM1,156,950 (i.e. RM25.71  45,000 actual
machine hour), compared to the actual costing of RM22.22 per machine hour.
The journal entries for recording normal overhead costing based on the example
of Jerat Manufacturing Sdn Bhd are:
Work in Process Account RM1,156,950

Manufacturing Overhead Account RM1,156,950
We can now conclude that the actual costing system employs actual overhead
cost rate whereas the normal costing system uses a predetermined overhead cost
rate.
To take this discussion further, we will examine the methods for allocation of
underapplied or overapplied overhead.

4.7 ALLOCATION FOR UNDERAPPLIED AND

OVERAPPLIED OVERHEAD
ACTIVITY 4.6
What causes a manufacturing overhead to be underapplied or

overapplied?
When the amount of normal overhead exceeds the actual overhead incurred,
then the Manufacturing Overhead Cost account will have a credit balance.
The resulting credit balance is known as overapplied overhead.
When the overhead is overabsorbed, the applied manufacturing overhead cost

will be too high (overapplied) thus overstating the cost of goods. The adjustment
for this is by reducing the inventory and/or expenses (downward adjustment).
Conversely, when the actual overhead exceeds the absorbed overhead, then
the Manufacturing Overhead Cost Account will have a debit balance,
described as underapplied overhead.
This means that the absorbed manufacturing overhead cost is too low
(underapplied) thus understating the cost of goods. The adjustment for this is by
increasing the inventory and/or expenses (upward adjustment).
Consider the above example from Jerat Manufacturing Sdn Bhd. Its
Manufacturing Overhead Cost Account has a credit balance which implies an
overapplied overhead.
The balance in the Manufacturing Overhead Cost Account will be brought

forward from one month to another. However, at the end of the financial year or
upon entering a new financial year, any balance in the account will be eliminated
by an adjustment entry.

One of the approaches to eliminate or adjust the balance of this account (whether
debit or credit) is by transferring it to the Cost of Goods Sold Account. For
example, the above company would like to transfer the balance in its
Manufacturing Overhead Cost Account to the Cost of Goods Sold Account. The
adjustment entry is:
Cost of Goods Sold RM1,156,950

Manufacturing Overhead Account RM1,156,950
With the above entry, the earlier overapplied overhead cost of RM1,156,950 will
be added back or charged to the Cost of Goods Sold in that period.
Another approach for eliminating the balance of overapplied overhead cost is by

transferring the balance to the Work in Process Account, Finished Goods
Inventory Account and Cost of Goods Sold Account by means of the weighted-
average of the balances in those accounts.
 Manufacturing overheads are all the manufacturing costs, which cannot be

assigned directly to the product. In general, the manufacturing overhead
costs are other than direct materials and direct labour which incurred in
support service departments and production departments.
 Support service departments provide supporting services to all departments

within the factory. They do not, add value directly to the product. On the
other hand, production or operational departments convert raw materials or
direct materials into finished goods.
 Cost driver describes the behaviour of indirect or overhead costs over a long
duration. It is a factor which causes the total costs of a given cost object to
change whenever the cost driver changes.
 There are several methods of allocating overhead costs to the cost object. A
predetermined rate is obtained based on the most appropriate form of the
absorption base. Usually, the overhead cost is allocated by combining all the
overhead costs of support departments in a pool and distributing the pooled
costs by using an allocation base.

 There are three methods for allocating costs to other departments:
ă The direct method;
ă Step down method; and
ă Reversal method.
 In determining overhead costs, two techniques can be employed:
ă Actual costing; and
ă Normal costing.
 Normal costing involves the calculation of predetermined overhead rate.
 The estimated absorption bases are used in computing the predetermined

overhead rates, such as machine hours, total units produced, direct labour
hours and so on.
 The difference between actual overhead and normal overhead will result in
underapplied or overapplied overheads.
1. What is meant by support departments?
2. What is meant by production departments?
3. What is predetermined overhead rate and how is the rate obtained?
4. What is the total overhead cost allocated, if a company decides that it is 10%
of the direct labour cost? Assume that the incurred direct labour cost is
RM10.
5. Calculate the predetermined overhead rate based on the following data

from Raja Company Sdn Bhd:
Estimated manufacturing overhead RM300,000

Actual manufacturing overhead RM250,000
Total expected production units 15,000
Total actual production units 14,500

6. How is the allocation base of a given overhead cost identified?
7. What are the steps of allocating the costs of support service departments to
production departments?
8. What are the techniques which can be employed in cost allocation?
9. The costs of six departments in Mussang Company are as follows:

Human
Canteen Security Processing Painting Assembly
Resource
Total Cost of 300,000 450,000 40,000 255,000 30,000 150,000
Department (RM)
No. of Staff 15 10 5 20 7 12
Machine Hour 800 200 155
Square Feet Area 3,000 1,500 500 5,000 2,500 2,500
(a) Identify the appropriate allocation bases to be used in allocating the

cost of each support service department; and
(b) Compute the new cost of each production department after costs
allocation by the support departments, by means of:
(i) Direct method (ii) Step down method
1. What is the definition of actual costing?
2. What is meant by normal costing?
3. What are the differences between actual costing and normal costing?
4. The information on Pokai Company Sdn Bhd is as follows:
(a) Actual overhead cost: RM1,500,000
(b) Budgeted overhead cost: RM1,000,000
(c) Actual machine hours: 30,000

(d) Budgeted machine hours: 22,000
(e) Costs of raw materials: RM6,000
(f) Costs of direct labour: RM10,000
(a) Compute the normal overhead rate;
(b) Compute the actual overhead rate; and
(c) Analyse the results obtained in (i) and (ii).
5. What do you understand from the terms underapplied overhead and

overapplied overhead?
6. How can the amount of overapplied overhead cost and that of underapplied
overhead cost be adjusted/eliminated at the end of an accounting period?
7. What will happen to an overhead rate that is based on direct labour hours
once the direct labour force is replaced by an automated equipment
system?
8. Calculate the predetermined overhead rate based on the information of

Senyum Company Sdn Bhd as follows:
Budgeted factory overhead RM350,000

Actual factory overhead RM300,000
Budgeted direct labour rate RM8.60
Budgeted direct labour hours 18,000
Actual direct labour rate RM10.00
Actual direct labour hours 17,500
9. Based on your answer and the above information, determine whether the
overhead cost is under or overapplied.

Actual costing Overapplied overhead

Allocation base Production/operational departments
Direct method Reversal method
Indirect labour Step down method
Indirect materials Support service departments
Manufacturing overhead Underapplied overhead
Normal costing

Topic  Activity-Based
Costing (ABC)
5
LEARNING OUTCOMES
1. Explain the significance of the activity-based costing system;
2. Compute the activity cost pool and cost driver for each activity;
3. List down the basic features of the activity-based costing system;
4. Distinguish between the traditional costing system and the activity-
based system;
5. Calculate the product cost per unit by using the activity-based
costing system; and
6. Summarise the advantages and disadvantages of the activity-based
costing system.
 INTRODUCTION
Supposed you are dining at a restaurant with three friends. Friend A ordered a
beef steak which costs RM35, Friend B ordered a roast chicken which costs RM25,
Friend C ordered a plate of spaghetti which costs RM15 while you only ordered a
plate of fried rice which costs RM5. The total bill is RM80. If the bill is equally
shared, each of you will have to pay RM20. By referring to the Figure 5.1, is the
bill distribution fair?

TOPIC 5 ACTIVITY-BASED COSTING (ABC)  115
Figure 5.1: Is this a fair distribution of the bill payment?
Consider the followings facts. You only ordered fried rice which costs you RM5
but you paid RM20. On the contrary, Friend A ordered beef steak which should
cost him RM35 but paid only RM20. Hence, some friends have to pay less than
what they actually ordered while others are paying more. This is due to the fact
that the restaurant bill is divided by the number of people eating the meals
instead of the value meals they ordered.
Similarly, in the traditional costing method, the manufacturing cost is allocated

by one base (predetermined rate) to differentiate the goods produced. It does not
take into account the possibility of a product utilising more manufacturing
overheads than other products.
Advancement in technology has clearly influenced the process of manufacturing

products. Previously, labour force was the key component used in converting
raw materials into finished goods. Nowadays, the role has been taken over by
machines. This transition has caused production firms to look for new costing
methods that recognises machine hours as one of the main source of production
costs.
In this topic, we will explore a costing system which is supposed to overcome the
weaknesses of job order costing system and process costing system. This costing
system is called activity-based costing system. The characteristics and calculation
steps of this system will be elaborated in this topic. The remainder of the topic
will discuss the advantages and disadvantages of the system.

116  TOPIC 5 ACTIVITY-BASED COSTING (ABC)
5.1 ACTIVITY-BASED COSTING (ABC)

In the traditional costing system, the costs of a product consist of direct materials,
direct labour and manufacturing overhead costs (Figure 5.2). In the previous
topic, we studied how a manufacturing overhead cost is allocated to products. A
single-unit predetermined rate is employed to allocate the overhead cost to
different products. The predetermined rate is the total estimated overhead cost
over a particular duration divided by the total (volume) of the allocation base,
which is either the expected total units produced, expected total direct labour
hour or expected total machine hour.
Figure 5.2: Product costing in traditional costing system
Advancement in technology has clearly influenced the method of manufacturing

products (Figure 5.3). Previously, labour force was the key component used in
converting raw materials into finished goods but nowadays, the role has been
taken over by machines. Today, labour costs or machine hours are not the only
factors influencing the overhead, as the complexity of the production process
also influences the overhead cost.
Figure 5.3: Why do we need a new costing method?

Complex products may be produced in small quantities. If the overhead cost is

allocated or absorbed according to labour hours or machine hours, the resulting
allocated overhead cost for this product is most likely to be small due to its small
production units.
In fact, the complexity of the product could be the cause of an increase in the
manufacturing overhead cost, in terms of the number of machines set up as well
as the adjustments of the machine designs which are required in the making of
such products.
The transition above has resulted in firms searching for a new costing method
that recognises machine hours as a main source of cost. This is because the
traditional costing method emphasises the total labour and machine hours when
allocating overhead cost to products.
In this topic, we will learn a new costing system, namely, the Activity-Based
System. This system is only useful for internal management purposes, such as
determining the price. However, for the purpose of reporting, the traditional
system is still required and employed. The new system is also supposed to
overcome any weaknesses related to the traditional costing system.
Activity-Based Costing (ABC) is a costing technique based on the analysis of

the resources used in manufacturing products or providing services.
The actual direct materials costs, direct labour costs and manufacturing overhead
costs as well as the actual non-manufacturing overhead costs incurred in the
process of manufacturing a product will be employed in ABC. Nonetheless, the
emphasis of ABC is on computing accurate manufacturing overhead cost and
non-manufacturing overhead cost.
SELF-CHECK 5.1
What is meant by the ABC System?

5.2 COMPARISON BETWEEN TRADITIONAL

COSTING SYSTEM AND ACTIVITY-BASED
(ABC) SYSTEM
ACTIVITY 5.1
Try to think for a moment, what are the differences between the
traditional costing systems and the activity-based costing system
(ABC)?
In traditional costing systems, the allocation of overhead costs is done in two

stages. In the first stage, overhead costs are accumulated by an individual
department (known as the cost centre), such as the Processing Department,
Painting Department and Assembly Department. These costs are normally
combined into one cost pool, which include all manufacturing costs except direct
materials costs and direct labour costs.
Subsequently, in the second stage, the pooled cost will be assigned to the
products using a cost driver which is based on quantity or volume related to the
overhead costs (total overhead cost). For example, if the overhead costs of
RM10,000 are incurred in producing 100 units of bicycles, then the allocated
overhead cost to a unit of bicycle is RM100.
The activity-based costing system (ABC) is a costing method which combines the
overhead costs for each activity. Then, the costs are allocated to products,
services or cost objects based on the required activities.
The ABC system emphasises on the comprehensive understanding of the

relationship between the activities that give rise to overhead cost and how
overhead cost is related to its cost objects. Overhead costs are accumulated
according to activity groups (overhead cost pools), such as assembling activity,
delivering activity, inspection activity as well as product designing activity.
Subsequently, the activity-based accumulated overhead cost is allocated to its
cost objects using cost drivers which are independent of the production quantity
(for instance, number of production lines, number of setting up hours and
number of purchase orders). This system employs the actual activities or factors
that cause the overhead to incur.

Generally, the differences between the traditional costing systems and the ABC
system are as follows (Figure 5.4):
(a) Most of the manufacturing and non-manufacturing overhead costs will be

allocated to the products;
(b) Some manufacturing costs (for a certain organisation) will not be allocated
to the products;
(c) Overhead costs pool is used to allocate the overhead costs to the products;
(d) The allocation base used in the activity-based costing system differs from
that of the traditional costing system; and
(e) Usually, the overhead rates will be allocated according to the actual activity
levels instead of the expected volume (budget).
Figure 5.4: Comparison between the traditional costing system and

activity-based costing system

5.3 DISADVANTAGES OF TRADITIONAL

COSTING SYSTEMS
The traditional costing systems, namely, the job order costing system and process
costing system have been badly criticised in the 1980s due to their weaknesses.
The traditional costing systems were designed to cater for businesses with the
following features:
(a) Small number of products;

(b) Direct materials and direct labour are the key components of the
production;
(c) Manufacturing overhead is not much, thus it is not suitable to use an

extensive system as the allocated overhead is minimal; and
(d) Assume that the direct and indirect materials consumed in manufacturing
the product are directly proportional to the production units.
Since the 1990s, most companies produce products in large quantities by using
machines. As a result, the involvement of direct labour has decreased but the
overhead costs have increased ever since.
Moreover, the traditional costing method that depends on the quantity-based

measurement is also debatable. This is due to the fact that there are costs which
cannot be directly related to quantity. For example, cost of handling raw
materials, cost of acquiring raw materials and cost of quality inspection for each
production line or batch.
To obtain product or service costs which are more accurate, a new costing system
with a better method for allocating overheads is required. Thus, the ABC system
was developed to cater for the current needs and as an alternative to the
traditional costing method.

5.4 IMPLEMENTATION OF ACTIVITY-BASED

COSTING
The ABC system can not only be implemented in the manufacturing industry but
also in the service industry.
ACTIVITY 5.2
Nowadays, most of the banks in Malaysia impose charges for over-the-

counter money withdrawal transactions. In fact, they also charge for
withdrawing more than certain number of times from the ATM. In your
opinion, are the banks using ABC? Explain your answer.
Implementing ABC requires the following steps:
(a) Identifying the core activities of the organisation;
(b) Identifying the activity costs and collecting them in a costs pool (cost
centre);
(c) Determining the cost driver for each core activity and computing the rate of
activity for each cost driver; and
(d) Allocating the cost of each activity to the cost object based on the cost driver
activity of the product.
Let us consider the above steps more closely.
5.4.1 Identifying the Core Activities in the

Organisation
Activity is an action which causes overhead costs. For instance, the activity of
purchasing raw materials involves several tasks, such as receiving the request for
purchasing, identifying the supplier, preparing the purchase order and posting
the purchase order.

In general, activities can be classified into four categories as shown in Figure 5.5.
Figure 5.5: Activity classification
5.4.2 Identifying the Activity Costs and Combining

the Costs in a Pool (Cost Centre)
In the ABC system, an organisation is required to identify its activities and
establish a cost pool or cost centre to accumulate all costs involved and related to
the activities.
Firstly, the overhead costs will be accumulated in the activity cost pool by using
appropriate cost drivers. These costs will be matched to the activities based on
the cause and effect of the cost drivers. Interview sessions with employees of the
organisation can provide reasonable estimates on the resources used in each of
the activities.

In other words, the cost pool or cost centre consists of individual costs that are
combined and will be allocated to cost objects by using a single cost driver, that
is, the appropriate activity.
ACTIVITY 5.3
What is meant by cost driver?
5.4.3 Determining the Cost Driver for Each Core

Activity and Computing the Rate of Activity
Cost Driver
Without considering the activity classes, the application of activity-based costing
system requires businesses to identify the cost driver for each of their activities.
The cost drivers are important as they are used to allocate the activity costs to
cost objects.
Factors which must be considered when selecting a cost driver are listed as
follows:
(a) The cost driver should provide a reasonable explanation and connection for
the existence of each cost in every cost centre activity; and
(b) The cost driver must be measurable and its data obtainable and assignable
to its cost object.
Examples of cost drivers for the following activities are given in Table 5.1:
Table 5.1: Examples of Cost Drivers and Activities
Activity Cost Driver

Engineering Machine hour
Product development Product developing hour, product designing hour
Machine assembly Number of machines assembled
Purchasing Number of purchases made
Receiving Number of receipts
Delivering Number of deliveries, number of orders
Setting up Number of set up, set up hour
Customer order Number of orders, number of customers, number of sales calls

ACTIVITY 5.4
How do we calculate the rate of activity cost driver?
After obtaining the total cost for each cost pool and identifying the cost driver for
each cost pool, you need to find the number of actual activities or budgeted
activities for every core activity category. The formula for computing the rate of
activity cost driver is as follow:
Total cost of activity cost pool (RM)

Rate of activity cost driver 
Total cost driver activities
This implies that, for every cost pool, the overhead cost will have a rate for each
of its activity cost driver.
5.4.4 Allocating the Costs of Each Activity to the

Object Cost Based on the Cost Driver Activity of
the Product
By using the selected cost driver, the accumulated overhead cost is assigned to
the cost objects (Figure 5.6).
Figure 5.6: The steps in an activity-based costing system

5.5 CALCULATIONS FOR TRADITIONAL

COSTING SYSTEMS AND ACTIVITY-BASED
COSTING SYSTEMS
SELF-CHECK 5.2
Recall the steps involved in the calculations of traditional costing

systems, i.e. the job order system and the process costing system?
To help you to understand the differences between traditional costing systems

and ABC systems, we will illustrate the following example:
Example 5.1
Che Ah Factory manufactures two radio brands, i.e. normal model radios with
brand name Alpha in large quantities and sophisticated radios with brand
name Beta in small quantities. The information on both products for year 2013
is as follows:
Alpha Radio Beta Radio Total

Units produced (units) 80,000 20,000 100,000
Selling price per unit (RM) 60 120
Per Unit Cost:

Raw materials costs (RM) 19 46 2,440,000
Direct labour costs (RM) 10 13 1,060,000
Operational Information:
Total labour hour (hours) 36,000 14,000 50,000
Total machine hour (hours) 11,000 15,000 26,000
Overhead Cost:
Setting up machines (RM) 600,000
Operating machines (RM) 2,200,000
Total (RM) 2,800,000

The activities which have been identified and are related to the production of
both radio brands are: setting up the machines and operating the machines.
Information regarding the above activities is as follows:
Total Cost (RM) Activity Count

Setting up machines 600,000 14,000 setting ups
Operating machines 2,200,000 26,000 machine hours
Each product has performed the above activities in the following manners:
Alpha Radio Beta Radio Total

Setting up machines (number of setting ups) 4,000 10,000 14,000
Operating machines (machine hours) 11,000 15,000 26,000
Based on the information provided earlier, you are required to calculate the
cost of Alpha radio and Beta radio by means of: (a) traditional costing systems,
and (b) activity-based costing system. For each of the costing systems,
determine which radio brand generates the highest profit.
Solution:
(a) Cost Calculation Using the Traditional System

The direct costs related to both radio brands are as follows:
Direct Cost Per Unit Alpha Radio Beta Radio

Direct materials cost (RM) 19 46
Direct labour cost (RM) 10 13
Total Direct Cost (RM) 29 59
The total indirect cost (overhead cost) for both brands is RM2,800,000. In
the traditional costing system, this overhead cost will be allocated to the
products using a single allocation base or rate.
Let us reflect on what we have learnt so far. What are the allocation bases
or rates which can be used for the radio costing purposes? From the
information provided, the overhead cost can be allocated based on:
(i) direct labour hour, (ii) direct machine hour, or (iii) number of radios
produced.

Compute the cost per unit for each of the radio brand by employing each
of the mentioned allocation bases.
(i) Overhead allocation rate which employs direct labour hour is

therefore;
Overhead cost allocation rate (base) = RM2,800,000/50,000 direct

labour hours
= RM56 per direct labour hour
How many direct labour hours are required to produce a unit of

Alpha brand radio?
Total direct labour hours 36, 000

  0.45 hours per unit
Total Alpha brand radios produced 80, 000
Hence the overhead cost for a unit of Alpha brand radio is = RM56 
0.45 hours = RM25.20.
Now, how many direct labour hours are needed to produce a unit of
radio with brand name Beta?
Total direct labour hours 14, 000

Total Beta brand radios produced 20, 000
Hence, the overhead cost for a unit of Beta brand radio is = RM56 
0.7 hours = RM39.20.
(ii) The overhead allocation rate which employs direct machine hour is
therefore;
Overhead cost allocation rate (base) = RM2,800,000/26,000 direct

machine hours
= RM107.70 per direct

machine hour

How many direct machine hours are required to produce a unit of

Alpha brand radio?
Total direct machine hours 11, 000

Hence, the overhead cost for a unit of Alpha brand radio is =

RM107.70  0.1375 hours = RM14.81.
Now, how many direct machine hours are needed to produce a unit
of radio with brand name Beta?
Total direct machine hours 15, 000

Hence the overhead cost for a unit of Beta brand radio is =

RM107.70  0.75 hours = RM80.78.
(iii) The overhead allocation rate which employs production unit is

therefore;
Overhead cost allocation rate (base) = RM2,800,000/100,000 units

produced
= RM28 per production unit
Now, let us look at the costs of both radio brands given by the different
allocation rates.
Direct Labour Direct Machine

Production Unit
Hour Hour
Per Unit Cost
Alpha Beta Alpha Beta Alpha Beta
(RM) (RM) (RM) (RM) (RM) (RM)
Direct 19 46 19 46 19 46
Materials Cost
Direct Labour 10 13 10 13 10 13
Cost
Overhead 25.20 39.20 14.81 80.78 28 28
Cost (Indirect
Cost)
54.20 98.20 43.81 139.78 57.00 87.00

The cost of each radio brand differs with different allocation rates
employed. To assist the decision-making process of determining the
selling price of each radio brand, it is necessary to have an accurate cost
for each brand.
Which rates should be employed by Che Ah Factory? Based on the

significant total direct labour hour (50,000 hours used), then the allocation
rate which is based on direct labour hour should be employed by Che Ah
Factory.
Assuming that the factory allocates the overhead cost to the radios using
direct labour hour, let us compute the gross profit margin for each radio
brand.
Alpha (RM) Beta (RM)

Selling price per unit 60.00 120.00
Less: Per unit cost (54.20) (98.30)
Gross profit per unit 5.80 21.70
Gross profit margin (%) 9.67% 18.08%
Through the traditional costing system, Beta brand radio is more

profitable than the Alpha brand radio (the gross profit margin for Beta is
higher than that of Alpha, i.e. 18.08% : 9.67%).
The effect of the above will be better illustrated by preparing an Income

Statement to derive the gross profits of Alpha and Beta radios.
Income Statement of Che Ah Factory

Traditional Costing System

Income 4,800,000 2,400,000
Less: Cost of Manufacturing Goods
Direct materials costs (1,520,000) (920,000)
Direct labour costs (800,000) (260,000)
Overhead costs (2,016,000) (784,000)
Gross profit per brand 464,000 436,000
Gross Profit Margin (%) 9.67% 18.17%

(b) Activity-Based Costing System

Under this system, the overhead cost will be allocated to the products
based on the activities involved. The steps that are required for this
system are as follows:
(i) Determine the core activities which are involved in the overhead
cost.
In the above illustration, there are two core activities, namely

operating machines and setting up machines. These would be the
cost pools. You need to know the amount of each of these cost
pools.
(ii) Determine the cost driver for each core activity.
For operating machines (core activity), the cost driver is machine

hour, while for setting up machines the cost driver is number of
setting ups. In addition, you need to know the total cost driver
activities for each of the cost pool.
(iii) Determine the rate of activity cost driver.
For operating machines, the rate of activity cost driver is:
Rate of operating machines cost driver = RM2,200,000/26,000

machine hours
= RM84.62 per machine

operating hour
For setting up machines, the rate of activity cost driver is:
Rate of setting up machines cost driver = RM600,000/14,000 setting

ups
= RM42.86 per machine

set up

The following is a summary for the information obtained from the

previous calculation:
Core Activity Operating Machines Setting Up Machines

1. Cost Pool RM2,200,00 RM600,000
2. Cost Driver Machine hours Number of setting ups
3. Total Core 26,000 machine hours 14,000 setting ups
Activities
4. Rate of Activity RM84.62 per machine RM42.86 per set up
Cost Driver hour
(iii) Allocate the core activity cost to each radio brand.
You need to know how many activity units are consumed by each
brand.
Activity ă Operating Machines

How many operating machine hours are consumed in producing a unit of
Alpha brand radio?
Total operating machine hours 11, 000

Hence, the overhead cost for a unit of Alpha brand radio is = RM84.62  0.1375
hours = RM11.64.
How many operating machine hours are used to make a unit of radio with
brand name Beta?
Total operating machine hours 15, 000

Hence, the overhead cost for a unit of Beta brand radio is = RM84.62  0.75
hours = RM63.47.

Activity ă Setting Up Machines

How many machines set ups are used in producing a unit of Alpha brand
radio?
Total number of set ups 4, 000

  0.05 set ups per unit
Hence, the overhead cost for a unit of Alpha brand radio= RM42.86  0.05 set
ups = RM2.14.
How many machines setting ups are used to produce a unit of Beta brand
radio?
Total number of set ups 10, 000

  0.5 set ups per unit
Hence, the overhead cost for a unit of Beta brand radio= RM42.86  0.5 set ups
= RM21.43.
After obtaining all the information above, we can now calculate per unit costs
for both brands. The per unit cost for each radio brand under the activity-based
costing system are:
Per Unit Cost Alpha (RM) Beta (RM)

Direct materials costs 19.00 46.00
Direct labour costs 10.00 13.00
Overhead costs
Operating machines 11.64 63.47
Setting up machines 2.14 21.43
Total cost per unit 42.78 143.90
Note that the costs of each brand differ with the different rates of allocation
used. To assist in determining the selling price for each radio brand, it is
necessary to have the accurate costs for each brand.

Let us now compute the gross profit margin for each radio brand.

Selling price per unit 60.00 120.00
Less: Per unit cost (42.78) (143.90)
Gross profit (loss) per unit 17.22 (23.90)
Gross profit (loss) margin (%) 28.71% (19.92)%
By the ABC system, a unit of Beta brand radio which is sold at a price of RM120
will incur a loss as the cost per unit of the radio is RM143.90. On the contrary,
the Alpha brand radio is more profitable with a gross profit margin of 28.72%.
Thus, we can conclude that without the application and knowledge of the ABC
system, a product can be significantly miscalculated. Such an action could
result in wrong decision making on product pricing, hence, leading to a loss
incurred by the company.
The effect is better described by the following Income Statement, which

illustrates the gross profits of Alpha and Beta radio brands.
Income Statement of Che Ah Factory

Activity-based Costing System

Income 4,800,000 2,400,000
Less: Cost of Goods Manufactured
Direct materials costs (1,520,000) (920,000)
Direct labour costs (800,000) (260,000)
Machine operating cost (930,400) (1,269,400)
Overhead costs (171,200) (428,600)
Gross profit per unit 1,378,400 (478,000)
Gross Profit Margin (%) 28.72% (19.92%)

5.6 ADVANTAGES AND DISADVANTAGES OF

THE ABC SYSTEM
ACTIVITY 5.5
After studying the differences between the traditional costing system

and the ABC system, can you suggest the advantages and
disadvantages of the ABC system?
The following are the advantages of the activity-based costing system:
(a) Costing based on activity provides reasonable correlations, causes and

effects between cost and activity costs incurred and subsequently to the cost
objects. These will enhance the accuracy of the product cost calculations.
The ABC system should be applied to companies with the following
features:
(i) The companyÊs overhead cost is relatively high in comparison with

the total cost;
(ii) There are several types of products produced;
(iii) Complicated products are perceived as more profitable than simple-

to-make (standard) products;
(iv) There are many input sources of overhead to the products; and
(v) The overhead costs involved are not volume-related.
(b) The use of the traditional costing system can cause a simple product to be
overcosted and a complex product undercosted. The application of the
activity-based costing system can avoid a situation where standard and
simple-to-produce products appear as incurring losses while complicated
products seem to be profitable.
The disadvantages of the activity-based costing system are:
(a) The system requires the management to estimate the costs of every cost
centre activity and identify the cost driver of the respective centres;
(b) The activity cost rate also needs to be updated. However, with the help of
computers, much of the calculations have been simplified; and

(c) A detailed activity-based costing system is very expensive to implement

and difficult to understand. Therefore, ABC requires a lot of effort as well
as huge costs.
 The disadvantages of traditional costing systems, namely, job order costing

and process costing have given rise to the development of the activity-based
costing system.
 The activity-based costing system is a costing method which accumulates

overhead costs for each activity.
 The costs are allocated to products, services or cost objects according to

the required activities. The system emphasises on the comprehensive
understanding of the relationship between the activities that give rise to the
overhead cost and the manner in which the overhead cost relates to its cost
objects.
1. What are the weaknesses of a traditional costing system?
2. What are the characteristics of an activity-based costing system?
3. Wakenababe manufactures three types of television. Each type is different

from the other in terms of the complexity of its making and the size of its
production batch. The following are the costs incurred in December 2013:
(a) The process of designing and drafting the process chart for products
amounts to RM2,000.
(b) The costs of acquiring raw materials, receiving raw materials and
paying suppliers according to the number of orders made add up to
RM3,000.
(c) The cost involved in setting up the machines each time a different
type of television is manufactured equals to RM4,000.
(d) The machine-related overhead costs, such as depreciation and

maintenance are RM10,000.
(e) Factory rental and insurance add up to RM20,000.

(f) The cost of indirect raw materials is RM15,000.
(g) The cost of indirect labour is RM22,000.
Categorise each of the mentioned cost as being unit level, batch level,
product level, facility or organisational level.
1. List down three significant factors in determining the cost drivers for the
ABC system.
2. Beeline Company produces three types of products, namely RZ, RX and

RV. The information regarding the production of the products for the
month of June 2013 is given as follows.
Product RZ RX RV
Production units (unit) 120 100 80
Per Unit Cost (RM)
Direct materials 40 50 30
Direct labour 28 21 14
Per unit machine hours 4 3 2
Right now, Beeline Company allocates its overhead cost based on direct
machine hours. The overhead costs in June 2013 with their matching cost
drivers are as follows:
Manufacturing Overhead Cost Driver RM Total Activity

Cost of Machinery Machine hours 10,430 5,215 machine
Department hours
Cost of setting up machines No. of production batches 5,250 50 production
batches
Cost of receiving goods No. of demands for goods 3,600 120 demands
Inspection cost No. of inspection groups 2,100 140 inspection
groups
Delivery cost No. of orders received 4,620 77 orders

The three types of products are processed and produced in production

batches of 20 units for every product type produced. The demand for goods
from the storeroom are processed in batches of 10 units for every product
type produced. Moreover, the orders received are processed in batches of
5 units for every product type produced.
Based on the information mentioned, you are required to:
(a) Calculate the total cost for every product by using machine hour as
the cost driver; and
(b) Calculate the total cost for every product by using the ABC system.
3. Twin Towers Company produces two types of bicycles, called Standard

and Sporty. The total manufacturing overhead cost is allocated to the
products at a rate of RM80 per machine hour. Other information on
production is given:
Sporty Standard
Direct raw materials (RM) 40 65
Direct labour (RM) 25 25
Expected production (units) 16,000 30,000
The management accountant wishes to employ the activity-based costing

method and has identified three activities related to the production, i.e. set
up, machine processing and delivery. The data regarding these three
activities are as follows:
Sporty Standard Total Total (RM)

Set up (No.) 100 60 160 1,344,000
Machine Processing 32,000 45,000 77,000 3,696,000
(Hours)
Delivery (No.) 200 150 350 1,120,000

Based on the information mentioned, you are required to:
(a) Calculate per unit cost of the Standard and Sporty bicycles by
employing the companyÊs current method of allocation.
(b) Calculate per unit cost of the Standard and Sporty bicycles by
employing the ABC method.
(c) Assuming the market selling price for Sporty bicycles is RM270 and
that the marketing manager is suggesting to reduce the price by RM30
to increase sales, should this suggestion be implemented?
Activity-based costing (ABC) Product level activity

Batch level activity Traditional costing
Cost pool/cost centre Unit level activity
Facility/organisational level activity

Topic  Job Order
6 Costing
LEARNING OUTCOMES
1. Describe the purposes and features of job order costing;
2. Explain the application of and the flow of documents involved in
job order costing;
3. Illustrate the flow of production activities and accounting activities;
4. Illustrate the flow of manufacturing costs in job order costing; and
5. Report the use of materials, labour and factory overhead.
 INTRODUCTION
The concepts and types of costs have been deliberated in the previous topic. This
topic will now discuss how to accumulate and allocate the costs involved in
producing a product or service. This process is known as product costing, which
is a crucial task in management accounting to determine the cost of a product or
service. The main purpose of product or service costing is to accumulate all costs
related to the production processes and subsequently to assign the costs to the
final products being produced. Product costing is relevant to all types of
businesses; whether they provide services or products; and is required for all
types of organisations; whether they are profit-making organisations or not.
There are two main types of product costing systems for manufacturing
operations, i.e. job order costing system and process costing system. The
following discussion in this topic will focus on product costing, particularly job
order costing for manufacturing operations. Process costing will be discussed in
the next topic.

140  TOPIC 6 JOB ORDER COSTING
6.1 PREFACE
Information on product cost is required for various reasons, among others, for
planning, preparing budgets, controlling costs and providing information for
decision-making such as pricing, determining the combination and quantity of
products to be produced, and evaluating the performance of the employees. In
addition, from an accounting and financial reporting point of view, product cost
information is necessary for measuring inventory in the balance sheet, computing
cost of goods sold in the income statement, as well as providing information for
tax purposes, determining the contract price, insurance claims and so on.
Product costing is developed not only for manufacturing firms but also for all
types of organisations, whether they are profit-orientated or not, providing
services or products. The roles and applications of product costing for
merchandising firms are similar to those in manufacturing firms, where product
costs can be inventoried and subsequently converted into cost of goods sold once
the products are sold. On the other hand, in service firms, service costs cannot be
inventoried due to the nature of services which cannot be stored and sold later
on, unlike products or goods. Nevertheless, service firms such as banks, post
offices, hospitals and city halls still require information on the costs of providing
certain services for planning, cost controlling and decision-making purposes.
ACTIVITY 6.1
Provide two examples of organisations which are not profit-orientated,
i.e. one example from service firms and another example from
merchandising or manufacturing firms; and then discuss the
application of product or service cost in your examples. Discuss this
with your friends in myVLE.

TOPIC 6 JOB ORDER COSTING  141
6.2 PRODUCT COSTING

Product costing involves measuring, recording and reporting of product costs.
Based on costs information gathered, both total cost and per unit cost for each
product can be determined. The accuracy of cost information is critical to the
companyÊs success, as it could result in a significant impact on the reported net
profit. This information will also be used in making important decisions,
specifically for determining which products to produce, how many to produce
and what price to fix for the products.
Product costing comprises several accounts which are required for recording
different types of manufacturing costs, i.e. direct raw materials, direct labour and
manufacturing overhead costs. The flow of the costs through manufacturing
accounts can be summarised in Figure 6.1. All these accounts are integrated in
the companyÊs general ledger. One of the key features of the product costing
system is the continuous application of inventory system (perpetual system),
where it allows cost information to be updated immediately.
Generally, there are two types of product costing systems which are widely used
in manufacturing operations, namely job order costing and process costing.
Determining the suitable product costing system depends on the industry type
and its production processes; there is also potential for the manufacturer to use
both methods.

Figure 6.1: The flow of costs through manufacturing accounts

6.3 JOB ORDER COSTING
The job order costing system provides separate records of cost information for
each product quantity (known as job) that proceeds through the production
process.
For this system, direct materials and labour as well as manufacturing overhead
must be allocated to each job or product. Control accounts for continuous
inventory and subsidiary ledgers must be prepared for recording raw materials,
work in process, and finished goods inventory. Every inventory account must be
debited for any increase and credited for any reduction so that the balance in
each account represents the balance in hand.
Job order costing is suitable for production involving different products being
produced in the same period and for products specially produced to the
customerÊs specifications.
Example 6.1
For instance, a printing company will print wedding invitation cards or name
cards with different designs, according to the order and specifications made by
their customers. Suppose a wedding card printing order is made for 500 cards
in standard size but using scented paper. This order of 500 pieces of cards is
called a job.
According to the job costing system, costs will be identified, accumulated and
assigned to the jobs. Then, the accumulated cost for a particular job will be
divided by the number of units contained in the job to arrive at the average per
unit cost.

Example 6.2
Similarly, in the case of a tailor shop, a tailor will produce different types of
clothes and uniforms in a given time. Other examples where the job order
costing system would be appropriate to employ include construction projects
such as building residential areas, shop lots and office buildings, catering
services provided by MAS Catering which supplies food to various
international airlines, and furniture productions which use teak wood and the
like.
Job order costing can also be applied to service firms. Architecture firms,
accounting firms, law firms, hospitals as well as advertising firms can apply job
order costing to determine the cost of each job done for recording and billing
purposes. Each completed job is different in terms of characteristics and hence
its costs. The use of job order costing will allow service firms to collect all costs
related to a particular job or service as in the case of manufacturing firms,
which apply similar basic concepts and procedures.
In terms of recording and cost allocation, the above tasks will become even more
challenging and difficult when a company sells many different types of products,
as opposed to producing a single product or service. Different product
specifications lead to different costs. As a result, separate cost records are
required for every product or job. An architect will keep separate records of his
or her consulting services and costs of producing house plans for each customer.
This means, job order costing requires a lot of effort and time in terms of keeping
records in comparison with the process costing system.
ACTIVITY 6.2
Apart from the above examples 6.2, provide another example and
describe briefly how the job order costing can be applied to it.
6.4 APPLICATION OF DOCUMENTS IN THE

JOB ORDER COSTING SYSTEM
Before further discussion, let us recall what manufacturing costs are. In the
previous topics, manufacturing costs were classified into three main categories,
namely, direct materials, direct labour and manufacturing overhead. In the
coming discussions on job order costing, you will observe how each of the above
categories is recorded and accumulated.

In job order costing, the costs of direct materials, direct labour and
manufacturing overhead will be allocated to each job produced. These costs are
the inputs for the product costing system. As soon as a cost is incurred, it will be
added to the Work in Process Inventory Account in the ledger. To trace the
manufacturing costs allocated to each job, subsidiary ledgers have to be updated.
A subsidiary ledger account that is assigned to each job is a document known as
job-cost sheet.
6.4.1 Job-Cost Sheet

As soon as a production order is issued, the accounting department will prepare
a job-cost sheet. The job-cost sheet is prepared separately for each job; an
example of a job-cost sheet is illustrated in Figure 6.2.
Figure 6.2: An example of a Job-cost sheet

There are three parts in a job-cost sheet. The first part is used to gather the costs
of direct materials, direct labour and manufacturing overhead which are
allocated to a job. The remaining two parts are used to record the total cost and
the average cost per unit, as well as to track the number of units delivered to
customers. Besides being a channel for charging the above costs to each job, the
job-cost sheet also serves as a subsidiary ledger containing detailed descriptions
of the work in process which increases the balance in the Work in Process
Inventory Account.
6.4.2 Materials Requisition Form

When raw materials are needed in production, they are transferred from the
warehouse or storeroom to the production department. To allow for the issuance
of the raw materials, the supervisor of the production department must prepare a
Materials Requisition form, which contains the signature of the authorised officer
to be presented to the store supervisor. Figure 6.3 provides an example of the
materials requisition form.
Figure 6.3: An example of Materials Requisition Form

This form comprises detailed information, i.e. the type, the price and the quantity
of materials which are required to be issued from the storeroom, and identifies
which jobs to be charged with the requisitioned materials. The form is a source
document, which serves as the starting point in accounting entries as well as a
method to control the flow of raw materials into the production operations. A
copy of this form is sent to the accounting department, where the costs of the
acquired raw materials are transferred from the Raw Materials Account to the
Work in Process Account, as well as to allow the information on raw materials
costs of the product or work in process to be recorded in the job-cost sheet.
In this era of technology, most factories are using computer systems to process
production activities, where every department is connected to an online system.
The online system can expedite the costing process, reduce paper usage and
minimise clerical work errors. By using this system, the materials requisition
form can be prepared by the supervisor of a production department via a
computer terminal, after which the form is forwarded automatically to another
terminal in the warehouse and subsequently to the Accounting Department.
In more complex production operations, where productions are carried out in

stages, a system or method of operational management known as Material-
Requisitions Planning (MRP) would be considered as appropriate. The
computerised system will assist managers in scheduling the production at each
production stage so as to ensure that every material, component or semi-finished
goods required in the later stages of production is readily available.

6.4.3 Time Ticket

Time ticket is also a source document which is used to capture the direct labour
hours used in a particular job. This form or ticket is prepared by an employee to
record the amount of time allocated to finish various production jobs. Referring
to the time ticket example shown in Figure 6.4, the total time used in each job will
be multiplied by the labour wage rate, and the direct labour cost will be recorded
in the Work in Process Account and Job-Cost Sheet by the Accounting
Department. This employee also spent one hour doing cleaning works in the
factory area. The Accounting Department will record the time spent in this job as
indirect labour, where its cost will be reported as part of its manufacturing
overhead.
Figure 6.4: An example of a Time ticket
There are many factories which adopt the time-hour system or computerised
time management system, where employees would enter the start time and stop
time for each job into the system by using a particular bar code. This system is
connected to computers which subsequently will transmit the information on
time records from a database via online to the Accounting Department for
recording purposes.

A summary of the flow of documents in job order costing is illustrated in

Figure 6.5.
Figure 6.5: The flow of documents in job order costing

SELF-CHECK 6.1
What are the important documents for collecting information required

in the job order costing system?
6.5 APPLICATION OF MANUFACTURING

OVERHEAD COST
ACTIVITY 6.3
In your opinion, what are the purposes of costing and what is the
significance of costing to a company?
Among the three manufacturing costs, overhead cost is apparently the most
difficult cost to allocate. This is because overhead cost is an indirect cost, as it
does not have a clear or direct relationship with the specific job or production
units. Therefore, it is difficult to trace or associate the overhead cost to a specific
job or product.
Furthermore, the overhead costs usually include many different types of items,
from the smallest such as the cost of a broom or lubricant oil of a machine, to the
salary of a manager in a production department. This makes it difficult to assign
the different types of overhead costs to a product. We know, however, that
overhead cost has to be engaged in order to implement production, and is
therefore, part of the product cost. Accordingly, it is necessary to assign or
allocate the manufacturing overhead cost to the specific job, so as to provide the
whole picture of the product cost.

Bearing in mind the mentioned problems, one of the techniques which can be
employed to allocate the overhead costs is by using the allocation process.
The process of allocating the overhead cost to a job is known as overhead

costs application.
To implement this process, an appropriate allocation base has to be selected. The

allocation base is a measurement based on activities. For instance, direct labour
hours or machine hours are used as the basis for allocating overhead costs to the
products. This allocation base is then used to calculate predetermined overhead,
as shown in the following formula:

Predetermined Overhead Cost 
Expected Total Activity of Allocation Base
Notice that, the predetermined overhead rate is calculated based on the estimates
and not the actual figures. This is due to the fact that the predetermined rates are
calculated before the period begins. Basically, a company can also calculate the
overhead rates based on actual information. Then, a company waits until the end
of an accounting period to identify and obtain the actual overhead costs as well
as the actual total allocation base, such as direct labour hours that were incurred
during that period. The rate obtained should be accurate but the information may
not be as useful as it was not presented on a timely basis.
In other words, managers will have to wait until the end of the period to obtain
the actual information, despite the fact that the information on product cost is
actually required at the beginning of an accounting period for the purpose of
planning, controlling, and making decisions including setting prices and so on.
The company also needs to calculate the actual rates more frequently as the rates
depend on the periods of completing the jobs, which differ for different jobs. This
will cause fluctuations in the actual overhead rates. Based on the mentioned
reasons, most companies prefer to use predetermined overhead rates than actual
overhead rates.

Next, the predetermined overhead rate is used to allocate the overhead cost to
the specific job. The allocated overhead, which is known as absorbed overhead, is
given by the formula as follows:
Predetermined Total Activity of Allocation Base

Absorbed Overhead  
Overhead Rate Related to the Job
Example 6.3
For example, a company estimates its total manufacturing overhead cost for the
following year to be RM240,000 and expects the total direct labour hour to reach
44,000. The job-cost sheet for Job J002 shows that the direct labour used is
1,500 hours. The predetermined overhead rate and the total overhead cost to be
allocated or absorbed to Job J002 are calculated as follows:
Predetermined Total Overhead Cost RM239,800

   RM5.45 per hour
Overhead Cost Direct Labour Hours 44, 000
Absorbed Overhead  Predetermined Rate  Direct Labour Hours Used by J002

 RM5.45  1,500 hours
 RM8,175
The overhead cost absorbed by Job J002 is RM8,175. This figure will be reported
in the Work in Process Account and Job-Cost Sheet.
6.6 THE FLOW OF ACTIVITIES AND COSTS IN

THE JOB ORDER COSTING SYSTEM
Following our understanding on the use of documents in job order costing, we
will now study a chart on recording and reporting the manufacturing costs of a
job through the job order costing system. As a guide, refer to the summarised
chart of the flow of production and accounting activities under the job order
costing system, as shown in Figure 6.6.

Figure 6.6: Summarised chart of the flow of production and accounting activities under
the job order costing system

To better understand this, we will examine a production process of a company

which specialises in making uniforms over a period of one month. For example,
Professional Attire Sdn Bhd which has two jobs in November:
(a) Job O157 is to manufacture 822 pieces of uniforms for factory workers,
which begun in October with a total manufacturing cost of RM12,000 up to
1 November. This job is expected to be completed at the end of November;
and
(b) Job N158 is an order of 150 pieces of uniforms for security officers, which
started in November. The job is expected to finish in the following month.
The production activities throughout November will be described together with

the journal entries concerning the activities.
6.6.1 Purchasing and Requisition of Materials

On 1 November, the balance in the companyÊs raw materials inventory is
RM5,000. Within the said month, two hundred rolls of plain blue fabric, five rolls
of plain green fabric and sewing kits such as threads, buttons, zips, etc. were
bought on credit terms which cost RM23,000. This transaction of purchasing raw
materials is entered in the journal as follows:
(1) Raw Materials 23,000

Unused raw materials are treated as assets to the company and hence recorded in
the inventory account, and are not treated as an expense account.
(a) Acquisition of Direct and Indirect Materials

Throughout the month, direct materials of RM17,000 and indirect materials
of RM2,500 were acquired from the storeroom for use in production. The
following are the journal entries to reflect the transfer of raw materials to
the production department:
(2) Work in Process 17,000

Manufacturing Overheads 2,500
Direct materials which are used in production must be recorded in the

Work in Process Account. When the direct cost enters the Work in Process
Account, it will also enter the job-cost sheet. This transaction is illustrated

in Figure 6.7, where RM5,000 and RM17,000 of direct materials are recorded
in the job-cost sheet no.N158 and its balance is transferred to the job-cost
sheet no. O157. Materials amounting to RM2,500, which is shown in the
previous journal entries, is recorded in the Manufacturing Overhead
Account since it refers to the indirect materials used in production during
the month.
Figure 6.7: The flow of direct materials cost
Observe Figure 6.7 again; job-cost sheet O157 has a beginning balance of
RM12,000, that is the accumulated manufacturing cost incurred in October
and its balance is brought forward to November. Assuming that there is no
other job brought forward from October besides job O157, the Work in
Process Account will show the same beginning balance. In other words, the
Work in Process account presents the total balance for all the costs
contained in the job-cost sheets for all the jobs in process at a particular
point of time. This is because the Work in Process account serves as a
control account while the job-cost sheet serves as a subsidiary ledger.

(b) Acquisition of Direct Materials Only

So far, the raw materials acquired include both direct materials and indirect
materials. However, in reality, there will be times when only direct
materials are required for acquisition and hence the following journal
entries:
Work in Process xxx

Raw Materials xxx
Figure 6.8 shows the flow of direct labour.
Figure 6.8: The flow of labour cost

6.6.2 Labour Use

The accounting department will use time tickets to compute the labour costs
according to the employeesÊ salary and wage rates. The computed labour costs
are then classified as direct labour or indirect labour. The direct labour cost is
recorded in the Work in Process Account while the indirect labour cost is
recorded in the Manufacturing Overhead Account.
Based on Figure 6.8, the company incurred RM24,024 of total labour cost in
November. It is learnt that RM3,204 of the total cost is indirect labour cost. From
the balance of RM20,820, RM13,500 (that is, 1,125 hours  RM12 per hour) is
direct labour, which is charged to Job O157 while the balance of RM7,320 (that is,
610 hours  RM12 per hour) is for Job N158. The journal entries for recording the
earlier mentioned labour cost are:
(3) Work in Process 20,820

Manufacturing Overhead 3,204
Salary and Wages Payable 24,024
When the earlier mentioned direct labour costs are recorded in the Work in
Process Account, they are also entered to the job-cost sheets for both jobs O157
and N158. The labour costs which are categorised as manufacturing overhead are
indirect labour costs, such as supervising cost, security controls, as well as
maintenance and repair works in the factory areas. These indirect labour costs
are not included in the job-cost sheet since they cannot be assigned to any specific
job.
6.6.3 Using Manufacturing Overhead

If you are able to recall, all costs other than direct materials and direct labour are
included in manufacturing overhead costs. The actual overhead costs are directly
recorded, i.e. they are debited into the Manufacturing Overhead account as soon
as they are incurred. The summary of the flow of the actual overhead cost and
the absorbed overhead cost is illustrated in Figure 6.9.

Figure 6.9: The flow of manufacturing overhead cost
(a) Recording the Actual Overhead Costs

Assuming that the company incurred the following costs in November:
Utilities (Water and Electricity) RM4,500

Lease of Factory Equipment 15,000
General Maintenance Cost 3,000
Total RM22,500

The following are the journal entries for recording the earlier mentioned
costs:
(4) Manufacturing Overhead 22,500

In addition, assume that the company has approved for a depreciation of

factory equipment of RM4,400, a total of RM1,200 of prepaid insurance
expired for the month of November and the accrued tax on factory
equipment is RM1,800. The following entries are required to record the
above:
(5) Manufacturing Overhead 7,400

Accumulated Depreciation 4,400
Prepaid Insurance 1,200
Tax Payable 1,800
Manufacturing overhead account is a control account and is connected to

many subsidiary accounts, such as utility, prepaid as well as various
payable accounts.
ACTIVITY 6.4
If the actual overhead cost incurred is debited directly to the

Manufacturing Overhead Account, how does the overhead get charged
in the Work in Process Account?
(b) Recording the Absorbed Overhead Cost

The overhead cost will be recorded in Work in Process Account by using a
predetermined overhead rate, which is set at the beginning of the year, as
discussed previously. The predetermined rate is calculated by dividing the
total estimated overhead costs for the year by the expected total units or
activities, which is the allocation base (e.g. machine hours, direct labour
hours, etc.).

Example 6.4
For example, suppose that Professional Attire Company is estimating a total
of RM752,000 of manufacturing overhead costs for the current year and is
expecting 40,000 direct labour hours to be employed in the current yearÊs
production. Based on Figures 6.8 and 6.9, the total direct labour hours required
are 1,735 hours, with the breakdown of 1,125 hours and 610 hours for Job O157
and Job N158, respectively. The calculations for the predetermined overhead
rate and the total overhead absorbed by the jobs O157 and N158 are:
Predetermined Total Overhead Cost RM752,000

   RM18.80 per hour
Overhead Cost Direct Labour Hours 40, 000
Absorbed Overhead by O157 = RM18.80  1,125 hours = RM21,250
Absorbed Overhead by N158 = RM18.80  610 hours = RM11,468
Hence, the total absorbed overhead is RM32,618 (that is, 1,735 hours 
RM18.80), and it will be applied or charged to the Work in Process Account.
The journal entries for recording the absorbed overhead cost to Work in
Process are:
(6) Work in process Account 32,618

Manufacturing Overhead Account 32,618
6.6.4 Problems Involving Over and Under-absorbed

Overhead
ACTIVITY 6.5
Why do over and under-absorbed overhead exist?
The actual overhead incurred in a given period and the absorbed overhead
(using predetermined rate) are usually different. The difference may be due to
inaccuracies in the estimates made in the predetermined rate, or inappropriate
activity level or allocation base used.

As a remedial step, a company can revise the applied rates. A Manufacturing

Overhead Account can have a debit or credit balance.
When the amount of the absorbed overhead exceeds the actual overhead
incurred, then the Manufacturing Overhead account will have a credit
balance.
On the contrary, when the actual overhead exceeds the absorbed overhead,
then the Overhead account will have a debit balance, described as under-
absorbed overhead.
If the overhead is overabsorbed, the absorbed manufacturing overhead cost will

be too high, thus the inventory and/or expenses have to be reduced (downward
adjustment).
If the overhead is under-absorbed, the absorbed manufacturing overhead cost

will be too low, and therefore, the inventory and/or expenses have to be
increased (upward adjustment).
If we look at the above example, by referring to Figure 6.9, we can see that the
company has a debit balance in its Manufacturing Overhead Account that is, the
actual overhead amount exceeds the absorbed amount by RM2,986. The balance
in the Overhead account will be brought forward from one month to another.
However, at the end of the financial year or upon entering a new financial year,
any balance in the account will be eliminated by an adjustment entry. One of the
approaches to eliminate or adjust the balance of this account (whether debit or
credit) is by transferring it to the Cost of Goods Sold account. For example, the
mentioned company would like to transfer the balance in its Manufacturing
Overhead Cost account to the Cost of Goods Sold account.
(7) Cost of Goods Sold 2,986

Manufacturing Overhead Account 2,986
With the above entry, the above underabsorbed overhead cost of RM2,986 will be
added back or charged to the Cost of Goods Sold in that period. Another
approach for eliminating the balance in an overhead account is by transferring
the balance to the Work in Process Account, Finished Goods Inventory and Cost
of Goods Sold account by means of the weighted-average of the balances in those
accounts.

6.6.5 Cost of Goods Manufactured

All costs incurred during the manufacturing process are debited to the Work in
Process Account. Detailed information on the costs involved in each job is as per
the job-cost sheet (example in Figure 6.2). Once a specific job is completed, the
finished goods or products will be transferred from the production department
to the finished goods warehouse. This physical transfer of goods must be
accompanied by a transfer of the manufacturing cost of the goods from the Work
in Process Account to the Finished Goods account. All the costs being transferred
in a particular period represents the cost of goods manufactured in that period.
From the illustration of the Professional Attire Company, we can see that
RM17,000 of direct materials, RM20,820 of direct labour and RM32,618 of
manufacturing overhead have been absorbed into the Work in Process Account.
In this example, Job O157 began in October and was completed in November.
The balance in the accumulated manufacturing cost of Job O157 of RM12,000 is a

cost which has been brought forward from October. On the other hand, Job N158
begins in November and is expected to finish in December. Therefore, its
accumulated manufacturing cost of RM23,788 for the unfinished job will remain
in the Work in Process Account and the balance will be carried forward to the
next month. This amount will be reported in the Balance Sheet on 30 September,
if it is prepared, as a Work in Process Inventory item.
Computing Per Unit Cost

The final step in the job-cost sheet is to calculate per unit cost. The total cost for
direct materials and labour, together with manufacturing overhead costs will be
entered in the Cost Summary column in the job-cost sheet, and consequently, the
calculation of the per unit cost can be made by dividing the total cost by the
completed units. Per unit cost cannot be obtained if the job is not completed.
Based on the Example 6.4, for the completed Job O157, all the direct materials
costs, direct labour costs and manufacturing overhead costs will be added up and
then distributed to 822 pieces to derive the per unit cost, that is RM71.35
(RM58,650/822). Bear in mind that the per unit cost derived is an average cost
and does not necessarily imply that the same cost will be incurred if another unit
is produced. In reality, most of the total overhead costs will remain the same
although another unit is produced. Therefore, the incremental cost for producing
another unit of product is less than the average cost per unit of the same product.

The completed job-cost sheet will be transferred to the Finished Goods account,
and subsequently taken out from the cost ledger and kept for future references.
For the example discussed in the previous paragraph, the transfer of the costs to
the Finished Goods account is done by the following entries:
(8) Cost of Goods Sold 58,650

Work in Process Account 58,650
The amount RM58,650 is a cost for the completed Job O157, as shown in the job-
cost sheet in Figure 6.10.
Figure 6.10: The flow of manufacturing costs for Professional Attire Sdn Bhd

6.6.6 Cost of Goods Sold

When finished goods are delivered or sent to the customer, the per unit cost,
which is recorded in the job-cost sheet is used as a basis for transferring the cost
of the goods sold from the Finished Goods account to the Cost of Goods Sold
account. If the job is a special order job, then the cost of the job can be transferred
more easily as all the costs can be transferred to the Cost of Goods Sold account.
By referring to the Figure 6.10, assume that only 400 pieces of uniforms (Job
O157) are delivered to the customers by the end of November with total sales
income of RM40,000.
(9) Accounts Receivable 40,000

Sales 40,000
Hence, only the cost of 400 pieces, that is RM28,540 (i.e. RM71.35  400 pieces)
will be transferred to the Cost of Goods account with the following entries:
(10) Cost of Goods Sold Account 28,540

Finished Goods Account 28,540
With the previous entries (10), the flow of manufacturing cost through the job-
order costing system is now completed. The summary of the cost flow based on
the above illustration is provided by Figure 6.10.
6.6.7 Reporting of Financial Statements

At the end of an accounting period, when financial statements of a company are
prepared, the Cost of Goods Sold account is reported in the income statement,
where it is deducted from sales earnings to obtain gross profit. Refer to
Figure 6.10, where the extract of the Balance Sheet and Income Statement are
shown (assuming that the company prepared its financial statements at the end
of November).

The costs of the unfinished job (Job N158 ă with a total accumulated cost of
RM23,788) will remain in the Work in Process Account. The balance in this
account is reported in the balance sheet as a Work in Process Inventory item. The
raw materials inventory, which has not been issued to production, will also be
reported as inventory in the balance sheet. The finished goods inventory (Job
O157 ă with a total cost of RM30,110), which is not sold or delivered to
customers, will also be reported in the balance sheet. In short, a manufacturing
company will have three types of inventory to be reported in its balance sheet.
6.7 JOB ORDER COSTING FOR SERVICE

PROVIDERS FIRMS
As we are aware, job order costing is not only limited to manufacturing firms.
Service firms such as architecture firms will regard each project received form its
customers as a job. The costs and the fees for the services provided will be
accumulated until the specific job or project is completed. The documents used
will serve as direct materials, the time spent by the architect to draw plans as
well as to give consultation services will be regarded as direct labour costs, the
clerical works as indirect labour, while the costs of depreciation of equipment,
rents and so on are included in the overhead costs.
For a dental clinic, each patient who turns up for a dental treatment is considered
a job. For denture treatment, the direct materials cost is the cost of making the
denture while the direct labour costs include the costs of time and expertise of
the dentist in designing the denture as well as the related treatment provided to
the patient and finally, the overhead cost for denture treatment includes the costs
of rental, depreciation of equipment utility, medication, etc. Basically, job order
costing can be applied in any company offering any type of product or service.
Figure 6.11 illustrates the flow of costs for service provider firms.

166  TO
OPIC 6 JOB ORDER
O COSTING
G
Figure 6.11: The

T flow of cossts for service provider
p firms
 Product coosting is cruciial in determiining the costt of a product or service. Job

J
order costiing is a produ
uct costing method
m or systtem which is widely used d in
organisatio
ons which offfer various ty ypes of produ ucts or servicces, such as laaw
firms, hosppitals, accoun
nting firms, furniture
f mannufacturers, clothing
c makeers
and printin
ng companiess.
 In job ordeer costing, maaterials and direct labour costs

c are alloccated to each job
j
by using the materialls requisition n form and time ticket. Manufacturiing
overhead costs
c are allo
ocated to jobss by using prredetermined d overhead raate,
which is a rate set at thee beginning of
o a specific peeriod by way y of dividing the
t
estimated total overheead cost durring the perriod by the expected to otal
allocation base. Examp ples of allocaation bases include
i direcct labour hou ur,
machine hour, or the co ombination off both, and so on.
 Moreover, there mightt be an over or underabssorbed overh head, whenevver

there is a difference
d bettween the actuual overhead and the abso
orbed overheaad.
The balancce in Manufa acturing Oveerhead accounnt which shoows an over or
underabsorbed overhead will be adjusted (increase or reduce the cost) by

transferring the balance to Cost of Goods Sold account only, or by dividing
the cost according to its weighted-average to three accounts, namely the
Work in Process account, the Finished Goods account and the Cost of Goods
Sold account.
 In the job order costing system, materials costs, direct labour costs and
manufacturing overhead costs incurred in completing a job are accumulated
in the Work in Process account that serves as a control account. These costs
are also recorded in the job-cost sheets which serve as a subsidiary ledger.
The cost of completed jobs will be transferred from the Work in Process
account to the Finished Good account. This transferred amount is the cost of
goods manufactured over that particular period.
 As soon as the goods or products are sold to customers, the cost of the
products will be transferred from the Finished Goods account to the Cost of
Goods Sold account. The cost of goods sold is calculated by using the per unit
cost which is obtained from the respective job-cost sheet.
 At the end of the financial period, the cost of unfinished jobs will remain in
the Work in Process account, which is reported in the balance sheet of the
company together with the Raw Materials Inventory account and Finished
Goods Inventory account. Conversely, the cost of completed jobs will be
reported in the Income Statement as cost of goods sold, which is then
deducted from sales earnings to arrive at the gross profit.
1. What are the functions of the job-cost sheet in job order costing?
2. Explain how a sales order, production order, materials requisition form and
labour-time ticket are involved in the production and product costing
process.
3. What is meant by the predetermined overhead rate and how is it

computed?
4. What is the account to be credited when an overhead is absorbed into Work

in Process? Do you expect the absorbed amount to be the same as the actual
overhead incurred? Why or why not?

1. What do you understand by the term underabsorbed overhead and

overabsorbed overhead? How do you eliminate or adjust these amounts at
the end of an accounting period?
2. What will happen to the overhead rate, which is based on direct labour
hour, if the direct labour force is replaced by an automated equipment
system?
3. Why do some companies employ many types of overhead rates instead of

just using a single rate?
4. Indah Architecture uses job order costing to trace the costs for each project
of developing bungalow houses received. The company offers house plan
drawing and consultation services to its customers. The following table
presents information on three projects of sketching plans for bungalow
houses, which are in still in the process for the month of October.
Project
Siti Tan Samy
Plan Sketcher ă Hours 84 70 63
Direct Materials Costs RM3,200 RM2,600 RM1,100
Direct Labour Costs RM6,700 RM5,500 RM5,000
The actual overhead cost is RM21,000 for October. The overhead costs are
allocated to the projects based on the plan-sketching hours since most of the
overheads are related to the costs of the equipment and office for sketching
the plans. The predetermined overhead rate is RM120 for every sketching
hour. Two projects, namely, Siti and Tan have been completed in October,
while SamyÊs project is still unfinished by the end of October.
(a) Calculate the amount of overhead cost which is supposed to be

charged to each project for the month of October.
(b) Prepare the journal entries to record the process of finishing SitiÊs and
TanÊs projects as well as to allow for the transfer of the Cost to the
Finished Project account (or Finished Goods).

TOPIC 6 JOB ORDER
R COSTING  169
(c) What is th
he balance in the Work in Process Acco
ount at the en
nd of the
month?
(d) What is thhe balance in the

t Overhead d account at the
t end of thee month?
Clarify thee meaning of the balance.
5. Serri Impiana Sdn Bhd employse job order costting and ap pplies a
preedetermined overhead rate to its jobs based
b on direect labour houurs. Last
yeaar, the manuffacturing oveerhead and diirect labour hours
h were esstimated
to be RM85,000 0 and 17,000 hours, respeectively. In March,
M Job B525
B was
commpleted. The materials cosst for the job is RM5,200 and
a the labou
ur cost is
RMM2,202 based on a rate of RM6 per hou ur. At the endd of the year,, records
shoow that the company
c actu
ually utilised 14,400 direcct labour hou urs while
thee actual manu
ufacturing oveerhead incurrred is RM68,2200.
(a) Determinee the cost peer unit, which

h will be rep
ported in the job-cost
sheet, for Job
J B525 that produces 1200 units.
(b) Determinee the amountt of over or under

u bed overhead for that
absorb
year.
Absorbeed overhead Overrhead costs ap

pplication
Job ordeer costing sysstem Pred
determined ov
verhead cost
Job-costt sheet Prod
duct costing
Materiaal requisitionss planning (M
MRP) Timee ticket
Materiaals requisition
n form Und
derabsorbed overhead
o

Topic  Process Costing
7 System
LEARNING OUTCOMES
1. Distinguish process costing and job order costing;
2. Describe the concept of equivalent units in process costing;
3. Prepare a Production Report by using the weighted-average
method and first-in, first-out (FIFO) method;
4. Examine the impact of inconsistent adding of manufacturing inputs
and the existence of various production departments; and
5. Prepare the journal entries for accounting the manufacturing costs.
 INTRODUCTION
This topic discusses the process costing system, which is a costing system
commonly used in industries that produce identical products which pass
through a series of sequential processes. Important concepts, such as the physical
unit concept and equivalent units concept will be deliberated before discussing in
detail the Weighted-Average and First-In, First-Out methods. The remainder of
this topic will discuss transferred-in cost.

TOPIC 7 PROCESS COSTING SYSTEM  171
7.1 PREFACE
In Topic 6, we discussed job order costing in depth. Apart from the job order
costing system, there is also another system which can be employed in
determining the cost of a product. This costing system which we are referring to
is called the process costing system, which is best-suited for production processes
that are sequential in nature and produce homogeneous products. Usually, when
a particular product requires several sequential processes in its production,
process costing will be used to account for all its costs and to calculate the per
unit cost.
7.2 THE ENVIRONMENT OF PROCESS COSTING

Earlier discussions touched on the suitability of the process costing system
application. It is important to know that process costing is best suited for
products that use their resources uniformly, i.e. the resources used for each unit
produced is the same. On the other hand, if the resources used are different, then
it is more suitable to employ job order costing.
Moreover, the products in process costing are produced in large quantity (bulk)
which normally takes place in the chemical, food, petroleum, pharmaceutical
industries and the like. For service firms, process costing will be suitable for firms
with large service dimensions or chains, such as banks, postal services, electricity
suppliers, water companies and so on.

172  TOPIC 7 PROCESS COSTING SYSTEM
7.2.1 Production Process

Essentially, a production process can be broken down into two types, i.e.
sequential processing and parallel processing, as shown in Figure 7.1.
Figure 7.1: Two types of production process
(a) Sequential Processing
Sequential processing refers to a series of processes where a specific

product must be completed in the previous process before it can be
transferred to the subsequent processes and eventually become finished
goods.
Example 7.1
An example of sequential processing applies in the following scenario:
Take the example of the procedure of frying chickens, where before the
chicken is fried, it has to be properly washed and sufficiently added with
salt before the frying process can begin. These processes are known as
sequential processes since they have to be in a sequence. We cannot fry
the chicken before it is washed and salted.

(b) Parallel Processing
Parallel processing means that there are more than one processes that
are running simultaneously and ultimately will be combined as one
final process which produces the finished goods.
From a different angle, parallel processing can be viewed as sequential

processing.
Example 7.2
For example, process 1, 2 and 3 are in the same cluster (cluster A), while
process 4, 5 and 6 are in another cluster (cluster B). The process in clusters
A and B are running concurrently.
Nevertheless, for instance, process 2 cannot begin until process 1 is

completed. In this situation, we can see that sequential processing exists
in parallel processing. Whatever form the production process takes, it is
crucial to recognise the key requirements for using process costing, i.e.
the use of resources must be the same for every unit produced and the
products produced must be identical.
A straightforward example for parallel processing is the preparation of a

curry chicken dish for a wedding feast. For this scenario, letÊs take two
which run simultaneously, i.e. preparing the ingredients and frying the
chicken. These two processes run concurrently (parallel), but in the end,
they will be combined as one final process, i.e. cooking everything in one
big pot.

7.3 DIFFERENCES BETWEEN PROCESS COSTING

AND JOB ORDER COSTING
ACTIVITY 7.1
You have so far learnt about process costing and job order costing. Try
to think for a moment; what are the key features which distinguish the
two costing methods?
This subtopic discusses the differences between process costing and job order
costing in a more structured manner. Table 7.1 illustrates four key features of
process costing and its differences from job order costing.
Table 7.1: Four Key Features of Process Costing and Its Differences from Job Order Costing
Process Costing Job Order Costing

1. Produces homogeneous and uniform Job order costing includes various types
products. and forms of products.
2. Products are produced in large quantities For job order costing, products are
for process costing. produced in small quantities, based on
customersÊ orders.
3. Products produced must go through The products of job order costing need not
several processing levels before they are go through different levels of processing
converted into finished products. Thus, the and the cost of job order product is
costs of finished products are calculated calculated upon the completion of the
based on the cost at the final processing. product.
4. Reporting of costs involved is done by Reporting of job order costing is done by
means of Production Reports. using the Job-Cost Sheet.
Usually, each process is performed by a
particular department. Thus, the cost is
accounted for according to that particular
department, based on the process
performed.
Relatively speaking, process costing
requires fewer resources than that of
job order costing. This is because, to
implement process costing, we do not
need to record all costs involved in each
product as in job order costing. Instead, it
is sufficient to record costs according to
the production department.

7.4 THE FLOW OF MANUFACTURING COSTS

IN PROCESS COSTING
The manufacturing cost flow of process costing demonstrates in Figure 7.2.
Figure 7.2: The flow of manufacturing costs in process costing
From Figure 7.2, we can see that manufacturing inputs which consist of direct
raw materials, direct labour and manufacturing overhead are used in each of the
sequential production processes. Nonetheless, in each process, the inputs can
enter the production at different levels. For example, in Process B, raw materials
cannot be included at the end of the process just before transferring the process
to Process C. If this happens, as long as the product is not completed in Process
B, the raw materials will not be added, which consequently will affect the result
in the calculation of the cost per unit. This issue will be discussed further in this
topic.

7.5 WORK IN PROCESS ACCOUNT FOR EACH

PROCESS
At the beginning of this topic it has been mentioned that process costing requires
several sequential processes. To demonstrate this more clearly, particularly in the
context of collecting and computing the costs, we will use the following
illustration:
Work in Work in Process Work in Process Finished Goods

Process A B C
xx xx xx xx xx xx xx xx
xx xx
The illustration demonstrates how a cost flow for a product requires three levels
of processing, i.e. process A, process B and process C.
(a) The product has to pass process A, where the total cost incurred in process
A consists of direct raw materials, direct labour and manufacturing costs.
These costs will be entered in an account called Work in Process A. At the
end of this process, the accumulated cost will be carried forward to the
Work in Process B account;
(b) In process B, the total costs from process A will be added to the total costs
of the direct raw materials, direct labour and manufacturing overhead used
in process B. At the end of the process, the same thing will be done, that is,
the total costs, which consist of the transferred cost from process A and the
costs incurred in process B, will be transferred to process C; and
(c) Finally, after all the costs are transferred to process C, they will be
combined with the costs incurred in process C to form the overall cost of
the final product.

7.6 JOURNAL ENTRIES TO RECORD THE COST

FLOW IN PROCESS COSTING
The following are journal entries required for transactions or activities which are
linked to process costing:
(a) Recording Transactions of Purchases of Direct Raw Materials

Dt Ct
Raw Materials Inventory xxx
Cash/Accounts Payable xxx
(b) Recording Production Costs Incurred in Process A
Dt Ct
Work in Process A Inventory xxx
Direct Raw Materials xxx
Salaries Payable xxx
Manufacturing Overhead xxx
(c) Recording Cost Transferred from Process A to Process B
Dt Ct
Work in Process B Inventory xxx
Work in Process A Inventory xxx
(d) Recording Production Costs Incurred in Process B
Dt Ct
(e) Recording Cost Transferred from Process B to Process C
Dt Ct
Work in Process C Inventory xxx

(f) Recording Production Costs Incurred in Process C

Dt Ct
(g) Recording Cost Transferred from Process C to Finished Goods
Dt Ct
Finished Goods Inventory xxx
(h) Recording Sales Revenues and Cost of Goods Sold
Dt Ct
Cash/Receivable Accounts xxx
Sales xxx
Cost of Goods Sold xxx

Finished Goods Inventory xxx
7.7 THE CONCEPT OF EQUIVALENT UNITS
ACTIVITY 7.2
What do you understand by the term equivalent units? In your own

opinion, how is this concept important in determining costs in process
costing?
After understanding the environment of process costing, the following subtopic

will discuss process costing in detail. To discuss this thoroughly, let us begin
with the concept of equivalent units.

Example 7.3
Consider the following scenario:
During your enrolment at OUM, you have taken several courses in each
semester. Suppose that one day you are given an assignment consisting of
five questions by a lecturer.
However, you managed to fully complete three questions only due to

insufficient time and the fact that you are a part time student. As for the other
two questions, you only managed to finish half of each question. In this case,
the equivalent units in the process of completing the assignment is equal to
four questions, which comprise three fully completed questions and two half-
completed questions. It is hoped that this illustration provides you with the
first idea of the concept of equivalent units which is vital in understanding
process costing.
Determining costs in process costing is performed at the end of the period. In an

actual production situation, not all processed goods will be fully completed.
Therefore, it is necessary to compute equivalent units so that the product cost per
unit, either fully completed or partially completed, can be derived accurately.
In process costing, the equivalent units are the portions of completed units
produced with respect to the allocated resources. The calculation for equivalent
units is simple: the percentage of completion is used to obtain the equivalent
units.
Equivalent units are the portion of completed units produced using the
allocated resources in a given period.

Example 7.4
Suppose there are 3,000 units of products processed by a particular production
department. Out of the 3,000 units, only 2,000 units were completed while
the remaining 1,000 units were categorised as partially completed with a
completion percentage of 25%. Hence, the equivalent units are 2,250 units
[i.e. 2000 + (25%  1000 units)].
This implies that the resources allocated for producing 3,000 units, which
consists of 2,000 fully completed units and 1,000 units of products with a
completion percentage of 25%, can only produce 2,250 fully completed units
if these resources were focused on producing finished products only. The
physical units in the above example are 3,000 units, i.e. the number of units
physically visible, without taking into account if the units are finished or not.
Assuming that the resources allocated by the department amounts to

RM27,000, it is not reasonable to say that the production cost per product unit
is RM9.00 (i.e. RM27,000/3,000 units). This is because the products are made up
of two components, namely, fully completed and partially completed products.
Thus, it is more appropriate to divide the cost of RM27,000 by the 2,250
equivalent units, which results in RM12.00 per unit. From here, the cost of
goods manufactured and transferred to the Finished Goods Inventory is
RM24,000 (i.e. RM12  2,000 units). Whereas the remaining RM3,000 (i.e.
RM12  250 units) will be accounted for as work in Process.
The Ended Work in Process of the current period will become the Beginning
Work in Process in the following period when we want to finish the partially
completed products. We can now conclude that the calculation of equivalent
units is vital in process costing.

7.8 TECHNIQUES OF TREATING BEGINNING

WORK IN PROCESS INVENTORY
In computing the product cost per unit for the beginning inventory of work in
Process that is linked to the current period, two techniques are available for use,
i.e. the weighted-average method and the first-in, first-out (FIFO) method, as
shown in Figure 7.3.
Figure 7.3: Techniques of handling/treating beginning work in Process Inventory
We will discuss both methods more clearly by demonstrating some examples.
7.8.1 Weighted-Average Method

Weighted-average is the first and easier technique to employ.
The weighted-average method accumulates all costs incurred in the previous

and current periods to derive the product cost per unit for the units
transferred out from the production department. At the end of the current
period, the remaining units in the department will be regarded as the ended
inventory. The costs are accumulated once and hence, only one per unit cost
will be computed.

The following example will be used to illustrate the application of the weighted-
average method:
Example 7.5
Muizuddin Berhad is a company producing a type of a product called Comele.
The production of the product has to go through two departments, namely,
the Mixing Department and the Bottling Department. The following is the
information obtained from the Mixing Department for October 2004:
Production: (in Units)

In process units, 1 October, 2004, 75% complete 40,000
Starting units 80,000
Completed and transferred out units 100,000
In process units, 31 October, 2004, 25% complete 20,000
Cost: (in RM)

Work in Process, 1 October, 2004 Raw Materials: 5,000
Conversion Cost: 2,000
The costs added throughout October 2004 Raw Materials: 17,050
Conversion Cost: 3,250
We are assuming that the direct labour and overhead costs (conversion cost)
will be transferred in uniformly throughout the production process. As
mentioned earlier, there will be a time in a different situation where raw
materials are transferred in either at the beginning or end of the process. When
this happens, the calculation of the equivalent units will differ according to
when the materials are transferred into the production process.

For instance, if the raw materials are transferred in the beginning of the period,
the equivalent units for raw materials in the ended work in Process inventory
will still be 100% although the products are not completed. This is because, in
terms of raw materials, they are 100% completed or ready, and only waiting for
the overhead cost to be included. On the contrary, if the raw materials are
transferred in at the end of the process, then the equivalent units for raw
materials in the ended work in Process inventory will be zero since as long as
the products are not ready, the raw materials will not be included.
Based on the above example, the beginning work in Process cost consists of two
components. The first is RM7,000 (i.e. raw materials of RM5,000 and conversion
cost of RM2,000) which was incurred in September 2004 and transferred to
October 2004 by the closing inventory of September.
The second component is a cost of RM20,300 (i.e. raw materials of RM17,050 and
conversion cost of RM3,250) which was incurred in the current period (October
2004). By using the weighted-average method, the two components will be
combined to amount to RM27,300. This combined amount is then divided by the
equivalent units to obtain the cost per equivalent unit. Therefore, we need to
compute the value of the equivalent units. The calculation for the equivalent
units based on example 7.5 is as follows:
Equivalent Units
Units Started and Completed 60,000 (100,000 ă 40,000)
Closing Inventory, 25% Complete 5,000
Total 105,000 units
Therefore, the cost per equivalent unit is RM0.26 (i.e. RM27,3000/105,000 units).
The cost of RM27,300 will be allocated to the finished and transferred out units
amounting to RM26,000 (i.e. RM0.26  100,000 units) while the remaining
RM1,300 (i.e. RM0.26  5,000) will be allocated to the closing inventory. More
detailed information can be obtained once we prepare the production report.

Based on example 7.5, we will prepare the Production Report for the month of
October 2013:
Muizzuddin Berhad
Production Report ă Weighted-Average Method
Mixing Department
for the month of October 2013
Physical Flow
Quantity Table
(units)
Units to be Accounted:
Units in Beginning Work in Process 40,000
Units Started 80,000
Units to be Accounted for 120,000
Equivalent Units
Direct RM Conversion
Units Accounted for:
Cost Cost
Units Completed 100,000 100,000 100,000
Units in Ended Work in Process 20,000 5,000 5,000
Units Accounted for 120,000 105,000 105,000
Cost Table
Total Cost Direct RM Conversion
Costs to be Accounted for:
(RM) Cost (RM) Cost (RM)
Costs in Beginning Work in Process 7,000 5,000 2,000
Current Cost Incurred 20,300 17,050 3,250
Total Cost to be Accounted for 27,300 22,050 5,250
Per Equivalent Unit Cost RM0.26 RM0.21 RM0.05
Transferred Out Ended WIP Total
Costs Accounted for:
Cost Cost Cost
Units Completed and Transferred 26,000 26,000
(100,000  RM0.26)
Ended WIP: 1,050 1,050
Raw Materials (5,000  RM0.21) 1,050 1,050
Conversion Cost (5,000  RM0.05) 250 250
Accounted For Total 26,000 1,300 27,300

7.8.2 First-In, First-Out (FIFO) Method
The FIFO method separates the costs incurred in the previous period from the
additional cost from the current period. This method also separates the
opening inventory units from the processed units in the current period. The
method assumes that the opening inventory units will be processed and
transferred out first before starting with the units from the current period.
According to this method, the product cost of units transferred out can be
divided into costs incurred in the previous period and costs added into the
current period for the purpose of completing the opening inventory. Products
which begin in the current period and are completed and transferred out by the
end of the period, will only carry the costs incurred in the current period. On the
contrary, if not completed, they are treated as closing inventory of work in
Process with its value equivalent to the manufacturing cost incurred in the
current period.
To sum up, the FIFO method provides a comprehensive calculation of the cost
incurred in the previous duration as well as in the current duration.
Based on the same example, is the case of Muizzuddin Berhad, but this time
assuming that the FIFO method is used, the calculation for the equivalent unit
will be as follows:
Example 7.6
Equivalent Units
Units Started and Completed 60,000 (100,000 ă 40,000)
Closing Inventory, 25% Complete 5,000
Total 75,000 units
The most distinctive difference in the calculation of the equivalent units using
the FIFO method is when computing the equivalent units for the beginning
inventory. According to the FIFO method, the equivalent unit for the opening
inventory is only calculated based on the effort required in October to complete
the opening inventory from September.

In this example, the opening inventory is already 75% complete and only 25% is
not finished. Therefore, to obtain the equivalent units, the opening inventory of
40,000 units will be multiplied by 25%, giving the result of 10,000 equivalent
units. The rationale behind this calculation is that, according to the FIFO
method, the production costs of the current period will be separated from the
costs incurred in the previous period. Thus, the beginning inventory must be
separated from the current periodÊs units. The portion of the beginning
inventory which was not completed (in our example, equals to 75%) can be
regarded as the current periodÊs units since they were completed in the current
period and involved current period costs.
Based on this example, the Production Report will now look as follows:
Muizzuddin Berhad
Production Report ă FIFO Method
Mixing Department
for the month of October 2013
Physical Flow
Quantity Table
(units)
Units to be Accounted for:
Units in Beginning Work in Process 40,000
Units to be Accounted For 120,000
Equivalent Units
Units Accounted for:
Cost Cost
Units Started and Completed 60,000 60,000 60,000
Completed Units from Beginning WIP 40,000 10,000 10,000
Units in Ended Work in Process 20,000 5,000 5,000

Cost Table
Costs in Beginning Work in Process 7,000 5,000 2,000
Total Cost to be Accounted for 27,300 22,050 5,250
Transferred Ended WIP Total

Costs Accounted For:
Out Cost Cost Cost
Units in Beginning WIP from:
Previous period 7,000 7,000
Current period (10,000  RM0.27) 2,700 2,700
Units Started and Completed 16,200 16,200
(60,000  RM0.27)
Ended WIP (5,000  RM0.27) 1,350 1,350
Accounted For Total 25,900 1,350 27,250
Notice that, when calculating the cost per equivalent unit using the FIFO
method, only the cost of the current period is taken into account. For example,
to compute the cost per equivalent unit of raw materials, only RM17,050 is taken
to be divided by 75,000 units. The resulting cost of raw materials per equivalent
unit is RM0.23. This practice is consistent and logical since the calculation of
equivalent units also ignores the opening inventory units. The method only
allows for the extra effort used when completing the opening inventory to be
taken into account (i.e. 0.25 x 40,000 = 10,000 units). Thus, it is also reasonable to
only allow for the cost incurred in the current period to be taken into account.

The second distinctive dissimilarity is when allocating costs to the completed

and uncompleted units. In this case, the transferred out units comprise two
components, i.e. from the opening inventory units that were completed in the
current period and from the units started and completed in the current period.
Based on this example, 100,000 units were transferred out, comprising 40,000
units from the opening inventory units while the remaining 60,000 were units
that were started and finished in the current period. From the 40,000 opening
inventory units, there are two costs components involved. The first component
is the cost carried forward from September which amounts to RM7,000. The
second cost component is the cost that is transferred in October to convert the
opening inventory into finished goods, which amounts to RM 2,700.
Finally, we can see that the total costs accounted for here is RM27,250 although
the costs which are supposed to be accounted for is RM27,300. The RM50
difference is due to the rounding error and it can be solved by standardising
the figures and regarding them as the transferred out costs.
Thus, we can conclude that there are two significant differences between the
weighted average method and the FIFO method:
(a) The first difference is in terms of computing the equivalent units for the
beginning inventory, followed by the calculation of the cost per equivalent
unit; and
(b) The second difference is when allocating costs of the units transferred out
to the balance units left at the end of the period.
According to the FIFO method, a clear cut separation must be done to identify
the source of each unit transferred out. In other words, we need to determine, out
of the whole units transferred out, how many units are from the opening
inventory and how many are from the units which were started and completed
in the current period. This identification is vital as the cost per unit differs for
each category. The difference is reasonable from a macro level perspective as the
production inputs used in the current period are usually more costly than those
of the past period, partly due to inflation.

7.9 TRANSFERRED-IN COST
ACTIVITY 7.3
What will happen to cost calculation if it involves two departments?

Think for a moment, how do you account for the costs received from a
different department into your department?
So far, our discussions focused only on one production department. This

subtopic will explore one particular situation where we receive materials for
processing from a previous department. If this situation happens, the issue of
transferred-in cost will arise. Transferred-in cost is a cost incurred in a previous
department and transferred to our department for the purpose of carrying on the
next process. If this happens, the only implication arising from this situation is
that we need to add another column in the Production Report, which is known as
the transferred-in column.
From one angle, this column can be viewed as the column of the raw materials of
a department which receives final products from the previous department.
Nevertheless, if the receiving department wishes to add more raw materials, then
the raw materials column must be provided to account for the additional raw
materials coming into the department. Furthermore, when calculating the units
to be accounted for, the relationship with the units transferred in from the
previous department must be given due attention. At the same time, when
calculating the equivalent units and per unit cost for the transferred-in category,
some changes that may arise will require your attention.
To explain the transferred-in cost, an illustration involving two departments,

namely the Processing Department and the Canning Department is provided
below. To help you understand, this illustration will employ the weighted
average method (refer to Example 7.7).

Example 7.7
Hafizuddin Berhad produces a paint called Juta. To calculate its production
cost, the company employs the process costing system. The process of
producing Juta involves two main departments, i.e. the Processing Department
and the Canning Department.
Data related to companyÊs operation for both departments for the month of
September 2013:
Processing Department Canning Department

Opening Inventory Units 2,400 units (100% 3,400 units (100%
complete for materials; complete for materials;
40% complete for 70% complete for
conversion cost) conversion cost)
Opening Inventory Costs:
Direct Materials RM5,050 RM9,000
Conversion Cost RM5,520 RM8,980
Previous DepartmentÊs Cost ă RM28,312
Units Started 15,400 ?
Closing Inventory Units 1,400 units (100% 600 units (100%
complete for materials; complete for materials;
80% complete for 50% complete for
conversion cost) conversion cost)
Current Costs:
Conversion Cost RM87,336 RM69,800
Based on Example 7.7, we will prepare a Production Report using the weighted
average method for both departments, i.e. the Processing Department and the
Canning Department. The Production Report of the Processing Department can
be considered as a revision for what we have learnt so far. The cost of the
transferred-in will be included in the Production Report of the Canning
Department, that is, the department which receives the finished products from
the Processing Department. These products will be regarded as raw materials
for the department.

The Production Reports for both the Processing Department and the Canning
Department for the month of September 2013 will be as follows:
Hafizuddin Berhad
Production Report
Processing Departments
for the month of September 2013
Physical Flow
Quantity Table
(units)
Units in Beginning WIP 2,400
Equivalent Units
Units Accounted:
Cost Cost
Units Completed 16,400 16,400 16,400
Units in Ended WIP 1,400 1,400 1,120
Cost Table
Costs to be Accounted:
Costs in Beginning WIP 10,570 5,050 5,520
Total Cost to be Accounted For 133,262 40,406 92,856
Transferred Ended WIP Total
Out Cost Cost Cost
Units Completed and Transferred 124,148 124,148
(16,400  RM7.57)
Ended WIP:
Raw Materials (1,400  RM2.27) 3,178 3,178
Conversion Cost (1,120  RM5.30) 5,936 5,938
Total Accounted for 124,148 9,114 133,262

7.10 JOURNAL ENTRY

This subtopic will discuss how to record the journal entries for the above
transactions which took place in the Processing Department and the Canning
Department.
The journal entries for the Processing Department are given as follows:
Dt Ct
Work in Process Inventory ă Processing Department 122,692
Direct Raw Materials 35,356
Salaries Payable +
87,336
Manufacturing Overhead
(Record the current costs transferred to the Processing
Department)
Work in Process Inventory ă Canning Department 124,148
Work in Process Inventory ă Processing Department 124,148
(Record the transferred-out costs from the Processing
Department to the Canning Department)
Meanwhile, the journal entries for the Canning Department are as follows:
Dt Ct
Direct Raw Materials 40,104
Salaries Payable +
69,800
Manufacturing Overhead
(Record the current costs transferred to the Canning
Department)
Work in Process Inventory ă Finished Goods 273,024
(Record the transferred-out costs from the Canning
Department to the Finished Goods)

TOPIC 7 PR
ROCESS COSTIN
NG SYSTEM  193
 This topic has disscussed in detail the envirronment of prrocess costing

g, how it
differrs from job order
o costing,, costs accounnting using the
t weighted average
methhod and thee FIFO metthod, and subsequently
s y, issues rellated to
transsferred-in costs.
 Furth
hermore, a su ubtopic on joournal entry involving transactions reelated to
proceess costing is also included
d to completee this topic.
1. The data is relatted to processs A in produccing Product X at the end of

o March
20113. All materrials were added in at thee beginning of o the processs, while
lab
bour and man nufacturing overheads
o w
were added uniformly
u thrroughout
thee production process.
p
Beg
ginning Work
k in Process t following costs:
16,000 units involving the
(M
March 1, 2013) Direct Matterials R
RM16,000
Direct Lab
bour R
RM13,200
Manufactu
uring Overhead R
RM9,600
nits Started in March

Un 172,0000 units
Raw
w Materials Cost
C Added in
n March RM
M190,800
Lab
bour Cost Ad
dded in March
h RM
M190,800
Ov
verhead Cost Added
A in Maarch RM
M172,400
Un
nits Completed and Transfeerred Out to Process
P B 180,0000 units
Ended Work in Process, 31 March,
M 2013 8,000 unitsôccomplete


Compute each of the following:
(a) The equivalent units for direct materials and conversion costs.
(b) Per unit cost for direct materials and conversion costs as well as the
cost of finished units transferred out to process B.
(c) The transferred-out cost and the ended work in Process cost.
(d) Prepare the journal entries to record the transactions involved in

process A.
(e) Prepare the Work in Process account for process A.
2. Anggun Fabric Bhd is the largest textile producing and exporting company
in the southern region. The company employs the job order costing system
and applies its manufacturing costs to jobs based on direct labour hours. At
the beginning of the year, estimates have been derived for the purpose of
calculating its predetermined overhead rate. The company estimates its
overall overhead cost to be RM697,000 and direct labour to be 1,700 hours.
The following transactions have occurred during the year (all purchasing
and services were acquired on credit term):
(a) Purchase of raw materials for production purpose of RM400,000.
(b) Issuance of direct raw materials for use in production amounted to

RM407,000.
(c) Utility bills received add up to RM150,000 (80% for factory

operations, and the remaining for administrative and sales activities).
(d) EmployeesÊ salaries and wages incurred:

Direct Labour (1,900 hours) RM483,000
Indirect Labour 189,000
Salaries for Administrative and Selling Staff 231,000
(e) Factory maintenance costs incurred is RM150,000.
(f) Marketing costs incurred is RM270,000.

(g) Depreciation of equipment for the year is RM190,000 (80% is related

to factoryÊs equipment while the remaining is for administration and
marketing).
(h) Building rental cost of RM252,000 (70% for factory, and the balance is
for administration and marketing).
(i) Manufacturing overhead costs are applied to jobs.
(j) Cost of goods manufactured for the year is RM1,550,000.
(i) Total sales for the year is RM2,400,000, on credit basis. These costs of
goods sold amount to RM1,650,000, based on the job-cost sheet.
The balances in the inventory accounts at the beginning of the year are as
follows:
Raw Materials RM66,000
Work in Process 45,000
Finished Goods 125,000
(a) Prepare journal entries to record all the above information.
(b) Transfer the journal entries in (a) into ÊTÊ accounts (do not forget to include
the respective beginning balance, if any). Determine the ended balances in
the inventory accounts and the Manufacturing Overhead account.
(c) Prepare the schedule of cost of goods manufactured.
(d) Prepare journal entries for closing or transferring any balance in the
Manufacturing Overhead account to the Cost of Goods Sold account.
Prepare the schedule of cost of goods sold.
(e) Prepare the income statement for the year.
(f) Suppose that Job K22 is one of the jobs that were started and completed
during the year. This job required RM16,500 of direct materials, and
80 hours of direct labour with a total direct labour cost of RM19,320. The job
quantity is 250 units. If the company set the price at 45% higher than the
cost per unit (as given in the job-cost sheet), what is the price per unit to be
charged to customers?

1. Nadhirah Berhad is a company producing a product that passes through

three processing stages, i.e. through Department X, Department Y and
Department Z. Direct raw materials are added in at the beginning of the
processes in both departments X and Y. Whereas in Department Z, the
direct raw materials are only added in at the end of the process. The
conversion costs are included uniformly in each department.
Department Y Department Z
Opening Inventory:
Physical Units 16,000 unit 14,000 unit
Direct Raw Materials Costs RM22,600 RM30,000
Direct Labour Costs RM21,600 RM22,000
Manufacturing Overhead Costs RM12,000 RM12,512
Transferred-in Costs RM90,640 RM86,500
Production in September:
Transferred-in Units 56,000 unit ?
Completed Units 66,000 unit ?
Direct Raw Materials Costs RM67,400 RM60,000
Direct Labour Costs RM140,000 RM126,400
Manufacturing Overhead Costs RM116,200 RM120,000
Transferred-in Costs RM319,760 ?
Ended Work in Process Units ? 6,000 unit
Completion Percentage:
Beginning Work in Process Units 50% 80%
Ended Work in Process Units 50% 60%

(By using the weighted average method)
(a) Prepare the Production Report for Department Y.
(b) Prepare the Production Report for Department Z.

2. Fadhilah Berhad is a manufacturing company which employs the process

costing system using the weighted-average method to determine its
manufacturing costs. Its manufacturing products must pass through three
processing departments, namely, Cutting, Designing and Finishing. The
following information is regarding the Designing Department for the
month of January 2013. The Work in Process at 1 January 2013 consists of
4,000 units incurring the following costs:
Cost Amount (RM)

Transferred-in 64,000 (100% complete)
The Cost Incurred in the Designing Department:
Direct Raw Materials 40,000 (100% complete)

Direct Labour 14,400 (60% complete)
Absorbed Manufacturing Overhead 11,000 (50% complete)
The activities of the Designing Department throughout January 2013 are as

follows:
20,000 units have been transferred from the Cutting Department with a cost
of RM320,000. A total cost of RM334,560 was incurred as follows:
Direct Raw Materials RM192,000

Direct Labour 106,560
Absorbed Manufacturing Overhead 36,000
RM334,560
On 31 January 2013 a total of 80,000 units are still in the Work in Process
stage. The completion percentages for the jobs are as follows:
Direct Raw Materials 90%

Direct Labour 70%
Absorbed Manufacturing Overhead 35%

198  TO
OPIC 7 PROCE
ESS COSTING SYSTEM
S
You are required

r to:
(a) Callculate the per unit co osts for the transferred-in cost, direct
d manufacturring overhead costs for the
maaterials, direcct labour and t
Designing Depa artment.
(b) Dettermine the transferred-ou

t ut cost and th
he closing inv
ventory cost for
f
thee Designing Department.
D
(c) Preepare journall entries relaated to all transactions occcurring in the

t
deppartment.
E
Equivalent un
nits Production
n process
F
First-in, first-o
out (FIFO) Sequentiall processing
J order costting
Job Transferreed-in column
J
Journal entriees Transferreed-in cost
P
Parallel proceessing Weighted--average
P
Process costin
ng

Topic  Marginal Costing
and Absorption
8 Costing
LEARNING OUTCOMES
1. Explain the differences between marginal costing and absorption
costing in terms of product costing, inventory evaluation and
preparation of income statement;
2. Calculate product cost by using the marginal costing and
absorption costing methods;
3. Prepare income statements by using the marginal and absorption
costing methods;
4. Adjust the difference in net incomes under the marginal and
absorption costing methods; and
5. Evaluate the effects of the differences of the production level and
sales level on the net income under marginal costing and
absorption costing methods.
 INTRODUCTION
This topic will discuss two traditional systems of product costing, namely,
marginal costing and absorption costing. The content of this topic will cover
topics like product cost per unit, calculation of ended inventory, preparation of
income statement and method evaluation. These topics will be elaborated in
detail to ensure that the students can distinguish the two methods discussed. The
ultimate purpose of this topic is for the students to appreciate and benefit from
the learning materials presented to them.

200  TOPIC 8 MARGINAL COSTING AND ABSORPTION COSTING
8.1 PREFACE
ACTIVITY 8.1
Based on your opinion, what are the purposes of costing, and its
significances to a company?
Costing is important to companies for various purposes, particularly for setting

prices. The process of price setting cannot be carried out properly if a good
costing system is not in place. Comprehensive understanding on costing shows
that there are two categories of costing systems, i.e. traditional costing and
modern costing.
(a) The traditional costing system consists of marginal costing and absorption
costing.
(b) The activity-based costing system is categorised as a modern costing

system.
Although the traditional costing system is claimed to have many weaknesses

compared to the modern costing system, it is still important to learn it and obtain
the right understanding on it to be able to suggest new and more effective
costing systems. It is better to have a less accurate costing system than not having
any at all. Thus, this topic will discuss the two traditional costing systems,
namely marginal costing and absorption costing.
8.2 ABSORPTION COSTING

Absorption costing, as mentioned earlier, is a traditional product costing method.
According to this method:
All manufacturing costs is treated as product cost regardless whether they are
variable costs or fixed costs. Because of this, this method is also known as full
costing.

TOPIC 8 MARGINAL COSTING AND ABSORPTION COSTING  201
When using the absorption costing method, a product cost includes direct
materials, direct labour, variable manufacturing overhead and fixed
manufacturing overhead. In short, any cost that is directly involved in a
production is considered a product cost.
8.2.1 Applications of Absorption Costing

Absorption costing is prepared for the purpose of external reporting since the
Generally Accepted Accounting Principles (GAAP) requires product cost, which
is reported as the cost of goods sold in the income statement and the value of
ended inventory which is presented in the balance sheet, to be calculated using
absorption costing. The reason for this is to provide an actual and fair picture of
all the costs incurred in producing the product.
8.3 MARGINAL COSTING

The second traditional method of product costing is called marginal costing.
The marginal costing method is also known as variable costing or direct

costing since it only assigns variable manufacturing overhead costs to
products and consider them part of product costs, leaving all fixed
manufacturing overhead costs as period costs.
In a nutshell, under marginal costing, only variable costs which change

proportionately with the output level are considered as product costs. In other
words, product costs under the marginal costing method are made up of direct
materials, direct labour and variable manufacturing overhead.
Logically speaking, when this method treats fixed manufacturing overhead as

period costs, the total product cost will become smaller compared to that which
uses the absorption costing method. The fixed manufacturing overhead will be
treated in the same manner as the sales and administration costs, and hence will
be included in the current period of income statement, and deducted from the
income of that period.

8.4 APPLICATIONS OF MARGINAL COSTING

Unlike absorption costing, marginal costing is used for the purpose of internal
reporting. Internal users may include managers, supervisors as well as
employees of various levels. The information on costs provided by the marginal
costing method is meant to assist in future planning and decision-making.
Breaking down all costs into variable costs and fixed costs under marginal
costing helps the management to distinguish the variable costs from the fixed
costs. In this way, the management can better control the costs since the variable
costs are controllable. Fixed costs, on the other hand, are irrelevant in decision-
making since they are uncontrollable costs and are unchanged regardless of the
change in production levels.
SELF-CHECK 8.1
Before we go to the next section, what have you understood so far
regarding absorption costing and marginal costing in terms of the costs
involved and the purposes of their reporting?
8.5 DIFFERENCES BETWEEN ABSORPTION

COSTING AND MARGINAL COSTING
The following figures clearly illustrate the differences between the products
under the absorption costing method and the marginal costing method:
(a) Absorption Costing

The product cost under the absorption costing method illustrated in Figure 8.1.
Figure 8.1: Product costing using the absorption costing method

Based on Figure 8.1, absorption costing considers direct materials, direct

labour and all the manufacturing overhead costs (both variable and fixed)
as product costs. Products which are sold will become the Cost of Goods
Sold and will be illustrated in the income statement while unsold products
will be reported as inventory in the balance sheet.
Further analysis shows that not all costs (including fixed manufacturing
overheads) will be regarded as expenses in the period when they are
incurred. Some of these costs will be regarded as assets if the products are
not sold. Further discussion on this aspect will be presented in the
subsequent section on calculation of ended inventory costs.
(b) Marginal Costing

The product cost under the marginal costing method illustrated in Figure 8.2.
Figure 8.2: Product costing using the marginal costing method
By means of marginal product costing, the product cost is divided into

direct materials cost, direct labour cost and variable manufacturing
overhead cost. It is now obvious that fixed manufacturing overhead costs
are not considered as part of the product costs but as period costs instead,
and are then reported as expenses for the period in which they were
incurred together with administrative and selling expenses.

Furthermore, the fixed manufacturing overhead costs will be considered as

the current period expenses whether the products are sold or are still held
as unsold. Since the fixed manufacturing overhead cannot be directly
associated with the products manufactured, therefore there is no element in
the fixed manufacturing overhead which can be qualified as assets at the
end of an accounting period, even though some of the products are unsold.
This is the most striking difference between absorption costing and
marginal costing, i.e. how fixed manufacturing overhead costs are treated.
Table 8.1 summarises the differences between marginal costing and absorption
costing from various aspects.
Table 8.1: The Differences between Marginal and Absorption

Costing from Various Aspects
Differences Between Marginal and Absorption Costing

Aspect Marginal Costing Absorption Costing
Purpose Internal Reporting External Reporting
Income Statement Sales Sales
Format ă Variable Costs ă Cost of Goods Sold
= Contribution Margin = Gross Margin
ă Fixed Costs ă Operating Expenses
= Net Income = Net Income
Product Cost Variable Manufacturing Costs All Manufacturing Costs
Period Cost Sales and administration All Sales and
Expenses and All Fixed Costs (i.e. administration Expenses
manufacturing overheads and
sales and administration costs)
ACTIVITY 8.2
Discuss, what are the differences between absorption costing and

marginal costing in terms of determining the costs of a product?

8.6 CALCULATION OF PRODUCT COST PER

UNIT
This section provides a clearer and more structured illustration on the per unit
product cost that is computed under marginal costing and absorption costing.
Example 8.1
The following data is related to Nadhirah Berhad, which is a company located
in Arau and operates by producing and selling diskettes to be used by personal
computers:
Direct Materials RM22.00 per unit

Direct Labour RM14.00 per unit
Variable Manufacturing Overhead Costs RM6.00 per unit
Fixed Manufacturing Overhead Costs RM117,000 per year
Other data are related to the beginning inventory units, production units,
selling units and ended inventory units for the year 2013 and 2014,
respectively, as follows:
2013 (units) 2014 (units)

Opening Inventory 0 3,000
Production 13,000 10,000
Sales 10,000 11,000
Closing Inventory 3,000 2,000
Information regarding selling prices, variable and fixed costs of sales and
administration activities are given as follows:
Selling Price RM75.00 per unit

Variable Manufacturing Overhead Costs RM7.00 per unit
Fixed Manufacturing Overhead Costs RM8,000 per year

Based on the above information, the calculations of the product cost per unit
under marginal costing and absorption costing are as follows:
(a) Marginal Costing
2013 (RM) 2014 (RM)

Direct Raw Materials 22.00 22.00
Direct Labour 14.00 14.00
Variable Manufacturing Overhead 6.00 6.00
42.00 42.00
Notice that the product cost per unit for the years 2013 and 2014 are the
same although the production levels for both years differ. This is due to
the fact that the fixed manufacturing overhead is not regarded as product
cost.
(b) Absorption Costing
2013 (RM) 2014 (RM)

Variable Manufacturing Overhead 6.00 6.00
Fixed Manufacturing Overhead 9.00 11.70
51.00 53.70
The product costs per unit under absorption costing for the year 2013
differs from that of the year 2014, where the per unit product cost for the
year 2014 is higher than that of the year 2013. The logic behind this is that
fixed costs are considered as part of product cost. Since the fixed
manufacturing overhead is always constant even though the production
levels differ from the year 2013 to 2014, the resulting costs per unit will be
different between the two years.

The fact that the fixed manufacturing overhead cost per unit for the year
2014 is higher than that of 2013 is actually the reason why the per unit
product cost for the year 2014 is higher than the corresponding cost of
2013. This is because the production units for the year 2014 are much
lower, that is 10,000 units, compared to 13,000 units in 2013. As a result,
the fixed manufacturing overhead per unit for year the 2014 becomes
higher than that of 2013. The computation of the fixed manufacturing
overhead per unit is provided as follows:
Fixed Manufacturing
Total Fixed Manufacturing Overhead During the Year

Overhead Per Unit 
Production Units
Table 8.2 shows the computation of the per unit fixed manufacturing overhead
cost for both years, 2013 and 2014.
2013 2014
117, 000 (RM) 117, 000 (RM)
 
13, 000 (units) 10, 000 (units)
 RM9.00 per unit  RM11.70 per unit
We can now conclude that the difference in the per unit product costs for the
year 2013 between the two methods is RM9.00 (that is, RM51.00 ă RM42.00)
while for the year 2014 it is RM11.70 (that is, RM53.70 ă RM42.00). The
difference is due to the treatment of the fixed manufacturing overhead cost of
RM117,000 which is not included in the product cost if we employ the marginal
costing method. Under this method, it will be regarded as a period expense or
cost which will be scrapped during the current period.

8.7 CALCULATION OF INVENTORY COST

Earlier on we discussed how product costs per unit are different under the two
different methods of costing. This difference is due to the fact that fixed
manufacturing overhead is included as product cost under absorption costing
while under marginal costing, it is not regarded as part of product cost. As a
result, the absorption costing product cost will be higher than the marginal
costing product cost.
The next question is whether the net income under absorption costing will be
lower than that of marginal costing since it has a higher product cost? The
answer is, not necessarily so, because net income depends very much on the
closing inventory. If the closing inventory exists, the net income under
absorption costing will be higher. However, if there is no closing inventory, the
resulting net incomes under both methods will be the same.
Based on Example 8.1, the production for the year 2013 was 13,000 units.
However, only 10,000 units were sold and the closing inventory was therefore
3,000 units. The cost of closing inventory can be calculated using the formula as
follows:
Closing Inventory Cost = Closing Inventory Units  Product Cost Per Unit
Therefore, the closing inventory costs at the end of the year 2013 under both
methods are as shown in Table 8.3.
Table 8.3: The Closing Inventory Cost for the Year 2013 Based on Both Methods
2013 Closing Inventory Cost

Marginal Costing Absorption Costing
= 3,000 units  RM42 = 3,000 units x RM51
= RM126,000 = RM153,000
The difference of RM27,000 (RM153,000 ă RM126,000) is due to the fixed

manufacturing overhead cost which is inventoried as product cost under the
absorption costing method. The fixed manufacturing overhead cost inventoried,
is RM9.00 per unit while the closing inventory equals 3,000 units. Thus, the total
of RM27,000 (that is, 3,000  RM9).

On the other hand, under the marginal costing method, the fixed manufacturing
overhead cost of RM117,000 is not inventoried but treated as period cost for the
year. As a result, if the closing inventory exists, the net income under the
absorption costing method will be higher since some portion of the fixed costs
has been inventoried, giving rise to a lower cost of goods sold. In contrast, under
marginal costing method, all overhead costs are treated as expenses incurred
during the year.
Consider this: will the absorption costing method encourage companies to

produce more products than what they actually expect to sell in the context of
obtaining higher net income? If so, what are its overall consequences to the
companies, particularly in terms of efficiency in using resources and companiesÊ
survival level? These questions need to be given due attention by the responsible
accountant particularly in this era of intense global competition. The critical
success factors of a company are determined by the costs, quality and products
or services offered to the customers.
In the year 2014, the closing inventory was 2,000 units, which is the opening
inventory (or ended inventory for the year 2013) of 3,000 units added to current
production level of 10,000 units and deducted from sales units of 11,000 units.
Therefore the closing inventory costs for the year 2014 based on both methods
are as illustrated by Table 8.4 as follows:
Table 8.4: The Closing Inventory Cost for the Year 2014 Based on Both Methods
2014 Closing Inventory Cost

Marginal Costing Absorption Costing
= 2,000 units  RM42 = 2,000 units  RM53.70
= RM84,000 = RM107,400
The difference in the value of the closing inventory is RM23,400 (that is,
RM107,400 ă RM84,000) and is due to the fixed manufacturing overhead
component which is inventoried based on 2,000 units of the ended inventory, at
the cost of RM11.70 per unit.
This subtopic has discussed clearly the reasons for the difference in the values of
the closing inventory under both methods. The next subtopic will discuss the
impact of using each of the costing methods on net income.

8.8 INCOME STATEMENTS UNDER

ABSORPTION COSTING AND MARGINAL
COSTING
ACTIVITY 8.3
You have learnt the different calculations of the product cost per unit
and the ended inventory by using both costing methods. The most
obvious difference in the calculations comes from the issue of whether
or not fixed manufacturing overhead costs are taken into account under
each of these methods. Do you think that the application of these
methods will have an impact on the income statement in terms of the
net income? Discuss this with your friends in myVLE forum.
Before we discuss further on what effects the different methods might have on
the net income, it is better to first discuss the format for preparing income
statement under both methods:
(a) The format under absorption costing is the same as the format used for
external financial reporting, based on the Generally Accepted Accounting
Principles (GAAP) and the requirement of external reporting set by the
national standard formulation body; and
(b) On the other hand, the format for the income statement under marginal
costing provides a clear separation between variable costs and fixed costs.
At the same time, it shows the calculation of marginal contribution, which
is the difference between sales income and variable costs. This format is
different from the format under absorption costing as it is specifically
prepared for use by the internal management only.
The cost of goods sold can also be determined directly by multiplying sales unit
by per unit product cost (for previous example 8.1; 10,000  RM42 = RM420,000).
The income statement under marginal costing categorises the costs according to
their behaviours, i.e. variable costs and fixed costs:
(a) Variable costs consist of variable cost of goods sold as well as variable sales
and administration expenses; and
(b) Fixed costs include fixed manufacturing overhead as well as fixed sales and
administration expenses.

The difference (excess) between sales income and variable costs is called
marginal costing. In the previous Example 8.1, the marginal costing derived is
RM260,000. After deducting fixed costs, the resulting net income is RM135,000.
8.8.1 Income Statements Under Marginal Costing

Based on Example 8.1, the income statements under marginal costing for the year
ended 2013 is illustrated in Table 8.5.
Table 8.5: Example of Income Statement Under Marginal Costing
Nadhirah Berhad
Income Statement under Marginal Costing for the year ended 31 December 2013
RM RM
Sales (10,000 units  RM75)
Variable Costs:
Cost of Goods Sold:
Opening Inventory 0
+ Cost of Goods Manufactured (13,000  RM42) 546,000
Cost of Goods Available for Sale 546,000
ă Closing Inventory (3,000  RM42) (126,000)
420,000
+ Variable Administrative and Selling Costs (10,000  RM7) 70,000
490,000
Contribution Margin 260,000
Fixed Costs:
Sales and administration 8,000 125,000
Net Income 135,000
This format of income statement under marginal costing provides an advantage

to the managers when making decisions. This is because, in the context of
decision making, only variable costs are relevant for consideration. Fixed costs
are irrelevant as they will incur no matter what alternatives are chosen. The
marginal contribution is also relevant in decision-making related to cost-volume-
profit analysis which will be discussed later in a separate section.

8.8.2 Income Statements Under Arbsoption Costing

Based on Example 8.1, the income statements under absorption costing for the
year ended 2013 and 2014 is illustrated in Table 8.6.
Table 8.6: Example of Income Statement Under Absorption Costing
Nadhirah Berhad
Income Statement under Absorption Costing for the year ended 31 December 2013
RM RM
Sales (10,000 units  RM75) 750,000
Cost of Goods Sold:
Opening Inventory 0
ă Closing Inventory (3,000  RM51) (153,000) 510,000
Gross Profit 240,000
Administrative and Selling Expenses:
Fixed 8,000
Variable (10,000  RM7) 70,000 78,000
Net Income 162,000
The cost of goods sold can also be calculated directly by multiplying selling units
by product cost per unit (that is, 10,000  RM51 = RM510,000). The income
statement under absorption costing categorises costs according to their functions
(not according to their behaviours as under marginal costing), i.e. production
costs, sales and administration expenses. The net income under absorption
costing is RM162,000 (compared to RM135,000 under marginal costing).

8.8.3 The Cause of Difference in Net Income Between

Marginal and Absorption Costing
The difference in net income, as previously discussed, is due to the existence of
the closing inventory of 3,000 units worth RM153,000. This implies that these
costs are not treated as expenses for the year 2013, but are instead carried
forward to the following year.
Do not get confused between the closing inventory of RM153,000 and the
difference in net income of RM27,000. Many students tend to get confused with
these two different things. The difference in net income between marginal and
absorption costing are not due to the existence of the closing inventory itself, but
rather to the element of fixed manufacturing overhead which is included in the
value of that closing inventory.
Let us elaborate further on this matter. Referring to the example given, we can
observe that the net income under absorption costing is higher by RM27,000 than
that under marginal costing, and as mentioned earlier, it is due to the fact that the
fixed manufacturing overhead cost is included in the closing inventory.
Conversely, under marginal costing, all fixed manufacturing overhead costs

amounting to RM117,000 are treated as expenses incurring in the current period,
as opposed to under absorption costing method where the costs are separated
into expenses amounting to RM90,000 (that is, RM9  10,000 sales units) leaving
RM27,000 (that is, RM9  3,000 inventory units) as closing inventory which will
be carried forward to the following year. This is a result of treating the fixed
manufacturing overhead costs as inventoriable product cost under absorption
costing. Thus, as long as the products are unsold the costs will not be considered
as part of the expenses in the calculation of cost of goods sold.
The subsequent discussions are related to the preparation of income statements

for the year 2014 under both methods and with closing inventory of only
2,000 units.

(a) Income Statement under Marginal Costing for the year ended 2014 is
illustrated in Table 8.7:
Table 8.7:
Nadhirah Berhad
Income Statement under Marginal Costing for the year ended 31 December 2014
RM RM
Sales (11,000 units  RM75 825,000
Variable Costs:
Cost of Goods Sold:
ă Closing Inventory (2,000  RM42) (84,000)
462,000
+ Variable Sales and Administration Costs (11,000  RM7) 77,000 539,000
Fixed Costs:
Sales and Administration 8,000 125,000
Net Income 161,000

(b) Income Statement under Absorption Costing for the year ended 2014 is
illustrated in Figure 8.8:
Table 8.8:
Nadhirah Berhad
Income Statement under Absorption Costing for the year ended 31 December 2014
RM RM
Sales (11,000 units  RM75) 825,000
Cost of Goods Sold:
+ Cost of Goods Manufactured (10,000  RM53.70) 537,000
ă Closing Inventory (2,000  RM53.70) (107,400) 582,600
Sales and Administration Expenses:
Fixed 8,000
Variable (11,000  RM7) 77,000 85,000
Net Income 157,400
Based on the current information, the closing inventory from 2013 is carried
forward to 2014 to become the opening inventory. The assumption used in
calculating the closing inventory cost is by means of the First In, First Out
(FIFO) method. By the FIFO method, we assume that the balance in the
closing inventory is the later stock acquired by the company as sales will
involve the earlier stock held in the company.
For instance, the closing inventory for the year 2014 is 2,000 units. Under
the absorption costing method, the value of this closing inventory is
RM107,400 (that is, 2,000 units  RM53.70). This calculation is done by
multiplying the closing inventory of 2,000 units by the per unit cost of
RM53.70. The reason is that, we assume that the remaining 2,000 units in
the closing inventory is part of the 10,000 units transferred out during the
year 2014 with the manufacturing cost of RM53.70 per unit, instead of from
the opening inventory of 3,000 units brought forward to the year 2014. The
opening inventory brought forward to the year 2014 from the year 2013 is
assumed to be sold completely. For this reason, the closing inventory of
2,000 units for the year 2014 is not multiplied by RM51 per unit (i.e. the
manufacturing cost per unit for the year 2013 under absorption costing).

8.9 ADJUSTING INCOMES UNDER THE TWO

METHODS
This subtopic will discuss and explain how the difference in net income
between marginal costing and absorption costing can be adjusted. The following
discussions will be divided into two: without opening inventory and with
opening inventory (refer to Figure 8.3).
Figure 8.3: Discussion on income adjustment from two aspects
(a) Income Adjustment without Opening Inventory

In 2013, Nadhirah Berhad does not possess any closing inventory, thus the
adjustment on the net income can be performed as follows:
Net Income under Absorption Costing (AC) ă = Closing Inventory Units 

Net Income under Marginal Costing (MC) Fixed Manufacturing
Overhead Per Unit
RM162,000 ă RM135,000 = 3,000  RM9
RM27,000 = RM27,000
The net income under absorption costing (AC) of RM162,000 is higher than
the net income of RM135,000 under marginal costing (MC). The difference
of RM27,000 for the year 2013 is due to the fact that under the marginal
costing method, the fixed manufacturing overhead cost is considered as
period cost and therefore needs to be deducted fully from the marginal
contribution for the year 2013. This is in contrast with absorption costing
which inventorises fixed manufacturing overhead cost as closing inventory
for the unsold units, which gives rise to an increase in net income (through
reduction in the cost of goods sold).

(b) Income Adjustment with Opening Inventory

By using the same example from Nadhirah Berhad for the year 2014 where
there is an opening inventory of 3,000 units, which is the closing inventory
for the year 2013.
Net Income under Absorption Costing (AC) ă = The Difference in Closing

Net Income under Marginal Costing (MC) Inventory ă The Difference in
Opening Inventory
RM157,400 ă RM161,000 = (107,400 ă 84,000) ă (153,000 ă
126,000)
RM3,600 = ă RM3,600
This adjustment on net income can also be performed by using the net
income adjustment table as illustrated in Table 8.9.
Table 8.9: Net Income Adjustment Table
2013 2014
(RM) (RM)
Net Income under Marginal Costing 135,000 161,000
Add: Fixed Manufacturing Overheads (3,000  RM9) (2,000  RM11.70)
Deferred under Absorption Costing 27,000 23,400
Less: Fixed Manufacturing Overheads (27,000)
Released under Absorption Costing
Net Income under Absorption Costing 162,000 157,400
Based on the adjustment table, it is apparent that in the year 2013, the net
income under absorption costing is higher than under marginal costing.
The reason is that under absorption costing, a portion of the fixed
manufacturing overhead cost (that is, RM27,000) has been deferred and
not recognised as expenses incurred during the year. The cost is only
recognised as expenses in the year 2014 after the products are sold.

8.10 RELATIONSHIP BETWEEN PRODUCTION

UNIT, SALES UNIT, INVENTORY VALUE
AND NET INCOME
The net income under both methods will be different from each other due to two
situations:
(a) When production units are higher than sales units; and
(b) When sales units are higher than production units.
In other words, if the opening and closing inventories do not exist, the net
incomes under both methods will be the same.
To demonstrate these situations, we will refer to the following Example 8.2:
Example 8.2
Hafizuddin Berhad
The Data for the years 2012, 2013 and 2014
Variable Cost Per Unit:
Direct Materials RM3.00

Direct Labour RM6.00
Manufacturing Overheads RM1.00
Sales and administration RM2.00
Fixed Cost Per Annum:
Manufacturing Overheads RM60,000

Sales and administration RM10,000

The data on production, sales and inventories are as follows:
2012 (units) 2013 (units) 2014 (units)

Opening Inventory 0 1,000 1,000
Production 5,000 5,000 4,000
Sales 4,000 5,000 5,000
Closing Inventory 1,000 1,000 0
The selling price per unit is RM30.00.
Based on the data above, the production cost per unit based on marginal
costing and absorption costing are as follows:
2012 (RM) 2013 (RM) 2014 (RM)

Marginal Costing 10.00 10.00 10.00
Absorption Costing 20.00* 22.00* 25.00**
Calculation:
(a) *RM3.00 + RM6.00 + RM1.00 + (RM60,000/5,000)
(b) **RM3.00 + RM6.00 + RM1.00 + (RM60,000/4,000)
Based on the above information, we will prepare the income statements under
both methods for three consecutive years, which are 2012, 2013 and 2014,
respectively. The income statements we are referring to will look as follows:

Hafizuddin Berhad
Comparing Income Statements under Marginal Costing between the year ended
2012, 2013 and 2014
2012 2013 2014 Total
Sales 120,000 150,000 150,000 420,000
Cost of Goods Sold:
Opening Inventory 0 10,000 10,000 20,000
+ Cost of Goods Manufactured 50,000 50,000 40,000 140,000
Cost of Goods Available for Sale 50,000 60,000 50,000 160,000
ă Closing Inventory (10,000) (10,000) (0) (20,000)
Cost of Goods Sold 40,000 50,000 50,000 140,000
Manufacturing Margin 80,000 100,000 100,000 280,000
Less: Variable Sales and (8,000) (10,000) (10,000) (28,000)
Administration Costs
Contribution Margin 72,000 90,000 90,000 252,000
Less: Fixed Manufacturing Overhead (60,000) (60,000) (60,000) (180,000)
Costs
Fixed Sales and Administration (10,000) (10,000) (10,000) (30,000)
Net Income 2,000 20,000 20,000 42,000
Hafizuddin Berhad
Comparing Income Statements under Absorption Costing between the year ended
2012, 2013 and 2014
2012 2013 2014 Total
Sales 120,000 150,000 150,000 420,000
Cost of Goods Sold:
Opening Inventory 0 22,000 22,000 44,000
+ Cost of Goods Manufactured 110,000 110,000 100,000 320,000
Cost of Goods Available for Sale 110,000 132,000 122,000 364,000
ă Closing Inventory (22,000) (22,000) (0) (44,000)
Cost of Goods Sold 88,000 110,000 122,000 320,000
Gross Profit 32,000 40,000 28,000 100,000
Less: Operating Expenses Variable (8,000) (10,000) (10,000) (28,000)
Sales and Administration Costs
Fixed Sales and Administration (10,000) (10,000) (10,000) (30,000)
Net Income 14,000 20,000 8,000 42,000

8.11 SUMMARY OF EFFECTS ON NET

INCOMES UNDER ABSORPTION COSTING
AND MARGINAL COSTING
Referring to the income statements above which have been prepared using both
costing methods for the years 2012, 2013 and 2014, we can see that in the year
2012, the net income under absorption costing is higher than that under marginal
costing. As for the year 2013, the net incomes in both years are the same; and
finally, for the year 2014, the net income under marginal costing method is higher
than under the absorption method. If these phenomena are associated with the
differences between production units and sales units, then we can summarise the
above in Table 8.10 as follows:
Table 8.10: Summary of Effects on Net Income Under Both Costing Methods
Summary of Effects on Net Income under Both Costing Methods

If Effects on Net Income
Production Units > Sales Units AC > MC
Production Units = Sales Units AC = MC
Production Units < Sales Units AC < MC
Note that:
(a) AC denotes Net Income under Absorption Costing; and
(b) MC denotes Net Income under Marginal Costing.
8.12 EVALUATION OF METHODS
ACTIVITY 8.4
Assuming that you are a manager in a manufacturing firm, which

costing method would you choose for the purpose of reporting?
Provide reasons for your answer.

This subtopic will explore the advantages and disadvantages of employing the
absorption costing method and the marginal costing method.
(a) Marginal Costing

The advantages and disadvantages of using the marginal costing method
are listed in Table 8.11.
Table 8.11: Advantages and Disadvantages of Using Marginal Costing
Application of Marginal Costing

Suitable for measuring performance The application of this method is not
and cost analysis, and subsequently extensive and is limited to the internal
provides useful and relevant management only, besides the fact that
information to assist the management it provides reports which do not
in planning, controlling and decision- comply with the requirements of
making. This is because for decision- GAAP.
making, only variable cost information
is relevant for consideration.
Setting the selling price becomes more The cost of preparing the reports
effective since we can measure the under this method is relatively high,
impact of the margin of safety under compared to that of the absorption
this method. Setting the price higher costing method. The reason is that this
than the margin of safety is sufficient method requires two types of reports,
for covering variable costs. namely, for external users and internal
users. Preparing two separate reports
for these two purposes increases the
cost of financial reporting which have
to be borne by the company.

TOPIC 8 MARGINALL COSTING AND
D ABSORPTION
N COSTING  223
(b) Abbsorption Costing

The advantagess and disadvaantages of usiing the absorp
ption costing
g method
aree provided in Table 8.12.
Table 8.12: Advantages

A an
nd Disadvantag
ges of Using Ab
bsorption Costting
Appliccation of Absorrption Costing

Advantages
A Dissadvantages
Thhe applications under this method
m can Not very su
N uitable for measuring
m
bee used extensiively. This is because
b the p
performance a
and cost analy
ysis. The
abbsorption costting method is already r
reason is thhat it includ des fixed
acccepted as th he costing method
m for m
manufacturing g overhead costs in
ex
xternal reportin
ng. p
production co
osts even thouugh fixed
c
costs are irrrelevant for making
Abbsorption costiing method is accepted as
d
decisions and beyond the control
c of
th
he method for external reporting
m
managers.
puurposes. Thereefore, there is no need to
prrepare two sepparate reports for external
annd internal rep
porting, thus reeducing the
fin
nancial reportiing cost of th
he company
co
oncerned.
 This topic discusssed two cossting method

ds, namely, marginal
m costting and
absorrption costing
g.
 You have also learnt the differences betweeen the two meethods in term
ms of the
calcu
ulation of prooduct cost, preparation off income stattement, adjussting the
differrence in net incomes as well as the effects of thee difference between
prodduction level and
a sales leveel on net incom
me.
 Finallly, the advan

ntages and disadvantages of both meth
hods were exp
plored at
the end
e of this top pic.

1. Fadilah Berhad manufactures and produces a herbal product which is sold

throughout Malaysia. The per unit costs for the year 2014 are as follows:
Per Unit Variable Cost: RM

Direct Materials 10.50
Direct Labour 9.50
Manufacturing Overhead 4.00
Sales and Administration 1.20
Fixed Expenses:
Salary of Factory Supervisor 26,000
Total Salary of Administration Staff 20,000
Insurance 24,000
Utility 22,000
Transportation Costs 6,000
Depreciation of Office Equipment 8,000
Depreciation of Plant 10,000
The companyÊs activities throughout the year are given below:
Opening Inventory 0 units

Sales 25,000 units
Closing Inventory 5,000 units
Selling Price Per Unit RM40
Additional information:
(a) 80% of insurance and utility are allocated for manufacturing purposes
while the remaining 20% are for administrative purposes.
(b) 30% of transportation expenses are for manufacturing purposes while

the remaining 70% are for administrative purposes.

(a) Calculate the product cost per unit according to the marginal and
absorption costing methods for the year ended 31 December 2014.
(b) Prepare the Income Statement for Fadhilah Berhad by using the
marginal costing and absorption costing methods.
(c) Perform adjustment for the difference in incomes under both

methods.
2. Arau Berhad is a company operating in the silk industry and promotes its
products in Pattani, Thailand. The followings are the costs incurred in the
year 2013 and 2014:
Direct Materials RM1.30 per unit

Direct Labour RM1.50 per unit
Manufacturing Overheads RM0.20 per unit
The fixed manufacturing overhead is RM150,000 per annum. Selling price

per unit is RM5.00. The fixed sales and administration expenses are
RM65,000 per annum, while the selling commission is set at 5% of total
sales in ringgit (RM).
Information related to the production is given as follows:
2012 (units) 2013 (units)

Production 170,000 140,000
Sales 140,000 160,000
Closing inventory for the year 2014 amounts to 10,000 units.
(a) Calculate the product cost per unit using both methods.
(b) Prepare the income statement for the year ended 2013 under marginal
costing.
(c) Prepare the income statement for the year ended 2014 under
absorption costing.

1. Muizzuddin Berhad is a company that produces and sells a type of product.

Information on the costs of the product is as follows:
RM
Per Unit Variable Cost:
Direct Materials 6.00
Direct Labour 12.00
Manufacturing Overheads 4.00
Sales and administration 3.00
Total Variable Cost Per Unit 25.00
Monthly Fixed Expenses:
Sales and administration 180,000
Total Fixed Cost in a Month 420,000
The selling price per unit is RM40.00. The following is the information on
the companyÊs production and sales in the first two months of its operation,
namely, in May and June 2014:
Units Produced Units Sold

May 30,000 26,000
June 30,000 34,000

Monthly income statements have been prepared by the accounting

department using the absorption costing method and are illustrated as
follows:
May June
(RM) (RM)
Sales 1,040,000 1,360,000
Less: Cost of Goods Sold
Cost of Goods Manufactured 900,000 900,000
Cost of Goods Available for Sale 900,000 1,020,000
Less: Closing Inventory 120,000 0
Cost of Goods Sold 780,000 1,020,000
Gross Profit 260,000 340,000
Less:
Sales and Administration Expenses 258,000 282,000
Net Income 2,000 58,000
(a) Determine the product costs per unit by using both marginal and
absorption costing methods.
(b) Prepare the income statements for the months of May and June by
using the marginal costing method.
(c) Adjust the difference in net incomes between marginal costing and
absorption costing for both months, May and June.
(d) Explain why the net income under marginal costing differs from that
of absorption costing.

228  TO
OPIC 8 MARG
GINAL COSTING
G AND ABSORP
PTION COSTING
G
A
Absorption co
osting Marginal costing
c
C
Closing inven
ntory cost Net incom
me
Generally Acccepted Accou
G unting Product co
ost
P
Principles (GA
AAP)
Production
n unit
I
Income statem
ment
Sales unit
I
Inventory vallue
M
Manufacturin
ng costs

Topic  Modern
9 Business
Environment
and
Management
Accounting
LEARNING OUTCOMES
1. Explain the impact of modern business environment on
management accounting;
2. Analyse the change in focus towards customers, quality and value;
3. Distinguish the differences between traditional production and
flexible production; and
4. Examine inventory management and cost reduction programs.
 INTRODUCTION
From a previous topic, you have learnt about a new costing method ă ABC
method. The ABC method is more suitable for a modern production
environment, in which machine hours is one of the main sources of production
costs. This modern manufacturing or production environment is the result of
advancement in technology. Technological development has contributed
230  TOPIC 9 MODERN BUSINESS ENVIRONMENT AND MANAGEMENT
ACCOUNTING
substantially to the changing business environment. So the ABC method is an

example of the impact of modern business environment on management
accounting practices, which is induced by advancement in technology.
Normally we go out to the mall or supermarket to do shopping for groceries and

other necessities. A decade ago, have we or our parents ever imagined that
whatever we need will be delivered to our door without going out to shop?
Nowadays, we find that online shopping and Internet banking are very
convenient. Recall back, years ago sometimes we were forced to buy products
with no quality because we did not have other options; and companies were not
concerned at all about our feelings and complaints. But today, you may observe
varieties of slogans like „customer first‰, „customerÊs satisfaction is our
satisfaction‰ and „customer is our top priority‰ are portrayed by companies
everywhere. These greatly indicate that the way we do business has changed and
improved. In fact, the business environment has undergone enormous changes
globally. In this topic, we shall explore the modern business environment and its
implications.
9.1 DRIVERS OF CHANGE TO BUSINESS

ENVIRONMENT
Figure 9.1: Examples of Traditional-Manual production and Modern-Robotic production
Many factors were responsible for causing the changes to the business
environment, which include advancement in technology, changes in consumerÊs
taste and demands, changes in socio-economic conditions, a competitive market,
changes in political situations, and changes in environmental and legal
framework. Rapid development in technology has created new environment, in

TOPIC 9 MODERN BUSINESS ENVIRONMENT AND MANAGEMENT  231
ACCOUNTING
which traditional-outdated methods or approaches were replaced with new

inventions and systems that essentially led to new creations of jobs, careers, skills
and competency, new forms of business and entertainments, new industries and
many more. The effects of and power of technology are immeasurable, it
dominates all aspects of business and significantly affects our daily lives.
Observe how technologies or those gadgets influence our kids, how they
penetrate into our lives, our job. Ask yourself, can I live a day without those
gadgets?
Besides technology advancement, customersÊ behaviours have changed ă they

are more demanding for quality products and services, they are more
sophisticated and their voices and cries are louder, which cannot be simply
ignored. These could be due to higher awareness of consumerism among
consumers, exercising their rights and executing their roles towards the larger
society. Furthermore, changing lifestyles and social structures, improved
economic conditions of society, improved educational systems and stable
political scenarios have contributed to a new business environment. Moreover,
changes in legal and environmental frameworks that promote sustainable
development for the benefits of our future generations also drive business
environment to change. All these factors and changes together would cause
organisations to evaluate and revise their way of doing business.
9.1.1 Characteristics of Modern Business Environment

Modern business environment can be characterised by high-end technology,
globalisation, powerful customers, stringent competition, and social and
environmental responsibility. We will discuss these characteristics as follows:
(a) Technology
As mentioned earlier, technology plays an important role and dominates
business environment in many aspects. Information and communication
technologies offer a new range of communication media, which are cost
effective, faster and convenient. E-mail, live chatting and streaming,
teleconferencing and many more media made communications easier and
faster across the boundaries. Information systems and applications such as
Management Information System (MIS), Enterprise Resource Planning
(ERP) and many others supply relevant information for the business
decision-making process on timely basis, and at real-time.

ACCOUNTING
Figure 9.2: Examples of technology that affect business environment
(b) Globalisation
Modern business environment is also characterised by globalisation. As we
know, globalisation has removed geographical barriers among countries in
the world. As a result, the whole world becomes one huge single market, in
which business organisations have to compete for their shares of the cake.
Thus, todayÊs market is subject to intense competition.
(c) Powerful Customers

Organisations now operate in a global economy in which customers and
competitors come from all over the world. Customers become more
powerful and influential because they have far more choices than ever
before and are demanding ever improving levels of service in terms of cost,
quality, reliability and delivery.
(d) Stringent Competition

In order to be ahead of competitors, organisations must strategise and gain
competitive advantage, which can be achieved only thru high effectiveness
and efficiency in business operations. Competitive advantage is an
advantage that an organisation has over its competitors, that distinguishes
the organisation from its competitors. This advantage allows an
organisation to generate greater sales or margins and to retain more
customers than its competition.

ACCOUNTING
There are many sources of competitive advantages, which include the

firmÊs product offerings, cost structure, distribution network and customer
support services. In addition, organisations can sustain in this modern
business environment by responding to customersÊ needs and
requirements.
(e) Social and Environmental Responsibility

Further, business organisations are not only responsible to create wealth for
shareholders, but at the same time they also need to be socially and
environmentally responsible.
In this topic, we will discuss the impact of the modern environment on

management accounting. The impacts could be on the management
accounting practices, management accountantsÊ role and skills. Next, we
will look into differences between traditional and modern business
environments. Several dimensions of business such as the change in
business focus, traditional production versus flexible production, inventory
management and cost reduction programs will be discussed respectively.
SELF-CHECK 9.1
Make a list of the causes of change in business environment and list

down the attributes of modern business environment.
9.2 IMPACT OF MODERN BUSINESS

ENVIRONMENT ON MANAGEMENT
ACCOUNTING
From the previous subtopic you have learnt about the drivers of change and the
characteristics of modern business environment. Since management accounting
operates in a business environment, obviously it also has undergone significant
changes in order to adapt to the changing business environment. The modern
business environment has affected management accounting in many aspects.
Major impacts can be observed on the change in management accounting
practices, in management accountantsÊ role, and management accountantsÊ skills
and competency. Before we discuss further on the impacts, let us analyse what
factors drive changes in management accounting.

ACCOUNTING
9.2.1 Factors that Drive Changes in Management

Accounting
Contributing factors to management accounting changes can be classified into
three categories, namely the internal, external and organisational factors as
shown in Table 9.1
Table 9.1: Factors Contributing to Changes in Management Accounting
Internal  Core competencies aims

 New management style e.g. employee empowerment,
participative management
 New design of MA systems or techniques
 Information technology and production technologies
 Quality oriented initiatives
 New forms of business e.g. online business, e-commerce
External  Customer focused and value propositions
 Globalisation
 New reporting and legal requirements
 New or innovative accounting techniques
 External consultants; advice
Organisational  Merger and acquisition
 Organisational restructuring
 Corporate Governance ă induced by corporate failures
Source: Sulaiman, Ramli & Mitchell (2008)
If you compare, some of the contributing factors are similar to the ones that drive
changes to business environment. ItÊs not unusual since they are functioning in
the same environment on the same globe.

ACCOUNTING
9.2.2 Changes in Management Accounting

All of the above contributing factors simultaneously trigger changes in
management accounting. Consequently, these have resulted in new dimensions
and new issues that directly and indirectly have implications on management
accounting. These changes include computer-integrated manufacturing,
emergence of new industries, cross functional teams, markets and customer focus
and many others as depicted in Figure 9.3.
Figure 9.3: Direct and indirect changes in Management Accounting (MA)
In the next subtopic, we will analyse the direct and indirect implications of these
changes on the management accounting practices, management accountantsÊ role
and skills respectively.

ACCOUNTING
9.2.3 Impact on Management Accounting Practices

In this subtopic we will discuss the changes illustrated in Figure 9.3 in
management accounting and what are their impacts specifically on management
accounting practices. What do we mean by management accounting practices?
Management accounting practices refer to approaches, methods, techniques and
tool kits that are applied by management accountants in their organisations.
Technology advancement and technical innovations have great impacts on
management accounting practices, which give rise to new practices. Those
impacts and changes in practices could be in the forms of additions,
replacements, output modifications and operational modifications (Sulaiman and
Mitchell, 2005).
Some examples of these new techniques and methods are balance scorecard,
activity based costing and management, life cycle costing, target costing, quality
costing, kaizen costing and many others. They are accepted and adopted
worldwide but at diverse degrees depending on certain criteria such as company
size and industry type.
Many of these new management accounting practices were imported. These new
practices are mostly originated from developed countries like Japan, USA and
European countries. They are spreading across countries in the world as a result
of what we know as globalisation. The globalisation process has enabled
knowledge and technologies to be transferred from one nation to another nation
through agents such as external consultants, business partnerships and alliances,
and could be by mergers and acquisitions of foreign companies.
Furthermore, modern manufacturing and production technologies that are

computer integrated require different product costing practice. Likewise,
emergence of new forms of business either in manufacturing or service
industries, such as e-commerce and online business has created new ways of
operating and required modification or even replacement of the traditional
management accounting practices. In addition, companies have shifted their
orientation from internal focus to market and customer focus. This has led to
changes in companiesÊ performance measurements whereby nonfinancial and
financial elements are equally important, and more considerations are given to
quality initiatives. All these are the impacts of modern business environment on
the techniques and approaches of management accounting.

ACCOUNTING
In brief, changing business environment has resulted positively in changes in

management accounting practices towards improvement and advancement.
9.2.4 Impact on Management Accountant’s Role

We will examine the implication of modern business environment on the role
of the management accountant. Firstly, let us recall what the role of the
management accountant is. The management accounting profession has evolved
significantly over the years. Traditionally, management accountants were
regarded as „bean counters‰ and „scorekeepers‰ (Bromwich & Bhimani, 1989).
As you have learnt from a previous topic, the basic role of a management
accountant is to provide relevant information and assist managers in decision
making processes. This role has been changing and evolving mainly due to
changing information needs of managers or users, emergence of cross functional
teams, and are indirectly caused by changes in structure, top management styles,
modern manufacturing, etc.
Management accountants today are recognised as business partners, internal

consultants, change agents, strategy formulators and business analysts who
spend more time with the users of management accounting information rather
than serving their functional or departmental roles (Forsaith, Tilt and Lobo,
2004). In fact, they play multiple roles which require multidisciplinary skills,
which will be discussed further in the following section. For instance, they
involve and participate in various business processes such as in setting and
implementing business strategy, new product development, marketing, and
performance measurement. They will need to work together with other
functional specialists, creating cross functional teams or committees. In brief, the
role of management accountants is highly regarded and gaining greater
emphasis within the modern business environment.
9.2.5 Impact on Management Accountant’s Skills

Whenever the role changed, it must be equipped with necessary skills and
knowledge. Besides, the core competencies or work characteristics determined
for the role have to be satisfied in order for the role to be effective and efficient.
The role as business partners or consultants requires management accountants to
possess general and specific skills and knowledge.

ACCOUNTING
Management accountantÊs skills have also been affected by the changing business
environment. Basically, todayÊs management accountants need the following
skills (Burns et al., 1999):
(a) Solid knowledge of both financial and management accounting;
(b) Problem solving skills;
(c) Analytical skills;
(d) Knowledge of how a business functions e.g. marketing, production;
(e) Ability to work as a team;
(f) Technical skills related to information technology and information system;

and
(g) Personal and interpersonal skills.
The skills are not limited to the above list. In addition to that, management
accountants should be more creative, innovative, proactive, forward looking and
have flexible approaches to cost and financial analyses. To sum up, in the
modern business environment management accountants need to adapt to their
changing role successfully by acquiring those skills and knowledge.
ACTIVITY 9.1
Summarise the impacts of the modern business environment on

management accounting and present it in your tutorial class.
9.3 MODERN VS TRADITIONAL BUSINESS

ENVIRONMENT
To recall, in the earlier part of this topic we have explained the characteristics
of the modern business environment. These include globalisation, technology,
powerful customers, stringent competition, and social and environmental
responsibility. In the subsequent subtopics, we will analyse further some of those
characteristics or you may refer them as dimensions of the modern business
environment.

ACCOUNTING
9.3.1 Change in Focus Towards Customers, Quality

and Value
When you want to buy a product, let us say a mobile phone, what do you
actually expect from the product? Or what aspects or attributes of the phone are
you looking for? All of your expectations from the product including the
functionality of the product, price, quality, and related services such as repair,
applications downloaded, and user friendliness are known as values. Successful
companies are well aware of these values; they know what values and quality are
expected by their targeted customers. In this modern business environment,
companies who are ignorant of their customersÊ taste, preferences and needs will
not survive long in the business.
Let us compare traditional and modern businesses. Traditional business focuses

on internal operations, associated with inward-looking and output or sales
driven thinking. In contrast, modern business focuses on external factors,
connected with outward and forward-looking views and are customer or market
driven. To date, many organisations have shifted their focus towards customers,
quality and value. What do you know about customer focus or orientation?
(a) Customer Focus

Customer focus is an approach or orientation taken by organisations
whereby customer satisfaction is the top priority to be considered in any
business decision. Customers can be both ă the external consumers to the
company and also the internal employees of the company. In relation to
that, a company will set strategies and plans of action that eventually will
create value to customers.
Organisational objectives and employeesÊ objectives are aligned to

achieving customer satisfaction and retention. Moreover, customer-
orientated organisation places greater emphasis on customer relationship
and customer retention programs through which employees identify and
then fulfil customersÊ long-term needs and expectations (Heiens, 2000).
Simply put, the company is customer pre-occupied; the entire efforts of the
company ă any decision making, policies will be directed towards making
your customers happy. On top of that, customer focus strategy requires
long term commitment involving the entire company with the new target of
satisfying customerÊs expectations.

ACCOUNTING
(b) Customer Satisfaction

Customer satisfaction measures how products or services offered by a
company satisfy or exceed a customerÊs expectation. Degree of satisfaction
relies on several factors such as the quality of the product and service
provided, the atmosphere of the location where the product or service is
purchased, and the price of the product or service.
There are several elements or initiatives contributing to customer

satisfaction. Figure 9.4 highlights those elements that include four key
success factors, continuous improvement, total value chain analysis and
employee empowerment.
Figure 9.4: Elements contributed to customer satisfaction
(i) Key Success Factors

First, we will discuss how the key success factors promote customer
satisfaction. Modern business environment is characterised by intense
competition, thus an organisation must find a source of competitive
advantage. Pricing, cost-effective, innovation or branding can be
reliable sources, but they are easily imitated by competitors.
Alternatively, offering quality product and service that satisfy
customersÊ expectations would be the most sustainable way to
outperform competitors. Customer focus also needs a marketing
strategy with strong customer value proposition. What do you know
about customer value proposition (CVP)?

ACCOUNTING
CVP is a business statement describing why a customer should

buy a product or use a service, which also differentiates your
product from competitorsÊ.
A good CVP should be expressed from the customerÊs point of view

and it reflects tangible and intangible benefits and experience that
customers can expect from using the product or service. A compelling
and convincing customer value proposition should enable your
company to gain a selling point, and attract customersÊ attention and
approval that would result in growth in sales. Furthermore, a strong
CVP can be developed by having profound knowledge of existing
and potential customers, which can be acquired through market
research and analysis.
How do we, as customers, differentiate products? Based on our

experience, we focus on these two attributes ă price and quality when
we compare products. Most of the time we want to spend as little as
possible and get as much as we can. Thus, it is crucial for companies
to find the right balance between these two attributes and it should
be well highlighted in the companiesÊ consumer value proposition
statement.
Ask yourself, why should people buy your product? What makes
your product stand out? Successful products must offer value to
customers either through price or quality or both.
(ii) Continuous Improvement

A second element that contributes to customer satisfaction is
continuous improvement. Basically, continuous improvement refers
to systematic ongoing effort towards improving products, services or
processes. Aligning their goals, organisations and employees keep
searching for more effective and efficient ways to do things. Thus,
continuous improvement requires advancement in knowledge and
skills, as well as involvement of everyone at all levels of organisation.
So it could be a good culture to be developed in organisations because
it drives toward excellence and breakthroughs.

ACCOUNTING
ACTIVITY 9.2
The following URL links you to a case study of Nestle on responding to

changing customer requirement.
http://businesscasestudies.co.uk/nestle/responding-to-changing-
customer-requirements-the-drive-towards-
wellness/introduction.html#axzz32vj5DBPZ
Read the case study posted individually. Next, during tutorial, form a
group of four members and discuss the case. Try to answer the
following questions. Be ready to discuss them with your tutor during
the next tutorial meeting.
1. How does Nestle keep updated on changing lifestyles and

requirements of consumers?
2. How did Nestle benefit from its huge spending in research and
development activity?
3. What strategy is adopted by Nestle?
4. What are the values that Nestle proposed to consumers?
There are many approaches or methods available to support the

implementation of continuous improvement. Some of those widely
used methods are Deming Cycle: Plan-Do-Check-Act (PDCA), Six
Sigma, Lean, Kaizen, Balance Scorecard and Total Quality
Management (Bhuiyan & Baghel, 2005). Continuous improvement
initiatives would definitely enhance organisational abilities to meet
customersÊ expectations via improved products and processes.
(iii) Employee Empowerment

Third, we will look into employee empowerment. Employee
empowerment in essence means giving or delegating responsibility
and authority to your employees for making important decisions.
Employee empowerment comprises job enlargement and job
enrichment by allowing employees to have control over input and
output of their work, and to openly contribute ideas and suggestions
(Honold, 1997).

ACCOUNTING
Does it do any good to the company? Of course, because empowered

employees are committed, loyal and reliable, this in turn would result
in higher productivity and better quality of work life. Figure 9.5
describes the three levels of employee empowerment and the benefits
to the organisation.
Furthermore, employee empowerment is very crucial especially for

those staff at the forefront who deal directly with customers.
Empowered employees will listen and be more responsive to
customersÊ needs and complaints and take necessary actions faster.
Consequently, customers would feel that they are being appreciated,
and importantly they are satisfied and happier in dealing with the
company.
Figure 9.5: Three levels of employee empowerment.

Adapted from Empowering People by Jane Smith
Source: http://www.1000ventures.com

ACCOUNTING
(iv) Total Value Chain Analysis

Finally, the forth element that is significant to customer orientation is
the value chain approach. Value chain approach or analysis (VCA)
was first introduced by Michel Porter in 1985. Value chain analysis is
a strategic analysis tool used to identify and understand how values
are created in an organisation. Moreover, VCA helps a company to
understand its internal chain of activities and its linkage with
suppliers, customers and other companies in the industry.
How does your organisation create value?
Next, let us try to understand how a firm creates value and how it
relates to VCA.
 Manufacturers create value by acquiring raw materials and

then transform them into functional products;
 Banks offer a variety of financial services and are normally

supported by services such as Internet banking or personal
investment consultation; and
 Retailers supply diverse readymade products and display

them in an attractive and convenient way to customers, which
sometimes includes delivery and credit sales.
The value created by firms is represented by margin or profit. The

profit or margin is the positive difference between value created and
captured, and cost of creating that value. More value means more
profits. Whenever your customers receive more value that means you
already create a competitive advantage.
Firms carry out sets of activities to create value to customers. These

sets of activities are interdependent and together they form what we
call value chain activities. These value chain activities must be value
adding activities. How your firm performs value chain activities
would definitely affect your costs and profits. So this VCA can really
help you understand the sources of value for your firm.

ACCOUNTING
PorterÊs Value Chain

PorterÊs Value Chain concerns how inputs are converted into the outputs
purchased by consumers. Using this viewpoint, Porter divided the chain of
activities into primary and support activities, as shown in Figure 9.6. The
primary activities consist of inbound distribution or logistics, manufacturing
operations, outbound distribution or logistics, marketing and selling, and after-
sales service.
Figure 9.6: PorterÊs Value Chain Framework

Source: http://www.kenfinnegan.com
Primary activities are supported by support activities that include purchasing or

procurement, research and development, human resource development, and
corporate infrastructure. This whole thing is the internal value chain of a firm.
This model can be extended to include the external value chain which comprises
the suppliers on one end and customers on the other end. Internal and external
value chain activities are interlinked and interdependent.
In a similar way, a firm may analyse its external value chain so as to identify
other sources of creating value by exploiting its linkages with the suppliers and
customers. For instance, good networking with suppliers promises prompt
delivery and quality raw materials, which consequently will improve the quality
of the firmÊs output, and eventually will meet consumersÊ expectation.

ACCOUNTING
ACTIVITY 9.3
Recall your recent visit to a clinic, to a supermarket or to an office to

pay your bills or make a new visit to any of those offices. From your
point of view as a customer, do you think the organisation you visited
earlier is aware of your expectations from its service or product?
Discuss your experience and observation during your visit in your
tutorial class. Can you conclude whether the organisation has customer
focus or not?
The following Table 9.2 illustrates how the analysis can be performed. There are
two ways of using VCA, depending on what competitive advantage that the firm
wants to build, either cost or differentiation advantage. The table lists the
necessary steps to build competitive advantage using VCA.
Table 9.2: Necessary Steps to Achieve Cost or Differentiation Advantage Using VCA
Cost Advantage Differentiation Advantage

This approach is used when organisations The firms that strive to create superior
try to compete on costs and want to products or services use differentiation
understand the sources of their cost advantage approach.
advantage or disadvantage and what
factors drive those costs.
Step 1: Identify the firmÊs primary and Step 1: Identify the customersÊ value-
support activities. creating activities.
Step 2: Establish the relative importance Step 2: Evaluate the differentiation
of each activity in the total cost of strategies for improving
the product. customer value.
Step 3: Identify cost drivers for each Step 3: Identify the best sustainable
activity. differentiation.
Step 4: Identify links between activities.
Step 5: Identify opportunities for
reducing costs.
Source: http://www.strategicmanagementinsight.com
So what are the benefits of performing VCA to your firm? VCA analysis assists a
firm to analyse and exploit its internal and external value chain activities in order
to create more value to customers. VCA serves as a basic analysis prior to
employing other management techniques such as activity-based management,
benchmarking, information systems strategy and performance measurement.

ACCOUNTING
To summarise, customer focus approach requires firms to continuously search

for better ways of creating values in order to meet customersÊ expectations.
Quality product and service is the main expected value that will increase
customersÊ satisfaction. Higher satisfaction leads to higher profit to the company.
9.4 TRADITIONAL PRODUCTION VS FLEXIBLE

PRODUCTION
Have you ever visited a manufacturing company and observed how the
production process was carried out? If you have not, please take a short break
now and go to YouTube and watch videos showing modern production. What
can you observe? Yes, lots of machine and robots, controlled by computerised
systems, very smooth and efficient and there may not be a lot of labour.
Let us differentiate traditional and modern or flexible productions. Traditional

production is characterised by long hours, mass production with large batches,
standardised products, manual systems, costly and labour intensive operations.
On the other hand, flexible production is attributed to shorter hours, small

batches, lower cost, machine intensive, use of robotics, a computer-integrated
system, efficient and smooth. Traditional production seems quite rigid that it
impedes manufacturers from reaching customers on time and has less variation
in products. Flexible production is a good replacement to overcome these
drawbacks in traditional production.
Figure 9.7: Traditional production versus Flexible production characteristics

ACCOUNTING
Flexible production has emerged from the changing business environment which
was induced mainly by high technology and competitive global market. In a
previous section we talked about customerÊs expectations and values. Speed of
delivery is one of the required values, especially crucial when there is intense
competition among companies.
The word agility is used to describe flexible manufacturing or production in

present environment. A successful manufacturer achieves agility when it
operates with the lowest total cost, responds to the market at high-speed and is at
its best ability to meet customersÊ expectations. Thus, in order to be agile,
manufacturers need flexible production.
Figure 9.8: Example of Flexible Manufacturing System (FMS) in flexible production

Source: http://www04.abb.com
What does it mean by flexible production? According to an article retrieved from

internet (Flexible Manufacturing Systems, 2004) flexibility in manufacturing
refers to the ability to produce reasonably priced customised products of high
quality that can be quickly delivered to customers. Moreover, the flexible
processes are not the only requirement to permit rapid low cost switching from
one product line to another, but it also needs flexible workforce with multiple
skills.
Flexible processes and flexible workers coupled with flexible plants which can
adapt to changes in real time using mobile and movable equipment, knockdown
walls and easily accessible and re-routable utilities, would definitely increase the
ability of switching easily between product lines and thus increase quality and
speed.

ACCOUNTING
Flexible production becomes feasible with the help of manufacturing

technologies such as Flexible Manufacturing System (FMS), Computer Aided
Manufacturing (CAM), Computer Integrated Manufacturing (CIM), Computer
Assisted Design (CAD), Robotics and Cellular Manufacturing.
FMS is particularly used to support flexible production. The following are some
facts and information on Flexible Manufacturing System:
(a) FMS is a computerised network of automated equipment that produces one

or more groups of parts or variations of a product in a flexible manner;
(b) It uses robots and computer-controlled material-handlings systems to link

several standalone numerically controlled machines in switching from one
production run to another;
(c) It is a manufacturing system in which there is some amount of flexibility

that allows the system to react in the case of changes, whether predicted or
unpredicted;
(d) It comprises several machine tools along with part and tool handling
devices such as robots, arranged so that it can handle any family of parts for
which it has been designed and developed, and they are often automated
and computerised;
(e) Main advantages of FMS is its high flexibility in managing manufacturing

resources like time and effort; lower direct labor cost due to the reduction in
number of workers; reduced inventory due to the planning and
programming precision; consistent and better quality due to the automated
control; and lower cost/unit of output; and
(f) Disadvantages of FMS include substantial pre-planning activity; expensive,

costing millions of dollars; technological problems of exact component
positioning and precise timing necessary to process a component; and
sophisticated manufacturing system.
Despite wide acceptance, there is slow adoption of FMS in the industry mainly
due to its expensive initial investment and complex systems. In brief, flexible
production allows quick response to the market, and lowers the production costs
which enable a company to gain competitive advantage. This eventually will
increase customerÊs satisfaction and will result in profitability.

ACCOUNTING
ACTIVITY 9.4
Explain to your study group or your classmates, how flexible

production is related to competitive advantage and customerÊs
satisfaction.
9.5 INVENTORY MANAGEMENT

Inventory of products constitutes a large portion of a companyÊs asset or invested
capital, which is especially true for manufacturers. That means a great amount
of money is tied up in inventory, which could be used more productively
elsewhere. In addition, holding a high level of inventory is associated with high
risks and problems such high asset insolvency, high storage capacity and
cost, diminishing quality and obsolete products. Thus effective inventory
management could offer potential substantial cost savings.
Inventories comprise raw materials and purchased components, in process

inventory, finished products, and maintenance, repair and tooling inventories.
Why do companies keep stocks or inventory of products in the first place? Let us
understand what really motivates manufacturers to keep large inventories. Here
are some of the reasons (Hansen & Mowen, 2006):
(a) To balance ordering or setup costs and carrying costs;
(b) To meet the uncertainty demand;
(c) To protect against machine failure;
(d) To replace defective parts;
(e) To overcome possibility of unavailable parts;
(f) To protect against late delivery of parts;
(g) To protect against unreliable production processes;
(h) To take advantage of discounts by buying in bulk; and
(i) To hedge against future price increases.

ACCOUNTING
Sometimes, manufacturers also hold safety stocks in order to avoid „Stock outs‰
if the rate of consumption increased and or the lead time gets extended from
earlier estimation. Firms realise that keeping excessive inventory is very costly.
There are three types of costs associated with inventory:
(a) The cost of acquiring inventory ă Including setup costs ă costs of labour,
materials and overhead; or ordering costs ă costs of processing an order,
insurance for shipment, and unloading costs;
(b) The cost of holding/carrying inventory ă Including interest on capital,

insurance and tax charges, storage costs, allowance for deterioration or
spoilage, salaries of stores staff and obsolescence; and
(c) The cost of not having inventory on hand when needed, also known as
Stock-out costs ă This includes the cost of lost production during the period
of stock out, lost sales, and the extra cost for expediting, like increased
transportation charges, overtime and cost of interrupted production.
It is very crucial for companies to use an effective inventory management that

could balance between costs and items in stocks and customer service.
Inventories that are mismanaged can generate significant financial distress for a
business.
9.5.1 What is Inventory Management?
Inventory management refers to the managing and controlling of the

ordering, storage and use of components that a company will use in the
production of the products it will sell plus the overseeing and controlling of
quantities of finished products for sale.
There are many ways to manage inventory including the traditional model
known as the economic order quantity (EOQ) or Just in Case, and contemporary
inventory models such as Just in Time (JIT), Theory of Constraints, Materials
Requirement Planning (MRP) and Distribution Requirement Planning (DRP).
The traditional production systems are based on a push system, whereby

acquisition or production of inventory is determined by expected future demand,
not in responding to current demand. It tends to keep large inventories on hand,
which is very costly.

ACCOUNTING
(a) Traditional Model ă Economic Order Quantity (EOQ) or Just in Case

A traditional inventory method applied under push system is known as
economic order quantity (EOQ) and also referred to as Just in Case method
(JIC). EOQ method will find the order quantity that minimises the total
cost, basically by balancing acquisition costs and carrying costs. EOQ
addresses two basic questions:
(i) How much to order/produce in order to minimise inventory costs?;

and
(ii) When to place order or to setup for production?
Let us look at Example 9.1 to see how EOQ is determined using a

simple formula.
 How much to order/produce in order to minimise inventory

costs?
Example 9.1
TC = PD/Q + CQ/2
TC = The total ordering (or setup) and carrying cost
P = The cost of placing and receiving an order (or the cost of setting up a
production run)
Q = The number of units ordered each time an order is placed (or the lot size
for production)
D = The known annual demand
C = The cost of carrying one unit of stock for one year
Calculation of EOQ
Q = EOQ = 2DP/C
EOQ =  2  50,000  RM200/RM5

EOQ = 4, 000, 000
EOQ = 2,000 units

ACCOUNTING
The following information is given for illustration:
D = 50,000 units
Q = 1000
P = RM200 per order
C = RM5 per unit
Let us compare the total cost (TC) for an order quantity of 2,000 units as
the given EOQ in Example 9.1 with the current order quantity (Q) of 1000
units.
Using the formula
TC = PD/Q + CQ/2
TC = Ordering (or setup) cost + Carrying cost
Substitute EOQ of 2,000 units
TC = RM200 (50,000/2,000) + RM5 (2,000/2)
= RM5, 000 + RM5,000 = RM10,000
Substitute Q = 1000 units
TC = RM200(50,000/1,000) + RM5(1,000/2)
= RM10,000 + RM2,500 = RM12,500
What can we conclude from the calculation? The order quantity as

given by EOQ (2,000 units in Example 9.1) will make the carrying
cost equals the ordering cost (RM5,000 each). Also notice that an
order quantity of 2,000 is less costly than an order quantity of
1,000 (RM10,000 versus RM12,500). So EOQ (2,000 units) is the
right amount to order, responding to the first question.

ACCOUNTING
 When to Place Order or to Setup for Production?

In answering this second question, we need to know the lead time
and rate of usage of inventory. Lead time is the time taken for the
economic order quantity to be received after an order is placed or
setup is initiated.
Reorder point is the time (day) when a new order must be placed
(or setup started). An order should be placed so that it arrives just
as the last item in inventory is used. This is to avoid stock-out
costs and at the same time minimise carrying costs. In addition,
due to uncertainties in demand, companies may carry safety stock.
Safety stock can be determined by multiplying the difference
between the maximum rate of usage and the average rate of usage
by the lead time.
Next, let us compute the EOQ and reorder point in Example 9.2.
Example 9.2
Assume that we have the following information for an item X, which is
produced internally.
Average demand for Item X : 360 per day

Maximum demand for Item X : 390 per day
Annual demand for Item X : 90,000
Carrying cost per unit : RM5
Setup cost : RM6,250
Lead time : 10 days
Calculation of EOQ:
Q = EOQ = 2DP/C
EOQ =  2  90,000  RM6,250/RM5

EOQ = 225, 000, 000
EOQ = 15,000 units

ACCOUNTING
Computation of Safety Stock:
Maximum usage 390

Average usage (360)
Difference 30
Lead time  10
Safety stock 300
Computation of Reorder Point:
Reorder point = (Average usage  Lead time) + Safety stock
= (360  10) + 300
= 3,900 units Item X
Based on Example 9.2, we can summarise that Item X should be produced in

batches of 15,000 units. The new setup should be started when the stock of Item X
drops to 3,900 units. Alternatively, if Item X is purchased from outside, that
means the economic order quantity is 15,000 units and the reorder point is when
the stock of Item X drops to 3,900 units.
Traditional inventory like EOQ model is still applicable and sensible for certain
industries or organisations like hospitals. Smaller manufacturers and retail stores
may not adopt contemporary inventory management systems like JIT due to cost
factor. To understand why EOQ model was widely used in the past, we need
to understand the nature of the traditional manufacturing environment. The
attributes of traditional manufacturing environment include mass production of
a few standardised products, large batch size due to high setup cost, long
production runs due to large batch size, less diversity in products because
product variations are expensive thus avoided.
Competition from global market, and advances in technology, communication

and transportation have changed the manufacturing environment significantly.
As a result, new or modern manufacturing environment are characterised by
higher diversity, shorter life cycles, and higher quality of products and lower cost
of production. Thus, contemporary methods were sought to replace EOQ model.

ACCOUNTING
Efficient inventory management would create an acquiring plan to ensure items

are available when they are needed (neither too much nor too little is purchased)
and monitor the existing inventory and its use. Specifically, there are the just-in-
time (JIT) method, where companies arrange to receive items as they are needed
rather than maintaining high inventory levels, and materials requirement
planning (MRP), which schedules material deliveries based on sales forecasts.
ACTIVITY 9.5
During your next tutorial session, pair up with a friend or classmate
and discuss the following questions for 15 minutes. Later, share your
findings with others in the class.
1. Why do you think traditional inventory methods like EOQ model

is still relevant today?
2. Think of several industries/organisations that might still use

traditional inventory methods. What are the rational or reasons
for these industries/organisations to stick to traditional inventory
methods?
3. What kind of organisations critically need contemporary methods

like JIT and MRP?
(b) Contemporary Inventory Models ă Just in Time (JIT)

JIT inventory management can improve profitability and a firmÊs
competitive position by controlling costs, improving delivery performance,
and improving quality. JIT generates flexibility to respond to customer
demands for higher quality and more diversity and offers cost efficiency.
JIT works in a pull system, whereby inventory or goods are pulled through
the system by present demand rather than by future anticipated demand.
JIT is capable to drive inventory to the lowest level possible or even zero
level. Accordingly, each operation produces only the quantity necessary for
the subsequent operation. JIT ensures materials and parts arrive just in time
for production to occur by the use of the Kanban system. The Kanban
system uses a card system to monitor and control movement of work and
parts among the manufacturing processes and outside suppliers. It is
responsible to make sure that the needed products or parts, are produced or
acquired in the necessary quantities at the right time.

ACCOUNTING
Next, let us examine how JIT minimises setup and carrying costs.
Previously, EOQ model seeks to balance these two costs by finding the
economic order quantity. However, JIT attempts to drive these costs to
zero, meaning that it is going for zero inventories. How is it possible?
Having close relationships and long-term contracts with suppliers will
certainly help to reduce ordering costs. Selection of suppliers is carefully
done, which later allows for negotiations on stipulated prices, acceptable
quality levels, frequency and on time delivery. Furthermore, JIT purchasing
can be described by fewer, but more ultra-reliable suppliers, frequent JIT
deliveries in small lots, and defect-free supplier deliveries.
Moreover, through a continuous replenishment arrangement between

manufacturers and retailers, inventory is reduced and no more stock-out
problems faced by retailers. In this arrangement, suppliers take charge of
inventory management of its buyers, telling buyers when and how much to
order. This continuous replenishment process is made possible by
electronic data interchange (EDI) that permits suppliers to have access to
the buyersÊ online database including production schedule.
Another attempt by JIT is to reduce setup times. Many companies have

experienced significant reduction in setup times generally by at least 75
percent, through continuous effort. JIT improves delivery performance not
by building up inventory but by drastically reducing lead times. Lead times
are cut by reducing setup times, improving quality, and using cellular
manufacturing. In fact, cellular manufacturing layout reduces travel
distance and movement between machines, inventory and labour, which in
turn has a great impact on lead time. It also creates a flexible and multi-
skills workforce.
In addition, JIT avoids shutdown and its related problems by adopting total
preventive maintenance and total quality control that strive for zero
machine failures and zero defects. Lean production supports and works
well with JIT inventory. Lean production has the strategic goal of
eliminating wastes and costs in every aspect of production.
JIT has its own limitations. Implementing JIT is not simple, and rather
needs careful and thorough planning and preparation. The workforce may
be put under pressure and stressful conditions. At the early stage,
companies may experience shortages, interrupted productions, and lost
sales. Despite that, many retailers and manufacturers are still strongly
committed to JIT. Alternative inventory management methods like MRP
and TOC are gaining greater attention.

ACCOUNTING
(c) Material Requirement Planning (MRP)

It is the oldest manufacturing control system. It is an operation
management tool that uses a computer to help manage materials and
inventories. It consists of three components, namely, Bills of materials
(BOM), Master production schedule (MPS), and Material requirement
planning system (MRPS). Nowadays MRP/MRPII is embedded in
Enterprise Resource Planning (ERP). Objectives of MRP are to ensure that
right materials, in right quantities and at right time are on hand. The
strength of MRP lies in its ability to determine precisely the feasibility of a
schedule within capacity constraints.
(d) Theory of Constraints (TOC)

TOC emphasises on protecting current sales while is also determined to
increase future sales by increasing quality, lowering response time, and
decreasing operating costs. TOC attempts to maximise throughput, and
minimise inventory and operating costs by identifying the organisationÊs
constraints and then exploiting them. Throughput refers to the rate at
which the organisation generates money through sales. It is represented
and measured as follows:
Throughput = (Sales revenue ă Unit-level variable expenses)/Time
Linear programming is useful for finding the optimal mix. A time buffer is used
and located in front of critical constraints, thus protecting throughput from any
interruptions. Eventually, since the buffer is located in front of critical
constraints, TOC is able to produce smaller inventories than JIT.
In brief, an effective inventory model leads to cost saving and efficiency.

Contemporary inventory management models are able to overcome excessive
inventory holding, which are associated with high cost and risks.
9.6 COST REDUCTION PROGRAMMES

Cost reduction programmes refer to systematic and well-structured plans, with
the aim to minimise the current level of costs and expense, while maintaining the
production level. Simply put, they are cost cutting plans, which are carefully
implemented in phases as not to give rise to adverse effects on the overall
performance of the organisation.

ACCOUNTING
Changing economic conditions are not always in our favour for business growth.
Sometimes our organisations have to endure prolonged extreme competition
and face funding constraints. In addition, natural disasters like earth quakes
and flood, political riots, workersÊ strike and many more events produce
unproductive environment and cause our organisations to suffer financial crisis.
Thus, these affected companies need to make a comeback and recover from the
situations maybe through cost reduction programmes. Not necessarily only those
financially unhealthy companies, but successful companies aiming for cost
efficiency or pursuing cost-leadership strategy may also adopt cost reduction
programmes to gain competitive advantage in the industry.
According to an article on Delivering Successful Strategic Cost Reduction

Programmes (Delivering Successful Strategic, 2014) cost reduction is a
challenging and high risk activity. To be successful and gain sustainable impact,
cost reduction needs to take a programmed approach, and be managed in full
alignment with the corporate strategy and implemented in phases across all
levels of the business.
There are a number of approaches or methods for performing cost reduction such
as Kaizen, lean production and value chain analysis. Thoughtful planning has to
be laid out prior to actually initiating any phase of a cost reduction programme.
Firstly, the manager needs to identify possible outcomes of each phase, and
forecast for any possible impact each of those scenarios would have on the
overall operation and performance. Next, managers need to determine whether
or not a given change in one phase would most likely increase costs in another
area of the operation. If one reduction leads to an increase in a different area of
the production, managers need to justify whether they should go ahead with the
changes because the changes may lead to overall cost reduction or merely
transfer expenses from one area to another.
ACTIVITY 9.6
What are the factors that contribute to a successful cost reduction

programme? Post your answer to this question in the myLMS forum
and respond to some of the postings by your coursemates.
Prior to implementation, initially organisations need to ensure that accurate,

detailed cost data to underpin the programme must be made available. The
programme should be sufficiently resourced to carry out the cost reduction
targets. Full commitment and support from the top and senior management
throughout the lifetime of the programme will induce organisations to face
significant challenge and changes.

ACCOUNTING
At most, a cost reduction programme indirectly drives existing resources to be

used to best advantage, employees are able to perform more efficiently and at the
end of the day customers experience the highest quality of goods and services.
 Modern business environment has significantly affected management

accounting. Major impacts can be observed on the changing in management
accounting practices, changing in management accountantsÊ role, and
management accountantsÊ skills and competency.
 In modern business environment, organisations have shifted their focus

toward customers, quality and value, whereby any decision-making and
policies are directed toward creating and increasing values to customer.
 Flexible production allows quick response to the market, and lowers the
production costs which enable a company to gain competitive advantage,
which eventually will increase customerÊs satisfaction and result in
profitability.
 Efficient and effective inventory management and systematic implementation

of cost reduction programmes would enable organisation to pursue cost
efficiency and cost-leadership strategy successfully.
1. Describe three impacts of modern business environment on management

accounting practices.
2. Discuss the characteristics of customer-oriented organisations.
3. Discuss the differences between traditional and flexible productions. How

does flexible production respond to the demands of modern business
environment?

TOPIC 9 MODERN BUSIN
NESS ENVIRONM
MENT AND MA
ANAGEMENT  261
A
ACCOUNTING
1. Describe the chaanging role of

o a managem
ment accountaant due to ch
hanges in
bussiness environ
nment.
2. Disscuss the facto

ors that may have
h influencce on customeer satisfaction
n.
3. An
nalyse what determines thee choice of inv
ventory manaagement mod
del.
4. Exaamine the aima of costt reduction programme and how it helps

org
ganisations to
o gain compettitive advantaage.
Compettitive advanta
age nagement acco
Man ounting practtices
Contem
mporary inven
ntory models Mateerial Requirem
ment Plannin
ng
(MR
RP)
Continu
uous improveement
Mod
dern manufaccturing enviro
onment
Cost red
duction progrram
Pull system
Custom
mer focus
h system
Push
Custom
mer satisfaction
n
Rolee of managem
ment accountant
Custom
mer value prop
position
Theo
ory of Constraaints (TOC)
Econom
mic Order Qua
antity (EOQ)
Thro
oughput
Employ
yee empowerm
ment
Trad
ditional inven
ntory method
Flexiblee manufacturiing system (FMS)
Trad
ditional manu
ufacturing
Flexiblee production
environment
JIT purcchasing
ditional produ
Trad uction
Just-in-T
Time (JIT) inv
ventory
Valu
ue chain analy
ysis
manageement
Manageement accoun
ntantÊs skills

Answers
Topic 1: Introduction to Management Accounting

Self-Test 1
1.
Financial Accounting Management Accounting

Users External users Internal users
Focus A summary of past activity, Emphasis on future oriented
based on historical costs activities
Information More objective and diverse More flexible and relevant
Nature of Only accurate (often audited) Data are presented as a whole
Information data are reported in annual or a segment of an entity, e.g. a
reports division, products, customers
and process
Compliance Must comply with Generally Need not comply with GAAP
Accepted Accounting (Generally Accepted
Principles (GAAP). Accounting Principles).
2. Relevant; Comprehensible; Timely; Comparable; Reliable and Complete;

and cost benefit characteristic.
(a) Determine the cost for every product and service offered.
(b) Implement the planning, directing, controlling and performance

evaluating functions.

ANSWERS  263
Self-Test 2
1. Ramlee acts as a staff manager.
Reasons:
(a) Ramlee is not directly responsible for the production.
(b) Ramlee is responsible for preparing reports for the use of production
and factory managers.
(c) Ramlee has a duty that supports other production sections.
Amreel acts as a line manager.
Reasons:
(a) Amreel is directly responsible for the production.
(b) Amreel supervises the workersÊ line, assists in developing the

production plan and ensures that the production target is achieved.
(c) Amreel is also responsible for monitoring the production costs.
2. Competency, Confidentiality, Integrity and Objectivity.
Topic 2: The Concepts and Classification of Costs

Self-Test 1
1. Product cost is the cost which can be assigned directly to a product. It is an

inventoriable cost, which is included in the calculation of the cost of a single
unit product. The product cost is an asset since it will remain in the
inventory for as long as the product is not sold.
Period cost is the cost that is charged as expenses in the period in which it is
incurred and cannot be inventoried. For instance, administrative and selling
expenses.
Prime costs are primary costs, such as the direct raw materials and direct
labour costs used in producing the finished product.

264  ANSWERS
Conversion costs equal direct labour and factory overhead costs. These
costs are known as conversion costs because they are the costs incurred in
converting raw materials into finished goods.
2. Rendasulam Sdn Bhd Company

Statement of Cost of Goods Manufactured for the year ended 31 December 2013
RM
Used Raw Materials (1/2  RM40,000) 20,000
Factory Overheads (6  RM20,000) 120,000
180,000
+ Opening Work in Process (WIP) Inventory 20,000
200,000
– Closing (WIP) Inventory (20,000 + 5,000) 25,000
Cost of Goods Manufactured (CGM) 175,000
Rendasulam Sdn Bhd Company

Income Statement for the year ended 31 December 2013
RM RM
Sales 300,000
– Cost of Goods Sold:
Closing Finished
Opening Finished Goods Inventory 45,000
Goods Inventory
+ Cost of Goods Manufactured (CGM) 175,000
220,000 – 180,000
220,000
Closing Inventory* (40,000) (180,000)
Gross Profit (40%  300,000) 120,000

– Marketing and Administration Costs (80,000)
Operating Income 40,000

ANSWERS  265
3.
Lis Company
RM RM
Beginning Direct Raw Materials Inventory 48,000
+ Purchase of Raw Materials 240,000
Ready-to-Use Raw Materials 288,000
– Ended Direct Raw Materials Inventory (70,000)
Used Raw Materials 218,000
Factory Overhead 640,000
Manufacturing Cost 1,218,000
Cost of Beginning WIP 176,000
Cost of Readily Goods Manufactured 1,394,000
– Cost of Ended WIP 150,000

266  ANSWERS
(a) Statement of Cost of Goods Manufactured
Russ Company
RM RM
Direct Raw Materials:
+ Purchase of Raw Materials 260,000
Ready-to-Use Raw Materials 310,000
– Closing inventory 40,000
[1]
Raw Materials Used in Production 27,000
Direct Labour 65,000* *K 675000 – 270000
Factory Overheads: *– 340000 = 65000
Factory Insurance 8,000

Rental of Factory Building 90,000
Factory Utility 52,000
Factory Cleaning Supply 6,000
Depreciation of Factory 110,000
Equipment
Total Overhead Cost 340,000
Total Manufacturing Cost 675,000 [3]
+ Opening WIP Inventory 48,000* * 690000 + 33000
– 340000 = 65000
– Closing WIP Inventory 33,000
Cost of Goods Manufactured 690,000
Note: Only manufacturing costs incurred are taken into account.

ANSWERS  267
Russ Company
Statement of Cost of Goods Sold for the year ended 31 December 2013
RM [2]
Opening Finished Goods Inventory 30,000 * 720000 – 30000
= 690000
+ Cost of Goods Manufactured 690,000*
Cost of Readily Goods Manufactured 720,000 [4]
– Closing Finished Goods Inventory 85,000* * 720000 – 635000
= 85000
Cost of Goods Sold 635,000
The items denoted with * signs have to be computed backward.
(b) Raw Materials: RM270,000 / 30,000 units = RM9 per unit
Factory Building Rental: RM90,000 / 30,000 units = RM3 per unit.

268  ANSWERS
Self-Test 2
1.
Hull Company
Statement of Cost of Goods Manufactured for the month ended 31 August 2013
RM RM RM
Direct Raw Materials: (Plastic)
Opening Inventory 2,200,000 (A)
(+) Purchase 4,500,000
Ready-To-Use Raw Materials 6,700,000

(–) Closing Inventory (800,000)
Direct Raw Materials Used 5,900,000
(DRM)
Direct Labour 3,000,000
Prime Cost 8,900,000
Factory Overheads: 1,200,000
Rent (60%) 360,000
Utility (60%)
Glue, Paint, Small Items:
+ Purchase 100,000
– Closing inventory 300,000 50,000 1,610,000
10,510,000
+ Beginning WIP 1,000,000
11,510,000
– Ended WIP (500,000)

ANSWERS  269
Hull Company
Income Statement for the month ended 31 August 2013
RM RM RM
Sales 18,000,000
Less: Cost of Goods Sold:
Opening Inventory 12,000,000
+ Cost of Goods 11,010,000
Manufactured (CGM)
Cost of Readily Available Goods 23,010,000
– Closing Inventory 8,500,000 (B) [4]
(14,510,000)
Gross Margin 3,490,000
Other Costs/Expenses:
Supply
(75,000 + 210,000 – 90,000) 195,000
Marketing and 2,000,000
Administration Salary
Rent (40%) 800,000
Utility (40%) 240,000
Advertising 350,000
(3,585,000)
Net Loss (95,000)

270  ANSWERS
2.
Cost Total Fixed Variable

SupervisorÊs Salary 4,700 4,700
Labour Wages 16,700 16,700
Machine Depreciation 6,000 6,000
Machine Repair Cost 5,100 5,100
Total 10,700 21,800
On average, 5,000 machine hours are used.
Hence, the variable cost per machine hour is RM21,800/5,000 machine

hours = RM4.36 per machine hour.
In terms of the cost function: Y = RM10,700 + RM4.36 per machine hour
3. (a) The followings are the steps to be taken to solve the problems of
Fantasia Sdn Bhd Company.
Step 1: Identify the period between the highest and lowest activity
(operation) levels.
Hours RM
Highest Level (in December) 125,000 250,000
Lowest Level (in May) 85,000 170,000
Difference 40,000 80,000

ANSWERS  271
Step 2: Analyse the changes in both operation levels to estimate

the variable cost per unit.
The difference between the two points in terms of the costs
(in RM) is divided by the difference in terms of operation
levels (in units) to estimate the variable cost.
The formula which can be used is:
RM250,000  RM170,000
Variable cost 
125, 000  85, 000
RM80,000

40, 000
 RM2 per unit.
Step 3: Determine the fixed cost.

The fixed cost can be computed by selecting either the
lowest or highest point and deducting the variable cost
from the total cost.
Suppose we choose the highest point, then:

RM250,000 = Fixed Cost + (125,000 machine hours  RM2)
Fixed Cost = RM250,000 – RM250,000
= 0
If we choose the lowest point:

RM170,000 = Fixed Cost + (85,000 machine hours  RM2)
Fixed Cost = RM170,000 – RM170,000
= 0

272  ANSWERS
Step 4: Determine the cost function.

(a) The cost function for the electricity cost of Bulat Sdn.
Bhd. Company is:
Y = RM2x
(b) Substituting 90,000 machine hours into the cost

function obtained in (a) gives:
Y = RM2(90,000)
Y = RM180,000
Thus, the repair cost for the month is RM180,000.
4. The Least Squares Method involves the process of assessing the cost
function objectively by using a statistical method for matching the cost
function with all the data.
5.
x y xy x2
20 82 1,640 400
16 70 1,120 256
24 90 2,160 576
22 85 1,870 484
18 73 1,314 324
  x   100   y   400   xy   8, 104   x   2, 040

2
n=5

ANSWERS  273
n   xy     x   y 
b
n  x    x 
2 2
5  8,104    100  400 

b
5  2, 040    100 
2
520
b  2.6
200
a  y  bx
 400   100 
a    2.6    28
 5   5 
thus, y = 28 + 2.6x
That means, the estimated fixed cost is RM28 while the estimated variable
cost is RM2.60 per unit.
Topic 3: Materials and Labour Accounting

Self-Test 1
1. Three examples of direct materials are flour, sugar and butter. Three
examples of indirect materials are boxes, cutter and ribbons.
2.
Document Purpose and Usage

 SupplierÊs Invoice Records the quantity of goods received and the
price agreed between the supplier and the
 Purchasing Claim Records the goods required for acquisition by the
 Memo of Records information on the actual goods received.
Acknowledgement
 Inspection Report Records the condition of goods received from the
supplier.
 Purchase Order Form Records detailed information on the code, quantity
and price of goods to be purchased. The form is sent
to the selected supplier.

274  ANSWERS
3. This method explains how the first goods purchased must be fully used
and produced first in the production process. This means, the first goods
transferred-in into the store must be completely consumed first before the
later purchased goods can be used.
According to the FIFO method, goods will be valued at cost price.

However, if the cost of the goods changes, there will be a difference
between the current (market) price and the cost price charged to the
production departments. Nonetheless, this method appears to be more
profitable during times of inflation where the cost price is lower than the
market price of the goods. In this way, the manufacturing cost is reduced,
thus increasing the companyÊs net income.
Self-Test 2
1.
Loss Factor Description

Production Problems which may occur in production include
inefficient labour, insufficient equipment and defective
or incorrect materials used.
Rejection Problems occur when the materials delivered are
inconsistent with the specification. They may not be
approved when the inspection process is performed on
them. This might happen during the receiving of
materials or production process.
Obsolescence Problems arise when a new type of material required in
production differs from the purchased material. This
normally happens if there are changes in the
specifications or demands for the material.
Loss in Handling Problems occur during the handling of materials in
production process and are caused by carelessness or
theft.
Storage Procedure Problems caused by evaporation, corrosion and fading
(colour).
Inefficient Procedure Problems may arise when materials transferred to the
of Production production department are more than what is needed.
This may result in a loss if the materials are damaged
before they are returned to the store.
Material Features Materials which are prone to damage by evaporation
require intensive care to avoid any losses.

ANSWERS  275
2. (a) The main purposes of the JIT purchasing system are to:
(i) Eliminate waste from production activities
(ii) Reduce the stock to nil
(iii) Achieve continuous production
(iv) Minimise any activity with no value adding
(b) Three key features in the JIT system are:
(i) Suppliers
(ii) Factory Layout
(iii) Inventory Level
(c) The advantages and disadvantages of a JIT system can be viewed in

the following table:
 Reduces production time.  Difficult to perform quickly.
 Increases productivity and  Increases pressures among
working capital. workers.
 Reduces inventory cost and  Bears high risks if suppliers fail
storing cost. to perform efficiently.
 Reduces defect items and waste.  Failing to complete orders will
increase the risk of not making
future sales.
3. Three examples of direct labour:
(a) Carpenter
(b) Wood Polisher
(c) Wood Cutter
Three examples of indirect labour:
(a) Storekeeper
(b) Van Delivery Driver
(c) Account Clerk

276  ANSWERS
Topic 4: Overhead Cost Accounting

Self-Test 1
1. Support service departments provide supporting service to other

departments within the company. These departments do not add value to
the products.
2. Production or operational departments convert raw materials or direct

materials into finished goods.
3. Usually, overhead costs are combined in a pool of costs and are then
allocated by using a predetermined rate. The rate is determined according
to the most appropriate form of the allocation base.
The general formula for calculating the predetermined overhead rate is as

follows:
Predetermined Overhead Rate =
Estimated Total Manufacturing Overhead Cost (RM)

Estimated Total Activity or Allocation Basis (Base)
4. 10%  RM10 = RM11.00
RM300,000
5.  RM20.00
15, 000
6. The cost of the service department can be allocated by using different bases
of allocation. For instance, the costs of a human resource department can be
divided into two categories, namely, training cost and other costs. Training
cost is allocated to other departments by using the training hours provided,
while other costs are allocated using the number of staff within the
department.
7. The followings are the steps which must be taken:
(a) Identify the allocation base for each department.
(b) Allocate the cost of each department to other departments.
8. Direct method, step down method and reversal method.

ANSWERS  277
9. (a) Based on the information given, below are the allocation bases which
will be used.
(i) Canteen Department – Number of employees
(ii) Human Resource Department – Number of employees
(iii) Security Department – Square feet area
(b) (i) The costs of the support service department allocated based on
the direct method.

Human
Resource
Total Cost of
Department 300,000 450,000 40,000 255,000 30,000 150,000
(RM)
Canteen
300,000 153,846 53,846 92,308
Allocation
Human Resource
450,000 230,769 80,769 138,462
Allocation
Security
40,000 20,000 10,000 10,000
Allocation
Total Costs After
659,615 174,615 390,770
Allocation

278  ANSWERS
(ii) The costs of the support service department allocated based on the
step down method.

Human
Resource
Total Cost of
Department 450,000 300,000 40,000 255,000 30,000 150,000
(RM)
Canteen
450,000 114,407 38,136 152,542 53,390 91,525
Allocation
Human
Resource 414,407 47,092 188,367 65,928 113,020
Allocation
Security
125,228 62,614 31,307 31,307
Allocation
Total Costs After
658,523 180,625 385,852
Allocation
Self-Test 2
1. Actual costing is a costing system where calculations of manufacturing

costs are performed after all the works are fully completed.
2. Normal costing is a costing system which assigns costs to activities or jobs.
3. An actual costing system employs actual overhead cost rate whereas a

normal costing system uses a predetermined overhead cost rate.
4. (i) RM45.46
(ii) RM50.00
(iii) The normal overhead rate is lower than the actual overhead rate,
where the difference between the two is RM4.54.
5. When the amount of normal overhead exceeds the actual overhead

incurred, then the Manufacturing Overhead Cost account will have a credit
balance. The resulting credit balance is known as overapplied overhead.
Conversely, when the actual overhead exceeds the absorbed overhead, the
Manufacturing Overhead Cost account will have a debit balance, described
as underapplied overhead.

ANSWERS  279
6. One of the approaches to eliminate or adjust the balance of this account

(whether debit or credit) is by transferring it to the Cost of Goods Sold
account.
7. When direct labour is replaced by automated machines, the manufacturing

overhead cost will increase while the cost of direct labour will decrease.
This will result in an increase in the predetermined overhead cost rate if it
is based on direct labour.
8. The predetermined cost rate: direct labour hour = RM350,000/18,000

= RM19.44 per direct
labour hour
9. Therefore
RM300,000 – (17,500  RM19.44) = RM300,000 – RM340,200

= (RM40,200) overapplied overhead
Topic 5: Activity-Based Costing (ABC)

Self-Test 1
1. The disadvantages of traditional costing systems:
The traditional costing systems are designed to cater for the businesses with
the following features:
(a) Small number of products.
(b) Direct materials and direct labour are the key components of the
production.
(c) Manufacturing overhead is low, thus it is not suitable to use an

extensive system as the allocated overhead is minimal.
(d) Assumes that the direct and indirect materials consumed in

manufacturing the product are directly proportional to the
production units.

280  ANSWERS
2. The features of an activity-based costing system are as follows:
(a) A costing method which combines the overhead costs for each
activity. Consequently, the costs are allocated to products, services or
cost objects according to the required activity.
(b) Emphasises the comprehensive understanding of the relationship

between the activities that give rise to the overhead cost and the
manners to which the overhead cost relate to its cost objects.
(c) Overhead costs are accumulated according to the activity.
 Uses cost drivers which are independent of the production

quantity (for instance, number of production lines, number of
setting up hours and number of purchase orders). Subsequently,
the overhead cost is allocated to its cost objects.
3. The classification of costs:
(a) Product level: The costs of designing and drafting process chart which
are related to the type of products manufactured.
(b) Batch level: The costs of ordering and receiving raw materials as well
as the cost of paying the suppliers are the costs related to the batch of
raw materials ordered and received.
(c) Batch level: The costs of setting up the machines which are related to
the batch of the televisions produced.
(d) Unit level: The cost of depreciation of machinery is related to the

number of units produced as the machines are used to manufacture
products.
(e) Facility level: Factory rental and insurance are not related to the
number of units or products produced.
(f) Unit level: The indirect materials costs which are related to the
number of units produced.
(g) Unit level: The indirect labour costs which are related to the number
of units produced.

ANSWERS  281
Self-Test 2
1. Three main factors in selecting a cost driver in the activity-based costing

system are:
(a) The relationship between the activity and the application of its cost
driver;
(b) The cost of measuring the cost driver; and
(c) The behavioural impact, i.e. how the selected cost driver can affect the
individual behaviour involved in the activities related to the cost
driver.
2. (a) By using the current method of costing used by the company,
The cost allocation rate is:
Total Overhead Cost

Allocated Overhead Cost Rate =
Total Machine Hour
Allocated Overhead Cost Rate =
RM  10, 430  5, 250  3, 600  2,100  4, 620 

5,215 machine hours
Allocated Overhead Cost Rate = RM5.00 for every machine hour.
Overhead cost for a single unit of RZ: 4 machine hours  RM5 = RM20
Overhead cost for a single unit of RX: 3 machine hours  RM5 = RM15
Overhead cost for a single unit of RV: 2 machine hours  RM5 = RM10
Per Unit Cost RZ (RM) RX (RM) RV (RM)

Direct Raw Materials Cost 40 50 30
Direct Labour Cost 28 21 14
Overhead Cost 20 15 10
Total Cost Per Unit 88 86 54

282  ANSWERS
(b) By using the activity-based costing method, the allocation rates are as
follows:
Total Cost Total Allocation

(RM) Activity Rate (RM)
Machinery department 10,430 5,215 2
Setting up machines 5,250 50 105
Receiving goods 3,600 120 30
Inspection 2,100 140 15
Delivery 4,620 77 60
The overhead costs for products RZ, RX and RV are as follows:
Product
RZ (RM) RX (RM) RV (RM)
Activity Cost
Processing
(120  4) machine hours  RM2 960
Setting Up
6 setting up  RM105 630
Receiving Goods
12 receipts  RM30 360
Inspection
6 inspection  RM15 90
Delivery
24 deliveries  RM60 1,440
20 deliveries  RM60 1,200
16 deliveries  RM60 960
Total Overhead 3,480 2,700 2,000
Production Units 120 100 80
Overhead Cost Per Unit 29 27 25

ANSWERS  283
The costs per unit of products RZ, RX and RV under the activity-
based costing method are as follows:
RZ(RM) RX(RM) RV(RM)

Direct Raw Materials 40 50 30
Direct Labour 28 21 14
Overhead Cost 29 27 25
Cost Per Unit 97 98 69
3. (a) By using the current method of costing used by the company:
How many machine hours are required to produce Sporty and

Standard bicycles?
Standard Sporty
1. Total machine hours 45,000 hours 32,000 hours
2. Total production units 30,000 units 16,000 units
3. Machine hours per bicycle unit 1.5 hours 2 hours
4. Predetermined overhead rate RM80 RM80
5. Total overhead per bicycle unit RM120 RM160
Otherwise, according to the following calculation:
Overhead Cost for Standard Bicycles:

45,000 machine hours  RM80 = RM3,600,000
RM3,600,000/30,000 units = RM120 per unit.
Overhead Cost for Sporty Bicycles:

32,000 machine hours  RM80 = RM2,560,000
RM2,560,000/16,000 units = RM160 per unit.
Sporty Standard
Direct Raw Materials 40 65
Direct Labour 25 25
Overhead Cost 160 120
Cost Per Unit 225 210

284  ANSWERS
(b) By using the activity-based costing method, the allocation rates are as
follows:
Total Cost Allocation Rate

Total Activity
(RM) (RM)
Setting up machines 1,344,000 160 8,400
Processing 3,696,000 77,000 48
Delivery 1,120,000 350 3,200
The overhead costs for Sporty and Standard bicycles are as follows:
Sporty Standard
Setting Up
100 setting ups  RM8,400 840,000
60 setting ups  RM8,400 504,000
Processing
32,000 hours  RM48 1,536,000
45,000 hours  RM48 2,160,000
Delivery
200 deliveries  RM3,200 640,000
150 deliveries  RM3,200 480,000
Total Overhead 3,016,000 3,144,000

Production Units 16,000 30,000
Overhead Cost Per Unit 188.50 104.80
The costs per unit of Sporty and Standard bicycles under the activity-
based costing method are as follows:
Sporty Standard
Overhead Cost 188.50 104.80
Cost Per Unit 253.60 194.80

ANSWERS  285
(c) The company cannot reduce the price of Sporty bicycle from RM270 to
RM240 since its production cost is RM253.60, based on the ABC
system. In fact, Twin Tower Company will incur a loss at the selling
price of RM240.
Topic 6: Job Order Costing

Self-Test 1
1. The job-cost sheet is used to record all costs incurred allocated to a specific
job. These costs include direct raw materials and direct labour, which are
traceable to the job as well as manufacturing overhead, which is absorbed
into the job. When the job is completed, the job-cost sheet is used to record
the costs of finished goods. In addition, it also serves as a control document
for the purpose of:
(a) Determining the number of units sold as well as the costs related to
the sold units; and
(b) Determining the number of the remaining units in the inventory as

well as determining its value in the balance sheet or Notes To The
Accounts.
A sales order is issued as soon as the confirmation is made by customers

regarding the quantity, price, delivery date and so on. The sales order
serves as a basis for preparing a production order or as an instruction for
production by the production department. The production order
summarises the details on product specification or ordered job and it will
become the basis for the accounting department to prepare the job-cost
sheet. Subsequently, the job-cost sheet will be used to summarise various
production costs incurred in completing the job. These costs are recorded in
the job-cost sheet based on the materials requisition form, time ticket for
direct labour and overhead allocation that is based on a predetermined
overhead rate.
2. The predetermined overhead rate is used to allocate and apply the

overhead cost to a specific job. It is determined before a particular period
begins and is calculated by dividing the estimated total overhead cost
during the period by the expected total allocation base. Based on the
obtained predetermined rate, we can then apply or absorb the overhead
cost to the job by multiplying it with the total activity unit or actual
allocation base used for completing the job.

286  ANSWERS
3. The Manufacturing Overhead Account will be credited when the overhead

cost is applied or absorbed to Work in Process. In general, the absorbed
amount of the overhead will not be the same as the actual overhead amount
involved due to the fact that its predetermined rate is derived based on
estimation.
Self-Test 2
1. Underabsorbed overhead occurs when the actual overhead cost exceeds the
overhead cost absorbed to Work in Process over a given period of time.
Conversely, overabsorbed overhead takes place when the actual overhead
cost is less than the overhead cost absorbed to Work in Process. The
overabsorbed or underabsorbed overhead will be eliminated by either
closing or transferring the amount to the Cost of Goods Sold account, or
distributing and transferring the amount between the Cost of Goods Sold
account and the Inventory account, based on the value of the absorbed
overhead in each account. The adjustment for underabsorbed overhead will
increase the Cost of Goods Sold (and Inventory), while the adjustment for
overabsorbed overhead will reduce the Cost of Goods Sold (and Inventory).
2. When direct labour is substituted by automated machines, the

manufacturing overhead cost will increase while the cost of direct labour
will reduce. This will result in an increase in the predetermined overhead
cost rate if it is based on direct labour.
3. Some companies employ various overhead rates (more than one rate) in
order to enhance the accuracy of the overhead costs allocation to products.
Multiple overhead rates are suitable for companies producing many types
of products with different rates of resources used. In addition, the multiples
rates are also suitable for allocating the overhead costs of a department
which uses machines intensively while other departments are more
inclined towards direct labour force.

ANSWERS  287
4. (a)
Siti Tan Samy

Plan Sketcher – Hours 84 70 63
Predetermined Overhead Rate  RM120  RM120  RM120
Absorbed Overhead RM10,080 RM8,400 RM7,560
(b)
Siti Tan
Direct Labour 6,700 5,500
Absorbed Overhead 10,080 8,400
Total Cost (a) RM19,980 RM16,500
*RM9,980 + RM16,500 = RM36,480
(c) The balance in Work in Process (WIP) account is made up of all the
costs related to project Samy which are unfinished as follows:
Direct Materials RM1,100

Direct Labour 5,000
Absorbed Overhead 7,560
Total Cost in WIP RM13,660
(d) The balance in the Overhead account can be determined as follows:
Overhead
Actual Cost 21,000 26,040 Absorbed Cost
22,100 5,040 Overabsorbed
As mentioned earlier, the credit balance in the Overhead account

implies that the overhead cost has been overabsorbed. In other words,
the actual overhead cost is less than the overhead cost absorbed in the
Work in Process account.

288  ANSWERS
5. (a)

Direct Labour 2,202
Absorbed Overhead (367*RM5.00**) 1,835
Total RM9,923
Per Unit Cost (120 units) RM76.98
*RM2,202  RM6.00/DLH = 367 Direct Labour Hours (DLH)
*RM85,000  17,000 DLH = RM5/DLH
(b)
Actual Overhead RM68,200

Absorbed Overhead:
14,400 DLH  RM5.00 72,000
Absorbed Overhead (RM3,800)
Topic 7: Process Costing System

Self-Test 1
1. (a) Equivalent Units
= Finished Units + Ended Work in Process (completed percentage)

Direct Materials Equivalent Units
= 180,000 Units + 8,000 Units * (100% – Direct materials transferred
in the beginning of process)
= 188,000 Units.
Conversion Costs Equivalent Units = 180,000 Units + (8,000 Units x)

= 182,000 Units.

ANSWERS  289
(b) Per Unit Cost for Direct Materials and Conversion Costs as well as
The Cost of Finished Units Transferred-Out to Process B.
Per Unit Direct Materials Cost
Direct Raw Materials Costs WIP 

Current Cost (DRM) for Beginning of DRM Incurred

DRM Equivalent Units
RM16,000  RM190,800

182, 000 units
 RM1.10
Per Unit Conversion Cost
Conversion Costs for Beginning WIP 

Current Cost of Conversion Cost Incurred

Conversion Costs Equivalent Units
RM22,800  RM377,600

182, 000 units
 RM2.20
Cost of Finished Units Transferred-Out
 Per Unit Direct Materials Costs  Per Unit Conversion Cost

 RM1.10  RM2.20
 RM3.30

290  ANSWERS
(c) Transferred-Out Cost and Ended Work in Process Inventory Cost
Closing Inventory Cost = Closing Inventory DRM Costs +

Closing Inventory Conversion
Costs
Closing Inventory DRM Cost = Closing Inventory DRM Units 

Per Unit Direct Materials Cost
= 8,000 units  RM1.10
= RM8,800
Closing Inventory Conversion = Closing Inventory Conversion

Cost Units  Per Unit Conversion Cost
= 2,000 units  RM2.20
= RM4,400
Thus, Closing Inventory Cost = RM8,800 + RM4,400

= RM13,200
(d) Journal Entries for Process A
RM RM
Dt. Work in Process A Inventory 568,400
Ct. DRM Inventory 190,800
Ct. Salaries Payable 205,200
Ct. Manufacturing Overheads 172,400
(Record the current costs incurred in process A)
Dt. Work in Process B Inventory 594,000
Ct. Work in Process A Inventory 594,000
(Record the transferred-out costs from Process A to Process B)

ANSWERS  291
(e) Account for Work in Process A
RM RM
Balance b/f 38,800 Work in Process B
Inventory 594,000
DRM Inventory 190,800 Balance c/f 13,200
Salaries Payable 205,200
Manufacturing
Overheads 172,400
607,200 607,200
2. (a) (i) Raw Materials 400,000

(ii) Work in Process 407,000

(iii) Manufacturing Overheads 120,000

Utility Expenses 30,000
(iv) Work in Process 483,000

Salary Expenses 231,000
Payable Salaries and Wage 903,000
(v) Manufacturing Overheads 150,000

(vi) Advertising Expenses 270,000

(vii) Manufacturing Overheads 152,000

Depreciation Costs 38,000
Accumulated Depreciation Cost 190,000

292  ANSWERS
(viii) Manufacturing Overheads 176,400

Rents 75,600
(ix) Work in Process 779,000

Estimated Overhead Cost of RM697,000

 RM410 per Direct Labour Hour (DLH)
Expected DLH of 1,700
1,900 of actual DLH  RM410 per DLH  RM779,000.
(x) Finished Goods 1,550,000

Accounts Payable 1,550,000
(xi) Receivable Accounts 2,400,000

Sales 2,400,000
Cost of Goods Sold 1,650,000
Finished Goods 1,650,000
(b)
Receivable Account Sales

(xi) 2,400,000 2,400,000 (xi)
Raw Materials Cost of Goods Sold

Balance 66,000 (xi) 1,650,000
400,000
Balance 59,000

ANSWERS  293
Work in Process Manufacturing Overheads

Balance 45,000 1,550,000 (x) (iii) 120,000 779,000 (i)
(ii) 407,000 (iv) 189,000
(iv) 483,000 (v) 150,000
(ix) 779,000 (vii) 150,000
(viii) 176,400
Balance 164,000 Balance 8,400
Finished Goods Advertising Expenses

Balance 125,000 1,650,000 (xi) (vi) 270,000
(x) 1,150,000
Balance 25,000
Accumulated Depreciation Utility Expenses

190,000 (vii) (iii) 30,000
Payable Account Salary Expenses

400,000 (i) (iv) 231,000
150,000 (iii)
150,000 (v)
270,000 (vi) Depreciation
252,000 (viii) (vii) 38,000
Salaries Payable and Wages Rent

903,000 (iv) (viii) 75,600

294  ANSWERS
(c)
Anggun Fabrics Bhd.

Statement of Cost of Goods Manufactured
Direct Materials:
Beginning Balance in Raw Materials
Inventory RM66,000
Purchased of Raw Materials 400,000
Ready-to-Use 466,000
Closing Balance in Raw Materials Inventory 59,000
Used Raw Materials in Production RM407,000
Factory Overhead Absorbed into WIP
Account 779,000
Total Manufacturing Cost 1,669,000
Add: Beginning WIP 45,000
1,714,000
Less: Ending WIP 164,000
Cost of Goods Manufactured RM1,550,000
(d)

Manufacturing Overhead 8,400
Statement of Cost of Goods Sold:

Opening Balance of Finished Goods RM125,000
Add: Cost of Goods Manufactured 1,550,000
Readily Available Goods for Sales 1,675,000

Less: Closing Balance of Finished Goods 25,000
Cost of Goods Sold before Adjustment 1,650,000

Add: Underabsorbed Overhead 8,400
Cost of Goods Sold after Adjustment RM1,658,400

ANSWERS  295
(e)
Anggun Fabrics Bhd.

Income Statement
Sales RM2,400,000
Less: Cost of Goods Manufactured 1,658,400
Less: Administrative and Selling Expenses:
Advertising costs RM270,000
Utility costs 30,000
Salaries 231,000
Depreciation 38,000
Rent 75,600 644,600
Net Profit RM97,000
(f)

Underabsorbed Overhead (80 hours  RM410 per hour) 32,800
Total Manufacturing Cost 68,620
Add: margin (% profit) = (45%  RM68,620) 30,879
Total Price for Job No. K22 RM99,499
RM99,499  250 units = RM398 per unit

296  ANSWERS
Self-Test 2
1.
Nadhirah Berhad
Production Costs Report Department Y for the month of September 2013
Physical
QUANTITY TABLE Flow
(units)
Units to be Accounted:
Units to be Accounted for 72,000 Equivalent Units
Transferred-In Direct RM Conversion
Units Accounted:
Units Cost Cost
Units Completed 66,000 66,000 66,000 66,000
Units in Ended WIP 6,000 6,000 *6,000 3,000
Units Accounted for 72,000 72,000 72,000 72,000
COST TABLE (RM) (RM) (RM) (RM)
Total Transferred-In Direct RM Conversion
Cost Cost Cost Cost
Costs in Beginning WIP 146,840 90,640 22,600 33,600
Current Cost Incurred 643,360 319,760 67,400 256,200
Total Cost to be Accounted for 790,200 410,400 90,000 289,800
Per Equivalent Unit Cost RM11.15 RM5.70 RM1.25 RM4.20
Cost Cost Cost
Units Completed and Transferred
(66,000  RM11.15) 735,900 735,900
Ended WIP:
Transferred-In Cost (6,000 units  RM5.70) 34,200 34,200
Raw Materials (6,000  RM1.25) 7,500 7,500
Accounted for Total 735,900 54,300 790,200
* (100% units of direct raw materials in ended WIP as the direct raw materials were
transferred-in at the beginning of the process).

ANSWERS  297
Nadhirah Berhad
Production Costs Report Department Z for the month of September 2013
Physical
QUANTITY TABLE
Flow (units)
Equivalent Units
Transferred-In Direct RM Conversion
Units Accounted:
Units Cost Cost
Units Completed 74,000 74,000 74,000 74,000
Units in Ended WIP 6,000 6,000 *0 3,600
Units Accounted for 80,000 80,000 74,000 77,600
COST TABLE
Total Cost Transferred-In Direct RM Conversion
Costs To Be Accounted For:
(RM) Cost (RM) Cost (RM) Cost (RM)
Costs in Beginning WIP 150,552 86,500 29,540 34,512
Current Cost Incurred 1,042,300 735,900 60,000 246,400
Total Cost to be Accounted
for 1,192,852 822,400 89,540 280,912
Per Equivalent Unit Cost RM15.11 RM10.28 RM1.21 RM3.62

Cost Cost Cost
Units Completed and Transferred
(74,000  RM15.11) 1,118,140 1,118,140
Ended WIP:
Transferred-In Cost (6,000 units  RM10.28) 61,680 61,680
Raw Materials (6,000  RM1.25) 0 0
Accounted for Total 1,118,140 74,712 1,192,852
* (0% units of direct raw materials in ended WIP as the direct raw materials were
transferred-in at the end of the process).

298  ANSWERS
2. (a) Per unit costs for direct materials, direct labour, manufacturing
overhead costs and transferred-in-costs for the Designing
Department.
Equivalent Units = Finished Units + Ended WIP (completed

percentage)
Transferred-In = (Beginning Inventory Units + Started

Equivalent Units Units – Ended Inventory Units) + Ended
WIP
= (4,000 + 20,000 – 8,000 units) + 8,000 units
= 16,000 units + 8,000 units
= 24,000 units
DRM Equivalent Units = 16,000 units + (8,000 units  90%)

= 23,200 units.
Direct Labour = 16,000 units + (8,000 units  70%)

Equivalent Units = 21,600 units.
Manufacturing = 16,000 units + (8,000 units  35%)

Overheads Equivalent = 18,800 units.
Units
Per Unit Transferred-In Cost

Beginning WIP Transferred-in Costs +
Transferred-in Cost from Cutting Dept.

Transferred-in Equivalent
RM64,000  RM320,000

24, 000 units
RM384,000

24, 000 units
 RM16.00

ANSWERS  299
Per Unit DRM Cost

Beginning WIP DRM Costs + Current DRM Cost Incurred

DRM Equivalent Units
RM40,000  RM192,000

23, 200 units
RM232,000

23, 200 units
 RM10.00
Per Unit Direct Labour Cost

Beginning WIP Direct Labour +
Current Direct Labour Cost Incurred

Direct Labour Equivalent Units
RM14,400  RM106,560

21, 600 units
RM120,960

21, 600 units
 RM5.60
Per Unit Manufacturing Overhead Cost

Beginning WIP Overhead Costs +
Current Manufacturing Overhead Cost

Manufacturing Overhead Equivalent Units
RM11,000  RM36,000

18, 800 units
RM47,000

18, 800 units
 RM2.50
Cost of Finished Units = Per Unit Transferred-in Cost + Per Unit

Transferred-Out Direct Materials Cost + Per Unit Direct
Labour Cost + Per Unit Manufacturing
Overhead Cost
= RM16.00 + RM10.00 + RM5.60 + RM2.50
= RM34.10

300  ANSWERS
(b) Transferred-Out Cost and The Ended Work in Process Cost
Transferred-Out Cost = Finished Units  Cost of Finished Units

Transferred-Out
= 16,000 units  RM34.10
= RM545,600
Closing Inventory Cost = Closing Inventory Transferred-in Cost +

DRM + Direct Labour + Manufacturing
Overheads
Cost of Closing = Closing Inventory Transferred-in Units 

Inventory Per Unit Transferred-in Cost
Transferred-In
= 8,000 units  RM16.00
= RM128,000
Cost of Closing = Closing Inventory DRM Units  Per Unit

Inventory DRM DRM Cost
= (8,000 units  90%)  RM10.00
= RM72,000
Cost of Closing Closing Inventory Direct Labour Units 

Inventory Direct Per Unit Direct Labour Cost
Labour
= (8,000 units  70%)  RM5.60
= RM31,360
Cost of Closing = Closing Inventory Manufacturing

Inventory Overhead Units  Per Unit Manufacturing
Manufacturing Overhead Cost
Overheads
= (8,000 units  35%)  RM2.50
= RM7,000
Closing Inventory = RM128,000 + RM72,000 + RM31,360 +

Cost RM7,000
= RM238,360

ANSWERS  301
(c) Journal Entries for the Designing Department
Debit Credit
(RM) (RM)
Dt. Work in Process Inventory of Designing 320,000
Department
Ct. Work in Process Inventory of Cutting 320,000
Department
(Record the transferred-in costs from Cutting
Department to Designing Department)
Dt. Work in Process Inventory of Designing 334,560
Department
Ct. Direct Raw Materials (DRM) Inventory 192,000
Ct. Salaries Payable 106,560
Ct. Manufacturing Overheads 36,000
(Record the current costs incurred in Designing
Department)
Dt. Work in Process Inventory of Finishing Department 545,600
Ct. Work in Process Inventory of Designing 545,600
Department
(Record the transferred-out costs from Designing
Department to Finishing Department)
Topic 8: Marginal Costing and Absorption Costing

Self-Test 1
1. (a) Per Unit Product Cost
Marginal Costing RM Absorption Costing RM

Direct Materials 10.50 Direct Materials 10.50
Direct Labour 9.50 Direct Labour 9.50
Variable Manufacturing 4.00 Variable Manufacturing 4.00
Overheads Overheads
*Fixed Manufacturing 2.62
Overheads
Total 24.00 Total 26.62

302  ANSWERS
* Calculation of Fixed Manufacturing Overheads Per Unit:
Salary of Factory Supervisor RM26,000

Insurance 19,200
Utility 17,600
Transportation Costs 1,800
Depreciation of Plant 10,000
Total 78,600
Production 30,000 units
Per Unit Cost RM2.62
(b) Income Statement
Fadhilah Berhad
Income Statement – Absorption Costing for the year ended
31 December 2014
(RM) (RM)
Sales (25,000units  RM40) 1,000,000
Cost of Goods Sold:

Opening Inventory 0
Cost of Goods Manufactured (30,000 units 
RM26.62) 798,600
Closing Inventory (5,000 units  RM26.62)
Cost of Goods Sold (133,100) 665,500
Less:
Fixed Sales and Administration Expenses
Salaries of Administrative Staff 20,000
Insurance 4,800
Utilities 4,400
Transportation 4,200
Depreciation of Office Equipment 8,000
Variable Sales and Administration
Expenses (RM1.20  25,000 units) 30,000 (71,400)
Net Income 263,100

ANSWERS  303
Fadhilah Berhad
Income Statement – Marginal Costing for the year ended
31 December 2014
(RM) (RM)
Sales (25,000units  RM40) 1,000,000
Variable Costs:
Cost of Goods Sold:
Opening Inventory 0
Cost of Goods Manufactured (30,000 units 
RM24.00) 720,000
Closing Inventory (5,000 units  RM24.00) (120,000)
+ Variable Sales and administration Costs
(RM1.20  25,000 units) 30,000 (630,000)
Less:
Fixed Manufacturing Overheads 78,600
Fixed Sales and Administration Expenses 20,000
Salaries of Administrative Staff
Insurance 4,800
Utilities 4,400
Transportation 4,200
Depreciation of Office Equipment 8,000 (120,000)
Net Income 250,000
(c)
RM
Net Income under Marginal Costing 250,000
Add: Deferred Fixed Manufacturing Overheads under 13,100
Absorption Costing
Less: Released Fixed Manufacturing Overheads under –
Absorption Costing
Net Income under Absorption Costing 263,100

304  ANSWERS
2. (a) Per Unit Product Cost:
Absorption Marginal
2013 2014 2013 2014
Costing Costing
Direct Materials RM1.30 RM1.30 Direct Materials RM1.30 RM1.30
Direct Labour 1.50 1.50 Direct Labour 1.50 1.50
Variable 0.20 0.20 Variable 0.20 0.20
Manufacturing Manufacturing
Overheads Overheads
Fixed 0.88 1.07
Manufacturing
Overheads
Total RM3.88 RM4.07 Total RM3.00 RM3.00
(b)
Arau Berhad
Income Statement – Marginal Costing for the year ended
31 December 2013
(RM) (RM)
Sales (140,000units  RM5) 700,000
Variable Costs:
Cost of Goods Sold:
Opening Inventory 0
Cost of Goods Manufactured (170,000  510,000
RM3)
Closing Inventory (30,000  RM3) 90,000
Variable Sales and administration Costs
(5%  RM700,000) 35,000
Total Variable Cost (455,000)
Fixed Costs:
Sales and Administration Expenses 65,000
Manufacturing Overhead Costs 150,000 (215,000)
Net Income RM30,000

ANSWERS  305
(c)
Arau Berhad
Income Statement – Absorption Costing for the year ended 31 December
2014
(RM) (RM)
Sales (160,000units  RM5.00) 800,000
Cost of Goods Sold:

Opening Inventory (30,000 units  RM116,400
RM3.88)
Cost of Goods Manufactured (140,000 569,800
units  RM4.07)
Closing Inventory (10,000 units 
RM4.07) (40,700)
Cost of Goods Sold (645,500)
Sales and administration Costs

Variable 35,000
Fixed 65,000 (105,000)
Net Income RM49,500
Self-Test 2
1. (a) Per Unit Product Cost
Absorption Costing RM Marginal Costing RM

Direct Materials 6.00 Direct Materials 6.00
Direct Labour 12.00 Direct Labour 12.00
Variable Manufacturing 4.00 Variable Manufacturing 4.00
Overheads Overheads
Fixed Manufacturing 8.00
Overheads
Total 30.00 Total 22.00

306  ANSWERS
(b)
Muizzuddin Berhad
Income Statement – Marginal Costing for the month ended May 2014
(RM) (RM)
Sales (26,000 units  RM40) 1,040,000
Variable Costs:
Cost of Goods Sold
Opening Inventory 0
(30,000  RM22)
Closing Inventory
(4,000 units  RM22) (88,000)
(26,000 units  RM3) 78,000
Total Variable Cost (650,000)
Fixed Costs:
Net Income (30,000)

ANSWERS  307
Muizzuddin Berhad
Income Statement – Marginal Costing for the month ended June 2014
(RM) (RM)
Sales (34,000 units  RM40) 1,360,000
Variable Costs:
Cost of Goods Sold
(30,000  RM22)
Closing Inventory
(4,000 units  RM22) (0)
(26,000 units  RM3) 102,000
Total Variable Cost 850,000
Fixed Costs:
Net Income 90,000
(c) Adjustment to Net Income
May June
(RM) (RM)
Net Income under Marginal Costing (30,000) 90,000
Add: Deferred Fixed Manufacturing Overheads 32,000
under Absorption Costing
Less: Released Fixed Manufacturing Overheads (32,000)
under Absorption Costing
Net Income under Absorption Costing 2,000 58,000
(d) The difference in net income between the two methods is due to the
way the fixed manufacturing overhead cost is treated: it is regarded
as a product cost if we employ the absorption costing method and as a
period expense if we employ the marginal costing method.

308  ANSWERS
Topic 9: Modern Business Environment and

Management Accounting
Self-Test 1
1. Three impacts of modern business environment on management

accounting practices:
(a) Gives rise to new management accounting techniques such as target

costing, kaizen and life cycle costing.
(b) Emergence of new business environment/industries requires

different operating and accounting methods such ABC method.
(c) Shift to customer focus requires nonfinancial and financial

performance measurement to be equally important, like in balance
scorecard.
2. Characteristics of customer-oriented organisation include the following:
(a) Have a clear vision of the customer experience which is aligned with
the business objectives.
(b) Proactive approach towards customersÊ query/concerns/complaints.
(c) Have well developed customer relationship management and

customer retention programmes.
(d) Train the staff at every customer touch point to deliver: get them to
stand in the customerÊs shoes, treat customers as individuals.
(e) Keep on training the staff – this is an on-going journey not a

destination.
(f) Treating every piece of customer information as confidential and as

top priority.
(g) Every leader and manager in the organisation should focus on the
customer experience.
(h) Reward structures, top to bottom, should support delivery of the

(i) The culture should recognise, on a regular basis, delivery of a good

(j) Metrics & feedback mechanisms need to support the goal.

ANSWERS  309
3. Traditional production is characterised by long hours, mass production

with large batches, standardised products, manual systems, and costly
and labour intensive operations. On the other hand, flexible production is
attributed to shorter hours, small batches, lower cost, machine intensive,
use of robotics, computer-integrated systems, efficient and smooth
operation. Traditional production seems quite rigid, which impedes
manufacturers from reaching customers on time and has less variation in
products. Flexible production is a good replacement to overcome these
drawbacks in traditional production.
Flexible production operates with the lowest total cost, responds to the
market at high-speed and is at its best ability to meet customersÊ
expectations and gains competitive advantage. This eventually will increase
customerÊs satisfaction and will result in profitability. Moreover,
the flexible processes are not the only requirement to permit rapid low cost
switching from one product line to another, but it also needs a flexible
workforce with multiple skills. Flexible processes and flexible workforce
would definitely increase the ability of switching easily between product
lines and thus increase quality and speed, which are the elements highly
demanded in the modern business environment.
Self-Test 2
1. The traditional role of management accountants as scorekeepers has

subsequently changed due to the changing business environment. Today,
management accountants play the roles of business partners, internal
consultants, change agents, strategy formulators, and business and
information analysts. They spend more time with the users of management
accounting information rather than serving their functional or
departmental role. In fact, those multiple roles require multidisciplinary
skills. For instance, they involve and participate in various business
processes such as in setting and implementing business strategy, new
product development, marketing, and performance measurement. They
will need to work together with other functional specialists, creating cross
functional teams or committees. Briefly, the role of management
accountants is highly regarded and gaining greater emphasis within the
modern business environment.

310  ANSWERS
2. There are many factors that may have influence on customer satisfaction
such as the quality of the product and service provided, the atmosphere of
the location where the product or service is purchased, the price of the
product or service and face to face experience when dealing with staff.
Organisations may invest some efforts and initiatives in order to increase
customerÊs satisfaction through managing the value chain, continuous
improvement programmes and employee empowerment and so on.
3. Selection of an appropriate inventory management model depends on

many factors. There are traditional inventory models, such as, EOQ model
and contemporary models such as JIT, Theory of Constraints and Material
Requirement Planning (MRP). Important factors to be considered prior to
adopting any inventory method include cost factor, employeesÊ
commitment and top managementÊs support, degree of variation in
products, size of batches, degree of uncertainty in demand, life cycles of
products and nature of the industry or business.
4. The primary aim of cost reduction programmes is to minimise the current

level of costs and expense while maintaining the production level. They are
cost cutting plans, which are carefully implemented in phases as not to give
rise to adverse effects on the overall performance of the organisation.
Successful companies, aiming for cost efficiency or pursuing cost-

leadership strategy, may also adopt cost reduction programmes to gain
competitive advantage in the industry. A successful cost reduction
programme indirectly drives existing resources to be used to the best
advantage, employees are able to perform more efficiently, and at the end
of the day customers experience the highest quality of goods and services.
All these are potential sources of competitive advantage.

MODULE FEEDBACK
MAKLUM BALAS MODUL
If you have any comment or feedback, you are welcome to:
1. E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2. Fill in the Print Module online evaluation form available on myINSPIRE.
Thank you.
Centre for Instructional Design and Technology

(Pusat Reka Bentuk Pengajaran dan Teknologi )
Tel No.: 03-27732578
Fax No.: 03-26978702


BBMA3103

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BBMA3103

Uploaded by

Copyright:

Available Formats

OUM Business School

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Module Writers: Noor Asma Jamaludin (Leader)

Azlina Abdul Aziz

Moderators: Assoc Prof Dr Arfah Salleh

Lilian Kek Siew Yick

Developed by: Centre for Instructional Design and Technology

First Edition, February 2008

Copyright © Open University Malaysia (OUM), December 2014, BBMA3103

Copyright © Open University Malaysia (OUM)

Topic 1 Introduction to Management Accounting 1

Copyright © Open University Malaysia (OUM)

Topic 2 The Concepts and Classifications of Costs 18

Topic 3 Materials and Labour Accounting 60

Copyright © Open University Malaysia (OUM)

Topic 4 Overhead Cost Accounting 86

Topic 5 Activity-Based Costing (ABC) 114

Copyright © Open University Malaysia (OUM)

5.6 Advantages and Disadvantages of the ABC System 134

Topic 6 Job Order Costing 139

Topic 7 Process Costing System 170

Copyright © Open University Malaysia (OUM)

7.7 The Concept of Equivalent Units 178

Topic 8 Marginal Costing and Absorption Costing 199

Copyright © Open University Malaysia (OUM)

Topic 9 Modern Business Environment and Management Accounting 229

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

Copyright © Open University Malaysia (OUM)

Table 1: Estimation of Time Accumulation of Study Hours

1. Appraise the fundamentals of management and financial accounting;

3. Apply accounting equations in purchasing of materials and explore the

5. Differentiate traditional costing system and activity based costing;

6. Calculate break-even point and prepare an income statement using the

7. Apply management accounting techniques and analyses to facilitate

Copyright © Open University Malaysia (OUM)

Topic 1 introduces the environment of management accounting which

Topic 3 elaborates on the significance of materials and labour in manufacturing

Topic 4 elaborates on manufacturing costs. You will be exposed to the differences

Topic 5 explains Activity-Based Costing (ABC) System which is supposed to

Topic 9 discuss about the impact of modern business environment on

Copyright © Open University Malaysia (OUM)

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Activity: Like Self-Check, the Activity component is also placed at various

Copyright © Open University Malaysia (OUM)

References: The References section is where a list of relevant and useful

Wild, J. J., Larson, K. D., & Chiappetta, B. (2006). Fundamental accounting

Roger, H. H. et al. (1997). Accounting: A business perspective (7th ed.). New

Weygandth, J. J., Keison, D. E., Kimmel, P. D. (2008). Accounting principles (9th

TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

1.1 THE DEFINITION OF MANAGEMENT

Management accounting is a field of accounting which provides economic

In any organisation, the position of its management accounting can be seen

Apart from the management accountant, an organisation also comprises of other

Copyright © Open University Malaysia (OUM)

A common assumption is that we perceive an accountant as someone who only

Discuss the status and functions of the management accountant in a

Copyright © Open University Malaysia (OUM)