Chapter 2

COSTS ACCOUNTING CYCLE

Learning Objectives:
At the end of the chapter, the students are expected to have learned the following:
1. Summarize the inventory accounts of a manufacturing company;
2. Illustrate the flow of manufacturing costs from purchase of raw materials to the completion into a
finished product; and
3. Prepare statement of costs of goods manufactured and sold.

INVENTORY ACCOUNTS

Manufacturing companies maintain three inventory accounts, namely:

Raw Materials Inventory. This account shows the raw materials available for use in the manufacturing
process. It serves as a controlling account if the company maintains only one account for its direct
materials and indirect materials. However, if the company maintains a separate account for its direct and
indirect materials or supplies, the account may be changed to Direct Materials Inventory which is meant
to include only direct materials. Factory Supplies Inventory account includes indirect materials such as
supplies to be used in the production including janitorial, operating and repairs supplies intended for use
in the factory.

Work in Process. This account represents the costs of partially completed jobs on which production
activities have been started but not yet completed as of a certain period (Rante). Reflects the cost of raw
materials, direct labor, and manufacturing overhead of goods on which manufacturing has begun but has
not been completed at the end of the fiscal period (Guerrero).

Finished Goods. This account summarizes the costs of completed jobs in the warehouse ready for
delivery to the customers (Rante). Reflects the cost of goods that have been completed and are ready for
sale. This account corresponds to the Merchandise Inventory account of a merchandising business. Any
changes in the Finished Goods Inventory account are reflected in the Cost of Goods Sold section of the
income statement (Guerrero).

RAW MATERIALS INVENTORY SYSTEM

Perpetual Inventory System

The perpetual inventory system requires the need to maintain stock cards for each type of raw materials to
show the summary of the inflow, outflow and balance of raw materials in quantity and in peso amount.
Under this system, the movement of raw materials is summarized in a Raw Materials Inventory account.
This method is easier for a company to determine the amount of inventory on hand at any given time.
Although the quantity of raw materials is available any time by just referring to the stock card, it is
necessary to take physical counting of raw materials at least once a year to confirm the balance reflected
in the materials stock cards and in the Raw Materials Inventory account.

Periodic Inventory System

Under periodic inventory system, there is no need to maintain a stock card for the raw materials. Physical
count is made periodically which is near the end of a period to determine the units on hand. The latest
purchases are normally left in the warehouse. The raw materials issued are the residual amount after
deducting the physical inventory counted from goods available for sale.

FLOW OF COSTS

Purchases of Materials Materials

Inventory

Pay Direct Laborers Work in Finished Cost of

Direct Labor Process Goods Goods
Inventory Inventory Sold

Incur Overhead Manufacturing

Overhead

METHODS OF ACCUMULATING PRODUCT COSTS

Actual Costing System (Historical). Very few companies adopt this method of costing because the
overhead costs cannot be traced easily to individual jobs. This method requires that all production
overhead must be available before any cost allocation can be made to the jobs in process. Under this
system, the actual costs of direct materials used, direct labor and manufacturing overhead incurred in
production are charged to the job (Rante). Under this system, direct materials, direct labor and factory
overhead costs are determined as they occur simultaneously with the manufacturing operation but the
total of these costs is known only after the operation has been completed (Guerrero).

Normal Costing System. Under this system, the actual costs of direct labor materials and direct labor are
charged to the job. The manufacturing overhead applied to production differs from actual costing in the
sense that a pre-determined overhead rate is used in computing for the amount of overhead charged to the
job. The predetermined overhead rate is the ratio of estimated total overhead to the estimated total of cost
driver selected. A company can use one rate (plant-wide) or several rates (departmental rates). If several
rates are used, the budgeted manufacturing overhead is actually divided into several cost pools and uses
each driver as the denominator in computing for the predetermined overhead rate (Rante). This is a
combination of the actual cost system and the standard cost system. This system accumulates only the
actual amounts of direct material and direct labor costs. Factory overhead costs are accumulated on the
basis of a predetermined rate (Guerrero).

Standard Cost System (Predetermined). Under this system, costs are determined in advance from analysis
and forecast made before the actual production begins. In a standard cost system, standard unit cost are
computed for direct materials, direct labor and factory overhead; these amounts, rather than the actual
cost, are carried to Finished Goods inventory (Guerrero).

A comparison of the alternative product costing system is presented below.

Product Cost Actual Costing Standard Costing Normal Costing

Direct Materials Actual Standard Actual
Direct Labor Actual Standard Actual
Factory Overhead Actual Standard Predetermined
COST ACCOUNTING CYCLE
(Actual Costing Method – Perpetual Inventory System)

Transactions Entries
1. Purchase Raw Materials 5,000 units @ P20.50, Raw Materials Inventory 102,500
on account. Accounts Payable 102,500

If one control account for all materials (direct and

indirect materials) is maintained, the raw materials
purchased is debited to Raw Materials Inventory
account.
2. Transportation cost or freight for the purchase, Raw Materials Inventory 10,000
P10,000. Cash 10,000

Before updating the inventory card, the unit cost of

the raw materials purchased is adjusted to include
the freight. The freight in this example is
apportioned equally to the number of units
purchased.

Computation:
Invoice price per unit P20.50
Freight costs (10,000/5,000) 2.00
Adjusted unit costs 22.50

3. Returned 200 units to the supplier due to Accounts Payable (invoice cost) 4,100
defective quality. Manufacturing Overhead (freight) 400
Raw Materials Inventory 4,500
Take note that the accounts payable is decreased by
the invoice cost of the returned merchandise and
the freight associated with the 200 units is charged
to manufacturing overhead.

Computation:
Invoice Cost = 200 x 20.50 = 4,100
Freight = 200 x 2.00 = 400

4. Issuance of Raw Materials: 2,800 units. Work in Process 63,000

Raw Materials Inventory 63,000
Computation: 2,800 units x 22.50 = 63,000

5. Return of excess materials to storeroom, 200 Raw Materials Inventory 4,500

units. Work in Process 4,500

Computation: 2,800 units x 22.50 = 63,000

6. Factory Payroll: Factory Payroll 125,000

Gross 125,000 SSS Payable 4,800
SSS Payable (4,800) PhilHealth Payable 1,200
PhilHealth (1,200) Pag-Ibig Payable 1,200
WHT Payable (9,600) WHT Payable 9,600
Pag-IBIG (1,200) Cash or Wages Payable 108,200
Net Payroll 108,200

Computation:
Total Salary Deductions
(4,800 + 1,200 + 1,200 + 9,600) = 16,800

Wages Payable (net payroll)

125,000 – 16,800 = 108,200
7. Distribution of factory payroll: Work in Process 100,000
80% to Direct Laborers Manufacturing Overhead 25,000
20% to Indirect Laborers Factory Payroll 125,000

Computation:
Work in Process (Direct Labor)
125,000 x 80% = 100,000

Manufacturing Overhead (Indirect Labor)

125,000 x 20% = 25,000

8. Utility expenses, P20,000. Manufacturing Overhead 20,000

Cash or Accounts Payable 20,000

9. Maintenance of factory machineries, P5,000. Manufacturing Overhead 5,000

Cash 5,000

10. Year-end adjustments for:

a. Expired insurance, P1,200 Manufacturing Overhead 1,200
Prepaid Insurance 1,200

b. Depreciation of plant assets, P15,000 Manufacturing Overhead 15,000

Accumulated Depreciation 15,000

11. Actual Overhead applied to the job. Work in Process 66,200

Manufacturing Overhead 66,200
Computation:
Indirect Labor 25,000
Utility 20,000
Maintenance 5,000
Insurance 1,200
Depreciation 15,000
Total 66,200

12. Completion of the process. Finished Goods 224,700

Work in Process 224,700
Computation:
Direct Materials 58,500
Direct Labor 100,000
Manufacturing Overhead 66,200
Manufacturing Costs 224,700

13. Sold the manufactured goods at cost plus 40% Accounts Receivable 314,580
mark-up. Sales 314,580

Computation: Cost of Sales 224,700

Manufacturing Costs 224,700 Finished Goods 224,700
Mark-up 40% 89,880
Sales Price 314,580

COST OF GOODS MANUFACTURED AND SOLD

In addition to the two basic financial statements, the Balance Sheet and the Income Statement,
manufacturing companies are required to prepare a Statement of Cost of Goods Manufactured. This
statement summarizes the total production cost, the direct labor and the overhead that transform the
materials into work in process inventory. When the work in process inventory is completed, it becomes
finished goods inventory. The finished goods inventory is the only inventory that is ready to sell. The cost
of finished goods inventory become Cost of Goods Sold on the income statement. A pro-forma statement
of Costs of Goods Manufactured and Sold:

Name of the Company

Statement of Cost of Goods Manufactured and Sold
Period ____________

Direct Materials, beginning P000

Add: Purchases P000
Freight In 000
Gross Purchases 000
Less: Purchase Discounts 000
Purchase Returns and Allowances 000
Net Purchases 000
Direct Materials Available for Use P000
Less: Direct Materials, end 000
Direct Material Used P000
Direct Labor 000
Manufacturing Overhead 000
Total Manufacturing Costs P000
Add: Work in Process, beginning 000
Total Cost of Goods Placed into Process P000
Less: Work in Process, end 000
Cost of Goods Manufactured P000
Add: Finished Goods, beginning 000
Total Goods Available for Sale 000
Less: Finished Goods, end 000
Cost of Goods Sold P000

After studying the different types of businesses, service, merchandising and manufacturing, let us now
take at how cost of goods sold is computed in each type of business:

Service Companies Merchandising Companies Manufacturing Companies

No cost of goods sold because
they don’t sell merchandise but
service.
The counterpart of cost of goods
sold is Cost of Service
Merchandise Inventory, beg
+ Purchases
+ Freight In
Total Goods Available for Sale
- Merchandise Inventory, end
Cost of Goods Sold /
Cost of Sales
Finished Goods Inventory, beg
+ Cost of Goods Manufactured
Total Goods Available for Sale
- Finished Goods Inventory, end
Cost of Goods Sold