CHAPTER 1: Decision-making based on price setting and capacity utilisation

CHAPTER 1

LEARNING UNIT 3: Cost accounting systems

ASSESSMENT CRITERIA
After working through this learning unit, you should be able to
• identify and describe the functions of a cost and management accounting system
• distinguish between the three bases of accounting for production cost
• describe the five methods used for dealing with production costs

You should spend approximately 3-4 hours on mastering the learning outcomes of this Learning Unit.

3.1 INTRODUCTION

A cost and management accounting system should generate information to meet the following
requirements:
• allocate costs between cost of goods sold and inventories for internal and external profit reporting
and inventory valuation.
• provide relevant information to help managers make better decisions.
• provide information for planning, control and performance measurement.
The purpose of this learning unit is to provide you with a bird’s eye view of the bases and methods
used to determine the cost of manufactured goods for planning and reporting purposes, and to lay the
foundation for your understanding of the application of the bases and methods of cost determination
that will be dealt with in greater depth in later learning units of this study guide. Although this learning
unit provides an overview, you must read it for understanding and not merely scan through it. You are
expected to attempt the activities included in the learning unit.
This learning unit will provide some insight into how cost accounting is used for the planning and control
of costs discussed in Learning Unit 1. At the outset, it is important to understand that accountants are
not responsible for cost control; line managers responsible for incurring costs are responsible for
controlling the costs. Accountants are responsible for making information available for controlling costs.
It is also important that you will understand that only actual costs flow though the financial accounting
system, i.e., only actual amounts are posted in the general ledger.
The cost accounting system is the framework used to determine costs of goods manufactured for
profitability analysis in the planning stage, budgeting to give effect to the operational plan, cost control,
i.e., comparing budgeted figures with actual figures and, ultimately inventory valuation. A cost
accounting system is either an integrated cost accounting system in which the cost and financial
accounts are combined in one set of accounts, or it is an interlocking cost accounting system in which
the cost and financial accounts are maintained independently. An integrated cost accounting system
is preferable to the interlocking cost accounting system, because it avoids duplication of accounting
entries. For the purposes of this study guide, we shall assume an integrated cost accounting system.

3.2 ELEMENTS OF A COST ACCOUNTING SYSTEM

One of the main objectives of an integrated cost accounting system is to determine the cost of products
for planning and control purposes. Determining the cost of products is not as straightforward as it may
seem. We already know that total production costs consist of the cost of direct materials, direct labour
and production overheads. But how readily available is information about the costs when we need them
when we are setting the budget? As a result of among others inflation, some costs are always subject to
change. Even during actual production, costs are not readily available, especially as far as overheads
are concerned. For example, the cost of electricity is known only after units of inventory have already
been manufactured and in some instances even after they have been sold.
The management of an organisation is tasked with developing accounting policies for the organisation,
in compliance with the prescripts of applicable legislation and accounting standards. The choice of
accounting policies will influence the design of the integrated cost accounting system. A brief
discussion of policies that will affect product costs and the value of inventory follows below. These
policies are concerned with the basis and more specifically the methods of product cost determination.

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Don’t be too concerned if you do not yet fully understand some of these terms; as you work through
your study guide, they will become clear to you.

3.2.1 The basis for the measurement of production (manufacturing) costs

A basis is that on which something else is built. There are three possible bases that can be used for
the building the cost accounting system that will be used for financial planning in the organisation. They
are
• an actual costing basis, which spreads actual production costs across the actual production output
• a normal costing basis, which applies actual production costs of direct materials and direct labour,
and a pre-determined rate to overhead costs, across the actual production output
• a standard costing basis, which applies standard rates that are based on standard quantities to
actual production outputs

3.2.1.1 Actual costing basis

Actual costs are the historical costs incurred at the time of recording transactions in the accounting
records of the entity. An actual costing basis can also be called a historical cost basis and a best
estimate of actual costs will be used in budgeting. When an actual costing basis is applied, the actual
costs incurred during the month (or any other accounting period) are used as a basis for cost
determination. The actual cost of direct materials and the actual cost of direct labour are traced and
allocated directly to the actual number of units produced. The actual costs of production overheads are
apportioned to the actual number of units produced.
Example 3.1
The Great Outdoors Ltd manufactures tents. It uses actual costing as a basis for determining the cost
of manufactured goods. Assume that there was no opening inventory of tents. During June, 400 tents
were manufactured and the following costs were actually incurred:
Total cost
Direct materials R100 000
Direct labour R120 000
Production overheads R180 000
The total cost of production and the cost per unit for June will be:
Total cost Units made Unit cost
R R
Direct materials R100 000 400 250
Direct labour R120 000 400 300
Production overheads R180 000 400 450
Total production costs R400 000 1 000
________________________________________________________________________________

Most companies experience a fluctuation in production output from the one month to the next resulting
in a variation in overhead costs from month to month. A factory will, for example, carry insurance over
its factory building and equipment and the insurance premium for the year is typically paid in a single
payment. This will result in a much higher cost per unit in the month that the insurance is paid. Although
this is a simple and uncomplicated costing basis for budgeting purposes and to apply to actual
production during the financial year, it may require a lot of time at the end of the financial year to
determine the value of closing inventory in compliance with International Financial Reporting Standards
(IFRS). An actual costing basis is seldom used in practice.

3.2.1.2 Normal costing basis

When budgeting on a normal costing basis, best estimates of the actual cost of direct materials and
direct labour are used. Production overheads are budgeted for at a pre-determined rate. During actual
production the actual cost of material and labour are charged to production, but overheads are charged
at the pre-determined budgeted rate according to the actual production output achieved. The output
level can be direct labour hours, machine hours, units of production, etc.

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Example 3.2
The Great Outdoors Ltd manufactures tents. It uses normal costing as a basis for determining the cost
of manufactured goods. Overhead costs are assigned to production at a pre-determined rate of R430
per tent (unit) manufactured. Assume that there was no opening inventory of tents. During June, 400
tents were manufactured and the following costs were actually incurred:
Direct materials R100 000
Direct labour R120 000
Production overheads R180 000
Total costs assigned to production units will be:
Direct materials R100 000 actual cost
Direct labour R120 000 actual cost
Production overheads R172 000 (400 units × R430) assigned costs
Total input costs R392 000
Cost per unit R980 (392 000 / 400)
________________________________________________________________________________

You will notice that in applying the normal costing basis, there is a difference between the total cost of
overheads assigned to production and the actual total overhead costs incurred. In Example 3.2, the
amount for overheads assigned to production was R172 000, i.e., R8 000 less than the actual overhead
costs of R180 000. This difference of R8 000 would be referred to as under-absorbed overheads; we
absorbed fewer costs into the cost of production than was actually incurred.
What happens when a different output level is used for the apportionment of overheads?

Example 3.3
The Great Outdoors Ltd manufactures tents. It uses normal costing as a basis for determining the cost
of manufactured goods. Overhead costs are assigned to production at a pre-determined rate of R310
per direct labour hour. During June, a total of 600 direct labour hours were actually worked. Assume
that there was no opening inventory of tents. During June, 400 tents were started and completed and
the following costs were actually incurred:
Direct materials R100 000
Direct labour R120 000
Production overheads R180 000
Note that only direct labour hours (DLH) and not all labour hours are used as output. DLH is the basis
direct labour cost. Therefore, an overhead rate per direct labour hour that must be apportioned to units
produced, meaning the level of one output is applied to another output level. It is very important that
you understand that first of all the total apportioned overheads must be determined (rate × actual DLH)
and then divided by the actual total number of units manufactured to determine the overheads per unit.
Total DLH × pre-determined rate = 600 hours × R310 = R186 000. (Note that 600 is the actual hours
worked; remember that the predetermined rate is applied to actual output.) The overheads rate per
unit is then determined as: R186 000 ÷ 400 units = R465. The total costs assigned to production for
the month is therefore:
Total (R) Per unit (R)
Direct materials 100 000 250
Direct labour 120 000 300
Production overheads 186 000 465
Total input costs 406 000 1 015
________________________________________________________________________________

In Example 3.3, the total amount for overheads assigned to production was R186 000, i.e., R6 000
more was charged to production than the R180 000 actually incurred. This difference of R6 000 is
referred to as over-absorbed overheads: we absorbed more costs into the cost of production than was
actually incurred.
The accumulated amount of over-absorbed or under-absorbed overheads at the end of the financial
period must also be accounted for because only actual amounts must be recorded in the general
ledger. If the amount is not significant, it will usually be charged to the cost of goods sold. If the amount

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is significant, it should be charged to cost of goods sold and inventories on a pro-rata basis. (These
differences are also referred to as over-recovered and under-recovered overheads, over-applied and
under-applied overheads or even, not entirely correctly, over-allocated and under-allocated
overheads.)
You will appreciate that using this basis will result in a more uniform and realistic overhead rate that is
applied to all the units manufactured during the entire year, thereby avoiding the sudden cost spikes
that might occur if the actual overheads are used.

3.2.1.3 Standard costing basis

Standard costing uses only pre-determined costs and quantities for all the elements of production cost
in the budget. Pre-determined overhead rates, based on standard quantities and costs are applied to
actual output in the apportionment of production overheads. A standard costing basis is the most
common basis used in larger organisations as it lends itself to performance measurement.

Example 3.4
The Great Outdoors Ltd manufactures tents. It uses standard costing as a basis for budgeting for the
cost of goods manufactured. Assume that there was no opening inventory of tents. The following is the
budget for June, based on the standard production cost:
Standard to manufacture one tent Unit Budget Budget calculations
cost 380 tents
Direct materials: R R
Sides: 10 metres of canvas at R15 per metre 150 57 000 (380 × R150)
Floor: 2 metres of plastic at R7 per metre 14 5 320 (380 × R14)
Frame poles: one set at R85 per set 85 32 300 (380 × R85)
Total direct materials cost per unit 249 94 620
Direct labour: 1½ hours at R190 per hour 285 108 300 (380 × R285)
Variable overheads per unit 180 68 400 (380 × R180)
Total standard variable cost per tent 714 271 320
Fixed production overheads 114 000
Total production cost of 380 tents 385 320

Note that the standard cost per unit above includes only variable costs, i.e., the fixed overheads are
excluded. Fixed overhead cost is not always absorbed into the cost of production; see paragraph
3.2.2.1 below. When it is absorbed into the cost of production, fixed production overhead cost is
apportioned to production using a pre-determined rate based on budgeted output and costs. The
apportionment of fixed overheads is not relevant to this discussion and will be dealt with in Learning
Unit 16.
Actual results for June are as follows:
400 tents were started and completed
600 direct labour hours were actually worked.
The following costs were actually incurred:
Direct materials R100 000
Direct labour R120 000
Variable production overheads R75 000
Fixed production overheads R105 000
Total input costs R400 000
There is therefore a difference in the budgeted production cost and actual production cost of R14 680
(R400 000 – R385 320). This difference is referred to as a variance and this variance is unfavourable,
because actual cost is more than budgeted cost. As part of the company's cost control, this variance
will be investigated. Two reasons for this variance are obvious:
1. More units were manufactured than planned, which would cause an increase in total variable cost.
2. There was an underspending on fixed production overheads.

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1. A variance that occurs as a result of a difference in planned output and actual output (20 more
tents were manufactured than planned), is called a volume variance. The volume variance will be equal
to 20 × R714 (the standard variable cost per unit), i.e., R14 280 (unfavourable, because actual cost is
higher). Although we call the variance an unfavourable variance, it is not necessarily bad, because we
have more units produced than anticipated.
2. The variance in fixed production overhead of R9 000 (R114 000 – R105 000) is a performance
variance. The variance is favourable because actual cost is less.

We can determine performance variances by first of all establishing what the budget would have been
if we had correctly budgeted for 400 tents instead of only 380 tents. We call this flexing the budget.

Actual Variance *
Standard production Flexed Actual Flexed –
cost budget costs Actual)
R units R R
Direct materials 249 × 400 99 600 100 000 (400)
Direct labour 285 × 400 114 000 120 000 (6 000)
Variable overheads 180 × 400 72 000 75 000 (3 000)
Total variable costs 714 × 400 285 600 295 000 (9 400)
* These performance variances are unfavourable because the actual spending was more than the
(flexed) budget; they will be further analysed to determine the cause and to classify them as either
quantity/efficiency variances or cost/rate variances. We have now identified the following variances:
R
1. Volume variance (14 280)
2. Performance variance
Fixed cost spending variance 9 000
3. Other variances * (9 400)
Overall unfavourable variance (14 680)
* The other variances are classified as either quantity/efficiency variances or price/rate variances. We
shall discuss variances in greater detail in Learning Units 15 and 16.
________________________________________________________________________________

It is important to note that whatever the costing base applied, ultimately only the actual cost of direct
materials, direct labour and production overheads are included in the general ledger accounts. Normal
costing and standard costing apportion overheads, based on budgeted pre-determined rates, but any
over-absorption or under-absorption is adjusted against cost of sales, thereby ensuring that all actual
production costs are included in the accounting records.

Standard costing can be used as a management tool for planning and budget setting purposes, as well
as performance evaluation and cost control. In the setting of standards, efficient operating conditions
are assumed. Unit standard costs can be used to prepare a flexible budget. A flexible budget can be
adjusted for changes in the output level, for example the number of units manufactured and sold.

Example 3.5
Use the information in Example 3.4 and prepare a flexible budget for Great Outdoors at production
levels of 300, 400 and 500 tents.
Flexible budget for Great Outdoors

Production level (number of tents) 300 400 500

R R R
Variable cost at R714 214 200 285 600 357 000
Fixed costs 114 000 114 000 114 000
Total production cost 328 200 399 600 471 000
Production cost per unit 1 094 999 942
Fixed overheads per unit * 380 285 228

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Variable cost per unit * 714 714 714

* Notice how the fixed unit cost decreases as production increases, while the variable unit cost stays
the same.
________________________________________________________________________________

The preparation of a flexible budget requires the separation of overheads into its fixed and variable
components. Methods for separating fixed costs and variable costs are discussed in Learning Unit 4.

The cost of goods manufactured will also depend on the methods employed to deal with production
costs, whether those production costs are determined using a basis of actual costs, normal costs or
standard costs. An overview of these methods follows and they will be discussed in greater detail in
their own dedicated learning units later in this guide.

ACTIVITY 3.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Normal costing avoids price spikes in overhead items.
1.2 The difference between an actual cost and a standard cost is known as a profit or loss.
1.3 A standard costing basis is most suitable for service providers.
1.4 Standard costing can be used to measure efficiency.

3.2.2 The methods used for the treatment of production costs

There are five sets of methods for the treatment of production costs and management must select one
from each as stated policy.

3.2.2.1 The method used for valuing finished goods manufactured

Which production costs are taken into account in the valuation of unsold units manufactured, i.e.,
finished goods inventory? One of two methods can be selected to determine the cost of goods
manufactured and, by extension, the cost of goods sold and the value of finished goods inventory:
• Absorption costing method
• Variable costing method
The absorption costing method, also known as the full costing method, treats all production costs, i.e.,
direct materials, direct labour, as well as fixed overheads and variable overheads as product costs.
The variable costing method, also known as the direct costing method and the marginal costing
method, treats only variable production costs as product costs. Fixed production overheads are treated
as period costs.
You must not confuse the basis of costing with methods of costing. The absorption costing method, for
example, can be used on a basis of actual costing, normal costing or standard costing, and a variable
costing method can also be used on any basis of costing. In the following example, any costing base
could have been applied because you are provided with the costs.

Example 3.6
The following are extracts from the accounting records of Loapi Limited for December:
R
Sales 8 000 000
Sales and distribution expenses 1 000 000
Administration expenses 1 400 000
Direct materials used in production 600 000
Direct labour cost 800 000
Fixed production overheads 3 120 000
Variable production overheads 280 000

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Assume that all goods manufactured were sold and that there was no opening inventory. The gross
and net profits under each method will be as follows:
Absorption (R) Variable (R)
Sales 8 000 000 8 000 000
Cost of goods manufactured and sold 4 800 000 1 680 000
Direct materials 600 000 600 000
Direct labour cost 800 000 800 000
Fixed production overheads 3 120 000 -
Variable production overheads 280 000 280 000

Gross profit/Contribution * 3 200 000 6 320 000

The net profit under the two methods will be determined as follows:
Absorption (R) Variable (R)
Gross profit/Contribution 3 200 000 6 320 000
Period costs 2 400 000 5 520 000
Sales and distribution expenses 1 000 000 1 000 000
Administration expenses 1 400 000 1 400 000
Fixed production overheads - 3 120 000
Net profit 800 000 800 000
* Under the variable costing method, we refer to contribution, rather than gross profit. The contribution
concept will be explained in later learning units.
________________________________________________________________________________

In Example 3.6 the net profit under the two methods is the same. This is because there was no opening
or closing inventory. It does, however, demonstrate that ultimately all production costs will be expensed
against income. Let’s see what the position will be where there is unsold inventory at the end of the
period.

Example 3.7
Assume that during December 100 000 units were manufactured and that only 99 000 were sold (for
R8 000 000) i.e., there were 1 000 units in inventory at the end of December. The unit cost of goods
manufactured was:
Absorption (R) Variable (R)
Direct materials (600 000 / 100 000) 6,00 6,00
Direct labour (800 000 / 100 000) 8,00 8,00
Variable overheads (280 000 / 100 000) 2,80 2,80
Total variable costs 16,80 16,80
Fixed overheads (3 120 000 / 100 000) 31,20 -

Total manufacturing cost per unit 48,00 16,80

From this information we can determine the value of the closing inventory of 1 000 units, as well as the
cost of sales of the 99 000 units that had been sold. The net profit for the period under the two methods
will now be as follows:
Absorption (R) Variable (R)
Sales 8 000 000 8 000 000
Cost of sales:
99 000 × R48,00 4 752 000
99 000 × R16,80 1 663 200
Gross profit/Contribution 3 248 000 6 336 800
Period costs 2 400 000 5 520 000
Sales and distribution expenses 1 000 000 1 000 000
Administration expenses 1 400 000 1 400 000

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Fixed production overheads - 3 120 000

Net profit reported for the period 848 000 816 800

Value of closing inventory

1 000 × R48,00 48 000
1 000 × R16,80 16 800

The differences in reported net profit and the value of closing inventory are:
Net profit (R) Closing inventory (R)
Absorption costing 848 000 48 000
Direct costing 816 800 16 800
Difference 31 200 31 200

This difference of R31 200 is ascribed to the fixed cost element of the 1 000 unsold units: fixed cost of
R31,20 × 1 000 units = R31 200.
• Absorption costing includes fixed costs in its cost of inventory; therefore, the closing inventory
under absorption costing is higher than under variable costing.
• Variable (direct) costing includes fixed costs in its period costs; therefore, the net profit under
variable costing is lower than under absorption costing.
________________________________________________________________________________

We said in Learning Unit 2 that financial accounting must comply with legislation and reporting standards.
The financial statements of companies must be prepared in compliance with International Financial
Reporting Standards (IFRS). You will learn about these standards in detail in your Financial Accounting
studies. The reporting standard that deals with the disclosure of Inventories is IAS 2 (International
Accounting Standard 2). The following extracts from IAS 2 are important for the valuation of inventories:
IAS2.8: Inventories encompass … finished goods produced
IAS 2.10: The cost of inventories shall comprise all costs of purchase, costs of conversion …
IAS2.12: The costs of conversion … include a systematic allocation of fixed and variable production
overheads that are incurred in converting materials into finished goods.

From the above extracts it is clear that manufactured goods are classified as inventory (finished goods
produced). It is also clear that the cost of finished goods must include the costs of conversion and that
the costs of conversion must include fixed and variable production overheads. International Accounting
Standards therefore prescribe the absorption costing method for determining the value of inventory. The
costing system used for external reporting purposes must therefore also assign fixed overhead costs to
the value of inventory. Most companies will, however, use both methods to determine the cost of goods.
The absorption costing method will be used for financial reporting purposes i.e., to determine the value
of the closing inventory and cost of sales that will be disclosed in the Statement of Financial Position and
Statement of Comprehensive Income respectively. The variable costing method will be used for internal
planning purposes, e. g., for preparing a flexible budget.

ACTIVITY 3.2

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Marginal costing is also known as full costing.
1.2 Absorption costing is most suitable for planning purposes and internal reporting.
1.3 Absorption costing treats non-manufacturing fixed costs as a period cost.
1.4 Reported net income will be higher under the variable costing method.
1.5 The cost of inventory will be higher under absorption costing than under variable costing.

3.2.2.2 The method used for apportioning production overheads

How are overheads apportioned to the cost of units manufactured? If fixed production overhead costs,
such as rent, insurance, etc remain the same regardless of the level of production, how do we know

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how much fixed cost must be assigned to each unit produced? For example, if the fixed overhead cost
is R300 000 per month and 20 000, 21 000 and 23 000 cans of corned beef are produced in three
consecutive months, how much fixed overhead cost is apportioned to each can in each month?

The answer is that, under the normal costing and standard costing bases, an overhead rate is applied
for allocating overhead costs to production. But now the question is, how is that rate determined? One
of two methods can be selected to determine the rate for the apportionment of overheads-
• Traditional costing method
• Activity-based costing (ABC) method
In Learning Unit 2, a cost driver was defined as the activity, volume or quantity that causes a change
in the cost of a cost object. An activity is an actual activity, e.g., quality inspections, orders places,
changes of machine settings, etc. Volume usually refers to the number of units produced. Quantity
may refer to, for example, number of direct labour hours, etc.
The number of units produced is therefore a volume-based cost driver of the cost of the units
manufactured (cost objects). It is easy to see how the volume of production output drives direct material
and direct labour costs: the more units being manufactured, the higher the total cost of direct materials
and direct labour will be. This is true for all variable costs: total variable costs increase in proportion to
an increase in the level of production output. But what about the rent of the factory; the rent does not
increase in proportion to an increase in the level of production output, so what drives the cost of factory
rent? Rental cost is driven by space; the more space is rented, the higher the cost of rent will be. So
every fixed overhead will have its own cost driver.
When accountants prepare the budget of the company, it is important that they understand what the
drivers of the different costs are. Information such as historical data, agreements with suppliers,
agreements with trade unions and economic forecasts will assist the accountant in budgeting what the
direct material and direct labour cost per unit will be in the forthcoming year. The accountant knows that
the total number of units produced drives the cost of direct materials, the cost of direct labour and the
cost of other purely variable costs. (You will remember that costs behave as either fixed costs, variable
costs, mixed costs or stepped costs.) But the accountant must also know what the drivers of the other
overhead costs are. Once these drivers are known, rates on which to apportion the overhead costs to
production can be determined.
The rates for apportioning overheads can be determined in terms of either of two methods: the
traditional costing method and the activity-based costing method.

Traditional costing
Under traditional costing (where the absorption costing method is applied), all the fixed production
overheads are pooled together, either for the factory as a whole, or per production department, such
as the cutting department, assembling department, finishing department, etc. The most suitable cost
driver is then selected to determine the apportionment rate. The rate is determined by using either a
volume-based or a cost-based driver and then overheads are apportioned to the cost objects by
applying the rate to the actual output level. Examples of volume-based cost drivers are the number of
units produced, the number of direct labour hours worked, and the number of machine hours. Examples
of cost-based cost drivers are direct labour cost, direct materials cost and prime costs. Where only a
single rate is determined, we talk of a blanket rate or plant-wide rate.

Example 3.8
Imvula Ltd has two production departments. The budgeted fixed overhead cost and output level for the
two departments are as follows:
Fixed overheads Output 
apportioned 
Machining department R400 000 400 machine hours and 100 direct labour hours
Packing department R35 000 700 direct labour hours and 35 machine hours
Total R435 000

Normal production is 1 000 units.

At the most basic level, the total overheads of R435 000 would be assigned equally to units
manufactured, i.e., R435 000 ÷ 1 000 = R435 per unit. This approach is only feasible for a very small

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operation where a single product is manufactured. Where more than one product is manufactured, a
single, plant-wide (blanket) rate based on, for example, direct labour hours or machine hours, could be
used to assign overheads to groups of products first before being assigned to the units manufactured.
If, for example, machine hours were selected as basis for the plant wide rate, then the rate would be
R435 000 ÷ 435 = R1 000 per machine hour. If 500 units of Product A were manufactured using a total
of 200 machine hours, overheads of 200 × R1 000 = R200 000 would be assigned to product group A
and R200 000 / 500 = R400 overheads would be assigned to each unit of A. Similar apportionment
would occur for other product groups.
A fairer process would be to determine recovery rates per department, based on the resource most
used in that department.
 Some fixed overheads are directly incurred by a department; e.g., the salaries of supervisors in
the Machining department will be directly allocated to Machining. Other fixed overheads will be
apportioned to departments; e.g., factory rent will be apportioned to departments based on
space occupied. Ultimately, all costs must be absorbed in the cost of goods manufactured,
hence the need to determine absorption rates.
 Conversion of direct materials in Machining is done mainly by machines while in Packing most
work is done manually. The most suitable cost drivers have therefore been identified as machine
hours for Machining and direct labour hours (DLH) for Packing.
Fixed overheads rate per production department:
Machining: R400 000 ÷ 400 machine hours = R1 000 per machine hour
Packing: R35 000 ÷ 700 direct labour hours = R50 per direct labour hour
If Product A received 190 machine hours in Machining and 50 direct labour hours in Packing,
overheads assigned to Product A would be: (190 hours × R1 000) + (50 hours × R50) = R192 500 and
each unit of A will be allocated R192 500 / 500 = R385.
________________________________________________________________________________

In practice, factories would generally manufacture multiple products that move through several
departments. For example, the production of aluminium cans has the following processes: cutting, where
discs are cut from rolls of aluminium sheeting; tooling, where the discs are shaped into the form of a can;
then follows trimming, washing, drying, varnishing, printing, varnishing again, hardening, varnishing the
inside, necking, etc. The cans are sold to soft drinks manufacturers. A drinks manufacturer fills the cans
with several flavours of soft drinks, after their own processes of mixing, flavouring, carbonating, etc after
which the pull-tab lid is fitted to the cans.

Activity-based costing (ABC)

Under activity-based costing (also referred to as ABC), activities are identified and production overhead
costs are collected into several activity cost pools; the cost drivers are those events that cause a
change in the costs in that activity cost pool. The following are examples of activity cost pools and the
driver that will cause a change in the costs in the cost pool:
Activity cost pool Cost driver
i Machine set-ups in the factory Number of set-ups
ii Materials orders Number of orders
iii Quality control inspections Number of inspections
i Every set-up of machines will cause a change in the cost of the activity machine set-ups.
ii Every order will cause a change in the cost of the activity materials orders.
iii Every inspection will cause a change in the cost of the activity quality control inspections.
The costs collected in the activity cost pools are allocated to units of production on the basis of the
volume of activity of the cost driver.

Example 3.9
Umthi Ltd manufactures three products: Product K, Product L and Product M. During March, 24 quality
control inspections were carried out on Product K, 22 on Product L and 34 on Product M. The total cost
of overheads collected in the activity cost pool quality control inspections for March was R80 000.

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The overhead recovery rate for the cost pool is the total cost accumulated in the pool divided by the number
of inspections: R80000 ÷ 80 inspections (24+22+34) = R1 000 per inspection. The apportionment of
overheads is as follows:
Product K R1000 × 24 R24 000
Product L R1000 × 22 R22 000
Product M R1000 × 34 R34 000
R80 000
The apportionment rate for overhead costs collected in other activity cost pools will be determined in
similar fashion and allocated to products K, L and M.
________________________________________________________________________________

Have you noticed that the traditional costing method identifies output volumes as cost drivers, while
activity-based costing identifies actual activities as cost drivers?

ACTIVITY 3.3

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 When using machine hours for apportioning manufacturing overheads, items with a low production
run that require significant special handling will be assigned too little manufacturing overhead.
1.2 Under activity-based costing, manufacturing overhead costs are sorted by activities.
1.3 Activity-based costing uses a plant-wide overhead rate to assign overheads.
1.4 In traditional costing, overheads are apportioned to products on the basis of volume-based
measures.

3.2.2.3 The method used for accumulating production costs

So far, we have seen that we must select a basis for the measurement of production costs (actual
costing, normal costing or standard costing), we must decide if fixed overheads will be included in the
cost of production (absorption costing or variable costing) and if we select absorption costing, we must
decide how to determine the overhead recovery rates (traditional costing or activity-based methods).
But we still do not know how we are going to accumulate all the costs assigned to production units until
the goods are completed and a final calculation of the cost to manufacture them can be made.

The general ledger account into which production costs are collected is called a Work-in-Progress
Account. The two most widely used methods of cost accumulation are–
• Job costing (also called job-order costing)
• Process costing

Job costing
Job costing is most appropriate where goods are made according to customer specifications, for
example, where a tender had been accepted. It is also suited to goods that are produced in batches,
e.g., the printing of a company's annual report. Therefore, a ‘job’ can consist of a single product, or a
batch of similar products, or a special order. Product costs are assigned and computed per job and not
per period of time. This implies that the goods manufactured for a job must be markedly different from
other jobs for cost assignment per job to be possible. Examples of manufacturers that may apply job-
costing, are aircraft manufacturers and manufacturers of custom designed furniture. Job costing is also
used for special orders, e.g., the printing a company's annual report. Each job represents a separate
Work-in-Progress Account until the job is completed and the goods manufactured in that job are
transferred to finished goods.

Process costing
Under process costing, production costs are assigned to processes or departments rather than
individual jobs. Process costing is used when identical goods are mass produced on a continuous
basis for a long time. An example of the application of a process costing system would be companies
that manufacture fast moving consumer goods (FMCG) such as canned foods, blankets, etc.

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Process costing accumulates costs in departments (processes). A separate Work-in-Progress Account

is opened for each process (department), for example the cutting department, the stitching department,
the packing department, etc. The cost of direct materials, direct labour and production overheads are
accumulated and assigned to departments first and the costs of the departments are then assigned to
the cost of the goods manufactured. Direct materials are expected to be added in the first department.
(You cannot add labour and overheads unless the labour and overheads have materials to convert.)
More direct materials may be added in subsequent departments.
Think for a moment of the production of chocolates, films, academic text-books and paint and then
consider in each instance whether you would recommend a job-costing method or process costing
method as more appropriate. Chocolates is a single product that will be worked on for a longer period,
undergoing different processes and therefore process costing is recommended. A film is a single
product that is markedly different from other films and therefore job-costing is appropriate. The
production of academic textbooks occurs in batches markedly different from other batches and
therefore job-costing is recommended. Paint is a single product that will be worked on for a longer
period, undergoing different processes and therefore process costing is recommended.

ACTIVITY 3.4

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 In process costing, costs are accumulated in processing departments, rather than by job.
1.2 A manufacturer of blank memory sticks would ordinarily use job-costing rather than process
costing.
1.3 The flow of costs through the accounting records would be the same for job and process costing.
1.4 An accounting firm would use job-costing rather than process costing.

3.2.2.4 The assumption on which cost flows are based

By now we have selected a basis for the measurement of production costs (actual costing, normal
costing or standard costing), we have decided if fixed overheads will be included in the cost of
production (absorption costing or variable costing) and if we selected absorption costing, we had to
decide how to determine the overheads recovery rates (traditional costing or activity-based costing
methods). We then decided if costs will be accumulated by applying either job-costing or process
costing methods.
Due to the effect of inflation, unit costs under the process costing method may be different from period
to period. Say for example a company manufactures brooms. How do we know which brooms in
finished goods inventory are sold first so that the accurate production cost can be transferred from
inventory to cost of sales? The short answer is we don’t know the cost of each individual broom and it
doesn't matter because it really is irrelevant which actual brooms are physically taken out of the store
and sent to customers. What matters is the cost that we transfer from the Inventory of Finished Goods
Account to the Cost of Sales Account. Certain assumptions will have to be made about cost flows.
IFRS allow only three cost flow assumptions.
IAS 2.23 states that the cost of inventories of items that are not ordinarily interchangeable and goods
or services produced and segregated for specific projects shall be assigned by using specific
identification of their individual costs. This assumption will apply to most inventories manufactured
under a job-costing method, e.g., motor car manufacturing, where each vehicle has a unique vehicle
identification number (VIN).
IAS2.25 states that the cost of inventories, other than those dealt with in paragraph 23, shall be
assigned by using the first-in first-out (FIFO) or weighted average cost formula. … This paragraph
relates mostly to goods manufactured under a process costing method.
In this study guide we shall consider the above three cost flow assumptions (cost formulas), i.e.,
• first-in-first-out (FIFO) method (process costing)
• weighted average method (process costing)
• specific identification (job-costing)

Example 3.10

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Impofu (Pty) Limited manufactures luxury, light-weight, four-wheel suitcases in a process costing
system. There are 314 suitcases in Inventory of Finished Goods. These suitcases were received from
the production department as follows:

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Date Number of units Unit cost (R) Total cost (R)

28 February 14 3 000 42 000
4 March 180 3 100 558 000
10 March 120 3 305 396 600
Total 314 996 600
If 10 suitcases are sold on 11 March, what is the amount that will be transferred from Inventory of
Finished Goods to Cost of Sales?
Under FIFO, we assume that the cost that came in first (R3 000 per unit) will flow out first. Therefore,
on 11 March we shall transfer R30 000 (10 × R3 000) from Inventory of Finished Goods to Cost of
Goods Sold. Note that even if the physical suitcases shipped out on 11 March, were completed on
10 March at a cost of R3 305 each, we assume that the first costs (not physical suitcases) that came
into inventory will flow out of inventory.
Under the weighted average method, the cost of inventory is continuously averaged after each transfer
into inventory and the cost of sales of the 10 suitcases sold will be assumed to be R31 738,85
(R996 600 / 314 × 10).
________________________________________________________________________________

ACTIVITY 3.5

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Using the FIFO method of inventory valuation will result in the most current costs in closing
inventory.
1.2 The specific identification method of inventory valuation is based on the actual cost of each item
in inventory.
1.3 Opening inventory of 5 000 units had a value of R50 000. During in the year, 10 000 units were
manufactured at a unit cost of R11,50 each. Closing inventory was 3 000 units. Using the
weighted average, the cost of sales for the year was R132 000.

3.2.2.5 The frequency with which inventory records are updated

Apart from the cost of goods completed flowing into the inventory account and the cost of goods sold
flowing out of the inventory account, it is true that often, items of inventory must be written off. This
may be due to breakages, obsolescence, theft, damage, etc. The last decision that must be taken
when an integrated cost accounting system is designed relates to how often inventory records will be
up-dated. Inventory records can be maintained according to the
• perpetual method
• periodic method
A perpetual inventory method (system) maintains a continuous record of the quantities and cost of
inventory flowing in and out of the inventory account. Therefore, the information is always current and
up-to-date. The periodic inventory method (system) only periodically, e.g., once a month, quarter, year,
updates inventory records. In this study guide you can assume the perpetual method, unless otherwise
stated.
You must not confuse the basis of costing with methods of dealing with production cost. For example,
a company may adopt a perpetual inventory method, value the inventory according to the absorption
costing method, after accumulating the costs according to the process costing method and assigning
overheads using the traditional costing method and using a first-in-first-out cost flow assumption. All
these methods can be applied on a basis of either actual costing, normal costing or standard costing.

ACTIVITY 3.6

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).

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1.1 The perpetual inventory method continually updates accounting records for inventory
transactions.
1.2 A purchases account is used in the perpetual method but not in the periodic method.
1.3 In a perpetual inventory system, cost of sales is recorded at the end of the financial year only.

QUESTION 2

Kobo Limited manufactures blankets. The information below pertains to June, its first month of operation:

Standard cost per blanket Actual cost per blanket

Direct materials R40 R38
Direct labour R30 R41
Production overheads R75 R73
Total cost per blanket R145 R152

Kobo had budgeted for 9 000 blankets, but during June, only 8 000 blankets were actually manufactured.
There was no inventory of blankets at the beginning of June and no sales occurred during June.
REQUIRED
2.1 Calculate the value of Inventory of Finished Goods at the end of June by applying an actual
costing basis
2.2 Calculate the total production cost for June by applying a standard costing basis.
2.3 Calculate the over- or under-absorption of overheads under standard costing.
2.4 From the available information, calculate the direct labour variance under the standard costing
basis.

3.3 SUMMARY

In this learning unit, we identified and described the functions of a cost and management accounting
system (paragraph 3.1), and we distinguished between the three bases of accounting for production
costs as well as the five methods used for dealing with production costs (paragraph 3.2).
You should now have a fair idea of all the elements that must be built into an integrated cost accounting
system. You will understand that a company must choose
• how (i.e., on what basis) to budget for the cost of its products; will it apply actual costing, normal
costing, or standard costing as a basis to measure input costs?
• which input costs will be included in the cost of production; will all costs or only variable costs be
included, i.e., will absorption costing or variable costing be applied?
• how overhead recovery rates for absorption costing will be determined; will traditional costing
pre-determined rates be applied to output or will activity-based costing rates per activity be applied?
• where costs will be accumulated, i.e., will work-in-progress be recorded in jobs according to the
job-costing method, or in departments using the process costing method?
• when inventory costs will flow, i.e., will the first-in-first-out (FIFO) method, the weighted average
method or specific identification method be applied?
• what reporting capability is required of the inventory system, i.e., must a perpetual or a periodic
inventory system be used?
All these methods, as well as the standard costing basis, will be discussed in greater detail in further
learning units.

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