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A product costing system is a set of procedures used to account for an organizations product
costs and provide timely and accurate unit cost information for pricing, cost planning and
control, inventory valuation and financial statement preparation
There are three main types of cost accounting systems for manufacturing operations: Job order,
process and operational cost systems.
(a) Job order costing system: A job order costing system is a product costing system used
by both manufacturing companies and service organizations that make large, unique, or
special order products such as customized publications, specially built cabinets, custom
printing business etc. Under such a system, the costs of direct materials, direct labor,
and manufacturing overhead is traced to a specific job order or a batch of products. A
job order is a customer order for a specific number of specially designed, made to order
products. Job order costing measures the cost of each complete unit. It uses one work in
process inventory account to summarize the cost of all jobs. This account is supported
by job order cost cards or a subsidiary ledger of accounts for each job.
(b) Process costing system: A process costing system is a product costing system used by
companies that produce large amounts of similar products or liquids, or that have a
continuous production flow. Makers of paint, soft drinks, bricks, milk or paper would
use a process costing system. Under such a system the cost of direct materials, direct
labor and manufacturing overhead are first traced to processes, departments, or work
cells and then assigned to the products manufactured by those processes, departments
or work cells. A process costing system uses several works in process inventory
accounts, one for each process, department or work cell.
Manufacturing overhead costs are applied and charged to the work in process inventory
account using a predetermined overhead rate. Those charges are used to reduce the balance in
the manufacturing overhead account. They too are recorded on the job’s job order cost card.
When products and jobs are complete, the costs assigned to them are transferred to the finished
goods inventory account.
When the products are sold and shipped, their costs are transferred to the cost of goods sold
account.
1. Actual costing means the aggregate of actual direct material costs, actual direct labor
cost and actual manufacturing overhead. The actual manufacturing overhead can be
2. Normal Costing:
A predetermined or budgeted indirect cost rate is calculated for each cost pool at the
beginning of a fiscal year and overhead costs are allocated to jobs as work in progresses.
Normal costing is a costing method that traces direct costs to a cost object by using the
actual direct cost rate(s) times the actual quantity of the direct cost input(s) and allocates
indirect costs based on the budgeted indirect cost rate(s) times the actual quantity of cost
allocation base(s). Note that both actual costing and normal costing trace direct costs to
jobs in the same way. The only difference between actual costing and normal costing is
that actual costing uses an actual indirect cost rate(s), whereas normal costing uses a
budgeted indirect cost rate(s) to cost jobs.
Example: XYZ Manufacturer uses a job-costing system with two direct cost categories
(direct materials and direct manufacturing Labor) and one manufacturing overhead cost
pool. XYZ allocates manufacturing overheard cost using direct manufacturing Labor costs.
Xyz provides the following information:
Budget for Actual Results for
Year 2020 Year 2020
Direct material cost $ 375,000 $362,500
Direct manufacturing labor cost 250,000 245,000
Manufacturing overhead cost 437,500 465,500
(a) Compute the actual and budgeted manufacturing overall rates for 2020.
(b) During June the job cost record for job No. 205
Contained the following information:
Direct materials used $ 10,000
Direct manufacturing Labor costs 7,500
Compute the cost of job No 205 using (s) actual costing and (b) Normal costing, and c)
At the end of 2006, Compute the under- or over allocated manufacturing overhead
under normal costing why is there no under- or over-allocated overhead under actual
costing?
Solution:
(a) Computation of manufacturing overhead Rate for 2020
Actual Budgeted
190
(i) Actual= 7,500x
100
175
(ii) normal= 7,500x
100
Under actual costing method, allocation of manufacturing overhead costs are based on
actual manufacturing overhead rates
The actual manufacturing overheads and allocated manufacturing overhead costs are
equal. Therefore, there will be no under or over allocation of manufacturing overhead
cost under actual costing methods.
The multiple overhead cost rate may be followed if the existence of multiple overhead
cost pools. Some overhead costs can be allocated to jobs based on labor cost or labor
hour basis if it is labor oriented job. On the other hand, machine hour rate may be used
if the jobs are undertaken automated machines.
To implement a normal costing system with multiple overhead cost pools, it is required
to determine the budgeted total manufacturing labor hours and the budgeted total
machine hours and identity the associated budgeted indirect total cost for each cost
pool. It would then calculate two indirect cost rates, one based on direct manufacturing
labor hours and the other based on machine hours. Indirect costs would be allocated to
jobs using these indirect cost rates and the direct manufacturing labor hours and
machine hours used by various jobs. The general ledger would contain manufacturing
overhead control and manufacturing overhead-allocated amounts for each cost pool.
End of period adjustments for under or over allocated indirect costs would then need be
made separately for each cost pool.
Example:
The Lucas Incorporation uses a job – costing system. The plant has a machining
department and an assembly department. Its job costing system has two direct cost
categories (direct materials and direct manufacturing labor) and two manufacturing
overhead cost pools (the machining department overhead, allocated using actual
machine hours, and the Assembly Department overhead, allocated using actual direct
manufacturing labor cost).
Machining Assembly
Department Department
Manufacturing overhead $ 900,000 $ 1,800,000
Direct manufacturing labor
Cost $ 700,000 1,000,000
Direct manufacturing labor
Hours 50,000 100,000
Machine hours 25,000 100,000
Required:
(a) Present an overview diagram of Lucas Incorporation’s job – costing
system. Compute the budgeted manufacturing overhead rate for
each department
(b) During March 2021, the job cost record for job No. 555 contained the
following.
Machining Assembly
Department Department
Direct Materials used $22,500 $ 35,000
Direct manufacturing 7,000 7,500
Labor costs
Direct manufacturing
Labor – hours 500 750
Machine hours 1,000 50
Process costing is vitally important to companies in many ways. The costs assigned to products
are commonly used to help set prices particularly in periods of severe competition or economic
down turn. Product costs also are used to identify which products appear to be too costly and
need to be redesigned or dropped.
Costs assigned to products often are used to determine inventory value for financial reporting.
Managers can use product costs to evaluate the efficiency of production operations.
Case 1: Process costing with zero beginning and ending work in process
Case 2: Process costing with zero beginning work in process but some ending work in
process
Case 3: Process costing with some beginning and some ending work in process
Case 1: Process costing with zero beginning and ending work in process:
This case presents the most basic concepts of process costing and illustrates the key features of
averaging of costs.
This case is common for companies that successfully use just in time production. Some
companies schedule production so that they will have no inventory at the end of a day because
work in process could deteriorate or spoil.
This case shows that in process costing system, unit costs can be averaged by dividing total
costs in a given accounting period by total units produced in that period.
This situation frequently occurs in service sector organization. For example, a bank can adopt
this process costing approach to compute the unit cost of processing 10,000 similar customer
deposits made in a month.
Example1: Compute the cost per unit from the following details:
Physical units for April 2003:
Work in process, beginning inventory (April 1) = 0 units
Started during April = 500 units
Completed and transferred out during April = 500 units
Work in process, ending inventory (April 30) = 0 units
This case builds on the basics and introduces the concept of equivalent units.
In this case, the units started during the period may not be fully completed during the period. In
other words part of the units introduced may be completed and part of the units introduced may
not be fully completed i.e. partially completed.
As far as units completed are concerned there is no difficulty in computing cost per unit. On
the other hand for partially completed units it is difficult to compute cost per unit. For partially
completed units we have to convert the partially converted units into equivalent units. The
following steps are followed in this case. 2.
For step 1, summarize the flow of physical units, using the basic cost-flow model to help
account for units:
This step focuses on how the output for the period should be measured. Step 2 requires us to
understand the concept of equivalent units. Equivalent units are a derived amount of output
units that takes the quantity of each input (factor of production) in units completed or in work
in process and converts it into the amount of completed output units that could be made with
their quantity of input.
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For example, if 1000 units of a product in ending work in process are 75% complete with
respect to conversion costs, there are 750 units’ 1000x 75
equivalent units of output for
100
conversion costs.
When calculating equivalent units in this step, focus on quantities, disregard dollar amounts
until equivalent units are completed.
Step 3 calculates equivalent unit costs by dividing direct materials and conversion costs added
during the period by the related quantity of equivalent units of work done in given period.
This step summarizes total costs to account for. Because the beginning balance of the work in
process inventory is zero, total costs to account for consist of the costs added during the period.
Step 5: Assign total costs of units completed and to units in ending in process:
Under this step, costs are assigned to units completed and transferred out and to units still in
process at the end of the period. The key idea is to attach dollar amounts to the equivalent
output units for direct materials and conversion costs in (a) units completed and transferred out
by calculation of ending work in process
To do so, the equivalent output units for each input are multiplied by the cost per equivalent
unit calculated in step 3.
Example: 2
XYZ Inc. furnisher the following data for August 2020, the department- assembly:
Work in process, beginning inventory (August 1) = 0 units
Started during August = 5000 units
Completed and transferred = 3750 units
Work in process, ending inventory (August 31) = 1250 units
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Solution:
Step 1 and 2: Summarize output in physical units and computation of equivalent units:
(Step 1) (Step 2)
Flow of Production Physical Equivalent units
Units Direct Conversation
Material Costs
Step 3, 4 and 5: Computation of Equivalent unit costs summarize total costs to account for, and
Assign cost’s to units completed and to units in ending work in process:
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Journal entries:
Case 3: Process Costing with Both some Beginning and some ends work in process
inventory:
Most of the cases the incomplete units in both beginning and ending work in process inventory
to account for. By using five steps to calculate
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The weighted average process- costing method calculates the equivalent – unit cost of the work
done to date (regardless of the period in which it was done) and assigns this cost to equivalent
units completed and transferred out of the process and to equivalent units in ending work in
process inventory.
The weighted average cost is the total of all costs entering the work in process account
(regardless of whether it is from beginning work in process or from work started during the
period) divided by total equivalent units of work done to date.
Steps:
Step 1: Summarize the flow of physical units
Step 2: Compute output in terms of equivalent units
Step 3: Compute Equivalent unit costs
Step 4: Summarize total costs to Account for
Step.5: Assign costs to units completed and to units in ending work in process.
Example: 3
At the beginning of September 2020, XYZ Inc. had 1250 units partially assembled units in the
Assembly Department. During September 2003, XYZ Inc. placed another 4000 units into
production. Data for the Assembly Department for Sept, 2003 are:
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Required:
Step 1 Step 2
Physical unit Equivalent units
Flow of Production Direct Conversion
Materials Costs
* Degree of competition in this department, direct materials 100%, conversion costs 50%
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(To record direct materials purchased and used in production during September)
(To record cost of goods completed and transferred from assembly to Testing during
September)
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In contrast to the weighted- average method, the first in first out (FIFO) process- costing
method assigns the cost of the previous period’s equivalent units in beginning work in process
inventory to the first units completed and transferred out of process, and assigns the cost of
equivalent units worked on during the current period first to complete beginning inventory,
then to start and complete new units, and finally to units in ending work in process inventory.
This method assumes that the earliest equivalent units in the work in process – Assembly
account are completed first.
A distinctive feature of the FIFO process – costing method is that work done on beginning
inventory before the current period is kept separate from work done in the current period.
Costs incurred in the current period and units produced in the current period are used to
calculate cost per equivalent unit of work done in the current period.
In contrast, equivalent unit and cost per equivalent unit calculations in the weighted average
method merge the units and costs in beginning inventory with units and costs of work done in
the current period.
Example- 4:
Refer the example 3 and compute equivalent units and cost of equivalent units under FIFO
method.
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(2) Computation Equivalent unit costs, Summarize total costs to account for, and assign
costs to units completed and to units in Ending work in process:
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