Chapter two

Cost determination: The costing of resource inputs

2.1. Materials
Material is one of the important elements of cost and it has been observed that in the total cost
structure of a product, material content is about 40 to 80%. The substantial proportion of material
cost in the total cost demands more and more attention of the management towards this element.
The term ‘material’ generally used in manufacturing concerns, refers to raw materials used for
production, sub-assemblies and fabricated parts. The terms ‘materials’ and ‘stores’ are
sometimes used interchangeably. However, both the terms differ. ‘Stores’ is wider in meaning
and comprises many other items besides raw materials, such as tools, equipments, maintenance
and repair items, factory supplies, components, jigs, fixtures. Sometimes, finished goods and
partly finished goods are also included within the scope of this item.
Accounting for stock (inventory) movements
Meaning of Material Control
The success of any industry or enterprise depends, to a greater extent, upon the successful
control of material. Further, this input provides a number of avenues and wide scope for
improvement of overall performance of the industry. Inventory control, therefore, aims at
ensuring the availability of required quality material in required quantity, at required time or
period and place with minimum cost. Inventory involves investment of money and locking up of
precious space which has alternate uses. It is said that inventory is a necessary evil. As a result,
proper control has to be exercised over it. In controlling inventory, firms or industries use a
number of techniques and models. Inventory control is generally exercised over raw materials
and work in progress. The basic purpose of inventory control is to maintain optimum level of
inventory.
The objectives of material control are as follows:
 Proper estimation of inventory requirements-quantity, quality, specifications of inventory,
etc. This will help the purchase manager to quality and quantity of materials. The
purchase department has to exercise utmost care to procure the quality materials at lower
prices.
 The stores department has also an effective role to play for stock levels. By keeping only
the required quantities of materials, excess employment of capital on materials can be
avoided. Further, it can reduce the loss of materials during the storage period and keep
the materials in good condition.
 It is the production departments which are capable of extracting the maximum output
from each unit of materials thereby contributing heavily to minimize the loss of materials
during the production period and to maximize the productivity.
 Methods and Techniques of Material Control
There are many methods and techniques of material control, the most important being:
A. Economic Ordering Quantity
The ordering of materials is usually tagged with three different components of costs viz:
 Acquisition cost of materials
 Ordering cost of materials and
 Carrying cost of materials
The ordering quantity of materials may be either larger or lesser in volume, which carries its own
advantages and disadvantages
If the quantity ordered is larger in volume, the following are some of the important advantages:
 The bulk purchase order reduces the ordering cost of the materials.
 The greater the size of the order leads to reduce the number of the orders in procuring the
materials.
Quantity discounts: The discount can be classified into two categories viz trade discount and cash
discount Trade discount is the discount granted by the supplier to the buyer of materials at the
moment of bulk purchase. This % of discount is greatly possible only during the periods of
greater volume of purchase, which reduces the overall cost of the acquisition.
If the quantity is procured in lesser volume, the following are construed as advantages:
 The carrying cost will come down in the case of lesser inventories.
 The cost of storage is lesser as far as the lesser quantities of materials.
 Loss due to deterioration, obsolescence, wastage will be minimum.
 Insurance cost is less due to lesser volume of materials.

Example
 B. ABC Analysis
Normally the materials are classified on the basis of the following covenants viz
 Volume and
 Value
Based on the following basis, the materials are classified into three categories:
 Lesser percentage in volume and Greater percentage in Value – Category A
 Greater percentage in volume and Lesser percentage in Value – Category B and
 Percentage in volume and Percentage in value are more or less similar –Category C
Example1:A store has 4,000 items of consumption and a monthly consumption of 2,000,000.
320 items will have a consumption of 1,500,000. 500 items will account for 400,000 and 2,680
items consume material worth 100,000 only.

 Group A items are high valued items among the other items of the enterprise, requiring
greater monitoring and controlling.
 Group B items are comparatively lesser in value among the three items given next to the
Group A; require less rigid control and monitoring.
 Group C items are the major volume of items among the 4000 items of the enterprise
which are least in value; need very little control and monitoring.
Example2:The following shows the control of inventory on A, B and C items of the enterprise:

From the above table, it is obviously seen that the items which have greater percentage (75%) in
the total value require rigid control than any other quantity of materials. The Group C items bear
67% of total consumption amount to 5% of total value of the items procured by the enterprise.
Pricing of Material Issues
The important operation of the inventory management is inventory valuation through stores
register. Inventory valuation under pricing is being executed through the following various
methodologies:
 First in First out (FIFO)
 Last in First out (LIFO)
 Highest in First out (HIFO)
 Simple Average Method (SAM)
  Weighted Average Method (WAM)
 Base Stock Method
First in First out (FIFO)
The material which is first issued from the earliest consignment on hand and priced at the cost at
which that consignment was placed in stores. The material is which are received at First to be
issued first. This is the method suitable for the trend of falling prices in the market.
Advantages
 It is very simple to understand.
 It is issued on the basis of purchases.
 The materials are issued at purchase price.
 It is most advantageous during the moment of falling prices due to lower cost of
replacement through purchases against the issues.
 The closing stock reflects the market price due to recent purchase of materials.
Disadvantages
 There may be the possibility of clerical errors at the moment of maintaining the stock
register due to price fluctuations.
 The comparison between the jobs cannot be made possible due to various prices
involved. The materials issued for one job is at earlier prices which do not agree with the
materials issued for another job at later prices. When the price of materials does not agree
with each other, they will not be considered for comparison.
 The issue prices do not reflect the market price due to upward price trend. The main
reason is that the issues are only due to earliest consignments.
Last in first out
Under this method, the issues are made at the price of latest consignment. The current cost of the
jobs/work orders are denominated only in terms of the price of the latest consignment. During
the rising prices, this is considered to be a most suitable method.
This method helps the management to quote competitive prices on the basis of latest
consignments.
This method was considered by all the firms in the US as a predominant one over the others in
fixing the price on the commodities competitively during the post Second World War years
Advantages
 It has greater applicability only when the transactions are very minimal and prices are
steady in the environment.
 The recent purchase through the latest consignment reflects the current market prices in
the cost of sales of the firm.
 The issue of materials through latest consignments is denominated in terms of higher
prices; led to illustrate lesser profits due to higher charge during the production and
lessens the income tax burden.
Disadvantages
 Greater possibility for more number of clerical errors.
 This method also helps to compare the jobs or works.
  There may be a possibility of either overstating or understating the value of the stock in
the balance sheet.
Highest in First out (HIFO)
The major underlying assumption of this method is to value the closing stock as minimum as
possible at the end of concluding the stores register. The high priced materials are issued one
after another, among the various consignments of the materials available in the stores. This
method may not only assist the firm to devalue the stock, but also to price the issue exorbitantly.
It leads to a charge through cost plus contracts. It may be possible for the firm during the
monopoly situations to increase the price of materials.
Method of Average
In practice, the issue of materials cannot be made from any singular lot purchases. Normally
speaking, the materials are grouped together in categories on the basis of similar characteristics
but not on the basis of purchase price. If the materials are grouped together irrespective of
purchase price, the issues should be done appropriately on the basis of average cost method.
The average cost method is bifurcated as follows:
 Simple Average Method
 Weighted Average Method
 Base Stock Method
A. Simple Average Method (SAM)
Under the simple average method, the issues are made only on the basis of simple average price.
Definition: “Simple Average Price”
“A price which is calculated by dividing the total of the prices of materials in the stock from
which the material to be priced could be drawn by the number of prices used in that total”
Example:A pillow manufacturer purchases raw cotton from three different quantities at three
different prices.

As a manufacturer of pillows, he should find out the cost of the raw cotton material at the
moment of issuance to the production center. The issue price should be computed as follows

B. Weighted Average Method (WAM)

Under the weighted average method, the issue price is found out through the appropriate
assignment of weights considered for the determination of weighted average price.
Weighted Average Price
“Weighted average price which is calculated by dividing the total cost of materials in the stock
from which the materials to be priced could be drawn by the total quantity of materials in that
stock.”

Q = Quantity of materials
P = Price of the materials
Q = Assigned as weights i.e. volume of the quantities are used weights
The above example is taken for the computation weighted average price

Advantages
 This method is a most rational method in finding out the issue price of the materials.
 It never takes into consideration the price fluctuations either during the trend of rising or
falling.
 Issue prices mainly depend upon the number of purchases.
 Under this method, the issue price is able to recover the cost of the materials.
 The issue price reflects or resembles the market price.
Disadvantages
 Due to different volumes of materials, clerical errors may arise.
 It lost its expression in terms of actual price of materials due to average price.
C. Base Stock Method
Under this method, the minimum or safety stock of materials is to be stored from the initial lot of
purchase by the enterprise. The ultimate purpose of maintaining the stock in order to meet the
emergency whenever arises. Once the base stock is created out of the first lot of purchase, should
be considered as a fixed volume forwarded from one point of time to another.
It is the only method having the prime objective of issuing the materials to the adjust current
prices. This method normally carries out its operations either with FIFO or LIFO. While
applying the FIFO or LIFO method in the applications of the base stock method it bears the
advantages and disadvantages of the fundamental procedures of earlier two methods.
The basic objective of the method could be met out only with the conjunction of LIFO method.
Accounting for material losses
Losses of materials may arise during handling, storage or during process of manufacture. Such
losses may be classified into two categories, i.e. normal loss and abnormal loss. Normal loss is
that loss which has necessarily incurred and thus is unavoidable. Examples:
o Loss by evaporation
o Loss due to loading and unloading
o Loss due to breaking the bulk, etc.
Normal losses of material cannot be completely avoided but may be controlled to a limited
extent.
Abnormal loss is that loss which arises due to inefficiency in operations, mischief, carelessness,
etc.
Examples
o Theft or pilferage
o Breakage
o Fire, accident, flood, etc.
o Use of inaccurate instruments
o Improper storage, etc.
Accounting Treatment
As a principle, all normal losses which are necessarily incurred are treated as a part of the cost
and abnormal losses should not be included in the cost. In order to absorb normal material losses
in cost, the rates of usable units are inflated so that such losses are absorbed. Alternatively,
normal material loss is transferred to factory overhead. However abnormal loss of material is
charged to Costing Profit and Loss account.
o Materials losses may arise in the form of waste, scrap, spoilage or defectives.

1.1. Labor
The difference between direct and indirect labor
Labor cost is a significant element of cost especially in an organization using more manual
operations. It is the cost of human endeavor in the product and requires coordinated efforts for its
control. The management objective of keeping labor cost as low as possible is achieved by
balancing productivity with wages. Low wages do not necessarily mean low labor cost. Low
labor cost is possible by giving substantial increase in wages against corresponding increase in
productivity.
The total labor cost can be classified as follows:
A. Direct labor costs;
B. Indirect labor costs.
A. Direct Labor Cost
It refers to all labor expended in altering the construction, composition, conformation or
condition of the product. The wages paid to skilled and unskilled workers for his labor can be
allocated specifically to the particular product or the process as the case may be. In any
manufacturing process or department, the workers employed may be of the following two
categories:
(i) Those who are directly engaged on the production or in the carrying out of an operation or
process;
(ii) Those that are assisting in the process by way of supervision, maintenance, transportation of
materials, etc.
The workers coming under the first category constitute direct labor and the wages paid to them
are called direct wages. In a factory, where production of a number of products is undertaken or
in a jobbing concern, workers are given job cards on which they note the time devoted to each
job or product. These job cards are then analyzed job wise so that the wages attributable to each
job can be computed.
Direct labor cost is that portion of wages or salaries which can be identified with and charged to
a single costing unit. It can be easily identified with and charged to a single costing unit as there
is a direct relationship with the product/process. Direct labor cost can be easily calculated and is
quite significant in amount
B. Indirect Labor Costs
It refers to labor expended that does not alter the construction, conformation, composition or
condition of the product, but which contributes generally to such work and to the completion of
the product and its progressive movement and handling up to the point of dispatch. In other
words, labor employed for the purpose of carrying out tasks incidental to goods produced or
services provided is regarded as indirect labor. Wages or salaries paid to foremen, supervisors,
inspectors, clerks, store-keepers, managers, accountants, salesmen, directors, etc., are examples
of indirect labor cost.
Need for distinguishing between direct and indirect labor cost:
The distinction has to be made
o For calculating accurate labor cost and thus provide a basis for strict control;
o For facilitating calculation of labor efficiency;
o For proper allocation of overheads;
o For introduction of incentive schemes;
o For inter-unit comparison; and
o For estimating total labor costs.
Control of labor cost
Accounting for labor by a manufacturer usually involves three activities:
 o Time keeping;
o Computation of total payroll; and
o Allocation of payroll costs.
These activities must be performed before the payroll is recorded in the accounting records. In a
large organization, the control of labor cost involves the coordinated efforts of the following
departments:–
 Personnel department — this department is responsible for manpower planning,
recruitment, training, maintaining records of staff and workmen and reporting to chief
inspector of factories and to top management on performance, overtime, absenteeism,
leave, etc.
 Industrial engineering department — this department prepares plans and specifications
of each job, supervises production activities, undertakes time and motion studies, performs
job-analysis, etc.
 Time-office — this department is primarily responsible for collection of data relating to
attendance, time spent on jobs or process by the workmen, and providing information on
attendance and leave to Payroll department.
 Payroll department — this department is responsible for computing total and net
earnings of each worker, preparation of payroll and maintenance of various records
relating to payroll.
 Cost department — this department collects and classifies all cost data relating to labor
utilization by departments, and allocates them to respective job or process as per available
documents.
Basic methods of Remuneration system
1. Time Rate System
The time rate or day rate is related to the hours of wage and is commonly used. The wage rate
can be fixed on hourly, daily, weekly, fortnightly or monthly basis depending on the nature of his
skill.
This method can be applied in the following circumstances:
 The quality of work is more important;
 The output of a worker cannot be measured;
 Where output of a worker is not in his control;
  Where the work can be closely supervised;
 Where increase in output is negligible compared to the incentive.
Advantages of Time Rate System
The advantages of time rate system are:
 It is simple and easy to understand;
 It is recognized by trade unions as all workers are paid alike;
 It involves less clerical expenditure;
 A steady income is assured;
 As there is no hurry, tools and materials are handled carefully. Wastage is minimized.
Disadvantages of Time Rate System
 It does not encourage initiative;
 Tab our cost may raise thereby decreasing profit. This may be caused by decrease in
productivity;
 Standards for labor are difficult to set;
 Production may decrease thus upsetting production schedules, creating production
bottlenecks and increasing cost per unit;
 Labor cost cannot be estimated for the purpose of quotations;
 It creates more idle time;
 This system encourages inefficiency;
 It requires close supervision to ensure that employees are working.
2. Payment by Results (piece rate method)
Payment by results is a method of paying wages which depends on the output or units produced
by the worker. The worker can increase his income by producing more units. The main
classifications of payment by results are:
(i) Payment is directly proportionate to the worker’s production; for example, straight piece
work system;
(ii) Payment proportionately increases as the production increases, like the differential piece-
work system;
(iii) The rate of payment decreases as output increases e.g. premium bonus methods;
(iv)The payment varies at different levels of production like the accelerated premium method.
 3. Bonus Systems
The bonus to be paid to the workers is computed on the basis of savings in the hours, i.e. the
difference between the time allowed and time taken. The time allowed is the standard time,
which is fixed by conducting a time and motion study by the work-study engineers. While fixing
the standard time, due allowance is given for physical and mental fatigue as well as for normal
idle time. The actual time taken is compared with this standard time and bonus is payable to the
worker if the time taken is less than the standard time.
4. Indirect Monetary Incentives: These methods aim at giving additional remuneration
based on the prosperity of the concern. The following schemes fall in this category.
5. Non-Monetary Incentives: These incentives are given in addition to monetary incentives
for further boosting the moral of the employees. Though these benefits do not result in
additional remuneration, they help to improve productivity by boosting the morale of the
employees.
Some of the non-monetary incentives are as follows.
o Free education and training.
o Subsidized canteens
o Superannuation benefits like pensions, gratuity, life assurance schemes
o Sports and recreation facilities, housing facilities, long service awards.

1.2. Overheads
Overhead cost analyses
Allocation, Apportionment and Reapportionment of Overheads
After the collection, classification and codification of overheads, the next step is allocation and
apportionment of overheads into the product units. The following steps are required to complete
this process.
Departmentalization
Before the allocation and apportionment process starts, the first step in this direction is
‘Departmentalization’ of overhead expenses. Departmentalization means creating departments in
the firm so that the overhead expenses can be conveniently allocated or apportioned to these
departments. For efficient working and to facilitate the process of allocation, apportionment and
reapportionment process, an organization is divided into number of departments like, machining,
personnel, fabrication, assembling, maintenance, power, tool room, stores, accounts, costing etc.
and the overheads are collected, allocated or apportioned to these departments. This process is
known as ‘departmentalization’ of overheads which will help in ascertainment of cost of each
department and control of expenses.
Allocation
CIMA defines Cost Allocation as, ‘the charging of discrete, identifiable items of cost to cost
centers or cost units’. In simple words complete distribution of an item of overhead to the
departments or C products on logical or equitable basis is called allocation. Where a cost can be
clearly identified with a cost center or cost unit, then it can be allocated to that particular cost
center or unit. In other words, allocation is the process by which cost items are charged directly
to a cost unit or cost center. For example, electricity charges can be allocated to various
departments if separate meters are installed, depreciation of machinery can be allocated to
various departments as the machines can be identified, salary of stores clerk can be allocated to
stores department, cost of coal used in boiler can be directly allocated to boiler house division.
Thus allocation is a direct process of identifying overheads to cost units or cost centers. So the
term allocation means allotment of whole item of cost to a particular cost center or cost object
without any division.
Apportionment
Cost Apportionment is the allotment of proportions of items to cost centers. Wherever possible,
the overheads are to be allocated. However, if it is not possible to charge the overheads to a
particular cost center or cost unit, they are to be apportioned to various departments on some
suitable basis. This process is called as ‘Apportionment’ of overheads. The basis for
apportionment is normally predetermined and is decided after a careful study of relationships
between the base and the other variables withinthe organization. The Cost Accountant must
ensure that the selected basis is the most logical. A lot of quantitative information has to be
collected and constantly updated for the purpose of apportionment.
The basis selected should be applied consistently to avoid vitiations. However, there should be a
periodical review of the same to revise the basis if needed.
In simple words, distribution of various items of overheads in portions to the departments or
products on logical or equitable basis is called apportionment. D Distinction between
Allocation & Apportionment
Although the purpose of both allocation and apportionment is identical, i.e to identify or allot the
costs to the cost centers or cost unit, both are not the same.
Allocation deals with the whole items of cost and apportionment deals with proportion of items
of cost.
Allocation is direct process of departmentalization of overheads, whereas apportionment needs a
suitable basis for sub-division of the cost.
Whether a particular item of expense can be allocated or apportioned does not depends on the
nature of expense, but depends on the relation with the cost center or cost unit to which it is to be
charged.
Principles of Apportionment of Overhead Cost
A. Services Rendered
The principle followed in this method is quite simple. A production department which receives
maximum services from service departments should be charged with the largest share of the
overheads. Accordingly, the overheads of service departments are charged to the production
departments.
B. Ability to Pay
This method suggests that a large share of service department’s overhead costs should be
assigned to those producing departments whose product contributes the most to the income of the
business firm. However the practical difficulty in this method is that, it is difficult to decide the
most paying department and hence difficult to operate.
C. Survey or Analysis Method
This method is used where a suitable base is difficult to find or it would be too costly to select a
method which is considered suitable. For example, the postage cost could be apportioned on a
survey of postage used during a year.
D. Efficiency Method
Under this method, the apportionment of expenses is made on the basis of production targets. If
the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the
target is not achieved, the unit cost goes up, disclosing there by, the inefficiency of the
department.
Absorption of Overheads
Once the steps of primary and secondary distribution are carried out, what we get is total indirect
costs of production departments. The next step is to assign these totals to the individual product
units. A job or a product passes through all or many production departments before it is formed
into a finished saleable product. It is necessary to know the cost of each department it passes
through per unit. The absorption of overhead enables a Cost Accountant to recover the overhead
cost spent on each product department through each unit produced. Overhead absorption is also
known as levy or recovery of overheads.
Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the
help of a predetermined overhead rate, which is computed at normal or average or maximum
capacity’
In general, the formula for overhead absorption rate is give as:
Overhead Rate = Amount of Overhead / No of units of the base
Overhead Absorption Rates: For the purpose of absorption of overhead in costs of jobs,
processes, or products overhead rates related to suitable factors or bases to be determined. There
are several methods in use for determining the overhead rates i.e. Actual or Predetermined
Overhead Rate, Blanket or Multiple Rates.
Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in
forecasting costs and volume of output. If these balances of under or over absorbed/recovery are
not written off to costing profit and loss account, the actual amount incurred is not shown in it. In
marginal costing, however, the actual fixed overhead incurred is wholly charged against
contribution and hence, there will be some difference in net profits.
IAS 2 inventories on Overhead allocations
The cost structure of most organizations contains a small proportion of variable costs and a great
many other costs that are lumped into overhead. It is common for companies to have three or
more times the amount of their variable costs invested in overhead. Because GAAP requires that
some portion of overhead costs be assigned to inventory, the inventory accountant has the dual
tasks of determining which costs to include in overhead and how to assign these costs to
inventory. The latter task is especially difficult, because the basis of allocation has historically
been direct labor, which usually constitutes only a small portion of a product’s cost, and which
therefore can result in significant misallocations of overhead costs to specific inventory items.
In this chapter, we review the types of costs to assign to inventory through overhead allocation,
the assignment of overhead costs to raw materials, the contents of a bill of activities, and the use
of activity-based costing to derive the most accurate possible overhead allocation.
Overhead Identification and Allocation to Inventory
Some overhead costs can be charged off to inventory, rather than being recognized in the cost of
goods sold or some other expense category within the current period. Because the proper
allocation of these costs can have a large impact on the level of reported income in any given
period, it is important for the inventory accountant to fully understand which costs can be shifted
to a cost pool for eventual allocation and how this allocation is to be accomplished. The first
question is answered by
Exhibit 9-1, which itemizes precisely which costs can be shifted into a cost pool. The only cost
category about which there is some uncertainty is rework labor, scrap, and spoilage. The exhibit
shows that this cost can be charged in either direction. The rule in this case is that any rework,
scrap, or spoilage that falls within a normally expected level can be charged to a cost pool for
allocation, whereas unusual amounts must be charged off at once. This is clearly a highly
subjective area, where some historical records should be maintained that will reveal the trend of
these costs and that can be used as the basis for proving the charging of costs to either category.
With Exhibit 9-1 in hand, one can easily construct a cost pool into which the correct costs can be
accumulated for later distribution to inventory as allocated overhead costs. The next problem is
how to go about making the allocation. This problem consists of four issues, which are as
follows:
How to smooth out sudden changes in the cost pool. It is common to see an unusual expenditure
cause a large jump or drop in the costs accumulated in the cost pool, resulting in a significant
difference between periods in the amount of per-unit costs that are allocated out. This can cause
large changes in overhead costs from period to period. Although perfectly acceptable from the
perspective of GAAP, one may desire a more smoothed-out set of costs from period to period. If
so, it is allowable to average the costs in the cost pool over several months, as long as the
underlying inventory is actually in stock for a similar period. For example, if the inventory turns
over four times a year, then it is acceptable to allocate overhead costs each month based on a
rolling average of the costs for the preceding three months.
What basis to use when allocating costs. The accounting literature has bemoaned the allocation
of costs based on direct labor for many years. The reason for this judgment is that direct labor
makes up such a small component of total product cost that small swings in the direct labor
component can result in a large corresponding swing in the amount of allocated overhead. To
avoid this issue, some other unit of activity can be used as the basis for allocation that not only
comprises a larger share of total product cost, but that also relates to the incurrence of overhead
costs. Another criterion that is frequently overlooked is that the accounting or manufacturing
system must have a means of accumulating information about this activity measure, so that the
inventory accountant does not have to spend additional time manually compiling the underlying
data. An example of an activity measure that generally fulfills these three criteria is machine
hours, because standard machine hours are readily available in the bill of materials or labor
routing for each product, many overhead costs are related to machine usage, and the proportion
of machine time used per product is commonly greater than the proportion of direct labor.
An even better alternative than the use of machine hours (or some similar single measure) as the
basis for allocation is the use of multiple cost pools that are allocated with multiple activity
measures. This allows a company to (for example)allocate building costs based on the square
footage taken up by each product, machine costs based on machine time used, labor costs based
on direct labor hours used, and so on. The main issue to be aware of when using this approach is
that the financial statements must still be produced in a timely manner, so one should not go
overboard with the use of too many cost pools that will require an inordinate amount of time to
allocate. Please review the discussion later in this chapter of activity-based costing for a more
complete review of this subject area.
How to calculate the overhead allocation.When allocating overhead costs, they are not simply
charged off in total to the on-hand inventory at the end of the month, because the result would be
an ever-increasing overhead balance stored in the on-hand inventory that would never be drawn
down. On the contrary, much of the overhead is also related to the cost of goods sold. In order to
make a proper allocation of costs between the inventory and cost of goods sold, the inventory
accountant must determine the total amount of each basis of activity that occurred during the
reporting period and divide this amount into the total amount of overhead in the cost pool,
yielding an overhead cost per unit of activity.
This cost per unit should then be multiplied by the total amount of the basis of activity related to
the period-end inventory to determine the total amount of overhead that should be charged to
inventory. This is then compared to the amount of overhead already charged to inventory in the
previous reporting period to see if any additional overhead costs should be added or subtracted to
arrive at the new allocated overhead figure. All other overhead costs, by default, are charged to
the cost of goods sold. For example, if there is a cost pool of
$100,000 to be allocated, and a total of 25,000 machine hours were used in the period, then the
overhead cost per hour of machine time is $4. According to the standard labor routings for all
inventory items in stock, it required 17,250 hours of machine time to create the items currently
stored in inventory. Using the current cost per machine hour of $4, this means that $69,000
(17,250 hours × $4/hour) can be charged to inventory. However, the inventory overhead account
already contains $52,000 of overhead that was charged to it in the preceding month, so the new
entry is to debit the inventory overhead account for $17,000 ($69,000–$52,000), and to debit the
cost of goods sold for the remaining amount of overhead, which is $83,000, while the cost pool
is credited for $100,000.
How to adjust for any unallocated or over allocated costs. It was recommended earlier in this
section that one could smooth out the cost totals in a company’s overhead cost pools by
averaging the costs on a rolling basis over several months.
The only problem with this approach is that the amount of costs allocated each month will differ
somewhat from the actual costs stored in the cost pools. How do we reconcile this difference?
The annual financial statements should not include any differences between actual and allocated
overhead costs, so the variance should be allocated between inventory and the cost of goods sold
at that time, using the usual bases of allocation. If shareholder reporting occurs more frequently
than that (such as quarterly), then the inventory accountant should consider making the same
adjustment more frequently. However, if the amount in question will not have a material impact
on the financial statement results, the adjustment can be completed just once, at the end of the
fiscal year.
Overhead Allocation to Raw Materials
Overhead is not normally applied to raw materials, but arguments have been presented in favor
of the following two issues:
Inbound transportation costs. Where the cost of getting the goods to the factory site is
identifiable with particular material or lots, the cost may properly be added to the raw material. If
such allocation is impractical, it may be considered part of the manufacturing overhead.
Purchasing department expense. The cost of this department generally would continue at the
same level from period to period regardless of receipts, so allocating the cost to raw materials
would not be a proper matching of expenses with effort expended. The cost may be more
properly treated as manufacturing overhead for application to other types of inventory and the
cost of goods sold.

1.3. Recording of costs and schedule of costs of products.

Components of Product Costs
Full cost: The sum of all costs of manufacturing and selling a unit of the product
Full absorption cost: The sum of all variable and fixed costs of manufacturing a unit of the
product
Variable cost: The sum of all variable costs of manufacturing and selling a unit of the
product
Components of Product Costs

Distinction between Financial and Contribution margin income statements.

Full absorption costingVariable costing
• Required by GAAP
• Used for:
 Financial purposes
 External reporting
Sales revenue
– Cost of goods sold
= Gross margin

• Used for:
 Managerial purposes
 Internal decision making
Sales revenue
– Variable costs
= Contribution margin
Format of Absorption costing income statement
Sales ------------------------------XX
Cost of goods sold
Direct material ----------xx
Direct labor --------------xx
Variable MOH -----------xx
Fixed MOH ---------------xx
Gross profit -------------------------XX
Variable operating expense ---------xx
Fixed operating expense -------------xx
Operating income --------------------XX
Format of direct (variable) costing income statement
Sales revenue -------------------------XX
Variable cost
Direct material ---------------xx
Direct labor ------------------xx
Variable MOH ---------------xx
Variable expense ------------xx
Contribution margin ---------------------XX
Fixed MOH cost --------------------------XX
Fixed operating expense -----------------XX
Operating income -------------------------XX