UNIT ONE

INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING

 Unit Objective
 Introduction
 Contents:
1.1 Introduction to Management Accounting
1.2 Financial and Management Accounting
1.3 Functions of the Management Accountant
1.4 Cost Accounting
 Unit Summary
 Model Exam Questions

Unit Objective
Dear learners, in this unit, you will learn about Management Accounting, the
difference and similarities between Management and Financial accounting, the
functions of management accountant and few concepts about Cost accounting.
Specifically, after completing this chapter you should be able to:
 explain the main emphasis of Management accounting.
 State the similarities and differences between Management accounting and
Financial accounting.
 explain functions and roles of the Management accountant in an
organization.
 define Cost accounting.

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 1.1Introduction to Management Accounting

Pretest
Dear Learner, What is Management accounting? And what is its importance?

In a global market in the contemporary economic environment, business organizations

need relevant and appropriate information system both quantitative and qualitative that
helps to survive and grow in a market. All businesses must have a management
information system which includes from simple information to a complex statistical,
analytical and decision support system. The management information system or the
subcomponent, management accounting gives regular financial report to management at
all levels regarding performance measures in financial and non financial performance
criteria.

Management Accounting can be defined as the process of identification, measurement,

accumulation, analysis, preparation, interpretation, and communication of financial as
well as non financial information used by management to plan, evaluate, control within
the organization and to assure appropriate use and accountability for its resources.
Management accounting consists of accounting techniques and procedures of gathering
and reporting financial data in order to meet management’s information needs. The
management accountant is expected to provide timely, accurate information-.including
budgets, standard costs, variance analysis, support day-to-day operating decisions, and
analyses of expenditures. Management accounting measures and reports financial
information as well as other type of information that assists managers in fulfilling the
goals of the organization.

Management accounting enables the organization to understand and identify weakness in

terms of efficiency and quality improvement of its products and services compared to the
major competitors and suggest cost effective measures to improve organizational
flexibility and innovative potential to meet competitive pressure. As well, it gives the
organization the capacity to grow with minimum volatility in its profitability and

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performance. The management accounting system is a cost control system as well as a
tool for planning and controlling operations and suggests solutions to improve
organizational efficiency and productivity of the organization as a whole. It also gives the
manager the importance of non financial factors, which can be crucial factor that
determines the innovative capacity of the organization particularly, the human factor in
all organizations. There fore, it is important to design a management accounting system
to be profitable in short term as well as in the long term in a dynamic and unpredictable
global market. Specifically, the followings are some of the purposes of Management
accounting.
 Formulating over all strategies and long range plans
 Resource allocation decision such as product and customer emphasis pricing.
 Cost planning and cost control operations and activities.
 Performance measurement and evaluation.
Activity 1.1
1. What is Management accounting?
2. Mention some of the roles of Management accounting in an organization?

1.2 Financial and Management Accounting

Pretest
Dear Learner, What is the difference between management and financial
accounting?
Accounting system takes economic events and transactions, such as sales and purchases,
and process the data in to information helpful to managers, sales representatives,
production supervisors and others. Processing any economic transaction means
collecting, categorizing, summarizing and analyzing. For example, costs are collected by
category, such as materials, lobar and overhead. These costs are then summarized to
determine total cost by month, quarter, or year. The results are analyzed to evaluate, say,
how costs have changed relative to revenue from one period to the next. Managers use
this information to administer the activities or functional areas they oversee and to
coordinate those activities or functions with in the frame work of the organization.

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Individual managers often require the information in an accounting system to be
presented and reported differently. Consider, for example, sales order information. A
sales manager may be interested in the total birr amount of sales to determine the
commission to be paid. A distribution manager may be interested in sales order quantities
by geographical regions and by customers requested delivery dates to ensure timely
delivery. This indicates that the financial information required by different bodies is not
the same.

Financial accounting includes all the principles that regulate the accounting and reporting
for financial information that must be disclosed to people outside the company, to
stockholders, bankers, creditors, and brokers. In contrast, management accounting exists
primarily for the benefit of those inside the company, the people who are responsible for
its operations.

Management and financial accounting have differing goals. Management accounting

measures analyzes, and reports financial and non financial information that helps
managers make decision to fulfill the goals of an organization. Managers use
management accounting information to choose, communicate, and implement strategies.
They also use management accounting information to coordinate product design,
production, and marketing. Management accounting focuses on internal reporting.
Financial accounting focuses on reporting to external parties such as, investors,
government agencies, banks and suppliers. It measures and records business transactions
and provides financial statement that are based on Generally Accepted Accounting
Principles (GAAPs). A manager’s compensation can be affected by the numbers in this
financial statement. Consequently, managers are interested in both management
accounting and financial accounting.

Many of the procedures and principles that stem from financial accounting can also
apply to management accounting. Depreciation techniques, cash collection and
disbursement procedures, inventory valuation methods, and the recognition of what is an
asset or a liability are all essential to the study of management accounting. The reports

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such as balance sheet, income statement and statement of of cash flow are common to
both management accounting and financial accounting. But, because their output is
communicated to different audiences for different reasons, financial accountants and
management accountants follow different rules. The rules of management accounting are
somewhat less defined and place fewer restrictions on the accountant’s day-to-day
activities where as financial accounting strictly follows GAAP. The following table
summarizes the major difference between Management accounting and financial
accounting.
Areas of Comparison Financial Accounting Management Accounting

1. Primary users of Persons and organizations outside the Various levels of internal management
information business entity
2.Purpose of the Communicate organization’s financial Help managers make decisions to fulfill
Information and operating information to investors, an organizations goal
banks, regulators and other outside parties
3. Types of accounting Double entry system Not restricted to double entry system;
systems any useful system can be used
4. Restrictive guidelines Adherence to GAAP No formal guidelines or restrictions,
only criterion is usefulness
5. Units of Historical (past) Monetary unit Any useful monetary (historical and
measurement future) or physical measure such as
machine hours, labor hours etc
6. Focal point for Business entity as a whole Various segments of the business
analysis entity.
7.Report Summarized report; concerned primarily Detailed report; concerned about details
with the entity as a whole of parts of the entity’s products,
departments, territories
7. Frequency of Periodical on a regular basis When ever needed; may not be on a
reporting regular basis
8. Degree of objectivity Demands objectivity; historical in nature Heavily subjective for planning
purposes, but objective data are used
when relevant and future in nature.
Activity 1.2
Compare and contrast Financial Accounting and Management Accounting?

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1.3 Functions of the Management Accountant

Pretest
Dear Learner, what functions do the management accountant provides? Can
you mention some of the responsibilities of the management accountant?

Management accountant provides a staff function. He/she gives advice and assistance to
line managers. Management accountants contribute to the company’s decision about
strategy, planning and control by Scorekeeping, Attention directing, and Problem solving.
1. Score keeping function- is a function of accumulating data and reporting reliable
result to all levels of the management describing how the organization is doing and how
well it is implementing its strategies. The collection, classification, and reporting of
scorekeeping information is the task that dominates day to day accounting. The
followings are some of the scorekeeping functions an accountant will provide.
 Recording sales, purchase and payroll data
 Preparing financial reports
 Preparing depreciation schedules
2. Attention directing function: is reporting and interpreting information that helps
managers to focus on operating problems, imperfections, inefficiency and opportunities.
This aspect of accounting helps managers to concentrate on the importance of operation
promptly enough for effective action. Attention directing is commonly associated with
current planning and control, and with the analysis and investigation of recurring routine
internal accounting reports. What opportunities and problems should managers focus on?
Making visible both opportunities and problems on which managers need to focus. For
example, the followings are attention directing functions provided by an accountant.
 Highlighting rapidly growing market opportunity
 Variance analysis and interpretation
 Explaining performance report
3. Problem solving function: The problem solving aspect of accounting quantifies the
likely results of possible courses of action and often recommends the best course to
follow. Problem solving is commonly associated with non recurring decisions, situations

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that require special accounting analysis or report. Comparison and analysis to identify the
best alternatives in relation to the organizations objectives is a problem solving function.
The followings are some of the decision area in which the management accountant gives
problem solving function.
 Make or buy decision
 Add or drop decision
 Sell at split off or process further decision
Scorekeeping is a general purpose data collection function without knowing weather the
data is used for internal or external reporting. However, the scorekeeping and attention
directing functions are closely related. The same information may serve as scorecard
function for a manger and an attention directing function for the managers’ superior.

The accounting or finance department in an organization is usually lead by a finance

officer. A finance officer is a senior officer empowered with overseeing the financial
operations of an organization. If the organization is large, the finance officer can be
supported by a controller and a treasurer both of whom are usually accountants. A
controller is responsible for preparing the information and report used in both managerial
and external reporting where as the treasurer is concerned mainly with the company’s
financial matters. The following table summarizes the roles and responsibilities of the
Controller and the Treasurer
Controller Treasurer
 Planning & control  Provision of capital
 Reporting and interpreting  Investors relation
 Evaluating and consulting  Short term financing
 Government reporting  Banking and custody
 Tax planning and administration  Credits and collections
 Protection of assets  Investment
 Economic appraisal  Risk management and insurance
Activity 1.3
1. What are the three functions of the management accountant?
2. Explain the responsibilities of the controller and treasure?

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1.4 Cost Accounting

Pretest
Dear Learner, up to now, we have been discussing about management
accounting. What do you think about cost accounting and why it is studied?
Cost accounting is an accounting information system that records, measures and reports
information about cost. Every business operates with the objective of making profit for its
owners, which is revenue generated less cost of producing that revenue. Cost accounting
deals with accumulating cost of manufacturing a product and other functional processes
and identifying these costs with units produced or some other cost object to enable the
determination of profit. Cost Accounting measures and reports financial and other
information related to the organization’s acquisition or consumption of resource. Cost
accounting can be applied in any type of organization but primarily applied in
manufacturing organization that combine and process raw material in to finished product.

Cost accounting provides information for both management accounting and financial
accounting. Cost accounting is required every where cost information needs to be
collected or analyzed. Cost information is required for financial accounting to determine
the cost of goods manufactured or sold and operational costs while preparing the income
statement and to determine the value of inventories on the balance sheet. Management
accounting requires cost information to set product price, to identify potential areas that
could be taken care of, or area of possible cost reduction and the like. Hence, cost
accounting is important for both financial accounting and management accounting. It is a
subfield of managerial accounting that interfaces with both managerial and financial
accounting.
Activity 1.4
What is cost accounting and what is its relation with management and financial
accounting?

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 Unit Summary
 Management Accounting is the process of identification, measurement,
accumulation, preparation, analysis, interpretation, and communication of
financial as well as non financial information mainly for internal users.
 The main emphasis of financial accounting is for external users such as investors,
banks, suppliers whereas the main emphasis of management accounting is for
internal users such as the different management bodies.
 The management accountant provides scorekeeping, attention directing and
problem solving functions. Management accountant can also be a controller or
treasurer in an organization.
 Cost Accounting is the process of accumulating cost of production and assigning
these costs to the final product (cost object).
Model Exam Questions
Part I: Discussion questions
1. What is management accounting?
2. What are the similarities and differences between management accounting and
financial accounting?
3. Explain the functions and roles of the management accountant
4. What is cost accounting?
Part II: Multiple choices
1. Which of the following is true about management accounting?
A) It is source of information for external users
B) Restricted to double entry accounting system
C) There are no principles that stem from financial accounting which are also
applied to management accounting.
D) Highly regulated by GAAP.
E) Non of the above
2. A management accountant prepared a decision model which solve sell at split off or
process further decision problem. Which function did he provided?
A. Scorekeeping function C) Problem solving function
B. Attention directing function. D) Record keeping function E) None

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3. Which of the following is not true about cost accounting?
A) It is the process of accumulating cost and assigning this cost to cost object
B) Provides cost data for both management accounting and financial accounting
C) It is subfield of management accounting.
D) Applied only in manufacturing companies
E) None of the above
4. Management accounting differs from financial accounting in that management
accounting
A) Adhere to GAAP
B) Presents historical information only
C) Information’s produced are heavily objective
D) Report is produced for the business as hole not at segment level
E) None

Answer Key for Model Exam Questions

Part I: Discussion Question Part II: Multiple Choice
1. Refer section 1.1 1. E
2. Refer section 1.2 2. C
3. Refer section 1.3 3. D
4. Refer section 1.4 4. E

UNIT TWO

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 COST TERMINOLOGIES AND CLASSIFICATIONS
 Unit Objective
 Introduction
 Contents:
2.1 Cost Concepts and Terminologies
2.2 Classification of Cost
2.3 Manufacturing Costs
2.4 Financial Statement for Manufacturing Company
 Unit Summary
 Model Exam Questions

Unit Objectives
Dear learners, you are now at the second unit of the module. The main objectives of this
unit is to introduce cost terminologies and concepts, show how cost is classified in
different ways from different points of view and illustrate how financial statements are
prepared for a manufacturing business organization. Therefore, after completion of this
chapter you are expected to:
 define the different cost terminologies.
 explain how cost is classified in different ways from different points of view.
 categorize costs incurred by a manufacturing organizations as manufacturing and
non manufacturing, direct and indirect etc.
 prepare cost of production report and financial statements for a given
manufacturing business organization.

Introduction

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 Dear learners, this unit is mainly an introductory one. It lays the ground for the
remaining units. It is subdivided in to four sub units. The first sub unit deals with
definition of some cost terminologies and concepts that are important in the study of this
course. The second subunit discusses how cost is classified in different ways from
different angles. The third subunit discusses about costs incurred in manufacturing
companies and the last subunit will discusses how financial statements are prepared for a
manufacturing business organization using numerical illustrative examples.

2.1 Cost Concepts and Terminologies

Pretest
Dear Learner, what is the difference between cost, expense and loss? What about
cost objects and cost drivers?
Many accounting reports contain several cost terminologies. A good understanding of the
different cost terminology is essential at least for the following two reasons.
 It enables accounting information users to best use the information provided.
 Use of common terminology avoids confusion and misunderstanding among the
users
The following are some of the terms and concepts used in cost accounting
Cost, Expense and loss
One of the common confusion in accounting is the distinction between cost and expense.
Many people use cost and expense interchangeably. Thus, we start with the definition of
these terms.

Accountants usually define cost as resource sacrificed or forgone to achieve a specific

objective. It refers to an outlay or expenditure of money to acquire goods and services in
the course of generating revenue. For instance purchase of raw martial represent a cost as
the raw material is used to produce finished goods that generate revenue when sold.
However some disbursements are not costs. For example, payment of dividend is
disbursement but it does not help to generate revenue, hence it is not a cost.

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All costs initially represent an asset. As the asset is used in generating revenue, the
amount consumed becomes an expense. The cost of the asset used should then be
recognized as an expense to properly match revenues and expenses in the process of
determining the income of the organization over a given period. For instance, insurance
premium paid in advance to serve the coming period are initially recognized as an asset
(prepaid insurance), but as time passes on, the asset is continually converted in to an
expense (Insurance expanse). Another example may be a motor vehicle bought for use for
the coming five years is an asset when initially purchased. However, as the asset is used
up in the process of generating revenue, the cost gradually becomes an expense. Thus,
expenses are expired costs or costs used up in the course of generating revenue.

The distinction between cost and expenses is important for the preparation of financial
statement for service, merchandising and manufacturing firms. In fact, it has more
importance relatively for manufacturing enterprise. This is because, costs incurred in the
manufacturing process don’t become expense until the product is sold and thus, items that
are fully or partially manufactured represent costs and should be recognized as assets on
the balance sheet. Therefore, financial reporting in manufacturing firms has some
complication as compared to financial reporting in the service and merchandising
business.

Some times, a firm may incur a cost that produces neither immediate nor future benefit.
This is called a loss. For example damage caused by fire or flood on property held is a
loss.

Cost object: is any thing for which a separate measurement of cost is desired. In
manufacturing company, the cost object is the unit of finished goods manufactured.

Cost Accumulation and cost Assignment: A costing system typically account for costs
in two basic stages, accumulation followed by assignment. Cost accumulation is the
collection of cost data in some organized means of accounting system and cost
assignment is a general term that encompass both (1) tracing accumulated cost that have

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direct relationship to the cost object and (2) allocating accumulated costs that have an
indirect relationship to the cost object. For example, a publisher that purchase paper rolls
for printing magazines collect the cost of paper bought and used in any one month to
obtain the total monthly cost of paper used. Beyond accumulating costs, the cost
accountant assign cost to the different magazines the publisher publish to help decision
making

Cost driver: is any factor that affects total cost. That is a change in the cost driver will
cause a change in the level of the cost of a related cost object. For example, the following
are some of the cost drivers used for each types of costs mentioned.
 Mile driven for transport cost
 Length of time of call for telephone cost
 Metric cube of water consumed for water cost
 Unit sold for cost of goods sold
Cost management: cost management is the essence of cost accounting. Cost
management refers to the planning and execution of activities both in the short run and
long run to control costs. Profoundly, cost management is about cost reduction but it is
not confined to it alone. Some times managers may incur additional costs in order to
increase their future sales. This activity is also a cost management. It is the set of actions
that a manager takes to satisfy customers while continuously reducing and controlling
cost. Cost reduction efforts frequently focus on two key areas:
 Doing only value adding activities, that is, those activities that customers perceive
as adding value to the product or service they purchase
 Efficiently managing the use of the cost drivers in the value adding activities.

Activity 2.1
1. What is the difference between cost, expense and loss?
2. What does it mean by cost object and cost deriver? Give examples?
3. What are the two processes in cost accounting? And what does cost management
mean?

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2.2 Classifications of Cost

Pretest
Dear Learner, what are the different classifications of cost?

There are several standard cost classifications and each classification has its own unique
terminology. In this subunit, we present a comprehensive list of ways costs may be
grouped, the concepts underlying each, and the terminology commonly used. Remember
that the same cost may be included in several or in all of the following classifications.

1. Time Period for Which the Cost is computed

Time can be broadly classified in to past and future. Costs can also be classified
according to these time periods. Historical costs are those costs that were incurred in past
period. Future costs, generally called budgeted costs, are those costs that are expected to
be incurred in the future period. For example, the Br.8,000 cost of a computer acquired in
2008 is a historical cost in the financial statement of 2009. How ever, the Br.10, 000 cost
to acquire a new computer in 2011 to replace the existing computer is a future cost.

2. Management Function
An organization may be separated into functional areas. A manufacturing company’s
functional areas generally include manufacturing, marketing, and general administration.
One individual, such as a vice president of manufacturing or a vice president of
marketing, has primary responsibility for a specific functional area. To evaluate the
effectiveness of the functional area and the individual in charge of it, costs also must be
grouped by functional area as follows.
 Manufacturing Costs - include costs from the acquisition of raw materials
through production, until the product is turned over to the marketing division to
be sold. Manufacturing costs include the cost of the raw materials, payroll costs
for people working on the product, and incidental costs such as taxes, power,
depreciation, and repairs associated with manufacturing the product.
 Selling Costs - are all costs associated with marketing and selling a product. They
include all costs incurred by the marketing division from the time the

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 manufacturing process is complete until the product is delivered to the customer.
These costs include advertising, promotional offers, freight to deliver the product,
and warehouse costs while the product is waiting to be sold.
 Administrative Costs are all costs associated with the management of the
company and include expenditures for accounting, legal, and administrative
activities. Interest costs are also included among administrative costs.

3. Generally Accepted Accounting Treatment

The alternatives in accounting for a cost are to expense it or to capitalize it.
 Periodic Costs are costs that are expensed in the period in which they are
incurred. Periodic costs possess no future benefit and are generally associated
with a non manufacturing area of the business. Examples of periodic costs include
advertising, Interest, president’s salary and sales commissions.
 Product Costs consist of all costs associated with the manufacturing function of
the business. They include materials, labor, and 0ther factory overhead costs
associated with assembling and processing the units. Because the company still
holds the product and its usefulness has not yet expired, it is not appropriate to
expense these costs. They are capitalized as inventory and held as unexpired until
they are sold.
 Capital Costs are similar to product costs in that they are also capitalized as
assets. However, capital cost is the term used to describe the equipment, building
and land held permanently for making business. These items are capitalized as
tangible fixed assets and are depreciated over their useful lives. Product costs are
reserved for inventorable costs associated with the manufacturing process
4. Traceability to Products
From traceability point of view, cost is divided in to direct and Indirect cost:
 Direct Cost: is a cost that can be economically traced to a single unit of finished
product. For example; direct material & direct labor are direct costs
 Indirect Cost: is one that is not directly traceable to the manufactured product.It
is associated with the manufacture of two or more units of finished product, or is
an immaterial cost that cannot be economically traced to single units of finished

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 product. For example: Cost of electricity, Depreciation of equipment, indirect
labor, indirect material, Cost of different utilities, Cost of repair and maintenance,
Insurance for the factory are indirect costs.

A comparison of the labor cost of an assembly worker and a repair person in a cabinet
shop will illustrate the difference between a direct and an indirect cost. The assembly
worker’s salary is typically classified as a direct cost because, it is a significant portion of
the cabinet’s total cost and because it is easy to trace the assembly worker’s efforts to a
particular set of cabinets. The machine repair person’s salary would probably be
classified as an indirect cost because; it is difficult or impossible to trace that individual’s
efforts to a unit of output. The repairperson is responsible for keeping all machines
running properly. Since he or she work on several machines and the machines work on
several different cabinets each day, we cannot trace this person’s salary to a particular set
of cabinets. The lack of traceability requires that it should be classified as an indirect
cost. The economics of tracing a cost to a particular unit of finished product is an
important distinction between direct costs and indirect costs. Take a table that requires a
few screws and a little glue to complete the assembly. Both of these items can be traced
to a particular unit of finished product and would, therefore, qualify as direct costs.
However, these items are usually classified as indirect costs if their amounts are
immaterial when compared to the other materials going into the product. Also, the cost
involved in tracing and recording the items as direct costs would be greater than the

benefit of having that information.

5. Cost Behavior
Cost behavior describes how a cost changes with time or with changes in volume.
Variable costs are costs that vary proportionately in total as the volume of production or
sales changes. For example, if it takes Br.100 of lumber to make one unit of table and if
five units are produced, the total cost of the lumber is Br. 50. The total variable cost
increases in proportion with the number of unit’s produced, but the cost of each unit
remains the same. Fixed cost remains constant in amount as volume of production or

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sales changes. Straight-line depreciation on a plant asset is an example of a fixed cost.
The amount of depreciation is the same regardless of the number of units produced.

6. Decision Significance
A decision involves making choices among alternative courses of action. The decision
maker generally collects cost information to assist in making the decision. Relevant cost
is future costs that differ with the various decision alternatives. They are costs that make
a difference in a decision-making process. Irrelevant Costs do not relate to any of the
decision alternatives, are historical in nature or are the same under all decision
alternatives. Irrelevant costs are generally excluded from the analysis.

7. Managerial Influence
Managerial influence refers to the ability of a manager to control a particular cost.
Remember that all costs are controlled by some one at some level in the organization if
the time period is long enough. However, when we see for a particular manager at a
particular level in the organization and for a short period of time, there are some costs
that can be influenced and some that cannot. Controllable costs are subject to significant
influence by a particular manager within the time period under consideration.
Uncontrollable costs are those costs over which a given manager does not have a
significant influence.

8. Commitment to Cost Expenditure

Commitment to a cost expenditure focuses on fixed costs as opposed to variable costs and
on budgeted costs as opposed to historical costs. Budgeted fixed costs can be broadly
classified as committed costs and discretionary costs.
Committed cost is one that is an inevitable consequence of a previous commitment.
Property tax budgeted for the coming year is an example of a committed cost. Suppose
top management made the decision two years ago to construct a new warehouse. After it
was completed, the tax commission placed an assessed value on it, and a property tax
notice is now recapped annually according to the tax law. The property tax must be paid
or the warehouse will be seized by the tax authority and sold to cover the unpaid taxes.

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Property tax is a committed cost that resulted from the decision to construct the
warehouse.
Discretionary Cost, also called a programmed cost or a managed cost, is one for
which the amount or the time of incurrence is a matter of choice. There are some
nonrecurring costs for which a final commitment has not yet been made and that can be
postponed until a future period or cancelled entirely. Replacing the carpet in the
demolished offices and repainting the walls of the factory are examples of discretionary
costs where the right timing is a matter of judgment. Even though the carpet is beginning
to show some wear, it could continue to be used for several months without any
interruption to normal operations.

9. Other Cost Classifications

Several other cost classifications are frequently used in discussing cost accounting and
management decisions. Their primary usefulness is in helping to place correct perspective
of the potential benefit of a possible course of action. These classifications include
marginal costs, out –of –pocket costs, sunk costs, and opportunity costs.

Marginal Costs, also called incremental costs, are the costs that are associated with the
next unit or the next project. The term marginal cost is widely used in economics to refer
to the added cost associated with the production of an additional unit of output.

Out- of – Pocket Cost: is a cost that must be met with a current expenditure. Generally
an out – of – pocket cost is a cash expenditure associated with a particular decision
alternative.

Sunk Costs: are defined as past costs that have already been incurred. Because sunk
costs are historical costs, they are generally irrelevant to decisions affecting the current or
future use of the asset.

Opportunity Cost: is defined as the cost or value of an opportunity forgone when one
course of action is chosen over another. Opportunity cost is not an out-of –pocket cost, or

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even a future cost associated with the selected alternative, but represents the lost
opportunity associated with each of the alternatives that are rejected.
Activity 2.2
1. What are the different points of view based on which we classify cost?
2. What is the purpose of classifying costs as such?

2.3 Manufacturing Costs

Pretest
Dear Learner, what are the different types of costs incurred by manufacturing
companies?
Accounting for manufacturing process has the finished products as the primary cost
object. The cost accounting system applied to the cost object is designed to accumulate
the manufacturing cost and assign them to the units produced. We will first identify the
terminology used for different types of manufacturing costs and then illustrate how they
are combined in to a statement of cost of goods manufactured. Product costs are
classified for accounting purpose in to direct material, direct labor and indirect
manufacturing cost. The criteria used for the classification are the type of cost
traceability to particular units of finished product and materiality.

Direct Material: Product costs that relates to the use of raw material and supplies must
be identified as either direct material or indirect material. Direct material includes the
raw material component that can be physically identified with or traced to the finished
product. It is distinguished from indirect material by the ability to identify it
economically with finished products. Indirect material lacks traceability to the finished
product and is included as an element of indirect manufacturing costs.

The type of manufacturing process and the products being produced must be identified to
evaluate whether a raw material input is direct or indirect. For example, paper used in a
printing shop would be classified as direct material because the paper is a significant part
of each printing job and can easily be identified with the finished product. How ever,
paper used in a glass factory to pack around the finished product would probably be

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classified as indirect material. Here, the paper is an insignificant part of the finished
product, and it is not economically feasible to identify the quantity and cost of the paper
used with each product. Other example of direct materials includes wheat in a flour mill,
malt in a beer factory, and lumber in manufacturing wooden tables.

Direct Labor: salaries and wages properly classified as product cost must be separated
into direct labor or indirect labor for accounting purposes. Direct labor includes the wage
of employees who work directly on the product and whose efforts can economically be
traced to a particular unit. The wage paid to a laborer who will cut and polish lumber and
assemble it to a table is a direct labor cost for the table. But the salary of a supervisor
who will oversee the production process of the different products in the factory is an in
direct cost as he will not be directly involved in the production process.

Indirect Manufacturing Costs: All manufacturing costs other than direct materials and
direct labor are classified as indirect manufacturing costs. There are several other titles
commonly used to describe this group of manufacturing costs, including factory
overhead, manufacturing overhead or factory burden. The followings are some of the
manufacturing overhead costs for a furniture manufacturing company:
1. Indirect materials, such as glue, nails, screws
2. Indirect labor, such as supervisor’s salary and Janitorial services.
3. Taxes on manufacturing facilities.
4. Utilities for the manufacturing process.
5. Depreciation on manufacturing faculties.
Prime Costs and Conversion Cost
Prime costs and conversion cost are two other terms used to describe production costs.
Prime Costs are the most important or significant costs traceable to unit of finished
product. They include direct material and direct labor. Conversion costs are those
required to convert raw materials into finished product and consists of direct labor and
factory overhead. As noted earlier, the same cost may be given different titles and used
for different purpose. Paper in a copy center, for example, would be classified as direct
material for accounting purposes, but it would also be called a prime cost.

21
 Prime cost = Direct Material Cost + Direct Labor Cost
Conversion cost = Direct Labor Cost + Manufacturing Overhead Cost
Activity 2.3
What are the three main categories of manufacturing costs?

2.4 Financial Statement for a Manufacturing Organization

Pretest
Dear Learner, how do we prepare financial statement for a manufacturing
company?
Financial statement of a manufacturing company is more complex as compared to
financial statement of merchandising and service giving companies. Particularly, the
balance sheet and income statement of a manufacturing enterprise are some what
different from their merchandising and service counterpart. All costs mentioned above
should be properly accounted for and reported in the financial statement of a
manufacturing firm.

Manufacturing organizations perform selling and administrative functions similar to

merchandising firms. However, instead of purchasing goods that are ready for resale, a
manufacturing firm buys raw materials, labor, and other components needed to perform
the manufacturing function of converting the raw materials into finished products. This
difference is shown in the cost-of –goods –sold statements. In addition, the balance sheet
at the end of the period will show ending inventories for raw materials, work in process,
and finished goods. Our objective here is to explain the computation of cost of goods
manufactured and to illustrate the development of external financial statements for a
manufacturing organization.
1. Balance Sheet of a Manufacturing Firm
The balance sheet of a manufacturing firm differs from the balance sheet of a
merchandising firm principally by the type of inventories reported. A manufacturing firm
carries three types of inventory. Namely, Raw material inventory, Work in Process
inventory and Finished Goods inventory.

22
  Raw Material Inventories: are raw materials in stock and waiting to be used in
manufacturing process.
 Work in Process Inventories: are goods partially processed but not yet
completed. They are also called Work In Progress (WIP).
 Finished Goods Inventories: are goods fully completed but not yet sold.
The balance sheet presented below for a hypothetical manufacturing company shows how
the three types of inventories are presented.
Abajifar Furniture Factory
Balance Sheet
June 30, 2009
Current assets:
Cash --------------------------------------------------- Br.250, 000
Accounts receivable ------------- Br. 315,000
Allowance for uncollectible-------- (15,000) 300,000
Inventories:
Raw material ------------------------Br.150,000
Work in process ----------------------- 75,000
Finished goods --------------------- . 225,000 450,000

2. Income Statement of a Manufacturing Firm

Income statement of a manufacturing firm differs from income statement of a
merchandising firm by the cost of goods manufactured section. A merchandising firm
sells goods that are bought from another merchandising firm or from a manufacturing
firm. But a manufacturing company sells goods that are internally produced. Hence, the
cost of goods sold section contains cost of goods manufactured instead of purchase. Cost
of goods manufactured must first be computed before the income statement is prepared.
The cost of goods manufactured by itself needs a computation that presents the cost of
direct material used, cost of labor incurred, and factory overhead costs. The direct
material used is a separate schedule that shows the direct material placed in to the
production process in that period. In general, the following four steps are required to
prepare income statement of a manufacturing firm.

23
Step 1: The Schedule of Direct Materials Used in Production
The cost of direct material used is equivalent to the beginning inventory of direct material
plus purchase made during that period less the direct material left at the end of the period.
Schedule1: Cost of Direct Material Used
Beginning direct material inventory XX
Add: Purchase in the period XX
Direct material available for use XX
Less: Ending direct material inventory (XX)
Cost of direct material used XX
Illustration: Assume that the direct material inventory of Gibe furniture factory
amounts to Br. 248, 000 at the beginning of the year i.e., as of July 1, 2008. Purchase
of direct material amounting Br. 440,000 was made and freight cost of Br.3, 200 is
incurred during the year, and the amount of direct materials inventory at the end of
the year is Br. 234, 900. The direct material used is therefore determined as follows
using schedule 1 above.
Schedule of Direct Material Used
Beginning direct materials Inventory Br.248,000
Add: Total cost of direct material purchased
Direct Materials purchased Br.440,000
Freight in 3,200 443,200
Direct material available for use Br.691,200
Deduct: Ending direct material inventory 234,900
Cost of Direct materials used Br.456,300

Step 2: The Schedule of Cost Goods Manufactured

Cost of goods manufactured refers to the cost of goods brought to completion
whether they were started before or during the accounting period. To determine the
cost of goods manufactured, three factors are necessary; cost of direct materials used,
cost of direct labor and manufacturing overhead. In addition, work in process at the
beginning and at the end should be incorporated in the calculation. The following is
the schedule used to calculate the cost of goods manufactured.

24
 Schedule 2: Cost of Goods Manufactured
Work in process at the beginning----------------------- XX
Add: Cost of direct material used -------------XX
Direct labor cost --------------------------XX
Manufacturing over head cost -----------XX
Cost incurred in current period ----------------------- (XX)
Total cost incurred to date ------------------------------ XX
Less: Work in process ending ---------------------------XX
Cost of goods manufactured ----------------------------XX

Assume Gibe furniture factory has beginning work in process of Br. 220,000 and ending
work in process of Br. 263,200. The direct labor cost incurred in the year is Br.875,000
and the different manufacturing over head costs incurred during the year are given below:
Indirect labor Br.98, 600
Depreciation on factory equipment 44,600
Light and power 43,600
Depreciation of factory building 12,000
Insurance expense on factory properties 9,500
Property tax 19,500
Factory supplies 9,900
Total Manufacturing over head cost Br.237, 700

The cost of goods manufactured for Gibe Furniture factory will be computed as follows
using schedule 2:
Schedule of Cost of Goods Manufactured
Beginning Work in process Br.220,000
Add: Cost of direct material used Br.456,300
Direct labor cost 875, 000
Manufacturing over head cost 237, 700
Cost incurred in current period Br.1,569,000
Total cost incurred to date Br.1,789,000
Ending work in process (263,200)
Cost of goods manufactured Br. 1,525,800

25
 Step 3: The Schedule of Cost of Goods Sold
The cost of goods sold represents the cost of goods that are sold during a given
period. In computing cost of goods sold amount, cost of finished goods at the
beginning, cost of goods manufactured in the period and cost of finished goods at the
end will be taken in to account. The following is the schedule used to compute cost of
goods sold.
Schedule 3: Cost of Goods Sold
Finished goods beginning --------------------- XX
Add: Cost of goods manufactured ------------XX
Cost of goods available for sale -------------- XX
Less: Finished goods ending ---------------- (XX)
Cost of Goods Sold -----------------------------XX
Assume that the finished goods inventory at the beginning of the year was Br. 314,000
and the ending inventory of finished goods is Br.364,000 for Gibe furniture factory. The
cost of goods sold is then calculated as follows.
Schedule of Cost of Goods Sold
Finished Goods Beginning Br.314,000
Add: Cost of goods manufactured 1,525,800
Cost of goods available for sale 1,839,800
Finished Goods Ending 364, 000
Cost of Goods sold Br. 1,475,800

Step 4: Income Statement

All of the above schedules are inputs one to the other. The ultimate goal of making all the
schedules is to prepare the income statement. The income statement contains three main
elements. These are sales, cost of goods sold and operational expense. The cost of goods
sold is deducted from sales to arrive at gross profit. From gross profit, operational
expense is deducted to arrive at operating income. The following is the schedule used to
calculate operating income.
Schedule 4: Income Statement
Revenues XX
Cost of goods sold XX
Gross profit XX
Operating expenses (XX)
Operating income XX

26
Assume that the sales amount for the year for Gibe Furniture factory is Br.3,663,200 and
the operating expense for the year is Br.1,498,850, the income statement for Gibe
Furniture factory can be prepared as follows.
Gibe Furniture Factory
Income Statement
For the year ended June 30, 2008
Sales revenue Br.3,663,200
Cost of Goods sold ( 1,475,800)
Gross profit 2,187400
Operating expenses (1, 498,850)
Operating Income Br.688,550

The above income statement is called a single step or condensed income statement, as it
does not show how each element is constructed. The separate schedules are inputs to the
income statement. It is also possible to include all the schedules at a time to prepare the
income statement. Such statement contains detailed information about each item and is
called Multiple Step Income Statement.

Activity 2.4
What are the different schedules used in calculating net income?
Unit Summary
 Common cost terminologies and common understanding of the different cost
terminologies enhances the importance of financial reports. Managers need to
know the different cost terminologies to best use financial report as such financial
reports contain many cost terms. Common cost terminologies also help avoid
confusion and misunderstanding.
 Costs can be classified in different ways. The needs of the managers and
accountant govern the manner in which costs are classified. Costs can be
classified as direct and indirect. Direct costs are those costs that can be traced to
the cost object in an economically feasible way. Indirect costs are costs that are
related to the cost object but cannot be traced to the cost object in an
economically feasible way. The classification of costs as direct and indirect is
relative. Some costs are indirect to one cost object but may be direct to another
cost objects.

27
  Costs can also be classified as product and periodic cost. Product costs are
manufacturing costs that are recorded as asset when incurred and become part of
cost of goods sold when the product is sold. Product costs include direct material,
direct labor, and manufacturing overhead. Manufacturing costs can further be
classified as prime and conversion costs. Prime cost is the combination of direct
material and direct labor used in production. Prime costs are the combination of
direct material and direct labor used in production. Conversion cost is the
combination of direct manufacturing overhead. These costs help to convert
materials into finished products. Conversion costs can also be called processing
costs. Periodic costs are non-manufacturing costs that are recognized as expenses
when they are incurred. Often they benefit the current period only. Selling and
administrative costs make up periodic cost.
 .Financial statements of a manufacturing firm differ from financial statements of
merchandising and service companies in some respects. The balance sheet of
manufacturing firms presents three types of inventories: direct material, work in
process, and finished goods. The income statement of a manufacturing firm is
some what difficult to prepare as compared to that of income statement of a
merchandising and service counterparts. The reason is that the cost of goods
manufactured caption cannot be determined simply from the ledger as done in the
case of merchandising firms.

Model Exam Questions

Part I: Multiple choices
1. A company’s gross profit is 50% of cost of goods sold and its net income is 40% of
gross profit. If the total sale revenue during a period is Br.600, 000, what is the operating
expense in the period?
A) Br.200, 000 B) Br 80,000 C) Br 120,000 D) Br 180,000 E) None
2. Total cost of production incurred in a given month is Br.420, 000 of which 75% is
conversion cost. The cost of direct material at the beginning is Br.30, 000 and cost of
direct material ending is half of the beginning. What is cost of direct material purchased
during the month?

28
A) Br.105,000 B) 15,000 C) Br.315,000 D)Br.90,000 E) None
3. In a production process, the total prime cost incurred is Br400, 000 and the total
conversion cost is Br320, 000.If the sum of direct material cost and MOH cost is Br.500,
000, the total cost incurred in the period will be:
A) Br.290, 000 B) Br 110,000 C) Br 580,000 D) Br 610,000 E) None
4. Which of the following is common for both prime cost and conversion cost?
A) Direct material cost D) Direct labor cost
B) Manufacturing over head cost E) None
C) Indirect labor cost
5. Any thing for which separate measurement of cost is desired
A) Cost driver B) Cost object C) Cost management D) Cost tracing E) None
6. Which of the following is not traceable cost?
A) Direct material B) Direct labor C) Indirect labor D) Insurance premium for plant
E) C and D are correct answers
7. Select the false statement
A. Fixed cost always remains constant regardless of change in output and time
period
B. Unit variable cost remains constant regardless of change in out put
C. Unit fixed cost decrease as out put increase
D. Total variable cost increase as out put increase
E. None of the above
8. Which of the following is true?
A. Opportunity cost is an out of pocket cost
B. Controllability of a cost depend on the level of management and time period
C. Past or sunk cost is relevant for decision making
D. Marketing costs are costs associated manufacturing a product
E. None capitalized costs are product costs

29
Part II: Work out Problems
1. Supply the missing data for each company listed below all the amounts are given
in Br.
Company W X Y Z
Sales 300,000 D 390,000 660,000
DM Beginning 27,000 30,000 21,000 J
DM purchased 42,000 45,000 48,000 63,000
DM ending A 24,000 27,000 24,000
Direct labor 75,000 E 51,000 95,500
MOH cost 60,000 54,000 76,500 95,500
WIP beginning 57,000 18,000 G 36,000
WIP ending 48,000 24,000 45,000 30,000
FG beginning 60,000 F 51,000 48,000
FG ending 69,000 33,000 H 54,000
Cost of goods manufactured B 126,000 210,000 K
Cost of goods sold C 132,000 I 300,000
Gross margin 129,000 144,000 162,000 L

2. A fire destroyed XYZ manufacturing company completely on January 29, 2004.

Fortunately certain accounting records were kept in another building. It revealed the
following for the period from January 1, 2004 to January 29, 2004.
Direct material purchased Br.160, 000
WIP January1 34,000
Direct material january1, 2004 16,000
Finished goods january1, 2004 30,000
MOH cost 40% of conversion cost
Revenue 500,000
Direct labor cost 180,000
Prime cost 294,000
Gross profit based on sales 20%
Cost of goods available for sale 450,000
Required:
a. Direct material destroyed
b. Cost of goods manufactured
c. Finished goods destroyed
d. WIP destroyed
3. Assume that Lemma was graduated from Jimma Technical and vocational college four
years ago. He was working in Agaro Furniture Company for the last 3 years under
different positions. 12 months ago he started his own furniture factory called LAMMA
office and House hold furniture. After he started operation, he learnt that maintaining
an accounting record is essential. He thought he know how to establish an accounting
system, maintain an accounting record and prepare financial statements by virtue of his

30
college knowledge. He prepared the following income statement at the end of the current
year Sene 30, 2001
LEMMA Office and House hold furniture
Income statement
For the year ended Sene 30, 2001
Sales Br.135,000
Cost of goods sold
Beginning inventory
 Direct material 9,000
 Work in process 3.000
 Finished goods 12,000
Direct material purchased 30,000
Direct labor 45,000
Rent 14,000
Light, heat, and power 5,000
Telephone 1,500
Depreciation 4,000
Indirect labor 6,000
Marketing and administrative 9,000
Insurance 8,000
Miscellaneous MOH cost 2,000
Miscellaneous marketing and adm. 1,800
Total 143,100
Net loss ( Br.8,100)

The ending inventory of direct material, work in process and finished goods is birr 3,000,
4,500 and 15,000 respectively. The following costs should be allocated

Manufacturing Non Manufacturing

Rent 60% 40%
Light, heat and power 70% 30%
Telephone 70% 30%
Insurance 60% 40%
Depreciation 80% 20%
He worried why the loss comes; he doubted his capacity of accountancy, and asked you
to help him prepare the income statement as new. Can you help him by preparing the
income statement as new?

4. Han plc is nine month old since established to manufacture different parts of a manual
irrigation pump. The company owners failed to maintain a formal accounting record for
the nine months of operation with the presumption that the volume of activity is small
and can thus be effectively administered by them. Lately, they have discovered the
importance of maintaining an accounting record. Assume that the firm hires you and your
first duty is to prepare a six month income statement covering the period from January 1,

31
to June 30. The company management is capable of supplying actual data on some items
but the rest are estimates. You are given the following actual data.
1 Sales for the first six month is Br.240, 000
2. Inventory January 1.
Direct material --------------- 12,000
Work in process -------------- 8,800
Finished goods ---------------28,500
3. The gross margin is fairly estimated at 40% of sales, and direct labor is estimated to be
one third of conversion cost and one fourth of prime cost.
4. The period cost is totally estimated at 54,000 and marketing cost is estimated to be
40%.
5. Physical count of all inventories made as of June 30 reveals the following.
Direct material --------------- 9,000
Work in process --------------7,500
Finished goods --------------52,000
Required
a) Calculate the cost of goods sold
b) Calculate the cost goods manufactured
c) Calculate the direct labor cost
d) Calculate the direct material cost
e) Calculate the direct MOH cost

Answer Key for Model Exam Questions

Part II: Multiple Choice Part II: Work out problems
Problem 1
1.C 5.B A= Br.33,000 G = Br.85,500
2.D 6.E B= Br.180,000 H= Br 33,000
3.D 7.A C= Br 171,000 I= Br 228,000
4.D 8.B D= Br 276,000 J= Br 70,000
E= Br 27,000 K= Br 306,000
F= Br 39,000 L= Br 360,000
Problem 2 Problem 4
a) DM destroyed = Br 62,000 a)Cost of goods sold = Br. 144,000
b) Cost of goods Manufactured = Br.420,000 b)Cost of goods Manufactured = 167,500
c) Finished Goods Destroyed = Br. 50,000 c)Direct Labor cost = Br. 27,700
d) WIP destroyed = Br.28,000 d)Direct Material cost = Br.83,100
Problem 3: e) MOH Cost = Br. 55,400
If the income statement is properly prepared,
the Net Income will be Br. 7,200

32
 CHAPTER THREE
COST ALLOCATION

 Unit objective
 Introduction
 Contents:
3.1 Purpose of Cost allocation
3.2 Allocating Cost of a Single Support Department to Operating Departments
3.3 Allocating Cost of Multiple Support Departments to Operating Departments
3.4 Comparison among the Three Cost Allocation Methods
 Unit Summary
 Model Exam Questions

Unit Objective
In a manufacturing process, every cost incurred for the production of goods should be
taken in to account in order to come up with cost of production. The main objective of
this unit is to discuss how we allocate manufacturing overhead costs and costs incurred in
support giving department to the production departments and finally to the final goods
and service. Specifically, after completing this chapter you are expected to:
 explain the purpose for which cost is allocated.
 mention some of the guiding criteria for allocation of cost.
 allocate cost incurred in a single department to two or more service giving
department using single rate and dual rate methods.
 allocate cost incurred in two or more support giving departments to two or more
production department using direct method, step down method and reciprocal
method.

33
 Introduction
For control purpose, costs can be accumulated in cost centers or departments. But for
product costing purpose costs in support giving departments should be allocated to
operating departments and finally to the cost object. This unit is totally about cost
allocation. The first subunit discusses about the purposes and criteria in cost allocation.
The second subunit discusses how to allocate cost of a single support giving department
and the third subunit discusses allocation of multiple support giving departments’ cost
and the last subunit compare and contrast the three cost allocation approaches.

3.1 Purpose of Cost Allocation

Pretest
Dear Learner, what is the purpose of cost allocation?

Costs that are related to a particular cost object but can not be traced to it in an
economically feasible way are called manufacturing overhead cost or indirect cost. The
term cost allocation describes assigning indirect cost to the chosen cost object. Cost
allocation can also be assigning cost from one or more service giving departments to
operating departments. The followings are some of the purposes of cost allocation.
 To provide information for economic decision
 To justify cost or compute reimbursement
 To measure income and asset for reporting
 To encourage managers of operating departments to make wise use
of services provided by service departments.
 To provide more complete cost data for making decisions in
operating departments
 To help measure profitability in the operating departments
 To put pressure on the service departments to operate efficiently
 To develop overhead rates in the operating departments.
There is no one best way of allocating cost to cost objects. However, the followings are
the Criteria for guiding cost allocation decisions usually used by cost accountants.

34
1. Cause and Effect Criteria: Using this criterion, a manager identifies the variables that
cause a resource to be consumed. For example, managers may use hours of testing as a
variable when allocating the cost of quality test area to products. Cost allocation based on
cause and effect criteria are likely to be the most credible to operating personnel

2. Benefit Received Criteria: using these criteria managers identifies the beneficiary of
the output of the cost object. The cost of the cost object is allocated among the
beneficiaries in proportion to the benefit each received. Consider corporate wide
advertising program that promote the general image of the corporation rather than any
individual product. The cost of this program may be allocated on the basis of individual
revenue; the higher the revenue, the higher the divisions allocated cost of the advertising
program. The rational behind this allocation is that division with higher revenue has
apparently benefited from the advertising more than division with lower revenue and,
therefore ought to be allocated more of the advertising cost.

3. Fairness or Equity: This criterion is often cited in government contracts when cost
allocations are the basis of establishing a price satisfactory to the government and its
suppliers. Cost allocation here is viewed as a reasonable or fair means of establishing a
selling price in the mind of the contracting parties.

4. Ability to Bear: This criteria advocates allocating costs in proportion to the cost
objects ability to bear cost allocated to income. An example is the allocation of corporate
executive salaries on the basis of division operating income. The presumption is that the
more profitable division have a greater ability to absorb corporate headquarters cost.
Activity 3.1
1. What are the purposes of allocating cost?
2. What are some of the guiding criteria used to allocate cost?

35
3.2 Allocating Costs of a single Support Department

Pretest
Dear Learner, how do we allocate cost of a single support giving department to
two or more main departments?
Companies distinguish operating departments from support giving departments. An
operating department, which is also called a production department in manufacturing
companies, directly adds value to a product or service. These are departments which
participate in production of goods and service. For example, for a furniture company, the
production department might be assembly department and finishing department. A
support giving department, which is also called a service department, provides services
that assist other internal departments (operating departments and other support
departments) in the company. Examples of support departments are information systems
and plant maintenance departments. Managers face two questions when allocating the
costs of a support department to operating divisions:
(1) Should fixed costs of support departments be allocated to operating divisions?
(2) If fixed costs are allocated, should variable and fixed cost be allocated in the
same way?
Most companies believe that fixed costs of support department should be allocated,
because the support department needs to incur fixed cost to provide operating divisions
with the service they require. Managers use two basic methods to allocate support –
department costs: the Single – rate cost – allocation method and the Dual – rate cost –
allocation method.

1. Single – Rate and Dual – Rate Methods

The single – rate method – also called the single – rate cost – allocation method –
allocates costs in each service department to cost objects using the same rate per unit of a
single allocation base. No distinction is made between fixed and variable costs. The dual
– rate method – also called the dual-rate cost – allocation method – classifies costs in
each service department into two pools – a variable – cost pool and a fixed- cost pool –
with each pool using a different cost – allocation base. When using the single – rate
method and the dual-rate method, managers can allocate support – department costs to

36
operating divisions based on (a) budgeted rate and hours budgeted to be used by
operating divisions, (b) budgeted rate and actual hours used by operating divisions, and
(c) actual rate and actual hours used by operating divisions. In this module budgeted rate
and actual hours used by operating divisions is used to allocate cost of service
departments to operating departments.
Illustration: Consider ABC Electronics Company that manufactures computers and its
accessories. The company has one central computer department which gives service to
other operating departments. This department has only two users: the Microcomputer
Division and the Peripheral Equipment Division. The following data relate to the 2007
budget:
Fixed costs of operating the computer facility
in the 6,000 - 18,750-hour relevant range Br.3,000,000
Maximum capacity 18,750 hours
Budgeted long –run usage (quantity) in hours:
Microcomputer Division 8,000 hours
Peripheral Equipment division 4,000 hours
Total 12,000 hours
Budgeted variable cost per hour
in the 6,000 – 18,750 – hour relevant range Br. 200 per hour used
Actual usage in 2007 in hours:
Microcomputer Division 9,000 hours
Peripheral Equipment Division 3,000 hours
Total 12,000 hours
Single – rate Method: ABC Electronics can allocate central computer department’s cost
based on the budget rate and actual hours used by the operating divisions.
Budgeted usage 12,000 hours
Budgeted total cost pool: Br. 3,000,000 + (12,000 hours  Br. 200/hour) Br.5, 400,000
Budgeted total rate per hour: Br. 5,400,000  12,000 hours Br. 450 per hour used

37
Note that, the budgeted rate of Br. 450 per hour differs significantly from the Br. 200
budgeted variable cost per hour. That’s because the Br.450 rate includes an allocated
amount of Br. 250 per hour (budgeted fixed costs, Br. 3,000,000,  budgeted usage,
12,000 hours) for the fixed costs of operating the facility. These fixed costs will be
incurred whether the computer runs at its maximum capacity of 18,750 hours, or, say, at
its 12,000 hours budgeted usage. The central computer department costs are allocated to
the two divisions on the basis of actual hours used as follows.
Microcomputer Division: 9,000 hours  Br. 450 per hour Br. 4,050,000
Peripheral Equipment Division: 3,000 hours  Br.450 per hour Br. 1,350,000

A problem with single – rate method is that it makes the Br. 250 allocated fixed cost per
hour of the central computer department appear as a variable cost to users of the central
computer department. This could lead operating divisions to take actions that could harm
ABC as a whole. For example, suppose an external vendor offers the Microcomputer
Division computer services at a rate of Br. 340 per hour when the central computer
department has unused capacity. The microcomputer division’s managers may be
tempted to use this vendor because it would appear to decrease costs (Br. 340 per hour
instead of Br. 450 per hour if it uses the central computer department). In the short run,
however, ABC would actually incur an extra Br.140 per hour - Br. 340 external purchase
price per hour minus the savings of Br. 200 in internal variable cost per hour from not
using the central computer department because the fixed costs of the central computer
department will remain the same.

Dual – rate Method: When the dual – rate method is used, allocation bases must be
chosen for both the variable and fixed cost pools of the central computer department.
ABC allocates variable costs to each division based on budgeted variable cost per hour of
Br. 200 for actual hours used by each division. ABC allocates fixed costs based on
budgeted fixed costs per hour and budgeted number of hours for each division. The
Central Computer department budgets usage of 12,000 hours: 8,000 hours for the
microcomputer Division and 4,000 hours for the peripheral Equipment Division. The

38
budgeted fixed – cost rate is Br. 250 per hour (Br. 3,000,000,  budgeted usage, 12,000
hours). The costs allocated to the Microcomputer Division in 2007 would be:
Fixed costs: Br. 250 per hour  8,000 (budgeted) hours Br. 2,000,000
Variable costs: Br. 200 per hour  9,000 (actual) hours 1,800,000
Total costs Br.3,800,000
The costs allocated to the peripheral Equipment Division in 2007 would be:
Fixed costs: Br. 250 per hour  4,000 (budgeted) hours Br.1, 000,000
Variable costs: Br.200 per hour  3,000 (actual) hours 600,000
Total costs Br.1,600,000

If actual costs of the central computer department differ from allocated costs of Br.
5,400,000 (Br. 3,800,000 + Br. 1,600,000), ABC would have to dispose of the over
allocated or under allocated cost using methods described in unit four.

Note that the difference between the single – rate and dual – rate methods in the ABC
example arises because, the single – rate and the dual – rate methods allocates only the
actual fixed – cost resources used or the budgeted fixed – cost resources to be used by the
microcomputer and peripheral equipment divisions.

There are benefits and costs of both the single – rate and dual – rate methods. One
benefit of the single – rate method is the low cost to implement it. The single –rate
method avoids the often – expensive analysis necessary to classify the individual cost
items of a department in to fixed and variable categories. However, the single – rate
method makes allocated fixed costs of the support department appear as variable costs to
the operating division. Consequently, the single – rate method may lead division
managers to make outsourcing decisions that is in their own best interest but not in the
best interest of the organization as a whole.

A big benefit of the dual – rate method is that it signals to division managers how
variable costs and fixed costs behave differently. This information guides division
managers to make decisions that benefit the organization as a whole, as well as each

39
division. For example, using a third – party computer provider that charges more than
Br.200 per hour would result in ABC and each division being worse off than if ABC own
Central computer department, were used, because it has a variable cost of Br.200 per
hour. That’s because fixed costs of resources budgeted to be used by the divisions would
be charged to each division, regardless of whether a division bought the service inside or
outside the company.

Activity 3.2
1. Explain how cost is allocated using single rate and dual rate methods?
2. What is the advantages and disadvantage of each of these methods?

3.3 Allocating Costs of Multiple Support Departments

Pretest
Dear Learner, how do we allocate cost of two or more support giving departments
to two or more operating departments?
We just examined general issues that arise when allocating costs from one support
department to operating divisions. In this section, we examine the special cost –
allocation problems that arise when two or more of the support departments whose costs
are being allocated provide reciprocal support to each other as well as to operating
departments. An example of reciprocal support is a corporate human resource (HR)
department providing services to a corporate legal department (such as advice about
hiring attorneys) while the corporate legal department provides services to the HR
department (such as advice on compliance with labor laws). More – accurate support –
department cost allocations result in more – accurate product, service, and customer
costs.
Illustration: Consider Mesfin engineering, which operates at maximum capacity to
assemble Vehicles in its factory. Mesfin Engineering has two support departments and
two operating departments in its manufacturing facility.
Support Departments Operating Department
Plant Maintenance (PM) Machining (M)
Information Systems (IS) Assembly (A)

40
The two support departments provide reciprocal support to each other as well as support
to the two operating departments. Costs are accumulated in each department for planning
and control purposes. For inventory costing, how ever, the support department cost must
be allocated to the operating departments. The data for our example is given below
Support department Operating department
PM IS M A
Budgeted MOH cost
before allocation Br.600,000 Br.116,000 Br.400,000 Br.200,000
Service provide by:
Plant maintenance - 1600hrs 2400hrs 4000hrs
Information system 200hrs - 1600hrs 200hrs

Plant maintenance department provides a total of 8,000 hours of support work: 20%
(1,600  8,000 = 0.20) for the information systems department, 30% (2,400  8,000 =
0.30) for the machining department and 50% (4,000  8,000 = 0.50) for the Assembly
department. The percentage of service provided by information systems is 10% to PM,
80% to M and 10% to A, computed in the same way. We now examine the three methods
of allocating the costs of reciprocal support departments: direct, step – down and
reciprocal methods. To simplify the exposition and to focus on concepts, we use the
single – rate method to allocate the costs of each support department using budgeted rates
and budgeted hours used by the other departments.
1. Direct Method
The direct method – also called direct allocation method – allocates each support
department’s costs to operating departments only. The direct method does not allocate
support department costs to other support departments. The base used to allocate plant
maintenance costs to the operating departments is the budgeted total maintenance labor –
hours worked in the operating department: 2,400 + 4,000 = 6,400 hours. This amount
excludes the 1,600 hours of budgeted support time provided by plant maintenance to
information systems. Similarly, the base used for allocation of information systems costs
to the operating departments is 1,600 + 200 = 1,800 budgeted hours of computer time,
which excludes the 200 hours of budgeted support time provided by information systems
to plant maintenance. The following diagram shows the relationship between the
departments.

41
 PM 2,400 Hrs M
Br. 600,000
4,000 Hrs
1,600 Hrs
IS A
Br 116,000
200 Hrs

The cost in each service departments will be allocated to the operating departments as
follows:
 Allocating cost of Plant maintenance to :
Machining = (2400/6400) ×Br. 600,000 = Br. 225,000
Assembly = (4000/6400) ×Br. 600,000 = Br. 375,000
 Allocating cost of Information systems to :
Machining = (1600/1800) ×Br. 116,000 = Br. 103,111
Assembly = (200/1800) × Br. 116,000 = Br. 12,889
The above allocated costs can be summarized for the two operating departments using the
following cost summary as follows
Machining Assembly Total
Cost before Allocation Br.400,000 Br.200,000 Br.600,000
Cost allocated from PM 225,000 375,000 600,000
Cost allocated from IS 103,111 12,889 116,000
Total cost Br 728,111 Br.587,889 Br.1,316,000

The direct method is widely accepted because of its ease of use. The benefit of the direct
method is simplicity. There is no need to predict the usage of support department
services by other departments. A disadvantage of the direct method is that it ignores
reciprocal services provided among support departments by other support departments.
2. Step – Down Method
Some organizations use the step – down method – also called the step –down allocation
method or the sequential allocation method – which allocates support – department costs
to other support departments and to operating departments in a sequential manner that
partially recognizes the mutual services provided among all support departments. Step
down method requires the support departments to be ranked (sequenced) in the order that

42
the step – down allocation is to proceed. A popular step – down sequence begins with the
support department that renders the highest percentage of its total services to other
support departments. The sequence continues with the department that renders the next –
highest percentage, and so on, ending with the support department that renders the lowest
percentage. In our example, costs of the plant maintenance department should be
allocated first because it provides 20% of its services to the information systems
department, whereas the information systems department provides only 10% of its
services to the plant maintenance department. Under the step – down method, once a
support department’s costs have been allocated, no subsequent support – department
costs are allocated back to it. Once the plant maintenance department costs are allocated,
it receives no further allocation from other (lower – ranked) support departments. The
result is that the step – down method does not recognize the total services that support
departments provide to each other, the reciprocal method fully recognizes all such
services, as you will see next.

PM 2,400 Hrs M
Br. 600,000
4,000 Hrs
1,600 Hrs 1,600 hrs
IS A
Br 116,000
200 Hrs
The cost in each service departments will be allocated to the operating departments as
follows using step down method:
 Allocating cost of Plant maintenance to :
Machining = (2400/8000) ×Br. 600,000 = Br. 180,000
Assembly = (4000/8000) ×Br. 600,000 = Br. 300,000
Information system = (1600/8000) ×Br. 600,000 = Br. 120,000
 Allocating cost of Information systems( 116,000 + 120,000 = Br.236,000) to :
Machining = (1600/1800) ×Br. 236,000 = Br. 209,778
Assembly = (200/1800) × Br. 236,000 = Br. 26,222
The plant maintenance costs of Br.600,000 are allocated first. Plant maintenance
provides 20% of its services to information systems, 30% to Machining, and 50% to

43
Assembly. Therefore, Br.120,000 is allocated to information systems (20% of
Br.600,000), Br. 180,000 to machining (30% of Br.600,000), and Br.300,000 to
Assembly (50% of Br.600,000). The information systems costs now total Br.236,000:
budgeted costs of the information systems department before any interdepartmental cost
allocations Br.116,000, plus Br.120,000 from the allocation of plant maintenance costs to
the information systems department. The 236,000 is then only allocated between the two
operating departments based on the proportion of the information systems department
services provided to machining and assembly. Information systems department provides
80% of its services to Machining and 10% to Assembly, so Br. 209,778 (8/9  Br.
236,000) is allocated to machining and Br. 26,222 (1/9  Br.236,000) is allocated to
Assembly. The cost summary for step down cost allocation will be given as follows:
Machining Assembly Total
Cost before Allocation Br.400,000 Br.200,000 Br.600,000
Cost allocated from PM 180,000 300,000 480,000
Cost allocated from IS 209,778 26,222 236,000
Total cost Br. 789,778 Br.526,222 Br.1,316,000
3. Reciprocal Method
The reciprocal method –also called the reciprocal allocation method – allocates support –
department costs to operating departments by fully recognizing the mutual services
provided among all support departments. For example, the plant maintenance department
maintains all the computer equipment in the information systems department. Similarly,
information systems provide database support for plant maintenance. The reciprocal
method fully incorporates interdepartmental relationships into the support – department
cost allocations. The following diagram shows the relationship among the departments
under the reciprocal method

PM 2,400 Hrs M
Br. 600,000
4,000 Hrs
200 hrs 1,600 Hrs 1,600 hrs
IS A
Br 116,000
200 Hrs
The reciprocal method requires formulation and solving of linear equations. This
requires three steps.

44
Step 1: Express support – Department costs and support – Department Reciprocal
relationships in the form of linear equations. Let PM be the complete reciprocated costs
of plant maintenance and IS be the complete reciprocated costs of information systems.
We then express the relation ship between support giving departments as:
PM = Br. 600, 000 + 0.1IS (1)
IS = Br. 116, 000 + 0.2PM (2)
The 0.1IS term in equation (1) is the percentage of the information systems services used
by plant maintenance. The 0.2PM term in equation (2) is the percentage of plant
maintenance services used by information systems. By complete reciprocated costs in
equations (1) and (2), we mean the support departments own costs plus any
interdepartmental cost allocations. This complete – reciprocated – costs figure is
sometimes called the artificial costs of the support department.

Step 2: Solve the set of linear equations to obtain the complete reciprocated costs of
each support department. Substituting equation (2) in to (1):
PM = Br. 600, 000 + [0.1(Br.116, 000 + 0.2PM]
PM = Br. 600, 000 + Br.11, 600 + 0.02PM
0.98PM = Br. 611, 600
PM = Br. 624, 082
Substituting into equation (2):
IS = Br.116, 600+0.2(Br. 624, 082)
IS = Br.116, 000 + Br.124, 816 = Br. 240, 816
When there are more than two support departments with reciprocal relationships,
software such as excel can be used to calculate the complete reciprocated costs of each
support department.
Step 3: Allocate the Complete Reciprocated costs of each support department to all other
departments (Both support departments and operating departments) on the basis of the
usage percentages (based on total units of service provided to all departments).

The cost in each service departments will be allocated to the operating departments and
the service departments using reciprocal method as follows

45
  Allocating cost of Plant maintenance (Br. 624, 082) to :
Machining = (2400/8000) × Br. 624, 082= Br. 187,225
Assembly = (4000/8000) × Br. 624, 082= Br. 312,041
Information system = (1600/8000) × Br. 624, 082= Br.124,816
 Allocating cost of Information systems( 116,000 + 120,000 = Br. 236,000) to :
Machining = (1600/2000) × Br. 240, 816= Br.192,653
Assembly = (200/2000) × Br. 240, 816= Br. 24,082
Plant Maintenance = 200/2000) × Br. 240, 816 = Br. 24,082
The cost summary for reciprocal cost allocation method will be given as follows
Machining Assembly Total
Cost before Allocation Br.400,000 Br.200,000 Br.600,000
Cost allocated from PM Br. 187,225 Br. 312,041 Br.499,269
Cost allocated from IS Br.192,653 Br. 24,082 Br.216,735
Total cost Br. 779,878 Br.536,123 Br.1,316,000

Note that the cost allocated to the service departments will not be included in the cost
summary.
Activity 3.3
1. What are the three cost allocation approaches?
2. What is the difference among the three approaches?

3.4 Comparison among the Three Cost Allocation Methods

Pretest
Dear Learner, which one can you choose for cost allocation purpose?

Assume that Mesfin Engineering reallocates the total budgeted overhead costs of each
operating departments to individual products on the basis of budgeted machine-hours for
the machining department (4,000 hours) and budgeted direct manufacturing labor-hours
for the Assembly department (3,000 hours). The budgeted over head allocation rates for
each operating department by each allocation methods are:

46
 Budgeted overhead rate per hour
Total Budgeted over head costs for product – costing purposes
After Allocation of All Support- Machining Assembly
Support Department Cost (4,000 machine (3,000 labor
Department cost hours) hours)
Allocation Method Machining Assembly
Direct Br. 728,111 Br. 587,889 Br. 182 Br. 196
Step-down 789,778 526,222 197 175
Reciprocal 779,878 536,123 195 179
These differences in budgeted overhead rates under the three support – department cost
allocation methods can, for example, affect the amount of costs Mesfin Engineering is
reimbursed for vehicles it assembles under cost – reimbursement contracts. Consider a
cost-reimbursement contract that uses 100 machine – hours in the machining department
and 15 direct manufacturing labor – hours in the assembly department. The support
department costs allocated to this contract under the three methods would be:
Direct: Br. 21, 140 (Br.182 per hour × 100 hours + Br.196 per hour × 15 hours)
Step – down: 22,325 (Br.197 per hour × 100 hours + Br.175 per hour × 15 hours)
Reciprocal: 22,185 (Br.195 per hour × 100 hours + Br.179 per hour × 15 hours)
The amount of cost reimbursed to Mesfin Engineering will be different depending on the
methods used to allocate support – department costs to the contract. To avoid disputes in
cost-reimbursement contracts that require allocation of support – department costs,
managers should always clarify the method to be used for allocation.

The reciprocal method is conceptually the most precise method because it considers the
mutual services provided among all support departments. The advantage of the direct
and step – down methods is that they are simple to compute and understand relative to the
reciprocal method. The direct method is widely used, however, as computing power to
do repeated iterations or to solve sets of simultaneous equations increases, more
companies find the reciprocal method easier to implement.
Activity 3.4
1. Which of the three cost allocation approaches is the simplest?
2. Which of the three cost allocation approaches is theoretically sound?

47
 Unit summary
 Allocating cost has many advantages and accountants can use cause & effect,
Benefit received, fairness and ability to bear criteria as a base for cost allocation
 Cost of a single support giving departments can be allocated to the operating
departments using either the single rate or dual rate method
 When multiple support giving departments give support to each other and to the
other operating departments, three other cost allocation methods such as direct
methods, step-down method, and reciprocal method can be used. Reciprocal
method is theoretically the best method but practically, many companies use
direct method because of its simplicity.
Model Exam Questions
Part One: Multiple choices
1. An accountant allocate advertising cost on the bases of division’s revenue assuming that
division with high revenue was benefited more from the advertising than division with
less revenue. Which criteria was used to allocate the advertising cost
A) Ability to beer B) Fairness or equity C) Fairness or equity
D) Benefit received E) None
2. Which of the following is true about cost allocation methods?
A. Single rate method divides cost in to fixed and variable cost pools
B. Dual rate method is simple to implement
C. Theoretically single rate method is preferable than dual rate
D. Budgeted allocation base is used to allocate fixed cost in dual rate method.
E. None of the above.
3. Which cost allocation method is conceptually the best to allocate cost of service
department to production department?
A. Direct method. B) Reciprocal method C) Step down method
D) Single step method E) none of the above
Part two: work out problems
Problem one : Phonex consultancy company provides consultancy service to both
government and corporate clients .For costing purpose, phonex classifies its departments
in to two support departments (Administration and information systems) and two

48
operating departments (Government consultancy and corporate consultancy). For the first
quarter of 2007, phonex incurs the following costs in the 4 departments.
Departments Cost incurred
Administration(A) Br.600,000
Information system (I) 2,400,000
Government(G) 8,756,000
Corporate(C) 12,452,000
The actual level of support relation ship among the four departments for the first quarter
of 2007 is:

Support provided by Support used by

A I G C
A _ 25% 40% 35%
I 10% - 30% 60%
Required: Allocate the support departments’ cost to operating departments using
a. Step down method
b. Reciprocal method
Problem two: Rensselar Corporation is developing department overhead rates based on
direct labor hours for its two production department. Etching and Finishing. Etching
department hires 20 people and the Finishing department employees 80 people. Each
person in the two department works 2000 hours per year. The production related over
hear head cost for Etching department is budgeted at Br.320,000 and Br.480,000 for
finishing department. Two service department, maintenance and computing directly
support the two production departments. The service departments have budgeted cost of
Br.48,000 and Br.250,000 respectively. The production department overhead rates cannot
be determined until the service department costs are allocated. The following schedule
reflects the use of the maintenance department and computing departments output by
various department.
Using departments
Service department Maintenance Computing Etching Finishing
Maintenance (hours) 0 1000 1000 8000
Computing (minutes) 240,000 0 840,000 120,000
Required: Calculate the overhead rates per direct labor for the Etching and Finishing
department after allocating manufacturing overhead cost in the service departments using
1. Direct method
2. Step down method
3. Reciprocal method
Answer Key for Model Exam Questions

49
Part I: Multiple Choice
1. D 2. D 3. B

Part II: work out : Problem 1

a) Step down method G C Total
Cost before Allocation Br.8,756,000 Br.12,452,000 Br.21,208,000
Cost allocated from A 240,000 210,000 450,000
Cost allocated from I 850,000 1,700,000 2,550,000
Total cost Br 9,846,000 Br.14,362,000 Br.24,208,000

b) Reciprocal Method
G C Total
Cost before Allocation Br.8,756,000 Br.12,452,000 Br.21,208,000
Cost allocated from A 344,615.38 301,538.46 646,153.84
Cost allocated from I 784,615.39 1,569,230.77 2353,846.16
Total cost Br 9,885,230.77 Br.14,322,769.23 Br.24,208,000

Problem 2
a) Direct method Etching Finishing Total
Cost before Allocation Br.320,000 Br.480,000 Br.800,000
Cost allocated from M 5,333 42,667 48,000
Cost allocated from C 218,750 31,250 250,000
Total cost Br 544,083 Br.553,917 Br.1,098,000
Lobar Hours ÷ 40,000Hrs ÷160,000 Hrs
MOH rate Br.13.6/hr Br.3.46/hr

Problem 2
b) step down method Etching Finishing Total
Cost before Allocation Br.320,000 Br.480,000 Br.800,000
Cost allocated from C 175,000 25,000 200,000
Cost allocated from M 10,889 87,111 98,000
Total cost Br 505,889 Br.592,111 Br.1,098,000
Lobar Hours ÷ 40,000Hrs ÷160,000 Hrs
MOH rate Br.12.65/hr Br.3.7/hr

50
 Problem 2
a) Reciprocal method Etching Finishing Total
Cost before Allocation Br.320,000 Br.480,000 Br.800,000
Cost allocated from M 10,000 80,000 90,000
Cost allocated from C 182,000 26,000 208,000
Total cost Br 512,000 Br.586,000 Br.1,098,000
Lobar Hours ÷ 40,000Hrs ÷160,000 Hrs
MOH rate Br.12.8/hr Br.3.66/hr

UNIT FOUR
JOB ORDER COSTING SYSTEM

 Unit objectives
 Introduction
 Contents:
4.1 Job Order and Process Costing Systems
4.2 Source Documents for Job Order Costing
4.3 Accounting Procedures for Job Order Costing
4.5 Under Applied and Over Applied Factory Overhead
 Unit summary
 Model Exam Questions

Unit Objective

51
Dear learner, welcome to the fourth unit of the course. This unit is entitled “Job Order
Costing System”. It deals with how product costs are determined in manufacturing
settings where different types of products that also differ in terms of their consumption of
material labor and other manufacturing costs are manufactured. The cost system that is
used under such manufacturing settings is called job order costing system. Therefore,
after completing this unit, you are expected to:
 explain what job order costing systems is and when it is applicable.
 distinguish between job order costing system and process costing system.
 describe workflow and the flow of product cost under this manufacturing setting.
 explain the treatment of overhead cost in job order costing system.
 explain the different allocation bases to apply manufacturing overhead to the
different jobs.
 explain the three ways of disposing under or over applied manufacturing over
head costs.

Introduction
To properly account product cost, a company must use an accounting system that
accumulates and assigns costs to manufactured units. Proper accounting for product cost
is particularly essential in the preparation of financial statements. Costs that are assigned
to goods sold appear on the income statement and costs assigned to the unsold units
appear on the balance sheet. Product costs will be assigned to the final cost object using
either job order costing system or process costing system.

This unit discusses about job order costing system in detail. The unit is divided in to four
subunits. The first subunit deals with the features of job order and process costing
systems in general. The second subunit discusses about the different source documents
used in job order costing system. The third subunit discusses the accounting procedures
in job order costing system. The last sub unit discusses the accounting treatment of
manufacturing over head cost & the different methods used to dispose under/over applied
manufacturing overhead cost.

52
4.1 Job Order and Process Costing Systems

Pretest
What are job order and process costing systems and when do we apply each of
them?

Manufacturers can use two basic accounting systems; general accounting system, and
cost accounting system. A general accounting system is the logical extension of
accounting for merchandising firms, and uses the periodic inventory system. However,
since managers require frequent accounting reports on manufacturing costs for decision
making purpose, the use of the general accounting system is very limited. Cost
accounting system uses the perpetual inventory system and it is most widely used,
because it helps to gather information that are needed in order to prepare periodic reports
without physical counting and related cumbersome tasks.
The cost accounting system uses the perpetual inventory system, and achieves greater
accuracy in the determination of product cost than is possible with the general accounting
system. It also permits far more effective control by supplying data on costs incurred by
each manufacturing department or process and it provides a fairly accurate unit cost of
manufacturing each type of product that helps managers make good decisions timely.

There are two extremes of cost accounting systems for manufacturing operation-Job
order costing system and Process costing system.

A job order costing system provides a separate record of the cost of each particular batch
of product that passes through the factory. The system accumulates costs for a particular
batch of production, commonly referred to as a job. A job has a definite starting and
completion time as would, for example, the production of 10 pieces of windows, or 50
coffee tables. As the name implies, job order means, the units are produced as per the
order of a customer, each customer order is different in terms of specification. A
difference in specification means a difference in quantity of inputs used. An individual

53
job does not mean a single output; rather it means a single order which can be just for
stock that can be sold later to ready-made buyers. Whatever, whether for customer or
stock, jobs are not similar, and their costs are also different. In job order costing system,
costs are accumulated by job. For each job, the firm maintains a separate job cost sheet,
which is a record on which manufacturing costs of the job are accumulated

In job order costing, costs are accumulated by jobs, orders, contracts, or lots. The key is
that, the work is done to the customer's specifications. As a result, each job tends to be
different. For example, job order costing is used for construction projects, government
contracts, shipbuilding, automobile repair, printing jobs, wood furniture, office machines,
machine tools, and luggage. Accumulating the cost of professional services such as
lawyers, doctors and CPA's also falls into this category.

Process costing system is a costing system used for manufacturing processes which
produce a single product or single mix of products continuously for an extended period of
time. In process costing, costs are accumulated by departments, operations, or processes.
The work performed on each unit is standardized or uniform where a continuous mass
production or assembly operation is involved. For example, process costing is used by
companies that produce appliances, alcoholic beverages, tires, sugar, breakfast cereals,
leather, paint, coal, textiles, lumber, candy, coke, plastics, rubber, cigarettes, shoes,
typewriters, cement, gasoline, steel, baby foods, flour, glass, men's suits, pharmaceuticals
and automobiles. Process costing is also used in meat packing and for public utility
services such as water, gas and electricity.

Activity 4.1
1. Define job order costing and processing costing systems?
2. Explain when to use each of them?

4.2 Source Documents in Job order Costing System

Pretest
What are the different source documents used in job order costing system?

54
1. Measuring Direct Materials Cost in Job Order Costing System:

At the beginning of production process, a document known as bill of materials is used for
standard products. "A bill of materials is a document that lists the type and quantity of
each item of materials needed to complete a unit of standard product". In case where it is
not possible to use a bill of materials, the production staff determines the material
requirements from the blueprints submitted by the customer.

When an agreement is reached with the customer concerning the quantities, price and
shipment date for the order, a production order is issued. The production department then
prepares a materials requisition form. Materials requisition form is a detailed source
document that specifies the type and quantity of materials to be drawn from the
storeroom, and identifies the job to which the costs of the materials are to be charged.
The form is used to control the flow of materials into production and also for making
entries in the accounting records. The completed form is presented to the storeroom clerk
who then issues the necessary raw materials. The storeroom clerk is not allowed to
release materials without such a form bearing an authorized signature. The following is a
sample material requisition form for job 2B47.

Sample Materials Requisition Form:

Materials Requisition Number14873 Date March 2 ,2009
Job Number to Be Charged 2B47
Department Milling
Description Quantity Unit Cost Total Cost
M46 Housing 2 Br.124 Br.248
G7 Connector 4 103 412
Br.660
Authorized Signature __________________

After being notified that the production order has been issued, the accounting department
prepares a job cost sheet. A job cost sheet is a form prepared for each separate job that
records the materials, labor and overhead costs charged to the job. After direct materials
are issued, the accounting department records their costs directly on the job cost sheet. In
addition to serving as a means for charging costs to jobs, the job cost sheet also serves as

55
a key part of a firm's accounting records. The job cost sheets form a subsidiary ledger to
the work in process (WIP) account. They are detailed records for the jobs in process that
add up to the balance in the work in process (WIP). The raw material cost Br.660 for job
2B47 is accumulated on a job cost sheet as follows:

JOB COST SHEET

Job Number 2B47
Department Milling Date Initiated March 2 ,2009
Item Date Completed
For Stock Units Completed

Direct Materials Direct Labor Manufacturing Overhead

Req. No. Amount Ticket Hours Amount Hours Rate Amount
14873 Br.660

2. Measuring Direct Labor Cost under Job Order Costing System:

Direct labor cost is handled in much the same way as direct materials cost. Direct labor
consists of labor charges that are easily traced to a particular job. Labor charges that
cannot be easily traced directly to any job are treated as part of manufacturing overhead.
The later category of labor cost is known as indirect labor and includes tasks such as
maintenance, supervision, and cleanup. Workers use time tickets to record the time they
spend on each job and task. A completed labor time ticket is an hour by hour summary of
the employees activities throughout a specific job, the employee enters the job number on
the time ticket and notes the amount of time spent on that job. When not assigned to a
particular job, the employee records the nature of the indirect labor task (such as cleanup
and maintenance) and the amount of time spent on the task. The daily time tickets are
also used as the basis for labor cost entries into the accounting records. Following is an
example of employees’ time ticket.

Time Ticket No. 843 Date March 3 ,2009

Employee : Jaleta Bulli Station 4

Started Ended Time Rate Amount Job Number

Completed
7:00 12:00 5.0 Br.9 Br.45 2B47

56
 12:30 2:30 2.0 9 18 2B50
2:30 3:30 1.0 9 9 Maintenance

At the end of the day, the time tickets are gathered and accounting department enters the
direct labor hours and costs on individual job cost sheets. The following is how to do that
for job 2B47.

JOB COST SHEET

Job Number 2B47
Department Milling Date Initiated March 2 ,2009
Item Date Completed
For Stock Units Completed

Direct Materials Direct Labor Manufacturing Overhead

Req. No. Amount Ticket Hours Amount Hours Rate Amount
14873 Br.660 843 5 Br.45

3. Application of Manufacturing Overhead Cost in Job Order Costing:

Manufacturing overhead must be included with direct labor on the job cost sheet since
manufacturing overhead is also a product cost. However, assigning manufacturing
overhead to units of products can be a difficult task. There are two reasons for this:

1. Manufacturing overhead is an indirect cost. This means that it is either impossible

or difficult to trace these costs to a particular product or job.
2. Manufacturing overhead consists of many different items ranging from the grease
used in machines to the annual salary of production manager.

Given these problems, the only way to assign overhead costs to production is to use an
allocation process. This allocation of overhead cost is accomplished by selecting an
allocation base that is common to all of the company's products and services. An
allocation base is a measure such as direct labor hours or machine hours that is used to
assign overhead costs to products and services. The most widely used allocation bases are
direct labor hours, direct labor cost, machine hours and even units of product can also be
used to some extent. The allocation base is used to compute "predetermined overhead
rate" in the following formula or equation.

57
 Predetermined Overhead Rate = Estimated total MOH cost
Estimated total allocation base

For example, if a company has estimated that its total manufacturing overhead cost will
be Br.320, 000 for the year and its total direct labor hour will be Br.40, 000, its
predetermined overhead rate (POR) for the year will be Br.8 per direct labor hour,
calculated as follows:

Br. 320,000 / 40,000 = Br.8 per direct labor hour

Predetermined overhead rate is based on estimates rather than actual result. This is
because the predetermined overhead rate is computed before the period begins and is
used to apply overhead cost throughout the period. The process of assigning overhead
costs to jobs is called overhead application. The formula for determining the amount of
overhead cost to apply to a particular job is:

Overhead applied to a particular job = POR × Amount of allocation base

Note that the job cost sheet in the example below indicates that 27 labor hours have been
worked. Therefore a total of Br.216 of manufacturing overhead cost would be applied to
the job.

Overhead applied to Job 2B47 = Predetermined overhead rate × Actual direct labor hours

= Br.8 per DLH × 27 DLHrs

= Br.216

In addition to direct material and direct labor cost, the applied manufacturing overhead
cost will be entered in the job cost sheet and the total estimated cost to complete the job
will be summarized as shown below.

JOB COST SHEET

Job Number 2B47

Department Milling Date Initiated March 2 ,2009
Date Completed March 8 ,2009

58
 Direct Materials Direct Labor Manufacturing Overhead
Req.
Amount Ticket Hours Amount Hours Rate Amount
No.
14873 Br.660 843 5 Br.45 27 Br.8/DLH Br.216
14875 506 846 8 60
14912 238 850 4 21
--------- 851 10 54
Br.1,404 -------- --------
===== 27 Br.180
===== =====
Cost Summary Units Shipped
Direct Materials Br.1,404 Date Number Balance
Direct Labor 180 March 8 -- 2
Manufacturing Overhead 216
Total Cost Br.1800
900
Unit Product Cost

The amount of overhead cost entered in the job cost sheet is not the actual amount of
overhead caused by the job. There is no attempt to trace actual overhead costs to jobs. If
that could be done, the costs would be direct costs, not overhead costs. Overhead
assigned to the job is simply a share of the total overhead that was estimated at the
beginning of the year. When a company applies overhead cost to jobs as we have done, it
is called normal costing system. The overhead may be applied as direct labor-hours are
charged to jobs, or all of the overhead can be applied at once when the job is completed.
The choice is up to the company. If a job is not completed at the year-end, however,
overhead should be applied to value the work in process inventory.

Instead of using a predetermined overhead rate, a company could wait until the end of the
accounting period to compute an actual overhead rate based on actual total manufacturing
costs and the actual total units in the allocation base for the period. However, managers
cite the following two reasons for using predetermined over head rates instead of actual
overhead rates:

59
 1. Managers would like to know the accounting system's valuation of completed
jobs before the end of the accounting period. Suppose, for example a company
waits until the end of the year to compute its overhead rate. Then there would be
no way for managers to know the cost of goods sold for a job until the close of the
year. The job may be completed and shipped before the end of the year. The
seriousness of this problem can be reduced to some extent by computing the
actual overhead more frequently, but that immediately leads to another problem as
discussed below.
2. The use of predetermined overhead rate simplifies the record keeping. To
determine the overhead cost to apply to a job, the accounting staff simply
multiplies the direct labor hours recorded for the job by the predetermined
overhead rate.

Materials The job

requisition cost sheet
form is used to
A These compute
production production Job unit
Sales A sales Production Direct labor
→ order costs are → cost product
Order order is Order time ticket
initiates accumulated sheet costs that
prepared
work on a → on a form, in turn are
as a
job, prepared by used to
basis for
whereby the value
issuing
costs are accounting ending
a.....
charged Predetermined department inventories
through... overhead rates known as... and to
determine
cost of
goods sold

The Flow of Documents in a Job Order Costing System

Activity 4.2

Can you mention some of the source documents used in job order costing system?

4.3 Accounting Procedures for Job order Costing System

60
 Pretest
Dear learner, how do we record the different types of costs in job order costing
system?

To understand the flow of costs in job order costing system, we shall consider a single
month's activity for Gibe Furniture Company, a producer of product A and product B.
The company has two jobs in process during April, the first month of its fiscal year. Job 1
(1000 units of product A) was started in March. By the end of March, Br. 30,000 in
manufacturing costs had been recorded for job 1. Job 2, an order for 10,000 units of
product B was started in April.

1. The Purchase and Issue of Materials:

On April 1, the company had Br.7,000 in raw materials on hand. During the month, the
company purchased an additional Br.60,000 in raw materials. The purchase is recorded in
journal entry (1) below:

(1) Raw Materials 60,000

Accounts Payable 60,000

A raw material is an asset account. Thus, when raw materials are purchased, they are
initially recorded as an asset--not as an expense.

2. Issue of Direct and Indirect Materials:

During April, Br.52,000 in raw materials was requisitioned from the storeroom for use in
production. These raw materials include Br. 2,000 indirect materials. Entry (2) records
issuing the materials to the production department.

(2) Work in Process 50,000

Manufacturing Overhead 2,000
Raw Materials 52,000

The materials charged to work in process (WIP) represent direct materials for specific
jobs. As these materials are entered into the work in process account, they are also

61
recorded on the appropriate job cost sheets. The Br.2, 000 charged to manufacturing
overhead in entry (2) represents indirect materials used in production during April.
Observe that the manufacturing overhead account is separate from work in process
account. The purpose of the manufacturing overhead account is to accumulate all
manufacturing overhead costs as they are incurred during a period. Work in process
account contains a summarized total of all costs appearing on the individual job cost
sheet for all jobs in process at any given point in time.

3. Labor Cost:

As work is performed each day in various departments of the company, employee time
tickets are filled out by workers, collected, and forwarded to the accounting department.
In the accounting department, wages are computed and the resulting costs are classified
as either direct or indirect labor. This costing and classification for April resulted in a
total labor cost Br.75, 000 of which Br.15, 000 is indirect material. The journal entry to
record this is given as follows

(3)
Work in process 60,000
Manufacturing overhead 15,000
Salaries and wages payable 75,000

Only direct labor is added to the work in process account. At the same time the direct
labor costs are added to work in process, they are also added to the individual job cost
sheets. During April, Br.40, 000 of direct labor cost was charged to job 1 and the
remaining Br.20, 000 was charged to job 2. The labor cost charged to manufacturing
overhead represent the indirect costs of the period, such as supervision, janitorial work,
and maintenance for the two jobs in common.

4. Manufacturing Overhead Costs:

All costs of operating the factory other than direct materials and direct labor are classified
as manufacturing overhead costs. These costs are entered directly into the manufacturing

62
overhead account as they are incurred. To illustrate, assume that the company incurred
the following general factory costs during April:

Utilities (heat, water, and power)

Br.21,000
Rent on factory equipment 16,000
Miscellaneous factory costs 3,000
Total Br.40,000

The following entry records the incurrence of these costs:

(4a)
Manufacturing overhead 40,000
Accounts Payable 40,000

In addition, let us assume that during April, the company recognized Br.13, 000 in
accrued property taxes and that Br.7,000 in prepaid insurance expired on factory
buildings and equipment. The following entry records these items:

(4b)
Manufacturing overhead 20,000
Property taxes payable 13,000
Prepaid insurance 7,000

Finally let us assume that the company recognizes Br.18, 000 in depreciation on factory
equipment during April. The following entry records the accrual of this depreciation:

(4c)
Manufacturing overhead 18,000
Accumulated Depreciation 18,000

In short, all manufacturing overhead costs are recorded directly into the manufacturing
overhead account as they are incurred day by day through a period. It is important to
understand that manufacturing overhead is a control account for many--perhaps

63
thousands--of subsidiary accounts such as indirect materials, indirect labor, factory
utilities, and so forth. As the manufacturing overhead account is debited for costs during
a period, the various subsidiary accounts are also debited. In this example, we omit the
entries to the subsidiary accounts for the sake of brevity.

5. Calculation of Predetermined Overhead Rate and Application of Manufacturing

Overhead to Work in Process (WIP):

Since actual manufacturing costs are charged to the manufacturing overhead control
account rather than work in process account. How are manufacturing costs assigned to
work in process? The answer is, by means of the predetermined overhead rate. A
predetermined overhead rate is established at the beginning of each year. The
predetermined overhead rate is calculated by dividing the estimated total manufacturing
overhead cost for the year by the estimated total units in the allocation base (measured in
machine hours, direct labor hours, or some other base). This rate is then used to apply
overhead costs to jobs.

To illustrate, assume that the company has used machine hours to compute predetermined
overhead rate and that this rate is Br.6 per machine hour. Also assume that during April,
10,000 machine hours were worked on Job 1 and 5,000 machine hours were worked on
Job 2 (a total of 15,000 machine hours). Thus, Br.90, 000 in overhead cost (15,000
machine hours times Br.6 per machine hour = Br.90, 000) would be applied to work in
process. The following entry records the application of manufacturing overhead to work
in process:

(5)
Work in process 90,000
Manufacturing overhead 90,000

The manufacturing overhead account operates as a clearing account. As we have noted,

actual factory overhead costs are debited to the accounts as they are incurred day by day
through the year. A certain intervals during the year, usually when a job is completed,

64
overhead cost is applied to the job by means of the predetermined overhead rate, and
work in process is debited and manufacturing overhead is credited.

As we emphasized earlier, the predetermined overhead rate is based on estimates of what

overhead costs are expected to be, and it is established before the year begins. As a result,
the overhead cost applied during a year will almost certainly turn out to be more or less
than the overhead cost that is actually incurred. For example, the company's actual
overhead costs for the period in the above example are Br.5,000 greater than the overhead
cost that has been applied to work in process (WIP), resulting in a Br.5,000 debit balance
in the manufacturing overhead account. This debit balance in manufacturing overhead
account is called under-applied overhead. Any credit balance in manufacturing overhead
account is called over-applied overhead.

The accounting for MOH over/under applied is discussed in the next section. For the
moment, we can conclude that the cost of a completed job consists of the actual material
cost of the job, the actual labor cost of the job, and the overhead cost applied to the job.
This is called Normal costing. Pay particular attention to the following important point:
Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the
job cost sheet nor do they appear in the work in process account. Only the applied
overhead cost, based on the predetermined overhead rate, appear on the job cost sheet and
in the work in process account.

6. Non-Manufacturing Costs:

In addition to manufacturing costs, companies also incur marketing and selling costs.
These costs should be treated as periodic expenses and charged directly to the income
statement and therefore should not go into the manufacturing overhead account. To
illustrate the correct treatment of non-manufacturing costs, assume that the company (in
this example) incurred Br.30,000 in selling and administrative salary costs during a
months, the following entry records these salaries.

(6a)
Salaries expense 30,000
Salaries and wages payable 30,000

65
Depreciation on factory equipment is debited to manufacturing overhead account but
depreciation on office equipment is considered a period expense and is not included in
manufacturing overhead. Assume that depreciation of office equipment during the month
was Br.7, 000. The entry is as follows.

(6b)
Depreciation expense 7,000
Accumulated depreciation 7,000

Finally, assume that advertising was Br.42,000 and that other selling and administrative
expenses during the month were Br.8,000. The following journal entry records these
items:

(6c) Advertising expenses 42,000

Other selling and admin. expense 8,000
Accounts payable 50,000

Since the amounts in entries above all go directly into expense accounts, they will have
no effect on the costing of the company's production for the month. The same will be true
of any other selling and administrative expenses incurred during the month including
sales commission, depreciation on sales equipment, rent on office facilities, insurance on
office facilities, and related costs.

7. Cost of Goods Manufactured (COGM):

When a job has been completed, the finished out put is transferred from the production
department to the finished goods warehouse. By this time, the accounting department will
have charged the job with direct materials and direct labor cost and manufacturing
overhead will have been applied using the predetermined overhead rate. A transfer of
costs is made within the costing system that parallels the physical transfer of the goods to
the finished goods warehouse. The costs of the completed jobs are transferred out of the
work in process (WIP) account and into the finished goods account. The sum of all

66
amounts transferred between these two accounts represents the cost of goods
manufactured for the period. Let us assume that job 1 was completed at a total cost of
Br.158,000 during the period. The following entry transfers the cost of job 1 from work
in process (WIP) to finished goods.

(7)
Finished goods 158,000
Work in process 158,000

Since Job 1 was the only Job completed during April, the Br.158,000 also represents the
cost of goods manufactured for the month. Job 2 was not completed by month-end, so its
cost will remain in the work in process (WIP) account and carry over to the next month.
If a balance sheet is prepared at the end of April, the cost accumulated thus far on the job
2 will appear as "work in process inventory" in the assets section.

8. Cost of Goods Sold (COGS):

As units in the finished goods are shipped to the customers, their costs are transferred
from the finished goods account into the cost of goods sold account. If complete job is
shipped, as in the case where a job has been done to a customer's specification, then it is a
simple matter to transfer the entire cost appearing on the job cost sheet into the cost of
goods sold account. In most cases, only a portion of the units involved in a particular job
will be immediately sold. In these situations, the unit cost must be used to determine how
much product cost should be removed from finished goods and charged to cost of goods
sold. Assume that the company has completed 1000 units and 750 out of 1000 units have
been shipped to customers for a price of Br.225,000. The unit product cost is Br.158. The
Following journal entries would record the sales (all sales are on account).

(8a)
Accounts receivable 225,000
(8b) Sales 225,000
Cost of goods sold 118,5000
Finished goods 118,5000

67
 (Br.158 × 750units = Br.118, 500)

With entry (8), the flow of cost through our job order costing system is completed. To
pull the entire example together, journal entries (1) through (8), T-accounts, and
schedules of cost of goods manufactured and cost of goods sold are presented below:

(1)
Raw Materials 60,000
Accounts Payable 60,000
(2)
Work in process 50,000
Manufacturing overhead 2,000
Raw materials 52,000
(3)
Work in process 60,000
Manufacturing overhead 15,000
Salaries and wages payable 75,000
(4a)
Manufacturing overhead 40,000
Accounts payable 40,000
(4b)
Manufacturing overhead 20,000
Property taxes payable 13,000
Prepaid insurance 7,000
(4c)
Manufacturing overhead 18,000
Accumulated depreciation 18,000
(5)
Work in process 90,000
Manufacturing overhead 90,000
(6a)
Salaries expenses 30,000
Salaries and wages payable 30,000
(6b)
Depreciation expense 7,000 .
Accumulated depreciation 7,000
(6c)
Advertising expense 42,000
Other selling and administrative expense 8,000
Accounts payable 50,000
(7)
Finished goods 158,000
Work in process 158,000
(8a)

68
Accounts receivable 225,000
Sales 225,000
(8b)
Cost of goods sold 118,500
Finished goods 118,500
The above journal entries can be summarized using T-account as follows

Accounts Receivable Accounts Payable Capital Stock

xx xx xx
(12) 225,000 (1) 60,000
(4) 40,000
(10) 50,000

Prepaid Insurance Salaries and Wages Retained Earnings

Payable
xx xx xx
(3) 75,000
(4b) 7,000 (6a) 30,000

Raw Materials Property Taxes Payable Sales

Bal. 7,000 (2) 52,000 xx (12)
(1) 60,000 (4b) 13,000 225,000
Bal. 15,000

Cost of Goods Sold

(8b)118500
Work in Process Salaries expenses
Bal. 30,000 (7 158,000 (6a)30,000
(2) 50,000
(3) 60,000 Depreciation expenses
(5 90,000 (6b) 7,000
Bal. 72,000

Finished Goods Advertising Expenses

Bal. 10,000 (8b)118,500 (6c)42,000
(7) 158,000

Bal. 49,000

Accumulated Depreciation Other Selling and

Administrative expenses
xx (6c) 8,000
(4c) 18,000

69
 (6b) 7,000

Manufacturing Overhead
(2) 2000 (5) 90,000
(3) 15,000
(4a) 40,000
(4b) 20,000
(4c) 18,000
Bal. 5,000
:
After accounts are summarized in a T-account, cost of goods manufactured, cost of goods
sold and Income statement for the job completed (Job1) is presented as follows.

1. Cost of Goods Manufactured:

Direct materials Br.50,000
Direct labor 60,000
Manufacturing overhead applied to work in process 90,000
Total Manufacturing cost Br.200,000
Add: Beginning work in process 30,000
Total cost incurred to date Br.230,000
Deduct: Ending work in process inventory (Job-2) 72,000
Cost of goods manufactured Br.158,000

2. Cost of Goods Sold:

Finished goods inventory beginning Br.10,000
Add: cost of Goods manufactured 158,000
Goods available for sale Br.168,000
Deduct: Finished goods inventory ending 49,500
Unadjusted cost of goods sold Br.118,500
Add: Under applied overhead 5,000
Adjusted cost of goods sold Br.123,500
3. Income Statement:
Sales Br.225,000
Less cost of goods sold (Br. 118,500 + Br.5,000) 123,500
Gross margin Br.101,500
Less selling and administrative expenses:
Salaries Br.30,000
Depreciation 7,000
Advertising expenses 42,000
Other expense 8,000 87,000
Net operating income Br.14,500
Activity 4.3

70
1. Explain how manufacturing costs are recorded in job order costing?
2. What is the difference between Manufacturing over head cost applied and actual
manufacturing overhead cost?

4.4 Accounting for Under/Over-Applied MOH cost

Pretest
Dear learner, what is over applied or under applied manufacturing overhead cost?

Since predetermined overhead rate is established before a period begins and is based
entirely on estimated data, the overhead cost applied to work in process (WIP) will
generally differ from the amount of overhead cost actually incurred during a period. The
difference between the overhead cost applied to work in process (WIP) and the actual
overhead costs of a period is termed as either under applied overhead or over applied
overhead. For example if a company calculates it’s predetermined overhead rate Br.6 per
machine hour. 15,000 machine hours are actually worked and overhead applied to
production is therefore Br.90, 000 (15,000 hours × Br.6). If actual factory overhead is
Br.95, 000 then under applied overhead is Br.5, 000 (Br.95, 000 – Br.90, 000). If the
situation is reversed and the company applies Br.95, 000 and actual overhead is Br.90,
000, the over applied overhead would be Br.5, 000.

The causes / reasons of under or over-applied overhead can be complex.

Nevertheless the basic problem is that, the method of applying overhead to jobs
using a predetermined overhead rate assumes that actual overhead costs will be
proportional to the actual amount of the allocation base incurred during the period.
If, for example, the predetermined overhead rate is Br.6 per machine hour, then it is
assumed that actual overhead cost incurred will be Br.6 for every machine hour that
is actually worked. There are actually two reasons why this may not be true. First,
much of the overhead often consists of fixed costs that do not grow as the number of
machine hours incurred increases. Second, spending on overhead items may or may
not be under control. If individuals who are responsible for overhead costs do a
good job, those costs should be less than were expected at the beginning of the
period. If they do a poor job, those costs will be more than expected. For example,

71
suppose that two companies A and B have prepared the following estimated data for
the coming year:

Company
A B
Predetermined overhead rate based on Machine-hours Direct materials cost
Estimated manufacturing overhead Br.300,000 Br.120,000
Estimated machine-hours 75,000 --
Estimated direct materials cost Br.80,000
Br.4 per machine 150% of direct
Predetermined overhead rate, (a) ÷ (b)
hour materials cost
Now assume that because of unexpected changes in overhead spending and changes in
demand for the companies' products, the actual overhead cost and the actual activity
recorded during the year in each company are as follows:

Company
A B
Actual manufacturing overhead costs Br.290,000 Br.130,000
Actual machine-hours 68,000 --
Actual direct materials costs -- Br.90,000
For each company, note that the actual data for both cost and activity differ from the
estimates used in computing the predetermined overhead rate. This results in under
applied overhead and over applied overhead as follows:

Company
A B
Actual Manufacturing overhead costs Br.290,000 Br.130,000
Manufacturing overhead cost applied to work in
process during the year:
68,000 actual machine hours × Br.4 per machine hour 272,000
Br.90,000 actual direct materials cost × 150% of
135,000
direct materials cost
Under applied (over applied) overhead Br. 18,000 Br. (5,000)

For company A, notice that the amount of overhead cost that has been applied to work
in process (Br.272, 000) is less than the actual overhead cost for the year (Br.290,
000). Therefore the overhead is under applied. Also notice that original estimate of

72
overhead in company A (Br.300, 000) is not directly involved in this computation. Its
impact is felt only through the Br.4 predetermined overhead rate that is used. For B
company the amount of overhead cost that has been applied to work in process (WIP)
(Br.135, 000) is greater than the actual overhead cost for the year (Br.130, 000), and so
overhead is over applied.

There are three main approaches to accounting for the under/over applied manufacturing
overhead.

1. Adjusted Allocation Rate Approach: The adjusted allocation rate approach restates
all overhead entries in the general ledger and subsidiary ledger using actual cost rates
than budget cost rates. First, the actual manufacturing overhead rate is computed at the
end of the fiscal year. Then, the manufacturing overhead costs allocated to every job
during the year are recomputed using the actual manufacturing overhead rate rather than
the budgeted manufacturing overhead rate. The result is that at year end, every job cost
record and finished goods record accurately represent actual manufacturing overhead
costs incurred.

2. Closed Out to Cost of Goods Sold: Closing out the balance in manufacturing
overhead account to cost of goods sold is simpler than the adjusted allocation rate

approach. Where the overhead is under applied, the following journal entry is made:
Cost of goods sold XX
Manufacturing overhead
XX

Where the overhead is over applied, the following journal entry is made:

Manufacturing Overhead XX
Cost of goods sold
XX

After passing one of these journal entries, cost of goods sold is adjusted. Consequently
cost of goods sold is increased by the amount of under applied and decreased by the

73
amount of over applied overhead. For Gibe furniture factory, the under applied amount is
Br.5, 000 and is closed to cost of goods sold as follows

Cost of goods sold 5,000

Manufacturing overhead
5,000

This is the reason why we have added the under applied manufacturing overhead to the
unadjusted cost of goods sold amount and arrive at the adjusted amount of Br.123, 500

3.Peroration Approach: Allocation of under or over applied overhead between work in

process (WIP), finished goods and cost of goods sold (COGS) is more accurate than
closing the entire balance into cost of goods sold. The reason is that allocation assigns
overhead costs to where they would have gone in the first place had it not been for the
errors in the estimates going into the predetermined overhead rate.

The followings are end balance of the three accounts for Gibe Furniture Company

Accounts End balance Percentage

Work In process 72,000 30%
Cost of Goods Sold 118,500 50%
Finished Goods 49,000 20%
Total 239,500
The under applied
manufacturing overhead can be prorated based on the end balance percentage computed
above as follows

Accounts Percentage Prorated amount

Work In process 30% 30%×5000 = 1,500
Cost of Goods Sold 50% 50%×5000 = 2,500
Finished Goods 20% 20%×5000 = 1000
Total 5,000

After peroration the under applied amount will be closed to the three accounts as shown
below
Work in Process 1,500
Cost of goods sold 2,500

74
 Finished Goods 1000
Manufacturing overhead 5,000

Activity 4.4
What are the three approaches to dispose under/over applied MOH cost?
Unit Summary

 Product costing is the process of accumulating the costs of production and

assigning these costs to units produced. Two product-costing systems are widely
used depending on the nature of the manufacturing. Firms producing relatively
small number of dissimilar products use job order costing system: where as firms
producing large number of identical unit’s uses process costing system. Among
firms that use job order costing system are Airplane manufacturers, furniture
manufactures, and manufacturers of customized clothes. Companies that use
process costing are like oil refineries, sugar processing companies, and food
complexes.

 In job order costing system, the costs of direct material, direct labor, and
manufacturing overhead are first entered into the work in process inventory
account. When goods are completed, the accumulated manufacturing cost is
transferred from work in process inventory to finished goods. When sales are
made, the cost of finished goods is transferred from finished good inventory to
cost of goods sold. The movement of cost in this manner form what is called the
cost accounting cycle.

 Direct materials and direct labors can easily be traced to a job. In contrast,
manufacturing overhead costs are indirect manufacturing costs to a job and cannot
be traced to specific jobs. Therefore, overhead costs are allocated to jobs on the
basis of a predetermined overhead rate that is developed based on the relationship
between the indirect manufacturing cost, and cost allocation base.

 The actual overhead costs and the amount applied rarely matches. At the end of
the year, the under and over applied overhead can be disposed to cost of goods

75
 sold, or prorated to work in process, finished goods, and cost of goods sold on the
basis of either their actual balance or overhead applied
Model Exam Questions
Part one: Multiple Choices
1. One of the following companies most likely use job order costing system
A) Cement factories D) Beer factories
B) Petroleum refineries C) None of the above
C) Repair shops and garages
2. Which of the following is false about manufacturing over head cost?
A) Is incurred for the benefit of all jobs produced during a given period
B) Can not be traced to any particular job
C) Some manufacturing over head cost will not be known until the end of a
period although a job is completed
D) We must hold a finished good until all manufacturing overhead cost
attributable to it is known
E) None of The above
3. Sunshine Construction Company applies MOH cost to its projects at a rate of Br.100
per direct labor hour. Laborers are paid an average rate of Br.25 per labor hour. The
actual direct material and direct labor cost to complete one project (Building) were
Br.450, 000 and Br.150, 000 respectively. The total estimated cost to complete the project
will be
A) Br.1, 500,000 B) Br.600, 000 C) Br.602, 500 D) Br.1, 200,000 E) None

Part two: Workout Problems

1. Assume that Addis Ababa university press is wholly owned by the university and
performs the bulk of its work for other university department, which pay as though the
press were an outside business enterprise. The press also publishes and maintains a stock of
books for general sale. A job costing system is used to cost each job. There are two direct
cost category (direct material and direct labor) and one indirect cost pool ( MOH cost,
allocated on the basis of direct labor cost). During the year 2008, the following transactions
occurred:

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 1. Raw materials of Br. 800,000 was purchased on account
2. Raw material of Br. 810,000 was used in the production of which Br.100,000 is
indirect material.
3. Labor cost of Br. 2,200,000 was incurred of which Br. 900,000 is indirect labor.
4. Actual MOH cost other than indirect material and indirect labor is Br.750,000
5. MOH is applied at a rate of 160% of direct labor cost.
6. Cost of goods manufactured in the year is Br. 4,120,000
7. Revenue from sale of finished goods is Br. 8,000,000 for which cost of goods sold
is Br. 4,020,000.All sales are on account.
Required: a) Record the above transactions using controlling account
b)Calculate the under or over applied MOH cost
c) Close the under or over applied MOH cost to cost of goods sold
2. Denbi Furniture factory uses a job order costing system. Its job costing system has two
direct cost categories (Direct material and Direct labor) and one indirect cost category
( MOH cost allocated at budgeted rate of Br.60 per machine hour in 2009). The following
transactions occurred in January 2009.
a) Purchase of raw material on account for Br.300,000.
b) Direct material of Br.280,000 and indirect material of Br.20,000 was used in the
production process.
c) Direct labor cost of Br.180,000 and indirect of Br.60,000 was incurred in the
month.
d) The actual machine hours used to complete the job was 4,200 machine hours. The
MOH cost is allocated using this actual machine hour.
e) Miscellaneous MOH cost actually incurred by department were Br.160,000
f) Cost of finished goods completed and transferred out was Br.588,000
g) Finished goods costing Br.584,000 was sold for Br.800,000 on cash
Requirements
1. Journalize the transactions for the month of January 2009
2. Calculate the under or over applied MOH cost
3. Give the year end adjusting entry closing the over or under applied MOH cost to
cost good sold.

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 4. If the year end balance before peroration for three accounts is given as shown
below, prorate the over or under applied MOH cost to the three accounts
 Cost of goods sold-------- Br.584,000
 Work in process ----------- 6,000
 Finished goods ------------ 10,000

Answer Key for Model Exam Questions

Part I: Multiple Choice
1. C 2. D 3. D
Part II: Work out
Problem 1a)
(1)
Raw Materials 800,000
Accounts Payable 800,000
(2)
Work in process 710,000
Manufacturing overhead 100,000
Raw materials 810,000

(3)
Work in process 1,300,000
Manufacturing overhead 900,000
Salaries and wages 2,200,000
(4)
Manufacturing overhead 750,000
Accounts payable 750,000
(5)
Work in process 2,080,000
Manufacturing overhead 2,080,000
(6)
Finished goods 4,120,000
Work in process 4,120,000
(7a)
Accounts receivable 8,000,000
Sales 8,000,000
(7b)
Cost of goods sold 4,020,000
Finished goods 4,020,000

b) Over applied MOH cost = Br.2,080,000 – Br. 1,750,000 = Br. 330,000

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c)
Manufacturing Overhead 330,000
Cost of Goods sold 330,000

Problem 2:
1) The journal entries are recorded in the same way as in problem one above
2) Over applied MOH cost = $12,000
3)
Manufacturing Overhead 12,000
Cost of Goods sold 12,000
4) The overhead amount is prorated to the three accounts as follows

Accounts End Balance Percentage Prorated amount

Work In process $6,000 1% 1%×12,000 = 120
Cost of Goods Sold 584,000 97% 97%×12,000 = 11,640
Finished Goods 10,000 2% 2%×12,000 = 240
Total $600,000 Br.12,000

UNIT FIVE
PROCESS COSTING SYSTEM
 Unit objectives
 Introduction
 Contents:
5.1 Similarities and Differences between Process and Job Order Costing
5.2 Process Costing System - Different Cases
5.3 Transferred In Cost Using WA and FIFO Methods
5.4 Spoilage and Process Costing System
5.5 Job Order Costing System and Spoilage, Rework and Scrap
 Unit Summary
 Model Exam Question
Unit Objective

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Dear learner, this unit is an extension of job order costing system. The main objective of
this unit is to discuss how and when processing costing system is applied. It further
discusses the treatment of spoiled units and scrap materials in the production process.
There fore, after completing this unit, you are expected to:
 identify the situation under which process costing is most appropriate.
 describe the five steps used in process costing to accumulate and assign costs to
units produced.
 compute equivalent units of production.
 prepare journal entries for process costing.
 explain weighted average method of process costing system.
 explain the first in first out method of process costing system.
 explain the treatment of transferred in costing system.
 explain the treatment of spoiled units and scrape materials in process costing.

Introduction
Dear learners, you are now at the fifth unit of the course. This unit is subdivided in to five
sub units. The first sub unit deals with the similarities and difference between process and
job order costing systems. In the second sub unit, you will find illustrations on process
costing under three different cases. This sub unit also illustrates the application of the two
inventory costing methods in process costing. The third sub unit deals with transferred in
costs. When there are multiple departments that are arranged sequentially, the cost
accumulated in one department will pass along with the unit to the next department in the
production line. Costs of the preceding department are said to be transferred in costs.
The fourth sub unit deals with process costing when there are spoiled units. The treatment
of scrap materials and reworked units under process costing will also be discussed in this
subunit. The last subunit is about the treatment of spoilage, rework and scraps under job
order costing system.

5.1Similarities and Difference between Process and Job order Costing

80
 Pretest
Dear learner, what distinguish process costing form job order costing?

As discussed in the previous unit, the production process influences the choices of cost
accounting system. Firms producing distinct and unique products use job order costing
system where as firms producing similar or identical units use process-costing system.
Process costing system accumulate costs by departments for a period of time, just as a job
order costing system accumulate costs by jobs, and the total cost will be assigned to the
units produced in that period.

Process costing system is product costing system which is applied when identical units
are produced in mass. Identical units are assumed to take the same amount of direct
material, direct labor & manufacturing overhead. These costs are accumulated over a
period of time and the total cost is assigned to units produced in the period the cost is
accumulated
In process costing system, each unit is assumed to take equal amount of direct material,
direct labor and manufacturing overhead. The difference between job order and process
costing system is, thus, the extent of the averaging used to compute unit cost. In job order
costing each job differs in terms of material used, labor incurred, and manufacturing
overhead. Hence, it is impossible to assign the same cost for different jobs. On the
contrary, identical units produced in mass take equal amount of direct material, direct
labor, and manufacturing overhead. Thus, the unit cost can be found by dividing total
cost by the number of units produced.

When a firm produces identical lots of goods repetitively, maintaining a separate job cost
sheet would be unnecessarily expensive. The aggregate cost and the unit cost can be
computed with out a job cost sheet, thus saving the cost associated with producing such
records. Costs are accumulated by departments over a certain period and the unit cost can
be found by dividing the total cost to the units produced during that period. Process
costing system fit among others to, paint manufacturers; oil refineries, sugar refineries,
and salt producers.

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 The difference between job order and process costing arise from two factors. The first is
that, the flow of units in process costing system is more or less continuous, and the
second is that these units are indistinguishable from one another. Under process costing,
it makes no sense to try to identify material, labor and overhead costs with a particular
order from customers as we did in job order costing system, since each order is just one
of the many that are filled from a continuous flow of virtually identical units from the
production line. Under process costing, we accumulate costs by department, rather than
by order, and assign these costs equally to all units that pass through the department
during the period.

A further difference between the two costing system is that the job order cost sheet has no
use in process costing, since the focal point of that method is on department. Instead of
using job order cost sheets, a document known as cost of production report is prepared
for each department in which work is done on products. The production report serves
several functions. It provides a summary of the number of units moving through a
department during a period, and it also provides a computation of unit costs. In addition,
it shows what costs were charged to the department and what disposition was made of
these costs. The department production report is a key document in process costing
system. The major difference between job order and process costing systems is
summarized in the table below.

Base of comparison Job order costing Process costing

Type of product Diversified, heterogeneous and Homogeneous products produced
unique products continuously
Cost accumulation By job for a specified number By department or cost center for a
of units specified period of time
Work in process One for each job One for each department
Basic document Job cost sheet for each job Cost of production report for each
department or cost centers
Cost per unit Cost accumulated by job Cost accumulated by cost centers
divided by units in job divided by equivalent unit of
production during a period of time
Reporting By job By cost center or department
Nature of costs for Each job may use different Each units produced uses the same

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each cost object amount of material, labor and slandered amount of materials, labor
overhead cost and overhead cost

It is important to recognize that much of what was learned in the preceding unit about
costing and about cost flows equally applies well to process costing in this chapter. That
is, we are not throwing out all that we have learned about costing and starting from
scratch with a whole new system. The similarities that exist between job orders costing
and process costing can be summarized as follows:

 The same basic purposes exist in both systems, which are to assign material,
Labor, and overhead cost to products and to provide a mechanism for computing
unit cost.
 Both systems maintain and use the same basic manufacturing account including
manufacturing overhead, raw material, work in process and finished goods.
 The flow of costs through the manufacturing accounts is basically the same in
both systems. As can be seen from these comparisons, much of the knowledge
that we have already acquired about costing is applicable to process costing
system. our task is simply to refine and extend this knowledge to process costing

In process costing system, direct material, labor, and manufacturing overhead costs are
accumulated in the same way as job order costing system. However, the costs are
accumulated by department over some period of time than by individual jobs. The time
period over which the cost is to be accumulated depends on the information needs of the
company. It can be a week, two weeks, but no longer than a month most often. Cost
accumulation is much simpler in process costing system than in job order costing.

Hybrid Costing System: Product-costing systems must often be designed to fit the
particular characteristics of different production systems. Many production systems are a
hybrid- they have some features of customer-order manufacturing and other features of
mass-production manufacturing. Manufacturers of relatively wide variety of closely
related standardized products (for example televisions, dishwashers and washing
machines) tend to use a hybrid-costing system. A hybrid-costing system blends

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characteristics from both job-costing and process costing systems. Job-costing and
process-costing systems are best viewed as the ends of a continuum.
Activity 5.1
1. Explain the difference between job order and process costing systems?
2. How is cost accumulated and assigned in process costing system?

5.2 Process Costing System – Different Cases

Pretest
Dear learner, how do we prepare cost of production report in process costing
system?
A processing department is any location in organizations where work is performed on a
product and where materials, labor or overhead costs are added to the product. For
example, a potato chip factory might have three processing department-one for preparing
potatoes, one for cooking, and one for inspecting and packaging. A company can have as
many or as few processing departments as are needed to complete a product or service.
Some products and service may go through several processing departments, while others
may go through only one or two. Regardless of the number of departments involved, all
processing departments have essential features. First, the activity performed in the
processing department must be performed uniformly on all of the units passing through it,
second; the output of the processing department must be homogenous. The discussion on
process costing will be clear when we use examples. Hence, we use the case of SNAP
computers to illustrate three cases under process costing.

Illustration 1: SNAP computers imports component parts of a computer and its

accessories from abroad and assemble computers here in Ethiopia. The components parts
are first assembled in the assembly department. Up on completion, units are transferred to
finishing department for testing, loading the different office software and packaging.
Since all computers assembled are the same, the company uses process costing system for
cost accumulation. The process costing system for the computer has two cost categories
(Direct material and Conversion cost). Each unit of computers passes through two
departments, the assembly department and Finishing department. Every effort is made to

84
ensure that all computers are identical and meet assets of demanding performance
specification. Direct material is added at the beginning of the process in assembly
department. Additional direct material is added at the end of the process in finishing
department when each computer is completed. Conversion cost is added evenly during
both processes. When the finishing department finishes work on each computer, it is
immediately transferred to finished goods and taken to warehouse until it is sold. The
following diagram presents these facts.
Conversion cost added
evenly during the process
Assembly Finishing
Department Transfer Department

Direct material
added at the beginning

Process costing system separates costs in two categories according to when costs are
introduced in to the process. Often, as in our SNAP computer example, only two cost
classifications, direct material and conversion costs are necessary to assign costs to
products. Because all direct materials are added to the process at one time and all
conversion costs are generally added to the process evenly through time. If, how ever
two different direct materials were added to the process at different times, two
different direct material cost categories would be needed to assign these costs to
products. Similarly, if manufacturing labor costs were added to the process at a
different time than when the other conversion costs were added, an additional cost
category-direct manufacturing cost - would be needed to separately assign these costs
to products. We will use the assembling of each computer in the assembly department
to illustrate three cases, starting with the simplest case and introducing additional
complexities in subsequent cases.

Case 1: Process Costing with No Beginning or Ending Work In Process

Inventory. That is, all units are started and fully completed by the end of the
accounting period. This case illustrates the basic averaging of cost data, which is a

85
 key feature of process costing. On January 1, 2008, there were no beginnings WIP of
computers in the assembly department. During January 2008, SNAP computers
started and completed assembly of computers and transferred out to finishing
department 400 units. Additional information for assembly department is given
below:
Physical unit for January, 2008:
 WIP beginning------------- 0 unit
 Started during January ------- 400 unit
 Completed and transferred --- 400 unit
 WIP ending ------------------ 0 unit
Total cost for January, 2008:
 DM cost added during January --Br. 640,000
 Conversion cost added -------------- 480,000
 Total assembly department cost -Br.1,120,000
SNAP computer should record direct materials and conversions in the assembly
department as these costs are incurred as follows:

Work In process – Assembly 640,000

Raw material control 640,000
(To record the use of direct materials in the production process)

Work In process – Assembly 480,000

Various accounts 480,000
(To record the use of conversion costs in the production process)
In the above journal entry, various accounts consists of many accounts that can be
credited when conversion cost is incurred such as cash, accounts payable, accumulated
depreciation, prepaid insurance etc. In this case, average cost can be calculated easily by
dividing the total cost incurred to units assembled and completed in the assembly
department as follows

Average cost = Total cost = Br.640, 000 + Br.480, 000

Total units completed 400 units

= Br 2,800

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When the 400 units completed in assembly department are transferred to the finishing
department, the following journal entries will be recorded:
Work In process – Finishing 1,120,000
Work In process- Assembly 1,120,000

In the real manufacturing process, the above case is a very simplified case, because,
usually all units started in a given period will not be completed and transferred to the next
department. There might be some units which are started but not completed. That is, there
might be some ending work in process. This leads us to the 2nd case of process costing.

Case 2: Process costing with Zero Beginning but Some Ending WIP inventory
Assume that in February, 2008, SNAP computer place another 400 unit in to the
assembly process. Because all units placed in production in January were completely
assembled, there is no beginning WIP on February 1. Because of different reasons, not all
units started in February were completed by the end of the month. Only 175 units are
completed and transferred to the finishing department. Data for the assembly department
for the month of February 2008 are:
 Physical unit for february2008:
 WIP beginning(February 1) ------------------ 0 unit
 Units Started during February --------------- 400 unit
 Completed and transferred out ------------- 175 unit
 WIP ending ( February 29) ---------------- 225 unit
 Direct material (100% complete)
 Conversion cost (60% complete)
 Total cost for February:
 DM cost added during February ------------Br.640,000
 CC cost added during February -------------- 372,000
 Total assembly department cost------------Br.1,012,000

The 225 partially assembled units as of February 29, 2008, are fully processed with
respect to direct materials. This is because; all direct materials in the assembly
department are added at the beginning of the assembly process. Conversion costs
however are added evenly during assembly process. Based on work completed relative to
the total work required to complete each computer units still in process at the end of

87
February, an assembly department supervisor estimates that the partially assembled units
are on average 60% complete with respect to conversion costs.

The accuracy of the completion estimates of conversion costs depends on the care, skill
and experience of the estimator and the nature of conversion process. Estimating
conversion is usually easier for direct material cost than for conversion costs. That is
because, the quantity of direct material needed for completed units and the quantity of
direct materials in partially completed units can be measured more accurately. In contrast,
the conversion cost sequence usually consists of a number of basic operations specified
for a specified number of hours, days, or weeks for various steps in the production
process. The point to understand here is that, a partially assembled unit is not the same as
fully assembled unit, faced with some fully assembled units and some partially assembled
units, SNAP Computers calculates in five steps:
1. the cost of fully assembled units and
2. the cost of partially assembled units still in process at the end of that month

Step 1: Summarize the Flow of Physical Units

Physical unit’s express the physical flow of production. It is a measure of the units of
production that have been started and that may or may not be completed. The physical
units’ summary, tracks where the physical units came from and where they went. It does
not consider the degree of completion. The physical flow can be summarized as shown in
the schedule below:
Physical flow
Beginning WIP -------------------------XX
Units started ----------------------------- XX
Units to account for------------------ XX
Units completed ------------------------ XX
Ending WIP-------------------------------XX
Units accounted for ------------------ -- XX

Step 2: Compute Output in Terms of Equivalent Units (EU)

Equivalent units measure out put in terms of the physical quantity of each of the input
(factor of production) that has been consumed when producing the units. Equivalent

88
units are computed using physical units. It disregard birr amount. Equivalent unit of
each major category of production inputs is calculated using the following formula:

Equivalent unit = Physical unit x Percentage of completion

For instance, the 225 partially assembled units in the above case are 100% complete
with respect to direct material. This means that the equivalent units in terms of direct
material are 225 units. but with respect to conversion cost, they are 60% complete,
which means, the 225 partially completed units are equivalent to 135 fully completed
units (225x60%= 135 units)

Step 3: Compute Equivalent Unite Cost

After computing equivalent units of partially completed units in terms of each cost
category, cost per equivalent unit can be computed using the following formula. This
cost per equivalent unit can be used to assign total cost incurred in the period to units
completed and units in work in process ending.
Cost per EU = Production cost
Equivalent units
Step 4: Summarize Total Cost to Account For
In this step, we add up all costs incurred in the period. For SNAP computer, the cost
to account for the month of February, 2008 is Br. 1,012,000 (Br.640, 000 + Br.
372,000 = Br. 1,012,000)

Step 5: Assign Total Cost to Units Completed and Units in Ending WIP
In this step, we assign the total cost to account for to units completed and transferred
out and to units in ending working process at the end of the month. The idea is to
attach the Birr amounts to the equivalent output units for direct material and
conversion costs of units completed and ending working process. Equivalent output
units for each inputs are multiplied by cost per equivalent unit both for units
completed and ending work in process. After costs have been assigned to units
completed and units in work in process ending, the total cost assigned should agree
with the amount we have to account for. The following cost of production report for

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 SNAP computer summarizes the five steps discussed above for the month of
February, 2008.

(Step 1)
Flow of production Physical flow
Work in process beginning 0 (Step 2)
Units started in current period 400 Equivalent Units
Direct Conversion
Units to account for 400 Materials Costs
Units completed and transferred out 175 175 175
Work in process ending 225 225 135
Units accounted for 400
Work done in current period only
(Equivalent units) 400 310
(Step 3): Cost Summary
Costs added during February Br. 1,012,000 Br 640,000 Br 372,000
Divide by equivalent units ÷ 400 ÷ 310
Cost per equivalent units Br. 1,600 Br. 1,200
(Step 4):
Total cost to account for Br. 1,012,000
(Step 5) Assignment of cost:
To completed and transferred units
(175 units) Br. 490,000 Br. 1,600×175 + Br. 1,200×175
To work in process ending (225 units) 522,000 Br. 1,600×225 + Br. 1,200×135
Total cost accounted for Br. 1,012,000

The cost of production per unit for the month of February is the sum of the cost per
equivalent unit for both direct material and conversion cost which is Br. 2,800 (Br. 1600
+ Br. 1200). The journal entries for SNAP computer for the month of February, 2008 are
given below:
Work In process – Assembly 640,000
Raw material control 640,000
(To record the use of direct materials in the production process)

Work In process – Assembly 372,000

Various accounts 372,000
(To record the use of conversion costs in the production process)

Work In process – Finishing 490,000

Work in process - Assembly 490,000
(To record the transfer of completed products from assembly department to finishing)

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Case 3: Process costing with some beginning and some ending work in process
inventory. In a production process, in addition to work in process ending, their might be
some work in process available at the beginning of the period. When this is the case, the
five steps in the preparation of cost of production report involve two additional inventory
costing systems (Weighted Average and FIFO methods).

Weighted Average Method: The weighted average process costing method calculates
cost per equivalent unit of all work done to date( regardless of the accounting 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 (whether they
are from beginning work in process or from work started during the current period)
divided by the total equivalent units of work done to date.

Illustration 3: At the beginning of March, 2008, SNAP computers had 225 units of
partially assembled computers in the assembly department. It started production of
another 275 units in March, 2008; data for assembly department for the month of March
are:
Physical units for March 2008
 WIP beginning------------------------------------ 225 unit
Direct material (100% complete)
Conversion cost (60% complete)
 Started during March ---------------------------- 275 unit
 Completed and transferred out -------------------- 400 unit
 WIP ending ----------------------------------------- 100 units
Direct material (100% complete)
Conversion cost (50% complete)
Total cost for March:
WIP beginning:
DM -------------------------Br.360, 000
CC-------------------------- 162,000 - Br.522, 000
DM added during March ---------------------------- 396,000
CC added during March ------------------------------ 327,600
Total cost to account for --------------------------Br.1, 245,600

The cost of production report for Assembly department for the month of March using the
five steps is presented below under weighted Average method.

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 (Step 1)
Flow of production Physical flow
Work in process beginning 225 (Step 2)
Units started in current period 275 Equivalent Units
Direct Conversion
Units to account for 500 materials costs
Units completed and transferred out 400 400 400
Work in process ending 100 100 50
Units accounted for 500
Work done to date (Equivalent units) 500 450
(Step 3) ; Cost summary
Work in process beginning Br. 522, 000 Br. 360, 000 Br. 162,000
Costs added during February 723,600 396,000 327,600
Total cost incurred to date Br. 756,000 Br. 489,600
Divide by equivalent units ÷ 500 ÷ 450
Cost per equivalent units Br 1,512 Br 1,088
(Step 4)
Total cost to account for Br. 1,245,600
(Step 5) Assignment of cost:
To completed and transferred units
(400 units) Br. 1,040,000 Br. 1,512×400 + Br. 1,088×400
To work in process ending (100units) 205,600 Br. 1,512×100 + Br. 1,088×50
Total cost accounted for Br. 1,245,600

In the equivalent unit column of work done to date, there are 500 equivalent units of
direct materials and 450 units of conversion costs. All completed and transferred out units
are 100% complete as to both direct material and conversion cost because direct material
is added at the beginning of the assembly process and they are 100% complete with
respect to conversion cost. But units in WIP ending are 50% complete as to conversion
cost, hence the equivalent unit of WIP ending are 50 units (100x50%) with respect to
conversion cost. In step 3, the cost per equivalent unit is calculated by merging together
the cost of beginning inventory and the manufacturing cost of the period and dividing by
equivalent units of work done to date. The journal entry to recognize the consumption of
raw material, conversion cost and transfer of assembled computers from assembling to
finishing department using weighted average costing method is given below:
Work In process – Assembly 396,000
Raw material control 396,000
(To record the use of direct materials in the production process)
Work In process – Assembly 327,600
Various accounts 327,600
(To record the use of conversion cost in the production process)

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 Work In process – Finishing 1,040,000
Work in process - Assembly 1,040,000
(To record the transfer of completed products from assembly department to finishing
department)

2. First In First Out (FIFO) Method: the first in first out process costing method
assigns the cost of the previous accounting period’s equivalent units in beginning work in
process inventory to the first units completed and transferred out of the process and
assigns the cost of equivalent units worked on during the current period first to completed
beginning inventory, next to started and completed new units, and finally to units in
ending work in process inventory. The FIFO method assumes that the earliest equivalent
units in work in process are completed first. A distinctive feature of the FIFO process
costing method is the work done on beginning inventory before the current period is kept
separate from work done in the current period. Costs incurred and units produced in the
current period are used to calculate cost per equivalent units of work done in the current
period. In contrast, equivalent unit and cost per equivalent unit calculation under the
weighted average method merges units and costs in beginning inventory with units and
costs of work done in the current period. For SNAP computers, Under the FIFO method,
equivalent units of work done in March on the beginning work in process inventory
equals 225 physical units times the percentage of work remaining to be done in march to
complete these units: 0% for direct materials, because beginning work in process is 100%
complete with respect to directs material last month and 40% (100%- 60%) for
conversion costs, because beginning work in process is 60% complete with respect to
conversion costs last month. The results are 0(0%×225) equivalent units of work for direct
materials and 90(40%×225) equivalent units of work for conversion cost . The following
is the cost of production report under FIFO method.

(Step 1)
Flow of production Physical flow
Work in process beginning 225 (Step 2)
Units started in current period 275 Equivalent Units
Direct Conversion
Units to account for 500 Materials Costs
Units completed and transferred out:

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 From beginning work in process 225 0 90
Started and completed 175 175 175
Work in process ending 100 100 50
Units accounted for 500
Work done in current period only 275 315
(Step 3): Cost summary
Work in process beginning Br. 522, 000 Incurred Last Month
Costs added during March 723,600 Br. 396,000 Br. 327,600
Divide by equivalent units ÷ 275 ÷ 315
Cost per equivalent units Br. 1,440 Br. 1,040
(Step 4)
Total cost to account for Br. 1,245,600
(Step 5) Assignment of cost:
To completed units (400 units)
Work In process beginning (225 units) Br. 522, 000 -------------------------------------
Cost added to beginning WIP in the
current month 93600 0×Br. 1,440 + 90×Br. 1,040
Total from beginning Inventory Br. 615,600
Started and completed 434000 175×Br. 1,440 + 175×Br. 1,040
Total cost of units completed Br. 1,049,600
To work in process ending (100units) 196,000 Br. 1,440×100 + Br. 1,040×50
Total cost accounted for Br. 1,245,600

The equivalent unit of work done on the 175 physical unit started and completed equals
175 units times 100% for both direct material and conversion cost, because all works on
these units is done in the current period. The equivalent units of work done on the 100
units of ending work in process equals 100 physical units times 100% for direct
materials(because all direct materials for these units are added in the current period) and
50% for conversion costs because only 50% of conversion cost work on these units is
done in the current period.

Computation of cost per equivalent units for work done in the current period is only
based on direct material and conversion costs of the current period. Under FIFO method,
cost of work done in the current period is assigned, First to the additional work done to
complete the beginning work in process, then to work done on units started and
completed during the current period, and finally to ending work in process. The journal
entry to recognize the consumption of raw material, conversion cost and transfer of
assembled computers from assembling to finishing department using FIFO costing
method is given below

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 Work In process – Assembly 396,000
Raw material control 396,000
(To record the use of direct materials in the production process)
Work In process – Assembly 327,600
Various accounts 327,600
To record the use of conversion cost in the production process)
Work In process – Finishing 1,049,000
Work in process - Assembly 1,049,000
(To record the transfer of completed products from assembly department to finishing
department)

Managers use information from process costing system to aid them in pricing and product
mix decision and to provide them with feedback about their performance. The weighted
average method merges units’ costs from different accounting periods obscuring period
to period comparison. Advantages of the weighted method however, are its relative
computational simplicity and its reporting of a more-representative average unit cost
when inputs prices fluctuate markedly from month to month. FIFO provides managers
with information about changes in cost per unit from one period to the next. Managers
can use this information to adjust selling price and evaluate performance in the current
period. By focusing on work done and cost of work done during the current period, the
FIFO method provides useful information for planning and control purpose.
Activity 5.2
1. What are the five steps used to prepare cost of production report under process
costing systems?
2. Why and when do we apply the two inventory costing method in process costing
system?

5.3 Transferred in Cost

Pretest
Up to now, we have seen how to prepare cost of production report for the first
department in SNAP computer, how do we accumulate cost in the second
department?

Many process-costing systems have two or more departments or processes in the

production cycle. As units move from department to department, the related cost is also
transferred by monthly journal entries. If standard costs are used, accounting for such

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transfers is simple. However, if the weighted-average or FIFO method is used, the
accounting can become more complex. We now extend our SNAP computer example to
the finishing department. As the assembly process is completed, the assembly department
of SNAP computer immediately transfers each unit to its finishing department. Here,
each unit will be loaded with appropriate office and application soft wares and the units
receive additional direct material such as crating and other packing materials at the end of
the process, to prepare the units for shipment. Conversion cost is added evenly during the
finishing department’s process. As units are completed in finishing department, they are
immediately transferred to finished goods and taken to warehouse. The following
diagram shows this fact diagrammatically.
Conversion cost added
evenly during the process

WIP
Assembly Finishing
Department Transfer Department

Direct material
added at the end
Transferred-in costs (also called previous departments’ cost) are the cost incurred in the
previous process in the production cycle. That is, as the units move from one department
to the next, their costs are transferred with them. Computations of finishing department
costs consist of transferred-in costs as well as the direct materials and conversion costs
added in finishing department. Transferred-in cost is treated as if it is a separate type of
direct material added at the beginning of the process. When successive departments are
involved, transferred units from one department become all or part of the direct materials
of the next department; however, they are called transferred-in costs not direct materials
costs.
Transferred-In costs and the Weighted-Average Method
To examine the weighted-average process-costing method with transferred-in costs, we
use the five-step procedure described earlier to assign costs of the finishing department to
units completed and transferred out and to units in ending work in process. Let us assume
the following data for SNAP computer for the month of April, 2008.

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Illustration 4: The assembly department of SNAP computer transfers assembled units to
its finishing department. Here, the units receive additional direct material such as crating
and other packing material to prepare the units for sell at the end of the process.
Conversion costs are added evenly during the process. As units are completed in finishing
department, they are immediately transferred to finished goods.
Physical units
WIP beginning ----------------------------- 240 units
Transferred in Cost (100% complete)
Direct material (0% complete)
Conversion cost (62.5% complete)
Transferred in during April -------------- 400 unit
Completed during April ------------------------- 440 unit
WIP ending ---------------------------------------200 units
Transferred in Cost (100% complete)
Direct material (0% complete)
Conversion cost (80% complete
Cost for finishing department in April:
WIP beginning
Transferred In cost --------------------------Br.672, 000
Direct materials ---------------------------------- 0
Conversion cost ---------------------------- 360,000
Transferred in during April:
Under WA method -------------------------------Br.1, 040,000
Under FIFO method ----------------------------- 1, 049,600
Direct material cost added during April --------- -- -- 13,200
Conversion cost during April ----------------------- --- 48,600

The production report for the month of April for finishing department can be prepared
under weighted average method as follow:

(Step 1)
Physical
Flow of production flow
Work in process beginning 240 (Step 2)
Units started in current period 400 Equivalent Units
Transferred in Direct Conversion
Units to account for 640 cost material costs
Units completed and transferred
out: 440 440 440 440
Work in process ending 200 200 0 160
Units accounted for 640 - - -
Work done in current period only 640 440 600
(Step 3): Cost summary
Work in process beginning Br. 1,032,000 Br. 672,000 0 Br. 360,000
Costs added during March 1,101,800 1, 040,000 13,200 48,600

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 Total cost Br. 1,712,000 Br. 13,200 408,600
Divide by equivalent units ÷ 640 ÷ 440 ÷ 600
Cost per equivalent units Br. 2,675 Br. 30 Br. 681
(Step 4)
Total cost to account for Br.2,133,800
(Step 5) Assignment of cost:
To completed units (440 units) Br.1,489,840 (440×2,675) + (440×30) + (440×681)
To work in process ending (200
units) 643,960 (200×2675) + (0×30) + (160×681)
Total cost accounted for Br. 2,133,800

The computations are the same as the calculations of equivalent units under the weighted-
average method for the assembly department, but here we also have transferred-in costs
as another input. The units, of course are fully completed as to transferred-in costs carried
forward from the previous process. Direct material costs have a zero degree of
completion in both the beginning and ending work-in process inventories because, in
finishing department direct materials are introduced at the end of the process. Beginning
work in process and work done in the current period are combined for purposes of
computing equivalent-unit costs for transferred-in costs, direct material costs and
conversion costs. The necessary journal entries for the month of April in the finishing
department are given as follows:
Work In process – Finishing 13,200
Raw material control 13,200
(To record the use of direct materials in the production process)
Work In process – Finishing 48,600
Various accounts 48,600
To record the use of conversion cost in the production process)
Finished Goods 1,489,840
Work in process - Assembly 1,489,840
(To record the transfer of completed products from finishing department to warehouse)

2. Transferred-In Costs and the FIFO Method:

The cost of production report for finishing department for the month of April can be
prepared using FIFO method as follows:

(Step 1)
Physical
Flow of production flow
Work in process beginning 240 (Step 2)
Units started in current period 400 Equivalent Units

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 Transferred in Direct Conversio
Units to account for 640 cost material n costs
Units completed
From WIP Beginning 240 0 240 90
Started and completed 200 200 200 200
WIP Ending 200 200 0 160
Units accounted for 640 - - -
Work done in current period only 400 440 450
(Step 3): Cost summary
Work in process beginning Br. 1,032,000 Incurred last month
Costs added during March 1,111,400 Br. 1, 049,600 Br. 13,200 48,600
Divide by equivalent units ÷ 400 ÷ 440 ÷ 450
Cost per equivalent units Br. 2,624 Br. 30 Br. 108
(Step 4)
Total cost to account for 2,143,400
(Step 5) Assignment of cost:
To completed units (440 units)
From WIP Beginning (240 units) Br.1,032,000
Cost added to WIP Beginning 16,920 (0×2,624) + (240×30) + (90×108)
Total from beginning Inventory Br. 1,048,920
Started and completed 552,400 (200×2,624)+(200×30)+ (200×108)
Total cost of units completed Br. 1,601,320
To WIP ending (200 units) 542,080 (200×2,624) + (0×30) + (160×108)
Total cost accounted for Br.2,143,400
To examine the FIFO process-costing method with transferred-in costs, we again use the
five step procedure. Other than considering transferred-in costs in the computations of
equivalent units, the remaining are the same as under the weighted average method for
the assembly department. The necessary journal entries for the month of April in the
finishing department are given as follows:
Work In process – Finishing 13,200
Raw material control 13,200
(To record the use of direct materials in the production process)
Work In process – Finishing 48,600
Various accounts 48,600
To record the use of conversion cost in the production process)
Finished Goods 1,601,320
Work in process - Assembly 1,601,320
(To record the transfer of completed products from finishing department to warehouse)

Activity 5.3
What are transferred in costs? How are they entered in cost of production
report?
5.4 Process Costing System and Spoilage

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 Pretest
Up to now we have assumed as if there are no spoiled units in the production
process, what if there are spoiled products in the production process?

Spoilage is units of production – whether fully or partially completed – that do not meet
the specifications required by customers for good units and that are discarded or sold at
reduced price. Some examples of spoilage are defective shirts, jeans, shoes, and
carpeting sold as “second hand,” or defective aluminum cans sold to aluminum
manufacturers for remolding to produce other aluminum products. Accounting for
spoilage aims to determine the magnitude of spoilage costs and to distinguish between
costs of normal and abnormal spoilage
Normal spoilage is spoilage inherent in a particular production process that arises even
under efficient operating conditions. Management decides the spoilage rate it considers
normal depending on the production process. Costs of normal spoilage are typically
included as a component of the costs of good units manufactured because good units
cannot be made without also making some units that are spoiled.

Abnormal spoilage is spoilage that is not inherent in a particular production process and
would not arise under efficient operating conditions. Abnormal spoilage is usually
regarded as avoidable and controllable. Line operators and other plant personnel
generally can decrease or eliminate abnormal spoilage by identifying the reasons for
machine breakdowns, operator errors, and the like, and by taking steps to prevent their
recurrence. To highlight the effect of abnormal spoilage costs, companies calculate the
units of abnormal spoilage and record the cost in the loss from abnormal spoilage
account, which appears as a separate line time in the income statement. Issues about
accounting for spoilage arise in both process – costing and job – costing systems. We
first present the accounting for spoilage in process – costing systems using illustrative
example
Illustration 5: ABC Company manufactures a recycling container in its forming
department. Direct materials are added at the beginning of the production process. Some
units of this product are spoiled as a result of defects, which are detectable only upon

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 inspection of finished units. Normally, spoiled units are 10% of the finished output of
good units. That is, for every 10 good units produced, there is 1 unit of normal spoilage.
Summary data for July 2009 are:

Physical Direct Conversion Total

Units (1) Materials Costs (3) Costs
Work in process, beginning inventory (July 1) 1,500 Br.12,000 Br.9,000 Br.21,000
Degree of completion of beginning work in process 100% 60%
Started during July 8,500
Good units completed and transferred out in July 7,000
Work in process, ending inventory (July 31) 2,000
Degree of completion of ending work in process 100% 50%
Total costs added during July Br.76,500 Br.89,100 Br.165,600
Normal spoilage as a percentage of good units 10%
Degree of completion of normal spoilage 100% 100%
Degree of completion of abnormal spoilage 100% 100%
The five – step procedure for process costing used in the pervious sub section need only
slight modification to accommodate spoilage.
Step 1: Summarize the flow of Physical units of Output. Identify units of both normal
and abnormal spoilage.
Total spoilage = (WIP Beginning + Units started) _ (Good units completed + WIP End)
= (1,500 + 8,500) – (7, 000 + 2,000)
= 10,000 – 9,000
= 1,000 units
Recall that normal spoilage is 10% of good output at ABC Corporation. Therefore,
normal spoilage = 10% of the 7,000 units of good output = 700 units.
Abnormal Spoilage = Total spoilage – Normal spoilage
= 1,000 units – 700 units
= 300 units
Step 2: Compute output in terms of equivalent units. Compute equivalent unit for
spoilage in the same way we compute equivalent units for good units. All spoiled units
are included in the computation of output units. Because ABC’s inspection point is at the

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completion of production, the same amount of work will have been done on each spoiled
and each completed good unit.

Step 3: Compute cost per Equivalent unit.

Step 4: Summarize Total costs to Account for. The total costs to account for are all the
costs debited to work in process.
Step 5: Assign total Costs to units Completed, to Spoiled Units, and to units in ending
work in process. This step now includes computation of the cost of spoiled units and the
cost of good units. We will illustrate these five steps of process costing for the weighted
– average and FIFO methods using the example of ABC corporation.

1. Weighted – Average Method and Spoilage

(Step 1)
Flow of production Physical flow
Work in process beginning 1,500 (Step 2)
Units started in current period 8,500 Equivalent Units
Direct Conversion
Units to account for 10,000 materials costs
Good units completed 7,000 7000 7000
Normal spoilage 700 700 700
Abnormal spoilage 300 300 300
Work in process ending 2,000 2,000 1,000
Units accounted for 10,000
Work done to date (Equivalent units) 10,000 10,000
(Step 3) ; Cost summary
Work in process beginning Br.21,000 Br.12,000 Br. 9,000
Costs added during February 165,600 76,500 89,100
Total cost incurred to date Br.88,500 Br.98,100
Divide by equivalent units ÷ 10,000 ÷ 9,000
Cost per equivalent units Br. 8.85 Br. 10.90
(Step 4)
Total cost to account for Br. 186,600
(Step 5) Assignment of cost:
To Good units completed (7000 units) Br. 138,250 Br 8.85×7000 + Br 10.90×7000
Normal spoilage 13,825 Br 8.85×700 + Br 10.90×700

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Total cost of good units Br. 152,075
Abnormal spoilage 5,925 Br 8.85×300 + Br 10.90×300
To work in process ending (2000 units) 28,600 Br 8.85×2000 + Br 10.90×1000
Total cost accounted for Br. 186,600

The journal entry to be recorded are given below:

Work In process – Forming 76,500
Raw material control 76,500
(To record the use of direct materials in the production process)
Work In process – Forming 89,100
Various accounts 89,100
To record the use of conversion cost in the production process)
Finished Goods 152,075
Work in process - forming 152,075
(To record the transfer of completed products from finishing
department to warehouse)
Loss from abnormal spoilage 5,925
Work in process - forming 5,925
(To record the loss from abnormal spoilage)

2. FIFO Method & Spoilage

(Step 1)
Flow of production Physical flow
Work in process beginning 1,500 (Step 2)
Units started in current period 8,500 Equivalent Units
Direct Conversion
Units to account for 10,000 materials costs
Good units completed :
From WIP Beg. 1,500 0 600
Started and completed 5,500 5,500 5,500
Normal spoilage 700 700 700
Abnormal spoilage 300 300 300
Work in process ending 2,000 2,000 1,000
Units accounted for 10,000
Work done in the current period 8,500 8,100
(Step 3) ; Cost summary
Work in process beginning Br.21,000 ----------------- --------------------
Costs added during February 165,600 76,500 89,100
Divide by equivalent units ÷ 8,500 ÷ 8,100
Cost per equivalent units Br. 9 Br. 11
(Step 4)
Total cost to account for Br.186,600
(Step 5) Assignment of cost:
Good units completed (7000 units)
WIP Beginning (1,500 units) 21,000

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 Cost added during the period 6,600 Br. 9×0+ Br. 11×600
Total from beginning inventory 27,600
Started and completed (5,500 units) 110,000 Br. 9×5,500+ Br. 11×5,500
Normal spoilage (700 units) 14,000 Br. 9×700+ Br. 11×700
Total cost of good units completed Br.151,600
Abnormal spoilage 6,000 Br. 9×300 + Br. 11×300
To work in process ending (2000 units) 29,000 Br. 9×2000 + Br. 11×1000
Total cost accounted for Br.186,600

The journal entry for recording consumption of raw material and conversion cost is the
same as in the weighted average method but the remaining journal entries are slightly
different & are given as follows:
Finished Goods 151,160
Work in process - forming 151,160
(To record the transfer of completed products from finishing
department to warehouse)

Loss from abnormal spoilage 6,000

Work in process - forming 6,000
(To record the loss from abnormal spoilage)

Note that Costs of abnormal spoilage are separately accounted for as losses of the
accounting period in which they are detected. However, the cost of normal spoilage is
added to the costs of good units completed in the period.
Activity 5.4
1. What is the difference between normal and abnormal spoilage
2. How do we treat normal and abnormal spoilage in process costing system?

5.5 Job Costing System and Spoilage, Rework & Scrap

Pretest
Dear learner, how do we treat spoilage, rework and scraps in job order costing
system?
The concepts of normal and abnormal spoilage can also apply to job order costing
systems. Abnormal spoilage is separately identified so companies can work to eliminate
it altogether. Costs of abnormal spoilage are not considered to be inventorable cost and
are written of as costs of the accounting period in which the abnormal spoilage is

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detected. Normal spoilage costs in job – costing systems – as in process – costing
systems – are inventorable costs, although increasingly companies are tolerating only
small amounts of spoilage as normal. When assigning costs, job costing systems
generally distinguish normal spoilage attributable to a specific job from normal spoilage
common to all jobs. We describe accounting for spoilage in job costing using the
following example.
Illustration 5.5: In the BOING Machine Shop, 5 aircraft parts out of a job lot of 50
aircraft parts are spoiled. Costs assigned prior to the inspection point are Br. 2, 000 per
part. Our presentation here and in subsequent sections focuses on how the Br. 2, 000 cost
per part is accounted for. When the spoilage is detected, the spoiled goods are
inventoried at Br. 600 per part which is the net disposal value.
Normal Spoilage attributable to a specific job: when normal spoilage occurs because
of the specifications of a particular job, that job bears the cost of the spoilage minus the
disposal value of the spoilage. The journal entry to recognize disposal value is:

Materials Control - spoiled goods (5  Br. 600) 3,000

Work-in-Process Control (specific job) 3,000
Note, the Work – in – process Control (specific job) has already been debited (charged)
Br.10, 000 for the spoiled parts (5 spoiled parts  Br.2, 000 per part). The net cost of
normal spoilage = Br. 7, 000 (Br.10, 000 - Br.3, 000), which is an additional cost of the
45(50 – 5) good units produced. Therefore, total cost of the 45 good units is Br.97, 000:
Br.90, 000 (45 units  Br.2, 000 per unit) incurred to produce the good units plus the
Br.7, 000 net cost of normal spoilage. Cost per good unit is Br.2, 155.56 (97,000  45
good units).
Normal spoilage common to all jobs: In some cases, spoilage may be considered a
normal characteristic of the production process. The spoilage inherent in production will
of course, occur when a specific job is being worked on. But the spoilage is not
attributable to, and hence is not charged directly to, the specific job. Instead, the spoilage
is allocated indirectly to the job as manufacturing overhead because the spoilage is
common to all jobs. The journal entry is:
Materials Control -spoiled goods (5 Br. 600) 3,000

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 MOH control - normal spoilage (Br.10, 000 - Br. 3, 000) 7,000
Work-in-Process control (specific job): 5 unit  Br.2, 000 10,000
When normal spoilage is common to all jobs, the budgeted manufacturing overhead rate
includes a provision for normal spoilage cost. Normal spoilage cost is spread, through
overhead allocation, over all jobs rather than allocated to a specific job.

Abnormal Spoilage: If the spoilage is abnormal, the net loss is charged to the loss from
abnormal spoilage account. Unlike normal spoilage costs, abnormal spoilage costs are
not included as a part of the cost of good units produced. Total cost of the 45 good units
is Br.90,000 (45 units  Br.2,000 per unit). Cost per good unit is Br.2,000 (Br.90,000 
45 good units).
Materials Control - spoiled goods (5  Br.600) 3,000
Loss from Abnormal Spoilage: (Br.10,000 - Br.3,000) 7,000
Work – in- process control (specific job): 5 units  Br.2,000 10,000
Job costing and Rework: Rework is units of production that are inspected, determined
to be unacceptable, repaired, and sold as acceptable finished goods. We again distinguish
(1) normal rework attributable to a specific job, (2) normal rework common to all jobs,
and (3) abnormal rework.
1. Normal Rework attributable to specific job: Consider the BOING Machine shop
data in illustration above; assume the five spoiled parts are reworked. The journal entry
for the Br.10,000 of total costs (the details of these costs are assumed) assigned to the
five spoiled units before considering rework costs is:
Work-in-Process Control (specific job) 10,000
Materials Control 4,000
Wages payable control 4,000
Manufacturing Overhead Allocated 2,000
2. Normal rework common to all jobs: When rework is normal and not attributable to a
specific job, the costs of rework are charged to manufacturing overhead and are spread,
through overhead allocation, over all jobs.
Manufacturing overhead control (rework costs) 10,000
Materials Control 4,000

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 Wage Payable Control 4,000
Manufacturing overhead allocated 2,000
3. Abnormal rework: If the rework is abnormal, it is recorded by charging abnormal
rework to a loss account.
Loss from Abnormal Rework 10,000
Materials Control 4,000
Wages Payable Control 4,000
Manufacturing Overhead Allocated 2,000
Accounting for rework in a process – costing system also requires abnormal rework to be
distinguished from normal rework. Process costing system accounts for abnormal rework
in the same way as job order costing. Accounting for normal rework follows the
accounting described for normal rework common to all jobs (units) because masses of
identical or similar units are being manufactured.
Accounting for Scrap: Scrap is residual material that results from manufacturing a
product; it has low total sales value compared with the total sales value of the product.
No distinction is made between normal and abnormal scrap because no cost is assigned to
scrap. The only distinction made is between scrap attributable to a specific job and scrap
common to all jobs.

When should the value of scrap be recognized in the accounting records – at the time
scrap is produced or at the time scrap is sold? How should revenues from scrap be
accounted for? To illustrate this, we extend the case of BOING machine shop. Assume
the manufacture of aircraft parts generates scrap and that the scrap from a job has a net
sales value of Br.900.

1. Recognizing Scrap at the Time of Its Sale

When the Birr amount of the scrap is immaterial, the simplest accounting is to record the
physical quantity of scrap returned to the storeroom and to regard scrap sales as a
separate line item in the income statement. In this case, the only journal entry is:
Sales of Scrap: Cash or Accounts Receivable 900
Scrap Revenues 900

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When the Birr amount of scrap is material and the scrap is sold quickly after it is
produced, the accounting depends on whether the scrap is attributable to a specific job or
is common to all jobs.

Scrap Attributable to a Specific Job: Job-costing systems sometimes trace scrap

revenues to the jobs that yielded the scrap. This method is used only when the tracing
can be done in an economically feasible way. For example, BOING Machine Shop and
its customers may reach an agreement that provides for charging specific jobs with all
rework or spoilage costs and then crediting these jobs with all scrap revenues that arise
from the jobs. The journal entry is:
Scrap returned to storeroom: No journal entry.
Sale of scrap: Cash or Accounts Receivable 900
Work-in-Process Control 900
Unlike spoilage and rework, there is not cost assigned to the scrap, so no distinction is
made between normal and abnormal scrap. All scrap revenues, whatever the amount, are
credited to the specific job. Scrap revenues reduce the costs of the job. The journal entry
for Scrap common to all jobs is given as follows
Scrap returned to storeroom: No journal entry.
Sale of Scrap: Cash or accounts receivable 900
MOH control 900

2. Recognizing Scrap at the Time of its Production

Our Preceding illustrations assume that scrap returned to the storeroom is sold quickly, is
not assigned an inventory cost figure. Sometimes, as in the case with edges of molded
plastic parts, the value of scrap is not immaterial, and the time between storing it and
selling reusing it can be long. In these situations, the company assigns an inventory cost
to scrap at a conservative estimate of its net realizable value so that production costs and
related scrap revenues are recognized in the same accounting period. Some companies
tend to delay sales scrap until its market price is considered attractive. Volatile price
fluctuations are typical for scrap metal. In these cases, it’s not easy to determine some
“reasonable inventory value.”

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Scrap attributable to a specific job: The journal entry in the BOING example is:
Scrap retuned to storeroom: Materials Control 900
Work-in-process control 900
Scrap common to all jobs: The journal entry in this case is:
Scrap returned to storeroom: Materials Control 900
Manufacturing Overhead Control 900
Observe that the materials control account is debited in place of cash or account
receivable. When the scrap is sold, the journal entry is:
Sale of Scrap: Cash or Accounts Receivable 900
Materials Control 900

Scrap is sometimes reused as direct material rather than sold as scrap. In this case,
materials control is debited at its estimated net realizable value when the scrap is reused.
For example, the entries when the scrap is common to all jobs are:

Scrap returned to storeroom: Materials Control 900

Manufacturing overhead control 900
Reuse of scrap: Work-in-process control 900
Materials Control 900
Accounting for scrap under process costing is like the accounting under job costing when
scrap is common to all jobs. That is because; the scrap in process costing is common to
the manufacture of mass of identical or similar units.
Activities 5.5
1. What are Rework and scarps?
2. Explain the accounting for rework and scrap under job order and process costing
system?
Unit summary
 Process costing system is used by companies that produce relatively huge number
of virtually identical or similar products. When a company produces similar or
identical items, maintaining in a separate job cost sheet for each individual unit or
batch of production entails an unnecessarily high cost. Such firms can simply

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 accumulate costs by department and then assign these costs to total units produced
in that department.
 The flow of costs in process costing is the same as the flow of costs in job order
costing system. All manufacturing costs: cost of direct material, cost of indirect
manufacturing costs is added to the respective work in process account.
Completed units in one department will either transfer to the next department’s
work in process account, or become finished good if there is no further processing
department.
 Product costing in process costing system needs to follow some five steps. The
first step is to summarize the flow of physical units of output. The second step is
to compute output in terms of equivalent units. Equivalent units mean the number
completed units that could have been made with that quantity of input placed in
production. Equivalent units are important when all units started are not uniformly
completed during an accounting period. The third step is to compute the unit
equivalent cost. The fourth and fourth and fifth step are to summarize total cost to
account for and thereby assign the cost to units completed and units in ending
work in process.
 When there are both beginning and ending work in process inventory, it is
important to assume as to the flow of costs because the unit cost in the previous
period may be different from the unit cost of the current period. The weighted
average and the first in, first out method are the two cost flow assumptions used in
process costing system. The weighted method of process costing computes unit
cost by dividing the total cost incurred to date by the total equivalent units
produced using these costs. Unit cost is simply the quotient of total cost incurred
to date and the total equivalent units of work done to date. The FIFO method
assumes that the first units completed are from the beginning work in process, and
hence the cost of the beginning work in process is allocated to the first units
completed. The cost incurred during the current period is first used to the first
units completed. The cost incurred during the current period is first used to finish
the beginning work in process, and then used to finish units started in the current
period and finally assigned to equivalent units in ending work in process.

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  When there are two or more departments that are sequentially arranged, units
completed in one department transfer to the next department. All manufacturing
cost in the previous department are held as separate costs category called
transferred in cost.
 A production process cannot be free from defects. Defects are inherent part of any
production process. Some defective items can be reworked and sold for normal
prices and some cannot be reworked and thus may be sold for a lower price or
discarded at zero disposal prices. Defective items that cannot be reworked and
that can be sold at less than normal price are called spoilage. Those defective
items that can be reworked and sold are called rework. Sometime crumbles that
left when items are produced have some sales value. Such items are called scrap.
Model Exam Questions
Part one: Multiple choices
1. A company has 2000 units in beginning work in process, 30,000 units started in current
period and 3,000 units in ending work in process. The units completed are:
A) 30,000 B) 32,000 C) 29,000 D) 27,000 E) none
2. In process costing using weighted average method, cost per equivalent unit is based on
A) Cost of work in process beginning only
B) Equivalent unit of work done in current period only
C) Current period cost only
D) Equivalent unit of work done to date
E) None
3. The equivalent unit of 700 units in ending work in process inventory that is 30 %
incomplete as to direct material will be
A) 210 B) 490 C) 700 D) 730 E) None of the above
4. Which of the following is false about transferred in cost?
A) It is the cost of units completed in the first department
B) It can be considered as direct material for the second department
C) Its value is the same under both weighted average and FIFO method
D) Band C
E) None

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5. Which of the following is false?
A) Normal spoilage is planned spoilage
B) Abnormal spoilage can be avoided
C) Normal spoilage does not arise under efficient operating condition
D) Cost of abnormal spoilage is lost cost
E) Cost of normal spoilage is added to cost of good units completed
6. Tony company has equivalent unit cost of Br.10 for direct material and Br.20 for
conversion cost. If there are 2,500 units in ending working in process, 100% complete to
direct material and 40% complete as to conversion cost. The total cost assigned to the
ending inventory is
A) Br. 45,000 B) Br.55,000 C) Br.30,000 D) Br.40,000 E) None
7. Other things being the same, the value of one of the following is greater than the value
of all the others
A) Spoiled units B) Scraps C) Byproduct D) Main product E) None
8. Which of the following is not a characteristic of process costing system?
A) Once production begins, it continue until the finished product emerges
B) Cost accumulation is by departments or cost centers
C) When the finished product emerges, all units have precisely the same
amount of material labor and overhead cost
D) The products produced are heterogeneous
E) None of the above
Part II: Work out problems
1. The following data pertain to the coating department of ABC Ceramics Company for
the month ended August 31, 2009.
Work in process, August1( units) A
Units started during august(units) B
Total units to account for C
Units completed and transferred out 70,000
WIP, August31(units) 50,000
EU of Work done in august- Direct material 80,000
EU of Work done in august-conversion cost D
WIP,August1,Direct material cost Br.304,000

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 WIP,August1,conversion cost E
WIP, August1-total cost F
Cost incurred during August-Direct material Br.612,000
Cost incurred during August-conversion cost G
Total cost incurred during August 1,493,400
Total cost to account for Br.1,933,400
Cost per equivalent unit –direct material H
Cost per equivalent unit-conversion cost I
Total cost per equivalent unit J
Total Cost of units completed K
Total cost of WIP August31 L

Additional information
1. There are no spoiled units
2. Direct material is added at the beginning of the production process and conversion
cost is added uniformly through out the process
3. The company uses FIFO process costing
4. The August1, WIP was 30% complete as to conversion cost
5. The August31, WIP was 40% complete as to conversion cost
Required: compute the missing amounts and prepare the August product report for
coating department
Problem 1: ABC manufacturing company uses the FIFO method of process costing. The
company has two operating departments: Assembly and finishing department. Direct
materials and conversion costs are added evenly during the process in assembly
department. Spoiled units are detected up on inspection at the end of the assembly
process and are disposed of at zero disposal value. Summery data in assembly department
for March 2006 are:
Physical units Direct material conversion cost
WIP, March1 15,000 $120,000 $90,000
Units started in March 25,000
Good units completed 20,000
WIP, March31 16,000
Cost added during March $210,000 $228,000
Additional information

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  Normal spoilage is 75% of the total spoilage
 Degree of completion of WIP beginning is 80% with respect to direct material
and 60% with respect to conversion cost
 Degree of completion of WIP ending is 50% with respect to direct material and
25% with respect to conversion cost
 All spoiled units are from unit started in March

Required:
1) Compute the normal and abnormal spoilage.
2) Prepare production report using the 5 steps
3) Pass the necessary journal entries
Answer Key to Model Exam Questions
Part I: Multiple Choice
1. C 2. D 3. B 4.A 5. C 6. A 7. D 8. D
Part II
Problem 1

(Step 1)
Flow of production Physical flow
Work in process beginning 40,000 (Step 2)
Units started in current period 80,000 Equivalent Units
Direct Conversion
Units to account for 120,000 Materials Costs
Units completed and transferred out:
From beginning work in process 40,000 0 28,000
Started and completed 30,000 30,000 30,000
Work in process ending 50,000 50,000 20,000
Units accounted for 120,000
Work done in current period only 80,000 78,000
(Step 3): Cost summary
Work in process beginning Br. 440, 000 Incurred Last Month
Costs added during march 1,493,400 Br.612,000 Br.881,400
Divide by equivalent units ÷ 80,000 ÷ 78,000
Cost per equivalent units Br. 7.65 Br. 11.30
(Step 4)
Total cost to account for Br. 1,933,400
(Step 5) Assignment of cost:
To completed units (70,000 units)
Work In process beginning (40,000) Br.440,000 -------------------------------------
Cost added to beginning WIP in the
current month 316,400 0× 7.65 + 28,000×11.3

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Total from beginning Inventory Br.756,400
Started and completed (30,000) 568,500 30,000×7.65 + 30,000×11.3
Total cost of units completed Br. 1,324,900
To work in process ending (50,000) 608,500 50,000×7.65 + 20,000×11.3
Total cost accounted for Br.1,933,400

Problem 2:

(Step 1)
Flow of production Physical flow
Work in process beginning 15,000 (Step 2)
Units started in current period 25,000 Equivalent Units
Direct Conversion
Units to account for 40,000 materials costs
Good units completed :
From WIP Beg. 15,000 3,000 6,000
Started and completed 5,000 5,000 5,000
Normal spoilage 3,000 3,000 3,000
Abnormal spoilage 1,000 1,000 1,000
Work in process ending 16,000 8,000 4,000
Units accounted for 40,000
Work done in the current period 20,000 19,000
(Step 3) ; Cost summary
Work in process beginning Br.210,000 ----------------- --------------------
Costs added during February 438,000 Br. 210,000 Br. 228,000
Divide by equivalent units ÷ 20,000 ÷ 19,000
Cost per equivalent units Br. 10.5 Br. 12
(Step 4)
Total cost to account for Br.648,000
(Step 5) Assignment of cost:
Good units completed (20,000 units)
WIP Beginning (15,000 units) Br.210,000
Cost added during the period 103,500 Br. 10.5×3,000+ Br 12×6,000
Total from beginning inventory 313,500
Started and completed (5,000 units) 112,500 Br. 10.5×5,000+ Br. 12×5,000
Normal spoilage (3,000 units) 67,500 Br. 10.5×3,000+ Br 12×3,000
Total cost of good units completed Br.493,500
Abnormal spoilage 22,500 Br. 10.5×1,000 + Br 12×1,000

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To work in process ending (2000 units) 132,000 Br. 10.5×8,000 + Br 12×4,000
Total cost accounted for Br.648,000
The journal entries to be recorded are given below:
Work In process – Assembly 210,000
Raw material control 210,000
(To record the use of direct materials in the production process)
Work In Process – Assembly 228,000
Various accounts 228,000
To record the use of conversion cost in the production process)
Work in process - Finishing 493,500
Work in process - Assembly 493,000
(To record the transfer of completed products from assembly
department to finishing department)
Loss from abnormal spoilage 22,500
Work in process - Assembly 22,500
UNIT SIX
ACCOUNTNG FOR JOINT PRODUCATS AND BY
PRODUCTS

 Unit Objective

 Introduction

 Contents:
6.1 Joint Products
6.2 Approaches to Joint Cost Allocation
6.3 Further Processing Decision
6.3 Accounting for By products
 Unit summary
 Model Exam Questions

Unit Objective
Dear learners, this is the sixth unit of the module. In certain manufacturing processes, two
or more products simultaneously emerge from the same production processes. These
products are called joint products. The main objective of this unit is to discuss the

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accounting of joint products and byproducts. Specifically, after going through this unit,
you should be able to:
 define joint products and joint production costs
 identify the approaches to allocate joint production costs to joint products
 explain the relative advantage and limitation of each of the four methods of joint
cost allocation
 explain how the decision to sell or process further intermediate products is made
 describe the accounting treatment of byproducts

Introduction
This unit has four sub units. In the first sub unit we will look at the core of the unit which
is about joint production process. The second sub unit deals with the approaches to joint
cost allocation. Customarily, there are four general ways of allocating joint products.
These are the physical measure method, the sales value at split off method, the net
realizable value method and the constant gross margin net realizable value methods. The
third sub unit deals with the decision to process intermediate products further or sell at
the split off point. Some times products that emerge at the split off point may have higher
sales value if they are processed further to yield another product that has higher sales
value. The decision, to process further, however, depends on the cost benefit analysis. If
the additional revenue is higher than the separable cost, processing further results in an
incremental profit. If the additional cost is lower than the additional revenue, then the
best decision is to sale the product at the split off point. The last sub unit is about
byproducts. A joint production process may also provide a byproduct that has a lower
sales value as compared to the others. Such products with lower sales values are called
byproducts. The issue concerning byproducts is when to recognize them.

6.1 Joint Products

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 Pretest
Dear learner, what are joint products and what does it mean by joint
production processes?

In some manufacturing processes, multiple products emerge from the same material and
the same production process. For instance, edible oil and animal feed emerge from the
same material and production process. Joint products are products that simultaneously
emerge from the same material and manufacturing process. The cost of the material and
production process is called joint production cost or simply joint cost. The followings are
some examples of industries that simultaneously yield two or more products from the
same production process.

1. Agriculture and food Joint Products

processing
 Cocoa beans Coca butter , cocoa powder, cocoa drink , Tanning cream
 Lamb Lamb Cuts, Hides, Bones, Fat
 Raw milk Cream, Liquid Skim
 Lumber Lumber of different grades and shapes
2. Extractive industry
 Coal Coke, Gas, Bezel, Tar, Ammonia
 Copper ore Copper, Silver, Lead, Zinc
 Petroleum Crude oil, Gas raw LPG (liquefied petroleum gas)
 Salt Hydrogen, Chlorine, Caustic soda
3. Chemical industries
 Raw LPG Butane, Ethane, Propane

The point where the products emerge as separate and distinct goods is called the split off
point. Additional costs may be incurred to process the intermediate products further in
order to secure a higher sales value. The additional cost incurred beyond the split off
point is called separable cost. Separable cost includes all manufacturing, marketing and
distribution costs incurred in an effort to process intermediate products further at or

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beyond the split off point. Decisions to sale or process further are considered
independently.

A joint production process at times produces two types of products; some with positive
sales value and some with zero sale value. An item is considered as a product only if it
has a positive sales value. Thus, items with zero sales value are not considered as a
product. Consequently, no journal entry is required in the accounting records to recognize
the processing of outputs with zero sales value. For example, the joint production of gold
and silver also produces dirt that would be recycled back into the ground.

Output of a joint production process with a positive sales value can also exhibit wide
differences in terms of sales value. Those outputs that have a higher sales value are called
joint products. When only one output has a relatively high sales value as compared to the
others, the output with higher sales value is called the main product. Outputs with a lower
sales value as compared to the joint or main product are called byproducts. The
distinction between a joint or main product and by product is a matter of degree and it
changes as the value of the out put changes. The classification of goods as byproduct or
main joint product changes overtime. A lower sales value today does not imply a lower
sales value forever. The sales value of an item changes through time. Thus, as the sales
value increase an item is considered as a byproduct no more remains as a byproduct. It
becomes a joint product. Also an item with a higher sales value may show consistent
decrease in price which in turn means that it will become a byproduct.
Activity 6.1
1. What are joint products? give some examples of joint products
2. What is joint cost?
2.2 Approaches to Joint Cost Allocation

Pretest
Dear learner, what are the methods used to allocate joint costs to joint
products?

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As mentioned earlier, a joint production process results in multiple products. Normally,
the different outputs produced are not sold uniformly altogether and may not have the
same sales value. Thus, it is essential to allocate the join cost among the products. Here,
one thing you need to be sure is that it is impossible to know the cost of each output, as
the products themselves are not even separate till the split off point. The following are
some of the reasons for the allocation of joint costs:
 Without joint cost allocation, it is impossible to prepare external purpose financial
reports. What is the value of units in the ending inventory?
 Without cost, it is impossible to price units. Further, management information for
internal reporting purposes is impossible.
 Sometimes, an organization may enter into a contract that works on the basis of
commission and cost reimbursement. When such is the case, to determine the
amount of reimbursement, cost information on the units is essential.
 In the event of possible loss of a main or joint product, insurance claims would be
raised based on cost information.
 When rate regulation exists, it is important to determine the cost of the product
that is under the price regulation.
Cost allocation is the process of apportioning costs among cost objects. Allocation is
made in areas where cost tracing is impossible. Nonetheless, the allocation process
should not be arbitrary. It should follow some reason. There are common ways of
allocating cost to cost objects. The most common of which are allocating costs to cost
objects through cause and effect consideration, and allocating costs based on benefits
received criteria. Costs also be allocated based on some form of physical measure. Joint
cost allocation could not follow the cause and effect consideration. Joint costs are
allocated based on benefits received criteria and through physical measures. The
following are the most common method of allocating joint cost to the products;
1. Allocating costs using physical measure methods
2. Allocating costs using revenue method
A. Sales value at split off point method
B. Estimated net realizable value method
C. Constant gross profit NRV method

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 The physical measure method uses physical measures like weight and volume as a base
to allocate joint costs. Sometimes the metric of the joint products may not be identical.
When such happens, a common measurement would be used to allocate the joint cost.

In the second method, revenue data are used as a means to allocate joint costs. The sales
value at split off point method uses the revenue of the joint products at the split off point
to allocate the joint cost. The items that generate the highest revenue would take the
highest cost and the item with the lowest revenue would share a proportionately lower
cost. The other two methods work when the products at the split off point are further
processed and sold at a higher sales value. The estimated net realizable value method
deducts the separable costs from the value of the final product to arrive at the product at
the split off point. The net value will then be used to allocate the joint cost to the joint
products. The constant gross profit margin keeps the gross margin percentage of all the
products constant. And the joint cost is allocated in such a way that the gross margin
percentage of all products becomes equal.

In the simplest joint production process, the joint products are sold at split off point
without further processing. The above joint cost allocation methods will be clear when
we see their applications using illustrative examples. To illustrate the four joint cost
allocation approaches, we use the case of Sheno Lega farmer’s cooperative.

Illustration 1: Sheno Lega Farmer’s cooperative purchase raw milk from individual
farmers and process it until the split of point, where two products – cream and liquid
skim emerges. These two products are sold to an independent company, which markets
and distributes them to super-markets and other retail outlets in Addis Ababa. In the year
2008, 110,000 gallon of raw milk was purchased and processed. Of this, 10,000 gallon
was lost in the production process due to evaporation, spoilage and the like, yielding
25,000 gallons of cream and 75,000 gallons of liquid skim. Cost of purchasing 110,000
gallon of raw milk and processing it until the split of point to yield cream and liquid skim
is Br.400, 000. The following table shows production and sales data for the year ended
December 31, 2008

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 Products Production Sales
Cream 25,000 gallons 20,000 gallons at Br.8 per gallon
Liquid skim 75,000 gallons 30,000 gallons at Br.4 per gallon
The following diagram depicts the basic relationship in this example

Cream
25,000 gallon

Raw milk Processing

Br.400, 000
110,000 gallon
Liquid skim
75,000 gallon

Split off point

Required: Allocate the joint cost using

1. Physical measure method
2. Sales value at split off method
1. Physical-measure method
The physical- measure method allocates joint costs to products on the basis of the relative
weight, volume, or other physical measures at the split off point of the total production of
these products during the accounting period. In the illustration above, the Br.400, 000
joint costs produces 25,000 gallons of cream and 75,000 gallons of liquid skim. Using the
number of gallons produced as the physical measure, joint costs are allocated as follows.
Cream Liquid Skim Total
Physical measure of total production(gallons) 25,000 75,000 100,000
weighting (cream: 25,000/100,000, liquid skim: 75,000/100,000) 0.25 0.75
Joint costs allocated (cream: 0.25xBr. 400,000, liquid skim
0.75xBr. 400,000) Br100,000 Br300,000 Br.400,000
Joint production cost per gallon (cream: Br. 100,000/25,000 gal, Br4/gal Br4/gal
liquid skim, Br. 300,000/75, 000 gal)

The table below presents the product-line income statement using the physical –measure
method:

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 Cream Liquid skim Total
Revenues (Cream, 20,000 gal x Br. 8/gal, Liquid skim, 30,000 Br. 160,000 Br. 120,000 Br.280,000
gal x Br. 4/gal )
Costs of goods sold ( 20,000 gal x Br 4; 30,000 gal x Br. 4) 80,000 120,000 200,000
Gross margin percentage Br. 80,000 0 Br. 80,000
Gross margin percentage 50% 0% 28.8%

Under the benefits- received criterion, the physical –measure method is less preferred
than the sales value at split off method. Why? Because, it has no relationship to the
revenue producing power of the individual products. Consider a gold mine that extracts
ore containing gold, silver and lead. Use of a common physical measure (tons) would
result in almost all costs being allocated to the products that weighs the most but has the
lowest revenue-producing power. In this case, the method of cost allocation is
inconsistent with the reason for the mine owner incurring mining costs- to find gold and
silver, not lead.

In order to use physical measure method for joint cost allocation, the joint products
should be expressed in the same measuring unit. Determining which products of a joint
process to include in a physical measure computation can greatly affect the allocations
between or among those products. Outputs with no sales value (such as dirt in gold
mining) are always excluded. Although many more tons of dirt than gold is produced
costs are not incurred to produce outputs that have zero sales vales. Byproducts with low
sales values relative to the joint products or the main product also are often excluded
from the denominator used in the physical measure method. The general guideline for the
physical measure method is to include only the joint product outputs in the weighting
computations.
2. Sales Value at Split off Point Method
The sales value at split of point method allocates joint costs to joint products on the bases
of the relative sales value at the split off point of the total production of these products
during the accounting period. For Sheno Lega farmer’s cooperative, the joint cost will be
allocated using sales value at the split off point method as follows:
Cream Liquid Total

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 skim
Sales value of total production at split off point (in Br.)
(Cream;25,000 gal x 8/gal; Liquid skim; 75,000 gal x 4/gal) 200,000 300,000 500,000
Weighting(200,000/500,000; 300,000/500,000) 0.40 0.60
Joint cost allocated (In Br.) (Cream,0.4 x Br. 400,000;
Liquidskim,0.60 x Br. 400,000) 160,000 240,000 400,000
Joint cost per gallon(Cream,160,000/25,000 gal; liquid Br. Br.
skim,240,000/75,000 gal) 6.4/gal 3.2/gal

This method uses sales value of the entire production of the accounting period. The
reason is that, the joint costs were incurred on all units produced not just the portion sold
during the current period. The table below presents the product-line income statement
using the sales value at split off point method. Both cream and liquid skims have gross-
margin percentages of 20%.

Cream Liquid skim Total

Revenues (Cream, 20,000 gal x Br. 8/gal; Liquid Br. 160,000 Br. 120,000 Br. 280,000
skim, 30,000 gal x Br. 4/gal )
Costs of goods sold ( 20,000 gal x Br. 6.4; 30,000 gal 128,000 96,0000 224,000
x Br. 3.2)
Gross margin percentage Br. 32,000 Br. 24,000 Br. 56,000
Gross margin percentage 20% 20% 20%

You can now see why the sales values at split off method follow the benefits-received
criterion of cost allocation. Costs are allocated to products in proportion to their expected
revenues. This method is both straightforward and intuitive. The cost allocation base is
total sales value at split off point that is systematically recorded in the accounting system.
To use this method, a company needs the market selling price for all products at the split
off point.
.3. Net Realizable Value (NRV) Method
In many cases, products are processed beyond the split off point to bring them to a
marketable form or to increase their value above their selling price at the split off point.
To illustrate the cost allocation in this case, let’s extend the case of Sheno Lega farmers
cooperative.

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Illustration 2: Assume the same data as in illustration 1, except that, here both cream and
liquid skim can be processed further. 25,000 gallons of cream are further processed to
yield 20,000 gallons of butter ream at additional processing costs of Br. 280, 000. Butter
cream, which sells for Br. 25 per gallon, is used in the manufacture of butter-based
products. 75, 000 gallons of liquid skim are further processed to yield 50,000 gallons of
condensed milk at additional processing costs of Br. 520, 000. Condensed milk sells for
Br. 22 per gallon. The following diagram depicts how raw milk is converted into cream
and liquid skim in a joint production process and how the cream is separately processed
into butter cream and liquid skim is separately processed into condensed milk.

Br.280, 000
Cream B. Cream
25,000 20,000gal
gallon
Raw milk Processing
Br.400, 000
110,000 gallon
Liquid skim
75,000 gal Br.520, 000 C. Milk
50,000gal

Split off point

Sales during the accounting period were 12,000 gallons of butter cream and 45,000
gallons of condensed milk leaving 8,000 gallons of better cream and 5,000 gallons of
condensed milk as end inventory. There is no other beginning or end inventory than these
two.
The net realizable value (NRV) method allocates joint cost to joint products on the basis
of the relative NRV. NRV is final sales value minus the separable costs of the total
production of the joint products during the accounting period. The NRV method is
typically used in preference to the sales value at split off method only when we don’t
know the market selling prices for one or more products at split off point. Joint costs in
this example are allocated as follows:

Butter Condensed Total

Cream Milk

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Final sales value (Butter cream: 20,000 gal x Br. Br. 500,000 Br. 1,100,000 Br1,600,000
25/gal, condensed milk 50,000 gal xBr.22/gal)
Deduct: Separable costs to complete and sell 280,000 520,000 800,000

Net realizable value at split off point Br. 220,000 Br. 580,000 Br. 800,000
Weighting (220,000/800,000;580,000/800,00) 0.275 0,725
Joint costs allocated (Butter cream 0.275x Br.110,000 Br.290,000 Br.400,000
400,000; condensed milk 0.725 x 400,000)
Production cost per gallon(Butter cream: Br.19.50/gal Br.16.20/gal.
{Br.110,000+Br.280,000}/20,000gal;condense
d milk {Br.290,000+Br.520,000}/50,000 gal)

The product line Income statement using the estimated NRV method can be prepared as
follows
Butter Condensed
Cream Milk
Revenues (Butter cream, 12,000gal x Br.25/gal;
Condensed milk 45,000 gal x Br.22/gal) Br. 300,000 Br. 990,000
Cost of goods sold :(Butter cream ,12,000gal x Br.19.50/gal;
Condensed Milk, 45,000 gal x Br.16.20/gal) 234,000 729,000
Gross Margin Br. 66,000 Br. 261,000
Gross Margin percentage 22% 26.4%

Because the sales value at split off method does not require knowledge of the processing
steps beyond the split off point, it is less complex than the NRV method. However using
the sales value at split off method is not always feasible. That is because; there may not
be market prices for at least one of the products at the split off point. Market prices may
only be available after processing occurs beyond the split off point. In this case, we have
to use NRV method.

4. Constant Gross Margin Percentage NRV Method

The constant gross margin percentage NRV method allocates joint cost to joint products
in such a way that the overall gross margin percentage is identical for the individual
products. This method entails three steps:
Step 1: Compute the overall gross margin percentage for all joint products together.

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Step 2: Multiply the overall gross margin percentage and the final sales values of each
product to calculate the gross margin for each product. Subtract the gross margin for each
product from the final sales value of each product to obtain the costs that each product
will bear.
Step 3: Deduct the separable costs from the total costs that each product will bear to
obtain the joint cost allocated.

The joint costs allocated to a product can be negative under this method. Some products
may receive negative allocation of joint costs to bring gross margin percentages up to the
overall average. The following table presents the overall income statement for the
constant gross margin percentage NRV method.
Step 1 Total
Final sales value of total production ( 20,000 gal x
Br. 25/gal + 50,000 gal x Br. 22/gal Br. 1,600,000
Less; Total cost (Br. 400,000 + Br. 800,000) 1,200,000
Gross Margin Br. 400,000
Gross Margin percentage(Br. 400,000/Br.1,600,000) 25%

Butter Condensed
Step 2 & 3 Cream Milk
Final sales value of total production (Butter cream,
20,000 x Br.25/gal; con. Milk , 50,000 gal x Br.22/gal) Br. 500,000 Br.1,100,000
Less : Gross margin (25% x Br.500,000, 25% x
Br.1,100,000) 125,000 275,000
Cost of Goods available for sale Br. 375,000 Br. 825,000
Less: Separable cost to complete and sell 280,000 520,000
Joint costs Allocated Br.95,000 Br.305,000
Total cost per gallon ( Br. 375,000/20,000gal, Br.
825,000/50,000 gal Br.18.75/gal Br.16.5/gal

The constant gross margin percentage NRV method is different in one fundamental way
from the two other market based joint cost allocation methods described earlier. The sales
value at split off method and the NRV method allocate only the joint costs to the joint
products. Neither method takes account of profits earned either before or after the split
off point when allocating the joint cost. In contrast, the constant gross margin percentage
NRV method is both a joint cost method and a profit allocation method. The total
difference between the sales value of production of all products and the separable cost of
all products includes both (a) the joint costs and (b) the total gross margin. Gross margin

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is allocated to the joint products under the constant gross margin method to determine the
joint cost allocation so that each product has the same gross margin percentage. The
following table presents the product line income statement under constant gross margin
NRV method.
Butter Condensed
Cream Milk
Revenues (butter cream, 12,000 gal x Br.25/gal; condensed Br.
milk 45,000 gal x Br. 22/gal) 300,000 Br. 990,000
Cost of goods sold:(Butter cream ,12,000gal x Br. 18.75/gal;
Condensed Milk, 45,000 gal x Br. 16.50/gal) 225,000 742,500
Gross Margin Br. 75,000 Br. 247,500
Gross Margin percentage 25% 25%

Which method of allocating joint costs should be used? Use the sales value at split off
method when selling price data are available (even if further processing is done). Reasons
for using the sales value at split off method include:

 It measures the value of the joint product immediately at the end of the joint
process.
 The sales value at split off is the best measure of the benefits received as a result
of joint processing relative to all the other method of allocating joint costs.
 The sales value at split off method does not require information on the processing
steps after split off, if there is further processing. In contrast, the NRV method
and constant gross margin percentage NRV method require information on (a) the
specific sequence of further processing decisions (b) the separable costs of further
processing and (c) the point at which individual products are sold.
 The sales value at Split off method and the other market-based methods have a
meaningful basis to allocate joint costs to products. In contrast the physical
measure method may lack a meaningful basis that can be used to allocate joint
costs to individual products.
 The sales value at split off method is simple. In contrast, the NRV and constant
gross margin percentage NRV method can be complex for processing operations
having multiple products and multiple split off points. This complexity is
increased when management makes frequent changes in the specific sequence of

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 post split off processing decisions or in the point at which individual products are
sold.

When selling prices of all products at the split off point are not available, other joint cost
allocation methods are used. The NRV method attempts to approximate the sales value at
split off by subtracting separable costs incurred after the split off point on each product
from selling prices. The NRV method assumes that the markup or profit margin is
attributable to the joint process and none of the markup is attributable to the separable
costs. Profit however, is attributable to all phase of production and marketing not just the
joint process. Despite its complexities, the NRV method is used when selling prices at
split off are not available. It is a better measure of benefits received compared with the
constant gross margin percentage NRV method and the physical measure method.

The main advantage of the constant gross margin percentage NRV method is that, it is
easy to implement. This method treats the joint products as though they comprise a single
gross margin percentage to each products and back into the joint costs allocated to each
products. This method avoids the complexities inherent in the NRV method to measure
the benefits received by each of the joint products at the split off point. The main issue
with the constant gross margin percentage NRV method is the assumption that all the
products have the same ratio of cost to sales value across products is very uncommon in
companies that produce multiple products that do not involve joint cost.

Although there are difficulties in using the physical measure method, the lack of
congruence with the benefits received criterion and the possible lack of a meaningful
common denominator for allocating the joint costs, there are instances when it may be
preferred, consider rate regulation. Market based measures are difficult to use in the
context of rate or price regulation. It is circular reasoning to use selling prices as a basis
for setting prices (rates) and at the same time use selling prices to allocate the costs on
which prices (rates) are based. To avoid this circular reasoning the physical measure
method may be used in rate regulation.
Activity 6.2

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 1. Explain the four joint cost allocation methods?
2. When do we apply each of them? Which one is preferable?

6.3 Further Processing Decision

Pretest
Dear learner, shall we sell the two joint products at the split off point or
shall we further process?

Many manufacturing companies constantly face the decision of whether to further

process a joint product. For example, Sheno Lega can sell the joint products: cream and
liquid skim at the split off point or further process them into butter cream and condensed
milk. In the petroleum refining industry, the refiner must decide whether to see raw
liquefied petroleum gas as a product or process it further into butane, ethane and propane.

Should the joint costs allocated to the joint products be used in making pricing decisions
for each joint product? No. why not? Because all joint cost allocations to products are
somewhat arbitrary. There is no cause and effect relationship that identifies the resources
demanded by each joint product that can be used as a basis for pricing.

Relevant revenues are expected future revenues that differ among alternative courses of
action. These concepts have important implications for decisions on whether a joint
product should be sold at the split off point or processed further. Joint costs incurred up
to the split off point are irrelevant because these costs will be incurred whether the
product is sold at the split off point or processed further. Therefore, the decision whether
to process further should not be influenced by the total amount of the joint costs. The
decision to incur additional costs for further processing should be based on the
incremental operating income attainable beyond the split off point. The incremental
analysis for these decisions to process further is given below
Butter Condensed
Cream Milk
Incremental revenue (Butter cream, 20,000gal x Br. 25/gal-
25,000 gal x Br. 8/gal ; Condensed milk 50,000 gal x Br.
22/gal – 75,000 gal x Br. 4/gal) Br. 300,000 Br.800,000

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 Less: Incremental cost 280,000 520,000
Incremental income from further processing Br.20,000 Br.280,000

In this example, operating income increases for both products so the manager should
process cream into butter cream and liquid skim in to condensed milk. The Br. 400,000
joint costs incurred up to split off and how they are allocated are irrelevant in deciding
whether to process further. Why irrelevant? Because the joint costs of Br. 400, 000 are
the same whether or not further processing occurs.

Incremental costs are the additional costs incurred for an activity such as process further.
Do not assume all separable costs in joint cost allocation are always incremental costs.
Some separable costs may be fixed costs such as lease costs on building where the further
processing is done: some costs may be sunk costs such as depreciation on the equipment
that converts cream into butter cream. Some separable costs may be allocated costs such
as corporate costs allocated to the condensed milk operations. None of these costs will
differ between the automotives of selling products at the split off point or processing
further.
Activity 6.3
Why joint cost is irrelevant for further process decision?

6.4 Accounting for Byproducts

Pretest
Dear learners, what are by products, how do we treat them in accounting?

Joint production processes may yield not only join products and main products but
byproducts as well. Although byproducts have much lower sales values than the sales
values of joint or main products, the presence of byproducts in a joint production process
can affect the allocation of joint costs. Let’s consider a two product example consisting of
a main product and a byproduct.

Illustration 3: Kierra meat processing company processes meat from slaughterhouses.

One of its departments cuts lamb shoulders and generates two products: Shoulder meat

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(the main product) sold for Br. 60 per pack. Hock meat (the byproduct)-sold for Br.4 per
pack (net of any selling costs). The data below indicates the number of packs produced
and packed in this department in July 2009:
Production Sales Ending inventory
Shoulder meat 5,000 4,000 1,000
Hock meat 1,000 300 700

The joint manufacturing costs of these products in July 2009 were Br. 250,000
comprising Br. 150, 000 for direct materials and Br.100, 000 for conversion costs. Both
products are sold at the split off point without further processing. There are two
byproduct accounting methods:
. Method A: Byproducts Recognized at Time Production is Completed
The production method - recognizes byproducts in the financial statements at the time
production is completed. This method recognizes the byproduct in the financial
statements - the 1,000 packs of hock meat - in the month it is produced, July 2009. The
NRV form the byproduct produced is offset against the costs of the main product
1. Work in process--------------------150,000
Accounts payable------------------------- 150,000
(To record direct materials of Br 150,000 used in production during July)

2. Work in process-------------------100,000
Various accounts -------------------100,000
(To record the consumption of conversion costs of Br. 100,000 in July)
3. Byproduct inventory—hock meat (1,000 packs x Br. 4/pack) -- 4,000
Finished goods—shoulder meat (Br.250, 000-Br.4, 000) ------- 246,000
Work in process (Br.150, 000+Br.100, 000) ---------- --------250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000 packs /5,000 packs) x Br. 246, 000--196,800
Finished goods –shoulder meat----------------------------------196,800
(To record the cost of the main product sold during July)
4b) Cash or Accounts receivable (4,000 packs x Br.60/pack) ---240,000
Revenues----shoulder meat----------------------------240,000
(To record the sales of the main product during July)
5) Cash or Accounts receivable (300 packs x Br. 4/pack) -----1,200
Byproducts inventory---hock meant------ ------1,200
(To record the sales of the byproduct during July)

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This method reports the byproduct inventory of hock meat in the balance sheet prepared
on July 31,2009 at its Br. 4 per pack selling price [(1,000 packs-300 packs) x Br. 4/pack
= Br. 2, 800]

Method B: Byproducts Recognized at Time of Sale

The sales method delays recognition of byproducts until the time of sale. Recognition of
byproducts at the time of production is conceptually correct recognition than at the time
of sales. However, sales method is often used in practice when the birr amounts of the
byproduct are immaterial. This method makes no journal entries until sales of the
byproduct occur. Revenues of the byproduct are reported as a revenue item in the income
statement at the time of sales. These revenues are grouped with other sales, included as
other income or deducted from cost of goods sold. In the above example, byproduct
revenues in July 2004 are Br. 1, 200 (300 packs x Br. 4/pack) because only 300 packs of
the hock meat are sold in July (of the 1,000 packs produced). The journal entices are
presented below:
Journal entries 1 and 2 are the same as for method A.
3. Finished goods---- shoulder meat 250,000
Work in process 250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000 packs/ 5, 000packs) x Br.250, 000] 200,000
Finished goods-------------- ------------------------------200, 000
4b) The same as for method A.
5. Cash or account receivable------------ 1,200
Revenues----shoulder meat ----------- 1,200
(To record the sales of the byproduct during July)
Method B is used in practice primarily on the ground that the birr amounts of byproducts
are immaterial. However, this method permits managers to report earnings by timing
when they sell byproducts. Managers may store byproducts for several periods and give
revenues and income a “small boost” by selling byproducts accumulated over several
periods when revenues and profits from the main product or joint products are low. The
following table presents the income statement and balance sheet under both methods:

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 Production Sales method
Income statement method
Revenue:
Main product 4,000 pack x Br. Br. 240,000 Br. 240,000
60/pack
By product 300 packs x Br 4/pack - 1,200
Total Revenue Br. 240,000 Br. 241,200
Cost of goods sold 196,800 200,000
Gross Margin Br. 43,200 Br. 41,200
Gross Margin Percentage 18% 17%
Balance sheet
End of period Inventory:
 Main product Br. 49,200 Br. 50,000
 Byproduct 2,800 0
Total Inventory Br. 52,000 Br. 50,000
Activity 6.4
1. What are the two methods of accounting byproducts?
2. Which one is widely used? Why?
Unit Summary
 A joint cost refers to the total manufacturing cost of a joint production process. It
includes direct material, direct labor and manufacturing overhead costs. A joint
manufacturing process provides multiple products from the same process. The
point where the products separate is called the split off point.
 When there is only one product that has a relatively higher sales value as
compared to the others, it is called main product. When there are two or more
products that have higher sales value, they are called joint products. A joint
manufacturing process could also produce outputs that do not have positive sales
value. Such outputs are not considered products as they do not have positive sales
value. An example is the production of dirt along with gold and silver.
 Joint costs need to be allocated to the joint products for various reasons. Since it is
impossible to specifically trace the cost to the individual products, it is essential to
allocate the cost in some way. There are four methods of allocating joint costs to
joint products. These methods are the sales value at split off point, the estimated
NRV method, the constant gross margin percentage NRV method and physical
measure method.

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  Each method has its own advantage and limitation. The choice among these
methods depends on several factors. One factor that determines the choice among
the method is the purpose for allocating the joint cost. Nonetheless, the sale value
at split off method is the most common in practice.
 Products that emerge at the split off point can further be processed at additional
separable costs in order to bring them into a marketable from or secure a higher
sales value. Products that can be sold at split off point are further processed in
order to gain better advantage. A product is further processed when the additional
revenue is more than the additional separable cost.
 A joint production process could also produce products that have lower sales
value as compared to the others. When a product has a lower sales value, it is then
called a byproduct. There are two accounting methods for byproducts. These are
the sales method and the production method. The sales method recognizes
byproducts when byproducts are sold. The production method recognizes
byproducts when they are produced.

Model Exam Questions

Part I: Multiple choices
1. When there is joint and byproducts to gather, which of the following is false?
A) The cost per unit output of the joint product’s is less under the sales method than
production method
B) Total revenue would be higher under the sales method than the production method
C) The value of the by product will be deducted from total joint cost before
allocation under production method
D) The value of the byproduct is recorded when it is sold under sale method
E) None
2. Separable cost refers to:
A) The amount of joint cost allocated to joint products
B) The entire cost of the joint production process.
C) The additional cost incurred to process intermediate products further.
D) Cost of a byproduct

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 E) None
3. Which of the following is false?
A) Joint cost is irrelevant in sell at split off or process further decision
B) If the incremental cost of further processing is less than the additional revenue,
the best decision is to process further instead of selling at split off point
C) A joint production process could have several split off point
D) The physical measure method is more appropriate than the sales value method
when there are significant difference among the sales value of the joint products
E) None
4. Which of the following assumes constant cost to sales ratio for all joint products
produced?
A) Physical measure method
B) Sales value at split off method
C) Net realizable value method
D) Constant gross margin NRV method
E) None
Use the following information for question 5-6
Andy Company manufactures products N, P and R from joint production process
Products
N P R Total
Units produced 12,000 ? ? 24,000
Sales value at split-off ? ? Br50,000 Br200,000
Joint cost allocated Br48,000 ? ? Br120,000

5. What is the sales value at split off for product N if joint costs are allocated using the
sales value at split-off method?
A) Br48, 000 B) Br 80,000 C) Br 30,000 D) Br 70,000 E) None
6.. What is the sales value at split-off for product P if joint costs are allocated using the
sales value at split-off method?
A) Br.42, 000 B) Br 80,000 C) Br 30,000 D) Br 70,000 E) None
7. Which of the following is true about a by-product?

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 A. It’s sale value is small compared to the main product
B. It’s value is treated as a cost reduction under production method
C. It’s value is treated as separate revenue under sales method
D. If the value of a by product is negligible, sale method of recording by
product is preferable
E. All of the above

Problem 1: ABC company operates a simple chemical process to convert a single raw
material in to three separate products referred to as A, B and C. All the three products are
separated simultaneously at a single split of point. All the three products can be sold at
split of point but A and B can also be further processed with out loss in units to super A
and super B respectively. The table below presents operating budget for ABC Company
for the year 2007.
products Units produced Units sold Selling price Further Selling price
in quintals in quintal at the split off processing cost after further
point processing
Super A 6000 4000 Br30 Br50,000 Br40
Super B 9000 6000 25 100,000 36
C 1200 1000 5 - -
The total joint cost incurred to process the three products up to the split off point for the
year was Br. 300,000. There were no beginning inventories for the three products
Requirement:
a) Allocate the joint cost to the three products and calculate units cost using
estimated neat realizable value method
b) Prepare partial income statement for the three products
c) Should product A and B be sold at split off point or further processed? make
analysis

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 d) The sales value of product C is small in amount compared to the other products.
Hence the company decides to treat product c as a byproduct and allocate the joint
cost only to Super A and Super B using physical measure method. What will the
joint cost allocated to super A and super B be:
1) If the byproduct is accounted using production method
2) If the byproduct is accounted using sales method

Answer key to Model Exam Questions

Part I: Multiple Choice
1. A 2. C 3. A 4.D 5. B 6. D 7. E

Part II: Work out

a) Joint cost allocation
Final sales Separable NRV %age Joint cost Unit
Products value cost allocated cost
Super A Br. 240,000 Br. 50,000 Br. 190,000 45.2% Br. 135,714 Br.30.9
Super B 324,000 100,000 224,000 53.3% 160,000 28.9
C 6,000 0 6,000 1.4% 4200 3.5
Total Br. 570,000 Br. 420,000 Br. 300,000
b) Product line income statement

Super A Super B C
Sales Br.160,000 Br. 216,000 Br. 5,000
Cost of goods sold 123,600 173,400 3,500
Gross margin Br. 36,400 Br. 42,600 Br. 1,500
Gross margin %age 22.8% 19.7% 30%

c) Further process or sale at the split off point

Super A Super B
Final sales value Br.240,000 Br.324,000
Sales value at split off point 180,000 225,000
Incremental revenue Br. 60,000 Br. 99,000
Separable cost (50,000) (100,000)
Incremental Income Br.10,000 (Br.1,000)
Decision: Further process “A” to “super A” but sale “B” at split off point
d1) Production method
Total joint cost Br. 300,000
Value of byproduct (C) 6,000
Net joint cost to be allocated Br. 294,000

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 Physical Joint cost allocated
Products measures %age
Super A 6,000 40% 40%x294,0000 = Br.117,600
Super B 9,000 60% 60%x294,000 = Br.176,400
Total 15,000 Br.294,000
d 2)sales method
Net joint cost to be allocated = Br. 300,000. The value of Byproduct (C) is treated as
additional revenue
Physical Joint cost allocated
Products measures %age
Super A 6,000 40% 40%x300,0000 = Br.120,000
Super B 9,000 60% 60%x300,000 = Br.180,000
Total 15,000 Br.300,000

UNIT SEVEN
INCOME EFFECT OF ALTERNATIVE INVENORY COSTING
SYSTEMS

 Unit Objectives
 Introduction
 Contents:
7.1 Inventory Costing Approaches
7.2 Income Statement under the Three Costing Methods
7.3 Comparisons of the Three Inventory Costing Methods
 Unit Summary
 Model Exam Questions

Unit Objectives
Dear learners, this is the last unit of the Module. This unit discusses the effect of the
different inventory costing system on cost of inventory and income statement. It
discusses the three alternative inventory costing systems using illustrative examples.
Therefore, after completing this unit, you are expected to:
 distinguish among variable costing ,absorption costing and throughput costing.
 explain the effect of the three costing approaches on cost of inventory and income
statement.
 compare and contrast the three inventory costing systems.

139
  compute cost of inventory under the three inventory costing systems.
 prepare income statement for a given company under the three inventory costing
systems.

Introduction
The evaluation of manager’s performance is often based on at least partly on the income
of the organizational segment they manage. Therefore, managers strive to make their
performance look good by making decision that increases income. But, how should we
measure income? Accountants make many judgments when measuring income and one
of the most important is choosing the appropriate methods for calculating product cost.

This unit focuses on major variation of product costing. The unit is divided in to three sub
units. The first sub unit discusses how product cost is computed using Variable costing,
Absorption costing and Throughput costing approaches. The second sub unit discusses
how income statement is prepared under the three costing methods. And finally, the last
sub unit compares and contrasts the three inventory costing methods.

7.1 Inventory Costing Approaches

Pretest
Dear learner, what does inventory costing means and what are the three
inventory costing systems

After a product is manufactured in a manufacturing process, the cost of the product

should be determined. The purposes of determining cost of a product are many.
Therefore, a single cost can not satisfy all purposes of product costing. Because of this,
accountant will calculate different cost for different purpose. For example, for pricing

140
decision, each and every cost should be added and considered as cost of production but
for financial reporting purpose, Generally Accepted Accounting Principles states that
only manufacturing cost should be considered as a product cost. In a manufacturing
company, the three main manufacturing costs are direct material cost, direct labor cost
and manufacturing overhead costs. Direct material and direct labor costs are usually
variable in nature where as part of MOH cost is variable and the remaining is fixed.
Based on this, there are three known inventory costing methods. The following is a
discussion of the three inventory costing methods.

Variable costing and Absorption costing

Variable costing is a method of inventory costing in which all variable manufacturing
costs are included as inventorable costs. All fixed manufacturing costs are excluded from
inventorable costs and instead treated as costs of the period in which they are incurred
Absorption costing is a method of inventory costing in which all variable manufacturing
costs and all fixed manufacturing costs are included as inventorable costs, that is
inventory absorbs all manufacturing cost. Under both variable costing and absorption
costing, all variable manufacturing costs are inventorable and all non manufacturing
costs in the value chain such as research and development and marketing), whether
variable or fixed are period costs and are recorded as expenses when incurred.

To summarize, how fixed manufacturing costs are accounted for is the main difference
between variable costing and absorption costing.
 Under variable costing, fixed manufacturing costs are treated as an expense of the
period.
 Under absorption costing, fixed manufacturing costs are inventorable costs.

Illustration 1: To evaluate the performance of a given product line, ABC Company’s

management wants to prepare an income statement for the year 2008. The operating
information for the year are given below:
Beginning inventory 0

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 Production 800 units
Sales 600units
Ending Inventory 200 units
Selling price Br.100
Variable manufacturing cost per unit:
 Direct material cost per unit 11
 Direct manufacturing labor cost per unit 4
 Manufacturing overhead cost per unit 5
Total variable manufacturing cost per unit 20
Variable marketing cost per unit ( all indirect) 19
Total Fixed manufacturing costs (all indirect) 12,000
Total Fixed marketing costs (all indirect) 10,800

For simplicity and to focus on the main idea, we assume the following about ABC
Company:
 ABC incurs manufacturing and marketing cost only.
 The cost driver for all variable manufacturing costs is units produced.
 The cost driver for variable marketing costs is units sold.
 There are no batch level costs and no product sustaining cost.
 Work in process inventory is assumed to be zero
 The budgeted level of production for 2008 is 800 units which are used to calculate
the budgeted fixed manufacturing cost per unit. Fixed MOH cost per unit is Br.15
( Br.12,000 / 800 units)
For ABC Company, Inventorable cost per unit in 2008 under the two methods is
calculated as follows:
Variable Absorption
costing costing
Variable Manufacturing cost per unit produced
 Direct material cost per unit Br. 11 Br. 11
 Direct manufacturing labor cost per unit 4 4
 Manufacturing overhead cost per unit 5 5
Fixed manufacturing cost per unit produced - 15
Total invntorable cost per unit Br.20 Br. 35

The basis of the difference between variable costing and absorption costing is how fixed
manufacturing costs are accounted for. As you see in the above table, fixed
manufacturing cost is added under absorption costing but is not included under variable

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costing. If inventory level changes, operating income will differ between the two methods
because of the difference in accounting for fixed manufacturing costs.

Throughput costing
Some managers maintain that even variable costing promotes an excessive amount of
costs being inventoried. They argue that only direct materials are truly variable.
Throughput costing is also called super variable costing because it is an extreme form of
variable costing. It is a method of inventory costing in which only direct material costs
are included as inventorable costs. All other costs are expensed in the period in which
they are incurred. In particular, variable direct manufacturing labor costs and variable
manufacturing overhead costs are regarded as periodic costs and deducted as expense of
the period. For the ABC Company, in the illustration above, only the Br. 11 direct
material cost per unit is inventoraible under throughput costing compared with Br. 35 per
unit for absorption costing and Br. 20 per unit for variable costing. Through put costing is
a more recent phenomenon in comparison with variable and absorption costing and has
vivid supporters, but so far it has not been widely adopted.
Activity 6.1
1. What are the three inventory costing approaches
2. How are costs of inventory calculated under each approach?

7.2 Income Statement under the Three Costing Approaches

Pretest
What will ABC’s operating income under the three inventory costing
approaches?

The measurement of net income under the three costing methods differs. The difference
results from the amount of fixed manufacturing overhead cost. In general, the income
measurements under the three methods will differ when production and sales amount
differs. The variable costing income statement uses the contribution margin formats
where as the variable costing income statement uses the gross margin format. Absorption

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costing income statement need not differentiate between variable and fixed coasts. The
followings are the formats used to prepare income statement under the three methods:
1. Format of Absorption Costing Income Statement
Sales ------------------------------- XX
Cost of goods sold:
Direct material ---------- xx
Direct labor ------------ xx
Variable MOH ---------- xx
Fixed MOH -------------- xx XX
Gross profit ----------------------- XX
Variable operating expense --------xx
Fixed operating expense ----------- xx
Operating income ------------------- XX

2. Format of Direct costing Income Statement

Sales revenue --------------------------XX
Variable costs & Expense:
Direct material -------------- xx
Direct labor ---------------- xx
Variable MOH ---------------xx
Variable expense ------------ xx XX
Contribution margin ------------------ XX
Fixed MOH cost ---------------------- XX
Fixed operating expense ---------------XX
Operating income ----------------------- XX

3. Format of Throughput Costing Income Statement

Sales revenue ------------------------ XX
Direct material cost ------------------XX
Throughput contribution ---------- XX
Direct labor cost ----------- xx
Variable MOH cost -------- xx
Fixed MOH cost ------------ xx
Variable operating expense --xx
Fixed operating expense ------xx XX
Operating income -----------------------XX

For ABC Company above, income statement under the three approaches can be prepared
as follows for the year ended December 3, 2008:

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 ABC Company
Absorption Costing Income Statement
For the year ended December 31, 2008
Sales (600xBr.100) Br.60,000
Cost of goods sold
Direct material cost (600xBr. 11) Br. 6,600
Direct labor cost (600xBr.4) 2,400
Variable overhead cost ( 600xBr.5) 3,000
Fixed overhead cost ( 600x Br.15) 9,000
Cost of goods sold 21,000
Gross profit 39,000
Variable marketing expense (600xBr.19) 11,400
Fixed marketing expense 10,800
Operating Income Br. 16,800

ABC Company
Variable Costing Income Statement
For the year ended December 31, 2008
Sales (600xBr.100) Br.60,000
Variable cost and expenses:
Direct material cost (600xBr. 11) Br. 6,600
Direct labor cost (600xBr.4) 2,400
Variable overhead cost ( 600xBr.5) 3,000
Variable marketing expense ( 600xBr.19) 11,400
Total variable costs and expenses 23,400
Gross profit Br.36,600
Fixed overhead cost 12,000
Fixed marketing expense 10,800
Operating Income Br.13,800

ABC Company
Throughput Costing Income Statement
For the year ended December 31, 2008
Sales (600xBr.100) Br.60,000
Direct material Cost of goods sold 6,600
Throughput contribution Br.53,400
Other costs and expenses
Direct labor cost (800xBr.4) 3,200
Variable overhead cost ( 800xBr.5) 4,000
Fixed overhead cost ( 800x Br.15) 12,000
Variable marketing expense (600xBr.19) 11,400
Fixed marketing expense 10,800
Total other costs and expenses 41,400

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 Operating Income Br.12,000

In the above three income statement, we can see how the fixed manufacturing cost of
Br.12, 000 are accounted for under the three methods. The income statement under
variable costing deducts the lump sum Br. 12, 000 as an expense for the year. In
contrast, the income statement under absorption costing regards each finished good
units as absorbing Br15 of fixed manufacturing costs. Under absorption costing, the
Br 12,000 is initially treated as an inventorable cost of the year. If this Br. 9000
(Br.15x600) subsequently becomes a part of goods in the year and Br. 3000
(Br.15x200) remains an asset part of ending finished goods inventory on December
31, 2006. Operating income is Br. 3, 000 higher under absorption costing compared
to variable costing. The variable manufacturing costs are accounted the same way
under both methods. The base of the difference between variable costing and
absorption costing is how fixed manufacturing costs are accounted for.

The net income under throughput costing is less than that under absorption costing
and variable costing. This is because; all costs except direct material cost is
considered as periodic expense under throughput costing. That is all direct labor cost,
variable manufacturing cost and all fixed manufacturing costs are considered as
expense under throughput costing approaches.

If inventory level changes from one year to another, operating income will differ
among the three methods, because of the difference in the treatment of fixed MOH
cost. Assume ABC Company above, if the production and sales amount for the year
2009 are 800 units and 950 units respectively and all the remaining data are the same
as in 2008. Prepare the income statement under the three inventory costing
approaches
ABC Company
Absorption Costing Income Statement
For the year ended December 31, 2009
Sales (950xBr.100) Br.95,000
Cost of goods sold:
Direct material cost (950xBr. 11) Br. 10,450

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 Direct labor cost (950xBr.4) 3,800
Variable overhead cost ( 950xBr.5) 4,750
Fixed overhead cost ( 950x Br.15) 14,250
Cost of goods sold 33,250
Gross profit 61,750
Variable marketing expense (950xBr.19) 18,050
Fixed marketing expense 10,800
Operating Income Br.32,900

ABC Company
Variable Costing Income Statement
For the year ended December 31, 2009
Sales (950xBr.100) Br. 95,000
Variable cost and expenses:
Direct material cost (950xBr. 11) Br. 10,450
Direct labor cost (950xBr.4) 3,800
Variable overhead cost ( 950xBr.5) 4,750
Variable marketing expense ( 950xBr.19) 18,050
Total variable costs and expenses 37,050
Gross profit Br.57,950
Fixed overhead cost 12,000
Fixed marketing expense 10,800
Operating Income Br.35,150

ABC Company
Throughput Costing Income Statement
For the year ended December 31, 2009
Sales (950xBr.100) Br. 95,000
Direct material Cost of goods sold Br. 10,450
Throughput contribution Br. 84,550
Other costs and expenses:
Direct labor cost (800xBr.4) 3,200
Variable overhead cost ( 800xBr.5) 4,000
Fixed overhead cost ( 800x Br.15) 12,000
Variable marketing expense (600xBr.19) 18,050
Fixed marketing expense 10,800
Total other costs and expenses 48,050

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 Operating Income Br.36,500

Why do variable costing and absorption costing usually report different income? In
general, if the unit level of inventory increase during an accounting period, less
operating income will be reported under variable costing than absorption costing.
Conversely, if the inventory level decreases, more operating income will be reported
under variable costing than absorption costing. The difference in reported operating
income is due solely to;
 Moving fixed manufacturing costs in to inventories as inventories increase
and
 Moving fixed manufacturing costs out of inventories as inventory decreases
The difference between operating income under absorption costing and variable
costing can be computed by the following formula which focuses on fixed
manufacturing cost in beginning inventory and ending inventory.

Absorption costing - Variable costing = FMOH cost - FMOH cost

Operating income Operating income in end. Inventory in beg. Inventory

2003: 16,800 – 13,800 = 200x15 -15x0

3000 = 3000
2004: 32,900 – 35,150 = 15x50 – 15x200
-2250 = -2250
To summarize:
 If production is equal to sales, the operating income under the three approaches is
the same.
 If production is greater than sales, the operating income under absorption costing
is greater than operating income under direct costing. Throughput costing gives
the least operating income.
 If production is less than sales, the operating income under throughput costing is
the largest and operating income under absorption costing is the least as in the
case of ABC Company above.
Activity 7.2

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1. Explain the difference among the three inventory costing approaches
2. Which inventory costing approach gives large operating income when inventory level
decreases?
7.4 Comparison among the Three Costing Systems

Pretest
Dear learner, can you compare and contrast the three inventory costing
approaches?

Variable costing has been controversial among accountants-not because of the

disagreement about the need to delineate between variable and fixed cost for internal
planning and control but as it pertains to external reporting. Accountants who favor
variable costing for external reporting mention that, the fixed portion of manufacturing
variable costs is more closely related to the capacity to produce than to the actual
production of specific units . Hence, fixed costs should be expensed not inventoried.
Accountants who support absorption costing maintain that inventories should carry a
fixed manufacturing cost component. Why? Because both variable manufacturing costs
and fixed manufacturing costs are necessary to produce goods. Therefore, both types of
costs should be inventorable, regardless of their difference in behavior.

For external reporting to shareholders, companies around the glob tend to follow the
Generally Accepted Accounting Principles that all manufacturing costs are inventorable
Absorption costing is the required inventory method for external reporting in most
countries. A majority of companies use absorption costing for internal costing as well.
Why because, it is cost effective and less confusing to managers to use one common
method of inventory costing for both external and internal reporting and performance
evaluation. A common method of inventory can also help prevent managers from taking
action that make performance measure looks good but hurt the income they report to
shareholders. Another advantage of absorption costing is that it measures the cost of all
manufacturing resources, whether variable or fixed, necessary to produce inventory.
Many companies use inventory costing information for long-run decisions such as pricing

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and choosing a product mix. For these long-run decisions, inventory costs should include
both variable and fixed costs.

One problem with absorption costing is that, it enables a manager to increase operating
income in a specific period by increasing production-even if there is no customer demand
for the additional production. For example, ABC’s manager may be tempted to do this to
get higher bonus based on absorption-costing operating income. Generally, higher
operating income also has a positive effect on stock price, which increases managers,
stock based compensation. To reduce the undesirable incentives to build up inventories
that absorption costing can create; many companies also use variable costing for internal
reporting. Variable costing focuses attention on distinguishing variable manufacturing
costs from fixed Manufacturing costs. The following table summarizes the main
difference among the three inventory costing approaches
Items of comparisonAbsorption costing Direct costing Through put costing
Direct material Product cost Product cost Product cost
Direct labor Product cost Product cost periodic cost
Variable MOH Product cost Product cost periodic cost
Fixed MOH Product cost periodic cost periodic cost
Variable Op.Exp. periodic cost periodic cost periodic cost
Fixed Op. Exp. periodic cost periodic cost periodic cost
GAAP Acceptable Not Acceptable Not Acceptable
Usefulness For external reporting For internal reporting For internal reporting
Performance eval. Not useful Useful useful
Terms used Gross profit Contribution margin Throughput cont.
If Sales= prod. ,NI Equal Equal Equal
If Sales < prod., NI Higher Medium lower
If Sales >prod., NI lower Medium Higher

Activity 7.3
1. Which inventory costing approach gives higher operating income when
production is greater than sales?

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2. Which inventory costing approach is used for external financial reporting? Why?
Unit Summary
The three alternative inventory costing approaches are direct costing, absorption costing
and throughput costing. The main difference between direct costing and absorption
costing is the treatment of fixed MOH cost. If production is not equal to sales the three
methods gives different operating income.
Model Exam Questions
Part I: Multiple choices
1. Which of the following is the reason for the difference in the amount of net income
under absorption costing and variable costing?
A) Direct material cost B) Direct labor cost C) Variable MOH cost
D) Fixed MOH cost E) None
2. Income statement prepared under which of the following costing system is acceptable
by GAAP.
A) Absorption costing B) Direct costing C) Throughput costing
D) B and C E) None
3. Under direct costing system, which of the following is not considered as product cost?
A) Direct material cost B) Direct labor cost C) Variable MOH cost
D) Fixed MOH cost E) None
4. Which of the following is not properly matched?
A) Super variable- throughput contribution
B) Full costing- gross margin
C) Absorption costing-gross profit
D) Variable costing-contribution margin
E) None of the above
5. A company has income of Br40, 000 using direct costing for a given period.
Beginning and ending inventory for that period were 22,000 and 27,000 units
respectively. If the fixed MOH cost per unit was Br.3 for both beginning and ending
inventory, what was the income under absorption costing?
A) Br 15, 000 B) Br 25,000 C) Br 40,000 D) Br 55,000 E) None
Part II: Work out

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1. The following is income statement of ABC manufacturing company prepared under
throughput costing system for the year ended 2009
Throughput costing income statement
Sales revenue Br. 180,000
Direct material cost 36,000
Throughput contribution Br.144,000
Other costs and expense
Direct labor cost 30,000
MOH cost 60,000
Operating expense 30,000 120,000
Operating income Br. 24,000
Additional information
 The company manufactured 3,000 units of which 2,400 units were sold
 There was no beginning finished goods inventory
 There were no WIP at the beginning as well as at the end
 40% of MOH cost and 40% of operating expense is variable in nature
 The company uses actual costing system
Requirement: Prepare income statement under each of the following costing systems
1. Absorption costing
2. Variable costing

Answer key to Model Exam Questions

Part I: Multiple choices

1.D 2. A 3.D 4. E

Part II: Work out

a)
ABC Company
Absorption Costing Income Statement
For the year ended December 31, 2009
Sales Br.180,000
Cost of goods sold
Direct material cost Br. 36,000
Direct labor cost 24,000
Variable overhead cost 19,200
Fixed overhead cost 28,800
Cost of goods sold Br. 108,000
Gross profit 72,000
Variable marketing expense 12,000
Fixed marketing expense 18,000
Operating Income Br.42,000
b)

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 ABC Company
Variable Costing Income Statement
For the year ended December 31, 2009
Sales Br.180,000
Variable cost and expenses:
Direct material cost Br. 36,000
Direct labor cost 24,000
Variable overhead cost 19,200
Variable marketing expense 12,000
Total variable costs and expenses 91,200
Gross profit Br.88,800
Fixed overhead cost 36,000
Fixed marketing expense 18,000
Operating Income Br.34,800
References
1. Charrington J.O.,1996, Cost Accounting, 2nd ed., USA, West Publishing company
2. Horngren C.T., Datar S. M. & Foster G., 2006, Cost Accounting: A managerial
Emphasis, 12th edition, USA, Prentice Hall
3. Horngren C.T., Datar S. M. & Foster G., 2004, Cost Accounting: A managerial
Emphasis, 11th edition, USA, Prentice Hall
4. Horngren C.T., 1992, Management Accounting, 11th ed., USA, prentice hall
International Inc.
5. Hilton R.W., 2000, Managerial Accounting: Creating value in a Dynamic
Business Environmnt,5th ed. USA, McGraw-Hill
6. Garrison & Noreen, 2000, Managerial Accounting, 9th ed., USA, McGraw-Hill.

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