CHAPTER-4

PRODUCT COSTING SYSTEMS

Production Cost information:

Management depends on relevant and reliable information about costs in managing their
organizations. The role of management accountant is to develop management information
systems that provide managers with the cost information they need.

Product costing system:

Management need extensive information about product related costs. To meet this, it is
necessary to develop a highly reliable product costing system that is specifically designed to
record and report the organization’s operation.

A product costing system is a set of procedures used to account for an organizations product
costs and provide timely and accurate unit cost information for pricing, cost planning and
control, inventory valuation and financial statement preparation

Types of cost accounting systems:

There are three main types of cost accounting systems for manufacturing operations: Job order,
process and operational cost systems.

(a) Job order costing system: A job order costing system is a product costing system used
by both manufacturing companies and service organizations that make large, unique, or
special order products such as customized publications, specially built cabinets, custom
printing business etc. Under such a system, the costs of direct materials, direct labor,
and manufacturing overhead is traced to a specific job order or a batch of products. A
job order is a customer order for a specific number of specially designed, made to order
products. Job order costing measures the cost of each complete unit. It uses one work in
process inventory account to summarize the cost of all jobs. This account is supported
by job order cost cards or a subsidiary ledger of accounts for each job.
(b) Process costing system: A process costing system is a product costing system used by
companies that produce large amounts of similar products or liquids, or that have a
continuous production flow. Makers of paint, soft drinks, bricks, milk or paper would
use a process costing system. Under such a system the cost of direct materials, direct
labor and manufacturing overhead are first traced to processes, departments, or work
cells and then assigned to the products manufactured by those processes, departments
or work cells. A process costing system uses several works in process inventory
accounts, one for each process, department or work cell.

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 (c) Operational costing system: In reality, few actual production processes perfectly
match either a job order costing system or a process costing system. Thus, the typical
product costing system combines parts of both job order costing and process costing to
create a hybrid system designed specifically for an organizations particular production
process. An example of a company that would use an operational cost system is an
automobile man
Job order costing system
A job order costing system emphasizes cost flow, it is important to understand how costs are
incurred, recorded and transferred within the system. This cost flow along with the job order
cost cards and the subsidiary ledgers for materials and finished goods inventory forms the core
of the job order costing system. Familiarity with the flow of costs enables to fully understand
how system works.

Cost flow overview

Costs follow the flow of production, starting with materials, and move through work in
process, finished good and cost of goods sold to completion and sale.
The costs of materials are first charged to the materials inventory account and to the respective
materials accounts in the subsidiary ledger. Labor costs are accumulated in the factory payroll
account. The various manufacturing overhead costs are charged to the manufacturing overhead
account.
As products are manufactured, the costs of direct materials and direct labor are transferred to
the work in process inventory account and are recorded on the job’s job order cost card.

Manufacturing overhead costs are applied and charged to the work in process inventory
account using a predetermined overhead rate. Those charges are used to reduce the balance in
the manufacturing overhead account. They too are recorded on the job’s job order cost card.
When products and jobs are complete, the costs assigned to them are transferred to the finished
goods inventory account.
When the products are sold and shipped, their costs are transferred to the cost of goods sold
account.

Accounting of factory overhead in a job cost system:

Materials requisitions and labor time tickets make it easy to identify direct materials and direct
labor with a specific job. Factory overhead on the other hand, includes a variety of costs that
cannot be linked to a particular job. Overhead costs are recorded as incurred. All the overhead
costs are debited to a single account – factory overhead in the general ledger.
Actual Costing and Normal Costing

1. Actual costing means the aggregate of actual direct material costs, actual direct labor
cost and actual manufacturing overhead. The actual manufacturing overhead can be
known only at the end of the month or year. Therefore, under this method the managers

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 cannot know the cost of job before completion of the job. Managers often want to close
approximation of the manufacturing costs of various jobs on a timely basis, not just at
the end of the year. Managers want these costs for various ongoing uses, including
choosing which job to emphasize or de-emphasize, pricing jobs, managing costs and
preparing interim financial statements. Because management benefits from having
immediate access to the costs of jobs.

2. Normal Costing:

A predetermined or budgeted indirect cost rate is calculated for each cost pool at the
beginning of a fiscal year and overhead costs are allocated to jobs as work in progresses.
Normal costing is a costing method that traces direct costs to a cost object by using the
actual direct cost rate(s) times the actual quantity of the direct cost input(s) and allocates
indirect costs based on the budgeted indirect cost rate(s) times the actual quantity of cost
allocation base(s). Note that both actual costing and normal costing trace direct costs to
jobs in the same way. The only difference between actual costing and normal costing is that
actual costing uses an actual indirect cost rate(s), whereas normal costing uses a budgeted
indirect cost rate(s) to cost jobs.

Distinction between Actual costing and Normal costing

Actual costing Normal costing
Items
Direct costs Actual direct cost Actual direct cost rate(s)X
rate(s) X Actual Actual quantity of direct
quantity of direct cost cost input(s)
input(s)
Indirect costs Actual indirect- cost Budgeted indirect cost
rate(s)X Actual rate(s)X Actual quantity of
quantity of cost cost allocation bases
allocation bases

Example: XYZ Manufacturer uses a job-costing system with two direct cost categories
(direct materials and direct manufacturing Labor) and one manufacturing overhead cost pool.
XYZ allocates manufacturing overheard cost using direct manufacturing Labor costs. Xyz
provides the following information:
Budget for Actual Results for
Year 2006 Year 2006
Direct material cost $ 375,000 $362,500
Direct manufacturing labor cost 250,000 245,000
Manufacturing overhead cost 437,500 465,500

Required:

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(a) Compute the actual and budgeted manufacturing overall rates for 2006.
(b) During June the job cost record for job No. 205
Contained the following information:
Direct materials used $ 10,000
Direct manufacturing Labor costs 7,500

Compute the cost of job No 205 using (s) actual costing and (b) Normal costing, and c)
At the end of 2006, Compute the under- or over allocated manufacturing overhead
under normal costing why is there no under- or over-allocated overhead under actual
costing?

Solution:
(a) Computation of manufacturing overhead Rate for 2002.
Actual Budgeted

Manufacturing meatheads $ 465,500 $437500

Manufacturing Labor cost 245,000 250,000
Manufacturing overhead $ 465,500x100 $437,500x100
rate 245,000 250,000
= 190 % 175 %
(b) Computation of cost of job No 205 under actual costing and normal costing:
Actual costing Normal costing
Direct Materials used $ 10,000 $ 10,000
Direct manufacturing 7,500 7,500
Labor cost-
Allocated manufacturing 14,250 13,125
Overheads

190
(i) Actual= 7,500x
100
175
(ii) normal= 7,500x
100

Total cost of job 31,750 30,625

c) Computation of under or over allocated manufacturing overhead under

normal costing at the end of 2006:
Actual manufacturing overhead for the year 2002 = $ 465,500

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 Budgeted or allocated manufacturing for the year 2002 = 437,500
Under allocated manufacturing cost = 28,000

Reasons for no under or over allocated overhead under actual costing:

Under actual costing method, allocation of manufacturing overhead costs are based on
actual manufacturing overhead rates

The actual manufacturing overheads and allocated manufacturing overhead costs are
equal. Therefore, there will be no under or over allocation of manufacturing overhead
cost under actual costing methods.

e) Multiple overhead cost pools

The multiple overhead cost rate may be followed if the existence of multiple overhead
cost pools. Some overhead costs can be allocated to jobs based on labor cost or labor
hour basis if it is labor oriented job. On the other hand, machine hour rate may be used
if the jobs are undertaken automated machines.
To implement a normal costing system with multiple overhead cost pools, it is required
to determine the budgeted total manufacturing labor hours and the budgeted total
machine hours and identity the associated budgeted indirect total cost for each cost
pool. It would then calculate two indirect cost rates, one based on direct manufacturing
labor hours and the other based on machine hours. Indirect costs would be allocated to
jobs using these indirect cost rates and the direct manufacturing labor hours and
machine hours used by various jobs. The general ledger would contain manufacturing
overhead control and manufacturing overhead-allocated amounts for each cost pool.
End of period adjustments for under or over allocated indirect costs would then need be
made separately for each cost pool.

Example:
The Lucas Incorporation uses a job – costing system. The plant has a machining
department and an assembly department. Its job costing system has two direct cost
categories (direct materials and direct manufacturing labor) and two manufacturing
overhead cost pools (the machining department overhead, allocated using actual
machine hours, and the Assembly Department overhead, allocated using actual direct
manufacturing labor cost).

The 2002 budget for the plant is as follows:

Machining Assembly
Department Department

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Manufacturing overhead $ 900,000 $ 1,800,000
Direct manufacturing labor
Cost $ 700,000 1,000,000
Direct manufacturing labor
Hours 50,000 100,000
Machine hours 25,000 100,000

Required:
(a) Present an overview diagram of Lucas Incorporation’s job – costing system.
Compute the budgeted manufacturing overhead rate for each department
(b) During March 2002, the job cost record for job No. 555 contained the
following.
Machining Assembly
Department Department
Direct Materials used $22,500 $ 35,000
Direct manufacturing 7,000 7,500
Labor costs
Direct manufacturing
Labor – hours 500 750
Machine hours 1,000 50

Compute the total manufacturing overhead costs of job 555.

Solution: Job costing overview for determining

a) Budgeted Manufacturing overhead rate:

(i) Machining Department: 36 per machine hour [$ 900,000  25,000) hours.
(ii) Assembly Department: 180% of direct manufacturing labor cost
1,800,000
($ 1,000,000 x 100)

b) Computation of manufacturing overhead cost of job No. 555 and total job cost No 555:
(i) Total manufacturing cost of job No. 555:
Machining department - = $ 36,000
($ 36per machine hour for 1000
machine hours)
Assembly department –

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 (180% of direct manufacturing = $ 13,500
labor cost of $ 7500)

Total manufacturing overhead cost = $ 49,500

of job No. 555

Total cost of job No. 555

Machining Assembly Total
Dept. Dept.
Direct material cost $ 22,500 $ 35,000 $ 57,500
Direct manufacturing labor 7,000 7,500 14,500
Manufacturing overhead
Allocated 36,000 13,500 49,500

Total job cost $65,500 $56,000 $121,500

Process Cost Information

Process costing is vitally important to companies in many ways. The costs assigned to products
are commonly used to help set prices particularly in periods of severe competition or economic
down turn. Product costs also are used to identify which products appear to be too costly and
need to be redesigned or dropped.

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Costs assigned to products often are used to determine inventory value for financial reporting.
Managers can use product costs to evaluate the efficiency of production operations.

The accounting of process costing can be analyzed by three different cases:

Case 1: Process costing with zero beginning and ending work in process

Case 2: Process costing with zero beginning work in process but some ending work in
process

Case 3: Process costing with some beginning and some ending work in process

Case 1: Process costing with zero beginning and ending work in process:

This case presents the most basic concepts of process costing and illustrates the key features of
averaging of costs.

This case is common for companies that successfully use just in time production. Some
companies schedule production so that they will have no inventory at the end of a day because
work in process could deteriorate or spoil.
This case shows that in process costing system, unit costs can be averaged by dividing total
costs in a given accounting period by total units produced in that period.

This situation frequently occurs in service sector organization. For example, a bank can adopt
this process costing approach to compute the unit cost of processing 10,000 similar customer
deposits made in a month.

Example1: Compute the cost per unit from the following details:
Physical units for April 2003:
Work in process, beginning inventory (April 1) = 0 units
Started during April = 500 units
Completed and transferred out during April = 500 units
Work in process, ending inventory (April 30) = 0 units

Total costs for April 2003:

Direct materials costs added during January = Br 75,000

Conversion costs added during April = 25,000
Total costs Br 100,000
Solution:

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Items Total Cost Per unit cost
75000
Direct material cost Br 75,000 = Br150
500
25000
Conversion costs Br 25,000 = Br 50
500
Cost per unit =Br 200
Case 2: Process costing with zero beginning but some ending work in
Process inventory:

This case builds on the basics and introduces the concept of equivalent units.
In this case, the units started during the period may not be fully completed during the period. In
other words part of the units introduced may be completed and part of the units introduced may
not be fully completed i.e. partially completed.
As far as units completed are concerned there is no difficulty in computing cost per unit. On
the other hand for partially completed units it is difficult to compute cost per unit. For partially
completed units we have to convert the partially converted units into equivalent units. The
following steps are followed in this case. 2.

Step- 1: Summarize the flow of physical units:

For step 1, summarize the flow of physical units, using the basic cost-flow model to help
account for units:

Beginning inventory + Transfers in – Transfers out = Ending inventory.

Step- 2: Computation of the equivalent number of units produced:

This step focuses on how the output for the period should be measured. Step 2 requires us to
understand the concept of equivalent units. Equivalent units are a derived amount of output
units that takes the quantity of each input (factor of production) in units completed or in work
in process and converts it into the amount of completed output units that could be made with
their quantity of input.

For example, if 1000 units of a product in ending work in process are 75% complete with

respect to conversion costs, there are 750 units’ 1000x 75100 equivalent units of output for
conversion costs.

When calculating equivalent units in this step, focus on quantities, disregard dollar amounts
until equivalent units are completed.

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Step 3: Computation of equivalent unit costs:

Step 3 calculates equivalent unit costs by dividing direct materials and conversion costs added
during the period by the related quantity of equivalent units of work done in given period.

Step 4: Summarize total costs to account for:

This step summarizes total costs to account for. Because the beginning balance of the work in
process inventory is zero, total costs to account for consist of the costs added during the period.

Step 5: Assign total costs of units completed and to units in ending in process:

Under this step, costs are assigned to units completed and transferred out and to units still in
process at the end of the period. The key idea is to attach dollar amounts to the equivalent
output units for direct materials and conversion costs in (a) units completed and transferred out
by calculation of ending work in process

To do so, the equivalent output units for each input are multiplied by the cost per equivalent
unit calculated in step 3.

Example: 2

XYZ Inc. furnisher the following data for August 2003, the department- assembly:
Work in process, beginning inventory (August 1) = 0 units
Started during August = 5000 units
Completed and transferred = 3750 units
Work in process, ending inventory (August 31) = 1250 units

Direct material costs added during August = Br 125,000

Conversion costs added during August = 71,250
Total cost Br 196,250

Degree of completion in this department:

Direct materials 100%; conversions cost 80%. Compute the cost per unit of completed and
work in process ending inventory.

Solution:

Step 1 and 2: Summarize output in physical units and computation of equivalent units:

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 (Step 1) (Step 2)
Flow of Production Physical Equivalent units
Units Direct Conversation
Material Costs

Work in Process, beginning 0

Started during current period 5000
Total account for 5000

Completed and transferred

out during current period 3750 3750 3750
Work in process, ending 1250
1250 x 100%; 1250 x 80% 1250 1000
Accounted for 5000
Work done in current period only 5000 4750

Step 3, 4 and 5: Computation of Equivalent unit costs summarize total costs to account for, and
Assign cost’s to units completed and to units in ending work in process:

Total Direct Conversation

Production cost Materials Costs

Step 3 Costs added Br 196250 Br 125,000 Br 71250

During August
Divide by equivalent
units of work done in  5000  4750
current period
Cost per equivalent units Br 25 Br 15

Step 4: Total cost accounted for Br 196250

Step 5: Assignment of costs:

Completed and transferred
out 3750 units Br 150,000 3750 x Br 25 + 3750 x Br15
Work in process ending
(1750 units)
Direct materials Br 31250 1250 x 25
Conversion costs 15000 1000x15

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Total work in process 46250
Total costs accounted for Br196250

Journal entries:

1. Work in process – Assembly Br 125,000

Accounts Payable control 125,000

(To record direct materials purchased

and used in production during August 2003)

2. Work in Process Assembly Br 71,250

Various Accounts 71,250
(To record Assembly department
conversion costs for August 2003)
3. Work in process – Testing Br 150,000
Work in process- Assembly 150,000
(To record cost of goods completed
and transferred from Assembly to testing August 2003)

Case 3: Process Costing with Both some Beginning and some ends work in process
inventory:

Most of the cases the incomplete units in both beginning and ending work in process inventory
to account for. By using five steps to calculate

I The cost of units completed and transferred out and

II The cost of ending works in process.
To assign costs to each of these categories, however, we need to choose an inventory cost
flow method. The process costing using two alternative inventory cost – flow methods the
weighted average method and the first in first out method. The different assumptions will
produce different numbers for cost of units completed and for ending work in process.

I. Weighted Average Method:

The weighted average process- costing method calculates the equivalent – unit cost of the work
done to date (regardless of the period in which it was done) and assigns this cost to equivalent
units completed and transferred out of the process and to equivalent units in ending work in
process inventory.

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The weighted average cost is the total of all costs entering the work in process account
(regardless of whether it is from beginning work in process or from work started during the
period) divided by total equivalent units of work done to date.

Steps:
Step 1: Summarize the flow of physical units
Step 2: Compute output in terms of equivalent units
Step 3: Compute Equivalent unit costs
Step 4: Summarize total costs to Account for
Step.5: Assign costs to units completed and to units in ending work in process.

Example: 3
At the beginning of September 2003, XYZ Inc. had 1250 units partially assembled units in the
Assembly Department. During September 2003, XYZ Inc. placed another 4000 units into
production. Data for the Assembly Department for Sept, 2003 are:

Physical units for September, 2003

Work in process, beginning inventory (Sep 1) 1250 units

Direct Materials (100% complete)
Conversion costs (80% Complete)
Started during September 4000 units
Completed and transferred out
during September 4250 units
Work in process, ending inventory (Sep 30) 1000units
Direct Materials (100% complete)
Conversion cost (60% complete)

Total Costs for Sep 2003

Work in Process, beginning inventory

Direct Materials (1250 equivalent unit x Br25 per unit 31250
Conversion cost (1000, equivalent units x Br15 per unit) 15000
46250
Direct materials costs added during September 100000
Conversion costs added during September. 72300

Total costs to account for 218550

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Required:

1 Compute equivalent units for direct materials and conversion costs.

2 Also calculate the cost per equivalent unit for direct materials and conversion costs,
Summarized total cost to account for.

Solution: WEIGHTED AVERAGE COST METHOD

1. Computation of equivalent units. (step 1, and 2)

Step 1 Step 2
Physical unit Equivalent units
Flow of Production Direct Conversion
Materials Costs

Work in process beginning 1250

Started during September 4000
Total account for 5250
Completed and transferred
out during current period 4250 4250 4250
Work in process, ending * 1000
1000 x 100; 1000 x 60% 1000 600
Accounted for 5250
Work done to date 5250 4850

* Degree of competition in this department, direct materials 100%, conversion costs 50%

2) Computation of cost of equivalent units and cost assigned: (Step 3, 4, and 5)

Total Direct Conversion
Production Materials Costs
Costs

(Step 3) Work in process

beginning 46250 31250 15000
Cost added to current
period 172300 100000 72300
Cost incurred to date 31250 87300
Divide by equivalent units

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 of work done to date  5250  4850
Cost per equivalent unit of
work done to date Br 25 Br 18
(Step 4) Total costs to account for 218550
(Step 5) Assignment of costs:
Completed and transferred 182750 (4250x25) + (4250x18)
Out (4250 units)
Work in Process ending
(1000 units)
Direct materials 25000 (1000 x 25)
Conversion costs 10800 (600x18)
Total work in process 35800
Total costs accounted for Br 218550

Journal entries: Debit Credit

1. Work in process Assembly Br 100,000
Accounts payable control Br 100,000

(To record direct materials purchased and used in production during September)

2. Work in process – Assembly 72300

Various accounts 72300

(To record Assembly department Conversion cost for September)

3. Work in process- Testing 182750
Work in process – Assembly 182750

(To record cost of goods completed and transferred from assembly to Testing during
September)
II- FIRST IN FIRST OUT METHOD

In contrast to the weighted- average method, the first in first out (FIFO) process- costing
method assigns the cost of the previous period’s equivalent units in beginning work in process
inventory to the first units completed and transferred out of process, and assigns the cost of
equivalent units worked on during the current period first to complete beginning inventory,
then to start and complete new units, and finally to units in ending work in process inventory.
This method assumes that the earliest equivalent units in the work in process – Assembly
account are completed first.

A distinctive feature of the FIFO process – costing method is that work done on beginning
inventory before the current period is kept separate from work done in the current period.

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Costs incurred in the current period and units produced in the current period are used to
calculate cost per equivalent unit of work done in the current period.

In contrast, equivalent unit and cost per equivalent unit calculations in the weighted average
method merge the units and costs in beginning inventory with units and costs of work done in
the current period.

Example- 4:

Refer the example 3 and compute equivalent units and cost of equivalent units under FIFO
method.

Solution: FIFO Method

1. Computation of equivalent units.
(Step 1) (Step 2)
Flow of Production Physical units Equivalent units
Direct Conversion
Material costs

Work in process beginning 1250 (work done before current period)

Started during current period 4000
To account for 5250
Completed and transferred
out during current period:
(a) From the beginning work in process 1250
1250x (100% -100%); 1250x (100%-80) 0 250
Started and completed 3000
(3000x100%, 3000x100) 3000 3000
(b) Work in process ending 1000
1000 x 100%; 1000x60% 1000 600
Accounted for 5250
Work done in current period only 4000 3850
(a) Degree of completion in this department: direct materials 100% conversion costs 80%
(b) 4250 physical units completed and transferred out minus 1250 physical units completed
and transferred out from beginning work in process inventory.
(c) Degree of completion in this department: direct materials, 100% conversion costs 60%.

(2) Computation Equivalent unit costs, Summarize total costs to account for, and assign
costs to units completed and to units in Ending work in process:

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FIFO method of process costing:

Assembly department of XYZ Inc, for September 2003

Total Direct Conversion

Production Materials Costs
Costs

Work in process, beginning 46250 (costs of work done before

current period)
(Step3) costs added in current
period- 172300 Br 100000 Br 72300
Divide by equivalent unit
of work done in current 4000 3850
period
Cost per equivalent unit of Br 25 Br 18.78
Work done in current period
(Step 4) Total costs to account for Br 218,550
(Step 5) Assignment of costs:
Completed and transferred
out (4250 units)
Work in process, beg, (1250units) 46250
Direct materials added in current period 0 0 x 25
Conversion cost added in
current period 4695 250xBr 18.78
Total from beginning inventory 50945
Started and completed
(3000 units) 131340 (3000x25) + (3000x18.78)

Total costs of units completed 182285

& transferred out
Work in process ending (100units)
Direct materials 25000 (1000x25)
Conversion costs 1265 (600x18.78)

Total work in process, ending 36265

Total costs accounted for Br 218550

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