ARBA MINCH UNIVERSITY COLLEGE OF BUSINESS

AND ECONOMICS; DEPARTEMENT OF

ACCOUNTING AND FINANCE

Cost and management accounting I

Compiled by: Abreham Kassie

Wudneh Amare.
4/11/2023

In this course, you will study management accounting, which is also

concerned withproviding information to assist with decision-making.
Unlike financial accounting,management accounting provides information
for internal decision makers; that is, themanagers of an organization.
 Chapter one
1. Overview of Cost and Management Accounting
This chapter discuss about cost accounting and management accounting. The study of modern cost
accounting yields insights into how managers and accountants can contribute to successfully
running their businesses. It also prepares them for leadership roles. Managers use cost accounting
information to make decisions related to strategy formulation, research and development,
budgeting, production planning, and pricing, among others. To manage diverse operations of
organizations managers need monetary and nonmonetary information that helps them to analyze
and solve problems by reducing uncertainty. Accounting, often referred to as the language of
business, provides much of that necessary information. Accounting language has two primary
“variations.” financial accounting and management accounting. Cost accounting is a bridge
between financial and management accounting. Managers use this information to make decisions,
such as: -
✓ how many units to produce,
✓ what price to charge for the product, and
✓ whether to purchase a new piece of equipment.
✓ And how to allocate resources to the most efficient and profitable areas of the business.
Since the decisions managers make are different from those made by creditors and stockholders,
managers often need different information than do creditors and stockholders. In addition, the
information that managers’ need differs with the type of decision they are making. All types of
business entities manufacturing, merchandising, and service businesses require cost accounting
information systems to track their activities.
1.1. Objectives of Cost & Management Accounting
The primary goal of cost accounting is to ascertain the cost of production for every process,
department or service of a business. The accountants define cost accounting as an accounting
information system that records, measures, summarizes and reports information about costs.
Management Accounting is responsible for generating financial information require by the firm
for internal and external reporting. This involves responsibility for collecting processing, and
reporting information that will help managers in their planning, controlling, reducing costs and
other decision-making activities.
Planning
The detailed formulation of future actions to achieve a particular end is the management activity
called planning. Planning therefore requires setting objectives and identifying methods to achieve
those objectives. A firm may have the objective of increasing it is shortened long-term
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 profitability by improving the overall quality of its products. By improving product quality, the
firm should be able to reduce scrap and rework, decrease the number of customer complaints and
the amount of warranty work, reduce the resources currently assigned to inspection, and so on,
thus increasing profitability. This is accomplished by working with suppliers to improve the
quality of incoming raw materials, establishing quality control circles, and studying defects to
ascertain their cause.

Controlling
The processes of monitoring a plan’s implementation and taking corrective action as needed are
referred to as controlling. Control is usually achieved with the use of feedback. Feedback is
information that can be used to evaluate or correct the steps that are actually being taken to
implement a plan. Based on the feedback, a manager may decide to let the implementation continue
as is, take corrective action of some type to put the actions back in harmony with the original plan,
or do some midstream replanting. Feedback is a critical facet of the control function. It is here that
accounting once again plays a vital role. Accounting reports that provide feedback by comparing
planned (budgeted) data with actual data are called performance reports.
Performance report that compares budgeted sales and cost of goods sold with the actual amounts
for the month of August. Deviations from the planned amounts that increase profits are labeled
“favorable,” while those that decrease profits are called “unfavorable. “These performance reports
can have a dramatic impact on managerial actions—but they must be realistic andsupportive of
management plans. Revenue and spending targets must be based (as closely as possible) on actual
operating conditions.

Decision Making
The process of choosing among competing alternatives is decision making. Decision can be
improved if information about the alternatives is gathered and made available to managers. One
of the major roles of the accounting information system is to supply information that facilitates
decision making. This pervasive managerial function is an important part of both planning and
control. A manager cannot plan without making decisions. Managers must choose among
competing objectives and methods to carry out the chosen objectives. Only one of numerous
mutually exclusive plans can be chosen. Similar comments can be made concerning the control
function.

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 1.2. Cost and management accounting in comparison with financial accounting

1. Management Accounting: - Measures and reports financial and non.-financial information

that helps managers makes decisions to fulfill the goals of an organization. Managers use
management accounting information to choose, communicate and implement strategy. They
also use management accounting information to coordinate product design, production, and
marketing decisions. Management accounting focuses on internal reporting. The internal
reporting- external reporting distinction just mentioned is only one of several significant
differences between management accounting and financial accounting. Other distinctions
include management accounting's emphasis on the future- that's budgeting and management
accounting's emphasis on the future- that's budgeting and management accounting's emphasis
on influencing the behavior of managers and employees. Another distinction is that
management accounting is not nearly.

2. Financial accounting: - It focuses on reporting to external parties. It measures and records

business transactions and provides financial statements that are based on generally accepted
accounting principles (GAAP) Managers are responsible for the financial statements issued to
investors, government regulator, and other parties outside the organization. Executive
compensation is often directly affected by the numbers in these financial statements.
3. Cost accounting: - it provides information for management accounting and financial
accounting. Cost accounting measures and reports financial and non- financial information
relating to the cost of acquiring or utilizing resources in organization. It includes those parts of
both management accounting and financial accounting in which cost information's is collected
or analyzed.

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 Major Difference between Financial and Cost Accounting

Financial accounting Cost accounting

1. Purpose

-To record the actual or accrued expense and To record the normal revenue, expenses for
incomes and capital expenditures ascertaining cost
-To know the profit or loss for the accounting -To analyze, control, and reduce cost
period -To help management in decision making activities
-To know the financial position of the firm

2.Accounts and records

➢ Income statement Balance sheet ➢ Cost statements and sheets

➢ Stock and asset registers ➢ Variance analysis
➢ Annual reports ➢ Reports of wastage etc
➢ Quotations and estimations

3.Nature

➢ Deals with past experience • Deals with expected expenses

➢ Estimations and quotations are not • Estimations and quotations are prepared
prepared

4.Period

Annually or end of the month Whenever required by a management

5.To whom

❑ for external users ❑ For internal users

6.Compulsory

❑ compulsory by the acts ❑ not compulsory for all

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 Major Difference between Financial and Management Accounting

1. Primary users of information

Primary users of information statements and then financial accounting outcome are people and
organization outside a company. In comparison, management accounting produces internal reports
and analyses that are used by all managers. The internal reports can be financial summaries to the
financial statement, special financial analyses, or reports of non-financial data. Because the reports
must supply information that is relevant to their user specific activities, their content varies
depending on the level of management being served, the department or segment being analyzed,
and the reports’ purpose.
2. Types of accounting system
The statements generated by financial accountants show dollar totals that reflect the balance of the
accounts in the general ledger. Before financial data can be entered in to a general ledger,they
must be in a form suitable for double entry accounting. In contrast, management accounting uses
systems that are more varied and flexible .The analyses and flow of accounting data inside a
company need not depend on the double-entry format. Management accounting may gather data
for small segments or large division and they may express the data in units of measure other than
historical dollars. The information need not be organized in general ledger accounts, and special
reports can be prepared for a particular manager use. Thus to support the many activities of
management accounting, the information storage and retrieval system must be flexible and have
broad capabilities.
3. Restrictive Guidelines
Financial accounting is concerned with analyzing, classifying recording and reporting a
company’s financial activities. Financial accountants must adhere to generally accepted
accounting principles that govern the measuring, recording and reporting of financial
information. Such principles are necessary to ensure the accuracy and reliability of information,
but they limit accountants to a finite number of accounting practices.
Usually, much more information is available to managers than to people outside the company. The
presentation and analysis of that information are not limited by asset of rigid rules. Management
accounting has one primary guideline; the accounting practice or technique must produce useful
information. Before taking a problem, the management accountant must decide what information
will be useful to the recipient of the report and then must choose concepts, procedures and
techniques to generate that information, as always, the benefits of preparing each report should
outweigh the costs of preparation.

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 4. Units of measure

The fourth area of comparison between financial and management accounting is the unit of
measure used in reports and analyses. Financial accountings generate financial information about
events in the past. The common unit of measure in financial accounting is the historical dollar/birr.
Management accountants on the other hand are not restricted to using only the historical
dollar/birr; they can employ any useful units of measure. Historical dollar /birr may be used for
cost control analyses and for measuring trend for routine planning. However, for most management
decisions require forecasts and projections that rely on estimates of future dollar/ birr flow. In
addition to money units the management accountant uses which non-financial measures as
machine hour Labor hours, product or service units.
5. Focal point for Analysis
Typically, Financial accounting records and reports information on assets, liabilities, equities and
net income of a company as whole, financial statements summarize the transaction of entire
organization. Management accounting, in contrast, usually focuses on segments of business-cost
centers, profit centers, divisions or departments or some specific aspect of operations. Reports of
management accounting range from an analysis of revenues and expenses for an entire division
to an examination of the materials used by one machine.
6. Frequency of Reporting
Financial statements for external use are usually prepared on a regular basis; Monthly, quarterly,
or annually, periodic reporting at a regular interval is a basic concept of financial accounting.
Management accounting reports can be prepared monthly, quarterly or annually on the regular
basis, but they also can be requested daily or on an irregular basis. What is important is that
management accounting report is prepared whenever it is needed.
7. Degree of objectivity
Financial statements consist of data about transactions that have already happened. As result the
information is determined objectively and is verifiable. In contrast, management accounting is
concerned primarily with planning and controlling internal operations- activities that are often
future-related. Thus, the information prepared by management accountants typically consist of
subjective estimates of future events.

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 1.3. Cost classification concepts and terms

➢ Cost in general
Understanding the concepts and terms discussed in this chapter is a prerequisite to successfully
completing the remaining chapters of the text. Costs are a critical element in most business
decisions. Students also need to recognize that companies pay particular attention to costsbecause
every dollar in cost reduction is one more dollar of operating income, whereas one more dollar of
sales does not necessarily result in the same impact due to the additional costs that may be incurred
in generating those sales.
Accountant usually defines cost as a resource sacrificed or forgone to achieve a specific objective.
For now, consider cost as being measured in the conventional accounting way, as monetary unit
(for example birr) that must be paid for goods and services. Again, the term ‘cost’ can hardly be
meaningful using a suffix or a prefix. The cost is always ascertained with referenceto some object,
such as, material, Labor, direct, indirect, fixed, variable, job, process, etc. Thus, each suffix or
prefix implies certain attribute which will explain its nature and limitations.
Cost object and cost driver
Cost object is defined ‘any activity for which a separate measurement of cost is desired’. It may
be an activity or operation in which resources, like materials, labor and like that are consumed.
The cost objects maybe a department e.g. (producing department, procurement department. The
cost object may be a program e.g. (Corona control program, athletic program). The cost object
may be a product or service. E.g. Renting room, Flying passenger from Addis Ababa to Dire Dawa
and etc. The cost object may be project. E.g. constructing a house
Cost measurement must be tied to at least one cost object. Again, the same cost may pertain to
more than one cost objects simultaneously. For example, material cost may be a part of product
cost as well as production department cost. A cost driver is any factor whose change causes a
change in the total cost of a related cost object. Drivers are casual factors whose effects are
increases in total costs. There are many possible cost drivers. E.g. In factory setting, the total cost
of material used may be driven not only by the production volume but also by the quality of the
material, the skills of the worker, and the number of parts in a finished product, and the condition
of the applicable machines.
Cost accumulation, assignment and tracing /Allocation
➢ Cost accounting has two step systems
1. Cost accumulation-a process of storing or accumulating different cost data in a
Systematic manner or the collection of cost data in same organized way through an

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 accounting system. E.g. It accumulates costs by some “natural” classification such as raw
materials used, fuel consumed, or advertising placed, and then
2. Cost assignment-a process of assigning costs to the cost object using:

i. tracing accumulated costs that have a direct relationship to the cost objects and
ii. ii. Allocating accumulated costs that have an indirect relationship with the cost
object
➢ Cost Allocation /tracing
Cost assignment is a general term for assigning costs, whether direct or indirect, to a cost object.
Cost allocation is a specific term that refers to identifying indirect accumulated cost -to-cost object
such as department, activities, or products. Cost tracing is a specific term for assigning direct costs.
Classification of costs
Cost may be classified in different ways from different point of view. The same cost may be
included in several or in all of the following classification.
1. Direct and indirect costs
Based on Cost assignment point of view costs are classified as direct cost and indirect cost.
Direct costs are costs that are directly traceable to the product. Example: direct material cost and
direct labor cost.
Indirect cost is a manufacturing overhead or factory overhead: are costs which are not directly
traced to the product but allocated to it using some criteria. Example: cost of electricity,
depreciation of equipment, indirect labor, indirect material, cost of different utilities, cost of repair
and maintenance and insurance for the plant.
➢ Depending on Cost Object cost also classified as direct and in direct cost
A major question concerning costs in both manufacturing and non-manufacturing functions is
whether the cost has a direct or an indirect relationship to particular cost object.
➢ Direct costs – Costs that can be identified specifically with or traced to a given cost object
in an economically feasible way.
➢ Indirect cost – Costs that cannot be identified specifically with or traced to a given cost
object in an economically feasible way.

2. Fixed and variable costs,

Variable Costs: A variable cost is a cost that changes in total in direct proportion to a change in
the level of activity (or cost driver). A 10% increase in the units of production, for instance, would
produce a 10% increase in variable costs. However, the variable cost per unit remains the

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 same as activity changes. There are many examples of variable costs. In a manufacturingcompany,
they would usually include direct materials, direct labor, some items of manufacturing overhead
(such as utilities, supplies, and lubricants), and perhaps shipping costs and salescommissions. In a
merchandising company, they would include cost of goods sold, commissions to sales persons,
and billing costs.
Fixed Cost: A fixed cost remains unchanged in total as the level of activity (or cost driver) varies.
It means that they are not immediately affected by changes in the cost driver.
❖ Some costs that are usually fixed include:
• Some manufacturing overhead costs, like
• Rent or depreciation expenses for factory building.
• Depreciation on factory machinery and equipment.
• Insurance and property taxes on manufacturing facilities and
• Production supervisory salaries.
❖ Some non-manufacturing costs, such as
• Office property taxes.
• Office fire insurances.
• Advertising and promotion and
• Supervisory salaries (related to administrative functions)
3. Period and product costs,
The alternatives in accounting for cost are to expense it or to capitalize it. Costs that are
expensed in the period in which they are incurred are called non-capitalized costs or periodic
cost. These costs possess no future benefit and are generally associated with a non- manufacturing
area such as advertising, distribution, sales commission etc. These costs arerequired to generate
revenues but they cannot be directly related with units of product.
Product costs are costs incurred to manufacture a product (product cost) or to acquire long term
assets. These costs are recorded as an as asset at the beginning and expensed periodically.
➢ Direct material
➢ Direct Labor and
➢ Manufacturing Over Head are cost of production
4. Controllable and uncontrollable costs
The concept of controllable cost is very significant in cost accounting and contributes to the
achievement of the goals of cost control and responsibility accounting. Controllable cost is that

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 cost which is subject to direct control at some level of managerial supervision. Accountants explain
controllable cost as a cost which can be influenced by the action of a specified memberof an
undertaking whereas; non-controllable cost is the cost which is not subject to control at anylevel
of managerial supervision. Basically, a controllable cost is the cost over which a manager has
direct and full decision authority. That is, controllable costs can be controlled (reduced) by a
manager at a given organizational level. Some controllable can be partly controlled by one person
or partly by another person (centre manager). For example, the cost of raw materials is controlled
by the production managers as well as purchase managers. The production manager controls at
quantity level, and the purchase manager at the price level. Such costs are reported to both of them,
but one responsible manager should be held accountable for those costs which he can control. The
term controllable cost means variable cost whereas the term uncontrollable cos mean fixed cost.
❑ All variable costs are controllable and fixed costs are uncontrollable
❑ All direct costs are controllable and in direct costs are uncontrollable
❑ All long-term costs are controllable

5. Avoidable and unavoidable costs,

➢ Avoidable cost: Costs that are specifically incurred of an activity or sector of a business
and can be identified with the activity and such costs would be avoided, if the activity or the
sector of the business does not exist are avoidable costs. For example, the cost of a machine
hired specially to make a particular product will be avoided by discontinuing production of
that product, and therefore, is an avoidable cost.
➢ Unavoidable cost: Common costs apportioned to a particular activity or segments of a
business are usually unavoidable cost, because total common costs cannot be avoided or
even reduced even if that activity or sector does not exist. For example, rent of factory
premises apportioned to various activities is unavoidable cost “Sunk” costs,
➢ Sunk cost: It represents historical costs, incurred in the past and is irrevocable in a given
situation. Hence, a sunk cost is not relevant to current decision making. Generally, the book
value of an asset is treated as sunk cost, while considering the replacement of the asset.
6. Budgeted, standard and actual costs and their comparisons and analyses
Standard Cost: Standard costs are those costs which are planned or pre-determined cost estimates
for a unit of output in order to get a basis for comparison with actual costs. The preparation of
standard costs and applying them to measure the variations from actual cost and analyzing the
causes of variations with a view to maintain maximum efficiency in production is known as
standard costing. It is evaluated at assuming a particular level of efficiency in

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 utilization of material, labour and indirect services. Standard costs are used to prepare budgets.
Standard cost is a unit concept and indicates standard cost per unit of output, per labour hour etc.
On the other hand, the term budgeted Cost’ is a total concept and implies total budgeted cost of an
item at some activity level or output level such as budgeted cost of material is Br 8,00,000 if 8000
units are produced. Budgeted costs are costs expected to be incurred in the future period where as
actual cost are costs incurred in the past period.
1.4. The use of linear, curvilinear and step functions and how their calculations are used to
analyze cost behavior
• Linear function: It is important to note that when we speak of a cost as being variable, we
mean the total rises and fall as the activity level rises and falls. This idea is presented below,
assuming that a company's products cost $24:

Units produced cost per unit Total variable

1 $24 $24
500 24 12,000
1,000 24 24,000

TVC
24,000
12,000 VC/U

500 1000 1500

Volume of cost driver 500 1000 1500
Volume of cost driver
As the above graphs show, total variable cost increases proportionately with activity. When the
volume of activity (units produced) doubles from 500 to 1000 total variable cost doubles from birr
12000 to 24000. In contrast, a variable cost on a per unit basis remains constant birr 24 asthe
volume of output increases. The following formula can used to show total variable and unit
variable costs respectively.
TVC=UVC x A, where
TVC-Total variable cost
UVC-unit variable cost
A-activity volume
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 UVC=TVC/A
Non liner costs: A non-linear cost is a cost that varies with the volume of activity but not
proportionally or consistently. Non-linear costs may increase at a decreasing rate or at anincreasing
rate. Exhibit shows a non-linear cost that increases at a decreasing rate. This type of cost is referred
to as a learning curve cost. The terms originate from the observed decrease in labor costs that
sometimes occurs, as employee becomes familiar with a new task.

Average
DL
Hours
Per unit Average cost
Cumulative units

The behavior of non-linear cost

As the graph above shows, the unit variable cost declines as activity increase. Put differently, this
cost exhibit decreasing marginal costs (the cost of producing the next unit) or this type of cost
behavior is characterized by smaller cost per unit of output as activity level increases.
Step costs: A step cost is fixed for a given amount of production and then rises in a constant
amount at a higher production level. For example, in a manufacturing concern, one supervisor is
needed at a salary of Br 20,000 p.m. for every 50 workers. So long as 50 workers or less than that
are working, the supervision costs will be Br. 20,000 p.m. But, as soon as the 51st worker is
employed, the cost of supervision rises by Br. 20,000 p.m. and will be Br. 40,000. Up to 100
workers the cost of supervision remains fixed at Rs. 40,000. But, if more than 100 workers are
employed the cost of supervision will go up further. The following figure can be used to explain
this concept:

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 Other classification of cost

➢ Marginal cost: is cost incurred to manufacture one more product.

➢ Out of pocket cost: is cash expenditure associated with a particular decision alternative.
➢ Opportunity cost: is the cost of an opportunity for gone when one course of action is
chosen over another. Opportunity cost is not an out-of-pocket cost but represents an
opportunity associated with each of the alternatives that are rejected.
Manufacturing cost
In manufacturing enterprises production costs are grouped in to three categories.
➢ Direct material
➢ Direct labor and
➢ Manufacturing overhead cost
Prime cost and conversion costs are two other terms used to describe production cost.
➢ Prime cost: are the most important or significant costs traceable to unit of finished
product. They include direct material and direct labor cost.
Prime cost= Direct material cost + Direct labor cost
➢ Conversion costs are those required to convert raw material in to finished product and
consists of direct labor and manicuring and manufacturing overhead cost.
Conversion cost = Direct labor cost + Manufacturing overhead cost
1.5. The concepts of cost units, cost centers and profit centers
A cost center is a department or a unit that supervises, allocates, segregates, and eliminates all
sorts of costs related to a company. The cost center’s prime work is to check the cost of an
organization and to limit the unwanted expenditure that the company may acquire. The cost can
be the determination of both people and location. In multinational companies, the cost center is
authorized to decrease and manage the cost. These costs are generally monitored by analyzing and
deducting the actual cost incurred with the standard cost.
❑ Types of cost centers are:

• Production cost center

• Personal cost center
• Service cost center
• Impersonal cost center
• Process cost center
• Operation cost center

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 For example, the customer service department may not generate direct profits for a business, but
it helps to control the expenses of the business (by conceptualizing what customers want) and also
aids in reducing the costs of the company.
Profit Centre Meaning
A profit center is a division or department of a company that operates for the calculation of profit.
In an organization, different profit centres are managed by managers who identify profits on the
basis of costs and revenues. The profit center is accountable for all the actions associated with the
sale of goods and production. The principal object of a profit centres is to generate and maximize
the profit by minimizing the cost incurred and increasing sales. This objective helps to uplift the
profit-making capability of a company. The accomplishment of a profit centres is estimated in
terms of profit growth during a definite period. The achievement of a profit center is examined by
subtracting the actual cost from the budgeted cost.
The difference between a cost center and a profit center

Cost center Profit center

Definition
A cost centre is a company’s department that A profit centre is a company’s department that
supervises all the costs of the company. is responsible for the profits of the company.
Responsibilities
Reducing costs and effective cost control Helping in earning profits and maximizing
within the organization revenue
Complexity involved
A cost centre has lesser complexity as the only A profit centre is more complex as it has to
focus in on costs. focus on costs, profits, and revenue.
Approach followed
Short term approach Both short and long term approaches are
followed
Scope of operations
Comparatively narrow Comparatively wide

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 Chapter two
2. Cost determination: The costing of resource inputs
2.1 Materials
The term “materials" generally used in manufacturing concern refers to raw materials used for
production, sub-assemblies and fabricated parts. These materials will be, directly or indirectly,
entered in to the production of the final product. Thus, proper accounting and control over
materials are required for effective & efficient materials management.
Concepts and Objectives of Materials Control
Materials cost constitute the major part of the total cost of production in manufacturing firms.
Therefore, proper accounting for and control over materials purchase, consumption, and
inventories are important for effective management of a business. Basically, materials control aims
at efficient purchasing, & receiving of materials, their Storing and efficient Use, or Consumption.
In general, the following are the objectives in a good system of materials control.
In short, control over materials enables us to achieve the five R's.
1. Right quantity materials 4. At the right place
2. Right Quality materials 5. From right suppliers
3. At the right time

2.1.1 Accounting for stock (inventory) movements

The most important steps in materials purchasing and receiving procedures are summarized
below:
1. Purchase Requisition
The purchase requisition is properly approved, or authorized, written request for materials.
Usually, purchase requisitions are prepared by the storekeepers for regular store items, which are
below, or approaching the minimum level of stock. The purchase of specialized materials may be
requested by production of user departments.
Purchasing requisition serves three general purposes:
i) It automatically starts the purchasing process and informs the purchasing department
of the need for the purchase of materials.
ii) It fixes the responsibility of the department making the purchase requisition
iii) It can be used for future reference.

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 2. Purchase order
After receiving requisition, the purchasing department places an order with a supplier. For routine
purchases, the order is placed with established suppliers. In other cases, the purchasing department
may ask from bids or send out request for price quotation before placing the order.
Purchase order should clearly state the materials required and the price: and provide information
such as delivery period and the department for whom in the materials is purchased. Purchase order
may be prepared in several copies depending on the need of the firm. The original copy however
is sent to the supplier: Second copy to accounting department: third copy to store: and so on.
While the PO process for your company may be unique in some ways, there are 7 elements of
the workflow that are common to most, if not all, purchase order processes:
1. Purchase order creation 4. Binding contract
2. Approval 5. Goods delivery
3. Dispatch 6. Three way match and 7. Closure
7 steps of the purchase order process
1. Order creation
The first step in the PO process is to create a purchase request. At this point, you’ll need to know
what is being purchased, the priority level of the requisition, your budget, when the product or
service is needed, who needs to approve the order, and the suppliers.
2. Approval
After the order has been created, the next step in the process is to get approval of the purchase
requisition. In some cases, this approval may be verbal or sent as an email. In other companies,
more formal actions, such as completing paperwork, may be required. The level of approvals
depends on the purchase amount, company policies or guidelines, and the requirements of the
supplier.
3. Dispatch
After the requisition is approved, the PO is sent to the selected vendors. The vendors then submit
bids based on the POs. The bids are approved based on price, quality, support, service, schedule,
and other factors relevant to your business.
4. Binding contract
After the bid is accepted, the company and the vendor must agree to a contract. The contract
typically includes terms and conditions relevant to the purchase, such as what support comes
with the item being purchased or how to handle any disputes.

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Cost and management accounting I
 5. Goods delivery
The supplier will then produce and deliver the items being purchased based on the outlined
schedule and shipping requirements. Your company will verify quality and match the goods
received against the expected goods. Typically, the supplier will send the purchasing company
an invoice that outlines the price and payment terms.
6. Three -way match
After the goods received are approved, the purchasing company will then match the purchase order
with the PO and invoice from the supplier. Companies should check to ensure that all charges are
accurate.
7. Closure
After the three-way match is approved, the purchase order is closed out.

3. Receiving Materials
The receiving department performs the function of unloading and unpacking materials which are
received by an organization. Materials are inspected and inspection report is prepared, indicating the
items accepted and rejected, with reason. Receiving report is prepared by the receiving department.
Receiving report may be prepared in several copies, one going to each department interested in the
arrival of materials, including stories, purchasing department, and accounting department.
4. Preparing and Recoding the Voucher:
After the receiving report is received, the purchasing unit compares the supplier's invoice with
the purchase order and receiving report to make sure that:
➢ Goods ordered have been received in good condition and those listed on the invoice.
➢ Terms, unit prices, shipping charges, and other details agree with order specifications.
➢ Computations are correct.
Then the purchase of materials is recorded as follows:
Raw materials xxx
Vouchers payable xxx
The above entry is recorded in a voucher register, and the voucher is sent to the treasurer’s office,
the voucher is filed in the unpaid vouchers file according to the last date on which the discount may
be taken.
5. Paying the voucher

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Cost and management accounting I
A check is prepared for the net amount. The check is then recorded in the check register. The
employee marks the voucher “paid "by using a rubber stamp and enters the check is mailed to the
supplier, and the voucher is returned to the voucher clerk.

2.1.2 Accounting for materials returned

Occasionally, damaged or defective materials received. These items are usually returned to the
supplier immediately. A note of the return is made on the receiving clerk' copy of the purchase
order and on the receiving repot. The purchasing agent then prepares a debit memorandum. A debit
memorandum is a notice to the vendor (means suppler) of a reduction from the invoice for the cost
of the returned materials. Then the following entry is recorded.
Example
A furniture manufacturer has issued a debit memorandum to a supplier for materials returned
costing $3000. The entry to record this transaction in the book of the buyer is
Vouchers payable 3000
Purchase returns and allowances ------------3000
A credit memorandum is a notice to the supplier of an addition to the invoice a supplier ships more
materials than were ordered. In this case, if the buyer needs the excess materials, they will be kept
by issuing credit memorandum for additional cost. The accounting entry is shown below:
Raw materials xxx
Vouchers payable xxx
Illustration:-The following are transactions of ABC manufacturing company for the month of
June 2005. Record in general journal form those transactions that require entries.
June 2 Purchase requisition 201 for 2000 units of materials k-70 is prepared by the storeroom clerk.
The material is to be ordered from Family International at a cost of $8.00 per unit.
Terms 2/10, n/60.
June 4. Purchase order 79 is completed for the materials specified on purchase requisition 201
16 Materials ordered on purchase order 79 are received. Of the 2000 units received, 100
units are rejected because they have imperfections and are immediately returned.
Receiving report 95 is prepared. The purchase invoice is included in the carton, dated
May 16.
17 A debit memorandum to Family International for materials returned is prepared
17 Materials received yesterday from Family International (except those returned) are
transferred to the storeroom and entered in the materials ledger.
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Cost and management accounting I
 25 A check to Family international for the amount due, within discount, is prepared and
mailed.
Solution
June 2 No entry is made when materials requisition is issued (prepared). It initiates the
purchasing procedures.
4 No entry is made when purchase order is place with supplier.
16 No entry is made when receiving report is prepared
16 Raw materials (2000 x 8) ----------------------- 16,000
Vouchers payable (Family international)-------------------- 16,000
17 Vouchers payable (Family International) ------------------ 800
Purchase Returns & Allowances -------------------------------- 800
17 No journal entry is made when materials are received by the storekeeper. Rather materials
ledger card and other necessary documents are updated.
25 Vouchers payable (Family International) --------------------- 15,200
Purchase Discounts 304
Cash 14896
2.1.3. Storing and Issuing Materials
2.1.4 Storage of Materials
Two types of control are made in store, one is physical control of materials and the second is
accounting control.
a) Physical control of materials involves restricting admission to the storeroom area only for
authorized personnel. If the store room is open to everybody, materials may be stolen.
b) Accounting control of materials involves maintaining the necessary records for the materials; one
important record is materials ledger. The materials ledger and bin tag are shown below.
2.1.5 Issuance (Use)of Materials
Materials requisition is prepared by production (using) departments in order receive materials from
the store. No material is issued without a materials requisition. Materials requisition is prepared by
department head or job supervisor.
Materials requisition shows the quantity materials number, description, and job number to which the
materials are charged (for direct materials) or department (for indirect materials)
Up on receipt of materials requisition, the storeroom supervisor issues the materials and makes the
necessary notations or the requisition. The storeroom clerk enters the unit price and computers and
enters the total amount.
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The Journal entry is as follows:
Work in process xxx
MOH control xxx
Raw materials xxx
Note that materials Requisition Journal is a special journal used in a job-cost system.
2.1.6 Return of Materials to storeroom
Sometimes materials that have been issued are returned to the storeroom. This may be due to
requisitioning too many materials, withdrawing the wrong materials, or some other reasons. Then
the cost clerk will make the following entry and post to job cost sheet and/or department overhead
analysis sheet.
Raw materials xxx
Work in process xxx
MOH xxx
Inventory Control
Inventory management refers to the planning, organizing, and controlling activities to ensure that
inventories are kept at levels which provide maximum services at minimum cost. The mainobjective
of inventory control is to ensure that stock outs do not occur and that surplus stocks are not
accumulated and carried. Inventory management includes management of finishedgoods, work-
in-process, and raw materials.
In controlling inventories or stock levels are established for standardized materials which are
regularly used by the firm so that inventory holding can be controlled. Control of raw materials
requires the purchasing department to determine the reorder point and reorder quantity.
Reorder quantity: - refers the quantity to be covered in a single purchase order.
Reorder point (or the level): - is the level at which store-keeper initiates purchase requisitions for
new supplies of materials. to determine reorder quantity and reorder level the following variables
are important.
Lead time: refers to the amount of time it takes for the materials to be delivered from the supplier.
Usage is also used to determine the reorder quantity. Usage represents the consumption patterns.
safety stock (if any). Safety stock is the minimum level of material that should be on hand to ensure
that the company does not run out of materials.
➢ Determining the Recorder point

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Cost and management accounting I
In order to determine the reorder point, we need to have the lead time, usage and safety stock (if
any). Safety stock is the minimum level of material that should be on hand to ensure that the
company does not run out of materials.
Example:- Assume that XYZ manufacturing wants to have at least 180 units on hand at all
times. The factory uses 10 units every day. It takes fifteen days to receive an order. The reorder
point is
Lead time usage (10x 15 days) -------------------------- 150 units
Add, Safety Stock 180
Reorder point 330 units
The reorder point represents the inventory level at which a new purchase order must be issued.
According to the above example, a new purchase order is placed when the quantities of raw
materials on hand reached 330 units. If the new purchase order is processed as expected within
15 days, the inventory reaches the safety stock of 180 units when the new units arrive at the premise
of the factory.
Another problem is determining how much to order at a time (Economic order Quantity). EOQ
refers to the level of inventory at which the total cost of inventory comprising ordering cost and
carrying cost. To determine this quantity, it is necessary to consider the costs of placing an order
and the costs of carrying items in the store. If the frequency of ordering materials is increasing, the
cost of order will be higher and vice versa. Holding many items involve higher holding costs.
Determining an optimum level involves two types of cost such as ordering cost and carrying
cost. The EOQ is that inventory level that minimizes the total of ordering and carrying cost.
Some examples of order costs are:
1. Costs of maintaining the purchasing department
2. Costs of operating the receiving department
3. Clerical costs of processing an order.
The costs of holding items in the inventory includes:
1. Costs of handling and storing materials
2. Costs of operating the receiving department
3. Clerical costs of processing an order
4. Clerical costs of maintaining inventory records
In order to determine the quantity that should be ordered at a time, the following formula is used.

EOQ = ට2DCൗ H

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 Were
EOQ = Economic order quantity
D = Annual requirements (demand)
C = Ordering cost per unit
H = Holding cost per unit
Example
ABC printing has determined that the cost to place an order for papers is Br. 10 and the cost to
carry this item in inventory is Br. 0.8 per dozen. 10,000 dozen of papers are required for production
each year, what is the economic order quantity?
Solution

EOQ =ට2x10,000x10ൗ
0.8
=500 dozens of papers per order is the economic order quantity
2.2. Accounting for labor Cost
Labor cost is an important element of costs, it constitutes a significant portion of total cost of
production. This it is important to establish an efficient system of labor control and selecting the
most appropriate method of remunerating them. The productivity of all other resources is linked
to the productivity of employees. Assets cannot operate by themselves.
2.2.1. Type of labor costs
Labor costs are composed of direct and indirect payments to workers and other personnelengaged
in manufacturing activities. In other words, labor costs represent the costs of purchasingthe labor
hours and employee's services. Thus, labor costs are classified as direct labor indirect labor.
1. Direct labor: - is the personnel who work directly with the raw materials in converting
them to finished goods. In other words, direct labor is the time spent by a work,identifiable
with the particular job or a process.
2. Indirect labor: -is the wage of factory personnel who do not work directly on raw
materials. Indirect labor does not directly spend time on a particular job or product. The
distinction between direct labor and indirect labor is based on the convenience of linking
the time spent on a particular job or product. Although indirect workers spend time on
work of general nature, they also equally support production activities

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2.2.2.Types of labor remuneration methods
The remuneration of employees is a reward of services rendered by him. It is an agreement
among employer and employee. For remuneration, B.K. Bhar has rightly point out that,
"Remuneration is the reward for labor and services, whereas incentive is the stimulation of
effort and effusiveness by offering monetary inducement or extra facilities."
A. Normal Remuneration Method
It has already been stated that labor is one of the main elements of production. The success of
a business organization is based on the efficiency of labor. There are several methods of wage
payment. These are differing from each organization to another organization. The methods of
wage payment are as follows:
1. Time Rate Method: This method is very popular method of payment of wages. Under
this method, the payment is made on the basis of time devoted by worker in the factory.
It is an oldest form of wage payment. In this method wages are calculated as follows:
Wages = Hours Worked x Rate per Hour
2. Piece Rate Method: In this method, wages are paid on the basis of units produced by the
workers. The rate of payment is determined by production department. Under this method,
wages of workers are calculated by following formula:
Total Wages = No. of Units Produced x Rate Per Unit
Illustration: From the following information, calculate total wages by piece rate method and
time rate method.
Standard Hours 60
Actual Hours Worked 50
No. of Unit Produced 500
Rate per Hour Br.20
Rate per unit produced Br.5
Solution:
The total wages paid to workers is calculated as follows:
➢ Time Rate Method
Formula = Actual Hours Worked x Rate per Hour = 50 x Br. 20 = Br. 1,000
➢ Piece Rate Method:
Formula = No. of Unit Produced X Rate per unit produced = 500XBr.5=2500
B. Incentive Wages Method

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 Generally, incentive may be deemed as an extra payment paid by employer to
worker/employees for his additional efficiency. The main objective of an incentive plan to
induce a worker to produce more to earn higher wages. Incentive plans increase the efficiency
and capacity of workers
2.3. Accounting for Factory Over Head Costs
Overhead refers to any cost which is not directly attributable to a particular unit. In other words,
overheads are real costs and represent spending on resources or services which benefitall units
of products and services. Overhead costs are costs common to more than one unit cannot be
linked to a particular unit.
Factory overhead
Factory overhead is the aggregate of indirect costs associated with manufacturing activities,
Factory overhead is also called factory burden, manufacturing overhead, manufacturing
expresses, or indirect manufacturing costs.
Factory overhead includes:
➢ Factory rent, lighting a heating
➢ Depreciation repairs and maintenance
➢ Salaries and related costs of production management
➢ Wages of indirect costs of production management
➢ Indirect materials and etc
In general, factory overhead costs are classified into three. There are:
1. Indirect labor
2. Indirect materials
3. Other factory overhead
In order to record the entry is:
Manufacturing overhead control ----------------------------- xxx
Various accounts xxx
Setting Overhead Rates
Manufacturing overhead costs are not directly traceable to a unit of output. Instead, these costs are
accumulated during the year and charged to jobs or products at the end of the year. However,
management cannot wait until the end of the year, or month to find out how much particular job
costs. Cost date are most useful when they are immediately available then they can be used to
evaluate efficiency, to suggest changes in procedures, and to help setting profitable selling prices.
The cost accountant is usually expected to report the total setting profitable selling prices.
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The cost accountant is usually expected to report the total cost of a job as soon as its finished. At
this time the actual total overhead costs are available, as they would be the end of a fiscal period.
Thus, the accountant has to devise a method of estimating overhead costs applicable of the
completed jobs. This is achieved by establishing a predetermined overhead rate, or predetermined
overhead application rate.
Predetermined overhead application rate refers to the rate determined before the commencement
of the period during which the same would be used.
Types of overhead rate bases
The overhead rate is calculated with reference to the amount of overhead provided in the budget
and a predetermined volume of production in terms of the base which will be used as denominator.
The base should be the best available of the cause-and-effect relationships between overhead
costs and cost drivers.
Overhead rate = Estimated manufacturing overhead during the year
Estimated activity base
Activity base may be any one of the six bases mentioned below:
1. Units of production 4. Prime cost
2. Direct material cost 5. Direct labor hours
3. Direct labor cost 6. Machine hours

Illustration
A summary of the budget data for Abdi manufacturer for the year ended December 31, 2019 is
given below:
Budgeted Manufacturing overhead costs during the year = $ 600,000

" Units of production = 30,000 units

" Direct labor costs = $400,000
" Direct labor hours = 240,000 hours
" Direct material costs = $ 360,000
"
Required: Machine
Determine hoursapplication rate under
overhead = 350,000
each ofhours
the following bases:
Units of production d) Prime cost
Direct material cost e) Direct labor hours
Direct labor cost f) Machine hours
a) Units of production
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 Units of production result in a meaningful rate only if the manufacturing process is simple and
only if one type or a few very similar types of goods are produced.
Rate = Estimated Manufacturing Overhead
Estimated units of production
= 600,000 = $ 20 /unit
30,000
The rate implies that if one unit is produced, the overhead applied (charged) to this unit is $20.
If a job of 100 units is produced, the overhead applied to the job would be $2000 (i.e., $20 x 100
units= $2000)
b) Direct Material cost
Under this method, the overhead application rate is expressed as a percentage of direct material
costs. Rate = Estimated Manufacturing Overhead
Estimated Direct material costs
= 600,000
360,000
= 1.67 or 167% of direct maternal costs
If direct materials consumed of job No. 15 totaled $22,000, the overhead applied to this job
would be $36,740 (i.e 167%22000: 36,740)
Direct material cost is more appropriate when each article manufactured must require
approximately the same amount of materials, or usage must distribute uniformly thought out the
manufacturing process.
However, in practice, most overhead costs have little relationship to materials used. As a result,
it is likely to give totally inaccurate results.

a) Direct labor hours:

This method assumes that overhead costs tend to vary with the number of hours of direct labor
used:
Rate= Estimated Manufacturing Overhead
Estimated Direct labor hours
= 600,000
240,000
= 250% of direct labor hours, or
= $2.50 direct labor hour.
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 If a job required 100 direct labor hours is completed, the overhead applied to job would be
$25000 (i.e $2.50 x 100 hours = $2500)
The direct labor hour basis is more appropriate if labor operations are the major part of the
production process.
Applying manufacturing overhead
In the preceding discussion, the methods of determining overhead application rate were
introduced. However, accounting for applied overhead was not introduced. Thus, this topic is
intended to introduce how manufacturing overhead is applied to jobs or products, how to record
in the accounting records, and how to treat the difference between actual manufacturing overhead
and applied manufacturing overhead.
In general, the following procedures are used to apply manufacturing overhead to jobs orproducts.
Step 1. Select the application base (bases described earlier)
Step 2. Prepare a factory overhead budget for the planning period. The two key items are
(a) Budgeted total overhead and
(b) Budgeted total volume of the application base.
Step 3 Compute the overhead application rate by dividing the budgeted total overhead cost by the
budgeted total volume of the application base.

Step 4 Obtain the actual application base (such as machine hours) for the period.

Step5 Apply the overhead to the jobs by multiplying the overhead application rate by the actual
application base data.

Step 6 prepare the necessary entry to the applied factory overhead by the following entry
Work in process xxx
Manufacturing applied ----------------------------- xxx

Step 7 At the end of the period, account for any difference between the amount of overhead
actually incurred and overhead applied to products.
➢ Example Suppose that a company budgeted its factory overhead for the fourth coming year
as $900,000. Assume that manufacturing overhead is applied to products on the basis of

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 machine hours of 600,000 hours. Assume further that a job cost sheet for job 243 included
the following information:

Actual direct materials cost ---------------------------- $ 2500

Actual direct labor cost ------------------------------------ 3000
Actual machine hours ------------------------------------- 2000 hours
Required
A. Determine the overhead application rate
B. Compute the applied overhead to job 243
C. Prepare the entry to record applied overhead to job 243
D. Determine the total manufacturing costs of job 243.
Solution
a. Overhead application rate = Estimated Manufacturing Overhead
Budgeted machine hours
= 900,000
600,000
= $ 1.51 machine hour
b. Applied overhead = overhead rate x Actual activity base
= 1.50 x 2000
= $ 3000
c. Entry
Work in process 3000
Manufacturing overhead applied --------------------------- 3000
d. Actual direct material cost ------------------------------- $ 2500
Actual direct labor cost 3000
Applied manufacturing overhead --------------------------- 3000
Total manufacturing or production costs (Job 243) … $ 7500
Note that the applied manufacturing overhead is posted to job cost sheet.
Some accountants prefer to credit special departmental overhead applied account, instead of
directly crediting manufacturing overhead control account. i.e.
Work in process ...................................... 3000
Manufacturing overhead applied .......................... 3000

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Then manufacturing overhead applied account is closed to manufacturing overhead control
account as follows:
Manufacturing overhead applied ................. 3000
Manufacturing overhead control .................................. 3000

Over Applied or Under Applied Overhead

Actual manufacturing overhead costs have been debited to MOH control account, and the same
account has been credited from the manufacturing overhead applied to jobs or products. At the end
of the period, MOH control account may have debit or credit balance. A credit balance in the
account implies over applied manufacturing overhead. In other words, over applied overhead
occurs when applied overhead is greater than actual manufacturing overhead. If actual
manufacturing overhead, on the other hand, exceeds applied overhead, the difference is called
under applied overhead. In other words, under applied overhead is said to exist if MOH control
account has debit balance.
Problems of overhead application
When FOH control Account is over Applied WIP, FG, and CGS as the same time increases but if
FOH control account is under applied it is vice versa. To eliminate the above problems there are
three types of adjustments.
The next question is how to treat under applied or over applied overhead. The treatment depends
on whether the objective is to prepare interim or annual financial statements. The manner of
treating under applied or over applied overhead varies, depending on whether the intention is for
interim or annual report
1. Monthly procedures (Interim Reporting)
The balance of MOH control account is closed to over “applied or under applied manufacturing
overhead” account at the end of the month.
Under applied overhead is closed as follows:

Under applied manufacturing overhead .......................... xxx

Manufacturing overhead control ...................................... xxx
Over applied overhead is closed as follows:
Manufacturing overhead control ............................. xxx
Over applied manufacturing overhead ................................. xxx

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The under applied or over applied manufacturing overhead is not closed monthly. The amount of
under applied is considered a deferred charge and is shown under prepaid expenses on the interim
balance sheet as a deferred credit.
Note that the amount of under applied or over applied overhead does not appear in the interim
income statement. The statement of cost of goods manufactured shows direct materials used, direct
labor, and manufacturing overhead applied.
2. End-of-year procedures
The balance of under applied or over applied manufacturing overhead represents a difference
between overhead costs applied to goods worked on during the year and the actual overhead costs
that were incurred in producing these goods. There are two ways of treating under applied or over
applied overhead at the end of the year.

Immediate write off method

If the amount of under applied or over applied overhead is small, it is regarded as an adjustment
to Cost of Goods sold (i.e., written-off against cost of goods sold account).
Example
Assume that factory overhead incurred is $800.000 and that factory overhead applied is
$750.000. The difference is under applied of $50.000. The closing entry is:
Cost of Goods sold .................................. 50.000
Manufacturing overhead control ............ 50.000
If the difference were over applied, the closing entry would be:
Manufacturing overhead control ................. 50.000
Cost of Goods sold ........................................ 50.000
Perorations Method
If the amount of under applied or over applied overhead is considered to be material, it is divided
among Cost of Goods Sold. Work in Process, and Finished Goods Inventory.

Example Assume that factory overhead incurred is $900.000 and that factory overhead applied is
$1,200,000. The difference is considered to the material. Assume further that the ending balances
(before prorating) were as follows:
Cost of goods sold............................... $1,000,000
Work in Process ........................................ 400,000
Finished goods ……………………… 600,000
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Required
1. Compute under applied or over applied overhead at year end.
2. Prorate under applied or over applied overhead among the three balances.
3. Prepare the closing entry to record the prorated amount assuming that applied overhead was
recorded in manufacturing overhead control account.
4. Compute the new balances of the account after proration.
Solution
1. Over applied overhead:
Factory overhead applied ............................................... $1,200,000
Less Factory overhead incurred ......................................... 900.000
Over applied overhead ………………………………… $ 300.000
2. Proration of over applied overhead is shown below:
1,000,000X300,000
Cost of Goods Sold = = $ 150.000
2,000,000
400,000X300,000
Work in Process = = 60,000
2,000,000
600,000X300,000
Finished Goods = = 90,000
2,000,000

3. Manufacturing overhead control ......................... 300,000

Cost of Goods sold ................................................. 150,000
Work in Process ........................................................ 60,000
Finished Goods ......................................................... 90,000
4. The balance of the three accounts after proration are computed below.
Cost of Goods sold = 1,000,000 - $150,000 = $850,000
Work in Process = 400,000 - 60,000 = 340,000
Finished Goods = 600,000 - 90,000 = 510,000
2.4. Recording of costs and schedule of costs of products.
1. Recording of raw material purchase.
Raw material ------------------ xx
Cash/account payable --------------- xx
2. Recording of raw material used in to production.
Work-in-process inventory ---------------- xx
Raw material xx
3. Recording of labor cost incurred in production.
Work-in-process inventory ------------------- xx
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 Salary/ wage payable --------------------------- xx
4. Recording of actual manufacturing overhead cost.
Manufacturing overhead cost --------- xx
Various accounts xx
5. Recording of applied manufacturing overhead cost.
Work-in process inventory-------------- xx
Manufacturing overhead applied ------------ xx
6. Recording of completion of production.
Finished goods inventory --------------- xx
Work in process inventory ----------------- xx
7. Recording sales of product.
Cash/account receivable --------------- xx
Sales xx
Finished goods inventory ------------- xx
Cost of goods sold expense --------------- xx

Schedule of cost of goods manufactured

Alpha-Manufacturing company
Schedule of cost of Goods Manufactured
For the month of November, 20xx
Direct material used:
Raw-material inventory, November-1 ------------------------ xx
Add: November purchase of raw material -------------------- xx
Raw material available for use --------------------------------- xx
Deduct: Raw-material inventory, November-30 -------------- xx
Raw material used xx
Direct labor xx
Manufacturing overhead applied to work in process ---------------------------- xx
Total manufacturing costs xxx
Add: Work in process inventory, November-1 ------------------------------------ xx
Subtotal xx
Deduct: Work in process, November-30, ------------------------------------------- xx
Cost of goods produced xxx

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 Chapter Three

3. Costing methods: The costing of resource outputs

Costing methods: Costing system is also called as product costing system or cost accounting
system. It is a frame work used by a firm to estimate the costs of their product. Estimating the
accurate costs of product is a critical for profitable operation. A firm must know which product is
profitable and which one are not. This can be ascertained only when it has estimated the correct
cost of the product. Further, a product costing system helps in estimating the closing value of
material inventory, work in progress and finished goods inventory for the purpose of financial
statement preparation.
Any product costing system is acceptable in practice if it is effective and efficient in serving the
company’s unique production needs, provides information desired by management, meets external
reporting demands, and can be maintained at a cost that is reasonable when compared to the
benefits received. These criteria apply equally well to both manufacturers and service companies.
Purpose of product costs-Product costs are needed for a variety of purpose in both financial
accounting and managerial accounting.
Use in financial accounting- in financial accounting, product costs are needed to value inventory
on the balance sheet and to compute cost of goods sold expense on the income statement. Under
generally accepted accounting principles, inventory is valued at its cost until it is sold. The cost of
the inventory becomes an expense of the period in which it is sold.

Use in managerial accounting- In managerial accounting, product costs are needed for planning,
for cost control, and to provide managers with data for decision making. Decisions about product
price, the mix of products to be produced, and the quantity of output to be manufactured are among
those decisions for which product cost information is needed.
In addition to financial statement preparation and internal decision making, there is an ever-
growing need for product cost information in relationships between firms and various outside
organizations. For example, Hospitals keep track of the costs of medical procedures that are
reimbursed by insurance companies or by the federal government under the Medicare program.
Some manufacturing firms sign cost-plus contracts with the government, where the contract price
depends on the cost of manufacturing the product.

The need for product costs is not limited to manufacturing firms. Merchandising firms include
the costs of buying and transporting merchandise in their product costs.

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Service firms and nonprofit organizations- their production output consists of different services
that are consumed as they are produced ie since services cannot be stored and sold later like
manufacturing goods, there are no inventor able costs in service industries firms and nonprofit
organizations. However, organizations such as Banks, insurance companies, restaurants, airlines,
law firms, hospitals, and city governments all record the costs of producing various services for
the purposes of planning, cost control, and decision making. For example, in making decision
about adding a flight from Addis Ababa to New York, Ethiopian air lines’ management needs to
know the cost of flying the proposed route.
Types of product costing systems-The accounting procedures of companies use different product
costing systems depending on the nature of the activities being undertaken. Accordingly,
companies may use one or more of the following product costing systems- Activity Based Costing
system, Job order costing system, batch costing system, contract costing system and Process
costing system.
Job order, batch and contract costing methods
1. Job order costing system: is a type of cost system that provides for a separate record of
the cost of each particular quantity of product that passes through the factory.
Job order costing system is commonly used by companies with products that are unique and
divisible. In this system, costs are assigned to a distinct unit, batch or lot of product or service.
Job is a task for which resources are expended in bringing a distinct product or service to market
A job order cost system accumulates costs for each quantity of product, or “job,” that passes
through the factory. Direct materials, direct labor, and factory overhead are accumulated on the
job cost sheet, which is the subsidiary cost ledger for each job. Direct materials and direct labor
are assigned to individual jobs based on the quantity used. Factory overhead costs are assigned to
each job based on an activity base that reflects the use of factory overhead costs. As a job is
finished, its costs are transferred to the finished goods ledger. When goods are sold, the cost is
transferred from finished goods inventory to cost of goods sold.
Examples of business that use job order costing includes: construction companies, Furniture
manufacturers, printing firms, Repair shops, Service giving organization and Garages etc.
2. Batch costing

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 3. Contract costing, also known as terminal costing, is a variant of job costing. Contract means
a big job in which work is done at site and not in factory premises. The cost of each contract
is ascertained. Thus, in this method of costing, each contract is a cost unit and an account is
opened for each contract in the books of contractor to ascertain profit/loss thereon.
➢ Characteristics of Contract Costing
Contract costing usually shows the following features:
1. Contracts are generally of large size and, therefore, a contractor usually carries out a small
number of contracts at a particular point of time.
2. A contract generally takes more than one year to complete,
3. Work on contracts is carried out at the site of contracts and not in factory premises.
4. Each contract undertaken is treated as a cost unit.
5. A separate contract account is prepared for each contract in the books of contractor to
ascertain profit or loss on each contract.
6. Nearly all labor cost will be direct.
7. Most expenses (e.g., electricity, telephone, insurance, etc.) are also direct.

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 8. Specialist subcontractors may be employed for say, electrical fittings, welding work, glass
work, etc.
9. Plant and equipment may be purchased for the contract or may be hired for the duration of
the contract.
➢ Contract Costing and Job Costing — Distinction
Main points of distinction between contract costing and job costing are as follows:
1. Contract is generally big while job is small. It is well said, “a job is a small contract and a
contract is a big job.”
2. The number of jobs undertaken at a time is usually large as compared to number of
contracts because contracts are generally much bigger in size.
3. In contract costing most of the costs are chargeable direct to contract accounts. Under
job costing, direct allocation to such an extent is not possible.
4. Allocation and apportionment of overhead costs is simpler in contract costing as
compared to job costing.
5. Jobs are usually carried out in factory premises while contract work is done at site.
3.2. Accounting procedures for job order costing system.
Accounting procedures for job order costing
Job order costing system requires a subsidiary ledger for each job order and general ledger
(controlling account) for the total amount. Entries in subsidiary ledger will be made frequently and
summarized in control account in weekly or monthly interval.
Major Accounting procedures in job order costing system
Receiving job order and purchase of raw materials
Transferring raw material to work in process
Recording labor to work in process.
Recording actual manufacturing overhead cost incurred
Allocating manufacturing overhead cost to work in process
work in process to finished goods
Transferring finished goods to customers.
Manufacturing overhead cost is incurred for the benefit of all jobs produced during a period and
cannot be related to any particular job. As manufacturing overhead costs are incurred, they are
accumulated as manufacturing overhead control account.
Some manufacturing costs such as utility will not be known until the end of the period. Hence,
rather than holding a finished good job until all costs can be attributed to it, it is necessary to
develop a method of allocating manufacturing overhead cost to the job completed. This is called
normal costing. In normal costing direct material and direct labor costs are directly traced to the

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job completed but MOH cost is allocated to it using budgeted rate and actual allocation base. To
determine budgeted rate:
❖ Estimate manufacturing overhead cost for the year.
❖ Choose allocation base such as labor hour, direct labor cost or machine hour.
❖ Estimate the allocation base for the year
❖ Calculate the budgeted rate using the formula
Budgeted rate = Budgeted MOH cost
Budgeted allocation base
3.3.Job order costing system- - illustration
To illustrate the procedures used in job-order costing, we will examine the accounting entries made
by Alpha-manufacturing co. during November 2003. The company uses machine hours to allocate
overhead costs to the individual jobs. It has worked on two production jobs during the month.
Job-1: 80 deluxe wooden tables
Job-2: 80 deluxe aluminum boats
The company undertaken the following activities/transaction during the month of November and
a balance of beginning direct material 30,000, working in process inventory 4,000, finished good
12,000
Transaction-1: Acquisition of direct materials
4000-square feet of rolled aluminum sheet metal were purchased on account for $10,000. The
purchase is recorded with the following journal entry.
Raw-material Inventory --------------------- 10,000
Accounts payable 10,000
Transaction-2: Use of direct material
On November -1, the following material requisitions were filed.
Requisition number-001 (for job-1) --------- 8,000 board feet of lumber, at $2 per board foot, for a
total of $16,000
Requisition number-002 (for job-2) ---7,200 square feet of aluminum sheet metal, at $2.50 per
square foot, for a total of $18,000
The following journal entry records the release of these raw materials to production.
Work-in-process inventory -------------- 34,000
Raw-material inventory --------------------34,000
Transaction-3: Use of indirect material
On November 15, the following material requisition was filed.
Requisition 003: 5-gallons of bonding glue, at $10 per gallon, for a total cost of $50
Manufacturing overhead ------------------ 50

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 Manufacturing supplies inventory --------- 50
Since only small amounts of bonding glue are used in the production of all classes of boats
manufactured by the company, the costs incurred is small, and no attempt is made to trace the cost
of glue to specific jobs. Instead, glue is considered an indirect material, and its cost is included in
manufacturing overhead. The company accumulates all manufacturing-overhead cost in
Manufacturing Overhead account. All actual overhead cost is recorded by debiting the account
when indirect materials are requisitioned, when indirect-labor costs are incurred, when utility bills
are paid, when depreciation is recorded on manufacturing equipment, and so on.
Transaction-4: Use of direct labor
At the end of November, the cost-accounting department used the labor time tickets filed during
the month to determine the following direct-labor costs of each job.
Direct labor: Job-1 --------------- $9,000
Direct labor: Job-2 -------------- 12,000
Total direct labor ----------------- $21,000
The journal entry used to record these costs should be
Work-in-process Inventory -------------- 21,000
Wages payable 21,000
Transaction-5: Use of indirect labor
The analysis of large time card undertaken on November-30 also revealed the following use of
indirect labor that is not charged to either of the products specifically amounts to $14,000.
This cost is comprised of the production supervisor’s salary and the wages of various employees
who spent some of their time on maintenance, general cleanup duties and salary of guards and
store keepers during November.
Manufacturing overhead ------------------- 14,000
Wages Payable 14,000
No entry is made on any job cost sheet, since indirect-labor costs are not traceable to any particular
job. In practice, journal entries (4) and (5) are usually combined into one compound entry as
follows:
Work in process inventory ----------------- 21,000
Manufacturing overhead -------------------- 14,000
Wages payable 35,000
Transaction-6: Other manufacturing overhead costs
During November, the company incurred the following other manufacturing overhead costbesides
the indirect materials and indirect labors costs.
Rent on factory building (expired prepaid rent) ------------ $3,000
Depreciation on equipment ------------------------------------ 5,000
Utilities (electricity, water, telephone) ----------------------- 4,000
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 Property taxes 2,000
Insurance (amount expire during the month) ----------------- 1,000
Total $15,000
The following compound entry is made on November-30, to record these costs.
Manufacturing overhead ----------------------- 15,000
Prepaid Rent 3,000
Accumulated depreciation-Equipment --------------- 5,000
Accounts Payable (utilities and property tax) --------6,000
Prepaid Insurance 1,000
Application of manufacturing overhead
Various manufacturing-overhead costs were incurred during November, and these costs were
accumulated by debiting the Manufacturing-Overhead accounts. However, no manufacturing-
overhead cost have yet been added to Work- in-Process Inventory or recorded on the job-cost
sheets. The application of overhead to the firm’s products is based on a predetermined overhead
rate. This rate computed by the accounting department at the beginning of the period.
Transaction-7: Allocation of overhead costs
Factory machine-usage records indicate the following usage of machine hours during November.
Machine hour used: Job-1 ----------------------------- 1, 200 hours
Machine hour used: Job-2 ------------------------------ 2,000 hours
Total machine hours ------------------------------------- 3,200 hours
The total manufacturing overhead applied to Work-in Process Inventory during November is
calculated as follows:
The total manufacturing overhead applied to Work-in-Process Inventory during November is
calculated as follows:
Machine hour Predetermined Manufacturing
Overhead rate overhead applied
Job-1 1,200 × $9.00 = $10,800
Job-2 2,000 × $9.00 = $18,000
Total manufacturing overhead applied $28,800
The following journal entry is made to apply manufacturing overhead to Work-in-Process
Inventory.
Work-in-Process Inventory ---------------------- 28,800
Manufacturing overhead -------------------------------- 28,800
NB. As the following time line shows, three concepts are used in accounting for overhead.
Overhead is budgeted at the beginning of the accounting period, it is applied during the period,
and actual overhead is measured at the end of the period.

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Transaction-8: Selling and administrative costs
During November, Alpha-manufacturing co. incurred the following selling and administrative
costs.
Rental of sales and administrative offices --------------------------$1,500
Salaries of sales personnel 4,000
Salaries of management 8,000
Advertising 1,000
Office supplies used 300
Total $14,800
Since these are not manufacturing costs, they are not added to Work-in-Process Inventory. Selling
and administrative costs are period costs, not product costs. They are treated as expenses of the
accounting period. The following journal entry is made
Selling and Administrative Expenses --------------------- 14,800
Wages Payable 12,000
Accounts payable 1,000
Prepaid Rent 1,500
Office Supplies inventory 300
Transaction-9: Completion of production job
Job-2 was completed during November, whereas job-1 remained in process. The job sheet
indicates that the total cost of job-2 was $48,000. The following journal entry records the transfer
of these job costs from Work-in-Process Inventory to finished goods inventory.
Finished goods inventory -------------------- 48,000
Work-in- Process inventory ------------------ 48,000
Transaction-10: Sales of goods
Sixty deluxe aluminum fishing boats manufactured in job-2 were sold for $900 each during
November. The cost of each unit sold was $600 as shown on the job cost sheet. The following
journal entries were made
a) Accounts Receivable ----------------- 54,000
Sales Revenue 54,000
a) Cost of goods sold----------------------- 36,000
Finished goods inventory ---------------- 36,000
The reminder of the manufacturing cost of job-2 remains in Finished –goods inventory until
some subsequent accounting period when the units are sold. Therefore, the cost balance for job-2
remaining in inventory is $12,000 (20 units remaining times $600 per unit.)
Transaction-11: Disposition of overhead balances
During November, Alpha-Manufacturing co. incurred total actual manufacturing-overhead costs
of $29,050, but only $28,800 of overhead was applied to Work-in-Process Inventory. The
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amount by which the company’s actual overhead exceeds applied overhead, called under
applied overhead, is calculated below.
Actual manufacturing overhead* ----------------------------------$29,050
Applied manufacturing overhead+ -------------------------------- 28,800
Under applied overhead $ 250
The company disposes its overhead balances at the end of the year by directly writing the amount
to cost goods sold during the period. Accordingly, the following journal entry is made by the
company. This entry reduces the balance of Manufacturing Overhead accounts to zero and increase
the balance of cost of goods sold account by $250.
Cost of goods sold 250 Manufacturing
Overhead control -------------------------------- 250
Schedule of cost of goods sold
Schedule of cost of goods sold for Alpha-manufacturing Company is displayed in exhibit. This
schedule shows the November cost of goods sold and detailed the changes in Finished-Goods
Inventory during the month.
Schedule of cost of goods manufactured
Alpha-Manufacturing company
Schedule of cost of Goods Manufactured
For the month of November, 2003
Direct material:
Raw-material inventory, November-1 ------------------------- $30,000
Add: November purchase of raw material -------------------- 10,000
Raw material available for use---------------------------------- $40,000
Deduct: Raw-material inventory, November-30 -------------- 6000
Raw material used $34,000
Direct labor 21,000
Manufacturing overhead:
Indirect material $50
Indirect labor 14,000
Rent on factory building 3,000
Depreciation on equipment 5,000
Utilities 4,000
Property taxes 2,000
Insurance 1,000
Total actual manufacturing overhead ------------------------------ $29,050
Deduct: Under applied overhead ----------------------------------- 250*
Overhead applied to work in process --------------------------------------------- 28,800
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 Total manufacturing costs $83,800
Add: Work in process inventory, November-1 --------------------------------- 4,000
Subtotal $87,800
Deduct: Work in process, November-30, --------------------------------------- 39,800
Cost of goods manufactured $48,000
The schedule of cost of goods manufactured lists the manufacturing costs applied to Work in
Process. Therefore, the under applied overhead of $250 must be deducted from total actual
overhead to arrive at the amount of overhead applied to work in process during November. If there
had been over applied overhead, the balance would have been added to total actualmanufacturing
overhead.
Schedule of cost of goods sold
Alpha-Manufacturing company
Schedule of cost of goods sold
For the Month of November, 2003
Finished goods inventory, November-1 ------------------------------------- $12,000
Add: Cost of goods manufactured* -------------------------------------------- 48,000
Cost of goods available for sale ---------------------------------------------- $60,000
Deduct: Finished-goods inventory, November-30 -------------------------- 24,000
Cost of goods sold (before adjustment) ------------------------------------- $36,000
Add: Under applied overhead + 250
Cost of goods sold (adjusted for under applied overhead) ----------------$36,250
Income statements
Alpha-Manufacturing company
Income statement
For the Month of November, 2003
Sales revenue $54,000
Less: Cost of goods sold* 36,250
Gross margin $17,750
Selling and administrative expenses ---------------------------------------------14,800
Income before taxes $ 2,950
Accounting for the treatment of waste, scrap, spoilage and re work costs,
➢ Spoilage, reworked units and scrap
Spoilage, rework and scrap in general: Spoilages (Defective): are units of production whether fully
or partially completed that don’t meet the standard required by customers for good unitsand
that are discarded or sold for reduced price. Example, Defective shirts, shoes, electronic devices

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Types of spoilage
Normal spoilage: is spoilage inherent in a particular production process that arises even under
efficient operating condition. Depending on the production process, management decides the
spoilage it considers normal.
Cost of normal spoilage is typically included as a component of cost of good unit’s manufactured
because good units cannot be made without also making some units that are spoiled.
Abnormal spoilage: is spoilage that would not arise under efficient operating condition. It is not
inherent in a particular production process. It arises because of machine break down and operators’
error. Abnormal spoilage is usually avoidable or controllable. Abnormal spoilage cost is recorded
separately and treated as loss of the current year.
Reworks: are units of production that don’t meet the standard required by customers for finished
units that are subsequently repaired and sold as acceptable finished unit.
In job order costing system, like spoilage, they are divided as normal rework attributable to a
specific job, normal rework common to all jobs and abnormal rework.
Scrapes: are materials left over when making a product. They have low sales value compared with
the sales value of the main products. Example, short lengths from wood working operations,frayed
cloth etc.
The treatment of spoilage in job order costing
There are normal and abnormal spoilages in job order costing. Costs of normal spoilage are
inventoriable whereas abnormal spoilage is not inventoriable and are written off as losses of the
period in which they are identified. In Job order costing system abnormal spoilage are regarded
as controllable by the first stage supervisor. Normal spoilage in Job order costing is two types
normal spoilage attributable to specific job and common to all jobs.
Normal spoilage attributable to a specific Job
When the spoilage is caused due to the specification related to a particular Job, that job should
absorb this cost of the spoilage by net of the salvage value of the spoiled units, if salable. To
recognize the estimated selling price (disposal value) of the spoilage, J. entry should be recorded
Materials xx
Work in process ---------------------- xx
➢ Disposal value
Example:
In fasica machine shop, 10 machine parts of a job lot of 100 machine parts are spoiled. Costs
assigned period to the inspection point are Br. 4000 per part. The current disposal price of the
spoiled parts is estimated to be Br. 1200 per part.
Required: Prepare the necessary J. entry at the time the spoiled parts are identified and given
❖ That they are related to the particular job.
Materials 12000
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 Work –in process --------------------- 12000
The cost of the spoiled units = (10 parts X Br 4000) - Br 12000)
= Br. 40,000 – Br. 12,000
= 28,000
The cost of good units =
= (90 units X Br.4000) + Br 28,000
= Br. 360,000 +Br.28,000
= Br. 388,000
Normal spoilage common to all jobs
Normal spoilage may coincidentally occur due to the inherent problem in the manufacturing.
Process where different jobs are being worked on. Under this condition, the costs of the spoilage
cannot be assigned to the particular job but to all jobs manufacturing overhead. The j. entry based
on the above examples is recorded as follows:

Manufacturing overhead control ------------- 28,000

Work in process 28,000
When normal spoilage is common to all jobs, the budgeted manufacturing overhead application
rate is applied to spoilage cost. Therefore, the normal spoilage cost is allocated, to all jobs based
on the application rate under this condition;
The costs of goods units = 90 parts X Br 4000 = Br. 360,000
Plus the allocated share of Br. 28000
Cost of good unit. = 388,000
Abnormal spoilage
If the spoilage is abnormal, the cost of the abnormal spoilage net of any disposal value is debited
to an account titled loss from abnormal spoilage. Abnormal spoilage is not part of the cost of good
units. If the spoilage in the above example was abnormal, the J. entry the cost of ab normal spoilage
net of salvage value would be:
Loss from abnormal spoilage --------- 28,000
Work – in process ----------------------- 28,000
Abnormal spoilage is reported as the loss of the period in which it is identified.
Reworked units
As it has been defined before is the cost of unacceptable units of production that are
subsequently repaired and sold as normal finished goods. Rework is distinguished
As
i. Normal rework attributable to specific jog
ii. Normal rework common to all jobs
iii. Abnormal rework
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Assume the 10 spoiled machine parts in our previous illustration are reworked at a total costs of
Br 40,000 details of costs assumed) assigned to the 10 spoiled parts before considering rework
costs are as follows.
Work in process 40,000
Material 15000
Wages payable 15000
Manufacturing overhead control-------------------- 10000
Normal rework attributable to a specific job: - If the rework is normal and if it is related to the
specification of a particular job, the costs of the rework should be assigned to that particular job.
Work – in process ----------------------- 7600
Materials control ----------------------- 1600
Wages payable ------------------------ 4000
Manufacturing overhead control 2000
Normal rework common to all jobs
When rework is normal and is caused to the inherent problem of the manufacturing process
different jobs, the costs of the rework are charged to manufacturing overhead control account and
allocated to all jobs like the other overhead costs and the journal entry recorded the rework costs
is as follows – assume the rework costs in the previous example.
Manufacturing overhead control ----------------------------------- 7600
Materials control 1600
Wages payable 4000
Manufacturing overhead control ----------------------------------- 2000

Abnormal Rework
If the rework is abnormal, it is charged to loss form abnormal rework account. The accounting
treatment for abnormal rework is the same in both job costing and process costing if the rework
cost in the previous example is abnormal; the J. entry is recorded as follows:
Loss from abnormal rework ----------------------------------- 7600
Materials control 1600
Wages payable 4000
Manufacturing overhead control --------------------------------- 2000
Accounting for scrap
A scrap as has been defined before represents remains of materials left over from the
manufacturing process. They have low sales value as compared with the sales value of the main
products.
The accounting issue related to scrap is

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 1. 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?
2. How should revenue from scrap be accounted for?
Recognizing scrap at the time of sale
Scrap is recognized at the time of sale when its dollar amount is immaterial (make no difference).
The accounting treatment is to make a memo of the quantity of the scrap returned to the store room
and to recorded the following J. entry at the time of sale.
Assume the selling price of a given quantity of material is Br. 500.
Cash (A/R)------------------- 500
Sales of scrap 500
The sale of scrap is an account that represents the revenue generated from the selling of the
scrap.
It is reported the income statement as other income.
When the dollar amount of scrap is material and the scrap is sold quickly after it is known,
the accounting treatment depend on whether the scrap is attributable to a specific job or is
common to all jobs.
Scrap attributable to a specific job
If a scrap is feasible with the making of a specific job the selling price of the scrap reduces the
cost of the particular job.
Cash (A/R) 500
work in process job(x) ----------------------------- 500
. Scrap common to all jobs When it is not possible to identify scrap with a specific job, the
selling price of the scrap will be prorated and deducted from the costs of all jobs.

Cash (A/R) 500 Manufacturing

overhead control ---------------------------- 500
Recognizing scrap at the time of its production
In the discussion of above it was assumed that the scrap is sold immediately as if is produced
(identified) however, there may be a time interval between its production and it’s selling or reusing
it. In this case, separate scrap inventory account is maintained or the scrap is recorded in the
materials control account like the other materials at its expected net realizable value. The scrap is
than stored until sold or reused. The scrap may be attributable to specific job or many be common
to all jobs.
Scrap Attributable to a Specific Job: The journal entry in the Company to record scrap returned
to storeroom is:
Material Control ............. xx
WIP .................................. xx
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Scrap Common to All Jobs: The journal entry in this case Scrap returned to storeroom is :
Material Control .................. xx
MOH Control… .................... xx
Observe that Materials Control account is debited in place of Cash or Account Receivable.
When scrap is sold, the journal entry is:
Sales of Scrap:
Cash (Account Receivable)............. xxx
Material Control… .................... xxx
Scrap attributable to a specific job
It’s expected net realizable value should be deducted from the cost of that particular job’s and the
scrap inventory should increase the balance of the materials control account.
Let us assume that the estimate selling price of a given scrap is Br. 1000 and its related costs of
selling (disposal, is estimated to be Br. 200, the net realizable value of the scrap is Br. 800 (Br
1000 – Br 200) and, the storage of the scrap is recorded as follows:
Material 800 Work
- in process ------------------800
Scrap common to all jobs
When scrap is not identified with a specific job but caused due to the common to all jobs associated
in the prorated amount of manufacturing process, the expected net realizable value of the scrap
reduces the cost of all jobs.
Material control 800
Manufacturing overhead control 800
(Returning to store)
Later, when the scrap is sold, the actual selling price of the scrap may be different from its expected
net realizable value; the situation could be one of the following.
➢ the selling price = net realizable value
➢ the selling price < net realizable value
➢ the selling price > net realizable value
Because of the difference in the selling price and net realizable value of the scrap the journal
entry that is recorded at the time of the sales also different.
Lt’s see the J. entry assuming the above example the selling price is Br. 800 Br.700 and Br. 900
is respectively.
If (i) the selling price = Net realizable value
Cash (A/R) 800
Material control----------------------- 800
(ii) The selling price < Net realizable value
Cash (A/R) 700
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 Work – in process (Manu OHD) ----------- 100
Material control --------------------- 800
(iii) The selling price > Net realizable value
Cash 900
Material control 800
Work – in process (Manu OHD) ------------ 100
*Manufacturing overhead control.

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CHAPTER FOUR: - The Process and Operation or service costing methods
Process costing system is used for manufacturing processes which produce a single product or
single mix of products continuously for an extended period of time.

❖ It is used by companies that produce large numbers of identical units.

❖ In these kinds of firms, there is no need to trace costs to specific batches of production,
because the products in the different batches are identical.
❖ A process costing system accumulates all the production costs for a large number of units
of outputs, and then costs are averaged over all of the units.
❖ In this system, the unit cost of a product or service is obtained by using broad averages to
assign costs to mass of similar units produced for general sale and not for any specific
customers.
Companies that use process costing system are: Cement factories, Petroleum refineries, Flour
companies, Beer factories, Textile factories and Beverage companies.

Similarity between job order and process costing

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 costs. Both systems maintain

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and use the same basic manufacturing accounts, including MOH, Raw Materials, Work inProcess,
and Finished Goods.

Illustration (WA & FIFO methods) Valuation of process transfers to FG and working-
process using equivalent units of production using FIFO and average method

ABC Manufacturing Company manufactures thousands of Products A. These components are

assembled in the Assembly Department, upon completion the units are completely transferred to
the Testing Department. The process-costing system for Product A has a single direct cost category
(direct materials) and a single indirect-cost category (conversion costs). Materials are added at
the beginning of the process in Assembly. Conversion costs are added evenly during Assembly.

Case 1: Process costing with zero beginning and zero ending work in process inventory that
is all units are started and fully completed by the end of the accounting period.
Data for the Assembly Department for January 2001
Physical Units for January 2001
WIP (January 1) 0 units
Started during January --------------------------------------- 400 units
Completed & transferred out during January-------------- 400 units
WIP ending inventory (January 31) ------------------------ 0 units

Total Costs for January 2001

Direct materials costs added during January-- Br.32, 000

Conversion costs added during January ------------ 24,000
Total Assembly Department costs added during January ----------- 56,000

Solution:

Direct Material costs per unit (32,000/400) Br. 80

Conversion costs per unit (24000/400) 60
Assembly Department costs per unit 140

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

• The cost of fully assembled units in the period and the cost of partially assembled units
still in process at the end of the period should calculate based on the following steps.

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Steps

1. Summarize the flow of physical units of output.

2. Compute output in terms of equivalent units.

3. Compute equivalent unit costs.

4. Summarize total costs to account for.

5. Assign total costs to unit’s completed and to units in ending work in process.

• Equivalent Units: A key Concept

Material, labor and overhead costs are incurred at different rates in production process. Direct
material usually placed in production at one or more discreet points in the process. In contrast,
direct labor and manufacturing overhead, called conversion costs, and usually are incurred
continuously throughout the process. When an accounting period ends, the partially completed
goods that remain in process generally are at different stages of completion with respect to material
and conversion activity.

• The term equivalent units are used in process costing to refer to the amount of
manufacturing activity that has been applied to a batch of physical units.

• The 1000 physical units 75% complete with respect to conversion in process represent 750
equivalent units of conversion activity.

• The term equivalent unit is also used to measure the amount of direct materials represented
by the partially completed goods.

• Since direct materials are incorporated at the beginning of the production process, the
1000 physical units represent 1000 equivalent units of direct material ( 1000 physical units
* 100% complete with respect to direct materials)

• Equivalent units is 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 that quantity of input.

Data for the Assembly Department for February 2001

❖ Physical Units for February 2001

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 WIP, beginning inventory (February 1) ------------ 0 units
Started during February ----------------------------- 400 units
Completed & transferred out during February --- 175 units
WIP, ending inventory (February 28) ------------- 225 units

❖ Total Costs for February 2001

DM costs added during February ---------------Br.32, 000

CC added during February -------------------------- 18,600
Total Assembly Dep't costs added during February ------- 50,600

❑ In addition, the Assembly Department estimates that the partially assembled units are on
averages 60% complete as to conversion costs.

• Required: Prepare cost of production report.

➢ Step 1 & 2. Summarize the flow of physical units of output and equivalent unit.

➢ Step 3&4 Compute equivalent unit costs and Summarize total costs to account for.

➢ Step 5 assign costs to completed and transfer out and work-in process ending inventory.

Flow of production Physical units Equivalent units

Direct material conversion costs

Work in process, beginning 0

Started during current period 400

To account for 400

Completed and transferred out during 175 175 175

current period
Work in process, ending 225*100% 225 225 135
225*60%
Accounted for 400

Work done in current period 400 310

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Calculation of Product Costs (Steps 3, 4, and 5)

Total Direct Conversion

Production Cost Materials cost

(Step 3) Costs added during February divided by 50,600 400 310

equivalent units of work done in current period
Cost per equivalent unit Br. 80 Br. 60
(Step 4) Total costs to account for Br. 50,600 Br.32,000 Br.18,600
(Step 5) Assignment of costs:
Completed & transferred out (175 units) Br. 24,500 (175*80) (175*60)
Work in process, ending (225 units) 26,100 225*80 225*60
Total costs accounted for Br. 50,600
Journal Entries

Work in Process- Assembly ------ 32,000

Raw martial Control ----------- 32,000

(To record direct materials purchased and used in production)

Work in Process- Assembly ------- 18,600

Various accounts -------------- --- 18,600

(To record Assembly department conversion costs)

Work in Process- Testing ------------- 24,500

Work in Process- Assembly ------- -- 24,500

(To record cost of goods completed and transferred from Assembly to Testing Department)

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

Data for the Assembly Department for March 2001

❑ Physical Units for March 2001

WIP, beginning inventory (March1) ------------------------ 225 units

Direct Materials (100% complete)

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 Conversion costs (60% complete)

Started during March 275 units

Completed and transferred out during March -------------- 400 units

Work in Process, ending inventory (March 31) ----------- 100 units

Direct Materials (100% complete)

Conversion costs (50% complete)

Total Costs for March 2001

Work in process, beginning inventory

Direct materials (225 equivalent units * Br. 80/unit)---- Br. 18,000
Conversioncosts (135 equivalent units * Br.60/unit) --------- 8,100 Br. 26,100
Direct materials costs added during March --------------------------------------------- 19,800
Conversion costs added during March --------------------------------------------------- 16,380
Total costs to account for Br.62, 280
Weighted-Average process costing method

• It merges equivalent unit in beginning WIP with equivalent unit of work done in the
current period.

❖ This 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.

1. Weighted average method (WA)

Physical units and Equivalent units (Step 1&2)

Flow of Production Physical units Equivalent Units

Direct materials Conversion costs

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Work in process, beginning 225

Started during current period 275

To account for 500

Completed and transferred out during 400 400 400

current period

Work in process, ending 100*100%; 100 100 50

100*50%

Accounted for 500

Work done to date 500 500 450

Calculation of Product Costs (Steps 3, 4, and 5)

Total Direct Conversion

production cost material cost

(Step-3) Work in process, beginning Br.26,100 Br.18,000 Br.8,100

Costs added during the current period

Costs incurred to date divided by Equivalent units 36,180 19,800 16380

of work done to date 500 450

Cost per equivalent unit of work done to date Br. 75.60 Br.54.40

(Step 4) Total costs to account for Br.62,280

(Step 5) Assignment of Costs

Completed and transferred out (400 units) 52,000 (400*75.60) (400*54.40)

=30,240 =21,760

Work in process, Ending (100 units) 10,280 100*75.60= 50*54.40=

2,720
7,560

Total costs accounted for Br. 62,280

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FIFO methods

• Work done on WIP beginning before the current period is kept separate from work done in
the current period.

• Cost 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.

• The 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
the process, and

• Assigns the cost added during the current period first to complete beginning inventory,
then to both start and complete new units, last ending work in process inventory.

Physical units and Equivalent units (Step 1&2)

Flow of Production Physical units Equivalent units

Direct material Conversion cost

Work in process, beginning 225

Started during current period 275

To account for 500

Completed and transferred out during 225 0 90

current period 225*(100%-100%);
225*(100%-60%)
Started and Completed 175*100%, 175 175 175
175*100%
Work in process, ending 100*100%; 100 100 50
100*50%
Work done in current period 500 275 315

Calculation of Product Costs (Steps 3, 4, and 5)

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 Total Direct Conversion
Production Materials costs
Costs

(Step 3) Work in process, beginning Br.26,100 Br.18,000 Br.8,100

Costs added current period Divided by 36,180 19,800/ 275 16,380/ 315
equivalent units of work done
Costs per equivalent unit of work done in Br. 72 Br. 52
the current period
(Step 4) Total costs to account for Br.62,280

Work in process, beginning (225 units) Br. 26,100 Br.18,000 Br.8,100

added in current period to complete WIP 4680 0*72 =0 90*52 =4680

beginning 30,780
Total cost to beginning inventory
Started and completed (175 units) 21,700 175*72 175*52

Total costs of units completed & 52,480

transferred
Work in process, ending (100 units) 9,800 100*72 50*52

Total costs accounted for Br. 62,280

Important points to note:

The first physical units assumed to be completed and transferred out during the period are the
225 units from the beginning work-in process inventory. Of the 275 physical units started, 175 are
assumed to be completed. 400 physical units were completed during March, the FIFO
method assumes that the first 225 of these units must have been started and completed during the
march. Ending work-in process inventory consists of 100 physical units-the 275 physical units
started minus the 175 of these physical units complete.

Note that the physical units “to account for” equal the physical units “accounted for” (500 units).
The equivalent unit calculated for each cost category focus on the equivalent units of work done

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in the current period only. Under the FIFO method, the work done in the current period is assumed
to first complete the 225 units in beginning work in process. The equivalent unit’s works done in
March on the beginning work-in process inventory are computed by multiplying the 225 physical
units by the percentage of work remaining to be done to complete these units: 0% for direct
materials, and 40% for conversion costs.

Accounting for normal and abnormal losses and gains

Loss of material is inherent during processing operation. Process loss is defined as the loss of
material arising during the course of a processing operation due to reasons like evaporation or a
change in the moisture content etc and is equal to the difference between the input quantity of the
material and its output.

❑ There are two types of material losses

i. Normal loss and

ii. Abnormal loss,

❑ Normal Process Loss: It is defined as the loss of material which is inherent in the nature
of work.

• Treatment in Cost Accounts: The cost of normal process loss in practice is

absorbed by good units produced under the process net of salvage value.

❑ Abnormal Process Loss: It is defined as the loss in excess of the pre-determined loss
(Normal process loss). This type of loss may occur due to the carelessness of workers, a
bad plant design or operation, Sabotage etc. Such a loss cannot obviously be estimated in
advance. But it can be kept under control by taking suitable measures.

• Treatment in Cost Accounts:-Cost of abnormal process loss is not treated as a part of

the cost of the product.

➢ In fact, the total cost of abnormal process loss is debited to costing profit and loss
account.

• Abnormal Gain:- Sometimes, loss under a process is less than the anticipated normal
figure. In other words, the actual production exceeds the expected figures. Under such a
situation the difference between actual and expected loss and actual and expected
production is known as abnormal gain. So abnormal gain may be defined as unexpected
gain in production under normal conditions.
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 Operations costing or service costing

Not all manufacturing firms have a pure job-order production environment or a pure process
production environment. Some manufacturing firms have characteristics of both job and process
environments. Batch production processes produce batches of different products that are identical
in many ways but differ in others. Computation-the costs with common characteristics are
allocated to the units manufactured using a process costing calculation and the costs with
individual characteristics are allocated to the units produced using a job order costing system. Most
companies have costing system that are neither pure job costing nor pure process costing, rather
they combine elements of both job costing and process costing.

The flow of costs through the manufacturing accounts is basically the same in both systems.

Steps for Process Costing

• Analyze inventory flow.
• Convert in-process inventory to equivalent units.
• Compute all applicable costs.
• Calculate the cost per unit of finished and in-process inventory.
• Allocate costs to units of finished and in-process inventory.
Operation costing
Operation costing helps businesses account for the total cost of each operation, which allows
accounting professionals to better understand and control costs. Companies often try to decrease
the operating costs to their most profitable level while maintaining reliable and efficient
production.

Why is operation costing is important

Operation costing helps businesses account for the total cost of each operation, which allows
accounting professionals to better understand and control costs. Companies often try to decrease
the operating costs to their most profitable level while maintaining reliable and efficient
production.

How to calculate operation costing

Depending on how many variables there are in the production of a product, a company may
calculate its costs differently. For example, a furniture company that allows customers to select
different materials, colors and styles may have more operation steps to factor than a company

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that allows customers to select only from specific styles. Here are some basic steps you can take
to calculate operation costing:

✓ Evaluate process costing

✓ Determine job costing
✓ Find the sum of all operation costs
✓ Assess totals for each process

Benefits of understanding operation costing

• Control expenses
• Assess management
• Improve efficiency
• Increase accuracy
• Prepare for market changes

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CHAPTER FIVE
5. Cost Allocation
Cost allocation refers to a process of accounting and recording the full costs of a government
service by including its indirect costs or "overhead" in addition to its direct costs.
5.1.Explain the notions of ‘overhead costs’, ‘indirect costs’, ‘direct costs’, ‘traceable
costs’ and ‘allocated costs’.

Overhead costs
Overhead costs are those that are not directly related to the production of goods or services, but
are necessary for the operation of a business. Examples of overhead costs include rent, utilities,
insurance, legal fees, office supplies, advertising, payroll, and accounting fees. These costs are
fairly predictable and constant, whereas direct costs, such as raw materials or packaging supplies,
are directly correlated to the product or service you provide. Allocation of overhead costs is
essential in calculating the total cost of manufacturing a product or service and hence in setting a
profitable selling price.

Overhead Allocation Rate

To allocate the overhead costs, first we need to calculate the overhead allocation rate. This is done
by dividing total overhead by the number of direct labor hours.

For example, if the total overhead for making a product is $500 and the total direct labor hours is
150 hours, the overhead allocation rate is:

Overhead allocation rate = Total overhead / Total labor hours

$500/150 = $3.33. This means for every hour needed to make a product,
you need to allocate $3.33 worth of overhead to that product.

Indirect costs

These are expenses that cannot be directly linked to the making or selling of goods or services.

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Indirect costs represent the expenses of doing business that are not readily identified with a
particular grant, contract, project function or activity, but are necessary for the general operation
of the organization and the conduct of activities it performs.

Example

• Administrative salaries,
• Office expenses,
• Security expenses, and
• Telephone expense

Direct costs

These are costs that can be directly linked to the making or selling of goods or services. If a
company pays for equipment rental to produce their product, this cost is considered direct because
it links back to how many units have been produced.

Example

• Direct material and

• Direct labor

5.2. Explain how accountants choose to create ‘cost centres or ‘cost pools’ in which to
gather together cost data.
Accountants defined Cost centre as a location, person or item of equipment (or group of them) in
respect of which costs may be ascertained and related to cost units for the purposes of cost control.
It is the smallest segment of activity or area of responsibility for which costs are accumulated.
Thus cost centres can be of two kinds.
(a) Impersonal cost centre consisting of a location or item of equipment (or group of these) such
as machine shop, and (b) Personal cost centre consisting of a person or a group of persons such
as factory manager, sales manager, etc.
Cost centres are also classified in manufacturing concerns into production and service cost centres.
Production cost centres relate to those centres where production or manufacturing

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activities take place. Service cost centres are those, which are ancillary and render services to the
production cost centres, so that manufacturing activities can take place. In a biscuit manufacturing
company, making, baking and packing are production cost centres while personnel, purchase,
stores, canteen, accounts are service cost centres.
The main purpose of cost centre is:–
(i) Recovery of cost: Costs are collected, classified and accumulated in respect of a location,
person or an item of equipment and then the costs are distributed over the products for recovery of
incurred cost, and
(ii) Cost control: Cost centres assist in making a person responsible for the control of expenditure
incurred by the cost centre. Manager of each cost centre shall control costs incurred in his area of
responsibility.
The size of the cost centre depends on the activity and operation, and feasibility of cost control.
Sub-cost centres are created if the size of the cost centres become too big from control point of
view.
Cost Unit
While cost centres assist in ascertaining costs by location, person, equipment, operation or process,
cost unit is a unit of product, service or a combination of them in relation to which costs are
ascertained or expressed. The selection of suitable cost unit depends upon several factors, such as,
nature of business, process of information, requirements of costing system, etc. but usually relates
to the natural unit of the product or service. For example, in steel and cement industry, the cost
unit is ‘tonne’, while in transportation services, the unit may be passenger- kilometre or tonne-km,
etc. It may be noted that while the former is a single cost unit, the latter isa composite unit, i.e. a
combination of two units. Examples of cost units are:- lndustry or product Cost unit, Automobile
Number, Biscuit Kilogram and Bread Thousand loaves and etc.
5.3.Why and how costs may be allocated from one cost pool or centre to another and
Support department cost allocation

Benefits of Cost Allocation

Cost allocation provides the management with important data about cost utilization that they can
use in making decisions. It shows the cost objects that take up most of the costs and helps determine
if the departments or products are profitable enough to justify the costs allocated.
Costs that are related to a particular cost object but cannot 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.
Purpose of Cost Allocation
➢ To provide information for economic decision
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 ➢ 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.
Cost allocation criteria
Cause and Effect Criteria: Using this criterion, a manager identifies the variables that cause a
resource to be consumed.
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
Fairness or Equity: - is often cited in government contracts when cost allocations are the basis of
establishing a price satisfactory to the government and its suppliers.
Ability to Bear: This criteria advocates allocating costs in proportion to the cost objects ability
to bear cost allocated to income. The presumption is that the more profitable division have a greater
ability to absorb corporate headquarters cost.
Allocating Costs of Multiple Support 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. 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. 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.
➢ 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 department Operating department

Plant maintenance (PM) Machining (M)
Information system (IS) Assembly (A)
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
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purposes. For inventory costing, however, 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 provides by:
Plant maintenance - 1600hrs 2400hrs 4000hrs
Information system 200hrs - 1600hrs 200hrs

We now examine the three methods of allocating the costs of reciprocal support departments:
❖ Direct method,
❖ Step – down method and
❖ Reciprocal methods.
Direct Method
It allocates each support department 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 cost in each service departments will be allocated to the operating departmentsas 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

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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.
Step – Down Method
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 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.

PM 2,400 Hrs M
Br. 600,000

1,600 Hrs
IS A
Br 116,000

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
Reciprocal Method

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Allocates support – department costs to operating departments by fully recognizing the mutual
services provided among all support departments. For example, the plant maintenance maintains
all the computer equipment in the information systems department. Similarly, information systems
provide database support for plant maintenance. This 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

The reciprocal method requires formulation and solving of linear equations. This requires three
steps.
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 relationship
between support giving departments as:
PM = Br. 600, 000 + 0.1IS (1)
IS = Br. 116, 000 + 0.2PM (2)
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
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
▪ Allocating cost of Plant maintenance (Br. 624, 082) to:
Machining = (2400/8000) × Br. 624, 082= Br. 187,225
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 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
Br. 312,041
Cost allocated from PM Br. 187,225 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.
5.4. Joint and By-products
Joint product: are products which are processed and manufactured in the same processes.
All have relatively high sale value but are not separately identified as individual product until
split- off point.
For example
Cream

Raw Milk

Liquid Skim

Accounting for byproducts

Byproducts are joint products that have low sales value compared to the main product. There are
two accounting methods for by products
Production method: recognize by products in the financial statement at the time production is
completed as a cost reduction.
Sales method: recognizes by products in the financial statement at the time when the byproduct
is sold as a separate income i.e. revenue generated from sales of by product.
5.5. Common Cost allocation
A common cost is a cost that is not attributable to a specific cost object, such as a product or
process. When a common cost is associated with the manufacturing process, it is included in
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factory overhead and allocated to the units produced. Some common costs might refer to products
that multiple departments use. Office supplies are one example of a product many within a
business might rely on, but that doesn't correlate to the production of one specific good or
department activity. Pens, paper and printers are some examples of this type of common cost.
Joint Costs and Common Cost
Joint costs arise when the same resource results in two or more different products at the same time
but Common costs are harder to identify. It includes all costs that keep the business running but
which cannot be attributed to one product, department, project, territory or other specific cost
center.

Understanding Common Cost

Common costs are general, not attributable to any one department or area of the small business.
For example, a manager's salary would be a common cost. Companies normally use common
costing information in managerial decisions, but this type of cost tracking is particularly useful
for external accountants. Production costs remain universal, or common,until a split-off point
where the product undergoes different processes. For example, an entire field of corn costs the
same to grow, but after harvest and distribution these processes change when half is prepared as
popcorn and the other designated as corn flour. At first the single product had a common cost, and
then at the split-off point, the two products' costs began to differ.

Understanding Joint Cost

A joint cost is a kind of common cost that occurs after a raw product, such as a sunflower crop,
undergoes two separate production processes and reports Strategic. For example, the cost of
fertilizing and harvesting sunflowers qualifies as a common cost. If a company uses the kernels
in two or more different processes – such as roasting and crushing – the costs become joint costs.
Another example of joint costing is feeding both sheep and cattle. In the end, you'll have two
different kinds of products but with similar shared costing until a split-off point.

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 CHAPTER SIX
Activity-Based Costing and Management

This chapter introduces the concept of activity-based costing which has been embraced by a wide
variety of manufacturing, service, and non-profit organizations. Activity-based costing (ABC) is
a costing method that is designed to provide managers with cost information for strategic and other
decisions that potentially affect capacity and therefore “fixed” as well as variable costs. Activity-
based costing (ABC) refines a costing system by identifying individual activities as the
fundamental cost objects or a technique that is designed to reflect diverse factors more accurately
when costing products.

❑ The most common steps to allocate overhead costs to cost objects:

✓ Identify and define activities and activity cost pools.

✓ Wherever possible, directly trace costs to activities and cost objects.

✓ Assign costs to activity cost pools.

✓ Calculate activity rates.

✓ Assign costs to cost objects using the activity rates and activity measures.

✓ Prepare management reports.

6.1 Activity-Based Costing; Use of Cost Drivers and Activities

To measure the costs and expenses, some companies use activity-based costing. Activity-based
costing (ABC) identifies and traces costs and expenses to activities and then to specific products.
Multiple predetermined OH rates are then calculated using the various cost drivers of
organizational activities. Activity-based costing is particularly useful when manufacturing
operations involve large amounts of factory overhead.
Steps in activity costing
Step1: Identify the Products. That is the chosen cost objects.
Step2: Select the activities and cost-allocation bases to use for allocating indirect costs to the
products.
Step3: Identify the indirect costs associated with each cost-allocation base.
Step4: Compute the rate per unit of each cost-allocation base.
Step 5: Compute the Indirect Costs Allocated to the Products.
Step 6: Compute the total cost of the products by adding all direct and indirect costs assigned to
the products.
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 ➢ The following illustrates an activity-based costing framework for Ruiz Company, which
produces snowmobiles and lawnmowers.
Steps in activity costing
• Step 1: Identify the Products :-Ruiz Company produced 1000 snowmobiles and 1000
lawnmowers.
• Step 2: Select the Activities:-The activities used in producing snowmobiles and
lawnmowers are as follows:
1. Fabrication, which consists of cutting metal to shape the product.
2. Assembly, which consists of manually assembling machined pieces into a final
product.
3. Setup, which consists of changing tooling in machines in preparing to make a
new product.
4. Quality control inspection, which consists of inspecting the product for
conformance to specifications.
Engineering changes, which consist of processing changes in design or process specifications
for a product?
• Step 3: Identify the Indirect Costs Associated with Each Cost-Allocation Base.
Activities Indirect cost associated with each
allocation
Fabrication Activity $530,000
Assembly Activity $70,000
Setup Activity $480,000
Quality Control Inspection Activity $312,000
Engineering Change Activity $208,000

• Estimated Activity-Base Usage—Ruiz Company

Products Activities
Fabrication Assembly Setup Quality Engineering
(Machine (Direct labor Control Change
hours) hours) Inspection (orders)

Snowmobile 8,000mh 2,000 dlh 100 setups 100 12 ECOs

inspections
Lawnmower 2,000 8,000 20 4 4
Total activity 10,000mh 10,000 dlh 120 setups 104 16 ECOs

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base inspections

• Activity rates for each activity are determined as follows:

Budgeted Activity Cost

𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑅𝑎𝑡𝑒 =
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝐵𝑎𝑠𝑒 𝑈𝑠𝑎𝑔𝑒

• The activity rates for Ruiz Company are shown as follows:

Activity Budgeted =Activity Rate
Activity Cost / Activity Base
Usage
Fabrication $530,000/ 10,000 mh = $ 53 per mh
Assembly 70,000/ 10,000 dlh = 7 per dlh
Setup 480,000/ 120 setups = 4,000 per setup
Quality control inspection 312,000/ 104 inspections = 3,000 per inspection
Engineering change 208,000/ 16 engineering changes = 13,000 per ECO

• The factory overhead costs for the snowmobile and lawnmower are computed by
multiplying the activity-base usage by the activity rate.
• Activity-Base Product Cost Calculations
Activity Snowmobile Lawnmower
Activity Activity Activity cost Activity Activity Activity
Usage (1) rate (2) (3= 1x2) usage (4) rate (5) cost (4x5)
Fabrication 8,000 mh $ 53 $ 424,000 2,000 mh $ 53 $106,000
Assembly 2,000 dlh 7 14,000 8,000 dlh 7 56,000
Setup 100 setups 4,000 400,000 20 setups 4,000 80,000
Quality 100 3,000 300,000 4 3,000 12,000
control inspections inspections
inspection
Engineering 12 ECOs 13,000 156,000 4 ECOs 13,000 52,000
change
Total factory overhead cost $1,294,000/1000 $306,000/
Estimated units of production = $1,294 1000
Factory overhead cost per unit $306

• ABC is used when there is:

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 ➢ High Overheads
➢ Product Diversity or Multiple Products
➢ Customer Diversity
➢ Service Diversity
➢ Stiff Competition

6.2 Activity Based Costing for Customer Profitability

Activity-based costing (ABC) is a strategy implemented by an organization to accurately identify
the true profitability of its customers. When analyzing customer profitability, ABC is able to
identify both direct and indirect activities that are incurred servicing a given customer. Thus, ABC
allows its users to assign a more accurate cost of service estimate to each customer. ABC is an
essential management instrument used predominantly in making strategic managerial decisions
such as pricing, outsourcing, and process improvement opportunities.

Activity Based Costing looks at the various cost drivers to accurately isolate costs and determine
a product's profitability. In contrast, Customer Profitability Analysis is a method of looking at the
various activities and expenses incurred in servicing a particular customer. When analyzing
customer profitability, ABC is able to identify both direct and indirect activities that are incurred
servicing a given customer. Thus, ABC allows its users to assign a more accurate cost of service
estimate to each customer.
The accuracy of customer profitability analysis is a fundamental prerequisite for financial
management decisions such as pricing, growth strategies, and sales initiatives. Small and mid-
sized firms tend to utilize rules of thumb based upon gross profit computations rather than more
robust activity based costing models.

6.3 Activity Based Management

Activity-based management (ABM) is a means of analyzing a company's profitability by looking
at each aspect of its business to determine strengths and weaknesses. ABM is used to help
management find out which areas of the business are losing money so that they can be improved
or cut altogether. Is a method of management decision making that uses activity-based costing
information to improve customer satisfaction and profitability.

We define ABM broadly to include:

1. Pricing and product mix decisions

2. Process improvement decisions and cost reduction, and

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 3. Product and process designs.

4. Planning and Managing Activities

Advantages of Activity Based Management

This management method has proved its value in

• Reducing wastage,
• Improving the (process) quality,
• Shortening of lead times and
• Introducing new products faster

Examples of Activity-Based Management (ABM)

For example, to analyze the profitability of a new product a company is offering, by looking at
marketing and production costs, sales, warranty claims, and any costs or repair time needed for
returned or exchanged products. If a company is reliant on a research and development department,
ABM can be used to look at the costs of operating the department, the costs of testing out new
products and whether the products developed there turned out to be profitable.

Another example might be a company that has opened an office in a second location. ABM can
help management assess the costs of the running that location, including the staff, facilities, and
overhead, and then determine whether any subsequent profits are enough to make up for or justify
those costs.

Difference between ABC and ABM

ABC means Activity Based Coasting and ABM means Activity Based Management. Both the
ABC and ABM are management tools that help in managing business activities. These two help
in improving the performance of a business firm or an organization.

The activity based management is;

✓ It is focuses on the business processes and managing activities aimed at deriving

organizational objectives.

✓ It helps in reducing cost drivers and transfers the resources.

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 ✓ It improves the value obtained by the customer and the profit got by giving this value.

✓ Focuses on management of activities as a method for improving the value obtained by the

customer and the profit got by giving this value.

The Activity Based Coasting is;

✓ The measurements of the cost and the performance of the various activities, cost objects

and resources.

✓ Recognizes casual relationships of cost drivers to activities.

✓ It is called as a subset of Activity Based Management.

✓ Helps in improving the costing by outlining the various expenses like supplies, salaries and

rent to activities and outlining these activities to services, business processes, products,

customers and distribution.

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