Sun Daero college

Distance and continuing education

Program degree

Department of accounting and finance

Course title: cost and management accounting l

Course code acfn 3112

Cr.hr 3

NOV 2021
MEKELLE

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CHAPTER 1: INTRODUCTION TO COST AND MANAGEMENT
ACCOUNTING

Chapter Contents
The Work of Management and the Need for Managerial Accounting Information
1. Planning
2. Directing and Motivating
3. Controlling
4. The Planning and Control Cycle
Comparison of Financial and Managerial Accounting
 Emphasis on the Future
 Relevance of Data
 Less Emphasis on Precision
 Segments of an Organization
 Generally Accepted Accounting Principles (GAAP)
 Managerial Accounting—Not Mandatory
Cost and management accounting
Management accounting in service organization
Cost benefit and behavioral considerations in management accounting system
Ethical considerations in management accounting
Cost and management accounting
Cost accounting provides information for management accounting and financial accounting.
Cost accounting measures, analyzes, and reports financial and nonfinancial information
relating to the costs of acquiring or using resources in an organization. For example,
calculating the cost of a product is a cost accounting function that answers financial
accounting’s inventory-valuation needs and management accounting’s decision-making
needs (such as deciding how to price products and choosing which products to promote).
Modern cost accounting takes the perspective that collecting cost information is a function
of the management decisions being made. Thus, the distinction between management
accounting and cost accounting is not so clear-cut, and we often use these terms
interchangeably in the book.
We frequently hear business people use the term cost management. Unfortunately, that term
has no uniform definition.
We use cost management to describe the approaches and activities of managers to use
resources to increase value to customers and to achieve organizational goals. Cost
management decisions include decisions such as whether to enter new markets, implement
new organizational processes, and change product designs. Information from accounting
systems helps managers to manage costs, but the information and the accounting systems
themselves are not cost management.
The Role of Management Accounting in the Organization
The purpose of management accounting in the organization is to support competitive
decision making by collecting, processing, and communicating information that helps
management plan, control, and evaluate business processes and company strategy.
The Work of Management and the Need for Managerial Accounting Information

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 Planning involves establishing a basic strategy, selecting a course of action, and specifying
how the action will be implemented.
Directing and motivating involves mobilizing people to carry out plans and run routine
operations.
Controlling involves ensuring that the plan is actually carried out and is appropriately
modified as circumstances change. Management accounting information plays a vital role in
these basic management activities—but most particularly in the planning and control
functions.
Feedback, which signals whether operations are on track, is the key to effective control. In
sophisticated organizations, this feedback is provided by various detailed reports. One of
these reports, which compares budgeted to actual results, is called a performance report.
Performance reports suggest where operations are not proceeding as planned and where some parts of the
organization may require additional attention.
The Planning and Control Cycle
Exhibit 1–1 depicts the work of management in the form of the planning and control cycle .The planning
and control cycle involves the smooth flow of management activities from planning through directing and
motivating, controlling, and then back to planning again. All of these activities involve decision making,
which is the hub around which the other activities revolve.

Goals of Managerial Accounting

To provide information for internal decision making, primarily for planning and
control purposes. The types of decisions made by managers rely substantially on
accounting information. Because financial accounting information does not
provide enough detail for internal decisions, to carry out these planning and
control responsibilities, managers need information about the organization.
From an accounting point of view, this information often relates to the costs of
the organization.
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In managerial accounting, the term cost is used in many different ways. The
reason is that there are many types of costs, and these costs are classified
differently according to the immediate needs of management.
For example, managers may want cost data to prepare external financial reports,
to prepare planning budgets, or to make decisions. Each different use of cost
data may demand a different kind of cost. For example, historical cost data is
used to prepare external financial reports whereas decision making may require
current cost data.
COMPARISON OF FINANCIAL AND MANAGERIAL ACCOUNTING
Both provide information to users to make decisions. One difference between
the two concerns which users for which the information is provided.
Managerial accounting is concerned with providing information to managers—
that is, the people inside an organization who direct and control its operations.
Financial accounting is concerned with providing information to stockholders,
creditors, and others who are outside/external to the organization.

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Cost benefit and behavioral considerations

Managers keep the following ideas in mind when designing accounting systems:

1. Simplicity
2. The cost-benefit balance:
 Primary consideration in choosing among accounting systems and methods.
 Comparing estimated costs with probable benefits.

Behavioral implications: the accounting system's effect on the behavior (decisions) of managers (The system must
provide accurate, timely budgets and performance reports in a form useful to managers

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Ethical considerations in management accounting
IMA developed “Standards of Ethical Conduct for Management Accountants”. These standards require the
compliance with four basic principles: competence, confidentiality, integrity, and objectivity.
Management accountants have the obligation to improve on a continuous basis in order to insure a high
level of professional competence.

Taking into account the nature of the information supplied by the management accounting, it is important
to ensure its confidentiality. Management accountants have the obligation not to communicate confidential
information; with the exception of the cases when they have the legal obligation to do so.
According to their position within the compartment, management accountants have the obligation to inform
their subordinates concerning the confidentiality of the information obtained during work, and to supervise
their subordinates’ compliance with these principles. Management accounting practitioners must be
incorruptible. They must avoid conflicts of interests, and refuse presents or benefits that might influence
their current or future actions.
The objectivity expected from management accountants is related to their obligation to communicate the
information correctly, objectively, even if this information is not in the favors of those who requested it.
The balance statements can be manipulated in order to obtain the results expected by current or potential
shareholders. The objective of the professional ethics guides is not to provide solutions to all practical
ethical problems encountered. Integrity is the practice of being honest and showing a consistent and
uncompromising adherence to strong moral and ethical principles and values. In ethics, integrity is
regarded as the honesty and truthfulness or accuracy of one's actions
CHAPTER 2: COST TERMS, CONCEPTS AND CONCEPTS
COST TERMS
Cost is a resource sacrificed or forgone to achieve a specific objective. It is usually measured as the
monetary amount that must be paid to acquire goods and services.
An actual cost is the cost incurred (a historical cost) as distinguished from budgeted costs.
A cost object is anything for which a separate measurement of costs is desired.
Cost accumulation is the collection of cost data in some organized way by means of an accounting system.
Cost assignment is a general term that encompasses...
–tracing Accumulated costs to a cost object, and
–allocating accumulated costs to a cost object.
A cost driver is a factor, such as the level of activity or volume, that causally affects costs (over a given
time span). The cost driver of variable costs is the level of activity or volume whose change causes the
(variable) costs to change proportionately.
A relevant range is the band of the level of activity or volume in which a specific relationship between the
level of activity or volume and the cost in question is valid.
GENERAL COST CLASSIFICATIONS
 Manufacturing Costs
 Nonmanufacturing Costs
PRODUCT COSTS VERSUS PERIOD COSTS
 Product Costs
 Period Costs
 Prime Cost and Conversion Cost
COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
 Variable Cost
 Fixed Cost
COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST OBJECTS
 Direct Cost
 Indirect Cost
COST CLASSIFICATIONS FOR DECISION MAKING
 Differential Cost and Revenue
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  Opportunity Cost
 Sunk Cost
Manufacturing Costs
Most manufacturing companies separate manufacturing costs into three broad categories: direct materials,
direct labor, and manufacturing overhead. A discussion of each of these categories follows.
Direct Materials
The materials that go into the final product are called raw materials. This term is somewhat misleading
because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials
refer to any materials that are used in the final product; and the finished product of one company can
become the raw materials of another company.
Raw materials may include both direct and indirect materials. Direct materials are those materials that
become an integral part of the finished product and whose costs can be conveniently traced to the finished
product.
Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materials to end products.
Such minor item would include the glue used to assemble a chair. Materials such as solder and glue are
called indirect materials and are included as part of manufacturing overhead.
Direct labor: consists of labor costs that can be easily (i.e., physically and conveniently) traced to
individual units of product. Direct labor is sometimes called touch labor because direct labor workers
typically touch the product while it is being made. Examples of direct labor include assembly-line workers
at Toyota, carpenters at the home builder, and electricians who install equipment on aircraft.
Labor costs that cannot be physically traced to particular products, or that can be traced only at great cost
and inconvenience, are termed indirect labor. Just like indirect materials, indirect labor is treated as part of
manufacturing overhead. Indirect labor includes the labor costs of janitors, supervisors, materials handlers,
and night security guards. Although the efforts of these workers are essential, it would be either impractical
or impossible to accurately trace their costs to specific units of product. Hence, such labor costs are treated
as indirect labor.
Manufacturing overhead: the third element of manufacturing cost, includes all manufacturing costs
except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials;
indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes,
depreciation, and insurance on manufacturing facilities. A company also incurs costs for heat and light,
property taxes, insurance, depreciation, and so forth, associated with its selling and administrative
functions, but these costs are not included as part of manufacturing overhead. Only those costs associated
with operating the factory are included in manufacturing overhead.
Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory
overhead, and factory burden. All of these terms are synonyms for manufacturing overhead.
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs.
Selling costs include all costs that are incurred to secure customer orders and get the finished product to the
customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs
include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods
warehouses.
Administrative costs include all costs associated with the general management of an organization rather
than with manufacturing or selling. Examples of administrative costs include executive compensation,
general accounting, secretarial, public relations, and similar costs involved in the overall, general
administration of the organization as a whole.
Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or just
selling and administrative costs.
PRODUCT COSTS VERSUS PERIOD COSTS
In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways to look at
costs. For instance, they can also be classified as either product costs or period costs. To understand the
difference between product costs and period costs, we must first discuss the matching principle from
financial accounting.

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Generally, costs are recognized as expenses on the income statement in the period that benefits from the
cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is
not considered an expense of the year in which the payment is made. Instead, one-half of the cost would be
recognized as an expense each year. The reason is that both years—not just the first year—benefit from the
insurance payment. The un expensed portion of the insurance payment is carried on the balance sheet as an
asset called prepaid insurance.
Product Costs
For financial accounting purposes, product costs include all costs involved in acquiring or making a
product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and
manufacturing overhead. Product costs “attach” to units of product as the goods are purchased or
manufactured and they remain attached as the goods go into inventory awaiting sale. Product costs are
initially assigned to an inventory account on the balance sheet. When the goods are sold, the costs are
released from inventory as expenses (typically called cost of goods sold) and matched against sales
revenue. Because product costs are initially assigned to inventories, they are also known as inventorial
costs.
We want to emphasize that product costs are not necessarily treated as expenses in the period in which they
are incurred. Rather, as explained above, they are treated as expenses in the period in which the related
products are sold. This means that a product cost such as direct materials or direct labor might be incurred
during one period but not recorded as an expense until a following period when the completed product is
sold.
Period costs: are all the costs that are not product costs. For example, sales commissions and the rental
costs of administrative offices are period costs. Period costs are not included as part of the cost of either
purchased or manufactured goods; instead, period costs are expensed on the income statement in the period
in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in
which a cost is incurred is not necessarily the period in which cash changes hands. For example, as
discussed earlier, the costs of liability insurance are spread across the periods that benefit from the
insurance—regardless of the period in which the insurance premium is paid. As suggested above, all
selling and administrative expenses are considered to be period costs. Advertising, executive salaries, sales
commissions, public relations, and other nonmanufacturing costs discussed earlier are all examples of
period costs. They will appear on the income statement as expenses in the period in which they are
incurred.
Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs— prime cost and conversion
cost.
Prime cost is the sum of direct materials cost and direct labor cost.
Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost
is used to describe direct labor and manufacturing overhead because these costs are incurred to convert
materials into the finished product.
PRODUCT COST FLOWS
Earlier in the chapter, we defined product costs as costs incurred to either purchase or manufacture goods.
For manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead.
It will be helpful at this point to look briefly at the flow of costs in a manufacturing company. This will
help us understand how product costs move through the various accounts and how they affect the balance
sheet and the income statement.
Notice from the exhibit that as goods are completed, their costs are transferred from Work in Process to
Finished Goods. Here the goods await sale to customers. As goods are sold, their costs are transferred from
Finished Goods to Cost of Goods Sold. At this point the various costs required to make the product are
finally recorded as an expense. Until that point, these costs are in inventory accounts on the balance sheet.
Inventorial Costs
Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then
become cost of goods sold when the product is sold.

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For manufacturing-sector companies, almost all manufacturing costs are inventoriable costs. Inventoriable
costs (direct materials, direct labor and indirect manufacturing costs) are included in work-in-process and
finished goods inventory.
•For merchandising-sector companies, inventoriable costs are the costs of purchasing the goods which are
resold in their same form.
•For service-sector companies, the absence of inventories means there are no inventoriable costs.
The three categories of inventory found in many manufacturing companies depict stages in the conversion
process:
1. Direct materials inventory
 Direct materials in stock and awaiting use in the manufacturing process
Direct materials inventory costs are used to compute the cost of materials used.
Direct materials used= Beginning direct materials inventory + Purchases of direct materials −Ending direct
materials inventory
2. Work-in-process inventory (work in progress)
 Goods partially worked on but not yet fully completed.
Work-in-process- Work-in-process inventory costs are used to compute the cost of goods manufactured.
Beginning work-in-process inventory + Manufacturing costs incurred during the period −Ending work-in-
process inventory = Cost of goods manufactured
3. Finished goods inventory
 Goods fully completed but not sold.
Finished goods inventory costs are used to compute the cost of goods sold.
Beginning finished goods inventory + Cost of goods manufactured −Ending finished goods inventory =
Cost of goods sold.
COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in
activity. Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level
rises and falls, a particular cost may rise and fall as well—or it may remain constant. For planning
purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to
change, the manager must be able to estimate how much it will change. To help make such distinctions,
costs are often categorized as variable or fixed.
Variable Cost: is a cost that varies, in total, in direct proportion to changes in the level of activity. The
activity can be expressed in many ways, such as units produced, units sold, miles driven, beds occupied,
lines of print, hours worked, and so forth. A good example of a variable cost is direct materials. The cost of
direct materials used during a period will vary, in total, in direct proportion to the number of units that are
produced. To illustrate this idea, consider the Saturn Division of GM. Each auto requires one battery. As
the output of autos increases and decreases, the number of batteries used will increase and decrease
proportionately. If auto production goes up 10%, then the number of batteries used will also go up 10%.
The concept of a variable cost is shown graphically in Exhibit 2–6.
The graph on the left-hand side of Exhibit 2–6 illustrates that the total variable cost rises and falls as the
activity level rises and falls. This idea is presented below, assuming that a Saturn’s battery costs $24:

While total variable costs change as the activity level changes, it is important to note that a variable cost is
constant if expressed on a per unit basis. For example, the per unit cost of batteries remains constant at $24
even though the total cost of the batteries increases and decreases with activity.
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There are many examples of costs that are variable with respect to the products and services provided by a
company. In a manufacturing company, variable costs include items such as direct materials, shipping
costs, and sales commissions and some elements of manufacturing overhead such as lubricants. We will
also usually assume that direct labor is a variable cost, although direct labor may act more like a fixed cost
in some situations. In a merchandising company, the variable costs of carrying and selling products include
items such as cost of goods sold, sales commissions, and billing costs. In a hospital, the variable costs of
providing health care services to patients would include the costs of the supplies, drugs, meals, and perhaps
nursing services.
When we say that a cost is variable, we ordinarily mean that it is variable with respect to the amount of
goods or services the organization produces. This could be how many Jeep Cherokees are produced, how
many videos are rented, how many patients are treated, and so on. However, costs can be variable with
respect to other things.
Fixed Cost
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike
variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises
and falls, total fixed costs remain constant unless influenced by some outside force, such as a price change.
Rent is a good example of a fixed cost. Suppose the Mayo Clinic rents a machine for $8,000 per month
that tests blood samples for the presence of leukemia cells. The $8,000 monthly rental cost will be incurred
regardless of the number of tests that may be performed during the month. Very few costs are completely
fixed. Most will change if activity changes enough. For example, suppose that the capacity of the leukemia
diagnostic machine at the Mayo Clinic is 2,000 tests per month. If the clinic wishes to perform more than
2,000 tests in a month, it would be necessary to rent an additional machine, which would cause a jump in
the fixed costs. When we say a cost is fixed, we mean it is fixed within some relevant range.
The relevant range is the range of activity within which the assumptions about variable and fixed costs are
valid. For example, the assumption that the rent for diagnostic machines is $8,000 per month is valid within
the relevant range of 0 to 2,000 tests per month.
Fixed costs can create confusion if they are expressed on a per unit basis. This is because the average fixed
cost per unit increases and decreases inversely with changes in activity. In the Mayo Clinic, for example,
the average cost per test will fall as the number of tests performed increases because the $8,000 rental cost
will be spread over more tests. Conversely, as the number of tests performed in the clinic declines, the
average cost per test will rise as the $8,000 rental cost is spread over fewer tests. This concept is illustrated
in the table below:

Note that if the Mayo Clinic performs only 10 tests each month, the rental cost of the equipment will
average $800 per test. But if 2,000 tests are performed each month, the average cost will drop to only $4
per test.
Examples of fixed costs include straight-line depreciation, insurance, property taxes, rent, supervisory
salaries, administrative salaries, and advertising.
Exhibit 2–6 Variable and Fixed Cost Behavior

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Exhibit 2–7 Summary of Variable and Fixed Cost Behavior

COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST OBJECTS

Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies,
and controlling spending. A cost object is anything for which cost data are desired—including products,
customers, jobs, and organizational subunits. For purposes of assigning costs to cost objects, costs are
classified as either direct or indirect.
Direct Cost
A direct cost is a cost that can be easily and conveniently traced to a specified cost object. The concept of
direct cost extends beyond just direct materials and direct labor. For example, if Reebok is assigning costs
to its various regional and national sales offices, then the salary of the sales manager in its Tokyo office
would be a direct cost of that office.
Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost object. For
example, a Campbell Soup factory may produce dozens of varieties of canned soups. The factory
manager’s salary would be an indirect cost of a particular variety such as chicken noodle soup. The reason
is that the factory manager’s salary is incurred as a consequence of running the entire factory—it is not
incurred to produce any one soup variety. To be traced to a cost object such as a particular product, the
cost must be caused by the cost object. The factory manager’s salary is called a common cost of producing
the various products of the factory. A common cost is a cost that is incurred to support a number of cost
objects but cannot be traced to them individually. A common cost is a type of indirect cost.
A particular cost may be direct or indirect, depending on the cost object. While the Campbell Soup factory
manager’s salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the
manufacturing division. In the first case, the cost object is chicken noodle soup. In the second case, the cost
object is the entire manufacturing division.
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COST CLASSIFICATIONS FOR DECISION MAKING
Costs are an important feature of many business decisions. In making decisions, it is essential to have a
firm grasp of the concepts differential cost, opportunity cost, and sunk cost.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and
benefits that must be compared to the costs and benefits of the other available alternatives. A difference in
costs between any two alternatives is known as a differential cost.
A difference in revenues between any two alternatives is known as differential revenue. A differential cost
is also known as an incremental cost , although technically an incremental cost should refer only to an
increase in cost from one alternative to another; decreases in cost should be referred to as decremental
costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost
decreases (decremental costs) between alternatives.
The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. In
speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue.
The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the
cost involved in producing one more unit of product is called marginal cost. The economist’s marginal
concept is basically the same as the accountant’s differential concept applied to a single unit of output.
Differential costs can be either fixed or variable. To illustrate, assume that Nature Way Cosmetics, Inc., is
thinking about changing its marketing method from distribution through retailers to distribution by a
network of neighborhood sales representatives. Present costs and revenues are compared to projected costs
and revenues in the following table:

According to the above analysis, the differential revenue is $100,000 and the differential costs total
$85,000, leaving a positive differential net operating income of $15,000 under the proposed marketing
plan.
The decision of whether Nature Way Cosmetics should stay with the present retail distribution or switch to
sales representatives could be made on the basis of the net operating incomes of the two alternatives. As we
see in the above analysis, the net operating income under the present distribution method is $160,000,
whereas the net operating income with sales representatives is estimated to be $175,000. Therefore, using
sales representatives is preferred because it would result in $15,000 higher net operating income. Note that
we would have arrived at exactly the same conclusion by simply focusing on the differential revenues,
differential costs, and differential net operating income, which also show a $15,000 advantage for sales
representatives.
In general, only the differences between alternatives are relevant in decisions. Those items that are the
same under all alternatives and that are not affected by the decision can be ignored. For example, in the
Nature Way Cosmetics example above, the “Other expenses” category, which is $60,000 under both
alternatives, can be ignored because it has no effect on the decision. If it were removed from the
calculations, the sales representatives would still be preferred by $15,000. This is an extremely important
principle in management accounting.
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. To
illustrate this important concept, consider the following examples:
Example 1 Vicki has a part-time job that pays $200 per week while attending college. She would like to
spend a week at the beach during spring break, and her employer has agreed to give her the time off, but
without pay. The $200 in lost wages would be an opportunity cost of taking the week off to be at the beach.
Example 2 Suppose that Neiman Marcus is considering investing a large sum of money in land that may
be a site for a future store. Rather than invest the funds in land, the company could invest the funds in high-
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grade securities. The opportunity cost of buying the land is the investment income that could have been
realized by purchasing the securities instead.
Example 3 Steve is employed by a company that pays him a salary of $38,000 per year. He is thinking
about leaving the company and returning to school. Because returning to school would require that he give
up his $38,000 salary, the forgone salary would be an opportunity cost of seeking further education.
Opportunity costs are not usually found in accounting records, but they are costs that must be explicitly
considered in every decision a manager makes. Virtually every alternative involves an opportunity cost.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now
or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And
because only differential costs are relevant in a decision, sunk costs can and should be ignored.
To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special-purpose
machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even
though in hindsight purchasing the machine may have been unwise, the $50,000 cost has already been
incurred and cannot be undone. And it would be folly to continue making the obsolete product in a
misguided attempt to “recover” the original cost of the machine. In short, the $50,000 originally paid for
the machine is a sunk cost that should be ignored in current decisions.
CHAPTER 3: JOB, PROCESS AND OPERATION COSTINGING SYSTEM
INTRODUCTION
Cost pool is a grouping of individual indirect cost items. Cost pools can range from broad, such as all
manufacturing-plant costs, to narrow, such as the costs of operating metal-cutting machines. Cost pools are
often organized in conjunction with cost-allocation bases.
The cost-allocation base (number of machine-hours) is a systematic way to link an indirect cost or group
of indirect costs (operating costs of all metal-cutting machines) to cost objects (different products). For
example, if indirect costs of operating metal-cutting machines is$500,000 based on running these machines
for 10,000 hours, the cost allocation rate is $500,000 ÷ 10,000 hours = $50 per machine-hour, where
machine-hours is the cost allocation base. If a product uses 800 machine-hours, it will be allocated $40,000,
$50 per machine-hour * 800 machine-hours. The ideal cost-allocation base is the cost driver of the indirect
costs, because there is a cause-and-effect relationship between the cost allocation base and the indirect
costs.
Job-costing system. In this system, the cost object is a unit or multiple units of a distinct product or service
called a job. Each job generally uses different amounts of resources.
Process-costing system. In this system, the cost object is masses of identical or similar units of a product
or service
Equivalent units: - are output interims of completed units.
FIFO - Method of inventory that charges earliest costs to goods Completed and recent costs to the units in
the ending Work in process inventory.
Transferred in costs - costs of previous department.
Weighted Average Method - Method of Inventory that charges uniform costs to goods Completed and
to goods in the ending work – in process Inventory.
Applied overhead is overhead added to a job by taking the predetermined overhead rate multiplied by
the actual activity. Applied overhead is added to direct materials and direct labor to calculate total job cost.
Total Job Cost = Direct Materials + Direct Labor + Applied Overhead
Per unit cost = Total cost applicable to job / Number of units in the job
Illustrating Process Costing: Before we examine process costing in more detail, let’s briefly compare job
costing and process costing. Job-costing and process-costing systems are best viewed as ends of a
continuum:
Job costing system Process costing system

Distinct, identifiable units of a Masses of identical or similar

product or service (for example, units
custom-made machines and of a product or service (for
houses) example, food or chemical
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 Definition of Job Costing
A method of costing in which cost of each ‘job’ is determined is known as Job Costing. Here job refers to a
specific work or assignment or a contract where the work is performed according to the customer’s
instructions and requirements.
The output of each job consists of normally one or less of units. In this method, each job is considered as a
distinct entity, for which cost is ascertained. Job Costing is applied when:
 The execution of the jobs is on the basis of client’s specification.
 All the jobs heterogeneous in many respects and each job require separate treatment.
 There is a difference in WIP (Work in progress), of each period.
Job Costing is best suited for the industries where specialized products are manufactured as per customer
needs and demands. Some examples of those industries are Furniture, Ship Building, Printing Press,
Interior Decoration, etc. material costs, including manufacturing labor, energy, plant depreciation, and so
on. Direct materials are added at the beginning of the assembly process. Conversion costs are added evenly
during assembly.
Features of Job order costing system
1 Each Job distinguishable
Each job can be clearly distinguishable from other jobs. Each job is given a unique Job number, which
clearly distinguish that job from other jobs performed by the organization.
2. Customer Specific
Job costing is used, where job is performed at the request of the customer. Each job is performed as per
specific requirement of customer.
3. Job Price
Job price is agreed with customer on the bases of cost estimation. An appropriate percentage is added to the
cost for quoting a price to the customer.
4. Separate Record
Separate record is kept for each job. This record is handy for calculating the profit from the job.
5. Job Cost Sheet
All cost related to job are collected on jobs cost sheet or job card. These costs are then charged to job work
in progress account.
The procedure for job order cost system may be summarized as follows
1. Identify the chosen cost object(s).
2. Identify the direct costs of the job.
3. Select the cost allocation on base(s).
4. Identify the indirect costs associated with each cost-allocation base.
5. Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the job.
6. Compute the indirect costs allocated to the job.
7. Compute the cost of the job by adding all direct and indirect costs assigned to it.
Illustrations
Example 1
K’s Premier Cabinets uses job costing to calculate the cost of jobs as they are completed. The company
estimates that it will have $1,250,000 in overhead costs in 2015. The company believes that employees will
work 200,000 hours and that 150,000 machine hours will be used during 2015. Calculate the predetermined
overhead rate assuming that the company uses direct labor hours to allocate overhead to jobs.
Predetermined overhead rate is estimated overhead divided by estimated activity. The example states that
estimated activity is 200,000 direct labor hours.
$1,250,000 / 200,000 direct labor hours = $6.25 per direct labor hour (don’t forget to label your numbers)
Applying the predetermined overhead rate to jobs
We must apply the rate to our jobs. The rate from our example above is $6.25 per direct labor hour. How
do we apply this to our jobs? Based on the direct labor hours worked on the job. For each direct labor hour
worked, we will add $6.25 of overhead to the job.
Applied overhead is overhead added to a job by taking the predetermined overhead rate multiplied by
the actual activity. Applied overhead is added to direct materials and direct labor to calculate total job cost.
14
Total Job Cost = Direct Materials + Direct Labor + Applied Overhead
Every time a job is completed, overhead is applied to the job. The total cost of all the jobs completed over
the course of the year is cost of goods sold.
Example #2
K’s Premier Cabinets completes job #322 on July 7. The job used 45 direct labor hours and 30 machine
hours. The job consumed $1,800 worth of materials. The average direct labor rate is $18.00 per hour and
the company uses the predetermined overhead rate calculated in Example #1. Calculate the total cost of job
#322.
There are three components of job cost: direct materials, direct labor and applied overhead.
We are told that direct materials are $1,800.
We must calculate total direct labor cost. Direct labor is a variable cost. Our rate is $18.00 per direct labor
hour. Our driver is 45 hours. If we calculate rate x activity, our total direct labor cost for job #322 is:
$18.00 per direct labor hour X 45 direct labor hours = $810
Lastly, we just apply overhead to the job. Overhead is applied by taking our predetermined overhead rate
and multiplying it by activity. We are given activity for direct labor hours and for machine hours. Which
one do we use? $6.25 per direct labor hour
Therefore, we are going to apply the rate based on direct labor hours.
$6.25 per direct labor hour X 45 direct labor hours = $281.25
We now have the components of job cost. Now to add them up and see what the total cost of the job is.
Direct-materials=$1,800
Direct-labor=$810
Applied-overhead=$281.25
Total job cost = $2,891.25
FEATUREs OF PROCESS COSTING
The essential features of process costing system are:
i. The production is continuous and mass production and the final product is the result
of a sequence of processes or departments.
ii. Costs are accumulated by processes or operations or department.
iii. The products are standardized and home generous.
iv. The cost per unit produced is the average cost which is calculated by dividing the
total process cost by the number of units produced
v. The finished product of each but last process becomes the row material for the next
process.
THE FIVE KEY STEPS IN PROCESS COSTING
Introduction: In process costing system to determine the cost per unit of the product, you need to follow
five key steps
Step 1. Summarize the flow of physical units.
Step 2. Compute output in – terms of equivalent units.
Step 3. Summarize the total costs to account for, which are the total debits to work – in Process inventory
account of the related process.
Step 4. Compute equivalent unit costs.
Step 5. Apply costs to units completed and to units in the ending WIP inventory.
The first two steps are based on physical or engineering terms. The dollar impact of the production process
is measured in the final three steps and these three steps are affected by the cost flow assumptions
To show the transfer of the completed products from mixing dep’t to cooking dep’
Step 2 Setp2
(2) Equivalent units
Flow of Production Physical units Material Can. Cos.
Work – in process beginning -0- (No work done previous period)
Started during current period 4800
Units to be accounted for 4800
Completed & transferred out

15
 From beg. Inventory -0-
Started & completed 3800 3800 3800
Work in process ending 1000(50%) 1000 500
Unit accounted for 4800 4800 4300
Equivalent units (work done current period’s 4800 4300
Details
Costs Total Direct Conversion
material Cost

Work – in process –beg 0

Costs Added currently 279400 120,000 159,100
Step.3 Total costs to be accounted 279,100
Divide by equiv. Units ÷ 4800 ÷ 4300
Step. 4 Equivalent units 6.241 25 37
Step. 5 Applying costs: 235600 The
Cost Trans. Out 3800 (62) above
W/P Inv, ending steps
should be
Material 25000 1000(25%)
strictly
Conversion costs 185055
followed
Total W/P ending 43500 500(37)
specially
Total costs Accounted for 279100
when
there are beginning inventories because the final aim of using these five steps is in order to determine the
amount to be charged to the subsequent dep’t at the end of the period.
The source of data for the 1 st step is the production report which is prepared by the production supervisor of
the respective departments then based on the production report, the cost accountant will go through the first
two steps. The source of data for the last three steps is the balance of related work in processes inventory.
Account in the general ledger. As Mentioned above when there are beginning inventories in the processes,
(in the general lager), cost flow assumption should be used.
These five steps are the same in either of the product costing methods i.e. either weighted average or FIFO
methods are used.
Under this condition the two cost flow assumption that may be used are (1) weighted average process
method. (2) FIFO Method
Process costing under the weighted average method.
The weighted average method combines the beginning work – in process inventory and the manufacturing
costs incurred in the current period to determine a single cumulated total costs to be accounted for, the
respective department during a given period of time usually a month. This cumulative amount is the
summation of the total manufacturing cost elements. The total of each cost element is divided by the
equivalent units of the related cost element in order to determine equivalent unit cost to each cost element.
The equivalent unit cost is then the basis to apply costs to the units completed and transferred out and the
units, which are to remain in the ending, work in process inventory.
Illustration:
A Company has two processes. Material is introduced at the beginning of the process in Dep’t A, is
completed, goods are immediately transferred to department B, A goods are completed in Department B,
then they are transferred out to finished goods inventory.
The Company adds direct materials at the beginning of the process in department
A. Conversion cost was 75%. Complete as to the 8000 units in working process on may 1, 2002, and 50%
complete as to the 6000 units in work in process on may 31, 2002. During May, 2002 units were
completed and transferred out to Department B Analysis of the costs relating to work –in process and the
production activity for may are follows:
Costs
Direct materials Conversion costs

16
Work in process, beginning Br. 9,600 Br. 4,800
Costs added in may 15,600 14,400
Required:
(1) Determine the cost of the units completed and transferred out to department B.
(2) Determine the cost of the units remained incomplete in Department A. (Work – in process, ending)
To do the above illustration, you should apply the five key steps in process costing.
Step 1. Summary of physical units.
Work – in process beginning --------------------- 10,000 units
Started in current period ----------------------------- 10,000 “
Units to be accounted for ----------------------------- 20,000 “
Step 2. Compute out –put in terms of equivalent units. Equivalent units
Direct materials Conversion costs
Completed and transferred --------------- 12,000 12,000
WIP Ending ----------------- 6,000 3,000
Equivalent units 18,000 15,000
Step 3. Summarize the total costs to account for.
Total costs

Manufacturing Distribution Administration

Cost
DM DL Mfc. Direct
Sales Conversion
Delivery

OHD
Material Costs Total
Work –in processes Br. 9,600 Br. 4800 Br.4, 400
Costs Added Currently 15,600 14,400 30,000
Total costs to account for 25,200 19,200 44,400
Step 4. Compute equivalent unit costs
 Equivalent unit cost $ for Direct M:
Br. 25,200 = 1.4 /unit
18000 units
 Equivalent unit cost for conversion costs:
= Total costs to account for CC
Equivalent units for CC
= Br. 19200 =Br.1.28 /unit
15000 equ.units.
 Total equivalent unit cost =Br 2.68/unit
=Equivalent unit cost for direct material plus equivalent unit cost for conversion costs.
Step 5. Applying costs
 To units completed and transferred out:
12000 units X Br. 2.68 =Br. 32,160
 To units in the ending work - in -process inventory:
Material ----------------------- 6000 units X Br.1.4 = 8400
Conversion Costs ------------ 3000 units X 1.28 = 3840
Total cost work in process, ending = 12240
Total costs to account for
The above detailed work can be placed in a report form: as follows

17
 Step 2 Steps 2
Physical Equivalent units
Flow of production units Direct M Can. Costs
Work in process Beginning 10,000
Started in current period 10,000
Unit to account for 20,000
Completed and Transferred Out. 12,000 12,000
Work – in process, ending 6,000 3,000
Equivalent units 18,000 15,000

Costs Total Direct Materials Conversion costs

Work – in process, beginning Br 14,400 Br. 9,600 Br. 4,800
Costs added currently 30,000 15,600 14,400
Steps 3
Cost to account for Br. 44,400 Br. 25,200 Br. 9,200
Divided – equivalent units ÷18000 ÷15000
Step 4. Equivalent unit costs
Step 5. Applying costs:
Completed and trans.
Out (12000 units) Br. 32.160 12000(02.68)
Work – in process, Ending
Materials Br.8, 400 6000(Br. 1.4) 1.40
Conversion Costs 3840 3000(Br.1.28)
Total Costs of W/P, ending 12,240
Total Costs accounted for Br. 44,400
Process costing under First In, First out
In process costing system under the assumption of first in first out method the equivalent unit cost to each
cost element is determined based on the costs incurred in the current period and the equivalent units of each
cost element. The computed equivalent cost is then the basis to apply to the units completed and
transferred out to the next department or to finished goods if it is the last department in the process and also
to work in process to the unity that are remaining.
The five key steps in process costing are used in FIFO method too. The 1st step, which is the summary of
physical units, will be the same under both product-costing methods.
But the last four steps are different in FIFO methods. The reason is, FIFO method does not include the
units from the beginning inventory in determining the equivalent units. The equivalent units are based on
the work done in the current period. It also excludes the costs in the beg. inventory in the computation of
equivalent unit costs. Equivalent unit costs are computed by dividing the costs, which are incurred in the
current period by the equivalent units (work done) in the same period. Therefore the outcome of the last
four steps discussed above are different under FIFO method as compared to weighted average method.
To understand the FIFO Method, let us use the same illustration we used for weighted average method.
To determine the cost of the units completed and ending work in process inventory you need to follow the
five steps discussed above
Step 1. Summary of physical units.
Work in process, beg…………10,000 units
Started in current period.10, 000 units
Units be accounted for. 20,000 units
As mentioned above the physical units are the same under FIFO and weighted average.
Step 2. Compute equivalent units.
Direct material Convention cost
Completed and trans. Out. 12,000 12,000
Work – in – process, ending 6,000 3,000
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 Total 18,000 15,000
Less: work – in- process beg. 10,000 4,000
Equivalent units 8,000 11,000
There is an alternative method to determine the equivalent units under FIFO method:
Direct material Convention cost
Work in process, beg. ---- 6,000
Started and completed. 2,000 2,000
Work – Process, ending. 6,000 3,000
Equivalent units 8,000 11,000
Step 3. Compute summary of cost:
Total Dm CC
Work in process begs. 14,400
Costs Added current period 30,000 15,600 14,400
Total Costs to be accounted for 44,400
Divided by equivalent units ÷ 8000 ÷ 11,000
Step 4. Equivalent units Br.1.95 Br. 1.31
Step 5. Applying Costs
Completed and transferred out (12,000 units):
Work – in process, beg. (10,000) ……… Br. 14,400
Cost Added currently
Conversion costs 7860 6000(1.31)
Total from W IP beg. 22,260
Start & completed (2000) 6,500 2000(3.26)
Total from WIP beg. 28,780
Work in process, ending (6000) 11,700 – 6000(1.95)
Direct material 3,900
Conversion cost 15,630
To Detected Total WIP 3000(1.3)
Comparison of FIFO and weighted average methods
FIFO process costing is based on the work done (equivalent units of production) and costs of the current
period. It gives accurate information of current costs of materials and conversion costs per unit of the
product.
In weighted average process costing, the costs in the beg WIP inventory are added to the current periods
cost. The total of the beg costs in the WIP inventory and current cost is then divided by the total of the
equivalent units. The beginning WIP inventory represents the work done in the previous period, it will be
averaged in with the current periods equivalent units computation.
A. Job-Order Costing vs. Process Costing.
Process costing is used in industries that produce homogenous products such as bricks, flour, and cement
on a continuous basis.
1. Similarities between job-order and process costing. Job-order and process costing systems share some
characteristics:
a. Both systems have the same basic purpose—to assign material, labor, and overhead cost to products.
b. Both systems use the same basic manufacturing accounts: Manufacturing Overhead, Raw Materials,
Work In Process, and Finished Goods.
c. The flow of costs through the manufacturing accounts is basically the same.
2. Differences between job-order and process costing. The differences between job order and process
costing occur because the flow of units in a process costing system is more or less continuous and the units
are essentially indistinguishable from one another.

19
Under process costing:
a. A single homogenous product is produced on a continuous basis over a long period of time. This differs
from job-order costing in which many different products may be produced in a single period.
b. Costs in process costing are accumulated by department, rather than by individual job.
c. The department production report is the key document in process costing, showing the accumulation and
disposition of cost. In job-order costing, the job-cost sheet is the key document

Overview of Operation – Costing Systems

An operation – costing system is a hybrid-costing system applied to batches of similar, but not identical,
products. Each batch of products is often a variation of a single design, and it proceeds through a sequence
of operations. Within each operation, all product units are treated exactly alike, using identical amounts of
the operation’s resources. A key point in the operation system is that each batch does not necessarily move
through the same operations as other batches. Batches are also called production runs. In a company that
makes suits, management may select a single basic design for every suit to be made, but depending on
specifications, each batch of suits varies somewhat from other batches. Batches may vary with respect to
the material used or the type of stitching. Semiconductors, textiles, and shoes are also manufactured in
batches and may have similar variations from batch to batch. An operation – costing system uses work
orders that specify the needed direct materials and step – by – step operations. Product costs are compiled
for each work order. Direct materials that are unique to different work orders are specifically identified
with the appropriate work order, as in job costing. However, each unit is assumed to use an identical
amount of conversion costs for a given operation, as in process costing. A single average conversion cost
per unit is calculated for each operation, by dividing total conversion costs for that operation by the number
20
of units that pass through it. This average cost is then assigned to each unit passing through the operation.
Units that do not pass through an operation are not allocated any costs of that operation. Our examples
assume only two cost categories – direct materials and conversion costs – but operation costing can have
more than two cost categories. Costs in each category are identified with specific work orders using job-
costing or process costing methods as appropriate. It is used in manufacturing goods that have some
common characteristics plus some individual characteristics
UNIT 4: SPOILAGE, REWORK UNITS AND SCRAP
Improving quality and minimizing defects are the major aim of management. To attain this objective,
management needs to get accurate information about the costs of these defects on time, which will help it to
make cost related informed decisions such as cost control; product costing valuing Inventory valuing (cost
of good sold).
In the previous units on product costing systems, the whole discussion was in the absence of defects, but in
any manufacturing process having defects is obvious.
TERMINOLOGIES
Abnormal spoilage: Are spoilages that are not expected under efficient operating condition.
Defects: Lost units in the process of manufacturing.
Net Realizable value: Expected selling price less estimated selling costs
Normal spoilage: Is spoilage that is expected under efficient operating condition.
Rework costs _ are additional costs to rectify rework to normal goods.
Scrap – Are remaining of materials left – over process
Spoilage – Are unacceptable units that have a reduced selling price.
Spoilage: - Are completed or semi-completed products that do not meet the standard or specification and
that are discarded or are sold for a disposal value. Net spoilage cost is the total of the costs accumulated to
the point of inspection less any disposal value if any.
Reworks (defective) are completed units that do not meet the standard or the specification but while can
subsequently repaired and sold as acceptable finished goods with incurrence of additional costs which are
called Rectifying or rework costs. These units are salable as seconds of firsts depending on the market
condition. The accounting issue related to rework is how to accumulate and record the rework costs.
Scrap is material residue from the manufacturing operations that has measurable but relatively minor
recovery value. For example, out lined metal from a stamping operation, shavings, filings, turning, baring,
sawdust, and short lengths from wood working etc. scrap is unavoidable but can be kept, to a minimum.
Scrap may be either reused or discarded.
TYPES OF SPOILAGE
The accounting for spoilage is assumed at determining the size of the spoilage and differentiating between
normal and abnormal spoilage.
The costs of spoilage should be identified as normal and abnormal and the costs of normal spoilage should
included as part of the costs of goods or units manufactured so that management can use this information to
determine the costs of products and to control and reduce costs by spoilage taking measures to minimize
spoilage.
1. Normal Spoilage
Normal spoilage is a spoilage that arises under efficient operating conditions; it is an inherent result of the
particular process and is thus uncontrollable in the short run. Management must establish the rate of
spoilage that is to be regarded as normal within its selected set of production conditions.
The costs of normal spoilage are typically viewed as part of the costs of good units (products) because the
production of good units necessitates the simultaneous presence of spoiled units. In other words normal
spoilage is planned spoilage, in the sense that the choice of a given combination of factors of production
entails a spoilage rate that management is willing to accept.
Normal spoilage is computed by using total good units as a base, not total units started in production, since
these units include any abnormal spoilage in addition to the normal spoilage.
2. Abnormal Spoilage
Abnormal spoilage is a spoilage that is not expected to arise under efficient operating conditions. It is not
an inherent part of the manufacturing process. Most of this spoilage is usually regarded as controllable in
21
the sense that the first line supervision can exert influence over inefficiency such causes as machine
breakdowns, accidents, and inferior materials are typically regarded as being subject to some
management’s influence costs of abnormal spoilage are the cost of inferior products that should be written
off directly as losses for the period using a separate account known as loss from abnormal spoilage.
PROCESS COSTING AND SPOILAGE
In the accounting treatment for spoilage in process costing is first to know the spoiled units and then to
identify them into normal and abnormal spoilage.
The units of normal spoilage can be determined by either counting or without counting. To determine the
equivalent units the 1st approach, i.e., counting the normal spoiled units results with accurate data because it
spreads spoiled units to good units only. If the other approach is used it will spread the normal spoilage not
only to good units but also to all units produced as well as to those units not completed. The problem with
this approach is it results in spreading spoilage to the incomplete goods twice, first in the current period and
second in the following period when these units are completed.
There is a five steps procedure for process costing with spoilage. The steps were discussed in the previous
unit, but with some modifications it is stated below to show the effect of spoilage.
Step 1. Summarize the flow of physical units of out put
The normal and abnormal spoilage should be separately identified in this step using the following formula.
Units Units Good Units
- Spoiled =
At the + currently __ Units + at the end
Unit
Beginning Started
After determining the spoiled units, the normal spoilage is determined by multiplying the accepted rate by
the cost good units. Then the abnormal spoilage is equal to the total spoilage less the normal spoilage as
shown below:
Normal spoilage = Accepted X Cost of
Rate good units.
Total
Abnormal = Spoiled – Normal
Spoilage Spoilage
Step 2 compute output in terms of equivalent units
Spoilage is identified at the inspection point which can be made only once or more times during a period.
The equivalent unit for both spoiled and good units is determined at the inspection point. The work done
for good and spoiled units is the same to that point of inspection. The spoiled and good units are 100%
completed for both direct material and conversion cost at the point of inspection.
Step 3 computes equivalent unit costs. To compute the equivalent unit cost for each cost element, divide
the total costs of each cost element by the equivalent units of each cost element.
Step 4 summarize total costs to account for
The total costs to account for represents the direct material and conversion costs which is debited to work
in process inventory account of the related department or process at the end of a given period.
Step 5. Assign total costs to units completed to spoiled units and to units in the ending work in process
inventory. To assign costs the assignment should be made to good units, normal spoilage, abnormal
spoilage and ending work in process inventory separately. To go through the last three steps, we should
know the inventory costing method used: weighted average or First-In, First-Out.
1. Weighted-Average Method
The equivalent unit cost is computed by dividing the total cost to date (beg. WiP Inventory + Costs incurred
currently) by the equivalent units of each cost element as shown below:
The computation of physical units (step 2) and equivalent units (step 2) are the same except that normal and
abnormal spoilage are include
Equivalent Total
unit cost = Direct  Equivalent
of D.M materials units for
22
 Cost to date B.eg + current direct material
Period
Costs

Equivalent Total
unit cost = Conversion  Equivalent
of conversion Costs to Unit costs
Costs date (Beg. + for Conversion
current costs) costs
Based on the equivalent unit costs computed as shown above, the total direct material costs and conversion
costs are assigned to good units, normal spoilage abnormal spoilage and units in the ending inventory.
Costs Beg. Unit cost
Assigned = good X Direct.M + good X equ.
To good units units unit
Units cost of cc.
+ Normal the total
Spoiled X Equivalents
Units units cost of Direct
material and
conversion costs
Costs Assigned
to abnormal = Abnormal X The total
spoilage spoiled Equivalent unit
units costs of direct
material and
conversion costs
costs assigned to units in the ending inventory is done as usual.
WIp Ending
D.m costs = units X Equivalent
at the unit
end cost of Dm
Conv. costs = units X equivalent
at the end unit cost of
Conversion costs
To understand the accounting treatment process costing and spoilage under weighted Average Method, see
the following illustration:
Consider the following data for November 2002 For Hiwot Manufacturing company, which makes
chemical products and operates a process costing system – All direct materials are added at the beginning
of the process and conversion costs are added evenly during the process. Spoilage is detected upon
inspection at the completion of the process. Spoiled units are disposed at zero net disposal prices. Hiwot
manufacturing Co. uses the weighted average method for inventory valuation.
Physical Direct Conv.
Flow of production . Units Material Costs
Work-in process, Nov. 1. 1000 1423 1110
Started in Nov. 2002 ?
Good units Cam. & trans
Out during Nov. 2002 9000
Normal spoilage 100
Abnormal spoilage 50
Work-in process, Nov. 30 2000
Costs added during Nov. 12,180 27,750
Note: - Degree of completion:
Beg. Work –in process

23
 Direct materials ------ 100%
Conversion Costs ----- 50%
Ending work-in process:
Direct materials 100%
Conversion costs 30%
Required:
(1) Compute equivalent units for direct materials and conversion costs.
(2) Summarize total costs to account for
(3) Compute the cost per equivalent unit for direct materials and conversion costs
(4) Assign the costs in (2) to
(a) Units completed and transferred and (including normal spoilage)
(b) Abnormal spoilage
(c) Units in ending work-in process
Answers
Equivalent units
Physical Direct Conversion
Flow of Production units Materials Costs
Work-in process, beginning 1000
Started during current period 10150
To account for 11150
Good unit completed
and transferred out 9000 9000 9000
Normal spoilage 100 100 100
Abnormal spoilage 50 50 50
Work-in process, ending 2000 2000 600
Total accounted for 11150
Work done to date 11150 9750
Total
Prodn. Direct Conversion
Costs Materials Costs
Work-in process, beginning Br. 2533 Br. 1423 Br. 1110
Costs added current period 39930 12180 27750
Total costs to account for Br. 42463 Br. 13603 Br. 28860
Divide by equivalent units 11150 9750
Equivalent unit costs Br. 1.22 Br. 2.96
Assignment of costs
Good units completed and
Transferred out (9000 units)
Costs before adding normal spoiled Br. 37620 9000 x Br. 1.22 + 9000 x Br. 2.96
Normal spoilage (100 units) 418 100 x Br. 1.22 + 100 x Br. 2.96
Total costs of good units
Completed and transferred out 38038
Abnormal spoilage (50 units) 209 50 x Br. 1.22 + 50 x Br. 2.96
Work-in process, ending (2000 units):
Direct materials Br. 2440 2000 x Br. 1.22
Conversion costs 1776 600 x Br. 2.96
Total work-in process, ending Br. 4216
Total costs accounted for Br. 42463
2.FIFO method and spoilage
The FIFO method that focuses on equivalent units of work done in the current period is the same as before
except that here it includes spoiled units. The spoiled units are identified after the inspection point and

24
these spoiled units are related only to the current work done and are included in determining equivalent
units and equivalent unit cost . the same data used for Weighted Average Method will be used again here:
Let’s see the answer for each of the requirements below:
(1)
Equivalent units
Physical Direct Conversion
Flow of production units Materials Costs
Work-in process, beginning 1000
Started during current period 10150
To account for 11150
Good units completed & transferred
Out during current period:
From beginning work-in process 1000 500
Started and completed 8000 8000 8000
Normal spoilage 100 100 100
Abnormal spoilage 50 50 50
Work-in process, ending 2000 2000 600
Accounted for 11150
Work done in current period only 10150 9250

Of view Total
Production Direct Conversion
Costs Materials Costs
Work - in process, beginning Br. 2533
Costs added current period 39930 Br.12180 Br. 27750
(2) Total cost to account for Br. 42463
Divide by equivalent units. ÷ 10150 ÷ 9250
(3) Equivalent unit costs. Br. 1.20 Br. 3.
(4) Assignment of costs:
Good units completed & transferred out (9000 units)
Work – in process, beginning (1000 units): Br 2533
Direct materials added current period 0 0 X Br. 1.20
Conversion costs added current period 1500 500 X Br. 3
Total From beginning work – in process Br.4033
Started & completed before normal
Spoilage (8000 units) 33600 8000 X 1.20 50 X Br.3
Abnormal spoilage (100units) 420 100 X Br. 1.20 50 X Br.3
Total cost of goods units transferred out 38053
Abnormal spoilage (50 units) 210 50 X Br. 1.20 50 X Br. 3
Work – in process ending (2000 units):
Direct materials 2400 2000 X Br. 1.20
Conversion costs 1800 600X Br.3
Total work – in process, ending 4200
Total Costs accounted for Br.42463
Inspection points and Allocating
Costs of normal spoilage
Inspection for quality of the units can be made at one or mare specific points usually; inspection is made at
the point of completion. If this is true all spoiled units are part of the goods completed and transferred out,
no spoilage is assigned to the units in process /ending work in process inventory) The unit cost of normal
and abnormal spoilage is general if both are detected at the same point of inspection. But if they are
identified at different stages in the manufacturing process, each will have different unit cost.

25
Costs of normal spoilage are included to the costs of good units net of their salvage value of any where as
the costs of abnormal spoilage is reported as loss of the period in which it is detected.
JOB COSTING AND SPOILAGE
There are normal and abnormal spoilages in job order costing as in process costing the main concepts
discussed in process costing to these units’ remains the some except that the accounting treatment differs.
Costs of normal spoilage are inventor able where as abnormal spoilage is not inventor able and are written
of 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 are two types –
attributable to specific job and common to all jobs . Normal spoilage attributable to all Jobs. Normal
spoilage attributable to a specific Job is assigned to that specific job this step is not related to process
costing because in process costing all products are identical normal spoiler common to all jobs is allocated
to jobs with the other indirect manufacturing costs at the end of the month.
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 soluble. To recognize the estimated
selling price (disposal value) if the spoilage, J. entry should be recorded
Materials control------------------------------Disposal
Work in process --------------------- Value.
After posting the above entry the work in process inventory account balance represents the costs of good
units (including normal spoilage)
Example:
In fasica machine shop, 10machine parts of a job lot of 100 machine parts are spoiled. Costs assigned
period to the inspection point are Br. 4000 per part. The company calculates these costs on the basis of its
inventory costing assumptions weighted average or FIFO. But the Co-does not consider the cost how
assumptions. The current disposal price of the spoiled parts is estimated to be Br. 1200 per past 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 control-------------------------------- 12000
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. 3,32000
Normal spoilage common to all jobs
Normal spoilage may coincidentally occurs due to the inherent problem in the manufacturing. Process
where a gover job is being worked on. Under this condition, the costs of the spoilage can not be assigned
to that particular job but to all jobs manufacturing overhead the j. entry based on the above examples is
recorded as follows:
Materials Control ------------------------------ 12,000
Manufacturing over head control ------------ 28,000
Work in process ------------------------------------- 40,000
When normal spoilage is common to all jobs, the budgeted manufacturing over head application rate
spoilage cost. Therefore, the normal spoilage is allocated, to all jobs based on the application rate under
this condition;
The costs of goods units = 90 parts X Br 4000 = Br. 36000
Plus the allocated share of the Br. 28000
Overhead costs of the normal spoilage.
Abnormal spoilage

26
If the spoilage is abnormal, the cost of the abnormal spoilage het 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 would be:
Material control ------------------------- 12,000
Loss form abnormal spoilage --------- 28,000
Work – in process -----------------------40,000
Abnormal spoilage is reported as the loss of the period in which it is identified.
JOB COSTING AND REWORK
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 (1) normal rework attributable to specific jog
(2) normal rework common to all jobs
(3) abnormal rework
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 control -------------------------------------- 15000
Wages payable --------------------------------------- 15000
Manufacturing overhead control ------------------- 10000
Assume that rework costs equal Br. 7600 (direct materials Br. 1600. direct labor 4000; manufacturing over
head, Br 2000
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-----
Normal rework common to all jobs
When rework is normal and is caused to the inherent problem of the manufacturing process the costs of the
rework are charged to manufacturing process 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 SCRAPS
A scrap as has been defined before represents remains of materials left over from the manufacturing
process. They have low soles value as compared with the soles value of the products. The accounting issue
related to scrap is (1) when should the value of screp be recognized in the accounting records- at the time
scrap is produced or at the line scrap is sold?
(2) how should revenue from scrap be accounted for?
1 Recognizing scrap at the time of sole
27
Scrap is recognized at the time of sole when its dollar amount is immaterial. 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
the the time of well
Assume the selling price of a given quantity of material is Br. 500
Cash (A/R)------------------
Sales of scrap ----- 500
The soles of scrap are 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 gnockly after it is known, the accounting
treatment depend in whether the scrap is attributable to a specific job or is common to all jobs.
2. 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. In the above example is attributable to a specific job, the J. entry will be recorded as
follows: Unlike spoilage and rework, there is no cost attached to the scrap, and hence no distinction is made
between normal and abnormal scrap.
3.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. If the in the previous example is assumed to be common to all jobs
the J. entry is:
Cash (A/R)-----------------------------------
Manufacturing over head control ----- 500
The expected disposal price of the scrap should be considered in setting the manufacturing overhead
application rate. Thus, the budgeted overhead application rate is lower than it would be if the overhead
budget had not been reduced by the expected sales of scrap. The accounting for scrap as common to both
job costing and process costing.
Recognizing scrap at the time of its production
It was assumed that the scrap is sold immediately as if is produced (identified) and there many be a time
interval between its production and its selling or remising 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 so that production cost and related scrap recovery ate recognized in the same
accounting period. The scrap is than stirred until sold or reused. The scrap may be attributable to specific
job or many be common to all jobs.
1. Scrap attributable to a specific job
When a scrap is identifiable with a specific job its 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:
Cash (A/R)------------------
Work - in process ----- 800
2.Scrap common to all jobs
When scrap is not identified with a specific job but caused due to the inherent problem associated in the
prorated amount of manufacturing process, the expected net realizable value of the scrap reduces the cost of
all jobs. Let us use the previous example to recurred the J. entry the time the scrape is resulted
Cash (A/R)-----------------------------------
Manufacturing overhead control ----- 800
The accounting for scrap under process costing is like the accounting under job costing when scrap is
common to all jobs-because process costing appears to the manufacture of masses of identical or similar
units.

28
 High cost of scrap is an indicator of inefficiency attracts manager’s attenuation. Even though scrap is an
inherent part of every manufacturing process and unavoidable, mechanisms should be implemented to keep
it to the possible minimum.
Chapter 5: Income effect of alternative product costing methods
Two general approaches are used in manufacturing companies for costing products for the purposes of
valuing inventories and cost of goods sold. One approach is the absorption costing. Absorption costing is
generally used for external financial reports. The other approach, called variable costing, is preferred by
some managers for internal decision making and must be used when an income statement is prepared in the
contribution format. Ordinarily, absorption costing and variable costing produce different figures for net
operating income, and the difference can be quite large. In addition to showing how these two methods
differ, we will consider the arguments for and against each costing method and we will show how
management decisions can be affected by the costing method chosen. Absorption costing is required for
external financial reports and for tax reporting. Variable costing is an alternative for internal management
reports.
Cost Classifications – Absorption versus Variable Costing
Absorption Costing Variable
Costing
Direct materials
Direct labor
Product costs Product costs
Variable manufacturing overhead

Fixed manufacturing
Variable selling andoverhead
administrative
Period costs
expenses
Period costs
Absorption cost formula = Direct labor cost per unit + Direct material cost per unit + Variable
manufacturing overhead cost per unit + Fixed manufacturing overhead per unit
Or Absorption cost formula = (Direct labor cost + Direct material cost + Variable manufacturing overhead
cost + Fixed manufacturing overhead) / No. of units produce .To illustrate the computation of unit product
costs under both absorption and variable costing, consider Boley Company, a small company that produces
a single product and that has the following cost structure:
Number of units produced each year 6,000
Variable costs per unit:
Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
Variable selling and administrative exp $3
Fixed costs per year:
Fixed manufacturing overhead $30,000
Fixed selling and administrative expe $10,000
Required: 1.Compute the unit product cost under absorption costing.
2. Compute the unit product cost under variable costing. Solution
Absorption Costing
Direct materials $2
Direct labor 4
Variable manufacturing overhead 1
Total variable manufacturing cost 7
Fixed manufacturing overhead ($30,000/6,000 units of product) 5
Unit product cost $12
Variable Costing

29
 Direct materials $2
Direct labor 4
Variable manufacturing overhead 1
Unit product cost $7
(Under variable costing, the $30,000 fixed manufacturing overhead is
a period expense along with selling and administrative expenses.)
Under the absorption costing method, all manufacturing costs, variable and fixed, are included when
determining the unit product cost. Thus, if the company sells a unit of product and absorption costing is
being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income
statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance
sheet at $12 each.
Under the variable costing method, only the variable manufacturing costs are included in product costs.
Thus, if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold
units will be carried as inventory on the balance sheet at only $7 each.
Income Comparison of Absorption and Variable Costing
To displays income statements prepared under the absorption and variable costing approaches. In preparing
these statements, we use the data for Boley Company presented earlier, along with other information about
the company as given below.
Units in beginning inventory 0
.Units produced 6,000
Units sold 5,000
Units in ending inventory 1,000
Selling price per unit $20
Selling and administrative expenses:
Variable per unit $3
Fixed per year $10,000
Comparison of Absorption and Variable Costing – Boley Company
Absorption Costing
Sales (5,000 units × $20 per unit) $100,000
Cost of goods sold:
Beginning inventory $0
Add cost of goods manufactured (6,000 units x $12 per unit) 72,000
Goods available for sale 72,000
Less ending inventory (1,000 units x $12 per unit) 12,000*
Cost of goods sold 60,000
Gross margin 40,000
Selling and administrative expenses: (5,000 units x $3 per unit variable + $10,000 25,000
fixed)
Net operating income $ 15,000
Variable Costing
Sales (5,000 units x $20 per unit) $100,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory $0
Add variable manufacturing costs(6,000 units x $7 per unit) 42,000
Goods available for sale 42,000
Less ending inventory(1,000 units x $7 per unit) 7,000*
Variable cost of goods sold 35,000
Variable selling and administrative expenses (5,000 units x $3 per unit) 15,000 5 0,000
Contribution margin 50,000
Fixed expenses:
Fixed manufacturing overhead 30,000
Fixed selling and administrative expenses 10,000 4 0,000

30
 Net operating income $ 10,000
*Note the difference in ending inventories. Fixed manufacturing overhead cost at $5 per unit is included
under the absorption approach. This explains the difference in ending inventory and in net operating
income (1,000 units x $5 per unit = $5,000). The net operating income under absorption costing is higher
than under variable costing by $5,000. Why is this? Under absorption costing, each of the units produced
during the period is assigned $5 of fixed manufacturing overhead cost. This is true of the 1,000 units in
ending inventory as well as the 5,000 units that were sold. Consequently, the ending inventory under
absorption costing contains $5,000 of fixed manufacturing overhead and the cost of goods sold contains
$25,000 of fixed manufacturing overhead. In contrast, the entire $30,000 of fixed manufacturing overhead
is expensed under variable costing. As a direct result, the net operating income under variable costing is
$5,000 higher than under absorption costing. In effect, the $5,000 of fixed manufacturing overhead in
ending inventory under absorption costing is deferred to the future period in which these units are sold.
This $5,000 of fixed manufacturing overhead cost in the ending inventory is referred to as fixed
manufacturing overhead cost deferred in inventory. In general, under absorption costing, when
inventories increase, some of the fixed manufacturing costs of the current period are reported on the
balance sheet as part of the ending inventories rather than on the income statement as part of cost of goods
sold. Second, the absorption costing income statement makes no distinction between fixed and variable
costs – a distinction that is crucial for CVP analysis and for much of the planning and control concepts
discussed in later chapters. It is difficult or even impossible to determine from an absorption costing
income statement which costs are variable and which are fixed. In contrast, on a variable costing income
statement the fixed and variable costs are explicitly identified – making CVP analysis far easier. The
difference between the absorption and variable costing approaches to accounting for fixed manufacturing
costs centers on timing. Advocates of variable costing say that fixed manufacturing costs should be
expensed immediately in total, whereas advocates of absorption costing say that fixed manufacturing costs
should be charged against revenues gradually as units of product are sold. Any units of product not sold
under absorption costing result in fixed manufacturing costs being inventoried and carried forward on the
balance sheet as assets to the next period. The following discussion of Emerald Isle Knitters expands on the
discussion of the absorption and variable costing approaches to accounting for fixed manufacturing costs
Comparative Income Effects – Absorption and Variable Costing
Relation between Relation between
Production and Sales Effect on Absorption and Variable Costing
for the Period Inventories Net Operating Income
Production = Sales No change in Absorption costing = Variable costing
inventories net operating income net operating income
Production > Sales Inventories increase Absorption costing > Variable costing
net operating income net operating income *
Production < Sales Inventories decrease Absorption costing < Variable costing
net operating income net operating income †
*
Net operating income is higher under absorption costing, since fixed manufacturing overhead cost is
deferred in inventory under absorption costing as inventories increase.
†
Net operating income is lower under absorption costing, since fixed manufacturing overhead cost is
released from inventory under absorption costing as inventories
Role of various denominator levels in absorption costing
There are several alternative denominator activity levels that might be chosen as a basis for the overhead
rate calculations. These include: 1) maximum capacity, 2) practical capacity, 3) the normal or long run
average production level, and 4) planned production, i.e., master budget units to be produced.
Maximum capacity is defined as the annual output the firm could produce assuming perfect conditions,
i.e., if there were no problems such as downtime caused by shortages of inputs or machinery breakdowns.
Practical capacity is defined as a somewhat lower level of output assuming efficient operations, but
allowing for some unavoidable downtime or idle time. Using either maximum or practical capacity as the
denominator will result in relatively large planned and actual production volume variances.
Normal capacity is an average output level expected over the next several years.
31
Using normal capacity as the denominator would cause unfavorable production volume variances in some
years and favorable variances in other years.
Planned capacity is represented by the number of units the firm plans to produce during the year as stated
in the master budget. Using planned capacity eliminates planned production volume variances (in annual
statements, but not monthly or quarterly statements), and tends to minimize the actual production volume
variances.
A 1980 survey of Fortune 500 firms revealed that approximately 57% of the 247 firms that responded to
the questionnaire used planned production as the basis for calculating overhead rates, while 21.1% used
practical capacity, 18.2% used normal capacity and only 1.6% used maximum capacity
Although, it is not clear why certain firms choose a particular denominator, the choice of denominator
activity can have a significant effect on product cost and absorption costing net income.
CHAPTER 6: COST ALLOCATION
How a company allocates its overhead and internal support costs – costs related to marketing, advertising,
and other internal services – among its various production departments or projects, can have a big impact
on how profitable those departments or projects are. Cost allocation is the process of assigning indirect
costs to cost objects
Four purposes of cost allocation
1. To provide information for economic decisions
2. To motivate managers and employees
3. To justify costs or compute reimbursement
4. To measure income and assets for reporting to external parties
Allocation for economic decisions and motivations
For some decision related to the economic-decision purpose (for example, long-run product pricing), the
costs in all six functions should be included. For the motivation purpose, costs from more than one
business function are often included to emphasize to managers how costs in different functions are
related to each other. For example, product designers in some Japanese companies incorporate costs of
other functions in the value chain - such as production, distribution, and customer service into their
product-cost estimates. The aim is to focus attention on how different product design options affect total
costs.
Cost allocations can be used to motivate managers to consume less or more of the company's resources
To discourage use, the cost of a department's services could be allocated according to the amount of
services used. To encourage use of a department's services (for example, internal audit). Top
management might not allocate any of the cost of that department's services or allocate a fixed amount of
the cost of that department to other departments regardless of how much of those services are used by
those other departments (the other departments may feel obligated to use the services to get their
"money's worth")
Criteria for Guiding Cost Allocation Decisions
Cause and effect
 allocate based on the variable or variables that cause cost to be incurred
Benefits received
 allocate costs among the beneficiaries in proportion to the benefits each receives
Fairness or equity
 allocate costs in such a manner as to be “fair” or “reasonable” for both parties
Ability to bear
 allocate costs based on who can best absorb them
Cost allocation Methods
1. Single rate
Allocate costs to cost objects using a single rate = manufacturing overhead costs / labor hours
The single – rate method makes no distinction between fixed and variable costs. It allocates costs in each
cost pool (support department in this section) to cost objects (operating divisions in this section) using the
same rate per unit of a single allocation base. One benefit of the single-rate method is the low cost to

32
implement it. The single – rate method avoids the often – expensive analysis necessary to classify the
individual cost items of a department into fixed and variable categories
a. Pools all costs regardless of behavior in a cost pool
b. Allocates to cost object using same rate per unit of single allocation base
c. Cost to implement is low—avoids often expensive analysis to classify individual cost items into fixed
and variable categories
d. Often leads to decisions in own best interests of individual manager but not best interest for organization
as a whole
example: Fixed costs $2,000,000
Variable costs
Variable cost per hour $200
Budgeted hours 3,200
Total variable costs $640,000
Total cost pool $2,640,000
Your single rate budgeted cost allocation rate is
Single rate budgeted cost allocation rate = cost pool ÷ budgeted hours
Single rate budgeted cost allocation rate = $2,640,000 ÷ 3,200
Single rate budgeted cost allocation rate = $825 per hour
The single cost allocation rate is $825 per hour.
2. Dual-rate
Separate costs into cost variable and fixed cost pools allocate fixed costs as lump sums based on long-term
usage allocate variable costs based on a single variable cost rate. The dual – rate method partitions the
cost of each support department into two pools, a variable cost pool and a fixed-cost pool, and allocates
each pool using a different cost – allocation base. When the dual-rate method is used, allocation bases must
be chosen for both the variable and fixed cost pools of the central computer department
a. Pools cost into two separate cost pools according to behavior—fixed and variable
b. Allocates to cost object with each cost pool using different cost-allocation base
c. Signals to managers how costs behave differently
d. Provides better information for making decisions (should be method used)
3. Budgeted versus actual allocations
In both the single – rate and dual – rate methods, we use budgeted rates to assign support department costs
(fixed as well as variable costs). An alternative approach would involve using the actual rates based on the
support costs realized during the period. This method is much less common because of the level of
uncertainty it imposes on user divisions. When allocations are made using budgeted rates, managers of
divisions to which costs are allocated know with certainty the rates to be used in that budget period. Users
can then determine the amount of the service to request and – if company policy allows – whether to use
the internal source or an external vendor. In contrast, when actual rates are used for cost allocation, user
divisions are kept unaware of their charges until the end of the budget period.
Budgeted rates also help motivate the manager of the support (or supplier) department (for example, the
central computer department) to improve efficiency. During the budget period, the support department, not
the user divisions, bears the risk of any unfavorable cost variances. That’s because user divisions do not
pay for any costs or inefficiencies of the supplier department that cause actual rates to exceed budgeted
rates.
1. Budgeted cost rates
a. Rates known in advance reduce uncertainty
b. Users can determine amount of service to request as rates known in advance
c. Managers motivated to improve efficiency bear risk of unfavorable cost variances
2. Actual cost rates
a. Rates not known until end of period
b. Amounts allocated fluctuate so users bear the risk
4. Direct approach
Allocate support costs directly to operating departments. The direct method allocates each support
department’s costs to operating departments only. The direct method does not allocate support-department
33
costs to other support departments. Data for Allocating Support – Department Costs at Castleford
Engineering for 2012 Direct Method of Allocating Support – Department Costs at Castleford Engineering
for 2012
SUPPORT DEPARTMENTS OPERATING DEPARTMENTS

Plant Maintenance $2,362,500 Machining

$6,300,000 $3,937,500 Department

$1,290,800

Information Assembly
Systems $161,350 Department
$1,452,150 5. Step-down approach
Recognize some of the work support departments do for each other allocate support costs to other support
departments and operating departments in a pre-determined order. Some organizations use the step-down
method, also called the sequential allocation method, which allocates support – department costs to other
support departments and to operating departments in a sequential manner that partially recognizes the
mutual services provided among all support departments. the step – down method.. Step – Down Method of
Allocating Support – Department Costs at Castleford Engineering for 2011
Plant Maintenance $1,890,000
$6,300,000 Machining
Department
$3,150,000
$1,260,000

Information Systems $2,410,800

$1,260,000 + $1,452,150 Assembly
= $2,712,150 Department
$301,350
Note that this method requires the support departments to be ranked (sequenced) in the order that the step –
down allocation is to proceed. In our example, the costs of the plant maintenance department were
allocated first to all other departments, including the information systems department
6. Reciprocal approach
The reciprocal method allocates support-department costs to operating departments by fully recognizing
the mutual services provided among all support departments. For example, the plant maintenance
department maintains all the computer equipment in the information systems department. Similarly,
information systems provide database support for plant maintenance. The reciprocal method fully
incorporates interdepartmental relationships into the support – department cost allocations. The reciprocal
method
a. Theoretically, this method is the most appropriate for allocating service department costs.
b. It allows reflection of all reciprocal services among service departments.
c. Simultaneous equations are used to compute the completed reciprocated cost.
The reciprocal method is by far the most complex and most accurate of the three methods.
, Simultaneous equations are used to allocate each service department's costs among all other service
departments and production departments. The reciprocal method is superior because:
– It considers all services provided to other service departments.
– The total cost of operating a service department is computed. The reciprocal method requires the use of
matrix algebra with three or more service departments. Theoretically, this method is the most appropriate
for allocating service department costs.

34
 Choosing Between Methods
 Reciprocal is the most precise
 Direct and Step-Down are simple to compute and understand
 Direct Method is widely used

CHAPTER 7: Cost Allocation: Joint Products and By Products

Definitions
a. Joint Cost: the cost of a single process that yield multiple products simultaneously. Includes DM, DL,
and mfg. Ohd up to the split-off point
b. Split-off Point: the point in the process at which the products become separately identifiable.
c. Separable Costs: those costs incurred beyond the split-off point that are identifiable with individual
products
d. Main Product: the product with the highest sales value relative to other products beyond split-off
e. Joint Products: other products with a relative high sales value that are not identifiable as individual
products until the split-off point
f. Byproduct: a product beyond the split-off point with a relatively low sales value in comparison with
main and joint products
g. Scrap: products beyond split-off with minimal value (May have a negative sales value if must be hauled
away to a landfill)
h. Waste—residual output with no sales value
Reasons for Allocating Joint Costs to Individual Products
i. To value inventory and COGS for external reports
j. To value inventory and COGS for internal reports (including profitability analysis and performance
evaluation)
k. For cost reimbursement under contracts where not all the separable products go to a single customer
so that allocation of the joint costs is necessary.
l. For settlement of insurance claims involving separable products at or beyond split-off.
m. For rate regulation when one or more jointly produced products or services are subject to rate
regulation based on cost. E.g. services using telephone lines
Methods of Allocating Joint Costs
a. Methods where a measure is available at the Split-off point for each separable product.
i. Sales Value at Split-off: This method allocates joint costs to the separable products based
on the relative slaves value of each product at the split-off point
Includes the sales value of the entire production----not just actual sales

35
 Simple to apply because it provides a common measure applicable to all products if sales
value is readily available
Also, relates cost allocated to the revenue-generating power of individual products.
ii. Physical Measures Method: This method uses some measure of weight of volume
common to all separable products at the split-off point.
The problem with this method is that the physical measure may bear no relationship to the
revenue producing power of the separable products. For example, if a company mines
gold and lead, an ounce of gold will be much more valuable than an ounce of lead but both
would get the same allocation when ounces is used as the measure. This causes high value
items per unit of the physical measure to show high profits and low value items per unit of
the physical measure to show low profits. Demo 15-16
b. Methods where there isn’t a market for all of the separable products at split-off. Therefore, some
other method has to be used that approximates the situation at the split-off point. (The allocation
must relate to the situation at split-off because joint costs cease to have meaning beyong the
splitoff point). There are two methods that can approximate the situation at split-off.
i. Estimated Net Realizable Value Method (NRV)
The NRV for each product as a % of the total NRV of all products, is the basis for the
allocation.
Est’d NRV = Final sales value of production – Separable Costs
(to get an estimated NRV for all products combined that is approximately equal to joint
costs, you would also need to deduct selling and admin expenses and gross profit. This is
not usually done in practice just to keep things simple)
iii. Constant Gross Profit % NRV Method
This method assumes every separable product earns the same GP% (this may not be very
realistic) It starts with the final sales value of production and subtracts the Gross Profit
(which is equal to Sales x constant GP%), and then subtracts the Separable Costs. The
result is an approximation of the Joint Costs for each separable product at split-off.
Steps:
1. Compute the overall GP% (called the constant GP%) for all products combined (i.e.,
GP = FSVP – JC – SC
2. Calculate the GP in $ for each product (i.e., FSVP x constant GP% determined in
part 1.)
3. Calculate the Joint Costs for each product as follows:
FSVP xx
Less: GP in $ (xx)
Less Sep. Costs (xx)
= Joint Costs allocated xx
Note: Some products may end up with a negative allocation of Joint costs;
Accounting for By-products
A by-product is a product having a relatively low sales value compared with the main or joint products; by-
products can be sold at split-off or processed further; also, if sales increase, a by-product may be re-classified as a
joint product at some point.
There are several methods of accounting for by-products in terms or recognizing when to record the cost of the by-
product. We will recognize the cost of the by-product only when production is completed.
Steps:
1. Calculate the NRV of the by product (i.e., FSVP – SC, or sometimes if specified, FSVP – SC – normal GP).
2. Subtract this NRV of the by-product from the total joint cost and set the amount up as by-product
inventory.

36
 By-product inventory xxx
Joint costs xxx
3. Allocate the revised joint cost in the usual way to the joint products using one of the four methods
4. Record any sales of the by-product as follows:
A/R xxx
By product inventory xxx
Note: Because the NRV of the by-product is treated as a reduction in the total joint cost allocation and
because the by-product is given no status as a separate product, there is no Sales a/c and no COGS a/c for
the by-product itself------only Balance Sheet accounts.
The sales of the by-product are either added to the sales of the other joint products or deducted from the COGS of
the other joint products. These Sales or COGS adjustments are done on the financial statement and not in the
accounting records. (This procedure assumes that the selling price and inventory cost per unit of the by-product
are both valued at the NRV per unit of the by-product)
Allocate joint costs based on the relative physical measurement of the products after the split-off point
Often difficult to determine a reasonable unit of measure which is common to all products
Relative Allocation of
Product Litres Weighting Joint Cost
X 1,000,000 10/15 $66,667
Y 500,000 5/15 33,333
Total 1,500,000 $100,000
Allocate joint costs based on the relative sales value of the products after the split-off point
Allocations are interdependent
Sales Value Relative Allocation of
Product@ Split-off Weighting Joint Cost
X $90,000 90/120 $75,000
Y 30,000 30/120 25,000
Total $120,000 $100,000
A saw mill processes logs into four grades of lumber totaling 3,000,000 board feet as follows:
Percent of Joint Cost
Grades Board Feet Units Allocation
First and second 450,000 0.15 $ 27,900
No. 1 common 1,200,000 0.40 74,400
No. 2 common 600,000 0.20 37,200
No. 3 common 750,000 0.25 46,500
Totals 3,000,000 $186,000
This “joint cost” problem arises when companies inescapably produce two or more products simultaneously out of
the same process. How do they allocate costs to jointly-produced products?
How are the resulting allocations useful? Joint costs are the costs of a single production process that yields
multiple products simultaneously. Joint products have relatively high sales value at the split off point. Main product
is the result of a joint production process that yields only one product with a relatively high sales value. By-products
are incidental products resulting from the processing of another product. How to classify outputs? Primary, By-
product, Scrap, Waste and Joint costs, reduced by the value of by-products and scrap, are assigned to primary
products only
Eample: Joint products A, B, C and D are produced at a total joint production cost of $120,000. Quantities are
produced: A, 20,000 UNITS, B, 15,000 UNITS; C, 10,000 UNITS and D, 15,000 UNITS. Calculate the joint production
cost allocation. Solution

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Using figures from the above example, weight factors assigned to the four products might be as follows:
Product A 3points ,Product B 12 points ,Product C 13.5 point, and Product D 15 points
Calculate the joint production cost allocation.
Solution: The joint production cost allocation would result in these values::

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