CHAPTER THREE

COST ALLOCATION
Major Reasons for Allocating Costs
Cost allocation that is a challenge in every organization and nearly in every facet of accounting
provides information needed for both strategic and operating decisions. For example, your
University/College may be bother about how costs should be allocated among undergraduate
programs, graduate programs, and research. Hospitals think how they should allocate costs
among expensive medical equipment, facilities, and staff. Manufacturing companies bother how
costs should be allocated to individual products.

In the previous chapter, we have discussed that accounting system accounts for costs in two basic
stages: cost accumulation followed by cost assignment. Cost assignment is a general term that
encompasses both cost allocation and cost tracing. As you may recall cost allocation is a term
used for assignment of indirect costs to cost objects. Thus, cost allocation is fundamentally a
problem of linking some cost or group of costs with one or more cost objects such as products,
departments, customer classes, activities and divisions. Ideally, cost allocation should assign
each cost to the cost object that caused it. We link costs with cost objects by selecting
appropriate cost drivers. A cost driver that is used for allocating costs is often called a cost –
allocation base. Indirect costs of a particular cost object are costs that are related to that cost
object but cannot be traced to it in an economically feasible (cost – effective) way. These costs
often comprise a large percentage of the overall costs assigned to such cost objects as products
customers and distribution channels.

Why do managers allocate costs to cost objects? Here are the four major purposes of cost
allocation:

1. To Provide Information for Economic Decision

Mangers within an organizational unit should be aware of all the consequences of their decision;
even consequences outside their units. Cost allocation helps managers to predict the economic
effects of planning and control decisions and to provide feedback for performance evaluation.
For example- the addition of new course in university causes additional work in registrar’s
office, the addition of new flight by airline requires additional booking and reservation services.
Cost allocation helps managers in allocating (assigning) costs to these additional works so that
managers can evaluate their decision before taking action. Furthermore, it helps managers to
decide on issues such as to manufacture a component part of its product or to purchase it from
another manufacturer, to decide on the selling price for a product or service, to evaluate the cost
of available capacity used to support different predicts. This reason of cost allocation supports
the strategic decision- making and operational control purposes of cost management system.

2. To Motivate Manager and Other Employees

Cost allocations often influence management behavior and thus promote goal congruence and
managerial effort. This helps to encourage the design of products that are simpler to manufacture
or less costly to service, and to encourage sales representatives to emphasize high- margin
products or services.

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 3. To Compute Income and Asset Valuation
Companies allocate costs to products and projects to measure inventory costs and cost of goods
sold. Thus, cost allocation helps to cost inventories for financial reporting to external parties, and
also to cost inventories for reporting to tax authorities.

4. To justify costs or obtain reimbursement:

Sometimes prices are based directly on costs, i.e. a price includes reimbursement for costs plus
some profit margin. In these instances, cost allocations become substitutes for the usual working
of the market place in setting prices.

Costs are allocated for various reasons as mentioned above, and each of these reasons has its
roots in the major purposes of any cost management system. As we discussed in chapter two, a
cost accounting system is a primary tool used to implement a cost management system, and cost
allocation is a key element of the cost accounting system. There are three major purposes of a
cost management system:
 To provide cost measurement for external reporting
 To provide cost measurement for strategic decision-making and
 To provide cost measurement for operational control.
The above four reasons of cost allocation will match with these general purpose of cost
management system.

Ideally a single cost allocation serves all purposes simultaneously. But thousands of managers
and accountants will testify that for most costs this ideal is rarely achieved. Instead, cost
allocations are often a major source of discontent and confusion to the affected parties.
Allocating fixed costs usually causes the greatest problems. When all purposes cannot be
attained simultaneously, the manager and the accountant should start attacking a cost – allocation
problem by trying to identify which of the purposes should dominate in the particular situation at
hand.

Types of Cost Allocation

There are three basic types of cost allocations.
1. Allocation of costs to the appropriate organizational unit: Direct costs are physically traced
to the unit, but costs of resources that are used jointly by more than one unit are allocated
based on the cost driver activity in the unit. Examples include allocating rent costs to
different departments based on the floor space occupied, allocating general administrative
expenses based on total direct costs, etc.
2. Reallocation of costs from one organizational unit to another: when one organizational unit
provides products or services to another the costs are transferred along with the products or
services. Some organizational units, called service departments, exist only to support other
departments, and their costs are totally reallocated. Examples of such organizational units
include personnel department, laundry department in hospitals, legal department in industrial
firm, etc.
3. Allocation of costs of a particular organizational unit to activities, products, services or
customers: the pediatrics department of a medical clinic allocates its costs to patients, the
assembly activity of a manufacturing firm to units assembled, and a tax department of a CPA

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 firm to clients. The costs allocated to activities, products services, or customers include those
costs allocated to the organizational unit in allocation type 1 and 2 above.

Allocation of Variable & Fixed Costs of Service Department to Other Organizational Unit
General Guidelines:
The preferred guidelines for allocating service department costs are:
1. Establish part or all of the details regarding cost allocation in advance of rendering the
service rather than after the fact. This approach establishes “the rules of the game” so that all
departments can plan appropriately.
2. Allocate variable – and – fixed cost pools separately. Note that one service department such
as a computer department can contain multiple cost pools if more than one cost driver causes
the department’s costs. At a minimum there should be a variable and a fixed cost pool.
3. Evaluate performance using budgets for each service department (staff department) just as
for each production department or operating (line) department. The performance of a service
department should be evaluated by comparing actual costs with a budget, regardless of how
the costs are allocated. From the budget, variable cost pools and fixed cost pools can be
identified for use in allocation.

Methods of Cost Allocation

1) Single Rate and Dual Rate
Support department costs are allocated through the use of a charging rate. Considerations that go
into determining an appropriate charging rate include (1) the choice of a single or a dual rate and
(2) the use of budgeted versus actual support department costs.

A) Single Charging Rate

Both fixed and variable costs are combined into a single rate. The amount of service cost
allocated is solely a function of usage/volume. The use of a single rate treats the fixed cost as if it
were variable. It ignores the differential impact of changes in usage on costs. Fixed costs do not
vary with the level of services.

B) Dual Charging Rates

Two separate rates, one for fixed cost and one for variable cost, are used to avoid the treatment
of fixed costs as variable. The variable rate is used in conjunction with the fixed amount
allocated to determine the total charge.

Developing a Fixed Rate

Fixed service costs can be considered capacity costs because when the support department was
established, its delivery capacity was designed to serve the long-term needs of the producing
departments. Support department fixed costs can be allocated using a three-step procedure:
a. Determination of budgeted fixed support service costs.
b. Computation of the allocation ratio:
Producing department capacity
Allocation ratio =
Total capacity
c. Allocation:
Allocation = Allocation ratio × Budgeted fixed support service costs

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Developing a Variable Rate
Need to identify the appropriate cost driver. The benefits of dual charging rates include the
following:
 Fixed costs are allocated to producing departments according to their original needs of
support capacity.
 Variable costs are allocated to producing departments based on their usage of the support
department service.

C) Budgeted versus Actual Usage

Use the budgeted usage as the allocation base when fixed costs are involved. Allocation of
budgeted support service costs is better than allocation of actual support service costs because
allocating actual costs passes on the efficiencies or inefficiencies of the service department,
something that the manager of the producing department cannot control.

Support department cost allocation for product costing is calculated as follows:

Cost allocated based on dual rate method =

(Total budgeted fixed cost × Allocation ratio)
+ (Budgeted unit variable cost × Budgeted activity level)

Support department cost allocation for performance evaluation is calculated as follows:

Cost allocated based on dual rate method =

(Total budgeted fixed cost × Allocation ratio)
+ (Budgeted unit variable cost × Actual activity level)

D) Fixed versus Variable Bases: A Note of Caution

1. Use the normal or practical capacity to allocate fixed support department costs as long as the
capacity demands from the producing departments remain at the level originally anticipated.
2. Note that allocation of fixed costs based on actual usage will allow the actions of one
department to affect the amount of cost allocated to another department.

Illustration - Single and Dual Charging Rates

Gibe #1 Power Plant that services all manufacturing departments of South-West Engineering has
a budget for the coming year. This budget has been expressed in the following on monthly basis:

Needed at Practical Capacity Average expected monthly usage

Mfg Dept Production Level (kwH) (kwH)
A 10,000 8,000
B 20,000 9,000
C 12,000 7,000
D 8,000 6,000
Total 50,000 30,000
The expected monthly costs for operating the power plant during the budget year are $15,000
($6,000 is variable cost and $9,000 is fixed cost).

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Required:
a) Assume that a single cost pool (single rate) is used for power plant cost allocation; what
dollar amount will be allocated to each manufacturing department? Use (i) the practical
capacity and (ii) the average expected monthly usage as allocation base.
b) Assume that a dual cost pool (dual rate) is used with separate cost pools for variable cost and
fixed cost. Variable cost is allocated based on the average expected monthly usage and fixed
cost is allocated based on the practical capacity; what dollar amount will be allocated to each
manufacturing department?
Solution:
a) (i) Single rate with practical capacity

AR = $15,000/50,000kwH = $0.3/kwH
Mfg Dept A B C D Total
Practical capacity (kwH) 10,000 20,000 12,000 8,000 50,000
Times Allocation Rate X0.3 X0.3 X0.3 X0.3 X0.3
Cost Allocated to $3,000 $6,000 $3,600 $2,400 $15,000

(ii) Single rate with average expected monthly usage

AR = $15,000/30,000kwH = $0.5/kwH
Mfg Dept A B C D Total
Average expected monthly usage (kwH) 8,000 9,000 7,000 6,000 30,000
Times Allocation Rate X0.5 X0.5 X0.5 X0.5 X0.5
Cost Allocated to $4,000 $4,500 $3,500 $3,000 $15,000

b) Dual rate method - separately treat variable cost and fixed cost
(i) Variable cost allocation rate: - allocation base is - Average expected monthly usage

ARV = $6,000/30,000kwH = $0.2/kwH

(ii) Fixed cost allocation rate: - allocation base is - Practical capacity

ARf = $9,000/50,000kwH = $0.18/kwH

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 Mfg Dept A B C D Total
Average expected monthly usage (kwH) 8,000 9,000 7,000 6,000 30,000
Times ARV X0.2 X0.2 X0.2 X0.2 X0.2
VC Allocated to $1,600 $1,800 $1,400 $1,200 $6,000

Practical capacity (kwH) 10,000 20,000 12,000 8,000 50,000

Times ARf X0.18 X0.18 X0.18 X0.18 X0.18
FC Allocated to $1,800 $3,600 $2,160 $1,440 $9,000
Total VC & FC allocated to $3,400 $5,400 $3,560 $2,640 $15,000

Many companies have multiple support departments, and they frequently interact. These
interactions among support departments need to be considered to produce accurate cost
assignments. Three methods can be used to allocate support department costs: the direct,
sequential, and reciprocal methods. Commonly these methods are known as Support
Department Cost Allocation Methods. In determining which support department cost allocation
method to use, companies must:
 Determine the extent of support department interaction.
 Weigh the costs and benefits associated with each method.

2) Direct Method of Allocation

When support department costs are allocated only to the producing departments, the direct
method of allocation is being used. This is the most simple and straightforward of the three
allocation methods. Under this method,
 No support department costs are allocated to any other support department.
 All interactions between the support departments are ignored.

3) Sequential Method of Allocation

The sequential (or step-down) method of allocation recognizes that interactions among support
departments do occur. Cost allocations are performed in a step-down fashion.
 The costs of the support department rendering the greatest service are allocated first.
 Once a support department’s costs have been allocated, no costs are allocated back to it.
 The costs allocated from a support department are its direct costs plus any costs it receives
in allocations from other support departments.

Sequential allocation may be more accurate than the direct method because it recognizes some
interactions among the support departments. Its disadvantage, however, is that it does not
recognize all of the interactions between support departments.

4) Reciprocal Method of Allocation

In the reciprocal method of allocation, all of the interactions between support departments are
recognized by its reciprocity on cost allocation.
1. The total cost of a support department is the sum of its direct costs plus the proportion of
service received from other support departments. The total cost reflects interactions among
the support departments.
Total cost = Direct costs + Allocated costs

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2. A series of simultaneous linear equations must be constructed and solved to perform
reciprocal cost allocation.

Comparison of the Three Methods

The advantages of better allocation must outweigh the increased cost of using a more
theoretically preferred method. Rapid changes in technology make allocation unnecessary. For
example, there is no need for support department cost allocation in the JIT (Just-In-Time)
environment because the manufacturing cells (i.e., producing departments) are performing many
support functions.

Illustration - Support Department Cost Allocation Methods (direct, sequential and reciprocal)
The table below shows the direct costs, square footage occupied and number of employees for
each department in ABC manufacturing company. Note that facilities management provides
services for the personnel department in addition to providing services for the producing
departments, and those personnel aids employees in facilities management as well as those in
production departments.
Service Departments Production Departments
Facilities Mgt Personnel Molding Finishing
Direct department costs $126,000 $24,000 $100,000 $160,000
Square feet occupied 3,000 9,000 15,000 3,000
Number of Employees 20 30 80 320
Direct Labor hours 2,100 10,000
Machine hours 30,000 5,400
There are three popular methods for allocating service department costs in such cases; the direct
step-down and reciprocal methods.

(a) The Direct Method

As its name implies, the direct method ignores other service departments when allocating any
given service department’s costs to the revenue–producing (operating) departments. In other
words, the direct method ignores the services that facilities management provides for personnel
and the services that personnel provide to facilities management. Facilities management costs are
allocated based on the relative square footage occupied by the production departments only:

 Total square footage in production departments = 15,000 + 3,000 = 18,000sq. footage

 Facilities management Cost allocated to Molding =15,000/18,000 x $126,000 = $105,000
 Facilities management Cost allocated to Finishing = 3,000/18,000 x $126,000 = $21,000

Likewise, personnel department costs are allocated only to the production departments on the
basis of the relative number of employees in production departments:

 Total number of Employees in production departments = 80 + 320 = 400 employees

 Personnel costs allocated to molding = 80/400 x $24,000 = $4,800
 Personnel costs allocated to Finishing = 320/400 x $24,000 = $1,920

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 Total cost of dept: Molding Finishing
Its direct cost $100,000 $160,000
Add cost allocated from Facility management 105,000 21,000
Add cost allocated from personnel 4,800 19,200
Total cost $209,800 $200,200

(b) The Step-Down Method

This method recognizes that some service departments support the activities in other service
departments as well as those in operating departments. A sequence of allocations is chosen,
usually by starting with the service department that renders the greatest service (as measured by
costs) to the greatest number of other service departments. The last service department in the
sequence is the one that renders the least service to the least number of other service
departments. Once a department’s costs are allocated to other departments, no subsequent service
department costs are allocated back to it.

In our example, which service department’s cost, should be allocated first? You are right
Facilities Management cost should be allocated first because facilities management renders more
support to personnel than personnel provides for facilities management. At this point, it is known
that you already raised a question of “how should we determine which of the two service
departments provides more service to the other? One way is to carry out step 1 of step-down with
facilities management allocated first and then repeat it assuming personnel is allocated first. With
facilities management allocated first $42,000 (9000/27000 x $126,000) is allocated to personnel
if a personnel is allocated first $1,143 (20/420 x $24,000) would have been allocated to facilities
management. Because $1,143 is smaller than $42,000 facilities management is allocated first.

Facilities management cost as mentioned already is the service department cost which should be
allocated first; therefore, it is allocated to personnel department too beside the two producing
departments: molding and finishing.

 Thus, total sq. footage in these three departments is = 9,000 + 15,000 + 3,000 = 27,000sq.ft
 Facilities management cost allocated to molding = 15,000/27,000 x $126,000 = 70,000
 Facilities management cost allocation to Finishing = 3,000/27,000 x $126,000 = $14,000
 Facilities management cost allocated to personnel = 9,000/27,000 x $126,000 = $42,000
Note:
 After allocating Facilities management cost, we do not allocates any costs back to facilities
management.
 The personnel cost to be allocated to the production departments includes the amount
allocated to personnel from the facilities management ($42,000) in addition to the direct
personnel department costs of $24,000; hence the total cost of personnel department to be
allocated becomes $66,000 ($24,000 + $42,000).

As before this personnel department costs are allocated only to production departments on the
basis of the relative number of employees in production departments:

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 Total number of employees in production department = 80 + 320 = 400 employees
 Costs allocated from personnel to molding = 80/400 x 66,000 = $13,200
 Costs allocated from personnel to Finishing = 320/400 x 66,000 = $52,800

Thus; the total cost of dept: Molding Finishing

Its direct cost $100,000 $160,000
Add cost allocated from Facility management 70,000 14,000
Add cost allocated from personnel 13,200 52,800
Total cost $183,200 $226,800

(c) The Reciprocal Method

The reciprocal method – allocate service department costs to producing departments by fully
recognizing the mutual services provided among all support departments. To implement the
reciprocal method you are required to formulate and solve linear equations, which requires three
steps as illustrated below

Step1: Express service department costs and service department reciprocal relationships in the
form of linear equation.
Let “F” be complete reciprocated costs of facilities management and
“P” be complete reciprocated costs of the personnel department. Then express data as follow:

F = $126,000 + 20/420P -------------------------------------- 1

P = $24,000 + 9,000/27,000F -------------------------------- 2

 The ratio 20/420 or 4.76% in equation (1) is the percentage of personnel services used by
facilities management.
 The 9000/27000 or 33.33% in equation (2) is the percentage of facilities management used
by the personnel department.
 By compete reciprocated costs in equation (1) and (2); it means that the support departments
own costs plus any interdepartmental cost allocations.

Step 2: Solve the set of linear equations to obtain the complete reciprocated costs of each
service departments.

Substituting equation (2) in to (1)

F = $126,000 + 20/420P
F = $126,000 + 20/420 [$24,000 + 9,000/27,000F]
F = $126,000 + $1,143 + 18/1,134 F
F = $127,143 + 18/1,134F
(1-18/1134) F = $127,143
F = 127143/(1-18/1134) = $129,194

Substituting the amount of “F” in Equation (2)

P = $24,000 + 9000/27000 F
P = $24,000 + 9,000/27,000($129,194)
P = $67,065

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 Step 3: Allocate the complete reciprocated costs of each service department to all other
departments (both service departments and operating departments) on the basis of cost driver
used.
Accordingly:
Total sq. footage in all depts other than the facilities mgt = 9,000 + 15,000 + 3,000 = 27,000 sq.ft
 Facilities mgt complete reciprocated cost allocated to molding
 = 15,000/27,000 x $129,194 = $71,774
 Facilities management complete reciprocated cost allocated to Finishing
 = 3,000/27,000 x $129,194 = $14,355
 Facilities management complete reciprocated cost allocated to personnel
 = 9,000/27,000 x $129,194 = $43,065

Total number of employees in all depts other than personnel = 20 +80 +320 = 420 employees
 Personnel Department complete reciprocated cost allocated to molding
 = 80/420 x $67,065 = $12,774
 Personnel Department complete reciprocated cost allocated to Finishing
 = 320/420 x $67,065 = $51,097
 Personnel Department complete reciprocated cost allocated to Facilities management
 = 20/420 x $67,065 = $3,194

As you may perceive, there is a difference between complete reciprocated costs of the support
department and its direct cost:
Service Department Complete Reciprocated cost Direct cost Difference
Facilities management $129,194 $126,000 $3194
Personnel 67,065 24,000 43,065

Each support department’s complete reciprocated cost is greater than the budgeted direct cost
amount to take into account that the allocation of support costs will be made to all departments
using its services and not just to operating departments. It is this step that ensures that the
reciprocal method fully recognizes all interrelationships among support departments as well as
operating departments. However, the total costs allocated to operating departments always
remain the same amount, i.e. the total direct costs of support departments, here ($126,000 +
$24,000 = $150,000).

Use the Physical Units and Relative Sales-Value

Plant maintenance

Method
624,082 = 24,082 + 600,000to Allocate Joint Costs to Products:

Information system

240,816 = 124,816 + 116000

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 Chapter 6
Accounting for Joint Products and By-Products
Several manufacturing firm have a single production process yielding two or more products
simultaneously. For example, sugar producing companies, such as Finchawa Sugar Factory,
produces sugar as a main product and other products like molasses as by-products; other
companies may produce different main products as in the case of petroleum companies, which
produce different products: Kerosene, Naphtha, Gasoline, Benzene, etc from crude oil, using the
same process. You may raise, the question “why we allocate joint costs to individual products or
by products? This section will give you an answer for this question, and with the methods
employed by companies in order to do so. Let us begin by definition of some terminology:

Joint Product - Joint products are those products manufactured through a single production
process or simultaneous process.
Joint Costs - Joint costs are the costs of a production process that yields multiple products
simultaneously.
Split-off Point - The split-off point is the juncture/stage in a joint production process when two
or more products become separately identifiable.
Separable Costs - these are costs incurred beyond the split-off that are assignable to each of the
specific products identified at the split-off point.
Main Product - this is a product of a single process yielding two or more products that has
relatively high sales value.
By Product - This is a product produced with the main product having relatively low sales value.
Scrap - This is an output that has a minimal sales value.

The classification as main products, by products or scrap are basically based on their relative
sales value, and this can change over time, especially for products whose market price can
increase or decrease by large percentage in any one year. The distinction between these terms is
not firm in practice, thus, it is important to understand the terms as used by the particular
organization.

Why Allocate Joint costs?

There are several reasons why joint costs are allocated to individual products or services. These
reasons include the following:
1. Computation of inventorible costs and cost of goods sold for financial accounting purposes
and reports for income tax authorities.
2. Computation of inventorible costs and cost of goods sold for internal reporting purposes-
such reports are used in division- profitability analysis, and they affect evaluation of division
managers’ performance.
3. Cost reimbursement under contracts when only a portion of a business’s products or services
is sold or delivered to a single customer, say, government agency.
4. Insurance- settlement computations for damage claims made on the basis of cost information
of jointly produced products.
5. Rate regulations for one or more of the jointly produced products or services that are subject
to price regulation.

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For all these reasons; and of course, of several other reasons joint cost allocation is an important
issue in accounting; therefore your next question should be “How to allocate the joint cost to
individual products?”

Approaches to Allocating Joint Costs

There are two basic approaches used to allocate joint costs:
Approach 1: Allocate joint costs using market-based data such as the following approach:
1. Sales value at split-off method,
2. Net Realizable value (NRV) method, and
3. Constant gross-margin percentage Net Realizable value (NRV) method.
Approach 2: Allocate joint costs using physical measures, such as the weigh (say, kilograms) or
volume (say, cubic feet) of the joint products.

Joint costs do not have a cause-and-effect relationship with individual products because the
production process simultaneously yields multiple products. Using the benefit received criterion
leads to a preference for methods under approach 1 because revenues are in general, a better
indicator of benefits received than physical measures. Mining companies for example, receive
more benefits from 1 ton of gold than they do from 10 tons of coal. In the simplest joint
production process, the joint products are sold at split off point without further processing.

Example 1 below illustrates the two methods that apply in this case, i.e., the sales value at split
off point method and the physical measure method. Then introduce you with joint production
process that yield products that can be further processed beyond the split-off point. Example 2
below illustrates the NRV method and the constant-gross margin percentage NRV method.

Example 1: Farmer’s Dairy purchases raw milk from individual farms and processes it until the
split-off point, when two products-cream and Liquid skim-emerge. These two products are sold
to an independent company, which markets and distributes them to supermarkets and other retail
outlets. Summary data for illustration is as follow:
o Raw Milk Processed: 110 gallons of raw milk- 110 gallons of raw milk yield 100 gallons of
good products (cream and Liquid skim) i.e., 10 gallons shrinkage due to evaporation,
spoilage, and the like
o Production: 25 gallons of cream and 75 gallons of Liquid skim
o Sales: Cream, 20 gallons at Br 8 per gallon and Liquid skim, 30 gallons at Br 4 per gallon.
o Inventories- There was no beginning inventories for both products; and there are 5 gallons
of creams and 45 gallons of Liquid skim as ending inventory.
o The joint cost of purchasing the raw milk and processing to split-off point is Br 400.

Required: Allocate the joint cost using the sales value at split-off point method, and the physical
measure method. i.e., how much of the Br 400 joint costs should be allocated to the cost of
goods sold of 20 gallons of cream and 30 gallons of Liquid skim, how much should be allocated
to the ending inventory of 5 gallons of cream and the 45 gallons of liquid skim?

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 Joint Cost (Br 400)
Cream
nt 25 gallons
poi
t-off
Raw Milk Process Spli
110 gallons

Liquid
Liquid skim
skim
75 gallons
75 gallons

a) Sales value at split-off method

This method allocates joint costs to joint products on the basis of the relative total sales value at
the split-off point of the total production of these products during the accounting period. This
method uses the sales value of the entire production of the accounting period (25 gallons of
cream and 75 gallons of Liquid skim).

Crea Liquid Skim Total

m
Total sales value at split-off Point (25 x8, 75 x 4) Br 200 Br 300 Br 500
Allocation Rate (200/500, 300/500) 40% 60% 100%
Joint cost allocation (0.4 x 400, 0.6 x 400) Br 160 Br 240 Br 400
Product cost per unit (160/25, 240/75) Br 6.4 Br 3.2

Note that this method uses the sales value of the entire production of the accounting period not
just the quantity sold; the justification is that the joint costs were incurred on all units produced,
not just the portion sold during the current period.
 The product line income statement is prepared below using the above data

Cream Liquid Skim Total

Sales (20x8; 30x4) Br 160 Br 120 Br 280
Cost of goods sold (20x 6.4; 30x3.2) (128) (96) (224)
Gross margin 32 24 56
Gross margin percentage (32/160; 24/120; 56/280) 20% 20% 20%

Note that, the gross margin percentage is the same for both products here; but the gross-margin
percentage will depend on how much of the sales of each product came from beginning
inventory and how much came from current period production. The sales value at split-off
method follows the benefits-received criterion of cost allocation; costs are allocated in proportion
to their revenue-generating power. This method is both straightforward and intuitive. The cost
allocation base (total sales value at split-off) is expressed in terms of common currency (birr,

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dollar, etc) that is systematically recorded in the accounting system. Thus, to use this method,
selling prices must exist for all products at the split-off point.
b) Physical Measure Method
The physical-measure method allocates joint costs to joint products on the basis of the relative weight,
volume or other physical measure at split-off point of total production of these products during the
accounting period. In Example 1, the Br 400 joint cost produced 25 gallons of cream and 75 gallons of
liquid skim. The joint cost allocation using these quantities would be as follows:
Cream Liquid Skim Total
Physical measures of Production in gallons 25 75 100
Allocation Rate (25/100, 75/100) 25% 75% 100%
Joint cost allocation (0.25 x 400, 0.75 x 400) Br 100 Br 300 Br 400
Product cost per unit (100/25, 300/75) Br 4 Br 4
Note - because the physical-measure method allocates joint costs on the basis of gallons
produced, cost per gallon is the same for both products.
 The following is product line income statement under this method:
Cream Liquid Skim Total
Sales (20x8; 30x4) Br 1 60 Br 120 Br 280
Cost of goods sold (20x4; 30x4) (80) (120) (200)
Gross margin 80 0 80
Gross margin percentage (80/160; 0/120; 80/280) 50% 0% 28.6%

Under the benefit-received criterion, the physical-measure method is less desirable than the sales
value at split-off point method. That is because the physical measure of the individual products
has no relationship to the revenue generating power of the individual products. For example for
mining companies, the individual products unit produced or extracted may not have relationship
with the revenue generating power of the product extracted. Consider a gold mine at Laga
Dambi- that extracts ore containing Gold, Silver and Lead. Use of a common physical measure
(tones) may result in almost costs being allocated to lead the product that weights the most but
has the lowest revenue-generating power. In this case, this method of cost allocation is
inconsistent with the main reason that the mining company is incurring mining costs – to earn
revenues from gold and silver, not lead. Thus, when a company uses the physical-measure
method in a product line income statement, products that have a high sales value per unit of
physical measure (e.g. Gold and silver) would show a large “profit” and products that have a low
sales value per physical measure unit (e.g. Lead) would show sizable losses.

Example 2 - Assume the same situation as in example 1 except that both cream and liquid skim
can be processed further.
o Cream can be further processed to give butter cream. The 25 gallons of cream yield 20
gallons of butter cream at additional processing cost of Br 280.
o Liquid skim is processed further to get condensed milk. The 75 gallons of liquid skim are
processed further to yield 50 gallons of condensed milk at additional processing cost of Br
520.
o Sales during the month were 12 gallons of butter cream for Br 25 per gallon and 45 gallons
of condensed milk for Br 22 per gallon.
o Ending inventory 8 gallon of butter cream and 5 gallon of condensed milk

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 Now let us see how the joint cost of Br 400 is allocated to the butter cream and condensed milk
using:
1. Estimated Net Realizable (NRV) method,
2. Constant gross margin percentage NRV method

Look at the following Exhibit which depicts the basic relationship of how raw milk is converted
in to cream and liquid skim in joint production process, and how cream is separately processed
into butter cream and liquid skim is separately processed to condensed milk.

Separable
Separable Cost
Cost
Joint (Br
(Br 800)
800)
Joint Cost
Cost (Br
(Br 400)
400)
Sp
lit-
off
Butter
Butter Cream
Cream
Cream
Cream 25glns
25glns
20gallons
20gallons
Raw
Raw Milk
Milk Process
110
110 gallons
gallons

Liquid
Liquid Milk
Milk Condensed
Condensed
75gallons
75gallons Milk
Milk 50glns
50glns
glns
glns == gallons
gallons

c) Estimated Net- Realizable Value Method

This method allocates joint costs on the basis of the relative estimated net-realizable, i.e.,
expected final sales value in the ordinary course of business minus the expected separable costs
of production and marketing. The joint costs in our example would be allocated as follows.

Butter Condensed Milk Total

Cream
Expected final Sales (20x25; 50x22) Br 500 Br 1,100 Br 1,600
Less: Expected Separable Cost (280) (520) (800)
Expected NRV at split-off point 220 580 800
Allocation Rate (220/800; 580/800) 27.5% 72.5% 100%
Joint cost allocation (0.275x400; 0.725x400) Br 110 Br 290 Br 400
Joint cost per unit (110/20; 290/50) 5.50 5.80
Separate cost per unit (280/20; 520/50) 14.00 10.40
Total production cost per unit 19.50 16.20

 Product line income statement using the estimated net-realizable value method is
presented below:

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 Butter Condensed Milk Total
Cream
Sales (12x25; 45x22) Br 300 Br 990 Br 1,290
Less: Cost of goods sold (12 x 19.5; 45 x16.2) (234) (729) (963)
Gross margin 66 261 327
Gross margin % (66/300; 261/990; 327/1,290) 22% 26.36% 25.35%
Ending inventory cost (8x19.5; 5x16.2) Br 156 Br 81 Br 237

Note the Following about NRV Method:

o The expected final sales value of the total production of the period is used and not the actual
final sales of the period.
o The NRV method is typically used in preference to the sales value at split off method only
when selling prices for one or more products at split off do not exist.
o Estimating the net realizable value of each product at the split off point requires information
about the subsequent processing steps to be taken and their expected separable costs.
o The expected net realizable value method is clear-cut when there is only one split off point.
However, when there are multiple split off points, additional allocations may be required if
processes subsequent to the initial split off point remerge with each other to create a second
joint cost situation.

d) Constant Gross Margin Percentage NRV Method

This method allocates joint costs in such a way that the overall gross margin percentage is
identical for all the individual products. This method entails three steps:

Step 1: Compute the overall gross margin percentage for all joint products together.
Step 2: Use the overall gross margin percentage and deduct the gross margin from the final sales
values to obtain the total costs that each product should bear.
 Multiply the overall gross-margin percentage by final sales values of total
production for each product to calculate gross margin for each product. Subtract
gross margin for each product from final sales value of production for each product
to obtain total costs that each product will bear.
Step 3: Deduct separable costs from total costs that each product will bear to obtain the joint-
cost allocation.

The three steps to allocate the Br 400 joint cost in our example would be as follow:

Step 1: Expected Final sales value of products (20x25) + (50x22) Br 1,600

Less: Joint costs and separable costs (400 + 280 + 520) 1,200
Overall-gross margin 400
Gross margin percentage (400/1600) 25%

Step 2: Butter Condensed Milk Total

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 Cream
Expected sales value of products Br 500 Br 1,100 Br 1,600
Less: Gross margin (500x0.25; 1,100x0.75) (125) (275) (400)
Cost of goods sold 375 825 1,200

Step 3:
Cost of goods sold 375 825 1,200
Less: separable costs 280 520 800
Joint cost allocated Br 95 Br 305 Br 400
Cost per unit (375/20; 825/50) 18.75 16.50

 Presented below is a product line income statement using the above method of joint cost
allocation:

Butter Condensed Milk Total

Cream
Sales (12x25; 45x22) Br 300 Br 990 Br 1,290
Less: CGS (12x18.75; 45x16.50) (225) (742.5) (967.5)
Gross margin 75 247.5 322.5
Gross margin % (75/300; 247.5/300) 25% 25% 25%
Ending inventory cost (8 x 18.75; 5 x 16.50) 150 82.5 232.5

The assumption underlying the constant gross margin percentage NRV method is that all the
products have the same ratio of cost to sales value. A constant ration of cost to sales value across
products rarely has been in companies that produce multiple products but have no joint cost
situations. Another limitation of the constant gross margin percentage NRV method is that it uses
all separable costs (not just separable manufacturing costs) to compute constant gross margin.
The result is that inventory figures may implicitly include separable marketing and other
“downstream” costs, which is contrary to generally accepted accounting principles.

Note also that the constant gross-margin percentage NRV method is different in one fundamental
way from the two other market-based joint-cost-allocation methods described earlier. Recall that
the sales value at split-off point method and the NRV method allocate only the joint costs to the
joint products. Neither method takes account of profits earned either before or after the split-off
point when allocating the joint costs. In contrast, the constant gross margin percentage NRV
method is both a joint-cost allocation method and a profit allocation method. The total difference
between sales values of production of all products and separable costs of all products includes
joint products and total gross margin. Gross margin is allocated to the joint products under the
constant gross-margin, percentage NRV method to determine the joint cost allocations so that
each product has the same gross-margin percentage.

Choosing a method
Which method of allocating joint costs should be used?
Each method of joint cost allocation has its advantage and weakness. Because the costs are joint
in nature, as was mentioned, managers cannot use the cause and effect criterion in making this
choice.

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The sales value at split-off method is widely used when selling price data are available (even if
further processing is done). Reasons for using the sales value at split-off method include:
1. Measurement of the value of the joint products at the split-off point- sales value at split-off is
the best measure of the benefits received as a result of joint processing relative to all other
methods of allocating joint costs, it is a meaningful basis for allocating joint costs because
generating revenue is the reason why a company incurs joint costs in the first place.
2. No anticipation of subsequent management decisions. The sales value at split-off method
does not require information on the processing steps after split-off, if there is further
processing. In contrast, the NRV and constant gross margin percentage NRV methods require
information on the specific sequence of further processing decisions, the separable costs of
further processing, and the point at which individual products will be sold.
3. Availability of a common basis to allocate joint costs to products. The sales value at split-off
method has a common basis to allocated joint costs to products, which is revenue. In contrast,
the physical measure may lack an easily identifiable common basis that can be used to
allocate joint costs to individual producers.
4. Simplicity- the sales values at split-off method is simple. In Contrast, the NRV and constant
gross- margin percentage NRV methods can be complex for processing operations having
multiple products and multiple split-off points.

 When selling prices of all products at the split-off point are not available, the NRV
method is commonly used because it attempts to approximate sales value at split-off by
subtracting separable costs incurred after the split-off point on each product form selling
prices.
 The main advantage of constant gross- margin percentage NRV method is that it is
relatively easy to implement. This method treats the joint products as though they
comprise product by calculating an aggregate gross-margin percentage, applying this
gross margin percentage to each product, and backing into the joint costs allocated to
each product. It avoids the complexities inherent in the NRV method to measure the
benefits received by each of the joint products at the split-off point.
 Although there are difficulties in using the physical-measure method, such as lack of
congruence with the benefit received criterion, there are instances when the physical
measure is preferred, for instance in case of rate regulation.

Accounting For By Products

Joint production process may yield not only joint products and main products but by products as
well. Although by products have low total sales values compared with total sales values joint or
main products, the presence of by products in joint production process can affect the allocation
of joint costs. The accounting methods for by products address two major questions. These are:
1. When are by products recognized in the general ledger?
At the time of production or At the time of sales
2. Where do by products revenue appear in the income statement?
As a cost reduction of the main joint product or
As a separate item of revenue or other income

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Combining the above two questions and choices give us the following four possible ways of
accounting for by products:

When to Recognize Where by product

by product in the Where Revenue of by product inventory appear on
Method general ledger? appear on income statement? balance sheet?
1 Production Reduction of cost Inventory reported at
2 Production Revenue-Other Revenue selling price
3 Sales Reduction of costs
4 Sales Revenue-Other income No by product inventory

As you can see from the above exhibit methods 1 and 2 recognize the by product at the point of
production. However, by product inventories are reported at selling price on the balance sheet
rather than at a cost amount. One variant of method 1 and 2 is to report by product inventories at
selling price minus a normal profit margin; this variant avoids including unrealized gains as an
offset to cost of goods sold in the period of production.

Method 3 and 4 above are justified primarily on the grounds of immediately or on cost benefit
criterion. By products are not recognized in general ledger until a sale occurs. By products are
viewed as incidental and therefore does not warrant costly accounting procedures.

To illustrate, assume that Brown Coal Company purchases coal at $30 a ton. Its coking plant
produces two products-open fire coke and tar. The only saleable product at split-off point is tar,
which is a by-product. After further processing open fire coke appears. Each 100 tons of coal
costs $1,000 to process up to split-off point. The separable costs of further processing the 100
tons of coal beyond split-off point is $1,400. The outputs from 100 tons of coal are:

Out put Tons Selling price Per ton

Open fire 70 $100
Tar 10 20
In Jan 2011 Brown Coal Company processed 10,000 tons of Coal. It had no beginning
inventories of finished product coal. On Jan 31, it has also no ending inventories of coal. No
work in process, and 300 tons of open fire and 20 tons of tar in ending inventory.
Required:
 Prepare an income statement using the methods (1, 2, 3 and 4) expressed in above Exhibit
 Record all the necessary journal entries.
Solution:
Method 1: Recognize by products in the general ledger at production and treat by products as
reduction of cost:
Revenues:
Open fire Coke (6,700x100) $670,000
Cost of goods sold:
Total manufacturing cost (300,000 + 100,000) $400,000
Less: By-product Sales (980x20) 19,600
Net manufacturing cost $380,400
Less: Main product inventory (300 x 380,400)/7000 16,303
Byproduct inventory (20x20) 400 16,703
Cost of goods sold 363,697
Gross margin 73 306,303
Gross margin percentage 45.72%
Ending inventory: Main product = $16,303 and By product = $400
Method 2: Recognize by products in the general ledger at production and revenue form by
products as an income:
Revenues:
Open fire Coke (6,700x100) $670,000
Tar (980x20) 19,600
Total Revenue $689,600
Cost of goods sold:
Total manufacturing cost (300,000 + 100,000) $400,000
Less: Main product inventory (300 x 400,000)/7000 17,143
Byproduct inventory (20x20) 400
Total inventory cost 17,543
Cost of goods sold 382,457
Gross margin 307,143
Gross margin percentage 44.54%
Ending inventory-Main product = $17,143 and By product = $400

Method 3: Recognize by product in general ledger when sold and treat it as a reduction from
cost:
Revenues:
Open fire Coke (6,700x100) $670,000
Cost of goods sold:
Total manufacturing cost (300,000 + 100,000) $400,000
Less: By-product Sales (980x20) 19,600
Net manufacturing costs $380,400
Less: Main product inventory (300 x 380,400)/7000 16,303
Cost of goods sold 364,097
Gross margin 305,903
Gross margin percentage 45.66%
End inventory cost – main product = $16,303 and By product= $0

Method 4: Recognize by product in the general ledger when sold and treat it as revenue (other
income):
Revenues:
Open fire Coke (6,700x100) $670,000
Tar (980x20) 19,600
Total Revenue $689,600
Cost of goods sold:
Total manufacturing cost (300,000 + 100,000) $400,000
Less: Ending inventory (300 x 400,000)/7000 17,143
Cost of goods sold 382,857
Gross margin 306,743
Gross margin percentage 44.48%
Ending inventory- main product $17,143 and By product $0.

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In any method the joint cost is not allocated to the by product; the product is valued at expected selling
price. The following are required journal entry for the byproduct part only:
Metho Descriptions Dr Cr
d
1) (i) To record the Production of by product – Here “Tar”:
By product (tar) 20,000
WIP inventory 20,000
(ii) To record Sales of by product :
Cash (A/R) 19,600
By product (tar) 19,600

2) (i) To record the Production of by product (Tar):

By product inventory (tar) 20,000
WIP inventory 20,000
(ii) To record Sales of by product :
Cash (A/R) 19,600
By product (tar) 19,600

3) (i) To record the Production of by product (Tar):

No journal entry is made to record production of by product
(ii) To record Sales of by product (tar) :
Cash (A/R) 19,600
Finished Goods (Cost of Sales) 19,600

4) (i) To record the Production of by product (Tar):

No journal entry is made to record production of by product
(ii) To record Sales of by product (tar) :
Cash (A/R) 19,600
Other income 19,600

CHAPTER FOUR
JOB ORDER COSTING SYSTEM
In order to be successful and survive, business must employ some type of product costing
system. In other words, they need to track the cost of making a product or furnishing a service.

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This chapter will discuss one of the two broad product costing system; job-order costing system,
in the next chapter (chapter 5) the other product costing; process costing system will be
discussed. For now, let’s begin by distinguishing between the two systems.

Difference between Job Order and Process Costing:

As mentioned above, the two common product costing systems are: Job order costing and
Process costing systems. Job order costing system is a system of cost accumulation where there
is identifiable activity for which costs may be collected. The activity is usually specified in terms
of job work or group of tasks contributing to a stage in the production or service process. Job
order costing system allocates costs to products that are readily identifiable by individual units or
batches each of which requires varying degree of attention and skill. It is used by companies
where products are identifiable individual or batches; thus, costs attributable to a particular job
are assigned directly to it. Industries that use commonly job order costing system include:
construction, auto-repair, printing aircraft, furniture, special-purpose machinery, tax-return
preparation, and so on.

Process costing is on the other hand, used in industries where there is mass-production of
similar/identical products. This costing system averages costs over large number of nearly
identical products. It is most often found in such industries as chemicals, oils, plastics, rubber,
lumber, food processing, glass mining, cement, meatpacking, etc.

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

A further difference between the two costing systems is that the job cost sheet is not used in
process costing, since the focal point of process costing is on departments. Instead of using job
cost sheet a production report is prepared for each department in which work is done on
products. The production report serves several functions. It provides a summary of number of
units moving through a department during a period, and it also provides a computation of unit
costs. In addition it shows what costs were charged to the department and what disposition was
made on these costs. The department production report is a key document in a process costing
system. These differences are summarized below:

Job Order Costing Process Costing

1. Many different jobs are worked on during 1. A single product is produced either on
each period, with each job having different continuous basis or for long periods. All
production requirements. units of product are identical.

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2. Costs are accumulated by individual job. 2. Costs are accumulated by departments.
3. Job cost sheet is the key document 3. The department production report is the key
controlling the accumulation of costs by a document showing the accumulation and
job. disposition of costs.
4. Unit costs are computed by job on the job 4. Unit costs are computed by department on
cost sheet. the department production report.

Advantages & Disadvantages of Job Order Costing & Process Costing

Costing is an accounting technique used to determine the exact expenses for materials, labor and
overhead incurred in operations. Job order costing records the actual materials and labor
expenses for specific jobs, and assigns overhead to jobs at a pre-determined rate. Process costing
applies costs to departments based on the average number of units produced per day. Job order
and process costing have unique advantages and disadvantages that make them best suited for
specific situations.

Assigning Costs
One advantage of job order costing is that it allows managers to calculate the profit earned on
individual jobs, helping them to better ascertain whether specific jobs are desirable to pursue in
the future. This is best for businesses that do highly custom work, such as construction
contractors and consultants. An advantage of process costing is that it allows managers to get
detailed information on the production statistics of individual departments or workgroups. This is
best suited for continuous manufacturing settings, such as factories and utility companies.

Record Keeping
A disadvantage of job order costing is that employees are required to track all materials and labor
used during the job. Process costing simplifies record keeping by relying on statistical
calculations rather than actual inputs. As an example, consider a construction contractor using a
job order costing system. The contractor has to keep track of all the wood, nails, screws,
electrical fixtures, paint and other materials used on the job, as well as tracking workers' lunch
breaks and hours worked. In a factory setting, on the other hand, materials are calculated using
an average of units produced, and salaries expenses are often relatively consistent between pay
periods.

Reporting
Job order costing gives managers the advantage of being able to keep track of individuals' and
teams' performance in terms of cost-control, efficiency and productivity. Process costing, on the
other hand, gives managers the advantage of being able to ascertain the same qualities in entire
departments and compare performance over time.

Unit Cost Calculation

Job order and process costing are adequate to determine the average cost of each unit produced.
The formula for unit cost calculation in a job order costing system is: Unit Cost = Total Job
Cost/Number of Units Produced in Job. In many cases, such as the construction contractor
example, only one unit is technically being produced per job—in this case one deck or one
bathroom remodeling. The formula for unit cost calculation in a process cost system is: Unit Cost

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= Department's Periodic Cost / Number of Units Produced in the Period. Unit cost considerations
are generally more relevant in situations suited for process costing.

Accounting for Job order costing system

Job order costing system is used in situations where many different products are produced each
period. For example clothing factory would typically made many different types of jeans for both
men and women during a month. In a job order costing system, costs are traced to the jobs and
then the costs of the job are divided by the number of units in the job to arrive at an average cost
per unit.

Job order costing system is also extensively used in service industries. Hospitals, law firms,
movie studios, accounting firms, advertising agencies and repair shops all use a variety of job
order costing system to accumulate costs for accounting and billing purposes. The details here
deal with a manufacturing firm, the same concept and procedures are used by many service
organizations.

The record keeping and cost assignment problems are more complex in a job order costing
system when a company sells many different products and services than when it has only a single
product or service. Since the products are different, the costs are typically different.
Consequently, cost records must be maintained for each distinct product or job. For example an
attorney in a large criminal law practice would ordinarily keep separate records of the costs of
advising and defending each of his/her clients. And a clothing factory would keep separate track
of the costs of filling orders for particular styles, sizes, and colors of jeans. A job order costing
system requires more effort than a process costing system. Companies classify manufacturing
costs into three broad categories: 1) direct materials, 2) direct labor, and 3) manufacturing
overhead. As we study the operation of a job costing system, we will see how each of these three
types of costs is recorded and accumulated.

1. Measuring Direct Materials Cost in Job Order Costing System: At the beginning of
production process a document known as bill of materials is used for standard products. "A
bill of materials is a document that lists the type and quantity of each item of materials
needed to complete a unit of standard product". 
2. Measuring Direct Labor Cost in Job Order Costing System: Direct labor cost is
handled in much the same way as direct materials cost. Direct labor consists of labor
charges that are easily traced to a particular job. Labor charges that cannot be easily traced
directly to any job are treated as part of manufacturing overhead.
3. Application of Manufacturing Overhead: Manufacturing overhead must be included
with direct labor on the job cost sheet since manufacturing overhead is also a product cost.
However, assigning manufacturing overhead to units of product can be a difficult task. 
4. Job Order Costing System - The Flow of Costs: To understand the flow of costs in job
order costing system, we shall consider a single month's activity for a company, say for
instance, a producer of product A and product B. 
5. Multiple Predetermined Overhead Rates: When a single predetermined overhead rate is
used for entire factory it is called plant wide overhead rate. This is fairly common practice -
particularly in smaller companies. 

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 6. Under-applied overhead and over-applied overhead calculation: Since the
predetermined overhead rate is established before a period begins and is based entirely on
estimated data, the overhead cost applied to work in process (WIP) will generally differ
from the amount of overhead cost actually incurred during a period. 
7. Disposition of any balance remaining in the manufacturing overhead account at the
end of a period: What disposition should be made of an under-applied overhead or over-
applied overhead balance remaining in the manufacturing overhead account at the end of a
period?
8. Predetermined Overhead Rate and Capacity: Companies typically base their
predetermined overhead rates on the estimated, or budgeted, amount of allocation base for
the upcoming period. This is the method that is used in this chapter, but it is practice that is
recently come under severe criticism. An example will be very helpful anyway.
9. Recording Non - manufacturing Costs: In addition to manufacturing costs, companies
also incur marketing and selling costs. These costs should be treated as period expenses and
charged directly to the income statement and therefore should not go into the
manufacturing overhead account. 
10. Recording Cost of Goods Manufactured and Sold: When a job has been completed, the
finished output is transferred from the production department to the finished
goods warehouse. By this time, the accounting department will have charged the job with
direct materials and direct labor cost and manufacturing overhead will have been applied
using the predetermined overhead rate.
11. Job Order Costing in Services Companies: Job order costing is also used in service
organizations such as law firms, movie studios, hospitals, and repair shops, as well as
manufacturing companies. 
12. Use of Information Technology in Job Order Costing: Bar code technology can be
used to record labor time--reducing the drudgery (hard boring work) in that task and
increasing accuracy. Bar codes also have many other uses. In a company with a well-
developed bar code system, the manufacturing cycle begins with the receipt of a customer's
order in electronic form.

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

The Purchase and Issue of Materials:

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

Raw Materials 60,000

Accounts Payable              60,000
Raw materials are an asset account. Thus, when raw materials are purchased, they are initially
recorded as an asset-not as an expense.

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 (1) Issue of Direct and Indirect Materials:
During April, $52,000 in raw materials was requisitioned from the storeroom for use in
production. These raw materials include both direct and indirect materials. Entry (2) records
issuing the materials to the production department.

Work in Process 50,000

Manufacturing Overhead 2,000
  Raw Materials   52,000

The materials charged to work in process (WIP) represent direct materials for specific jobs. As
these materials are entered into the work in process account, they are also recorded on the
appropriate job cost sheets. This point is illustrated in Exhibit 4.1; where $28,000 of the $50,000
in direct materials is charged to Job 1 cost sheet and the remaining $22,000 is charged to job 2
cost sheet. (In this example, all data are presented in summary form and the job cost sheet is
abbreviated.)

The $2,000 charged to manufacturing overhead in entry (2) represents indirect materials used in
production during April. Observe that the manufacturing overhead account is separate from work
in process account. The purpose of the manufacturing overhead account is to accumulate all
manufacturing overhead costs as they are incurred during a period.

Before leaving Exhibit 2.1 we need to point out one additional thing. Notice from the exhibit that
the job cost sheet for job 1 contains a beginning balance of $30,000. We stated earlier that this
balance represents the cost of work done during March that has been carried forward to April.
Also note that work in process account contains the same $30,000 balance. The reason the
$30,000 appears in both places is that the work in process account is a control account and the
job cost sheets form a subsidiary ledger. Thus, the work in process account contains a
summarized total of all costs appearing on the individual job cost sheet for all jobs in process at
any given point in time. (Since the company had only job 1 in process at the beginning of April,
job 1's $30,000 balance on that date is equal to the balance in the work in process account.

Exhibit 4.1

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Issue of Direct Materials Only:
Sometimes the materials drawn from the raw materials inventory account are all direct materials.
In this case, the entry to record the issue of the materials into production would be as follows:
Work in process XXX
  Raw materials   XXX

Labor Cost:
As work is performed each day in various departments of the company, employee time tickets
are filled out by workers, collected, and forward to the accounting department. In the accounting
department, wages are computed and the resulting costs are classified as either direct or indirect
labor. This costing and classification for April resulted in the following summary entry (3):

Work in process 60,000

Manufacturing overhead 15,000
  Salaries and wages payable   75,000

Only direct labor is added to the work in process account. In this example, direct labor is $60,000
for April.

At the same time the direct labor costs are added to work in process, they are also added to the
individual job cost sheets, as shown in the Exhibit 4.2. During April, $40,000 of direct labor cost
was charged to job 1 and the remaining $20,000 was charged to job 2. The labor cost charged to
manufacturing overhead represent the indirect costs of the period, such as supervision, janitorial
work, and maintenance.

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Exhibit 4.2

Manufacturing Overhead Costs:

All costs of operating the factory other than direct materials and direct labor are classified as
manufacturing overhead costs. These costs are entered directly into the manufacturing overhead
account as they are incurred. To illustrate, assume that the company incurred the following
general factory costs during April, on account:

Utilities (heat, water, and power) $21,000

Rent on factory equipment 16,000
Miscellaneous factory costs 3,000
Total $40,000
The following entry (4) records the incurrence of these costs:
40,000
Manufacturing overhead
  Accounts Payable   40,000

In addition, let us assume that during April, the company recognized $13,000 in accrued property
taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The
following entry (5) records these items:

Manufacturing overhead 20,000

  Property taxes payable   13,000
  Prepaid insurance   7,000

Finally let us assume that the company recognizes $18,000 in depreciation on factory equipment
during April. The following entry (6) records the accrual of this depreciation:

Manufacturing overhead 18,000

  Accumulated Depreciation   18,000

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In short, all manufacturing overhead costs are recorded directly into the manufacturing overhead
account as they are incurred day by day through a period. It is important to understand that
manufacturing overhead is a control account for many--perhaps thousands--of subsidiary
accounts such as indirect materials, indirect labor, factory utilities, and so forth. As the
manufacturing overhead account is debited for costs during a period the various subsidiary
accounts are also debited. In this example, I omit the entries to the subsidiary accounts for the
sake of brevity.

Calculation of Predetermined Overhead Rate and Application of

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

To illustrate assume that the company has used machine hours to compute predetermined
overhead rate and that this rate is $6 per machine hour. Also assume that during April, 10,000
machine hours were worked on Job 1 and 5,000 machine hours were worked on Job 2 (a total of
15,000 machine hours). Thus, $90,000 in overhead cost (15,000 machine x hours $6 per machine
hour = $90,000) would be applied to work in process. The following entry (7) records the
application of manufacturing overhead to work in process:

Work in process 90,000

  Manufacturing overhead   90,000
The flow of cost through the manufacturing overhead account in Exhibit 2.3

Exhibit 4.3

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The actual overhead costs in the manufacturing overhead account in Exhibit 4.3 are the costs that
were added to the account in entries (2)-(6).  Observe that the incurrence of these actual
overhead costs and the application of overhead to work in process represent two separate and
entirely distinct processes.

The Concept of Clearing Account:

The manufacturing overhead account operates as a clearing account. As I have noted, actual
factory overhead costs are debited to the accounts as they are incurred day by day through the
year. A certain intervals during the year, usually when a job is completed, overhead cost is
applied to the job by means of the predetermined overhead rate, and work in process is debited
and manufacturing overhead is credited. This sequence of events is illustrated below:

Manufacturing Overhead (a clearing account)

Actual overhead costs are charged to this Overhead is applied to work in process using
account as they are incurred throughout the the predetermined overhead rate.
period.

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

overhead costs are expected to be, and it is established before the year begins. As a result, the
overhead cost applied during a year will almost certainly turn out to be more or less than the
overhead cost that is actually incurred. For example, notice from Exhibit 4.3 that the company's
actual overhead costs for the period are $5,000 greater than the overhead cost that has been
applied to work in process (WIP), resulting in a $5,000 debit balance in the manufacturing
overhead account. This debit balance in manufacturing overhead account is called under-applied
overhead. Any credit balance in manufacturing overhead account is called over-applied
overhead. Any balance in the manufacturing overhead account (under or over-applied overhead)
is treated in one of the following ways:
1. Closed out to cost of goods sold
2. Allocated between work in process, finished goods, and cost of goods sold in proportion
to the overhead applied during the current period in the ending balance of these accounts.

These two methods are illustrated on Disposition of Under- or Over-applied Overhead Balances
page. For the moment, we can conclude by nothing from Exhibit 4.3 that the cost of a completed
job consists of the actual materials cost of the job, the actual labor cost of the job, and the
overhead cost applied to the job. Pay particular attention to the following subtle but important
point: Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the
job cost sheet nor do they appear in the work in process account. Only the applied overhead
cost, based on the predetermined overhead rate, appear on the job cost sheet and in the work in
process account. Study this point carefully.

(8) Non-manufacturing Costs:

In addition to manufacturing costs, companies also incur marketing and selling costs. These costs
should be treated as period expenses and charged directly to the income statement and therefore
should not go into the manufacturing overhead account. To illustrate the correct treatment of
non-manufacturing costs, assume that the company (in this example) incurred $30,000 in selling
and administrative salary costs during a months, the following entry (8) records these salaries.

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Salaries expense 30,000
   Salaries and wages payable   30,000

Depreciation on factory equipment is debited to manufacturing overhead account but

depreciation on office equipment is considered a period expense and is not included in
manufacturing overhead. Assume that depreciation of office equipment during the month was
$7,000. The entry (9) is as follows.
7,000
Depreciation expense
    Accumulated depreciation   7,000

Finally assume that advertising was $42,000 and that other selling and administrative expenses
during the month were $8,000. The following journal entry (10) records these items:

Advertising expenses 42,000

Other selling and administrative expense 8,000
   Accounts payable   50,000

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

Cost of Goods Manufactured (CGM):

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

Let us assume that the job 1 was completed during the period. The following entry (11) transfers
the cost of job 1 from work in process (WIP) to finished goods.

Finished goods 158,000

   Work in process   158,000

The $158,000 represents the completed cost of job 1, as shown on the job cost sheet in Exhibit
4.3. Since job 1 was the only job completed during April, the $158,000 also represents the cost
of goods manufactured for the month. The job 2 was not completed by month-end, so its cost
will remain in the work in process (WIP) account and carry over to the next month. If a balance

73
sheet is prepared at the end of April, the cost accumulated thus far on the job 2 will appear as
"work in process inventory" in the assets section.

Cost of Goods Sold (CGS):

As units in the finished goods are shipped to the customers, their costs are transferred from the
finished goods account into the cost of goods sold account. If complete job is shipped, as in the
case where a job has been done to a customer's specification then it is a simple matter to transfer
the entire cost appearing on the job cost sheet into the cost of goods sold account. In most cases,
only a portion of the units involved in a particular job will be immediately sold. In these
situations the unit cost must be used to determine how much product cost should be removed
from finished goods and charged to cost of goods sold.

Assume that the company has completed 1000 units and 750 out of 1000 units have been shipped
to customers for a price of $225,000. The unit product cost is $158. Following journal entries
(12) and (13) would record the sales (all sales are on account).
Accounts receivable 225,000
  Sales   225,000

Cost of goods sold 118,5000*

  Finished goods   118,5000
($158 × 750units = $118,500*)
 With entry (13), the flow of cost through our job order costing system is completed.

Summary of Cost Flow:

To pull the entire example together, journal entries (1) through (13), T accounts, and schedules
of cost of goods manufactured and cost of goods sold are presented below:

Journal Entries:
(1)
Raw Materials 60,000
Accounts Payable 60,000
(2)
Work in process 50,000
Manufacturing overhead 2,000  
Raw materials   52,000
(3)    
Work in process 60,000
Manufacturing overhead 15,000  
Salaries and wages   75,000
(4)
Manufacturing overhead 40,000
Accounts payable   40,000
(5)
Manufacturing overhead 20,000  
Property taxes payable   13,000
Prepaid insurance   7,000

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(6)
Work in process 18,000  
Manufacturing overhead   18,000  
(7)
Work in process 90,000
Manufacturing overhead   90,000
(8)    
Salaries expenses 30,000
Salaries and wages payable   30,000
(9)
Depreciation expense 7,000
Accumulated depreciation   7,000
(10)    
Advertising expense 42,000
Other selling and administrative expense 8,000
Accounts payable   50,000
(11)    
Finished goods 158,000
  Work in process   158,000
(12)    
Accounts receivable 225,000  
  Sales   225,000  
(13)    
Cost of goods sold 118,500  
Finished goods 118,500

T-Accounts:

Accounts Receivable Accounts Payable Capital Stock

         xx                  xx            xx
(12)  225,000  (1)      60,000
 (4)      40,000
 (10)    50,000
               
Prepaid Insurance   Salaries & Wages Payable   Retained Earnings
              xx                      xx               xx
(3)       75,000
(5)       7,000 (8)       30,000
               
Raw Materials   Property Taxes Payable   Sales
Bal.      7,000(2)   52,000        xx    (12) 225,000
(1)     60,000  (5)  13,000   
Bal.    15,000            

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           Cost of Goods Sold
Work in Process Salaries expenses (13)  118500
Bal.    30,000(11)  158,000 (8)  30,000
(2)      50,000 Depreciation expenses
(3)      60,000 (9)    7,000
(7)      90,000
Bal.    72,000              
             
Finished Goods   Advertising Expenses      
Bal.     10,000(13)  118,500   (10)  42,000        
(11)  158,000

Bal.    49,000

Other Selling &

Accumulated Depreciation Administrative expenses
               xx (10)   8,000
(6)     18,000
(9)      7,000

Manufacturing Overhead
(2)        2000 (7)     90,000
(3)     15,000
(4)     40,000
(5)     20,000
(6)     18,000
Bal.      5,000

Explanation of entries:
1) Raw materials purchased
2) Direct and indirect materials issued 8) Administrative salaries expenses incurred.
into production.
3) Direct and indirect factory labor cost 9) Depreciation recorded on office equipment.
incurred.
4) Utilities and other factory costs 10) Advertising and other expenses incurred
incurred.
5) Property taxes and insurance incurred 11) CGM transferred into finished goods.
on the factory.
6) Depreciation recorded on the factory 12) Sale of job 1 recorded.
assets.
7) Overhead cost applied to work in 13) Cost of goods sold recorded for job 1.
process.

XX = Normal balance in the account (for example accounts receivable normally carries a debit balance).

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Cost of Goods Manufactured:
Direct materials $50,000
Direct labor $60,000
Manufacturing overhead applied to work in process $90,000*
------------
Total Manufacturing cost incurred $200,000
Add: Beginning work in process $30,000
  ------------
  $230,000
Deduct: Ending work in process inventory $72,000
  -----------
Cost of goods manufactured $158,000
=======
Cost of Goods Sold:
Finished goods inventory beginning $10,000
Cost of goods manufactured $158,000
-----------
Goods available for sale $168,000
Deduct: Finished goods inventory ending $49,500
----------
Unadjusted cost of goods sold $118,500
Add: Under applied overhead $5,000*
-----------
Adjusted cost of goods sold $123,500
=======
*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 Predetermined
overhead rate)
Actual overhead = $95,000
Under applied overhead = $95,000 (actual) - $90,000 (applied) = $5,000
Entry to close the $5,000 of under applied  to cost of goods sold would be as follows:
Cost of goods sold-------------------------- 5,000
Manufacturing overhead--------------------------- 5,000

Note that the under-applied overhead is added to cost of goods sold. If overhead were
over-applied, it would be deducted from cost of goods sold.

Income Statement:
Sales (750 units@$300) $225,000
Less cost of goods sold ($ 118,500 + $5,000)   123,500
Gross margin/profit 101,500
Less operating expenses:    
      Salaries $30,000  
      Depreciation 7,000  
      Advertising expenses 42,000  
      Other expense 8,000 87,000
Net operating income   $14,500

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Under-applied and Over-applied Overhead
Exercise1: Define, explain and calculate under-applied and over-applied overhead rate. Give an
example.

Definition and Explanation of Over and Under-applied Overhead:

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

Causes / Reasons of under applied or over applied overhead:

The causes / reasons of under or over-applied overhead can be complex. Nevertheless the basic
problem is that the method of applying overhead to jobs using a predetermined overhead rate
assumes that actual overhead costs will be proportional to the actual amount of the allocation
base incurred during the period. If, for example, the predetermined overhead rate is $6 per
machine hour, then it is assumed that actual overhead cost incurred will be $6 for every machine
hour that is actually worked. There are actually two reasons why this may not be true. First,
much of the overhead often consists of fixed costs that do not grow as the number of machine
hours incurred increases. Second, spending on overhead items may or may not be under control.
If individuals who are responsible for overhead costs do a good job, those costs should be less
than were expected at the beginning of the period. If they do a poor job, those costs will be more
than expected.
Example: Suppose that two companies A and B have prepared the following estimated data
for the coming year:
             Company            
A B
Predetermined overhead rate based on Machine-hours DM cost
Estimated manufacturing overhead (a) $300,000 $120,000
Estimated machine-hours (b) for A co. 75,000 --
Estimated direct materials cost (b) for B co. -- $80,000
$4 per machine 150% of direct
Predetermined overhead rate, (a) ÷ (b)
hour materials cost

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Now assume that because of unexpected changes in overhead spending and changes in demand
for the companies' products, the actual overhead cost and the actual activity recorded during the
year in each company are as follows:
                Company             
  A B
Actual manufacturing overhead costs $290,000 $130,000
Actual machine-hours 68,000 --
Actual direct materials costs -- $90,000

For each company, note that the actual data for both cost and activity differ from the estimates
used in computing the predetermined overhead rate. This results in under-applied overhead and
over-applied overhead as follows:
Company
A B
Actual manufacturing overhead costs $290,000 $130,000
Manufacturing overhead cost applied to WIP during the year:
68,000 actual machine hours × $4 per machine hour 272,000
$90,000 actual direct materials cost × 150% of direct materials
135,000
cost
------------- -------------
Under-applied (over-applied) overhead $ 18,000 $ (5,000)

For company A, notice that the amount of overhead cost that has been applied to work in process
($272,000) is less than the actual overhead cost for the year ($290,000). Therefore the overhead
is under-applied. Also notice that original estimate of overhead in company A ($300,000) is not
directly involved in this computation. Its impact is felt only through the $4 predetermined
overhead rate that is used.

For company B the amount of overhead cost that has been applied to work in process (WIP)
($135,000) is greater than the actual overhead cost for the year ($130,000), and so overhead is over-
applied. A summary of the concepts discussed so for is presented below:

At the beginning of the period

Estimated total
Estimated total units in the Predetermined overhead
manufacturing overhead ÷ =
allocation base rate
cost 
During the period
Actual total units of the
Total manufacturing
Predetermined overhead rate × allocation base incurred =
overhead applied
during the period
At the end of the period
Total manufacturing Under-applied (over-
Actual total manufacturing
– overhead = applied)
overhead cost
applied overhead

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What disposition should be made of an under-applied overhead or over-applied overhead
balance remaining in the manufacturing overhead account at the end of a period?
Generally any balance in the account is treated in one of the two ways.
1. Closed out to cost of goods sold.
2. Allocated between work in process (WIP), finished goods and cost of goods sold in
proportion to the overhead applied during the current period in the ending balances of
these account.
The second method, which allocates the under or over-applied overhead among ending
inventories and cost of goods sold is equivalent to using an "actual" overhead rate and is for that
reason considered by many to be more accurate than the first method. Consequently, if the
amount of under-applied or over-applied overhead is material, many accountants would insist
that the second method be used.

1. Closed Out to Cost of Goods Sold:

Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than
the allocation method.

Where the overhead is under-applied following journal entry is made:

Cost of goods sold   XX
Manufacturing overhead XX

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

Manufacturing overhead   XX
Cost of goods sold XX

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

2. Allocated Between Accounts:

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

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Example:

If the amount of under-applied or over-applied overhead is significant, it should be allocated

among the accounts containing applied overhead: Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied”
overhead mean that the balances in these accounts are quite different from what they would have
been if actual overhead costs had been assigned to production.
Allocation restates the account balances to conform more closely to actual historical cost as
required for external reporting by generally accepted accounting principles. The above
figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of
over-applied overhead among the necessary accounts; had the amount been under-applied, the
accounts debited and credited in the journal entry would be the reverse of that presented for over-
applied overhead. A single overhead account is used in this illustration.
Theoretically, under-applied or over-applied overhead should be allocated based on the amounts
of applied overhead contained in each account rather than on total account balances. Use of total
account balances could cause distortion because they contain direct material and direct labor
costs that are not related to actual or applied overhead. In spite of this potential distortion, use of
total balances is more common in practice for two reasons: First, the theoretical method is
complex and requires detailed account analysis. Second, overhead tends to lose its identity after
leaving Work in Process Inventory, thus making more difficult the determination of the amount
of overhead in Finished Goods Inventory and Cost of Goods Sold account balances

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 CHAPTER FIVE
PROCESS COSTING SYSTEM
Process costing systems are used to apply costs to similar products that are mass produced in a
continuous fashion, such as the production of ice cream, steel or soft drinks. In comparison, costs
in a job order cost system are assigned to a specific job, such as the construction of a customized
home, the making of a motion picture, or the manufacturing of a specialized machine. Job order
cost and process cost systems are similar in that:
a) Both use the same three manufacturing cost elements of direct materials, direct labor, and
manufacturing overhead;
b) Both accumulate costs of raw materials by debiting Raw Materials Inventory, factory labor
by debiting Factory Labor, and manufacturing overhead costs by debiting Manufacturing
Overhead; and
c) Both flow costs to the same accounts of Work in Process, Finished Goods Inventory, and
Cost of Goods Sold.

The major differences between a job order cost system and a process cost system are as follows:
Feature Job Order Cost System Process Cost System
Work in process accounts One for each job One for each process
Documents used Job cost sheets Production cost reports
Determination of total Each job Each period
manufacturing costs
Unit-cost computations Cost of each job ÷ Units Total manufacturing costs ÷
produced for the job Units produced during the period

Process Cost Flow

Let’s assume that we have a manufacturing company with two processes, processing (or
machining) and assembly. In the Machining Department, the raw materials are shaped, honed,
and drilled. In the Assembly Department, the parts are assembled and packaged. Materials, labor,
and manufacturing overhead can be added in both the Machining and Assembly Departments.
When the Machining Department finishes its work, the partially completed units are transferred
to the Assembly Department. In the Assembly Department, the goods are finished and are then
transferred to the finished goods inventory. Upon sale, the goods are removed from the finished
goods inventory.

Manufacturing Work in Process Work in Process Finished Goods Cost of Goods

Costs Machining Department Assembly Department Inventory Sold
Raw Materials Assigned Costs Cost of Cost of
Factory Labor To transferred completed goods
Manufacturing out to work sold
Overhead

As the flow of costs indicates, the company can add materials, labor, and manufacturing
overhead in both the Machining and Assembly Departments. When it finishes its work, the

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Machining Department transfers the partially completed units to the Assembly Department. The
Assembly Department finishes the goods and then transfers them to the finished goods inventory.
Upon sale, the Company removes the goods from the finished goods inventory. Within each
department, a similar set of activities is performed on each unit processed.

Flow of Costs in Process Cost System- Assignment of Manufacturing Costs

All raw materials issued for production are a materials cost to the producing department.
Materials requisitions slips may be used in a process cost system, but fewer requisitions are
generally required than in a job order cost system, because the materials are used for processes
rather than for specific jobs. The entry to record the materials used is:

Work in Process--Machining........................................ XX
Work in Process--Assembly......................................... XX
Raw Materials Inventory.................................. XX

Time tickets may be used in determining the cost of labor assignable to the production
departments. The labor cost chargeable to a process can be obtained from the payroll register or
departmental payroll summaries. All labor costs incurred within a producing department are a
cost of processing the raw materials. The entry to assign the labor costs is:

Work in Process--Machining........................................ XX
Work in Process--Assembly......................................... XX
Factory Labor..................................................... XX

The basis for allocating the overhead costs to the production departments in an objective and
equitable manner is the activity that "drives" or causes the costs. A primary driver of overhead
costs in continuous manufacturing operations is machine time used, not direct labor. Thus,
machine hours are widely used in allocating manufacturing overhead costs. The entry to allocate
overhead is:

Work in Process--Machining........................................XX
Work in Process--Assembly.........................................XX
Manufacturing Overhead..................................... XX

At the end of the period, the following transfer entries are needed:
Work in Process--Assembly........................................XX
Work in Process--Machining..................................XX

Finished Goods Inventory............................................XX

Work in Process--Assembly................................... XX

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Cost of Goods Sold...................................................... XX
Finished Goods Inventory....................................... XX

Illustration 5.1
A drug Company manufactures drugs through two processes: blending and bottling. In June, raw
materials used were blending $18,000 and bottling $4,000. Factory labor costs were blending
$12,000 and bottling $5,000. Manufacturing overhead costs were blending $6,000 and bottling
$2,500. The company transfers units completed at a cost of $19,000 in the Blending Department
to the Bottling Department. The Bottling Department transfers units completed at a cost of
$11,000 to Finished Goods. Journalize the assignment of these costs to the two processes and the
transfer of units as appropriate.
Solution:
The entries are:
Work in Process—Blending 18,000
Work in Process—Bottling 4,000
Raw Materials Inventory 22,000
(To record materials used)

Work in Process—Blending 12,000

Work in Process—Bottling 5,000
Factory Labor 17,000
(To assign factory labor to production)

Work in Process—Blending 6,000

Work in Process—Bottling 2,500
Manufacturing Overhead 8,500
(To assign overhead to production)

Work in Process—Bottling 19,000

Work in Process—Blending 19,000
(To record transfer of units to the Bottling
Department)

Finished Goods Inventory 11,000

Work in Process—Bottling 11,000
(To record transfer of units to finished goods)

Equivalent Units (EU)

A major step in process cost accounting is the calculation of equivalent units. Equivalent units of
production measure the work done during the period, expressed in fully completed units. This
concept is used to determine the cost per unit of completed product. The formula to compute
equivalent units of production is given below under weighted average method.

Equivalent Units of = Units Completed and + Equivalent Units of Ending Work in

Production Transferred Out Process

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Weighted-Average Method
It is a process costing method that blends together units and costs from both the current and prior
periods. It considers the degree of completion (weighting) of the units completed and transferred
out and the ending work in process. There is another method called the First in, First out method
(or FIFO); discussed below.

Production Cost Report

A production cost report is the key document used by management to understand the activities in
a department because it shows the production quantity and cost data related to that department.
In order to be ready to complete a production cost report, the company must perform the
following four Production Cost Report steps:
1. Compute the physical unit flow.
2. Compute the equivalent units of production.
3. Compute unit production costs.
4. Prepare a cost reconciliation schedule.

The computation of physical units involves:

a) Adding the units started (or transferred) into production during the period to the units in
process at the beginning of the period to determine the total units to be accounted for; and
b) Accounting for these units by determining the output for the period - which consists of units
transferred out during the period plus the units in process at the end of the period. These units
added together equal the total units accounted for.

Note: Total units to account for and Total units accounted for must ALWAYS BE EQUAL! (We
are talking about physical units.)

In computing unit costs, production costs are expressed in terms of equivalent units of
production. When equivalent units are different for materials and conversion costs, the formulas
for computing unit costs are as follows:
Unit Materials Cost = Total Materials Cost ÷ Equivalent Units of Materials
Unit Conversion Cost = Total Conversion Costs ÷ Equivalent Units of Conversion Costs
Total Manufacturing Cost per Unit = Unit Materials Cost + Unit Conversion Cost
The cost reconciliation schedule shows that the total costs accounted for equal the total costs to
be accounted for as follows:
Costs to be accounted for
Transferred out …………………………………………………$XX
Work in process, End
Materials …………………………. $XX
Conversion costs …………………..XX XX
Total costs ……………………………………………………..$XXX

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Process costing system is usually illustrated under three cases:
1) Process costing with no beginning or ending work in process inventory
 All units are started and fully completed by the end of the accounting period. This simplify
the assumption that how materials and conversion costs applied to units of products.
2) Process costing with no beginning work in process inventory, but with ending work in
process inventory
 Some units are started during the accounting period are not completed at the end of the
period.
3) Process costing with both beginning and ending work in process inventories
 This case describes the effect of weighted average and first-in-first-out (FIFO) cost flow
assumptions on cost of units completed and cost of work in process inventory.

Illustration 5.2
To illustrate the computation of equivalent units using the weighted-average method, assume that
materials are entered at the beginning of the process and the following information is provided
for the Processing Department of the Silva Company:

Units in WIP, Beginning: Materials 100% complete; Conversion 80% complete = 2,500 units
Units in WIP, Ending: Materials 100% complete; Conversion 60% complete … = 1,000 units
Units started into Production …………………………………………………….. = 4,500 units
Units transferred out ……………………………………………………………… = 6,000 units

Assume the Processing Department of the Silva Company has the following additional cost
information:
Work in process, Beginning:
Direct materials: 100% complete = $ 24,000
Conversion costs: 80% complete = 19,620
Cost of work in process, Beginning = $ 43,620
Costs incurred during production:
Direct materials = $200,000
Conversion costs = 150,000
Costs incurred = $350,000

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The two equivalent unit computations are as follows:
(Step 2)
(Step 1) Equivalent Units
Quantities (Flow of production) Physical Units Direct Material Conversion
Units to be accounted for:
Work in process, Beg. 2,500
Started into production 4,500
Total units 7,000
Units accounted for:
Transferred out 6,000 6,000 6,000
Work in process, End. 1,000 1,000 600*
Total units 7,000 7,000 6,600
*(1,000x 60%)

The Silva Company's Processing Department Production Cost Report at the end of the period is
as follows:

(Step 3) Unit Cost Total Costs Direct Material Conversion Costs

Cost during the period (a) $393,620 $224,000 $169,620
Equivalent Units (b) 7,000 6,600
Unit cost (a) ÷ (b) $57.7 $32 $25.7
Costs to be accounted for:
Work in process, Beg. $43,620
Started into production 350,000
Total costs $393,620
(Step 4) Cost Reconciliation Schedule
Costs accounted for:
Transferred out (6,000*$57.7) $346,200
Work in process, End.
Materials (1,000*$32) 32,000
Conversion costs (600*$25.7) 15,420
Total costs $393,620
Production cost reports provide a basis for evaluating the productivity of a department. In
addition, managers can use the cost data to assess whether unit costs and total costs are
reasonable. By comparing the quantity and cost data with predetermined goals, top management
can also judge whether current performance is meeting planned objectives.

FIFO Method
The FIFO method of process costing differs from the weighted-average method in two ways:
(1) The computation of equivalent units, and
(2) The way in which costs of beginning inventory are treated.
The FIFO method is generally considered more accurate than the weighted-average method, but
it is more complex. The complexity is not a problem for computers, but the FIFO method is a
little more difficult to understand and to learn than the weighted-average method.

Equivalent Units—FIFO Method

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The computation of equivalent units under the FIFO method differs from the computation under
the weighted-average method in two ways:
 First, the “units transferred out” is divided into two parts. One part consists of the units from
the beginning inventory that were completed and transferred out, and the other part consists
of the units that were both started and completed during the current period.
 Second, full consideration is given to the amount of work expended during the current period
on units in the beginning work in process inventory as well as on units in the ending
inventory.

Thus, under the FIFO method, both beginning and ending inventories are converted to equivalent
units basis. For the beginning inventory, the equivalent units represent the work done to
complete the units; for the ending inventory, the equivalent units represent the work done to
bring the units to a stage of partial completion at the end of the period (the same as with the
weighted-average method).

Operations Costing
Companies often use a combination of a process cost and a job order cost system, called operations
costing. An operation costing is similar to process costing in that standardized methods are used to
manufacture the product. At the same time, the product may have some customized, individual features
that require the use of a job order cost system.

Discussion Questions, Exercises and Problems

5-1. Under what conditions would it be appropriate to use a process costing system?
5-2. In what ways are job-order and process costing similar?
5-3. Why is cost accumulation simpler in a process costing system than it is in a job-
order costing system?
5-4. How many Work in Process accounts are maintained in a company that uses
process costing?
5-5. Assume that a company has two processing departments—Mixing followed by
Firing. Prepare a journal entry to show a transfer of work in process from the Mixing
Department to the Firing Department.
5-6. Assume that a company has two processing departments—Mixing followed by
Firing. Explain what costs might be added to the Firing Department’s Work in
Process account during a period.
5-7. What is meant by the term equivalent units of production when the weighted-average
method is used?
5-8. Arada Jewelry plc produces thousands of medallions made of bronze, silver, and
gold. The medallions are identical except for the materials used in their manufacture.
What costing system would you advise the company to use?

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 Ex 5-1 ABC Corporation produces bricks in two processing departments—
Molding and Firing. Information relating to the company’s operations in March
follows:

a) Raw materials were issued for use in production: Molding Department, $28,000; and
Firing Department, $5,000.
b) Direct labor costs were incurred: Molding Department, $18,000; and Firing
Department, $5,000.
c) Manufacturing overhead was applied: Molding Department, $24,000; and Firing
Department, $37,000.
d) Unfired, molded bricks were transferred from the Molding Department to the Firing
Department. According to the company’s process costing system, the cost of the
unfired, molded bricks was $67,000.
e) Finished bricks were transferred from the Firing Department to the finished goods
warehouse. According to the company’s process costing system, the cost of the
finished bricks was $108,000.
f) Finished bricks were sold to customers. According to the company’s process costing
system, the cost of the finished bricks sold was $106,000.
Required: Prepare journal entries to record items (a) through (f) above.

Ex 5-2 The PVC Company manufactures a high-quality plastic pipe that goes
through three processing stages prior to completion. Information on work in the
first department, Cooking, is given below for May:
Production data:
Units in process, May 1: materials 100% complete; conversion 90%
complete . . . . . . . . . .. . . . . .. 70,000
Units started into production during
May . . ... . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . .. . . . . . . . . . 350,000
Units completed and transferred to the next department . . . . . . . . ... . . . . . . . . . . . . . . .
. . . . .. . . . . ?
Units in process, May 31: materials 75% complete; conversion 25%
complete . . . . . . . . . . .. . . . . . 40,000
Cost data:
Work in process inventory, May 1:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$86,000
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,000

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Cost added during May:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $447,000
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $198,000
The company uses the weighted-average method.
Required:
a. Compute the equivalent units of production.
b. Compute the costs per equivalent unit for the month.
c. Determine the cost of ending work in process inventory and of the units transferred out
to the next department.
d. Prepare a cost reconciliation report for the month.

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