1

Study Unit Eight

Cost Accumulation Systems

8.1 Job-Order Costing ............................................................................................................ 2

8.2 Process Costing ............................................................................................................... 6
8.3 Activity-Based Costing ..................................................................................................... 9
8.4 Life-Cycle Costing ............................................................................................................ 19

This study unit is the second of five on cost management. The relative weight assigned to this
major topic in Part 1 of the exam is 15%. The five study units are
● Study Unit 7: Cost Management Concepts
● Study Unit 8: Cost Accumulation Systems
● Study Unit 9: Cost Allocation Techniques
● Study Unit 10: Supply Chain Management
● Study Unit 11: Business Process Improvement

This study unit discusses cost accumulation systems. Topics covered in this study unit include
● Cost flows
● Calculating cost of goods sold and inventory values
● Normal and abnormal spoilage

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2 SU 8: Cost Accumulation Systems

8.1 Job-Order Costing

Job-order costing is concerned with accumulating costs by specific job. This method is appropriate
when producing products with individual characteristics (e.g., yachts), or when identifiable groupings
are possible (e.g., jewelry). Products are usually custom made for a specific customer.

Costs are recorded by classification, such as direct materials, direct labor, and manufacturing
overhead, on a job-cost sheet (may be manual or electronic) that is specifically prepared for each job.
● The direct materials and direct labor costs are accumulated on job-cost sheets. Overhead
application is also recorded on the job-cost sheet.

● The total of all job-cost sheets for jobs in progress will equal the balance in the work-in-process
inventory account.

Steps in Job-Order Costing

A flowchart with T-accounts can be used to illustrate the flow of costs in a job-order costing system.
Inventory accounts are increased by transactions on the left side of the T-account and decreased
by transactions on the right side of the T-account. The transaction types illustrated in Figure 8-1 are
numbered to correspond with the steps outlined on the following pages.

Job-Order Cost Flow Diagram

Figure 8-1

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 SU 8: Cost Accumulation Systems 3

The first step in the process is the receipt of a sales order from a customer requesting a product or
special group of products. The sales order is approved, and a production order is issued.

Accumulating Costs

Step 1: The physical inputs required for the production process are obtained from suppliers.

Under job-order costing, direct materials and direct labor are charged based on the amounts actually
applied to each job.

Step 2: Materials requisition forms request direct materials to be pulled from the warehouse and sent
to the production line.

Step 3: Time tickets track the direct labor that workers expend on various jobs.

Step 4: Under job-order costing, the third component of product cost, manufacturing overhead, is
charged using an estimated rate.
● The application of an estimated overhead rate is necessary under job-order costing because the
outputs are customized and the processes vary from period to period.

Step 5: As indirect costs are paid throughout the year, the transactions are recorded in the
manufacturing overhead control account, not work-in-process. Work-in-process is not affected when
actual overhead costs are incurred.
● Examples of indirect costs include indirect materials, indirect labor, and other overhead costs
(such as rent, depreciation, insurance, and property taxes for the manufacturing facilities).

Application of Overhead

Overhead costs are applied to (“absorbed” by) each job based on a predetermined overhead
application rate for the year (such as $5 per direct labor hour, or machine hour, etc., or based on
an activity-based costing system). If activity-based costing is used, the procedure for overhead
applications is the same, except that multiple rates based on multiple cost drivers will be used (such
as $5 per direct labor hour, plus $2 per machine hour, plus $1 per material requisition used).
● At the beginning of the year, an estimate is made of the total amount that will be spent for
manufacturing overhead during that year.

● An estimate is also made of the total quantity of allocation base, such as direct labor hours or
machine hours, that will be required for manufacturing overhead during that year.

Estimated total manufacturing overhead

Application rate =
Estimated total quantity of allocation base

● During the period as jobs are worked on, the amount applied equals the number of units of the
allocation base used during the period times the application rate.

Amount overhead applied = Total quantity of allocation base × Application rate

● Step 4 in Figure 8-1 represents this application of overhead. The transaction increases work-in-
process inventory and manufacturing overhead applied.

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4 SU 8: Cost Accumulation Systems

● At the end of the period, the overhead control and applied accounts are netted to examine any
differences, which are called variances. Overhead allocation is covered in detail in Study Unit 9,
Subunit 2.
■ If applied overhead is less than actual overhead, overhead was underapplied for the period.

■ If applied overhead is more than actual overhead, overhead was overapplied for the period.

■ If the difference is immaterial, the dollar amount of the difference is closed to cost of goods sold.

■ If the difference is material, the dollar amount of the difference is closed through allocation to
work-in-process inventory, finished goods inventory, and cost of goods sold.

Completing and Selling Job

Step 6: When a job order is completed, all the costs are transferred to finished goods.

Step 7: When the job is sold, the cost is transferred to cost of goods sold.

Spoilage, Rework, and Scrap

Output that does not meet the quality standards for salability is considered spoilage.

Normal spoilage is the amount expected in the ordinary course of production.

● Because management understands that good units cannot be produced without some risk of
spoilage, the cost of the normal spoilage is included in the cost of the good units produced (i.e.,
treated as a product cost).

● This is accomplished by allowing the net cost of the spoilage to remain in the work-in-process
account of the job that generated it.
■ If the normal spoilage is worthless, it should be discarded. No transaction will be recorded.

■ If the normal spoilage can be sold, its value should not be included in the cost of the good units
produced. The transaction will record spoiled inventory and reduce work-in-process inventory.

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 SU 8: Cost Accumulation Systems 5

Abnormal spoilage is spoilage over and above the amount expected in the ordinary course of
production.
● Abnormal spoilage is not treated as a manufacturing cost and is not included in the cost of the
good units produced.

● Instead, abnormal spoilage costs are expensed in the period they occurred and treated as a period
cost. A loss from abnormal spoilage is recorded.

Spoilage Defined Accounting Treatment

Normal Expected in ordinary course of production ● Product cost

● Included in the cost of good units produced

Abnormal Spoilage over and above the amount ● Period cost

expected in the ordinary course of production ● Loss from abnormal spoilage

Rework consists of unacceptable units that can be repaired and sold as acceptable units. Normal
rework may be attributable to a job or to all jobs. It is recorded to a job (job costing) or manufacturing
overhead and allocated (job and process costing).
● Abnormal rework is recorded as a loss (job and process costing).

■ Process costing is covered in Subunit 8.2.

Scrap is leftover material with no attached cost and low sales value. It may be recognized as revenue
at the time of sale.

Waste is raw material leftover from the production cycle for which there is no further use. Waste is
not salable at any price and must be discarded.

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6 SU 8: Cost Accumulation Systems

8.2 Process Costing

Process cost accounting is used to assign costs to inventoriable goods or services. It is applicable
to relatively homogeneous products that are mass produced on a continuous basis (e.g., petroleum
products, thread, computer monitors).
● Assigning an exact amount of materials, labor, and indirect costs to thousands, or even millions,
of individual end products is simply not cost-effective. For this reason, process costing involves
averaging the costs of production and allocating them to work-in-process and finished goods.
Process Costing Cost Flow Diagram

Figure 8-2
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 SU 8: Cost Accumulation Systems 7

Process Costing Cost Flow

A flowchart with T-accounts can be used to illustrate the flow of costs in a process costing system.
Inventory accounts are increased by transactions on the left side of the T-account and decreased
by transactions on the right side of the T-account. The transaction types illustrated in Figure 8-2 are
numbered to correspond with the steps outlined below.

The accumulation of costs under a process costing system is by department rather than by project.
There will normally be a work-in-process inventory account for each department. This reflects the
continuous, homogeneous nature of the manufacturing process.

Step 1: As in job-order costing, the physical inputs required for the production process are obtained
from suppliers.

Step 2: Direct materials actually used by the first department in the process (Department A) are
added to work-in-process for that department.

Step 3: Conversion costs, which include direct labor and manufacturing overhead used by the first
department, are added to work-in-process for that department. Actual amounts are used.

Step 4: The products can move from one department to the next (from Department A to
Department B).

Step 5: The second department (Department B) can add more direct materials and conversion costs.

Step 6: When processing is finished in the last department, all the costs are transferred to finished
goods.

Step 7: As products are sold, the costs are transferred to cost of goods sold.

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8 SU 8: Cost Accumulation Systems

Equivalent Units of Production – Basics

Some units remain unfinished at the end of the period. For each department to account adequately
for costs attached to its unfinished units, the units must be restated in terms of equivalent units of
production (EUP).
● EUP are the number of complete units that could have been produced using the inputs consumed
during the period.

● Cost-per-unit can be calculated using EUP (cost per EUP).

Example 8-1 EUP

One thousand work-in-process units 80% completed for direct materials and 60% for conversion costs
represent 800 EUP of direct materials (1,000 × 80%) and 600 EUP of conversion costs (1,000 × 60%).

Calculations are not required for process costing on the CMA exam. Candidates should
be able to demonstrate that they have a general understanding of process costing and the
concept of equivalent units.

Spoilage in Process Costing

As with job-order costing, the cost of a normal level of spoilage is left in cost of goods sold; abnormal
spoilage is recognized separately as a loss.

Recognizing the loss resulting from abnormal spoilage under process costing involves the
manufacturer establishing inspection points, that is, the places in the production process where those
goods not meeting specifications are pulled from the process. This is in contrast to job-order costing,
in which a unit can be judged to be spoiled at any time.
● The typical arrangement is to inspect units as they are being transferred from one department
to the next. This way, each department has its own amount of spoilage, calculated using its own
equivalent-unit costs.

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 SU 8: Cost Accumulation Systems 9

8.3 Activity-Based Costing

Use of Activity-Based Costing

Activity-based costing (ABC) is a response to the significant increase in indirect costs resulting from
the rapid advance of technology. ABC is a refinement of an existing cost accounting system (job-
order or process) for use in internal reporting and management planning and control. It is also used
for external reporting to the extent its product-costing function satisfies the relevant standard setter’s
requirements. ABC may be used by manufacturing, service, or retail entities.
● Under a traditional (volume-based) costing system, overhead is accumulated into a single cost
pool and spread evenly across all end products.

● Under ABC, indirect costs are attached to activities that are then rationally allocated to end
products.

Companies use ABC because of its ability to solve costing problems that conventional cost
accounting either creates or fails to address.

Traditional (Volume-Based) Costing System

The inaccurate averaging or spreading of indirect costs over products or service units that use
different amounts of resources is sometimes called peanut-butter costing. Peanut-butter costing
results in product-cost cross-subsidization, the condition in which the miscosting of one product
causes the miscosting of other products.

The peanut-butter effect of using a traditional (i.e., volume-based) costing system can be summarized
as follows:
● Direct labor and direct materials are traced to products or service units.

● A single pool of indirect costs (overhead) is accumulated for a given organizational unit.

● Indirect costs from the pool are assigned using an allocative (rather than a tracing) procedure,
such as using a single overhead rate for an entire department, e.g., $3 of overhead for every direct
labor hour.
■ The effect is an averaging of costs that may result in significant inaccuracy when products or
service units do not use similar amounts of resources.

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10 SU 8: Cost Accumulation Systems

Example 8-2 Product-Cost Cross-Subsidization

A company produces two similar products. Both products require one unit of raw material and one hour
of direct labor. Raw materials costs are $14 per unit, and direct labor is $70 per hour. During the month
just ended, the company produced 1,000 units of Product A and 100 units of Product B. Manufacturing
overhead for the month totaled $20,000.

Using direct labor hours as the overhead allocation base, per-unit costs and profits are calculated as
follows:

Product A Product B Total

Raw materials $ 14,000 $ 1,400
Direct labor 70,000 7,000
Overhead {$20,000 × [1,000 ÷ (1,000 + 100)]} 18,182
Overhead {$20,000 × [100 ÷ (1,000 + 100)]} 1,818
Total costs $102,182 $ 10,218 $112,400

Selling price $ 119.99 $ 119.99

Cost per unit (102.18) (102.18)
Profit per unit $ 17.81 $ 17.81

The company’s management accountants have determined that overhead consists almost entirely of
production line setup costs, and that the two products require equal setup times. Allocating overhead on
this basis yields vastly different results.

Product A Product B Total

Raw materials $14,000 $ 1,400
Direct labor 70,000 7,000
Overhead ($20,000 × 50%) 10,000
Overhead ($20,000 × 50%) 10,000
Total costs $94,000 $ 18,400 $112,400

Selling price $119.99 $ 119.99

Cost per unit (94.00) (184.00)
Profit per unit $ 25.99 $ (64.01)

Rather than the comfortable profit the company believed it was making on both products using peanut-
butter costing, it becomes clear that the company is losing money on every unit of Product B that it sells.
The high-volume Product A has been heavily subsidizing the setup costs for the low-volume Product B.

Example 8-2 assumes a single component of overhead for clarity. In reality, overhead is made up of
many components.

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 SU 8: Cost Accumulation Systems 11

The peanut-butter effect of traditional overhead allocation is illustrated below.

Figure 8-3

Traditional-Based Systems vs. Activity-Based Systems

Traditional-based systems were appropriate when direct costs were the bulk of manufacturing costs.
However, increased automation led to increased overhead. ABC was developed to address the
increasing complexity of overhead costs.
● Traditional-based systems, as illustrated above, involve

■ Accumulating costs in general ledger accounts (utilities, taxes, etc.),

■ Using a single cost pool to combine the costs in all the related accounts,
■ Selecting a single driver to use for the entire indirect cost pool, and
■ Allocating the indirect cost pool to final cost objects.

● Activity-based systems, by contrast, involve

■ Identifying organization activities that constitute overhead,

■ Assigning the costs of resources consumed by the activities, and

■ Assigning the costs of the activities to final cost objects, based on the activity that drives
(causes) the costs.

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12 SU 8: Cost Accumulation Systems

Steps in Activity-Based Costing

Step 1 – Activity Analysis

An activity is a set of work actions undertaken within the entity, and a cost pool is established for
each activity. Activities are classified in a hierarchy according to the level of the production process at
which they take place.
● Unit-level activities are performed for each unit of output produced. Examples are using direct
materials and using direct labor.

● Batch-level activities occur for each group of outputs produced. Examples are materials ordering,
materials handling, and production line setup.

● Product-sustaining (or service-sustaining) activities support the production of a particular

product (or service), irrespective of the level of production. Examples are product design,
engineering changes, and testing.

● Facility-sustaining activities concern overall operations and therefore cannot be traced to

products at any point in the production process. Examples are accounting, human resources,
maintenance of physical plant, and safety and security arrangements.

Example 8-3 Identification of Activities

Fabulous Foundry uses a job-order system to accumulate costs for the custom pipe fittings of all sizes that
it produces. Since the 1950s, Fabulous has accumulated overhead costs in six general ledger accounts
(indirect materials, indirect labor, utilities, real estate taxes, insurance, and depreciation), combined them
into a single indirect cost pool, and allocated the total to its products based on machine hours.
● At the time this system was established, overhead was a relatively small percentage of the foundry’s
total manufacturing costs.
● With increasing reliance on robots in the production process and computers for monitoring and control,
overhead is now a greater percentage of the manufacturing costs while direct labor costs have shrunk

To obtain better data about product costs, Fabulous has decided to refine its job-order costing system by
switching to activity-based costing for the allocation of overhead.
● The foundry’s management accountants conducted extensive interviews with production and sales
personnel to determine how the incurrence of indirect costs can be viewed as activities that consume
resources.
● The accountants identified five activities and created a cost pool for each to capture the incurrence of
indirect costs:

Activity Hierarchy
Product design Product-sustaining
Production setup Batch-level
Machining Unit-level
Inspection & testing Unit-level
Customer maintenance Facility-sustaining

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 SU 8: Cost Accumulation Systems 13

Step 2 – Assign Resource Drivers to Resource Costs

Identifying resource costs in ABC is more complex than it is in volume-based overhead allocation. A
separate accounting system may be necessary to track resource costs separately from the general
ledger.

Once the resources have been identified, resource drivers are designated to allocate resource costs
to the activity cost pools. Resource drivers (causes) are measures of the resources consumed by an
activity.

Example 8-4 Resource Drivers

Fabulous Foundry’s management accountants identified the following resources used by its indirect cost
processes:

Resource Driver
Computer processing CPU cycles
Production line Machine hours
Materials management Hours worked
Accounting Hours worked
Sales & marketing Number of orders

Step 3 – Allocate Resource Costs to Activity Cost Pools

Once the resource drivers are determined, the dollar amount of resources per resource driver can be
determined.
● One method of doing this is by dividing the total dollar amount of a resource cost by the total
amount of the resource driver used by the entire entity.

Costs of resources are then allocated to activity cost pools based on the amount of resource drivers
used by each activity cost pool.

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14 SU 8: Cost Accumulation Systems

Example 8-5 Allocation to Activity Pools

Fabulous Foundry’s management accountants have determined that a total amount of $1,000,000
of Materials Management was used over a total of 100,000 hours worked. Fabulous’s management
accountants will therefore allocate $10 ($1,000,000 ÷ 100,000 hours) to each activity pool for each hour of
Materials Management worked for each cost pool.

Activity Amount Allocated

Product Design $250,000 for 25,000 hours

Production Setup $270,000 for 27,000 hours

Machining $450,000 for 45,000 hours

Inspection & Testing $30,000 for 3,000 hours

Customer Maintenance $0 for 0 hours

This first-stage allocation is made for each resource.

● Resources will not be allocated to a cost activity that did not use them.

Step 4 – Allocate Activity Cost Pools to Final Cost Objects

The final step in enacting an ABC system is allocating the activity cost pools to final cost objects. This
is termed second-stage allocation. Once the cost drivers are determined, the dollar amount of activity
pool per activity driver can be determined.
● One method of doing this is by dividing the total dollar amount assigned to an activity cost pool by
the total amount of the activity driver used by the entire entity.

Costs are reassigned to final-stage (or, if intermediate cost objects are used, next-stage) cost objects
on the basis of activity drivers. Activity drivers are measures of the demands made on an activity
by next-stage cost objects, such as the number of parts in a product used to measure an assembly
activity.

Example 8-6 Activity Drivers

Fabulous Foundry’s management accountants have designated the following drivers to associate with their
corresponding activities:

Activity Driver
Product design Number of products
Production setup Number of setups
Machining Number of units produced
Inspection & testing Number of units produced
Customer maintenance Number of orders

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 SU 8: Cost Accumulation Systems 15

Indirect Cost Assignment Diagram

The differences between traditional overhead allocation and ABC are illustrated below.

Figure 8-4

Process Value Analysis

Design of an ABC system starts with process value analysis, a comprehensive understanding of how
an organization generates its output. A process value analysis involves a determination of which
activities that use resources are value-adding or nonvalue-adding and how nonvalue-adding activities
may be reduced or eliminated.
● A value-adding activity contributes to customer satisfaction or meets a need of the entity. The
perception is that it cannot be omitted without a loss of the quantity, quality, or responsiveness of
output demanded by the entity or its customers.
● A nonvalue-adding activity does not make such a contribution. It can be eliminated, reduced,
or redesigned without impairing the quantity, quality, or responsiveness of the product or service
desired by customers or the entity.

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16 SU 8: Cost Accumulation Systems

Activity-based management (ABM) links product costing and continuous improvement of processes
through driver analysis, activity analysis, and performance measurement.

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 SU 8: Cost Accumulation Systems 17

Cost Drivers
Drivers (both resource and activity) must be chosen on the basis of a cause-and-effect relationship
with the resource or activity cost being allocated, not simply a high positive correlation.
● A cost object may be a job, product, process, activity, service, or anything else for which a cost
measure is desired.

● Intermediate cost objects receive temporary accumulations of costs as the cost pools move from
their originating points to the final cost objects.
■ For example, work-in-process is an intermediate cost object, and finished salable goods are
final cost objects.

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18 SU 8: Cost Accumulation Systems

Advantages and Disadvantages of Activity-Based Costing

An advantage of ABC is that product costing is improved, making for better decision making.
● The process value analysis performed as part of ABC provides information for eliminating or
reducing nonvalue-adding activities (e.g., scheduling production, moving components, waiting for
the next operating step, inspecting output, or storing inventories).
■ The result is therefore not only more accurate cost assignments, especially of overhead, but
also better cost control and more efficient operations.

● The real benefits of ABC occur when a company has a high level of fixed costs and produces a
wide variety of products with widely varying levels of production.

Disadvantages of ABC are

◙ The cost of implementation.

■ Initial costs are quite high, and continuing costs of application can also be significant. Thus,
if a company has a low level of fixed costs, there is little to no advantage in using ABC as
compared to a simple overhead application method (such as a fixed amount per direct labor
hour).

◙ The increased time and effort needed to

■ Maintain a separate accounting system to capture resource costs and

■ Design and implement drivers and cost pools.

Organizational Benefits
An organization most likely to benefit from ABC is one with
● A line of products or services that varies significantly in volume, diversity of activities, and
complexity of operations;

● Relatively high overhead costs; or

● Operations that have undergone major technological or design changes.

Service organizations as well as manufacturers may benefit from ABC, but implementation can be
difficult in these entities.
● They tend to have relatively high facility-level costs that are not readily allocable.
● Their employees perform tasks for which information is not easily accumulated.
● Output measurement is less precise than in manufacturing entities.

Nevertheless, ABC has been adopted by insurers, banks, railroads, and healthcare providers.

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 SU 8: Cost Accumulation Systems 19

8.4 Life-Cycle Costing

Life-Cycle Approach
A life-cycle approach to budgeting estimates a product’s revenues and expenses over its entire sales
life cycle.

The product life cycle has five phases:

1. The research and development phase typically has no sales and high costs.
2. The introduction phase is characterized by few competitors. Profits are usually low in the
introduction stage because of slow sales growth. Also, costs are high for sales promotion and
relatively high for unit costs of production.
3. In the growth stage, the number of competitors increases but does not peak. The opportunity
for cost reductions is at its maximum during the growth stage because production volume is
increasing at a high rate. Thus, fixed costs are spread over more units of production.
4. In the maturity phase, sales growth declines and competitors are most numerous.
5. The number of competitors decreases in the decline stage.

Life-cycle costing takes a long-term view of the entire cost life cycle, also known as the value chain.
● Costs incurred before production, such as R&D and product design, are upstream costs.
● Costs incurred after production, such as marketing and customer service, are downstream costs.

Value Chain for a Manufacturer

Figure 8-5

This information is important for pricing decisions because revenues must cover costs incurred in
each stage of the value chain, not only production.

Potential Benefits of Life-Cycle Costing

Life-cycle costing emphasizes the relationships among costs incurred at different value-chain stages,
for example, the effect of reduced design costs on future customer-service costs. Because it makes
a distinction between incurring costs (actually using resources) and locking in (designing in) costs,
life-cycle costing highlights the potential for cost reduction activities during the upstream phase of the
value chain. It is in this phase that the greatest opportunity exists to minimize downstream costs.

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20 SU 8: Cost Accumulation Systems

Life-Cycle vs. Other Costing Methods

Traditional approaches focus on cost control (as opposed to cost reduction) during production and
treat pre- and postproduction (upstream and downstream) costs as period costs that are largely
ignored in determining the profitability of specific products.
● Other costs that traditional methods ignore are the after-purchase costs (operating, support, repair,
and disposal) incurred by customers.

● Whole-life cost is a concept closely associated with life-cycle cost. Whole-life cost equals the
life-cycle cost plus after-purchase costs. Attention to the reduction of all whole-life costs through
analysis and management of all value-chain activities is a powerful competitive tool because of the
potential for increasing customer satisfaction.

Internal and External Reporting Effects

For internal management accounting purposes, the costs (such as R&D) that result in marketable
products represent a life-cycle investment and must be capitalized. The reporting system should also
allow for capitalization and subsequent allocation of upstream costs for management accounting
purposes.

For external financial statement purposes, costs during the upstream phase must be expensed in
the period incurred. As a result, organizations that focus on a product’s life cycle must develop an
accounting system consistent with GAAP for external financial reporting purposes.

Evaluating Management
The overall advantage of life-cycle costing is that it provides a better measure for evaluating the
performance of product managers. Life-cycle costing combines all costs and revenues for all periods
to provide a better view of a product’s overall performance.
● Traditional financial statements, however, might report that certain products were extremely
profitable because upstream costs were expensed in previous periods.
■ For example, if a substantial investment is made in the development of a new product but that
product quickly becomes obsolete due to new technology, how worthwhile was the investment?

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