Product & Service Costing Systems

Week 3
Chapter 4 Product Costing
Chapter 5 Process Costing
Chapter 6 Service Costing

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Agenda:
Flow of costs in
Financial
manufacturing Journal entries
accounting:
businesses

3 types of Service
Job Product
product costing Costing
costing costing
systems:

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Product Costing - what do we Types of product costing systems
know so far (weeks 1-2)

Product cost $ 1. Job Costing

Direct Material Direct Labour Manufacturing 2. Process Costing

$ $ Overhead $

3. Service Costing

This Photo by

CRICOS No.00213J
Unknown Author
is licensed under
CC BY-SA-NC
Physical flow vs Financial flow of costs

HPQ-Combined-2021-Annual-Report-and-2022-Proxy-Statement.pdf (q4cdn.com)

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 Product costing

• Product costing systems

• Accumulate product-related costs to assign to the organisation’s final
products
• Product-related costs are called production costs

Langfield-Smith et al. (2018). Management Accounting: Information for Creating and Managing Value, p. 134.

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Designing costing systems

• Identify the managers’ needs

• Identify where product cost information may come from (note can be more than one
system)

• Evaluate the costs and benefits of providing various types of cost estimates
• Businesses sometimes use product costs developed for external reporting for managerial
decision making; more comprehensive systems will include more upstream and
downstream costs in addition to the product costs.

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Flow of costs in manufacturing businesses (need to match physical
flows with financial flows
• For inventory valuation in external financial reports, only manufacturing costs are assigned to
products, as required by Australian accounting standards.
• Manufacturing costs consist of three components
• Direct material
• Direct labour
• Manufacturing overhead
• Manufacturing costs flow through several ledger* accounts
*Recall that a ledger is an account or record used to sort, store and summarize a company's
transactions.
• Australian accounting standards require that upstream and downstream costs are expensed in
the period in which they are incurred

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 Langfield-Smith et al. (2018). Management
Accounting: Information for Creating and
Managing Value, p. 140.

Financial flow of costs through manufacturing accounts

Note that each ‘T’
accounts is a
graphical
representation of a
ledger account

DR CR

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 Allocating overhead costs to products

• Some resources are consumed directly to each product (e.g. direct material and
direct labour)
• Indirect costs are essential to production but have no observable relationship
with the product (i.e. overhead costs) and need to be allocated to products.

Langfield-Smith et al. (2018).

Management Accounting:
Information for Creating and
Managing Value, p. 141.

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 Accounting for manufacturing overhead (MOH)

Langfield-Smith et al. (2018).

Management Accounting:
Information for Creating and
Managing Value, p.143.

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Understanding the overhead account

• If we use a predetermined rate to apply our overhead, it is likely that by the year
end we will have either overapplied or underapplied the overhead.
• Overapplied overhead means that the overhead applied to production is greater
than the actual overhead costs incurred.
• Underapplied overhead means the overhead applied is less than the actual
overhead costs incurred.
Prorate between:
Close to - Cost of Goods Sold,
2 options to correct this: Cost of Goods Sold OR - work in process inventory
(COGS) - finished goods inventory.

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Types of product costing systems: (manufacturing)
1. Job costing
2. Process costing

• Job costing
• Manufacturing costs traced to individual
jobs
• Products produced are significantly
different and may be produced in
distinct jobs/batches
• E.g. wedding invitations, aircrafts, many
services.
• Job cost sheets are used to record the
details of the costs of direct materials,
direct labour and manufacturing
overhead used to complete the job.
Each job has its own job cost sheet.

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 Job Costing vs Process Costing
Continuum of conventional costing systems

Langfield-Smith et al. (2018). Management

Accounting: Information for Creating and
Managing Value, p. 144

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Recording the cost of a job: journal entries

DR CR
Purchase of materials
Raw material inventory xxxx
Accounts payable xxxx

Transferring direct material to jobs

Work in process inventory xxxx Materials
Raw material inventory xxxx requisition form

Use of indirect material in production Manufacturing overhead journal entries

Manufacturing overhead xxxx depend on materials requisition form,
Manufacturing supplies inventory xxxx indirect labour, electricity bills are paid,
depreciation is recorded on manufacturing
Charging direct labour to jobs
Work in process inventory xxxx equipment etc.
Wages payable xxxx Time sheet

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 Job costing: journal entries
CR
Accounting for indirect labour
Manufacturing overhead xxxx
Wages payable xxxx

Accounting for manufacturing costs

Manufacturing overhead xxxx
Rent xxxx
Depreciation on equipment xxxx
Note that an entry is not made when the
Application of manufacturing overhead
indirect materials are USED, because they
Work in process inventory xxxx are not traceable to individual production
Manufacturing overhead xxxx jobs. Instead, overhead is applied using this
Completion of production job
journal entry.

Finished goods inventory xxxx

Work in process inventory xxxx

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Job costing: journal entries

Sale of goods
Accounts receivable xxxx
Sales revenue xxxx

Cost of goods sold xxxx

Finished goods inventory xxxx

Underapplied overhead
Cost of goods sold xxxx
Manufacturing overhead xxxx

Overapplied overhead
Manufacturing overhead xxxx
Cost of goods sold xxxx

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 Job Costing
– financial
accounting
flows

Langfield-Smith et al. (2018). Management

Accounting: Information for Creating and
Job costing
Managing Value, p. 139.
Chapter 5
Process Costing

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2. Process Costing
Process costing

• Production costs traced to process/departments and averaged across all units

produced
• Mass production or repetitive activities environment (e.g. beverages, ATM)
• Sequential processes
• No need to assign the production costs specifically to each individual unit
produced.

Process costing involves two steps

• Estimating the cost of production processes

• Calculating an average cost per unit by dividing the cost of the process by the
number of units produced.

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Comparison of
job costing and
process costing

Langfield-Smith et al. (2018). Management

Accounting: Information for Creating and
Managing Value, p. 147
Process costing –
financial accounting
flows

Note that in many process costing

businesses, products undergo a number of
separate processes, undertaken by
production departments and therefore
costs are accumulated by department
Langfield-Smith et al. (2018). Management
Accounting: Information for Creating and
Managing Value, p. 146
3 different departments (laptop computer manufacturer)

Department #1 Department #2 Department #3

DM DL MOH DM DL MOH DM DL MOH

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Process costing – what we need to think about..

The approach taken in process costing

depends on:

1. Is there is work in process (WIP)

inventory at the end of the accounting
period? (half-finished products)

2. Are our products identical in how they

consume direct material and
specific production processes

This Photo by Unknown Author is licensed under CC BY

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Effects of beginning and ending work in
process inventories

1. Analyse the physical flow of units

2. Calculate the equivalent units
Four steps in process costing 3. Calculate the unit costs
4. Analyse the total costs

Products are costed using one of Weighted average method (averages cost of opening WIP
inventory w current production costs)
two assumptions about the physical First-in, first-out (FIFO) method; assumes that the oldest
flow of inventory inventory is processed and completed first.

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Service costing

Chapter 6

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Service Organizations
• Deliver help, utility or care; provide an
experience, information or other intellectual
content,
• In some economies service organizations
dominate (i.e. Australia – tourism and
education).
• Key examples: doctors, lawyers,
accountants, hairdressers, hotels, sports
centres, cafes, car maintenance.
• Services are also produced outside of the
service sector; consider Dell computers
aftersales service.
• Also includes public sector, not-for-profit.

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 27

Agenda

Analyse costs in service

Understand the value
Service organizations vs. organizations using fixed,
chain of service
manufacturing variable, direct and
organizations
indirect costs

Explain the concepts of

Identify whether job, billable hours, charge-out
process or hybrid costing Estimate service costs in rates and realisation, and
is most appropriate for a job costing environment their use in estimating
service organizations service costs, prices and
profits

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 28

Service vs. Manufacturing

1. Most service outputs are • Manufacturers produce goods /
intangible – outputs tend to be physical objects (you can touch)
performances or experiences
rather than physical objects.
2. Outputs are often heterogeneous
– repetition can be difficult  • Produce limited range of similar
individuals may carry out services products (eg iphones)
differently.
3. Services may be consumed as
they are produced (eg a boat tour) • Goods are stored as inventory till
4. Services are perishable and sold
cannot be stored.

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Where do Merchandisers fit in?
ALDI
KMART
Include retailers and WOOLWORTHS
wholesalers –
Retailers sell goods
purchase goods
directly to the public.
without any further
conversion.

Included in the
Wholesalers sell service sector – but
goods to other do not clearly fit the
businesses for use defining features of
in their production a service
processes or for organization
resale to the public. because they store
tangible goods.

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 30

The value chain in service firms

SUPPORT SERVICES
• Human Resources
• Finance
• Legal
• Information Systems
• Telecommunications

Research and Production/ Customer Value of

Design Marketing
Development delivery Support Services

PRIMARY PROCESSES

UPSTREAM DOWNSTREAM

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Note that producing a service is effectively the same as delivering a service (i.e. no separate delivery function).
 31

Cost classifications

The approach to estimating service costs, and the relevance of service cost
information vary with the types of services produced and the service production
environment.
The costs may be like a manufacturing firm (e.g. airline  food, fuel are direct costs,
steward and pilot wages are direct wages, overhead include depreciation of the
aircraft and baggage handling equipment, insurance and airport landing fees).
In many service organizations, direct labour costs dominate  leaving all other costs
to be classified as indirect or overhead costs.
There is often no inventory to value; costs in upstream and downstream areas may
be included as overhead costs.

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 How can we identify service costing principles and
practices, given such a large variety of different types
of service entities?

Professional Service Firms Service Shops Mass service organisations

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Different types of service organisations

1. Professional Services Firms:

• Provide individual services to

customers.
• Tend to serve relatively few
customers, despite often having
large numbers of staff.
• Front office oriented.
• Include medical, legal, accounting,
management consulting,
architectural.

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This Photo by Unknown Author is licensed under CC BY-SA
 34

Different types of service organisations

2. Service shops

• Process more customers than

professional firms but less than mass
service entities.
• Fit between professional and mass
services in terms of the degree of
customisation.
• Front office/back office oriented.
• Examples: hotel chains, bank, cafes
and restaurants, and car repair
workshops.

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This Photo by Unknown Author is licensed under CC BY
 35

Different types of service organisations

3. Mass service organisations:

• Serve many customers, with each

one requiring limited staff time and This Photo by Unknown Author is licensed under CC BY-SA

little customisation.
• May not require professional staff.
• Back office oriented.
• Include public transport, airline
companies, post offices, electricity
suppliers, telecommunication This Photo by Unknown Author is licensed under CC BY-SA

companies.

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Retailers and wholesalers

This Photo by Unknown Author is

• Depends on the scape of operations – may licensed under CC BY-SA

exhibit features of mass service entities or

service shops.
This Photo by Unknown Author is

• A large supermarket has large numbers of licensed under CC BY-SA

customer and little customisation and the

extensive use of equipment for storing and
managing inventory and for selling goods.This Photo
by Unknown
• Small boutique –fewer customers, little Author is
licensed
equipment, lots of service and room for under
CC BY-NC-N
discretion in the sales process. D

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 37

Q what type of costing system should we

use for costing for service entities?

Job Costing Hybrid Costing Process

Costing

• Used in situations where many different products or services are • Used in situations where the company produces many units of
produced each period (i.e. batches or individual jobs), with each the same product for long periods of time. All units of product
job having different production/service requirements. are identical.
• Cost records are maintained for each distinct product or job. • Costs are accumulated by department.
• The job cost sheet is the key document controlling the • The department production report is an accumulation and
accumulation of costs by a job. disposition of costs by a department.
• Unit costs are computed by job on the job cost sheet. • Unit costs are computed by department on the department
• Used to accumulate costs for accounting and billing purposes. production report.

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Costing Job Costing Hybrid Costing Process Costing
System

Service Entity Professional Services Service Shops (e.g. local Mass Services (e.g. Telstra)
café, bank)
Service Features Unique & Customised Some standardisation Standardised service
Some customisation
Production Number of services produced is Substantial number of Number of services produced
Environment relatively low. services produced. is very high.
Some aspects of the Processes are highly
Considerable discretion in the production process repetitive; repetitive, with limited
way the service is produced. some discretion. discretion in the production
Some contact with customer process. Contact time with
but supported by large amount each customer is very low.
Staffed by professionally
qualified staff who provide of back-office involvement. Production occurs mainly in
personal services to small Often involves equipment. the back office.
number of customers Equipment is usually a key
input

Despite some standardisation, each service experience depends on the requirements of the
customer. The greater the scope for discretion in the service provision, the 38
less accurate will be
the service cost based on process costing
 39

1. Job costing systems for professional

service firms
• Tend to use little material and
equipment and tend to produce no
inventories. Primary input is direct
labour.
• Because they deal with relatively
few clients, a detailed job costing
system is feasible.
• The production process for each
‘client’ is unique. This Photo by Unknown Author is licensed under
CC BY-SA

• Labour cost can be traced to a job.

• Job billing may be used.

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 Client Costing Sheet
Client Number: 234
Service Provided: Investment Advice
40

DATE: MARCH 28, 2020

DESCRIPTION HOURS RATE AMOUNT
Professional Labour
4 Feb Initial Meeting with Donovan 2.5 90 225

14 Feb Superannuation advice meeting with

Donovan:

Roland 1.20 90 108

Fairfield 1.20 100 120

17-21 Feb Development of investment strategies

13 90 1170
for Donovan

28 Feb Presentation of Investment Strategies 2 90 180

14 March Review of strategies 1.5 90 135
31 March Finalisation 1 90 90
Overhead
4-28 Feb Professional Labour Cost 1803 .25 450.75
1-31 March 225 .25 56.25
2028 507
Cost Summary
Total Professional Labour 2028
Total Overhead 507

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Total Cost TOTAL $2535
 41

2. Hybrid costing systems for service

shops and (other) mass services

• Suitable for some service shops and some

mass service entities.
• Costing system will vary on a continuum
from job costing to process costing;
• Use of job costing depends on the level of
repetition of activity, the number of activities,
the degree of customisation and discretion.

This Photo by Unknown Author is licensed under CC BY-SA

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 42

Service Shops - example Banks

• Investment advice: professional
services tailored to the needs of
individual clients after extensive
consultation.
• ATM; mass services involving
standardised procedures with no
customisation or room for discretion in
service production process.
• Loans: products with standard terms
such as interest rates; staff have some
discretion over the establishment of fees
and repayment periods.

This Photo by Unknown Author

CRICOS No.00213J
is licensed under
CC BY-NC-ND
 43

Which costing system is appropriate for

each different banking activity?

1. Investment advice: job costing

2. ATM: process costing
3. Loan: hybrid costing

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 44

3. Process costing systems for (some)

mass services
Services tend to be produced in very large quantities, so tracking the cost to
each service is not feasible.

Little customisation is involved so each service consumes much of the same

resources (This makes them repetitive).

Because there is a low level of contact with customers, a substantial part of the
labour costs is indirect.

Costs can be tracked directly to production.

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 45

Summary of factors affecting the decision to implement service

costing
Professional Service shops Mass Services
services

Complexity of costing system Low High Low

Accuracy of estimated service High Medium Low

costs
Relevance for:
• Assessing service High High High
profitability/service mix
• Pricing Depends on Depends on Depends on competitive
competitive competitive environment
environment environment Low
• Planning and controlling costs Low Low

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Langfield-Smith et al. (2018). Management Accounting: Information for Creating and Managing Value, McGraw Hill. Sydney, p. 260.
Billing vs Costing

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 47

Job Billing e.g. accounting firm send bill for

preparing tax returns at end of job
PROFESSIONAL SERVICE FIRMS
Some firms (legal, accounting, consulting) develop billing systems that accumulate client
charges for services rather than using costing services.

A billing system estimates the fees to be charged to the client for the service, based on
charge out rates per billable hour. E.g a graduate accountant at PwC is charged out at
$140.00 per hour of time working on a job.

This charge out rate should cover the cost of labour and overheads and a profit margin- but
few firms used a cost-based approach. Rather they use market-based rates (competitors).

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Job billing

Job billing considers the hourly labour cost, overhead costs and required profit margin.

A realisation rate may be used instead of the proposed client chares. This considers the current market
conditions.

E.g. if the job billing system estimates a job at $3295.50 the manager may only charge $3000. Thus the
realisation rate for the service is 91%.

Realisation rates are used to monitor the profitability of the entire business by comparing the total fee
invoiced to clients per accounting period with the amount based on charge out rates and accumulated in the
billing system.

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 49

When should firms estimate their service

costs?
• Manufacturing firms need to ESTIMATE the
product costs so they can value their Should the service firm estimate their
inventory and the cost of goods sold (COGS). costs? Depends on if benefits > costs

• Service organisations estimate their cost of 1. The complexity of the costing system
services to help managers create shareholder
value and manage their resources effectively 2. The accuracy of the service cost
and efficiently. information; and
• NB service firms don’t need to estimate –
because they use actual costs for 3. The relevance of service cost information
financial reporting to managing resources and creating value.
• Estimates are used for internal
information

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 50

Costing in retail and wholesale businesses

• Retail and wholesale differ from

other service entities as they
have two distinct components
to their output:

• They have tangible goods

that they sell to customers;
• They also provide a range of This Photo by Unknown Author is licensed under CC BY-SA

services to customers.

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 51

Costing the goods sold by retailers and wholesalers

• The cost of inventories purchased for resale must be determined in

accordance with financial reporting requirements. This may include:
• The purchase price of the merchandise
• Any import duties and other purchase taxes (VAT)
• The cost of transportation into the business and handling
• Other costs of acquiring the inventory
• Less deductions for trade discounts, rebates etc.
• This information is also useful for determining the profitability of
various product lines and responsibility centres.

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 52

Summary
Need to appreciate the important differences between manufacturing and service
organizations; service organization outputs are intangible, heterogeneous,
consumed as they are produced and are perishable and cannot be stored.

Consider the different types of service entities - and what type of costing system
is most commonly used: Professional Services (job costing), Service Shops
(hybrid) or Mass Service entity (process costing)

Consider the types of organizations where a hybrid costing approach is likely to

be the most appropriate.

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