CHAPTER TWO

COST TERMINOLOGY AND CLASSIFICATIONS

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 2.1. Cost in General
 Definition of Terms
1. Cost
 CIMA defines cost as ''the amount of expenditure (actual or
estimated) incurred on, or attributable to, a specified thing or
activity.”
 An Actual Cost that has been incurred and determined after it has
been incurred
 A Notional Cost for which there has not been any cash payment, but
whose benefit has been enjoyed in the process of production of a
commodity.
2. Cost Object:
 Cost object is anything for which measurement of cost is desired.
 Example: product, activity, a service, or a job, or a process costs.
 Cont’d
3. Cost Driver: is any factor that affects total costs.
 i.e. a change in the level of the cost driver will cause a
change in the level of the total costs.
 Example: number of units produced, number of items
distributed, number of advertisements, number of
customers, etc.
 2.2. COST CLASSIFICATIONS
 Cost can be classified into different parts based on different
criteria.
 Based on traceability, Costs can be divided in to:
Direct costs
Indirect costs
1. Direct Costs are those costs which are related to the
particular cost object and that can be easily and
conveniently traced to it.
 Example: Direct materials cost and Direct labor costs
employed in producing an article/product.
 Cont’d
2. Indirect Costs are those costs which are related to the
particular cost object but cannot be easily and conveniently
traced to it.
 i.e. indirect costs cannot be conveniently identified.
 They are also termed as factory overheads.
Example: Rent of factory Building, managerial salaries,
depreciation on machinery etc.
 Classification Costs by Behavior
Cost behavior refers to how a cost reacts to changes in the
level of activity/output. So, Costs can be classified as:
1. Fixed–a cost which does not change as the volume of activity
(production) changes.
 E.g. rent, The per-unit fixed cost decreases with increases
in the activity level
2. Variable – a cost which changes with changes in the volume
of activity. E.g. direct materials.
 The cost of direct materials used during a period will vary,
in total, in direct proportion to the number of units
produced.
 Cont’d
3. Mixed – a cost which has both fixed and variable components.
 E.g. Telephone charges which consists hire and call
expenses.
 Cost can expressed as Total Costs and Unit
Costs
 A unit cost also called as average cost. It is computed by
dividing total costs by number of units.
 Eg. Suppose $980,000 of manufacturing costs were incurred to
produce 10,000 units of finished goods. Then what is the unit
cost would be per unit cost?
Unit cost = total cost / total units produced
= $980,000 / 10,000 units
= $98 per unit
Cost classification Based on Functions
 Based on their functions costs can be categorized into Product
costs and period costs.
A. Product Costs are those costs which are traceable or
allocated to the product and each are included in inventory.
 Product costs are inventorial costs and they become basis for
product pricing.
 They comprise
direct materials,
direct labor, and
manufacturing over heads.
 Cont’d
 Direct Materials are those materials which can be identified with
the product and can be conveniently measured and directly
charged to the product.
 Eg: raw cotton in yarn, Timber in furniture, Cloth in dress, etc.
 Direct Labor is that labor cost which can be conveniently
identified with the product wages and such labor costs are
known as direct manufacturing labor costs.
 It is wages and salaries that can be easily traced to
individual units of product or job.
 Costs for employees’ efforts and skill applied directly to a product
 Eg. Wages of production operatives, waiters, sales assistants,
etc.
 Cont’d
• Mfg Overhead Costs considered to be part of the product cost
but cannot be individually traced to the product. Eg. plant
depreciation, supervisor salary
Some of these costs are as below:
– Maintenance wages/supplies
– Production supervision & expenses
– Depreciation expense of manufacturing assets
– Rent expense for buildings/machinery
– Electricity for manufacturing
– Insurance expense for manufacturing
– Indirect labor & indirect materials
– Manufacturing clerical wages
 Summary of Product Costs

Direct Direct Indirect Indirect

Other
Materials Labor Labor Materials

Manufacturing Overhead
 Cont’d
B. Period Costs are costs which incurred on the basis of time, such
as rent, salaries etc.
 These are also known as operating costs and sometimes called
nonmanufacturing costs.
 These are all costs associated with generating revenues other than
cost of goods sold such as
 Selling, General and Administrative expenses.
 Cont’d
1. Selling Costs – all costs incurred to secure customer orders and
get the finished product to the customer
 Also called order getting and order filling costs
 Eg. Sales Commission, advertising cost, sales persons’
salaries, shipping costs, costs of FGs warehouses, etc
2. General and Administrative Costs - all executive,
organizational, and clerical costs associated with the general
management of an organization.
o Legal staff wages and benefits, General accountant
salary, public relation, secretarial salary, Depreciation on
office equipment etc
 Accounting for Manufacturing Costs
• Mfg costs’ accounting systems vary among companies.
• Some use a three part classification of manufacturing costs
whereas others use a two part classification.
1. Three part classification
• Direct material costs
• Direct manufacturing labor costs
• Indirect manufacturing costs
2. Two part classification
• Direct material cost
• Indirect manufacturing costs
 1.3. Prime and Conversion Costs
• The combinations of different production costs also produce the
concepts of prime costs and conversion costs.
 Prime cost is the sum of direct materials cost and direct labor
cost
 Conversion cost is the sum of direct labor cost and overhead
cost.
For a mfg firm, conversion cost can be interpreted as
the cost of converting raw materials into a final product.
MANUFACTURING COSTS
• Example: Assume that Almeda Textile Factory produces Weavers Beam in
its weaving department. For the year just ended, the factory produced
100,000kg of Weavers Beam with the following total costs: Direct
materials 120,000 birr Direct labor 105,000 birr and Factory Overhead
15,000 birr
• Required: Compute SOLUTION
a) Prime cost a). Prime Cost = D M Cost + DL Cost
d) Conv. Cost /Kg = 120,000 birr ÷ 100,000
b) Conversion costb) Conversion
= Br120,000
Cost =+DL
= 1.2 Br105,000
Costs
birr/ Kg + FOH
c) Prime costs per kilogram= Br225,000
= Br.105,000 + Br.15,000
c) per
d) Conversion cost Prime Cost/Kg == 225,000
kilogram Br.120,000
birr ÷ 100,000
= 2.25birr/Kg
 2.3. Flow of Inventory Cost in Mfg Companies
The three different types of sectors are:
1. Mfg Sector Companies Purchase materials and components and
convert them into finished goods. Eg: food processing, textile
companies, etc.
2. Merchandising Sector Companies Purchase and then sell
tangible products without changing their basic forms. This sector
includes companies engaged in retailing such as book stores,
medicine stores etc.
3. Service Sector Companies Provides services. Eg. law firms,
accounting firms, banks, insurance, transportation companies,
advertising agencies, radio and television stations, etc.
 2.3. Flow of Inventory Cost in Mfg Companies
• Product costs flow from one inventory account to another.
• The final resting place prior to sale is FGs Inventory.
• Manufacturing companies purchase materials and components
and convert them into finished goods.
Flow of Inventory Cost in Mfg Companies

Raw Direct
Materials
Indirect

Factory Applied
Work-in- Finished
Overhead Process Goods
Indirect

Cost of
Direct
Labor Goods
Sold
 Cont’d
• 3 types of inventory in Mfg Companies.
1. DM inventory - materials in stock and awaiting use in the
manufacturing process (Eg. cotton and components needed
to manufacture clothes).
2. Work in process inventory - goods partially worked on but not
yet completed. Example: yarn
3. Finished goods inventory--- includes products which are
complete, in inventory and ready for sale. Eg. Bed sheet
 2.4. Reporting of result of operation in I/Stmt
• Income statement for manufacturing companies
Sales revenues xxx
Less:- Cost of goods sold
Beginning finished goods xxx
(+)Cost of goods manufactured xxx
(-) Ending finished goods xxx
Cost of goods sold xxx
Gross margin xxx
Less:- operating costs
Marketing, distribution and
Customer service costs xxx
Operating income xxxx
 Cont’d
• Income Statement For Merchandising Companies
Sales revenues xxx
Less:- cost of goods sold
Beginning merchandise inventory xxx
Add:- purchase of merchandise xxx
Cost of goods available for sale xxx
Less:- ending mdse inventory xxx
Cost of goods sold xxx
Gross margin xxx
Less:- operating costs xxx
Operating income xxx
 Balance Sheet Presentation of Product Costs
 The balance sheet or statement of financial position, of a
manufacturing company is similar to that of a merchandising
company.
 However, their inventory accounts differ.
 A merchandising company has only one class of inventory—
goods purchased from suppliers for resale to customers.
 In contrast, manufacturing companies have three classes of
inventories—raw materials, work in process, and finished
goods
 Cont’d
Case of Manufacturing Company
Inventory Accounts
Beg. Balance End. Balance
Raw materials ………………………………………………$ 60,000 $ 50,000
Work in process …………………….…………………….. 90,000 60,000
Finished goods ………………………………………………125,000 175,000
Total inventory accounts………………………………$275,000 $285,000
Case of Merchandising Company
Inventory Accounts
Beg. Balance End. Balance
• Merchandise Inventory ……………………… $ 100,000 $ 150,000
 SCHEDULE OF COST OF GOODS MANUFACTURED

• Cost of goods manufactured is computed in three steps:

Step1. Compute cost of direct material used
Step2. Compute total mfg cost incurred during the period
Step3. compute cost of good manufactured during the period
Illustration
THANK YOU!
 CHAPTER THREE
JOB ORDER COSTING SYSTEM

Objectives
At the end of this chapter students would be able to:
• Describe features of job order & process costing
• Identify source documents for job order costing
• Calculate job order costing computation
 Introduction
• In practice, assigning costs to products and services involves
averaging across time and across products. The way in which this
averaging is carried out depends heavily on the type of production
process.
• The two most commonly used types of costing systems are:
Job order costing system
Process costing system
 Job order costing or job costing
• Type of cost system that provide for a separate record of the cost of each
particular quantity of product that passes through the factory.
 It cost that to product that are unique and divisible.
 used by organizations whose production and services can be
identified with individual jobs, or units
 Example: construction, furniture manufacturers, repair shop,
service giving in the organization and etc.
NB. The purpose of job costing is to bring together all the
costs incurred for completing a job.
 process-costing system
 Process Costing is a costing system in which the cost of a
product or service is obtained by assigning costs to masses
of like or similar units (homogenous products).
 (used to cost masses of identical or similar units)
 used by organizations those make products in mass
quantities using a continuous processes.
 Example: oil refining factory, textile factory, chemical
processing, sugar industries, steel manufacturing, etc.
3.1.1. Assigning Manufacturing Costs To
Jobs
• Cost assignment is a general term for assigning costs to job
 It includes tracing direct costs and applying indirect costs to a cost
object.
3.1.2. Source of Documents for Job Order Costing
• A source document is an original record that supports
journal entries in an accounting system used to determine
the cost of the job.
• The key source document in job order costing system is job
cost sheet (job cost record).job cost [Link]
• This document records and accumulates all the costs (direct
material, direct labour, and FOH cost) assigned to a specific
job.
• Two primary source documents provide the information
recorded on the job cost sheet:
» materials requisition notes, and
» Direct labour time tickets,
 Materials Requisition Note
• A note that lists the quantity & cost of direct material used on specific job
• Used to control physical flow of materials out of store
• It provide the information needed to record the cost of material issued
• Journal Entry
Work-in-process (Job No) xx
Material (Specific) xx
(Source Document)
 Materials Requisition Note
Almeda Textile Industry
Performa Material Requisition Note

Material Requisition No: 46

Job No to be charged: 202
Date: 13/2/2012

Description Quantity Unit Cost Total Cost

XX1 100 Br. 4 Br. 400
ZZ4 20 10 200
Total Br.600
Authorized Signature : Mankir
Store keeper sign.
 Direct Labour Time Ticket
• Record the time spent on each job
• Used as the basis for labour cost entries into the accounting
records
• Generally, it is a doc’t that indicates the employee, the hours
worked, the account and the job to be charged, and the total
labor cost.
• [Link]
 Job cost sheet
• Accumulate and summarizes all of the costs incurred on a
specific jobs
• It shows actual direct material cost, direct labour cost and
applied factory overhead
• Factory OH applied to a job by using predetermined overhead
 Application of FOH to the Job
• Overhead costs are assigned to Jobs with the predetermined
overhead rate.
• predetermined FOH Rate = Estimated Annual Overhead Costs
Estimated Allocation Base(cost driver)
• Different allocation base may be used; direct labour hour, machine
hour, cost of building, number of mile travel etc
• Example: Assume Ambo mineral water Factory has estimated
overhead costs for the coming year of Br.900,000 and expected
activity is 90,000 direct labor hours.
• The predetermined FOH rate is Br.10 (Br.900,000/90,000) per
direct labor hour.
• During the period job 2012 consumed 6 direct labour hours
and the factory used direct labour hour as allocation base.
Cont’d
• Thus, overhead cost applied to job2012 would be:
• FOH Applied =Actual DL Hours incurred X
Predetermined FOH Rate
= 6 DL hours *Br. 10/hrs
= Br.60
 Activity : Individual (5’)
• Assume that ALTEX applies FOH to jobs on the basis of direct
labor hours. The company estimated FOH of Br. 96,000 and direct
labor hour of 12,000 and actually incurred FOH of Br 90,000 and
direct labor hour of 11,000. Based on these data, calculate the
following:
Predetermined overhead rate.
Applied Factory overhead.

Solution
Solution
2. Applied FOH = predetermined FOH rate * Actual DL hours
1. Predetermined FOH rate = Budgeted FOH / Budgeted DL hour
= Br 8/DL hours * 11,000 DL hours
= Br 96,000/12,000 hours
= Br 88,000
= Br 8/ DL hrs
3.1. 3. Recording The Flow Of Costs
• Cost flow is how we account for costs from the point at which they are
incurred to the point at which they are recognized as an expense on the
income statement.
• This described how mfg costs are recorded in job costing
 Three inventory accounts used to record these costs
1. Raw material inventory
2. Work in process
3. Finished goods inventory
 Recording purchases and Issues of Materials
 Purchase of material initially recorded in Raw Materials Inventory.
 This account shows the cost of all materials purchased but not yet
issued, and includes both direct and indirect material purchases.
 Journal Entry:
Material ……………………………. XX

Accounts payable ………….. XX

(To record purchase of materials on account)
 Raw materials issued based on a materials requisition note to production.
 Direct materials are recorded on the specific cost sheet and in WIP
 Indirect materials are accumulated in the mfg overhead account and
will be applied to the job
 Cont’d
• Journal Entry
 Direct materials used in production
Work in process …………………… xx
Material ……………………. xx
(To record direct materials used in production)
 In direct materials used in production
Manufacturing OH control ………… xx
Material ……………………. xx
(To record indirect materials used in production)
 Recording Labour costs
 Labor costs are recorded based on the direct labor time tickets that
show how much time was spent on each job.
 Direct labour recorded on job cost sheet and WIP inventory account
 Indirect labour debited to FOH control
 Journal Entry
 Direct Labor used in production
Work in process …………………. xx
Wage payable ……………..… xx
(To record direct wages liability)
 Indirect Labor used in production
Manufacturing OH control ………… xx
Wages payable …………………….. xx
(To record indirect wages liability)
 Recording Actual Mfg OH
• Actual mfg OH costs include all of the indirect manufacturing costs, or
those that cannot be traced to specific units or jobs.
 these costs are accumulated in the Mfg OH control account.
 They are always shown on the debit side of the Mfg Overhead
account.

Example: Factory Building Depreciation

Manufacturing OH control ………………………………….. XXX
Accu. Depreciation - (Factory building)………… XXX
 Recording Applied Mfg OH
 Many of the time, Mfg OH costs are applied to jobs based on the
predetermined overhead rate.
The amount of Mfg OH cost applied to specific jobs is determined
by multiplying the predetermined overhead rate by the actual
number of cost-allocation bases.
• Journal Entry
 Allocation of manufacturing OH
Work in Process ………………………………….. xx
Manufacturing OH allocated /applied ….. xx
(To record allocation of manufacturing OH)
 Transferring Costs to FGs and CGS
• When job completed, the total cost to complete the job is referred to as the
cost of goods manufactured or cost of goods completed.
 This cost must be transferred from the WIP Inventory account to the
Finished Goods Inventory account.
 Journal Entry;
Finished goods ………………………. xx
Work in process ……………… xx
(To record cost of gods manufactured)
 Once the sale is final, the total cost of the job transferred from the
Finished Goods Inventory account to Cost of Goods Sold
 Journal Entry:
Cost of goods sold …………………. xx
Finished goods ……………… xx
(To record cost of goods sold)
 Recording Nonmanufacturing Costs
• Nonmanufacturing costs are expensed during the period in which they
are incurred.
would be recorded in individual expense accounts, such as
Commissions Expense, Advertising Expense, Depreciation
Expense, and Miscellaneous Expenses
 3.1.4. Underapplied or Overapplied Mfg OH
• Since Mfg OH applied based on predetermined OH rate, it will probably
differ from actual Mfg OH incurred
 The balance is called overapplied or underapplied overhead
 Overapplied OH costs occur when the applied amount is greater than
the actual (incurred) amount.
 Overapplied Mfg OH = Mfg OH applied – Mfg OH incurred
 Underapplied OH costs occur when the applied amount is less than
the actual (incurred) amount.
 Underapplied Mfg OH = Mfg OH Incurred – Mfg OH Allocated
 Calculating Underapplied or Overapplied Mfg
OH
• There are two indirect cost accounts in general ledger which relates to
manufacturing OH.
1. Mfg OH control – which is the record of the actual costs in all the
individual OH categories such as indirect material, indirect Labor, power
and Rent etc.,
2. Mfg OH allocated – is the record of the manufacturing OH allocated to
individual jobs.
• Computation:
 Over Allocated Mfg OH = Mfg OH applied – Mfg OH incurred, Or
 Underapplied Mfg OH = Mfg OH Incurred – Mfg OH Allocated
3.1.5. Disposing Underapplied or Overapplied Mfg OH
• There are two main approaches to accounting for the under or over
allocated manufacturing overhead:
– write-off to cost of goods sold approach, and
– proration approach
 Direct write-off approach – is the most common disposing the balance
of Mfg OH
But this makes sense as long as most jobs worked on completed
and sold
However, if a significant amount of cost remains in WIP Inventory
or Finished Goods Inventory, then part of the over- or
underapplied Mfg overhead technically should be adjusted
(prorated) to those accounts.
 Cont’d
• Proration Approach - spreads under or over allocated overhead among
ending work-in-process inventory, finished goods inventory, and cost of
goods sold.
– Raw Materials inventory is not included in this proration, because no
manufacturing overhead costs have been allocated to it.
For under allocated FOHC
• work in in process inventory………x
• Finished goods inventory…………….xx
• Cost of goods gold ……………………….xxx
• manufacturing overhead control………xxxx
 Illustration
 Assume that ALTEX estimates budgeted direct Labor hours of 25,000
and budgeted factory overhead costs of Br. 150,000 to complete order
received from AMBO University graduate students. However, the factory
incurred actual direct labor hours of 30,000 and actual factory overhead
costs of Br. 160,000 to complete the job.
 Required:
i. Calculated the Budgeted overhead rate
ii. Make Journal entries to record
a. Actual factory OH incurred
b. Applied factory OH
iii. Determine the amount of under applied or over applied factory OH
and make the necessary Journal entry to write-off that amount to
CGS. And the proration
• Solution
i. Budgeted FOH Rate = Budgeted FOH ÷ Budgeted Direct Labor hrs
= Br. 150,000 ÷ 25,000 hrs.
= Br.6 per hour
ii. Journal Entries
a. Factory OH control 160,000
Accounts payable 160,000
(To record actual factory OH incurred)
b. Factory OH applied = Budgeted OH rate x actual hours used
= Br.6 per hour x 30,000 hours
= Br.180,000
 Entry
Work-in-process 180,000
Factory OH applied 180,000
(To record factory OH applied to production)
 Cont’d
iii. Since, applied FOH is greater than actual factory overhead, it is
overapplied. Hence,
 Overapplied FOH = FOH applied – Actual FOH
= Br. 180,000 - Br. 160,000
= Br. 20,000
• Journal Entry
Factory OH applied 180,000
Factory OH control 160,000
Cost of goods sold 20,000
(To close over applied factory OH to cost of goods sold)
Thank you !
 CHAPTER FOUR
PROCESS COSTING
• Objectives: At the end of this chapter students will be
able to:
 Understand the process costing system
 Know WA&FIFO methods of process costing
 Identify waste, defective units and scrap
 Introduction
• Companies that produce identical or similar units of a product or service
often use process costing.
• A process costing is a costing system in which the cost of a product or
service is obtained by assigning costs to products of similar units.
• Unit costs are computed on an average basis.
• Process costing is used in industries which are producing similar product.
 Examples of industries that use Process costing:
 Plastic industries
 Beverages
 Milk diary firms
 Pharmaceuticals
 Paper mills
 Comparison of Job Order and Process Costing
 Similarities between Job-Order and Process Costing
 The similarities between job-order and process costing can be
summarized as follows:
 Both systems have the same basic purposes—to assign
material, labor, and manufacturing overhead costs to products
and to provide a mechanism for computing unit product costs.
 Both systems use the same basic manufacturing accounts,
including MOH, RMs, WIP, and FG.
 The flow of costs through the manufacturing accounts is
basically the same in both systems.
 Cont’d
 Differences between job costing and process costing
 Three differences between job-order and process costing.
1. In job costing production is against specific orders. In process
costing production is going through several processes.
2. In job costing, costs are determined for each job. In process
costing, costs are determined for each process.
3. In job costing the cost of each unit is to be calculated
separately. In process costing averaging is used to compute
unit cost of production.
 4.1. Characteristics Of Process Costing
 The basic characteristics of process costing are:
 Homogeneous units pass through a series of similar processes.
 Each unit in each process receives a similar dose of manufacturing
costs.
 Mfg costs are accumulated by a process for a given period of time.
 There is a work-in-process account for each process.
 Mfg cost flows and the associated journal entries are generally
similar to job order costing.
 The departmental production report is the key document for tracking
manufacturing activity and costs.
 Unit costs are computed by dividing the departmental costs of the
period by the output of the period.
 STEPS IN PROCESS COSTING
The following are the five key steps in process costing.
• Step 1: Summarize the flow of Physical units of output
 Means from where the units are coming in and went out.
• Step 2: Compute output in terms of Equivalent units:
 This is measuring output in terms of the physical quantities of each of the
inputs that have been consumed when producing the units. Process-
costing systems separate costs into Direct materials and conversion
costs are necessary to assign costs to production.
Direct materials are added at the beginning of the assembly process.
Conversion costs are added evenly during assembly.
• Step 3: Summarize total costs to account for
• Step4: Compute cost per equivalent unit. Equivalent unit cost is
calculated by dividing dms and cc added by the quantity of equivalent
units of work done.
 Cont’d
• Step 5: Assign total costs to units completed and to units in
ending work in process
• ILLUSTRATION
• Process costing can be illustrated in three cases:
 Case 1: Process costing with no beginning or ending work in
process
 Case 2: Process costing with no beginning work in process, but
with ending work in process inventory.
 Case 3 : Process costing with both beginning and ending
work in process inventory.
Case 1: Process costing with no beg. or end inventory
Solution
Cont’d
 Know WA&FIFO methods of process costing

Based on
• Normal spoilage 10% of cost of goods sold
• Abnormal spoilage = Total spoilage - Normal
spoilage
NB Total spoilage = (Beg. WIP units + units
started) – (units completed and transferred out
+ end. WIP units)
 Identify waste, defective units and scrap

• Scrap is residual material that results from

manufacturing a product; it has low total sales value
compared with the total sales value of the product.
• No distinction is made between normal and
abnormal scrap because no cost is assigned to scrap.
• The only distinction made is between scrap
attributable to a specific job and scrap common to all
jobs.
• Recognition of scrap: Scrap recognized either at the
time of sale or at the time of production.
 Cont…
• Example: Assume that the manufacture of
aircraft parts generates scrap and that the
scrap from a job has a net sales value of $900.
• Journal entry:
• At the time of sale:
Cash or Account Receivable 900
Scrap Revenues 900
THANK YOU!