A job costing system is useful when a business is producing customized products or

services. It involves the accumulation of the costs of materials, labor, and overhead
for a specific job. This approach is an excellent tool for tracing specific costs to
individual jobs and examining them to see if the costs can be reduced in later jobs .
Job costing is a substantial topic, and so is covered separately in the Job Costing
chapter. That chapter gives an overview of job costing, which journal entries to use, how
to track job costs, and which controls to implement for a job costing system.
A process costing system is used when an entity manufactures large quantities of the
same product. Process costing involves tracking the number of units passing through
the production process during a given period, collecting cost information for each stage
and then using the collected information to calculate per-unit cost.
There are several calculation options for process costing, which are addressed in the
Process Costing chapter. The weighted average method is the most commonly used,
though variations are available that incorporate standard costs or the first in, first out
cost flow model. The chapter also includes the journal entries to use in a process
costing environment.
By-Product and Joint Product Costing
There are manufacturing processes where a number of products can be derived from a
single set of production steps. If so, a method is needed to allocate the cost of
production to the various products that are created. We address a variety of allocation
options in the Joint and By Product Costing chapter. When reviewing the chapter,
please note that all of the options presented are merely allocations – there is no
justifiable basis for accurately assigning joint costs to products. A joint cost is a cost
which benefits more than one product, and for which it may not be possible to separate
its contribution to each product.
The valuation step3: Overhead Allocation was concerned with charging the direct
costs of production (those costs that can be clearly associated with products) to
inventory, but what about overhead expenses? In many businesses, the cost of
overhead is substantially greater than direct costs, so the cost accountant must expend
considerable attention on the proper method of allocating overhead to inventory.
There are two types of overhead, the first one is Administrative overhead, this includes
those costs not involved in the development or production of goods or services, such as
the costs of front office administration and sales. And then the Manufacturing overhead,
it is all of the costs that a factory incurs, other than direct costs.
The typical procedure for allocating overhead is to accumulate all manufacturing
overhead costs into one or more cost pools (which are groups of similar costs), and
then use an activity measure to apportion the overhead costs in the cost pools to
inventory. Thus, the overhead allocation formula is: Cost pool ÷ Total activity measure =
Overhead allocation per unit.
A key issue is that overhead allocation is not a precisely defined science – there is
plenty of latitude in how to allocate overhead. The amount of allowable diversity in
practice can result in slipshod accounting, so be sure to use a standardized and well-
documented method to allocate overhead using the same calculation in every reporting
period. This allows for great consistency, which auditors appreciate when they validate
the supporting calculations.
Valuation Step 4: Inventory Valuation
Many cost accountants may complete the preceding steps to create an inventory
valuation, and go no further. However, there are two situations worth reviewing on a
regular basis, which are to reduce the recorded cost of inventory under either the lower
of cost or market rule, or to account for obsolete inventory. The next two sections
address these issues. Of the two, the one to be most careful of is obsolete inventory,
which nearly always is present in any inventory that has been in existence for more than
a few years.
The Lower of Cost or Market Rule
The lower of cost or market rule (LCM) is required by generally accepted accounting
principles, and essentially states that the cost of inventory is recorded at whichever cost
is lower – the original cost or its current market price (hence the name of the rule). More
specifically, the rule mandates that the recognized cost of an inventory item should be
reduced to a level that does not exceed its replacement cost as derived in an open
market. This replacement cost is subject to the following two conditions: The recognized
cost cannot be greater than the likely selling price minus costs of disposal (known as
net realizable value). The recognized cost cannot be lower than the net realizable value
minus a normal profit percentage.
The LCM decisions noted in the last table are explained as follows: • • • • •
Free Swing clubs. It would cost Mulligan $260 to replace these clubs, which is above
the upper price boundary of $225. This means the market value for the purposes of this
calculation is $225. Since the market price is higher than the existing recognized cost,
the LCM decision is to leave the recognized cost at $140 each.
Golf Elite clubs. The replacement cost of these clubs has declined to a level below the
existing recognized cost, so the LCM decision is to revise the recognized cost to $171.
This amount is a small reduction from the unadjusted replacement cost of $175 to the
upper price boundary of $171.
Hi-Flight clubs. The replacement cost is less than the recognized cost, and is between
the price boundaries. Consequently, there is no need to revise the replacement cost.
The LCM decision is to revise the recognized cost to $110.
Iridescent clubs. The replacement cost of these clubs is below the existing recognized
cost, but is below the lower price boundary. Thus, the LCM decision is to set the market
price at the lower price boundary, which will be the revised cost of the clubs.
Titanium clubs. The replacement cost is much less than the existing recognized cost,
but also well below the lower price boundary. The LCM decision is therefore to set the
market price at the lower price boundary, which is also the new product cost
A variation on the LCM rule simplifies matters somewhat, but only if a business is not
using the last in, first out method or the retail method. The variation states that the
measurement can be restricted to just the lower of cost and net realizable value.
Additional factors to consider when applying the LCM rule are:
Analysis by category. The LCM rule is normally applied to a specific inventory item, but
it can be applied to entire inventory categories. In the latter case, an LCM adjustment
can be avoided if there is a balance within an inventory category of items having market
below cost and in excess of cost.
Hedges. If inventory is being hedged by a fair value hedge, add the effects of the hedge
to the cost of the inventory, which frequently eliminates the need for an LCM
adjustment.
Last in, first out layer recovery. A write-down to the lower of cost or market can be
avoided in an interim period if there is substantial evidence that inventory amounts will
be restored by year end, thereby avoiding recognition of an earlier inventory layer.
Raw materials. Do not write down the cost of raw materials if the finished goods in
which they are used are expected to sell either at or above their costs.
Recovery. A write-down to the lower of cost or market can be avoided if there is
substantial evidence that market prices will increase before the inventory is sold. • Sales
incentives. If there are unexpired sales incentives that will result in a loss on the sale of
a specific item, this is a strong indicator that there may be an LCM problem with that
item.
Obsolete Inventory Accounting
What should the accountant do if there is obsolete inventory on hand? Determine the
most likely disposition of the obsolete items, subtract the amount of this projected
amount from the book value of the obsolete items, and set aside the difference as a
reserve. As the company later disposes of the items, or the estimated amounts to be
received from disposition change, adjust the reserve account to reflect these events.

The example makes inventory obsolescence accounting look simple enough, but it is
not. The issues are:
Timing. One can improperly alter a company’s reported financial results by altering the
timing of the actual dispositions. As an example, if a supervisor knows that he can
receive a higher-than-estimated price on the disposition of obsolete inventory, he can
either accelerate or delay the sale in order to shift gains into whichever reporting period
needs the extra profit.
Expense recognition. Management may be reluctant to suddenly drop a large expense
reserve into the financial statements, preferring instead to recognize small incremental
amounts which make inventory obsolescence appear to be a minor problem. Since
generally accepted accounting principles mandate immediate recognition of any
obsolescence as soon as it is detected, the cost accountant may have a struggle forcing
immediate recognition through the objections of management.
Timely reviews. Inventory obsolescence is likely to be a minor issue as long as
management reviews inventory on a regular basis, so that the incremental amount of
obsolescence detected is small in any given period. However, if management does not
conduct a review for a long time, this allows obsolete inventory to build up to quite
impressive proportions, along with an equally impressive amount of expense
recognition. To avoid this issue, conduct frequent obsolescence reviews, and maintain a
reserve based on historical or expected obsolescence, even if the specific inventory
items have not yet been identified. Also, encourage the warehouse manager to make
full use of the reserve, which he should treat as an opportunity to eliminate ancient
items from stock.
Management resistance. Senior managers may not believe the cost accountant when
he presents them with a massive write down, and so will reject any attempt to recognize
an obsolescence reserve. If so, hire outside consultants who will independently review
the inventory and present their own obsolescence report to management. This second
opinion may bring sufficient professional weight to bear that management will grudgingly
allow the creation of a reserve.
Summary
This chapter has described the four steps involved in creating an accurate inventory
valuation. All four are fraught with problems. There are a multitude of ways in which to
incorrectly arrive at the quantity of units in stock, and a similar number of ways in which
to arrive at an incorrect product cost. Further, given the large amount of costs in
overhead, even a small change in the overhead allocation methodology can result in a
startling change in reported profit levels. And finally, many companies do not spend
sufficient time reviewing inventory obsolescence issues, so that their inventories should
be valued lower than the cost at which they are actually reported. Given this potential
morass of issues, it is no surprise that inventory valuation causes the most problems for
cost accountants out of all their responsibilities, and is an area in which they spend a
substantial proportion of their time.
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