Chapter 4

Costing system:
A system that determines how much resources are sacrificed to
achieve a job.

When talking about the costing system, we need to keep these four
points in mind:
1. The benefits of the costing system should exceed its cost.
2. The costing system should be tailored to the operations.
3. Costing systems are used in decision making.
4. Managers should depend on other sources when making decisions.

Concepts related to a costing system:

1. Cost object.
2. Direct cost
3. Indirect cost
4. Cost pool: grouping of individual cost items.
5. Cost allocation base: a factor that links an indirect cost to a cost
object.

Examples of cost allocation basis:

1. Number of units produced
2. Direct labor hours
3. Machine hours
4. Direct labor cost
5. Direct material cost

To understand the concepts of “cost pool” and “cost allocation base” think
of them as followed:
1. We have many indirect costs such as: rent of the building, machine
depreciation…etc
2. We gather all these indirect costs in a cost pool.
3. Managers want to know how much of the total indirect cost should be
allocated to different cost objects. Therefore, they use a cost allocation
base. For example, based on how many machine hours (cost allocation
base) a cost object uses, we’ll allocate the indirect cost.

Ahmed Majeed Askar Hussain 1

 Indirect costs rent $400 depreciation $600

Cost pool: $1.000

Cost allocation 38 hours for product A 12 hours for product B

base(machine
houers)
Cost object Product A ($760) Product B ($240)

Now let’s talk about the costing systems:

Costing systems

Job costing Process costing

We have different goods and services We have identical goods and services
(the cost objects are distinct from each
other)

In the other words, job costing system is used when the cost objects have
different processes. Process costing system is used when all cost objects use
the resources in the same way.

Chapter 4 &5 explain job costing systems. Chapter 17 explains process

costing systems.

Job costing

Actual costing Normal costing

Traces direct cost by 1. Same as actual costing.
1. Actual direct cost rate × actual
quantity as direct input.

2. Allocates indirect cost by: 2. Allocates indirect cost by:

Actual indirect cost rate ×actual budgeted indirect cost rate ×
quantity of cost allocation base. actual quantity of cost allocation
base.

Ahmed Majeed Askar Hussain 2

In short:

1. Both actual costing and normal costing trace direct costs in the same
way. The problem is in allocating the indirect costs.
2. The difference between them is:
Actual costing = actual indirect cost rate.
Normal costing =estimated indirect cost rate.

What is the rate we keep talking about?

Indirect cost rate = total indirect cost / total quantity of cost allocation base

Job costing steps for both actual and normal costing:

1. Identify the job (cost object)
2. Identify the direct costs of a job.
3. Select the direct costs allocation base
4. Identify the total indirect costs.
5. Compute the (actual/normal) indirect cost rate.
6. Compute the indirect cost allocated t the job.
7. Compute the total cost.

Notes:
2- Direct costs include:
I. Direct materials
II. Direct manufacturing labor

5- Compute the rates:

I. Actual indirect cost rate= actual total indirect costs ÷ actual total
quantity of cost allocation base

II. Normal indirect cost rate

Normal total indirect costs ÷ Normal total quantity of cost allocation base.

6- Compute the indirect cost allocated to the job:

(Actual/normal) indirect cost rate (step 5) × actual quantity of cost allocation
base used for the job.

7- Compute total costs:

Direct cost (step 2) + indirect costs (step 6)

Ahmed Majeed Askar Hussain 3

The difference between actual costing and normal costing is in steps :5, 6
and 7.

Lets take two examples, one for the actual costing job system and another
one for the normal costing hob system.

Examples:
Assume the following information:
 Direct materials: $ 4,606
 Direct labor :$1,579
 Total indirect costs: $1,215,000
 Total direct labor hours: 27,000 hours
 Quantity of direct labor hours used to produce the car = 88 hours.

The previous information is used to produce a car, assume that the cost
allocation base is the direct labor hours.

Required: use the 7 steps to calculate the actual cost.

Step 1:
The job = the car

Step 2

Direct costs
Direct materials $4,606
Direct labor $1,579
Total direct costs $6,185

Step 3
Cost allocation base = direct labor hour (27,000 hours)

Step 4
Total indirect cost = $1,215,000

Step 5
Actual indirect cost rate = 1,215,000÷ 27,000 = $45 per direct labor hour.

Ahmed Majeed Askar Hussain 4

Step 6
Indirect cost
Allocated to the job = 45 × 88 = $3,960

Step 7
Total cost = 6,185 + 3,960 = $ 10,145

Example 2:
Assume the following information:
Direct materials $4,606
Direct labor $1,579
Total budget direct manufacturing overhead costs $1,120,000
Total budget direct manufacturing labor hours 28,000 hours
Quantity of cost allocation base used to produce a car is 88 hours

Required: assuming the cost allocation base is the direct labor hour, use the
7 steps to calculate the normal cost.

Step 1
The job = the car

Step 2
Direct costs:
Direct materials + direct labor = $6,185

Step 3
The cost allocation base = direct labor hour (28,000)

Step 4
Total budgeted indirect cost = $ 1,120,000

Step 5
Normal indirect
Cost rate = 1,120,000 ÷ 28,000 = $40 per direct labor hour

Step 6
Indirect cost allocated to the job = 40 × 88 = $3,520

Step 7
Total cost = 6,185 + 3,520 = $9,705

Ahmed Majeed Askar Hussain 5

Indirect cost rate:
we usually calculate these rates annually fro 2 reasons:
1-numerator reasons: (total indirect cost)
I. The shorter the period, the greater the influence of seasonal partners
on the amount of the cost.
Example:
People consume more electricity in August than they do in September, and
more in September than in October. If we calculate the value monthly, the
allocation won’t be efficient.

II. Non seasonal erratic costs: there may be seasonal effects that will
increase the cost in one season more than the other.

2-Denominator reasons: (cost allocation base):

I. Non equal design of the calendar.
Example:
In February there is 28 days, where by in August there are 31 days. So the
cost allocation base (such as labor hours) might be morel less in one month
than the others.

II. Spreading an unchanged foxed cost over a change quantity of cost

allocation base.
Example:
Suppose that the rent for a building is $20,000 and it is fixed. Now suppose
that the total cost allocation base in one month is 10,000 hours, for example,
and 20,000 hours in another month.

‫المختصر المفيد‬:
We calculate the rates annually so that we have one rate for the entire year,
so that we can compare the costs more efficiently.

Source documents:

 Source documents:
A document that supports journal entries in an accounting system.

 job cost record/ job cost sheet:

a source documents that contains information about costs assigned to a job.

Ahmed Majeed Askar Hussain 6

  Materials requisition record:
A source documents that contain information about costs of direct materials
for a specific job.

 Labor time record:

A source documents that contains information about costs of labor for a
specific job.

Chapter 4 journal entries:

Before going to journal entries:

The physical flow of the product:

1. Purchase of direct materials
2. Convert materials into work in process
3. Convert work in process into finished goods
4. Sales of finished goods

The 10 journal entries:

1-purchase of materials (direct & indirect) on credit:

Material control XXX

Accounts payable control XXX

2-materials sent to manufacturing department:

$ 81,000 is direct materials
$ 4,000 is indirect materials

Work in process control 81,000

Manufacturing overhead control 4,000
Materials control 85,000

3-total manufacturing payroll paid fro labor accrued:

$ 39,000 direct
$ 15,000 indirect

Work in process control 39,000

Manufacturing overhead control 15,000
Wage payable control 54,000

Ahmed Majeed Askar Hussain 7

Notes:
That in journal entries 2 & 3, when we have direct costs we debit (work in
process).
When we have indirect costs we debit (manufacturing overhead control).

4-payment of the payroll incurred in 3

Wage payable control 54,000

Cash control 54,000

5- Additional indirect costs incurred during the month:

Indirect labor salaries $ 44,000 (accrued)

Plant utilities $ 11,000(on credit)
plant depreciation $ 18,000
Plant insurance $ 2,000

Total indirect costs = (44,000+11,000+18,000+2,000) = $75,000

Manufacturing overhead control 75,000

Salaries payable control 44,000
Accounts payable control 11,000
Accumulated depreciation control 18,000
Prepaid insurance control 2,000

6- Manufacturing overhead allocated to a job

Work in process control 80,000

Manufacturing overhead allocated 80,000

Note:
There’s a difference between manufacturing overhead allocated and
manufacturing overhead control. Manufacturing allocated is the estimated
amount of the indirect cost. Manufacturing overhead control is the actual
indirect costs that incurred

7- Completed jobs to finished goods with the amount of $188,800

Finished goods control 188,800

Work in process control 188,800

Ahmed Majeed Askar Hussain 8

8- Cost of goods sold $180,000

Cost of goods sold 180,000

Finished goods control 180,000

9- Extra costs incurred (period costs):

Marketing department salaries 35,000

Advertising costs 10,000
Customer service department salaries 15,000

All costs are on credit or accrued.

Marketing and customer service salaries 50,000

Advertising costs 10,000
Accounts payable control 10,000
Salaries payable control 50,000

10- Sold a job for $270,000 on credit

Accounts receivable control 270,000

Revenues 270,000

Manufacturing overhead control VS manufacturing overhead allocated

When the actual indirect cost (manufacturing overhead control) is different

than the estimated indirect cost (manufacturing overhead allocated), we will
have one of the following:

Under allocated indirect cost: Over allocated indirect cost:

Estimated indirect cost > actual estimated indirect cost < actual
indirect cost indirect cost

Over allocated (under located) indirect cost =

Actual indirect cost – estimated indirect cost

The difference between the actual and estimated indirect costs can be
eliminated in three approaches:
1. Adjusted allocation – rate approach.
2. The prorating approach.

Ahmed Majeed Askar Hussain 9

 3. Write off to cost of goods sold approach.

1-Adjusted allocation – rate approach:

Using this approach, managers revise the journal entries and use the
actual indirect cost rather than the estimated indirect cost.

2-The prorating approach:

Example:
Assume the following information:

Account balance Manufacturing

before prorating overhead costs
allocated
Work in process $30,000 $10,000
Finished goods $50,000 $20,000
Cost of goods sold $120,000 $50,000
Total $200,000 $80,000

Actual indirect costs incurred = $200,000

Estimated indirect costs = $80,000

Required: dispose of the over allocated (under allocated) indirect cost

using:
I. The prorating approach based on the amounts in the ending balance.
II. The prorating approach based on the amounts of indirect cost
allocated to inventories (WIP, FG, and CGS)

Follow these 3 simple steps to answer such Q

1. Find the amounts that you’ll use for the entries.

2. Determine if we have under allocated or over allocated indirect cost.
3. Write the journal entry.

I. based on the amounts in the ending balance:

1- find the amounts the you’ll use for the entries

Over allocated The amount in the The total amount

(under allocated) × ending balance ÷ in the ending
amount balance

Ahmed Majeed Askar Hussain 10

Work in process:
(200,000-80,000) × 30,000 ÷ 200,000 = $18,000

Finished goods:
(200,000-80,000) × 50,000 ÷ 200,000 = $30,000

Cost of goods sold:

(200,000-80,000) × 120,000 ÷ 200,000 = $72,000

2-determine if we have over allocated or under allocated indirect cost:

A. If we have over allocated indirect cost, work in process, finished
goods and cost of goods sold will be credited in the journal entry.
B. If we have under allocated indirect cost, work in process, finished
goods and cost of goods sold will be debited in the journal entry.

In our example we have under allocated indirect cost because the acual
indirect cost < estimated indirect cost (200,000 < 80,000)

3-the journal entry:

Since we have under allocated indirect cost, work in process, finished goods
and cost of goods sold will be debited:

Work in process control 18,000

Finished goods control 30,000
Cost of goods sold 72,000
Manufacturing overhead allocated 80,000
Manufacturing overhead control 200,000

II- based on the amounts of indirect costs allocated to the inventories:

1- the amounts that will be used for the entries:

Over allocated The amount The total amount

(under allocated) × allocated for the ÷ allocated
amount inventory

WIP = 120,000 × 10,000 ÷ 80,000 = $15,000

FG = 120,000 × 20,000 ÷ 80,000 = $30,000
CGS = 120,000 × 50,000 ÷ 80,000 = $75,000

Ahmed Majeed Askar Hussain 11

Step 2 & 3 are the same as requirement (I):

Work in process control 15,000

Finished goods control 30,000
Cost of goods sold 75,000
Manufacturing overhead allocated 80,000
Manufacturing overhead control 200,000

3-write off the cost of goods sold:

Use these steps:
1. Calculate the amounts of the over allocated (under allocated) indirect
cost using the formula on page 15. This amount will be used for cost
of goods sold. (we debit cost of goods sold by this amount)

2.
I. if we have under allocated indirect cost:

Cost of goods sold XXX

Manufacturing overhead allocated XXX
Manufacturing overhead control XXX

II. If we have over allocated indirect cost:

Cost of goods sold XXX

Manufacturing overhead control XXX
Manufacturing overhead allocated XXX

Example:
Assume the following information
 manufacturing overhead control: $100,000
 manufacturing overhead allocated: $80,000

Required: dispose of the over allocated (under allocated) indirect cost using
the write off to cost of goods sold.

Cost of goods sold 20,000

Manufacturing overhead allocated 80,000
Manufacturing overhead control 100,000

Ahmed Majeed Askar Hussain 12

Example:
Assume the following information
 manufacturing overhead control: $80,000
 manufacturing overhead allocated: $100,000

Required: dispose of the over allocated (under allocated) indirect cost using
the write off to cost of goods sold.

Cost of goods sold 20,000

Manufacturing overhead control 80,000
Manufacturing overhead allocated 100,000

Ahmed Majeed Askar Hussain 13