Cost Accounting I

For management 2nd year students

Crhrs;-3
Instructor;- Lemma A (MSc)
January ,2021
 CLASSIFICATION OF COST
INTRODUCTION

 Accountant usually defines cost as a resource

sacrificed or forgone to achieve a specific objective.
For now, consider cost as being measured in the
conventional accounting way, as monetary unit (for
example birr) that must be paid for goods and
services
• cost object define it as any activity or item for
which a separate measurement of costs is desired.
• The cost object is a key feature of management
accounting
 Continued…
• It may be an activity or operation in which resources are
consumed or received (repairing automobiles, responding
in inquires for information, reconciling bank statement).
The cost object may be a product or service e.g. (Renting
room, flying passenger from Addis Ababa to Dambi Dollo).
The cost object may be project e.g. constructing a house.
•  The cost objects maybe a department e.g. (producing
department, procurement department. The cost object
may be a program e.g. (CORONA control program, athletic
program).
 Cost object

 activity or operations
Product or services
Project
Department
Program
Cost measurement must be tied to at least one
cost object.
 1.1.1 Cost Accumulation and Allocation

• Cost accumulation is the collection of cost

data in same organized way through an
accounting system.
• Cost allocation is a general term that refers to
identifying accumulated cost with or tracing
accumulated cost-to-cost object such as
department, activities, or products.
 1.2 DIRECT COSTS AND INDIRECT COSTS

• Direct costs – Costs that can be identified specifically with

or traced to a given cost object in an economically feasible
way.
• Indirect cost – Costs that cannot be identified specifically
with or traced to a given cost object in an economically
feasible way.
• Economically feasible” means “Cost effective”. Managers
do not want cost accounting to be too expensive in
relation to expected benefits. The cost of tracing relatively
in expensive items may exceed the benefit of having the
resulting information
 Continued…

• For example, it may be economically feasible to trace specifically

the exact cost of steel and fabric (direct cost) to a specific lot of
desk chairs, but it may be economically not feasible to trace
specific the exact cost of rivets or thread (indirect costs) to the
chars.
•  Managers prefer to classify costs as direct rather than indirect.
Why? Because they have greater confidence in the accuracy of
the reported cost of products and services. When is a cost
considered direct or indirect? The answer depends on the
particular cost object. Consider a supervisor’s salary in a
maintenance department of a telephone company. If the cost
object is the department, the supervisor salary is a direct cost.
•  In contrast, if the cost object is a service (the product of the
company), such as a telephone call, the supervisor salary is an
indirect cost.
 1.3 COST DRIVERS

•  A cost driver is any factor whose change causes a

change in the total cost of a related cost object.
Drivers are casual factors whose effects are increases
in total costs. There are many possible cost drivers.
• Ex. In factory setting, the total cost of material used
may be driven not only by the production volume but
also by the quality of the material, the skills of the
worker, and the number of parts in a finished product,
and the condition of the applicable machines.
 Continued…
• Example of cost drivers ;-product design,
number of products, number of parts, type of
transportation ;-number of stops, speed
• Manufacturing;- production volume, in unit of
products ,number of set ups number of parts
1.4 VARIABLE COSTS AND FIXED COSTS

• A variable cost is a cost that does change in

total in direct proportion to changes of a cost
driver.
• A fixed cost is a cost that does not change in
total despite changes of a cost driver.
 Examples:

– If A.M.C.H plc buys one type of special clamp at 1 birr for

each of its cars, then the total cost of clamps should be 1
times the number of cars produced. This is an example of a
variable cost a cost that is unchanged per unit of cost
driver but change in total in direct proportion to changes in
the cost driver.
• A.M.C.H plc may incur 100,000 in a given year for a
factory taxes, executive salaries, rent, and insurances.
These are examples of fixed costs, costs that are
unchanged in total over a wide range of the cost
deriver during a given time span but became
progressively smaller on a per unit basis as the cost
driver increases
 1.4.1 Major Assumptions

•
• The definitions of variable costs and fixed costs
have important underlying assumptions.
• The cost object must be specified.
Examples are activities, products, services,
projects, departments etc.
• The time span must be specified.
Examples are months, quarters, years and
product life cycles.
• Costs are linear: That is, when plotted on ordinary
graph paper, a total cost in relation to the cost
drive will appear as an unbroken straight line.
 Continued…
• For the time being, all costs are either variable or
fixed. In practices, of course, classification is difficult
and nearly always necessitates some simplifying
assumptions.
• There is only one cost drive. The influences of other
possible cost drivers on the total cost are held
constant or deemed to be insignificant. Volume, often
expressed in measures of units produced or sold.
• The relevant range of fluctuations in the cost driver
must be specified
 1.5 MANUFACTURING COSTS

1,5,1  components of manufacturing costs

• The objective of the topic is to define and
identify each of the three categories of a
manufacturing product costs.
• Manufacturing is the transformation of
materials into other goods through the use of
labor and factory facilities. Merchandising is
the marketing of goods without changing their
basic form.
 1.6 THREE MANUFACTURING COST CATEGORIES

•  Many companies recognize three major

categories of the cost of manufactured product:
• Direct materials cost: - The acquisition costs of
all materials that are identified as part of the cost
object and that may be traced to the cost object
in an economically feasible way. Acquisition costs
of direct materials include in ward delivery
charges, sales tax, and custom duties
 Continued…
• Direct labor: - The compensation of all labor that can
be identified in an economically feasible way with a
cost object. Examples in manufacturing are the labor
of machine operators and assembler. Indirect labor
costs are all factory labor compensation other than
direct labor compensation. These are labor costs that
are impassible or impractical to trace to a specific
product. They are classified as part of the indirect
manufacturing cost ex. Wages of janitors and plant
guards.
 1.6.1 Prime Costs, and Conversion Costs

• Two of the three major categories of the cost

of a manufactured product are sometimes
combined in cost terminology as follow: -
Prime costs are all direct manufacturing costs.
Conversion costs are all manufacturing costs
other than direct materials costs.
• Two folded categories and three folded categories
• 1, three folded categories
• Direct material cost
• Direct labor cost
• Manufacturing overhead cost
2, two folded categories
 conversion cost
Direct material cost
1.7 COST AS ASSETS AND EXPENSES
• The rules of financial accounting have major influence on
accounting for manufacturing costs. For example, under
generally accepted accounting principles, the
manufacturing costs of a product are initially regarded as
measure of assets. They are inventor able costs, which are
all cost of a product that are regarded as an asset for
financial reporting under generally accepted accounting
principles. Such cost become expenses (in the form of cost
of good sold) only when the units in inventory are sold.
•  Other costs, often called period cost, are regarded as
immediate expenses. These costs are always expensed in
the same period in which they are incurred; they are not
considered inventeriable costs. Example: research,
marketing, and administrative costs
• Indirect manufacturing costs (manufacturing
overhead): - all manufacturing costs that cannot be
identified specifically with or traced to the cost object
in an economically feasible way. Other terms used are
factory overhead, factory burden, manufacturing
overhead and manufacturing expenses. The term
indirect manufacturing costs is a clear descriptor than
factory overhead, but the latter will be used through
this text because it is briefer. Examples of factory
overhead when products are cost object include
power, supplies, indirect labor, factory rent, insurance,
property taxes, and depreciation
 Chapter two
Job order costing system
• 2.1 INTRODUCTION
•  The job order cost system accumulate costs applicable to each
specific job order or cost of similar goods manufactured on a
specific order for stock or for customer. When production on a
job begins, the job is assigned a number, and a form called a job
cost sheet is set up. As direct materials are used, their costs are
entered on the job cost sheet.
• Similarly, direct labor cost incurred on a job is recorded
periodically. When the job is completed (or periodically as the
job is worked on), manufacturing overhead cost applicable to
the job are estimated and entered on the job cost sheet.
• The job cost sheet, when complete, shows the total cost of the
completed job. The cost per unit may then be obtained by
dividing the total cost of the job by the number of units
completed.
 2.2 WORK FLOW

• A firm’s cost accounting system should go along with its flow of

operation. The sequence of operation firms that makes and
sells it own products are indicated below.
•  Procurement – Raw materials and supplies needed for
manufacturing are ordered, received and stored. Direct and
indirect factory labor and services are obtained.
• Production - Raw materials are transferred from the
storeroom to the factory. Labor tools, machine, power, and
other costs are applied to complete the product.
• Warehousing – Finished goods are moved from the production
floor to the warehouse and remain there until they are sold.
• Selling – Merchandise is shipped from the warehouse. Sales to
customers are recorded.
 2.3 RECORDING COSTS AS INCURRED

•  As each cost is incurred, it must be recorded in an appropriate general

ledger account. At different point in the operating cycle different accounts
are needed. For example;
•  Procurement – accounts must be provided to record the purchase of
materials cost, labor cost, and overhead cost. These costs will later be
charged to production. Typical general ledger account titles used for this
purpose are Raw material, factory payroll clearing, and manufacturing
overhead control.
• Production – An account is required to gather procurement costs as they
become chargeable to manufacturing operation and this account is called
work in process.
• Warehousing – an account should be setup to record the cost of goods
that have been completely manufactured. This account is finished goods.
• Selling – The cost of the completed goods that have been sold must be
recorded, and for this purpose a general ledger account called cost of good
solids is maintained.
 Continued…

Procurement
Raw material Production Ware housing Selling
Factory overhead WIP Finished goods CGS
Payroll clearing
 2.4 MATCHING COST FLOW AND WORKFLOW

•  The provision for special cost accounts sets the stage for the more intricate job
of charging costs in accordance with the flow of work. The process can best be
under stood if it is analyzed step by step.
•  Procurement: - Purchases of materials, labor, and overhead are recorded as
debits to raw material, factory payroll clearing, and manufacturing overhead
control. As these costs are used, or applied, in factory operation, they are
credited to these accounts and transferred to production.
• Production: - costs of materials, labor, and overhead transferred into
production are debited to work in process account. As goods are finished and
moved from the factory floor, their total cost is removed from the work in
process account by a credit entry and charged (debited) to finished goods.
• Warehousing: - The cost of finished goods transferred from work in process is
recorded as a debit to finished goods. The cost of merchandise shipped from
warehouse to customers is credited to finished goods and charged (debited) to
cost of goods sold.
• Selling: - As finished goods are sold and shipped from the warehouse, this cost
is debited to cost of good sold. At the end of the accounting period, this
account is closed by crediting cost of good sold and debiting income summery
 2.5 DEPARTMENTAL COST CENTER

•  Of the four steps in the operating cycle, production is

probably the most complicated to account for and to control.
Tons of materials and supplies of every description might be
used daily by hundreds of workers who complete a wide
verity of processes on countless machine. Total costs are not
very useful as indicators of efficiency under such conditions.
Therefore, when several operations are performed in the
factory, it is customary to group similar activities into
departments or cost center. The cost accounting system is
then devised to accumulate and report costs separately by
department or cost center. Such reporting matches cost flow
with workflow down to the smallest functional unit. The
person in charge of the department is then holding
accountable for its efficient performance.
Departmentalization thus helps to provide operation Control
over manufacturing activities and cost.
• Factory operations normally include two types
of department’s production and service.
Production department or producing
department, engages in work directly related
to the product. A service department serves
or assists production departments. For
example, maintenance department maintains
a plant so that production can be carried on
under the best possible working condition.
 2.6 RECORDING COST FLOWS, RAW MATERIAL, LABOR, OVERHEADS

• Recording Cost Flows: -

•  You have seen how a cost accounting system is developed by
matching the flow of costs with the flow of factory activities. The
next thing is for you to examine the cost system of a typical
manufacturing corporation in operation.
•  3F company produces different house hold product based on the
customer specification, ever the some standard furniture are also
produced and held in inventory for future sales. The firm is
organized into three major divisions: Administration, Production,
and sales. The production division, which directs factory operation,
consists of four departments three producing department and one
service department. The three producing department are dep.1
dep.2, dep.3. The service department is building service
department.
• The activities involved in each department are as follows: -
 Con…
• Dep. 1 – rough lumber is trimmed and shaped into finished form for use in manufacturing
• Furniture.
• Dep. 2 – here the individual pieces are put together with screws and glue, and various
• Hardware is attached. When pre fabricated parts are purchased to be assembled,
• work on an order begins in this department. The operation of this department is
• Performed primarily by hand.
• Dep. 3 – In this department, the varnish is applied to the product. Sanding, staining,
• Rubbing operations are performed. The completed goods go from the finishing
• Department to the finished goods warehouse for shipment.
• Building service and Administration department – which include:
• Accounting section, Procurement , Personnel, Janitors , Maintenance
• General lager accounts maintained by 3F with beginning balance are as follows
• Raw material = begging balance = $55,450
• Work in process = begging balance = 45,500
• Finished goods = begging balance = 29,500
• Factory payroll cleaning
• Manufacturing overhead control.
•  During the period the company purchased additional raw materials at a cost of $ 75,000 on account, and
the company is using voucher system. The journal entry will be as follow:
•  
• Raw material ……………………. $ 75,000
• Voucher payable ……….…………… $ 75,000
• To recorded cost of raw materials purchased
• Raw material used
• During the month, raw material costing $85, 750.00 were used
• Direct materials, chargeable to work in process $ 75,899.00
• Indirect materials, chargeable to manufacturing overhead control is l $
9,851.00 the entry will be as follow.
• WIP…………….. $ 75,899.00
• MOH. Control……….9,851.00
• Raw material …………….. $ 85,750.00
• To record the cost of material used
•  Factory wage Earned
• During the month, wage and salaries totaling $94,875.45 were earned
by the factory employees and charged from the factory payroll register
to the factory payroll clearing accounts. The entry is as follows.
• Factory payroll clearing ……….. 94,875.45
• Salaries and wage payable ……………. 94,875.45
• To record factory payroll for the period
 Labor charged to operation

• An analysis of the records indicates that labor cost of $94,875.45 should

be allocated.
• Direct labor, chargeable to work in process - $70,544.20
• Indirect labor, chargeable to manufacturing overhead control = 24,331.25
• The entry will be
• Wp ……… $70,544.20
• MHO control ….24,331.25
• Factory payroll clearing – 94,875.45
• To recorded cost of labor used in operation during the period.
•  Manufacturing Overhead cost
• In addition to the indirect material $9,851 and indirect labor $24,331.25,
other over head cost totaling $16,790.75 incurred during the period were
charged from various journals.
• MOH Control. 16,790.75
• Voucher payable ………… 16,790.75
• To record overhead applied to jobs during the month.
 Manufacturing overhead applied to products

•  It is estimated that overhead cost totaling $48,223 are chargeable

to jobs worked on during the period. An estimate of overhead
applicable to each job must be made because it is impossible to
determine the exact amount applicable. The entry is as follows.
•   Wip………….. $48,223.00
• MOH Control ………………… $48,233.00
• To recorded overhead applied to job during the period.
•  Transfer of finished goods
• During the month, some jobs were completed and transferred to
the finished goods warehouse. The job costs $150,000. This flow
of goods is shown by a debit to finished goods and credit to work
in process.
• Finished goods. 150,000
• W I P………………………….. 150,000
• To recorded the transfer of finished goods.
 Sales of Finished goods

• During the month finished goods costing

$160,000 were sold to various customer. The
entry to record the flow is as follow.
• Cost of good sold ………….. $160,000
• Finished goods ………….. $160,000
• To recorded cost of good sold.
 End of period statement

•The cost accounts in the general ledger contain essential figures needed to
complete the statement of cost of goods manufactured and the income
statement. The statement of cost of goods manufactured is supported by a
schedule of manufacturing overhead, which shows details overhead items.
•Schedule of manufacturing overhead End of period

  Actual overhead cost include

•Indirect material…………………………9,851.00
•Indirect labor……………………………24,331.25
• Other overhead cost. 16,790.75
• 50,973.00
•Deduct under applied overhead 2,750.00
•Manufacturing overhead applied 48,223.0 0
•  
 Statement of cost of goods manufactured end of the period

•  Direct material
• Raw material Beginning …………… $ 55,450.00
• Material purchased ………………… 75,000.00
• Total material available for use……. 130,450.00
• Raw material ending ………………. (44,700.00)
• Total material used ………………… 85,750.00
• Deduct indirect material used ……… (9,851.00)
• Direct material used ………………………………. 75,899.00
• Direct labor………………………………………… 70,544.20
• Manufacturing overhead applied…………………… 48,223.00
• Total manufacturing cost……………………………194,666.20
• Add wip-beginning ………………………………… 45,500.00
• Less wip ending ……………………………………. (90,166.20)
• Cost of goods manufactured ……………………….. 150,000.00
 Chapter three
Material control
3.1 INTRODUCTION
•  The word material (Raw material) may include, Direct material,
indirect material, and supplies. Therefore, materials refer to all
types of commodities consumed in the process of manufacture.
 3.2 NEED FOR CONTROL OF MATERIALS
•  In most manufacturing businesses, the cost of raw materials is
a major part of the total manufacturing cost of each product.
Decisions regarding materials and their management are based
on product knowledge, good judgment, and accurate, up to the
minute data. Some of the problem involved is the following:
• Quality and cost of materials must meet the specification on
which sales price are based.
• Materials must be protected from loss or the theft.
• Correct quantities and types of materials must be on hand at
the right time for production to move on schedule.
• Risks of spoilage and obsolescence must be minimized.
• Cost of material handling and storage must be kept to a
minimum.
•  From company to company the specific procedures and
methods for controlling materials vary. The size of the
company, the type of product manufactured and the nature
of the organization are some of the factors involved. Most
modern systems of inventory control include the following
features.
• Formal procedures for ordering and paying for
materials.
• Physical safeguarded for reaching, storing, and
issuing materials.
• Perpetual inventory system to provide a
written record of the quantity and value of
each type of material received, issued, and on
hand.
 3.3 MATERIAL PURCHASING PROCEDURES

• The responsibility for purchasing materials is given to the purchasing

department or agent. This individual should buy materials at proper
time, at the most economical cost, and in correct quantities to the
company.
• The purchasing staff keeps informed of various sources of supply,
negotiates purchase contracts, prepares purchase orders, and follows
through on delivery. The routine work of the purchasing staff begins
upon receipt of a purchase requisition.
•  a) Reorder Routine: - Now you need to look at the typical recorder
routine step by step. To determine when an item has reached a level
where it should be reorder you should consider the following factors.
• The frequency at which the material is used.
• The amount of time it takes for the material to be delivered from the
supplier. This is called lead-time.
• The minimum level of materials that should be on hand to ensure that
the company does not run out of the material. This is known as safety
stock
• For examples A.B.C want to have at least 250 sacks of cements on hand at
all time. Since 40 sack of cement are used in production each day and if
takes eight days to receive an order, the reorder point is calculated as
follows.
• Daily usage = 40 x 8 days (lead time) = 320
• Plus safely stock …………………… 250
• Reorder point ………………… 570
•  If an order for cement is processed as expected within eight days, then
these new cement should arrive at A.B.C as the inventory reach the safety
stock level of 250. Even the order is delayed; there will still be 250 sack of
cement on hand to meet production requirements.
• The standard quantity to be ordered varies from item to item. If should
reflect the quantity necessary to get the best price while keeping inventory
at an appropriate level to ensure uninterrupted production. To determine
this quantity, it is necessary to consider the cost of placing an order as well
as the costs of caring the items in the inventory. The cost of placing an
order includes.
• Costs of maintain the purchasing department
• Cost of operating the receiving department
• Clerical costs of processing an order
• The cost of carrying items in the inventory includes.
• Costs of handling and storing materials
• Insurance costs
• Losses due to the theft, obsolescence, and spoilage
• Clerical cost of maintaining inventory control
•  To determine the most advantageous number of units to order;
a special formula called EOQ has been developed. It is computed
as indicated below
• EOQ= 2*annual requirement *cost of an order
cost to carry a single item
For ABC a single sack of cement cost to order is
$2.5 and caring cost $1.25 and if the firm requires
10,000 sack of cement for the year: then the EOQ is
calculated as follows
EOQ= 2*10,000*2.5/1.25
=40,000
=200
• b) Purchase requisition: - Once the quantity of material falls
below Reorder point, the
• Storeroom supervisor completes a purchase requisition
requesting that material should be
Ordered.
The purchase requisition is a properly approved (authorized),
written request for materials.
An original and one copy of the purchase requisition should be
prepared.
The Original should be sent to the purchasing unit or
department as a request for the materials.
• c) Purchase order: - When the purchasing staff receives the
purchase requisition, a supplier should be selected. In most
cases several suppliers are asked to quote prices or make
bids. In choosing a supplier, the purchasing unit considers
dependability, quality of materials, delivery date, and
similar factor as well as price.
• After the supplier has been chosen, the purchasing agent
prepares a purchase order.
• The purchase order represents written authorization to the
supplier to ship the specified materials.
• This form contains all necessary details, such as delivery
date, method of shipment, unit price, and account number
to be charged. The number of copies prepared varies from
company to company.
• Most companies prepare in five copies.
• (1) The original is sent to the supplier
• (2) Two copies are maintained by the purchasing unit in an unfilled order
file.
• (3) One copy is sent to the storeroom for verification.
• The storeroom clerk compares the purchase order with the requisition
and keeps the Purchas order in an on-order file.
• The final copy tells the receiving clerk when the materials should arrive.
• This procedure gives time for any preparation like space and so forth.
• For internal control purpose all purchase order should be pre numbered.
At the end of the month the cost accountant verifies that all numbered
form either have been sent to the supplier or are on hand. This
mechanism ensures that purchase orders are used only for authorized
person.
• The sample for purchase order is indicated below
 
• Receiving report: - When materials are received from the suppler,
they go to the receiving clerk. The receiving clerk is responsible for: -
Unpacking them
• Checking quantities and physical condition
• Delivering them to the storeroom.
•  At a time materials may be of such a technical nature that laboratory
tests must be conducted to make sure that they meet all
specification. In this case, the receiving clerk counts the items to
make sure of the quantities. Laboratory personal test the materials
and send a report on the results to the purchasing units. The
receiving clerk’s copy of the purchase order is a blind copy. This
means that it does not indicate the quantities ordered. It ensures an
independent check of quantities by the receiving clerk.
•  After counting and inspecting the materials, the clerk prepares a
receiving report. The receiving report shows all details of the
shipment, including comment on the condition of materials received.
 3.4 COMPARING DOCUMENTS

•  When the invoice is received from the supplier, it is sent to the

purchasing unit. Many companies prefer the invoice to arrive before the
shipment, because it allows, for verification of the purchase order before
the shipment is accepted. The purchasing units hold the invoice and the
purchase order in the open purchase order file until the receiving report
is available for comparison. The purchasing unit compares the supplier
invoice (purchase invoice) with the purchase order and receiving report to
make sure the following point.
•  Goods ordered must have been received in good condition and same as
indicated on the purchase invoice.
• Details on the invoice like, terms, unit price, shipping charge agrees with
order specifications.
• Correct computation.
•  If all documents agree, responsible person in purchasing unit, attaché
together one copy each of the invoice, receiving report, and purchase
order and keep them in a completed purchase file alphabetically by
supplier. Next step is preparing disbursement voucher which should also
reflect the value of items net of damaged and rejected with other
documents will be sent to the accounting department.
 3.5 RECORDING THE VOUCHER

• When accounting department receives the voucher, invoice, and

attached paper; verifies extension and footing compute discounts, and
checks all other computation. The voucher clerk also checks that all
supporting documents are included in the file and that they are properly
approved and signed. This double check is part of the internal control
system.
• After verifying the account distribution against the purchase order, the
voucher clerk enters the purchase in the voucher register as a debit to
Raw material account and credit to voucher payable. After entry is made
in the voucher register, the voucher is sent to the treasurer’s office and it
will be filed in the unpaid voucher file according to the last date on which
the discount may be taken.
• 3.6 PAYING VOUCHER
• Before the due date, the voucher is removed from unpaid voucher file. A
staff from treasury department will prepare a check for the amount of the
voucher. Then the check will be entered in the check register and will be
sent to the supplier. Then the voucher and the entire supporting
document should be placed in the paid voucher file.
 3.7 PRINCIPLES OF INTERNAL CONTROL

•  The above-discussed purchasing procedures are practical

and efficient. They also follow important principles of
internal control as out lined below.
•  An authorized person must make a request of a purchase.
• A purchase order must be prepared and approved by an
authorized person after a purchase requisition has been
received.
• All materials received must be carefully checked to see that,
they correspond to those ordered and are in good condition.
• Payment is made only upon proper approval.
• To lessen the risk of fraud or error, the steps in the
purchasing procedure should be delegated to different
individual.
• All documents should be pre numbered.
 UNIT 5
CONTROLLING AND VALUING INVENTORY
• 5.2 INVENTORY COSTING METHOD
•  Most if not all manufacturers keep perpetual inventory records. Unit
costs and total costs should be computed each time materials are
received or issued. The major basis of inventory valuation is cost.
• The accountant should make an assumption about the flow of costs
since unit prices often vary from one purchase to another.
• For inventory valuation purposes, it is not necessary that the flow of
costs match the physical flow of goods.
• It is the responsibility of the accountant to choose inventory
valuation system that beast meets the need of the company.
• The method chosen determine what unit price should be used to
determine the cost of material issued and the ending inventory.
• In this unit it is not discussed the assumption of FIFO, LIFO, and
Moving Average because it is clearly discussed in principles of
accounting part II.
 5.3 VALUATION AT COST OR MARKET, WHICH EVER IS LOWER

•  The inventory valuation method like FIFO, LIFO, and Moving

Average are based on cost.
• Most accountants agree that firms should be conservator
regarding the asset valuation because it is better to understate
than overset its value.
• If the market value of raw materials has declined, the company
will probably have problem selling its product at usual prices. If
the price decline is especially sever, the manufacturer may even
have to sell the product at loss.
• Therefore, accountants may prefer to value raw materials
inventory according to the rule cost or market, which ever is low.
• Market should be interpreted as the cost of replacing materials
(not selling price).
 Lower of cost or market buy item

•  The cost of each item in inventory is

determined according to acceptable valuation
method.
• The replacement cost (current market price)
should be determined for each material.
• Then the basis of valuation (the lower figure) is
identified for each and is multiplied by the
quantity on hand to obtain the value at the
lower of cost or market.
Description Quantity Cost price Market price Valuation Lower of
per unit per unit basis cost or
market
Material W 200 2 2.25 cost 400
Material Z 300 2.75 2.5 Market 750
Inventory 1150
valuation
Lower of total cost or total market
 

• Another method of valuation is to determine

the total cost and the total market value of the
entire inventory. The lower of these total
figures is then used as the inventory valuation
as indicated below.
Description Quantity Cost price Market price Total cost Total
per unit per unit market
Material W 200 2 2.25 400 450
Material X 300 2.75 2.5 825 750
1225 1200
Inventory 1200
valuation
3, Lower of total cost or total market by group
 

• The difference on the preceding plan is to classify inventory

materials by group or department and to determine the lower
of total cost or total market for each classification.
• The lower figure (cost or market) for each group is added to
the lower figure for each of the other groups to obtain the
total inventory valuation.
• Assume materials W and X constitute Group I and material X
and Z constitute Group II the computation required for the
group is as follow
 Cont’d…
Description Quantity Cost per Market Total cost Total
unit price per market
unit
Group I Material w 200 2 2.25 400 450
Material x 300 2.75 2.5 825 750
1225 1200*
Group II Material y 150 3 4 450 600
Material Z 180 3.5 3.25 630 585
1080* 1185
Grand
total 2305* 2385
 5.4 APPLING THE RULE OF COST OR MARKET, WHICH EVER IS LOWER

• If market value is lower than cost, the inventory will be

adjusted to show the lower value.
• This procedure is applied except when selling price are
expected to be not affected by the decline in market price. In
such a case, a write – down of inventory would amount to a
fictions loss.
• Because of that cost rather than market would be used.
Among accountants there is an argument when should the
loss be recognized.
• Some accountant argues that the loss should not be recorded
on the book until the transaction takes place. Others prefer
that the loss be recorded so that overstatement of assets on
the balance that could be prevented.
•  
• When a company adjust inventory to show the lower value one of the
following two methods may be used if perpetual inventory records
are kept.
• To show the new unit values, each material ledger card may be
adjusted.
• A valuation account can be set up to reduce the total value of the
inventory to market. In this case material ledger cards are not
adjusted and will continue to reflect cost.
•  Under the first procedure each material ledger card is adjusted
according to the lower of cost or market value. To determine the new
valuation, the cards are totaled. The loss is recorded by a general
journal entry debiting an account called loss on Reduction of
inventory to market and crediting Raw material. After posting this
entry, the total of the materials ledger cards will agree with the
balance of the Raw material account the general ledger.
• This method results in an increase to cost of good sold for the
difference between the cost and the market value and does not show
the inventory loss as a separate item on the income statement.
• A second procedure, which overcomes this
objection and identifies the inventory loss as a
separate item on the income statement, uses a
valuation account that serves a purpose similar
to that of allowance for uncollectible accounts.
T
• his valuation account is usually called
Allowance for reduction of inventory to
market. It is adjusted at the end of each fiscal
period to value the inventory at the lower of
cost of market.
• Assume the following data for year 2002, 2003, operations.
•  Dec. 31/2002 Dec. 31/2003
• Inventory at cost per material $250,000 $300,000
• Ledger cards
• Inventory at market value $240,000 $297,000
•  On December 31/2002 the adjusting entry, to set up the valuation accounts for
$10,000 the difference between inventory cost and market value.
• Loss on reduction of inventory - $10,000
• To market
• Allowance for reduction of. $ 10,000
• Inventory to market
• To record loss resulting from decline in market value of inventory.
•  In practice the loss on reduction of inventory to market account is treated as an
adjustment of cost of goods sold on the income statement, although there is some
argument for showing it as an adjustment of either the cost of raw materials used or
manufacturing overhead.
•  Treating the loss as an adjustment of the cost of goods sold is very simple and
eliminates the necessity for allocating the loss among the raw materials, work in
process, and finished goods inventories. A partial income statement showing the loss
as an adjustment of the cost of good sold is as follows.
 • ABEBE METAL LTD
• Partial Income Statement
• Year ended December 31- Year 2002
•  Revenue
• Net sales 1,700,000
• Cost of Goods Sold
• Finished goods inventory – Jan. 1 0
• Add cost of goods manufactured $ 1,470,000
• Total Goods available for sale $ 1,470,000
• Deduct finished goods inventory 90,000
• Dec. 31 at cost 1,380,000
• Add loss on reduction of inventory 10,000
• To market
Cost of good sold (1,390,000)
• Gross profit on sale 310,000

• .
• The allowance for reduction of inventory to market account is shown on
the balance sheet as a deduction from inventory.
•  Abebe Metal Ltd.
• Partial Balance sheet
• December 31-2002
•  Inventory at cost $250,000
• Deduct allowance for reduction of
• Inventory to market value 10,000
• Inventory at lower of cost or market $ 240,000
•  At the end of later period, the allowance account will adjusted to reflect
inventory value at that time.
• The example given at the end of 2003, the allowance account balance of
$10,000 should be reduced to $3000, which is the difference between the
cost $300,000, and market value $297,000. To adjust the balance of the
allowance account from $10,000 to $3000, you should debit the
allowance account for $7000, and credit an account called recovery form
decrease in allowance for reduction on inventory to market.
• At the end of later period, the allowance account will adjusted
to reflect inventory value at that time. The example given at
the end of 2003, the allowance account balance of $10,000
should be reduced to $3000, which is the difference between
the cost $300,000, and market value $297,000. To adjust the
balance of the allowance account from $10,000 to $3000, you
should debit the allowance account for $7000, and credit an
account called recovery form decrease in allowance for
reduction on inventory to market. The journal entry will be.
• Allowance for reduction of inventory To market $ 7,000
• Recovery from Decrees in Allowance for reduction on invTo market $
7000
To record recovery resulting from adjustment Of allowance
account
• On the income statement the recovery account will be shown as a reduction in cost
of goods sold as follow.
• ABEBWE Metal Ltd.
• Partial income statement
• Year ended December 31-2003
•  Revenue
• Sales (Net) 1,950,000
• Cost of Goods sold
• Finished goods inventory Jan. 1 $ 90,000
• Add cost of goods manufactured 1,825,000
• Total goods available for sale 1,915,000
• Deduct finished goods inventory Dec. 31 (110,000)
• At cost 1,805,000
• Deduct Recovery from decrease in
• Allowance for reduction of inventory to market (7000)
• Cost of goods sold (1,798,000)
• Gross profit on sales 152,000
• The allowance account balance $3000 at the
end of 2003 will again be treated as a
deduction from the inventory at cost on the
balance sheet. If the cost of inventory should
exceed the market value, the valuation
account is no longer needed. An entry would
be made to close Allowance for reduction of
inventory to market by debiting that account
for its current balance and crediting recovery
from Decrease in Allowance for Reduction of
inventory to market.
 5.5 INVENTORY MANAGEMENT

•  The major objective of inventory

management is to gain highest profit by
keeping the material inventory at the lowest
level consistent with efficient manufacturing
operations.
• Procedures such as holding larger quantities of
materials in storage than are needed for
normal operations, or purchasing required
materials earlier than they are needed for
manufacturer, tie up working capital
unnecessarily.
 5.6 CUTOFF DATE
• To prepare reliable financial statement accuracy in calculating
cost of ending materials, work in process, and finished goods
inventories is essential. For ending inventories to be valued as
accurate as possible, it is necessary that all costs associated
with the items included be recorded. In order to ensure that
these costs have been recorded, business establishes a cutoff
date for including transactions in a specified period.
•  The cutoff date is usually the last day of the company’s fiscal
year or the end of an interim period such as a calendar quarter
or month.
•  The accountant examines transactions just before and just
after the cutoff date to determine if they are properly classified.
• All transaction associated with items in the ending inventories
are included in the current period.
• Transaction affecting events after the cutoff date either are not
recorded or are entered as deferred item.
 5.7 PERIODIC PHYSICAL INVENTORY
Modern inventory control system use perpetual inventory
system. Still, despite carefully planned procedures and
control, some differences often occur between the quantity
of a material on hand and the quantity shown on the
material ledger card. It is necessary to count the materials
on hand periodically to detect errors and to correct the
records.
A physical inventory can be scheduled in one of two ways.
• Inventory taking technique
•  At the end of accounting period, all production is stopped
all employee count and record materials on hand until the
inventory counting is completed the plant does not
resume operation.
• Continues or cycle inventory – under this plan, only a few
materials are counted each day. A schedule is developed
so that materials will be inventoried at lest once each year.
 Adjustment of inventory:

• Adjusting for inventory shortage and overage is done in two steps

•  The individual materials ledger cards must be corrected. A
shortage is recorded by an entry in the issued section of the
materials ledger card for the material found to be short.
• The cost is computed on the regular costing basis (FIFO, LIFO, or
Moving Average) as though the missing materials were being
charged out on a requisition on the closing date of the period.
• An overage is entered in the received section of the materials
ledger card. The cost to be used is the cost of the last issue of that
material.
• A general journal entry is made to adjust the firm’s ledger accounts
for the net shortage or overage.
• If shortage were reveled by the periodic inventory total inventory
shortage would be journalized as a debit to manufacturing
overhead control and credit to Raw material.
• The amount of shortage is also entered under indirect materials
column on the department overhead analysis sheet of the
responsible department.
 5.8 REASON FOR INVENTORY SHORTAGE AND OVERAGE

• 5.8.1 Pressure of large-scale operation

•  Due to large – scale of operation it is certain
that there may be inventory shortage or
overage. Some of the reasons are as follows.
• Failure to complete required paperwork at
each step of the flow of materials.
• Failure to post receipts
• In correct posting receipts and issue
• Computation error in day – to – day posting
• Errors in recognizing the correct cutoff dates.
 5.8.2 The nature of the material

• Spoilage as a result of natural processes or from

poor storage conditions.
• Shrinkage due to such natural cases as
dehydration.
• Computation error arising from different unit of
measurement. Ex. Material might be bought in
ton but issued in kilogram
•  There are also other reasons other than the
nature of material and large scale of operation
which requires the management due attention.
• Losses due to theft of materials by employee.
• Losses arising from theft by outsiders owing to
inadequate plant protection
 Chapter six
TIME KEEPING AND PAYROLL
• 6.1 INTRODUCTION
•  In modern manufacturing operation the second
major cost element is labor cost. The cost must be
controlled for good management. A modern system
of accounting for labor cost includes keeping record
of time worked, computing and recording earnings
and charging costs to production. In this unit, you will
learn about time keeping, computing, and recording
procedures as they relate to the payment of the
wages. The amounts involved are debited to the
Factory payroll clearing accounts.
•  
 6.2 TIME KEEPING PROCEDURE

• Time keeping is the process or procedure for keeping

records of time worked by each employee. It serves as a
basis to calculate employee earnings. From these
amounts appropriate deductions are computed to
determine employee net pay.
• 6.2.1 Time Card
•  Time cards are prepared every month for each employee
by the payroll unit. They are placed in a rack next to an
electronic time clock near the plant entrance. When
employees enter the factory, they select their time cards
and insert them in the clock to record the time of arrival.
Employees then replace their card in the rack. Each time
employee enter or leave the plant, they record their time
in or out in this way. The clerk makes sure that all
employee record his or her time properly and that no
one records a time for an employee who is not present.
 Name __________________
No. ________________
Month_______________

Time card

Regular Extra

Hrs. In Out In Out In Out Hrs.

 
 
 
• 6.2.2 Time Tickets
•  The time card only show the number of hours worked by the
employee, but does not show which particular work the employees
were performing. Some record showing the use of time must be
prepared, since labor costs are charged to specific jobs or department.
For this purpose time ticket or some times called job time card should
be used.
• The time ticket (card) shows the employee’s name and number,
department worked on, operation, starting and stopping time on the
job and time spent on each job.
• It is advisable that all employee weather their labor cost is classified
either direct or indirect labor should fell out the time ticket provided
that their earning is on hourly basis.
 Cont’d…
• Employee no_________ Date---------
• Job no____________ Department------
• Start time_________ hours rate amount-----
• Stop time________
• Operation_______
• If workers who normally do direct labor spend time
performing indirect function (such as cleaning or repairing
machinery) they also complete a section of the time ticket for
this work. The employee doing direct labor will seldom work
on more than one job in a day most employees doing indirect
labor work in only in one department
 Idle time

• Some times it is not possible to charge every hour spent in the factory
to a specific job or department, some non productive, time will bound
to occur no matter how efficient the system is.
• The treatment of idle time differs according to its nature and extent.
• A short time rest in the morning or in the afternoon should not
consider as idle time. It should be absorbed by what ever job the
employee is working on at the time of the break. But some times due
to power interruption, hour lost waiting for material; the company
may have idle time.
• In this case the idle time cost should be charged to manufacturing
overhead cost.
• A time ticket should be prepared for the idle time in exactly the same
manner as for time spent on a job.
• At the end of each week the production manager prepares an analysis
of idle time for appropriate action.
 6.2.3 Daily analysis of Data

•  At the end of the day the clerk suppose to collect

all time ticket and completes the following
procedure.
• Compares the hours shown on each employee’s
time tickets with the total time shown on the
employee’s time card.
• Investigate discrepancies between time ticket and
time card.
• Enter earnings on the time tickets
• Enter in the payroll register the number of hours
worked during the day by each worker.
 6.3 PAYROLL PROCEDURE

•  The record of hours worked each day by hourly wage rate

employees is transferred daily form the time tickets to the
monthly payroll register.
• After all hours worked by each employee during the month
should be entered in the payroll register regular earnings,
overtime premium earning and total earnings are
computed and extended.
• Appropriate deduction are made and entered in the proper
column and net pay for each employee is determined.
• In this course it is assumed that you know how to prepare
payroll and calculate the net earning of employee as per
the ministry of finance rule and regulations
 Cont’d…
• Overtime compensation: - firms engaged in commerce are subject to labor act,
which regulates wages and working hours of employees. This law requires that
employee be paid at one and a half times the regular hourly rate for all time
worked in excess of 40 hours in any one working week.
• For example, an employee with pay rate $10 per hour works 45 hours during a
week five hours are overtime (subject to payment in excess of the regular
rate).
• During these five hours the employee earns his or her regular rate of $10 per
hour place on overtime premium of $5 per hour.
• Thus the employee total pay for five hours of overtime is (15 x 5hrs) $75 of
which (10 x 40) $40 is the regular rate (5 x 5) $25 is the overtime premium.
•  The problem arise as to whether overtime premium should be charged to
specific job as a direct labor or should be charged as manufacturing overhead.
• When charged as overhead, the overtime premium is spread over all jobs
worked on during the period. Some companies charges all over time premium
to manufacturing overhead.
 chapter 7
CHANGING LABOR COSTS INTO PRODUCTION

7.1 INTRODUCTION
•  To charge Labor cost to production an analysis has to be made
to classify the direct labor cost that should be charged to
working process account and the indirect labor cost to be
charged to manufacture overhead control accounts. The last
day of the weekly pay period (assuming employee get their
salary on a weekly basis) usually differs from the last day of the
fiscal period. Therefore it is necessary to prepare an analysis of
time ticket at the end of the month for those labor costs that
have been incurred since the last weekly payroll date and have
not yet been paid. In this unit you will learn how to make this
analysis
 7.2 LABOR COST ANALYSIS

•  7.2.1 Analysis of Payroll

•  Every week or every fifteen days or every month depending
on the policy of the firm an analysis is made of the time
tickets that were filled out by the hourly employees; the
analysis shows the direct labor cost for each department.
• It also indicates the indirect labor costs for each department.
Postings are made from this summary to the job cost sheets
and to the department over head analysis sheet.
• Example assume A.B.C manufacturing enterprise analyze
time ticket every week.
•  The firm has three department namely molding, assembling
and panting department all of them are engaged in
production.
 ABC enterprise
Analysis of time tickets
week ended Jan5,2003

Job Molding Assembling Painting Total

Hrs amount Hrs amount Hrs Amount

No 550 250 2500 420 4200 200 2000 8700

 Indirect labor
Dep Reg.earning O.T Total Summary

Molding 450 200 650 D.L=8700

Assembling 350 150 500 IL=1150

Job cost sheet Job No
customer------ Date started--------
description _____ Date completed -----
Quantity________

Material Direct labor MOH-

Control

date Rf no amount Molding Assembling painting date ref

date ref hrs am hrs amou hrs amo

nt unt

250 2500 420 4200 200 2000

 Analysis of semi monthly (or monthly) Payroll

•  The semimonthly or (monthly) payroll is also analyzed. This

Payroll represents the wage earned by employee, such as
custodial workers and factory office personnel, who are on a
fixed monthly salary. Their earning is classified as indirect labor
and is earned in the department overhead analysis sheet.
• The indirect wages paid in each department are entered in the
indirect labor column of the appropriate department overhead
analysis sheet.
•  7.2.2 Analysis of Unpaid Wage
•  The last day of the weekly pay period usually differ form the
last day of the fiscal period. Therefore it is necessary to
prepare an analysis of time tickets at the end of the month for
that labor cost that have been incurred since the last weekly
payroll date but have not yet been paid. Assume the following
example.
• ABC manufacturing enterprise
• Summary of factory wage
• January 2002
•  
• Payroll Molding Assembling Panting General Total
• Period Factory_________
• Direct indirect Direct indirect Direct indirect Direct
• Jan.1-5= 4350 340 5530 450 4450 550 2355 =$18,025
• 6-12= 3240 450 6320 360 5580 470 3320 = 19,740
• 1-15= -0- -0- -0- -0- -0- -0- 5570 = 5570
• 13-19= 5240 336 6420 240 4990 385 2455 = 20,066
• 20-26= 6320 600 6000 380 5000 420 4300 = 23,020
• 16-31= -0- -0- -0- -0- -0- -0- 5570 = 5570 27-
31= 5000 320 5500 600 6000 220 1000 = 8,640unpaid
• Total =$24,150 2046 29,770 2030 26,020 2045 24,570 110,631
•  
• Summary
• D.L = 79,940
• I.L = 30,691
• Total= $110,631
• A.B.C Enterprise
• Analysis of time ticket
• Jan.27-31 (Unpaid Wage)
•  
• Molding Assembling Panting Total
• Hrs Amount Hrs. Amount Hrs. Amount
• 200 5000 240 5500 280 6000
16500
•  
• Indirect Labor
• Department Regular earning Total
• Molding 320 $ 320
• Assembling 600 $ 600
• Painting 220 $ 220
• General factory 1000 $1000
• Total 2140
•  
• To charge labor cost to the production the following entry will be recorded.
• Work in Process - 79,940
• MoH. Control - 30,691
• Factory payroll clearing control – 110,631
Date Explanation P.R Debit Credit Balance Dr or Cr

Jan. 8   Wp 18,025   18025-Dr

12   Wp 19,740   37765- Dr

15   Sp 5570   43335- Dr

19   Wp 20,066   63,401- Dr

26   Wp 23,020   86,421- Dr

31   S-p 5570   91,991- Dr

31       110,631 18,640-Cr

The unpaid wage will be shown as a credit balance on the factory payroll clearing account a
below.
Factory payroll clearing account
W.p- Stands for weekly payroll
S.p - Stands for Semi monthly payroll
The Credit to factory payroll clearing ($110,631) Consists of January earnings both paid and
• Paid Unpaid Total
• Direct labor chargeable to work in process
$ 63,440 16,500 79,940
• Indirect labor chargeable to MOH. Control
28,551 2140 30,691
• Total labor credited to Factory payroll
91,991 18,640 110,631
• clearing account
 7.3 FLOW OF COST
•  As a result of time keeping and computing procedure labor costs flow into the
factory payroll clearing accounts. Cost flow out of the account as the direct and
indirect labor cost are applied to production. The steps in the complete cycle are
given below for review.
•  Record the number of hours worked each day by each employee on time card.
• Record the hours and type of work performed each day by each employee on a
time ticket.
• Convert the labor hours into dollar amount
• Rescored the total earning, deduction and net pay of all employees for a payroll
period in the payroll register. Post the totals from the payroll register to the
general ledger accounts
• Post the earnings, deduction, and net pay for each employee to an individual
earnings record, which provides cumulative figures for the year
• Charge the direct labor costs to the individual job sheets. Enter the indirect
labor costs on the departmental overhead analysis sheets by means of posting
from analysis of end – of- month unpaid earnings
• Prepare a general journal voucher based on the monthly labor summary. Post
the amounts to the work in process account, the manufacturing overhead
control account, and the factory payroll clearing account.
 7.4 FRINGE BENEFIT COST

•  Fringe benefit includes vacation and holiday pay, workers

compensation insurance, pension plans, hospitalization
insurance, and group life insurance. Some firms charge this
cost to manufacturing overhead control.
• They are entered on the appropriate departmental
overhead analysis sheet as they are incurred. For example,
if a factory employee is paid while on vacation, the
earnings are charged to manufacturing overhead control.
• They are entered on the overhead analysis sheet of the
department in which the employee regularly works. This
procedure is the most common one.
• Other companies do classify the fringe benefits associated
with direct labor as part of the direct labor cost rather than
as manufacturing overhead
• The end of chapter 7
 UNIT 8 DEPARTMENTALIZING OVERHEAD COST

• 8.1 INTRODUCTION
•  In job cost system, the costs of direct materials and
direct labor are charged to specific jobs. All other
costs, including indirect materials and indirect labor,
are changed to manufacturing overhead.
•  In this unit, you will learn how the many other
manufacturing costs are classified, recorded
summarized, and distributed. On the next two units
you will learn the steps involved in charging
overhead costs to production
 8.2 TYPES OF MANUFACTURING OVERHEAD COST

•  Manufacturing overhead includes all factory costs

other than direct materials and direct labor. The
followings are common costs in manufacturing firms.
•  Indirect material
• Items used in small amount in the manufacturing
process
• Factory office supplies
• Small tools.
• Packing materials
• Lubricants
• Shop supplies
 Indirect labor

• Overtime premium of direct workers (unless the

time is identified with a specific job).
• Idle –time costs of direct workers
• Purchasing employee
• Storeroom clerk
• Store room supervisor
• Factory line supervisor
• Factory clerical workers
• Time keeper
• Factory superintendent
 Other manufacturing overhead
Employee fringe benefit
• Spoiled goods
• Property tax
• Fire and casualty insurance
• Group insurance for factory employees
• Repair & maintenance
• Workers compensation insurance
• Payroll tax.
 8.3 CONTROL OF MANUFACTURING OVERHEAD COST

•  The size of the company

• How it operate
• The types of product manufactured are key factors that have
an important bearing upon the method used to account for
manufacturing overhead cost.
• A small company producing only one product or a few
products may simply keep a separate general ledger account
for each manufacturing overhead cost. If there were many
different types of overhead costs, manufacturing overhead
analysis sheets would be maintained. These analysis sheets
function as a subsidiary ledger that is controlled by the
manufacturing overhead control accounts in the ledger. This
account summarizes the data in the analysis sheets.
 8.4 DEPARTMENTALIZATION OF OVERHEAD COST
•  In large businesses it is necessary to divide the factory operations into
departments become the center for effective control of costs. There are
two method of achieving cost departmentalization.
1,  SEPARATE CONTROL ACCOUNT
•  One method is to maintain a control account for each different
manufacturing overhead cost.
• In a subsidiary ledger, analysis sheets are used to show the amount
chargeable to each department. For example a control account for indirect
labor through out the factory may be set up.
• A record of the indirect labor costs charged to each department in the
factory is maintained in the subsidiary ledger made up of analysis sheet.
•  The disadvantage of this method is, when there are many different types
of overhead costs, it is necessary to have a large number of general ledger
account and the procedure of posting to the control account then be
comes inefficient.
• Because of this reason it is not used by most manufacturing firms.
 2, SINGLE CONTROL ACCOUNT

•  The second method of a controlling cost departmentalization is to set up

one control account for all manufacturing overhead costs. (This cut down
the number of accounts in the general ledger).
• The subsidiary ledger may be organized in two ways.
– By type of cost
– By department
• a) Subsidiary ledger by type of cost- a subsidiary ledger account may be
kept for each manufacturing overhead cost.
• For example- a separate account would be established for indirect
material.
• This arrangement eliminates many entries in the general ledger and
accumulates data by type of cost.
• It does not however accumulate the total factory overhead cost by
departments. Department total are needed at the end of the accounting
period
 8.5 RECORDING OVERHEAD COST

•  Entries for indirect materials from material

requisitions and indirect labor from labor time
analysis are recorded on department
overhead analysis sheet.
• Other manufacturing overhead cost are
posted from disbursement voucher (purchase
from out side) and at the end of the month
from general journal vouchers (ex adjusting
entries to cover accrued or differed costs)
•  
• Additional analysis is required to obtain this information.
• b) Subsidiary ledger by department: The subsidiary ledger
accounts may also take the form of department overhead
analysis sheets. This is the practice in most manufacturing
enterprise because it offers the most efficient control of
costs. Each sheet contain special column for recording
common types of overhead costs such as the following:
• - Indirect material - Repair and maintenances.
• -Indirect labor -Utilities
• - Payroll tax - Insurance
• - Depreciation - Other expense
• Each sheet also contains another column for entry
infrequent costs
 Vouchers register entries
• .The cost of repair, utilities, or other overhead items purchased
from outsiders is usually obtained from an invoice. A control
routine is similar to the one, discussed in unit 3
– The invoice is compared with the purchase order, and all
computation are charged
– A voucher is prepared, including a notation of the department to be
charged
– Upon approval of the voucher, the purchase is entered in the
voucher register as a debit to manufacturing overhead control and as
a credit to voucher payable
– The cost clerk charges the cost to the appropriate department
overhead analysis sheet.
 GENERAL JOURNAL VOUCHER

•  Most of the manufacturing overhead cost recorded

by the end of the period adjusting entries involves
fixed costs that do not vary from month to month.
For example depreciation charges, taxes, and
property insurance usually remain constant each
month. These fixed costs are recorded by adjusting
entries. To speed up the journalizing of the
adjustments and to facilitate posting to the
department overhead analysis a journal voucher
can be quickly prepared from schedule.
•  
• Schedule of monthly fixed
• Overhead charge
•  Department Depreciation of Depreciation of Property Total
• Equipment buildings tax =
• Production 1 3450 95 3545
• Production 2 4000 100 4100
• Production 3 5240 120 3360
• Building service 300 2540 145
2985
• General factory 550 120 670
• Total 13,540 2540 580
16,660
 Date--------------
Account Acc No Debit Credit

Manufacturing-OH Control   16,660  

Accumulate – dep. Of eq.     13,540 _________

Acc. Dep – building .     2540

Properly tax     580

 8.7 SUMMARY SCHEDULE OF DEPARTMENTAL COSTS

•  At the end of the month, the cost clerk totals the department overhead analysis
sheets. The clerk then prepares a schedule showing the total amount of each
type of cost incurred in each department. For example, A.B.C manufacturing
company’s schedule of department overhead data is us follow.
• A.B.C manufacturing Ltd.
• Schedule of department overhead cost
• Production Production2 Production 3 Build General Service
• Service
• I- material 3000 2000 1000 200 500
• I – Labor 2000 1450 2100 5000 13,450
• Depreciation 3450 4000 5240 300 550
• Properly 95 100 120 145 120
• 8545 7550 8460 5645 14,420
•  When all charges have been entered for the month, the subsidiary ledger should
agree with its related controlling accounts.
• The total amount of overhead shown on the department overhead analysis
sheet will equal the total charge (debits) in the general ledger account
manufacturing overhead control.
 8.8 ALLOCATING OVERHEAD TO JOBS

• You have seen where all the debit entries in the manufacturing
overhead control account come from and how they are entered on
department overhead analysis sheets.
• Now the credit side of the control account must be examined.
• Much more is involved than simply transferring the total
manufacturing overhead costs to working process in a quick journal
entry.
• This procedure would produce only a vague total cost of production.

• The goal of accounting is to obtain specific, precise unit cost data.

• The overhead costs must be associated with products or jobs so that
the transfer (the cost flow) will actually parallel the workflow.
Distributing overhead cost to department is the first step in this over
all allocation process
 8.9 DISTRIBUTING SERVICE DEPARTMENT COST

•  Service department help producing departments and other service

departments to operate efficiently. But service department do not
produce goods themselves. The manufacturing overhead expense charged
to service department operation must be redistributed to where goods are
produced. (These goods produce the revenue needed to pay for costs)
•  Service department costs should be distributed in proportion to the
services provided.
• There are usually as many separate distribution computation as there are
service departments.
• Ex. Building service provides floor cleaning, heating and culling service for
all other department.
• The general service department serves all other department including the
building service department.
• This mutual exchange of services might cause difficulty in apportioning
service department costs because the apportionment and apportionment
could be repeated endlessly.
 Continued…
• To solve this problem most enterprise adapts the following rules.
• Distribute first the costs of the service department that serves the
greatest number of other department
• Distribute second the costs of the service department that serve
the next greatest number of other department
• Follow this procedure until all service department costs are
distributed.
• If no one department services a larger number of other service
departments, apportion the costs of the service department with
the largest expenditure first.
• Once the cost of a service department have been apportioned no
farther costs are prorated to it
 8.9.1 Basis For Allocation
•  The costs of each service department are redistributed by ratios
that express the relationship between the services provided and
some functional factor or basis.
• For example buildings service cost may be redistributed
according to the floor area occupied by other deportments. This
guideline is logical because the larger the area the more
sweeping, cleaning, and other service required.
• On the other hand, since general service expenses include the
cost of factory management, it would be equally logical to
allocate these costs in proportion to the amount or value of the
labor or labor and materials that are being supervised and
controlled.
• Thus direct labor cost, direct labor hours and even conversion
costs may be used as meaning full base.
 1) Allocating Building Service department costs

• The cost of building service department is appertained first

because it provides service to all other department.
•  This apporeshment at the end of the month is made on the basis
of the factory floor space occupied by each of the other
department.
• Department Sq. feet percent
• General service 22,000 31%
• Production I 18,000 26%
• Production II 16,000 23%
• Production III 14,000 20%
• Total; 70,000 100%

• Building service cost $5645

• Dep. Dollars Percent
• General services ---------5645 X 31% = 1749.95
• Production I------------- 5645 X 26% = 1467.7
• Production II-------------5645 X 23% = 1298.35
• Production III-------------5645 X 20% = 1129.00
• 100% 5645.00
 8.10 RECORDING OVERHEAD DISTRIBUTION IN THE GENERAL LEDGER

• At the end of the month the distribution of overhead costs is

entered in the general ledger by serious of general journal
entries.
• Manufacturing overhead control is closed in to five special
department overhead account so that the ledger will reflect the
same departmentalized data as summarized in the departmental
overhead analysis sheets.
• Ex. MOH – Production I dep – 8545
• MOH – Production II dep - 7550
• MOH – Production III dep - 8460
• MOH – Bulding dep - 5645
• MOH – General service dep – 14,420
• MOH Control________________ 44,620
• 2 . Distribution of service department cost are
journalized in order of allocation
• a) Building service department is allocated
• MOH – General service dep – 1749.95
• MOH – Production I dep – 1467.70
• MOH – Production II dep – 1298.35
• MOH – Production III dep – 1129.00
• MOH – Building service dep – 5645
• Prorating building service dep. to other dep
• b) General service dep- costs are allocated to the producing
department
• MOH – Production I dep – 5545.096
• MOH – Production II dep – 6292.520
• MOH – Production III dep – 4332.334
• MOH-General service dep- 16,169.95
• After completing the entry Manufacturing Overhead Control
account, MOH account of general service department and
MOH account of Building service account will have “O”
balance
 UNIT 9
SETTING OVERHEAD RATES
• 9.1 INTRODUCTION
•  After manufacturing overhead cost have been accumulated by
departments, they must be allocated to jobs or departments. In
this unit you will learn how the cost accountant selects bases for
allocating the departmentalized overhead costs to specific units of
production.
• 9.2 PURPOSE OVERHEAD RATES
• Management cannot wait until the end of the year, or even until
the end of the month, to find out how much a particular job costs.
• Cost data are most useful when they are immediately available.
They can then be used to evaluate efficiency, to suggest changes in
procedure and to help in setting profitable selling price.
• The cost accountant is usually expected to support the
total cost of a job as soon as it is finished. At this time
the actual total overhead cost are not available, as they
would be at the end of a fiscal period.
• For example – various bills such as telephone or utility
bills, may not arrive before a job is completed.
• The accountant must device a method rapidly and
reliable to estimate the overhead costs applicable to the
completed job.
• Since these costs are not yet fully known, predetermined
overhead rates are used for estimating overhead costs
 DETERMINING THE OVERHEAD RATES

• The basic procedure for determining an overhead rate is

quite simple. First a relationship is formed between the
company’s total overhead costs and some second factor
or basis that relates to the overhead costs of the job in a
realistic way.
• The basis must also be accurately measurable.
•  The basis for allocating overhead might be an amount or
quantity, such a direct labor costs, material costs, or direct
labor hours.
• The ratio between the total overhead costs and the basis,
expressed as a percent is called the overhead application
rate
 Departmental and factory rates

•  A small plant with only one or a few similar departments

manufacturing very few types of goods may successfully
use a single common rate for the entire factory.
• However, if several different types of product are
manufactured, or if all product do not go through all
departments, a single rate is not appropriate. Nor is a
single rate suitable if some departments perform largely
machine operation and other departments use primarily
hand labor.
• In such a case, a separate rate must be used for each of
the producing departments
 TYPES OF OVERHEAD RATE BASES

•  The primary purpose of using predetermined overhead rates is to

charge a fair share of overhead costs to each job. A number of
basis for determining overhead rates may be used in computing
factory wide rates and in setting departmental rates.
• The most common basis are the following:
• unit of production
• Material costs
• Machine hrs
• Direct labor hrs
• Direct labor cost
• The cost and production figures used in the calculation are usually
derived from budget estimate
 Continued…
• The following budgeted data are extracted
• From Zenu House hold producing enterprise
• Manufacturing overhead costs for the year $ 96,000
• Number of units of production in the year 24,000 units
• Direct material costs for the year $ 470,000
• Direct machine hrs for the year 11,000
• Direct labor hrs for the year 38,000
• Direct labor costs for the year $198,000
• 9.4.1 Unit of Production Method
•  Overhead may be applied on the basis of the number of units
manufactured during the period.
• The estimated manufacturing overhead cost is divided by the
estimated total number of units of production to get the overhead to
be applied to each units of production.
•  Estimated manufacturing overhead cost = overhead cost par
• Estimated units of production unit of production
•  = $96,000 = 4 per unit
• 24,000
• If a job of 2500 units were produced, the overhead applied to the job
would be
• (2500 X $4) = $10,000
• 9.4.2 Material Cost Basis
•  Overhead may be applied on the basis of the cost of direct materials used to
produce the product. The estimated manufacturing overhead cost are divided by
the estimated direct material
• Estimated manufacturing overhead cost = percentage
• Estimated direct material cost of material cost
•  
= $96,000 = 20%
• $470,000
• If direct materials consumed on a specific job cost $ 22,000, the overhead applied
to the job would be (22,000 X 20%) = 4400
• For material cost to make a good rate base each article manufactured must require
approximately, the same amount of material or material usage must be distributed
uniformly through the manufacturing process. In practice, most overhead cost
bear little relationship to materials used, there for this base in rarely used.
 9.4.3 Machine Hours Basis

•  Overhead may be applied as a rate for each machine

hrs when work is performed primarily by machines.
• A large part of the manufacturing overhead costs
consists of depreciation, power, repair, and other
costs associated with machinery.
• Thus a logical relation ship exists between the use of
the machinery and the amount of cost incurred.
• To determine this basis, divide the estimated
manufacturing overhead cost by the estimated
number of machine hours to get the rate for each
machine hour.
• = Estimated manufacturing overhead cost = Rate per machine
• Estimated machine hrs hrs
•  
• = 96,000 = $8.7 = rate per machine hrs
• 11,000
•  If a job requires 500 machine hrs, the overhead applied would be $8.7 X
500 = $4350
• In a highly automated factory where machine perform most of the labor
and each time goes through a similar sequence of machinery, this basis
makes since.
• However, a machine hrs basis is not a curate if differ]rent kinds of
machine are used for various products.
• In such case, variation in original cost, operation cost, machine speed,
and labor cost would make this rate in appropriate as an overall formula
 9.4.4 Direct Laber Hours Basis

•  Overhead may be applied as a rate for each direct labor hours. This
widely used method assumes that overhead costs tend to vary with
the number of hours of direct labor used.
•  The estimated manufacturing overhead costs are divided by the
estimated number of direct labor hours to obtain an application
rate for each hours.
• = Estimated manufacturing overhead cost = Rate per machine
• Estimated direct labor hrs labor hrs
• = 96,000 = $2.53 =
• 38,000
•  If a job required 2455 direct labor hrs to be completed the
overhead applied would be.
• (2455 X 2.53) = $6211.15
 Continued…
• The direct labor hours basis is usually appropriate if labor
operations are a major part of the production process and
the wage rates paid different workers vary considerably.
• As a general rule there is correlation between total
manufacturing overhead costs and the number of direct
labor hours worked.
•  However, the direct labor hrs method requires a record of
the number of direct labor hours spent on each day,
which may necessitate additional record keeping.
• Total labor costs are part of the company record, but
separate computation of total hrs is not typically made
• 9.4.5 Direct Labor Cost Basis
•  Overhead may be applied as a percentage of cost of direct labor. This
method is the most widely used overhead application basis because it is
simple and easy to use. Information concerning direct labor cost of each
department and each job is available from the payroll record and the time
tickets.
•  The estimated manufacturing overhead cost is divided by the estimated
direct labor costs.
• This calculation results in the percentage of direct labor costs.
• = Estimated MOH = Percentage of direct labor
• Estimated direct labor Costs
• = 96,000 = $48%
• 198,000
•  If the direct labor costs incurred on a particular job totaled $5750, the
applied overhead would be ($5750 X 48%)=$2760.
 9.5 SELECTING OVERHEAD BASIS

•  The following guideline should be used in order to select the

overhead basis
• The rate must be easily computed
• The factor chosen as the basis must be one that can easily be
measured for each job.
• There must be some direct relationship between the amount
of overhead costs incurred and the factor chosen as a basis.
• The basis should be representative of the overhead costs
applicable to each unit
• Department rates should be used if possible.
• As a result a number of different basis many be selected to
meet the needs of different departments.
 8.11 SUMMARY

•  The most effective way to achieve control of costs is by

departmentalization. Overhead costs may be departmentalized
by one of the two methods.
• A separate control account is used for each cost, and a subsidiary
ledger shows the amount chargeable to each department.
• Or a single control account is used for all costs, and the subsidiary
ledger account takes the form of an overhead analysis sheet for
each department.
•  Indirect materials and indirect labor costs are recorded from
materials requisitions and labor time analysis.
• Other manufacturing overhead appears in the voucher register or
general journal voucher. After total overhead costs are known,
they must be associated with specific department
 UNIT 10
PROCESS COSTING SYSTEM

• 10.1 INTRODUCTION
• In the previous units, you have seen the accounting
cycle of the Job –order-costing system which is
product costing system appropriate to manufacturing
firms that produce custom mode products which
differ according to the differences in customer’s
specifications. In this unit the accounting treatment
of process costing system, which is a product costing
system used when continuous mass production of
standard products will be discussed
• In process costing the whole process is averaging. The averaging process is
affected by the method of process costing employed. Depending on the nature
of the manufacturing process, the company may use the weighted average or
the first in, first out method. In either of the methods there is a need to
accumulate manufacturing costs using separate work in process general ledger
accounts to each department or process. Then based on the production
report, equivalent units are computed, which are the basis to compute
equivalent unit costs. For each cost element the accumulated material and
conversion costs of each process are divided by the equivalent units of the
related cost element in order to determine the equivalent unit cost of each
cost element. Once the equivalent unit cost by each cost element is
determined the accounted costs of each process are applied to the units
completed and transferred out to the next process and to the units remained
in the same process for farther processing in the next period or to the ending
work- in process inventory.
• The above discussed process will be simply if
1. There are no beginning inventories.
2. There is no abnormal spoilage, shrinkage, or waste
3. The flow of all manufacturing cost is uniformly applied in the
manufacturing processes. If the above three points do not met,
the accounting for process costing system will be difficult under
conditions where the above there points do not meet, the
following cost flow assumptions should be used:
• Weighted average – method
• First –in, first –out method. These two methods will be
discussed later in related topics.
 THE GENERAL CHARACTERISTICS OF PROCESS COSTING

•  The essential characteristics of process costing system

are:
– The production is continuous and mass production and the
final product is the result of a sequence of processes or
departments.
– Costs are accumulated by processes or operations or
department.
– The products are standardized and home generous.
– The cost per unit produced is the average cost which is
calculated by dividing the total process cost by the number of
units produced
– The finished product of each but last process becomes the row
material for the next process.
 DESCRIBE THE FIVE KEY STEPS IN PROCESS COSTING

• Introduction: In process costing system to determine the cost per unit

of the product, you need to follow five key steps
•  Step 1. Summarize the flow of physical units.
• Step 2. Compute output in – terms of equivalent units.
• Step 3. Summarize the total costs to account for, which are the total
debits to work – in
• Process inventory account of the related process.
• Step 4. Compute equivalent unit costs.
• Step 5. Apply costs to units completed and to units in the ending WIP
inventory.
•  The first two steps are based on physical or engineering terms. The
dollar impact of the production process is measured in the final three
steps and these three steps are affected by the cost flow assumptions
 10.4 PROCESS COSTING SYSTEM

• Process costing with no beginning Inventories

and with uniform application of manufacturing
costs.
•   Under process costing where there are no beg
balances, the five steps mentioned above will be
simple to apply. The only thing to do is to
summarize and compute equivalent units based
on the production report and then to determine
the equivalent unit costs dived the accumulated
cost of the related dep’t by the equivalent units
• Illustration
• Fitsum food processing companies begin operations on Oct 2, 2002. During
the month of October, 4800 units of its product were started in production
in the first department, the mixing Department. Of these, all but 1000 were
completed during the month and transferred out to the second department,
the cooking department. All materials had been added to the 1000 units but
only 50% of the labor & overhead (conversion costs) had been added. The
costs increased during the month were direct materials, $120,000, direct
labor $88,000; and manufacturing overhead, $71,100
•  Summarize Physical units and computation equivalent units for mixing dep’t
• Determine equivalent unit costs and supply costs to the completed and the
incomplete units
• Recorded the necessary J. entry to show
 Step 2 Setp2
(2 ) Equivalent units
Flow of Production Physical units Material Can. Cos.
Work – in process beginning -0 - (No work done previous period)
Started during current period 4800
Units to be accounted for 4800
Completed & transferred out
From beg. Inventory -0 -
Started & completed 3800 3800 3800
Work in process ending 1000(50%) 1000 500
Unit accounted for 4800 4800 4300
Equivalent units (work done current periods 4800 4300
     Details
Costs Total
Direct Conversion
material Cost

Work – in process –beg 0    

Costs Added currently 279,100 120,000 159,100
Step.3 Total costs to be accounted 279,100    
Divide by equiv. Units   ÷ 4800 ÷ 4300
Step. 4 Equivalent units 62 25 37
Step. 5 Applying costs: 235600    
Cost Trans. Out 3800 (62)    
W/P Inv, ending      
Material 25000 1000(25)  
Conversion costs 18500    
Total W/P ending 43500   500(37)
Total costs Accounted for 279100    
 Continued…
• 10.5 PROCESS COSTING UNDER CONDITIONS WHERE THERE ARE BEG. INV AND
WHERE MFG. COSTS ARE NOT APPLIED UNIFORMLY.
• Introduction: In the previous discussion process-costing system was assumed
under conditions where there are no beginning inventories and where material
and conversion costs are applied uniformly through the manufacturing
processes. In this unit you will learn process costing system where there are
beginning inventories and when materials are applied at the beg of the 1st
process and at the beg or end of the subsequent process and where conversion
costs are uniformly applied through the processes. Under this condition the two
cost flow assumption that may be used are (1) weighted average process
method. (2) FIFO Method
•  Process costing under the weighted average method.
•  The weighted average method combines the beginning work – in process
inventory and the manufacturing costs incurred in the current period to
determine a single cumulated total costs to be accounted for, the respective
department during a given period of time usually a month. This cumulative
amount is the summation of the total manufacturing cost elements. The total of
each cost element is divided by the equivalent units of the related cost element
in order to determine equivalent unit cost to each cost element. The equivalent
unit cost is then the basis to apply costs to the units completed and transferred
out and the units, which are to remain in the ending, work in process inventory.
• Illustration:
• A Company has two processes. Material is introduced at the
beginning of the process in Dep’t A, is completed, goods are
immediately transferred to department B, A goods are
completed in Department B, then they are transferred out to
finished goods inventory.
•  The Company adds direct materials at the beginning of the
process in department
• A. Conversion cost was 75%. Complete as to the 8000 units in
working process on may 1, 2002, and 50% complete as to the
6000 units in work in process on may 31, 2002. During May,
2002 units were completed and transferred out to Department
B Analysis of the costs relating to work –in process and the
production activity for may are follows:
 Costs
Direct materials Conversion costs
Work in process, beginning Br. 9,600 Br. 4,800
Costs added in may 15,600 14,400

Required:
(1) Determine the cost of the units completed and transferred out to department B.
(2) Determine the cost of the units remained incomplete in Department
A. (Work – in process, ending)
To do the above illustration, you should appl y the five key steps in process costing.
Step 1. Summary of ph ysical units.
Work – in process beginning --------------------- 10,000 units
Started in current period ----------------------------- 10,000 “
Units to be accounted for ----------------------------- 20,000 “
Step 2. Compute out –put in terms of equivalent units.
Equivalent units
Direct materials Conversion costs
Completed and transferred --------------- 12,000 12,000
WIP Ending ----------------- 6,000 3,000
Equivalent units 18,000 15,000
Step 3. Summarize the total costs to account for.
 Material Costs Total
Work –in processes Br. 9,600 Br. 4800 Br.14, 400
Costs Added Currently 15,600 14,400 30,000
Total costs to account for 25,200 19,200 44,400
Step 4. Compute equivalent unit costs
 Equivalent unit cost $ for Direct M:
Br. 25,200 = 1.4 /unit
18000 units
 Equivalent unit cost for conversion costs:
= Total costs to account for CC
Equivalent units for CC
= Br. 19200 =Br.1.28 /unit
15000 equ.units.
 Total equivalent unit cost =Br 2.68/unit
=Equivalent unit cost for direct material plus equivalent unit cost for conversion costs
• Step 5. Applying costs
• To units completed and transferred out:
• 12000 units X Br. 2.68 =Br. 32,160
• To units in the ending work - in -process inventory:
Material ----------------------- 6000 units X Br.1.4 = 8400
• Conversion Costs ------------ 3000 units X 1.28 = 384
• Total cost work in process, ending =
12240
The above detailed work can be placed in a report form: as follows

Step 2 Steps 2
Physical Equivalent units
Flow of production units Direct M Can. Costs
Work in process Beginning 10,000
Started in current period 10,000
Unit to account for 20,000
Completed and Transferred Out. 12,000 12,000
Work – in process, ending 6,000 3,000
Equivalent units 18,000 15,000
Costs Total Direct Materials Conversion costs
Work – in process, beginning Br 14,400 Br. 9,600 Br. 4,800
Costs added currentl y 30,000 15,600 14,400
Steps 3
Cost to account for Br. 44,400 Br. 25,200 Br. 9,200
Divided – equivalent units ÷ 18000 ÷1 5 0 0 0

Step 4. Equivalent unit costs

Step 5. Appl ying costs:
Completed and trans.
Out (12000 units) Br. 32.160 12000(02.68)
Work – in process, Ending
Materials Br.8, 400 6000(Br. 1.4) 1.40
Conversion Costs 3840 3000(Br.1.28)
Total Costs of W/P, ending 12,240
Total Costs accounted for Br. 44,400