01 Full CH Cost and Management Accounting Chapter 1 Copy 1

CHAPTER ONE
INTRODUCTION TO COST AND

MANAGEMENT ACCOUNTING
Introduction to Management Accounting
Management Accounting can be defined as the
process of identification, measurement, accumulation,
analysis, preparation, interpretation, and
communication of financial as well as non financial
information used by management to plan, evaluate,
control within the organization and to assure
appropriate use and accountability for its resources.
BY: TESFAYE E. (MSc. in Accounting and Finance)

CONT’D
• It consists of accounting techniques and procedures
of gathering and reporting financial data in order to
meet management’s information needs.
• expected to provide timely, accurate information,
including budgets, standard costs, variance analysis,
support day-to-day operating decisions, and
analyses of expenditures.
• It measures and reports financial information as well
as other type of information that assists managers in
fulfilling the goals of the organization.

CONT’D
• The management accounting system is a cost control

system as well as a tool for planning and controlling
operations and suggests solutions to improve
organizational efficiency and productivity of the
organization as a whole.
• It also gives the manager the importance of non
financial factors, which can be crucial factor that
determines the innovative capacity of the organization
particularly, the human factor in all organizations.
• There fore, it is important to design a management
accounting system to be profitable in short term as well
as in the long term in a dynamic and unpredictable
global market.
CONT’D
Specifically, the followings are some of the
purposes of Management accounting.
Formulating over all strategies and long range
plans
Resource allocation decision such as product and
customer emphasis pricing.
Cost planning and cost control operations and
activities.
Performance measurement and evaluation.

1.2 Financial and Management Accounting
Accounting system takes economic events and

transactions, such as sales and purchases, and process
the data in to information helpful to managers, sales
representatives, production supervisors and others.
Processing any economic transaction means
collecting, categorizing, summarizing and analyzing.
For example, costs are collected by category, such as
materials, lobar and overhead. These costs are then
summarized to determine total cost by month,
quarter, or year.
BY: TESFAYE E. (MSc. in Accounting and

Finance)
Cont’d
• Financial accounting includes all the principles that
regulate the accounting and reporting for financial
information that must be disclosed to people outside the
company, to stockholders, bankers, creditors, and brokers.
• In contrast, management accounting exists primarily for the
benefit of those inside the company, the people who are
responsible for its operations.
• Management and financial accounting have differing goals.
• Management accounting measures analyzes, and reports
financial and non financial information that helps managers
make decision to fulfill the goals of an organization.

Cont’d
• Management accounting focuses on internal
reporting.
• Financial accounting focuses on reporting to
external parties such as, investors, government
agencies, banks and suppliers.
• It measures and records business transactions and
provides financial statement that are based on
Generally Accepted Accounting Principles
(GAAPs).
• managers are interested in both management
accounting and financial accounting.
The difference between managerial accounting and financial accounting
Areas of Comparison Financial Accounting Management Accounting
1. Primary users of Persons and organizations outside the business Various levels of internal management
information entity
2.Purpose of the Information Communicate organization’s financial and operating Help managers make decisions to fulfill an
information to investors, banks, regulators and organizations goal
other outside parties
3. Types of accounting Double entry system Not restricted to double entry system; any useful
systems system can be used
4. Restrictive guidelines Adherence to GAAP No formal guidelines or restrictions, only criterion is
usefulness
5. Units of measurement Historical (past) Monetary unit Any useful monetary (historical and future) or
physical measure such as machine hours, labor
hours etc
6. Focal point for analysis Business entity as a whole Various segments of the business entity.
7.Report Summarized report; concerned primarily with the Detailed report; concerned about details of parts of
entity as a whole the entity’s products, departments, territories
7. Frequency of reporting Periodical on a regular basis When ever needed; may not be on a regular basis
8. Degree of objectivity Demands objectivity; historical in nature Heavily subjective for planning purposes, but
objective data are used when relevant and future in
nature.

Finance)
1.3 Functions of the Management Accountant
• Management accountant provides a staff function.
• He/she gives advice and assistance to line managers.
• Management accountants contribute to the
company’s decision about strategy, planning and
control by Scorekeeping, Attention directing, and
Problem solving.
1. Score keeping function:The followings are some of
the scorekeeping functions an accountant will provide.
 Recording sales, purchase and payroll data
 Preparing financial reports
 Preparing depreciation schedules
Cont’d
2. Attention directing function: For example, the

followings are attention directing functions provided by an
accountant.
 Highlighting rapidly growing market opportunity
 Variance analysis and interpretation
 Explaining performance report
3. Problem solving function: The followings are some of the
decision area in which the management accountant gives
problem solving function.
 Make or buy decision
 Add or drop decision
 Sell at split off or process
BY: TESFAYE E.further decision
(MSc. in Accounting and
Finance)
1.4 Cost Accounting
• Cost accounting is an accounting information system that

records, measures and reports information about cost.
• Every business operates with the objective of making
profit for its owners, which is revenue generated less cost
of producing that revenue.
• Cost Accounting measures and reports financial and
other information related to the organization’s acquisition
or consumption of resource.
• Cost accounting can be applied in any type of
organization but primarily applied in manufacturing
organization that combine and process raw material in to
finished product.
Cont’d
• Cost accounting provides information for both
management accounting and financial accounting.
• Cost accounting is required every where cost
information needs to be collected or analyzed.
 Cost information is required for financial accounting to
determine the cost of goods manufactured or sold and operational
costs while preparing the income statement and to determine the
value of inventories on the balance sheet.
 Management accounting requires cost information to set product
price, to identify potential areas that could be taken care of, or
area of possible cost reduction and the like.
 It is a subfield of managerial accounting that interfaces
with both managerial and financial accounting.
END OF CHAPTER
1
THANK YOU!
Finance)
CHAPTER TWO
COST TERMINOLOGIES
AND CLASSIFICATIONS
A good understanding of the different cost

terminology is essential at least for the following
two reasons.
1. It enables accounting information users to best
use the information provided.
2. Use of common terminology avoids confusion
and misunderstanding among the users.

Cost, Expense and loss
• One of the common confusion in accounting is the distinction
between cost and expense.
• Many people use cost and expense interchangeably.
• Accountants usually define cost as resource sacrificed or
forgone to achieve a specific objective.
• It refers to an outlay or expenditure of money to acquire
goods and services in the course of generating revenue.
• For instance purchase of raw martial represent a cost as the
raw material is used to produce finished goods that generate
revenue when sold.
• However some disbursements are not costs. For example,
payment of dividend is disbursement but it does not help to
generate revenue, hence it is not a cost.
CONT’D
All costs initially represent an asset.

As the asset is used in generating
revenue, the amount consumed becomes
an expense.
The cost of the asset used should then be
recognized as an expense to properly
match revenues and expenses in the
process of determining the income of the
organization over a given period.

Finance)
CONT’D
• For instance, insurance premium paid in advance to
serve the coming period are initially recognized as an
asset (prepaid insurance), but as time passes on, the
asset is continually converted in to an expense
(Insurance expense).
• Another example may be a motor vehicle bought for
use for the coming five years is an asset when
initially purchased. However, as the asset is used up
in the process of generating revenue, the cost
gradually becomes an expense.
• Thus, expenses are expired costs or costs used up in
the course of generating revenue.
CONT’D
 The distinction between cost and expenses is
important for the preparation of financial statement
for service, merchandising and manufacturing firms.
 In fact, it has more importance relatively for
manufacturing enterprise.
 This is because, costs incurred in the manufacturing
process don’t become expense until the product is
sold and thus, items that are fully or partially
manufactured represent costs and should be
recognized as assets on the balance sheet.
CONT’D
Some times, a firm may incur a cost

that produces neither immediate nor
future benefit.
This is called a loss. For example
damage caused by fire or flood on
property held is a loss.

Finance)
Cont’d
 Cost object: is any thing for which a separate measurement

of cost is desired.
In manufacturing company, the cost object is the unit of
finished goods manufactured.
 Cost Accumulation and cost Assignment: A costing system
typically account for costs in two basic stages, accumulation
followed by assignment. Cost accumulation is the collection
of cost data in some organized means of accounting system
and cost assignment is a general term that encompass both
(1) tracing accumulated cost that have direct relationship to
the cost object and (2) allocating accumulated costs that
have an indirect relationship to the cost object.

Cont’d
 Cost driver: is any factor that affects total cost.
That is a change in the cost driver will cause a
change in the level of the cost of a related cost
object.
For example, the following are some of the cost
drivers used for each types of costs mentioned.
• Mile driven for transport cost
• Length of time of call for telephone cost
• Metric cube of water consumed for water cost
• Unit sold for cost of goods sold
Finance)
Cont’d
 Cost management: cost management is the

essence of cost accounting.
- Cost management refers to the planning and
execution of activities both in the short run and
long run to control costs.
- cost management is about cost reduction but it
is not confined to it alone.
- Some times managers may incur additional
costs in order to increase their future sales.

2.2 Classifications of Cost
• There are several standard cost classifications
and each classification has its own unique
terminology.
1. Time Period for Which the Cost is computed
It can be Historical costs are those costs that were
incurred in past period and Future costs,
generally called budgeted costs, are those costs
that are expected to be incurred in the future
period.

Finance)
Cont’d
2. Management Function
• Manufacturing company’s functional areas
generally include manufacturing, marketing, and
general administration. One individual, such as a
vice president of manufacturing or a vice
president of marketing, has primary responsibility
for a specific functional area. To evaluate the
effectiveness of the functional area and the
individual in charge of it, costs also must be
grouped by functional area as follows.
Cont’d
A. Manufacturing Costs - include costs from the acquisition of raw
materials through production, until the product is turned over to the
marketing division to be sold. Manufacturing costs include the cost of
the raw materials, payroll costs for people working on the product,
and incidental costs such as taxes, power, depreciation, and repairs
associated with manufacturing the product.
B. Selling Costs - are all costs associated with marketing and selling a
product. They include all costs incurred by the marketing division
from the time the manufacturing process is complete until the product
is delivered to the customer. These costs include advertising,
promotional offers, freight to deliver the product, and warehouse costs
while the product is waiting to be sold.
C. Administrative Costs are all costs associated with the management of
the company and include expenditures for accounting, legal, and
administrative activities. Interest costs are also included among
administrative costs.
Finance)
Cont’d
3. Generally Accepted Accounting Treatment

The alternatives in accounting for a cost are to expense it
or to capitalize it.
I. Periodic Costs are costs that are expensed in the
period in which they are incurred.
II. Product Costs consist of all costs associated with the
manufacturing function of the business.
III.Capital Costs are similar to product costs in that they
are also capitalized as assets. However, capital cost is
the term used to describe the equipment, building and
land held permanently for making business.

Finance)
CONT’D
4. Traceability to Products
a. Direct Cost: is a cost that can be economically traced
to a single unit of finished product. For example;
direct material & direct labor are direct costs
b. Indirect Cost: is one that is not directly traceable to
the manufactured product. It is associated with the
manufacture of two or more units of finished product,
or is an immaterial cost that cannot be economically
traced to single units of finished product. For example:
Cost of electricity, Depreciation of equipment, indirect
labor, indirect material, Cost of different utilities, Cost
of repair and maintenance, Insurance for the factory
are indirect costs.
Finance)
Cont’d
5. Cost Behavior
• Cost behavior describes how a cost changes with
time or with changes in volume.
A. Variable costs are costs that vary proportionately
in total as the volume of production or sales
changes.
Fixed cost remains constant in amount as volume of
production or sales changes.

Finance)
Cont’d
6. Decision Significance
• A decision involves making choices among
alternative courses of action.
i. Relevant cost is future costs that differ with the
various decision alternatives. They are costs that
make a difference in a decision-making process.
ii. Irrelevant Costs do not relate to any of the
decision alternatives, are historical in nature or are
the same under all decision alternatives. Irrelevant
costs are generally excluded from the analysis.

Finance)
CONT’D
7. Managerial Influence
• Managerial influence refers to the ability of a manager to
control a particular cost.
• Remember that all costs are controlled by some one at some
level in the organization if the time period is long enough.
• However, when we see for a particular manager at a
particular level in the organization and for a short period of
time, there are some costs that can be influenced and some
that cannot.
A. Controllable costs are subject to significant influence by a
particular manager within the time period under
consideration.
B. Uncontrollable costs are those costs over which a given
manager does not have a significant influence.
Cont’d
8. Commitment to Cost Expenditure

I. Committed cost is one that is an inevitable
consequence of a previous commitment.
II. Discretionary Cost, also called a
programmed cost or a managed cost, is one
for which the amount or the time of
incurrence is a matter of choice.

Cont’d
9. Other Cost Classifications
• Several other cost classifications are frequently used in discussing cost
accounting and management decisions.
A. Marginal Costs, also called incremental costs, are the costs that are associated
with the next unit or the next project. The term marginal cost is widely used in
economics to refer to the added cost associated with the production of an
additional unit of output.
B. Out- of – Pocket Cost: is a cost that must be met with a current expenditure.
Expenditure associated with a particular decision alternative.
C. Sunk Costs: are defined as past costs that have already been incurred. Because
sunk costs are historical costs, they are generally irrelevant to decisions
affecting the current or future use of the asset.
D. Opportunity Cost: is defined as the cost or value of an opportunity forgone
when one course of action is chosen over another. Opportunity cost is not an
out-of –pocket cost, or even a future cost associated with the selected
alternative, but represents the lost opportunity associated with each of the
alternatives that are rejected.
2.3 Manufacturing Costs
Accounting for manufacturing process has the finished products

as the primary cost object.
A. Direct Material: Direct material includes the raw material
component that can be physically identified with or traced to
the finished product.
B. Direct Labor: Direct labor includes the wage of employees
who work directly on the product and whose efforts can
economically be traced to a particular unit.
C. Indirect Manufacturing Costs: All manufacturing costs other
than direct materials and direct labor are classified as indirect
manufacturing costs. There are several other titles commonly
used to describe this group of manufacturing costs, including
factory overhead, manufacturing overhead or factory burden.

Cont’d
Prime Costs and Conversion Cost

• Prime costs and conversion cost are two other
terms used to describe production costs.
a) Prime Costs are the most important or significant
costs traceable to unit of finished product. They
include direct material and direct labor.
• Conversion costs are those required to convert raw
materials into finished product and consists of
direct labor and factory overhead
Prime cost = Direct Material Cost + Direct Labor Cost
Conversion cost = Direct Labor Cost + Manufacturing Overhead Cost
Finance)
END OF CHAPTER
2
THANK YOU!
Finance)
UNIT 3
JOB ORDER COSTING SYSTEM
• The job order cost system accumulate costs

applicable to each specific job order or lots 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.
CONT’D
• 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.
CONT’D
• Manufacturers, such as a furniture

manufacturer, who produce a verity of
products, often use the job order cost
system.
• Because such producers need to keep track
of each specific order to ensure correct
allocation of costs.
• Also, the actual cost shown on the job cost
sheet may be compared with the estimated
costs on which sales prices were based.
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.
1. Procurement – Raw materials and supplies
needed for manufacturing are ordered, received
and stored. Direct and indirect factory labor and
services are obtained.
2. Production - Raw materials are transferred
from the storeroom to the factory. Labor tools,
machine, power, and other costs are applied to
complete the product.
CONT’D
3. Warehousing – Finished goods are moved from the

production floor to the warehouse and remain there
until they are sold.
4. 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;
CONT’D
A. 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.
B. Production – An account is required to gather
procurement costs as they become chargeable to
manufacturing operation and this account is called
work in process.
CONT’D
C. Warehousing – an account should be setup to record the
cost of goods that have been completely manufactured. This
account is finished goods.
D. 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 sold is maintained.
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.
Cont’d
 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.
Cont’d
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 account.
RECORDING COST FLOWS, RAW MATERIAL,
LABOR, OVERHEADS
• 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.
EXAMPLE: 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.
Cont’d
• 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: -
I. Dep. 1 – rough lumber is trimmed and shaped into finished form for
use in manufacturing Furniture.
II. 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.
III. 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.
Cont’d
 Building service and Administration department – which include:
• Accounting section
• Procurement
• Personnel
• Janitors
• Maintenance
 General ledger accounts maintained by 3F with beginning balance are as follows
• Raw material = beginning balance = $55,450
• Work in process = beginning balance = 45,500
• Finished goods = beginning balance = 29,500
• Factory payroll clearing
• Manufacturing overhead control.
Cont’d
• 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.
Cont’d
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 $ 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
Cont’d
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
Cont’d
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
Wip ……… $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.
Cont’d
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.
Cont’d
• It should be remembered that, the credit to MOH
control is an estimate.
• This will usually be a small balance in the account.
• A debit balance means that less overhead was
charged, or applied, to production than the total
cost incurred.
• This is called under applied overhead.
• If the estimated overhead transferred is greater
than the actual costs incurred, manufacturing
overhead control will have a credit balance.
• This is called over applied overhead.
Cont’d
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 …………$48,223.00
To recorded overhead applied to job during the period.
Cont’d
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.
Cont’d
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.
Cont’d
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.
Cont’d
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…………………48,223.00
Cont’d
• 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
Cont’d
INDIVIDUAL ASSIGNMENT
• A.B.C furniture manufactures bookshelves. The
total manufacturing cost for September is as
follows.
1. Raw marital purchased $92,430.00
2. Raw material used – direct materials $82,475.00 indirect
materials, $16,175.00
3. Factory wage earned $106,620.00
4. Factory wage allocated direct labor-$84,060, indirect labor
$22,560
5. Other overhead cost incurred $30,563 (credit the total to
voucher payable)
6. Estimated manufacturing overhead cost applied to jobs
worked on $67,248
Cont’d
7. Finished goods transferred to ware house $229,348
8. Finished goods sold and shipped to customer $231,898
9. Finished goods sold and billed to customer $336,252
• Instruction
A. Prepare a journal entry
B. Assuming beginning balance of
• Raw material-----$64820 Dr
• Work in process-----$48,370 Dr
• Finished goods-------$32,090 Dr
• Calculate the cost of goods manufactured
END OF CHAPTER
3
THANK YOU!
Finance)
CHAPTER 4
PROCESS COSTING SYSTEM
• Process costing system is product costing system which

is applied when identical units are produced in mass.
• Identical units are assumed to take the same amount of
direct material, direct labor & manufacturing overhead.
• These costs are accumulated over a period of time and
the total cost is assigned to units produced in the period
the cost is accumulated.
• In process costing system, each unit is assumed to take
equal amount of direct material, direct labor and
manufacturing overhead.
BASE OF COMPARISON
JOB ORDER COSTING PROCESS COSTING
Type of product Diversified, heterogeneous and Homogeneous products produced
unique products continuously
Cost accumulation By job for a specified number By department or cost center for a
of units specified period of time
Work in process One for each job One for each department
Basic document Job cost sheet for each job Cost of production report for each
department or cost centers
Cost per unit Cost accumulated by job Cost accumulated by cost centers
divided by units in job divided by equivalent unit of
production during a period of time
Reporting By job By cost center or department

Nature of costs for Each job may use different Each units produced uses the same
each cost object amount of material, labor and slandered amount of materials, labor
overhead cost and overhead cost

Process Costing System – Different Cases
• A company can have as many or as few processing
departments as are needed to complete a product or
service.
• Some products and service may go through several
processing departments, while others may go through
only one or two.
• Regardless of the number of departments involved, all
processing departments have essential features. First,
the activity performed in the processing department
must be performed uniformly on all of the units passing
through it, second; the output of the processing
department must be homogenous.

CONT’D
Illustration 1:
SNAP computers imports component parts of a computer
and its accessories from abroad and assemble computers
here in Ethiopia.
The components parts are first assembled in the assembly
department.
Up on completion, units are transferred to finishing
department for testing, loading the different office
software and packaging.
Since all computers assembled are the same, the company
uses process costing system for cost accumulation.
The process costing system for the computer has two cost
categories (Direct material and Conversion cost).
Cont’d
• Each unit of computers passes through two departments, the
assembly department and Finishing department.
• Every effort is made to ensure that all computers are identical
and meet assets of demanding performance specification.
• Direct material is added at the beginning of the process in
assembly department.
• Additional direct material is added at the end of the process
in finishing department when each computer is completed.
• Conversion cost is added evenly during both processes.
• When the finishing department finishes work on each
computer, it is immediately transferred to finished goods and
taken to warehouse until it is sold.

Cont’d
• In our SNAP computer example, only two cost
classifications, direct material and conversion costs
are necessary to assign costs to products.
• Because all direct materials are added to the
process at one time and all conversion costs are
generally added to the process evenly through time.
• If, however two different direct materials were
added to the process at different times, two
different direct material cost categories would be
needed to assign these costs to products.

Cont’d
 Similarly, if manufacturing labor costs were added to the

process at a different time than when the other
conversion costs were added, an additional cost
category-direct manufacturing cost would be needed to
separately assign these costs to products.
 There are three cases of production of process costing
Case 1: Process Costing with No Beginning or Ending Work-
in-Process Inventory
Case 2: Process costing with zero beginning work-in-process
inventory and some ending working work in process inventory.
Case 3: Process costing with both some beginning and some
ending work-in-process inventory

Case 1: Process Costing with No Beginning
or Ending Work In Process Inventory.
• That is, all units are started and fully completed by the end
of the accounting period.
• This case illustrates the basic averaging of cost data, which
is a key feature of process costing.
• On January 1, 2008, there were no beginnings WIP of
computers in the assembly department.
• During January 2008, SNAP computers started and
completed assembly of computers and transferred out to
finishing department 400 units.
• Additional information for assembly department is given
below:
Cont’d
Physical unit for January, 2008:
 WIP beginning…………………….0 unit
 Started during January………….400 unit
 Completed and transferred……...400 unit
 WIP ending………………………...0 unit
Total cost for January, 2008:
 DM cost added during January…………..Br. 640,000
 Conversion cost added……………………….480,000
Total assembly department cost..Br.1,120,000

CONT’D
SNAP computer should record direct

materials and conversions in the assembly
department as these costs are incurred as
follows:
Work In process – Assembly 640,000
Raw material control 640,000
(To record the use of direct materials in the production process)

Various accounts 480,000
(To record the use of conversion costs in the production process)

CONT’D
• In the above journal entry, various accounts
consists of many accounts that can be credited
when conversion cost is incurred such as cash,
accounts payable, accumulated depreciation,
prepaid insurance etc.
• In this case, average cost can be calculated easily
by dividing the total cost incurred to units
assembled and completed in the assembly
department as follows

CONT’D
• Average cost = Total cost =
Total units completed Br.640,
000 + Br.480, 000
400 units
= Br 2,800
When the 400 units completed in assembly
department are transferred to the finishing
department, the following journal entries will be
recorded:
Work In process – Finishing 1,120,000
Work In process- Assembly 1,120,000
Case 2: Process costing with Zero
Beginning but Some Ending WIP inventory
• Assume that in February, 2008, SNAP computer
place another 400 unit in to the assembly process.
• Because all units placed in production in January
were completely assembled, there is no beginning
WIP on February 1. Because of different reasons, not
all units started in February were completed by the
end of the month.
• Only 175 units are completed and transferred to the
finishing department. Data for the assembly
department for the month of February 2008 are:
Cont’d
• Physical unit for february2008:

WIP beginning(February 1)………………….0 unit
Units Started during February……………..400 unit
Completed and transferred out…………….175 unit
WIP ending ( February 29)………………...225 unit
– Direct material (100% complete)
– Conversion cost (60% complete)
• Total cost for February:

DM cost added during February……………Br.640,000
CC cost added during February………………..372,000
Total assembly department cost…………..Br.1,012,000

Cont’d
• The 225 partially assembled units as of February 29,
2008, are fully processed with respect to direct materials.
• This is because; all direct materials in the assembly
department are added at the beginning of the assembly
process.
• Conversion costs however are added evenly during
assembly process.
• Based on work completed relative to the total work
required to complete each computer units still in process
at the end of February, an assembly department supervisor
estimates that the partially assembled units are on average
60% complete with respect to conversion costs.
Finance)
Cont’d
 The accuracy of the completion estimates of conversion

costs depends on the care, skill and experience of the
estimator and the nature of conversion process.
 Estimating conversion is usually easier for direct material
cost than for conversion costs.
 That is because, the quantity of direct material needed for
completed units and the quantity of direct materials in
partially completed units can be measured more accurately.
 In contrast, the conversion cost sequence usually consists
of a number of basic operations specified for a specified
number of hours, days, or weeks for various steps in the
production process.

Cont’d
The point to understand here is that, a

partially assembled unit is not the same as
fully assembled unit, faced with some fully
assembled units and some partially assembled
units, SNAP Computers calculates in five
steps the cost of fully assembled units and the
cost of partially assembled units still in
process at the end of that month

Cont’d
Step 1: Summarize the Flow of Physical Units

• Physical unit’s express the physical flow of
production.
• It is a measure of the units of production that have
been started and that may or may not be
completed.
• The physical units’ summary, tracks where the
physical units came from and where they went.
• It does not consider the degree of completion.
• The physical flow can be summarized as shown in
the schedule below:
Finance)
Cont’d
Physical flow
• Beginning WIP……………………………..XX
• Units started………………………………. XX
• Units to account for………………………...XX
• Units completed…………………………….XX
• Ending WIP…………………………………XX
• Units accounted for……………………..…..XX

Finance)
Cont’d
Step 2: Compute Output in Terms of Equivalent

Units (EU)
• Equivalent units measure output in terms of the
physical quantity of each of the input (factor of
production) that has been consumed when producing
the units.
• Equivalent units are computed using physical units.
• It disregard birr amount.
• Equivalent unit of each major category of production
inputs is calculated using the following formula:
Equivalent unit = Physical unit x Percentage of completion
Cont’d
• For instance, the 225 partially assembled units in

the above case are 100% complete with respect
to direct material.
• This means that the equivalent units in terms of
direct material are 225 units.
• but with respect to conversion cost, they are
60% complete, which means, the 225 partially
completed units are equivalent to 135 fully
completed units (225x60%= 135 units)

CONT’D
Step 3: Compute Equivalent Unit Cost

• After computing equivalent units of partially
completed units in terms of each cost category,
cost per equivalent unit can be computed using
the following formula.
• This cost per equivalent unit can be used to
assign total cost incurred in the period to units
completed and units in work in process ending.
Cost per EU = Production cost
Equivalent units

Cont’d
Step 4: Summarize Total Cost to Account For

• In this step, we add up all costs incurred in the
period.
• For SNAP computer, the cost to account for the
month of February, 2008 is Br. 1,012,000
(Br.640, 000 + Br.372,000 = Br. 1,012,000)

Cont’d
Step 5: Assign Total Cost to Units Completed and Units in Ending
WIP
• In this step, we assign the total cost to account for to units completed
and transferred out and to units in ending working process at the end
of the month.
• The idea is to attach the Birr amounts to the equivalent output units for
direct material and conversion costs of units completed and ending
working process.
• Equivalent output units for each inputs are multiplied by cost per
equivalent unit both for units completed and ending work in process.
• After costs have been assigned to units completed and units in work in
process ending, the total cost assigned should agree with the amount
we have to account for.
• The following cost of production report for SNAP computer
summarizes the five steps discussed above for the month of February,
2008.

(Step 1)
Flow of production Physical flow
Work in process beginning 0
(Step 2)
Units started in current period 400 Equivalent Units
Direct
Units to account for 400 Materials Conversion Costs
Units completed and transferred out 175 175 175
Work in process ending 225 225 135
Units accounted for 400
Work done in current period only
(Equivalent units) 400 310
(Step 3): Cost Summary
Costs added during February Br. 1,012,000 Br 640,000 Br 372,000
Divide by equivalent units ÷ 400 ÷ 310
Cost per equivalent units Br. 1,600 Br. 1,200
(Step 4):
Total cost to account for Br. 1,012,000
(Step 5) Assignment of cost:
To completed and transferred units (175
units) Br. 490,000 Br. 1,600×175 + Br. 1,200×175
To work in process ending (225 units) 522,000 Br. 1,600×225 + Br. 1,200×135
Total cost accounted for Br. 1,012,000
CONT’D
• The cost of production per unit for the month of February is the
sum of the cost per equivalent unit for both direct material and
conversion cost which is Br. 2,800 (Br. 1600 + Br. 1200). The
journal entries for SNAP computer for the month of February,
2008 are given below:

(To record
Variousthe use of conversion costs
accounts in the production
372,000 process)
(To Work
recordInthe
process – Finishing
transfer 490,000
of completed products department to finishing)
from assembly
Work in process - Assembly 490,000

Case 3: Process costing with some beginning
and some ending work in process inventory
• In a production process, in addition to work in
process ending, there might be some work in
process available at the beginning of the
period.
• When this is the case, the five steps in the
preparation of cost of production report involve
two additional inventory costing systems
(Weighted Average and FIFO methods).

CONT’D
Weighted Average Method: The weighted average
process costing method calculates cost per equivalent
unit of all work done to date( regardless of the
accounting period in which it was done) and assigns
this cost to equivalent units completed and transferred
out of the process and to equivalent units in ending
work in process inventory.
• The weighted average cost is the total of all costs
entering the work in process account (whether they
are from beginning work in process or from work
started during the current period) divided by the
total equivalent units of work done to date.
Cont’d
Illustration 3: At the beginning of March, 2008, SNAP computers
had 225 units of partially assembled computers in the assembly
department. It started production of another 275 units in March,
2008; data for assembly department for the month of March are:
Physical units for March 2008
• WIP beginning………………………………225 unit
Direct material (100% complete)
Conversion cost (60% complete)
• Started during March………………………..275 unit
• Completed and transferred out……………...400 unit
• WIP ending………………………………….100 units
Direct material (100% complete)
Conversion cost (50% complete)
Cont’d
Total cost for March:
• WIP beginning:
DM…………………………….Br.360, 000
CC……………………………………162,000 Br.522, 000
• DM added during March……………………………………396,000
• CC added during March……………………………………..327,600
• Total cost to account for…………………………… Br.1, 245,600
The cost of production report for Assembly
department for the month of March using the five
steps is presented below under weighted Average
method.

(Step 1)
(Step 2)
Units to account for 500 Direct materials Conversion costs
Units completed and transferred out 400 400 400
Work done to date (Equivalent units) 500 450
(Step 3) ; Cost summary
Work in process beginning Br. 522, 000 Br. 360, 000 Br. 162,000
Costs added during February 723,600 396,000 327,600
Total cost incurred to date Br. 756,000 Br. 489,600
Cost per equivalent units Br 1,512 Br 1,088
(Step 4)
To completed and transferred units (400
units) Br. 1,040,000 Br. 1,512×400 + Br. 1,088×400
To work in process ending (100units) 205,600 Br. 1,512×100 + Br. 1,088×50
Total cost accounted for Br. 1,245,600
Cont’d
• In the equivalent unit column of work done to date, there are 500
equivalent units of direct materials and 450 units of conversion
costs.
• All completed and transferred out units are 100% complete as to
both direct material and conversion cost because direct material
is added at the beginning of the assembly process and they are
100% complete with respect to conversion cost.
• But units in WIP ending are 50% complete as to conversion cost,
hence the equivalent unit of WIP ending are 50 units (100x50%)
with respect to conversion cost.
• In step 3, the cost per equivalent unit is calculated by merging
together the cost of beginning inventory and the manufacturing
cost of the period and dividing by equivalent units of work done
to date.

CONT’D
• The journal entry to recognize the consumption of raw

material, conversion cost and transfer of assembled
computers from assembling to finishing department
using weighted average costing method is given below:
(To record the use of conversion cost in the production process)

Work in process - Assembly 1,040,000
(To record the transfer of completed products from assembly department to finishing department)

CONT’D
2. First In First Out (FIFO) Method: the first in
first out process costing method assigns the cost of
the previous accounting period’s equivalent units in
beginning work in process inventory to the first units
completed and transferred out of the process and
assigns the cost of equivalent units worked on during
the current period first to completed beginning
inventory, next to started and completed new units,
and finally to units in ending work in process
inventory.
The FIFO method assumes that the earliest equivalent
units in work in process are completed first.
CONT’D
 A distinctive feature of the FIFO process costing method
is the work done on beginning inventory before the
current period is kept separate from work done in the
current period.
 Costs incurred and units produced in the current period
are used to calculate cost per equivalent units of work
done in the current period.
 In contrast, equivalent unit and cost per equivalent unit
calculation under the weighted average method merges
units and costs in beginning inventory with units and
costs of work done in the current period.
CONT’D
• For SNAP computers, Under the FIFO method, equivalent
units of work done in March on the beginning work in process
inventory equals 225 physical units times the percentage of
work remaining to be done in march to complete these units:
0% for direct materials, because beginning work in process is
100% complete with respect to directs material last month and
40% (100%- 60%) for conversion costs, because beginning
work in process is 60% complete with respect to conversion
costs last month.
• The results are 0(0%×225) equivalent units of work for direct
materials and 90(40%×225) equivalent units of work for
conversion cost.
• The following is the cost of production report under FIFO
method.
Finance)

(Step 1)
(Step 2)
Units to account for 500 Direct Materials Conversion Costs

Units completed and transferred out:
From beginning work in process 225 0 90
Started and completed 175 175 175
Work done in current period only 275 315
(Step 3): Cost summary
Work in process beginning Br. 522, 000 Incurred Last Month
Costs added during March 723,600 Br. 396,000 Br. 327,600
Cost per equivalent units Br. 1,440 Br. 1,040
(Step 4)
To completed units (400 units)
Work In process beginning (225 units) Br. 522, 000 -------------------------------------
Cost added to beginning WIP in the current month 93600 0×Br. 1,440 + 90×Br. 1,040
Total from beginning Inventory Br. 615,600
Started and completed 434000 175×Br. 1,440 + 175×Br. 1,040
Total cost of units completed Br. 1,049,600
To work in process ending (100units) 196,000 Br. 1,440×100 + Br. 1,040×50
Total cost accounted for BY: TESFAYE E. (MSc. in
Br. 1,245,600 Accounting
and Finance)
Cont’d
• The equivalent unit of work done on the 175
physical unit started and completed equals 175
units times 100% for both direct material and
conversion cost, because all works on these units is
done in the current period.
• The equivalent units of work done on the 100 units
of ending work in process equals 100 physical
units times 100% for direct materials(because all
direct materials for these units are added in the
current period) and 50% for conversion costs
because only 50% of conversion cost work on
these units is done in the current period.
Cont’d
• Computation of cost per equivalent units for work done

in the current period is only based on direct material
and conversion costs of the current period.
• Under FIFO method, cost of work done in the current
period is assigned, First to the additional work done to
complete the beginning work in process, then to work
done on units started and completed during the current
period, and finally to ending work in process.
• The journal entry to recognize the consumption of raw
material, conversion cost and transfer of assembled
computers from assembling to finishing department
using FIFO costing method is given below
Cont’d


(To record the use of conversion cost in the production process)
Work in process - Assembly 1,049,000
(To record the transfer of completed products from assembly department to finishing department)

Cont’d
• Managers use information from process costing system to aid them in
pricing and product mix decision and to provide them with feedback
about their performance.
• The weighted average method merges units’ costs from different
accounting periods obscuring/confusing period to period comparison.
• Advantages of the weighted method however, are its relative
computational simplicity and its reporting of a more-representative
average unit cost when inputs prices fluctuate markedly from month
to month.
• FIFO provides managers with information about changes in cost per
unit from one period to the next.
• Managers can use this information to adjust selling price and evaluate
performance in the current period.
• By focusing on work done and cost of work done during the current
period, the FIFO method provides useful information for planning
and control purpose.
4.3 Process Costing System and Spoilage
• Spoilage is units of production – whether fully or
partially completed – that do not meet the
specifications required by customers for good units
and that are discarded or sold at reduced price.
• Some examples of spoilage are defective shirts, jeans,
shoes, and carpeting sold as “second hand,” or
defective aluminum cans sold to aluminum
manufacturers for remolding to produce other
aluminum products.
• Accounting for spoilage aims to determine the
magnitude of spoilage costs and to distinguish between
costs of normal and abnormal spoilage
Finance)
CONT’D
• Normal spoilage is spoilage inherent in a
particular production process that arises even
under efficient operating conditions.
• Management decides the spoilage rate it
considers normal depending on the production
process.
• Costs of normal spoilage are typically included
as a component of the costs of good units
manufactured because good units cannot be
made without also making some units that are
spoiled.
Finance)
Cont’d
• Abnormal spoilage is spoilage that is not inherent in a particular
production process and would not arise under efficient operating
conditions.
• Abnormal spoilage is usually regarded as avoidable and controllable.
• Line operators and other plant personnel generally can decrease or
eliminate abnormal spoilage by identifying the reasons for machine
breakdowns, operator errors, and the like, and by taking steps to
prevent their recurrence.
• To highlight the effect of abnormal spoilage costs, companies
calculate the units of abnormal spoilage and record the cost in the
loss from abnormal spoilage account, which appears as a separate
line time in the income statement.
• Issues about accounting for spoilage arise in both process costing
and job costing systems. We first present the accounting for spoilage
in process costing systems using illustrative example

Cont’d
• Illustration 4: ABC Company manufactures a

recycling container in its forming department.
Direct materials are added at the beginning of the
production process. Some units of this product
are spoiled as a result of defects, which are
detectable only upon inspection of finished units.
Normally, spoiled units are 10% of the finished
output of good units. That is, for every 10 good
units produced, there is 1 unit of normal spoilage.
Summary data for July 2009 are:

Physical Direct Conversion Total
Units (1) Materials Costs (3) Costs
Work in process, beginning inventory (July 1) 1,500 Br.12,000 Br.9,000 Br.21,000
Degree of completion of beginning work in 100% 60%

process
Started during July 8,500
Good units completed and transferred out in 7,000

July
Work in process, ending inventory (July 31) 2,000
Degree of completion of ending work in 100% 50%

process
Total costs added during July Br.76,500 Br.89,100 Br.165,600
Normal spoilage as a percentage of good units 10%
Degree of completion of normal spoilage 100% 100%
Degree of completion of abnormal spoilage 100% 100%

Cont’d
• The five – step procedure for process costing used

in the previous sub section need only slight
modification to accommodate spoilage.
Step 1: Summarize the flow of Physical units of
Output. Identify units of both normal and abnormal
spoilage.
Total spoilage = (WIP Beginning + Units started)-
(Good units completed + WIP End)
= (1,500 + 8,500) – (7, 000 + 2,000)
= 10,000 – 9,000
= 1,000 units
Cont’d
• Recall that normal spoilage is 10% of good

output at ABC Corporation. Therefore, normal
spoilage = 10% of the 7,000 units of good output
= 700 units.
Abnormal Spoilage = Total spoilage – Normal
spoilage
1,000 units – 700 units = 300 units

Cont’d
Step 2: Compute output in terms of equivalent units. Compute

equivalent unit for spoilage in the same way we compute equivalent
units for good units. All spoiled units are included in the
computation of output units. Because ABC’s inspection point is at
the completion of production, the same amount of work will have
been done on each spoiled and each completed good unit.
Step 3: Compute cost per Equivalent unit.
Step 4: Summarize Total costs to Account for. The total costs to
account for are all the costs debited to work in process.
Step 5: Assign total Costs to units Completed, to Spoiled Units, and
to units in ending work in process. This step now includes
computation of the cost of spoiled units and the cost of good units.
We will illustrate these five steps of process costing for the weighted
– average and FIFO methods using the example of ABC corporation.
1. Weighted – Average Method and Spoilage

(Step 1)
Work in process beginning 1,500
(Step 2)
Units started in current period 8,500 Equivalent Units
Units to account for 10,000 Direct materials Conversion costs
Good units completed 7,000 7000 7000
Normal spoilage 700 700 700
Abnormal spoilage 300 300 300
Work in process ending 2,000 2,000 1,000
Units accounted for 10,000
Work done to date (Equivalent units) 10,000 9000
Work in process beginning Br.21,000 Br.12,000 Br. 9,000

Total cost incurred to date Br.88,500 Br.98,100
Divide by equivalent units ÷ 10,000 ÷ 9,000
Cost per equivalent units Br. 8.85 Br. 10.90
(Step 4)
Total cost to account for Br. 186,600
To Good units completed (7000 units) Br. 138,250 Br 8.85×7000 + Br 10.90×7000
Normal spoilage 13,825 Br 8.85×700 + Br 10.90×700
Total cost of good units Br. 152,075
Abnormal spoilage 5,925 Br 8.85×300 + Br 10.90×300
To work in process ending (2000 units) 28,600 Br 8.85×2000 + Br 10.90×1000
Total cost accounted for Br. 186,600
CONT’D
• The journal entry to be recorded are
given below:
Work In process – Forming 76,500
(To Raw
record the material
use control
of direct materials in the 76,500 process)
production
Work In process – Forming 89,100

(To record the use
Various of conversion
accounts cost in the production
89,100 process)
Finished Goods 152,075

(To record Work in process
the transfer - forming
of completed finishing department
products from 152,075 to warehouse)
Loss(To
from abnormal
record spoilage
the loss from abnormal 5,925
spoilage)
Work in process - forming 5,925
CONT’D
2. FIFO Method & Spoilage

(Step 1)
Work in process beginning 1,500
(Step 2)
Units started in current period 8,500 Equivalent Units
Units to account for 10,000 Direct materials Conversion costs

Good units completed :
From WIP Beg. 1,500 0 600
Started and completed 5,500 5,500 5,500
Normal spoilage 700 700 700
Abnormal spoilage 300 300 300
Work in process ending 2,000 2,000 1,000
Units accounted for 10,000
Work done in the current period 8,500 8,100
Work in process beginning Br.21,000 ----------------- --------------------
Divide by equivalent units ÷ 8,500 ÷ 8,100
Cost per equivalent units Br. 9 Br. 11
(Step 4)
Total cost to account for Br.186,600
Good units completed (7000 units)
WIP Beginning (1,500 units) 21,000
Cost added during the period 6,600 Br. 9×0+ Br. 11×600
Total from beginning inventory 27,600
Started and completed (5,500 units) 110,000 Br. 9×5,500+ Br. 11×5,500
Normal spoilage (700 units) 14,000 Br. 9×700+ Br. 11×700
Total cost of good units completed Br.151,600
Abnormal spoilage 6,000 Br. 9×300 + Br. 11×300
To work in process ending (2000 units) 29,000 Br. 9×2000 + Br. 11×1000
Total cost accounted for Br.186,600
CONT’D
The journal entry for recording consumption of raw material and
conversion cost is the same as in the weighted average method but the
remaining journal entries are slightly different & are given as follows:
Finished Goods 151,160
Work in process - forming 151,160
(To record the transfer of completed products from finishing department to warehouse)
Loss from abnormal spoilage 6,000

(To record
Work in process the loss from abnormal spoilage)
- forming 6,000
• Note that Costs of abnormal spoilage are separately accounted for
as losses of the accounting period in which they are detected.
However, the cost of normal spoilage is added to the costs of good
units completed in the period.
4.4 Job Costing System and Spoilage, Rework & Scrap
• The concepts of normal and abnormal spoilage can also apply
to job order costing systems. Abnormal spoilage is separately
identified so companies can work to eliminate it altogether.
• Costs of abnormal spoilage are not considered to be
inventorable cost and are written off as costs of the accounting
period in which the abnormal spoilage is detected.
• Normal spoilage costs in job costing systems as in process
costing systems are inventorable costs, although increasingly
companies are tolerating only small amounts of spoilage as
normal.
• When assigning costs, job costing systems generally
distinguish normal spoilage attributable to a specific job from
normal spoilage common to all jobs. We describe accounting
for spoilage in job costing using the following example.
Cont’d
• Illustration: In the BOING Machine Shop, 5
aircraft parts out of a job lot of 50 aircraft parts are
spoiled. Costs assigned prior to the inspection point
are Br. 2, 000 per part. Our presentation here and in
subsequent sections focuses on how the Br. 2, 000
cost per part is accounted for. When the spoilage is
detected, the spoiled goods are inventoried at Br.
600 per part which is the net disposal value.
Cont’d
Normal Spoilage attributable to a specific job: when normal spoilage
occurs because of the specifications of a particular job, that job bears the
cost of the spoilage minus the disposal value of the spoilage. The journal
entry to recognize disposal value is:
Materials Control - spoiled goods (5  Br. 600) 3,000
Work-in-Process Control (specific job) 3,000
• Note, the Work – in – process Control (specific job) has already been
debited (charged)
• Br.10, 000 for the spoiled parts (5 spoiled parts  Br.2, 000 per part).
• The net cost of normal spoilage = Br. 7, 000 (Br.10, 000 - Br.3, 000),
which is an additional cost of the 45(50 – 5) good units produced.
• Therefore, total cost of the 45 good units is Br.97, 000: Br.90, 000 (45
units  Br.2, 000 per unit) incurred to produce the good units plus the
Br.7, 000 net cost of normal spoilage.
• Cost per good unit is Br.2, 155.56 (97,000  45 good units).
Cont’d
Normal spoilage common to all jobs: In some cases, spoilage may be
considered a normal characteristic of the production process. The spoilage
inherent in production will of course, occur when a specific job is being
worked on. But the spoilage is not attributable to, and hence is not charged
directly to, the specific job. Instead, the spoilage is allocated indirectly to the
job as manufacturing overhead because the spoilage is common to all jobs.
The journal entry is:
Materials Control -spoiled goods (5 Br. 600) 3,000
MOH control - normal spoilage (Br.10, 000 - Br. 3, 000) 7,000
Work-in-Process control (specific job): 5 unit  Br.2, 000
10,000
• When normal spoilage is common to all jobs, the budgeted manufacturing
overhead rate includes a provision for normal spoilage cost.
• Normal spoilage cost is spread, through overhead allocation, over all jobs
rather than allocated to a specific job.
Cont’d
Abnormal Spoilage: If the spoilage is abnormal,
the net loss is charged to the loss from abnormal
spoilage account. Unlike normal spoilage costs,
abnormal spoilage costs are not included as a part
of the cost of good units produced. Total cost of
the 45 good units is Br.90, 000 (45 units  Br.2,
000 per unit). Cost per good unit is Br.2, 000
(Br.90,000  45 good units).
Materials Control - spoiled goods (5  Br.600) 3,000
Loss from Abnormal Spoilage: (Br.10, 000 - Br.3, 000) 7,000
Work – in- process control (specific job): 5 units  Br.2,000 10,000
Cont’d
Job costing and Rework: Rework is units of

production that are inspected, determined to be
unacceptable, repaired, and sold as acceptable
finished goods. We again distinguish (1) normal
rework attributable to a specific job, (2) normal
rework common to all jobs, and (3) abnormal
rework.
Cont’d
1. Normal Rework attributable to specific job:
Consider the BOING Machine shop data in illustration
above; assume the five spoiled parts are reworked.
The journal entry for the Br.10,000 of total costs (the
details of these costs are assumed) assigned to the five
spoiled units before considering rework costs is:
Work-in-Process Control (specific job) 10,000
Materials Control 4,000
Wages payable control 4,000
Manufacturing Overhead Allocated 2,000
Cont’d
2. Normal rework common to all jobs:

When rework is normal and not attributable
to a specific job, the costs of rework are
charged to manufacturing overhead and are
spread, through overhead allocation, over all
jobs.
Manufacturing overhead control (rework costs) 10,000
Materials Control 4,00 Wage Payable
Control 4,00
Manufacturing overhead allocated 2,000
Cont’d
3. Abnormal rework: If the rework is abnormal, it is recorded by
charging abnormal rework to a loss account.
Loss from Abnormal Rework 10,000 Materials Control 4,000
Wages Payable Control 4,000
Manufacturing Overhead Allocated 2,000
• Accounting for rework in a process costing system also requires
abnormal rework to be distinguished from normal rework.
• Process costing system accounts for abnormal rework in the same
way as job order costing.
• Accounting for normal rework follows the accounting described
for normal rework common to all jobs (units) because masses of
identical or similar units are being manufactured.
Cont’d
Accounting for Scrap: Scrap is residual material that results
from manufacturing a product; it has low total sales value
compared with the total sales value of the product. No
distinction is made between normal and abnormal scrap
because no cost is assigned to scrap. The only distinction
made is between scrap attributable to a specific job and scrap
common to all jobs.
• When should the value of scrap be recognized in the
accounting records – at the time scrap is produced or at the
time scrap is sold? How should revenues from scrap be
accounted for? To illustrate this, we extend the case of
BOING machine shop. Assume the manufacture of aircraft
parts generates scrap and that the scrap from a job has a net
sales value of Br.900.
Cont’d
1. Recognizing Scrap at the Time of Its Sale

• When the Birr amount of the scrap is immaterial, the
simplest accounting is to record the physical quantity of
scrap returned to the storeroom and to regard scrap
sales as a separate line item in the income statement. In
this case, the only journal entry is:
Sales of Scrap: Cash or Accounts Receivable 900
Scrap Revenues 900
• When the Birr amount of scrap is material and the scrap
is sold quickly after it is produced, the accounting
depends on whether the scrap is attributable to a
specific job or is common to all jobs.
Cont’d
Scrap Attributable to a Specific Job: Job-costing systems
sometimes trace scrap revenues to the jobs that yielded the
scrap. This method is used only when the tracing can be
done in an economically feasible way. For example,
BOING Machine Shop and its customers may reach an
agreement that provides for charging specific jobs with all
rework or spoilage costs and then crediting these jobs with
all scrap revenues that arise from the jobs. The journal
entry is:
Scrap returned to storeroom: No journal entry.
Sale of scrap: Cash or Accounts Receivable 900
Work-in-Process Control 900
Cont’d
• Unlike spoilage and rework, there is not cost
assigned to the scrap, so no distinction is made
between normal and abnormal scrap. All scrap
revenues, whatever the amount, are credited to
the specific job. Scrap revenues reduce the costs
of the job. The journal entry for Scrap common
to all jobs is given as follows
Scrap returned to storeroom: No journal entry.
Sale of Scrap: Cash or accounts receivable 900
MOH control 900
Cont’d
2. Recognizing Scrap at the Time of its Production
• Our Preceding illustrations assume that scrap returned to the
storeroom is sold quickly, is not assigned an inventory cost figure.
• Sometimes, as in the case with edges of molded plastic parts, the
value of scrap is not immaterial, and the time between storing it and
selling reusing it can be long.
• In these situations, the company assigns an inventory cost to scrap
at a conservative estimate of its net realizable value so that
production costs and related scrap revenues are recognized in the
same accounting period.
• Some companies tend to delay sales scrap until its market price is
considered attractive.
• Volatile price fluctuations are typical for scrap metal. In these
cases, it’s not easy to determine some “reasonable inventory value.”
Cont’d
Scrap attributable to a specific job: The journal entry in the
BOING example is:
Scrap retuned to storeroom: Materials Control 900
Work-in-process control 900
Scrap common to all jobs: The journal entry in this case is:
Scrap returned to storeroom:
Materials Control 900
Manufacturing Overhead Control 900
• Observe that the materials control account is debited in place
of cash or account receivable. When the scrap is sold, the
journal entry is:
Sale of scrap: Cash or Accounts Receivable 900
Materials Control 900
END OF CHAPTER
4
THANK YOU!

CHAPTER FIVE
RELEVANT INFORMATION AND DECISION MAKING
5.1 INTRODUCTION
• Managers are charged with the responsibility of managing
organizational resources effectively and efficiently relative to
the organization’s goals and objectives.
• Making decisions about the use of organizational resources is a
key process in which managers fulfill this responsibility.
• Accounting and finance professionals contribute to the decision-
making process by providing expertise and information.
• Accounting information can improve, but not perfect,
management understands of the consequences of decision
alternatives.

CONT’D
• To the extent that accounting information can
reduce management’s uncertainty about economic
facts, outcomes, and relationships involved in
various courses of action, such information is
valuable for decision-making purposes.
• Many decisions can be made using relevant
costing, which focuses managerial attention on a
decision’s relevant (or pertinent) facts.
• Relevant costing techniques are applied in
virtually all business decisions in both short-term
and long-term contexts.
5.2. INFORMATION AND THE DECISION PROCESS

• Decision making is the process of choosing the best course of action

from alternatives available.
• Decision model is a method used by managers for deciding among
courses of action.
• Accounting information (revenue and cost information) are basic inputs
in to decision model.
• However, other quantitative as well as qualitative information can also
be used.
• In general information is divided in to relevant and irrelevant
information.
• Relevant information is information which is useful for decision
making where as irrelevant information is not useful for decision
making.
• The management accountant’s role in the decision making process is to
produce relevant information to the managers who make the decisions.
Cont’d
• Decision making process involves basically the following
activities.
1. Identify and Define the Problem. The most important
phase of decision making process because all other activities
in the process depend on this phase. Incorrectly defined
problems waste time and resources. That is why it is usually
said that defining a problem is solving half of the problem.
2. Specify the Criterion. The phase in which the purpose of
decision is to be made. Is the objective to maximize profit,
increase market share, minimize cost, or improve public
service? For example, cost minimization, increase the
quality of product, maximize profit, etc.

Cont’d
3. Identify Possible Alternatives: Determining the

possible alternatives is a critical step in the decision
process.
4. Gathering Relevant Information. Information
could be subjective or objective, internal or external
to the organization, historical (past) data, or future
(expected) ones.
5. Making the Decision: Select the best alternative
(course of action).

Cont’d
5.3. THE CONCEPT OF RELEVANCE

For information to be relevant, it must
possess three characteristics. It must
(1) be associated with the decision under
consideration,
(2) be important to the decision maker, and
(3) have a connection to or bearing on some
future endeavor.

CONT’D
1. Association with Decision
• Costs or revenues are relevant when they are logically
related to a decision and vary from one decision alternative
to another.
• Cost accountants can assist managers in determining which
costs and revenues are relevant to decisions at hand.
• To be relevant, a cost or revenue item must be differential
or incremental.
• An incremental revenue is the amount of revenue that
differs across decision choices and incremental cost
(differential cost) is the amount of cost that varies across
the decision choices.

CONT’D
• Although incremental costs can be variable or fixed, a general
guideline is that most variable costs are relevant and most
fixed costs are not.
• The logic of this guideline is that as sales or production
volume changes, within the relevant range, variable costs
change, but fixed costs do not change.
• The difference between the incremental revenue and the
incremental cost of a particular alternative is the positive or
negative incremental benefit (incremental profit) of that
course of action.
• Management can compare the incremental benefits of
alternatives to decide on the most profitable (or least costly)
alternative or set of alternatives.
Cont’d
• Some relevant factors, such as sales commissions or prime

costs of production, are easily identified and quantified
because they are integral parts of the accounting system.
• Other factors may be relevant and quantifiable, but are not
part of the accounting system.
• Such factors cannot be overlooked simply because they may
be more difficult to obtain or may require the use of
estimates.
• For instance, opportunity costs represent the benefits
foregone because one course of action is chosen over another.
• These costs are extremely important in decision making, but
are not included in the accounting records.
Cont’d
2.Importance to Decision Maker
• The need for specific information depends on
how important that information is relative to the
objectives that a manager wants to achieve.
• Moreover, if all other factors are equal, more
precise information is given greater weight in the
decision making process.
• However, if the information is extremely
important, but less precise, the manager must
weigh importance against precision.
Cont’d
3. Bearing on the Future

• Information can be based on past or present data, but is
relevant only if it pertains to a future decision choice.
• All managerial decisions are made to affect future events, so
the information on which decisions are based should reflect
future conditions.
• The future may be the short run (two hours from now or next
month) or the long run (three years from now).
• Future costs are the only costs that can be avoided, and a
longer time horizon equates to more costs that are controllable,
avoidable, and relevant.
• Only information that has a bearing on future events is
relevant in decision making.
Cont’d
Example 5.1 ABC Company, a manufacturer of a line

of ashtrays, is thinking of using aluminum instead of
copper in the manufacture of its product.
 Historical direct material cost was Br. 0.50 per unit.
 The company expected future costs for aluminum is
Br 0.40 and it is unchanged for copper.
 Direct labor cost were Br 0.80 per unit and will not
be affected by the switch in materials.
 The analysis in a nutshell is as follows:

Cont’d
Copper Aluminum Difference

Direct material Br 0.50 Br 0.40 Br 0.10
Direct labor 0.80 0.80 -
• In the foregoing analysis, the material cost (the expected future

cost of copper compared with expected future cost of aluminum) is
the only relevant cost.
• The material cost met both criteria for relevant information.
• That is, bearing on the future and an element of difference
between the alternatives. However, the direct labor cost will
continue to be Br 0.80 per unit regardless of the material used.
• It is irrelevant because the second criterion an element of
difference between theBY:alternatives is not met.
TESFAYE E. (MSc. in Accounting and
Finance)
5.4 RELEVANT INFORMATION FOR
SPECIFIC DECISIONS
 In evaluating courses of action, managers
should select the alternative that provides the
highest incremental benefit to the company.
 Rational decision-making behavior includes a
comprehensive evaluation of the monetary
effects of all alternative courses of action.
 The chosen course of action should be one that
will make the business better off.
 Decision choices can be evaluated using
relevant costing techniques.
Cont’d
5.4.1. Special Order Decisions

• One type of decision that affects output level is
accepting or rejecting a special order.
• A special order is a one-time order that is not considered
part of the company’s normal ongoing business.
• In general, a special order is profitable as long as the
incremental revenue from the special order exceeds the
incremental costs of the order.
• Thus, conditions to consider in a special order decisions
are: (i) Customers must be from markets not ordinarily
served by the company, and (ii) the company must
operate below it maximum productive capacity
Cont’d
Example 5.2.Consider the following details of the

income statement, on absorption costing basis (that
is, both variable and fixed manufacturing costs are
included in inventoriable costs and cost of goods
sold), of Hawassa Company for the year just ended
December 31, 2014
Total per unit
Sales (1,000,000 units) Br 20,000,000 Br 20
Cost of Goods Sold 15,000,000 15
Gross Margin Br 5,000,000 Br. 5

Selling and Administrative Expenses 4,000,000 4
Operating Income Br. 1,000,000 Br. 1

CONT’D
• Hawassa’s fixed manufacturing costs were Br

3 million and fixed selling and administrative
expenses were Br 2.9 million.
• Near the end of the year, Shashe Company
offered Hawassa Br 13 per unit for 100,000
unit special order.
• The special order would not affect Hawassa’s
regular business in any way.
• Furthermore, the special sales order would not
affect total fixed costs and would not require
any additional variable selling and
administrative expenses.
Cont’d
Required:
• Should Hawassa accept or reject the special
order?
• Could the special order affect Hawassa’s
regular business? Solution:
a). The correct analysis to the above problem
employs the contribution approach to income
statement, not the absorption or financial
approach that treats fixed costs, i.e., fixed
manufacturing costs as if it were variable.
Cont’d
• Variable manufacturing cost per unit ═ 15,000,000 - 3,000,000 ═
1,000,000
12 per unit
• Total Variable manufacturing cost ═ Br. 12 x 1,000,000 ═ Br.12,000,000
• Variable selling and administrative cost per unit═4,000,000 -2,900,000═1.1per unit
1, 000, 0000
• Total Variable selling and administrative cost ═ Br. 1.1 x 1, 000,

0000 ═ Br.1,100,000( the special order does not affect this cost)
• The analysis would be as follows on comparative contribution
income statement.

Without special order With special order Difference: relevant
1,000,000 units to be sold 1,100,000 units to be sold amount for the 100,000
units of special order
Sales Br. 20,000,000 Br. 21,300,00 Br. 1,300,000
Variable Expenses:
Manufacturing Br. 12,000,000 Br.13,200,000 Br.1,200,000
Selling and Adm. 1,100,000 1,100,000
Total Variable Exp. Br. 13,100,000 Br. 14,300,000 1,200,000
Contribution Margin Br. 6,900,000 Br. 7,000,000 Br. 100,000
Fixed Expenses:
Manufacturing Br. 3,000,000 Br. 3,000,000
Selling and Adm. 2,900,000 2,900,000
Total Fixed Expenses Br.5,900,000 Br. 5,900,000
Operating Income Br.1,000,000 Br.1,100,000 Br. 100,000

Cont’d
• The above comparative income statements for
Hawassa illustrates two key complete to
analyzing relevant revenues for decision:
(1) distinguish relevant costs and revenues from
irrelevant ones and
(2) use the contribution income statement to
focus on whether each variable cost and each
fixed cost is affected by the alternatives(i.e.
reject or accept) under consideration.

Finance)
Cont’d
• In this case, the relevant revenues and costs

are the expected future revenues and costs that
differ as a result of accepting the special offer
sales of Br 1,300,000(Br 13 per unit X
100,000 units) and variable manufacturing
costs of Br. 1,200,000 (Br 12 per units X
100,000 units).
• The fixed manufacturing costs and selling and
Administration costs (including variable costs)
are irrelevant.
Finance)
CONT’D
• That is because these costs will not change in total whether the
special order is accepted or rejected.
• Based on the relevant data analyzed above, Hawassa would
gain an additional Br100, 000 (relevant revenues, Br 1,300,000
less relevant costs Br 1,200,000) in operating income by
accepting the special order. In this example, comparing total
amounts for 1,000,000 units versus 1,100,000 units or focusing
only on the relevant amounts in the difference column in
comparative income statement avoids misleading implication
the implication that would result from comparing the Br 13 per
unit selling price against the manufacturing cost per unit of Br
15 (from Hawassa’s income statement on absorption costing
basis) which includes both Variable and fixed manufacturing
costs.
CONT’D
• Thus, based on the relevant data analyzed above,

Hawassa Company should accept the special order
because it brings an additional income of Br.
100,000 for the company as:
Income with special order Br. 1,100,000
Income without special order 1,000,000
Additional income if the order had been accepted Br. 100,000
B) Yes. Unless Hawassa Company has effectively

segments its market so that the special order to the
Shashe Company does not affect the regular
business. BY: TESFAYE E. (MSc. in Accounting and Finance)
CONT’D
5.4.2. Product Line Decisions
This is a decision relating to whether old product lines or
other segments of a company should be dropped and new
ones added are among the most difficult decision that a
manager has to make. Operating results of multiproduct
environments are often presented in a disaggregated
format that shows results for separate product lines within
the organization or division. In reviewing these
disaggregated statements, managers must distinguish
relevant from irrelevant information regarding individual
product lines. If all costs (variable and fixed) are allocated
to product lines, a product line or segment may be
perceived to be operating at a loss when actually it is not.
CONT’D
• In classifying product line costs, managers should be

aware that some costs may appear to be avoidable but
are actually not.
• For example, the salary of a supervisor working
directly with a product line appears to be an avoidable
fixed cost if the product line is eliminated.
• However, if this individual has significant experience,
the supervisor is often retained and transferred to other
areas of the company even if product lines are cut.
• Determinations such as these needs to be made before
costs can be appropriately classified in product line
elimination decisions.
Cont’d
• For instance, mostly on add or delete decisions,

fixed costs are divided into two categories,
avoidable and unavoidable.
• Avoidable costs are costs that will not continue if
an ongoing operation is changed, deleted or
eliminated.
• These costs are relevant costs in decision
making. Unavoidable costs are costs that
continue even if a subunit or an activity is
eliminated and are not relevant for decision.
Cont’d
• Example.5.3 Ebissa Department store has three
major departments: groceries, general
merchandise, and drugs.
• Management is considering dropping groceries,
which have consistently shown a net loss, as
shown below on statement of departments’
profitability analysis of Ebissa.

Finance)
Departments
Groceries General merchandise Drugs Total
Sales Br. 100,000 Br. 8,0000 Br. 10,000 Br.190,000
Variable CGS &

Expenses 80,000 56000 6,000 142,000
Contribution margin Br. 20,000 Br. 24000 Br. 4,000 Br. 48,000
Fixed expenses:
Avoidable
Br. 15,000 Br. 10,000 Br. 1,500 Br. 26,500
Unavoidable 6,000 10,000 2,000 18,000
Total fixed expenses Br.21,000 Br. 20,000 Br.3,500 Br. 44,500
Operating income Br. (1,000) Br.4,000 Br. 500 Br. 3,500

(loss)

Finance)
CONT’D
Required:
• Which alternative would be recommended if the only
alternatives to be considered are dropping or continuing the
grocery department? Assume that the total assets would be
unaffected by the decision and the space made available by
dropping groceries would remain idle.
• Refer the income statement presented above.
• Assume that the space made available by dropping groceries
could be used to expand the general merchandise
department.
• The space would be occupied by merchandise that increase
sales by Br. 50,000, generate a 30% contribution margin
percentage and have additional avoidable fixed costs of Br.7,
000.
• Should Ebissa discontinue grocery and expand merchandise
department? BY: TESFAYE E. (MSc. in Accounting and Finance)
(A) Total (B) Effect of (A – B) Total
Before dropping after change
change grocery
Sales Br. 190.000 Br 100.000 Br 90.000

Variable COGS and 142.000 80.000 62.000
Expenses
Contribution margin Br 48.000 Br 20.000 Br 28.000

Fixed expenses
Avoidable Br 26.500 Br 15,000 Br 11,500
Unavoidable 18.000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 29,500
Operating income (loss) Br 3,500 Br 5,000 Br (1,500)

Cont’d
• In this analysis, column 2, presents the relevant
revenues and relevant-cost analysis using data from
the grocery column in department profitability
analysis of Ebissa.
• Ebissa’s operating income will be Br.5, 000 (income
with grocery department, Br.3500 less loss assuming
grocery is dropped, Br.1500 or it implies that the cost
savings from dropping the grocery department,
Br.95, 000 (Br.80, 000+ Br.15, 000), will not be
enough to offset the loss of Br.100, 000 in revenues.
• So, under this condition Ebissa’s managers should
decide to keep the grocery department rather
dropping.
Cont’d
• Notice that all of the grocery’s variable expenses

are avoidable and relevant for decision making.
• If the grocery department is discontinued, the Br
6,000 of the fixed expenses will continue, which is
irrelevant.
• And also note that there is no opportunity costs of
using spaces for grocery because without grocery,
the space and equipment will remain idle.
(b) Analysis for dropping the grocery department

and expanding general merchandise.
(A) Total (B) Effect of (C) Effect of (A – B) + C Total
before Dropping Expanding after change
change Groceries General
Merchandise
Sales Br190,000 Br 100,000 Br 50,000 Br 140,000

Variable CGS and 142,000 80,000 35,000 97,000
expense
Contribution margin Br 48,000 Br 20,000 Br 15,000 Br 43,000
Fixed expenses
Avoidable Br 26,500 Br 15,000 Br 7,000 Br 18,500
Unavoidable 18,000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 7,000 Br 36,500
Operating income (loss) Br 3,500 Br 5,000 Br 8,000 Br 6,500

Cont’d
• Effect of expanding general merchandise:

Incremental revenue = Br 50,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (35,000)
Fixed cost =(7,000)
Incremental income = Br 8,000
• Recommendation: As the above analysis shows,
dropping grocery and using the vacated space to
expand general merchandise will be a good
decision.

Cont’d
5.4.3. Make or Buy (In source or out sourcing)

decision
• A concern with subcontracting or outsourcing
has dominated business in recent years as the
cost of providing goods and services in-house is
increasingly compared to the cost of purchasing
goods on the open market.
• Thus, a daily question faced by managers is
whether the right components and services will
be available at the right time to ensure that
production can occur.
CONT’D
• Additionally, the inputs must be of the appropriate
quality and obtainable at a reasonable price.
• Traditionally, companies ensured themselves of
service and part availability and quality by
controlling all functions internally.
• However, there is a growing trend toward
“outsourcing” (buying) a greater percentage of
required materials, components, and services.
• This outsourcing decision (buy decision) is made
only after an analysis that compares internal
production and opportunity costs with purchase cost
and assesses the best uses of available facilities.
Cont’d
• Consideration of an in source (make) option

implies that the company has available capacity for
that purpose or has considered the cost of obtaining
the necessary capacity.
• The make versus buy decision should be based on
which alternative is less costly on a relevant cost
basis; that is, taking into account only future,
incremental cash flows.
• In other words, in a make or buy situation with no
limiting factors, the relevant costs for the decision
are the differential costs between the two options.
Cont’d
• For example, the costs of in-house production of a

computer processing service that averages 10,000
transactions per month are calculated as Br. 25,000 per
month.
• This comprises Br.0.50 per transaction for stationery and
Br. 2 per transaction for labor.
• In addition, there is a Br. 10,000 charge from head office
as the share of the depreciation charge for equipment.
• An independent computer bureau has tendered a fixed
price of Br. 20,000 per month.
• Based on this information, stationery and labor costs are
variable costs that are both avoidable if processing is
outsourced.
Cont’d
• The depreciation charge is likely to be a fixed cost to the

business irrespective of the outsourcing decision. It is
therefore unavoidable.
• The fixed outsourcing cost will only be incurred if
outsourcing takes place.
• The relevant costs for each alternative can be compared as
shown in Table A below.
• The Br. 10,000 share of depreciation costs is not relevant as it
is unavoidable. The relevant costs for this decision are
therefore those shown in Table B
• Based on relevant costs, there would be a Br. 5,000 per
month saving by outsourcing the computer processing
service.

CONT’D
Table A. Relevant costs – make versus buy

Cost to make Cost to
buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Share of depreciation costs 10,000 10,000
Outsourcing cost 20,000
Total relevant cost Br. 35,000 Br. 30,000

CONT’D
• Table B. Relevant costs – make versus buy,

simplified
Relevant cost to make Relevant cost to buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Outsourcing cost 20,000
Total relevant cost Br. 25,000 Br. 20,000

CONT’D
• Note that relevant information for make or
buy decision includes both quantitative and
qualitative factors. Such as:

Quantitative Factors
Buy Make
 the amount paid to supplier  variable costs incurred to produce the
component
 transportation costs  special equipment to produce the product
 costs incurred to process the part  hire additional supervisory personnel to assist
upon receipt with making the product

Qualitative Factors
 Advantage of long term relationship  The quality of the product is decided to be
with suppliers controlled
 Possibility of shortage of material or  If the purchase price is likely to rise due to
labor for making the component increased demand in the market, it becomes
uneconomical to buy
 Uninterrupted supply of requisite  Where the technical know-how is to be kept
quality from reliable supplies secret and not to be passed on to the
suppliers

Cont’d
5.5 PRICING DECISIONS
• Companies are constantly making product and
service pricing decision.
• These are strategic decision that affects the
quantity produced and sold, and therefore cost and
revenues.
• To make these decisions, managers need to
understand cost behavior pattern and cost drivers.
• They can then evaluate demand at different prices
and manage costs across the value chain and over
a products life cycle to achieve profitability.
Cont’d
Major influences on pricing decision
How companies prices a product or a service ultimately
depends on the demand and supply of it. Three influences
on demand and supply are:-
• Customers: - customer influences price through their
effect on the demand for a product or services, based on
factors such as the features of a product and its quality.
• Competitors: when there are competitors, knowledge of
rivals’ technology, plant capacity, and operating policies
enables a company to estimate its competitors’ costs-
valuable information in setting its own prices.

Finance)
Cont’d
• Costs – costs influence prices because they

affect supply. As companies supply more
product the cost of producing each additional
unit initially declines but then eventually
increase managers who understand the cost of
producing their companies product set polices
that make the products attractive to customers.
In computing the relevant costs for a pricing
decision, the manager must consider relevant
costs in all business functions of the value chain.

CONT’D
Costing and pricing for the short run
• Short-run pricing decisions typically have a time
horizon of less than a year and include decision
such as (a) pricing one time only special order
with no long run implications and (b) adjusting
product mix and output volume in a competitive
market.
• Company’s short run pricing decisions need
identify a sufficiently low price at which company
would still make a profit and assumed that (a)
company has access to extra capacity and (b) a
competitor with an efficient plant and idle capacity
was likely to make a low bid.
Cont’d
• However, short run pricing does not always work this

way.
• Companies may experience strong demand for their
products in the short-run, but they may have limited
capacity.
• In these cases, companies strategically increase prices
in the short run to as much as the market will bear.
• In general, short run pricing decisions are responses
to short-run demand and supply condition, and the
relevant costs are only those costs that will change in
the short run.
Cont’d
Costing and pricing for the long run

• Long run pricing decisions have a time horizon of a year or
longer and include pricing a product in a major market in
which there is some see way in setting price. Two key
differences affect pricing for the long run versus the short
run:-
• Costs that are often irrelevant for short run pricing decisions,
such as fixed costs that cannot be changed, are generally
relevant in the long run because cost can be altered in the long
run.
• Profit margins in the long run pricing decision are often set to
earn a reasonable return on investment. Short run is
opportunistic, prices are decreased when demand is weak and
increased when demand is strong.
Cont’d
• Long run pricing is a strategic decision desired to build

long run relationship with customers based on stable and
predictable prices. But to change a stable price and earn
the target long run return, a company must, over the long
run, know and manage its costs of supplying product to
customers.
• Thus, relevant costs for long run pricing decision include
all future fixed and variable costs.
Long run pricing approaches
Two different approaches for pricing decision using product
cost information are:-
• Market based approach
• Cost based/cost plus approach
CONT’D
Market based pricing
• Market based pricing approach starts by
management asking, given that our customers
want and how our competitors will react to what
we do, what price should we charge?
• Companies operating in a very competitive
market, for example, commodities such as steel,
oil, and natural gas, use the market based
pricing. An important form of market based
pricing is target pricing.

Finance)
Cont’d
• Target price is the estimated price for a product or service

that potential customers will be willing to pay.
• This estimate is based on an understanding of customer’s
perceived value for a product or service and how
competitors will price competing product or service.
• Hence, target operating income is the operating income
that a company wants to earn on each unit of a product or
service sold and target price leads to a target cost, target
cost per unit is the estimated long run cost per unit of a
product or service that, when sold at the target price,
enables the company to achieve the target operating
income.
Cont’d
• Thus, Target price - Target operating income = Target cost
Implementing target pricing and target costing
• In developing target prices and target cost companies may
require to follow the following five steps:
• Develop a product that satisfy the needs of potential
customers
• Choose a target price based on customer’s perceived value for
the product and the price competitors charge, and target
operating income per unit.
• Drive a target cost per unit by subtracting the target operating
income per unit from the target price
• Perform cost analysis to analyze which aspects of a product
or service to target for cost reduction.
CONT’D
• Perform value engineering to achieve target
cost.
• Value engineering is a systematic evaluation of
all aspect of the value chain business function
with the objective of reducing cost while
satisfying customers’ needs.
• Value engineering can result in improvement in
product design, change in material specification,
and modification in process method.
• In this case, Costs can be value adding or non-
value adding.
CONT’D
• Value adding costs are costs that costumers
perceive as adding utility or value while non-
value adding cost that do not add value to the
product and to customers.
• Value engineering will focuses on eliminating
non value adding cost and reduce as much as
possible value adding cost without affecting
quality of the product and customers
satisfaction.

Cont’d
Example 5.5 : ABC Company is a manufacturer of

personal computer. ABC expects its competitors to
lower prices of PC. ABC management believes that
it must respond by reducing price by 20% from Br.
1000 per unit to Br.800 per unit. At this low price,
ABC marketing manager forecast an increase in
annual sales from 150,000 to 200,000 units. ABC
management wants a 10% target operating income
on sales revenue. The total production cost at the
moment for 150,000 units is Br. 135 million.

Cont’d
Required compute
• The total target revenue
• Total target operating income
• Target operating income per unit
• Current target cost per unit
Solution
• Total target revenue ═ target price per unit x
target annual unit sold ═ Br.800 per unit x
200,000 units ═ Br.160, 000,000

Finance)
Cont’d
• Total target operating income═ target rate x Total

target revenue ═ 10% x Br.160, 000,000═ Br.16,
000,000
• Target operating income per unit═ Total target
operating income/ annual unit sold ═ Br.16,
000,000/200,000 units ═ Br.80
• Current cost per unit═ target price per unit less
target operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720

Cont’d
2. Cost-plus pricing
• Accounting information may be used in pricing
decisions, particularly where the firm is a market
leader or price-maker.
• In these cases, firms may adopt cost-plus pricing,
in which a margin is added to the total
product/service cost in order to determine the
selling price.
• In many organizations, however, prices are set by
market leaders and competition requires that prices
follow the market (i.e. the firms are price-takers).

CONT’D
• Nevertheless, even in those cases an
understanding of cost helps in making
management decisions about what
product/services to produce, how many units to
make and whether the price that exists in the
market warrants the business risk involved in
any decision to sell in that market.
• An understanding of the firm’s marketing
strategy is therefore, essential in using cost
information for pricing decisions.

Cont’d
• In the long term, the prices that businesses charge must

cover all of its costs.
• If it is unable to do so, it will make losses and may not
survive.
• For every product/service, the full cost must be
calculated, to which the desired profit margin is added.
• Full cost includes an allocation to each product/service
of all the costs of the business, including producing
and delivering a good or service, and all its marketing,
selling, finance and administration costs.

Cont’d
• The general formula for setting a cost based price adds a

markup component to the cost base to
determine the prospective selling price.
• One way to determine the markup percentage is to
choose a markup to earn a target rate of return on
investment.
• The target rate of return on investment is the target annul
operating income that an organization aims to achieve
divided by invested capital (asset)
i.e. TRR = Target operating income
Invested capital
Therefore, Target operating income=TRR*Invested capital
CONT’D
Let illustrate a cost – plus pricing formula on top
company.
• Assume top’s engineers have redesigned product
CD into 2CD and that top uses a 12% markup
on the full unit cost of the product in developing
the prospective selling price.
• The target product 2CD profitability for 2000 is
as follows:

Estimated total Estimated total
amounts for 200,000 amount per unit (2) =
units (1) (1)  200,000
Revenues Bir 160,000,000 Bir 800

Cost of goods sold 108,000,000 540
Operating costs 36,000,000 180
Total cost of product Bir 144,000,000 720
Operating income 16,000,000 Bir 80

CONT’D
• Suppose that top’s target rate of return on investment
is 18% and 2CD’s capital investment is Bir 96 million.
The target annual operating income for 2CD is:
Invested capital ……………………………….Bir
96,000,000
Target rate of return on investment……………. 18%
Target Annual Operating income [0.18  Bir 96mln]
……………………………………………..Bir17,
280,000
Target operating income per unit of 2CD
[Bir17,280,000  200,000 units] …………. Bir 86.40

CONT’D
• This calculation indicates that top needs to

earn a target operating income of Bir86.40 on
each unit of 2CD.
• The mark up of Bir 86.40 expressed as a
percentage of the full production cost per unit
of Bir720 equals 12% (Bir 86.40  Bir 720]
• Thus the prospective selling price of product
2CD is Bir806.40 (Full unit cost of 2CD, Bir
720 plus the markup component of 12% (0.12
 Bir 720= Bir 86.40).
END OF CHAPTER
5
THANK YOU!

01 Full CH Cost and Management Accounting Chapter 1 Copy 1

Uploaded by

Copyright:

Available Formats

You might also like

01 Full CH Cost and Management Accounting Chapter 1 Copy 1

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

01 Full CH Cost and Management Accounting Chapter 1 Copy 1

Uploaded by

Copyright:

Available Formats

CHAPTER ONE

INTRODUCTION TO COST AND

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and Finance)

• The management accounting system is a cost control

BY: TESFAYE E. (MSc. in Accounting and Finance)

Accounting system takes economic events and

BY: TESFAYE E. (MSc. in Accounting and

BY: TESFAYE E. (MSc. in Accounting and Finance)

Areas of Comparison Financial Accounting Management Accounting

BY: TESFAYE E. (MSc. in Accounting and

2. Attention directing function: For example, the

• Cost accounting is an accounting information system that

A good understanding of the different cost

BY: TESFAYE E. (MSc. in Accounting and Finance)

All costs initially represent an asset.

BY: TESFAYE E. (MSc. in Accounting and

Some times, a firm may incur a cost

BY: TESFAYE E. (MSc. in Accounting and

 Cost object: is any thing for which a separate measurement

BY: TESFAYE E. (MSc. in Accounting and Finance)

 Cost management: cost management is the

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and

3. Generally Accepted Accounting Treatment

BY: TESFAYE E. (MSc. in Accounting and

BY: TESFAYE E. (MSc. in Accounting and

BY: TESFAYE E. (MSc. in Accounting and

8. Commitment to Cost Expenditure

BY: TESFAYE E. (MSc. in Accounting and Finance)

Accounting for manufacturing process has the finished products

BY: TESFAYE E. (MSc. in Accounting and Finance)

Prime Costs and Conversion Cost

• The job order cost system accumulate costs

• Manufacturers, such as a furniture

3. Warehousing – Finished goods are moved from the

Raw material used

Manufacturing overhead applied to products

Transfer of finished goods

• Process costing system is product costing system which

Reporting By job By cost center or department

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and Finance)

 Similarly, if manufacturing labor costs were added to the

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and Finance)

SNAP computer should record direct

Work In process – Assembly 480,000

BY: TESFAYE E. (MSc. in Accounting and Finance)

BY: TESFAYE E. (MSc. in Accounting and Finance)

• Physical unit for february2008:

• Total cost for February:

BY: TESFAYE E. (MSc. in Accounting and Finance)

 The accuracy of the completion estimates of conversion

BY: TESFAYE E. (MSc. in Accounting and Finance)