COST AND MANAGEMENT ACCOUNTING

Cost Accounting

Course Module
Prepared by: Delelegn Eyob (Masters of Professional Accounting)
Lecturer

APRIL 1, 2018
WOLKITE UNIVERSITY
[Link]@[Link]
Cost and Management Accounting I Teaching Module

Table of Contents
1. Introduction ............................................................................................................................. 3
1.1. Definition of accounting system ...................................................................................... 3
1.2. Purpose of Accounting System ........................................................................................ 3
1.3. Definitions and Meaning of Cost Accounting (Definitions from CIMA) ........................ 4
1.4. Objectives of Cost Accounting ........................................................................................ 5
1.5. The Role of Cost Accountant ........................................................................................... 6
1.6. Advantages of Cost Accounting....................................................................................... 6
1.7. Accounting Discipline ...................................................................................................... 8
1.9. Ethical considerations in Management Accounting ....................................................... 13
2.1. Cost, Expenses and Loss: ............................................................................................... 17
2.2. Cost Drivers, Cost Pools and Cost Objects .................................................................... 18
2.3. Cost Assignment and Cost Allocation: .......................................................................... 18
2.4. Classification of Costs.................................................................................................... 19
3.1. INTORDUCTION OF COSTING SYSTEM ................................................................ 29
3.2. JOB ORDER COSTING ................................................................................................ 30
3.2.1. Accounting Treatment Under JOC ......................................................................... 30
3.3. Illustration- JOC System .................................................................................................... 35
3.3.1. Disposition of Over and Under Applied Overheads ................................................... 39
3.4. PROCESS COSTING SYSTEM ................................................................................... 44
3.4.1. Difference Between Process Costing and Job Costing ........................................... 44
3.4.2. Classification and Assignment of Costs to Production Units ................................. 45
Case-1 Process costing with zero beginning and zero ending work in process inventory ........... 46
Case-2 process costing with zero beginning but some ending work-in process inventory .......... 46
Case-3 Process costing with some beginning and some ending work in process inventory ........ 49
3.5. Transferred – in Cost in Process Costing ................................................................... 53
4.1. Accounting for Spoilage .................................................................................................... 62
4.1.1. Job Order Costing System and Spoilage .................................................................... 62
4.1.2. Process Costing System and Spoilage ........................................................................ 64
4.2. Accounting for Rework .................................................................................................. 69
4.3. Accounting for Scrap ..................................................................................................... 71
5.1. Products Costs.................................................................................................................... 74
A. Variable Costing ................................................................................................................ 75

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5.2. Comparison of Absorption and Variable Costing Income Statements .......................... 75

Part One: Cost Allocation Introduction ........................................................................................ 81
A. Purpose of Allocating Cost to Cost Objects ...................................................................... 81
A. Criteria to Guide Cost-allocation Decisions- ..................................................................... 81
6.2. Allocating Corporate Cost to Divisions and Products- .................................................. 82
6.3. Part Two: Interdepartmental Cost Allocations ............................................................... 83
6.3.1. Single Rate Cost Allocation vs. Dual-Rate Cost Allocation Methods.................... 83
6.3.2. Budgeted vs Actual usage allocation ...................................................................... 86
6.4. Methods of Departmental Cost Allocation..................................................................... 87
6.4.1. Direct-method of allocating service department costs- .......................................... 87
6.4.2. Step-Down Allocation Method- ................................................................................. 88
6.4.3. Reciprocal Method of Service Department Cost Allocation .................................. 88
6.5. Allocation of Common Costs ......................................................................................... 90
7.1. TERMINOLOGIES ........................................................................................................... 92
7.2. Distinction between Joint & By-products ...................................................................... 93
7.3.1. Physical Measure Method or physical Units Method ............................................. 93
7.3.2. Sales Value at Split-off Method:............................................................................. 94
7.3.3. Estimated Net Realizable Value Method ................................................................ 94
7.3.4. Constant Gross Margin Percentage NRV Method .................................................. 94

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Chapter One
Introduction to Cost Accounting

1. Introduction
1.1. Definition of accounting system
Accounting-as defined by American Accounting Association (AAA) is the process of identifying,
measuring and communicating economic information to permit informed judgments and decisions
by users of the information.

Accounting as a language of business can be viewed as an information system that provides

essential information about economic activities of an entity to various individuals and groups.

Accounting as information system plays an important role in our economic and social system. The
decisions made by individuals, governments, and other entities determine the use of the nation’s
scarce resources.

The goal (objective) of accounting is to: identify record, analyze, report, and interpret
(communicate) economic data for use by decision makers.

1.2. Purpose of Accounting System

Identification of users
Investors, Bankers, suppliers
Government agencies, labor union,
User’s information employees and management

Accounting System Reports User’s decision

(Output)

Investing
Financial reports
Approving loans
Special reports
Assessing taxes
Tax returns
Negotiating labor
Regulatory reports
Establishing budget
Management reports
Other decision
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Accounting information address three different function

 Providing information to external parties

 Estimating the cost of products produced and services provided by the organization

 Providing information useful to internal managers who are responsible for planning,
controlling, decision making, and evaluating performance

1.3. Definitions and Meaning of Cost Accounting (Definitions from CIMA)

1. Cost: The amount of expenditure incurred or attributed on a given thing or given or
sacrificed to obtain something.
2. Cost Accountancy: The application of costing and cost accounting principle, methods and
techniques to the science, art and practice of cost and the ascertainment of profitability. Cost
accountancy is a science that consist of several subjects; cost accounting, costing, cost control
and cost audit.
2.1. Costing: Classifying, recording and appropriate allocation of expenditure for the
determination of the cost of products and services; and for the presentation of suitably
arranged data for the purpose of control and guidance of the management.
2.2. Cost Control: The guidance and regulation by executive actions of operating on
undertaking. Cost control extends to standard costing and budgetary control. Standard
costing controls the cost of each unit through determining beforehand what should be the
cost and then its comparison with actual cost and also analysis of variances together with
their causes. Budgetary control means laying down in monetary and quantitative terms what
exactly has to be done and how exactly it has to be done over coming period and then to
ensure that actual results do not diverge from the planned course more than necessary.
2.3. Cost Audit: The verification of cost accounts and check on the adherence to the cost
accounting plan. It is an independent expert examination of cost accounts of different outputs
of an undertaking and a verification whether such accounts of the different output, serve the
purpose intended.
2.4. Cost Accounting: The process of accounting for cost from point at which expenditure is
incurred or committed to establishment of ultimate relationship with cost centers and cost

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units. It is concerned with accumulation, classification, analysis and interpretation of cost

data for three major purposes;
a. Ascertainment of cost
b. Operational planning and control
c. Decision making

“Cost accounting is a specialized branch of accounting which provide processed set of information
/ statements to the management which assist them in decision making.” In cost accounting cost of
product or process is ascertained, measured and accumulated.

1.4. Objectives of Cost Accounting

The main objectives of cost accounting can be summarized as follows:

A. Ascertainment of cost: - The primary objective of cost accounting is to ascertain cost of

different products, job and services.
B. Determining Selling Price:-Cost accounting provides detailed information about the
composition of total cost for determining action of the selling price of the product or service
under different conditions.
C. Measure and increasing Efficiency: -Cost accounting involves a study of various
operations used in manufacturing a product or providing a service. The study facilitates
measuring the efficiency of an organization as a whole or department-wise as well as
devising means of increasing efficiency.
D. Control: - Cost accounting aims at improving the efficiency by controlling and reducing
cost. Budgetary control and standard costing are important techniques used to control cost.
E. Facilitating Preparation of Financial and Other Statements:- The other objective of
cost accounting is to produce statements whenever is required by management. The
financial statements are prepared under financial accounting generally once a year or
half-year and are spaced too far with respect to time to meet the needs of management. In
order to operate a business at a high level of efficiency, it is essential for management to
have a frequent review of production, sales and operating results. Cost accounting
provides daily, weekly or monthly volumes of units produced and accumulated costs with
appropriate analysis. A developed cost accounting system provides immediate

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information regarding stock of raw materials, work-in-progress and finished goods. This
helps in speedy preparation of financial statements.
F. Providing Basis for Operating Policy: - Cost accounting helps management to formulate
operating policies. These policies may relate to any of the following matters:
 Determination of a cost-volume-profit relationship
 Shutting down or operating at a loss
 Making for or buying from outside suppliers
 Continuing with the existing plant and machinery or replacing them by improved
and economic ones

1.5. The Role of Cost Accountant

- To workout cost per unit of products produced by the organization
- To provide accurate analysis of this cost
- To maintain cost to the lowest point consistent with the most efficient operating conditions.
It requires the examination of each cost in the light of the service or benefit obtained so
that the utilization of each dollar will be obtained
- To workout wastage on each process and prepare reports
- To provide necessary to fix price of commodity
- To compute profit earned in each unit level and advise management
- To help management in control of inventory so that there may be minimum locking up of
capital stocks in raw materials, stores, work in process and finished goods.
- To install and implement cost control systems like budgetary control and standard costing
- To carry out special cost studies and investigations which are invaluable to management in
determining policies and formulating plans directed towards profitable operation.

1.6. Advantages of Cost Accounting

A. Advantages of cost accounting to the managements
1. Supplies detailed cost information:- cost accounting supplies detailed and regular cost
information to the management to ascertain the cost of various products, process jobs
departments and services.
2. Help in price fixation:- cost plays an important role in the price fixation. Cost accounting
assists the management in fixing up selling price not only during depression period.

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3. Profitable and unprofitable activities are disclosed:- accounting makes possible for
management to distinguish between Profitable and unprofitable activities. Concentrating
on profitable operations and eliminating non-profitable ones can maximize profit.
4. Helps in estimates:- adequate cost records provide a reliable basis upon which tenders and
estimates may be prepared.
5. Wastages are eliminated:- as it is possible to know the cost of the article at every stage, it
becomes possible to check various forms of wastages such as time, expenses etc. or in the
usage of machine and equipment.
6. Guides future production policies: - if the costing records are kept, comparative cost data
for different periods and various volumes of production will be available. It will help the
management in forming future course of action.
7. Provides data for periodical profit and loss accounts:- adequate costing records supply to
the management such data as may be necessary for preparation of profit and loss account
and balance sheet, at such intervals as may be desired by the management.
8. Aids in determining and enhancing efficiency: - disclose of wastages, idle time and other
loses in various operates of manufacturing of a product are studied by the cost accountant.
The efficiency can be measured and costs are controlled through formulation of various
devices to increase the efficiency.
9. Helps in inventory control:- cost accounting furnishes data for controls which management
require in respect of stock of material, Work In Process, and Finished Goods.
10. Helps in cost reduction:- cost accounting helps in cost control, which aims at improving
efficiency by controlling and reducing cost. Budgetary controls and standard costing are
the two important cost accounting techniques, which are used to control costs.
B. Advantages to cost Accounting Workers

Workers are benefited by introduction of incentive plans which is an integral part of a cost system.
This results not only in higher productivity but also higher earning of them.

C. Advantages to Society

An efficient cost system is a bound to lower the cost of production, the benefit of which is passed
on to the public at large in the form of lower prices of products or services.

D. Advantages of cost accounting to Government agency and others

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A cost system produces ready figure for use by government, wage tribunals, chambers of
commerce and industry trade unions, etc., for use in problems like the price fixing, wage level
fixation, settlement of industrial disputes, policy matters, etc.

1.7. Accounting Discipline

Financial accounting measures and records business transactions and provides financial
statements that are based on generally accepted accounting principles (GAAP). Executive
compensation is tied to profit figures reported in the financial statements and equity share valuation
is also based to a large extent on this financial statements.

Cost accounting is the process of accounting for costs from the point at which expenditure is
incurred to the establishment of its ultimate relationship with cost centers and cost unit. Cost
accounting denotes the formal accounting mechanism by means of which costs are ascertained by
recording in the books of account.

Managerial accounting—measures, analyzes, and reports financial and nonfinancial information

to help managers make decisions to fulfill organizational goals. Managerial accounting need not
be GAAP compliant.

Reports generated through management accounting are used internally.

 Major function of management accounting:

 Planning & Forecasting

 Controlling

 Decision making

 Pricing

 Make or Buy

 Shut down or Continued operation

 Equipment Replacement

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.

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1. Score keeping function- is a function of accumulating data and reporting reliable result to all
levels of the management describing how the organization is doing and how well it is
implementing its strategies. The collection, classification, and reporting of scorekeeping
information is the task that dominates day to day accounting. The followings are some of the
scorekeeping functions an accountant will provide.
- Recording sales, purchase and payroll data
- Preparing financial reports
- Preparing depreciation schedules
2. Attention directing function: is reporting and interpreting information that helps managers
to focus on operating problems, imperfections, inefficiency and opportunities. This aspect of
accounting helps managers to concentrate on the importance of operation promptly enough for
effective action. Attention directing is commonly associated with current planning and control,
and with the analysis and investigation of recurring routine internal accounting reports. What8
opportunities and problems should manager’s focus on? Making visible both opportunities and
problems on which managers need to focus. 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 problem solving aspect of accounting quantifies the likely
results of possible courses of action and often recommends the best course to follow. Problem
solving is commonly associated with non-recurring decisions, situations that require special
accounting analysis or report. Comparison and analysis to identify the best alternatives in
relation to the organizations objectives is a 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 further decision

Scorekeeping is a general purpose data collection function without knowing whether the data is
used for internal or external reporting. However, the scorekeeping and attention directing functions

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are closely related. The same information may serve as scorecard function for a manger and an
attention directing function for the managers’ superior.

The accounting or finance department in an organization is usually lead by a finance officer. A

finance officer is a senior officer empowered with overseeing the financial operations of an
organization. If the organization is large, the finance officer can be supported by a controller and
a treasurer both of whom9 are usually accountants. A controller is responsible for preparing the
information and report used in both managerial and external reporting whereas the treasurer is
concerned mainly with the company’s financial matters. The following table summarizes the roles
and responsibilities of the Controller and the Treasurer

Controller Treasurer

∙ Planning & control ∙ Provision of capital

∙ Reporting and interpreting Investors relation

∙ Evaluating and consulting ∙ Short term financing

∙ Government reporting ∙ Banking and custody

∙ Tax planning and administration ∙ Credits and collections

∙ Protection of assets ∙ Investment

∙ Economic appraisal ∙ Risk management and insurance

Accounting system

(One part of the organizations Management information system)

-Accumulate data for use in both financial and managerial accounting.

Cost Accounting system

(One part of the organizations overall accounting system)

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 Accumulates cost information i.e. measuring and reporting financial and non- financial
information that relates to the cost of acquiring and consuming resources by organizations.
 It records and explains cost data, both actual and prospective that is used by managers
for planning and controlling, as well as costing products, Services and customers.
It provides information for both management accounting and financial accounting i.e. it
includes those parts of both management accounting and financial accounting where cost
information is collected and analyzed.

A. Comparison between Financial Accounting and Management Accounting

Areas of Management Accounting Financial accounting

Difference
Type of report - Preparation of information for - Preparation of published financial
decision making, planning directing, statements and other financial reports
and controlling an organizations’
- Measure and records business
operations (management reports)
transactions and report financial are
- Measures and reports financial and prepared according to GAAP
nonfinancial information that help
- It emphasizes the organization as a
managers make decisions to
whole.
information in a statement that fulfill
the goal of an organization
- It emphasizes basically on the
segment of an organization.
Users of Internal users of information i. e. External users such as stockholders,
information managers at all levels in the financial analysts, lenders, labor unions,
organizations. consumer groups governmental agencies,
general public and others.
Regulation and Not required to follow GAAP and not - Required and must conform to GAAP
requirement regulated by FASB, SEC, and other and regulated by FASB, SEC, and
authoritative bodies. Its report is based others and it is mandatory
on usefulness to management, and it is not
mandatory

Source of data The source of data is the organizations - The source of data is almost exclusively
basic accounting system, plus various the organizations basic accounting
other sources, such as rate of defective system, which accumulates financial
products manufactured, physical information.
quantities material and labor used in
production and others

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Nature of - Reports often focus on sub-units - Reports focus on the enterprises in its
reports and within the departments, divisions, entirety
procedures geographical regions or products
Based exclusively on historical
lines.
transactions data.
- Based on a combination of historical
data, estimates and projection of
future events
Characteristic - Futuristic, subjective proactive, - Historical, objective passive and static
of information dynamic

B. Comparison Cost Accounting and Management Accounting

Basis Cost Accounting Management accounting

1. Scope is limited to providing cost Information for Scope of management accounting is broader than
managerial uses cost accounting it provides cost accounting as well
as Financial accounting for managerial uses.

2. Emphasis Mainly emphasis on cost ascertainment & Control Main emphasis on planning controlling and
to ensure maximum profit. decision making to max profit.

3. Evaluation Evaluation of cost accounting is mainly due to the Evaluation of management accounting is due to
limitation of financial accounting. the limitation of cost accounting. In fact,
management accounting is an extent ion of the
managerial aspects of cost accounting.

[Link] Various techniques used by cost accounting Management accounting also uses all these
employed include standard costing and variance analysis, techniques used in cost accounting but in addition
marginal costing and cost-volume profit analysis, it also uses techniques like ratio analysis, funds
budgetary control, uniform costing and inter-firm flow statement, operation research and certain
comparison ,etc. techniques from various branches of knowledge
like mathematics which so-ever can help
management in its tasks.

1.8. Cost benefit philosophy and behavioral considerations in management accounting systems

Three major things govern the design of management accounting systems:

1. Simplicity: an overall watchword for system design.

2. The cost benefit theme of choosing among accounting systems and methods
a. All accounting information and systems are economic goods available at various costs.

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b. More extensive management accounting information system is desirable only if the

benefits (through improved decision making) exceed the costs of the information
c. Often it is easier to identify the costs of new information then the benefits
3. Behavioral implications of operating management accounting system:
a. The use of budgets stimulates planning activities, which is a beneficial behavioral effect
b. Individual motivations are strongly influenced by performance reports and incentives
that are used to appraise both decisions and managers. This can be a favorable
behavioral effect if the performance reports and incentives are designed properly.
Otherwise, adverse behavioral effects may result.

1.9. Ethical considerations in Management Accounting

Business ethics is learning what is right or wrong in the work environment and choosing what is
right. Business ethics could also be described as the science of conduct for the work environment.
Principles of personal ethical behavior include concern for the well-being of others, respect for
others, trustworthiness and honesty, fairness, doing good, and preventing harm to others. For
professionals such as accountants, managers, engineers, and physicians, ethical behavior principles
can be expanded to include concepts such as objectivity, full disclosure, confidentiality, due
diligence, and avoiding conflicts of interest.

Due to the importance of the information supplied, management accountants should observe
certain professional ethical standards.

Professional management accountant organizations worldwide have developed professional ethics

standards. Setting professional ethical standards is important due to the fact that:

- They provide trust in the employee-employer relationship,

- Standards represent a reference for management accountants facing ethical dilemmas;
- they provide a guarantee to the information users that concerning the quality of the
information.

The Institute of Management Accountants (IMA) has established ethical standards for
management accountants. Management accountants are subject to this professional code and have
been advised that, “they shall not commit acts contrary to these standards nor shall they condone
the commission of such acts by others in their organizations”.

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The standards and the recommended resolution of ethical conflict are presented here. The code has
five major divisions: competence, confidentiality, integrity, objectivity, and resolution of ethical
conflict.

I. Competence

Management accountants have a responsibility to:

- Maintain an appropriate level of professional competence by ongoing development of their

knowledge and skills.
- Perform their professional duties in accordance with relevant laws, regulations, and technical
standards.
- Prepare complete and clear reports and recommendations after appropriate analyses of relevant
and reliable information.
II. Confidentiality

Management accountants have a responsibility to:

- Refrain from disclosing confidential information acquired in the course of their work except
when authorized, unless legally obligated to do so.
- Inform subordinates as appropriate regarding the confidentiality of information acquired in the
course of their work and monitor their activities to ensure the maintenance of that
confidentiality.
- Refrain from using or appearing to use confidential information acquired in the course of their
work for unethical or illegal advantage either personally or through a third party.
III. Integrity

Management accountants have a responsibility to:

- Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential
conflict.
- Refrain from engaging in any activity that would prejudice their abilities to carry out their
duties ethically.
- Refuse any gift, favor, or hospitality that would influence their actions.

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- Refrain from either actively or passively subverting the attainment of the organization
legitimate and ethical objectives.
- Recognize and communicate professional limitations or other constraints that would preclude
responsible judgment or successful performance of an activity.
- Communicate unfavorable as well as favorable information and professional judgments or
opinions.
- Refrain from engaging in or supporting any activity that would discredit the profession.
IV. Objectivity

Management accountants have a responsibility to:

- Communicate information fairly and objectively.

- Disclose fully all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, comments, and recommendations presented.

Resolution of Ethical Conflict

In applying the standards of ethical conduct, management accountants may encounter problems in
identifying unethical behavior or in resolving ethical conflict. When faced with significant ethical
issues, management accountants should follow the established policies of the organization bearing
on the resolution of such conflict. If these policies do not resolve the ethical conflict, management
accountants should consider the following courses of action:

Discuss such problems with the immediate supervisor except when it appears that the superior is
involved, in which case the problem should be presented initially to the next higher management
level. If satisfactory resolution cannot be achieved when the problem is initially presented, submit
the issues to the next higher management level.

If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing
authority may be a group such as the audit committee, executive committee, board of directors,
board of trustees, or owners. Contact with levels above the immediate superior should be initiated
only with the superior’s knowledge, assuming the superior is not involved.

Clarify relevant concepts by confidential discussion with an objective advisor to obtain an

understanding of possible courses of action.

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If the ethical conflict still exists after exhausting all levels of internal review, the management
accountant may have no other recourse on significant matters than to resign from the organization
and to submit an informative memorandum to an appropriate representative of the organization.

Except where legally prescribed, communication of such problems to authorities or individuals not
employed or engaged by the organization is not considered appropriate

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CHAPTER-2
2. Classification, and Analysis of Costs and Related Cost Concepts and Terminologies

Different cost concepts and terms are often used in accounting reports. Managers who understand
these concepts and terms are able to:

A. Best use the information provided, and

B. Avoid misuse of that information.

Communication among managers is greatly facilitated by there being common understanding on

the meaning of cost concepts and terms.

Accountants usually define cost as a resource sacrificed or forgone to achieve a specific objective.
Most peoples consider cost as monetary amounts (such as Dollars, Pounds, Birr, Yuan) that must
be paid to acquire goods and services. But, the term cost does not have a definite meaning and its
scope is extremely broad and general.

According to oxford dictionary, Cost means the price paid for something. However, some of the
definitions of cost are given below:

 Cost is the amount of expenditure (actual or notional) incurred or attributable to a given

thing.
 A cost is the value of economic resources used as a result of producing or doing the things
costed (WM Harper )
 Cost means economic sacrifice, measured in terms of standard monetary unit, incurred or
potentially to be incurred, as a consequence of a business decision to achieve a specific
objective. (Committee on cost concept and SAAA)

2.1. Cost, Expenses and Loss:

Expense is defined as an expired cost resulting from a productive usage of an asset. An expense
is map portion of the revenue earning potential of an asset w/c has been consumed in the
generation of the revenue.

Loss is a reduction in firm’s equity other than from withdrawals of capital for which no
compensating value has been received. It is also an expired cost resulting from the decline in the

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service potential of an asset that generated no benefit to the firm. Ex. Obsolescence or destruction
of stock by fire.

2.2. Cost Drivers, Cost Pools and Cost Objects

A firm incurs a cost when it uses a resource for some purpose. For example, a company producing
kitchen appliances has costs of materials (such as sheet metal and bolts for the enclosure), costs of
manufacturing labor, and other costs. Often costs are assigned into meaningful groups called cost
pools. Individual costs can be grouped in many different ways, and therefore a cost pool can be
defined in many different ways, including by type of cost (labor costs in one pool, material costs
in another), by source (department 1, department 2, and so on), or by responsibility (manager 1,
manager 2, and so on). For example, an assembly department or a product engineering department
might be treated as a cost pool.

A cost driver is any factor that has the effect of changing the level of total cost. For a firm that
competes on the basis of cost leadership, management of the key cost drivers is essential. For firms
that are not cost leaders, the management of cost drivers may not be so critical, but attention to the
key cost drivers contributes directly to the firm’s success. For example, because an important cost
driver for retailers is loss and damage to merchandise, most of them establish careful procedures
for handling, displaying, and storing their merchandise.

A cost object is any product, service, customer, activity, or organizational unit to which costs are
assigned for some management purpose. Products, services, and customers are generally cost
objects; manufacturing departments are considered either cost pools or cost objects, depending on
whether management’s main focus is on the costs for the products or for the manufacturing
departments. The concept of cost objects is a broad concept. It also includes groups of products,
services, departments, and customers; suppliers; telephone service providers; and so on. Any item
to which costs can be traced and that has a key role in management strategy can be considered a
cost object.

2.3. Cost Assignment and Cost Allocation:

Cost assignment is the process of assigning costs to cost pools or from cost pools to cost objects.
A direct cost can be conveniently and economically traced directly to a cost pool or a cost object.
For example, the cost of materials required for a particular product is a direct cost because it can
be traced directly to the product.

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The materials cost is accumulated in cost pools (manufacturing departments) and then is traced to
each product manufactured, which is the cost object. Similarly, an airline’s cost of preparing a
passenger’s meal is a direct cost that can be traced to each passenger (the cost object). For a direct
cost, the cost driver is the number of units of that object.

In contrast, there is no convenient or economical way to trace an indirect cost from the cost to the
cost pool or from the cost pool to the cost object. The cost of supervising manufacturing employees
and the cost of handling materials are good examples of costs that generally cannot be traced to
individual products and therefore are considered indirect costs. Similarly, the cost of fueling an
aircraft is an indirect cost when the cost object is the individual airline customer since the aircraft’s
use of fuel cannot be traced directly to that customer. In contrast, if the cost object for the airline
is the flight, the cost of fuel is a direct cost that can be traced directly to the aircraft’s use of fuel
for that flight. Since indirect costs cannot be traced to the cost pool or cost object, the assignment
for indirect costs is made by using cost drivers. For example, if the cost driver for materials
handling cost is the number of parts, the total cost of materials handling can be assigned to each
product on the basis of its total number of parts relative to the total number of parts in all other
products. The result is that costs are assigned to the cost pool or cost object that caused the cost in
a manner that is fairly representative of the way the cost is incurred. For example, a product with
a large number of parts should bear a larger portion of the cost of materials handling than a product
with fewer parts. Similarly, a department with a large number of employees should bear a large
portion of the cost of supervision provided for all departments.

The assignment of indirect costs to cost pools and cost objects is called cost allocation, a form of
cost assignment in which direct tracing is not economically feasible, so cost drivers are used
instead. The cost drivers used to allocate costs are often called allocation bases.

2.4. Classification of Costs

We have chosen to start our discussion of cost concepts by focusing on manufacturing companies,
because they are involved in most of the activities found in other types of organizations.
Manufacturing companies are involved in acquiring raw materials, producing finished goods,
marketing, distributing, billing, and almost every other business activity. Therefore, an
understanding of costs in a manufacturing company can be very helpful in understanding costs in
other types of organizations.

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Classification is the process of grouping costs according to their common features. It is a

systematic placement of like items together according to their common characteristics.

A. Cost Classification on the Basis of Elements of Costs

1. Materials Cost: The substance from which a product is made is known as material. It may be
in a raw or a manufactured state. It can be direct as well as indirect.
[Link] Material: The material which becomes an integral part of a finished product and
which can be conveniently assigned to specific physical unit is termed as direct material.
Following are some of the examples of direct material:
 All material or components specifically purchased, produced or requisitioned
from stores
 Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.)
 Purchased or partly produced components

Direct material is also described as process material, prime cost material, production
material, stores material, constructional material etc.

[Link] Material: The material which is used for purposes ancillary to the business and
which cannot be conveniently assigned to specific physical units is termed as indirect
material. Consumable stores, oil and waste, printing and stationery material etc. are some
of the examples of indirect material.
Indirect material may be used in the factory, office or the selling and distribution divisions.
2. Labor: For conversion of materials into finished goods, human effort is needed and such
human effort is called labor. Labor can be direct as well as indirect.
[Link] Labor: The labor which actively and directly takes part in the production of a
particular commodity is called direct labor. Direct labor costs are, therefore, specifically
and conveniently traceable to specific products.
Direct labor can also be described as process labor, productive labor, operating labor, etc.
[Link] Labor: labor employed for the purpose of carrying out tasks incidental to goods
produced or services provided, is indirect labor. Such labor does not alter the construction,
composition or condition of the product. It cannot be practically traced to specific units of
output. Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen

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etc, are examples of indirect labor costs. Indirect labor may relate to the factory, the office
or the selling and distribution divisions.
3. Expenses: Expenses may be direct or indirect.
[Link] Expenses: These are the expenses that can be directly, conveniently and wholly
allocated to specific cost centers or cost units. Examples of such expenses are as follows:
 Hire of some special machinery required for a particular contract
 Cost of defective work incurred in connection with a particular job or contract etc.
 Direct expenses are sometimes also described as chargeable expenses.
[Link] Expenses: These are the expenses that cannot be directly, conveniently and
wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting,
insurance charges etc.
4. Overhead: The term overhead includes indirect material, indirect labor and indirect expenses.
Thus, all indirect costs are overheads.
A manufacturing organization can broadly be divided into the following three divisions:
[Link] Overheads: They include the following things:
 Indirect material used in a factory such as lubricants, oil, consumable stores etc.
 Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc.
 Indirect expenses such as factory rent, factory insurance, factory lighting etc.
[Link] and Administration Overheads: They include the following things:
 Indirect materials used in an office such as printing and stationery material, brooms and
dusters etc.
 Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.
 Indirect expenses such as rent, insurance, lighting of the office
[Link] and Distribution Overheads: They include the following things:
 Indirect materials used such as packing material, printing and stationery material etc.
 Indirect labor such as salaries of salesmen and sales manager etc.
 Indirect expenses such as rent, insurance, advertising expenses etc.
B. Cost Classifications for Predicting Cost Behavior

Quite frequently, it is necessary to predict how a certain cost will behave in response to a change
in activity. Cost behavior refers to how a cost reacts to changes in the level of activity. As the

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activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant.
For planning purposes, a manager must be able to anticipate which of these will happen; and if a
cost can be expected to change, the manager must be able to estimate how much it will change.

1. Variable Cost

A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity.
The activity can be expressed in many ways, such as units produced, units sold, miles driven, beds
occupied, lines of print, hours worked, and so forth. A good example of a variable cost is direct
materials. The cost of direct materials used during a period will vary, in total, in direct proportion
to the number of units that are produced.

2. Fixed Cost

A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity.
Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the
activity level rises and falls, total fixed costs remain constant unless influenced by some outside
force, such as a price change. Rent is a good example of a fixed cost.

3. Mixed Costs

Some costs have both variable and fixed characteristics. These costs are often called mixed costs
or semi-variable or semi-fixed costs. Mixed costs occur because the total cost relationship with the
activity base termed a cost function has an element that is constant (or fixed) to activity volume
change, and an element that is variable to activity volume changes. For example, the rental charge
for a mobile telephone might be birr 50 per month plus some other variable costs.

C. Classification of Cost on Function of Cost

1. Product Costs

The costs which are a part of the cost of a product rather than an expense of the period in which
they are incurred are called as “product costs.” They are included in inventory values. In financial
statements, such costs are treated as assets until the goods they are assigned to be sold. They
become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw
materials and direct wages, depreciation on plant and equipment etc.

2. Period Costs

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The costs which are not associated with production are called period costs. They are treated as an
expense of the period in which they are incurred. They may also be fixed as well as variable. Such
costs include general administration costs, salaries salesmen and commission, depreciation on
office facilities etc. They are charged against the revenue of the relevant period. Differences
between opinions exist regarding whether certain costs should be considered as product or period
costs. Some accountants feel that fixed manufacturing costs are more closely related to the passage
of time than to the manufacturing of a product.

Thus, according to them variable manufacturing costs are product costs whereas fixed
manufacturing and other costs are period costs. However, their view does not seem to have been
yet widely accepted.

i. Administrative cost: The cost of formulating the policy, directing the organization and
controlling the operations of an undertaking which is not related directly to a production,
selling, distribution, research or development activity or function.
ii. Selling Cost: It is the cost of selling to create and stimulate demand (sometimes termed as
marketing) and of securing orders.
iii. Distribution Cost: It is the cost of sequence of operations beginning with making the packed
product available for dispatch and ending with making the reconditioned returned empty
package, if any, available for reuse.
iv. Research Cost: It is the cost of searching for new or improved products, new application of
materials, or new or improved methods.
v. Development Cost: The cost of process which begins with the implementation of the decision
to produce a new or improved product or employ a new or improved method and ends with the
commencement of formal production of that product or by the method.
vi. Pre-Production Cost: The part of development cost incurred in making a trial production as
preliminary to formal production is called pre-production cost.

D. Classification of cost on Decision Making

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Decision-making costs are special purpose costs that are applicable only in the situation in which
they are compiled. They have no universal application. They need not tie into routine-financial
accounts.

They do not and should not confirm the accounting rules. Accounting costs are compiled primarily
from financial statements. They have to be altered before they can be used for decision-making.
Moreover, they are historical costs and show what has happened under an existing set of
circumstances. Decision-making costs are future costs. They represent what is expected to happen
under an assumed set of conditions.

1. Direct and Indirect Costs

The expenses incurred on material and labor which are economically and easily traceable for a
product, service or jobs are considered as direct costs. In the process of manufacturing of
production of articles, materials are purchased, laborers are employed and the wages are paid to
them. Certain other expenses are also incurred directly. All of these take an active and direct part
in the manufacture of a particular commodity and hence are called direct costs.

The expenses incurred on those items which are not directly chargeable to production are known
as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain
expenses incurred for running the administration are the indirect costs. All of these cannot be
conveniently allocated to production and hence are called indirect costs.

2. Relevant and Irrelevant Costs

Relevant costs are those which change by managerial decision. Irrelevant costs are those which do
not get affected by the decision. For example, if a manufacturer is planning to close down an
unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is
relevant in this connection since they will disappear on closing down of a shop. But prepaid rent
of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant
costs which should be ignored.

3. Shutdown and Sunk Costs

A manufacturer or an organization may have to suspend its operations for a period on account of
some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc.

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During this period, though no work is done yet certain fixed costs, such as rent and insurance of
buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs
of the idle plant are known as shutdown costs.

Sunk costs are historical or past costs. These are the costs which have been created by a decision
that was made in the past and cannot be changed by any decision that will be made in the future.
Investments in plant and machinery, buildings etc. are prime examples of such costs. Since sunk
costs cannot be altered by decisions made at the later stage, they are irrelevant for decision-making.

An individual may regret for purchasing or constructing an asset but this action could not be
avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset
will be matched against the proceeds from sale of the asset for the purpose of determining gain or
loss. The person may decide to continue to own the asset. In this case, the cost of asset will be
matched against the revenue realized over its effective life. However, he/she cannot avoid the cost
which has already been incurred by him/her for the acquisition of the asset. It is, as a matter of
fact, sunk cost for all present and future decisions.

Example

Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$
without any scrap value. Soon after making the purchase, management feels that the machine
should not have been purchased since it is not yielding the operating advantage originally
contemplated. It is expected to result in savings in operating costs of $. 18,000 over a period of
five years. The machine can be sold immediately for $. 22,000.

To take the decision whether the machine should be sold or be used, the relevant amounts to be
compared are $. 18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it
is immediately disposed. $. 30,000 invested in the asset is not relevant since it is same in both the
cases. The amount is the sunk cost. Jolly Ltd., therefore, sold the machinery for $. 22,000 since it
would result in an extra profit of $. 4,000 as compared to keeping and using it.

4. Controllable and Uncontrollable Costs

Controllable costs are those costs which can be influenced by the ratio or a specified member of
the undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs.

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A factory is usually divided into a number of responsibility centers, each of which is in charge of
a specific level of management. The officer in charge of a particular department can control costs
only of those matters which come directly under his control, not of other matter. For example, the
expenditure incurred by tool room is controlled by the foreman in charge of that section but the
share of the tool room expenditure which is apportioned to a machine shop cannot be controlled
by the foreman of that shop. Thus, the difference between controllable and uncontrollable costs is
only in relation to a particular individual or level of management. The expenditure which is
controllable by an individual may be uncontrollable by another individual.

5. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs

Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or
department) with which they are directly related is discontinued. Unavoidable costs are those
which will not be eliminated with the segment. Such costs are merely reallocated if the segment is
discontinued. For example, in case a product is discontinued, the salary of a factory manager or
factory rent cannot be eliminated. It will simply mean that certain other products will have to
absorb a large amount of such overheads. However, the salary of people attached to a product or
the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and
partly unavoidable. For example, closing of one department of a store might result in decrease in
delivery expenses but not in their altogether elimination.

It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate
a segment of a business.

6. Differentials, Incremental or Decrement Cost

The difference in total cost between two alternatives is termed as differential cost. In case the
choice of an alternative results in an increase in total cost, such increased costs are known as
incremental costs. While assessing the profitability of a proposed change, the incremental costs
are matched with incremental revenue. This is explained with the following example:

7. Out-of-Pocket Costs

Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that
will vary depending upon the nature of the decision made. For example, a company has its own

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trucks for transporting raw materials and finished products from one place to another. It seeks to
replace these trucks by keeping public carriers. In making this decision, of course, the depreciation
of the trucks is not to be considered but the management should take into account the present
expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as out-of-pocket
costs.

8. Opportunity Cost

Opportunity cost refers to an advantage in measurable terms that have foregone on account of not
using the facilities in the manner originally planned. For example, if a building is proposed to be
utilized for housing a new project plant, the likely revenue which the building could fetch, if rented
out, is the opportunity cost which should be taken into account while evaluating the profitability
of the project. Suppose, a manufacturer is confronted with the problem of selecting anyone of the
following alternatives:

a. Selling a semi-finished product at $. 2 per unit

b. Introducing it into a further process to make it more refined and valuable

Alternative (b) will prove to be remunerative only when after paying the cost of further processing,
the amount realized by the sale of the product is more than $. 2 per unit. Also, the revenue of $. 2
per unit is foregone in case alternative (b) is adopted. The term “opportunity cost” refers to this
alternative revenue foregone.

9. Traceable, Untraceable or Common Costs

The costs that can be easily identified with a department, process or product are termed as traceable
costs. For example, the cost of direct material, direct labor etc. The costs that cannot be identified
so are termed as untraceable or common costs. In other words, common costs are the costs incurred
collectively for a number of cost centers and are to be suitably apportioned for determining the
cost of individual cost centers. For example, overheads incurred for a factory as a whole, combined
purchase cost for purchasing several materials in one consignment etc.

Joint cost is a kind of common cost. When two or more products are produced out of one material
or process, the cost of such material or process is called joint cost. For example, when cottonseeds

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and cotton fibers are produced from the same material, the cost incurred till the split-off or
separation point will be joint costs.

10. Prime Cost and Conversion Cost

Prime Costs: Prime costs are all direct manufacturing costs. Prime costs consist of direct material
costs and direct manufacturing labor costs. The greater the proportion of prime costs in a
company’s cost structure, the more confident managers can be about the accuracy of the costs of
products. As information-gathering technology improves, companies can add more and more
direct cost categories. Computer software companies often have a “Purchased Technology “direct
manufacturing Cost item. This item which represents payments to suppliers, who develop software
algorithms for a product, is also included in prime costs.

Conversion Costs: Conversion Costs are all manufacturing costs other than direct material costs.
Conversion costs represent all manufacturing costs incurred to convert direct materials into
finished goods. Conversion costs would comprise direct manufacturing labor costs and indirect
manufacturing costs.

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CHAPTER 3
3. JOB ORDER AND PROCESS COSTING SYSTEM
3.1. INTORDUCTION OF COSTING SYSTEM
The building blocks of costing system
1. Cost object—anything for which a measurement of costs is desired for example, a product,
such as a board for computer, or a service, such as the cost of repairing an iMac computer.
2. Direct costs of a cost object—costs related to a particular cost object that can be traced to that
cost object in an economically feasible (cost-effective) way—for example the cost of
purchasing the main computer board or the cost of parts used to make a computer.
3. Indirect costs of a cost object—costs related to a particular cost object that cannot be traced to
that cost object in an economically feasible (cost-effective) way—for example, the costs of
supervisors who oversee multiple products, or the rent paid for the repair facility that repairs
many different Apple computer products besides the product. Indirect costs are allocated to the
cost object using a cost allocation method.
4. Cost pool. A cost pool is a grouping of individual indirect cost items. Cost pools can range
from broad, such as all manufacturing-plant costs, to narrow, such as the costs of operating
metal-cutting machines. Cost pools are often organized in conjunction with cost-allocation
bases.
5. Cost-allocation base. How should a company allocate costs to operate metal-cutting machines
among different products? One way to allocate costs is based on the number of machine-hours
used to produce different products. The cost-allocation base (number of machine-hours) is a
systematic way to link an indirect cost or group of indirect costs (operating costs of all metal-
cutting machines) to cost objects (different products). The ideal cost-allocation base is the cost
driver of the indirect costs, because there is a cause-and-effect relationship between the cost
allocation base and the indirect costs. A cost-allocation base can be either financial (such as
direct labor costs) or nonfinancial (such as the number of machine-hours). When the cost object
is a job, product, or customer, the cost-allocation base is also called a cost-application base.
Management accountants use two basic types of costing systems to assign costs to products or
services; Job-costing system and Process costing system.

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[Link] ORDER COSTING

Job order costing system is used in situations where many different products are produced each
period. For example clothing factory would typically made many different types of jeans for both
men and women during a month. In a job order costing system, costs are traced to the jobs and
then the costs of the job are divided by the number of units in the job to arrive at an average cost
per unit. Job order costing system is also extensively used in service industries. Hospitals, law
firms, movie studios, accounting firms, advertising agencies and repair shops all use a variety of
job order costing system to accumulate costs for accounting and billing purposes. The details here
deal with a manufacturing firm, the same concept and procedures are used by many service
organizations.

The record keeping and cost assignment problems are more complex in job order costing system
when a company sells many different products and services than when it has only a single product
or service. Since the products are different, the costs are typically different. Consequently, cost
records must be maintained for each distinct product or job. A job order costing system requires
more effort than a process costing system.

3.2.1. Accounting Treatment Under JOC

A. Job cost sheet

After being notified that the production order has been issued, the accounting department prepares
a job cost sheet. “A job cost sheet is a form prepared for each separate job that records the materials,
labor and overhead costs charged to the job. After direct materials are issued, the accounting
department records their costs directly on the job cost sheet.

In addition to serving as a means for charging costs to jobs, the job cost sheet also serves as a key
part of a firm’s accounting records. The job cost sheets form a subsidiary ledger to the Work in
Process (WIP) account. They are detailed records for the jobs in process that add up to the balance
in the Work in Process (WIP).

Manufacturing costs can be classified in to three classifications; direct materials, direct labor and
manufacturing overhead costs.

Let us use the cost treatment under JOC method for a manufacturing company established in the
center of Hossana city. Assume Handakina Furniture Company (HFC) received an order from

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Reshad Furniture Company (RFC) which headed in Wolkite town. The company received order
for 4 guest chairs on January, 2018 that should be completed and submitted before January 19,
2018.

[Link].Measuring direct material cost in JOC system

At the beginning of production process, a document known as bill of materials is issued for
standard products. “A bill of material is a document that lists the type and quantity of each item of
materials needed to complete a unit of standard product.” In case where it is not possible to use
bill of materials, the production staff determines the materials requirements from the blueprints
submitted by the customer.

Materials Requisition Form

When an agreement is reached with the customer concerning the quantities, price and shipment
date for the order, a production order is issued. The production department then prepares a
materials requisition form. “The materials requisition form is a detailed source document that
specifies the type and quality of materials to be drawn from the storeroom, and identifies the job
to which the costs of the materials are to be charged.” The form is used to control the flow of
materials into production and also for making entries in the accounting records. The completed
form is presented to the storeroom clerk who then issues the necessary raw materials. The
storeroom clerk is not allowed to release materials without such a form bearing an authorized
signature.

Example: 1. Assume that on January 1, 2018 direct material costing Br. 860 is issued from the
storeroom. At the time the materials are issued from the storeroom, the following entry is made:

January 1 2018 Work In Process--------------------------860

Direct Material and Supplies----------------860

In case if additional raw materials are issued amounting to Br. 506 through requisition number 85
and Br. 238; through requisition number 92 to job 2B47 on January 5, and 7/2018 respectively.
Assume that on January 7, 2018 different factory expense (factory supplies expense, factory rent
expense) of Br. 190 was incurred. Transaction for job 2B47 will be

Date R. No. Description Debit Credit

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January 5, 85 Work in process 506

18
Direct material and supplies 506
January 6, 92 Work in process 238
2018
Direct material and supplies 238
January 7, - - Manufacturing Overhead 190
2018
Various accounts 190

[Link].Measuring Direct Labor Cost in JOC System

Labor Time Ticket

Direct labor cost is handled in much the same ways as direct materials cost. Direct labor consists
of labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced
directly to any job are treated as part of manufacturing overhead. The latter category of labor cost
is known as indirect labor and includes tasks such as maintenance, supervision, and cleanup.
Workers use time tickets to record the time they spend on each job and task. A completed labor
time ticket is an hour by hour summary of the employees activities throughout on specific job, the
employee enters the job number on time ticket and notes the amount of time spent on that job.
When not assigned to a particular job, the employee records the nature of the indirect labor task
and the amount of time spent on the task. The daily time tickets are also used as the basis for labor
cost entries into the accounting records.

Example 3. Additional labor hours incurred amounting to 8 hours on time ticket No. 846, 4 hours
on time ticket No. 850 and 10 hours on time ticket No. 851 on job 2B47 on January 5, 6 and 7/2018
respectively (assume the payment rate is Br 45 per hour). The journal entry for the transaction:

Date T. No. Description Debit Credit

January 5, 846 Work in process 1 360
18
Wages Payable 360
January 6, 850 Work in process 2 180
2018
Wages Payable 180

1
DLC = Hours rate * No. of hours = 45 * 8
2
DLC = Hours rate * No. of hours = 45 * 4

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January 7, 851 Work in process 3 450

2018
Wages Payable 450

[Link].Application MOH in JOC system

Predetermined overhead Rate

Manufacturing overhead must be included with direct labor on the job cost sheet since
manufacturing overhead is also a product cost. However, assigning manufacturing overhead to
units of product can be difficult task. There are three reasons for this:

1. Manufacturing overhead is an indirect cost. This means that it is impossible or difficult

either to trace to a particular product or job.
2. Manufacturing overhead consists of many different items ranging from the grease
(Lubricant) used in machines to the annual salary of production manager.
3. Even though output may fluctuate due to seasonal or other factors, manufacturing overhead
costs tend to remain relatively constant due to the presence of fixed costs.

Actual Costing VS Normal Costing

Actual Costing: Allocate direct material and direct labor cost to cost objects on the basis of actual
direct cost rate(s) and actual quantity of direct cost input(s). Overhead costs are allocated to cost
object on the basis of actual overhead rate computed at the end of the period and actual amount of
cost driver used.

Normal Costing: Allocate direct material and direct labor cost to cost objects on the basis of actual
direct cost rate(s) and actual quantity of direct cost input(s). Overhead costs are allocated to cost
object on the bases of the predetermined /budgeted/overhead rate computed at the beginning of the
period and actual quantity of cost allocation base.

Actual costing Normal costing

Actual direct cost rate x actual Actual direct cost rate x actual
Direct cost quantity of direct cost input quantity of direct cost input

Actual indirect cost rate x Actual Budgeted indirect cost rate x

Indirect cost quantity of cost allocation Actual quantity of cost allocation base
Nature Accurate but not timely Timely but less accurate

3
DLC = Hours rate * No. of hours = 45 * 10

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It might be tempting to solve the overhead rate problem by using an actual rate and recomputed
the rate frequently to provide more timely information. This is generally because of the numerator
and denominator factors such as:

Numerator factors (indirect cost pool)

 For seasonal products, the shorter the period, the greater the influence of seasonal patterns
e.g.:- Cost of heating is higher in summer than winter, the cost of ventilator is high in winter than summer
 Non seasonal erratic costs such as cost incurred in a particular month that benefit operation
during future months.
e.g. Repair and maintenance of equipment, vocation and holiday pay.

Denominator factor (quantity of allocation base)

 Some costs such as costs of supplies may be variable with respect to the cost allocation base,
where as other indirect costs are fixed (for example, property taxes and rent)

Given these problems, the only way to assign overhead costs to production is to use an allocation
process. This allocation of overhead cost is accomplished by selecting an allocation base that is
common to all of the company’s products and services.

An allocation base is a measure such as direct labor hours or machine hours or direct labor
cost or prime cost that is used to assign overhead costs to products and services.
The most widely used allocation bases are direct labor hours, and direct labor cost, with
machine hours and even units of product (where a company has only a single product) also
used to some extent.
The allocation base is used to compute “predetermined overhead rate” in the following
formula or equation.
 Computing Predetermined Overhead

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑀𝑂𝐻

Predetermined overhead rate = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒

Example: If HFC has estimated that its total manufacturing overhead cost will be Br. 320,000 for
the year and its total direct labor hour will be 40,000. Its predetermined overhead rate for the year
will be Br. 8 per direct labor hour, as calculated below:

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320,000
= = 8 birr per direct labor hour
40,000

Predetermined overhead rate is based on estimates rather than actual results. This is because the
predetermined overhead rate is computed before the period begins and is used to apply overhead
cost through the period. The process of assigning overhead cost to jobs is called overhead
application. The formula for determining the amount of overhead cost to apply to a particular job
is:

𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑/𝑢𝑛𝑑𝑒𝑟𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑡𝑜 𝑎 𝑝𝑎𝑟𝑡𝑖𝑐𝑢𝑙𝑎𝑟 𝑗𝑜𝑏 =

(𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 𝑥 𝐴𝑐𝑡𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟) − (𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑)4

[Link]- JOC System

To illustrate the procedures used to accumulate and assign costs to a job in job order costing
system, assume that HFC has three jobs in the month of January and February 2018- Job No. 664,
Job No. 665 and Job No. 666. Job No.664 is a job order received from Wachemo University for
1,000 student arm chairs, and Job No. 665 is production of 30 coffee tables for stock, and Job No.
666 is production of 10 Cupboards for stock. To keep the illustration simple, assume there is no
beginning inventory of Work in Process and Finished goods.

Step One: Direct Material Accounting

The beginning inventory of direct material consisted of the following:

Material A………………………………………………………… 22,400

Material B………………………………………………………..…. 15,600

Material C…………………………………………………………… 21,000

Total …………………………………………………………………. 59,000

On January 26, 2018 the following direct materials are purchased from Yac Wood Processing
Enterprise on credit.

Material A……………………………………………………… 2,000

4
Under applied or over applied case may come latter.

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Material B……………………………………………………… 32,000

Material C……………………………………………………… 80,000
Material D………………………………………………………. 4,000
Total………………………………………………………………. 118,000
Journal record is necessary for purchase request

Date Description Debit credit

2018, Jan. 26 Direct materials and supplies-control 118,000

Account Payable 118,000

Assume on January 28/2018, production is to commence and the following material are requested
and issued from the store

Material A…………………………..20,000

Material C …………………………. 12,000

Journal record is necessary for issuance of direct materials on January 28/2018

Date Description Debit credit

2018, Jan. 28 Work in Process 32,000

Direct materials and supplies-control 32,000

Now a separate job cost sheet is needed to accumulate cost of each job. Assume from the total
materials issued from the store, the three jobs are charged as follows:

Job No. 664……………………………………………. Br. 12,800

Job No. 665……………………………………………..… 6,400
Job No. 666…………………………………………………12,800
Total……………………………………………………..Br. 32,000
Sometimes additional direct material may be requested from store, let say additional materials are
issued amounting to Br. 78000 from the store as shown below out of which materials amounting
Br. 18,000 are indirect materials.

Material A………………………………………………………… 18,000

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Material B………………………………………………………… 23,000

Material C………………………………………………………… 31,000

Material D…………………………………………………………. 6,000

Total…… ……………………………………………………….Br. 78,000

Thus the following entry is necessary for such transactions

Date Description Debit Credit

2018 Feb. 14 Work in Process 60,000

Manufacturing overhead 18,000

Direct materials and supplies-control 78,000

Thus Job No. 664: …………………………………….. Br. 24000

Job No. 665: ………………………………………… 12000
Job No. 666: ……………………………………….. 24000
Step two: Accounting for direct labor

The total labor cost of Birr 25,000 is incurred out of which Birr 20,000 is indirect. The journal
entry to record the payroll for the month is as follows:

Date Description Debit Credit

2018, Jan. 31 Work in Process 5,000

Manufacturing overhead 20,000

Wages Payable 25,000

During the month of February 2018, the indirect manufacturing costs incurred totaled Birr 4,000.
The payroll for the month of February 2018 totaled Birr 48,000, out of which the indirect labor
cost is Birr 20,000. The direct labor cost is charged to the three jobs- Job No. 664, Job N. 665 and
Job No. 666 in 40%, 20% and 40% respectively. The following journal entries are required to
record the actual manufacturing overhead and the payroll for the month of February.

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Date Description Debit Credit

2018, Feb. 14 Manufacturing overhead 4,000

Various accounts 4,000

2018, Feb. 28 Work in Process 28,000

Manufacturing overhead 20,000

Wages Payable 48,000

Manufacturing overhead is applied at 70% of direct labor cost. The total direct labor cost is Br.
33,000 which is Br. 28,000 plus Br. 5,000. The following journal entry is required to record the
manufacturing overhead applied to the three jobs.

Date Description Debit Credit

2018, Feb. 28 Work in Process 23,100
Manufacturing overhead applied 23,100
The manufacturing overhead applied will be charged to the three jobs at 70% 0f their respective
direct labor cost.

Jobs Direct labor cost Overhead rate MOH applied

Job No. 664 13,200 70% 9,240
Job No. 665 6,600 70% 4,620
Job No. 666 13,200 70% 9,240
Job No. 664 and 665 are completed and transferred to the finished goods inventory warehouse.
To record the transfer, the job cost sheet must be summarized. The summary of the two job cost
sheets gives a total cost amounted to Br.59,240 and Br.29,620 respectively. The journal entry to
record the transfer looks the following:

Date Description Debit credit

2018, Feb. 28 Finished goods 88,860
Work in Process 88,860

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Job No. 664 is for 1,000 Student chairs, and Job No. 665 is for 30 coffee tables. Thus, the unit cost
of each product is Br. 59.24 and 987.30 respectively. The following table shows the computation
of unit cost of items produced.

Job No. 664 Job No. 665

Total cost of production Br. 59,240 Br. 29,620
Number of units produced 1000 30
Cost per unit 59.24 987.30
Assume Wachemo University has paid Birr 85 per chair for all chairs and 5 coffee tables are sold
for Br. 1,400 each during the month of February. Assume the factory employs the perpetual
inventory system. The journal entry to record the sale of the student chairs and coffee tables is as
follows:

Date Description Debit Credit

2018, Feb. 28 Cash 92,000
Sales 92,000
2018, Feb. 28 Cost of goods sold 64,176.50
Finished goods inventory 64,176.50

3.3.1. Disposition of Over and Under Applied Overheads

Under normal costing, actual manufacturing overhead is not used to determine the cost of the
product. Manufacturing overhead is applied to individual jobs at a predetermined rate. The actual
amount of manufacturing overhead cost at the end of the period rarely matches with the applied
manufacturing overhead costs during that period.

Under and over applied overhead at the end of one fiscal year should not be carried to the upcoming
periods; rather they should be disposed-off in the year the difference happened. The disposition of
under and over applied overhead costs can take one of the following three ways:

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1) Adjusted allocation rate approach

2) Write-off to cost of goods sold approach
3) Proration approach (Allocating among work in process, finished goods, and Cost of
goods sold) in proportion to the overhead applied during the current period in the end
balances of these account.

The third method, which allocates the under or over applied overhead among ending inventories
and cost of goods sold is equivalent to using an “actual” overhead rate and is for that reason
considered by many to be more accurate than the 1st and 2nd method. Consequently, if the amount
of the under or over applied overhead is material, many accounts would insist that the 3rd method
be used.

1) Write-off the under or over applied Overhead to Cost of Goods sold

Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than
the allocation method.

Suppose that at the end of the period the Manufacturing Overhead- Control account has a debit
balance of Birr 95,000 and the Manufacturing costs applied is Birr 90,000.

The under applied manufacturing overhead cost can thus be disposed to cost of goods sold in the
following manner:
Cost of goods sold………………………… 5,000
Manufacturing overhead applied…………... 90,000
Manufacturing overhead control …………………………95,000
Assume the MOH applied is over applied by 5000 Birr.

MOH applied ………………………….95000

Cost of Goods sold ………………………………. 5000

Manufacturing overhead control …………………90000

The applied manufacturing overhead is a contra account to manufacturing overhead control, and
thus, the normal balance for the applied manufacturing overhead is credit. At the end of the period,
both must be closed. The applied manufacturing overhead is debited and the actual manufacturing
overhead is credited, and difference is closed to cost of goods sold.

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2) Prorating under and over applied overhead costs to WIP, FG and CGS

Under and over applied overhead costs can also be disposed-off by prorating to work in process,
finished goods inventory and cost of goods sold.

Assume the following information is pertaining to Juliana Furniture Factory for the year 2017

End of year balance before Mfg overhead allocated part

proration of year-end-balances (before
proration)

Work-In-Process Br. 72,000 Br. 1,800

Finished Good 49,500 3,600

Cost of Goods Sold 118,500 84,600

Total Br. 240,000 Br. 90,000

Prorating under and over applied overhead costs on manufacturing overhead applied balances
based on the manufacturing overhead balance before proration:

Account Account Manufacturing Proration of the over Account balance

balances overhead applied (%) allocated overhead after proration

Work in
process
Br.72,000 Br. 1,800= 2% 2%xBr.5,000=Br. 100 Br.1,900
Finished
goods
49,500 3,600=4% 4%xBr.5,000=Br.200 3,800
Cost of
goods sold
118,500 84,600=94% 94%xBr.5,000=Br.4,700 89,300
Total Br. 240,000 Br. 90,000 Br. 5,000 Br. 95,000

Description Debit Credit

Manufacturing overhead applied 90,000

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Work in Process 100

Finished good 200

Cost of goods sold 4,700

Manufacturing overhead – 95,000

control

The over allocated amount can be prorated on the basis of the year-end balance of the respective
accounts as well. The following table shows the proration of the over allocated cost on the basis
of the year-end balance of the three accounts.
Account Account balance Proration of the over allocated Account balance
overhead after proration
Work in process Br. 72,000 (72,000/240,000)x100=30% Br. 73,500
30%xBr.5,000=Br. 1,500
Finished good 49,500 (49,500/240,000)x100=20.62% 50,531
20.62%xBr.5,000=Br.1,031
Cost of goods sold 118,500 (118,500/240,000)x100=49.38% 120,969
49.38%xBr.5,000=Br. 2,469
Total Br. 240,000 Br.5,000 Br.245,000
The journal entry is the same except that the amount is different. It is presented as follows:
Description Debit Credit

Manufacturing overhead applied 90,000

Work in Process 1,500

Finished good 1,031

Cost of goods sold 2,469

Manufacturing overhead – 95,000

control

JOURNAL ENTRIES FOR JOB-ORDER COSTING

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Illustration of a Job-costing in manufacturing company

1. Transaction: Purchase of materials (direct and indirect) for $89,000 on account.
Journal Entry
Materials control 89,000
Accounts payable control 89,000
(To record purchase of materials)
2. Transaction: Materials sent to manufacturing plant floor; direct materials 81,000 and indirect
materials 4,000.
Work-in-process control 81,000
Manufacturing overhead control 4,000
Materials control 85,000
(To record issuance of direct and indirect materials to production)
3. Transaction: Manufacturing labor wages liability incurred, direct 39,000 and indirect 15,000.
Work-in-process control 39,000
Manufacturing overhead control 15,000
Wages payable control 54,000
(To record direct and indirect wages liability)
4. Transaction: Payment of total manufacturing payroll for the month 54,000.
Wages payable control 54,000
Cash control 54,000
(To record the payment of manufacturing payroll)
5. Transaction: Additional manufacturing overhead costs incurred during the month $75,000.
These costs consists of utilities and repairs, $23,000, insurance expired $2,000 and
depreciation on equipment $50,000.
Manufacturing overhead control 75,000
Accounts payable control 23,000
Accumulated depreciation control 50,000
Prepaid insurance control 2,000
(To record manufactured overhead costs incurred)
6. Transaction: Allocation of manufacturing overhead to products $80,000.
Work-in-process control 80,000
Manufacturing overhead allocated 80,000

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(To record Transaction allocation manufacturing overhead)

7. Transaction: Completion and transfer to finished goods of eight individual Jobs $188,800.
Finished goods control 188,800
Work-in-process control 188,800
(To record the transfer from work-in-process to finished goods inventory)
8. Transaction: Cost of goods sold $180,000
Cost of goods sold 180,000
Finished goods inventory 180,000
(To record cost of goods sold)
9. Transaction: Revenues/sales
Accounts Receivable (Cash)…………………xxx
Sales Revenue…………………………………………xxx
(To record sale of goods)
[Link] COSTING SYSTEM
Process costing is a method for assigning product costs to units of product when all units of products
are virtually the same.

In general, process costing is used:

- In homogeneous products

- In continuous processing

- In mass production techniques

3.4.1. Difference Between Process Costing and Job Costing

The principal difference between process costing and job order costing is the extent of
averaging used to compute unit cost of product or service. The cost object in a job order costing
system is a job that constitutes a distinctly identifiable product or service. Thus, costs are
assigned to each cost object (job) with minimal averaging. In contrast, in process costing
system, the cost object is a processing center which produces a mass of similar units of a
product or service. Unit costs are computed by averaging total cost of the process over the total
number of similar units. The other points of differences between the two are the following:

i) There is difference in the initial classification and accumulation of products.

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ii) In process costing, the amount of production is determined to a large extent by supply
and demand for the product, while in job costing it is by a specific order.
iii) Generally, there are no transfers from one job to another unless there is surplus of work
or excess production. But in process costing transfers from one process to another are
natural and fundamental.
iv) In job costing, work in progress at the end is rare, but in process costing some balance
of unfinished work in each process is always there.
v) Exercise of control over jobs is relatively difficult as each job is separate and unique in
some respects. However, in process costing the exercise of the control is easier since
the processes are repetitive and more or less identical from period to period.
vi) Process costing is considered as a capital intensive process, where as job order is
characterized as a labor intensive process.
3.4.2. Classification and Assignment of Costs to Production Units
In manufacturing firms, production may take place in several depts. When the units are transferred
from one producing dep’t to another, the accumulated costs are transferred to the subsequent dep’t.
The cost of materials, labor, and factory overhead are charged to work in process accounts which
are maintained for each dep’t.

- Process costing system separate costs in to cost categories according to when costs are
introduced in to the process.
- Only two cost classifications, direct materials and conversion costs, are necessary to assign
costs to products. Why only two?
Because all direct materials are added to the process at one time and all conversions costs are
generally added to the process evenly through time.

We will use the production of the DG-19 component in the Assembly dep’t of Global Defense
Company to illustrate process costing in three cases, starting with the simplest case.

Case-1process costing with zero beginning and zero ending work in process inventory of DG-19 This
case presents the most basic concepts of process costing and illustrates the feature of averaging of
costs.

Case-2 Process costing with zero beginning work in process but some ending work in process
inventory of DG-19 (some units of DG-19 started during the accounting period are incomplete at
the ending of the period). This case introduces the concept of equivalent units.

Case-3 Process costing with both some beginning and ending work in process inventory of DG-19

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Case-1 Process costing with zero beginning and zero ending work in process inventory
Physical units for January 2004

Work in process, beginning inventory (January 1) 0 units

Start during January 400 units

Completed and transferred out during January 400 units

Work in process, ending inventory (Jan,31) 0 units

Total costs for January 2004

Direct material costs added during January $ 32,000

Conversion costs added during January 24,000

Total assembly Dep’t costs added during January $ 56,000

By averaging, the assembly cost per unit of DG19 is $56,000 per 400 units= $140 per unit

Direct material cost per unit ($32,000 ÷400 units) $80

Conversion cost per units ($24,000÷400units) -------- 60

Assembly Dep’t cost per unit……………………….. $140

Case-2 process costing with zero beginning but some ending work-in process inventory
In February 2004, global defense places another 400units of DG-19 in to production.

Physical units for February 2004

Work in process, beginning inventory (Feb1)……… 0 units
Started during February……………………………….. 400 units
Completed and transferred out…………………………….175 units
Work in process, ending inventory (Feb, 29) … 225 units
The 225 partially assembled units as of February 28, 2004 are fully processed with respect to direct
materials. That is because all direct materials in the Assembly Dep’t are added at the beginning of
the assembly Process. Conversion costs, however, are added evenly during assembly. An
Assembly Dep’t supervisor estimates that the partially assembled units are, on average, 60%
complete from the perspective of conversion costs.

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Total costs for February 2004

Direct material costs added during February $32,000

Conversion costs added during February 18,600

Total Assembly Dep’t costs added during February … 50,600

The point to understand here is that a partially assembled unit is not the same as a fully assembled
unit. Faced with some fully assembled units and some partially assembled units, Global Defense
Calculates in five steps:

1. The cost of fully assembled units in February 2004 and

2. The cost of the partially assembled units still in process at the end of that month:
Step [Link] the flow of physical units of output.

2. Compute output in terms of equivalent units

3. Compute equivalent unit costs.

4. Summarize total costs to account for

5. Assign total costs to units completed and to units in ending work in process.

Physical units and Equivalent units (step-1& 2)

Flow of production Physical Equivalent units
units
Direct Conversion
material costs
Work in process, beginning 0
Started during current period 400
Total units to be accounted for 400
Completed & transferred out
during current period 175 175 175
Work in process, ending a
(225x100%, 225x60%) 225 225 135
Total units accounted for Work done in
current period only

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400 400 310

a Degree of completion in this department; direct matierials,100%; conversion costs, 60%

Calculation of product costs (Step 3,4 and 5)

Exhibit-2 shows steps3, 4 and 5
Description Total Equivalent units
production cost
Direct Conversion
material costs
(Step-3) costs added during February $50,600 $32,000 $18,600
Divide by Equivalent units of Work done 400 310
in current Period(Exhibit-1)
Cost per equivalent unit $80 $60
(Step-4) Total costs to account for $50,600
(Step-5)Assignment of costs:

Completed and transferred (175unitsx$80) (175

unitsx$60)
Out (175 units) $24,500 $14,000
$10,500
(225
unitsx$80)
Work in process, ending (225units): $26,100 135
$18,000 unitsx$60)
$8,100
Total costs accounted for $50,600
The costs assigned to the 225 physical units in ending work in process are
o Direct material costs of 225 equivalent unit (exhibit-1, step-2)x$80cost per equivalent unit
of direct material calculated in step-3…………………………………………$18,000
o Conversion costs of 135 equivalent unit (exhibit-1,step-2)x $60 cost
per equivalent unit of conversion costs calculated in step-3…………………... $8,100
Total costs of ending work in process……………………………………$26,100

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Case-3 Process costing with some beginning and some ending work in process inventory
At the beginning of March 2004, Global Defense had 225 partially assembled DG-19 units in the
Assembly Department. It started production of another 275 units and 400 units are completed and
transferred in March 2004. Data for the Assembly Dep’t for March are

Physical units for March 2004

Work in process, beginning inventory (March1) .........225 units

Direct materials (100% complete)
Conversion costs (60% complete)
Started during March……………………………..……275 units
Completed and transferred out during March…………..400 units
Work in process, ending inventory (March)……………..100 units
Direct materials (100% complete)
Conversion costs (50% complete)

Total costs for March 2004

Work in process, beginning inventory
Direct materials (225 equivalent units x $80per unit) $18,000
Conversion costs (135 equivalent units x$60 per unit) 8,100 $26,100
DM costs added during March…………………………………… 19,800
CC added during March………………………………………….. 16,380
Total costs to account for ……………………………………………..……. $62,280
Global Defense now has incomplete units in both beginning work in process inventory and
ending work in process inventory for March 2004. We use the five steps described earlier to
calculate:
1. The cost of units completed and transferred out
2. The cost of ending work in process.
To assign costs to each of these categories, however, we need to choose an inventory cost flow
method. We do have two methods to assign the cost to the products. These are:-
1. Weighted-Average-Method and

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2. FIFO Method
We first describe the five step approach for the weighted-average method and then for the first-in
first-out method.

1. Weighted average Method

The weighted-average process costing method calculates the equivalent-unit cost of all the work
done to date and assign this cost to equivalent units completed and transferred out of the process
and to equivalent units in ending work in process inventory.

Exhibit-3
Physical units and Equivalent units (step-1& 2)
Flow of production Physical Equivalent units
units
Direct Conversion
material costs
Work in process, beginning 225

Started during current period 275

Total units to be accounted for 500
Completed & transferred out
during current period 400 400 400
Work in process, endingb
(100x100%, 100x50%) 100 100 50
Total units accounted for Work done in
current period only
500 500 450
b Degree of completion in this department: direct matierials,100%; conversion costs, 50% )
Calculation of product costs (Step 3,4 and 5)
Description Total Equivalent units
production cost
Direct Conversion
material costs
(Step-3) work in process, beginning $26,100 $18,000 $8,100

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costs added during March $36,180 $19,800 $16,380

Costs incurred to date $37,800 $24,480

Divide by Equivalent units of Work done 500 450

in current Period (Exhibit-3)
Cost per equivalent unit $75.60 $54.40
(Step-4) Total costs to account for $62,280
(Step-5)Assignment of costs:

Completed and transferred (400 units x (400

$75.60) unitsx$54.40)
Out (400 units) $52,000
$30,240 $21,760
(100 50
unitsx$75.60) unitsx$54.40)
Work in process, ending (100 units): $10,280
$7,560 $2,720

Total costs accounted for $62,280

First-In First-Out Method

The FIFO process costing:-

a. Assigns the cost of the previous accounting period’s equivalent units in beginning work in
process inventory to the first unit completed and transferred out of the process, and
b. Assigns the cost of equivalent units worked on during the current period first to complete
beginning WIP inventory , next to start and complete new units, and finally to units in
ending work in process inventory. The FIFO method assumes that the earliest equivalent
units in work process are completed first. A distinct feature of the process costing method
is that work done on the beginning inventory before the current period is kept separate from
work done in the current period. Cost incurred in the current & units produced in the current
period are used to calculate cost per equivalent unit of work done in the current period.
Exhibit-4

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Flow of production Physical Equivalent units

units
Direct Conversion costs
material
Work in process, beginning 225

Started during current period 275

Total units to be accounted for 500
Completed & transferred out
during current period (400)
From beginning Work in process 225 0 (225 units x
40%)=90
Started and completed 175 175 175
Work in process, ending
(100 unitsx100%, 100 unitsx50%) 100 100 50
Total units accounted for Work done in
current period only
500 275 315
Calculation of product costs (Step 3,4 and 5)
Description Total Equivalent units
production
Direct material Conversion
cost
costs
(Step-3) work in process, beginning $26,100 (Cost of work done before current
period)
costs added during March $36,180 $19,800 $16,380
Divide by Equivalent units of Work
done in current Period (Exhibit-3)
275 315
Cost per equivalent unit of work done
in current period
$72 $52
(Step-4) Total costs to account for $62,280
(Step-5)Assignment of costs:

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Completed and transferred

Out (400 units):
Work in process, beginning (225units) $26,100
DM added in current period 0 0ax$72

CC added in current period 4,680 90a x$52

Total from beginning inventory 30,780

Started and completed (175 units) 21,700 (175bx$72) (175bx$52)
Total costs of units completed and

transferred out 52,480

Work in process, ending (100unit):

Direct Material 7,200 100Cx$72=7,200

Conversion Cost 2,600 50Cx$52=2,600
Total WIP, ending 9,800

Total costs accounted for $62,280

Remarks:- a. Equivalent units used to complete beginning work in process
b. Equivalent units started and completed
c. Equivalent units in ending work in process

Comparison of weighted average and FIFO methods

Here is the summary of the costs assigned to units completed and to units still in process under the
weighted average and FIFO process costing methods in above example for March 2004

Weighted Average FIFO Difference

Cost of units completed and transferred out $52,000 $52,480 +$480

Work in process , ending 10,280 9,800 -480

Total costs accounted for $62,280 $62,280

[Link] – in Cost in Process Costing

As units move from department to department, the related costs are also transferred by monthly
journal entries. If standard costs are used, accounting for such transfers is simple.

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We now extend our global defense, Inc. example to the Testing department. As the assembly
process is completed, the Assembly department of Global Defense immediately transfers DG - 19
units to its testing department.
Here the units receive additional direct materials at the end of the process, such as crating and
other packing materials to prepare the units for shipment. Conversion costs are added evenly
during the Testing Department’s process. As units are completed in Testing, they are immediately
transferred to finished goods.
Data for the testing department for March 2004 are
Physical units for March 2004
Work in process, beginning inventory (March 1) 240 units
Transferred- in costs (100% complete)
Direct materials (0% complete)
Conversion costs (5/8, or 62.5% complete)
Transferred –in during march -----------------------------400 units
Completed during March----------------------------------440 units
Work in process, ending inventory (March 28) --------200 units
Transferred- in costs (100% complete)
Direct materials (0% complete)
Conversion costs (80% complete)
Costs of testing Department for March 2004
Work in process, beginning inventory
Transferred- in costs (240 equivalent units X$140 per
Equivalent units) -------------------------------------------------$33,600
Cost of Direct materials-------------------------------------------- 0
Conversion costs (150 equivalent units X $120 per
Equivalent unit---------------------------------------------------18,000$51,600
Transferred-in costs during March:
Weighted –average ---------------------------------- $52,000
FIFO -------------------------------------------------------- 52,480
Direct materials costs added during March -------- 13,200

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Conversion costs added during March --------------- 48,600

Transferred in costs are the costs incurred in previous departments that are carried forward as the
product’s cost when it moves to a subsequent process in the production cycle.
Transferred-in costs are treated as if they are separate type of direct material added at the beginning
of the process. When successive departments are involved, transferred units from one dep’t
become all or a part of the DM of the next dept; however, they are called transferred-in costs, not
DM costs.
3.5.1. Transferred-in Costs and the Weighted Average Method
To examine the weighted average process costing method with transferred –in costs, we use the
five-step procedure described earlier to assign costs of the Testing department to units completed
and transferred out and to units in ending work in process. Note, direct material costs have a zero
degree of completion in both the beginning and ending work in process inventories because, in
testing, direct materials are introduced at the end of the process.
The next table shows step 1and2
Equivalent units
Flow of production Physical Transferred-in Direct Conversion
units cost materials costs
Work in process, beginning 240
Transferred in during current
period
400
Total units to be accounted for 640
Completed and transferred out
during current period
440 440 440 440
Work in process, ending a
(200x100%,200x0%, 200x80%)
200 200 0 160
Total units accounted for 640
Work done to date 640 440 600
a Degree of completion in this department: transferred-in costs,100% ; DM,0%; CC,80%
the following table describes step 3, 4 and5 for the weighted-average method.
Beginning work in process and work done in the current period are combined for purposes of
computing equivalent-unit costs for transferred-in costs, direct material and conversion costs.

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Total Transferred-in Direct Conversion

production costs materials costs
costs
(step-3) work in process,
beginning
$51,600 $33,600 $0 $18,000
Costs added in current
period
113,800 52,000 13,200 48,600
Costs incurred to date $85,600 $13,200 $66,600
Divide by equivalent units
of Work done to date
÷640 ÷440 ÷600
Cost per equivalent unit of
work done to date
$133.75 $30 $111

(Step-4) Total costs to $165,400

account for
(Step-5) Assignment of
costs:
Completed and
transferred
$120,890 (440ax$133.75) (440ax$30) (440ax$111)
out (440 units)
=58,850 13,200 48,840
Work in process, ending
(200units):

Transferred in costs $26,750 200bx$133.75

Direct materials 0 0bx$30
Conversion costs 17,760 160bx$111
Total work in process, 44,510
ending

Total costs accounted for $165,400

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Remark: a equivalent units completed and transferred out from step-2.

b equivalent unit in ending work in process step-2

 The journal entry for the transfer from testing to finished goods
Finished goods control $120,890
Work in process, testing $120,890
(To record costs of goods completed and transferred out from testing to finished goods)
 Entries in the work in process- testing account are
Work in process -testing

Beginning inventory, March $ 51,600 Transferred out $ 120,890

Transferred – in costs 52,000
Direct materials 13,200
Conversion costs 48,600
Ending inventory, March 31 44,510

3.5.2. Transferred –in costs and the FIFO method

To examine the FIFO process- costing method with transferred –in costs, we again use the five
step procedure. Other than considering transferred-in costs, the computations of equivalent unit
are the same as under the FIFO method for the Assembly Dep’t shown in Exhibit-4:
FIFO method of process costing
Testing Department of Global Defense, Inc, for March 2004
Equivalent units
Flow of production Physical Transferred-in Direct Conversion
units cost materials costs
Work in process, beginning 240
Transferred in during current period
400
Total units to be accounted for 640
Completed and transferred out during
current period:

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From beginning work in process- 240 0 240 90

{240 (100%-100%), 240X (100%-
0%)
240 x (100%-62.5%}
Started and completed 200 200 200 200
Work in process, ending a
(200x100%,200x0%, 200x80%)
200 200 0 160
Total units accounted for 640
Work done to date 400 440 450

Steps 3, 4 and 5

Total Transferred-in Direct Conversion

production costs materials costs
costs
(step-3) work in process,
beginning
$51,600 $33,600 $0 $18,000
Costs added in current period 114,280 52,480 13,200 48,600
Divide by equivalent units of
Work done to date
÷400 ÷440 ÷450
Cost per equivalent unit of
work done in current period
$131.20 $30 $108

(Step-4) Total costs to

account for
$165,880
(Step-5) Assignment of
costs:
Completed and transferred

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out (440 units):

Work-in process, beginning
(240units)
$51,600

Transferred –in costs added

in current Period
0 0x$131.20
Direct materials added in
current period
7,200 240ax$30
Conversion costs added in
current period
9,720 90ax108

Total from beginning WIP

inventory
$68,520
Started and completed
(200units)
53,840 (200bx131.20) (200bx30) (200bx108)

Total costs of units $122,360

completed &Transferred out

Work in process, ending

(200units):

Transferred in costs $26,240 200bx$131.20

Direct materials 0 0bx$30
Conversion costs 17,280 160bx$108
Total work in process, $43,520
ending

Total costs accounted for $165,880

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Entries in the work in process – testing account are

Work in process- Testing

Beginning inventory, March, $ 51,600 transferred out $122,360

Transferred –in costs 52,480
Digit materials ------------------- 13,200
Conversion costs ----------------- 48,600
Ending inventory march 28 ----43,520
Points to remember about transferred –in costs
Here are some points to remember when accounting for transferred –in costs:
1- Be sure to include transferred –in costs from previous department in your calculations.
2- In calculating costs to be transferred on a FIFO basis, do not overlook the costs assigned
in the previous period to units that were in process at the beginning of the current period
but are now included in the units transferred out.
For example, don’t overlook the $51,600 in Exhibit: 8
Remark: a Equivalent units used to complete beginning work in process from exhibit -7, step-2
b Equivalent units started and completed from exhibit 7, step-2
C Equivalent units in ending work-in process from exhibit - 7,step-2

Chapter Four
4. Accounting for Spoilage, Rework and Scrap

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Defects are natural to any production process, and thus cannot be totally avoided. In fact it
is possible to reduce the rate of defect and that is the important point of managing defects.
Reducing defects means reducing cost of products which in turn means adding value on
the products manufactured. Defective units are those units that cannot be sold at normal
prices without incurring additional costs in the form of rework. Defective units are either
spoiled units that cannot be reworked and that cannot be sold at all or that can be sold at
less than normal price or defective units that are sold at normal prices after they get
reworked.

Spoilage refers to defective units that are unacceptable and as a result cannot be sold for
normal prices. Spoiled units may or may not have any selling price. Spoiled units have
selling prices when the level of defect is insignificant and if it can be used for some purpose
with that defect remain intact. If the level of defect is significant, the defective unit may
not serve any purpose, and therefore, the spoiled units may not have any selling price.

Rework, on the other hand, refers to unacceptable units that can be reworked and then sold
for normal prices. After the units get repaired, they become good units and sold for normal
price.

Scrap refers to materials that are left over from production processes.

As defects are integral part of any production process, some level of defect is tolerable.
The important point is to determine that level of defect that is accepted as normal. There is
no hard and fast rule as to the level of defect that is considered as normal. It depends on
several factors like the philosophy of the management, and the nature of the manufacturing
process. Some managers may consider defective units up to 10% of good units as normal
spoilage. Another manager may say any defect level beyond 5% of good units is abnormal.
Thus, spoilage, rework and scrap can be classified as normal and abnormal based on the
level of defect.

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[Link] for Spoilage

Normal spoilage refers to unacceptable units that arise under an efficient production
process. The problem is the rate of defect that can arise under the most efficient operation
is unknown. Thus, the rate is left to subjective judgment of the management. The cost of
normal spoilage is added to the cost of good units produced because good units cannot be
produced without simultaneous production of spoiled units. In calculating normal spoilage,
the base is the number of good units produced. The total production is not considered as it
includes abnormal spoilage as well. Also normal spoilage represents the level of defect that
is linked with the production of good units

Abnormal spoilage refers to unacceptable units that are above and beyond the defect level
that is considered as normal. In other words, it is a level of defect that is not expected under
an efficient operation system. Abnormal spoilage represents defects that can be avoided
and controlled with increased level of efficiency. The cost of abnormal spoilage is
separately reported as loss from abnormal spoilage.

4.1.1. Job Order Costing System and Spoilage

The concept of spoilage is the same under both job order costing system and process
costing system. Normal spoilage is uncontrollable while abnormal spoilage can be
controlled by increasing the level of efficiency under which the firm operates. Cost of
normal spoilage is included to cost of the good units completed but cost of abnormal
spoilage is separately reported and written off in the same accounting period the defective
units occurred.

Normal spoilage can be attributable to a specific job i.e., the defect happened specifically
because of the nature of the job or it can be common to all jobs. Normal spoilage thus is
categorized into two as normal spoilage attributable to the specific job and normal spoilage
common to all jobs. To illustrate the treatment of cost of normal spoilage, let’s look into
the following example.

Example- Batu Technical and Vocational School manufactures and sells household and
office furniture. Job 478 is for 100 beds for customer called JJ Company. 10 out of the 100
beds are found spoiled. The cost of each bed before the inspection point is Birr 1,000. Thus,
the total cost of normal spoilage is Birr 10,000 (10x1000).

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Normal spoilage attributable to specific job- The spoilage is assumed to occur just because
of the specification of the job. The cost associated with the normal spoilage is already
included into the work in process account and thus no journal entry is required for this.
Suppose the spoiled units can be sold for Birr 450 each. The amount realized from sell of
the spoiled units is Birr 4,500 which is 10x450. This amount is used to reduce the balance
of work in process account. The following journal entry will be made to record the possible
selling price of the item.

Materials control------------------- 4,500

Work in process--------------------------4,500

The work in process account has now decreased by the sales value of the spoiled units. The
net cost of the spoiled units is Birr 5,500 which is their total cost of Birr 10,000 less net
realizable value of the spoiled units birr 4,500. The net cost is already added to the cost of
the remaining 90 good units completed.

Normal spoilage common to all jobs- Some spoilages are normal but they are not inherent
to a specific job. Under such circumstances, the net cost of the spoilage is charged to
manufacturing overhead. Assuming the same example above, the following journal entry
would be made assuming the spoilage is common to all:

Materials control……………….. 4,500

Manufacturing overhead……….. 5,500

Work in process…………………………….. 10,000

The work in process account has now decreased by Birr 10,000 which is the total cost of
the spoiled units. The cost of the spoilage should not be charged to the specific job because
it is not because of the nature of the job. Thus, it should spread to all jobs throughout that
period. When the predetermined overhead rate is calculated, the budgeted overhead should
include normal spoilage attributable to all jobs. The cost of the good units completed
includes only cost of the 90 units plus share of the 5,500 net costs of the spoiled units.

Abnormal Spoilage:- If the total spoiled units are beyond what is considered as normal,
the difference between the total spoilage and the normal spoilage is regarded as abnormal

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spoilage. The cost of abnormal spoilage is separately reported as loss from abnormal
spoilage. Cost of abnormal spoilage by no means included into the cost of good units
completed. The following journal entry will be made to record the abnormal spoilage:

Materials-control…………………4,500

Loss from abnormal spoilage…….5,500

Work in process……………………….10,000

The work in process account has now decreased by Birr 10,000 which is the total cost of
the spoiled units. The cost of abnormal spoilage cannot be added to the cost of good units
completed

4.1.2. Process Costing System and Spoilage

Accounting for spoilage under the Process Costing System is the same as the Job Order
Costing System. Since identical units are produced in mass, there is no difference among
batches of products, and therefore there is no spoilage attributable to a specific batch of
product. To illustrate process costing system and spoilage, let’s look at the following
example.

Example:- ODA Corporation produces item called Gonsho which is part of a mobile
apparatus in its three departments called Forming, Finishing and Packaging. During the
current month, June 2012,there were 3,000 units in the forming department in the form of
work in process which are 100% completed in regard to direct material and only 60%
complete in regard to conversion costs. 17,000 units are also started in the same month,
14,000 units were completed and transferred to the next department, and 4,000 units are in
the form of work in process at the end of the month that are 100% complete in regard to
direct material and 50% complete in regard to conversion cost. The rest units are inspected
and found to be defective that cannot be reworked and sold at normal prices. Under normal
circumstances, 10% of good units are expected to be spoiled. Direct materials added at the
beginning of production process, and conversion costs are added evenly during the
production process. The following is summary of the cost of production in the month of
June 2012.

Work in process June 2012:

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Direct material………………………..30,000
Conversion cost………………………. 21,600
Total cost of work in process June 2012…………………..…...... 51,600
Direct material ……………….....……….. 175,000
Conversion costs …………………………. 198,450
Total cost added during the period ................................................ 373450
Total cost to be accounted for……………………………….....….. 425,050
The Five Steps for Process Costing Remain the Same.
Step1-Summary of the physical flow of goods- the total number of units during the month
are 20,000 of which 3,000 were at the beginning of the month and 17,000 started new. Out
of these 20,000 units, 14,000 were completed and transferred out and 4,000 units are started
but not completed at the end of the month. The other 2,000 units are believed to be spoiled.

Physical units for June 2012

Work in process June 1, 2012(60%)……………………. 3,000 units

Started during June………………………………. 17,000 units

Total units to be accounted for…………………… 20,000 units

Completed and transferred out……………………… 14,000 units

Work in process June 31, 2012(50%)………………… 4,000 units

Spoiled units = (beginning units + newly started units)-(Good units completed +

Ending units)

=(3,000 + 17,000)-(14,000 + 4,000)

= 20,000-18,000

= 2,000 units

Normal spoilage is 10% of good units completed, i.e. 10% of 14,000 or 1,400 units

Abnormal spoilage= total spoilage –normal spoilage

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= 2,000-1,400

=600 units

Step 2- Equivalent unit calculation – equivalent units are calculated for spoiled units in the
same way it is done for good units. This is because here the assumption is that spoiled units
are found upon inspection of finished goods. So spoiled units are 100% complete in regard
to both direct material and conversion costs. Had there been inspection before the end of
the production process, the equivalent unit calculation would have been different. The
equivalent unit calculation is shown on the production cost report on the next pages.

Step 3- Summary of costs to account for- total cost to account for is the sum of the cost of
the beginning work in process and the current cost added.

Step 4-equivalent unit cost- the equivalent unit cost is calculated as total cost divided by
total units. The step is different among weighted average and FIFO method. The calculation
is shown on the production cost report on the following pages.

Step 5- Assignment of total cost to good units completed, abnormal spoilage and ending
work in process- Total cost to be accounted for will be assigned to good units completed,
abnormal spoilage, and ending work in process. The steps are shown below.
ODA Corporation
Production Cost Report-WA
For the Month of June 2012
Physical Equivalent units
units
Direct Conversi
materials on costs
Work in process, beginning 3,000
Started during June 17,000
Total units to be accounted for 20,000
Good units completed and
transferred out 14,000 14,000 14,000
Normal spoilage 1,400 1,400 1,400
Abnormal spoilage 600 600 600
Work in process ending 4,000 4,000 2,000
Total units accounted for 20,000
Work done to date 20,000 18,000
Summary of costs
Work in process beginning 51,600 30,000 21,600

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Current cost added 373,450 175,000 198,450

Total cost to be accounted for 425,050 205,000 220,050
Equivalent unit cost 205,000 220,050
20,000= 18,000=1
10.25 2.225
Assignment of total cost
Good units completed before
normal spoilage 314,650 14,000x1 14,000x1
0.25=143 2.225=17
,500 1,150
Normal spoilage 31,465 1,400x10 1,400x12.
.25=14,3 225=17,1
50 15
Total cost of good units
completed and transferred out 346,115
Abnormal spoilage 13,485 600x10.2 600x12.2
5=6,150 25=7,335
Working process ending 65,450 4,000x10 2,000x12.
.25=41,0 225=24,4
00 50
Total cost accounted for 425,050

ODA Corporation
Production Cost Report-FIFO
For the Month of June 2012
Physical Equivalent units
units
Direct Conversi
materials on costs
Work in process, beginning 3,000
Started during June 17,000
Total units to be accounted for 20,000
Good units completed and
transferred out:
From beginning work in 3,000 0 1,200
process 11,000 11,000 11,000
Currently started 1,400 1,400 1,400
Normal spoilage 600 600 600
Abnormal spoilage 4,000 4,000 2,000
Work in process ending 20,000
Total units accounted for
Work done to date 17,000 16,200
Summary of costs

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Work in process beginning 51,600 30,000 21,600

Current cost added 373,450 175,000 198,450
Total cost to be accounted for 425,050
Equivalent unit cost 175,0001 198,450
7,000 = 16,200=1
10.29 2.25
Assignment of total cost
Good units completed before
normal spoilage: 1,200x12.
From beginning work in 51,600 25=14,70
process 14,700 0
66,300 11,000 x 10.29 11,000 x 12.25
Total from beginning inventory 113,235.30 134,750
From currently started 247,985.30
314,285.30

Normal spoilage 31,561.7 1,400 1,400

5 x10.29 x12.25
=14,411. =17,150
75
Total cost of good units
completed and transferred out 345,847.
05
Abnormal spoilage 13,526.5 600 600
0 x10.29 x12.25
=6,176.5 =7,350
0
Working process ending 65,676.4 4,000 2,000
5 x10.29 x12.25
=41,176. =24,500
45
Total cost accounted for 425,050
The following journal entries are required to record the facts using the weighted
average method.

Work in process…………………………. 175,000

Direct material-control………………………………. 175,000
(To record the issuance of direct materials)
Work in process………………………….. 198,450
Conversion cost………………………………………….. 198,450
(To record conversion costs)

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Work in process-Finishing department………………… 346,115

Work in process-Forming department……………………………..346,115
(To record the transfer of goods from the forming department to the finishing
department)
Loss from abnormal spoilage…………………13,485
Work in process………………………………………….. 13,485
(To record cost of abnormal spoilage)
The following journal entries are required to record the facts using the FIFO method.
Work in process…………………………. 175,000
Direct material-control………………………………. 175,000
(To record the issuance of direct materials)
Work in process………………………….. 198,450
Conversion cost………………………………………….. 198,450
(To record conversion costs)
Work in process-Finishing department………………… 345,847.05
Work in process-Forming department……………………………..345,847.05
(To record the transfer of goods from the forming department to the finishing
department)
Loss from abnormal spoilage…………………13,526.50
Work in process………………………………………….. 13,526.50
(To record cost of abnormal spoilage)
[Link] for Rework
Rework refers to unacceptable units of production that can be repaired and subsequently
sold at normal price. Just like spoilage, rework can be classified as normal rework
attributable to a specific job, normal rework common to all jobs and abnormal rework.

To illustrate rework let’s look into the example given for spoilage about Batu Technical
and Vocational School.

Normal rework attributable to a specific job- If the rework comes because of the specific
order and it is within tolerable limit, then the rework is said as normal rework attributable
to specific job. The cost of the rework is also charged to the specific job. Suppose the 10

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defective units can be reworked at a cost of Birr 2,650 which is direct material Birr 1,050,
direct labor Birr 950 and manufacturing overhead is birr 650, the following entry is
required to record the rework:

Work in process…………………………2,650
Direct material control…………………………….. 1,050
Wage payable………………………………………. 950
Manufacturing overhead applied…………………… 650
The work in process account increases by Birr 2,650 which is the total cost of rework.

Normal reworks common to all jobs:- If the rework is under a tolerable limit and if it is not
attributable to a specific job, then the rework is said as normal rework common to all jobs.
The total cost of rework, when such is the case, would be charged to manufacturing
overhead control account. Assuming the same example and rework as normal rework
common to all jobs, the following journal entry is required to record the rework:

Manufacturing overhead-control…………………2,650
Direct material control………………………………1,050
Wages payable……………………………………… 950
Manufacturing over head applied………………….. 650
The work in process account is unaffected by the journal entry implying that the cost is not
added to the cost of the good units completed. The rework cost will be distributed to all
products produced in that period through the predetermined manufacturing overhead rate.
When the predetermined overhead is calculated, the budgeted manufacturing overhead also
includes budgeted cost for normal rework attributable to all jobs.

Abnormal reworks:- If the total units require rework are beyond the tolerable limit, the
rework cost above the limit set as the norm is said abnormal rework. Abnormal rework is
reported separately as a loss in the period the rework is made. The following entry is
required to record abnormal rework assuming the previous example:

Loss from abnormal rework…………………. 2,650

Direct material control………………………… 1,050

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Wage payable…………………………………… 950

Manufacturing overhead applied………………… 650
Accounting for rework is the same for process costing system except that there is no normal
rework attributable to a specific job. Normal and abnormal reworks are also separated in
process costing also. The way such transactions are recorded is also very similar.

[Link] for Scrap

Scrap refers to materials left over during production. Scraps are often salable though their
selling price is less as compared to the selling price of the products from which the scrap
is produced. Important considerations in accounting for scrap are when to recognize scrap
in the accounting records, and how the revenue from scrap should is accounted for.

With regard to the timing of recognition of scrap in the accounting records, there are two
accounting methods: these are the production method and sales method. The production
method recognizes scrap at the time of production whereas, the sales method recognizes
scrap at the time of sale and no journal entry is required when the scrap is produced.

Recognizing Scrap at the time of sale

When the sales value from scrap is immaterial, no journal entry is required by the time the
scrap is returned to store. That is scrap is not recognized during production when this
method is used. Sales of scrap are recorded by a debit to cash or account receivable and
credit to sales of scrap. Revenue from sales of scrap is reported separately under “other
revenue” column of the income statement. Suppose scrap is sold for Birr 500, the following
entry is made to record the sale:

Cash/Account receivable……………….. 500

Sale of scrap…………………………………….. 500
When the sales value of scrap is significant or material, first the scrap must be identified
whether it is attributable to a specific job or common to all jobs in that period. If the scrap
is attributable to a specific job, the sales value of the scrap would be credited to work in
process account which means the value of the work in process account decrease by the
amount of the sales value of the scrap. In short, the cost of the specific job will be less by

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the amount of the sales value of the scrap. Suppose a scrap is sold for Birr 3,000, the journal
entry required to record the sale is as follows:

Cash/Account receivable……………………….. 3,000

Work in process………………………………………… 3,000
If the scrap is common to all jobs, the sales value of the scrap is credited to manufacturing
overhead control account. The following journal entry is required assuming that the scrap
is common to all jobs and the amount is significant.

Cash/Account receivable……………………….. 3,000

Manufacturing overhead control…………………………… 3,000
Recognizing scrap at the time of production

No journal entry is required when scrap is produced under the sales method of recognizing
scrap. Recognizing scrap at the time of sale is appropriate when the time between
production and sale is short. When the time between production and sale is long and when
the amount is significant, scrap needs proper accounting. The production method of
recognizing scrap is theoretically sound and it is helpful when the size of the scrap is huge
and the time between production and sale is outsized.

Just like the sales method, the scrap must be identified as to whether it is attributable to a
specific job or common to all. The following journal entry is required when the scrap is
attributable to a specific job.

Materials control…………….. 3,000

Work in process control……………………… 3,000
The above journal entry is recorded by the time the scrap is produced. By the time the scrap
is sold, the following journal entry is required:

Cash/Account receivable……………………….. 3,000

Material control………………………………………… 3,000
When the scrap is found to be common to all jobs, the following entry is required by the
time the scrap is produced:

Materials control………………………3,000

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Manufacturing overhead…………………3,000
By the time the scrap is sold, the following entry is required:

Cash/Account receivable……………………. 3,000

Materials control……………………………………….. 3,000
Sometimes, instead of selling the scrap, it may be reused for production purposes. When
such is the case, the following entry is required:

Work in process…………………………….. 3,000

Materials control………………………….. 3,000
The above journal entry is the same whether the scrap is identifiable with a specific job or
common to all jobs, the same like when scrap is sold. The journal entry to record sale of
scrap is the same whether the scrap is attributable to a specific job or common to all.

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Chapter 5 :
5. Income Effect of Alternative Product Costing Methods
Income is one of many important measures used to evaluate the performance of both segments
and entire companies. There are two alternative methods for reporting income in a manufacturing
firm, depending on the accounting treatment of fixed manufacturing overhead. In this chapter we
will examine these two income-reporting alternatives, called absorption costing and variable
/marginal/costing.

[Link] Costs
in the products-costing systems we have studied so far, that manufacturing overhead is applied to
Work-in process Inventory as a product cost along with direct material and direct labor costs.
When the manufactured goods are sold finished, these product costs flow from Work-in process
Inventory into Finished-Goods Inventory. Finally, during the accounting period when the goods
are sold, the product costs flow from Finished Goods Inventory in to cost of goods sold, and
expense account.

 Absorption costing- in our study of product-costing systems, we included both variable and
fixed manufacturing overhead in the products costs that flow through the manufacturing
accounts in addition to direct costs. This approach to product costing is called absorption
costing (or full costing), because all manufacturing –overhead cost are applied to (or absorbed
by) manufactured goods.
 Variable (or direct costing)-is alternative approach to product costing is called variable
costing or direct costing, in which only variable manufacturing overhead is applied to Work-
in-Process Inventory as a product cost in addition to direct costs. Fixed manufacturing
overhead costs are expensed as they are incurred.
The distinction involves the timing with which fixed manufacturing overhead become an expense.
Eventually, fixed overhead is expensed under both product-costing systems. Under variable
costing, however, fixed overhead is expensed immediately, as it incurred. Under absorption
costing, fixed overhead is inventorial until the accounting period during which the manufactured
goods are sold.

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A. Variable Costing
Incurred Completed Sold
DM, DL and WIP on Balance FG on Balance Expense on
sold Sheet Sheet income
Variable MOH statements
When costs are incurred
Fixed manufacturing costs Expenses on income
statements
B. Absorption costing

Direct material Expense on

When costs Work-in process when Finished goods when income
Direct labor Inventory on statements
Are incurred Inventory on goods good
All manufacturing balance sheet balance sheet

overhead are sold are sold

[Link] of Absorption and Variable Costing Income Statements

The merits of variable costing may be viewed in terms of the usefulness of the data provided by
its application. Some company managers believe that variable costing furnishes more
understandable data regarding costs, volumes, revenues, and profits to members of management
who are not formally trained in the field of accounting. It presents cost data in a manner that
highlights the relationship between sales and variable production costs, which move in the same
direction as sales. Furthermore, they believe that variable costing helps management planning
because it presents a clearer picture of how changes in production volume affect costs and income.

Although variable costing may provide useful information for internal decision making, it is not a
generally accepted method of inventory costing for external reporting purposes. The measurement
of income, in traditional accounting theory, is based on the matching of revenues with all
associated costs. Under absorption costing, product costs include all variable and fixed
manufacturing costs. These costs are matched with the sales revenue in the period in which the
goods are sold. Variable costing, however, matches only the variable manufacturing costs with
revenue. Absorption costing must be used for income tax purposes as well as for external financial
statements. Regulations of the Internal Revenue Service specifically prohibit variable costing in
computing taxable income.

Variable costing is also criticized because no fixed factory overhead cost is included in work in
process or finished goods inventories. In the opinion of variable costing opponents, both fixed and

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variable costs are incurred in manufacturing products. Because the inventory figures do not reflect
the total cost of production, they do not present a realistic inventory cost valuation on the balance
sheet. Adjustments can be made to the inventory figures to reflect absorption cost on published
financial reports while retaining the benefits of variable costing for internal decision-making
purposes.

The advantages of variable costing can be summarized as follows:

1. Data required for CVP analysis can be taken directly from a contribution format income
statement. These data are not available on a conventional absorption costing income
statement.
2. Under variable costing, the profit for a period is not affected by changes in inventories.
Other things remaining the same (i.e., selling prices, costs, sales mix, etc.), profits move in
the same direction as sales when variable costing is used.
3. Managers often assume that unit product costs are variable costs. This is a problem under
absorption costing because unit product costs are a combination of both fixed and variable
costs. Under variable costing, unit product costs do not contain fixed costs.
4. The impact of fixed costs on profits is emphasized under the variable costing and
contribution approach. The total amount of fixed costs appears explicitly on the income
statement, highlighting that the whole amount of fixed costs must be covered for the
company to be truly profitable. In contrast, under absorption costing, the fixed costs are
mingled together with the variable costs and are buried in cost of goods sold and ending
inventories.
5. Variable costing data make it easier to estimate the profitability of products, customers,
and other business segments. With absorption costing, profitability is obscured by arbitrary
fixed cost allocations.
6. Variable costing ties in with cost control methods such as standard costs and flexible
7. Variable costing net operating income is closer to net cash flow than absorption costing net
operating income. This is particularly important for companies with potential cash flow
problems.

To summarize:

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Variable costing and absorption costing differ in only one basic respect i.e. how to account for
fixed manufacturing costs. Under variable costing, fixed manufacturing costs are excluded from
inventorial costs and are a cost of the period in which they are incurred. Thus, only variable
manufacturing costs are inventoried in this method. Under absorption costing method, all variable
manufacturing and all fixed manufacturing costs are included as inventoreable costs and become
a part of cost of goods sold in the period when sales occur.

1. The variable –costing income statement is based on the contribution-margin format. The
contribution margin in this case is measured as the deference between revenue of the period
and both variable manufacturing and variable non manufacturing costs. The absorption-
costing income statement is based on the gross-margin format. The gross margin is
measured as the difference between the revenue of the period and cost of goods sold.
2. Under variable costing, reported operating income is driven by the unit level of sales.
Under absorption costing, reported operating income is driven by the unit level of
production as well as by the unit level of sales.
3. Managers can increase operating income when absorption costing is used by producing
more units. Critics of absorption costing label this potential outcome as the major negative
consequence of treating fixed manufacturing overhead as an inventoreable cost.
4. The effect of changes in unit inventory levels on operating income is such that:
i) If production and sales of a given period are equal, then operating income
reported under both variable and absorption method will be equal.
ii) If production of a period is greater than the sales of the period, then,
lower operating income will be reported by variable costing method than
absorption costing method.
iii) If production of a given period is less than sales of that period, then
higher operating income will be reported by variable product costing
method than absorption product costing method.

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Illustration on variable and absorption costing- Assume that AB-company began operation on
January-1, 2013, to manufacture hand held electronic calculator.

2013 2014 2015

Production and inventory data:
Actual production (in units) --------50,000 ------------50,000 -------- 50,000
Sales (in units) ----------------------- 50,000 -------------35,000 ------- 65,000
Ending inventory (in units) --------- -0- -------------- 15,000 --------- -0-
Revenue and cost data, all three years:
-Sales price per unit-----------------------------------------------------------------$12
- Standard manufacturing costs per unit:
Direct material--------------------------------------------------------------$3
Direct labor------------------------------------------------------------------2
Variable manufacturing overhead ----------------------------------------1
Total variable standard cost per unit-------------------------------------- $ 6
Fixed manufacturing overhead per year……………………………150,000
- Variable selling and administrative costs per unit------------------------------$1
- Fixed selling and administrative costs per year ----------------------------- $25,000
Required:
a) Prepare income statement under both absorption and variable costing.
b) Reconcile the income statement reported by absorption and variable costing.

Exhibit 6-3: Income Statements comparison under Absorption and variable costing
AB- Company
Absorption-costing Income Statement
For the year ended 19x1 19x2 19x3

Sales revenue (at $12 per unit) ---------------$600,000 ----- $420,000 --- $780,000
Less: Cost of goods sold (at standard
absorption cost of $9 per unit) -------------450,000 ----- 315,000 ---- 585,000

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Gross margin--------------------------------- $150,000 ----- 105,000 --- $195,000

Less: Selling and Administrative expenses
(do not include fixed overhead):
- Variable (at $1 per unit) --------- 50,000 -------- 35,000 ---- 65,000
- Fixed ------------------------------ 25,000 --------- 25,000 ----- 25,000
Net income ----------------------------- $75,000 -------- $45,000 ---- $105,000
AB-Company
Variable-costing Income Statement
For the years ended 19x1 19x2 19x3

Sales revenue (at $12 per unit) ------------ $ 600,000 -------- $420,000 -------- $780,000
Less: Variable expense:
- Variable manufacturing cost
(at standard variable cost of $6
per unit)----------------------------300,000 ---------- $210,000 -------- 390,000
-Variable selling and administrative
( at $1 per unit)-------------------- 50,000 ------------- 35,000 ---------- 65,000
-Contribution margin--------------- $250,000 -----------175,000 ---------$325,000
Less: Fixed expenses:
- Fixed manufacturing overhead----150,000 ----------- 150,000 ------ 150,000
- Fixed selling and administrative
expenses--------------------------- 25,000 ------------ 25,000 --------- 25,000
-Net income-------------------------- $75,000 -------------$ 0 $150,000
Exhibit 6-4: Reconciliation of income under absorption and variable costing-AB Company.
19x1 19x2 19x3
1. Cost of goods under absorption costing---- $450,000 ----- $315,000 ---- $585,000
Variable manufacturing costs under

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variable costing method-----------------------300,000 -------- 210,000 ------ 390,000

Subtotal -------------------------------- $150,000 -------- 105,000 ------$195,000
2. Fixed manufacturing overhead as period
expense under variable costing -------------150,000 -------- 150,000 ------ 150,000
Total----------------------------------------------- $ 0 --------- $(45,000) ------ $45,000
Net income under variable costing--------- $75,000 ------- $ 0 ------ $150,000
Net income under absorption costing------ 75,000---------- 45,000 ------- 105,000
Difference in net income----------------------- $ 0 ---------- $(45,000) ------ $45,000

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Chapter 6
6. Cost Allocation

Part One: Cost Allocation Introduction

A. Purpose of Allocating Cost to Cost Objects
In earlier chapters, we studied cost allocation and explored its role in an organization’s overall
managerial-accounting system. We also examine several purposes of cost allocation. The goal of
cost allocation is to ensure that all costs incurred by the organization ultimately are assigned to its
products or services. This is important for several purposes, including cost based pricing and
bidding, cost reimbursements from outside parties such as insurance companies, valuation of
inventory, and determination of cost of goods sold. In addition, the allocation of all cost to
departments serves to make departmental managers aware of the cost incurred to produce services
their departments use.

Purposes of cost allocation are:

a) To provide information for economic decisions

b) To motivate managers and other employees
c) To justify cost or compute reimbursements
d) To measure income and assets for reporting to external parties excluding research,
marketing and distribution

This chapter is divided in two sections, each of which explores a particular cost-allocation topic in
greater detail. The two sections, which may be studied separately, cover the following topics.

a) Service department cost allocation

b) Joint products cost allocation
A. Criteria to Guide Cost-allocation Decisions-
While allocating cost to different units or products or some other cost objects, there should be
some criteria to be followed. Accordingly, the following some of the criteria used as guide lines
while allocating cost to units and/or products and services.

a) Cause and Effect- Using this criterion, managers identify the variable or variables that
cause resources to be consumed. For example, managers may use hours as the variables

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when allocating the costs of a quality-testing area to products. Cost allocations based on
the cause-and-effect criterion are likely to be the most credible to operating personnel.
b) Benefit Received- Using this criterion, managers identify the beneficiaries of the outputs
of the cost object. The costs of the cost object are allocated among the beneficiaries in
proportion to the benefits each receives. For example, consider a corporate wide
advertising program that promotes the general image of the corporation rather than any
individual product. The cost of this program may be allocated on the basis of division
revenues. The higher the revenues, the higher the division’s allocated cost of the
advertising program. The rationale behind this allocation is the belief that divisions with
higher revenues apparently benefit from the advertising more than division with lower
revenues and therefore ought to be allocated more of the advertising costs.
c) Fairness or Equity- This criterion is often cited in government contracts when cost
allocations are the basis for establishing a price satisfactory to the government and its
supplier. Cost allocation here is viewed as a “reasonable” or “fair” means of establishing
a selling price in the minds of the contracting parties. For most allocation decisions,
fairness is a lofty objective rather than an operational criterion.
d) Ability to bear-this criterion advocates allocating costs in proportion to the cost object’s
ability to bear them. An example is the allocation of corporate executive salaries on the
basis of divisions operating income. The presumption is that the more profitable a given
division is a greater ability it has to absorb corporate headquarters’ costs.

6.2. Allocating Corporate Cost to Divisions and Products-

There is different way of treating corporate costs by different organizations.

i. Some companies allocate all corporate costs to divisions. They maintain that corporate
costs are incurred to support the activities of the divisions. In this case there is a belief
that allocation of corporate costs sparks interest on the part of division managers
regarding how corporate costs are planned and controlled. Also, companies that want
to calculate the full cost of products must allocate corporate costs to activity-cost pools
of divisions
ii. Other companies do not allocate corporate costs to divisions. They maintain that
division managers generally have no say or role in incurring these costs.

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iii. Still other companies allocate only those corporate costs, such as corporate human
resources costs, for which there is widespread agreement that they are either causally
relate to division activities or they provide explicit benefits to divisions.
These companies exclude corporate costs such as corporate donations the charitable
foundations both because division manager often have no say in making these decisions
and because these benefits to the divisions are less evident or too remote

6.3. Part Two: Interdepartmental Cost Allocations

Departments in an organization can be divided into two broad classes: Operating departments
include those departments or units where the central purposes of the organization are carried out.
Example of such departments or units would include the surgery department in a hospital; the
undergraduate and graduate programs in a university; various flight groups in an airline; and
production department such as milling, assembly, and painting in a manufacturing company.

Service department-by contrast, do not engage directly in operating activities. Rather, they
provide services or assistance that facilitates the activities of the operating departments. Examples,
of such services include cafeteria, internal auditing, personnel, finance, cost accounting,
maintenance department and purchasing. Although service departments do not engage directly in
the operating activities of an organization, the costs that they incur are generally viewed as being
part of the cost of the final product or service, the same as are materials, labor, and overheads in a
manufacturing company or medications in a hospital.

6.3.1. Single Rate Cost Allocation vs. Dual-Rate Cost Allocation Methods
The single-rate-cost-allocation method- this method pools all cost in one cost pool and allocates
these costs to cost objects using the same rate per unit of the single allocation base. There is no
distinction between costs in the cost pool in terms of cost behavior (such as fixed costs versus
variable costs). Under some circumstances, this simple approach can result in an unfair cost
allocation among the using departments and may lead to un appropriate decisions.

The dual-rate cost-allocation method classifies costs in each cost pool into two sub cost pools (a
variable-cost sub pool and a fixed costs sub pool). These methods, by allocating fixed costs and
variable costs separately avoid fairness problem that is inherent in the case of single-rate allocation
method.

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To illustrate, suppose that Sand Hill Company, which has a Central Computer Department.
This department has only two users –Microcomputer Division and Peripheral Equipment
Division. The following data apply to the coming budget year.

Fixed costs of operating the computer facility

(In the 6,000 to 18,000 hours relevant range----------------$ 3,000,000 per year
Total capacity available-----------------------------------------18,000 hour
Budgeted long-run usage:
- Microcomputer Divisions------------------------------ 8,000 hours
- Peripheral Equipment Division------------------------4,000 hours
Total-----------------------------------------------------------------12,000 hours
Budgeted variable costs per hour
In the 6,000 to 18,000 hour relevant Range-----------------$ 200 per hour used
Under the single-rate method, the costs of the Central Computer Department would be
allocated as follows (assuming budgeted usage is the allocation base and budgeted rates
are used):

Total cost pool, $3,000,000 + (12,000 budgeted hours × $ 200) ---- = $ 5,400,000

Budgeted usage------------------------------------------------------------- 12,000 hours

Budgeted total rate per hour ($5,400,000 ÷ 12,000 hours) ----------- $450 per hour use

Here in this approach, the allocation rate for each Division will be the same i.e. $450 / hours used.

If the dual-rate method is used, allocation bases must be chosen for each cost pool. Assume
that the budged rate is used, and the allocation quantities chosen are budgeted usage for
fixed costs and actual usage for variable costs. The total budgeted usage of 12,000 hours
comprises 8,000 hours for the Microcomputer Division and 4,000 hours for the Peripheral
Equipment Division. The costs allocated to the two divisions will be:

Fixed costs = 8000 hour × $3,000,000 = $2,000,000

To Microcomputer Division = 12,000

Variable cost (budgeted) ---------------- = $200 per hour

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Fixed costs = 4,000 hours ×$3,000,000 = $ 1,000,000

To Peripheral Equipment Division = 12,000 hours
Variable cost (budgeted) --------- = $200 per hours used

Suppose that during the coming year, the actual labor hour of 9,000 hours and 3,000 hours is
used by Microcomputer Division and Peripheral Equipment Division respectively, the cost
allocated to these two divisions would be computed as follows:

Single-rate method To Microcomputer Division 9,000 hours × $ 450 per hour =$4,050,000

To Peripheral Equipment Division 3,000 hours × 450 per hour =$1,350,000

Dual-rate method To Microcomputer Division = $ 2,000,000 + (9,000 ×$200) = $ 3,800,000

To Peripheral Equipment Division $1,000,000 + (3,000 ×$200) = $1,600,000

Thus the allocation of these costs on the basis of single rate may lead to a decision that may
adversely affect the goal of the organization. For example suppose the Microcomputer Division
uses an external vender that charges $360 per hour, when the Central Computer Department has
unused capacity. These divisions that decide to use this vender can decrease its own cost, but the
overall cost to the Sand Hill Company will increase.

1. Budgeted vs Actual rates-

The decision whether to use budgeted cost rates or actual cost rates affects the level of uncertainty
user divisions face.
Budgeted rates- let the user departments know in advance the cost rates they will be charged.
Users are then better equipped to determine the amount of the services to request and-if the
option exists-whether to use the internal department source or an external vendor. Budgeted
rates also helps to motivate the managers of the supplier department (for example, the central
computer department) to improve efficiency. During the budget period, the supplier (support)
department, not the user department, bears the risk of any unfavorable cost variances. Because
the user department, do not pay for any costs that exceed the budgeted rates.

Actual rates- when, actual rates are used, the user department will not know the rates charged
until the end of the period

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NB. The managers of support department likely would view the budgeted rates negatively,
especially when unfavorable cost variances occur due to price increase outside of his or her control.
Thus, to overcome this problems, some organizations are recognizing that it may not always be
best to impose the risks of variance from budgeted amounts completely on the supplier department
( as when costs are allocated using budgeted rates) or completely on the user departments( as when
costs are allocated using actual rates).For example, the two departments may agree to share the
risk (through an explicit formula) of a large uncontrollable increase in the price of materials used
by the support department.

6.3.2. Budgeted vs Actual usage allocation

Should a service department allocate its actual costs to operating departments, or should it allocate
its budgeted costs? The answer is that budgeted costs should be allocated. The problem with
allocating actual costs is that it burdens the operating departments with the inefficiencies of the
service department’s managers. If actual costs are allocated, then any lack of cost control on the
part of the service department manager is simply buried in a routine allocation to other
departments.
When actual usage is the allocation base, user division will not know in advance the amount
of cost to be allocated to them until the end of the budged period.

When budgeted usage is the allocation base, user divisions will know in advance their allocated
costs. This information helps the user divisions with both short-run and long-run and long-run
planning.

The main justification given for the use of budgeted usage to allocate fixed costs relates to long-
run planning. Organizations commit to infrastructure costs (such as the fixed cost of a support
department) on the basis of a long-run planning horizon; the use of budgeted usage to allocate
these fixed costs is consist with the long-run horizon.

If fixed costs are allocated on the basis of budgeted long-run usage, some managers may be
tempted to underestimate their planned usage. In this way, they will bear a lower percentage of the
total costs (assuming all other managers do not similarly underestimate their usage). Some
organizations offer rewards in the form of salary increase and promote managers so that they make
better forecasts of long-run usage (the carrot approach) and/or impose cost penalties for under
predicting long-run usage(the stick approach).

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Support / service/ department cost allocation- the allocation of service department costs to
operating departments is very essential since the amounts allocated are presumed to represent each
department’s “ fair share” of the cost of services provided for it and, the allocations are included
in performance evaluations of the operating departments and also included in determining their
individual profitability
6.4. Methods of Departmental Cost Allocation
6.4.1. Direct-method of allocating service department costs-
Under the direct method, each service/support/ department’s costs are directly allocated to the
operating departments. These method ignore the fact that some service departments provide
service/ support/ to other service departments and allocate all costs of service departments to
operating departments. The benefit of direct method is its simplicity. There is no need to predict
the usage of support department services by other support departments. Its disadvantage is failure
to recognize reciprocal services provided among support departments.
NB. The proportion of each service department’s costs to be allocated to each operating department
is determined by the relative proportion of the service department’s output consumed by each
operating department.

To illustrate consider the case of Castleford Engineering, which manufactures engines used in
electric power generating plants. The Castleford has two support departments and two operating
departments in its manufacturing facility. The data for allocating support department costs at
Castleford Engineering for year 2001 is presented below

Support Departments Operating Departments

Plant Information
Maintenance Systems Machining Assembly Total

BMOH before allocation - $600,000 ---$ 116,000 $400,000 ---$200,000--- 1, 316, 00

Support work furnished:
By plant maintenance
Budgeted labor-hours - 1,600 2,400 4,000 8,000
By Information systems
Budgeted computer-hours 200 - 1,600 200 2,000
As it can be seen from the above exhibit, the Plant Maintenance Department provides a total of
8,000 hours of support work:20% (1,600 ÷ 8,000) goes to the Information Systems Department,
30% ( 2,400 ÷ 8,000) to the Machining Department, and 50% (4,000 ÷ 8,000) to the Assembly
Department.

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(Discussion part)
Support Departments Operating Departments
Plant Information
Maintenance Systems Machining Assembly Total

B MoH [Link] $600,000 ----- $ 116,000 - --$400,000 ----------$200,000----$ 1,316,000

Plant Maintenance: (600,000) 225,000 375,000
Information System: - (116,000) 103,111 12889

MOH of OD 0 0 $ 728,111 $ 589,889 $1,316,000

6.4.2. Step-Down Allocation Method-

(Discussion Part)

Support Departments Operating Departments

Plant Information
Maintenance Systems Machining Assembly Total

B MoH [Link] $600,000 ----- $ 116,000 - --$400,000 ----------$200,000----$ 1,316,000

Plant Maintenance: (600,000) 120000 180,000 300000
Information System: - (236,000) 209,778 26,222

MOH of OD 0 0 $ 789,778 $ 526,222 $1,316,000

6.4.3. Reciprocal Method of Service Department Cost Allocation

The reciprocal allocation method allocates cost by explicitly including the mutual services
provided among all support departments. Conceptually, the direct method and step-down method
are less accurate than the reciprocal method when support departments provided services to one
another reciprocally. For example, the Plant Maintenance Department maintains all the computer
equipment in the Information System Department. Similarly, Information System provides data
base support for Plant Maintenance. The reciprocal allocation method enables us to incorporate
interdepartmental relationships fully into the support department cost allocations by fully
accounting for the mutual provision of services. It is more complex than the others methods
discussed above. The application of reciprocal method requires three steps.

Step-1: Express support department costs and support Department Reciprocal relationships in the
form of linear Equations as follows.

Let PM -be the complete reciprocated costs of Plant Maintenance

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IS – be the complete reciprocated costs of Information Systems.

PM = $600,000 + 0.1 IS

IS = $116,000 + 0.2 PM

The 0.1 IS term in equation (1) is the percentage of the Information System work used by Plant
Maintenance. The 0.2 PM term in equation (2) is the percentage of the Plant Maintenance work
used by Information Systems.

The complete reciprocated costs in equations (1) and (2), means the support department’s own
costs plus any interdepartmental cost allocations.

Step-2: Solve the set of linear equations to obtain the complete Reciprocated costs of each support
department where there are two support department, the following substitution approach can be
used. Thus, by substituting equation (2) into equation (1) we have the following results.

PM = $600,000 + [0.1 ($116,000 + 0.2PM)]

PM = $600,000 + $11,600 + 0.02PM

0.98PM = $611,600

PM = $624,082

By substituting the above result into equation (2):

IS = $ 116,000 + 0.2 ($624,082)

= $116,000 + $124,816

Step-3: Allocate the complete reciprocal costs of each support department to all other departments
(both support departments and operating departments) on the basis of the usage percentages (based
on total units of service provided to all departments)

For example consider the Information Systems Department, which has complete reciprocated costs
of $240,816. This amount would be allocated as follows:

To Plant Maintenance (1/10×) ×$240,816 = $24,082

To Machining (8/10) ×$240,816 = 192,652

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To Assembly (1/10) × $24,082 = 24,082

Total ------------------------------------ = $ 240,816

Support Departments Operating Departments

Plant Information
Maintenance Systems Machining Assembly Total

B MoH [Link] $600,000 ----- $ 116,000 - - -$400,000 ----------$200,000----$ 1,316,000

Plant Maintenance: (624,082) 124,816 187,225 312,041
Information System: 24082 (240,816) 192,652 24082

MOH of OD 0 0 $ 779,877 $ 536,123 $1,316,000

6.5. Allocation of Common Costs

A common cost is a cost of operating a facility, activities, or like cost objects that is shared by two
or more users. Consider Jason Stevens, a senior student in Seattle who has been invited to a job
interview with an employer in Boston. The round trip Seattle-Boston airfare cost $1,200. A week
prior to leaving, Stevens is also invited to an interview with an employer in Chicago. The Seattle-
Chicago round-trip airfare cost $800. Stevens decides to combine the two recruiting steps into
Seattle-Boston-Chicago-Seattle trip that will cost $ 1,500 in air fare. The $1,500 is a common cost
that benefits both prospective employers. Two methods of allocating this common cost between
the two prospective employers are now discussed the stand-alone method and the incremental
method.
A. Stand-Alone Cost-Allocation Method- uses information pertaining to each user of a cost
object as a separate entity to determine the cost-allocation weights. For the common-cost
airfare of $1,500, information about the separate (stand-alone) round-trip airfares ($1,200 and
$800) is used to determine the allocation weights:
Boston employer: $ 1,200 × $1,500 = 0.60 ×$ 1,500 = $900
$1,200 + $800
Chicago employer: $ 800 × $1,500 = 0.40 ×$ 1,500 = $600
$800 + $1,200
The advocator of this method often emphasizes the fairness or equity criterion described earlier
i.e. fairness occurs because each employer bears a proportionate share of total costs in relation to
their individual stand-alone costs.

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B. Incremental cost-allocation method- The incremental cost allocation ranks the individual
users of a cost object and then uses this ranking to allocate costs among those users. The first-
ranked user of the cost object is termed the primary party and is allocated costs up to the costs
of the primary party as a stand-alone user. The second-ranked user is termed the incremental
party and is allocated the additional cost that arises from there being two users instead of only
the primary user.

Consider again Jason Stevens and his $1,500 airfare cost. Assume the Boston employer is viewed
as the primary party. Stevens’ rationale is that he had already committed to go to Boston before
accepting the invitation to interview in Chicago. The Boston employer is allocated the full Seattle-
Boston airfare. The non allocated part of the total airfare is then allocated to the Chicago employer
as follows

Party Costs allocated Cost remaining to be

Allocated to other parties
Boston (primary) $1,200 $ 300 ($1,500-$1,200)
Chicago (incremental) 300 - 0-
In the above case, had the Chicago employer been chosen as the primary party, the cost allocations
would have been Chicago $800 (the stand- alone Seattle-Chicago –Seattle round –trip airfare) and
Boston $700 ($1,500-$800).

Under these methods, the primary party typically receives the highest allocation of the common
costs. Not surprisingly, most users in common-cost situations propose themselves as the
incremental party. In some cases, the incremental parties are newly formed organizations or an
organization’s new subunits such as a new product line or a new sales territory.

Where both parties are viewed as primary user, and there is a large common cost that has to be
incurred even if there is only one user, the incremental method both lacks conceptual justification
and can cause a sizable dispute among the parties. One approach in situation is to use the Stand-
alone cost-allocation method.

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CHAPTER 7
7. ACCOUNTING FOR JOINT PRODUCTS AND BY-PRODUCTS

7.1. TERMINOLOGIES
1. Joint products: Joint products are products that are produced together and are not reading
identifiable as individual products until a certain point in the production process. Two or more
products simultaneously produced from a single set of inputs are called Joint products. Joint
products are produced from the same raw material. They are produced simultaneously by a
common process. They may require further processing after their point of separation. For example,
in the oil industry, Gasoline, fuel oil, lubricants, coal tar, kerosene are all products from crude oil.
These are known as Joint products. Other examples are dairy products, chemicals, meat products
and wood products. All Joint products have relatively high sales value but are not separately
identifiable as individual products until the split off point.
2. Joint Cost: A joint cost is the cost of a single process that yields multiple products
simultaneously. Production costs incurred prior to the split off point are called Joint Costs. This
chapter examines methods for allocating Joint costs to products and services. Joint costs are the
costs of producing joint products before the split off point.
3. Main Product: When a single process yielding two or more products yields only one product
with a relatively high sales value, that product is termed as main product.
4. Split-off point: The split-off point is the Juncture in the process where the Joint products
become separately identifiable. An example is the point where coal becomes coke, gas, tar and
other products.
5. Separable Costs: Separable costs are costs incurred beyond the split-off point that are
assignable to one or more individual products. At or beyond the split-off point decisions can be
made independently. Separable costs are the costs of further processing Joint products after the
split-off point.

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Joint costs and separable costs generally incurred direct materials, direct labor and factory
overhead costs.
6. By-products: There are certain industries where the production of main product is accompanied
by production of one or more by-products. The term By-product is generally used to denote one
or more products of relatively small value that are produced simultaneously with a product of
greater value. The product with the greater value is commonly called the main product. In brief,
by-products are products of comparatively small value that are produced incurred to the main
product.
Examples:
A refinery can not only produce gasoline from crude oil, it also simultaneously produces
kerosene, benzene, and naphtha.
These minor or secondary products have less commercial importance and are treated as by-
products. A by-product has a low sales value compared with the sales value of the main product.
7.2. Distinction between Joint & By-products
1. Joint products are major products having high total sales value. By-products have low total
sales value. This can be done due to small output or to low unit selling price or to both.
2. By-products are incidental items that accompany the production of major products. The
process would not be carried on to produce the by-products alone.
Methods of Allocating Joint Costs
The purpose of Joint-product cost allocation is to allocate joint costs to the joint products which
are the cost objectives. The cost allocation base is determined by the joint-product cost allocation
method used.
There are three methods of allocating Joint costs.
1. Physical measure method
2. Sales value at split-off method
3. Estimated Net Realizable value method
4. Constant Gross Margin Percentage NRV Method

7.3.1. Physical Measure Method or physical Units Method

The physical measure method uses same physical measure, such as pounds, gallons of units of
production, as the base for allocating Joint costs to Joint products.

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For example; if two joint products can be measured in terms of gallons, you can use the
proposition of gallons for each product to allocate joint costs to the two products. To allocate the
costs, you would multiply the proposition of the total base for each product by the joint costs.
7.3.2. Sales Value at Split-off Method:
The sales value at split-off method allocates Joint costs on the basis of the relative sales value of
each Joint product at the split-off point of the total production. Note that this method uses the sales
value of the entire production of the accounting period. The Joint costs were incurred on all units
produced and not just those sold.
You would compute this value by multiplying the sales price at the split-off point by the units of
production. You would then find each product’s proposition of the total sales value, and you use
this production to allocate the joint costs.
7.3.3. Estimated Net Realizable Value Method
The net realizable value method allocates joint cost based on the relative net realizable value of
the joint products at the split-off point. This method is generally used when the sales value at the
split-off point is not known. The net realizable value at the split-off point can be interpreted as an
estimate of the sales value at the split-off point. You would compute the net realizable value at the
split-off point as follows:
Estimated Net Realizable Value = Sales Value at Completion - Separable Costs
at the split-off point
7.3.4. Constant Gross Margin Percentage NRV Method
The separable processing costs must be deducted from the sales value to arrive at the net realizable
value at the split-off point.
The constant gross margin percentage NRV method allocates joint costs to joint products in such
a way that the overall gross margin percentage is identical for the individual products. This method
entails three steps:
Step 1: Compute the overall gross margin percentage for all joint products together.
Step 2: Multiply the overall gross margin percentage and the final sales values of each product to
calculate the gross margin for each product. Subtract the gross margin for each product from the
final sales value of each product to obtain the costs that each product will bear.
Step 3: Deduct the separable costs from the total costs that each product will bear to obtain the
joint cost allocated.

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The joint costs allocated to a product can be negative under this method. Some products may
receive negative allocation of joint costs to bring gross margin percentages up to the overall
average. The following table presents the product line income statement for the constant gross
margin percentage NRV method.

Choosing a method
Which method of allocating joint costs should be used? Use the sales value at split off method
when selling price data are available (even if further processing is done). Reasons for using the
sales value at split off method include.
1, It measures the value of the joint product immediately at the end of the joint process. The sales
value at split off is the best measure of the benefits received as a result of joint processing relative
to all the other method of allocating joint costs.
2, No anticipation of subsequent management decisions, the sales value at split off method does
not require information on the processing steps after split off if there is further processing. In
contrast the NRV method and constant gross margin percentage NRV method require information
on (a) the specific sequence of further processing decisions (b) the separable costs of further
processing and (c) the point at which individual products are sold.
3, Availability of a meaningful basis to allocate joint costs to products: The sales value at Split off
method and the other market-based methods have a meaningful basis to allocate joint costs to
products. In contrast the physical measure method may lack a meaningful basis that can be used
to allocate joint costs to individual products.
4. Simplicity: The sales vale at split off method is simple. In contrast the NRV and constant gross
margin percentage NRV methods can be complex for processing operations having multiple
products and multiple split off points. This complexity is increased when management makes
frequent changes in the specific sequence of post split off processing decisions or in the point at
which individual products are sold.
When selling prices of all products at the split off point are not available, other joint cost allocation
methods are used. The NRV method attempts to approximate the sales value at split off by
subtracting separable costs incurred after the split off point on each product from selling prices.
The NRV method assumes that the markup or profit margin is attributable to the joint process and

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none of the markup is attributable to the separable costs. Profit however is attributable to all phase
of production and marketing not just the joint process.
Despite its complexities, the NRV method is used when selling prices at split off are not available.
It is a better measure of benefits received compared with the constant gross margin percentage
NRV method and the physical measure method.
The main advantage of the constant gross margin percentage NRV method is that it is easy to
implement. This method treats the joint products as though they comprise a single gross margin
percentage to each products and back into the joint costs allocated to each products. This method
avoids the complexities inherent in the NRV method to measure the benefits received by each of
the joint products at the split off point. The main issue with the constant gross margin percentage
NRV method is the assumption that all the products have the same ratio of cost to sales value
across products is very uncommon in companies that produce multiple products that do not involve
joint cost.
Although there are difficulties in using the physical measure method, the lack of congruence with
the benefits received criterion and the possible lack of a meaningful common denominator for
allocating the joint costs there are instances when it may be preferred consider rate regulation.
Market based measures are difficult to use in the context of rate or price regulation. It is circular
reasoning to use selling prices as a basis for setting prices (rates) and at the same time use selling
prices to allocate the costs on which prices (rates) are based. To avoid this circular reasoning the
physical measure method may be used in rate regulation.
Example:

ABC Dairy Company purchases raw milk from individual farms and processes it until the
split off point, where two products- cream and liquid skim-emerges. These two products
are sold to an independent company, which markets and distributes them to supermarkets
and other retail out lets.

Summary data for May 2010 are

Raw milk processed(having joint costs $400,000), 110,000 gallons; 10,000 gallons are lost
in the production process due to evaporation, spoilage, and the like, yielding 25,000 gallons
of cream and 75,000 gallons of liquid skim.

Production Sales

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Cream………..25,000 gallons 20,000 gallons at $ 8 per gallon

Liquid skim…...75,000 gallons 30,000 gallons at $ 4 per gallon.

Note: - each gallon of cream sold at $8 and each gallon of liquid skim sold at $ 4

Beginning Ending

Inventory

Raw milk 0 Gallons 0 gallons

Cream 0 gallons 5,000 gallons

Liquid skim 0 gallons 45,000 gallons

Cost of purchasing 110,000 gallons of raw milk and processing it until the split off point to
yield cream and liquid skim is $400,000.

Example – 2:

Assume the same data as in example-1 except that here both cream and liquid skim can be processed
further:

Cream Butter cream: 25,000 gallons of cream are further processed to yield 20,000 gallons of butter
cream at additional processing costs of $ 280,[Link] cream is sold for $25 per gallon.

Liquid skim condensed milk: 75,000 gallons of liquid skim are further processed to yield
50,000 gallons of condensed milk at additional processing costs of $520,000; condensed milk
is sold for $22 per gallon

Required Compute the gross-margin percentage for each product sold in December, using the
following methods for allocating the 400,000 joint costs:

a. Sales value at split off

b. Physical-measure c. NRV

Solution
A. Sales method at split off

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Cream Liquid Total

skim
Sales value of total production at split- off point
(cream,
25,000 gallonsx8/gallon; liquid skim,75,000$200,000 $300,000 $500,000
gallonsx$4/
gallon)
Weighing ($200,000÷$500,000;0.40 0.60
$300,000÷$500,000)
Joint costs allocated (cream, 0.4x$400,000);
(Liquid skim, 0.6 x$400,000) $160,000 $240,000 $400,000
Joint production cost per gallon
(cream,$160,000÷25,000 gallon, liquid skim, $6.4/gallon $3.2/gallon
$240,000÷75,000gallon)
B. Physical measure method
Cream Liquid Total
skim
Physical measure of total production
(gallons) 25,000 75,000 100,000
Weighting (cream 25,000 gallons÷100,000 gallons, 0.25 0.75
Liquid Skim 75,000 gallons÷100,000 gallons)
Joint costs allocated (cream, 0.25X$400,000,
liquid skim, 0.75x$400,000) $100,000 $300,000 $400,000

Joint production cost per gallon (cream,

$100,000÷25,000Gallons; liquid skim, $4 per $4per
$300,000÷75,000 gallons) gallon gallon

C. Net realizable value Method

Butter condensed Total
cream milk
Final sales value of the total
production
(butter cream, 20,000 gallons x$25/gal
$500,000
; $1,100,000 $1,600,000
condensed milk 50,000gallonsx$22/gal)
Deduct: separable costs to complete and(280,000)
sell (520,000) (800,000)
Net realizable value at split off point $220,000 $580, 000 $800,000

Weighting ($220,000 ÷$800,000,

$580,000 ÷$800,000 0.275 0.725
Joint costs allocated (butter cream,
0.275x$400,000; condensed
milk 0.725x$400,000) $110,000 $290,000 $400,000

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Production cost per gallon (Butter

cream,
$110,000+$280,000) $19.5/gal $16.2/gal
÷20,000gal;
Condensed milk,
($290,000+$520,000) ÷50,000 gal,

Accounting for by product

Joint production processes may yield not only join products and main products but byproducts as
well. Although byproducts have much lower sales values than the sales values of joint or main
products, the presence of byproducts in a joint production process can affect the allocation of joint
costs. Let’s consider a two product example consisting of a main product and a byproduct.
Illustration 3: Kerra meat processing company processes meat from slaughterhouses. One of its
departments cuts lamb shoulders and generates two products: Shoulder meat (the main product)
sold for Br. 60 per pack. Hock meat (the byproduct)-sold for Br.4 per pack (net of any selling
costs). Data under each column indicates the number of packs for this department in July 2004 is:
Production Sales Ending inventory
Shoulder meat 5,000 4,000 1,000
Hock meat 1,000 300 700

The joint manufacturing costs of these products in July 2004 were Br.250, 000 comprising Br.150,
000 for direct materials and Br.100, 000 for conversion costs. Both products are sold at the split
off point without further processing.
Two byproducts accounting methods are presented. Method A, the production method recognizes
byproducts in the financial statements at the time production is completed. Method B, the sales
method delays recognition of byproducts until the time of sale. Recognition of byproducts at the
time of production is conceptually correct recognition at the time of sales. Sales often occur in
practice when the dollar amounts of byproducts are immaterial. The following table presents the
income statement under both methods.
Method A Method B
(Production (Sales method)
method)
Revenue:
Main product 4,000 pack x Br.240,000 Br.240,000
Br.60/pack
By product 300packs x Br4/pack - 1,200

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Total Revenue Br.240,000 Br.241,200

Cost of goods sold 196,800 200,000
Gross Margin Br.43,200 Br.41,200
Gross margin percentage 18% 17%

End of period Inventory:

Main product Br.49,200 Br50,000
Byproduct 2,800 0
Method A: Byproducts recognized at time production is completed
This method recognizes the byproduct in the financial statements - the 1,000 packs of hock meat -
in the month it is produced, July 2004. The NRV form the byproduct produced is offset against
the costs of the main product
1. Work in process--------------------150,000
Accounts payable------------------------- 150,000
(To record direct materials purchased and Used in production during the period)
2. Work in process-------------------100,000
Various accounts -------------------100,000
(To record conversion costs in the production process)

3. Byproduct inventory—hock meat (1,000packsxBr4/pack) ----- 4,000

Finished goods—shoulder meat (Br250, 000-Br4, 000) ------- 246,000
Work in process (Br150, 000+Br100, 000) ---------- 250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000packs /5,000packs) xBr.246, 000----- 196,800
Finished goods –shoulder meat----------------------------------196,800
(To record the cost of the main product sold during July)
4b) Cash or Accounts receivable (4,000 packsxBr.60/pack) ---240,000
Revenues----shoulder meat----------------------------240,000
(To record the sales of the main product during July)
5) Cash or Accounts receivable (300packsxBr4/pack) -----1,200
Byproducts inventory---hock meant------ 1,200
(To record the sales of the byproduct during July)
This method reports the byproduct inventory of hock meant in the balance sheet at its Br 4 per
pack selling price [(1,000packs-300packs)xBr.4/pack=Br.2, 800]

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One variation of this method would be to report byproduct inventory at its NRV reduced by a
normal profit margin. When the byproduct inventory is sold in a subsequent period, the income
statement would match the selling price with the “net” selling price reported for the byproduct
inventory.
Method B: Byproducts recognized at time of sale
This method makes no journal entries until sales of the byproduct occur. Revenues of the byproduct
are reported as a revenue item in the income statement at the time of sales. These revenues are
grouped with other sales, included as other income or deducted from cost of goods sold. In the
above example, byproduct revenues in July 2004 are Br1, 200(300packsxBr4/pack) because only
300packs of the hock meat are sold in July (of the 1,000 packs produced). The journal entices are
presented below:
1 and 2 are the same as for method A.
3. Finished goods---- shoulder meat 250,000
Work in process 250,000
(To record cost of goods completed during July)

4a) Cost of goods sold [(4,000 packs x 5, 000packs) x Br.250, 000] 200,000
Finished goods-------------- ------------------------------200, 000
4b) The same as for method A.
5. Cash or account receivable------------ 1,200
Revenues----shoulder meat ----------- 1,200
(To record the sales of the byproduct during July)
Method B is used in practice primarily on the grounds that the birr amounts of byproducts are
immaterial. However, this method permits managers to report earnings by timing when they sell
byproducts. Managers may store byproducts for several periods and give revenues and income a
“small boost” by selling byproducts accumulated over several periods when revenues and profits
from the main product or joint products are low.
Worksheet
1. Inorganic Chemicals (IC) processes salt into various industrial products. In July 2012, IC
incurred joint costs of $100,000 to purchase salt and convert it into two products: caustic soda
and chlorine. Although there is an active outside market for chlorine, IC processes all 800 tons

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of chlorine it produces into 500 tons of PVC (polyvinyl chloride), which is then sold. There
were no beginnings or ending inventories of salt, caustic soda, chlorine, or PVC in July.
Information for July 2012 production and sales follows:

Required
1. Allocate the joint costs of $100,000 between caustic soda and PVC under (a) the sales value at
split off method and (b) the physical-measure method.
2. Allocate the joint costs of $100,000 between caustic soda and PVC under the NRV method.
3. Under the three allocation methods in requirements 1 and 2, what is the gross-margin percentage
of (a) caustic soda and (b) PVC?
4. Lifetime Swimming Pool Products offers to purchase 800 tons of chlorine in August 2012 at
$75 per ton. Assume all other production and sales data are the same for August as they were for
July. This sale of chlorine to Lifetime would mean that no PVC would be produced by IC in
August. How would accepting this offer affect IC’s August 2012 operating income?
2. Sinclair Oil & Gas, a large energy conglomerate, jointly processes purchased hydrocarbons to
generate three non-saleable intermediate products: ICR8, ING4, and XGE3. These
intermediate products are further processed separately to produce crude oil, natural gas liquids
(NGL), and natural gas (measured in liquid equivalents). An overview of the process and
results for August 2012 are shown here. (Note: The numbers are small to keep the focus on
key concepts.)

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By assuming no beginning and ending of each product Allocate the August 2012 joint cost among
the three products using the following:
a. Physical-measure method
b. NRV method
3. Sunny Day Juice Company produces oranges from various organic growers in Florida. The
juice is extracted from the oranges and the pulp and peel remain. Sunny Day considers the pulp
and peel byproducts of its juice production and can sell them to a local farmer for $2.00 per
pound. During the most recent month, Sunny Day purchased 4,000 pounds of oranges and
produced 1,500 gallons of juice and 900 pounds of pulp and peel at a joint cost of $7,200. The
selling price for a half-gallon of orange juice is $2.50. Sunny Day sold 2,800 half-gallons of
juice and 860 pounds of pulp and peel during the most recent month. The company had no
beginning inventories.
Required
i. Assuming Sunny Day accounts for the byproduct using the production method, what is the
inventor able cost for each product and Sunny Day’s gross margin?
ii. Assuming Sunny Day accounts for the byproduct using the sales method, what is the
inventor able cost for each product and Sunny Day’s gross margin?
iii. Discuss the difference between the two methods of accounting for byproducts.
4. Mat Place purchases old tires and recycles them to produce rubber floor mats and car mats.
The company washes, shreds, and molds the recycled tires into sheets. The floor and car mats
are cut from these sheets. A small amount of rubber shred remains after themats are cut. The
rubber shreds can be sold to use as cover for paths and playgrounds. The company can produce

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25 floor mats, 75 car mats, and 40 pounds of rubber shreds from 100 old tires. In May, Mat
Place, which had no beginning inventory, processed 125,000 tires and had joint production
costs of $600,000. Mat Place sold 25,000 floor mats, 85,000 car mats, and 43,000 pounds of
rubber shreds. The company sells each floor mat for $12 and each car mat for $6. The company
treats the rubber shreds as a byproduct that can be sold for $0.70 per pound.
Required
1. Assume that Mat Place allocates the joint costs to floor mats and car mats using the sales value
at Split off method and accounts for the byproduct using the production method. What is the ending
inventory cost for each product and gross margin for Mat Place?
2. Assume that Mat Place allocates the joint costs to floor mats and car mats using the sales value
at split off method and accounts for the byproduct using the sales method. What is the ending
inventory cost for each product and gross margin for Mat Place?
3. Discuss the difference between the two methods of accounting for byproducts, focusing on what
conditions are necessary to use each method.
4. The Mat Place’s accountant needs to record the information about the joint and byproducts in
the general journal, but is not sure what the entries should be. The company has hired you as a
consultant to help its accountant.
I. Show journal entries at the time of production and at the time of sale assuming the Mat Place
accounts for the byproduct using the production method.
II. Show journal entries at the time of production and at the time of sale assuming the Mat Place
accounts for the byproduct using the sales method.

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