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Cost Accounting Systems

Introduction

The operations of a business can be classified as service, merchandising, or manufacturing. Merchandisers purchase a product and sell it. Manufacturers purchase parts and raw materials, make a product, and sell it. The cost of a manufactured product includes the cost of materials used in making the product, as well as the costs incurred in converting the materials into a finished product. For manufacturing operations, developing accurate information on product cost is a primary focus of the managerial accounting system. There are two main types of cost accounting systems for manufacturing operations: job order cost systems and process cost systems.

Describe the following manufacturing costs: direct and indirect materials, direct labor, factory overhead, and product and period costs

Costs may be classified in a number of ways. A cost is a payment of cash or the commitment to pay cash in the future of the purpose of generating revenue, for example, cash (or credit) used to purchase equipment for the cost of the equipment. If equipment is purchased by exchanging assets other than cash, the current market value of the assets given up is the cost of the equipment purchases. For management’s use in making decisions, costs are often classified in terms of how they relate to an object or segment of operations, often called a cost object. A cost object may be a product, a sales territory, a department, or some activity, such as research and development. Costs are identified with cost objects as either direct costs or indirect costs. Direct costs are specifically attributed to the cost object, and indirect costs cannot be identified directly with a cost object.

In a manufacturing business, the cost of a manufactured product includes the cost of materials used in the making of the product, as well as the costs incurred in converting the materials into a finished product. Common manufacturing cost terms are defined below:

Direct Materials - are materials and component parts that become an integral part of the final product. These materials can be traced directly to a finished unit of product.

Direct Labor - cost of wages paid to employees who work directly on the product.

Factory Overhead - all other costs incurred in making the product. These costs include the following:

1. General manufacturing costs that cannot be traced directly to the product; examples include:


Utilities (heating, lighting) Depreciation on machines Property taxes Insurance

2. Indirect Labor - wages/salaries paid to workers who are necessary to keep the factory running, but do not work directly on the product; examples include:

Maintenance workers Janitorial staff Factory personnel department Plant manager and supervisors

3. Indirect Materials - materials used in the manufacturing process that does not end up in the final product; examples include:

Materials used to test machines Lubrication used on machines

Note: Direct materials and direct labor costs may be treated as factory overhead costs if they are insignificant.

Direct materials, direct labor, and factory overhead costs are often grouped together for analysis and reporting purposes. Two common groupings of theses costs are prime costs and conversion costs. Prime costs consist of direct materials and direct labor costs. Conversion costs consist of direct labor and factory overhead costs. Conversion costs are the costs of converting the materials into a finished product. Direct labor is both a prime cost and a conversion cost.

For financial reporting purposes, costs are often classified as either product costs or period costs. Product costs consist of the three elements of manufacturing cost: direct materials, direct labor, and factory overhead. Period costs are generally classified into two categories: selling and administrative. Selling expenses are incurred in marketing the product and delivering the sold product to customers. Administrative expenses are incurred in the administration of the business and are not directly related to the manufacturing or selling functions.

Define and illustrate the financial statement elements and cost relationship for a manufacturing business

The financial statements for a manufacturing business are more complex than those for service and merchandising businesses. This is because a manufacturer makes the products that it sells. As a result, manufacturing costs must be properly accounted for and reported in the financial statements. These manufacturing costs primarily affect the preparation of the balance sheet and the income statement. The retained earnings and cash flow statement for merchandising and manufacturing businesses are similar to those in service and merchandising businesses.


A manufacturing business reports the following three types of inventory accounts on its balance sheet:

1. Materials inventory (sometimes called raw materials inventory)–Consists of the costs of the direct and indirect materials that have not yet entered into the manufacturing process.

2. Work In Process inventory–Consists of the direct materials costs, the direct labor costs, and the factory overhead costs that have entered the manufacturing process but are associated with products that have not been completed.

3. Finished goods inventory–Consists of completed (or finished) products that have not been sold.

The major difference in the income statements for merchandising and manufacturing businesses is in the reporting of cost of products sold during the period. A merchandising business purchases merchandise (products) in a finished state for resale to customers.

A manufacturer makes the product it sells, using direct materials, direct labor, and factory overhead. The cost of the product sold is generally called the cost of goods sold. For a manufacturer, the total cost of making and finishing the product is called the cost of goods manufactured. This is very similar to the cost of merchandise available for sale in a merchandising business. The income statement of a manufacturing company is supported by a statement of cost of goods manufactured, which provides the details of the cost of goods manufactured.

Since the Income Statement is the first statement that should be prepared in any type of business, so it is with a manufacturing-type business. Cost of Merchandise sold for a merchandising business is figured as below.

Beginning inventory + Purchases = Merchandise available for sale Merchandise available for sale - Ending inventory = Cost of merchandise sold

Cost of goods sold is calculated differently for a manufacturing company due to flow of costs through three different inventory accounts: raw materials, Work In Process, and finished goods.

The Statement of Cost of Goods Manufactured shows the flow of costs into and out of raw materials inventory. It also shows the flow of costs into Work In Process, and then it shows the Work In Process inventory into finished goods inventory.

The Raw Material (RM) inventory calculations involved are:

Beginning RM Inventory + Net Purchases = Total RM Available for Use Total RM Available for Use – Ending Inventory = RM Placed in Production

The Work In Process (WIP) inventory calculations involved are:

Beginning WIP + RM Placed in Production + Labor Charged to WIP + Overhead Charged to WIP – Ending WIP = Cost of Goods Manufactured


The Income Statement shows the flow of finished goods inventory into the cost of goods sold.

The calculations are:

Beginning Finished Goods Inventory + Cost of Goods Manufactured = Cost of Finished Goods Available for Sale

Cost of Finished Goods Available for Sale – Ending Finished Goods Inventory = Cost of Goods Sold

Describe accounting systems used by manufacturing businesses

Cost accounting systems accumulate manufacturing costs for the goods that are produced. This product cost information is used by mangers to establish product prices, control operations, and develop financial statements. In addition, the cost accounting system improves control by supplying data on the costs incurred by each manufacturing department or process.

There are two main types of cost accounting systems for manufacturing operations: job order cost systems and process cost systems. Each of the two systems is widely used, and any manufacturer may use more than one type.

A job order cost system provides a separate record for the cost of each quantity of product that passes through the factory. A particular quantity of product is termed a job. Job order systems are used by companies that make custom, special-order type goods or produce a high variety of products. Manufacturers that use a job order cost system are sometimes called job shops.

Under a process cost system, costs are accumulated for each of the departments or processes within the factory. Process cost systems are used by companies that make “a whole bunch of stuff that all looks the same” under a continuous manufacturing process.

Describe and prepare summary journal entries for a job order cost accounting system

In a job order cost accounting system, perpetual inventory controlling accounts and subsidiary ledgers are maintained for materials, Work In Process, and finished goods inventories. Each


inventory account is debited for all additions and is credited for all deductions. The balance of each account thus represents the balance on hand.

Materials

The procedures used to purchase, store, and issue materials to production often differ among manufacturers. Typically, purchased materials are first received and inspected by the receiving department. The receiving department personnel prepare a receiving report, showing the quantity received and its condition. Some organizations now use bar code scanner devices in place of receiving reports to record and electronically transmit incoming materials data. The receiving information and invoice are used to record the receipt and control the payment of purchased items.

To illustrate the journal entries for a job order cost accounting system, record the following entries for Jen Manufacturing.

• Purchased materials costing $20,000 on account.

Materials ..................................................................................... 20,000 Accounts Payable ................................................................. 20,000

The materials account in the general ledger is a controlling account. A separate account for each type of material is maintained in a subsidiary materials ledger. Details as to the quantity and cost of materials received are recorded in the materials ledger on the basis of the receiving reports.

Materials are released from the storeroom to the factory in response to materials requisitions from the Production Department. A summary of the materials requisitions completed during the month is the basis for transferring the cost of the direct materials from the materials account in the general ledger to the controlling account Work In Process. The flow of materials from the materials storeroom into production is recorded by the following entry for Jen Manufacturing.

• Materials costing $13,000 were requisitioned for use in making specific customer jobs. An additional $1,000 in materials was requisitioned for general factory use.

Work In Process ......................................................................... 13,000 Factory Overhead ...................................................................... 1,000 Materials ............................................................................... 14,000

Many organizations are using computerized information processes that account for the flow of materials. In a computerized setting, the storeroom manager would record the release of materials into a computer, which would automatically update the subsidiary materials records.

Factory Labor

There are two primary objectives in accounting for factory labor. One objective is to determine the correct amount to be paid each employee for each payroll period. A second objective is to properly allocate factory labor costs to factory overhead and individual job orders.


The amount of time spent by an employee in the factory is usually recorded on clock cards or in-and-out cards. The amount of time spent by each employee and the labor cost incurred for each individual job are recorded on time tickets.

A summary of the time ticked at the end of each month is the basis for recording the direct and indirect labor incurred in production. Direct labor is posted to each job cost sheet, while indirect labor is debited to Factory Overhead. The labor costs that flow into production are recorded by the following summary entry to the Work In Process controlling account:

• $7,800 was paid to direct laborers. An additional $9,500 was paid to factory employees who do not work directly on Jen's products.

Work In Process ......................................................................... Factory Overhead ...................................................................... Wages Payable ....................................................................

7,800 9,500

17,300

As with recording direct materials, many organizations are automating the labor recording process. Employees may log their time directly into computer terminals at their workstation. Alternatively employees may be issued magnetic cards, much like credit cards to log in and out of work assignments that are spread across a wide geographical area.

Factory Overhead Cost

Factory overhead includes all manufacturing costs, except direct materials and direct labor. Debits to Factory Overhead come from various sourced, such as indirect materials, indirect labor, factory power, and factory depreciation. Factory overhead and depreciation are recorded in the following entry for Jen Manufacturing:

• Factory overhead expenses, totaling $5,000, were paid in cash.

Factory Overhead ...................................................................... 5,000 Cash ..................................................................................... 5,000

• $3,700 in depreciation was recorded on factory machines.

Factory Overhead ...................................................................... 3,700 Accumulated Depreciation - Machinery 3,700

Allocating Factory Overhead

Factory overhead is much different from direct labor and direct materials because it is indirectly related to the jobs. Cost allocation is the process of assigning factory overhead costs to a cost object, such as a job. The factory overhead costs are assigned to the jobs on the basis of some known measure about each job. The measure used to allocate factory overhead is frequently called an activity base, allocation base, or activity driver. The estimated activity base should be a measure that reflects the use of factory overhead cost. For example, the direct labor is recorded for each job using time tickets. Thus, direct labor (hours or cost) could be used to allocate production–related factory overhead costs to each job. Likewise, direct materials costs are known about each job through the materials requisition. Thus, materials-related factory overhead, such as Purchasing Department salaries, could logically be allocated to each job on the basis of direct materials cost.


Predetermined Factory Overhead Rate

To provide current job costs, factory overhead may be allocated or applied to production, using a predetermined factory overhead rate. The predetermined factory overhead rate is calculated by dividing the estimated amount of factory overhead for the forthcoming year by the estimated activity base, such as machine hours, direct materials costs, direct labor costs, or direct labor hours.

Applying Factory Overhead to Work In Process

As factory overhead costs are incurred, they are debited to the factory overhead account, as shown previously. The entry to apply factory overhead is as follows:

• Overhead was applied to production, using a predetermined rate of $24.50 per direct labor hour. Jen used 780 direct labor hours during the period.

Work In Process ......................................................................... 19,110 Factory Overhead ................................................................. 19,110

(24.50 X 780 hours = $19,110)

The factory overhead costs applied and the actual factory overhead cost incurred during a period will usually differ. If the amount applied exceeds the actual costs incurred, the factory overhead account will have a credit balance. This credit is described as over-applied or over-absorbed factory overhead. If the amount applied is less than the actual costs incurred, the account will have debit balance. This debit is described as under-applied or under-absorbed factory overhead.

If the under-applied or over-applied balance increases in only one direction and it becomes large, the balance and the overhead rate should be investigated. For example, if a large balance is caused by changes in manufacturing methods or in production goals, the factory overhead rate should be revised. On the other hand, a large under-applied balance may indicate a serious control problem caused by inefficiencies in production methods, excessive cost, or a combination of factors.

Disposal of Factory Overhead Balance

The balance in the factory overhead account is carried forward from month to month. It is reported on interim balance sheets as a deferred debit or credit. This balance should not be carried over to the next year, however, since it applies to the operation of the year just ended. One approach for disposing of the balance of factory overhead at the end of the year is to transfer the entire balance to the cost of goods sold account. To illustrate the journal entries for the disposal of the balance for over applied factory overhead, record the following entries for Jen Manufacturing.

• Overhead applied to production for the year totaled $191,650; actual expenses for the year were $190,500. The adjustment for the over-applied total is $1,150.

Factory Overhead ...................................................................... 1,150 Cost of Goods Sold .............................................................. 1,150


Work In Process

Costs incurred for the various jobs are debited to Work In Process. At the end of the accounting period, the total costs for all completed jobs during the period are determined, and the following entry is made:

• Jobs costing $38,000 were completed.

Finished Goods .......................................................................... 38,000 Work In Process ................................................................... 38,000

The finished goods account is a controlling account. Its related subsidiary ledger, which has an account for each product, is called the finished goods ledger or stock ledger. Each account in the finished goods ledger contains cost data for the units manufactured, units sold, and units on hand. Just as there are various methods of costing materials entering into production, there are various methods of determining the cost of the finished goods sold. A summary of the cost data for the units shipped becomes the basis for the following entry:

• Jobs costing $32,000 were sold to credit customers for $55,000.

Accounts Receivable .................................................................. Sales ....................................................................................

55,000 55,000

Cost of Goods Sold .................................................................... Finished Goods ....................................................................

32,000 32,000

Describe transactions for a process manufacturer, using the average cost method cost flow assumption

Process manufacturers typically use large machines to process a flow of raw materials into a finished state. For example, a petrochemical business processes crude oil though numerous refining steps to produce higher grades of oil until gasoline is produced. A distinguishing feature of process manufacturers is that products produced are the same. This means that one unit of product cannot be distinguished from another. Thus, in a petrochemical business, one barrel of gasoline cannot be distinguished from another barrel. This is in contrast to a printing company, where one print job is not the same as another. The cost accounting system used by process manufacturers is called the process cost system.

Job order and process costing systems are similar in many ways. For example, both systems:

• Determine a product cost by measuring the amount of direct materials and direct labor used and allocating overhead costs.

• Allocate overhead using a predetermined overhead rate(s). • Maintain perpetual inventory records with subsidiary ledgers for materials, work in

process, and finished goods.


• Allocate costs to products. • Use product cost data for decision making.

The primary differences of job order and process cost systems reflect the underlying nature of the manufacturing systems. The difference influences the methods for accumulating and allocating costs. For example, the primary differences between job order and process cost systems are listed below:

• Manufacturing costs are accumulated to departments, rather than jobs. • Manufacturing costs are allocated to products based on units of production. • Manufacturing costs are accumulated and transferred between departments. • Work In Process inventory consists of partially completed production within a

department, rather than the sum of job cost sheets of partially completed jobs.

Costs Flows for a Process Manufacturer

Materials costs are a large portion of costs for most process manufacturers. Often, the materials costs can be as high as 70% of the total manufacturing costs. Thus, accounting for materials costs is very important for process operations. Because costs are accumulated by department in a process cost system, each department has its own Work In Process account. This allows the manufacturer to accumulate product costs by department. Costs transferred out of one department become the costs transferred in to the next department.

A manufacturer uses a cost flow assumption in determining the costs flowing into, flowing out of, and remaining in each manufacturing department. When using the cost flow assumption first-in-first-out (FIFIO) method, the manufacturing department adds materials at the beginning of production and conversion costs evenly throughout production. This requires two sets of equivalent unit calculations. When using the cost flow assumption average cost method, the manufacturing department shows materials and conversion costs both added evenly throughout production, requiring only one equivalent unit calculation. This assumption, along with the ability to combine beginning work in process with units started and completed, greatly simplifies the computations related to process costing.

The average cost method will still allow you to communicate the concept of equivalent units. Each department in a process costing system can compute the cost to manufacture one unit of product as follows:

The denominator of this equation assumes that whole units are completed during the month. However, this usually is not the case. As a result, companies are forced to calculate equivalent units. Equivalent units are the number of whole units that could have been made, using the same manufacturing effort. To illustrate, assume using the average cost flow method in the bakery company below:

Healthy Harvest Company is a bakery which makes breads. The manufacturing department is organized into three departments: dough making, baking, and packaging. The following information is related to the baking department.


The objective is to allocate the total costs of production completed and transferred to the packaging department and the costs remaining in the ending Work In Process inventory. These amounts are determined by using the following four steps:

1. Determine the units to be assigned costs. 2. Compute the equivalent units of production. 3. Determine the cost per equivalent unit. 4. Allocated costs to transferred and partially completed units.

STEP 1: Determine the units to be assigned costs. A unit can be any measure of completed production, such as tons, gallons, pounds, barrels, or cases. There are two categories of units to be assigned costs for the period: units completed and transferred out and units in the ending Work In Process inventory. In this step, determine the total number of units worked on in the dough-making department during April from both an “Input” and an “Output” perspective.


STEP 2: Calculate equivalent units of production. Assume that materials and conversion costs are added evenly throughout production. Therefore, only one equivalent unit calculation is required. In the average cost method, the calculation of equivalent units can be summarized in the following equation: No. of Whole Units × Percent of these units complete at the end of the month = Equivalent Units

(expressed as a fraction or a percentage)

The total equivalent units of production for the Baking Department is determined by adding the equivalent units in the ending Work In Process inventory to the units transferred and completed during the period as shown here:

STEP 3: Determine the cost per equivalent unit. Materials and conversion costs are often combined in computing cost per equivalent unit under the average cost method. In doing so, the cost per equivalent unit is determined by dividing the total production costs by the total equivalent units of production as follows:

Cost/Equivalent Unit = $ 1,044/ 2,320 equiv. units = $0.45

STEP 4: Allocate costs to transferred and partially completed units. Multiply the cost per equivalent unit by the equivalent units of production to determine the cost of transferred and partially completed units.

Use cost of production reports for decision making

A manufacturing cost system provides the user with a database of cost information. This database can be used to segment cost data in a number of ways, such as by product, by process, by production line, or by work shift. This detail gives manufacturers the ability to discover the root causes of cost problems. A cost of production report is a summary of the total manufacturing cost of an item. It involves charges to a processing department and the allocation of the total cost between the ending work-in-process inventory and the units completed and transferred out to the next department or finished goods inventory. A cost of


production report is normally prepared for each processing department at periodic intervals. The report provides the following production quantity and cost data:

1. The units for which the department is accountable and the disposition of those units. 2. The production costs incurred by the department and the allocation of those costs

between completed and partially completed units.

The cost of production report is also used to control costs. Each department manager is responsible for the units entering production and the costs incurred in the department. Any failure to account for all costs and any significant differences in unit product costs from one month to another should be investigated.

To prepare a cost of production report, using the average cost method, use the following information:

The increases to Work In Process–Cooking Department for Boston Beans Company for January 20xx, as well as information concerning production, are as follows:


In addition to unit production cost trends, managers of process manufactures are also concerned about yield trend. Yield is the ratio of the materials’ output quantity to the input quantity. A yield of less than one occurs when the output quantity is less than the input quantity, due to materials losses during the process.

To illustrate yield, the cost of energy consumed in producing good units in the Bottling Department of Rocky Springs Beverage Company was $4,200 and $3,700 for March and April, respectively. The number of equivalent units produced in March and April was 70,000 liters and 74,000 liters, respectively.

In this illustration, the equation for the calculation for cost of energy is:

producing good units / equivalent units = cost of energy

To evaluate the cost of energy between the two months: Energy cost per liter: March $4,200/ 70,000 liters = $0.06

Energy cost per liter: April $3,700/ 74,000 liters = $0.05

The cost of energy has appeared to improve by 1 cent per liter between March and April.


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