CHAPTER 5: ACCOUNTING FOR COST INVENTORY- products that are being purchased

FLOWS or manufactured by a company to sell to the

consumers. As long as the product is being sold in
APPLICATION OF COST ACCOUNTING TO THE a normal course of business, it is classified as an
VARIOUSBUSINESS SECTORS OF THE inventory.
ECONOMY
•Manufacturing Company
THE THREE DIFFERENT BUSINESS SECTORS:
1. Direct Materials/Supplies Inventory-
1. Merchandising-sector companies- purchase shows the cost of materials available for
and sell tangible products without changing their processing.
basic form. It includes companies engaged in
retailing (bookstores and department stores), 2. Factory Supplies Inventory
distribution or wholesaling. (Buy and sell)
3. Work in Process Inventory- the cost of
2. Manufacturing-sector companies- purchase unfinished goods.
raw materials and components and convert them
4. Finished Goods Inventory- the cost of
into various finished goods. Examples: automotive
completed but not yet sold goods.
companies, food-processing companies, and
textile companies. (Buy, process, and sell) •Retailers and other merchandising companies
3. Service-sector companies- provide services or 1. Merchandise inventory- shows goods
intangible products (legal advice or audits) to their available for sale.
customers. Examples: law firms, accounting firms,
banks, insurance companies, transportation •Service organization (may have the following
companies, advertising agencies, radio and inventories which represents the costs incurred for
television stations, and internet-based companies. work for clients which are unbilled as of reporting
(Intangible products) date.)

THREE GENERAL CLASSIFICATIONS OF 1. Direct Materials/Supplies Inventory-

COST: 2. Work in Process Inventory
1. Production costs- includes the direct materials, FLOW OF COSTS IN A MERCHANDISING
direct labor, and manufacturing overhead incurred COMPANY- their product costs are the price of the
to produce a good or service as well as product merchandise.
engineering and design costs occurring before
manufacturing. (Period costs classified as asset •When products are purchased, their costs are
under inventory) recorded as assets on the statement of financial
position under Merchandise Inventory.
2. Marketing costs- result from selling and
delivering products and include the cost of •Goods sold during the period, the costs are
promoting sales and retaining customers as well removed from the asset account and charged
as transportation, warehousing and other against sales revenue in the in the income
distribution costs. (Period costs which is reflected statement.
as expense immediately)
•Selling and administrative costs are charged also
3. Administrative costs- result from directing and against income statement a operating expenses
controlling the company and for general activities for the period in the income statement.
such as personnel and legal functions. Includes
management and financial accounting salaries, Merchandise Inventory- includes of goods
electrical costs, telephone and telex costs, and purchased for sale that remain unsold as of the
rental fees. (Period costs which is reflected as end of the accounting period.
expense immediately) TWO METHODS OF ACCOUNTING FOR
INVENTORY ACCOUNTS INVENTORIES ARE:

ACTG 22A: COST ACCOUNTING AND CONTROL

1. Perpetual Method- requires a continuing and •The manufacturer purchases materials, hires
ongoing record of transfers in, transfers out and workers to work on the material to convert it to a
inventory balances. Usually used by entities with finished good, then offers the product for sale.
low volume, high priced goods such as Vehicles,
Jewelry, and Furniture. THREE CATEGORIES OF MANUFACTURING
COSTS:
2. Periodic Method- required only a periodic
(often monthly) count and valuation of inventory. 1. Direct materials- also called raw materials from
Usually used by entities with high volume, low- which the product is made.
priced goods such as foods, clothes, and supplies. 2. Direct labor- wages of workers who transform
PERPETUAL PERIODIC the materials into a finished good.
INVENTORY INVENTORY 3. Manufacturing overhead- includes all other
METHOD METHOD costs of transforming the materials into a finished
Updates inventory Inventory subsidiary
product.
accounts after each ledger is not updated
purchase or sale. after each purchase or a. Indirect labor- cost of workers who do
sale of inventory. not work directly on the product yet are
Inventory subsidiary Inventory quantities required for the factory to operate
ledger is updated after are not updated (supervisors, janitors, maintenance works,
each transaction. continuously.
inventory keepers).
Inventory quantities Inventory quantities
are updated are updated on a b. Indirect materials- not part of the
continuously. periodic basis. finished product but are necessary to
manufacture the product (lubricants for the
machinery, polishing and cleaning
materials, repair parts, and light bulbs).

c. Other manufacturing costs-

depreciation of the factory building and
equipment, taxes on the factory assets,
insurance and so forth.

MANUFACTURING OVERHEAD CONTROL-

actual cost.

MANUFACTURING OVERHEAD APPLIED- can

FLOW OF COSTS IN A MANUFACTURING
be actual or budgeted cost. Part of manufacturing
COMPANY
overhead that is put into process.
•Most complex cost classifications where special
SELLING AND ADMINISTRATIVE COSTS-
statement must be prepared to determine the cost
charged against income as operating expenses for
of goods sold.
the period in the income statement.

•The raw materials unused as of the end of the

accounting period, the work in process or
noncompleted work on the production line and
finished goods not yet sold are reported as assets
in the statement of financial position.

•Cost of finished goods sold and selling and

administrative expenses are shown as deduction
from sales revenue in the income statement.

FLOW OF COSTS IN A SERVICE

ORGANIZATION

ACTG 22A: COST ACCOUNTING AND CONTROL

PURELY SERVICES- no inventory accounts and •Know the nature of each business sector/type and
cost of goods sold. master their cost structures:

•Do not need to account for inventories of finished 1. Merchandising- only 1 inventory
goods. account (Merchandise Inventory).

•Most service organizations maintain a Work in 2. Manufacturing- 3 inventory accounts

Process Inventory account for internal use which (Raw Materials, Work In Process, Finished
includes the cost of services performed for a Goods).
customer but not yet billed, labor and overhead are
accumulated for each job or unit. 3. Service- generally, no inventory
account.
•Work In Process is not reported in Statement of
Financial Position. •Cost flows of each business are depicted using t-
accounts.
•Flow of cost is similar to manufacturing business.
1. Understand their normal balances.
•Input costs include the labor and overhead that
are part of the service provided. 2. Know when a specific account is
debited and when it is credited.
•Costs are usually collected by departments for
performance evaluation purposes. •Be familiar with the financial statements of each
business.
•In public auditing/accounting firms, consulting,
and similar service organizations, costs are then 1. Income Statement
charged to jobs or clients. 2. Statement of Cost of Goods
•In manufacturing shops, costs are collected by job Manufactured and Sold
or engagement for:

a. Performance evaluation

b. Provide information for cost control

c. Compare actual costs with past

estimated costs for pricing of future job.

IMPORTANT POINTS IN ACCOUNTING FOR

COST FLOWS: CHAPTER 6: SYSTEM DESIGN – JOB
ORDER COSTING

ACTG 22A: COST ACCOUNTING AND CONTROL

PRODUCT COSTING (Heart of Cost (costs are based on
Accounting)- a process of accumulating, the total of all the
classifying, and assigning direct materials, direct costs in direct
labor and factory overhead costs to product or materials, direct labor,
services. and factory overhead
batch of products in the overall process
•The company’s strategy and processes guide and will be divided to
accountants in designing the costing system. the number of
products
SYSTEM DESIGN- the process or organized steps manufactured
in product costing made by accountants that must everyday)
be followed by the whole company/department. Heterogenous items or
different products in
FOUR MAIN POINTS WHEN CREATING A terms of materials,
SYSTEM DESIGN: ingredients, or labor. Homogenous items
Custom made or
1. The cost-benefit approach is essential in products are different
designing and choosing costing system- cost- in appearance.
benefit means that the benefits should always More costly as it
outweigh the cost or the company must have Less costly because it
requires more
income. Most complex costing system have more requires only one
recordkeeping that
recordkeeping.
costs. adds more costs

COST-BENEFIT APPROACH- every point in the

system has a cost. JOB ORDER COSTING SYSTEM COMPANIES:

2. Costing systems should be tailored to be 1. Construction Companies

underlying operations; the operations should
not be tailored to fit the costing systems- must 2. Printing Companies
not copy the costing design of other company even 3. Medical Services
if you sell the same products or services. Costing
system must be aligned with the operations and PROCESS COSTING SYSTEM COMPANIES:
operations must not be manipulated to fit in the
1. Food Products
costing system.
2. Petroleum Companies
3. Costing systems accumulate costs to
facilitate decisions- costing system design must 3. Bottling Companies
help managers to make decisions.

4. Costing systems are only one source of

information for managers- costing system design
is only for product pricing or costing and managers
must not rely on costing system design alone.

THREE CATEGORIES OF COSTING METHODS:

1. The Cost Accumulation Method: Job Order

vs Process Costing- must choose only one
costing because combination of the two will
provide an inaccurate information.

JOB ORDER PROCESS COSTING 2. The Cost Measurement Method: Actual,

COSTING SYSTEMS SYSTEM Normal, Or Standard Costing
Cost object: by job or Cost object: process

ACTG 22A: COST ACCOUNTING AND CONTROL

•ACTUAL COSTING- actual cost or the amount 1. Direct Labor Hours
paid/used in direct materials, direct labor and
factory overhead are used and it is rarely used 2. Number of units products
because the price in the market significantly Activity–Based (ABC)- allocate factory overhead
fluctuate that will also lead to fluctuation of pricing. costs to product using cause-and-effect criteria
Another disadvantage is most actual factory with multiple cost drivers. It uses both volume-
overhead are known at or after the end of the based and nonvolume-based cost drivers to more
period than completion of batch or products that accurately allocate factory overhead costs to
hinders the actual costing systems to provide products based on resource consumption during
accurate unit product cost information on a timely various activities.
basis.
JOB–ORDER COSTING SYSTEM
•NORMAL COSTING- uses actual cost in both
direct materials and direct labor but uses applied •The more specification of the product, the higher
overhead in factory overhead or the assumed the cost and price.
factory overhead for the whole period that is based
•Costs are assigned to each job that may be an
on the past experiences. It provides a timely
order, a contract, a unit of production, or a batch
estimate of the cost of producing each batch of
performed to meet customer’s specifications.
product.
•Job-order costing is appropriate for companies
•STANDARD COSTING- uses standard cost in
making different components for inventory.
direct material, direct labor, and factory overhead.
Usually used by companies that are very careful Example: Two students printed two projects for
with their performance evaluation. their subject, the one that printed a 10 pages black
and white pays lower cost while the other that
STANDARD COST- the desired level of activity or
prints 20 colored pages paid higher amount. The
cost that we need to reach.
printing company uses job-order costing because
the two boys have different specifications.

PRODUCTION ORDER- includes Materials

Requisition Form, Direct Labor Time Ticket, and
Predetermined Overhead Rates.

MATERIALS REQUISITION FORM- got from the

3. The Overhead Assignment Method- Volume supplies or the storage room.
– Based or Activity–Based DIRECT LABOR TIME TICKET- the time needed
Volume–Based- it relies on the assumption that for each laborer.
each product used\s the same amount of overhead PREDETERMINED OVERHEAD RATES-
that produces inaccuracy to some companies. overhead rate per product divided to cost drivers.
•Allocate overhead to products or jobs using one JOB COSTS SHEET- the summary of all the
common volume–based cost driver such as: costs.

ACTG 22A: COST ACCOUNTING AND CONTROL

 Wages Payable xxx
Incurrence of indirect labor costs.

STEP 3: Calculate a predetermined overhead rate

and use it to assign overhead costs to a job.

FORMULA:
Predetermined
overhead rate
=
Estimated Factory Overhead Costs for the Period
EstimatedCosts
•Estimated Factory Overhead Activity of the
for the AllocationBase
Whole
Period depends on your experience or your study.

•Estimated Activity of the Allocation Base depends

on the policy of the company that can be direct
labor hours or volume/number of the units of the
products produced.

STEP 4: Record applied factory overhead costs

ACCOUNTING PROCEDURES USING JOB with journal entries.
ORDER COSTING SYSTEM
Work in Process Inventory xxx
STEP 1: Record the purchase and issue of Factory Overhead Applied xxx
materials with journal entries.

Raw Materials Inventory xxx STEP 5: Complete a job cost sheet and calculate
Accounts Payable xxx the average cost per unit of a job.

•This is a source document.

Work in Process Inventory xxx
Raw Materials Inventory xxx STEP 6: Record actual factory overhead costs
Issuance of direct materials to with journal entries.
production
•This are the actual amounts of overhead at the
Factory Overhead Control xxx end of the period.
Raw Materials Inventory xxx •This is needed to be recorded to identify if the
Issuance of indirect materials to application of factory overhead is correct.
productions
STEP 7: Compute over– or underapplied
overhead.
Raw Materials Inventory- composed of direct
materials and indirect materials IMMATERIAL AMOUNT:
Deduct from
FACTORY OVERHEAD CONTROL- all the factory Overapplied APPLIED ¿
the cost of
overhead actual costs. Overhead ACTUAL
goods sold.
Add to the
STEP 2: Record labor costs with journal entries. Underapplied APPLIED ¿
cost of goods
Overhead ACTUAL
Work in Process Inventory xxx sold.
Wages Payable xxx MATERIAL AMOUNT:
Over- or Underapplied Divide among ending
Incurrence of labor costs.
OH balances of WIP
Inventory, FG
Factory Overhead Control xxx Inventory, and Cost of

ACTG 22A: COST ACCOUNTING AND CONTROL

 Goods Sold. Add: Beginning Balance, Work in Process
Inventory

Material Amount: Total costs put into process

Step 1: add and get the total of ending balances of Less: Ending balance, Work in Process Inventory
Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold. Cost of Goods Manufactured

Example: Add: Beginning Finished Goods Inventory

Overapplied amount is P10,000 and it is already Total Goods Available for Sale
material. Less: Ending Finished Goods Inventory
WIP Inventory = P5,000 Cost of Goods Sold
FG Inventory = P3,000 •Cost of Goods Sold should be the adjusted
COGS = P2,000 amount.

Total = P10,000 •Factory Overhead Control and Factory Overhead

Applied must be equal.
Step 2: Divide the amount of each to the total.
PRORATION- the allocation of underapplied or
Example: overapplied overhead among ending work-in-
process, finished goods, and cost of goods sold.
WIP Inventory 5,000
= = IMPORTANT POINTS IN JOB ORDER
Total of WIP, FG ,∧COGS(Step 1) 10,000
COSTING:
0.5 or 50%
•Each unit of output or batch of products is the
Step 3: The answer in step 2 will be the absorbed
cost object of job order costing
by the WIP, FG, and COGS.
1. Direct materials, direct labor, and
Example:
factory overhead are absorbed by each
50% of 10,000 overapplication will be absorbed cost object.
by/deducted to WIP Inventory.
2. This makes job order costing more
30% of 10,000 overapplication will be absorbed accurate than processing costing.
by/deducted to FG Inventory.
3. Record keeping costs are higher
20% of 10,000 overapplication will be absorbed because of a more detailed bookkeeping.
by/deducted to COGS.
•Factory overhead is normally applied to
•If underapplication material, the WIP Inventory, production in terms of a predetermined rate
FG Inventory, and COGS will just be added.
1. Predetermined Overhead rate =
NOTE: If the problem is silent, the amount is Estimated Factory Overhead costs in a
automatically immaterial. period ÷ Estimated level of activity.

STEP 8: Calculate cost of goods manufactured 2. Factory Overhead Control is the ledger
and cost of goods sold. for actual costs; Factory Overhead Applied
is the ledger for applied overhead.
Direct Materials
•Over- or underapplication of Factory Overhead
Direct Labor normally results from this costing system
Applied Factory Overhead

Total Manufacturing Costs

ACTG 22A: COST ACCOUNTING AND CONTROL

1. Overapplication makes Cost of Goods
Sold overstated; hence, this should reduce
Cost of Goods Sold.

2. Underapplication makes Cost of Goods

Sold understated; hence, this should
increase Cost of Goods Sold.

ACTG 22A: COST ACCOUNTING AND CONTROL