TOPIC MODULE 2

COST ACCOUNTING AND MANUFACTURING

OPERATIONS

OVERVIEW

How’s the first module? Have you learned something about managerial accounting? Well,
we’ve only just begun.

In this module 2, you will learn the cost terminologies and concepts of cost accounting and
manufacturing operations. We will explain here the different financial accounting and
managerial accounting terminologies and concepts needed for decision making.

READ & LEARN

Three of you are planning to take a vacation. One suggests to take have fourth to tag along,
remarking that the fourth can travel for the same cost as yours. Some costs will be same
whether you are three of four on a trip. Example of it is the hotel room/accommodation cost,
whether how many of you stay in the room the cost is all the same. That’s what we call fixed
cost. The total amount of a fixed cost does not change when the volume changes. In contrast,
some costs vary directly proportional with the changes in volume. When volume increases,
total variable increases; when volume decreases, total variable decreases. For example, the
cost of movie ticket is a variable cost. The total costs of buying the movie tickets will
increases as to how many persons are going to buy the tickets. Cost behavior (fixed vs.
variable) can impact the profitability of the business. This lesson will introduce you to
Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis of the book
Fundamental Managerial Accounting Concepts 6th edition pages 54-75.

GENERAL COST CLASSIFICATIONS

• Manufacturing Costs
Three broad categories of manufacturing costs:

1. DIRECT MATERIALS
➢ Materials that go into the final products are called raw materials
 ➢ Raw materials refer to any materials that are used in the final product; and
the finished product of one company can become the raw materials of another
company.
➢ Raw materials may include both direct and indirect materials.
➢ Direct materials are those materials that become an integral part of the
finished product and whose costs can be conveniently traced to the finished
product.
➢ Indirect materials are materials used in manufacturing processes that cannot
be traced to an individual product or job. These materials, while consumed as
part of the production process, are usually used in small amounts on a per-
product basis and purchased in mass quantities.
2. DIRECT LABOR
➢ Direct labor consists of labor costs that can be easily (i.e., physical and
conveniently) traced to individual units of product. Direct labor is sometimes
called touch labor because direct labor workers typically touch the product
while it is being made.
➢ Labor costs that cannot be physically traced to particular products, or that can
be traced only at great cost and inconvenience, are termed indirect labor.
3. MANUFACTURING OVERHEAD
➢ Manufacturing overhead includes all manufacturing costs except direct
materials and direct labor.
➢ These includes items such as indirect materials; indirect labor; maintenance
and repairs on production equipment; and heat and light, property taxes,
depreciation, and insurance on manufacturing facilities.
➢ A company also incurs costs for heat and light, property taxes, insurance,
depreciation, and so forth, associated with its selling and administrative
functions, but these costs are not included as part of manufacturing overhead.
Only those costs associated with operating the factory are included in
manufacturing overhead.

Manufacturing costs are often classified as follows:

Direct Materials Direct Labor Manufacturing

Overhead

PRIME COST CONVERSION

COST
 • Nonmanufacturing Costs

Nonmanufacturing costs have two categories:

SELLING COSTS

Selling costs include all costs that are incurred to secure customer orders and get the finished
product to the customer. These costs are sometimes called order-getting and order-filling
costs.

• Advertising
 • Shipping
• Sales travel
• Sales commission
• Sales salaries
• Costs of finished goods warehouses

ADMINISTRATIVE COSTS

Administrative costs include all costs associated with the general management of an
organization rather than with manufacturing or selling.

• Executive compensation
• General accounting
• Secretarial
• Public Relations
• Similar costs involved in the overall, general administration of the organization as a
whole.

COST CLASSIFICATIONS ON FINANCIAL STATEMENTS

• Balance Sheet
• Income Statement

COST CLASSIFICATIONS FOR DECISION MAKING

Differential Cost and Revenue

• A difference in costs between any two alternatives is known as a differential cost. A

difference in revenues between any two alternatives is known as differential revenue.
• A differential cost is also known as an incremental cost, although technically an
incremental cost should refer only to an increase in cost from one alternative to
another; decreases in cost should be referred to as decremental costs.
• The accountant’s differential cost concept can be compared to the economist’s
marginal cost concept. In speaking of changes in cost and revenue, the economist uses
the terms marginal cost and marginal revenue. The revenue that can be obtained from
selling one more unit of product is called marginal revenue, and the cost involved in
producing one more unit of product is called marginal cost.

Opportunity Cost

• Opportunity cost is the potential benefit that is given up when one alternative is
selected over another.
 • Example 1 Vicki has a part-time job that pays P5,000.00 per week while attending
college. She would like to spend a week at the beach during summer break, and her
employer has agreed to give her the time off, but without pay. The P5,000.00 in lost
wages would be an opportunity cost of taking the week off to be at the beach.
• Virtually every alternative involves an opportunity cost.

Sunk Cost

• A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Because sunk costs cannot be changed by any
decision, they are not differential costs. And because only differential costs are
relevant in a decision, sunk costs can and should be ignored.
ANALYSIS OF COST BEHAVIOR

Variable costs are those costs that vary in total with change in volume or level of activity.
Examples of variable costs include the costs of direct materials, direct labor, sales
commissions, and gasoline expenses. The following factory overhead items fall into the
variable-costs category:

Variable Factory Overhead

Supplies Receiving costs
Fuel and power Overtime premium
Spoilage and defective work

Fixed costs are costs that do not change in total regardless of the volume or level of activity.
Examples include rent, property taxes, insurance, and, in the case of automobiles, license fees
and annual insurance premiums. The following factory overhead items fall into the fixed-
costs category:

Salaries of production supervisors Rent on warehouse and factory building

Depreciation (by straight-line) Salaries of indirect labor
Property taxes Property insurance
Patent amortization

Semi-variable costs are costs that contain both a fixed element and a variable element.
Salespersons’ compensation including salary and commission is an example. The following
factory overhead items may be considered semi-variable costs:

Supervision Maintenance and repairs

Inspection Compensation insurance
Service department costs Employer’s payroll taxes
Rental of delivery truck Utilities
Fringe benefits
TYPES OF FIXED COSTS -COMMITTED OR DISCRETIONARY

Strictly speaking, there is no such thing as a fixed cost. In the long run, all costs are variable.
In the short run, however, some fixed costs, called discretionary (or managed or
programmed) fixed costs, change because of managerial decisions or changes in volume.
Examples of this type of fixed costs are advertising outlays, training costs, and research and
development costs. Another type of fixed costs, called committed fixed costs, are those costs
that are the results of commitments made previously. Fixed costs such as rent, depreciation,
insurance, and executive salaries are committed fixed costs, since management has
committed itself for a long period of time regarding the company’s production facilities and
labor requirements.

ANALYSIS OF SEMIVARIABLE COSTS (OR MIXED COSTS)

THE HIGH-LOW METHOD

The high-low method, as the name indicates, uses two extreme data points to determine the
values of a (the fixed cost portion) and b (the variable rate) in the equation y = a + bx. The
extreme data points are the highest representative x-y pair and the lowest representative x-
y pair. The activity level x, rather than the mixed cost item y, governs their selection.

The high-low method is explained, step by step, as follows.

Step 1 Select the highest pair and the lowest pair.

Step2 Compute the variable rate, b, using the formula

Step 3 Compute the fixed cost portion as

Fixed cost portion = Total semi-variable cost -Variable cost

Example 1

Flexible Manufacturing Company decides to relate total factory overhead costs to direct labor
hours (DLH) to develop a cost-volume formula in the form of y =: a + bx. Twelve monthly
observations are collected.

Table 1
The high-low points selected from the monthly observations are

where y ’ = estimated factory overhead

x = DLH

Note that the reason for using a new symbol y’ (read as y-prime) is that the cost-volume
formula just obtained gives an estimated value of y.

The high-low method is simple and easy to use. It has the disadvantage, however, of using
two extreme data points, which may not be representative of normal conditions. The method
may yield unreliable estimates of a and b in our formula. In such a case, it would be wise to
drop them and choose two other points that are more representative of normal situations.

THE SCATTERGRAPH METHOD

In the scatter graph method, a semi-variable expense is plotted on the vertical axis (or y axis)
and an activity measure is plotted on the horizontal axis (or x axis). Then, a regression line is
fitted by visual inspection of the plotted x-y data. The method is best explained by the
following example.
For purposes of illustration, let us use the data in Example 1. The factory overhead and direct
labor hours are plotted below.

REGRESSION ANALYSIS (THE METHOD OF LEAST SQUARES)

One popularly used method for estimating the cost-volume formula is regression analysis.
Regression analysis is a statistical procedure for estimating mathematically the average
relationship between the dependent variable y and the independent variable(s). Simple
regression involves one independent variable, such as DLH or machine hours alone, whereas
multiple regression involves two or more activity variables. (We will assume simple linear
regression throughout this chapter, which means that we will maintain the y = a + bx
relationship.)

Unlike the high-low method, in estimating the variable rate and the fixed cost portion, the
regression method does include all the observed data and attempts to find a line of best fit.
To find the line of best fit, a technique called the method of least squares is used.

THE METHOD OF LEAST SQUARES

Example

To illustrate the computations of b and a, we will once again refer to the data in Table 1. All
the sums required are computed and shown below.
Product Costing Methods (Job-Order Costing and Process Costing)

JOB-ORDER COSTING AND PROCESS COSTING COMPARED

The distinction between job-order costing and process costing centers largely around how
product costing is accomplished. With job-order costing, the focus is to apply costs to specific
jobs, which may consist of either a single physical unit or a few like units.

Under process costing, accounting data are accumulated by the production department (or
cost center) and averaged over all of the production that occurred in the department. There
is mass production of like units which are manufactured on a continuous basis through a
series of uniform production steps known as processes.

JOB-ORDER COSTING

Job-order costing is the cost accumulation system under which costs are accumulated by jobs,
contracts, or orders. This costing method is appropriate when the products are manufactured
in identifiable lots or batches or when the products are manufactured to customer
specifications. Job-order costing is widely used by custom manufacturers such as printing,
aircraft, and construction companies. It may also be used by service businesses such as auto
repair shops and professional services. Job-order costing keeps track of costs as follows:
Direct material and direct labor are traced to a particular job. Costs that are not directly
traceable-factory overhead-are applied to individual jobs using a predetermined overhead
(application) rate.

JOB COST SHEET

A job cost sheet is used to record various production costs for work-in-process inventory. A
separate cost sheet is kept for each identifiable job, accumulating the direct materials, direct
labor, and factory overhead assigned to that job as it moves through production. The form
varies according to the needs of the company. This is the key document in the system. It
summarizes all of the manufacturing costs-direct materials, direct labor, and applied factory
overhead (to be discussed in detail later) -of producing a given job or batch of products. One
sheet is maintained for each job, and the file of job cost sheets for unfinished jobs is the
subsidiary record for the Work-in-Process Inventory account. When the jobs are completed
and transferred, the job cost sheets are transferred to a “completed jobs” file and the number
of units and their unit costs are recorded on inventory cards supporting the Finished Goods
Inventory account.

PROCESS COSTING

Process costing is a cost accumulation system that aggregates manufacturing costs by

departments or by production processes. Total manufacturing costs are accumulated by two
major categories, direct materials and conversion costs (the sum of direct labor and factory
overhead applied). Unit cost is determined by dividing the total costs charged to a cost center
by the output of that cost center. In that sense, the unit costs are averages.

Process costing is appropriate for companies that produce a continuous mass of like units
through a series of operations or processes. Process costing is used in such industries as
petroleum, chemicals, oil refining, textiles, and food processing.

STEPS IN PROCESS COSTING CALCULATIONS

Step 1 Summarize the flow of physical units. The first step of the accounting provides a
summary of all units on which some work was done in the department during the period.
Input must equal output. This step helps to detect lost units during the process. The basic
relationship may be expressed in the following equation:

Beginning inventory + Units started for the period = Units completed and transferred
out+ Ending inventory

Step2 Compute output in terms of equivalent units. In order to determine the unit costs of
the product in a processing environment, it is important to measure the total amount of work
done during an accounting period. A special problem arises in processing industries in
connection with how to deal with work still in process, that is, work partially completed at
the end of the period. The partially completed units are measured on an equivalent whole-
unit basis for process costing purposes.

Equivalent units are a measure of how many whole units of production are represented by
the units completed plus the units partially completed. For example, 100 units that are 60
percent completed are the equivalent of 60 completed units in terms of conversion costs.

Step 3 Summarize the total costs to be accounted for by cost categories. This step summarizes
the total costs assigned to the department during the period.

Step 4 Compute the unit cost per equivalent unit. The unit cost per equivalent unit is
computed as follows:

Step 5 Apply total costs to units completed and transferred out and to units in ending Work
in Process.

COST-OF-PRODUCTION REPORT

The process costing method utilizes a cost-of-production report. This report summarizes
both total and unit costs charged to a department and indicates the allocation of total costs
between work-in-process inventory and units completed and transferred out to the next
department or the finished goods inventory.

The cost-of-production report covers all five steps described above. It is also the source for
monthly journal entries as well as a convenient compilation from which cost data may be
presented to management.

PROCESS COST COMPUTATION: NO BEGINNING INVENTORY

The first illustration of unit cost computations under a process system assumes for simplicity
that there is no beginning work-in-process inventory. A company produces and sells a
chemical product that is processed in two departments. In Department A the basic materials
are crushed, powdered, and mixed. In Department B the product is tested, packaged, and
labeled, before being transferred to finished goods inventory.
 ONLINE REFERENCES

• https://bit.ly/2IMqOEf Costs in Management Accounting

• https://bit.ly/32eGaYW Cost Accounting - Costs Concepts and Classifications
(Manufacturing Cost)
• https://bit.ly/2HW7Ivg Cost Accounting - Merchandising vs Manufacturing
• https://bit.ly/3kVYf57 Job Order Costing (Part 1)
• https://bit.ly/3mRZJOt Job Order Costing (Part 2)
• https://bit.ly/3kYZJeZ Relevant Costs (Managerial Accounting)
• https://bit.ly/34WY4Rq Managerial Accounting: Decision Making -Relevant Costs
and Benefits
• https://bit.ly/2UP1EYl Cost Behavior: Fixed, Variable, Mixed, and Step Costs
• https://bit.ly/2UBzwrp Process Costing - Equivalent Units of Production (EUP) - Part
1
• https://bit.ly/35G4Iw8 Process Costing - Equivalent Units of Production (EUP) - Part
2

MAIN TASK 1

Individually, do online research and list three (3) firms/ enterprises doing job order and
process costing.

MAIN TASK 2

Peer Grouping

Look for a partner. Research and write two (2) manufacturing firms identifying the elements
of costs and then, collate the costs involved and decide what are the relevant costs needed in
decision-making.
I will give you the link for your quiz after you pass all the practice exercises and main tasks. The link
will be email to your gmail/ yahoo account after confirming that you pass all the activities. Good
luck!

REFLECTION