Unit 1-4

UNIT ONE: COST AND MANAGEMENT ACCOUNTING FUNDAMENTAL
Content
1.0 Introduction
1.1 Objectives
1.2 Cost and Management Accounting
1.2.1 Overview of Accounting In general
1.2.2 The Need for General Accounting Systems
1.2.3 Purpose of Cost Accounting
1.2.4 Management Accounting, Cost Accounting, and Financial Accounting
1.3 Management Process and Accounting
1.3.1 Objectives
1.3.2 Element of Management Control
1.3.3 Cost Management and Accounting System
1.4 Summary
1.5 Answers To Learning Activities
1.6 Answers to Check Your Progress Exercises
1.7 Model Exam Questions
1.0 INTRODUCTION
This unit is an introduction to cost and management accounting that identifies the need for
general accounting system and purpose of accounting, compares management accounting,
cost accounting, and financial accounting and described elements of management control and
cost management.
1.1 OBJECTIVES
At the end of the unit you are expected to:

- gain and over view of accounting in gene4ral
- describe the need for general accounting system
- understand the purpose of cost accounting
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- compare and contrast management accounting, cost accounting, and financial
accounting.
- Understand how accounting can facilitate planning, and decision making.
1.2 COST AND MANAGEMENT ACCOUNTING
After you are completing this section you are able to provide an overview of accounting in
general, the need for general accounting system, purpose of cost accounting, and compare and
contrast management accounting, cost accounting, and financial accounting.
1.2.1 Overview of Accounting In General

Accounting is the system that measures business activities, processes that information into
reports, and communicates these findings to decision makers. Financial statements are the
documents that report on an individual or an organization's business in monetary amounts.
Is our business making a profit? Should we start up a new line of women's closing? Are sales
strong enough to warrant opening a new branch outlet? The most intelligent answers to
business questions like these use accounting information. Decision makers use the
information to develop sound business plans. As new programs affect the business’s
activities, accounting takes the company's financial pulse rate. The cycle continues as the
accounting system measures the results of activities and reports the results to decision makers.
1.2.2 The Need For General Accounting Systems
The accounting system is the principal and the most credible quantitative information system
in almost every organization. This system should provide information for four broad
purposes.
Purpose 1: Internal routine reporting to mangers for (a) cost planning and control of
operations, and (b) performance evaluation of people land activities.
Purpose 2: Internal routine reporting to managers on the profitability of products, brand
categories, customers and distribution channels, and so on. This information is used in
marking decision on resource allocation and in some cases decisions on pricing.
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Purpose 3: Internal non-routine reporting to managers for strategic and tactical decisions on
matters such as formulating overall polices and long-range plans, new products development
-investing in equipment and special orders or special situations.
Purpose 4: External reporting through financial statement to investors, government
authorities, and other outside parities. To satisfy external purposes, businesses must report
income and inventory costs, in accordance with the generally accepted accounting principles
that guide financial accounting.
1.2.3 Purpose Of Cost Accounting

Cost accounting has developed as a specialty within the field of accounting at the same time
that business enterprises become more complex. In simpler times, when individual artisans
provided goods and services, elaborate accounting records were unnecessary. An individual
producer could evaluate the viability of the operation simply by comparing cash receipts to
cash disbursements.
With the rise of multiply owned enterprises, owners saw a need to develop objective and
equitable procedures (financial accounting) to determine income so that they could calculate
their fair share of proceeds from the enterprise. But it was the rise of the large firm producing
numerous products and services that need for cost accounting. Firm wide net income no
longer provided sufficient information for owners to make operating decisions. The use of
common labor and facilities to produce a wide range of products made it extremely difficult
for them to determine profitability of each product. In turn, decisions concerning the
expansion or contraction of products lines became difficult.
Traditional cost accountants concentrated on developing reporting system that would yield
costs so that they could evaluate the profitability of individual product lines. Fortunately, the
discipline is changing and cost accountants are becoming much more concerned with
providing information that will help management meet the firm's goals.
In a nutshell, for many years ago cost accounting systems emphasized one purpose, i.e.,
product costing for inventory variations and income determination. As a result many systems
failed to collect the data in a form suitable for other purposes such as evaluating departmental
efficiency. Modern cost accounting systems are incorporating other purposes that may be
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characterized as planning and controlling. This includes getting a reliable data for predicting
the economic consequences of management decision.
The cost accounting department, under the direction of the controller (the higher officer of
accounting department), is responsible for keeping records of a company's manufacturing and
not manufacturing activities. In general the rule (or purpose) of cost accounting may be
summarized as follows:
PLANNING: the cost accounting system provides vital information needed to plan future
operations, cost data help to resolve questions relating to proposed projects or policies, such
as the following:
- Should we build a new plant or modernize the old one?

- How far can we go in lowering prices to increase our volume of sales?
- What will be the effects on costs of automating part of our factory operations?
BUDGETING: cost accounting is also in preparing a company's budgets. A budget is the

overall financial plan for the future activities. All levels of the management should be
involved in the development of budges.
CONTROLLING COSTS: Cost accounting is one of the most available management tools to
control operations. Company actual costs with budgeted costs are helpful in evaluating the
results of operations. The difference between the two sets of cost figured can be noted and
investigated while there is still time to take remedial (corrective) actions.
DETERMINING PROFITS: one of the objectives of cost accounting is the consistent

allocation of manufacturing costs to units in the ending inventory and to units sold during the
period. At the end of the fiscal year, the matching of costs with revenues determines profits
for the period.
PRODUCT PRICING: management's pricing policy should assure not only the recovery of all
costs but also the securing of a profit even under adverse conditions.
CHOOSING AMONG ALTERNATIVES: managers are constantly faced with the existence
of not just one or two alternatives but numerous alternative choices of action that might be
taken in any given situation facing a firm. The cost and management accounting system
assists the managers in arriving at a correct decision by presenting suitable analysis of the
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costs associated with the alternatives at hand. Cost accounting, for example, is a source of
information concerning different alternative course of action such as make or buy, continue or
discontinue production, developing new product or not, etc.
ESTIMATING AND BIDDING: in certain trades, knowledge of the costs of doing business is
needed to estimate job or to bid for other jobs or contracts. The order generally goes to the
lowest bidder under competitive pressure; the decisive difference in a bid may be as little as
fraction of a cent per unit. Attempting to bid without detailed cost information can mean
losing the job or it can mean winning the job but having to perform the work at a loss. Either
result is undesirable.
1.2.4 Management Accounting, Cost Accounting, And Financial Accounting
Accounting systems take economic events and transactions that have occurred and process the
data in those transactions into information that is helpful to managers and other users, such as
sales representative and production supervisors. Processing and economic transaction entails
collecting, categorizing, summarizing, and analyzing. For example, costs are collected by cost
categories (materials, labor, and overhead); summarized to determine total costs by month,
quarter , or year ; and analyzed to evaluate how costs have changed relative to revenues , say,
from one period to the next. Accounting systems provide information such as financial
statements (the income statement, balance sheets, and statement of cash flows) and
performance reports (such as the cost of operating a plant or providing services). Managers
use accounting (a) to administer each of the activity or functional areas for which they are
responsible and (b) to coordinate those activities or functions with in the framework of the
organization as a whole.
Individual managers often require the information in an accounting system to be presented or

reported differently. Consider, for example, sales order information. A sales manager may be
interested in the total dollar amount of sales to determine the commissions to be paid. A
distribution manger may be interested in the sales order quantities by geographic religion and
customer-requested delivery dates to ensure timely deliveries. . A manufacturing manager
may be interested in the quantities of various products and their desired delivery dates to
schedule production. An ideal database- sometimes called a data warehouse or info barn-
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consists of small, detailed bits of information that can be used for multiple purposes. For
example, the sales order database will contain detailed information about products, quantity
ordered, selling price, and delivering details (place and date) for each sales order. The data
warehouse stores information in a way that allows managers to access the information that
each needs.
Management accounting and financial accounting have different goals. Management

accounting measures and reports financial and non-financial information that helps mangers
make decisions to fulfill the goals of an organization. Managers use management accounting
information to choose communicates, and implement strategy. They also use management
accounting information to coordinate product design, production, and marketing decisions.
Management accounting focuses on internal reporting.
Financial accounting focuses on reporting to external parties. It measures and records business
transactions and provides financial statement that are based on generally accepted accounting
principles (GAAP). Managers are responsible for the financial statement issued to investors,
government regulators, and other parties outside the organization. Executive compensation is
often directly affected by the numbers in these financial statements. It is not difficult to see
that mangers are interested in both management accounting and financial accounting.
Cost accounting provides information for both management accounting and financial
accounting. Cost accounting measures and reports financial and non financial information
relating to the cost of acquiring or utilizing resources in an organization. Cost accounting
includes those parts of both management accounting and financial accounting in which cost
information is collected or analyzed.
The internal reporting-external reporting distinction just mentioned is only one of several
significant differences between management accounting and financial accounting. Other
distinctions include managements accounting and financial accounting emphasis on the
future that's budgeting and management accounting’s emphasis on the future-that is
budgeting-and management accounting’s emphasis on influencing the behavior of mangers
and employees. Another distinction is that management accounting is not nearly as restricted
by GAAP as is financial accounting. For example, mangers may charge interest on owners’
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capital to help judge a division’s performance even though such a charge is not allowable
under GAAP. Reports such as balance sheet, income statements, and statements of cash flows
are common to both management accounting and financial accounting. Most companies
adhere to, or only mildly depart from, GAAP for the basic internal financial statements. Why?
Because accrual accounting provides a uniform way to measure an organization's financial
performance for internal and external purposes. However, management accounting is more
wide-ranging than financial accounting's emphasis on financial statements. Management
accounting embraces more extensively such topics as the development and implementation of
strategies and policies, budgeting, special studies and forecasts, influence on employee
behavior, and non-financial as well as financial information.
Learning Activity 1.1

1. The accounting system should provide management accounting information for three
broad purposes. Describe them.
2. Distinguish between management accounting and financial accounting.
1.3 MANAGEMENT PROCESS AND ACCOUNTING
1.3.1 Objective
After completing this section you are able to provide an overview of elements of management
control and cost management and accounting system.
1.3.2 Element of management control
Planning and control

There are countless definitions of planning and control. Study the left side of exhibit 1.1,
which uses planning and control at the great sporting news (GSN- a hypothetical firm) as an
illustration.
Planning: is defined as (the top box) choosing goal, predicting results under various
alternative ways of achieving those goals, and then deciding how to attain the descried goals.
For example, one goal of GSN may be to increase operating income. Three main alternatives
are considered to achieve this goal:
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1. Income the price per newspaper
2. Increases the rates per charged to advertisers or
3. Reduce labor costs by having fewer workers at GSN's printing facility.
Management decisions Management Accounting

The daily sporting news system
PLANNING BUDGETS Financial

Increase advertising rates by Expected, advertising, pages, representation of
rate per page and revenue plans
CONTROL ACTION Accounting system Recording of actions and

Charging advertisers new * Source documents classifying them in
rates (invoices to advertisers and accounting records
PERFORMANCE their payments)
EVALUATION * Recording in subsiding and
*Advertising revenues 5.4% general ledgers
lower then budgeted
PERFORMANCE REPORT Report of actual
*Actual advertising pages, comparing budges with
average rate per page, and actual results
revenue
Exhibit 1.1 How Accounting facilitates, planning and control
Assume management opts for (2) and advertising rates by 4% to Br. 5.200 per page for 20X3.
It budgets advertising revenue to be Br. 4,160,000 (Br. 5,200X 800 pages predicted to be sold
in March, 20X3). A budget is the quantitative expression of a plan of action and an aid to the
coordination and implementation of the plan.
Control (the bottom box in exhibit 1.1) covers both action that implements the planning
decision and performance evaluation of its personnel and its operations. In the case of GSN,
action would include communicating the new advertising rate schedule to GSN's marketing
sales representatives and advertisers. Performance evaluation provides feedback on the actual
results.
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During March 12, 20X3, GSN sells advertising, sends out invoices, and receives payments.
These invoices and receipts are recorded in the accounting system. Exhibit 1.2 shows the
March 20X3 advertising (40 pages less than the budgeted 800 pages) were sold in March
20X3.
The average rate per page was Br 5,180 compared with the budgeted Br, 5,200 rates, yielding
actual advertising revenue in March 20X3 of Br 3,936,800. The actual advertising revenue in
March 20X3 is Br 223, 200 less than the actual results and budgeted amounts is an important
part of management by exception, which is the practice of concentrating on areas that deserve
attention and placing less attention on areas operating as expected . The term variance in
exhibit 1.2 refers to the difference between the actual results and the budgeted amount.
Exhibit 1.2
Advertising revenue performance report
At the daily sporting news for March 20X3
Actual results Budgeted Variance
Amounts
Advertising pages sold 760 pages 40 page u*
Average rate per page Br. 5,180 Br 5,200 Br 20
Advertising revenue Br, 3,93 6,800 Br 4,160,000 Br 223,200
U* = unfavorable
The performance report in exhibit 1.2 could spur investigation. For example, did other
newspaper experience a comparable decline in advertising? Did the marketing department
make sufficient efforts to convince advertisers that, even with the new rate of Br 5,200 per
page, advertising in the GSN was a good buy? Why was the actual average rate per page Br
5,180 instead of the budgeted rate of Br. 5,200? Did some sales representatives offer
discounted rates? Answers to there questions could prompt management as GSN to make
subsequent actions, including , For example, pushing its marketing people to make renewed
efforts to promote advertising to existing and potential advertises A well convinced plan
included enough flexibility so that managers can size opportunities unforeseen at the time the
plan is drawn up . In no case should control mean that mangers cling to a preexisting plan
when unfolding events indicate that actions not encompassed by the original plan would offer
the best results to the company.
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Planning and control are strongly intertwined that managers do not spend time drawing
artificially rigid distinctions between them. Control can be used in its broadest sense to denote
the entire management process of both planning and control. For example, management
control, system can be referring as management planning and control system.
Do not underestimate the role of people is management control systems. Both accountants and
mangers should always remember that management control systems are not confident
exclusively to technical matters such as the type of computer systems used and the frequency
with which reports are prepared. Management control is primarily a human activity that
should focus on how to help individuals do their jobs better.
1.3.3 Cost management and Accounting systems
The term cost management is widely used in businesses today. Unfortunately, there is no
uniform definition. We use cost management to describe the approaches and activities of
mangers in short-run and long -run planning and control decisions that increase value for
customers and lower costs of products and services. For example, managers make decisions
regarding the amount and kind of material being used, changes of plant processes , and
charges in product designs.
Information from accounting systems helps mangers make such decisions, but the information
and the accounting systems themselves are not cost management.
Cost management has a broad focus. For example, it includes but is not confined to - the
continues reduction of costs. The planning and control of costs is usually inextricably linked
with revenue and profit planning. For instance, to enhance revenues and profits, managers
often deliberately incur additional costs for advertising and products modifications.
Cost management is not practiced in isolation. It is an integral part of general management

strategies and their implementation. Examples include programs that enhance customer
satisfaction and quality, as well as programs that promote “blockbuster" new products
development.
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1. What are the steps involved in the managerial planning and control evaluation
process?
2. What is cost management?
1.4 SUMMARY
Accounting is the system that measures business activities, processes that information into
reports and communicates these findings to decision makers. As part of accounting,
managerial accounting and financial accounting both deal with economic events and reports
about them. But the two areas of accounting are different in many ways, primarily because
they serve different audiences. Managerial accounting serves internal mangers in
organizations. In businesses, mangers associated with sales, production, finance, and
accounting and top executives all use accounting date for planning and control, including
decision making and performance evaluation.
Cost accounting has developed as a specialty within the field of accounting at the same time
that business enterprises become more complex and its role, includes planning, budgeting,
controlling costs, determining profits, choosing among alternatives, and providing
information for bidding.
Check your progress exercises

1. A student planning a career in management wondered why it was important to learn about
accounting. How would you respond?
2. " Cost accounting is management accounting plus a part of financial accounting.” Explain.
3. What are the major differences between cost accounting and management accounting?
1.5 ANSWER KEY TO LEARNING ACTIVITY
Learning activity 1.1

1. Purpose 1: Internal routine reporting to mangers for cost planning and control of
operation and performance evaluation of people and activities.
Purpose 2: Internal routine reporting to mangers on the profitability of
Products, brand categories, customer and distribution channels, and so
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on.
Purpose 3: Internal non routine reporting to mangers for strategic and tactical
decisions on matters such as formulating overall polices and long rage plans, new
products development, investing in equipment, and special orders or special situations.
2. Management accounting focuses on internal measurement are reporting; financial
accounting focuses on reporting to external parties. Management accounting emphasis
is on the future, that is budgeting; financial accounting timeliness is historical,
management accounting is not regulated by GAAP rules; financial accounting is
regulated by rules driven by GAAP.
1. A) specify a criterion for actual performance (for example, standard or
Budgets).
b) Measure results of actual performance.
c) Evaluate performance by comparing actual results with the criterion.
2. Cost management refers to using information (for example, product costs and number
and type of customer complaints) for management decisions.
1.6 KEY TO CHECK YOUR PROGRESS EXERCISE
1. Managers who do not know how accounting systems work are like pilots who do not
know how airplanes work. Accounting information provides managerial activity. A
manager's own performance is reported on by accountants. They typically evaluate
their subordinates based on accounting reports. Further, accounting provides data for a
manager's economic decisions.
2. Cost accounting provides information for both management and financial accounting.
Cost accounting measures and reports financial and non-financial information relating
to the cost of acquiring or utilizing resources in an organization. Cost accounting
includes those parts of both management accounting and financial accounting in which
cost information is collected or analyzed.
3.
Items of difference Cost accounting Management Accounting
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Applicability It is generally applicable to Management accounting
manufacturing concerns methods and techniques are
applicable to all concerns
Accounting principles It is used in accordance It is not constrained by
with the GAAP GAAP
Double entry principles Double entry principle is
can be applied in cost not applied in the case of
accounting management accounting
Future activities Cost accounting does not Future activities are
attach importance to future primarily considered.
activities
1.7 MODEL EXAMINATION QUESTIONS
TRUE/ FALSE
1. Management and financial accounting have the same goals.
True
False
2. Cost accounting provides information for only financial accounting purposes.
True
False
3. The budget is the qualitative expression of the proposed management plan of action.
True
False
MULTIPLE CHOICE
1. Which of the following is true about cost accounting?
A. Cost accounting is the combination of financial and management accounting.
B. Main purpose of cost accounting is to maximize profits.
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C. Cost accounting can be used only in manufacturing organizations.
D. Cost accounting is helpful to evaluate alternative choice decisions.
E. A and C
F. A and D
2. Which one of the following would be considered a user of management accounting
information?
A. Stockholders
B. Controller
C. Creditors
D. Suppliers
3. Which one of the following would be considered an external user of the firm's accounting
information?
A. President
B. Controller
C. Stockholder
D. Sales manager
4. Planning involves all of the following activities except for
A. Selecting organization goals
B. Predicting results under various alternatives
C. Communicating the goals to the organization
D. Implementing the decisions
5. The planning process and the control process are linked by
A. Predictions
B. Feedback
C. Budgets
D. Marketing
6. For strategic decisions and planning decisions, the role that is most prominent is the
A. Problem-solving role
B. Attention-directing role
C. Scorekeeping role
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D. Implementation role
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UNIT TWO: BASIC COST CONCEPTS AND COST CLASSIFICATIONS
Content
2.0 Introduction
2.1 Objectives
2.2 Basic Cost Concepts
2.2.1 Objectives
2.2.2 Cost In General
2.2.3 Cost Accumulation and Assignments
2.3 Cost Classifications and Flow of Costs
2.3.1 Objectives
2.3.2 Cost Classification Approaches
2.3.3 Flow of Costs in a Manufacturing Company
2.3.4 The Flow of Costs and Schedule of Cost of Goods Manufactured
2.4 Summary
2.5 Answers to Learning Activities
2.0 INTRODUCTION
In managerial accounting, the term cost is used in many different ways. The reason is that
there are many types of costs, and these costs are classified differently according to the
immediate needs of management. For example, managers may want cost data to prepare
external financial reports, to prepare planning budgets, or to make decisions. Each different
use of cost data demands a different classification and definition of costs. For example, the
preparation of external financial reports requires the use of historical cost data, whereas
decision-making may require current cost data.
This unit is concerned with the possible uses of cost data and the various cost classification
systems that accountants have developed to facilitate management’s allocation of resources to
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the firm's various activities. Although it emphasizes the problems of manufacturing
enterprise, the concepts discussed here are also appropriate for non-manufacturing firms.
2.1 OBJECTIVES
After studying this unit you should be able to:

Define the following terms and explain how they are related: cost, expense, cost
objectives, cost accumulation, and cost assignment.
Identify and give examples of each of the three basic cost elements involved in the
manufacture of a product.
Distinguish between prime costs and conversion costs and give examples of each.
Distinguish between products costs and period costs and give examples of each.
Distinguish between directs and indirect costs.
Distinguish between controllable and uncontrollable costs.
Understand the concept of a cost driver and a cost behavior.
Describe the behavior of variable and fixed costs, both in total and on a per unit
basis.
Explain mixed, step, and non-liner costs.
Define and give examples of cost classifications used in making decisions,
differential cots, and opportunity costs and sunk costs.
Explain the cost flow in a manufacturing company.
2.2 BASIC COST CONCEPTS
2.2.1 Objectives
After completing this section you are able to provide an overview of cost, expense, cost
objective, cost accumulation, and cost assignment.
2.2.2 Costs in general

The term cost is frequently used in everyday conversation among different persons. As a
result, cost may have different meanings to different people. From accounting point of view,
cost may be defined as a sacrifice of giving up of economic resources for particular purposes,
usually in an exchange for some goods or services. The economic resource given up is
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measured in monetary units. It can be cash payment, usage of existing non-monetary assets, or
assuming liability.
Cost is distinguished from expense, which is the value of assets given up to generate revenue.
Clearly, most costs eventually become expenses. In fact some become expenses virtually at
the same time as the costs are incurred. When this is true, the terms cost and expenses are
interchangeably used. For example, if a firm buys supplies only as the supplies are needed and
if the supplies are used immediately to help generate sales, the outlay for supplies is usually
called an expense. But in facts there was both a cost and an expense involved. The distinction
between a cost and an expense can be made clearer if you change the example slightly.
Consider a firm that buys supplies in bulk and uses them overtime. Now the cost of supplies is
the value of the assets given up to acquire the inventory of supplies. The expense for supplies
will be the values of the assets (supplies) that are given up (used) during a particular period to
generate revenues.
2.2.3 Cost Accumulation and Assignment

A cost system typically accounts for costs in two broad stages:
(1) it accumulates costs by some " natural" classification such as raw materials used, fuel
consumed, or advertising placed , and then
(2) it allocates (traces) these costs to cost objects. Thus, cost accumulation involves the
collection of cost data in an organized way be some “Natural” classification, whereas cost
assignment allocation is a general term that encompasses both cost tracing and cost allocation,
cost tracing is the assigning of direct, cots, to the chosen cost object. Cost allocation is the
assigning of indirect costs to the chosen cost object
Cost tracing
Directs Costs → Cost Objects
Cost allocation
Indirect costs → Cost Objects
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Exhibit 2.1 Cost Tracing and Allocation
Cost objects are chosen not for their own sake but to help decision making. A cost object is
defined as any activity for which a separate measurement of costs is desired. Examples of cost
objectives include departments, facilities, stores, divisions, products, sales territories,
kilometers driven, patients seen, student hours taught, and product lines.

1. People often use expenses and costs interchangeably, yet the terms do not always
mean the same thing. Distinguish between the two terms.
2. What is cost objects?
3. What do you understand from the concepts of cost accumulation and cost assignment?
2.3 COST CLASSIFICATIONS AND FLOW OF COSTS
2.3.1 Objective
After you finish this section you are expected to understand the various cost classification
approaches and the flow of costs in a manufacturing company.
2.3.2 Cost classification approaches

Accountants have developed cost classifications that help to establish responsibility for
resource utilization and to plan the activity levels of departmental cost units. The following
are the different cost classification approaches:
a) General cost classifications

b) Product costs versus period costs
c) Cost classifications for assigning costs to cost objects
d) Cost classifications for predicting cost behavior
e) Cost classification for decision -making
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2.3.2.1 General cost classifications
(Manufacturing Vs Non-manufacturing costs)
Classification of costs as manufacturing and non- manufacturing costs depends on whether
the costs are considered direct costs in relation to the firm's manufacturing activities taken as
a whole.
Most manufacturing companies divide manufacturing costs, often called production cost of
factory cost, into three broad categories:
i) Direct materials ii) direct labor, and iii) Manufacturing overhead. A discussion of
each of these categories follows:
Direct materials: are those materials that become an integral part of the finished products and
that can be physically and conveniently traced to it. Examples include:
- Lumber used to manufacture furniture
- Cements and bricks to constructs building
- Cotton to produce garment
- Plastic to make toy
- Steel to manufacture automobiles
- Electronic chips to make calculator, and
- A handle of a hammer
It is impossible or economically infeasible to identify all raw material costs with individual
costs. For instance, screw used in the manufacture of a table is not considered as direct
materials even though they do become part of the products. Since each screw costs very little,
the additional record keeping required if they were classified as direct materials. In general,
small, relatively inexpensive parts are treated as indirect materials because it is not convenient
or cost effective to trace these costs to the products.
Direct labor: the terms directs labor is reserved for those labor costs that can be easily (i.e.
physically and conveniently) traced to individual units of products.. Direct labor is sometime
called touch labor, since directs labor workers typically touch the products while it is being
made. Examples include:
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- the wages of machine operators in a factory
- The wages of Assembles who make automobiles
- The wages of construction workers who build houses, and
- The labor costs of bricklayers.
Some labor such as that of janitors, forklift track operators, plant guards and storeroom clerks
is considered to be indirect because it is impossible or economically infeasible to trace such
activity to specific products.
In practice, most companies classify fringe benefits other than salaries and wages, of those
personnel who work directly on the management products as manufacturing overhead.
However, the cost of fringe benefit for directs labor personnel, such as employer-paid health
insurance premiums and the employer's pension contributions should be classified as directs
labor costs. Such costs are just as much a part of the employees’ compensation as are their
regular wages.
Manufacturing overhead: Manufacturing overhead, the third element of manufacturing costs,

include all costs associated with the manufacturing process that are not classified as direct
material or directs labor. It encompasses three types of costs: indirect material, indirect labor,
and other manufacturing costs.
Various names are used for manufacturing overhead, such as indirect manufacturing cost,
factory overhead, factory burden, overhead pool, factory expenses, manufacturing expanse,
and indirect factory expenses. All of the terms are synonymous with manufacturing overhead.
Indirect materials: materials needed for the completion of a production, but are insignificant in
cost and cannot be conveniently traced to the units produced, are termed indirect materials.
Examples of indirect materials include glue and screw used to put wooden items together,
welding materials used to weld metallic items, and factory supplies such as lubricating oil,
grease, and cleaning materials.
Indirect labor: Labor that do not work directly on the product but whose services are
necessary for the manufacturing process, are classified as indirect labor. Such personnel
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include janitors in the factory, production departments supervisors, employees engaged in
repairs and maintenance on production equipment, plant security guards and storeroom clerks.
Other manufacturing costs: All manufacturing costs other than indirect materials and indirect
labor are classified as other manufacturing costs. Examples include:
- Rental costs on factory building
- Depreciation on factory building
- Costs related to heat, light and power used by factories
- Repair and maintenance costs on factory machines and equipments, and
- Insurance and property taxes on manufacturing facilities
Other manufacturing costs also include overtime premiums and the cost of idle time. An
overtime premium is the extra compensation paid to an employee who works beyond the time
normally scheduled. Suppose an electronics technician who assembles radios earns birr 16.00
per hour. The technician works 48 hours during a week instead of the scheduled time or 40
hours. Assuming the overtime pay scale is 150 percent of the regular wage. The technician's
compensation for the week is classified as follows:
Directs labor costs (Br 16X48) Br. 768

Overhead (overtime premium: ½ ( Br 16X 18) ) 64
Total compensation paid Br. 832
Only the extra compensation of Br 8 per hour is classified as overtime premium. The regular
wage of Br 16 per hour is treated as directs labor, even for the eight overtime hours.
Idle time is time that is not spent productively by an employee due to such events as
equipment breakdowns or new set up of productions runs. The cost of an employee's idle time
is classified as overhead so that it may be spread across all production jobs, rather than being
associated with a particular job. Suppose that during one 40-hour shift, a machine
breakdown resulted in idle time of 1 hour and power failure idle workers for an additional
hour . If an employee earns birr 14 per hour, the employee’s wages for the week will be
classified as follows:
Direct labor cost (Br 14X38) Br 532

Overhead (idle time Br 14X2) 28
Total compensation paid Br 560
22
Both overtime premium and the cost of the idle time should be classified as manufacturing
overhead, rather than associated with a particular production job, because the particular job on
which idle time or overtime may occur tends to be selected at random. Suppose several
productions are scheduled during an eight hour shift, and the last job remains unfinished at the
end of the shift. The overtime to finish the last job is necessitated by all of scheduled during
the shifts not just the last one. Similarly, if a power failure occurs during one of several
production jobs, the idle time that results is not due to the job that happens to be in process at
the time. The power failure is a random event, and the resulting cost should be treated as a
cost of all of the department's production.
To summarize manufacturing costs include directs material, directs labor, and manufacturing
overhead. Direct materials and directs labor are often referred to as prime costs. They are
called so because direct materials and direct labor makes significant portion of production
costs in the past. Direct labor and overhead are often called conversion costs. This term stems
from the facts that direct labor costs and overhead costs are incurred in the conversion of raw
material into finished products.
Manufacturing
Manufacturingcosts
costs
Direct material Direct labor Factory overhead
Prime costs Conversion costs
Exhibit 2.2 manufacturing costs

In addition to manufacturing costs, an understanding of non-manufacturing costs is very
helpful. Generally, non-manufacturing costs or commercial expenses fall into two large
categories.
23
1. marketing (distribution or selling) costs
2. Administrative (General and administrative) costs
Marketing or selling costs: include all costs necessary to secure customer orders and get the
finished product or service into the hands of the customer. These costs are often called order-
getting and order-filling costs. Examples of marketing costs include advertising, shipping,
sales commissions, sales salaries, and costs of finished goods warehouse.
Administrative costs: include all executive, organizational, and clerical costs associated with
the general management of an organization rather than with manufacturing, marketing, or
selling. Examples of administrative costs include executive compensation, general
accounting, secretarial, public relations, and similar costs involved in the overall, general
administration of the organization as a whole.
The following example shows how cost components are classified into the different
manufacturing and non-manufacturing components.
Consider the following information for Arsema Dany Company, factious company, which is a
manufacture of quality clogs and managed by Mr. Binda.
Item Cost
a) Sandpaper, nails, and varnishes $ 8,400
b) Leather 140,000
c) Factory rent (Lease) 12,000
d) Labor-cutting 210,000
e) Supervisor’s salary 15,000
f) Maintenance and depreciation (factory, fixed) 2,000
g) Utilities-factory 6,000
h) Binda’s salary (general manger) 28,000
i) Labor assembling 175,000
J) Sales commissions to dealers 10,500
K) Shipping costs 7,000
L) Administrative manager’s salary 20,000
M) Office supplies 100
24
N) Administrative secretary's salary 10,000
O) Wood 70,000
P) Advertising 1,000
Required: - identify the following costs:

1. Direct materials costs
2. Direct labor costs
3. Manufacturing overhead costs
4. Marketing costs
5. Administrative Costs
6. Prime costs, and
7. Conversion costs.
Solution
1. Direct material costs:
D.M.C = B + 0
= 140,000 + 70,000
=$ 210,000
2. Direct labor costs:
D.L.C = D + I
= 210,000 + 175,000
= $385,000
3. Manufacturing overhead costs:
MOHC = a + c + e + f + g
= 8,400 + 12,000 + 15,000 + 2,000 + 6,000
= $43,400
4. Marketing costs:
M.C = J + K + P
= 10,500 + 7,000 + 1,000
= $18,500
5. Administrative costs:
A.C = h + L + m + n
25
= 28,000 + 20,000 + 100 + 10,000
=$58,100
6. Prime costs:
P.C = D.M.C + D.L.C
= 210,000+ 385,000
=$595,000
7. Conversion Costs:
C.C = D.L.C + MOHC
= 385,000 + 43,400
= $428,400

1. Identify and describe the three elements that make up manufacturing costs.
2. Compare and contrast prime costs and conversion costs.
3. Firms usually classify non manufacturing costs as either marketing costs or
administrative costs. How do these two types of costs differ?
2.3.2.2 Product costs versus period costs

In addition to the distinction between manufacturing and non-manufacturing costs, costs
can also be classified as either period costs or product costs. To understand the difference
between product costs and period costs, we must first refresh our understanding of the
matching principle.
Recall from your earlier accounting studies that the matching principle was followed in
preparing external financial reports. In financial accounting, the matching principle is based
on the accrual concept and states that costs incurred to generate particular revenue should be
recognized as expenses in the same time period that the revenue is recognized. This means
that if a cost is incurred to acquire or make something that will eventually be sold, then the
cost should be recognized as an expense only when the sale takes place.
Product costs
For financial accounting purposes, product costs include all the costs that are involved in
acquiring or making a product. In the case of manufactured goods, these costs consist of direct
26
materials, direct labor, and manufacturing overhead. Product costs are viewed as “attaching"
to units of product as the goods are purchased or manufactured, and they remain attached as
the goods go into inventory awaiting sale. So initially, product costs are assigned to an
inventory accounts on the balance sheet. When the goods are sold, the costs are released from
inventory as expense (typically called cost of goods sold) and matched against sales revenue.
Since product costs are initially assigned to inventories, they are also known as inventoriable
costs.
It is important to emphasize that product costs are not necessarily treated as expenses in the
period in which they re incurred. Rather, as explained above, they are treated as expense in
the period in which the related products are sold. This means that a product cost such as
direct materials or direct labor might be incurred during one period but not treated as an
expense until a following period when the completed product is sold.
Period costs
Period costs are all costs that are not included in product costs. These costs are expensed on
the income statement in the period in which they are incurred using the usual rules of accrual
accounting All research and development ( R & D) , selling and administrative costs are
treated as period costs.
Research and development costs include all costs of developing non-products and services.
The costs of running laboratories, building prototypes of new products, and testing new
products are classified as research and development costs. Selling costs include salaries,
commissions, and travel costs of sales personnel, and the costs of advertising and promotion.
Administrative costs refer to all costs of running the organization as a whole. The salaries of
top-management personnel and the costs of the accounting, legal, and public relations
activities etc Example of administrative costs.
2.3.2.3. Cost classifications for assigning costs to cost objects

Costs are assigned to cost objects for a variety of purposes including pricing profitability
studies, and control of spending. For purposes of assigning costs to cost objects, costs are
classified as either direct of indirect.
27
Direct Costs
A direct cost is a cost that can be easily and conveniently traced to the particular cost objects
under consideration in an economical feasible way. "Trace ability” refers to the existence of a
clear cause -and- effect relationship between the cost object and the incurrence of a cost.
“Economically feasible" means cost effective i.e. that managers do not want cost accounting
to be too expensive in relation to expected benefits. For example, it may be economically
feasible to trace the exact cost of steel and fabric (direct costs) to a specific lot of desk chairs,
but it may be economically infeasible to trace the exact cost of rivets or thread ( indirect cost)
to the chairs.
Indirect cost
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost
object under consideration. For example, a soup factory may produce dozens of varieties of
canned soups. The factory manger's salary would be an indirect cost f a particular variety
soup.
A particular cost may be direct or in direct depending on the cost object. For example, if Lucy
Company (a fictitious company based in Ethiopia) were assigning costs to its various original
sales offices, then the salary of the sales manger in its Awassa office would be direct cost of
that office. In contrast, the factory manger's salary at Awassa plant, for example, will be an
indirect cost of a particular product manufactured there.
The following can be good examples of directs costs:

- Direct materials and directs labor costs for a product.
- Salary paid for employees in the marketing (sales) department.
- Sales commissions paid for a consignee as a sales outlet. And
- Salary of a division manger for X division.
Few examples of indirect, costs are also listed below for some cost objects.
28
Cost objects Examples of indirect costs
- Product - indirect material costs, indirect labor costs, and
indirect manufacturing costs.
- Department A - Salary of the corporate general manger,

rental costs on building used by many
departments of the company.
- Customer - Costs incurred in reception department of a
hotel.
- Branch - Salary of the general manger and employee at

the head Office level serving the company as a
whole.
1. " Advertising is period cost." Do you agree? Explain.
2. The same cost can be direct or indirect cost" do you agree? Explain.
2.3.2.4 Cost classifications for predicting cost behavior

Quite frequently, it is necessary to predict how certain costs will behave in response to a
change in activity. For example, a manager at Lucy Company may want to estimate the
impact of a 5% increase in long distance calls would have on the company’s total electric bill
or the total wages the company pays its long-distance operators. Cost behavior means how a
cost will react or respond to changes in the level of business activity. As the 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 know by how much it will change.
Cost behavior and cost drivers

Cost behavior shows the direction in which the cost of an activity is affected by changes in the
level of cost driver. Some examples of activities include production, machine operation,
assembling, product inspection, purchasing and set-up.
29
Cost driver is any factor whose change causes a change in the total cost of a related cost
object. There are many possible cost drivers and the follo0wing are only some examples.
Activity Cost driver
- Production -number of units produced, number
of set ups, direct labor hours, direct
material costs.
-machine operation -machine hours operated
-assembling -labor hours assembled
-production inspection -no
-no of products inspected
-purchasing -purchase orders handled
-setup -set up hours
-maintenance - machine hours
-calling - number of calls
Costs based on cost behavior are classified as follows:

a) Variable costs.
b) Fixed costs
c) Mixed costs
d) Step costs
e) Non-linear costs
a) Variable costs
A variable cost is a cost that varies, in total, in direct proportion to changes in the level of
activity (cost driver). For instance, a 5% increase in the units production would produce a 5%
increase in variable costs. However, the variable cost per unit of cost driver remains the same
as activity changes. Some example of variable costs include direct material costs, direct labor
costs, indirect materials costs, factory utilities, power to run machine, shipping costs and sale
commission.
It is important to note that when we speak of a cost as being variable, we mean the total rises
and fall as the activity level rises and falls. This idea is presented below, assuming that a
company's products cost $24:
30
[
Units produced cost per unit Total variable

1 $24 $24
500 24 12,000
1,000 24 24,000
TVC
24,000
24 VC/U
12,000
500 1000 1500

500 1000 1500
Volume of cost driver Volume of cost driver
Exhibit 2.3 variable cost behavior

As the above graphs show, total variable cost increases proportionately with activity. When
the volume of activity (units produced) doubles from 500 to 1000 total variable cost doubles
from birr 12000 to 24000. In contrast, a variable cost on a per unit basis remains constant birr
24 as the volume of output increases. The following formula can used to show total variable
and unit variable costs respectively.
TVC=UVC x A, where
TVC-Total variable cost
UVC-unit variable cost
A-activity volume
UVC=TVC/A
b) Fixed costs
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, the fixed costs remain constant in total
31
amount unless influenced by some outside force, such as price changes. Some examples of
fixed costs include rental costs for building, machinery and equipment, depreciation of
building, machinery and equipment, property tax on building, insurance costs, salaries of
permanent workers; advertising costs, plant administration, and plant supervisor's salary.
When we say a cost is fixed we mean it is fixed within some relevant range. The relevant
range is the range of activity within which the assumptions about variable and fixed costs are
valid. For instance, assume that MAD electric plant has relevant range of between 40000 and
80000 cases of light bulbs per month and that total monthly fixed costs within relevant range
is birr 80000. Within the relevant range of 40000 to 80000 cases a month, fixed costs will
remain the same. If production falls below 40,000 cases, change in personnel and salaries
would slash fixed costs to an amount below birr 800,000. If operations rise above 80000
cases, increase in personnel and salaries would boost fixed costs above Br. 800000.
The basic idea of a relevant range also applies to variable costs. That is, outside relevant range
some variable cost such as fuel consumed may behave differently per unit of cost driver
activity. For example, the efficiency of motor is affected if they are used too much or too
little.
Fixed costs can create difficulties if it becomes necessary to express the cost on a per unit
bases. This is because if fixed costs are expressed on a per unit basis, they will reacts
inversely with changes in activity. For instance, suppose that MAD clinic rents a machine for
Br. 8000 per month that tests blood samples for the presence of leukemia cells. The Br. 8000
monthly rental cost will be sustained regardless of the number of tests that may be performed
during the month. Assume also that the capacity of the leukemia diagnostic machine at the
MAD clinic is Br. 2000 tests per month. In the clinic the average cost per test will fall as the
number of tests performed increases. This is because the Br. 8000 rental cost will be spread
over more tests. Conversely, as the number of tests performed in the clinic declines. The
average cost per test will rises as the Br. 8000 rental cost is spread over fewer tests. This
concept is illustrated in the table below and in graphic form in exhibit 2.4.
32
Monthly No. of Average
Rental costs Tests performed cost per test
Br. 8,000 10 Br. 8,000
8,000 500 16
8,000 2000 4
Cost 8000
8,000 TFC
Cost FC /unit
500 2000 500 2000

Volume of activity Volume of activity
Exhibit 2.4 fixed cost behavior
Major assumption
The definitions of variable and fixed costs have important underling assumptions:
1. The cost objects must be specified. Examples are activities, products, Services,
projects, departments, etc.
2. The time span must be specified. Examples are months, quarters, years, and product
life cycle.
3. Costs are linear that is, when plotted on ordinary graph paper; a total cost in relation to
the cost driver will appear as an unbroken straight line.
4. For the time being ,all costs are either variable or fixed .In practice, of course,
classification is difficult and nearly always necessities some simplifying assumptions
5. There is only one cost driver. The influences of other possible cost drivers in the total
cost are held constant or deemed to be insignificant. Volume, often expressed in
measures of units produced or sold.
6. The relevant range of fluctuation in the cost driver must be specified.
33
Committed fixed costs vs. discretionary fixed costs
Sometimes accountants further classify fixed costs as committed fixed costs and discretionary
fixed costs.
Committed fixed costs: they are costs that result from having property, plant, equipment, and
key managerial personnel. In the short run, managers can do little to change their amounts.
Examples include depreciation, property taxes, insurance for plant and equipment, long term
lease amounts, and salaries of key personnel.
Committed fixed costs usually are incurred in large, indivisible “chunks" that the organization
is obligate to incur or usually would not consider avoiding.
Discretionary fixed costs: discretionary fixed costs, also called managed fixed costs (1) arise
from periodic (usually yearly) budget decisions that reflect top- management polices, and (2)
have no clear relationship between inputs and outputs. Examples include advertising and
promotion, public relations, employee training programs, management salaries, short-term
renewable costs, system development, research and development, and contributions to
chartable organization.
C) Mixed costs
A mixed cost is a cost that has both a fixed and variable components. Many costs such as
repair and maintenance, electricity, telephone, and water costs are incurred in such a way that
part of the cost varies with the level of activity and part of it does not. The amount of repairs
required often depends on how much the equipment has been used. Thus, the repairs and their
cost vary with the level of production. Maintenance that is performed periodically depends
only on the passage of time, not on the level of activity. Therefore, the cost includes both a
fixed component and a variable component and as labeled a mixed cost.
Electricity costs also are often mixed costs. Part of the electricity costs depends on the amount
of time the equipment is operated. This part is variable. Part of the cost is incurred for lights
and perhaps heating or cooling. This part of the cost does not depend on the level of activity
and therefore is fixed.
Telephone costs are also typically mixed costs. The telephone cost is made up of a fixed
monthly service charges and a variable charge that depends or the number of message units
34
used charge that depends on the number of message units used during the month. The same
concept is true for water costs.
The sum up, the fixed portion of a mixed cost represents the basic, minimum cost of the just
having a service ready and available for use. The variable portion represents the cost incurred
for actual consumptions of the service. The variable element varies in proportion to the
amount of service that is consumed.
Mixed cost is represented by a straight line. The following equation for a straight line can be
used to express the relationship between mixed cost and the level of activity.
Y= a + bx, where
A= the total fixed cost
B= the variable cost per unit of activity
X= the level of activity
The behavior of mixed cost is shown graphically in exhibit 2.5
Variable component
x Fixed component
Exhibit 2.5 The behavior of mixed cost

d) Step costs
A step cost is a cost that remains fixed in total over a range of activity, then increases in steps
to another level of activity where it again remains fixed in total over a range of activity. This
process may repeat itself many times.
35
Example: Assume that the Three-Honey Company owned and operated by T, R, and D needs
a supervisor for every 20,000 units. Assume also that a supervisor's salary is also Br 1,000.
Out put No of Total monthly
Range supervisor Cost of supervisors
01- 20,000 1 Br 1,000
20,001- 40,000 2 2,000
40,001- 60,000 3 3,000
60,001 - 80,000 4 4,000
80,001 -100,000 5 5,000
The behavior of step cost is shown graphically in exhibit 2.6
6,000
5,000
4,000
3,000
2,000
1,000
20 40 60 80 100
Volume of activity ('000)
Exhibit 2.6 step cost behavior
e) Non liner costs
A non-linear cost is a cost that varies with the volume of activity but not proportionally or
consistently. Non-linear costs may increase at a decreasing rate or at an increasing rate.
Exhibit 2.7 shows a non-linear cost that increases at a decreasing rate. This type of cost is
referred to as a learning curve cost. The terms originate from the observed decrease in labor
costs that sometimes occurs, as employee becomes familiar with a new task.
36
Average
DL
Hours
Per unit
Average cost
Cumulative units
Exhibit 2.7 The behavior of non-linear cost
As the graph in exhibit 2.7 shows, the unit variable cost declines as activity increase. Put
differently, this cost exhibit decreasing marginal costs (the cost of producing the next unit) or
this type of cost behavior is characterized by smaller cost per unit of output as activity level
increases.
Controllable and uncontrollable costs

One of the primary uses of cost data is to facilitate control of the costing units of a firm. In
order to analyze effectively a costing unit's performance, it is necessary to know for which
costs the unit was responsible. Thus, accountants must develop reports that reflect cost
behavior according to responsibility. A cost is said to be controllable by the head of a costing
unit when the level of the cost incurred is under his influence. Thus, if the head of the costing
unit, through his supervision, is able to affect the amount of raw materials used to produce a
given output, raw material costs are to consider controllable by him.
However, if the supervisor has no control over the different skills of the workers assigned to
him, a large portion of his labor cost must be considered non controllable by him.
As another example, the head of the accounting department may be able to hire as many
accountants as he needs. But he must pay each accountant the wage established for persons
who possess the skills necessary for the job, and this wage is usually set by the personnel
department. Thus, the number of employees in the accounting department is controllable by
37
the department head, but the rate at which they are paid is controlled by the personnel
department.
Exhibit 2.8 lists several costs items along with typical classifications as controllable or
uncontrollable.
uncontrollable.
Cost item Manger Classification
Cost of raw materials used Productions department Controllable
to produce a products supervisors
Cost of national advertising Manager for Dessie Branch Uncontrollable
and promotion for moha
soft drink products by the
company
Exhibit 2.8: controllable and uncontrollable costs.

1. What do managerial accountants mean when they speak of cost behavior?
2. “Fixed costs are really variable. The more you produce , the smaller the unit of
production." Is that statement correct? Why or why not?
3. Classify each of the following costs as variable or fixed or mixed.
a) Depreciation of an office building based on straight line method.
b) Costs of raw materials used in producing a firm's products.
c) Leasing costs of a delivery truck, which is Br 9,500 per month and Br 38 per
mile.
d) Local property taxes on land and buildings.
4. Classify each of the following costs as controllable or uncontrollable for the south central
office of KRD Company that sells a variety of industrial products. It operates eight regional
sales offices.
a) Salaries of salespeople in the south -central region.
b) Rent on the south- central region office. The lease has five years to go.
2.3.2.5 Cost classification for decision -making
38
So far the focus has been on cost classifications that primarily serve management's need to
control and evaluate the operations of the firm. At this point we consider cost classifications
that are useful to management in making decisions that will affect future operations.
Decision problems arise whenever there are two or more alternative ways to accomplish the
same objective. They are resolved by forecasting the net benefits that would be received by
forecasting the net benefits that would be received under each alternative and selecting the
alternative that promises the highest net benefits. Expected net benefits of each alternative
may be defined, in general , as the expected value to be received less the expected costs
associated with the alternative. Cost estimates for decision making are based on forecasts of
the resources that would be consumed under the various alternatives.
Incremental costs
Incremental costs are defined as the change in costs that will occur as the result of a charge in
activity from base or reference level to another level. The nature of these costs is best
illustrated by the example shown in exhibit 2.9. The base or reference level is 400,000 units;
this might represent the current level of operation, or it might be a contemplated level of
activity for a future period.
The illustration assumes that management is considering an increase in the level of operations
from 400,000 to 500,000 units of output. The incremental costs of this increase in output are
shown in the last column.
39
MAD Inc
Statement of incremental cost of 100,000 units
Costs at 400,000 Costs at 500,000 Incremental
units units costs
Prime costs:
Direct materials Br 100,000 Br 125,00 Br 25,00
Directs labor 200,000 250,000
Overhead:
Variable 120,000 150,000 30,000
Fixed
Indirect labor 50,000 55,000 5,000
Depreciation 60,000 60,000 -
Other 25,000 25,000 -
Total costs Br 555,000 Br 665,000 Br 110,000
Exhibit 2.9 statement of incremental cost
If the output produced can be sold for Br 2.00 per unit, the incremental revenue from an
additional 100,000 units of output will be Br 200,000. The incremental, cots will be Br.
110,000 so the net benefit of increasing output is expected to be Br 90,000. Incremental costs
are similar in concept to the economist’s. The main difference is that the economists usually
speaks in terms of the marginal cost of a single incremental unit of output , whereas the
accountant is interested in the incremental cost of increasing production to whatever extent is
contemplated. The increment in the forgoing example is 100,000 units.
Sunk costs
Sunk costs are the costs of resources already acquired whose total will be unaffected by the
choice among alternatives. In exhibit 2.9, depreciation is a sunk cost since it represents an
allocation of the cost of resource services that will remain the same whether we accept or
reject the increased output. The original or present recorded cost of an asset acquired in the
past is also a sunk cost and should have no bearing on whether to use or sell that asset today..
Suppose we acquired a machine for Br 10, 000 two years ago that we now list at a depreciated
value of Br 8,000 the asset may be sold today for Br 6,000 or used for another operating cycle
, after which it will be sold for Br 5,000 . The fact that the asset is listed on our records at Br
8,000 is generally irrelevant to our decision to use or sell the assets today. It is relevant only
to our computation of the tax effects of selling the assets today. If the asset is sold today, a
40
book loss of Br 2,000 (br. 8,000 -Br 6,000) will be recognized and will produce a tax benefit
(by reducing our tax bill) in the amount of Br 2,000 multiplied by the tax rate.
Opportunity costs
The opportunity cost of an asset in a specific alternative is the net benefit that would be
received if the asset were utilized in its best alternative use. The opportunity costs of some
assets may be difficult to measure in practice since the best alternative may not be known.
Examples 1: ARMI has part - time job that pays him Br 1.00 per week while attending
college. He would like to spend a week at the beach during spring break, and his employer has
agreed to give him the time off, but without pay.. The Br 100 in cost wages would be an
opportunist cost of taking the week off to be at the beach.
Example 2: consider the following cost and revenue data fro two products, A and B.
Product A Product B
Revenue Br 65,000 Br 98,000
Cost 48,000 85,000
Net income Br 17,000 Br,
Br, 13,000
A manger’s decision is to choose which of the two product lines, A and B, to add to the
company. Which of these alternatives should the manager decide upon?
One way to compare these alternatives is to analyze the impacts of the two products on the
company's nets income: As computed above, product A is expected to increase net income by
Br 17,000 while product B is expected to increase net income by Br 13,000 Thus, adding
products A is preferred as compared to product B. This move has a net Br 4,000 Advantage
(Br 4,000 = Br 17,000 -Br 13,000).
Another way to compare the above two alternative is to use the concept of an opportunity
cost. If a product A is not added, the manger will add product B. The change in company net
income form A is the opportunity cost of adding products B. If A is added, B will now be
added and the company will forego increased net income of Br 13,000, appear as follows:
Add Product A
Revenue increase Br 65,000
41
Operating cost increase (48,000)
Opportunity cost (13,000)
(13,000)
Advantage to company from adding product Br 4,000
Opportunity cost is not usually entered in the accounting records of an organization, but it is a
cost that must be explicitly considered in every decision a manger makes. Virtually every
alternative has some opportunity cost attached to it.

1. The sales department urges developing a new product and, as part of the data
presented in support of its proposal, indicates total additional cost involved (the
increase in total cost). What cost concept is matched with the given statement?
2. The management of a corporation considering replacing a machine that operates
satisfactorily with a more efficient new model. Depreciation on the cost of the existing
machine is omitted from the data used in judging the proposal, because it has little or
no significance with respect to such a decision. What term of cost concept the above
sentences describe?
3. Distinguish between an opportunity cost and an outlay cost. Accountants do not
ordinarily record opportunity costs in the formal accounting records. Why?
2.3.3 Flow of costs in a manufacturing company

The principles and procedures existing in accounting would also exist in cost accounting. Cost
accounting consists of a system that is concerned with precise recording and measurement of
cost elements as they originate and flow through the productive process. These flows of costs
may be illustrated in the following diagram.
42
Raw materials Work-in -process finished goods
In Out In Out In Out
Factory payroll clearing Cost of goods sold Manufacturing overhead-Control

overhead-Control
In Out In In Out
Exhibit 2.10 cost flow in a manufacturing company
Generally, the accounts that describe manufacturing operations are materials, payroll, factory
overhead- control, and work -in -process, finished goods, and cost of goods sold. These
accounts are used to recognize, and measure the flow of costs in each fiscal period from the
acquisition of materials, through factory operations, to the cost of products sold and are
known as cost accounts.
As shown in exhibit 2-10, as direct materials are consumed in production, its cost is added to
work- in - process inventory. Similarly the cost of directs labor and manufacturing overhead
are accumulated in work-in- process. When products are finished, their costs are transferred
from work-in-process inventory to finished goods inventory. The costs then are stored in
finished goods until the time period when the products are sold. At the point of sale, the
products costs are transferred from finished goods to cost of goods sold, which is an expense
of the period when the sale is made.
2.3.4 The flow of costs and schedule of cost of goods manufactured

Cost of goods manufactured refers to the cost of goods brought to completion, whether they
were started before or during the current accounting period. Some of the manufacturing costs
incurred during the year are held back as cost of the ending work-in-process inventory.
43
Similarly, the costs of the beginning work-in-process inventory become part of the cost of
goods manufactured for the year. The schedule that shows this information is called schedule
of cost of goods manufactured. ARDAMI manufacturing company, a fictitious company, has
been considered for illustration purpose. The ARDAMI’s schedule of cost of goods
manufactured in exhibit 2.11 appears complex and perhaps over intimidating. However, it is
all quite logical. Notice that the schedule of costs of goods manufactured contains the three
elements of product costs that we discussed earlier-direct materials, directs labor, and
manufacturing overhead. The total of these three cost elements is not the cost of goods
manufactured, however. The reason is that some of the materials, labor and overhead costs
incurred during the period relate to goods that are not yet completed. The costs that relate to
goods that are not yet completed are shown in the work-in process inventory figures at the
bottom of the schedule.
44
ARDAMI Manufacturing Company
Schedule of cost of goods manufactured
For the year ended December 31,20xx
Direct material costs:

Beginning directs materials inventory Br 60,000
Add: purchases of directs materials (net) 400,000
Cost of directs materials available for use 460,000
Deduct: Ending direct materials inventory 50,000
Direct materials used in production Br 410,000
Directs labor cost 60,000
Manufacturing overhead:
Indirect labor Br 100,000
Insurance, factory 6,000
Machine rental 50,000
Heat, light, and power, factory 75,000
Supplies 21,000
Depreciation, factory 90,000
Property taxes, factory 8,000
Total overhead costs Br.350,
Br.350, 000
Manufacturing costs incurred during the year Br 820,000
Add: Beginning work -in-process inventory 90,000
Total manufacturing costs account for Br.910, 000
Deducts: ending work-in-process inventory 60,000
Cost of goods manufactured Br.850, 000
Exhibits 2.11 schedule of cost of goods manufactured
Note that the beginning work-in-process inventory must be added to the manufacturing costs
of the period, and the ending work-in-process inventory must be deducted to arrive at the cost
of goods manufactured.
45
In a manufacturing business cost of goods manufactured information is used to determine cost
of goods sold for the period as shown in Exhibit 2.12.
Computation of cost of goods sold
Beginning finished goods inventory Br. 125,000
Add: cost of goods manufactured 850,000
Cost of goods available for sale Br 975,000
Deducts: Ending finished goods inventory 175,000
Cost of goods sold Br 800,00
Exhibit 2.12 cost of goods sold computation

1. ARDAMI incorporated produces a single product. The following data apply to the
period just ended.
Inventories Beginning Ending

Direct materials br 100 Br 70
Work-in-process 140 150
Finished goods 200 300
The following additional information has been provided:

- The total materials available for use during the period amounted to br 250.
- Prime costs assigned to production during the period totaled Br 400.
- Overhead costs amounted to 50% of direct labor cost.
- Sales for the period were Br 1,000 and net income before taxes was br 250.
Required: Prepare a statement of cost of goods manufactured and an income
statement for ARDAMI Company.
2.4 SUMMARY
In this unit, several cost terms, concepts, and classification are defined and illustrated. How
the costs will be for preparing external reports, predicting cost behavior, assigning cost to cost
objects, or decision making will dictate how the costs will be classified.
46
For purposes of valuing inventories and determining expenses, costs are classified as either
products costs or period costs, product costs are assigned to inventories and are considered
assets until the products are sold. At the point of sale, product cost become cost of goods sold
on the income statement. Period costs, in contrast, are taken directly to the income statement
as expenses in the period in which they are incurred.
For purposes of predicting cost behavior how cost will reacts to changes in activity-mangers
commonly classify costs into five categories: variable, fixed, mixed , step, and nonlinear .
Variable costs, in total, are strictly proportional to activity. Thus, the variable cost per unit is
constant. Fixed costs, in total, remain at the same level for changes in activity that occurs
within the relevant range. Thus, the average fixed cost per unit decreases as the number of
unit increases and vice versa. Mixed cost has both a fixed and a variable component. Step cost
remains fixed in total over a range of volume, then jumps to a new level and remains fixed at
that level until the next jump. Nonlinear cost varies with the volume of activity but not
proportionately.
For purposes of assigning costs to cost objects such as products or departments, costs are
classified as directs or indirect. Direct costs can be conveniently traced to the cost objects.
Indirect costs cannot be conveniently traced to cost objects. The terms controllable and
uncontrollable are used to describe the extent to which a manger can influence a cost.
For purposes of making decisions, concepts of incremental costs, opportunity costs, and sunk
costs are of vital importance. Incremental costs are the cost items that differ between
alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected
over another. Sunk cost is a cost that occurred in the past and cannot be altered. Incremental
and opportunity costs should be carefully considered in decisions. Sunk cost is always
irrelevant in decisions and should be ignored.
Cost of goods manufactured refers to the cost of goods brought to completion, whether they
were started before or during the current accounting period. Schedule of cost of goods
manufactured shows how cost of goods manufactured during a year is determined.
47
Check your progress exercises
1. Following are several words; choose the cost term or terms above that appropriately
describe the costs identified in each of the following situations. A cost term can be used more
than once.
Fixed cost Conversion cost
Variable cost prime cost
Mixed cost opportunity cost
Period cost sunk cost
Product cost step cost
i) Deprecation on the equipment used to print the book would be classified by Artistic
printing enterprise as a __________________________ cost. However, depreciation on any
equipment used by the company is selling and administrator activities would be classified as a
___________cost. In terms of cost behavior, depreciation would be classified as a
__________________cost.
ii) Taken together, the direct labor cost and manufacturing overhead cost involved in the
manufacture of a product would be called a_____________cost.
iii) MAD company sells its product through agents who are paid a commission on each book
sold. The company would classify these commissions as a _______________ cost.
iv) The sum of direct material and direct labor makes up a _________cost.
2. “For a furniture manufacturer, glue or tacks become an integral part of the finished
product, so they would be direct material.” Do you agree? Explain.
3. Explain “economically feasible” or cost effective “as applied to cost accounting.
4. Give three examples of cost object.
__________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
_
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5. Classify each of the following costs based on function.
a) Directs labor costs
b) Quality inspection costs
c) Factory depreciation
d) Rent for plant facility
e) Advertising expenses
f) Directs materials costs
g) Sales commissions
h) Gasoline expenses for delivery trucks
i) Accounting clerks’ salaries
j) Office building property taxes
6. Classify each of the following costs as a variable or a fixed cost.
a) Transportation-in cots on materials purchased.
b) Assembly line workers’ wages.
c) Salaries of top executives in the company.
d) Overtime premium for assembly workers.
e) Production supervisory salaries.
f) Supplies used in assembly work.
g) Power to operate factory equipment.
7. What is the difference between discretionary and committed fixed costs?
8. “My variable costs are br 2 per unit. If I want to increase production from
100,000 units to 150,000 units, my costs should go up by only br 100,000.”
Comment.
9. Graph for the descriptions of cost elements given below.
a) Depreciation of equipment, where the amount of depreciation charged is computed by
the units of production method.
b) Electricity bill, a flat charge plus a variable cost after a certain number of kilowatt
hours are used.
c) Rent for a factory building donated by the country, where the agreement calls for rent
of Br, 100.000 less Br 1 for each hour laborers worked in excess of 200,000 hours, but
a minimum rental payment of Br 20,000 is required.
49
6. On January 30, 2004, a manufacturing facility of DAMI Company was severely
damaged by an earthquake followed by a fire. As a result, the company's directs
materials, work-in-process, and finished goods inventories were destroyed. The
company did have access to certain incomplete accounting records that revealed the
following:
a) beginning inventories January 1:
Directs materials Br 32,000
Work-in-process 68,000
Finished goods 30,000
b) key ratios for this plant are:
gross profit = 20% of net sales
Prime costs = 70% of manufacturing costs
Ending work -in- process averages 10% of the monthly manufacturing
Costs
Factory overhead = 40% conversion costs
c) All costs are incurred uniformly in the manufacturing process
d) Actual operating data for January:
Net sales= Br 900,000
Directs material purchase = Br 320,000
Directs labor cost incurred = Br 360,000
Required: from the above data, reconstruct a schedule of cost of goods manufactured.
2.5 ANSWER KEY TO LEARNING ACTIVITY

1. A cost is a sacrifice of resources, while an expense is a cost that is matched with revenue
earned during a particular accounting period. A cost is not necessarily an expense when the
cost is incurred (e.g., the cost of a building to be used as retail store).
2. A cost object (or cost objective) is any activity for which management desires a separate
measurement of costs examples include departments, products, and territories.
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3. Cost accumulation refers to brining together, usually in a single account, all costs of a
specified activity. Cost allocation includes assigning costs to individual products or time
periods.
1. Manufacturing costs are composed of directs materials, directs labor, and manufacturing
overhead. Directs materials are materials that can be directly traced to a unit of output.
Direct labor is worker labor that can be traced directly to a unit of output. Manufacturing
overhead is all manufacturing costs that can not be traced to a particular unit of a product
or at least are so difficult to trace that accountants do not consider it worth while to trace
them). These costs include indirect materials, indirect labor, utilities, property taxes,
depreciation, and other, similar manufacturing costs.
2. Prime costs are the sum of direct material and direct labor costs. Conversion costs are the
costs of converting raw materials to final products, and composed of manufacturing
overhead and direct labor.
3. Marketing costs are those required to obtain customer orders and to provide customers with
the final product. Administrative costs are those required to manage the organization and to
provide staff support.

Yes, because advertising costs are non manufacturing costs, particularly a selling expense.
1. The same cost can be direct or indirect cost. For example, if MAD Company were
assigning costs to its various regional sales offices, then the salary of the sales manger at
one of its branch office would be a direct cost of that office. In contrast, the sales
manger's salary of the same, plant, for example would be an indirect cost of a particular
product manufactured there.

1. Cost behavior is the concept used to describe the way costs vary with activity, for
example, production volume.
2. No, this statement confuses total cots with unit costs. Fixed costs remain constant.
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3. a) Fixed cost
b) Variable cost
c) Mixed cost
d) Fixed cost
4. a) Controllable
b) Uncontrollable
1. Incremental cost
2. Sunk cost
3. An opportunity cost is defined as the benefit that is sacrificed or forgone when an
alternative course of action is selected over another. This definition indicates that
opportunity cost is not the usual outlay cost recorded in accounting. An outlay cost,
which requires a cash disbursement sooner or later, is the typical cost recorded by
accountants.
ARDAMI Incorporation
Schedule of cost of goods manufactured
Directs material costs:
Beginning directs materials inventory Br 100
Add: purchases of directs materials 150
Cost of directs materials available for use Br. 250
Deduct: ending directs materials inventory 20
Directs materials used in production Br 180
Directs labor costs 220
Manufacturing overhead costs 110
Manufacturing costs incurred during the year Br. 510
Add: beginning work-in-process inventory 140
Total manufacturing costs to account for 650
Deducts: ending work-in-process inventory 150
52
Cost of goods manufactured Br 500
ARDAMI Incorporation
Income statement
xxxxxxxx
Sales: Br 1,000
Less: cost of goods sold:
Beginning finishes goods inventory Br 200
Add: cost of goods manufactured 500
Total cost of goods available for sale Br 700
Deducts: Ending finished goods inventory 300 400
Gross profit Br 600
Less: operating expenses:
Selling expenses xxx
Administrative expenses xx 350
Net income before tax Br 250
2.6 ANSWERS KEY TO CHECK YOUR PROGRESS EXERCISE
1. i) product, period, fixed

ii) Conversion
iii) Period, variable
iv) Prime
2. No, because it is impossible or economically infeasible to identify, give or take with
individual cost objects.
3. The results we get should be greater than the cost we have incurred
4. Product, project, department.
5. A) manufacturing costs
b) Manufacturing costs
c) Manufacturing costs
d) Manufacturing costs
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e) Selling costs
f) Manufacturing costs
g) Selling costs
h) Selling cost
i) Administrative costs
j) Administrative costs
6. a) Variable cost
b) variable cost
c) fixed cost
d) variable cost
e) fixed cost
f) variable cost
g) variable cost
7. Committed fixed costs are costs of resources that are made available before the demand for
them is determined. Discretionary costs are costs that are not related directly to the
production volume, but incurred at the discretion of the mangers
8. The Br 100,000 only accounts for the increase in variable cots. A 50 percent increase in
production could require some capacity changes that would increase some fixed costs too.
54
a)
b)
55
10.
DAMI Company
Statement of cost of goods manufactured
For the month ended January 30, 2004
Direct materials costs:
Beginning directs materials inventory Br 32,000

Plus: direct materials purchases 320.00
Materials available for use Br 352,000
Less: ending directs materials inventory 152,000
Directs material costs used in production Br 200,000
Directs labor costs incurred 360,000
Manufacture overhead costs 240,000
Manufacturing costs incurred during the month Br. 800,000 Plus: beginning
work in process inventory 68,000
Total WIP during the month Br 868,000
Less: ending WIP inventory 80,000
Cost of goods manufactured Br 788,000
2.7 MODEL EXAMINATION QUESTIONS
Write the word “True” if the statement is correct and the word “ False” if the statement is
incorrect.
___________1. Cost of finished goods does not include factory overhead costs-since factory
overhead costs can’t be identified cost effectively with a particular product or job.
________________2. After manufacturing overhead costs have been accumulated,
departments must allocate these costs to jobs or products.
________________3. Under a job order cost system, the costs are accumulated for each
department with in the factory.
________________4. Costs that are incurred in marketing the product and delivering the sold
product to customers are not part of manufacturing costs.
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________________5. As a practical matter, in order for costs to be classified as direct
material cost, the cost must only be an integral part of the finished product.
________________6. Manufacturing cost is the sum of conversion cost and prime cost of a
given period.
________________7. The time card shows the total hours worked by the employee each day
and also the particular job worked on.
________________8. A debit balance in the Manufacturing Overhead account at the end of a
period would mean that overhead was under applied for the period.
_________________9. All the raw materials purchased during a period are included in the
cost of goods manufactured figure.
_________________10. Actual manufacturing overhead costs are charged directly to the
Work in Process account as the costs are incurred.
MULTIPLE CHOICE
1. The term used to describe the assignment of direct costs to the particular cost object is
A. Cost allocation

B. Cost tracing

C. Cost accumulation

D. Cost assignment

2. As activity changes, a cost that is variable will
A. Vary per unit

B. Remain the same per unit

C. Vary inversely per unit

D. Remain the same in total amount

3. A cost that is constant in total amount is always considered a (n)

A. Direct

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B. Indirect

C. Variable

D. Fixed

4. An average cost is also known as a(n)
A. Fixed cost

B. Variable cost

C. Unit cost

D. Total cost

5. A merchandising-sector company engages in all of the following except for
A. Retailing

B. Manufacturing

C. Distributing

D. Wholesaling

6. Ford Automotive Company is an example of a(n)
A. Merchandiser

B. Service company

C. Manufacturer

D. Wholesaler

7. The cost of materials that have been started into production, but are not completely
processed, would be found in which inventory account on the balance sheet?
A. Direct materials inventory

B. Work-in-process inventory

C. Supplies inventory

D. Finished goods inventory

8. Finished goods inventory costs represent the cost of goods that are
A. Waiting to be worked on

B. Currently being worked on

C. Waiting to be sold

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D. Already delivered to customers

9. An example of an inventoriable cost would be
A. Direct materials

B. Sales commissions

C. Advertising flyers

D. Shipping fees

10. Prime costs would include
A. Direct material costs and direct labour costs

B. Direct material costs and indirect manufacturing costs

C. Direct labour costs and indirect manufacturing costs

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11. The following information pertains to Jasmine Company for the current year. Estimated
overhead cost, Br.400, 000; estimated direct labor hours, 100, 000 hours: actual overhead
cost incurred, Br.350, 000; actual direct labor hours worked, 90, 000 hours, if overhead is
applied on the basis of direct labor hours, the over or under applied for the year would be
A. Br.45, 000 under applied D. Br.5, 000 over applied
B. Br.10, 000 over applied E. None of the above
C. 0
12. Which of the following statements is correct in describing conversion costs:
A. Manufacturing costs incurred to produce units of output.
B. All costs associated with manufacturing other than direct labor costs and raw
material costs.
C. Costs associated with marketing, shipping, warehousing, and billing activities.
D. The sum of direct labor and all factory overhead costs.
E. The sum of raw material costs and direct labor costs.
13. Each of the following would be a product cost except:
A. Light and heat for the factory.
B. Sales manager’s travel costs.
C. Night watchmen’s salaries for the factory building
D. Factory superintendent’s salary
E. None of the above.
1. RICO PLC is a medium sized manufacturing business that started operation as
of December 1, 2003(no inventories were available). The following condensed
information is taken from the accounting records of the business maintained
for the month of December 2003:
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Raw materials purchased …………………………………… Br.135, 000
Direct labor costs……………………………………………. 50, 000
Inventories, December 31, 2003:
Raw materials inventory…………………………….. 18, 000
Work in process…………………………………….. 70, 000
Finished goods inventory…………………………… 45, 000
Factory overhead incurred consists of:
Indirect materials…………………………………… 16, 000
Indirect labor……………………………………….. 4, 500
Other overhead costs……………………………….. 20, 800
Assume no under or over applied manufacturing overhead.
a. Based on the above information, the conversion costs would be:
a. Br.158, 300 d. Br.176, 300
b. Br.91, 300 e. None of the above.
c. Br.86, 300
b. The cost of goods manufactured amounted to:
a. Br.158, 300 d. Br.176, 300
b. Br.91, 300 e. None of the above.
c. Br.86, 300
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2. The following data are given for SAJA manufacturing company for the year ended
December 31, 2004, the end of its fiscal period.
Administrative expense $ 65,700
Direct labor 230,400
Direct materials inventory, January1, 2004 62,000
Direct materials purchased 274,200
Factory overhead 92,000
Finished goods inventory 91,800
Interest expense 10,200
Sales 860,000
Work in process inventory, January1, 2004 67,000
Inventories at December 31 were as follows:
Finished goods $97,200
Work in process 71,500
Direct materials 64,500
Instruction: Prepare a statement of cost of goods manufactured. (Please show all the necessary
steps)
62
UNIT THREE: ACCOUNTING FOR RAW MATERIALS
Content
3.0 Introduction
3.1 Objectives
3.2 Raw Material Overview
3.3 Concepts and Objectives of Material Control
3.3.1 Accounting and Control for Purchase and Receipt of Materials
3.3.2 Accounting for Material Returned
3.3.3 Sorting and Issuing Material
3.4 Controlling and Valuing Inventory
3.4.1 Inventory Control
3.5 Summary
3.0 INTRODUCTION
This unit discusses where the cost of raw materials originates, how raw material costs are
accounted, how the raw materials are physically controlled. The detailed procedures and
records required to account for materials purchased and used will be introduced at the
beginning of the unit. The procedures required to control and value inventory of raw materials
are discussed by the end of the unit.
3.1 OBJECTIVES
After completing the unit you should be able to:
- Define materials control

- Describe documents and records used to control materials
- Describe the Accounting journal entries required to record major material transactions
- Know material inventory costing methods
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3.2
3.2 RAW MATERIALS: OVERVIEW
The term “materials" generally used in manufacturing concern refers to raw materials used for
production, sub-assemblies and fabricated parts.
These materials will be, directly or indirectly, entered in to the production of the final product.
Thus, proper accounting and control over materials are required for effective & efficient
materials management.
3.3 CONCEPTS AND OBJECTIVES OF MATERIALS CONTROL
Materials cost constitute the major part of the total cost of production in manufacturing firms.
Therefore, proper accounting for and control over materials purchase, consumption, and
inventories are important for effective management of a business. Basically, materials control
aims at efficient purchasing, &Receiving of materials, their Storing and efficient Use, or
Consumption.
In general, the following are the objectives in a good system of materials control.
1. Materials of the desired quality will be available when needed for efficient and
uninterrupted production.
2. Materials will be purchased only when need exists and in economic quantities.
3. The investment in materials will be maintained at the lowest level consistent with
operating requirements.
4. Purchase of materials will be made at the most favorable price under the best possible
terms.
5. Materials are protected against loss by fire & theft.
6. Materials should be handled in such a way that the handling time and cost can be
minimized.
7. Vouchers will be approved for payment only if the materials have been received and
are available fro use.
8. Issues of materials are properly authorized and properly accounted for.
9. At all times, materials are charged as the responsibility of some individual.
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In short, control over materials enables us to achieve the five R's.
1. Right quantity materials

2. Right Quality materials
3. At the right time
4. At the right place
5. From right suppliers
3.3.1 Accounting& Control for Purchase and Receipt Of Materials

Different firms may have different purchasing procedures, but all of them follow a general
pattern in the purchase and receipt of materials and payment of obligations. The most
important steps in materials purchasing and receiving procedures are summarized below:
2. Purchase Requisition
The purchase requisition is properly approved, or authorized, written request for materials.
Usually, purchase requisitions are prepared by the storekeepers for regular store items, which
are below, or approaching the minimum level of stock. The purchase of specialized materials
may be requested by production of user departments. These purchase requisitions are used as
a formal request to purchasing department to order goods. A typical purchase requisition
contains details, such as number, date, department, quantity description, and signatures of the
concerned individuals.
65
Purchase Requisition
Purchase Requisition No. _________________
Purchase order No. ______________________
Date__________________________________
Department ___________________
Delivery Required_______________
Item No Quantity Description Grade or Remarks

Quality
Requested by Checked by Approved by

_______________ ______________ _______________
Purchasing requisition serves three general purposes:
i) It automatically starts the purchasing process and informs the purchasing

department of the need for the purchase of materials.
ii) It fixes the responsibility of the department making the purchase
requisition
iii) It can be used for future reference.
k) Purchase order
After receiving requisition, the purchasing department places an order with a supplier. For
routine purchases, the order is placed with established suppliers. In other cases, the
purchasing department may ask fro bids or send out request for price quotation before placing
the order.
Purchase order should clearly state the materials required and the price: and provide
information such as delivery period and the department for whom in the materials is
purchased. Purchase order may be prepared in several copies depending on the need of the
66
firm. The original copy however is sent to the supplier: Second copy to accounting
department: third copy to store: fourth copy to receiving department and so on.
Purchase order
Date _________________ Purchase order No_____________
Supplier ______________ Requisition No.________________
______________________ Department No.________________
______________________ Date Required _________________
Please supply the following items on the terms and conditions mentioned herewith:
Terms and conditions: __________________
_____________________ purchase manger
______________________
______________________
3. Receiving Materials
The receiving department performs the function of unloading and unpacking materials which
are received by an organization. Materials are inspected and inspection report is prepared,
indicating the items accepted and rejected, with reason. Receiving report is prepared by the
receiving department. Inspection report may be incorporated in the receiving report, or may be
issued separately.
Receiving report may be prepared in several copies, one going to each department interested in
the arrival of materials, including stories, purchasing department, and accounting department.
Materials Receiving Report

Purchase order No. _________ Date _____________
Received from: ________
( Supplier's name)
Address _________________
_________________
Item No Quantity Description Weight, if any Remarks
Received
Counted ( measured) by ______________________ Approved by ____________

Inspected by _______________________________
4. Preparing and Recoding the Voucher:
67
The invoice received from the supplier is sent to the purchasing unit. The purchasing unit holds
the invoice and the purchase order in the open purchase order file until the receiving report is
received from store (receiving department). After the receiving report is received, the
purchasing unit compares the supplier's invoice with the purchase order and receiving report to
make sure that:
- Goods ordered have been received in good condition and those listed on the invoice.
- Terms, unit prices, shipping charges, and other details agree with order specifications.
- Computations are correct.
After comparisons, an employee of the purchasing unit staples together one copy of the invoice,
receiving report, and purchase order, and places them in a completed purchases file
alphabetically by supplier. Next a disbursement voucher is completed and a second set of
supporting documents is attached to it. Then the voucher is formally approved and sent to the
accounting unit for recording. A sample of disbursement voucher is shown below:
Disbursement Voucher
Voucher No____________
Payee ________________________ Issued date_____________
______________________________ Discount date___________
______________________________ Due date_______________
Invoice date Terms Invoice No Amount

September 2/10.n/30 124586 $12000.00
5/02 Less Damaged items returned 1000.00
11,000.00
Price O.K_________________________
Materials Received ________________
Extensions Ok_____________________
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Gross amount _____________________
Discount _________________________
Net paid__________________________
Approved for pay___________________
Paid by Check No.____________
Date______________
When the voucher, invoice, and attached papers reach the accounting unit, the voucher clerk
compared quantities, verifies intentions and footings, computes discounts, and checks all
other computations. The clerk also checks that all supporting documents are included in the
file and that they are properly approved and signed. Then the purchase of materials is
recorded as follows:
Raw materials-----------------------------------------------xxx
Vouchers payable ----------------------------------- xxx
The above entry is recorded in a voucher register, and the voucher is sent to the treasure's
office, the voucher is filed in the unpaid vouchers file according to the last date on which the
discount may be taken.
5. Paying the voucher
Before the due, the voucher is removed from the unpaid vouchers file. A check is prepared for
the net amount. The check is then recorded in the check register. The employee marks the
voucher “paid " by using a rubber stamp and enters the check is mailed to the supplier, and the
voucher is returned to the voucher clerk. The voucher clerk enters the check number and date of
payment in the voucher register. The voucher, with the invoice and supporting documents, is
then placed in the paid vouchers file.
3.3.2 Accounting for materials returned

Occasionally, damaged or defective materials received. These items are usually returned to
the supplier immediately. A note of the return is made on the receiving clerk' copy of the
purchase order and on the receiving repot. The purchasing agent then prepares a debit
memorandum. A debit memorandum is a notice to the vendor (means suppler) of a reduction
from the invoice for the cost of the returned materials. Then the following entry is recorded.
69
Vouchers payable --------------------------------------------xxx
Purchase returns and allowances ------------------ xxx
Example
A furniture manufacturer has issued a debit memorandum to a supplier for materials returned
costing $3000. The entry to record this transaction in the book of the buyer is
Vouchers payable --------------------------------------------3000

Purchase returns and allowances ------------------ 3000
A credit memorandum is a notice to the supplier of an addition to the invoice a supplier ships
more materials than were ordered. In this case, if the buyer needs the excess materials, they will
be kept by issuing credit memorandum for additional cost. The accounting entry is shown
below:
Raw materials ----------------------------xxx

Vouchers payable ----------------------------------xxx
Illustration
The following are transactions of Enat manufacturing company for the month of June 2005.
Record in general journal form those transactions that require entries.
June 2 Purchase requisition 201 for 2000 units of materials k-70 is prepared by the
storeroom clerk. The material is to be ordered from Family International at a cost
of $8.00 per unit. Terms 2/10, n/60.
June 4. Purchase order 79 is completed for the materials specified on purchase requisition
201
16 Materials ordered on purchase order 79 are received. Of the 2000 units received,
100 units are rejected because they have imperfections and are immediately
returned. Receiving report 95 is prepared. The purchase invoice is included in the
carton, dated may 16.
17 A debit memorandum to Family International for materials returned is prepared
17 Materials received yesterday from Family International (except those returned) are
transferred to the storeroom and entered in the materials ledger.
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26 Disbursement voucher 98 to Family International is prepared for the amount owed
on the firm's invoice.
25 A check to Family international for the amount due, after discount, is prepared
and mailed.
Solution
June 2 No entry is made when materials requisition is issued (prepared) . It initiates the
purchasing procedures.
4 No entry is made when purchase order is place with supplier.
16 No entry is made when receiving report is prepared
16 Raw materials (2000 x 8) --------------------- 16,000
Vouchers payable (Family international) --------------------16,000
17 Vouchers payable (Family International) ------------------800
Purchase Returns & Allowances --------------------------------800
17 No journal entry is made when materials are received by the storekeeper. Rather
materials ledger card and other necessary documents are up dated.
25 Vouchers payable (Family International) ---------------------15,200
Purchase Discounts -----------------------------------------------104
Cash ------------------------------------------------------------- 15096
3.3.3 Storing and Issuing Materials
3.3.3.1 Storage of Materials

Two types of control are made in store, one is physical control of materials and the second is
accounting control.
control.
a) Physical control of materials involves restricting admission to the storeroom area only for
authorized personnel. If the store room is open to every body, materials may be stolen.
b) Accounting control of materials involves maintaining the necessary records for the materials;
one important record is materials ledger. Materials ledger is used to protect materials in the
storeroom and to identify materials. Materials ledger is established for each type of materials
indicating material number, type of material and its location. Materials are stored in a
systematic manner on a bin, on racks, or on shelves. A bin tag may be attached to each bin. The
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bin tag is an informal but carefully maintained record to show the quantities of the materials
received, issued and on hand at all times. The materials ledger and bin tag are shown below.
Materials Ledger
Material ________________ Recorder point__________
Number _______________
Recorder Quantity_________
Received Issued Balance

Units Price Units Price Unit Price
Date Reference
Bin tag
Materials No_______________ Location _________
Recorder Point______________
Description ________________
Quantity Received Quantity Issued Balance

Date
3.3.3.2 Issuance of Materials
Materials requisition is prepared by production (using) departments in order receive materials

from the store. No material is issued without a materials requisition. Materials requisition is
prepared by department head or job supervisor.
Materials requisition shows the quantity materials number, description, and job number to
which the materials are charged (for direct materials) or department (for indirect materials)
Materials requisition may look like the following:
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Materials Requisition
Deliver to ___________________ Requisition No.__________
Acct._______________________ Date _______________
Charge -Job ________________
Dept.________________
Quantity Materials Neo Description Unit price Amount
Approved _______________ Delivered by_____________Received by ____________
Up on receipt of materials requisition, the storeroom supervisor issues the materials and makes
the necessary notations or the requisition. The storeroom clerk enters the unit price and
computers and enters the total amount. Then the storeroom clerk records the entry in the issued
section of the materials ledger, computes the new quantity on hand, and records it in the balance
section.
Note that the materials ledger is a subsidiary ledger that will be verified against the raw
materials control account. At the end of the accounting period, the sum of the dollar amount
balances on the materials ledger cards should equal the balance of the control account.
After the requisition has been recorded on the related materials ledger, card the requisition is
fore warded to the cost clerk. The cost clerk journalizes the transaction (issuance of materials)
requisition journal.
The Journal entry is as follows:

Work in process -------------------------------------xxx
MOH control ---------------------------------------xxx
Raw materials ----------------------------------------------xxx
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The above entry is recorded in the materials requisition journal. The format of this journal is
shown below:
Materials Requisition Journal
For months of _____________________ 19____ Page __________
Requisition Post Job Work in MOH MOH Raw

Date No. Ref. or Process Control Control Materials
Dept Dr Dr Dr Cr
Note that materials Requisition Journal is a special journal used in a job-cost system.
The next step is that the cost accountant will post the information from the requisition to the
materials section of the proper job cost sheet. Similarly, the direct materials cost is posted to
departmental overhead analysis sheet in the indirect materials section. Department overhead
analysis sheet is shown below:
Departmental Overhead Analysis Sheet

Department __________________ Month of ____________ 19_____
Date Ref. Total Indirect Indirect Payroll Depreciation Utilities Insurance

Materials Labor Taxes
The important principles of internal for storing and issuing materials are:
1. Admittance to the storage area is restricted.
2. Materials ledger cards are maintained to record all receipts and issues.
3. Each type of materials is clearly identified, stored in a particular place, and carefully
protected while in storage.
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4. Materials are issued only upon proper written authorization
5. The accounting system permits a periodic check of the materials ledger against the balance
of the Raw materials control account.
6. Separation of duties in storage and issuance operations.
Special Issuing procedures
1. Bill of Materials
The bill of materials lists all materials required on the job and the date they will be needed.
The bill of materials serves as a requisition. The format of bill of materials is shown below:
Bill of Materials
Job________________________ Date ___________________
To be Started ________________ For____________________
Will require the following Materials:
Units Materials Description

Requisition Materials Issued
Unit Cost Total Cost
3.3.3.3 Return of Materials to storeroom

Sometimes materials that have been issued are returned to the storeroom. This may be due to
requisitioning too many materials, withdrawing the wrong materials, or some other reasons. A
returned materials report has to be prepared. It is very similar to the materials requisition. The
bin tag is adjusted. Then the cost clerk will make the following entry and post to job cost sheet
and/or department overhead analysis sheet.
Raw materials --------------------------------------xxx

Work in process -----------------------------------------xxx
MOH-----------------------------------------------------xxx
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Returned materials report is the basis to post the above transaction to job cost sheet and
departmental overhead analysis sheet. Note that individual amount is not posted to general
ledger (controlling) account) from materials requisition journal. Rather the totals of each
column in the materials requisitions journal (work in process, MOH control and Raw materials)
are posted to the appropriate controlling account.
1. What is a materials requisition?

2. Difference between purchase requisition and materials requisition
3. What is a returned materials report?
3.4 CONTROLLING AND VALUING INVENTORY
3.4.1 Inventory Control

Inventory management refers to the planning, organizing, and controlling activities to ensure
that inventories are kept at levels which provide maximum services at minimum cost. The
main objective of inventory control is to ensure that stock outs do not occur and that surplus
stocks are not accumulated and carried. Inventory management includes management of
finished goods, work-in-process, and raw materials.
In controlling inventories or stock levels are established for standardized materials which are
regularly used by the firm so that inventory holding can be controlled.
Control of raw materials requires the purchasing department to determine the reorder point
and reorder quantity. Reorder quantity refers the quantity to be covered in a single purchase
order. Reorder point (or the level) is the level at which store-keeper initiates purchase
requisitions for new supplies of materials. Lead time is another factor that should be
considered in determining reorder quantity. Lead time refers to the amount of time it takes for
the materials to be delivered from the supplier. Usage is also used to determine the reorder
quantity. Usage represents the consumption patterns.
Determining the Recorder point
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In order to determine the reorder point, we need to have the lead time, usage and safety stock
(if any). Safety stock is the minimum level of material that should be on hand to ensure that
the company does not run out of materials.
Example
Assume that XYZ manufacturing wants to have at least 180 units on hand at all times. The
factory uses 10 units every day. It takes fifteen days to receive an order. The reorder point is
Lead time usage (10x 15 days) ------------------------- 150 units

Add, Safety Stock------------------------------------------180
Stock------------------------------------------180
Reorder point ----------------------------------------------330 units
The reorder point represents the inventory level at which a new purchase order must be
issued. According to the above example, a new purchase order is placed when the quantities
of raw materials on hand reached 330 units. If the new purchase order is processed as
expected within 15 days, the inventory reaches the safety stock of 180 units when the new
units arrive at the premise of the factory.
Another problem is determining how much to order at a time (Economic order Quantity). To
determine this quantity, it is necessary to consider the costs of placing an order and the costs
of carrying items in the store. If the frequency of ordering materials is increasing, the cost of
order will be higher and vise versa. Holding many items involve higher holding costs.
Some examples of order costs are:
1. Costs of maintaining the purchasing department

2. Costs of operating the receiving department
3. Clerical costs of processing an order.
The costs of holding items in the inventory includes:
1. Costs of handling and storing materials

2. Costs of operating the receiving department
3. Clerical costs of processing an order
4. Clerical costs of maintaining inventory records
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In order to determine the quantity that should be ordered at a time, the following formula is
used.
EOQ = 2DC
H
Where
EOQ = Economic order quantity
D = Annual requirements (demand)
C = Ordering cost per unit
H = Holding cost per unit
Example
ABC printing has determined that the cost to place an order for papers is Br. 10 and the cost
to carry this item in inventory is Br. 0.8 per dozen. 10,000 dozen of papers are required for
production each year, what is the economic order quantity?
Solution
EOQ = 2DC =2X10,000X10

=2X10,000X10 = 500dozen of papers
H 0.8
3.4.2 Valuing inventory

In the earlier part of this chapter, it was assumed that the prices of materials were constant.
However, prices vary from one purchase to the next, and it is often impossible to tell the
specific purchase from which an issue is made. This topic is intended to introduce how
accountants price issuance of materials. And the topic will introduce how to value the units on
hand.
The primary basis of inventory valuation is cost. In the situation where the purchase prices of
materials vary, accountants must make an assumption about the flow of costs. The flow of
costs may not match the physical flow of goods; these cost flow assumptions are called
inventory costing methods. There are four basic inventory flow assumptions. These are:
1. Specific identification method
2. First-in-first -out ( FIFO)
3. Last -in ,first out (LIFO)
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4. Moving Average Method
Specific identification Method
Some materials do not lose their identity when placed in the bin. These materials have unique
specification. Examples of these materials are electric motors for large pumps and
compressors where each motor is different from others. In this case, it is easy to identify the
purchase price of materials issued to production, and items remaining in store.
First-in, First-Out (FIFO) method
This method assumes that stocks (inventories) are issued in a strictly chronological order.
Materials issues are coasted at the unit cost of the oldest supply on hand. The ending
inventory is composed of the most recent costs of material or production of goods.
Last -in First-Out (LIFO) method
Under LIFO, the cost of the latest items purchased is assumed to be the first to be assigned to
units issued. The materials in the ending inventory are coasted at prices in existence at a much
earlier date since they represent the cost of the oldest stock on hand.
Moving Average method
This method allows the issuance to be coasted out currently at the average unit cos.
Cost of materials available for use
Average Unit Cost = Quantities of materials available for use
A new average unit cost is calculated after each purchase. Until another new purchase is
made, the current average cost is used to value the materials issued.
Valuation of inventory at Lower of Cost or market
The previous four methods have been on cost. When the market value ( replacement cost) has
declined, the most appropriate method is lower of cost or market, under lower of cost or
market, the inventory is valued at either a cost, or replacement cost, whichever is lower.
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1. Under what method of inventory costing are the materials on hand always considered to
be from the last ones purchased?
2. Under what method of inventory costing are the materials on hand always considered to be
from the first ones purchased?
l) What are the three ways that the lower of cost of market method can be applied to
inventory items?
3.5 SUMMARY
Raw materials must be controlled to safeguard the company's big investment and to ensure
enough supplies are on hand to meet the production schedules.
To achieve better accounting and control for raw materials major materials transaction should
be accounted and carefully. Controlled these major transaction include purchasing, receiving,
storing, issuing, using consuming and returning materials.
Check Your Progress Questions

Exercises
1. Information about materials cost of job No. 300 is summarized below:
Requisitions Returned Materials reports
Number Amount Number Amount
11 $300.00 10 $100.00
12 350.00 20 501.00
18 450.00
19 250.00
Required Calculate the materials cost of job No 300.
2. During the month of March 2005 the production department of Ethio pharmaceuticals
had requisition totaling $60,000 for direct materials and $18000 for indirect materials.
Prepare the necessary entry in general journal form, to record the cost of materials
requisitioned for the month.
3. Assume that the production department had returned $5,500 of indirect materials.
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Prepare the necessary journal entry to record the cost of the materials returned to the
storeroom.
4. Addis furniture factory uses 45000 units of materials XXX every day in production. It
takes 10 days for an order to be delivered. The factory always wants to have a four-day supply
on hand (or safety stock), what is the point at which it should reorder material XXX
. 5. A manufacturer has determined that the cost to place an order for its material is Br 15 and
the cost to carry this item in inventory is Br 2 per unit. The company requires 24,000 units for
production each year. Calculate the economic order quantity (EOQ)
6. The data given below relate to material XY for the month of October, 2003
Oct 1. Beginning Balance ------------------- 1000 units @ $ 10.00 each
2. Purchase order 220 -----------------5000 units @ 12.00 each
3. Requisition 310----------------------3000 units
15. Purchase order 226 -----------------2000 units @ 15.00
18. Requisition 316--------------------------4000 units
24. Purchase order 243----------------------6000 units 15.00
28. Requisition 334 ------------------------- 5000 units
30. Requisition 337 -------------------------- 500 units
The company uses perpetual inventory system for its materials.

Required: Determine the cost of materials issued to production and cost of inventory on
September 30 under.
1. FIFO method
2. LIFO method
3. Moving average method
7. Assume that Marble Manufacturing Company has four types of materials that can be
grouped into two categories. These materials with their costs and market values are
summarized below
Units Cost Market

Category 1
Material A 460 $1.40 $1.30
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Material B 880 0.85 0.90
Category 2
Material C 1290 1.20 1.45
Material D 580 0.65 0.55
Required: Determine the value of the inventory if the lower of cost or market method is
applied to:
a) individual inventory item
b) Category of items
c) Inventory as a whole
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3.6 ANSWER KEY FOR LEARNING ACTIVITY
1. Materials requisition is a form prepared by the production supervisor requesting materials

for production.
2. Purchase requisition is a form prepared by stores man indicating that raw materials should
be purchased. It is, then, sent to purchasing department.
3. Materials returned report is a form usually prepared by the production supervisor
indicating the return of materials from the production department to stores due to
such factors as excess materials, damage,..

1. First-in, first- out (FIFO)
2. Last -in, first-out (LIFO)
3. a. item by item or individual item base
b. Major category
C. the whole or total inventory
3.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress Questions

1. Total cost of materials for job 300 = total requisition less total cost of returned
materials
= ($ 300+ 350 + 450+ 250) - (100 + 501) =749
2. Work in process-control…………………..$60,000
Factory over head…………………………$18000
Raw materials………………………………………..78,00
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6
a) FIFO method
Cost of issued materials Balance
Date Purchases
Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost Cost cost Cost Cost Cost
Sept. 1 1000 10 10000
2 5000 12 60,000 1,000 10 10,000
5,000 12 60,000
8 1,000 10 10,000
2,000 12 24,000 3,000 12 36,000
15 2,000 15 30,000 3,000 12 36,000
2,000 15 30,000
18 3,000 12 36,000
1,000 15 15,000 1,000 15 15,000
24 6,000 18 108,000 1,000 15,000
6,000 18 108,000
28 1,000 15 15,000
4,000 18 72,000 2,000 18 36,000
30 500 18 9,000 1500 18 27,000
Inventory value is taken from the balance column on the last row, i.e. $27,000. Cost of
materials issued is obtained by adding the Total cost column of the cost of issued materials
(i.e. $81,000).
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b) LIFO method
Date Purchases
Sept 1 1000 10 10000
2 5000 12 60,000 1,000 10 10,000
5,000 12 60,000
8 1,000 10 10,000
2,000 12 24,000 3,000 12 36,000
15 2,000 15 30,000 3,000 12 36,000
2,000 15 30,000
18 3,000 12 36,000
1,000 15 15,000 1,000 15 15,000
24 6,000 18 108,000 1,000 15,000
6,000 18 108,000
28 1,000 15 15,000
4,000 18 72,000 2,000 18 36,000
30 500 18 9,000 1500 18 27,000
Cost of materials on hand = 10,000 + 9000 = $ 19,000

Cost of materials issued = 36,000+24000+90,000+9000
= 189,000
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c) Moving Average Method
Date Purchases
Sept.1 1000 10 10000
2 5000 12 60,000 1,000 10 10,000
5,000 12 60,000
8 1,000 10 10,000
2,000 12 24,000 3,000 12 36,000
15 2,000 15 30,000 3,000 12 36,000
2,000 15 30,000
18 3,000 12 36,000
1,000 15 15,000 1,000 15 15,000
24 6,000 18 108,000 1,000 15,000
6,000 18 108,000
28 1,000 15 15,000
4,000 18 72,000 2,000 18 36,000
30 500 18 9,000 1500 18 27,000
Cost of ending inventory = 25,905
= 35010+52000+86,450+8,645
= 182,105
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7. LCM applied to individual item
Units cost Market Cost Market LCM Category 1

Material A 460 1.40 1.30 644 598 598
Material B 880 0.85 0.90 748 792 748
Category 2
Material C 1290 1.20 1.45 1548 1,870.50 1548
Material D 580 0.65 0.55 377 319 319
3317 3579.50
3579.50 3213
:- The inventory value is $3213

.B) LCM applied to category of items
Unit Cost Market Total cost Total Inventory
market value
( LCM)
Category 1
Marital A 460 1.40 1.30 644 598
Marital B 880 0.85 0.90 748 792
Sub total
Category 2
Material C 1290 1.20 1.45 1548 1870.5
Material D 377 319
Sub total 1925 2189.50 1925
Grand 3317 3579.50 3315
Total
: - inventory value is $3315
c. If lower of cost market method is used, we need to compare total costs with total market
prices and choose the lower of the two. Thus, in the exercis under consideration, the inventory
value is $3317
3.8 GLOSSARY
Raw materials Materials including indirect materials, direct materials and

factory supplies
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Purchase requisition A form / document used to request material for purchase
and prepared by the store
Purchase order a legal document prepared by purchasing department and sent to
vendors asking them to deliver materials
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UNIT FOUR: ACCOUNTING FOR LABOR
Content
4.0 Introduction
4.1 Objectives
4.2 Accounting for Labor Costs
4.2.1 Type of Labor Costs
4.2.2 Pecting Procedures for Labor Costs
4.3 Employer's Payroll Taxes
4.4 Summary
4.0 INTRODUCTION
This chapter introduces major accounting and control system labor by discussing types of
labor costs the three commonly used procedures in controlling and accounting of labor such
as time keeping payroll procedure and changing labor costs to production.
4.1 OBJECTIVES
After studying this unit you should be able to:

- Describe the types of labor costs
- Know the general accounting control procedures for labor costs
- Describe the relevant documents and records used in labor costs control
- Present appropriate journal entries related to labor costs.
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4.2 ACCOUNTING FOR LABOR COSTS
Labour cost is an important element of costs, It constitutes a significant portion of total cost of
production. This it is important to establish an efficient system of labor control and selecting
the most appropriate method of remunerating them. The productivity of all other resources is
linked to the productivity of employees. Assets cannot operate by themselves.
4.2.1 Type of labor costs

Labor costs are composed of direct and indirect payments to workers and other personnel
engaged in manufacturing activities. In other words, labor costs represent the costs of
purchasing the labor hours and employee's services. Thus labor costs are classified as direct
labor indirect labor.
1. Direct labor is the personnel who work directly with the raw materials in converting them
to finished goods. In other words, direct labor is the time spent by a work, identifiable with
the particular job or a process.
2. Indirect labor is the wage of factory personnel who do not work directly on raw materials.
Indirect labor does not directly spend time on a particular job or product. The distinction
between direct labor and indirect labor is based on the convenience of linking the time spent
on a particular job or product. Although indirect workers spend time on work of general
nature, they also equally support production activities
1. Define direct labor costs

2. Define indirect labor costs
4.2.2 Accounting procedures for labor costs:

Accounting for labor cost requires
a) Strict control on labor recruitment
b) Correct time keeping
c) Time booking i.e analysis of time in terms of departments, operations and production
orders or jobs.
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d) Generation of adequate and effective manpower performance reports indicating
productivity and efficiency of labor.
e) Constant attempt to improve productivity and efficiency through improvement in the
remunerations, conversion of indirect labor into direct labor, etc.
In general, accounting for labor costs has three phases. These are:
A. Timekeeping procedures
B. payroll procedures
C. Charging labor costs into production
A. Timekeeping procedures
Timekeeping is the procedure for keeping records of time worked by each employee. There
are various methods for recording the time spent by an employee in the factory. Some of them
are described below.
1. Clock cards (or time cards)

Clock cards are produced by mechanical devices. They provide evidence of the presence of a
worker inside the plant and the time of his entry of departure. Clock cards are used with time
clocks. Time clock is installed at the entrance of the plant. Each employee has his or her own
time card which shows the dates worked and the time the employee entered and left each day.
If there is time Clock card is entered in to time clock. The time clock prints on the card the
“in" and “out" time. The clock card our time card may be filled out manually.
It is necessary that the timekeeping staffs are present at the time of filling the cards to
supervise and ensure smooth and rapid movement of workers and also to ensure that proper
clock card procedure is observed.
Time cards may be collected daily or at the end of the wage period. The format of clock card
is shown below:
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Clerk ( Time ) card
Name _____________________
No._______________________
Week ending _______________
Regular Extra
In Out In Out Hours In Out hours
Date
2. Time tickets (job tickets)

Time ticket show the time spent by each employee on individual job during the day. Time
tickets serve dual purposes:
a) it provides instructions for operations to be performed

b) It records time spent in performing the operations
The worker normally collects the ticket form the foreman's office. On completion of the
operations, the worker records time of completion on the ticket, submits the same to the
Forman and collects a new ticket for the next job to be worked on. Time ticket is needed
because time card or clock card indicates only the total time worked on by an employee. Time
card does not show the number of hours worked on a specific job by an employee.
However, time ticket clearly shows the number of hours worked on by an employee on a
specific job. The format of time ticket is shown below:
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Time Ticket
Date ___________ Employee name ( or No) _________
Time started _________________ Job. NO_______________
Time Stopped ________________ Department ____________________
Hours worked ________________ Operations ___________________
Rate ______________________
Amount __________________ Pieces completed ________________
Approved __________________________
Daily analysis of Data
At the end of the day all time tickets are colleted by a time clerk. The time clerk will complete
the following procedures.
1. Compare the hours shown on each employee’s time tickets with the total time shown
on the employee's time card.
2. Investigate the differences between time tickets and time cards.
3. Enter the earnings (Amount) on the time tickets.
4. Enter the number of hours worked during the day by each worker, in the payroll
register.
5. Separate individual parts of the time tickets to make it easier to sort by job or
department.
Idle time
Idle time is said to occur if time cards show more hours as compared to the time tickets. Idle
time may occur because of the following reasons:
- Hour lost waiting for materials

- Hour lost waiting for assignment to a new job
- Hour lost waiting for a machine to be repaired
- Strikers, fire floods etc.
Idle time costs are considered to be manufacturing overhead.
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Note that the short time spent during the morning an afternoon rest periods is not considered
idle time. It is absorbed into whatever job the employee is working on at the time of the break.
At the end of each week, an analysis of idle time is made an idle time sheet is prepared. Then
the idle time sheet is attached to time ticket.
If the clock card hours are less than hours recorded on time ticket the difference is as a result
of error. The error has to be corrected in consolation with the Forman and the worker
concerned.
B. Payroll Procedures
The payroll unit (or payroll department) is responsible for the following:
1. Maintain details of job classification cost center and wage rate of each employee
2. Maintain a list of mandatory deductions such as employee income taxes
3. Maintain a list of voluntary deductions, such as credit association contribution,
4. Determine for each employee the amount of income tax to be deducted from each
employee's gross pay.
5. Determine the net amount payable to each employee.
6. Prepare wage sheets which form the basis for disbursement of wages
7. Summarize the cost by cost center including the gross amount earned deductions, net
pay hours, worked overtime premium incurred, incentive earned by each employee
etc.
The time keeping procedures provide the data needed by the payroll department for
computing earnings and completing labor cost records. Factory payroll register may be
prepared weekly, and monthly (or semi monthly)
Weekly factory payroll Register
Information about hours worked and wages rate is transferred to weekly factory payroll
register from time daily. In other words, time tickets are the source of information for
preparing weekly factory payroll register. Weekly factory payroll register is usually prepared
for wage workers. The term “Wages” designates hourly or piece rate payment thus, wage
workers are those who are paid on an hourly rate basis.
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After all hours worked by each employee during the week have been entered in the payroll
register, regular earnings, overtime, earnings and total earnings are computed. Besides,
appropriate. Thus, in order to prepare a factory payroll department should make a distinction
among the following.
a) Normal hours worked and normal rate
b) Overtime hours worked
c) Overtime premium
Overtime premium varies from country to country. For example, in Ethiopia the overtime
premium is as follows:
From to 6:00 pm -10.00 PM ------ 125% of Regular rate
10:00 PM -6:00 AM ---------------------- 150% of Regular rate
Rest days ----------------------------------- 200% of Regular rate
Holidays ----------------------------------- 250% of Regular rate
Example
The regular hourly rate of Ato Abebe is 20 birr per hour. Ato Abebe has worked for 10 hours
during the week on his rest days. What is Ato Abebe's overtime pay?
Solution
OT = Regular rate x the premium x overtime hours

= 20 x 200% 10 = 40 birr hour x 10 = Br 400
Semi Monthly (or factory payroll register)

A separate monthly or semi monthly factory payroll is prepared for workers who are paid
fixed periodic (or salaried employees). Salaried employees are those who are paid fixed
periodic payment, usually semi monthly (every to weeks) monthly or yearly. Examples of
these workers are factory supervisor, managers, accountants etc.
Posting from the payroll register
At the end of the payroll, the total gross earnings and the totals for each of the various
liabilities are posted directly from the payroll register to the general ledger accounts. The total
gross earnings are debited to “Factory payroll clearing “Account. Deductions are credited.
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Salaries and wages, payable account is credited for the net pay. The general journal entry is
shown below:
Factory payroll clearing ----------------------------------xxx

Employee Income taxes payable --------------------------------xxx
Pension contribution -----------------------------------------------xxx
Salaries & wages payable -----------------------------------------xxx
Note that above general journal entry is made on any payroll date ( or at the end of each pay
day)
Paying the payroll
After the payroll register is completed and posted to general ledger accounts, the payroll clerk
prepares a voucher for the net amount of the payroll. The voucher is forwarded to the voucher
clerk completes the voucher and records in the payroll register.
The accounting entry is a debit to salaries and wages payable and a credit to vouchers
payable.
Salaries an wages payable -------------------------------------xxx

Vouchers payable ----------------------------------------------------------xxx
Then the voucher goes to the treasure, who preparers a check and record it in the check
register. If employees are paid by check is prepared for each employee. If employees are paid
in cash in the check will be cashed. When the check is prepared the required entry is:
Vouchers payable -------------------------------xxx

Cash in bank -------------------------------------------------xxx
Individual Earrings Records
An employer should keep an individual record of the earnings of each employee and
deductions. The source of information for individual earnings record is the payroll register
prepared at the end each pay period. The format of this record is shown below:
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Name________________________ Marital Status___________
Address ______________________ Date of Birth ____________
Employee No __________________
Week Houre Rate per Earnings Deductions Net
Period Ended worked hour Pay
Regular OT Regular OT Regular OT Total Tax Pension Total
*OT = over time
C. Charging labor costs in to production

In the preceding section, the various recording phases of accounting for labor costs have been
discussed. In that section, it was introduced that labor costs are classified in to direct labor and
indirect labor. Direct labor costs are charged to work in process account and indirect labor
costs are charged to manufacturing overhead control account. The direct labor costs are
transferred to job cost sheet. The indirect labor costs are posted to departmental overhead
analysis sheet.
However, an analysis should be each week (for wage workers) before posting has been made.
The main purposes of the analysis are summarized as follows:
a) The analysis divides total gross earnings (or total labor costs) in to direct labor and
indirect labor. The basis of information is the time tickets.
b) The analysis shows the direct labor costs incurred on each job by each department and
the total direct labor costs for each department.
c) The analysis indicates the indirect labor costs for each department.
97
Once the analysis is made, the next step is to direct labor costs to job cost sheet and indirect
labor costs to the departmental overhead analysis sheet.
An example of this analysis is shown below
Departmental analysis sheet

Milling Assembly Finishing
Job Hours Amount Hours Amount Hours Amount
Total
Indirect Labor
Department Regular
Earnings overtime Total
Milling xx xx xx
Assembly xx xx xx
Finishing xx xx xx
Building service xx xx xx
General Factory xx xx xx
Total xxx xxx xxx
Summary
Direct labor ------------------------ 62,200
Indirect Labour --------------------38,000
--------------------38,000
Total ----------------------------100,000
----------------------------100,000
In the above analysis sheet, five departments are involved. The first three departments are
production departments, and Building service and General factory are service department.
98
Job No. 11 has been worked in all of the three departments. It took 10 hours in milling
department 5 hours in Assembly department and 6 hours in finishing department. This job
took 21 hours in total.
Indirect labor costs may be incurred both in production departments and service departments.
The total direct labor and indirect labor costs should equal to the total labor costs incurred
during the week. It is from this analysis that posting is made to job cost sheet and
departmental overhead analysis sheet.
The semi monthly or monthly payroll is also analyzed. As mentioned earlier, the semi
monthly or monthly payroll represents the salaries earned by employees who are on a fixed
monthly salary. The earnings of these employees are classified as indirect labor. They are
directly posted to the departmental overhead analysis sheet. The purpose of the analysis is to
divide indirect semi monthly or monthly labor costs by departments.
Finfine Furniture Factory

Semi monthly ( monthly) Factory Payroll Analysis
Period ended ____________
Department indirect Labor
Milling xx
Assembly xx
Finishing xx
Building Services xx
General Factory xx
Total xx
Analysis of unpaid wages
99
If the last day weekly pay period is different from the last day of the fiscal period, it is
necessary to prepare an analysis of time tickets at the end of the month. This is to identify the
labor costs that have been incurred since the last weekly payroll date but have not yet.
The main objectives are to charge production with all labor costs in the month in which they
are incurred. The analysis is in the same manner as the previous analysis, classifying labor
indirect labor is posted to job cost sheet and the indirect labor is posted to department
overhead analysis sheet.
For example, assume that weekly pay day is Saturday for the work week from Monday to
Saturday. Assume further that the fiscal period ends on Wednesday. In this case, there is
accrued payroll for three days (i.e. Monday, Tuesday and Wednesday). Thus the salaries and
wages earned for the days have to be determined and divided between direct and indirect
labor.
Transferring labor costs to production
Labor costs are transferred to production by means of journal entries. The journal entry is
based on the analysis made above. After the analysis, the “work in process" account is debited
for total direct labor and “MOH control" account is debited for the total indirect labor costs.
The corresponding credit account if Factory payroll clearing account. This account is credited
for the total labor costs (i.e. direct labor +indirect labor). The general journal entry is
summarized below:
Work in process ---------------------------xxx

Manufacturing overhead control ---------xxx
Factory payroll clearing ----------------------------xxx
Balance of Factory payroll clearing
The factory payroll clearing account has been debited for he gross amount of factory wages
and salaries paid during the period. It is credited for the total amount of wagers and salaries
charged to production during the period. If theye are unpaid wagers at the end of the period.
Factory payroll clearing account has a credit balance. This credit balance represents the
amount of factory wages and salaries earned and charged to production but unpaid at the end
of the period. This balance will be shown on the balance sheet as a current liability called
100
Accrued wages payable or salaries and wages payable. The balance of factory payroll clearing
account may be shown in the name of either.
1) Factory payroll clearing

2) Salaries and wages payable, or Accrued wages payable. If this alternative is chosen,
the adjusting entry is made at the end of the period as follows:
Factory payroll Clearing ------------------------xxx

Salaries and wages payable --------------------------xxx
LEARNING ACTIVITY 4.2

1. Describe the Following Phases in Accounting for Labor
A. time keeping
B. payroll procedure
C. charging labor costs to production
2. Differentiate between time ticket and time card
4.3 EMPLOYER'S PAYROLL TAXES
Employer's payroll taxes represent the amount of pension contributed to the employee's
pension plan by the employer. Payroll taxes are usually part of the manufacturing overhead.
They are recorded as follows:
Manufacturing overhead control ---------------------xxx
Cash (or other account) -----------------------------------xxx
Fringe Benefit Costs
Fringe benefits are costs related to salaries and wages. These include vacation and holiday
pay, compensation insurance of workers, hospitalization, insurance, life insurance e.t.c. Fringe
benefit costs are usually charge to manufacturing overhead. In this case manufacturing
overhead control account is debited for the fringe benefit costs and posted to departmental
overhead control account is debited for the fringe benefit costs and posted to departmental
overhead analysis sheet. Alternatively, fringe benefits associated with direct labor may be
classified as part of the direct labor cost rather than as manufacturing overhead.
101
LEARNING ACTIVITY 4.3
1. What are fringe benefits?

2. How are they typically accounted for?
CHECK YOUR PROGRESS QUESTIONS
EXERCISES
1. Assume that the total labor costs paid during the month is Br 200,000. the analysis of time
tickets that labor costs amounted Br 40,000 were not paid at the end of the month.
Required
1. What is the amount by which factory payroll clearing account has been debited during
the month?
2. What is the amount by which factory payroll clearing account has been credited for
the month?
3. Determine the balance of factory payroll clearing account at the end of the month.
4. How much should be shown as a current liability in the balance sheet at the end of the
month?
2. At the end of the month, after posting, the Factory payroll clearing account has a $10,000
credit balance. What does this credit balance represent, and where is it shown on t financial
statements?
4.4 SUMMARY
Labor cost is an important element of costs; it constitutes a significant portion of total cost of
production. This it is important to establish an efficient system of labor control and selecting
the most appropriate method of remunerating them. The productivity of all other resources is
linked to the productivity of employees. Assets cannot operate by themselves.
4.5 ANSWER KEY FOR LEARNING ACTIVITY
102
1. Direct labor costs are compensations paid to those employees who directly work on
the production of the product
2. Indirect labor costs are compensations paid to those employees who do not directly
work on the production of the product rather their service is used in facilitating and
supervising the production process.
1. a. Time keeping is the process of controlling and recording the amount of time spent in
producing & completing a given work.
b. Payroll procedure is the process of determining the amount of money to be paid for
employees of the organization.
c. Charging labor costs to production is the process of assigning each and every job or
process for the related cost.
It is usually performed by charging the appropriate cost accounts such as WIP &FOH in
the accounting records
4.6 ANSWERS FOR CHECK YOUR PROGRESS QUESTION
a) Factory payroll clearing account has been debited for the amount of salaries and wages
paid during the month i.e. Br 200,000.
b) Factory payroll clearing account has been credited for the sum of the amount that has
been debited to the same account and unpaid wages at the end of the month. i.e.
200,000 +40,000 = 240,000
c) Factory payroll clearing account has a credit balance of Br. 40,000 at the end of the
month.
d) The amount of unpaid wages the salaries (Br, 40,000) will be shown as a current
liability in the balance sheet.
103
4.7 GLOSSARY
Time keeping is a procedure used to keep records of the total hours worked by each employee
Time ticket a document used to record the amount of time spent by each employee on the
job
Time card a card used to record the total hour spent by each employee in the plant
104

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UNIT ONE: COST AND MANAGEMENT ACCOUNTING FUNDAMENTAL

At the end of the unit you are expected to:

1.2 COST AND MANAGEMENT ACCOUNTING

1.2.1 Overview of Accounting In General

1.2.2 The Need For General Accounting Systems

1.2.3 Purpose Of Cost Accounting

- Should we build a new plant or modernize the old one?

BUDGETING: cost accounting is also in preparing a company's budgets. A budget is the

DETERMINING PROFITS: one of the objectives of cost accounting is the consistent

1.2.4 Management Accounting, Cost Accounting, And Financial Accounting

Individual managers often require the information in an accounting system to be presented or

Management accounting and financial accounting have different goals. Management

Learning Activity 1.1

1.3 MANAGEMENT PROCESS AND ACCOUNTING

1.3.2 Element of management control

Planning and control

Management decisions Management Accounting

PLANNING BUDGETS Financial

CONTROL ACTION Accounting system Recording of actions and

Exhibit 1.1 How Accounting facilitates, planning and control

1.3.3 Cost management and Accounting systems

Cost management is not practiced in isolation. It is an integral part of general management

Check your progress exercises

1.5 ANSWER KEY TO LEARNING ACTIVITY

Learning activity 1.1

1.6 KEY TO CHECK YOUR PROGRESS EXERCISE

1.7 MODEL EXAMINATION QUESTIONS

2. Cost accounting provides information for only financial accounting purposes.

After studying this unit you should be able to:

2.2 BASIC COST CONCEPTS

2.2.2 Costs in general

2.2.3 Cost Accumulation and Assignment

Learning Activity 2.1

2.3 COST CLASSIFICATIONS AND FLOW OF COSTS

2.3.2 Cost classification approaches

a) General cost classifications

Manufacturing overhead: Manufacturing overhead, the third element of manufacturing costs,

Directs labor costs (Br 16X48) Br. 768

Direct labor cost (Br 14X38) Br 532

Direct material Direct labor Factory overhead

Prime costs Conversion costs

Exhibit 2.2 manufacturing costs

Required: - identify the following costs:

Learning Activity 2.2

2.3.2.2 Product costs versus period costs

2.3.2.3. Cost classifications for assigning costs to cost objects

The following can be good examples of directs costs:

- Department A - Salary of the corporate general manger,

- Branch - Salary of the general manger and employee at

2.3.2.4 Cost classifications for predicting cost behavior

Cost behavior and cost drivers

Costs based on cost behavior are classified as follows:

Units produced cost per unit Total variable

500 1000 1500

Exhibit 2.3 variable cost behavior

500 2000 500 2000

The behavior of mixed cost is shown graphically in exhibit 2.5

Exhibit 2.5 The behavior of mixed cost

Counted ( measured) by __________ Approved by

Approved _________ Delivered by_Received by ______

For months of ___________ 19 Page