(Manufacturing and Production Engineering) Fariborz Tayyari - Cost Analysis For Engineers and Scientists-CRC Press (2021)

Cost Analysis for Engineers
and Scientists
Manufacturing and Production Engineering Series
Series Editors: Hamid R. Parsaei, Texas A&M University at Qatar, & Waldemar Karwowski,
University of Central Florida
This series will provide an outlet for the state-of-the-art topics in manufacturing and produc-
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Processes, Cybersecurity, Data Science, Automation and Robotics, Underwater Autonomous
Vehicles, Unmanned Autonomous Vehicles, Robotics and Automation, Six Sigma and Total
Quality Management, Manufacturing Cost Estimation and Cost Management, Industrial Safety,
and Programmable Logic Controllers, to name just a few.
Decision Making in Risk Management
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Christopher Cox
Reconfigurable Manufacturing Enterprises for Industry 4.0
Ibrahim H. Garbie and Hamid Parsaei
Recent Advances in Time Series Forecasting
Dinesh C. S. Bisht and Mangey Ram
Cost Analysis for Engineers and Scientists
Fariborz (Fred) Tayyari
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Cost Analysis for Engineers
and Scientists

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Library of Congress Cataloging‑in‑Publication Data
Names: Tayyari, F. (Fariborz), author.

Title: Cost analysis for engineers and scientists / Fariborz Tayyari.
Description: First edition. | Boca Raton, FL : CRC Press, 2022. | Series:
Manufacturing and production engineering | Includes bibliographical
references and index.
Identifiers: LCCN 2021027979 (print) | LCCN 2021027980 (ebook) | ISBN
9781138362284 (hbk) | ISBN 9781032147116 (pbk) | ISBN 9780429432163
(ebk)
Subjects: LCSH: Engineering economy.
Classification: LCC TA177.4 .T38 2022 (print) | LCC TA177.4 (ebook) | DDC
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LC ebook record available at https://lccn.loc.gov/2021027980
ISBN: 978-1-138-36228-4 (hbk)

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DOI: 10.1201/9780429432163
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Contents
Preface.......................................................................................................................xi
Author biography.................................................................................................... xiii
Chapter 1 Accounting and Cost Information Systems...........................................1

Learning Objectives...............................................................................1
1.1. Introduction................................................................................1
1.2. Terms and Definitions................................................................1
1.3. Financial Statements.................................................................. 5
1.3.1. The Income Statement................................................... 5
1.3.2. Owners’ Equity Statement............................................ 6
1.3.3. Balance Sheet................................................................7
1.3.4. Cash Flow Statement..................................................... 8
1.4. Bookkeeping............................................................................. 10
1.4.1. Double-Entry System of Accounting.......................... 10
1.4.2. General Journal........................................................... 10
1.4.3. General Ledger............................................................ 12
1.4.4. Posting Journal Entries into Ledger Accounts............ 13
1.4.5. Terms of Sales............................................................. 14
1.5. Recording Purchases and Sales of Merchandise...................... 14
1.5.1. Recording Purchases and Sales Using Periodic
Inventory System......................................................... 15
1.5.2. Recording Purchases and Sales Using Perpetual
Inventory System......................................................... 15
1.6. Trial Balance............................................................................ 15
1.7. Cash and Accrual Bases of Accounting................................... 16
1.8. Depreciation of Long-Lived Assets.......................................... 17
1.9. Completing an Accounting Period........................................... 18
1.9.1. Adjusting Entries......................................................... 18
1.9.2. Closing Entries............................................................ 19
1.10. Types of Accounts.................................................................... 22
1.11. Classified Balance Sheet and Income Statement...................... 23
1.11.1. Division of a Balance Sheet........................................ 23
1.11.2. Formatted Income Statement...................................... 27
Summary.............................................................................................28
Reference.............................................................................................28
Review Questions and Answers..........................................................28
Problems..............................................................................................28
Appendix 1.A...................................................................................... 33
v
vi Contents
Chapter 2 Cost Analysis Fundamentals............................................................... 35

Learning Objectives............................................................................. 35
2.1. Introduction.............................................................................. 35
2.2. Costs and Expenses.................................................................. 36
2.3. Product Costing........................................................................ 36
2.4. Classification of Costs.............................................................. 37
2.4.1. Classification of Costs by Behavior............................. 37
2.4.1.1. Classification of Fixed Costs by
Flexibility.....................................................40
2.4.1.2. Classification of Fixed Costs by
Controllability..............................................40
2.4.2. Classification of Costs by Traceability........................ 41
2.4.3. Cost Classification by Decision-Making..................... 43
2.4.4. Classification of Costs by External Reporting............ 47
2.4.5. Classification of Costs by Cash Flow.......................... 48
2.4.6. Classification of Costs by Time................................... 49
2.4.7. Classification of Costs by Other Basis........................ 49
2.5. Inventory Valuation.................................................................. 50
2.6. Statement of Cost of Goods Sold............................................. 53
2.7. Journal Entries for the Flow of Production Costs.................... 55
Summary............................................................................................. 59
Reference............................................................................................. 59
Review Questions................................................................................ 59
Problems..............................................................................................60
Appendix 2A.......................................................................................64
Chapter 3 Product Costing................................................................................... 65

3.1. Introduction.............................................................................. 65
3.2. Absorption Costing and Variable Costing................................66
3.3. Job-Order Costing System........................................................66
3.4. Process Costing........................................................................ 69
3.4.1. Process Costing Using Weighted-Average Method.... 70
3.4.2. Process Costing Using FIFO Method......................... 73
3.5. Normal Costing and Standard Costing.................................... 78
3.6. Journal Entries for Recording Job-Order Costs....................... 79
Summary............................................................................................. 83
Review Questions................................................................................ 83
Problems.............................................................................................. 85
Appendix 3A....................................................................................... 87
Glossary............................................................................................... 87
Contents vii
Chapter 4 Manufacturing Cost Allocation........................................................... 89

4.1. Introduction.............................................................................. 89
4.2. Types of Departments...............................................................90
4.3. Traditional Overhead Cost Allocation......................................90
4.3.1. Predetermined-Overhead-Rate Method...................... 91
4.3.2. Overhead Accumulation Method................................ 93
4.4. Activity-Based Costing (ABC)................................................. 93
4.4.1. Bases for Overhead Allocation.................................... 95
4.4.2. Overhead Cost Pools................................................. 100
4.5. Methods for Reallocating Costs of Support Departments..... 100
4.5.1. Direct Method of Reallocating Support Costs.......... 100
4.5.2. Step-Down Method of Reallocating
Support Costs............................................................ 102
4.5.3. Reciprocal Method of Reallocating
Support Costs............................................................ 104
Summary........................................................................................... 106
Reference........................................................................................... 108
Review Questions.............................................................................. 108
Problems............................................................................................ 109
Chapter 5 Joint Cost Allocation......................................................................... 115

Learning Objectives........................................................................... 115
5.1. Introduction............................................................................ 115
5.2. Joint Cost Allocation Terminology........................................ 116
5.3. Reasons for Joint Cost Allocation.......................................... 117
5.4. Profitability Analysis and Decision Scenarios....................... 118
5.4.1. Decision Scenario 1: Which Product to Produce?.... 118
5.4.2. Decision Scenario 2: Should Sell a Product at
Split-Off or Process Further?.................................... 118
5.4.3. Decision Scenario 3: How Much of Each Product
to Produce?................................................................ 119
5.5. Traditional Methods for Joint Cost Allocation to Main
Products.................................................................................. 120
5.5.1. Physical-Measure Method of
Joint Cost Allocation................................................. 120
5.5.2. Weighted-Average Method of
Joint Cost Allocation................................................. 122
5.5.3. Sales-Value Method of Joint Cost Allocation............ 124
5.5.4. Relative-Market-Value Method of Joint Cost
Allocation.................................................................. 126
5.5.5. Constant-Gross-Margin Method of Joint Cost
Allocation.................................................................. 129
viii Contents
5.6. Traditional Methods for Joint Cost Allocation to

By-products............................................................................. 131
5.6.1. Net-Realizable-Value or Production Method............ 131
5.6.2. Zero-Cost Method..................................................... 133
5.7. Quantitative Method for Joint Cost Allocation...................... 134
5.7.1 Formulating Joint Cost Allocation............................ 134
5.7.2. A Basis for Identifying By-products......................... 140
Summary........................................................................................... 142
References......................................................................................... 143
Problems............................................................................................ 144
Chapter 6 Manufacturing Cost Estimation........................................................ 151

6.1. Introduction............................................................................ 151
6.2. General Types of Cost Estimates........................................... 152
6.3. Assumptions for the Use of Cost Estimating Models............ 153
6.4. Methods for Developing a Cost Estimating Model................ 153
6.4.1. Account Analysis Method......................................... 155
6.4.2. Scatter-Graph Method............................................... 157
6.4.3. High-Low Method..................................................... 159
6.4.4. Regression Method and Excel® Solver..................... 162
Summary........................................................................................... 166
References......................................................................................... 167
Problems............................................................................................ 168
Chapter 7 Cost-Volume-Profit Analysis............................................................. 171

7.1. Introduction............................................................................ 171
7.2. Linear Cost-Volume-Profit Models for a Single Product........ 172
7.2.1. Underlying Assumptions in CVP Analysis............... 173
7.2.2. Marginal Cost and Revenue and Contribution
Margin....................................................................... 174
7.2.3. Break-even Analysis for a Single Product................. 176
7.2.3.1. Graphical Method for Finding the
Break-even Point........................................ 176
7.2.3.2. Algebraic Method for Finding the
Break-even Point........................................ 178
7.2.4. CVP Analysis for a Target Profit............................... 178
7.2.5. Margin of Safety....................................................... 179
7.2.6. Operating Leverage................................................... 180
Contents ix
7.3. Nonlinear CVP Analysis for a Single Product....................... 181

7.4. Cost-Volume-Profit Analysis for Multiple Products............... 186
7.4.1. CVP Analysis for Multiple Products with a Fixed
Sales Mix................................................................... 186
7.4.1.1. Product-Indexing Method for Sales-
Mix CVP Analysis..................................... 186
7.4.1.2. Weighted-Average Contribution
Margin Method for Sales-Mix CVP
Analysis..................................................... 187
7.4.2. CVP Analysis for Multiple Products without
Product Interdependencies........................................ 190
7.4.3. CVP Analysis for Multiple Products with a
Single Constraint....................................................... 192
7.4.4. CVP Analysis for Multiple Products with
Multiple Constraints and Unavoidable
Fixed Costs................................................................ 193
7.4.5. CVP Analysis for Multiple Products with
Multiple Constraints and Avoidable Fixed Costs...... 196
7.5. CVP Analysis for a Single Product in Multiple Periods........200
7.6. Usefulness and Applications of CVP Analysis...................... 203
Summary...........................................................................................204
Review Questions..............................................................................206
Problems............................................................................................207
Index....................................................................................................................... 213
Preface
Cost analysis is a powerful managerial tool that requires a systematic analysis that
results in a better understanding and budgeting costs of products and services.
This understanding, in turn, leads to improved program management in applying
resources and mitigating project risks.
This book is intended to empower engineers and scientists with skills for obtain-
ing needed financial data, and to apply cost analysis techniques for assessing product
and service costs, and costs associated with engineering projects. The readers will
learn how to keep records of financial transactions, prepare and analyze financial
statements, and interpret them to make sound decisions. They also develop skills for
manufacturing cost determination and estimation, overhead allocation, cost estima-
tion, and profitability analysis. The subject materials covered in this book help cost
engineers and scientists apply managerial accounting techniques to problems in the
areas of cost estimation, cost control, product pricing, product line or business seg-
ment discontinuation, profitability analysis, and project management.
This book is intended as a valuable resource for training students and learners
who will be part of a team that is responsible for the execution of industrial projects.
The contents of this book are aimed at all individuals who are involved in techni-
cal projects, cost estimation, cost control and planning, and contract review in their
organizations, including but not limited to:
• Organization managers.
• Division/department directors.
• Production managers.
• Project managers.
• Cost estimators.
• Cost analysts and engineers.
The book, first, introduces the fundamentals of accounting information systems and
manufacturing costs. Then, it presents product costing, manufacturing cost alloca-
tion to individual products and joint products, and manufacturing cost estimation.
Finally, it presents the concepts and applications of cost-volume-profit and break-
even analysis for a single product and multiple products, as well as single period and
multiple periods.
xi
Author biography
Fariborz (Fred) Tayyari is a professor of Industrial & Manufacturing Engineering
& Technology at Bradley University. He holds a bachelor’s degree in Cost Accounting,
Master of Business Administration (MBA), Master of Science in Industrial
Engineering (MSIE), and a PhD in Industrial Engineering. He has been teaching
Engineering Economy, Engineering Costs Analysis, and Operations Research for
more than 35 years. He also served a major technical and construction company
as chief accountant and as a budget officer during his military service. He received
a certification as a Professional Engineer (PE) from the state of Texas, a Certified
Professional Ergonomist (CPE), and a Certified Safety Professional (CSP). He has
published book chapters on topics such as Total Cost Analysis of Modern Automated
Systems and Joint Cost Allocation.
xiii
1 Accounting and Cost
Information Systems
LEARNING OBJECTIVES
• Learn the basics of the accounting process and information.
• Maintain accounting bookkeeping and records.
• Prepare financial statements for a newly established business.
• Recognize classes of assets, liabilities, and net worth.
• Understand the profitability of a business in financial reports, which
are sources of financial decision-making for both internal and external
individuals.
1.1. INTRODUCTION
A meaningful engineering economic and cost analysis needs familiarity with finan-
cial information. Accounting records provide such information. In order for the engi-
neering economics analysts to be able to efficiently communicate with accountants
and obtain the necessary data, they need to understand accounting terminologies
and the accounting and cost information systems.
Regardless of the type and size of a business, accounting information is crucial
for decision-making, financial planning, and assessing economic performance.
This chapter introduces some basic accounting terminologies, accounting prin-
ciples, and accounting concepts. Learning the terms and concepts, the reader will be
able to understand the financial reports and statements and other features of account-
ing and cost information systems. Knowledge of such information is crucial for engi-
neers and scientists who seek economic justification for their engineering proposals
or career in management.
1.2. TERMS AND DEFINITIONS

Accounting: The American Institute of Certified Public Accountants [1] defined
accounting as follows:
“Accounting is the art of recording, classifying and summarizing in a signifi-

cant manner and in terms of money, transactions and events which are, in
part at least, of a financial character and interpreting the results thereof.”
DOI: 10.1201/9780429432163-1 1
2 Cost Analysis for Engineers and Scientists
This definition helps the reader better understand accounting through the follow-
ing basic interpretations:
• Accounting is an art: Accounting is an art because it requires skills and

creative judgment. A trained accountant performs accounting functions.
• Accounting involves interconnected “phases”: Recording is the process
of writing down or keeping records of business transactions. Classifying
involves grouping similar items that have been recorded. The classified data
are summarized and reported in financial statements.
• Accounting is only concerned with transactions and events having
financial character: For example, purchase of materials or goods, sale of
goods, the payment of salaries, payment of taxed or insurance premium,
and acquisition of a facility are recorded because they have monetary val-
ues. However, hiring an engineer and signing a service contract is just qual-
itative information without financial characteristics. Hence, they are not
recorded in the accounting books.
• Interpreting the results: The data in the financial statements and reports
have meanings that are useful to the interested parties. Interpreting results
is part of accounting functions (the final phase of accounting).
Accounting records are sources of cost information systems for measuring, pro-
cessing, and communicating financial data that are valuable in making economic
decisions. In general, accounting practices include bookkeeping, preparation of
financial statements, and reports on all business activities (e.g., change in assets,
sales revenues and expenses, inventories, receivables, payables, and payments of
bills). However, the accounting functions widely vary among industries (e.g., man-
ufacturing, construction, service, and governments) and even among firms within
each industry.
Bookkeeping: Bookkeeping is the means of recording monetary transactions

and keeping records.
Cost Accounting: Cost accounting refers to the determination and control of
costs. Cost accountants deal with the costs of manufactured products as
well as the expenses of selling and distributing the products.
Account: An account is a basic data storage unit used in accounting.
Accountants use one account for each asset, liability, and components of
owner’s equity (capital), revenue, and expense.
Chart of Accounts: The chart of accounts is a listing of all accounts used in
the accounting books (i.e., general ledger) of an organization. An account-
ing system uses a chart to aggregate information into an entity’s financial
statements. Accountants sort the chart by account numbers to ease the task
of locating specific accounts. See Appendix 1.A.
Journal: A journal (or general journal) is a chronological record of all mon-
etary transactions. It is the first place for recording the transactions.
Ledger: A ledger is a book or all files of a company’s accounts.
Accounting and Cost Information Systems 3
Depreciation: Depreciation cost or expense is a periodic allocation of the cost

of a tangible, long-lived asset over its estimated useful life.
Cost of Goods Sold (COGS): Cost of goods sold (or costs of sales) is the “cost
of goods available for sale” during that period minus the cost of inventory
(merchandise) at the end of the period.
Cost of Goods Manufactured: Cost of goods manufactured represents the
total manufacturing costs assigned to units of a product manufactured dur-
ing a period.
Operating Expenses: Operating expenses are nonmanufacturing expenses
incurred due to normal operations of a business (e.g., selling and adminis-
trative expenses).
Nonoperating Expenses: Nonoperating expenses are expenses that are not
related to normal business operations, such as interest expenses incurred
due to borrowing money.
Double-Entry System. The field of accounting – both the older manual sys-
tems and today’s computerized systems – is based on an old accounting
procedure known as double entry, which has been practiced for several cen-
turies. Double entry is a simple yet powerful concept, based on which, the
accountants must record each monetary transaction into at least two of the
accounts in the accounting books, whereby the amounts entered as debits
must be equal to the amounts entered as credits.
T-Account: T-account is a simple form of an account that has a physical
resemblance to the letter “T,” used to analyze transactions. As shown in
Figure 1.1, a T-account has the following three parts:
• A title that describes the account (e.g., Cash, Accounts Receivable,
Notes Receivable, Inventories, Building, Equipment, Accounts Payable,
Notes Payable, Taxes Payable, Mortgage Payable, Common Stocks,
Preferred Stocks, and Retained Earnings).
• A left side, called the “debit” side.
• A right side, called the “credit” side.
Debit and Credit: The terms debit (abbreviated Dr., from the Latin debere)
and credit (abbreviated Cr., from the Latin credere) are two words used
by accountants to, respectively, show the left and right sides of an account.
The following rules for debit and credit are applied to increase or decrease
an account:
• A debited entry to an asset account increases that asset, while a credited
entry decreases the asset.
Title of the Account

"Debit" "Credit"
FIGURE 1.1 An illustration of a T-account.

ASSETS = LIABILITIES + OWNER'S EQUITY

Debit Credit Debit Credit Debit Credit
to to to to to to
increase decrease decrease increase decrease increase
FIGURE 1.2 The effects of debits and credits on account balances.
• A credited entry to a liability or owner’s equity account increases that

liability or owner’s equity account, while a debited entry decreases the
liability or owner’s equity account.
These rules can be summarized as shown in Figure 1.2.
Notice that revenues increase the owner’s equity (to which the rule of
owner’s equity is applied), and expenses decrease the owner’s equity (to
which the opposite rule of owner’s equity is applied, that is, treated like
assets).
Revenues: Revenues are the total amount received for the goods sold or ser-
vices provided to customers during a particular fiscal (financial or account-
ing) period. The company receives either cash or a promise to receive cash
in the future for its sales or services to the customers. Revenues increase
assets (Cash, Accounts Receivable, and/or Notes Receivable), and finally
result in an increase in the owner’s equity.
Expenses: Expenses are the costs of activities performed to carry out the com-
pany’s operations. Salaries to office employees and sales personnel, com-
missions, telephone services, utilities, office rent, advertising, and office
supplies are some examples of expenses. Expenses decrease assets and/or
increase liabilities. They are the opposite of revenue in that they finally
result in a decrease in owner’s equity.
Accrued Expenses: Accrued expenses are expenses that a firm incurs in one
accounting period but will pay for it in another period. Common examples
of accrued expenses are salaries and wages payable, taxes payable, interest
payable, and warranty services on products performed, all of which have
been incurred, but for which a firm has not received invoices or has received
close to the end of the fiscal period, and the firm has not paid them in that
period.
Accrued Revenues: Accrued revenues are revenues that a firm has earned in
one fiscal period but will receive payment for them in another period. The
balance of the “accounts receivable” account is the accrued revenues from
sales of products or services, and the balance of “dividends and interest
receivable” account is the accrued dividends or interests income in a fiscal
period but the firm will receive payments for them in another period.
Net Income and Net Loss: The term net income refers to the net increase in
owner’s equity resulting from the company’s profitable operations. It is the
end result of subtracting the costs of sales and expenses from revenues:
Net Income ( Loss ) = Revenues - Costs of Goods Sold and Expenses

The term “net loss” refers to the net decrease in owner’s equity due to
the company’s profit-seeking operations that result in a negative net income.
Net loss occurs whenever the company’s revenues are not enough to recover
all of its cost of goods sold and expenses.
Prepaid Expenses: Prepaid expenses are advance payments for services or
goods that a firm will receive in the near future. Prepaid expenses appear on
accounting books and reports as assets. When the firm receives the goods
or services, the prepaid expenses are expired, and the firm will convert
them into expenses. Prepaid insurance and prepaid rent are the two com-
mon examples of prepaid expenses.
Unearned Revenues: Unearned revenues are amounts a firm has collected
for goods or services to deliver to its customers in the future (not yet
delivered). Just as opposite to prepaid expenses, unearned revenues are
advance receipts of money from customers before they are actually
earned (or realized). Unearned revenues are obligations of the company
to provide goods or services to the customers. Therefore, an unearned rev-
enue (or fee) is a “current” liability. As the company fulfills any portion
of these obligations, it earns that portion of the advance receipts. Then, it
converts the earned portion from the unearned revenues (a current liabil-
ity) into earned revenue.
1.3. FINANCIAL STATEMENTS
The financial statements reflect the financial positions and periodical business activi-
ties of a firm. The most important financial statements are:
1) Income Statement.
2) Owners’ Equity Statement.
3) Balance Sheet.
4) Cash Flow Statement.
These reports are prepared in the given order and presented to the public as a set
of financial statements. This means they are not only published together but also
designed and intended to be used together. As each statement only gives information
about specific aspects of a company’s financial activities and position, it is important
that the reports are used together.
1.3.1. The Income Statement

An income statement is a financial statement that shows the amount of income
earned by a business (say, ABC Company) over an accounting period (e.g., for the
year ending December 31, 20XX). Figure 1.3 illustrates an income statement show-
ing the profitability of a hypothetical company during the year 20XX. The following
are the examples of income statement accounts:
ABC Company
Income Statement
For the year ended December 31, 20XX
Revenues (Total Sales) $32,000

Cost of Goods Sold 10,000
Gross Margin $22,000
Less: Operating Expenses:
Salaries & Wages $1,500
Heat, Light, & Power 1,000
Communications Expense 200
Insurance 500
Depreciation 1,800
Total Operating Expenses 5,000
Operating Income $17,000
Less: Non-operating Expenses:
Interest Expense 1,500
Income Before Income Taxes $15,500
Income Taxes 7,500
Net Income After Tax $ 8,000
FIGURE 1.3 An illustration of the income statement.
• Revenue accounts – Examples: Sales of Merchandise, Service Revenues,

Investment Revenues.
• Expense accounts – Examples: Cost of Goods (Merchandise) Sold, Sales
Commissions, Advertising Expenses, Wages Expense, Rent Expense,
Depreciation Expense.
1.3.2. Owners’ Equity Statement

The statement of stockholder’s equity, often called the statement of changes in
equity, is prepared for a fiscal period (e.g., quarter). This statement displays how
equity changes from the beginning of a fiscal period to the end.
The statement of stockholder’s equity shows the equity accounts that affect the
ending equity balance including common stock, net income, paid-in capital, and
dividends. This statement has four sequential sections:
1) Beginning balance.
2) Additions.
3) Subtractions.
4) Ending balance.
The beginning equity balance is followed by two indented sections: additions and
subtractions. Additions include new investments and net income if the company is
ABC Company
Statement of Owners’ Equity
For the year ended December 31, 20XX
Beginning Balance, January 1, 20XX $24,500
Add: Net Income 8,000
Less: Dividends (2,000)
Ending Balance, December 31, 20XX $30,500
FIGURE 1.4 An illustration of a statement of owners’ equity.
profitable. If the company is not profitable, net loss for the year is included in the
subtractions along with any dividends to the owners. The last line on this statement
always lists the ending equity balance. Figure 1.4 illustrates the four parts of a state-
ment of owners’ equity.
1.3.3. Balance Sheet
The balance sheet shows the financial position of a business on a particular date, usu-
ally on the last day of its fiscal period. The balance sheet presents a view of the busi-
ness as a collection of assets belonging to the company that is equal to the resources
or claims against those assets. The following are examples of balance sheet accounts:
• Asset accounts
• Current Assets – Examples: Cash, Marketable Securities, Accounts
Receivable, Supplies, Prepaid Insurance, and Inventories.
• Fixed Assets – Examples: Land, Buildings, and Equipment.
• Intangible Assets – Examples: Patents, Copyrights, and Goodwill.
• Liability accounts
• Current Liabilities – Examples: Accounts Payable, Wages Payable,
Taxes Payable, and Short-Term Notes Payable.
• Long-Term Liabilities – Examples: Notes Payable (Long-Term),
Bonds (matured in longer than one year), and Mortgage Loans.
• Stockholders’ Equity Accounts – Examples: Preferred Stock, Common
Stock, Paid-In Capital, and Retained Earnings.
The resources consist of liabilities (debts of external parties) and the owner’s equity
(the owner’s interest in the company). An example of the balance sheet for a hypo-
thetical company on December 31, 20XX, is given in Figure 1.5.
Accounting Equation: This is also known as the basic accounting equation

and balance sheet equation. As the balance sheet shows, the sum of assets
(left side) equals the sum of liabilities and owner’s equity (right side), as
shown in Figure 1.5. The following is the accounting equation:
Assets = Liabilities + Owners’ Equity ( or Net Worth )

XYZ Company
Balance Sheet
As of December 31, 20XX
ASSETS LIABILITIES
Cash $1,000 Accounts Payable $3,500
Accounts Receivable 1,200
Land 600 OWNERS’ EQUITY
Building 9,000 Mr. XYZ, Capital 19,300
Equipment 11,000
Total Assets $22,800 Total Liabilities & Owners’ Equity $22,800
FIGURE 1.5 A simple balance sheet.
Equation Equation Components

Owners’ (Stockholders’) Equity
Basic: Assets = Liabilities + Owners’ Equity
Expanded: Assets = Liabilities + Common Stock + Paid-in Capital – Treasury Stock

+ Revenues – Expenses – Dividends
FIGURE 1.6 The components of the basic and expanded accounting equations.
Expanded Accounting Equation: This equation splits the equity part of the
basic accounting equation into four elements: owner’s capital, owner’s with-
drawals, revenues, and expenses. Both the assets and liabilities sections of
the basic equation remain the same in the expanded equation. Figure 1.6
compares the components/elements of the two forms of the equation (basic
and expanded) for a corporation.
1.3.4. Cash Flow Statement

The cash flow statement presents a company’s cash or cash equivalent inflows and
outflows from operations, financing activities, and investing activities. It indicates
how well the company generates cash to pay its debt obligations and funds its
operating expenses. This statement is a document that shows the actual cash that
came in and went out of a firm during a given period from operating activities,
investing activities, and financing activities. Figure 1.7 exemplifies the cash flow
statement.
The operating activities on the cash flow statement include any sources and uses
of cash from business activities. Examples of operating activities include:
• Receipts from sales of goods and services.

• Payments made to suppliers of goods and services used in production.
KBL Company
Cash Flow Statement
For the Period Ended December 31, 20XX
Cash Flow from Operating Activities

Net Income (Earnings) $1,200,000
Depreciation 12,000
Decrease in Accounts Receivable 20,000
Decrease in Accounts Payable (55,000)
Accrued Expenses 4,000
Increase in Unearned Income 3,000
Increase in Taxes Payable 21,000
Increase in Prepaid Rent (20,000)
Increase in Inventory (25,000)
Net Cash from Operating Activities $1,160,000
Cash Flow from Investing Activities
Issuance and Sales of Common Stock 100,000
Purchase of Equipment (500,000)
Renovations and Improvements (220,000)
Net Cash from Investing Activities (620,000)
Cash Flow from Financing Activities
Dividends Payments (180,000)
Decrease in Notes Payable (200,000)
Net Cash from Financing Activities (380,000)
Change in Cash in period ended Dec. 31, 20XX $160,000
Beginning Cash Balance 125,000
Ending Cash Balance, December 31, 20XX $285,000
FIGURE 1.7 An example of a cash flow statement.
• Salary and wage payments to employees.

• Rent payments.
• Insurance premium payments.
• Income tax payments.
• Any other type of operating expenses.
Examples of investing activities include:
• Receipts from sales of marketable securities.

• Interests and revenues (e.g., dividends) received from investment.
Examples of financing activities include:

• Interest payments (on loans and bonds).
1.4. BOOKKEEPING
Bookkeeping is the process of recording transactions and keeping records.
1.4.1. Double-Entry System of Accounting

As previously stated, in the double-entry system, each transaction must be recorded
twice (debit and credit) in such a way that the total debits equal total credits. The
mechanism of double entry in bookkeeping is such that every transaction affects at
least two accounts with the total of debits equals to the total of credits.
Example 1.1
The list below contains the transactions for the H.T. Ram Property Management
for the month of January, 20XX.
1. On January 2, H.T. Ram invested $7,500 to establish his property man-

agement agency.
2. On January 3, rented an office, paying two months’ rent in advance,
$700. He also hired an office assistant and agreed to pay $400 every two
weeks.
3. On January 4, purchased office equipment from Sam Equipment for
$1,750, paying $750 in cash and agreeing to pay the rest next month.
4. On January 5, purchased on credit office supplies for $500 from York
Supply Company, and paid $120 for a one-year insurance policy.
5. On January 10, paid York Supply Company $250 of the amount owed.
6. On January 12, performed a service for a customer and collected a fee
of $850.
7. On January 16, paid the office assistant two weeks’ salary, $400.
8. On January 18, accepted $700 as an advance fee from Mr. Turner (one
of his customers).
9. On January 20, performed a service for a customer. The earned fees of
$950 will be collected next month.
10. On January 25, Mr. Ram withdrew $960 from the business for personal
living expenses.
11. On January 29, paid the office assistant two more weeks’ salary, $400.
12. On January 30, paid the utility bill, $85.
13. On January 31, received a telephone bill, $48.
Figure 1.8 illustrates the principle of duality (double entry) and how accountants
post the transactions in the affected T-accounts (ledger accounts).
1.4.2. General Journal
Bookkeepers journalize all transactions, chronologically in the “general journal.”
Journalizing transactions is the process of keeping a record of all your business
transactions in chronological order, which generally includes the date, the accounts
Cash Accounts Payable H.T. Ram, Capital Accounts Receivable

(1) 7,500 700 (2) (5) 250 1,000 (3) 7,500 (1) (9) 950
(6) 850 750 (3) 500 (4)
(8) 700 120 (4) 48 (13)
250 (5)
400 (7)
960 (10)
400 (11)
85 (12)
H.T. Ram,
Unearned Fees Withdrawals Office Supplies Fees Earned
700 (8) (10) 960 (4) 500 850 (6)
950 (9)
Prepaid Rent Utility Expense Wages (Expense) Prepaid Insurance

(4) 120
(2) 700 (12) 85 ( 7) 400
(11) 400
Telephone Expense Office Equipment

(13) 48 (3) 1,750
FIGURE 1.8 Posting transactions of Example 1.1 in the corresponding T-accounts.
debited and credited, and a brief description of the transactions. Each transaction is
recorded through a separate journal entry.
A company may use more than one kind of journal. The simplest and most flex-
ible type is the general journal. The general journal contains the following columns
for the recording:
• Date.
• Name of the accounts debited and credited.
• Dollar amounts debited or credited to each account.
• A brief explanation of the transaction (whenever necessary).
• Coding numbers to identify the accounts (known as posting reference).
Example 1.2
XYZ Company purchased $350 office supplies and $1,500 office equipment
on January 4 on credit, and prepaid $360 for a one-year insurance policy on
January 6. These two transactions are recorded in the general journal as shown
in Figure 1.9.
Note that at the time of recording the transactions, nothing is recorded in the
“post. ref.” (posting reference) column. If the company uses an identifying number
for each account in the ledger, the account numbers are placed in this column to
provide a cross-reference from the general journal to the ledger and indicate that
posting to the ledger has been made.
XYZ Company
General Journal Page 002
Post.
Date Description Ref.
Debit Credit
20XX
January 5 Office Supplies 350
Office Equipment 1,500
Accounts Payable 1,850
Purchase of Office Supplies
and equipment on credit
6 Prepaid Insurance 360

Cash 360
Paid for one-year insurance premium
FIGURE 1.9 A partial page of the general journal for Example 1.2.
1.4.3. General Ledger
Accountants, based on recording history, allocate one or more pages of the ledger
for each account. The ledger accounts provide the following information for posting
transactions (Figure 1.10).
• Name (title) of the account at the top of the page (e.g., Figure 1.10 shows
Accounts Receivable).
• Account number, at the top of the page (no. 112 for Accounts Receivable).
• Dates of the transactions.
• Description (or Item), usually not used unless special notes are desirable.
• Posting reference to show the page number of the general journal, where the
transaction was first recorded.
• Two columns for debiting or crediting the account.
• Two columns for the account balance (debit or credit).
XYZ Company
General Ledger
Accounts Receivable Account No. 112
Post. Balance
Date Item Ref. Debit Credit Debit Credit
20XX $ $
Jan. 3 500 500
5 200 300
12 750 1,050
25 450 1,500
Feb. 8 600 900
15 100 1,000
FIGURE 1.10 An illustration of a page (a cut out) of a “general ledger.”

1.4.4. Posting Journal Entries into Ledger Accounts

After bookkeepers have journalized the transactions (recorded transactions in the
general journal), they must post (transfer) the amounts to the corresponding ledger
accounts. The process of transferring the transactions from the journal to the ledger
is called posting. They usually perform posting at the end of each day or after sev-
eral journal entries, depending on the number of transactions. The posting process
includes the following steps:
1) Locate in the ledger the account named in the general journal to debit or
credit.
2) Enter the date of the transaction in the date column and the journal page
number, from which the entry comes, in the post. ref. column of the ledger.
3) Enter the amount of the debit (or credit) as appeared in the journal in the
debit (or credit) column of the ledger.
4) Enter the account number, to which the amount was posted, in the posting
reference column of the general journal.
The posting reference columns of the general journal and the general ledger are
for referencing between the journal entries and the ledger accounts. It indicates the
completion of posting of the item. Figure 1.11 shows the relationship between the
journal entries and the ledger accounts.
General Journal Page 14

DATE DESCRIPTION Post. Debit Credit
Ref.
20XX
July 15 Office Supplies 122 565
Accounts Payable 211 565
Purchase of Office Supplies on credit
General Ledger
Office Supplies Account No. 122
Post. Balance
20XX Balance from previous page 3,885
July 15 14 565 4,450
General Ledger
Accounts Payable Account No. 211
Post. Balance
20XX Balance from last page 43,310
July 15 14 565 43,875
FIGURE 1.11 The relationship between the journal entries and the ledger accounts.
1.4.5. Terms of Sales
When merchandise is sold on credit, both seller and buyer should have a clear under-
standing of the terms of sales. The terms are usually printed on the sales invoice. The
payment may be expected within a short period of time such as 15 days or 30 days.
In such cases, the sales invoice may carry the designation “n/15” or “n/30,” meaning
that the net sales amount is due 15 days or 30 days, respectively, after the invoice
date. Sometimes, the amount is due 10 days after the end of the month (eom). In this
case, the invoice is designated “n/10 eom.”
However, it is common to offer discounts to encourage early payment. In such a case,
the designated terms may be stated as “5/15, n/60” or “2/10, n/30.” The terms “5/15,
n/60” mean that the customer may take a 5% discount if the customer pays the invoice
within 15 days after the invoice date. Otherwise, the customer can delay payment until 60
days after the invoice date and pay the full invoice amount without the discount.
Since the seller is not sure that whether the customer will take the advantage of the
discount offer, the sales discounts are recorded on the date the payment is received
from the customer within the discount period. For example, assume that MacDowell
Fabric Company sells merchandise to Joe Smith, a customer, in the amount of $3,000
on terms of “3/10, n/45.” The journal entry by MacDowell Fabric Company at the
time of the sale would be as follows:
Nov. 18 Accounts Receivable 3,000

Sales 3,000
Merchandise sold on credit to
Joe Smith, terms 3/10, n/45
If the customer (Joe Smith) takes advantage of the sales discount and pays in ten days
or sooner, say on November 26, the journal entry would be as follows:
Nov. 26 Cash 2,910

Sales Discount 90
Receipt of payment from Joe Smith for Invoice of Nov.
18, less 3% discount
Similar to sales discounts, accountants debit the Sales Returns and Allowances
account for the sales items returned by the buyer. At the end of a fiscal period, to
determine the net sales, accountants deduct the totals of both the Sales Discount
account and Sales Returns and Allowances account from gross sales (balance of
Sales account). These two accounts are called sales contra-accounts.
1.5. RECORDING PURCHASES AND SALES OF MERCHANDISE

Firms may adopt either the periodic system or the perpetual system to account for
their inventories.
1.5.1. Recording Purchases and Sales Using Periodic Inventory System

Under the periodic inventory system, accountants debit the Purchases account for
merchandise purchased, and credit the “Purchases Returns and Allowances” and the
“Purchases Discount” accounts for returning any part of purchases and getting dis-
counts on the purchases, respectively. The firms update the Inventory account’s bal-
ance only at the end of each fiscal period. Similarly, they credit the Sales (Revenue)
account for merchandise sold, and debit the “Sale Returns and Allowances” and the
“Sales Discount” accounts for any part of items sold that are returned by custom-
ers and discounts given to them on the sales, respectively. The firms update the
Inventory account’s balance only at the end of each fiscal period; they, also, debit the
“Cost of Goods Sold” and credit inventories for the costs of the items sold as part of
inventory updating.
1.5.2. Recording Purchases and Sales Using Perpetual Inventory System

Under the perpetual inventory system, firms record purchases, purchase returns and
allowances, purchase discounts, sales, and sales returns at costs in the inventory
account. This system maintains the inventory account balance accurate (up-to-date),
assuming there are no spoilage or other losses.
Assume that a firm buys and sells gadgets; its several transactions during
the month of May of a given year (say 2020) under both systems are as given in
Figure 1.12. We have removed the reference columns from the general journal for
simplicity purposes and use the acronyms A/R for accounts receivable and A/P for
accounts payable.
Traditionally, firms selling small numbers of expensive items have used perpetual
inventory systems. Modern technology using bar-code scanning and computer data-
bases has enabled most merchandisers to adopt this system.
1.6. TRIAL BALANCE
In the ledger, the sum of all debit balances must always be equal to the sum of all
credit balances. Accountants periodically test this equality by preparing a trial bal-
ance. Figure 1.13 is an example of a trial balance.
A trial balance reveals that whether or not the ledger is in balance, that is, equal
debits and credits have been posted for all transactions in the ledger. When the sums
of debit and credit columns of the trial balance are not equal, one or more of the fol-
lowing common errors may have occurred:
• Error in summation.
• Error in computing the balance of one or more accounts.
• Error in carrying the account balance to the trial balance.
• Error in posting a debit as a credit, or vice versa.
• Error in permuting digits of recorded amounts.
Periodic Inventory System Perpetual Inventory System

General Journal General Journal
Date Description Dr. Cr. Date Description Dr. Cr.
2020 2020
May 3 Purchases 600 May 3 Inventory-Gadgets 600
A/P – XYZ 600 A/P - XYZ 600
Bought 6 gadgets @ $100 Bought 6 gadgets @ $100
(terms 5/10, n/30) (terms 5/10, n/30)
5 A/P - XYZ 100 5 A/P - XYZ 100
Purch. Returns & Allow. 100 Inventory-Gadgets 100
Return of 1 gadget to XYZ Return of 1 gadget to XYZ
9 A/R - ABC 450 9 A/R - ABC 450
Sales 450 Sales 450
Selling 3 Gadgets @ $150 Selling 3 Gadgets @ $150
11 A/P – XYZ 500 11 A/P – XYZ 500
Cash 475 Cash 475
Purchases Discount 25 Inventory – Gadgets 25
Paid for 5 gadgets to XYZ Paid for 5 gadgets to XYZ
11 Cost of Goods Sold 300
Inventory – Gadgets 300
Cost of 3 Gadgets @ $100
15 Sales Returns & Allowance 150 15 Sales Returns & Allowance 150
A/R – ABC 150 A/R – ABC 150
Return of 1 Gadget by ABC Return of 1 Gadget by ABC
15 Inventory – Gadgets 100
Cost of Goods Sold 100
Adding return to inventory
FIGURE 1.12 Comparing the general journal entries for purchases and sales transactions
using the periodic and perpetual inventory systems.
However, there is no way the trial balance can detect the following types of errors:
• A debit (or a credit) of an account being posted improperly in another

account.
• The omission of a transaction (not posted).
• An error of the same amount made in both debited and credited accounts.
1.7. CASH AND ACCRUAL BASES OF ACCOUNTING

Under the cash basis of accounting, expenses and revenues are accounted for when-
ever a cash payment is made or received, regardless of when the expenses accrued
or the revenues earned.
Under the accrual basis of accounting, expenses and revenues are accounted for
in the accounting period that they are realized regardless of when payment is made
or cash is received.
The accrual basis follows the “matching rule” of accounting. Under this rule,
revenues must be assigned to the accounting period in which the goods are sold or
the services rendered, and expenses must also be assigned to the accounting period
in which they are accrued.
XYZ Company
Trial Balance
As of July 31, 20XX
Account Dr. Cr.
Cash $1,250
Office Supplies 400
Prepaid Insurance 360
Accounts Payable $1,700
Notes Payable 1,000
Mr. XYZ, capital 19,300
Mr. XYZ, withdrawals 2,000
Fees Earned 8,000
Wages (Expense) 700
Utility Expense 100
Telephone Expense 50
Rent Expense 350
TOTAL $30,000 $30,000
FIGURE 1.13 An example of a trial balance.
1.8. DEPRECIATION OF LONG-LIVED ASSETS

A firm buys long-lived assets (such as automobiles, machinery, equipment, and
buildings) to use over a multiple number of years. Hence, the costs of such assets
should be allocated to the years of the estimated useful lives. The annual allocated
cost is called depreciation or depreciation cost/expense.
The main purpose of depreciation computation is to recover the capital invested
in an asset whose value is normally declined as a result of time and usage.
Since depreciation expenses are matched against revenues, they reduce the
income reported by the company and hence reduce income taxes. The cash pre-
served through tax reduction can, of course, be invested to earn more income in the
next accounting period.
The Accumulated Depreciation account is a contra-asset account on a company’s
accounting records and balance sheet with a credit balance. It appears on the balance
sheet as a reduction from the gross amount of the corresponding fixed asset. The
remainder of this subtraction is the book value of the asset.
1.9. COMPLETING AN ACCOUNTING PERIOD

An accounting period ends on a specific date. The income statement must con-
tain all revenues and expenses applicable to the period ended by this date, only.
The balance sheet must contain all assets, liabilities, and owner’s equity (on
company’s net worth) as of that date. For this purpose, accountants make adjust-
ing entries to update account balances. Then, they use closing entries to close
the accounting books and transfer the account balances to the books for the fol-
lowing fiscal year.
1.9.1. Adjusting Entries
Adjusting entries are made at the end of a fiscal period to the accounts for the trans-
actions that have not been recorded. Accountants record the adjusting in the general
journal and post them in the general ledger. The following are examples of items that
may require adjusting entries:
• Unrecorded revenues earned from services rendered but not yet collected or
billed to the customers.
• Unearned revenues that have been recorded as (earned) revenues.
• Accrued wages due to employees and the corresponding taxes that will be
paid in the following fiscal period.
• Interest expense paid on loans and the loan balance updates.
• Accrued interest expense.
• Prepaid insurance and insurance expenses to account for the expired por-
tions of prepaid insurance.
• Prepaid rent and rent expenses to account for the expired portions of pre-
paid rent.
• Supplies (inventory) and the supplies expense to account for the portions of
supplies (inventory) used.
• Appraised inventories on hand at the period end.
• Accrued interest and dividend income from bank accounts and investments
but not yet received.
• Depreciation expense and accumulated depreciation.
• Computed amount of bad debts and adjustment in accounts receivable.
• Accrued property taxes.
• Accrued income taxes.
• Updated net worth for net income or loss.
• Declared dividends (payable) due to stockholders.
After recording all adjusting entries in the general journal and posting them to
the general ledger, the account balances are determined, and an “adjusted trial
balance” is prepared. Using the account balances from the adjusted trial balance,
accountants prepare and report the financial statements.
1.9.2. Closing Entries
Accountants use an “income summary” account to summarize all revenues and
expenses, find the net income (or loss) and transfer the results to the Taxes Payable,
Dividends Payable, and Capital (Retained Earnings) accounts. All transfers are also
made by means of closing entries. Following are the required closing entries.
Required Closing Entries for a Single-Owner Company
• Transferring the balance of the revenue account to the Income Summary

account.
• Transferring the balances of all expense accounts to the Income Summary
account.
• Transferring the balance of the Income Summary account to the “Taxes
Payable” and “Capital” accounts.
• Transferring the balances of the Withdrawals account to the Capital account.
Required Closing Entries for a Corporation
• Transferring the balances of revenue accounts to the Income Summary

account.
• Transferring the balances of expense accounts to the Income Summary
account.
• Transferring the credit balance of the Income Summary account to the
“Taxes Payable,” “Dividends Payable” (if declared to be paid), and “Retained
Earnings” accounts. The Debit balance of Income Summary, which shows
a net loss, is transferred to the Retained Earnings account only (because
there is no profit to pay tax on or dividends to the stockholder from).
Example 1.3
Assume that at the end of year 20XX, a trial balance for McArden Dry Cleaning
was prepared as shown in Figure 1.14. The following information became avail-
able after the trial balance was prepared:
a) A study of insurance policies shows that $170 is unexpired at the end of

the year.
b) An inventory of cleaning supplies shows $414 on hand.
c) Estimated depreciation for the year was $4,300 on the building and
$1,300 on the delivery truck.
d) Accrued interest on the mortgage payable amounted to $500.
e) On November 1, 20XX, the company signed a contract with Morgan
County Hospital to dry clean, for a fixed monthly charge of $200, the
uniforms used by doctors in surgery. The hospital paid for four months in
advance.
McArden Dry Cleaning

Trial Balance
December 31, 20XX
Account Debit Credit
Cash $ 1,256
Cleaning Supplies 2,687
Land 9,000
Building 75,000
Accumulated Depreciation, Building $ 14,200
Delivery Truck 11,500
Accumulated Depreciation, Delivery Truck 2,600
Unearned Dry Cleaning Fees 800

Mortgage Payable 60,000
Ed McArden, Capital 23,642
Ed McArden, Withdrawals 12,000
Dry Cleaning Revenue 57,200
Laundry Revenue 18,650

Plant Wages 32,560
Sales and Delivery Wages 18,105
Cleaning Equipment Rent 3,000
Delivery Truck Expenses 2,187

Other Expenses 3,517
TOTAL $187,292 $187,292
FIGURE 1.14 A trial balance for Example 1.3.
f) Unrecorded plant wages totaled $982.

g) Sales and delivery wages are paid on Friday. The weekly wages are $350.
December 31, 20XX, was Thursday.
• Record the adjusting entries in a general journal format.
• Open T-accounts for each account in the trial balance plus the follow-
ing: Wages Payable; Accrued Interest; Insurance Expense; Cleaning
Supplies Expense; Depreciation Expense, Building; Depreciation

Expense, and Delivery Truck. Then, record the balances from the
trial balance in the T-accounts. Post all adjusting entries also to the
T-accounts.
• Prepare an adjusted trial balance.
• Prepare an income statement and balance sheet.
Solution
Adjusting entries are recorded in the general journal as shown in Figure 1.15. The
T-accounts and posting balances and adjusting entries into them are shown in
Figure 1.16. The adjusted trial balance is given in Figure 1.17. The income state-
ment and balance sheet are given in Figures 1.18 and 1.19, respectively.
General Journal Page ___914___

Post.
DATE DESCRIPTION Ref. Debit Credit
20XX
Dec. 31 Insurance Expense a 530
Prepaid Insurance a 530
(700 - 170 = 530)
Dec. 31 Cleaning Supplies Expense b 2,273

Cleaning Supplies b 2,273
(2687- 414 = 2,273)
Dec. 31 Depreciation--Building c 4,300

Depreciation--Truck c 1,300
Accumulated Dep.--Build. c 4,300
Accumulated Dep.--Truck c 1,300
Dec. 31 Interest Expense d 500

Accrued Interest d 500
Dec. 31 Unearned Dry Cleaning Fees e 400

Dry Cleaning Revenue e 400
($200 x 2 = $400)
Dec. 31 Plant Wages f 982

Wages Payable f 982
Dec. 31 Sale & Delivery Wages g 280

Wages Payable g 280
([$350/5] 4 = $280 wages
for last 6 days of Dec.)
FIGURE 1.15 Recording the end-of-year adjusting entries for Example 1.3.
Cash Accounts Receivable Prepaid Insurance Cleaning Supplies

1,256 10,280 700 530 (a) 2,687 2,273 (b)
170 414
Land Building Delivery Truck Accounts Payable

9,000 75,000 11,500 10,200
Sales & Del. Wages Accum. Depre.- Buid Accu. Depre.- Truck Unearned
18,105 14,200 2,600 Cleaning Fees
(g) 280 3,300 (c) 1,300 (c) (e) 400 800
18,385 18,500 3,900 400
Cleaning Supplies Exp. Dry Cleaning Revenue Mortgage Payable Capital, McArden
(b) 2,273 57,200 60,000 23,642
400 (e)
57,600
Withdrawals, McArden Laundry Revenue Plant Wages Cleaning

12,000 18,650 32,560 Equipment Rent
(f) 982 3,000
33,542
Delivery Truck Interest Expense Accrued Interest Wages Payable

Expenses 5,500 982 (f)
500 (d)
2,187 (d) 500 280 (g)
6,000 500
1,262
Insurance Expense Depre. Exp.-Build Depre. Exp.-Truck Insurance Expense
(a) 530 (c) 4,300 (c) 1,300 3,517
FIGURE 1.16 The T-accounts for Example 1.3.
1.10. TYPES OF ACCOUNTS
There are two major categories of accounts, which are listed below:
• Balance Sheet Accounts. These accounts (also called permanent

or real accounts) usually carry an initial balance from the previous
accounting period (or year), may increase or decrease during the current
period, and carry an ending balance to the next accounting period. They
include assets, liabilities, and capital accounts and are shown in the bal-
ance sheet.
• Nominal Accounts. This type of accounts includes all revenue- and
purchases-related accounts and expenses accounts, which are temporary
in nature. They begin each accounting period with a zero initial balance,
accumulate a balance during the period, and their end-of-period balances
are transferred to another temporary account, called Income Summary
account, by means of closing entries.

Adjusted Trial Balance
Account Debit Credit
Cash $ 1,256
Cleaning Supplies 414
Land 9,000
Building 75,000
Accumulated Depreciation, Building $ 18,500
Delivery Truck 11,500
Accumulated Depreciation, Del. Truck 3,900
Capital 23,642
Withdrawals 12,000
Dry Cleaning Revenue 57,600
Plant Wages 33,542
Delivery Truck Expense 2,187
Other Expenses 3,517
Wages Payable 1,262
Accrued Interest Payable 500
Insurance Expense 530
Cleaning Supplies Used 2,273
Depreciation Expense, Building 4,300
Depreciation Expense, Delivery Truck 1,300
Totals $194,654 $194,654
FIGURE 1.17 An adjusted trial balance for Example 1.3.
1.11. CLASSIFIED BALANCE SHEET AND INCOME STATEMENT

Balance sheets should be prepared in a classified fashion (Figure 1.20) to be informa-
tive and convenient for analysis. A common classification is presented as follows:
1.11.1. Division of a Balance Sheet

• Assets: A list of all resources owned by or owed to the company. The fol-
lowing are the three general classes of assets:

Income Statement
For the Period Ending December 31, 20XX
Revenues:
Dry Cleaning Revenue $57,600
Total Revenues $76,250
Plant Wages $33,542
Delivery Truck Expense 2,187
Insurance Expense 530
Cleaning Supplies Used 2,273
Depreciation Expense, Delivery Truck 1,300
Less: Other Expenses:
Interest Expense $6,000
Other Expenses _3,517
Total Other Expenses 9,517
Net Income (before-tax) $1,216
FIGURE 1.18 An income statement for Example 1.3. Notes: Since there is no information
regarding the tax rate, it is assumed that the net income (before-tax) is not taxable and hence
added to the capital as after-tax net income in the balance sheet.
• Current Assets: They are the company’s working capital that can be
converted into cash approximately within a year. They are listed in their
order of faster cashability and include Cash, Marketable Securities,
Accounts Receivable, Prepaid Expenses, Inventories, and Supplies.
• Fixed Assets: They are long-lived assets of the company. They include
Land, Buildings, Trucks, Automobiles, Plant, and Equipment.
• Intangible Assets: These assets do not physically exist. They include
Patent, Copyright, and Goodwill.
• Liabilities: A list of the company’s financial obligations. The following
are the two categories of liabilities:
• Current Liabilities: These are the company’s short-term financial obli-
gations that are due in the next accounting period. They include Accounts
Payable, Notes Payable (due within a year), Wages Payable, Interest
Payable, Accrued Expenses, Dividends Payable, and Taxes Payable.

Balance Sheet
ASSETS
Current Assets:
Cash $1,256
Cleaning Supplies ___414
Total Current Assets $12,120
Fixed Assets:
Land $9,000
Building $75,000
Less: Accum. Dep., Build. _18,500
Book Value of Building 56,500
Delivery Truck $11,500
Less: Accum. Dep., Truck __3,900
Book Value of Deliver Truck __7,600
Net Fixed Assets 73,100
TOTAL ASSETS $85,220
LIABILITIES
Current Liabilities:
Accounts Payable $10,200
Wages Payable 1,262
Accrued Interest Payable _ __500
Total Current Liabilities $12,362
Long-Term Liabilities:
Total Liabilities $72,362
OWNERS’ EQUITY
Capital--Beginning (1/1/20XX) $23,642
Add: Net Income (after-tax) $ 1,216
Less: Withdrawals _12,000
Excess of Withdrawals over Net Income (10,784)
Owner's Equity: Capital—Ending (12/31/20XX) 12,858
TOTAL LIABILITIES AND OWNER'S EQUITY $85,220
FIGURE 1.19 A balance sheet for Example 1.3.
• Long-Term Liabilities: These are the company’s long-term financial

obligations with a maturity date longer than a year. They include Notes
Payable (due longer than one year), Mortgages Payable, and Bonds Payable.
• Net Worth: The interests of the owners in the company, which is also
called the owner’s (or stockholders’) equity. They include Preferred
Stock, Common Stock, and Retained Earnings.
McAlter Corporation
Balance Sheet
December 31, 20XX
ASSETS
Current Assets:
Cash $36,758
Marketable Securities 28,500
Inventories 153,500
Supplies 1,750
Total Current Assets $285,950
Fixed Assets:
Land $87,500
Building $684,000
Less: Accumulated Depreciation 91,200
Book Value of Building 592,800
Equipment $849,000
Less: Accumulated Depreciation 195,800
Book Value of Equipment 653,200
Total Fixed Assets 1,333,500
Intangible Assets:
Patents 120,000
TOTAL ASSETS (NET) $1,739,450
LIABILITIES
Current Liabilities:
Accounts Payable $ 65,950
Wages Payable 3,250
Interest Payable 3,750
Dividends Payable 10,500
Taxes Payable 18,675
Total Current Liabilities $ 102,125
Long-Term Liabilities:
Notes Payable (due more than 1 year) $ 56,000
First Mortgage Bonds (8%) 181,000
Total Long-Term Liabilities 237,000
Total Liabilities $ 339,125
NET WORTH
Preferred Stocks $350,000
Common Stocks (par value $20) 962,500
Retained Earnings 87,825
NET WORTH (Owner's Equity) 1,400,325
TOTAL LIABILITIES AND NET WORTH $1,739,450
FIGURE 1.20 An example of a classified balance sheet.

1.11.2. Formatted Income Statement

Figure 1.21 shows the common format of an income statement:
• Sales Revenues: The amounts received through sales of goods or services

during a given fiscal period.
• Cost of Goods Sold: The net manufacturing cost of the product produced
and sold by a company during a given fiscal period.
• Gross Margin: The difference in revenues and cost of goods sold.
• Operating Expenses: All expenses related to the company’s normal opera-
tion incurred during the preceding accounting period.
• Operating Income: The amount of profit realized from a business’s opera-
tions, after deducting operating expenses (i.e., cost of goods sold, selling
and administrative expenses, and depreciation). It is equal to gross margin
minus operating expenses.
• Nonoperating Income: The revenues received from sources other than
sales of products or services, which include the interests and dividends
earned from its investments, rent received through leasing its properties,
and capital gains on selling assets.
McAlter Corporation
Income Statement
For the Year Ended December 31, l9XX
Revenues (Sales) $1,747,500

Cost of Goods Sold 1,015,000
Gross Profit (from sales) $ 782,500
Selling Expenses $99,500
Administrative Expenses 122,000
Other expenses (miscellaneous) 42,480
Other Income and Nonoperating Expenses:
Add: Interest Revenue $ 4,200
Less: Interest Expense 36,620
Less: Excess Expense over Income 32,420
Income Before Taxes $486,100
Federal Income Taxes (50%) 243,050
Net Income (after-tax) $243,050
FIGURE 1.21 An example of an income statement.

• Nonoperating Expenses: The expenses not related to the company’s nor-

mal operation (e.g., interest expense).
SUMMARY
The accounting system maintains accurate and timely records of the daily financial
transactions of a business. It compiles the transactions and prepares various impor-
tant financial statements such as the income statement, owners’ equity statement,
balance sheet, and cash flow statement. Decision-makers utilize the financial state-
ments for managerial and economic decisions.
REFERENCE
Committee on Accounting Terminology: Accounting Terminology, Bulletin No. 2., American
Institute of Certified PublicAccountants, p. 9, New York, 1953.
REVIEW QUESTIONS AND ANSWERS

1.1.
R What are revenues?
R1.2. What are an earned income and unearned income?
R1.3. What are operating and nonoperating revenues?
R1.4. What are prepaid expenses? Describe how accountants record and report
them in accounting records.
R1.5. What is the difference between the operating income and the net income
items?
R1.6. What are the items normally reported as current liabilities?
R1.7. What is the formula for the cost of goods sold?
R1.8. What is the cost of goods sold for merchandising and manufacturing
firms?
1.9. What is inventory?
R
PROBLEMS
P1.1. The following is the list of transactions for the John Smith Advertising
Company during the first two weeks of February, 20XX:
1) 2/01 John Smith invested $25,000 in his advertising company.

2) 2/02 Leased an office and paid $2,000 for two months’ rent in advance.
3) 2/02 Purchased some art equipment from Zoran Art Supplies on credit, $6,000.
4) 2/02 Hired an office assistant and agreed to pay her $500 every two weeks.
5) 2/03 Paid $300 cash for some office supplies.
6) 2/03 Paid $650 for a one-year insurance policy.
7) 2/04 Paid Zoran Art Supplies $1,000 of the amount owed.
8) 2/05 Performed an advertising service for a local store and delivered a fee invoice of
$900 to the store. The store manager agreed to pay the invoice in two weeks.
9) 2/06 Received $500 in advance to perform an advertising service for a local car
dealer by placing advertisements in the newspaper.
10) 2/12 John Smith withdrew $300 from the business for personal spending.
11) 2/13 Completed the service for the car dealer and sent them an invoice of $700 due
after deducting the $500 advance receipt on 2/06 (Transaction #9).
12) 2/14 Paid the office assistant two weeks’ salary, $500.
Required
a) Record the transactions in the company’s general journal.
b) Open and name appropriate T-accounts and post the entries to
them.
P1.2. The Bunyon Consulting Company is owned by William Woody. The fol-
lowing alphabetical list shows the account balances for the company as
of June 30, 20XX:
Accounts Receivable $206,281

Accumulated Depreciation, Building 171,200
Accumulated Depreciation, Equipment 162,702
Building 856,000
Cash 350,150
Depreciation Expense, Equipment 40,675
Equipment 406,750
Land 222,000
Marketable Securities 256,734
Revenues 765,435
Salary Expense 210,653
Supplies 12,789
Supplies Expense 8,662
Utilities Expense 3,238
William Woody, Capital 892,940
William Woody, Withdrawals ?
Note: The “?” mark is a missing item to be determined.
Required
a) Prepare a trial balance for the Bunyon Consulting Company
with the proper heading. Indicate the correct amount of William
Woody, Withdrawals balance in the trial balance.
b) Prepare an “Income Statement” for the 6-month period ending
June 30, 2005, for the company. Assume a 40% tax rate on the
company’s net income.
P1.3. At the end of the year 20XX, the trial balance for TBT Company, owned
by Mr Ken Ram, appeared as follows:
TBT Company
Trial Balance
December 31, 20XX
Account Dr. Cr.

Cash $21,742
Prepaid Insurance 1,200
Office Supplies 7,022
Building 60,000
Accumulated Depreciation, Building $4,000
Equipment 25,000
Ken Ram, Capital 35,000
Ken Ram, Withdrawals 36,900
Revenue 250,000
Telephone Expense 450
Wages (Expense) 90,575
Utilities Expense 12,325
Total $331,200 $331,200
The following information was also available:

1) Supplies on hand, on December 31, 20XX, were $2,232.
2) Insurance still unexpired amounted to $450.
3) Estimated depreciation of equipment was $1,000.
4) Estimated depreciation of building was $2,000.
5) A telephone bill has been received on December 31 showing $100
telephone usage during December but has not been recorded yet.
Required

a) Record the necessary adjusting entries.
b) Open T-accounts for the accounts given in the trial balance plus
the following: Office Supplies Expense; Insurance Expense;
Depreciation Expense, Equipment; Depreciation Expense, Building.
Record the balances shown in the trial balance in the T-accounts.
c) Post the adjusting entries to the T-accounts.
d) Prepare an adjusted trial balance.
e) Prepare an income statement (assume an income tax rate of 40%).
f) Prepare a balance sheet.
P1.4. The following accounting information at the end of year 20XX is avail-
able for Satoosh Corporation:
Account Balance
Cash $125,500
Common Stocks Outstanding 90,000
Retained Earning 30,000
Equipment 125,000
Building 135,000
Prepaid Insurance 1,200
Office Supplies Used (Expense) 7,000
Revenue 400,000
Selling and Administrative Expenses 232,800
Power and Utilities Expense 38,500
Depreciation Expense, Equipment 12,500
Assume that all end-of-year adjusting entries have already been recorded;
that is, the accounts listed above do not need any adjustment.
Required
a) Prepare an income statement (assume income tax rate of 40%).
b) Prepare a classified balance sheet.
P1.5. Three construction engineers established TADJ Construction
Corporation in early 20XX. The company had completed the following
transactions in the month of February 20XX:
Feb. 1. The founders contributed the following assets to the company
and received 2,000 shares of preferred stocks of $100 par value:
Cash $30,000
Land 150,000
Feb. 2. A total of 80,000 shares of common stocks of $10 par value
were issued and sold.
Feb. 4. A building was purchased for $500,000, of which $50,000 was
paid as down payment and the rest was by a 12% mortgage.
Feb. 5. Paid $24,000 for an insurance policy for the next 12 months.
Feb. 6. Paid $1,000 for advertisement announcing the establishing of

the company and its grand opening.
Feb. 7. Purchased construction equipment costing $500,000. Paid
$50,000 cash and a note was issued for the balance.
Feb. 10. Received a bill of commissions charged by the broker who sold
the stocks, $16,000.
The following accounts are established by the company’s accountants:
Cash, Prepaid Insurance, Land, Building, Office Equipment, Construction
Equipment, Accounts Payable, Notes Payable, Mortgages, Common Stocks,
Preferred Stocks, Advertising Expense, Commission Expense.
Required
a) Prepare journal entries to record the above transactions in the gen-
eral journal.
b) Post the entries of part (a) to the related T-accounts.
P1.6. The following trial balance was available for Roofing Company at the
end of the year 20XX.
Roofing Company
Trial Balance
Account Dr. Cr.
Cash $160,000
Inventories 250,000
Equipment 300,000
Accumulated Depreciation, Equipment $60,000
Building 500,000
Common Stocks 300,000
Retained Earnings 150,000
Revenue (Sales) 930,000
Selling Expenses 140,000
Totals $2,140,000 $2,140,000
Required
a) Prepare an income statement (assuming 50% tax rate).
b) Prepare a classified balance sheet (assume that the company declares
40% of net income as dividends).
APPENDIX 1.A
A Chart of Accounts Sample
Typical accounts found in the chart of accounts are (code numbers are suggested by
the author):
No. Account Name Type of Accounts

1XX ASSETS
11X Current Assets:
111 Cash (checking account) Current Asset
112 Petty Cash Current Asset
113 Marketable Securities Current Asset
114 Accounts Receivable Current Asset
115 Allowance for Doubtful Accounts Current Asset (contra)
106 Prepaid Expenses Current Asset
107 Inventory Current Asset
12X Fixed Assets:
121 Land Fixed Asset
122 Building Fixed Asset
123 Accumulated Depreciation – Building Fixed Asset (contra)
124 Equipment Fixed Asset
125 Accumulated Depreciation – Equipment Fixed Asset (contra)
126 Machineries Fixed Asset
127 Accumulated Depreciation – Machineries Fixed Asset (contra)
13X Intangible Assets:
131 Patents Intangible Asset
131 Copyrights Intangible Asset
132 Goodwill Intangible Asset
2XX LIABILITIES
21X Current Liabilities:
211 Accounts Payable Current Liabilities
212 Mortgage Payable (due within a year) Current Liabilities
213 Bonds Payable (due within a year) Current Liabilities
214 Unearned Income Current Liabilities
215 Accrued Expenses Current Liabilities
216 Wages Payable Current Liabilities
217 Taxes Payable Current Liabilities
218 Dividends Payable Current Liabilities
22X Long-Term Liabilities:
221 Notes Payable (due longer than a year) Long-Term Liabilities
222 Mortgage (due longer than a year) Long-Term Liabilities
223 Pension Liabilities Long-Term Liabilities
3XX STOCKHOLDERS’ EQUITY
311 Common Stock Net Worth
No. Account Name Type of Accounts

312 Preferred Stock Net Worth
313 Retained Earnings Net Worth
4XX REVENUES
411 Revenue (or Sales) Revenue
412 Sales Returns and Allowances Revenue (contra)
413 Sales Discounts Revenue (contra)
421 Service Revenues Revenue
422 Fees Earned Revenue
414 Sales Taxes Revenue (contra)
431 Interest Income Revenue
5XX PURCHASES & EXPENSES
501 Purchases Purchase
502 Purchases Returns and Allowances Purchases (contra)
503 Purchases Discounts Purchases (contra)
51X Cost of Sales:
511 Cost of Goods Sold (or Cost of Sales) Expense
52X Selling Expenses:
521 Advertising and Promotions Expenses Expense
522 Sales Salaries and Wages Expense
523 Sales Force Payroll Taxes Expense
524 Delivery Expense (Freight-Out) Expense
525 Cleaning Expense – Sales Department Expense
526 Depreciation Expenses – Sales Building Expense
527 Accumulated Depreciation– Sales Building Expense (contra)
528 Depreciation Expenses – Sales Vehicles Expense
529 Accumulated Depreciation– Sales Vehicles Expense (contra)
53X-55X Administrative Expenses:
531 Administrative Salaries Expense Expense
532 Administrative Other Compensations Expense
533 Administrative Payroll Taxes Expense
541 Insurance Expense – Administrative Building Expense
542 Maintenance Expense – Headquarter Expense
543 Repair Expense – Headquarter Expense
544 Supplies Expense – Headquarter Expense
545 Utilities Expense – Headquarter Expense
546 Depreciation Expense – Admin. Building Expense
547 Accumulated Depreciation – Admin. Building Expense (contra)
548 Depreciation Expenses – Admin. Vehicles Expense
549 Accumulated Depreciation – Admin. Vehicles Expense (contra)
551 Sundry (Other) Expenses Expense
56X Nonoperating Expenses:
561 Bank Fees Expense (nonoperating)
562 Interest Expense Expense (nonoperating)
591 Income Tax Expense Expense
2 Cost Analysis
Fundamentals
LEARNING OBJECTIVES
• Learn the manufacturing costs.
• Define and distinguish among various types of costs.
• Learn basic cost formulation.
• Compute manufacturing unit cost.
• Compute average, marginal, incremental, and total costs.
2.1. INTRODUCTION
Costs are the necessary expenditures that a business must spend to produce products
or provide services. Every factor of production has its associated costs, such as mate-
rial, labor, and overhead costs.
To remain competitive in a market, the management needs to know whether or
not certain products yield satisfactory profits. A product can successfully capture the
market if its “price is right!” Therefore, knowledge of the unit cost of each product
is necessary for setting its sales price. Higher manufacturing costs are recovered by
setting higher sales prices. However, market price–demand relation imposes a ceil-
ing on the sales price.
Deciding a sales price for a product is a critical managerial function. Before
deciding on the price tag of a product, it becomes essential to obtain a close (ideally,
exact) cost assessment of it. There are two types of inadequate product costing with
undesirable economic consequences. On the one hand, if the unit cost of a product
is over-estimated, there is a risk of over-pricing the product, which makes it highly
likely to lose part or all of its market share to the competitors. On the other hand, if
the unit cost of the product is under-estimated, there is a high chance of setting its
sales price high enough that may result in losses.
Product costing and price-setting decisions are particularly complex for manufac-
turers who produce multiple products. For such manufacturers, information concern-
ing product costing (i.e., assigning manufacturing costs) for each product becomes
the key factor for successful marketing. This chapter presents the fundamental con-
cepts and procedures of cost analysis. The techniques for cost allocation to multiple
products will be presented in Chapter 5, “Joint Cost Allocation.”
DOI: 10.1201/9780429432163-2 35
2.2. COSTS AND EXPENSES

Costs are expenditures for acquiring assets, while expenses refer to the consumption
of the items acquired. A cost would become an expense if it has expired or was nec-
essary to exchange to earn revenues and no longer belongs to the firm.
An example of costs is a firm’s property insurance premium paid for the next 12
months of insurance. This advance payment is initially recorded as the current asset
(in an account titled Prepaid Insurance, or Prepaid Expenses) since the cost has not
been used up (has not expired) if the firm cancels the insurance, it can get a refund
for the unused (unexpired) part of insurance. Otherwise, as time goes by, the firm
reduces this cost (asset value) and converts it to insurance expense. Another example
of costs is the manufacturing costs that a firm incurs for producing its products.
These costs remain as current assets in the firm (as Materials, Work-In-Process, and
Finished Goods Inventories). When the firm sells its manufactured items, it converts
the Finished Goods Inventory into an expense as “Cost of Goods Sold” or “Cost of
Sales.”
2.3. PRODUCT COSTING
Product or production costs refer to the costs that are incurred for manufacturing
a product or providing a service. Manufacturing costs of a product include costs of
direct labor, indirect labor (e.g., supervisory, human resources staff, maintenance,
warehousing, security, and custodial services), direct (or raw) materials, indirect
materials (consumable manufacturing supplies), and general factory overheads (e.g.,
rent, insurance, and property taxes). Costs of freight-in (shipping and handling for
receiving materials) are added to the cost of materials, whereas costs freight-out
(i.e., for delivering the product) to a customer are usually treated as periodic sales
expenses.
Whenever the sales price of a product falls below its production cost, produc-
ers should try cost cutting if possible. Otherwise, they may have to lower or even
shut down the production, temporarily or permanently. For example, the average
price of oil was over $90 per barrel during 2011–14; it fluctuated between in the
range of $30 and $75 during 2014–19. It collapsed (to around $12 per barrel)
in April 2020 due to the COVID-19 pandemic effect on economic slowdown
and demand for oil. The Organization of Petroleum Exporting Countries (OPEC)
agreed to historic production reduction to stabilize prices. If the production cost
of oil is over $20 per barrel, then the producers face significant negative cash
flows (losses).
The product cost is often referred to as “inventoriable cost.” Companies record the
costs of their unsold products as assets (Finished Goods Inventory) on their account-
ing records and report them on the balance sheet. When they sell their products,
they record the costs of units sold as an expense (Cost of Goods Sold) and deduct
the costs from their sales revenues to determine and report their profits (losses) on
the income statement.
Cost Analysis Fundamentals 37
2.4. CLASSIFICATION OF COSTS
An engineering economic and cost analysis deals with various types of costs. To be
able to perform such analysis, it is necessary to understand cost terminologies and
classifications. This section presents various types of costs, based on their uses or
purposes, with a brief description of each.
2.4.1. Classification of Costs by Behavior

The manufacturing (direct and indirect) cost is the total cost of all resources con-
sumed in the process of making the product or providing the service. Cost behavior
refers to the relationship between total costs and activity level. Based on the behavior,
there are three categories of costs: fixed, variable, or semi-variable (or semi-fixed)
costs. The fixed are further subcategorized based on flexibility and controllability. A
summary of these classifications is as follows:
• Variable costs
• Fixed costs
• Classification of fixed cost by flexibility
– Committed fixed costs.
– Discretionary fixed costs.
• Classification of fixed cost by controllability
– Avoidable (evitable or controllable) fixed costs.
– Unavoidable (inevitable or uncontrollable) fixed costs.
• Semi-variable (semi-fixed) costs
• Mixed (variable and fixed) costs.
• Step-variable fixed costs.
Variable Costs: A variable cost (in total amount) varies in direct propor-
tion to the changes in the level of activity (i.e., number of units produced
or amount of service provided). When more units of a product are pro-
duced (or an activity level increases), the total variable cost increases
by a multiplier. The costs of direct materials and labor are usually vari-
able because they change in direct proportion to the production output.
However, the variable cost per unit remains constant regardless of the
production quantity. The total variable cost is the product of the vari-
able cost per unit and the number of units produced, as expressed by the
following formula and illustrated in Figure 2.1:
TVC = f ( Q ) = V ·Q (2.1)
where
TVC = Total variable cost;
V = Unit variable cost (dollars per unit);
Q = Output level (quantity or volume);
f(Q) = A function of Q.
f(Q), $
Cost
Q
Output Level
FIGURE 2.1 An illustration of the total variable cost as a function of output level.
Examples of variable costs include direct (raw) materials, direct labor,

packaging costs, royalties, and commission as a percentage of the price.
Fixed Costs: A fixed cost (in total amount) remains constant regardless of
the change in the level of production output, within the relevant range.
Relevant range is the volume of output, over which cost behavior stays
valid. However, the fixed cost per unit varies with the number of units;
that is, as the level of activity increases, its fixed cost per unit decreases,
as the fixed cost per unit (FPU) equals the total fixed cost (F) divided
by the number of units produced (Q), as expressed by the following
formula, and graphically illustrated in Figure 2.2.
FPU = F /Q (2.2)
Examples of fixed costs include supervisory salaries, advertising, cost

of hazard insurance, warehouse, depreciation on equipment, rent and
property taxes, maintenance services, human resources, first-aid and
medical services, and safety and security regardless of the level of
activities.
Semi-Variable Costs: Semi-variable costs (or semi-fixed) are combinations
of fixed and variable costs. These costs vary (change) with output but
not in direct proportion. The fixed cost element is the part of the cost
that is incurred regardless of output or activity level. The variable com-
ponent of the cost varies in proportion to the level of output or activity.
For this reason, these costs are also called mixed costs.
$
Revenue / Cost
Fixed Costs (FC)
Q
Output Level
FIGURE 2.2 An illustration of the relationship between fixed costs and output level.
Common examples of semi-variable costs are utility and phone bills.

For example, most bills for water, gas, and electricity will consist of a
fixed subscription charge and a variable charge, which varies with the
usage. Telephone bills, also, may contain a fixed line charge and call
charges vary with the number of calls, the distance of the call, and the
time duration. Figure 2.3 illustrates the behavior of mixed costs.
There are, also, cases in which the cost is step-fixed; that is, the cost
does not change within certain ranges of activity, but it will change
when the activity falls out of each range. In other words, the step-fixed
costs vary step-wise, as illustrated in Figure 2.4.
Total Costs: Total cost of a product or service is the sum of all variable
costs, fixed costs, and semi-variable (mixed) costs for its given output
level. However, the total cost is usually the sum of total fixed costs and
total variable costs, as expressed in the following formula and graphi-
cally illustrated in Figure 2.5.
TC = V × Q + F (2.3)
where
TC = Total cost (may be designated by C);
V·Q = Total variable cost (may be designated by VC);
V = Unit variable cost (dollars per unit);
Q = Output level (quantity or volume);
F = Total fixed cost (may be designated by TF).
To develop a cost equation, a company must first determine the amount

of expense associated with producing and selling each of its products.
FIGURE 2.3 An illustration of a mixed cost as a function of output level.
$
Step Fixed Costs
Revenue / Cost
Q
Output Level
FIGURE 2.4 An illustration of the step-fixed cost as a function of output level.

$ TC
VC
Revenue / Cost FC
Q
Output Level
FIGURE 2.5 A graphical illustration of the fixed (FC), variable (VC), and total costs (TC)
against output level.
It must also determine the overhead costs associated with production.

The cost equation is typically the cost of manufacturing and selling one
item multiplied by the number of items sold and added to the company’s
overhead costs. For example, a company with $300,000 in overhead
costs that makes products that cost the company $5 each to manufac-
ture and sell has a cost equation of 300,000 + (5 × number of products
sold).
The fixed costs are further subcategorized by “flexibility” and by
“controllability” as described in the following subsections.
2.4.1.1. Classification of Fixed Costs by Flexibility

• Committed Fixed Costs: The expenditures that an organization has
already made and cannot change them, and the financial obligations that
the firm has already committed to and cannot get out of them (e.g., the lease
of equipment or a building).
• Discretionary Fixed Costs: The expenditures for a specific period that
the management can eliminate or reduce without having any immediate or
serious impacts on the business operations. Examples of discretionary fixed
costs are the costs of advertising, employee training, public relations, and
research and development.
2.4.1.2. Classification of Fixed Costs by Controllability

• Avoidable (Controllable) Fixed Costs: A decision-maker’s action can
influence a controllable (or avoidable) fixed cost. For example, the fixed
costs that are directly associated with the operation of a product line or
department can be eliminated or reduced if the production line is shut down.
• Unavoidable (Uncontrollable) Fixed Costs: Unavoidable costs are
unchangeable fixed costs. They are the general overhead costs that are allo-
cated to product lines and operating departments. For example, the general
factory fixed costs would not change if a firm terminates a product line or
department.
2.4.2. Classification of Costs by Traceability

Cost traceability refers to whether costs can conveniently and economically trace-
able to specific products or departments. Based on traceability, there are two catego-
ries of costs, direct and indirect.
Direct Costs: A direct cost is any cost that is conveniently and economically
traceable to a specific product manufactured or a service provided. The
direct costs are more of concern for a firm that produces various types of
products. Examples of this type of cost are direct materials and direct labor,
which usually vary in proportion with the output level. Thus, direct costs
are also variable costs.
Indirect Costs: An indirect cost is any cost that is not directly related (or
conveniently and economically traceable) to any specific product or depart-
ment. They are the general costs incurred to support all production lines or
operation departments but not directly for any specific product or depart-
ment. This type of costs includes all the overhead costs that are allocated to
all products or operation departments.
For example, assume that a furniture manufacturer makes chairs and tables. The
chairs produced use a certain type of wood, but the tables use another type of wood.
In such a case, the types of wood would be direct costs, because each type of wood
is directly related to a particular product. The wages paid to workers who work on
both types of products, the depreciation, and the cost of power used to run machinery
are indirect.
Prime Costs and Conversion Costs
A firm’s management may need to make decisions based on the costs categorized
as prime costs or conversion costs (Figure 2.6).
• Prime Cost: The prime cost is the sum of direct material costs, direct labor
costs, and all other direct costs. A firm should calculate the prime cost for
each of the product it manufactures to ensure they generate profit.
Total Manufacturing Costs, TC

Prime Costs, PC Conversion Costs, CC
Direct Direct
Overheads,
Material Labor
OHC
Cost, DMC Costs, DLC
FIGURE 2.6 Prime costs and conversion costs. Prime costs and conversion costs do not
sum up to total costs as direct labor is included in both.
• Conversion Cost: The conversion cost is the sum of direct labor and fac-
tory overhead costs. A firm incurs this cost to convert the raw materials into
finished products.
Note that the total manufacturing cost (TC) equals direct material cost (DMC) plus
direct labor cost (DLC) plus overhead cost (OHC); then,
Prime Costs ( PC ) = DMC + DLC (2.4)
Conversion Costs ( CC ) = DLC + OHC (2.5)
Total Cost ( TC ) = DMC + DLC + OHC (2.6)
Total Cost ( TC ) = PC + OHC (2.7)
Total Cost ( TC ) = DMC + CC (2.8)
Example 2.1 (Manufacturing prime, conversion, and total costs)
A firm incurred the following costs in a year to manufacture 500,000 units of its
single product:
Direct material costs: $1,250,000

Direct wages for workers: $300,000
Overheads (rent and general expenses): $850,000
Compute the prime, conversion, and total costs using equations (2.4) through (2.8)
as they may apply.
Solution
Prime Cost (PC ) = DMC + DLC = 1, 250, 000 + 300, 000 = $1, 550, 000
Conversion Cost ( CC ) = DLC + OHC = 300, 000 + 8500, 000 = $1150

, , 000
Total Cost ( TC ) = DMC + DLC + OHC = 1, 250, 000 + 300, 000 + 850, 000

= $2, 400, 000
Total Cost ( TC ) = PC + OHC = 1, 550, 000 + 850, 000 = $2, 400, 000
Total Cost ( TC ) = DMC + CC = 1, 250, 000 + 1150

, , 000 = $2, 400, 000
2.4.3. Cost Classification by Decision-Making

There are various types of costs that are useful for business decision-making. They
include the average cost per unit (or unit cost), marginal costs, incremental costs,
opportunity costs, and sunk costs.
Average (Unit) Cost: An average cost (or unit cost) is the cost of each unit of a
product, which equals the total cost of the product divided by the number of units
produced. The following formula gives the average cost:
Total Cost
Average (Unit) Cost = (2.9)
Total Number of Units Produced
or
V ×Q + F F
AC = = V + (2.10)
Q Q
where
Q = Production quantity (units);
F = Total fixed cost;
V = Variable cost per unit;
VQ = Total variable cost;
AC = Average cost (or unit cost, UC).
However, this is only possible if the manufacturer produces just one type of prod-
uct. If it produces a number of different products, it would be necessary to allocate
the material, labor, and overhead costs appropriately to products to arrive at the total
cost for each.
Example 2.2 (Unit cost)
single product:

Direct wages for workers: $300,000
The firm’s total product cost (TC) is:
TC = $1, 250, 000 + $300, 000 + $850, 000 = $2, 400, 000
The product unit cost (UC) is:
UC = $2,400,000 500,000 units = $4.80 per unit

The unit cost is a basis for measuring profitability. For example, if the unit cost,
including fixed and variable expenses, as in the previous example, is $4.80 per unit
and the firm sells the product at $6.10 per unit, it generates a profit of $1.30 for each
unit sold. A selling price of $4.00 creates a $0.80 loss per unit sold. However, this
analysis does not necessarily capture all market activities. For instance, there may be
additional costs due to sales returns shipping and disposals.
Marginal Cost: A marginal cost is an additional cost associated with producing
an additional unit of the product or activity. The marginal cost equals the variable
cost per unit if the production is within the relevant range. The marginal labor cost
is the amount of time taken to produce an additional unit of the product multiplied
by the time rate of labor cost.
Example 2.3 (Marginal cost)
single product:

Direct labor cost: $300,000
The firm’s marginal cost (MC) is:
MC = ($1, 250, 000 + $300, 000 ) 500, 000 = $3.10
Incremental Cost: An incremental cost (also known as a differential cost) is the

change in total costs due to a change in a business activity or switching from one
system (alternative) to another with a higher cost. One can determine the incremen-
tal cost by finding the additional costs involved in producing an additional unit of
a product or adding another staff or machine, or adding a second shift. The change
in the revenues of two alternatives is termed incremental revenue. Reviewing the
incremental costs can help companies improve their operations’ efficiency and prof-
itability. The following is the formula for computing the incremental cost per unit:
Change in Total Cost

Incremental Cost per Unit = (2.11)
Number of Additional Units Produced
An incremental/differential cost analysis is conducted when making decisions such

as: make or buy an item, change in the level of activity (product produced or service
provided), add or eliminate a product line or department, change in product mix, and
marketing goods in a new market. In an analysis, the analyst only considers variable
costs as the “relevant costs.” Fixed costs and sunk costs, which would not change
by a new action, are “irrelevant costs.” Future costs, which are mainly variable, are
relevant to consider. The use of differential costs is only for making management
decisions and has no accounting recordings.
Example 2.4 (Incremental cost)
Consider a machine shop that manufactures a certain product. The total fixed
cost is $300 per day, which does not change regardless of the number of employ-
ees or the level of production. The total variable cost varies by the rate of $100
per employee per day, which in total is equal to the number of employees hired
multiplied by this wage rate. For example, if three employees are hired, then the
total variable cost equals 3 × $100 = $300. The number of units (quantity) of the
product produced corresponding to the number of employees (labor) is as follows.
Labor Quantity
1 20
2 45
3 65
4 80
5 88
6 93
7 93
Determine the total cost, unit cost, and incremental cost per unit corresponding to
the number of employees hired.
Solution
Table 2.1 shows the solution in column 5 (total cost), in column 6 (unit cost), and
in column 7 (incremental cost per unit).
• The total cost (column 5) is the sum of the fixed cost (column 3) and the
total variable cost (column 4). For example, with four employees, the
output will be 80 units and the total cost is $300 + $400 = $700.
TABLE 2.1
Output and Total Costs Summary
(1) (2) (3) (4) (5) (6) (7)
Production Fixed Variable Total Unit Incremental
Labor Quantity Cost Cost Cost Cost Cost/Unit
0 0 $300 $0 $300 — —
1 20 300 100 400 $20.00 $5.00
2 45 300 200 500 11.11 4.00
3 65 300 300 600 9.23 5.00
4 80 300 400 700 8.75 6.67
5 88 300 500 800 9.09 12.50
6 93 300 600 900 9.68 20.00
7 93 300 700 1,000 10.75 ∞
• The unit cost or average cost (column 6) is equal to the total cost (in col-
umn 5) divided by the output quantity (column 2). For instance, with four
employees, for which the output is 80 units and the total cost is $700,
the unit cost is $700/80 = $8.75 (rounded to the nearest cents).
• The incremental cost per unit (column 7) for each increment in produc-
tion equals the change in the total cost divided by the change in the
output quantity. For instance, with four employees, the change in the
total cost is $700 − $600 = $100, the change in the output quantity
is 80 – 65 = 15 units, and the incremental cost per unit is $100/15 =
$6.67.
Figure 2.7 graphically illustrates how output affects the total cost. At zero (no)
production, the total fixed cost is still $300. The fixed cost is the vertical axis inter-
cept of the total cost curve. The graph shows that as production is increased, the
variable costs (in total) and, consequently, the total cost would also increase.
Figure 2.8 illustrates the relationship between the output and the unit cost, and
the incremental cost per unit. As production increases, unit cost decreases from an
output level of 20 to 80 units; then it is gradually rising. This explains why the total
cost increases at a decreasing rate up to an output level of 80 units and then increases
at an increasing rate. This is due to the fact that the unit cost is the rate of change in
the total cost.
The increase in the unit cost is caused by the economic law of diminishing
returns (or the principle of diminishing marginal productivity), which states as an
input for producing a commodity increases, while all other inputs are held fixed,
at some point at which addition of that input generates progressively smaller, or
diminishing, increases in output (Encyclopædia Britannica, 2020). As the num-
ber of employees increases from zero to one, output increases from 0 to 20 units
for a marginal gain of 20 units; as the number rises from one to two employees,
output increases from 20 to 45, a marginal gain of 25 units in the output. Beyond
$1,200
$1,000
$800
Total Cost
$600
$400
$200
$0
0 20 40 60 80 100
Production Quantity
FIGURE 2.7 An illustration of how output changes affect the total cost for Example 2.4.
$25 Unit Cost

Incremental Cost/Unit
$20
Cost per Unit

$15
$10
$5
$0
10 20 30 40 50 60 70 80 90 100
Production Quantity
FIGURE 2.8 Relationship between the output and the unit (average) cost, and the incremen-
tal unit cost for Example 2.4.
that point, the marginal gain in output diminishes as each additional employee is
hired.
The reason for the incremental cost per unit becomes lower than the current unit
cost is the fixed costs may remain unchanged or minimally increase. Although the
fixed costs may increase as production increases, the cost per unit declines if the
company uses the current facilities and does not have to acquire additional equip-
ment or facilities.
Opportunity Costs: An opportunity cost (or historical cost) is the profit lost
when choosing an alternative instead of another. The concept is useful sim-
ply as a reminder to evaluate and compare all feasible alternatives before
making the final decision. For example, a firm invests $1,000,000 and opens
a new line of product that will have an annual return of 8%, or $80,000. If
the firm could invest the fund in the expansion of its current product that
would have generated an additional annual profit of $95,000, or a return of
9.5%, then the 1.5%, or $15,000, difference between the two alternatives is
the foregone opportunity cost of the decision made.
Sunk Costs: A sunk cost is a cost that a firm incurred in the past, which it
cannot recover. Sunk costs should not be considered when making the deci-
sion about investing in a new project, since the sunk costs are irrelevant, as
they cannot be recovered. Instead, the only relevant cost of a current (old)
project (e.g., a production machine) in replacement analysis is its market
value if continued.
2.4.4. Classification of Costs by External Reporting

A manufacturing enterprise reports two types of costs: product (also known as
inventoriable and manufacturing) costs and period (expenses) costs (Figure 2.9).
Costs and Expenses

(Manufacturing)
Product Costs Period Costs (Expenses)

(Manufacturing Costs) Non-Manufacturing Costs)
Direct Direct Factory Prime Conversion

Materials Labor Overhead Costs Costs
Prime Conversion
Costs Costs
FIGURE 2.9 A Manufacturing enterprise’s product costs and period costs (expenses).
Materials ($)
Labor ($) Work-In-Process Goods Manufactured ($)
Overhead ($)
FIGURE 2.10 An illustration of cash flow (costs) for manufacturing goods.
Product Costs: Product costs (or inventoriable or manufacturing costs) are all
the costs associated with the manufacturing of products. Normally, product
costs include direct labor, direct materials (include freight-in), and factory
overhead (Figure 2.10).
Period Costs: Period costs (also known as commercial costs) are the expenses
that a firm incurs for its non-manufacturing general operations and sales
activities. They include the administrative expenses, selling and distribu-
tion expenses, as well as depreciation expenses for non-manufacturing
buildings and equipment. The period costs appear in a company’s income
statement for the fiscal period in which they incur.
2.4.5. Classification of Costs by Cash Flow

A firm may pay for costs incurred in a form of payment or accounting for the value
of resources used. Therefore, one may classify the costs as cash costs, book costs,
implicit (imputed) costs, and explicit costs.
Cash Costs: Cash costs (or out-of-pocket costs) are those that require the use of
current resources, usually cash or an alternative form of payment (e.g., notes
or loan payable, and accounts payable). For example, if a company purchases
an asset in cash or on credit. Cash costs are the before-tax cash flows, such
as cash outlays for a project’s initial cost, annual operating and maintenance
costs, and retirement/termination costs. They also include cash outlays due to
financing (e.g., payments on principal and interest) and taxes.
Book Costs: Book costs are those costs that do not involve a cash exchange;
instead, they only appear on the accounting books of the firm. For example,
depreciation costs are not before-tax cash flows. Book costs do not repre-
sent before-tax cash flows. However, engineering economic analyses con-
sider the book costs of depreciation expenses as they reduce the amount of
taxes paid to governments.
Implicit Costs: An implicit (also known as imputed or implied) cost is an
invisible cost that does not actually incur directly but is associated with
internal transactions when a firm uses an internal resource (e.g., building,
equipment, or owner’s time) for a particular application, rather than using
the resource to a different application. For example, when a firm can rent
out a building or piece of equipment to an external party and earn income
but uses it for an internal application, the estimated rent is an imputed cost.
Also, when a firm transfers the work-in-process from one production/oper-
ating department to another, it may use a method of transfer costing, for
budgetary reasons, and charge the assessed costs to the next department.
Although there is no actual purchase of materials, the firm charges the
receiving department with these imputed costs for the work it has received.
Explicit Costs: Explicit costs are those incurred due to a firm’s activities and
it pays for them in a form of payment. This makes the explicit costs equal
to out-of-pocket costs.
2.4.6. Classification of Costs by Time

A firm may use the costs incurred in the past to estimate its planned production or,
instead, it may use a predetermined costs rate, as described below.
Historical Costs: Historical costs are costs incurred in the past. They are sunk
costs.
Predetermined Costs: Predetermined costs are the computed costs in advance
on some basis of rate factors assigned to products.
2.4.7. Classification of Costs by Other Basis

Recurring Costs: Recurring costs (or normal costs) are those that occur on a
regular basis as anticipated. For example, the costs of materials and labor
used in manufacturing a product, utilities used by a production facility,
property taxes, and insurance premiums are recurring costs.
Nonrecurring Costs: Nonrecurring costs (or abnormal costs) are those that
do not occur on a regular basis (generally not anticipated). For example, the
costs of replacing a production machine, the extra compensation (severance
package paid for terminated employees), and a loss in the factory due to fire
are nonrecurring costs.
Life-cycle Costs: Life-cycle costs are all costs that occur over the various
phases of a product life cycle, from needs assessment through design, pro-
duction, operation, and retirement of the product.
Target Costing: Target costing is the process of determining the desired cost
for a product considering a given competitive price so that the product will
generate the desired profit.
2.5. INVENTORY VALUATION
The price or production cost of a particular merchandise may vary during the year,
and it is usually purchased at different points in time during the year and at different
prices. In addition, when identical items are bought and sold, it is often impossible
to tell which items have been sold and which are still in inventory. Therefore, it is
necessary to make an assumption about the order in which items have been sold.
Since the assumed order of sales may or may not approximate the actual order,
the assumption is, in reality, about the flow of costs rather than the flow of physi-
cal inventory. Thus, the term goods flow refers to the actual physical movement
of goods in the operations of the company, and the term cost flow refers to the
association of costs with their assumed flow within the operations of the company.
Therefore, the assumed cost flow may or may not correspond to the actual goods
flow.
Inventory may be measured (appraised) using one of the four commonly practiced
methods.
• Specific Identification Method: Under this method, the actual cost of a

particular item is assigned to the item. However, the application of the spe-
cific identification method is limited to certain situations, particularly when
the items have unique specifications or are very important and costly. For
example, the inventory of jet engines should be measured by this method.
• Average-Cost Method: In this method, it is assumed that each item carries
an equal cost, which is determined by dividing the total cost of the goods
available for sale by the number of units to arrive at an average unit cost.
• First-In, First-Out (FIFO) Method: Under the FIFO method, it is
assumed that the costs of the first items purchased are assigned to the first
items sold and the costs of the last items purchased are assigned to the items
remaining in inventory.
• Last-In, First-Out (LIFO) Method: Under the LIFO method, it is assumed
that the costs of the last items purchased are assigned to the first items sold.
As a consequence, the cost of the inventory on hand is composed of the
costs of items from the oldest purchases.
Example 2.5 (Inventory valuation)
To illustrate the four methods, the following data for the month of June will be
used:
Inventory Data, June 30
Date No. of units Unit cost Total cost

June 1 (On hand) 100 $1.00 $100
June 6 (Purchase) 100 $1.10 110
June 13 (Purchase) 100 $1.20 120
June 20 (Purchase) 100 $1.30 130
June 25 (Purchase) 100 $1.40 140
Totals 500 $600
Sales 280
June 30 (On hand) 220
Using the Specific Identification Method. If the units in the ending inventory
can be identified as coming from specific purchases, they may be priced at the
specific prices of these purchases. For instance, assume that the June 30 inventory
consisted of:
• 50 units of the June 1 inventory

• 100 units from the purchase of June 13, and
• 70 units from the purchase of June 25.
The cost to be assigned to the inventory under this method would be $268, deter-
mined as follows:
Inventory, June 30
(Specific Identification Method)
June 1 50 units @ $1.00 $ 50
June 13 100 units @ $1.20 120
June 25 70 units @ $1.40 98
Total 220 units at a value of $268
The cost of goods sold during June under the specific identification method is
determined as follows:
Cost of Goods Available for Sale $600

Less: Ending Inventory 268
Cost of Goods Sold $332
Using the Average-Cost Method. Under this method, the average cost is com-
puted by dividing the total cost of goods available for sale by the total units avail-
able for sale. That is,
Average unit cost = $600 ¸ 500 units = $1.20 per unit
Ending Inventory = 220 units ´ $1.20 per unit = $264
The cost of goods sold during June under the average-cost method would be as
follows:

Using the First-In, First-Out (FIFO) Method. When the FIFO method is used, the
June 30 (ending) inventory would be $294. It is computed as follows:
Inventory, June 30
(FIFO Method)
From purchases of June 25 100 units @ $1.40 $140
From purchases of June 20 100 units @ $1.30 130
The cost of goods sold during June under the FIFO method would be $306, deter-
mined as follows:

Using the Last-In, First-Out (LIFO) Method. Under this method, the June 30
inventory would be $234, computed as follows:
Inventory, June 30
(LIFO Method)
From inventory at June 1 100 units @ $1.00 $100
The cost of goods sold during June under the LIFO method would be $336, com-
puted as follows:

Now, let us compare the effects of the four methods on the net income. Assume
that sales during the month of June is $500.
Average
Specific Identification Cost FIFO LIFO
Sales $500 $500 $500 $500
Beginning Inventory $100 $100 $100 $100
Purchases 500 500 500 500
Cost of Goods Available for Sale $600 $600 $600 $600
Less: Ending Inventory 268 264 294 234
Cost of Goods Sold $332 $336 $306 $366
Gross Profit on Sales $168 $164 $194 $134
Keeping in mind that in this illustration June was a period of rising prices, it
can be seen that LIFO, which charges the most recent (and in this case, the highest)
prices to the cost of goods sold, resulted in the lowest net income. On the other hand,
FIFO, which charges the earliest (and in this case, the lowest) prices to the cost of
goods sold, produced the highest net income. The net income under the average-cost
method is between those computed under LIFO and FIFO.
During a period of declining prices, the reverse effects would occur. The LIFO
method would produce a higher net income than the FIFO method.
Each method has its own advantages and disadvantages, and none of them can be
considered as best or perfect. The factors that should be considered in choosing an
inventory method are the effects of each method on the balance sheet, income state-
ment, income taxes, and management decisions.
The LIFO method is best suited for the income statement because it best matches
revenues and the cost of goods sold. But it is not the best measure of the current bal-
ance sheet value of inventory, particularly when there has been a prolonged period of
price rises or decreases. Many businesses use LIFO to reduce the amount of income
taxes to be paid.
The FIFO method, on the other hand, is best suited to the balance sheet because
the ending inventory is closest to current values and thus gives a more realistic view
of the current financial assets of a business.
2.6. STATEMENT OF COST OF GOODS SOLD

To establish a foundation for the necessity and concepts of product costing, one must
understand the flow of costs through a manufacturing organization. The “Cost-of-
Goods-Sold Statement” reveals the flow of costs from raw material, which goes
through the manufacturing process, and then transferred to finished goods inven-
tory. In the period the finished goods are sold, their costs are transferred out of
finished goods inventory to the cost of goods sold. However, the flow of costs for a
merchandising company occurs somewhat differently. Costs and units move through
material, work-in-process, and finished goods inventories as follows:
Beginning Balance ( BB ) + Transfers In ( TI ) - Transfers Out ( TO )

= Ending Balance ( EB )
A merchandising company buys and sells goods that are ready for resale when it
receives them. The company does not need to do much to the goods to make them
salable other than preparing a special package or displaying the items. Inventory
cost generally includes the invoice price (less cash discount and purchases returns),
freight and transportation (including insurance in transit), and applicable taxes and
tariffs. Therefore, preparation of the cost of goods sold for a merchandising company
is usually a simple procedure.
The cost-of-goods-sold statement is an important statement to the cost engineers.
This statement is useful in determining the cost of manufacturing a particular prod-
uct during a given accounting period, for which the statement is prepared. In this
statement, all factory costs are entered. Figure 2.11 illustrates a general format of the
cost-of-goods-sold statement.
The cost-of-goods-sold statement can be trimmed, by eliminating the “change in
Finished Goods Inventory” and the “Cost of Goods Sold” (i.e., the bottom part), to
get the “Cost-of-Goods-Manufactured Statement.”
McAlter Corporation
Statement of Cost of Goods Sold
For Year Ended December 31, 20XX
Materials:
Beginning Inventory (1/1/20XX) $ 30,000
Purchases during the year 580,000
Total Materials available for use $610,000
Ending Inventory (12/31/20XX) 20,000
Cost of Materials used $590,000
Direct Labor 390,000
Factory Overhead 95,000
Total Factory Cost during the year $1,075,000
Change in Work-In-Process Inventory:
Decrease in Work-In-Process Inventory 5,000
COST OF GOODS MANUFACTURED $1,080,000
Change in Finished Goods Inventory:
Increase in Finished Goods Inventory (65,000)
COST OF GOODS SOLD $1,015,000
FIGURE 2.11 A general format of the cost-of-goods-sold statement.

Example 2.6 (Cost of goods sold for merchandising firms)
The following is an example to illustrate the cost of goods sold computation in a

hypothetical merchandising situation.
Merchandise Beginning Inventory $2, 000
Plus: Net Purchases ( transferred in) 8, 000
Cost of Goods Available for Sale $10, 000
Less: Merchandise Ending Inventory 2, 700
Cost of Goods Sold ( transferred out ) $7, 300
Figure 2.12 visualizes the cost flow (or goods flow) through a merchandising
company.
Accountants and cost analysts need information regarding the cost of raw
materials placed into the production process, cost of goods manufactured, and
cost of goods sold to prepare an income statement, appraise inventories, and pre-
pare a balance sheet for a manufacturing company.
The flow of costs through a manufacturing operation is more complex than
that in a merchandising company. In a manufacturing company, inventories are
of three types: raw materials, work-in-process (partially completed products),
and finished goods. As illustrated in Figure 2.13, a manufacturing firm buys raw
materials and adds them to the beginning Raw Materials Inventory to compute
raw materials available for use. The firm withdraws materials from this inventory
and transfers them to the Work-In-Process Inventory, and it reports the cost of
remaining unused materials on the company’s balance sheet at the end of its fiscal
period, as Raw Materials Ending Inventory. The firm adds the costs of direct labor
and overheads to the beginning Work-In-Process (WIP) Inventory. It transfers the
completed units and adds their costs to the Finished Goods Inventory and reports
the costs of the partially completed units in WIP as Work-In-Process Inventory on
its balance sheet. The firm deducts the cost of units sold (as an expense) from the
revenues on its income statement and reports the costs of the unsold units on the
balance sheet as the Finished Goods Ending Inventory (a current asset account).
The “Cost-of-Goods-Manufactured Statement” is similar to the Cost-of-
Goods-Sold Statement, except it does not contain the part of the “Change in
Finished Goods Inventory.” For example, Figure 2.14 shows the cost of goods man-
ufactured (transferred out) with the value of $1,080,000 for McAlter Corporation,
as previously was shown in Figure 2.11.
2.7. JOURNAL ENTRIES FOR THE FLOW OF PRODUCTION COSTS

Consider the cost flow shown in Figure 2.15 based on which the corresponding jour-
nal entries are given in Figure 2.16 (wherein, the column for date is used for the
referenced number, Ref).
Cash
Purchased
Merchandise
Merchandise Unsold Goods Available Sold Cost of

Ending Inventory Goods for Sale Goods Goods Sold
Balance Sheet Income Statement
FIGURE 2.12 The flow of costs in a merchandising operation.
FIGURE 2.13 The flow of working capital (costs) in a manufacturing operation.

FIGURE 2.14 A general format for the cost-of-goods-manufactured statement.
Raw Material Materials Direct Materials Used (4)

Purchases (1) Inventory
Indirect Materials Used (5)

WIP Completed Units Finished Goods
Inventory COG Mfg’d (9) Inventory
Employees Pay (2) Direct Labor (6) Items Sold (10)

Factory Payroll
Indirect Labor (7) Cost of Goods Sold
Factory Overheads
Allocated Overhead (8)
Other Factory Costs (3)
FIGURE 2.15 Production cost flowchart for journal entries (reference numbers in
parentheses).
Ref Account &Description Debit Credit

(1) Materials Inventory xxx
Cash or Accounts Payable xxx
Purchase of raw materials inventory
(2) Factory Payroll xxx
Wages Payable xxx
Recording accrued wages, not yet paid
(3) Factory Overheads xxx
Cash xxx
Recording factory hazard insurance
Factory Overheads xxx
Cash xxx
Recording factory rent paid with cash
Accumulated Depreciation xxx
Recording depreciation on factory equipment
Supplies (Inventory) xxx
Recording supplies consumed by the factory
(4) Work-In-Process Inventory xxx
Materials Inventory xxx
Recording direct materials used
Recording indirect materials used
Factory Payroll xxx
Recording direct labor
Factory Payroll xxx
Recording indirect labor
Recording overhead allocated to production
(9) Finished Goods Inventory xxx
Work-In-Process Inventory xxx
Recording completed goods transferred to storage
(10) Cost of goods sold xxx
Finished Goods Inventory xxx
Recording cost of goods sold
FIGURE 2.16 Journal entries by account flow (with referenced numbers in Figure 2.16).
SUMMARY
This chapter presents the terminologies and fundamental concepts required for per-
forming cost analysis. It provides cost classifications for various purposes and uses
along with illustrative figures and computational examples where needed. It also
presents the four common methods of inventory valuation and systematic proce-
dures for computing cost of goods manufactured and cost of goods sold by formatted
examples.
REFERENCE
Encyclopædia Britannica, Inc. (2020): Diminishing returns. Retrieved July 29, 2020 from:
https://www.britannica.com/topic/dim inishing-returns.
REVIEW QUESTIONS
2.1.
R What is the formula for computing total variable cost?
R 2.2. Describe the variable, fixed, and mixed costs.
R2.3. Describe the prime cost and conversion cost.
R 2.4. What is the result of dividing the cost of goods manufactured by the
number of units manufactured?
R2.5. The direct labor costs are added to the factory overhead costs to deter-
mine __________.
R 2.6. The total cost of goods manufactured is $900,000 for a company when
produced 12,000 units of a product, of which it sold 10,000 units.
Determine the product’s manufacturing unit cost.
R2.7. A company is to decide whether or not to replace an old production
machine with a new machine. Which of the following is not considered
in the incremental analysis?
• Annual operating cost of the new machine.
• Annual operating cost of the old machine.
• Net cost of the new machine.
• Book value of the old machine.
R 2.8. Explain why a company assigns product costs to its products and
expenses to the period costs immediately in the period they incur.
R2.9. Arrange the following items in the order of the flow of cost of goods.
• WIP: work-in-process inventory.
• COGS: cost of goods sold.
• RMI: raw materials inventory.
• FGI: finished goods inventory.
R 2.10. What is the difference between the cost of goods manufactured and the
cost of goods sold?
PROBLEMS
P2.1. A factory incurs these costs for the month:
Direct materials $25,000.
Direct labor 45,000.
Factory facility depreciation cost 30,000.
Factory utilities costs 2,500.
Staff’s payroll salaries 22,000.
How much are the factory’s prime costs and conversion cost?
P2.2. A small computer manufacturer produced 50,000 computers during the
previous fiscal year. Their variable costs included $1,550,000 of direct
materials (parts and supplies) and $1,200,000 of direct labor costs. The
annual fixed costs totaled $2,000,000. Their projected sales volume for
the next year is 60,000 computers. This sales increase will not change
the rate of direct materials but will increase the fixed costs by $160,000.
The company plans to give 2.5% raise to hourly workers who assemble
the computers.
a) Compute the manufacturing unit cost during the previous year.
b) Estimate the manufacturing unit cost for the next year.
P2.3. Assume that a firm currently has a monthly total cost of $416,000 for
manufacturing 16,000 units of its product. The management is consider-
ing expanding the production by 25%. The production expansion would
increase the company’s monthly costs to $480,000. The management
wants to find the incremental costs involved.
P2.4. Polka Company can manufacture 10,000 computers per month with the
following costs:
Direct material costs $500,000

Direct labor cost 250,000
Variable overhead 100,000
Fixed overhead 150,000
Total Monthly Manufacturing Cost $1,000,000
The company can purchase 10,000 computers from another company

for $950,000. Of the total monthly fixed overhead costs, $50,000 are
avoidable fixed costs if the computers are purchased externally. What
effects would the purchase of the computers externally have on the A&F
Company’s costs?
P2.5. KML Company incurs the following costs for making 10,000 units of a
component of its products:
Direct material costs $ 9,600

Direct labor costs 10,200
Variable overhead costs 14,600

Fixed overhead costs 14,600
Total Cost $49,000
The company can outsource manufacturing the component at $3.10 cost

per unit. If the company takes this action, it could allocate its production
capacity to increase the production of its other products that would gen-
erate an additional income of $4,600. Given that the fixed overhead costs
are unavoidable, how much the company’s net income would increase or
decrease if it chooses the outsourcing option?
P2.6. The Maroon Company manufactures products A and B. Their selling
prices of the products as they are partially and fully processed, and the
required further processing costs to fully process them are as follows.
Product Unfinished Price ($) Finished Price ($) Further Processing Costs ($)
A 70 125 45
B 85 220 160
Should any of the products be processed further? Why or why not?

P2.7. F&AT Company is selling a single product called TM4. The following
data for this product during the year 20XX are available:
Date Description No. of Units Unit Cost ($)

January 1 Beginning Inventory 17,000 6.00
February Purchases 20,000 6.50
March Purchases 40,000 6.20
May Purchases 30,000 6.30
July Purchases 50,000 6.40
September Purchases 40,000 6.30
November Purchases 15,000 6.60
Total Available for Sale 212,000
Sales of product TM4 totaled 192,000 units at $10.00 per unit. Selling
and administrative expenses totaled $592,000 for the year.
Required
1) Prepare a schedule to compute the cost of goods available for sale.
2) Prepare an income statement under each of the following
assumptions:
a) Costs are assigned to inventory on an average-cost basis.
b) Costs are assigned to inventory on a FIFO basis.
c) Costs are assigned to inventory on a LIFO basis.
P2.8. Rosan Company is merchandising a single product. The following infor-

mation on beginning inventory, purchases, and sales for this product
during the year 20XX is available
Date Description No. of Units Unit Cost ($)

January 1 Beginning Inventory 15,000 9.90
March Purchases 18,000 13.00
May Purchases 20,000 12.50
July Purchases 40,000 11.50
August Purchases 40,000 13.00
October Purchases 15,000 13.50
December Purchases 12,000 15.00
Sales of the product totaled 130,000 units.

Required
Prepare a schedule to compute the cost of goods sold using the following
methods:
a) Average-cost method.
b) First-In, First-Out (FIFO) method.
c) Last-In, First-Out (LIFO) method.
P2.9. The following data are available for Hee Haw Manufacturing Company.
Prepare the Cost-of-Goods-Sold statement for this company.
Inventories
01/01/20XX 12/31/20XX
Raw Materials $ 50,000 $100,000
Work-In-Process 75,000 25,000
Finished Goods 100,000 150,000
The company has purchased $650,000 of raw materials and paid

$400,000 as direct labor cost and $250,000 for factory indirect costs.
P2.10. Fragments of the operating data for a company for June and July are
shown below. The company applies an overhead rate of 150% of direct
labor cost. Fill in the blank with appropriate amounts.
June July
Raw Materials
Beginning balance (a) $__________ (b) $_________
Purchases 33,000 36,000
Requisitions (35,000) (c) (_________)
June July
Ending balance $10,000 $14,000
Work-In-Process
Beginning balance $56,000 (d) $_________
Raw material requisitioned (e) __________ 32,000
Direct labor charges 20,000 18,000
Factory overhead applied (f) __________ (g) _________
Total (h) __________ (i) __________

Ending balance (50,000) (j) (_________)
Cost of Goods Manufactured (k) $_________ $85,000
Finished Goods
Beginning balance $21,000 (l) $_________
Transfers from Work-In-Process (m) _________ (n) _________
Total goods available for sale (o) $_________ (p) $_________

Transfers to Cost of Goods Sold (86,000) (q) (_________)
Ending balance (r) $_________ $30,000
P2.11. The following balances were extracted from the “Trial Balance” of BBY
Manufacturing, Inc. at the end of the year 20XX. However, the Inventory
accounts still reflect balances at the beginning of the year.
Raw Materials Inventory (1/1/20XX) $505,000

Work-In-Process Inventory (1/1/20XX) 1,565,000
Finished Goods Inventory (1/1/20XX) 2,325,000
Purchases (Raw Materials) 4,752,000
Direct Labor Costs, Factory 2,210,000
Supplies Used, Factory 55,000
Depreciation, Machinery 60,000
Depreciation, Building, Factory 20,000
Depreciation, Building, Headquarters 31,500
Indirect Labor, Factory Services 842,000
Supervisory Salaries, Factory 280,000
Administrative Salaries, Non-factory 6,347,500
Sales Personnel Salaries and Wages 3,506,500
Property Taxes, Factory 60,000
Factory Miscellaneous Expenses 23,000
Advertising and Marketing Expenses 904,500
The year-end inventory balances are $457,000, $2,035,000, and

$1,265,000 for Raw Materials, Work-In-Process, and Finished Goods
Inventories, respectively.
Required
Prepare a statement (in good and organized form) to compute total man-
ufacturing costs, cost of goods manufactured, and cost of goods sold for
the year.
APPENDIX 2A
Cost classification
Committed
Variable By
Flexibility
Discretionary
By
Fixed
Behavior
Avoidable
By
Semi-variable Controllability
Unavoidable
Direct Materials
Prime costs
Direct costs
Direct Labor
By Conversion
Traceability costs
Variable OH
Indirect costs
(Overheads)
Fixed OH
Average (unit) cost
Marginal cost
Costs By Decision
Incremental cost
Classification Making
Opportunity cost
Sunk cost
Product costs
By External
Reporting Period costs
Cash costs
By
Cash flow Book costs
Historical costs
By Time
Predetermined costs
Recurrent costs
Others Non-recurrent costs
Life-Cycle Costs
3 Product Costing
LEARNING OBJECTIVES
• Understand the overall cost flow from raw materials to finished goods sold
throughout all stages within a firm.
• Understand the process for product costing.
• Be able to prepare the costs of goods manufactured and goods sold
statement.
• Understand the general methods for a product, such as absorption, variable,
job-order, and process costing.
• Understand the concept of equivalent units of production.
• Understand the overall cost flow from department to department, and how
total inventory costs are compiled.
• Assign total costs to completed units and incomplete units still in process.
3.1. INTRODUCTION
Product costs consist of the costs of direct materials, direct labor, and overhead (or
indirect costs). As presented in Chapter 2, the physical components of a product
(i.e., direct materials) and the work performed (i.e., direct labor) to produce products
are conveniently and economically traceable to the units of output, and assigning
these direct costs is straightforward. On the contrary, overhead costs are not directly
related to the production of products or providing services. As a result, these costs
are not easily traceable to specific products unlike the direct costs. Hence, compa-
nies adopt a costing method for allocating the indirect costs to the cost objects (i.e.,
products, departments, jobs, etc.)
Costing refers to any process for assigning costs to an element of a business such
as products, departments, employees, and customers. A product costing system is
a costing process by which a firm estimates the costs of producing its products for
managerial decision-making purposes, such as:
• Deciding what to sell.

• Product prices.
• Determining the cost of goods sold.
• Valuation of inventories.
• Finding potentials for cost reduction.
There are two main systems of product costing, job-order costing and process cost-
ing. The job-order costing (or job costing) system assigns costs to a specific cost
object (i.e., a job, product, department, or customer). A firm assigns the costs of
DOI: 10.1201/9780429432163-3 65
materials to jobs consuming them according to the information on a materials req-

uisition sheet (source document indicating the raw materials request for a specific
production job) and has its employees track their time by jobs using a time ticket (as
a source document indicating the number of hours an employee worked on specific
jobs). It also allocates overheads to jobs using a predetermined overhead rate. A
firm uses this costing method when individual products or batches of products are
unique, and especially when jobs are being billed directly to specific customers or
are expected to be audited by those customers.
Process costing is a method whereby, first, a firm accumulates its material, labor,
and overhead costs for each department; and then, it allocates the total departmental
cost to the individual product. Companies with continuous production processes use
process costing, where they manufacture large quantities of the same product that
passes through multiple cost centers (departments or stages of production), usually
in long production runs.
Under both cost systems, companies usually apply manufacturing overheads to
products or job orders using predetermined overhead rates, which are computed at
the beginning of each fiscal period by dividing the estimated manufacturing over-
head cost by an allocation base (also known as activity base or activity driver).
3.2. ABSORPTION COSTING AND VARIABLE COSTING

Absorption costing (also known as full costing) includes all manufacturing vari-
able and fixed costs incurred in producing a product, while variable costing only
includes the variable costs associated with the production of the product but not any
fixed costs. Absorption costing is required under the Generally Accepted Accounting
Principles (GAAP), established by the Financial Accounting Standards Board
(FASB). The GAAP mandates publicly traded companies to use absorption costing
for reporting to external stakeholders (e.g., investors, creditors, and tax agencies).
Variable costing will result in a lower breakeven point (or price) by showing a
lower cost of goods sold (COGS). This, however, makes it more difficult to set proper
pricing for a product. The variable costing reveals a higher gross profit margin as
compared to the absorption costing, which reports much higher COGS. Nevertheless,
the variable costing provides the management with a good foundation for the cost-
volume-profit (CVP) analysis. A later chapter will present such an analysis in detail.
Since the most commonly used method of costing is absorption costing, this
method is used in this chapter for product costing.
3.3. JOB-ORDER COSTING SYSTEM

Companies that produce special-order (or custom-made) products or services, or
several different products, would usually use the job-order costing system. A job
cost includes all the costs incurred for direct materials, direct labor, and overhead
to complete a job. Direct materials and direct labor hours are conveniently trace-
able for a specific job. Overheads that are indirect costs are not easily traceable for
a specific job.
Product Costing 67
When a firm starts a job and as it incurs costs (direct materials, direct labor, and
applied overhead), its accounting department records them as a debit in a “Work-in-
Process,” WIP, or “Jobs-in-Process” account. When the job is finished, the accoun-
tants remove the job from the WIP by debiting the job costs to the “Finished Goods
Inventory” account and crediting the WIP account.
The store personnel issue materials only upon receipt of a “Stores Requisition”
form (Figure 3.1) signed by an individual who is authorized to request materials. The
costs of direct materials are charged to each job according to the data on this form.
A time ticket or card (Figure 3.2), which shows how an employee’s time was
spent, is used to charge direct labor cost to specific jobs and indirect labor (e.g.,
maintenance) cost to WIP.
A firm may establish a predetermined overhead rate to budget overhead costs for
jobs. The firm chooses a base for the predetermined overhead rate (e.g., direct labor
costs, direct labor-hours, machine-hours, job size, and job volume). The formula for
calculating a predetermined OH rate is:
Estimated Overhead
Predetermined OH Rate = (3.1)
Estimated Units in Allocation Base ( Activity )
The firm allocates overhead costs to the jobs in WIP Inventory by taking the actual
amount of the base multiplied by the predetermined overhead rate. At the end of the
period or at the completion of a job, the firm compares the actual overhead costs to
the applied overhead costs. If applied overhead is more than the actual overhead, the
overhead is over-applied. If applied overhead is less than actual overhead, overhead
is under-applied. Then, the firm will record adjusting entries on accounting books to
correct the cost of goods sold. The formula for calculating the actual overhead rate is:
Actual Overhead
Actual OH Rate = (3.2)
Actual Units in the Allocation Base ( Activity )
ABC Company
STORES REQUISITION
Requisition Number: 3D38 Date: May 10, 20XX
Issued by: John Roberton
Department: Machining
For Store Personnel’s Use
Article Quantity Unit Cost Amount
T17 Connector 6 $ 95.65 $573.90
B34 Housing with cover 3 145.75 437.25
$1,011.15
Use: Direct Material Job No. 3D38 Indirect Material

Authorized By: John Doe
Posted by: Brad Eliac
FIGURE 3.1 An illustration of a materials requisition form.

ABC Company
Time Ticket
Time Ticket #: 1036 Date: May 15, 20XX
Employee: Martin Martini Station: 6
Hours
Started Ended Worked Rate Amount Job Number
8:00 12:00 4.0 $10.00 $40.00 3D38
12:30 3:00 2.5 10.00 25.00 2H69
3:00 4:00 1.0 10.00 10.00 Maintenance
FIGURE 3.2 An illustration of a time ticket form.
The following example illustrates how to compute a predetermined overhead rate.
Example 3.1
A manufacturing company, based on the costs incurred in the past three years,
projects the overhead for the next year to be $279,000, as detailed below:
Indirect labor cost $9,000

Indirect materials 28,000
Insurance 22,000
Factory utilities 65,000
Depreciation of equipment 75,000
Depreciation of building 63,000
Interest expense factory mortgage 17,000
Total $279,000
The estimated direct labor cost in the upcoming year is $120,000. Using the direct
labor cost as a basis (cost driver activity), calculate the predetermined overhead rate.
Estimated Overhead Cost ($279, 000 )

Predetermined Overhead Rate =
Estimated Level of Activity ($120, 000 )
= $2.325 per direct labor dollar
( or 232.5% of direct labor cost )
The criterion for choosing an allocation base (i.e., an activity base or cost driver)
should be the “cause-and-effect relationship” in determining the predetermined
overhead rate. The following are some possible drivers:
• Units produced.
• Direct labor-hours.
Product Costing 69
ABC Company
Job Cost Sheet
Job Number: Customer:
Job Description:
Direct Materials Direct Labor Applied Overhead
Date Description Quantity Unit Amount Hours Rate Amount Basis Quantity Rate Amount
Cost
Contract Date Material Cost

Date Started Labor Cost
Date Completed Applied OH
Job Cost
FIGURE 3.3 An illustration of a general job cost sheet form.
• Direct labor cost.

• Machine-hours.
• Direct material cost.
• Floor space occupied.
• Number of employees.
The job-order number and customer’s information as well as all pertaining cost
data (direct materials, direct labor, and applied overhead) are entered in a job
cost sheet. Figure 3.3 is an example of a job cost sheet form, which neither is a
standard form nor may be applicable to any particular company or industry sector.
Companies design a job cost sheet that fits their particular needs.
3.4. PROCESS COSTING
Under the process costing systems, each production department prepares a process
cost sheet for a given period, which usually shows some unfinished units either in its
beginning WIP inventory, ending WIP inventory, or both. Therefore, it is necessary
to determine a cost flow, that is, to determine the order in which costs are transferred
into and out of the department.
Process costing begins with the concept of an equivalent number of complete
units, ENCU (or simply EU), which is the amount of WIP inventory expressed in
terms of the number of complete units. The cost per equivalent unit becomes the
basis for the final cost allocated to WIP inventory and goods manufactured. A firm
may use either the weighted-average-cost (also called average-cost) method or the
first-in-first-out (FIFO) method for assessing the WIP inventory costs. A “production
cost report” (or “cost of production report”) provides an overall view of the entire
process costing method.
3.4.1. Process Costing Using Weighted-Average Method

Under the weighted-average method of process costing, the analyst averages costs
and uniformly applies them to both “completed and transferred-out units” and the
“equivalent number of complete units” of unfinished units in the ending WIP inven-
tory. Whereas, the FIFO process costing method assumes the units first entered a
department are the ones first completed and transferred out. The weighted-average
process costing method involves the following steps:
Determine the physical (actual) units to account for, that is, finding units
1)
in the WIP at the beginning of the period (from the end of the previous
period), units started during the prior period, units completed and trans-
ferred out to the next department (or finished goods storage if the depart-
ment is the final stage of the production), and unfinished units in WIP at the
end of the period.
Break up the costs into its components (i.e., transferred-in [if any], direct
2)
materials, direct labor, and factory overhead costs).
Determine the costs added during the current period for each cost com-
3)
ponent (i.e., transferred-in, direct materials, direct labor, and factory over-
head costs) from the preceding department and in the department.
Compute the total costs to account for each cost component (i.e., trans-
4)
ferred-in, direct materials, direct labor, and factory overhead costs). That
is, add the transferred-in cost of the units transferred in during the cur-
rent period to the transferred-in cost of units in the beginning inventory
of the WIP, and add the costs of direct materials, direct labor, and over-
head incurred during the period to the corresponding cost in the beginning
WIP balances for direct materials, direct labor, and factory overhead costs,
respectively.
Compute total equivalent units (i.e., all the completed units plus the
5)
equivalent number of complete units in the ending WIP inventory). The
equivalent units in the ending WIP are computed by the actual units multi-
plied by the percentages of their completion.
Compute the cost per equivalent unit for each cost component by divid-
6)
ing the total cost for each cost component (i.e., transferred-in, direct materi-
als, direct labor, and OH) by the total equivalent units corresponding to the
cost component.
Allocating the cost between the units completed and transferred out
7)
and the units in the ending WIP inventory by multiplying the sum of
costs per equivalent unit of all cost components by the number of units
Product Costing 71
completed and transferred out, and multiplying the cost per equivalent unit
for each cost components by the corresponding equivalent units in the WIP
ending inventory.
Example 3.2
Compute the cost of goods manufactured and the cost components of the work-
in-process ending inventory using the weighted-average method of process cost-
ing for the packaging department of KFA Company, which has the following data
for July:
• A total of 20,000 units in WIP inventory at the beginning of the month

with account balances of $95,000 for costs transferred in from the pro-
duction department, and $5,660 direct materials, $4,320 direct labor
costs, and $7,200 factory overheads. Note that these items form four cost
components (i.e., transferred-in, direct materials, direct labor, and OH).
• A total of 180,000 units transferred in from the production department
during the month at a total cost of $835,000.
• Costs added included direct material costs of $31,200, direct labor costs
of $18,240, and factory overheads of $29,200.
• A total of 170,000 units completed and transferred (out) to the finished
goods storage.
• The unfinished units in ending WIP inventory: 100% complete as for
transferred-in cost, 80% complete as for materials, 60% complete as for
direct labor cost, and 40% complete as for factory overheads.
Solution
The actual (physical) quantity:
WIP beginning inventory 20,000 units

Transferred in 180,000
To be accounted for 200,000 units
Completed and transferred out 170,000 units
In WIP ending inventory 30,000
Accounted for 200,000 units
Compute the equivalent units in the ending WIP inventory using the weighted-
average method as follows:
Transferred in: 30,000 (100%) = 30,000 units equivalent

Materials: 30,000 (80%) = 24,000 units equivalent
Direct labor: 30,000 (40%) = 18,000 units equivalent
Factory overheads: 30,000 (80%) = 12,000 units equivalent
By adding the 170,000 units completed and transferred out to the individually
computed equivalent units in the ending WIP inventory for each cost component,
we obtain the total equivalent number of complete units for the corresponding
cost element (row e below).
Direct Direct Factory

Transferred-in Materials Labor Overheads
(a) Units completed and 170,000 170,000 170,000 170,000
transferred out
(b) Units in ending WIP inventory 30,000 30,000 30,000 30,000
(c) Percentage of completion in 100 80 60 40
ending WIP
(d) Equivalent units in ending 30,000 24,000 18,000 12,000
WIP (d = b × c)
(e) Total equivalent units (a + d) 200,000 194,000 188,000 182,000
Compute the unit cost per equivalent using the weight-average method as follows:
The costs to be accounted for is the sum of the cost of the beginning WIP inven-
tory and the cost added during the period. We must compute this cost individually
for the cost components as their equivalent units are not equal and we need them
separately for cost control and managerial decision-making purposes.
Transferred-in cost: $930,000/200,000 units = $4.65 per unit

Direct material cost: $36,860/194,000 units = $0.19 per (equivalent) unit
Direct labor cost: $22,560/188,000 units = $0.12 per (equivalent) unit
Factory overhead cost: $36,400/182,000 units = $0.20 per (equivalent) unit
Overall manufacturing cost = 4.65 + 0.19 + 0.12 + 0.20 = $5.16 per complete
unit
Direct Labor Factory

Transferred-in Materials Costs Overheads Total
(f) WIP beginning $95,000 $5,660 $4,320 $7,200 $112,180
inventory
(g) Added costs during $835,000 $31,200 $18,240 $29,200 $913,640
the month
(h) Costs to account for $930,000 $36,860 $22,560 $36,400 $1,025,820
(i) Total equivalent 200,000 194,000 188,000 182,000
units (e)
(j) Cost per equivalent $4.65 $0.19 $0.12 $0.20 $5.16
unit (h/e)
Now, we can determine the cost of units completed and transferred to the finished
goods storage as follows.
Cost of goods transferred out = $5.16 ´ 170, 000 = $877, 200.

Product Costing 73
We can also determine the cost of the 30,000 partially finished units in the ending
WIP inventory as follows.
Transferred-in cost = $4.65 × 30,000 = $139,500

Material cost = $0.19 × 24,000 = $4,560
Direct labor cost = $0.12 × 18,000 = $2,160
Overhead cost = $0.20 × 12,000 = $2,400
We find the value of the ending work-in-process inventory to be:
Work -in-process inventory = $139, 500 = $4, 560 + $2,160 + $2, 400

= $148,620
Since the cost of beginning WIP inventory plus the added cost during the period
(cost to be accounted for) must be equal to the cost of units transferred out plus
the cost of the ending WIP inventory (the costs accounted for), the cost of ending
WIP can be determined by the following shortcut formula.
Cost of Ending WIP = Costs to Account For - Costs Transferred Out
In this example, we get the same amount for the ending WIP cost as follows:
Cost of ending WIP = $1, 025, 820 - $877, 200 = $148,620.
At the end of each period, a production manager prepares a “production cost

report” containing the information as presented in Figure 3.4. This report shows
both the flow of units and the flow of costs through a processing center. It also
shows how the costs are distributed between the units completed and transferred
out and the units still in the processing center’s ending inventory.
3.4.2. Process Costing Using FIFO Method

The FIFO method assumes any partially completed units from the previous period
(beginning work-in-process inventory) are finished before the work on the units
added during the current period starts. Table 3.1 clarifies the differences between the
weighted-average method and the FIFO cost method.
Under the FIFO method, the process costing system calculates equivalent units
for the following three items:
1) The units from beginning WIP: These units are completed first as the first-
in, first-out requires, based on how much more materials, labor, and over-
head will be needed to complete them. The percentage of the beginning
WIP units to be completed during the current period equals 100% minus
the percentage of completion in the previous period. So, the equivalent
units from the beginning WIP equal (physical units in beginning WIP) ×
(100% − the percentage of completion in the last period).
KFA Company
Production Cost Report
July 31, 20XX
Quantity Schedule:
Beginning inventory units, July 1 20,000 units
Transferred-in units 180,000
Total units to be accounted for 200,000 units
Transferred-out units 170,000
Ending inventory units, July 31 30,000
Total units accounted for 200,000 units
Cost Schedule:
Beginning inventory, Costs transferred in, $ 95,000
Direct material costs 5,660
Factory overhead costs 7,200
Total beginning inventory costs $112,180
Transferred-in cost during July 835,000
Direct material costs added 31,200
Direct labor costs added 18,240
Factory overhead costs added 29,200
Total costs to be accounted for $1,025,820
Transferred out finished good $877,200
Costs transferred-in, July 31 139,500
Direct material costs 4,560
Factory overhead costs 2,400
Total costs accounted for $1,025,820
FIGURE 3.4 An illustration of the “production cost report” for Example 3.2.
2) The units started and completed in the current period: These units equal to
total units completed in the current period minus the physical (actual) units
in the beginning WIP.
3) The units remaining in ending WIP: As with the weighted-average method,
we compute the equivalent units by taking the physical units’ ending WIP
multiplied by their percentage of competition.
The sum of these three equivalent units is the total equivalent number of units com-
pleted during the current period with the costs incurred during the period only (the
beginning WIP costs are not included).
Product Costing 75
TABLE 3.1
Comparison of the Weighted-Average and FIFO Methods
Weighted Average FIFO
Units completed and Total units completed during (All units in beginning WIP completed
transferred Out the period first)
+ (Units started and completed this
period)
Equivalent units (Units completed during the (Equivalent units in opening WIP
period) completed) + (Units started and
+ (Equivalent units in ending completed this period)
WIP) + (Equivalent units in the ending WIP)
Cost per equivalent Beginning WIP costs Costs added in current period only
unit in ending WIP + Costs added during the
inventory period
Assign costs using Equivalent units × (Cost per (Beginning WIP costs)
equivalent unit for units + (Equivalent units) × (Cost per
completed and units in equivalent unit for units finished from
ending WIP) beginning WIP, units started and
completed, and units in ending WIP)
Therefore, we can formulate the computation for the equivalent units during a
period under the FIFO as:
EU ( or ENCU ) = éë U B ´ ( 100% - PL ) ùû
(3.3)
+ ( U T - U B ) ´ ( 100%) + éë U E ´ PE ùû
where
EU = ENCU during the period (separately computed for each cost component);
UB = Actual (or physical) units in the beginning WIP inventory (carried over from
the last period);
US = Units added (started) during the current period;
UB + US = Total units to be accounted for;
UT = Units completed and transferred out (to finished goods or the next stage) in
the current period;
UT − UB = Units started and completed in the current period;
UE = Units in WIP inventory (partially completed) at the end of the current period.
UT + UE = Total units accounted for (= UB + US = Total units to be accounted
for);
PL = Percentage of the units in beginning WIP completed in the previous (last)
period;
(100% − PL) = Percentage of the units in beginning WIP completed in the current
period;
(US − UE) = Units started and completed and transferred out during the current
period;
PE = Percentage of completion of the units in WIP at the end of the current
period.
Example 3.3
Calculate equivalent units using the FIFO method for a production process with
the following production data:
% of Completion for
Actual
Units Materials Conversion
Units in beginning WIP (UB) 20,000 80% 60%
Units added in the current period 165,000 ? ?
(US)
Units completed this period (UT) 170,000 ? ?
Units in ending WIP (UE) 15,000 100% 60%
Cost of beginning WIP $39,200 $13,200
Cost of units added this period $425,880 $180,360
Total cost $465,080 $193,560
Solution
Direct Materials Conversion Costs

Units in beginning WIP (UB) 20,000 20,000
% of completion of beginning WIP in previous 80 60
period (PL)
% of beginning WIP completed this period [PB 20 40
= 100% − PL]
Equivalent units for beginning WIP [UB × 4,000 8,000
(100% − PL)]
Units started and completed in current period 150,000 150,000
(US − UB)
Units closing WIP (a) 15,000 15,000
% of completion of closing WIP (b) 100 60
Equivalent units in closing WIP (a × b) 15,000 9,000
Total equivalent units during the current 169,000 167,000
period (EU)
Product Costing 77
Computing the unit cost per equivalent under the FIFO method
Under the weighted-average method, we use beginning work-in-process costs
plus the costs added during the current period. Under the FIFO method, we only
use the costs added during the current period. As we did under the weighted-
average method, we must compute the unit costs individually for the cost
components.
Direct material cost: $425,880/169,000 units = $2.52 per unit

Conversion cost: $180,360 /167,000 units = $1.08 per unit
Overall manufacturing cost = 2.52 + 1.08 = $3.60 per unit
Computation for assigning cost to units completed using the FIFO method
Direct material cost = $39,200 + $2.52(20,000 × 0.20 + 150,000) = $427,280

Conversion cost = $13,200 + 1.08(20,000 × 0.40 + 150,000) = $183,840
Cost of goods manufactured = $427,280 + $183,840 = $611,120
Computation for assigning cost to ending work-in-process inventory
Direct material cost = $2.52(15,000 × 1.00) = $37,800

Conversion cost = $1.08(15,000 × 0.60) = $9,720
Total cost assigned to ending WIP inventory = $37,800 + $9,720 = $47,520
We can use the following shortcut method to calculate the total cost of goods
manufactured as follows.
Total cost to be accounted for = Cost of beginning WIP inventory
+ cost added during the period

= ($39, 200 + $13, 200 ) + ($425, 880 + $180, 360 )
= $658, 640

Cost of Goods Manufactured = Total cost to be accounted for - Cost Ending WIP
= $658, 640 - $47, 520
= $611,1120
Example 3.4
A manufacturing company, based on the costs incurred in the past three years,
projects the overhead for the next year to be $279,000 as detailed below.
Indirect labor cost $9,000

Indirect materials 28,000
Insurance 22,000
Factory utilities 65,000
Depreciation of equipment 75,000
Depreciation of building 63,000
Interest expense factory mortgage 17,000
Total $279,000
The estimated direct labor cost in the upcoming year is $120,000. Using the direct
labor cost as a basis (cost driver activity), calculate the predetermined overhead
rate.
Estimated overhead cost ($279,000 )

Predetermined overhead rate =
Estimated level of activity ($120,000 )
= $2.325 per direct labor dollar
( or 232.5% of direct labor cost )
3.5. NORMAL COSTING AND STANDARD COSTING

Normal costing is a process of computing the manufacturing costs of products,
which consists of:
• The actual cost of direct materials.

• The actual cost of direct labor.
• The applied manufacturing overhead is based on a predetermined manu-
facturing overhead rate.
The normal product costs are used for determining the cost of goods manufactured,
the cost of goods sold, and the cost of the inventories.
At the end of each fiscal period, the overhead variance, which is the amount of
over-applied or under-applied overhead, is determined. If the amount of the applied
overhead exceeds the actual overhead cost incurred, the variance is an over-applied
overhead; if the amount of the applied overhead is less than the actual overhead cost
incurred, the variance is an under-applied overhead.
If the amount of the variance is insignificant, it will usually be written off (entirely
allocated) to the COGS account. That is, the COGS account will be debited for the
under-applied overhead (added to COGS); it will be credited for the over-applied
overhead (deducted from COGS).
Product Costing 79
If the variance is significant, it should be prorated to the cost of goods sold, the
work-in-process inventory, and the finished goods inventory relative to the amounts
of applied overhead to them.
Standard costing is a system used by some manufacturing firms to identify the
differences (variances) between:
• The actual costs of the products manufactured, and

• The standard (budgeted or planned) costs that should have occurred for the
products produced.
Standard costs are planned (or budgeted) costs that should have occurred for pro-
ducing manufactured products, which consist of the following:
• Predetermined material costs.

• Predetermined direct labor costs.
• Predetermined manufacturing overhead costs.
These standard costs are used to determine the cost of goods sold and various inven-
tories. Under the normal costing, there may be only overhead variance. Under the
standard costing, there can be variances for all three cost components (direct materi-
als, direct labor, and overhead). The variances are adjusted as done for the overhead
variance under the normal costing. That is, if the actual costs vary insignificantly
from the standard costs, the variances will be allocated (written off) to the cost of
goods sold. Otherwise, they should be prorated to the cost of goods sold and various
inventories relative to the amounts of the standard costs.
3.6. JOURNAL ENTRIES FOR RECORDING JOB-ORDER COSTS

This section presents typical journal entries for overhead costs. The recording can
apply to both job-order and process costing systems. However, we focus on the job-
order costing system as it requires more details.
The following journal entries record the direct material (DM) and direct labor
(DL) costs as they are incurred:
Debit Credit
Work-In-Process-DM: Job J1 6,000
Work-In-Process-DM: Job J2 4,000
Materials Inventory 10,000
Work-In-Process-DL: Job J1 3,000

Work-In-Process-DL: Job J2 2,000
Wages Payable 5,000
The following journal entry is made when the wages (payable) are paid:
Debit Credit
Wages Payable 5,000
Cash 5,000
The Factory Overhead account is debited as the actual overhead incurred, whereas
the Work-In-Process (jobs or processes) account is debited and the Factory Overhead
account is credited for the applied (allocated) overheads. Table 3.2 presents some
examples of affected accounts for the actual overheads and Table 3.3 shows exam-
ples of affected accounts for the applied overheads.
The following is an example of a journal entry for recording the factory overhead
costs incurred:
Date Description Debit Credit

20XX-05-20 Factory Overhead 95,000
Supplies 12,000
Salaries Payable 15,600
Accumulated Depreciation 11,400
Taxes Payable 5,000
Utilities Payable 5,000
The applied (or budgeted) overhead for the period equals the actual hours worked
times the predetermined overhead rate. Predetermined overhead rate is that a com-
pany estimates, at the period, how much overhead will cost per unit of an activity
(e.g., labor hour). For example, a company estimates it will incur $10 per labor hour
of overhead. The employees work 1,000 hours during the period. Therefore, applied
(budgeted) overhead for the period equals $10,000 = $10 × 1,000 hours.
TABLE 3.2
Examples of the Affected Accounts for the Actual Overheads Incurred
Actual Overhead Item (example) Debit Credit
Indirect materials Factory Overhead Raw Materials or Supplies
Indirect labor (e.g., supervisory and HR) Factory Overhead Salaries Payable
Machineries depreciation cost Factory Overhead Accumulated Depreciation
Factory property taxes Factory Overhead Taxes Payable
Utilities Factory Overhead Accrued Expenses, or Utilities
Payable
Equipment leases Factory Overhead Prepaid Lease
Product Costing 81
TABLE 3.3
An Illustration of How the Budgeted (Estimated) Overheads Are Allocated
Applied Overhead Item (example) Debit Credit
Allocated overheads to Job J1 Work-In-Process Factory Overhead
Allocated overheads to Job J2 Work-In-Process Factory Overhead
⋮ ⋮ ⋮
Allocated overheads to Job Jn Factory Overhead Factory Overhead
Under-applied overhead occurs when a company has the actual overhead costs greater
than its applied overhead costs. Over-applied overhead, on the other hand, occurs when
a company has the actual overhead costs less than its applied overhead costs.
To determine whether the overhead is under- or over-applied, an overhead analy-
sis is necessary. The actual overhead costs are found through company recordings as
they incur. However, if the actual overhead cost rates are known, then multiply those
costs per unit of the activity (e.g., labor hour) by the number of activity units that
occurred (e.g., labor hours worked). For example, if the actual overhead rate for the
company is $11 per hour, then the actual overhead is $11,000 = $11 × 1,000 hours.
Subtracting the applied overhead costs from the actual overhead costs shows how the
overhead has been applied. In our example, $11,000 minus $10,000 equals $1,000 of
under-applied overhead. If the applied overhead costs were greater than the actual
overhead costs, then the overhead is over-applied.
The following is the journal entry to record the incurred indirect labor (e.g., man-
agerial and supervisory salaries):

Salaries Payable 8,000
The following is the journal entry to record the indirect materials raw materials are
used:

The following journal entry is to record to allocated (applied) manufacturing over-

head cost to jobs (or departments):
Work-In-Process-OH – Job J1 5,000

Work-In-Process-OH – Job J2 3,500
The following journal entry records a completed job and transferred from the pro-
duction department to the finished goods warehouse:
Finished Goods 23,500

Work-In-Process – Job J1 14,000
Work-In-Process – Job J2 9,500
Note that the total cost of a job includes direct material and direct labor costs plus
the allocated factory overheads.
As illustrated in the above journal entry examples and assuming they are the
only required journal recordings, the Factory Overhead account in the general ledger
would show the information as shown in Figure 3.5.
For our example, assume both jobs have been completed and shipped to the cus-
tomers, where the sales amounts charged to customers were $18,000 for job J1 and
$13,000 for job J2, totaling $31,000. The following journal entries record the sales
and cost of the completed jobs and shipped to the customers:

Sales 31,000
Finished Goods 23,500
The Factory Overhead account is not a regular account like an asset, liability, expense,
or any other typical accounts. It is a “clearing” account. All factory overhead costs
enter this account and are then transferred out to other accounts. In this case, actual
overheads go in (debited), and applied overheads go out (credited). The balance is
either negative (over-applied overheads) or positive (under-applied overheads).
In our example, we realize that we incurred $9,000 factory overheads, but we
have applied $8,500 to the jobs ($5,000 and $3,500 to jobs J1 and J2, respectively).
Therefore, we have $500 under-applied factory overhead costs to the jobs. The fol-
lowing journal entry corrects an under-applied manufacturing overhead balance by
adjusting the Cost of Goods Sold account:
Account Name: Factory Overheads
Date Description Ref. Debit Credit Balance

mm/dd Indirect labor 8,000 8,000
mm/dd Indirect materials 1,000 9,000
mm/dd OH Allocated to Job J1 5,000 4,000
mm/dd OH Allocated to Job J2 3,500 500
FIGURE 3.5 An illustration of posted transactions in a job-order costing system.

Product Costing 83
Cost of Goods Sold 500

Factory Overheads 500
Transfer the under-applied overhead to COGS
If the applied overheads exceed the actual overheads incurred, an over-applied over-
head occurs. Then, for the over-applied amount, the Factory Overheads account is
debited (to close it) and the Cost of Goods Sold account is credited (to reduce it to the
actual amount). For example, if the total actual factory overhead is $9,000 and the
applied overhead is $10,200, the following journal entry will be made:
Factory Overheads 1,200

To reduce COGS for the over-applied overhead
SUMMARY
In sequential production departments, units are typically transferred from one stage
to the next stage in the process. When the units are transferred, the accumulated
cost per unit is transferred along with them. Since the unit being produced includes
work from all of the prior departments, the transferred-in cost is the cost of the work
performed in all previous departments.
In any stage, the costs transferred in from the previous stage are added to the costs
incurred during the current period, then the total of each cost component (i.e., the direct
material, direct labor, and overhead costs) is divided by the equivalent units (units trans-
ferred out plus equivalent units in WIP) to determine the unit cost. The total unit cost in
this stage is multiplied by the units completed during the current period and transferred
out to the next stage to determine the total cost of the completed units and passed on to
the next stage of the process. The costs assigned to the WIP ending inventory by taking
the unit cost of each cost component (i.e., material, labor, and overhead cost) multiplied
by the corresponding equivalent units in the WIP at the end of the period.
REVIEW QUESTIONS
3.1.
R For what inventory accounts is the following equation true?

Beginning Balance + Transfers In - Transfers Out = Ending Balance
A. Raw Materials.
B. Work-in-Process.
C. Finished Goods.
D. All of the above.
E. B and C only.
3.2. The predetermined rate is used to apply overhead costs to:
R
A. Raw materials inventory.
B. WIP inventory.
C. Finished goods inventory.
D. Work-in-process inventory and units transferred out.

E. Sales units.
R3.3. The costs to be accounted for consist of:
A. Costs added during the period.
B. Costs of the units in ending inventory.
C. Costs started and transferred out during the period.
D. Costs in the beginning inventory and added during the period.
R3.4. The detailed materials, labor, and overhead costs are needed when:
A. Determining the units to which costs are assigned.
B. Determining the equivalent units of production.
C. Determining the cost per equivalent unit.
D. Allocating the costs to the units transferred out and the units par-
tially completed.
R3.5. How do job-order costing and process costing differ with respect to
recording direct materials and direct labor?
R3.6. How is the predetermined rate calculated for applying the overhead costs
to work-in-process?
R3.7. The companies that produce many different products or services usually
use:
A. Process costing.
B. Job-order costing.
C. Both process costing and job-order costing.
D. None of the above.
R3.8. Which of the following costs is recorded on the job cost sheet?
A. Direct material cost.
B. Direct labor cost.
C. Manufacturing overhead cost.
D. All of the above.
R3.9. Which of the following journal entries is correct for the issuance of
direct materials to production?
A. Materials debited and work-in-process credited.
B. Work-in-process debited and materials credited.
C. Work-in-process debited and accounts payable credited.
D. Materials debited and accounts payable credited.
R3.10. Production reports for the second quarter show the following data:
Month Direct Labor Hours Machine-Hours Applied Overhead ($)

May 12,000 10,000 50,000
June 11,000 12,000 60,000
July 9,500 11,000 55,000
Which variable would be the most likely basis for allocating overhead?
Product Costing 85
PROBLEMS
P3.1. A production department within a company received materials of $12,000
and conversion costs of $13,000 from the prior department. It added mate-
rials of $32,800 and conversion costs of $50,000. The equivalent units are
20,000 for material and 18,000 for conversion. Determine the unit cost for
materials and conversion, and the overall manufacturing unit cost.
P3.2. The finishing department received 5,350 units from the molding depart-
ment and started the month with 650 units in WIP inventory. It trans-
ferred out 5,330 units to the packaging department during the month.
How many units remain in process at the end of the month?
P3.3. A production department started a month with no WIP beginning inven-
tory. It also started 60,000 units in production during the month, and
completed and transferred out 56,800 units. Its remaining units in pro-
cess at the end of the month were 100% complete for materials and 60%
complete for conversion. Using the average cost method, compute the
equivalent units of production.
P3.4. A production department started a month with 2,200 units WIP begin-
ning inventory (100% complete for materials; 70% complete for con-
version). It also started 60,000 units in production during the month,
and completed and transferred out 56,800 units. The remaining units
were still in process at the end of the month, which were 100% complete
for materials and 50% complete for conversion. Using the average cost
method, compute the equivalent units of production.
P3.5. In a production department, materials are added at the beginning of the pro-
cess. There were 1,200 units in beginning WIP inventory, 11,800 units were
started during the period, and 11,500 units were completed and transferred
to finished goods inventory. The WIP ending inventory in the department
was 60% complete as to conversion costs. Under the average cost method,
what are the equivalent units of production for materials and conversion?
P3.6. The following data relate to work-in-process for a production department
during a given month:
Work-in-process – beginning inventory:

Units in process 1,200
Material cost (100% complete) $6,600
Conversion cost (50% complete) $2,400
Units added during the period 10,000
Costs incurred in this period:
Direct materials used $53,880
Direct labor cost $18,800
Overhead $23,000
Units of product transferred out 9,200
The unfinished units in the WIP ending inventory are 80% complete as
for material costs and 60% complete as for conversion costs.
Required: Using these data, compute:
a) The unit cost per equivalent unit for materials and conversion (use
the average cost method).
b) The cost of the product transferred out.
c) The cost of ending WIP inventory.
P3.7. The Abdo company has the following estimated costs for the next year:
Direct materials $21,000

Indirect materials $7,000
Direct labor $46,000
Salary of production supervisor $33,000
Rent on factory equipment $14,000
Sales commission $36,000
Advertising expenses $9,000
It is estimated that 35,000 machine-hours and 10,000 direct labor hours

will be worked during the next year.
Required: What will be the predetermined overhead rate if the company
applies manufacturing overhead cost to jobs on the basis of direct labor
hours.
P3.8. Balki Co. uses a predetermined overhead rate based on direct labor
hours to apply manufacturing overhead to jobs. For April, the company’s
estimated manufacturing overhead cost was $200,000 based on an esti-
mated activity level of 50,000 direct labor hours. The actual overhead
amounted to $208,000 with actual direct labor hours totaling 55,000 for
the month. How much was the over-applied or under-applied overhead?
3.9. The over-applied balance of the Factory Overhead ledger account is
P
$25,000. The ending balances of Work-in-Process inventory, Finished
Goods inventory, and Cost of Goods Sold accounts are $5,000, $8,000,
and $37,000, respectively. On the basis of ending balances, how much
of the over-applied balance should be proportionated to each of these
accounts?
P3.10. Production reports for the second quarter show the following data:
Month Direct Labor Hours Machine-Hours Applied Overhead ($)

May 12,000 10,000 50,000
June 11,000 12,000 60,000
July 9,500 11,000 55,000
Which variable would be the most likely basis for allocating overhead?
Product Costing 87
APPENDIX 3A
GLOSSARY
Actual Overhead Rate: Total actual manufacturing overhead divided by total actual
manufacturing activity.
Cost: A financial measure of the resources used or given up to achieve a purpose.
Cost Driver: Activity or transaction that causes costs to incur. For example, machine-
hours can be a cost driver for costs of electricity and fuel to run machines.
Cost of Goods Manufactured: Consists of the total costs of all goods completed
during the period; it includes all manufacturing costs incurred during a
period plus the beginning work-in-process inventory costs minus ending
work-in-process inventory costs.
Cost of Goods Sold: Cost of goods manufactured plus the beginning finished goods
inventory minus the ending finished goods inventory.
Direct Labor: Labor costs of all employees directly engaged in converting materials
into finished goods. Direct labor costs are clearly and conveniently trace-
able to specific products.
Direct Materials: Materials whose only use is to make specific products and their
costs are clearly and conveniently traceable to those products.
Finished Goods: Manufactured products that are ready for sale.
Finished Goods Inventory: The title of an account for maintaining a record for
finished products.
Indirect Costs: All costs of producing goods or providing services except for the
costs of direct materials and direct labor.
Indirect Labor: Employees who work to support the production process. However,
they do not take an active part in converting the materials into finished
goods. Maintenance staff, security, custodians, human resources staff, and
accountants are some examples of indirect labor.
Indirect Materials: Materials that a firm uses in producing the products but are
not easily traceable to specific products or jobs. Examples include glue, oil,
fuel, tapes, and cleaning supplies.
Job-Order Cost System (Job Costing System): A method for accumulating all
costs incurred for producing a specific product according to the individual
jobs, such as a building, a consulting job, or a batch of 100 desks.
Manufacturing Overheads: See Indirect Costs.
Materials: All items used in manufacturing processes.
Over-Applied (Over-Absorbed) Overhead: The amount by which the overhead
applied to production in a period exceeds the actual overhead costs incurred
in that same period.
Overheads: See Indirect Costs.
Period Costs: Costs not related to the production of products but incurred for the
general operations of a firm. They include administrative, selling, and inter-
est expenses.
Predetermined Overhead Rate: Determined by dividing estimated total overhead

costs for a period by the estimated level of activity, such as estimated total
machine-hours or direct labor-hours for the period.
Product Costs: Costs a company assigns to units produced. In manufacturing com-
panies, these costs are direct materials, direct labor, and manufacturing
overhead. In service companies that have no materials, these costs are
direct labor and overhead.
Statement of Cost of Goods Manufactured: An accounting report showing the
cost to manufacture and the cost of goods manufactured.
Total Manufacturing Costs: Includes the direct materials, direct labor, and manu-
facturing overhead costs incurred during a period.
Under-Applied (Under-Absorbed) Overhead: The amount by which actual over-
head costs incurred in a period exceed the overhead applied to production
in that period.
Work-in-Process: Partially completed products at the end of a period; a firm records
and reports such incomplete products as Work-in-Process Inventory.
4 Manufacturing
Cost Allocation
LEARNING OBJECTIVES
• Describe the cost allocation process.
• Compute predetermined overhead rates.
• Calculate departmental overhead rates.
• Describe the difference between support departments and operating
departments.
• Allocate support department costs to operating departments using the
direct, step-down (sequential), and reciprocal methods.
• Distinguish between plantwide overhead rates, departmental overhead
rates, and activity-based overhead rates.
4.1. INTRODUCTION
Costs are the necessary expenditures that a business must spend to produce prod-
ucts or provide services. Providing goods or services or undertaking projects have
economic consequences (costs and benefits). Costing is the process of determining
costs of all resources (capital, human, and equipment) consumed in producing and
delivering the products and services or completing the projects. Whereas, valuation
is the process of determining the worth of the products, services, or projects.
A proper cost allocation is a crucial process for a firm to accurately compute the
costs for all product lines or departments and, accordingly, to determine the per-unit
costs and profits. With such information, a firm would have insights for improv-
ing the profitability of certain products, or developing strategies for cost reductions.
However, misallocation of costs may cause making incorrect decisions. Cost ana-
lysts should make sure that they correctly allocate costs to the affected cost objects
and that they choose appropriate cost allocation bases.
The direct (materials and labor) costs may conveniently be traced and assigned to
specific products or operating departments. However, the overheads (costs of service
departments) may not be traceable to specific products or operating departments.
Therefore, a firm must use an appropriate method to allocate the overheads to its cost
objects (e.g., product lines, departments, or customers).
A firm needs a system to track the costs of its operations. Two of the most com-
monly used systems are traditional costing and activity-based costing. Of these,
one of these is easy to use and inexpensive, while the other requires more time and
effort (costlier) to implement but provides superior accuracy.
DOI: 10.1201/9780429432163-4 89
A firm should group the individual costs into cost pools, from which it allocates
the costs. Maintenance costs, warehouse costs, human resources costs, safety and
security costs, and custodial costs are some typical examples of cost pools. A firm
usually uses a single cost allocation basis, such as labor hours, machine hours, the
number of employees, or occupied floor space, to allocate costs from a cost pool to
the affected cost objects.
4.2. TYPES OF DEPARTMENTS
In a manufacturing firm, there are two types of departments, operating departments
and service departments. The operating departments carry out the main objectives
of the firm, which are producing products or providing services to clients. These
departments are directly engaged in the transformation of raw materials or assem-
bling the parts into finished goods in a manufacturing organization, or the provision
of services to clients in a service organization. The following are examples of oper-
ating/production departments:
• Assembling • Joining • Packaging

• Casting and molding • Knitting • Painting
• Cutting • Machining • Planing (woodworking)
• Electronics • Matching • Refining
• Fabricating • Milling • Shearing and forming
• Finishing • Mixing • Upholstery
The service departments are not directly engaged in manufacturing goods or provid-
ing services. However, they provide services to operating departments. The follow-
ing are examples of service departments:
• Accounting services • Internal auditing department • Receiving

• Cafeteria • Legal support • Research and Development
• Custodial services • Maintenance and Repairs • Parking and landscaping
• Engineering and Design • Medical services • Safety and Security
• Human resource • Production scheduling • Shipping
• Information and Technology • Purchasing • Supplier relations
• Inspection department • Quality assurance • Warehouse (storage)
4.3. TRADITIONAL OVERHEAD COST ALLOCATION

Recall that the total cost of a product is the sum of its direct materials, direct labor,
and share of manufacturing overhead costs. A firm can conveniently assign the direct
material costs to cost objects (i.e., products, jobs, or departments) using its preferred
inventory valuation method. It can also conveniently assign the direct labor costs to
the cost objects by determining the labor hours used by each cost object and multi-
plying them by the labor cost rates.
Manufacturing Cost Allocation 91
Costs allocation serves three main purposes: (1) make decisions, (2) reduce
non-value-added costs, and (3) determine pricing. Managing cost control and eval-
uation of various departments, the management needs a systematic process for
allocating the overhead (indirect) costs to multiple products or multiple depart-
ments. A typical cost allocation process in a multi-department company includes
the following steps:
1. Allocating the overhead costs to all cost objects/centers (i.e., production/

operating and service departments);
2. Reallocating the costs of service departments to the production/operating
departments;
3. Finally, assigning the costs of each production department (including the
allocated costs of service departments) to product lines.
Another challenge in costing is the adequacy of allocation of the overhead costs to

specific cost objects (departments, products, or jobs). Choosing a reasonable method
is the key to achieving this objective.
Cost analysts may use one of the two general common methods: “predetermined
overhead rate” or “overhead accumulation.”
4.3.1. Predetermined-Overhead-Rate Method
One of the most common approaches for assigning overhead costs is developing
and using a predetermined overhead rate. Such a rate is an overhead cost factor for
assigning factory overhead costs to specific units or jobs. A firm determines the
rate based on projected overhead costs and production volumes for the period. This
method is suitable for job-order costing, and for cases in which price determination
is necessary at the time the job orders are taken. The rate is computed in three steps:
1) Using cost behavior analysis, estimate all overhead costs for the coming
fiscal period.
2) Select an appropriate measure as the allocation basis, which can closely
relate overhead costs to the products produced. The most common mea-
sures for cost allocation are direct labor hours, direct labor dollars, machine
hours, units of output, number of requisitions, and floor space. The selected
allocation measure becomes the denominator of the fraction used for com-
puting the predetermined overhead rate.
3) Divide the total estimated overhead costs for the period by the total basis
(hours, dollars, units, square feet, etc.) expected for the period. The result is
a predetermined overhead rate, as expressed by the following formula.
Predetermined overhead rate Estimated overhead cost

= (4.1)
( per direct unit of measure ) Projected units of measure
For example, assume that the estimated overhead costs are $450,000 and manage-
ment projects that 25,000 direct labor hours will be required during the period.
Estimated overhead cost

Predetermined overhead rate =
( per direct labor hour ) Estimated direct labor hours
= $450,000/25,000 hours
= $118 per direct labor hour
Overhead costs are then applied to individual products on the basis of the number of
labor-hours required to produce each unit. For example, if it takes 1/2 hour of direct
labor to produce 1 unit of the product, that unit will be assigned $9 of manufacturing
overhead cost. This amount would be added to the direct materials and direct labor
costs to arrive at the overall manufacturing unit cost.
Example 4.1
Assume that, during a specific period, a company produced 6,000 units of its
product. The production costs during the period included the following:
Raw Materials $6,000

Direct Labor 10,800
The company can determine the production unit cost as follows:
Raw Materials ($6,000/6,000 units) $1.00

Direct Labor ($10,800/6,000 units) 1.80
Factory Overhead ($5,400/6,000 units) 0.90
Unit Cost (overall) $3.70
In this example, where all of the information is known, the unit cost was com-
puted at the completion of the job. However, before completion of the job, such
perfect information is not readily available. Then, the company needs a good
estimate of the unit cost to use for price mark-ups. The following is an example of
applying a predetermined overhead rate.
Example 4.2
Assume that the cost analyst of a company, based on historical cost information,
has developed the following data for one of the company’s products:
Raw Materials $3.50 per unit

Direct Labor $8.50 per unit
Factory Overhead 50% of direct labor cost
Based on the predetermined overhead rate of 50% of direct labor cost, the analyst
may compute the unit cost as follows:
Raw Materials $3.50

Direct Labor 8.50
Factory Overhead 0.5 × $8.50 = 4.25
Unit Cost $16.25
The computed unit cost of $16.25 is merely an estimate based on a predetermined

overhead rate and may not be an exact cost. Nevertheless, it is very helpful for
product pricing and job costing purposes.
4.3.2. Overhead Accumulation Method

Another method of assigning overhead costs to products is to accumulate all manu-
facturing overheads in cost pools during a period. Then, allocate the accumulated
amounts to the product lines. This method, which according to the process cost-
ing system (as opposed to the job-order costing system), involves no guesswork and
results in a fairly accurate allocation of overhead costs to products manufactured.
However, this method of costing has distinct disadvantages:
• It treats all products as being identical. Whereas, the products that require
more materials and time than others should absorb more overhead costs.
• A firm cannot compute the cost of goods manufactured until the end of a
period. Therefore, performing cost analysis is rather difficult during the
period.
• Such a method does not facilitate an advance determination of a product’s
price under the cost-plus pricing method. To obtain an effective pricing
tool, the manufacturer needs to know the cost prior to receiving an order to
quote the selling price for a product without waiting for the completion of
the ordered job.
In a traditional costing method, a firm may apply a single plantwide allocation

rate; or they may apply a single overhead allocation rate for each department. The
firm may use the department allocation approach, which applies several alloca-
tion rates (one for each department) and therefore uses several predetermined
overhead rates.
4.4. ACTIVITY-BASED COSTING (ABC)

Under the traditional methods, the measures of indirect costs allocated to prod-
ucts or departments are somewhat arbitrary. However, accountants have developed
activity-based costing (ABC), which is a more objective procedure for costs allo-
cation. Activity-based costing provides more detailed measures of costs than the
traditional methods. The Chartered Institute of Management Accountants (CIMA)

defines ABC as:
an approach to the costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to activities, and activi-
ties to cost objects based on consumption estimates. The latter utilize cost drivers to
attach activity costs to outputs. (CIMA, 2008)
Activity-based costing (ABC) is a costing method that assigns overhead (indirect)

costs to activities and to the cost objects (divisions or products) based on their
use of activities. That is, ABC is based on the concept that activities consume
resources (cost centers), and divisions or products (cost objects) consume activi-
ties. Figure 4.1 illustrates this concept for a hypothetical automobile manufactur-
ing company.
Under ABC, a firm may use a single-stage or a two-stage process for allocating
its overheads. A single-stage cost allocation process uses a single, plantwide, rate
to allocate costs. Whereas, a two-stage system first allocates costs to departments
or activities and then allocates costs from the departments or activities to the prod-
ucts or services. However, the two-stage provides more accurate results in allocating
costs.
Human Resource Insurance Safety Custodial Maintenance
Activity 1 Activity 2 Activity 3

Purchasing
Materials Press Body Paint Engine Assembly Finished

Warehouse Shop Shop Shop Plant Line Goods
Activity 4 Activity 5 Activity 6 Activity 7
Direct Costs
Indirect Costs Model A Model B Model C
FIGURE 4.1 ABC cost centers (departments), activities, and cost objects (automobile
models).
4.4.1. Bases for Overhead Allocation

Each department within a company incurs costs or expenses. Therefore, each
department is a cost center. Overhead costs are allocated to the affected cost
centers based on some output measures, known as cost drivers. A cost driver or
allocation base is a basis upon which an overhead cost is allocated to the cost
objects (production and service departments, products, jobs, or services). An
allocation base takes a quantity form, such as machine hours used, kilowatt-
hours consumed, or square-footage occupied. In many situations, a firm must
allocate its overheads to several departments or cost centers within the factory.
As examples, we present some practical bases for overhead costs allocation in
the following subsection.
When the use of a resource or the performance of an activity changes, the level
of the cost driver (or output measure) will also change, causing changes in costs.
Figure 4.2 presents examples of cost drivers for various types of service costs
(overheads).
A related concept to activity-based costing is Activity-Based Management
(ABM). Through ABM, managers try to identify activities that consume resources.
Then, they would develop strategies to manage costly activities to reduce costs and
improve quality.
Cost Driver (Allocation Basis) Service Cost (Overhead)

Number of employees Factory lunchroom costs, factory dispensary medical services,
human resource costs, and health insurance.
Direct materials, Indirect materials.
Number of requisitions Indirect materials, maintenance/repair and warehouse costs.
Number of machines Machinery maintenance and repair costs.
Machine hours Machinery maintenance and repair costs; and depreciation.
Number repair requests Machinery maintenance.
Kilowatt-hours Light and power (if meters are installed)
Floor space occupied Building depreciation, and maintenance, lease/rent, fire insurance,
property taxes, safety and security and custodial costs.
Investment in equipment Machinery depreciation and fire insurance.
Direct labor cost Payroll taxes and worker compensation insurance.
Maintenance labor hours Maintenance and repair costs
Employee training hours Human resource costs.
Units/volumes handled Warehouse, shipping and receiving costs.
Capacity of machines Light & power costs.
Number of computers Information technology service costs.
Weights of laundry Laundry costs
Number of flights Airport ground service costs.
FIGURE 4.2 Examples of costs drivers for various service costs (overheads).
Example 4.3
Shell Tech Company allocates its indirect material costs to its cost centers (depart-
ments) on the basis of direct charges according to the store requisitions, as follows:
Distribution of indirect material

costs
Department X $4,200
Department Y 3,500
Department Z 1,000
Maintenance Department 2,500
Warehouse 900
Total $12,100
The company allocates indirect labor costs to the cost centers (departments) on
the direct charges basis, according to the time card analysis, as follows:
Distribution of indirect labor costs

Department X $3,800
Department Y 3,000
Department Z 2,000
Maintenance Department 2,500
Warehouse 1,000
Total $12,300
The total cost of light and power, which was $3,000, is allocated in accordance
with the number of kilowatt-hours used. Therefore, the allocation rate will be 0.03
per kW-h (i.e., $3,000/100,000).
Distribution of light and power costs
kW-h Used Light and Power Cost

Department X 38,000 $1,140
Department Y 26,000 780
Department Z 20,000 600
Maintenance Department 11,000 330
Warehouse 5,000 150
Total 100,000 $3,000
Payroll taxes, amounting to $861, are allocated in accordance with the indirect
labor costs charged to each department, as follows: ($861/$12,300 = $0.07) ×
(Indirect Labor Cost)
Distribution of payroll taxes
Indirect Labor Payroll Taxes

Department X $3,800 $266
Department Y 3,000 210
Department Z 2,000 140
Maintenance Department 2,500 175
Warehouse 1,000 70
Total 12,300 $861
A total of $1,000 fuel was directly used by and charged to the Maintenance
Department. The cost of repairs amounted to $2,840, was directly charged to
each department, as follows:
Distribution of repair costs

Department X $1,000
Department Y 670
Department Z 195
Maintenance Department 560
Warehouse 415
Total $2,840
Rent and Fire Insurance costs were, $6,000 and $1,200, respectively, allocated in
proportion to the floor space occupied (square footage), as follows:
Distribution of rent and insurance costs
Floor Space Ratio (%) Rent Fire Insurance

Department X 3,200 40 $2,400 $480
Department Y 2,400 30 1,800 360
Department Z 1,200 15 900 180
Maintenance Department 800 10 600 120
Warehouse 400 5 300 60
Total 8,000 100 $6,000 $1,200
The depreciation of machinery is allocated using the straight-line method based

on cost, as follows:
Distribution of depreciation cost
Depreciation
Cost of Machinery Charged
Department X $25,000 $5,000
Department Y 20,000 4,000
Department Z 15,000 3,000
Maintenance Department 10,000 2,000
Warehouse 1,200 240
Total $71,200 $14,240
Sundry (miscellaneous) costs, of total $1,850, are allocated in proportion to the

number of employees in each department, as follows:
Distribution of sundry costs
Number of Employees Ratio (%) Sundry Costs

Department X 40 40 $740
Department Y 20 20 370
Department Z 20 20 370
Maintenance Department 15 15 278
Warehouse 5 5 92
Total 100 100 $1,850
All allocated costs are recorded in a “worksheet for allocation of factory over-
head.” Then the overhead costs allocated to service departments are reallocated
to operating/production departments. Assume that the company reallocates the
costs of the Storeroom first, according to the number of requisitions filled, as
shown below:
Number of Requisitions Ratio (%)

Department X 1,000 40
Department Y 750 30
Department Z 500 20
Maintenance Department 250 10
Total 2,500 100
The Maintenance Department’s costs are reallocated next, according to floor

space occupied by the production departments, as listed below:
Floor Space
Department (sq. ft.) Ratio
Department X 3,200 8/17
Department Y 2,400 6/17
Department Z 1,200 3/17
Total 6,800 1.00
The entire overhead cost allocation for this example is summarized in the work-
sheet shown in Figure 4.3.
Shell Tech Company

Work-Sheet for Allocation of Factory Overhead
For the Month of July, 2006
Production Departments Service Dept.
Maint- Store-
Overhead Cost Item Allocation Basis Total X Y Z
enance room
Indirect Materials Materials Used $12,100 $4,200 $3,500 $1,000 $2,500 $ 900
Indirect Labor Labor Performed 12,300 3,800 3,000 2,000 2,500 1,000
Payroll Taxes Wages 861 266 210 140 175 70
Fuel To Maintenance 1,000 1,000
Light and Power kW-h used 3,000 1,140 780 600 330 150
Repairs Cost of Repairs 2,840 1,000 670 195 560 415
Rent Floor Space 6,000 2,400 1,800 900 600 300
Depreciation, Machinery Cost of Machine 14,240 5,000 4,000 3,000 2,000 240
Fire Insurance Floor Space 1,200 480 360 180 120 60
Sundry Costs No. of Employees 1,850 740 370 370 278 92
TOTALS $55,391 $19,026 $14,690 $8,385 $10,063 $3,227
Reallocation of
Service Department Costs:
Storeroom Costs No. of Requisitions -------- 1,291 968 645 323 (3,227)
$55,391 $20,317 $15,658 $9,030 $10,386 ---
Maintenance Dept. Costs Floor Space -------- 4,888 3,666 1,832 (10,386)
Final Cost Distribution $55,391 $25,205 $19,324 $10,862 --- ---
FIGURE 4.3 A worksheet for overhead cost allocation for Example 4.3.
4.4.2. Overhead Cost Pools

Cost analysts and accountants follow a systematic process to allocate all costs to the
produced units. To accomplish this, they use cost pools for allocating their factory
overheads to units of products they produce. A cost pool is a grouping of all overhead
costs associated with performing a particular task, such as maintenance, warehous-
ing, human resources, security and safety, and physical plant services. Accountants
allocate costs in the cost pools to the operating and support departments based on
the cost drivers (activities) and, then, they reallocate the costs assigned to the support
departments to the operating departments. For example, a firm accumulates the costs
of the Maintenance Department in a cost pool and, then, allocates the costs in this
pool to the departments that have used its services. The difference between operating
(or production) and support (or service) departments is explained as follows:
• Operating/Production Departments: An operating/production depart-

ment is directly involved with manufacturing products; for instance, each
of the several stations in an assembly line is an operating department.
• Support Departments: A support/service department is not directly
involved with producing products, but it renders services to the operating
departments; examples of support departments are: warehouse, building
maintenance, human resources department, custodial services, purchasing
department, and transportation department.
Activity-Based Costing (ABC) uses cost pools to allocate costs to its activities. An
activity is the smallest possible unit of work. An activity consumes resources, such
as staff and machine times or funds. Conceptually, an activity is any action that con-
verts an input into an output.
4.5. METHODS FOR REALLOCATING COSTS

OF SUPPORT DEPARTMENTS
The costs allocated to the support departments are the company’s overhead costs.
Thus, they will be reallocated to the operating departments. There are three popular
methods for reallocating service department costs to operating departments: direct
method, step-down method, and reciprocal method. It is important to realize that
regardless of the method used to allocate support department costs, total factory
overhead costs remain unchanged. However, the different allocation methods split
up the costs differently among the production departments.
4.5.1. Direct Method of Reallocating Support Costs

The direct method is the simplest method of allocating the costs of service depart-
ments to production departments. Under this method, a firm does not allocate the
costs incurred by a service department to any other service departments; it rather
directly allocates them to the production departments based on relative uses.
Suppose, for example, a firm has two production and two service departments;
whereas departments P1 and P2 are production departments, and departments S1
and S2 are service departments. Under the direct method of cost allocation, the firm
allocates the costs incurred by departments S1 and S2 to departments P1 and P2
only. It would not allocate the costs of departments S1 and S2 to each other even
though these two departments provide service to each other.
Example 4.4
The Lantar Company has two service departments and two operating depart-
ments. The costs incurred during a given per are summaries as follows:
Production Service
Departments Departments
P1 P2 S1 S2 Total
Departmental costs ($) 255,550 335,850 99,000 68,400 758,800
Labor hours 10,000 14,000 3,000 8,000 29,000
Floor space occupied (sq. ft.) 13,000 27,000 12,000 8,000 65,000
The two service departments provide services to production departments and to

each other as well. The company allocates the costs of department S1 based on
direct labor hours and the costs of department S2 based on floor space occupied.
Determine how the company would allocate the costs of the service departments
to the production departments using the direct method of cost allocation.
Solution
The allocation of department S1’s costs based on the labor-hour rate:
Rate = $99,000/(10,000 + 14,000) = $4.125 per labor hour

Cost allocated to department P1: $4.125(10,000) = $41,250
Cost allocated to department P2: $3.3875(13,450) = $57,750
The allocation of department S1’s costs based on the labor-hour proportions
Proportion to production department P1 = 10,000/(10,000 + 14,000) = 5/12

Proportion to production department P2 = 14,000/(10,000 + 14,000) = 7/12
Cost allocated to department P1: (5/12)(99,000) = $41,250
Cost allocated to department P2: (7/12)(99,000) = $57,750
The allocation of department S2’s costs based on per square foot floor space rate:
Rate = $68,400/(13,000 + 27,000) = $1.71 per sq. ft.

To department P1: $1.71(13,000) = $22,230
To department P2: $1.71(27,000) = $46,170
The allocation of department S2’s costs based on floor space proportions:
Portion to production department P1 = 13,000/(13,000 + 27,000) = 0.325

(or 32.5%)
Portion to production department P2 = 27,000/(13,000 + 27,000) = 0.675
(or 67.5%)
Cost allocated to department P1: (0.325)(68,400) = $22,230
Cost allocated to department P2: (0.675)(68,400) = $46,170
The following is a summarized cost allocation using the direct method:
Production Departments Service Departments
P1 P2 S1 S2 Total
Cost before allocation $255,550 $335,850 $99,000 $68,400 $758,800
Allocation of:
Department S1’s costs $41,250 $57,750 (99,000) 0
Cost after allocation $319,030 $439,770 $0 $0 $758,800
The major advantage of the direct method for allocating service department costs
is its simplicity and ease of use. However, it comes with two major disadvantages.
First, it ignores the mutual services among service departments. This may hinder
reviewing the actual costs of such a department for finding cost reduction poten-
tials. The second disadvantage tails into the first one, and the inaccuracy in the
actual service costs can distort the final cost allocations to the products.
Periodically, cost accountants prepare a worksheet to allocate the factory over-
head costs to various cost centers (product lines and service departments).
4.5.2. Step-Down Method of Reallocating Support Costs

The step-down (or step method or sequential) method allocates the costs of a service
department to other service departments as well as to production departments. Under
the step method, the cost allocation is a sequential process. It starts with allocating
the costs of the service department that provides the highest level of service to other
service departments to production departments and all other service departments. It
ends with allocating the costs of the last service department (including the absorbed
costs from other service departments), which provides the least amount of service to
other service departments, to the production departments. This method follows the
following steps:
1) Select a service/support department and allocate its costs to the production

departments and support departments to which it provides services. Give
priority to the support department that provides the highest level of service
to all service departments. If this is not possible, then choose the service
department with the greatest total costs. Do not allocate costs back to the
service department itself.
2) Select another service department and allocate its cost to the production
departments and the remaining support departments. Do not allocate
any cost back to the service department whose costs have already been
allocated.
3) Proceed in this manner until the costs of all the service departments have
been allocated to the production departments.
The following is an example of allocating (overhead) costs of support/service depart-

ments using the step-down (or sequential) method.
Example 4.5
Recall the cost information for the Lantar Company, in the previous example, as
restated below. Allocates the costs of department S1 based on direct labor hours
and the costs of department S2 based on floor space occupied using the step-
down method.
Production Service
P1 P2 S1 S2 Total
Departmental costs ($) 255,550 335,850 99,000 68,400 758,800
Labor hours 10,000 14,000 3,000 8,000 29,000
Floor space occupied (sq. ft.) 13,000 27,000 12,000 8,000 65,000
Solution
We need to determine the costs of the service department of which allocation is
done first. We can determine this as follows:
Total labor hours of service provided by department S1:

10,000 + 14,000 + 8,000 = 32,000 sq. ft.
Proportion of service of department S1 provided to S2:
8,000/32,000 = 25%
Total floor space served by department S2:
13,000 + 27,000 + 10,000 = 50,000 sq. ft.
10,000/50,000 = 20%
Since department S1 provided a higher proportion of its service to department

S2 than vice versa, we start with allocating the costs of S1 to other departments.
Then, we allocate the updated costs of the service department S2 to the produc-
tion departments.
The allocation of department S1’s costs based on labor-hour proportions
Total labor hours used to serve other departments by S2 = 10,000 + 14,000

+ 8,000
= 32,000 hours
Proportion to service department S2 = 8,000/32,000 = 1/4 = 25%
Proportion to production department P1 = 10,000/32,000 = 5/16 = 31.25%
Proportion to production department P2 = 14,000/32,000 = 7/16 = 43.75%
Cost allocated to department S2: (1/4)(99,000) = $24,750
Cost allocated to department P1: (5/16)(99,000) = $30,938 (rounded up)
Cost allocated to department P2: (7/16)(99,000) = $43,312 (rounded down)
The allocation of department S2’s costs based on per square foot floor space rate:
Total cost of department S2 to allocate to departments P1 and P2:

$68,400 + 24,750 = $93,150
Rate = $93,150/(13,000 + 27,000) = $2.32875 per sq. ft.
To department P1: $2.32875(13,000) = $30,274
To department P2: $2.32875(27,000) = $62,876
The following is a summarized cost allocation using the step-down method:
Production Service
P1 P2 S1 S2 Total
Allocation of:
Department S1’s costs $30,938 $43,312 (99,000) 24,750 0
4.5.3. Reciprocal Method of Reallocating Support Costs

The reciprocal method fully recognizes the reciprocal services provided by support
departments to other support departments. As a result, the reciprocal is the most
accurate cost allocation method among the three. This method uses simultaneous
equations to allocate the costs incurred by each service department to other depart-
ments. The total cost of a support department is the sum of its own direct costs and
the allocated costs of other support departments.
Example 4.6
Recall the cost information for the Lantar Company, in the previous example, as
restated below. Allocates the costs of department S1 based on direct labor hours
and the costs of department S2 based on floor space occupied using the recipro-
cal method.
Production Service
P1 P2 S1 S2 Total
Departmental Costs ($) 255,550 335,850 99,000 68,400 758,800
Labor Hours 10,000 14,000 3,000 8,000 29,000
Floor Space Occupied (sq. ft.) 13,000 27,000 12,000 8,000 65,000
Solution
As we did under the step-down method, we need to determine the proportion of
the services received by each service department from other service departments,
as restated below:
Total labor hours of service provided by department S1:

10,000 + 14,000 + 8,000 = 32,000 sq. ft.
8,000/32,000 = 25% of S1 costs to S2
Total floor space served by department S2:
13,000 + 27,000 + 12,000 = 52,000 sq. ft.
12,000/52,000 = 3/13 (23.077%) of S2 costs to S1
The reciprocal method allocates 25% of the total cost of service department S1 to
service department S2; and 20% of the total cost of department S2 to department
S1, as expressed by the following cost equations:
S1 = $99,000 + (3/13)S2
S2 = S68,400 + 0.25S1
By the substitution method, the costs of department S1 (designated by S1) becomes:
S1 = 99,000 + (3/13)($68,400 + 0.25S1)

(49/52)S1 = $114,785.6154
S1 = $121,812 (equals departmental cost of $99,000 plus $22,812 service
cost from S2)
The costs of department S2 (designated by S2) becomes:
S2 = $68,400,000 + 0.25[$99,000 + (3/13)S1]

(49/52)S2 = $93,150
S2 = $98,853 (equals departmental cost plus $30,453 service cost from S1)
Note that the sum of the costs of departments S1 and S2 is higher than the sum of
their direct costs.
Now, we allocate the costs of the service departments to the production depart-
ment. We use the direct method but not the step-down method as we have already
performed the mutual service costs allocation between the two service departments.
The allocation of total costs of department S1 to production departments based
on labor hours in all other departments, including the service department S2:
Total labor hours to account for = 10,000 + 14,000 + 8,000 = 32,000 hours
Proportion to production department P1 = 10,000/32,000 = 5/16
Cost allocated to department P1: (5/16)($121,812) = $38,066 (rounded)
Cost allocated to department P2: (7/16)($121,812) = $53,293 (rounded)
To allocate the cost of department S2 based on floor space occupied by all other
departments, including the service department S1:
Total floor space served by S2 = 13,000 + 27,000 + 12,000 = 52,000

To department P1: (13/52)($98,853) = $24,713
To department P2: (27/52)($98,853) = $51,328
The following is a summarized cost allocation using the direct method:
Production
Departments Service Departments
P1 P2 S1 S2 Total
Allocated cost of:
Department S1 38,066 53,293 (121,812) 30,453 0
Department S2 24,713 51,328 22,812 (98,853) 0
After allocating the service costs, the firm can divide the final costs of the produc-
tion departments by their corresponding output units to determine the manufac-
turing unit cost for each product.
SUMMARY
Cost allocation is the process of assigning common overhead costs to two or more
cost objects (e.g., products, divisions/departments, customers). Ideally, cost alloca-
tion must reflect the cause-and-effect relationship between cost pools and the cost
objects to which they are allocated.
Firms try to select the basis for cost allocation that is the underlying cost driver.
For example, a firm may choose direct labor hours as the cost driver for allocating
its indirect costs (overheads). It would divide the total overhead costs incurred in a
fiscal period by the total number of direct labor hours for the period. Then, it applies
the per-hour overhead rate to each cost object based on the number of direct labor
hours used by the cost object.
Under the traditional allocation method, the firm chooses one overhead rate as a
means to allocate its overhead costs. Activity-based costing (ABC) is a more com-
plex but accurate approach to allocating overheads. Instead of using a single factor
in traditional methods, the ABC uses several factors to determine how to allocate
various overheads. Each factor is tied directly to an aspect of overheads. Then, the
firm allocates cost to each product based on how much of each element of overheads
is used to produce the product.
The ABC allocates overheads in two stages. In the first stage, a firm determines
the overhead cost per unit of each activity that causes (drive) costs. For example, say
that the total cost of the human resources (HR) department is $300,000 per year and
the firm has 500 employees. The first stage of allocation would be to compute the
HR’s cost per employee is $600. The second stage is to allocate the activity cost to
each department based on the number of employees. For this example, if department
X consists of 75 employees, $45,000 of HR’s annual costs (i.e., $600 × 75 employees)
is assigned to department X. The use of ABC can be summarized as follows:
List Cost Pools (Cost Centers): Identify and categorize all resources as
1)
cost pools or cost centers. Determine the amount of the costs pertaining to
each cost pool during the fiscal period.
List Cost Objects: List the relevant cost objects that consume resources
2)
(i.e., departments, product lines, customers).
List Cost Drivers (Activities): activities involved in the manufacturing
3)
process link the cost pools to the cost objects. For example, labor hours,
machine hours, set-up frequencies, number of machines, number of employ-
ees, floor spaces occupied, and testing.
Service department cost allocations are required to include the costs of support ser-
vices in the costs of products and services provided. The three major methods for
allocating the service department costs are the direct method, the step method, and
the reciprocal method. The use of the methods depends on the extent to which ser-
vices are provided by one service department to another.
Traditional costing simply applies an average (single) overhead rate to add over-
head costs to the direct costs of manufacturing products, which is best used when
the overhead of a company is low relative to the direct costs of production. Activity-
based costing identifies all of the operations that are indirectly related to the manu-
facture of each product or department.
Process costing is used for mass production (i.e., when high volumes of a stan-
dardized product is produced) according to the following five steps.
Step 1: Cost Accumulation. Lists all costs in the beginning WIP and add the
costs added during the period to get “Total Costs to Account For.”
Step 2: Physical Flow of Units. Determine the total number of units worked
during the period of interest to get “Total Units to Be Accounted For”;
and find what happened to those units to get “Total Units Accounted For.”
These are computed as follows:
Beginning work in process units + units started this period
= Total Units to Be Accounted For
Units completed and transferred + Ending work in process units
= Total Units Accounted For
Step 3: Equivalent Units. Equivalent units are the number of units completed
and transferred out plus the equivalent number of complete units for the
partially completed units in the WIP.
Step 4: Cost per Equivalent Unit. Compute the total costs incurred dur-
ing the period and the cost of the beginning WIP, and divide by the Total
Equivalent Units calculated in Step 3. The formula is applied to direct
materials, direct labor, and overhead individually. The calculation is:
( Cost of beginning work in process inventory )

+ ( costsadded this period )
Cost Unit = .
( Total equivalent units )
Step 5: Assign and Reconcile Costs. Multiply the equivalent units in WIP
calculated in Step 3 by the cost per equivalent unit calculated in Step 4 to
get the cost of ending WIP inventory. Multiply units completed and trans-
ferred by the cost per unit calculated in Step 4 to get the cost units com-
pleted and transferred out (in the final stage, the result will be the Cost of
Goods Manufactured).
REFERENCE
CIMA, (2008). CIMA Official Terminology. The Chartered Institute of Management
Accountants (CIMA). Retrieved January 21, 2021 from: http://www.cimaglobal.com/
Documents/ Impor tedDocuments/cid_tg_activity_based_costing_nov08.pdf.pdf.
REVIEW QUESTIONS
R4.1. Explain why companies allocate costs. What is the main issue in cost
allocation?
4.2.
R What are the different methods of cost allocation?
R4.3. What does it mean by cost allocation?
R4.4. What is the purpose of cost allocation?
R4.5. What are the steps in overhead allocation using predetermined rates?
R4.6. What are the three common methods of allocating costs of support/ser-
vice departments to operating departments?
R4.7. What is the difference between a service department and a production/
operating department?
4.8. What does the term “reciprocal services” refer to?

R
R4.9. Explain how direct, step-down, and reciprocal methods allocate the
costs of service departments to the production departments.
R4.10. Explain how a sequence of service departments is chosen under the step-
down method for allocating the costs of service departments to the pro-
duction departments.
R4.11. Explain the “single-stage” and “two-stage” cost allocation processes.
R4.12. Describe the plantwide and department rates for overhead cost allocation.
R4.13. What are the differences and similarities among the direct, step-down,
and reciprocal methods of allocating costs of service departments?
R4.14. What criterion should be used to determine the order of reallocating the
costs of service departments under the step-down method?
PROBLEMS
P4.1. The following worksheet for allocation of factory overhead of the
Waldoor Company for the month of August 20XX is given. Assume
that the Warehouse has received less service from the Building Service
Department than the other way around. So, first reallocate costs of the
Warehouse to the Building Department, according to the number of
store requisitions filled. Then, reallocate costs of the Building Service
Department according to the floor space occupied.
Waldoor Company
Worksheet for Allocation of Factory Overhead
For the Month of August, 20XX
Production Department Service Department

Allocation
Overhead Cost Item Basis Total A B C Building Warehouse
Indirect Materials Materials Used $21,425 $6,045 $5,400 $3,350 $4,915 $1,715
Indirect Labor Labor Performed 27,000 6,750 5,000 4,000 3,750 7,500
Payroll Taxes Wages 810
Light and Power kW-h Used 3,500
Repairs Cost of Repairs 2,740 1,250 430 250 635 175
Depreciation, Machinery Cost of Machine 7,500 2,640 1,800 1,200 1,860 —
Fire Insurance Floor Space 1,300
Other Expenses No. of Employees 1,800
TOTAL $66,075
Reallocation of Service
Department Costs:
Warehouse Costs No. of Requisitions
Building Service Floor Space

Department Costs
Final Cost
Required: Based on the following information, complete the worksheet.
Light and Power Floor Space No. of No. of Store

Department (kW-h) (sq. ft.) Employees Requisition
Department A 35,000 3,500 40 40
Department B 30,000 2,500 25 20
Department C 22,000 2,000 20 12
Building Service 9,000 1,200 10 8
Warehouse 4,000 800 5 —
Totals 100,000 10,000 100 80
P4.2. Delta Company has two service departments, Maintenance (Maint) and
Warehouse (Ware), and two operating departments (Departments A and
B). The costs of the Maintenance Department are allocated based on the
floor space occupied. The costs of Warehouse are allocated based on the
number of store requisitions. The following information is provided:
Service Department Operating Department
Maint Ware A B
Costs ($) 90,000 45,000 180,000 250,000
Floor Space (sq. ft.) 10,000 20,000 30,000 50,000
Number of Requisitions 7,000 500 10,000 15,000
Required: Allocate the costs service departments using:

a) The direct method.
b) The step-down method.
c) The reciprocal method.
P4.3. Using the provided worksheet allocate MKATZ Company’s factory
overheads to its service departments (Maintenance and Warehouse) and
production departments (X, Y, and Z).
MKATZ Company
Worksheet for Allocation of Factory Overhead
For the Month of July, 20XX
Production
Departments Service Department
Overhead Cost Allocation

Item Basis Total X Y Z Maintenance Warehouse
Indirect Materials Materials Used $24,300
Indirect Labor Labor 17,400
Performed
Payroll Taxes Wages 2,460
Fuel To Maintenance 1,134
Light and Power kW-h Used 3,400
Repairs Cost of Repairs 2,840
Rent Floor Space 6,000
Depreciation, Cost of 14,250
Machinery Machine
Fire Insurance Floor Space 1,200
Sundry Costs No. of 1,800
Employees
TOTALS $57,484
Reallocation of
Service
Department
Costs:
Warehouse Costs No. of
Requisitions
Maintenance Floor Space

Department
Costs
Final Cost
Distribution
A worksheet for overhead cost allocation for Problem P4.4.

The following data were obtained from the company’s records:
Number of Floor Space Number of kW-hrs

Department Employees (sq. ft.) Requisitions Used
Production X 60 5,500 1,000 33,000
Production Y 50 4,200 800 24,600
Production Z 34 3,800 700 16,900
Maintenance 10 2,000 1,500 3,200
Warehouse 6 4,500 — 2,300
Total 160 20,000 4,000 80,000
• Indirect materials are charged as they are requested by the consuming

department, the indirect labor is allocated to the cost centers accord-
ing to time card recordings, and repair costs are also charged directly
where repairs occurred, as follows:
Department Indirect Materials Indirect Labor Repair Cost

Production X $8,500 $4,600 $998
Production Y 6,500 4,200 670
Production Z 4,000 4,300 490
Maintenance 20,500 30,500 357
Warehouse — 12,900 345
Total $39,500 $56,500 $2,860
• Payroll taxes, amounting to $11,280, are allocated based on the indirect

labor cost charged to each department.
• A total of $3,600 fuel cost was directly used by and charged to the
Maintenance Department.
• The light and power cost of $3,200 is allocated according to the number
of kilowatt-hours used.
• Rent and Fire Insurance costs were, $9,000 and $1,200, respectively,
are based on the floor space occupied by each department.
• Depreciations of machinery were computed according to the compa-
ny’s depreciation schedules and are as shown below:
Department Depreciation Charged

Production X $2,200
Production Y 1,800
Production Z 1,200
Maintenance 1,000
Warehouse 500
Total $6,700
• The sundry (miscellaneous) expenses of a total of $320 are allocated

based on the number of employees in each department, as follows:
• The overhead allocated to service departments is reallocated to pro-
duction departments using the “step-down” method, assuming that the
Warehouse has provided more services to the Maintenance Department
than receiving from it. The Warehouse costs are reallocated based on
the number of store requisitions and the Maintenance Department’s
costs are reallocated based on the floor space occupied.
P4.4. The Talesh Company has the following data pertaining to its three ser-
vices and two operating departments:
Service Operating
S1 S2 S3 A B Total
Overhead Costs $84,000 $66,000 $40,000 $90,000 $97,000 $377,000
Number of Employees 15 25 15 110 90 255
Space Occupied (sq. ft.) 10,000 15,000 20,000 100,000 80,000 255,000
Machine Time (hours) — — — 15,000 25,000 40,000
The company allocates service department costs as follows:

1. Allocates Department S1’s costs based on the number of employees.
2. Allocates Department S2’s costs based on the square footage of
space occupied.
3. Allocates Department S3’s costs based on the hours of machine
time.
Required
Allocate the cost of service departments to operating departments using
the step-down method in descending order of their costs.
5 Joint Cost Allocation
LEARNING OBJECTIVES
• Describe joint products and joint costs.
• Identify the split-off point(s) in a common process for multiple products.
• Distinguish joint (main) products from by-products.
• State reasons for joint cost allocation.
• Allocate joint costs using various methods.
• Allocating cost to by-products.
• Decide to sell products at the split-off point or process further.
• Decide which products to produce.
• Apply mathematical programming to joint cost allocation.
5.1. INTRODUCTION
When processing a common input (material) results in producing two or more out-
puts (products or services), the output products are referred to as joint products
(occasionally, as common products). Joint costs allocation is the process of assigning
the common costs to the multiple products manufactured from a common input or
process. Companies allocate costs to establish a cost basis for pricing or perfor-
mance evaluation.
Figure 5.1 illustrates multiple products that are produced from the same set of
inputs through the same manufacturing process. As shown in the figure, in such a
manufacturing process, there is a point, called the “split-off point,” before which
it is not possible to identify the individual products. Beyond this point all products
are clearly identifiable, and separated and sent through their corresponding special
processing lines (if needed to complete the products). The costs incurred up to the
split-off point are referred to as “joint costs” and any costs incurred beyond the split-
off point (i.e., during the special process) are called “separable costs.”
The following are three examples of multiple products that are jointly produced
from the same input materials:
• Processing crude oil results in several different products, such as gaso-

line, diesel fuel, oil, kerosene, plastic, waxes, asphalt, and other oil-based
products.
• Processing a cow, in meatpacking, results in joint products, such as raw-
hide, ground beef, steaks, and other meat products.
• Processing raw milk results in joint products, such as whole milk, skim
milk, butter, cheese, cream, and other dairy products.
DOI: 10.1201/9780429432163-5 115
Further Processing Final Market

(Separable) costs Value
Product 1: Q1 units P1×Q1

Joint Costs
Common Process Split P1×Q1

Product 2: Q1 units
Off
Product 3: Q1 units P1×Q1
FIGURE 5.1 An illustration of production flow for manufacturing joint products through a
common (or joint) process.
5.2. JOINT COST ALLOCATION TERMINOLOGY

The reader should be familiar with the terminologies used in cost accounting for
multiple products in order to comprehend its concepts. In general, any of the manu-
factured multiple products can be a joint product, a common product, or by-product.
The classification of multiple products depends on how they are produced and their
market value. Joint and common products are defined as follows (Williams and
Kennedy, 1983; Tayyari and Parsaei, 1992).
• Joint products are those multiple products of a single production process

that are manufactured in fixed proportions.
• Common products are those products that are manufactured in common
by processing the same input materials and production facility in variable
proportion.
• A by-product is an output of a manufacturing process that adds a relatively
small amount to the total market value of all outputs and considered as
incidental product. For example, sawdust or wood barks are by-products
of the lumber industry and feathers are by-products of poultry processing.
The distinction between main (joint and common) products and by-products is usu-
ally based on the market value of the product. A main (joint or common) product
adds significantly to the total market value of all outputs. By-products do not add
significantly to the total market value of all multiple products. By-products may
also be defined as those joint products that are of minor importance, either because
their production is incidental to the main objectives of the manufacturing process or
because they have relatively little value. Hence, classification of a product as a main
product or a by-product requires personal judgment.
Other important terms used in joint cost allocations include:
• Main products are products that a manufacturer intends to produce and

have significant sales values as compared to the sales values of other
product(s).
Joint Cost Allocation 117
• Intermediate products are products that require further processing before

becoming salable.
• Final products are products that are completed and ready for sale without
requiring further processing.
• Split-off point (SOP) is the point at which a joint process ends and the indi-
vidual products are identified and separated from each other, beyond which
separate processes for the individual products begin if needed. This point of
production may also be referred to as the point of recovery.
• Joint costs (JC) include all costs of processing joint products prior to the
split-off point.
• Separable costs are the costs incurred after the split-off point to complete
the individual joint product.
• Relative market value (RMV) or net-realizable value (NRV), in joint
cost allocation, is an approximated sales value of a joint product at the split-
off point, which equals the final market (sales) value less the needed further
processing (separable) cost, as expressed in the following formula:
RMV = ( Selling Price – Unit Separable Cost ) ´ ( Units Produced )
• Scraps are products with no values or negative sales values if the manufac-
turer must haul them away to a landfill.
5.3. REASONS FOR JOINT COST ALLOCATION

Joint costs are production costs. There are several important reasons for allocating
joint costs to the individual products, which include the following:
• Financial reports: Joint costs are allocated to products to determine inven-

tory values of the unsold units of the products and the cost of goods sold for
both internal and external reports.
• Product pricing: The price of a product is usually set based on its total
cost; whereas the joint costs are part of the total manufacturing cost.
• Profitability analysis for decision-making: Profitability analysis is used
to determine which product to produce. Such analysis is based upon the
manufacturing costs and sales prices of the products.
• Decision about selling products at the split-off point: The management
may decide to sell some or all joint products at the split-off point when the
further processing (separable) costs cannot be justified.
• Contract reimbursement: Cost-based contracts require justification and
document for the incurred costs to authorize reimbursement, especially for
government contracts.
• Regulated products: For some products, the prices are set and controlled
by regulatory agencies. Prices are set based on the costs to the producers
of the products.
• Insurance settlement: When an insurance claim is filed for damaged

assets, documentation for each asset’s value is required.
• Litigations: When a company initiates legal action or defends itself against
a legal action regarding a product or service, it needs reasonable documen-
tation, including cost documentation.
5.4. PROFITABILITY ANALYSIS AND DECISION SCENARIOS

The objective of producing products is usually to maximize profits. To provide a
good basis for making decision about producing the products that maximize overall
profit, the following analysis procedure becomes necessary:
1) Identify final products from the joint process.

2) Forecast the sales volume and price relationship for each product.
3) Estimate the further processing costs needed beyond the split-off point for
converting each product into a final (or salable) product.
4) Continue producing the products that result in the overall maximum profit.
However, in the presence of multiple constraints and requirements, finding an opti-

mal solution may require mathematical programming (e.g., linear programming and
nonlinear programming). A firm that produces joint products may deal with the fol-
lowing decision scenarios:
1) Which product to produce?

2) Sell a product at split-off or process further?
3) How much of each product to produce?
5.4.1. Decision Scenario 1: Which Product to Produce?

When there are no constraints or requirements, it will be obvious the product(s) that
generate(s) the maximum overall profit would be produced.
5.4.2. Decision Scenario 2: Should Sell a Product

at Split-Off or Process Further?
A decision-maker may have to decide whether to sell a product at the split-off or

process it further. In such a case, a product should be processed beyond the split-off
point only if the incremental revenue exceeds its incremental processing costs.
In a “sell-or-process-further” decision, joint costs are sunk costs and irrelevant.
Joint products have been produced, and a prospective decision must be made to take
one of the following actions:
• Sell a product “as is” at the split-off point;

• Process further, which requires additional separable costs, and, then, sell
at a higher price.
Example 5.1
A lumber yard cuts logs of wood from which unfinished lumber and wood chips
are the joint products. The unfinished lumber can be sold “as is” or processed
further into finished lumber.
Wood chips can also be sold “as is” for landscaping or processed further into
composite boards. The data about the two joint products include:
Per Log
Lumber Wood Chips

Sales value at the split-off point $1,200 $300
Sales value after further processing 2,600 350
Allocated joint costs 290 60
Cost of further processing 500 65
An analysis of selling at the split-off point or further process:
Per Log
Lumber Wood Chips

Sales value after further processing $2,600 $350
Sales value at the split-off point 1,200 300
Incremental revenue $1,400 $50
Cost of further processing 500 65
Incremental profit (loss) from further processing $900 $(15)
Questions
a) Should they process the lumber further and sell the wood chips “as is” at
the split-off point?
b) How about wood chips?
Answers
a) They should process lumber further as it generates an additional $900
profit.
b) They should not process wood chips further and sell them at the SOP “as
is” since its further processing reduces the profit by $15 per log.
5.4.3. Decision Scenario 3: How Much of Each Product to Produce?

This scenario usually arises when the decision is made in the presence of one or
more constraints or requirements. Examples of such constraints are the limitations
on resources (e.g., materials, labor time, machine time availability) and the rate of
consumption of the resources by the individual products. In such cases, mathemati-

cal programming models play a major role in determining a product-mix that maxi-
mizes the overall profit.
5.5. TRADITIONAL METHODS FOR JOINT COST

ALLOCATION TO MAIN PRODUCTS
Joint costs are indivisible because the products cannot be obtained separately. All
joint costs that are incurred prior to the split-off point must be allocated among the
multiple products to determine a unit cost for each product. The unit costs are depen-
dent upon the allocation scheme employed. Any costs incurred beyond the split-off
point are separable and are directly traceable to a particular joint product thus they
are directly assigned to that particular output. Several traditional methods for allo-
cating joint costs to the multiple products are presented in many accounting books
(e.g., Myer, 1972; Needles et al., 1993; Kaplan, 1982).
The following are the common methods for allocating joint costs to the joint
(main) products:
• Physical-measure (or simple-average-cost or average-unit-cost) method.

• Weighted-average-cost method (an extension of physical-measure method).
• Sales-value method.
• Relative-market-value (or net-realizable-value) method.
• Constant-gross-margin method.
The following two common methods are used to account for by-products:
• Zero-cost method.
• Net-realizable-value (or reversal-cost) method.
5.5.1. Physical-Measure Method of Joint Cost Allocation

The physical-measure method (also known as quantitative unit, physical quantity,
simple-average-cost, and average-unit-cost method) allocates joint costs to prod-
ucts in proportion to a physical measure (for example, volume or weight). The is the
simplest method for allocating a joint production cost to joint products because it
assumes all the joint products are of the same units and have the same market values.
The average unit cost is calculated by dividing the total joint cost by the total number
of units of joint products produced.
Example 5.2
AAA Chemical Company processes a single material into two separate products, X
and Y. Both products are salable immediately at the split-off point. Product X sells
for $15 per gallon and Product Y for $3 per gallon. During the month of June, the
company incurred $16,000 for materials, labor, and overhead in processing 4,000
gallons of an input material. The process yielded 1,200 gallons of X and 2,000
gallons of Y. (Note that the total number of units of the output does not have to be
the same as the number of units of the input.) The company sold 900 gallons of
Product X and 1,500 gallons of Product Y during June. You are asked to allocate
the $16,000 joint costs to Products X and Y using the physical-measure method.
Solution
You can solve the problem by either of the following two procedures:
First procedure for joint cost allocation under the physical-measure method:
Step 1: Computing the average unit cost:
Average unit cost = ( Total cost ) ( Total number of units of output )

= $16, 000 (1, 200 + 2, 000 ) = $5.00 per gallon
Step 2: Allocating the joint cost:
Joint cost allocated to a Product = ( Average unit cost ) ´ (Number of units )
Joint cost allocated to Product X = $5.00 ´ 1, 200 gal. = $6, 000
Joint cost allocated to Product Y = $5.00 ´ 2, 000 gal. = $10, 000
Second procedure for joint cost allocation under the physical-measure method:
Step 1: Computing the proportion of production outputs:
Product production proportion = (Product output quantity ) ( Total output quantity )
Total output quantity = 1, 200 + 2, 000 = 3, 200 gallons
Proportion of Product X output = 1,200 3,200 = 0.375 ( or 37.5% )
Proportion of Product Y output = 2,000/3,200 = 0.625 ( or 62.5% )
Step 2: Allocating the joint cost:
Joint cost allocated to a Product = (Product output proportion) ´ ( Total joint cost )
Joint cost allocated to Product X = 0.375 ´ $16, 00 = $6, 000
Joint cost allocated to Product Y = 0.625 ´ $16, 00 = $10, 000
If it is desired, the average unit cost for each product can be determined by divid-
ing its allocated cost by its production quantity, as follows:
Average unit cost for Product X = ($6, 000 ) (1, 200 gallons ) = $5.00 per gallon
Average unit cost for Product Y = ($10, 000 ) ( 2,000 gallons ) = $5.00 per gallon
As you have noticed from this example, the joint costs per unit for all products are
the same. However, the final manufacturing will be different as the separable costs
(per unit) are different among the products.
The following is a partial product-line income statement for the above example.
AAA Chemical Company

Product-Line Income Statement
(Physical-Measure Method for Allocating Joint Costs)
Product X Product Y Total

Sales (900 × $15) = $13,500 (1,500 × $3) = $4,500 $18,000
Joint Costs (900 × $5) = 4,500 (1,500 × $5) = 7,500 12,000
Gross Margin $9,000 ($3,000) $6,000
Gross Margin as a % of Sales 66.67 −66.67 33.33
This example unveiled a major disadvantage of the physical-measure method of

cost allocation, which is an unfair cost assignment to Product Y whose market
value is not even close to that of Product X. The method is practical only for the
production processes in which the difference among the market values of the joint
products is very insignificant. However, if a process produces joint products that
substantially differ in values from each other, the physical-measure method would
not be appropriate for the joint costs allocation.
5.5.2. Weighted-Average Method of Joint Cost Allocation

In some situations, the simple-average method may not give a satisfactory result for
the joint cost apportionment. The weighted-average method would often provide
a better solution to the joint cost allocation problem. The weighted-average method
uses weight factors assigned to each unit of the joint products, such as the size of the
product, its complexity and difficulty to manufacture, time consumed in manufactur-
ing the unit, the type of labor skills, amount of materials used, etc.
Under the weighted-average method, the finished production quantity of each
product is multiplied by a weight factor as a basis for allocating the joint cost to the
individual products.
Example 5.3
In Example 5.2, assume that AAA Chemical Company uses the weighted-average
method for allocating its joint cost to Products X and Y with the following weight
factors:
Product X: 4.5 points

Product Y: 1.3 points
The total joint cost (JC) to be allocated to the joint products is $16,000.
Solution
Weighted units:
For Product X = 4.5 (1,200 gallons ) = 5, 400 gallons
For Product Y = 1.3 ( 2,000 gallons ) = 2, 600 gallons
Joint cost per weighted unit:
Total weighted units = 5, 400 + 2, 600 = 8, 000 gallons
$16,000/8,000 = $2.00 per weighted unit
Allocated joint cost:
To Product X = $2 ( 5, 400 ) = $10, 800
To Product Y = $2 ( 2, 600 ) = $5, 200
Joint cost per unit:
For Product X = $10,800/1,200 = $9.00 per gallon
For Product Y = $5,200/2,000 = $2.60 per gallon
The following is a partial product-line income statement in this example.


Sales 900 × $15 = $13,500 1,500 × $3 = $4,500 $18,000
Joint Costs 900 × $9 = 8,100 1,500 × $2.60 = 3,900 12,000
Gross Margin $5,400 $600 $6,000
Gross Margin as a % of 40.00 13.33 33.33
Sales
As you noticed, Product Y was not profitable under the simple-average-cost (i.e.,
the physical-measure) method, but under this method, it becomes profitable
because less joint cost is allocated to it.
5.5.3. Sales-Value Method of Joint Cost Allocation

The sales-value method is used when the joint products are sold at the split-off point
“as is” without further processing (i.e., there are no separable costs). This method is
similar to the weighted-average method. It uses the sales values of the products as
the basis (as a weight factor) for joint cost allocation. Under the sales-value method,
the user allocates the joint cost in the following steps:
Step 1: Compute the potential sales value (SVi) for each of the joint products:
SVi = ( Sales Price ) ´ ( Production Quantity )

where i = 1, 2, …, n is product index.
Step 2: Compute the total sales value (TSV) by summing the sales values of
all joint products, from Step 1.
n
TSV = å SV .
i =1
i
Step 3: Compute the proportion of sales value of total sales value (TSV) for
each product:
Proportion for product i = SVi / TSV.
Step 4: Allocate the joint cost to each joint product by multiplying its corre-
sponding proportion by the joint cost:
Joint cost allocated to product i = ( SVi / TSV ) ´ ( Joint cost ) .
Example 5.4
In Examples 5.2 and 5.3, assume that AAA Chemical Company uses the sales-
value method for allocating its joint cost to Products X and Y and sells the product
without any further processing at $15 per gallon of Product X and $3 per gallon
of Product Y.
Solution
Step 1: Compute the potential sales value (SVi ) for each of the joint products:
SVX = $15 ´ 1, 200 gallons = $18, 000
SVY = $3 ´ 2, 000 gallons = $6, 000

Step 2: Compute the total sales value (TSV) by summing the sales values of
all joint products, from Step 1.
TSV = $18, 000 + $6, 000 = $24, 000
Step 3: Compute the proportion of sales value of total sales value (TSV) for
each product:
Proportion for Product X = $18,000/$24,000 = 0.75 or 75%
Proportion for Product Y = $6,000/$24,000 = 0.25 or 25%
Step 4: Allocate the joint cost to each joint product by multiplying its cor-
responding proportion by the joint cost:
Joint cost allocated to Product X = 0.75 ($16, 000 ) = $12, 000
Joint cost allocated to Product Y = 0.25 ($16, 000 ) = $4, 000
Joint cost per unit:
For Product X = $12, 000 / 1, 200 = $10.00 per gallon
For Product Y = $4, 000 / 2, 000 = $2.00 per gallon
The following is a partial product-line income statement in this example.


Sales 900 × $15 = $13,500 1,500 × $3 = $4,500 $18,000
Joint Costs 900 × $10 = 9,000 1,500 × $2.00 = 3,000 12,000
Gross Margin $4,500 $1,500 $6,000
Gross Margin as a % of Sales 33.33 33.33 33.33
As you notice, both products would generate equal gross margin percentage
under this method since the allocated joint cost to each product is in proportion
to their sales value.
5.5.4. Relative-Market-Value Method of Joint Cost Allocation

At the split-off point, although the products are separated, they may not be salable
because they are not finished yet. Thus, finishing the products require further (sep-
arate) manufacturing or processing, which incur further processing (or separable)
costs. There may also be a separable selling costs for each product in addition to the
separable manufacturing costs.
Figure 5.1, as presented at the beginning of this chapter, illustrates the relation-
ship among joint costs, separable costs, and joint products.
The relative-market-value method (also known as the net-realizable-value method)
allocates joint costs to products in proportion to their relative sales values at the split-
off point. The relative market (or net realizable) values means approximated sales
values of the joint products at the split-off point, which is computed by subtracting
the further processing costs (incurred beyond the split-off point) from the estimated
final sales values. If no additional processing is required beyond the split-off point,
the method becomes the sales-value method (i.e., the previous method).
If the physical-measure or weighted-average method of joint cost allocation is
used, there is no need to know the relative market values of the products at the split-
off point. However, if we should use the relative-market-value method to allocate
joint costs, we will have to approximate the market value of each joint product at the
split-off point.
Under the sales-value method, the user allocates the joint cost in the following
steps:
Step 1: Compute the net realizable (relative market) value (RMVi or NRVi) for
each of the joint products:
NRV = ( Sales Price - Separable cost per unit ) ´ ( Production Quantity )
NRVi = ( Pi - SCi ) ´ Qi
where i = 1, 2, …, n is product index.

Step 2: Compute the total net realizable value (TNRV) by summing the net
realizable values computed in Step 1.
n
TNRV = å NRV .
i =1
i
Step 3: Compute the proportion of the net realizable value for each product
relative to the total net realizable value (TNRV):
Proportion for product i = NRVi / TNRV.

Step 4: Allocate the joint cost to each joint product by multiplying its corre-
sponding proportion by the joint cost:
Joint cost allocated to product i = ( NRVi / TNRV ) ´ ( Joint cost ) .
Example 5.5
The XYZ Chemical Company produces two products, A and B, using a single
input material in its manufacturing process.
Assumptions
• No market exists for either product at the split-off point.

• Additional manufacturing and selling costs must be incurred prior to the
final point, where both products become ready for sale.
• During the month of June, 50,000 gallons of materials were processed at
a joint cost of $100,000.
• All units have been completed at the end of June.
• The following table shows how many gallons of each product resulted
from the process, and for each product, the quantity sold, the selling
price per unit, as well as the separable cost per unit.
Product A Product B
Production (in gallons) 25,000 25,000
Sales (in gallons) 20,000 15,000
Ending Inventory – gallons 5,000 10,000
Sales Price – per gallon $8.00 $14.00
Separable Costs:
Manufacturing – per gallon $3.00 $6.00
Selling – per gallon $1.00 $2.00
The provided data can be visualized by the following diagram:

Separable Costs
Manufacturing Selling Sales
Price Volume
$3.00 $1.00
$15 900 gal.
Product A: 25,000 gal.
Joint Cost = $16,000
Input Material: 4,000
$6.00 $2.00 $ 3 1,500 gal.
Product B: 25,000 gal.
Since no actual sales price exists at the split-off point for Products A and B, we
must first approximate the relative market values of the total production volume
for each of the joint products at the split-off point. Then, we can allocate the joint
cost.
Product A Product B Total

Product Volume (gallons) 25,000 25,000 50,000
Sales Price – per gallon $8.00 $14.00 —
Total Sale Value of Products $200,000 $350,000 $550,000
Less: Separable costs:
Manufacturing (75,000) (150,000) (225,000)
Selling (25,000) ( 50,000) ( 75,000)
Approximate Market Value
at Split-Off Point $100,000 $150,000 $250,000
Proportion 100/250 = 40% 150/250 = 60% 100%
Share of joint cost $40,000 $60,000 $100,000
To obtain the total manufacturing cost for the purpose of calculating the manu-
facturing unit cost for each product, add the separable manufacturing cost (but
not the separable selling expenses) to the allocated joint cost for each product, as
shown below:

Allocated Joint Costs $40,000 $60,000 $100,000
Add: Separable Manufacturing 75,000 150,000 225,000
costs
Total Manufacturing Costs $115,000 $210,000 $325,000
Production Volume, gallons 25,000 25,000 —
Unit Cost (cost per gallon) $4.60 $8.40 —
The separable selling costs (expenses) are not included since they are periodic
costs that are expensed in the period they are expired. The costs per unit, $4.60/
gallon and $8.40/gallon, are used to value the ending inventories of Products A
and B, respectively.
XYZ Chemical Company

(Relative Market Value for Allocating Joint Costs)

Sales (gal. × $/gal.) $160,000 $210,000 $370,000
Manufacturing Costs* $115,000 $210,000 $325,000
Less: Ending Inventory** 23,000 84,000 107,000
Cost of Goods Sold $92,000 $126,000 $218,000
Gross Margin $68,000 $84,000 $152,000
Gross Margin as % of Sales 42.5 40 41.08
Less: Period Expenses*** $20,000 $30,000 $50,000
Profit before Taxes $48,000 $54,000 $102,000

Profit per Unit $2.40 $3.60 —
* Total manufacturing costs for all units.

** Ending Inventory: A: 5,000 gallons×$4.60/gal. = $23,000
B: 10,000 gallons×$8.40/gal. = $84,000
*** Selling Expense: A: ($25,000/25,000 gal.)×20,000 gals. sold = $20,000
B: ($50,000/25,000 gal.)×15,000 gals. sold = $30,000
5.5.5. Constant-Gross-Margin Method of Joint Cost Allocation

This method allocates joint costs to joint (main) products in such a way that each
individual product attains the same gross-margin ratio, rate, or percentage (GMR or
GM%). This ratio is computed as follows:
Gross Margin = Sales Value – Cost of Goods Sold
Gross Margin
GM% =
Sales
Note that, in joint cost allocation, the sales value is the potential sales values of all
joint products produced during a period (not just the units of products that were actu-
ally sold during the period), and the cost of goods sold would be the total of joint
costs and all separable costs.
Under the constant-gross-margin method, the user allocates the total joint cost in
5 steps:
Step 1: Compute the potential sales value (ultimate sales value) for all and
each product, which the products would eventually earn.
Step 2: Compute the total cost by summing the joint costs and all separable
costs for all joint products, as expressed by the following formula:
Total Cost = Joint Costs + Total Separable Costs
Step 3: Compute the overall gross margin by subtracting the total costs from
the total potential revenues, as expressed by the following formula:
Overall Gross Margin = Total Final Sales Value of All Products - Total Costs
Step 4: Compute the overall gross margin percentage by dividing the total
gross margin by the total potential revenues, as expressed by the following
formula:
Overall Gross Margin

Gross Margin Percentage ( or Ratio ) =
Total Sales Value of All Products
Step 5: Allocate joint cost to each product by multiplying the gross margin
percentage by the potentials sales value of the product and then deducting
its separable cost, as expressed by the following formula:
Joint Costs Allocated to a Product = ( Sales Value of the Product )
- ( Gross Margin of the Product )
- ( Separable Cost of the Product )
Example 5.6
During the previous month, the XYZ Company produced three products through
a single process and incurred a joint production cost of $350,000. The following
relevant financial data for the month are also provided:
Product Production Level Separable Cost Sales Price

X 12,500 $120,000 $32
Y 6,500 100,000 50
Z 7,000 60,000 25
Required: Allocate the joint production cost to Products X, Y, and Z using the
constant-gross-margin-percentage method.
Solution
Step 1: Compute the total potential revenue (TR):
TR = $32 (12, 500 ) + $50 (6, 500 ) + $25 (7, 000 )

= $400, 000 + $325, 000 + $175
5, 000 = $900, 000
Step 2: Compute the total cost (TC):
TC = $350, 000 + ($120, 000 + $100, 000 + $60, 000 ) = $630, 000
Step 3: Compute overall gross margin (GM)
GM = $900, 000 - $630, 000 = $270, 000
Step 4: Compute the gross margin percentage (GM%)
GM% = $270,000 / $900,000 = 0.3 = 30% of revenue

Step 5: Allocate joint cost to the joint products using GM%
(4) = (5) = (7) =

(1) (2) (3) (2)×(3) (2)−(4) (6) (5)−(6)
Potential Gross Separable Allocated

Product Revenue GM% Margin Total Cost Cost JC
X $400,000 30 $120,000 $280,000 $120,000 $160,000
Y 325,000 30 97,500 227,500 100,000 127,500
Z 175,000 30 52,500 122,500 60,000 62,500
Total $900,000 30 $270,000 $630,000 $280,000 $350,000
The manufacturing unit cost (UC) for the products are:
UCX = $280,000/12,500 = $22.40

UCY = $227,500/6,500 = $35.00
UCZ = $122,500/7,000 = $17.50
5.6. TRADITIONAL METHODS FOR JOINT COST

ALLOCATION TO BY-PRODUCTS
Because the market value of by-products is not significant as compared to the market
values of the main products, accountants usually follow simple methods in account-
ing for by-products. The two commonly used methods by accountants are (1) net-
realizable-value (or production) method and (2) zero-cost (or sales) method.
5.6.1. Net-Realizable-Value or Production Method

One method of accounting for by-products is the net-realizable-value (NRV) or pro-
duction method. A firm may use this method to value the quality of by-products
produced at their net realizable value at the split-off point. Net realizable value is
determined by the final sales price less separable costs. This method has the follow-
ing features:
• The joint cost assigned to a by-product equals its net realizable value (NRV)
at the split-off point. The joint cost assigned to the by-product reduces the
amount of joint costs assigned to the main products (i.e., the NRV of the
by-product is treated as cost savings).
• The by-product is recognized in the period in which it is produced.
• The cost of then by-product is added to the “By-product Inventory” account.
• When the by-product is sold, as its sales value and cost are equal to its NRV,
it will not generate any profit.
Accountants debit (charge) the total net realizable value of the by-products into the
“By-product Inventory” account and credit the “Joint Costs” account. Therefore,
joint costs of producing the main products are reduced by the net realizable value
of the by-products. The corresponding journal entry is usually recorded as follows:
By-product Inventory xxx
Joint Costs xxx
Example 5.5
Suppose that, during a period, a company by processing 13,700 kg of a certain

material jointly produced 9,000 kg of Product A, 4,000 kg of Product B, and 500
kg of a by-product (with some waste material). Assume that the company can sell
the product, at the split-off point without any further processing, as Product A at
$4.00/kg, Product B at $3.00/kg, and the by-product at $0.40/kg. The situation
can be diagrammed as:
Sales Price
Product A: 9,000 kg $4.00/kg
Joint Cost = $30,000 $3.00/kg

Product B: 4,000 kg
Material: 13,700 kg
By-product: 500 kg $0.40/kg
Assume, also, that company incurred the following joint costs:
Material costs $12,000

Labor costs $10,000
Predetermined overhead rate is 80% of the labor costs, that is, 10,000 × 80% $8,000
Total joint costs $30,000
In this example, the net realizable value of the by-product (NRVB) is equal to the
sales price since no additional costs are necessary to complete and sell the by-
product. Then,
NRVB = $0.40(500) = $200 (joint cost assigned to the by-product)

Joint cost to be assigned to main products = $30,000 − $200 = $29,800
The journal entries to record the transactions will be as follows:
Joint Cost 30,000

Wage Payable 10,000
Applied Overhead 8,000
To record the incurred joint costs
By-product Inventory 200
Joint Cost 200
To record the assigned cost to the by-product
If the firm uses the sales-value method, it would allocate the joint costs to the main
products as summarized in the following cost allocation schedule:
Selling Market
Price at Value at Joint Cost
Production Split-off Split-off to be Share of
Product Level (kg) Point Point Proportion* Allocated Joint Costs
A 9,000 $4.00 $36,000 75% $22,350
$29,800
B 4,000 $3.00 $12,000 25% $ 7,450
Total $48,000 100% $29,800 $29,800
* 36,000/48,000 = 75% and 12,000/48,000 = 25%.
The unit cost for Products A and B and the by-product (BP) would be:
Product Computation Cost per kg

A $22,350/9,000 $2.4833
B $7,450/4,000 $1.8625
BP $0.4000
5.6.2. Zero-Cost Method
The second method for accounting for by-products is the zero-cost or sale method.
This method assumes that no joint cost will be allocated to a by-product, so named
as the zero-cost method. Therefore, the entire joint cost, in the previous example
$30,000 (instead of $29,800), would be allocated to the two main products. Thus,
when a by-product is sold, its sales amount would be added to “revenues” in the
income statement and the cost of the by-product sold would be zero if there is no
further (separable) processing cost.
If separable processing costs are incurred to complete a by-product, the first method
would add the separable costs incurred for the by-product to its net realizable value.
If a firm uses the zero-cost method and does not assign any joint cost to the by-
product at the split-off point then only the separable costs would be debited to the
“By-product Inventory” account and credited to the corresponding accounts (i.e.,
materials and labor costs and applied overheads incurred for further processing), as
shown below:
By-product Inventory xxx

Direct Labor xxx
Applied Overhead xxx
To record by-product separable costs
The sales of the by-product are either added to the sales of the other joint products or
deducted from the cost of goods sold (COGS) of the other joint products. The sales
or COGS adjustments are done on the financial statement and not in the accounting
records.
5.7. QUANTITATIVE METHOD FOR JOINT COST ALLOCATION

The disagreement among practitioners in using joint cost allocation techniques has
made their techniques arbitrary and sometimes unjustifiable (Manes and Smith,
1965). To overcome this issue, engineers and quantitative analysts have applied
mathematical programming to joint cost allocation and by-product identifica-
tion (e.g., Manes and Smith, 1965; Weil, 1968; Kaplan, 1982; and Tayyari and
Parsaei, 1992). Engineering (mathematical programming) techniques are useful
in giving an insight into the nature of the joint-product problems and production
optimization. They also provide a basis for distinction between joint-product and
by-product.
5.7.1 Formulating Joint Cost Allocation

Tayyari and Parsaei (1992) presented a nonlinear programming model for joint cost
allocation to joint products as follows.
Let N be the set of n sequenced numbers representing the product indexes, and Xi
(i = 1, 2, …, n) be the sales quantity of the product i. The following assumptions are
made for the purposes of formulating the joint cost allocation:
1) n products are simultaneously produced in fixed proportions. That is, pro-

cessing each unit of the input material yields ai units of the ith product.
2) The production process is subject to a limited amount of K units of the input
material.
3) There exists enough information about the demand functions for the joint
products.
Hence, there will be n constraints representing the relationships between sales and
the input material quantities (i.e., Xi ≤ aiY, when Y units of input material are pro-
cessed and ai units of product i will be produced, where i = 1, 2, …, n).
Letting Pi indicate the price of the ith product (i = 1, 2, …, n) and Xi the number
of units of this product produced and sold, Pi can be expressed as a function of the
demand quantity. This function can be denoted as:
Pi = gi ( Xi ) , i = 1, 2,… , n (5.1)
Let’s assume that Y units of the input (raw) material are processed at a cost of
C dollars per unit (material and other processing variable costs). If Xi units of
product i (i = 1, …, n) are sold, the total revenue, TR(X), and total cost, TC(X),
are written as:
n n
TR ( X ) = å
i =1
Xi Pi + åX g ( X ) (5.2)
i =1
i i i
TC ( X ) = TC (Y ) = C × Y
(Note: X = (X1, X1, …, Xn), is the sales vector.)

The contribution margin is calculated as:
Z ( X, Y ) = TR ( X ) - TC (Y ) (5.3)
Therefore, the decision problem is to maximize the contribution margin (which

guarantees the maximum profits) subject to the availability and non-negativity con-
straints. That is,
Maximize: Z ( X, Y ) = åX g ( X ) - C × Y (5.4)
i =1
i i i
Subject to: Xi £ aiY , i = 1,… , n ( sales constraints )

Y £ K, ( material constraint )
Xi , Y ³ 0, i = 1,… , n ( non-negativity constraints )

This is a nonlinear programming problem that may be solved by classical quantita-
tive techniques in operations research. For example, the Lagrangian methods can be
used to obtain an optimal solution. This method will be particularly simple when the
demand–price functions are assumed to be linear. In such a case, the objective func-
tion would only involve linear and squared variables, and the problem, then, called a
quadratic programming problem.
Kaplan (1982) has applied the Lagrangian method in some numerical examples
with linear demand functions and relaxed the material constraint. By doing so, which
seems to be practical, and assuming Pi = bi − mi Xi (both bi and mi are non-negative
constant coefficients of the price–demand function for product i, where i = 1, 2, …,
n), the above nonlinear programming problem is reduced to the following form:
Maximize: Z ( X, Y ) = åX ( b - m X ) - C × Y (5.5)
i =1
i i i i
Subject to: aiY - Xi ³ 0, i = 1,… , n ( sales constraints )

Xi , Y ³ 0, i = 1,…,, n ( non-negativity constraints )
Under the Lagrangian method, each constraint is assigned a non-negative Lagrangian

multiplier, λi, such that λi(aiY − Xi) = 0, and add all λi(aiY − Xi) to the objective func-
tion to obtain the following form of nonlinear programming with non-negativity
constraints only:
n n
Maximize: Z ( X , Y , l ) = åi =1
Xi ( bi - mi Xi ) - C × Y + å ( a Y - X ) (5.6)
i =1
i i i
Subject to: Xi , Y , li ³ 0, i = 1,… , n ( non-negativity constraints )

Now, the optimal solution can be obtained by using Kuhn-Tucker conditions or simply
setting the first partial derivative of L(X, Y, λ) with respect to each variable (i.e., Xi, Y, λi)
equal to zero and then solving the following resulting equations simultaneously:
¶L
= bi – 2mi Xi - li = 0 i Î N (5.7)
¶Xi
åa l = 0
¶L
= –C + i i i Î N (5.8)
¶Y i =1
¶L
= aiY – Xi = 0 i Î N (5.9)
¶i
Xi , Y , li ³ 0 (5.10)
Given that all conditions expressed by Equations 5.7 through 5.10 are satisfied, the
results will be the optimal solution to the problem and appear in the following forms:
å ab
n
-C + i i
Y= i
2å m a
n
2
i i
(5.11)
i =1
Optimal number of units of input matterial to be processed
é
å a b ùúú
n
ê -C + i i
X j = aj ê i
Production and sales units of product j (5.12)
å m a úû
n
2
ê 2 i i
ë i =1
é
å a b ùúú
n
êC - i i
l j = bj + m ja j ê i
Joint cost assignedd to each unit of product j (5.13)
å a úû
n
2
ê i
ë i =1
In Equation 5.8, éê å ai li = C ùú , C is the joint cost allocated to the n products of

n
ë i =1 û
which λi dollars are allocated to each unit of product i.
However, if any of the λi is found to be negative, which violates the non-negativity
conditions, it must arbitrarily be set equal to zero and the corresponding product be
treated as a by-product, on a zero-cost basis. Then, the value λi = 0 is substituted in
Equations 5.7 and 5.8, the corresponding equation in the Equation set 5.9 is elimi-
nated, and the revised equations are solved again. In such circumstances, some units
of product i will remain unsold, which should be discarded. Otherwise, selling all
units of that by-product will reduce the price as well as the overall profits, unless the
residuals are sold in a different market.
Example 5.6
As an example, consider a situation in which for each unit of an input raw mate-
rial, one unit of Product 1 and two units of Product 2 are obtained. Assume that
the price of each product is affected by the volume of product supplied to the
market. Let
Pi = the price of product i , where i = 1, 2, and
Qi = the volume of product i produced and sold.
Assume the following relations for product’s volume and price:
P1 =15 – Q1 (5.14)
P2 = 49 – 2Q2 (5.15)
Assume, also, that the input material is bought at a price of $6/unit. Variable cost
is $4/unit of processed input material. The question is how many units of the input
material should be bought and processed.
Let Y be the number of units of the input material to be processed. Then, Y units
of Product 1 and 2Y units of Product 2 can be produced. The total revenue will be
TR = P1Q1 + P2Q2
Knowing that P1 is a function of Q1 and P2 is a function of Q2, substituting P1 and

P2 by their equivalent values in terms of Q1 and Q2 from Equation (5.14) and (5.15),
respectively, the total revenue will be a function of Q1 and Q2.
TR = Q1 × (15 - Q1) + Q2 × ( 49 - 2Q2 )
or
TR = 15Q1 - Q12 + 49Q2 –2Q22

Therefore, the objective will be to maximize the contribution margin (total rev-
enue minus processing variable cost):
Maximize: Z = 15Q1 - Q12 + 49Q2 – 2Q22 - (6 + 4 ) Y
or
Maximize: Z = 15Q1 - Q12 + 49Q2 –2Q22 - 10Y
subject to: Q1 £ Y
Q2 £ 2Y
Q1, Q2 , Y ³ 0
This is a nonlinear programming with two inequality constraints and non-negativ-

ity condition.
This problem can be solved using Lagrange multipliers. That is, for each
inequality constraint, a non-negative Lagrange multiplier, λi, will be associated:
l1 for Q1 £ Y
l2 for Q2 £ 2Y
If Q1 = Y , then l1 > 0 and if Q1 < Y , then l1 = 0.
If Q2 = 2Y , then l2 > 0 and if Q2 < 2Y , then l2 = 0.
Here, the Lagrange multipliers play roles of dual variables (as for linear program-
ming). The problem would be:
Maximize: L = 15Q1 - Q12 + 49Q2 –2Q22 - 10Y + l1(Y - Q1) + l2( 2Y - Q2 )

subject to: Q1, Q2 , Y , l1, l2 ³ 0.
To solve this problem, the first partial derivatives will be set equal to zero (the
first-order conditions):
¶L
= 15 – 2Q1 -l1 = 0 (5.16)
¶Q1
¶L
= 49 – 4Q2 -l2 = 0 (5.17)
¶Q2
¶L
= -10 + l1 +2l2 = 0 (5.18)
¶Y
¶L
= Y - Q1 = 0 (5.19)
¶1
¶L
= 2Y - Q2 = 0 (5.20)
¶2
Q1 = Y
Q2 = 2Y
15 - 2Y - l1 = 0 Þ l1 = 15 - 2Y
49 - 4 ( 2Y ) - l2 = 0 Þ l2 = 49 - 8Y
-10 + l1 + 2l2 = 0
-10 + (15 - 2Y ) + 2 ( 49 - 8Y ) = 0 or
18Y = 103 Þ Y = 5.72 units
Q1 = Y Þ Q1 = 5.72 units
Q2 = 2Y = 2 ( 5.72) Þ Q2 = 11.44 units
l1 = 15 - 2Y = 15 - 2 ( 5.72) Þ l1 = $3.56
l2 = 49 - 8Y = 49 - 8 ( 5.72) Þ l2 = $3.24
P1 = 15 - X1 Þ P1 = $9.28
P2 = 49 - 2X 2 Þ P2 = $37.56
Equation (5.18) can be rewritten as:
l1 +2l2 = 10 (5.21)
where 10 is the joint cost to be allocated to Products A and B. Equation (5.21)

provides the following cost allocation to the products:
λ1 dollars for each unit of product 1, and

λ2 dollars for each unit of product 2.
It is known, from economic theory and elementary calculus, that achieving the
maximum profit requires that the marginal revenue be equal to the marginal cost.
The marginal revenues of the two products in this example are:
¶
MR1 = 1 1) = 15 - 2Q1
(PQ
¶Q1
¶L
MR 2 = (P2Q2 ) = 49 – 4Q2
¶Q2
The numerical values of marginal revenues at the optimum values (i.e., Q1 = 5.72
units and Q2 = 11.44 units) are:
MR1 = 15 - 2 ( 5.72) = $3.56
MR 2 = 49 - 4 (11.44 ) = $3.24
The marginal cost of processing one unit of the input material (which produces
one unit of Product 1 and two units of Product 2) is $10. The marginal revenue
obtained through processing an additional unit of the input material is:
MR1 +2MR 2 = 3.56 + 2 ( 3.24 ) = $10.04
This is approximately $10, which is equal to the marginal cost. This result verifies
that the computations for the optimal solution were correct.
5.7.2. A Basis for Identifying By-products

Consider a situation in which the processing of 1 unit of raw material yields 3 units of
Product 1 and 2 units of Product 2. The demands for the two products in the market
as functions of sales prices are given as follows:
Q1 = 36 - P1 ( for Product 1)
Q2 = 19 - 0.5P2 ( for Product 2 )
Assume that the supply of the raw material is unlimited and it costs $8 per unit.
The variable cost of processing one unit of the raw material is $6 per unit. Find the
optimal quantity of the raw material and quantities and prices of the output products.
The problem is a nonlinear program.
P1 = 36 – Q1 Þ PQ
1 1 = 36Q1 – Q1
2
P2 = 38 – 2Q2 Þ P2Q2 = 38Q2 – 2Q2 2
Then the Lagrangian model is of the form:
Max L = 36Q1 - Q12 + 38Q2 –2Q2 2 – 14Y + l1 (3Y – Q1 ) + l2 (2Y – Q2 )
Subject to: Q1, Q2 , Y , l1 , l2 ³ 0

The first-order conditions of the problem are:
¶L
= 36 – 2Q1 -l1 = 0
¶Q1
¶L
= 38 – 4Q2 -l2 = 0
¶Q2
¶L
= -14 + 3l1 +2l2 = 0
¶Y
¶L
= 3Y - Q1 = 0
¶1
¶L
= 2Y - Q2 = 0
¶2
From the last two equations Q1 = 3Y and Q2 = 2Y. By substituting these values for Q1
and Q2 in the first two equations and solving for λ1 and λ2 in terms of Y, the following
would be the result: λ1 = 36 − 6Y and λ2 = 38 − 8Y.
Now, substitute these values for λ1 and λ2 in the third equation:
-14 + 3 ( 36 - 6Y ) + 2 ( 38 - 8Y ) = 0 Þ Y = 5
The other factors are:
Q1 = 15, Q2 = 10, l1 = 6, l2 = -2 < 0.
The value λ2 = −2 < 0 violates the non-negativity constraint of the problem.

Therefore, the solution is not acceptable. This shows that the manufacturer should
sell less quantity of Product 2 than what he produces. Also the marginal revenue of
product 2 (i.e., MR2 = 38 – 4Q2) will be zero at Q2 = 9.5, that is, the manufacturer
should not sell more than 9.5 units of this product.
Since Q2 = 9.5 < 10 = 2Y, then λ2 = 0 and another solution to the first-order condi-
tions must be found (given these values).
36 – 2Q1 -l1 = 0
-14 + 3l1 = 0
3Y - Q1 = 0
Thus the optimal solution is:
Q1 = 47/3 = 15.6 units, Q2 = 9.5 units, Y = 47/9 = 5.2 units,

l1 = $14/3 = $4.67, l2 = $0, P1 = $20.40, and P2 = $19.00
Noting that 0.9 unit of Product 2 from the total of 2(5.2) = 10.4 units produced should
be discarded.
Since some of the Product 2 is discarded, it must be a by-product. The dual vari-
able, λ2, associated with Product 2 is also zero, that is, no joint cost is allocated to it.
Hence, by-products are those products whose associated nonlinear programming
(Lagrangian) dual variables are zero.
SUMMARY
Joint costs are allocated to products that are produced through a common process or
from the same input material. The main objective of joint cost allocation is to fairly
relate the costs of the inputs to the joint products. As there is no direct method for
such cost allocation, some approximations become inevitably necessary.
The following are several methods that are commonly used for allocating joint
cost (or common cost) to products that are produced jointly or through the same
process. Where joint products are sold at the split-off point, one of the following
methods may be used for allocating joint cost to the products.
• Physical-Measures (or Simple-Average) Method: This method uses a

physical measure of the joint products, such as weight, count, volume, or
package, that is common to all joint products at the split-off point.
• The major disadvantage of this method is that the physical measure may not
have a relationship to the income-producing power of the products.
• Weighted-Average Method: This method is an improved version of the
physical-measure method. This method assigns a weight factor based on
the product’s market value, labor time and skill needed, size, weight, etc.
• Sales-Value at Split-off: This method allocates joint costs to the separable
products based on the sales value of each product at the split-off point. This
method is simple and reasonable to apply when all joint products do not
require further processing and are sold at the split-off point.
Where joint products cannot be sold at the split-off point without incur-
ring further processing costs, one of the following methods may be used for
allocating joint costs to the products.
• Relative-Market-Value (RMV) or Net-Realizable-Value (NRV) Method:
The RMV (or NRV) is the estimate of the sales value of each joint product,
computed by deducting the separable cost from the potential final sales
value for the product. Then, it uses the proportion of the approximated mar-
ket value of each product relative to the total of the approximated market
values of all products as the basis for joint cost allocation.
• Constant-Gross-Margin (GM%) Method: This method assumes that
every joint product earns the same gross-margin ratio (GM%) as the basis
for joint cost allocation. The same gross-margin ratio is computed in the
following steps:
1) Compute the overall or total gross margin for all products combined,
which is computed as follows:
TGM = TFSV – TJC – TSC
where
TGM = Total gross margin for all products combined;
TFSV = Total final sales value for all products combined;
TJC = Total joint cost;
TSC = Total separable cost.
2) Calculate the GMR (or GM%) for each product
æ TGM ö
GMR= ç ÷
è TFSV ø
æ TGM ö
GM% = 100 ´ ç ÷
è TFSV ø
3) Calculate the Joint Costs for each product as follows:
Join cost allocated to a product = GMR ´ ( Final sales value of the product )
A by-product is a product having a relatively low sales value as compared to the main
or joint products. By-products may be sold at split-off or processed further. However,
if sales value of a by-product increases, it may be re-classified as a main product.
There are two commonly used methods of accounting to record the cost of the
by-products. One method is the net realizable value of the by-product at the split-off
point (final potential sales value minus separable cost). The second method is the
zero-cost method by which no joint cost is allocated to the by-products; their only
costs would be their required separable costs.
When the sales price varies with the output level for one or more joint products,
the traditional method may not be capable of calculating proper joint cost allocation
to the product. In such cases, a nonlinear programming can provide a viable solution.
If there are constraints of resources (e.g., materials, capital, and production capacity),
linear programming may be applied (which is not covered in this chapter).
A company should choose a method for joint cost allocation that is specifically
appropriate to the values of its products and production requirements and consis-
tently use the selected method.
REFERENCES
Kaplan, R. S., (1982). Advanced Management Accounting, (Englewood Cliffs, NJ: Prentice-
Hall, Inc.)
Manes, R. P. and Smith, V. L., (1965). Economic Joint Cost Theory and Accounting Practice.
The Accounting Review, XL(1): 31–35.
Myer, J. N., (1972). Cost Accounting for Non-Accountants, (New York, NY: Hawthorn Books,
Inc.)
Needles, Jr., B. E.; Anderson, H. R. and Caldwell, J. C., (1993). Principles of Accounting, (5th
edition, Boston, MA: Houghton Mifflin Company).
Tayyari, F. and Parsaei, H. R., (1992). Joint Costs Allocation to Multiple Products: Cost
Accounting v. Engineering Techniques, Chapter 12 in: H. R. Parsaei and A. Mital (eds.):
Economic Aspects of Production and Manufacturing, (London: Chapman & Hall).
Weil, Jr., R. L., (1968). Allocating Joint Costs, (Communications). The American Economics
Review, LVIII(5, Part 1): 1342–1345.
Williams, D. J. and Kennedy, J. S., (1983). A Unique Procedure for Allocating Joint Costs
from a Production Process? Journal of Accounting Research, XXI(2): 644–645.
REVIEW QUESTIONS
5.1.
R What is a common cost?
R5.2. What is common cost allocation?
R5.3. Which joint cost allocation method is the most effective?
R5.4. What is the objective of joint cost allocation?
R5.5. Why would a number of accountants express a preference for the net-
realizable-value method of joint cost allocation over the physical quanti-
ties method?
R5.6. When would a physical quantities method for allocation be preferred?
R5.7. What is the basic difference between the allocation of joint costs to (a)
joint products and (b) by-products?
R5.8. What costs are irrelevant for the decision of whether to sell a joint prod-
uct or process it further?
R5.9. On what basis should a company choose a joint cost allocation method?
R5.10. A mining company recovers gold, silver, copper, and lead by refining ore
from the same mine site. What type of process would be this refining
process?
5.11. Which joint product allocation method produces the same gross profit
R
percentage for all joint products?
R5.12. If a company produces different products using the production process
or material, which of the method should it use to determine whether a
product is the main product or a by-product?
PROBLEMS
P5.1. A small company manufactures ballpoint pens in four different colors:
blue, black, green, and red. In a joint process, the company manufactures
the outer housings, the cartridges (reservoirs), and tip points with balls of
pens, which are the same in costs. However, the inks of different colors cost
different and this cost is added to the individual pens separately. During a
period, the company manufactures a total of 1,000,000 pens as follows:
Blue ink: 400,000 pens

Black ink: 300,000 pens
Green ink: 100,000 pens
Red ink: 200,000 pens
The total joint cost of the batch up to the split-off point is $150,000.
Required: Allocate the joint cost among all types of pens produced
using the physical-measure (simple-average-unit-cost) method.
P5.2. Harold & Sons Company produces two joint products, A and B. The
production process results in producing a by-product also. During the
month of July of the year 20XX, 50,000 gallons of input materials were
processed, which produced 30,000 gallons of product A, 15,500 gallons
of product B, and 4,500 gallons of the by-product. The total joint cost of
materials, labor, and overhead amounted $195,500. None of the products
were salable at split-off point. Additional manufacturing (separable) pro-
cessing costs were incurred as shown below:
Separable Cost
Product (per gallon)
A $3.80
B 3.00
By-Product 1.00
Assume that during July all of the products were completed and sales
were as follows:
Product Sales Price Sales Volume (gallons)

A $13.00 25,000
B 11.00 12,500
By-Product 4.00 1,750
Assume, also, that the company uses the net realizable value of the by-
product as a reduction in the production costs of the joint products.
Required
a) Use the Relative-market-value method to allocate the joint costs
and compute the total manufacturing unit cost of each product.
b) Prepare a product-line income statement to analyze the profitabil-
ity of the products.
c) Repeat part (a) using the physical-measure method to allocate the
joint cost.
P5.3. A certain raw material costs a manufacturing company $30 per unit to
process. Processing 1,000 units of this input material results in the pro-
duction of 100 units of Product A, 250 units of Product B, and 500 units
of a by-product. The following information is available:
Product A ($) Product B ($) BP ($)

Separable Manufacturing Cost (per unit) 50 25 5
Sales Price 400 165 15
The company uses the “relative-market-value” method in its joint cost

allocation and the “zero-cost” method to account for its by-products.
Required: Find the manufacturing unit cost for each product, including
the by-product.
P5.4. Barnow Manufacturing Company produces two joint products, A and B.
The production process results in producing a by-product also. During
the month of July 20XX, 100,000 gallons of input materials were pro-
cessed, which produced 45,000 gallons of Product A, 37,500 gallons
of Product B, 17,000 gallons of a by-product, and 500 gallons of waste
material. The total joint cost of materials, labor, and overhead amounted
to $450,000. None of the products were salable at split-off point.
Additional manufacturing (separable) processing costs were incurred as
shown below:
Separable Cost
Product (per gallons)
A $3.75
B 2.20
By-Product 1.00
Assume that during July, all of the products were completed and sales
were as follows:
Product Sales Price Sales Volume (gallons)

A $15.00 40,000
B 11.20 30,000
By-Product 2.00 15,000
Assume that the company applies no cost (zero cost) from the joint cost
to the by-product.
Required
a) Use the relative-market-value method to allocate the joint costs
and compute the total manufacturing unit cost of each product.
b) Prepare a product-line income statement to analyze the profitabil-
ity of the products.
c) Repeat part (a) using the physical-measure method to allocate the
joint cost.
P5.5. The Goodnext Company produces two products, A and B, from process-
ing a common input raw material. One unit of the raw material yields 1
unit of Product A and 3 units of Product B. Assume that the supply of
raw material is unlimited and it costs $35 per unit. The variable cost of
processing 1 unit of raw material is $25 per unit. The Goodnext’s econo-
mists have derived the following demand volume–price functions:
QA = 50 - PA and QB = 80 - 2 PB
where
QA = Number of units demanded of Product A;
QB = Number of units demanded of Product B;
PA = Price of Product A;
PB = Price of Product B.
Required: Find the optimal quantity of the raw material to be processed,

the price of each product at the optimal sales volumes, and the amount of
joint cost to be allocated to each product.
P5.6. The ABC Company produces 2 products, 1 and 2, from processing a
common input raw material. One unit of the raw material yields 2 units
of Product 1 and 3 units of Product 2. Assume that the supply of raw
material is unlimited and it costs $25 per unit. The variable cost of pro-
cessing 1 unit of the raw material is $20 per unit. The ABC’s economists
have derived the following demand volume–price functions:
Q1 = 47.5 - P1 and Q2 = 80 - 2 P2
where Q1 = Sales volume of Product 1;

Q2 = Sales volume of Product 2;
P1 = Sales price of Product 1;
P2 = Sales price of Product 2.
Required: Find the optimal quantity of the raw material to be processed,

the price of each product (i.e., P1 and P2) at the optimal sales volumes (i.e.,
Q1 and Q2), and the amount of joint cost to be allocated to each product.
P5.7. By processing a certain input material, a company produces three prod-
ucts (e.g., Product 1, Product 2, and Product 3) in fixed proportions.
Processing each unit of the input material results in producing 0.2 unit of
Product 1, 0.1 unit of Product 2, and 0.4 unit of Product 3. Assume that
the supply of the material is not limited and costs $50 per unit. A market
study has indicated the following weekly demand–price functions:
Q1 = 400 - 4 P1, Q2 = 60 - 0.2 P2 and Q3 200 - 4 P3
or inversely
P1 = 100 - 0.25Q1, P2 = 300 – 5Q2 and P3 = 50 - 0.25Q3
where Q1 = Demand quantity for Product 1;

Q2 = Demand quantity for Product 2;
Q3 = Demand quantity for Product 3;
P1 = Sales price for Product 1;
P2 = Sales price for Product 2;
P3 = Sales price for Product 3.
Required: What quantity of the input material should be processed to

maximize the company’s profit? Find the amount of joint cost to be allo-
cated to each unit of the products, the optimal sales quantity, and sales
price for each product.
P5.8. Three different products (namely, Product 1, Product 2, and Product 3)
are, simultaneously, produced through a common process in fixed pro-
portions. Processing each unit of the input material results in the produc-
tion of:
1.0 unit of Product 1;
0.5 units of Product 2;
1.5 units of Product 3.
Assume that the supply of the material is not limited and costs $50 per
unit and that it costs an additional $60 per unit to process the input mate-
rial. A market study has indicated the following weekly price–demand
relationships:
Q1 = 200 – 0.8P1,
Q2 = 40 – 0.4 P2 , and
800 2
Q3 = - P3
3 3
where Q1 = Demand quantity for Product 1, when its sales price is P1;
Q2 = Demand quantity for Product 2, when its sales price is P2;
Q3 = Demand quantity for Product 3, when its sales price is P3.
Required: What quantity of the input material should be processed

to maximize the company’s profit? Find the amount of joint cost that
should be allocated to each unit of each product, also the optimal sales
quantity and sales price for each product.
P5.9. A certain raw material costs a manufacturing company $34.50 per unit
to process. Processing 20,000 units of this input material results in the
production of 5,000 units of Product A, 11,500 units of Product B, and
10,000 units of a by-product. The following information is available:
Product A ($) Product B ($) By-Product ($)

Separable 30 10 2.50
Manufacturing Cost
(per unit)
Sales Price 200 110 4.50
The company uses the “relative-market-value” method in its joint cost

allocation and the “zero-cost” method to account for its by-products.
Required: Find the manufacturing unit cost for each product, including
the by-product.
6 Manufacturing
Cost Estimation
LEARNING OBJECTIVES
• Understand the concept of and needs for cost estimation.
• Understand reasons for estimating fixed and variable costs.
• Estimate costs using the account analysis method.
• Estimate costs using scatter-graph method.
• Estimate costs using the high-low method.
• Estimate costs using the linear regression method.
• Perform regression analysis using Excel® Solver software to fit regression
line into cost data.
• Interpret the results of linear regression analysis.
6.1. INTRODUCTION
Manufacturing cost estimation is a cost analysis process for predicting the cost of
manufacturing a product. Whereas, product costing, as presented in the previous
chapter, is a systematic procedure for accurately recording all allocated costs to
determine the cost of a manufactured product.
The cost estimation is imperative in managerial decision-making (such as which
product lines will be profitable and which product lines need to be reengineered to
stay cost-competitive). Cost estimation helps managers in making more successful
decisions in making their manufacturing systems cost-effective.
The depth of this analysis ranges from some simple calculations to a complex
mathematical and statistical methodology.
In a general sense, estimation is the prediction or forecast of resources (time, cost,
and materials) required to achieve or obtain an agreed-upon scope (of a project or
a volume of a product). Cost estimation is a process that helps to identify resource
requirements and capabilities, setting priorities, and allocating resources for project
planning and controlling. Costing and valuation are the byproducts of cost estima-
tion and help decision-makers in assessing their decision alternatives (Yeung, 2018).
The usefulness of estimation depends on its accuracy, which is judged by the
degree to which the final cost outcome for a given project will vary from the origi-
nal estimated cost. Nevertheless, there should be some allowance for contingencies,
which is an amount added to an estimate to allow for items, conditions, or events,
such as inflation and uncertainty, that will likely result in additional costs.
A detailed cost estimating process determines the overall cost estimate by sum-
ming detailed estimates done at lower levels of the Work Breakdown Structure
DOI: 10.1201/9780429432163-6 151
(WBS). The WBS is a technique that breaks down the system being costed into
lower-level components (such as parts or assemblies), each of which is costed sepa-
rately for direct material, direct labor, and overhead costs. Estimates of direct mate-
rials are often based on the bills of materials, which list the number of units and the
unit costs of all components that go into each product. Estimates for direct labor
hours are usually based on analyses of engineering drawings and some contractor
or industry-wide standards. Finally, the estimates for the overhead costs based on
predetermined rates are described in Chapter 3.
6.2. GENERAL TYPES OF COST ESTIMATES

For planning and determining resource requirements (budgeting) for any projects,
decision-makers need to have cost estimation. As the word implies, estimates are not
definite. The accuracy of an estimate depends on the project stage and the reliability
of data sources. The following are the three types of cost estimation, presented in the
order of their increasing level of accuracy (Hassib, 2012; Yeung, 2018):
1) Order of magnitude (ROM) estimate.

2) Budget estimate.
3) Definitive estimate.
• Order of magnitude (ROM) estimate: A ROM estimate is a rough
estimate of costs used at the very early stage of a project, particularly
during the planning stages. This type of estimation provides a “ball-
park” estimate based on the information available at the time for the
purpose of having an idea about general and total expenditures instead
of itemizing costs based on the project activities.
Planners usually use historical data of similar projects or an aggre-
gate of data from different projects to perform an order of magnitude
estimation. This type of estimate has a range of variance from −25%
(underestimate) all the way to +75% (overestimate) of the actual costs;
this range can become as wide as 50% underestimation to +100% over-
estimation (Hassib, 2012; Yeung, 2018; Phillips, 2020).
• Budget estimate: A budget estimate (or top-down estimate) is a
preliminary cost estimate, which is more accurate than an order of
magnitude estimate. The purpose of this type of estimation is to pro-
vide a preliminary itemized list of expenses based on the main com-
ponents of the project. With the budget estimate, the estimator starts
at the top of the project (major components) and works through to
the bottom of it (details). The accuracy of this type of estimate is
from 10% underestimate to 25% overestimate (Hassib, 2012; Yeung,
2018; Phillips, 2020). Therefore, this is done at the planning stage of
the project. Estimators, usually, make this type of estimation using
historical data of a related project or obtainable data from the proj-
ect plan, the expected labor cost, and costs of required equipment
and materials.
Manufacturing Cost Estimation 153
• Definitive estimate: A definitive estimate (also known as detailed cost

estimate or bottom-up estimate) is the most accurate of the three types
of cost estimation. This type of estimation breaks down the whole proj-
ect into its detailed compositions to prepare a list of all requirements, to
each of which an estimated cost is assigned. Definitive estimates have
an accuracy of about 5% underestimate to 15% overestimate (Hassib,
2012; Yeung, 2018).
With any type of estimate, the estimator should provide the range of
variance in the costs and an explanation of how he/she made the esti-
mate. Otherwise, the customer may take the quoted cost as a promised
cost (Phillips, 2020).
6.3. ASSUMPTIONS FOR THE USE OF COST ESTIMATING MODELS

Cost estimates are usually based on limited information and under certain con-
straints. These constraints usually take the form of assumptions that bind the esti-
mate’s scope, establishing baseline conditions under which the estimate will be
made. The following are three important assumptions that must be considered when
estimating costs using the methods presented in this chapter.
1) The variable costs per unit and total fixed costs assumed will remain con-
stant at all the activity levels.
2) The cost to estimate is assumed to have a linear relationship with the activ-
ity level (production quantity).
3) When costs are estimated for a planned activity level, it is assumed that the
activity level is within the relevant range.
These assumptions are realistic as long as the relevant range is clearly identified and
the linearity assumption does not significantly distort the resulting cost estimate.
In cost analysis, the term relevant range refers to a normal range of activity lev-
els in which the total fixed costs will not change as the volume of activity changes.
However, if a firm’s activity level drops to an extremely low level, the management
may take action to decrease the fixed costs. Similarly, if the firm’s activity level
increases beyond the relevant range, the firm would likely incur more fixed costs.
Then, the linearity assumption for the cost behavior as a straight line (linear) may
become reasonable.
Cost analysts should analyze costs within a relevant range to arrive at a valid cost
estimate. The range for a projection is usually between the upper and lower limits
(bounds) of past activity levels for which data is available.
6.4. METHODS FOR DEVELOPING A COST ESTIMATING MODEL

Cost estimation is the process of developing an approximation of the total cost of
a product, program, project, or operation. Cost estimation is crucial in managerial
decision-making and budgeting.
For manufacturing product costing and profitability analysis, cost estimators

establish cost estimate relationship (CER), which may be an algorithm or formula
that is used to perform the costing. A cost estimate function relates cost with quanti-
ties such as time and quantity or some other relevant elements.
There are various techniques for estimating the future costs of a production sys-
tem. The use of a specific approach will depend on the purpose of estimation and the
amount and type of available data.
In many production decision-making cases, the cost analysis involves the estima-
tion of two types of manufacturing costs: fixed costs and variable costs. For produc-
ing a product, labor and material costs are usually variable costs that vary as the
production output changes. A manufacturer consumes more labor and materials to
produce more units of its product. Accordingly, the cost of labor and material varies
in a direct proportion to the level of output.
To estimate the total cost associated with planned production in a future period,
analysts develop a mathematical cost equation. To do this, they must first determine
the amounts of variable and fixed costs associated with producing their products.
The cost equation for a given product is typically the direct (variable) cost of manu-
facturing per unit of the product multiplied by the number of units produced and sold
plus the fixed (overhead) costs. For example, a company with $100,000 in overhead
costs that makes products that cost the company $6 each to manufacture and sell has
a cost equation of $100,000 + ($6 × number of units sold). We can generalize this cost
equation in the following form:
Y = a + bX (6.1)
or
C = F + VQ (6.2)
where
Y = C = Total (mixed) cost;
a = F = Total fixed cost;
b = V = Variable cost per unit;
X = Q = Measure of activity or number of units produced;
bX = VQ = Total variable cost.
A company can use its cost estimating equations to determine how much
would it cost to make a certain level of sales. The equation would also allow
the company to determine the price it must charge for a certain number of units
sold in order to break even. Once the company has developed its cost equation
and determined its product’s selling price, the company can construct a profit
equation, called the Cost-Volume-Profit (CVP) model. With the CVP model, the
company can perform a variety of critical analyses, which will be presented in

Chapter 7.
There are four common approaches to identify the production cost behavior, as
fixed and variable costs, and construct the cost estimation equation:
• Account analysis.
• High-low method.
• Scatter-graph method.
• Regression analysis.
6.4.1. Account Analysis Method

The account analysis approach may be the most common starting point for estimat-
ing fixed and variable costs. This approach requires basic knowledge of accounting
and experience in cost analysis to review the relevant accounts to obtain cost data
and determine whether each cost item is fixed or variable. The total of all costs iden-
tified as fixed gives the estimate of total fixed costs. Similarly, the total of all costs
identified as variable provides an estimate of total variable costs, when divided by
the measure of activity (i.e., number of units produced), the result would be variable
cost per unit.
Example 6.1
The cost analyst at the Sambo Scooter Manufacturer asked the accounting depart-
ment to provide costs data regarding the scooters’ production department for the
month of August. The accountants provided the following financial information
about the scooters production department in August:
Number of scooters produced and sold 10,000

Materials used $80,000
The labor used in scooter department:
Assembly labor cost 14,500
Supervisory cost 5,000
Facility costs:
Rent 3,250
Utilities 750
Insurance 500
Total Production Cost $60,000
The analyst carefully reviewed the costs data in consultation with the production
manager. They sorted out the variable and fixed costs for the month of August as
follows:
Fixed Variable Total

Materials used $0 $80,000 $80,000
Labor used in scooter department
Assembly labor cost 0 14,500 14,500
Supervisory cost 5,000 0 5,000
Facility costs
Rent 3,250 0 3,250
Utilities 250 500 750
Insurance 500 500
Total Production Cost $9,000 $95,000 $104,000
The estimated total fixed cost (F) is $9,000, and the variable cost per unit (rate)
equals the total variable cost of $95,000 divided by 10,000 units produced in
August, as computed below:
V = $95,000 10,000 units = $9.50 per unit
The analyst would present the total cost (C) equation for estimating the future
monthly total cost, given the planned monthly production level (Q), as follows:
C = $9, 000 + $9.50Q
For example, if the manufacturer plans to produce 12,000 scooters in the follow-
ing month, its estimated total production cost would be:
C = $9, 000 + $9.50 (12, 000 ) = $123, 000
However, this estimate is reasonable if the level of production (12,000 units) is

within the relevant range, which does not require any additional resources.
In addition, one must be mindful when using the historical data for only one
period (month) to estimate future costs, as that specific period may not be a typi-
cal period for the demand for the product and production costs. For example,
when demand is higher in the months of May through August, the company may
get quantity discount on materials, the utility costs may be low relative to those in
the winter months, and other production costs could significantly change as the
company may make different arrangements for handling increased or decreased
demand during different months. To average out these fluctuations, one should
use the historical data over a year or more to develop a cost estimating model.
The major advantage of the account analysis method is that managers and
accountants are familiar with the company operations and how costs incur as the
activity level changes. However, this method has some disadvantages. Managers
and accountants may apply biased judgments; also, imperfect decisions often
have major economic consequences for the company.
6.4.2. Scatter-Graph Method
The scatter-graph method is a visual technique used for estimating the fixed and
variable elements of a semi-variable cost (i.e., a mixed cost) to budget for future
costs. Using the scatter-graph method, cost analysts plot the cost against the level
of activity on a graph and draw a line that they think is the best-fit line through the
points.
A scatter-graph uses a horizontal axis that represents an activity level (e.g., pro-
duction quantity, labor hours, machine hours) and a vertical axis that represents its
cost. Pairs of data points (i.e., activity levels and their corresponding costs) are plot-
ted on the graph and a regression line that runs through the dots represents the best fit
of the relationship between the variables. After determining the best-fit line through
the data points, the fixed cost is found at the intercept, the point where the regression
line crosses the vertical axis (y-axis), and the slope of the line is the variable cost per
unit. The procedure requires the following four steps:
Step 1: Draw a Scatter-Graph: Plot the coordinates of data points (the activ-
ity levels and their corresponding total costs) on graph paper, the activity
levels (i.e., production units, labor hours, machine hours, etc.) along the
horizontal axis (x-axis), and total mixed cost along the vertical axis (y-axis).
Step 2: Draw a Regression Line: Draw a regression line through the scat-
tered data points by visual inspection and try to minimize the total vertical
distances between the line and all the data points.
Step 3: Find Total Fixed Cost (F): Extend the regression line toward the
y-axis to locate its intercept; that is, the point at which the regression line
crosses the y-axis. Total fixed equals the y-intercept of the regression line.
Step 4: Compute Variable Cost Per Unit (V): Variable cost per unit is equal
to the slope of the line. Take the coordinates of two points (X1, Y1) and (X2,
Y2) on the regression line and compute the variable cost per unit using the
following formula:
Variable Cost per Unit (V ) = Slope of Regression Line

Change in Total Cost
=
Change in Activity Level
Y2 - Y1
The symbolic form of the formula is V =
X 2 - X1
Since the best-fit line is drawn subjectively, different individuals have
different ideas about drawing the line. That is, each person would have a
somewhat different estimate of the cost.
Example 6.2
Table 6.1 represents the monthly production cost information for Meemee Co.
during the previous year. Using the scatter-graph method, derive a cost estimating
equation for the company.
Solution
Step 1. Plot the data points for each period (month) on a graph (see
Figure 6.1).
Step 2. Visually fit a line through the data points such that to minimize the
distance from the data points to the line (i.e., to make the line as close to
the data points as possible). Make sure the line touches at least one data
point. Extend the line to the vertical axis. This is the total production cost
curve. Figure 6.1 shows the line through the data points. Notice that the
line hits the data point for 2,800 units produced and $220,000 total cost
(February production and cost data).
TABLE 6.1
Monthly Production Costs for Meemee Co.
Month Units Costs Month Units Costs
January 2,200 $185,000 July 4,200 $285,000
February 2,800 220,000 August 5,300 315,000
March 3,500 250,000 September 4,500 295,000
April 3,800 235,000 October 3,500 210,000
May 6,100 365,000 November 3,000 210,000
June 5,200 280,000 December 2,600 170,000
*Bold highlights the data points to be used.

Bold highlighted data points are the high (6,100) and low (2,200) volume points.
$400,000
$350,000
$300,000
$250,000
Total Cost
$200,000
$150,000
$100,000
$50,000
$0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000
Units Produced
FIGURE 6.1 Scatter-graph of total production costs for Meemee Company (Example 6.2).
Step 3. Estimate the total fixed cost (F). The total fixed cost is simply the
point at which the total cost line drawn in Step 2 crosses the vertical
axis. This is known as the y-intercept. Recall that the fixed costs remain
the same in total regardless of the level of production and variable costs
change in total with changes in levels of activity. Where the total cost
line intercepts the y-axis (total cost axis), the total cost equals the fixed
cost (plus zero variable cost), which corresponds to 0-activity (or pro-
duction) level. Therefore, the fixed cost for Meemee Co. is approximately
$55,000. The equation for the total cost line drawn in Step 1 is partially
complete and stated as:
C = $55, 000 + VQ.
Step 4. Calculated the variable cost per unit (V). Fill the data point through
which the line passes, that is, Q = 2,800 units and C = $220,000, in the
partially completed equation in Step 3 to find the unknown variable cost
per unit, as follows:
C = F + VQ
$220, 000 = $55, 000 + V ( 2, 800 )
V = $58.93 (rounded )
The variable cost is approximately $58.93 per unit.

Step 5. State the results in equation form C = F + VQ. We found in Step 3 that
the total fixed cost is $55,000, and in Step 4 that the variable cost per
unit is $58.93. Now, we can state the total cost estimating equation as:
C = $55, 000 + $58.93Q.
Now, the company can estimate total production costs for a given level
of production (Q). For example, if the company plans to produce 5,500
units during an upcoming month, the estimated total production cost is
found as follows:
C = $55, 000 + $58.93 ( 5, 500 ) = $379,115.
6.4.3. High-Low Method
The high-low method provides is an easy and quick approach to estimate fixed
and variable costs, which may not be as accurate as other methods. It uses the
historical data during several reporting periods; but, it uses only the data points
corresponding to the highest and lowest levels of activity (output) to derive the
algebraic equation for the total cost. Hence, it ignores all the data other than the
two extreme data. The slope of the resulting equation is the variable cost and its
y-intercept is the fixed cost.
However, if the highest and lowest levels of costs are not representative of the
costs to estimate, then this method would either overestimate or underestimate the
costs.
Given a historical production and total cost data set from several reporting peri-
ods, the high-low method uses the following steps to develop the total production
costs equation of the form C = F + VQ:
Step 1. Identify the highest and lowest levels of activity (units produced)
from the given data set.
Step 2. Calculate the variable cost per unit (V). Use the following formula
to find V:
C H - CL Change in Total Cost

V= = (6.3)
QH - QL Change in Activity Levvel
where
CH = Total cost at the highest level of activity (production quantity);
CL = Total cost at the lowest level of activity;
QH = The highest level of activity (production quantity);
QL = The lowest level of activity;
V = Variable cost per unit.
Step 3. Calculate the total fixed cost (F). Fill the units cost found in Step 1 (as
the slope) and the data point for either the lowest or highest activity levels
(as the coordinates of a point on the total cost curve) in the total cost equa-
tion of form C = F + VQ, as follows:
CL = F + VQL
or
C H = F + VQH
Then, solve the equation for F to find the estimated value for the total
fixed cost:
F = CL - VQL
or
F = C H - VQH
Step 4. State the results in equation form C = F + VQ. Replace F and V in the
total cost equation with the computed variable cost per unit (V) found in
Step 2 and the fixed cost (F) found in Step 3 to find the total cost estimating
equation for the problem at hand.
The following example clarifies the steps taken in the high-low method of cost
estimation.
Example 6.3
Use the monthly production costs data for Meemee Co., as given in Example 6.2,
to determine the total cost estimating equation using the “high-low” method.
Solution
Step 1. Although a graph isnot required in the high-low method, it is a
helpful visual toolto identify data points, one with the highest level of
activity and the other with thelowest level of activity.Alternatively, we
can identify the two extreme data points byarranging the data points in
an ascending or descending order ofthe activity levels (units produced).
The circled data pointsshown in Figure 6.2 are the required ones.
The lowest level of production was 2,200units (in January) and the
highest level of production was 6,100 units(in May). The difference
between the number of units produced and thedifference between the
total cost at the highest and lowest levels ofproduction are shown below:
Production (units) Total Cost ($)

Highest level 6,100 365,000
Lowest level 2,200 185,000
Difference 3,900 180,000
1
0.9
0.8
0.7
Total Cost
0.6
0.5
0.4
0.3
0.2
0.1
0
0 0.2 0.4 0.6 0.8 1
Units Produced
FIGURE 6.2 The circled data points are the high- and low-activity levels in the production
and cost datafor Meemee Co. (Example 6.3).
Step 2. Calculating thevariable cost per unit (V):
CH - CL $365, 000 - $170, 000 $180, 0000

V= = = = $46.15 (rounded )
QH - QL 6,100 - 2, 200 3, 900
Step 3. Calculating the totalfixed cost (F). Simply useeither the data for the
high- or low-activity level and fill inthe data in the equation and solve for
F (total fixed costs). For example, let’s plug the data for the high activity
level (6,100 units,$365,000) into the equation, as follows:
$365, 000 = F + 46.15 (6,100 )
Then, solving for F gives the estimated total fixed cost, as F = $83,485.
We will get the same result using the data for thelow activity level
(2,200 units, $185,000):
$185, 000 = F + 46.15 ( 2, 200 )
Then, solving for F gives the estimated total fixed cost as F = $83,470.
The differencebetween the two values is due to the rounding effect used
for thevariable cost per unit. However, as this is an estimated cost, we
mayeven state it as $83,500.
Step 4. Stating the resultsin a specific equation for the problem as:
C = $83, 485 + 46.15Q.
Now, if the company plans to produce 5,500units during the upcoming

month, its estimated total production costswill be $386,000, as com-
puted below:
C = $83, 485 + 46.15 ( 5, 500 ) = $337, 310.
Again, as this is an estimated cost, we may stateit as $337,300 or even as

$337,000.
6.4.4. Regression Method and Excel® Solver

Regression is a statistical method that has great applications in finance, invest-
ing, cost estimation, and many other areas that is used to establish the relationship
between one dependent variable (such as costs) and an independent variable (such
as production quantity). The regression analysis provides a mathematical equation
for the best possible line fit to the data points, which is a more accurate future cost
estimation than what is obtained through a scatter-graph.
Regression analysis is a statistical method for estimating the relationships between
one or more independent variables and dependent variables. The equation for a line
is Y = a + bX + ε. In this equation, Y is the dependent variable whose future value we

want to predict when the independent variable X will be of a certain value, a is the
y-intercept, b is the slope or rate of change in Y per unit change in X, and ε (epsilon)
is the residual (error) of the estimate. The formulas to calculate the intercept “a” and
the slope “b” are as follows:
n(å XY ) - ( å X ) ( å Y )
b= (6.4)
( )
n å X 2 - (å X )
2
a = Y - bX (6.5)
Based on the symbols used in this chapter for fixed, variable, and total costs and the
activity (production) level, we set the following correspondence between the two sets
of symbols:
a = F = Fixed cost (intercept);
b = V = variable cost per unit (slope);
n = Number of observations (number of reporting periods);
X = Q = Activity level (independent variable);
Y = C = Total cost (dependent variable);
X = Q = ∑X/n = Average of activity levels (average of production quantity);
Y = C = ∑C/n = Average total cost.
One of the greatest benefits of the regression method is its level of accuracy as
compared to the scatter-graph and high-low methods. The scatter-graph method of
cost estimation is somewhat subjective as the analyst draws his or her best visual fit
line through the cost data points. The high-low method only uses the highest and
lowest activity levels for cost estimation. Therefore, if these two data points are not
representative of the true cost behavior, the estimation would be biased.
The major disadvantage of the regression method is the difficulty in manual calcu-
lation of the equation’s slope and intercept estimates. The use of computer software,
such as spreadsheet software, helps overcome the level of difficulty in calculations.
If the software is not available, an understanding of algebra and some knowledge
of statistics are required to perform computations. However, since the process is
computationally intensive, there are possibilities for computational errors that would
affect the accuracy of the estimates. As such, in the case of unavailability of com-
puter software, the estimators may use another method.
Example 6.4
Using the regression method, develop the equation for estimating the total monthly
production cost for Meemee Co. based on its historical production costs given in
Table 6.1 of Example 6.2.
Solution
We add two more columns to the table of monthly production costs for Meemee
Co. to perform the preliminary computations for components of the regression
equations (6.4 and 6.5), as shown below:
Units Costs
Month (X) (Y) X2 X.Y
January 2,200 $185,000 4,840,000 407,000,000
February 2,800 220,000 7,840,000 616,000,000
March 3,500 250,000 12,250,000 875,000,000
April 3,800 235,000 14,440,000 893,000,000
May 6,100 365,000 37,210,000 2,226,500,000
June 5,200 280,000 27,040,000 1,456,000,000
July 4,200 285,000 17,640,000 1,197,000,000
August 5,300 315,000 28,090,000 1,669,500,000
September 4,500 295,000 20,250,000 1,327,500,000
October 3,500 210,000 12,250,000 735,000,000
November 3,000 210,000 9,000,000 630,000,000
December 2,600 170,000 6,760,000 442,000,000
Total 46,700 3,020,000 197,610,000 12,474,500,000
Symbol ∑X ∑Y ∑X2 ∑XY
Now, we can use the summation terms in the regression equations, as follows:
n( å XY ) - ( å X ) ( å Y )
b=
( )
n å X 2 - (å X )
2

12 (12, 474, 500, 000 ) - ( 46, 700 ) ( 3,, 020, 000 )
= = 45.476
12 (197, 610, 000 ) - ( 46, 700)2
a = Y - bX = ( 3, 020, 000 / 12) - 45.476 ( 46, 700 / 12) = 74, 689
The total cost estimating equation will then be:
C = $74, 689 + $45.476Q
The cost estimators can use computer software, such as Microsoft Excel® Solver,
Minitab®, and SAS®, to perform a regression analysis. The following is the instruc-
tion for using the Microsoft Excel® Solver add-in.
Using Excel® Solver [You need to activate the Solver in Excel®]
1) Enter the data set in the Excel spreadsheet, output level and total cost in
two columns, side-by-side.
2) Click on the “Data” button at the center-top of the window.

3) Click “Data Analysis” (of Solver)
4) Choose the “Regression” option, and click OK.
5) In the new window:
• Choosing the “Input Y Range” $C$2:$C$14, for example, chooses
data in cells C2 through C14.
• Choosing the “Input X Range” $B$2:$B$14, for example, chooses
data in cells B2 through B14.
• Output Range: Click on a cell below your data set, for example,
$A$17 (for choosing cell A17)
6) Click on OK to see the results of the regression analysis.
For the previous example, using the regression analysis of the Excel Solver® pro-
gram, we get F = $74,689 and V = $45.476 per unit. The program generated the
output shown in Figure 6.3.
We also get R2 = 0.89873, which is a measure of goodness of fit for linear regres-
sion models. This statistic indicates about 90% of the variability in the dependent
variable (total cost in this example) is explained by the independent variables (output
quantity in this example). The cost estimation model, as found manually, is:
C = $74, 689 + $45.476Q
where the fixed cost is $74,689, which may be set as $74,700 or even $75,000, and
the variable cost is $45.476, which may be set as $45.48, per unit. Figure 6.4 shows
the regression line fit into the given data in our example.
SUMMARY OUTPUT of Excel Solver

Regression Statistics
Multiple R 0.94801
R Square 0.89873
Adjusted R Square 0.88860
Standard Error 19230.5
Observations 12
ANOVA
df SS MS F P-value
Regression 1 32,818,533,494 32,818,533,494 88.74351 0.00000274
Residual 10 3,698,133,172 369,813,317
Total 11 36,516,666,667
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 74,689 19,589.71 3.812671 0.00341425 31,040.53 118,337.72
X (or Q) 45.4760 4.82741 9.42038 0.00000274 34.720 56.232
FIGURE 6.3 Excel® Solver output regarding regression line for data in Example 6.4.
$400,000
$350,000
$300,000
$250,000
Total Cost
$200,000
$150,000
$100,000
Historical Cost (C)
$50,000
Estimated Cost
$0
0 2,000 4,000 6,000 8,000
Activity Level (Output Quantity)
FIGURE 6.4 The regression line that fits into the cost-output data in Example 6.4.
SUMMARY
A cost-volume-profit (breakeven) analysis (Chapter 7) for a product(s) is only pos-
sible when the product’s sales price and variable and fixed costs are known. This
chapter presented four commonly practiced methods for establishing the relationship
between production output and total cost to predict future (e.g., upcoming) period
fixed cost and the variable cost per unit of the planned output level.
The account analysis method requires that a knowledgeable cost analyst, per-
haps in consultation with other individuals, determine and sort out the costs in terms
of fixed, variable, or mixed. If such a person is not available, another method should
be used.
The high-low method uses only the highest and lowest activity levels and per-
forms four steps to estimate fixed and variable costs: (1) identifying the high- and
low-activity data points, (2) computing variable cost per unit, (3) computing the total
fixed cost, and (4) stating the cost estimation equation.
The scatter-graph method uses five steps: (1) plotting all points on a graph, (2)
drawing a line that best fits through the points with the line passing through at least
one data point and extended to intercept the y-axis (total cost axis), (3) choosing the
y-intercept as the total fixed cost (F), (4) plugging this fixed cost value and the coor-
dinates of the point through which the line passes in the equation C = F + VQ to find
the variable cost per unit (V), and (5) stating the specific cost estimating equation
using the computed F and V. The scatter-graph is also used to identify any outliers
or data points that are unusually apart from the others, which may represent some
unusual circumstances in the historical data set.
The regression method mathematically determines the equation for the total cost
curve (line) that best fits the data points. Software packages such as Excel Solver®
are available to perform regression analysis.
The objective of all four methods is to develop the cost estimating equation of
the form C = F + VQ. The regression analysis provides the most accurate method as it
provides a cost equation that best fits a line through all the data points. However, the
goal of most analyses is to get a close predictive model, not necessarily a perfect one.
By now, you have learned that each method has its own advantages and disad-
vantages and the choice of a method will depend on the situation at hand. Therefore,
the following should be considered in choosing a method for developing a model for
predicting the total cost for a planned production output:
• Experienced employees may be able to effectively estimate fixed and vari-

able costs by using the account analysis approach.
• If a quick estimate is needed, the high-low method may be the choice.
• The scatter-graph method is used to identify unusual data points (outliers),
which may be excluded in developing a predictive cost model.
• Regression analysis is the most accurate method for developing a predic-
tive model for manufacturing cost estimation; the use of computer software
such as Excel® Solver makes it, probably, the most efficient method and the
easiest to use.
REFERENCES
Hassib, A., (2012). How to Develop a Rough Order of Magnitude Estimate (ROM Estimate).
PM Documents, Project Management Made Simple. Retrieved April 10, 2021 from:
https://pmdocuments.com / how-to-develop-a-rough-order-of-magnitude-estimate-rom
-estimate/ (posted: August 20, 2012).
Phillips, J., (2020). Project Cost Management. Project Smart. Retrieved April 10, 2021 from:
https://www.projectsmart.co.uk/project-cost-management.php.
Yeung, N., (2018). Three Types of Cost Estimation in Projects. Retrieved April 10, 2021
from: https://www.profolus.com/topics/three-types-of-cost-estimation/ (Posted: March
15, 2018).
REVIEW QUESTIONS
6.1.
R What is estimation?
R6.2. What is accuracy?
R6.3. What is contingency in cost estimation?
R6.4. What is Cost Estimate Relationship (CER)?
R6.5. On a scatter-graph for cost and output level, at what point the regression
line intercepts the y-axis?
R6.6. How is the account analysis approach used to estimate fixed and variable
costs?
R6.7. How can one use the high-low method to estimate fixed and variable
costs?
R6.8. Which cost estimation is used to classify cost accounts as fixed or vari-
able with respect to specific output levels?
R6.9. In what situation is the slope coefficient of a cost function equal to zero?
PROBLEMS
P6.1. The Albina Products Company’s production executive officer desires to
learn the behavior of production costs for a previous month, in which the
company produced 7,500 units of a given product. She asked the pro-
duction manager to analyze the production cost accounts for that month
and classify the costs as fixed and variable. The production manager
provided the following information:
Total Variable Fixed

Materials used $480,000 $480,000 $0
Labor used in 370,000 270,000 100,000
Factory facility costs 230,000 60,000 170,000
Total Production Cost $1,080,000 $810,000 $270,000
Required
a) Express the production costs by a mathematical equation of the
form C = F + VQ.
b) Assume that the company has planned to produce 8,000 units next
month. Estimate the total production costs for the month.
P6.2. Zaloo Company is using the account analysis method to identify the behav-
ior of production costs during the month of June, in which it produced 7,000
units. The production manager analyzed the production costs in June and
reported the following information to the company’s management:
Variable Fixed Total

Materials used in production $244,000 $0 $244,000
Labor used in production 96,000 12,000 108,000
Factory overhead costs 68,000 150,000 218,000
Total product cost $408,000 $162,000 $570,000
Required
a) Express the production costs in an equation of C = F + VQ form.
b) Assume Zaloo Company has planned to produce 8,000 units in the
month of July. Estimate the total production costs for that month.
P6.3. For each of the following three per-unit costs, determine whether it is a
variable, fixed, or mixed cost:
Production
(units) Cost A ($) Cost B ($) Cost C ($)
10,000 10.00 12.00 15.00
20,000 10.00 8.50 7.50
Required: What type of cost is each of the three costs?

P6.4. A manufacturing firm uses the high-low method of estimating costs.

The firm had total costs of $45,000 at its lowest level of activity, when
5,000 units were sold. When, at its highest level of activity, sales equaled
10,000 units, and total costs were $70,000.
Required: Develop a cost estimation model for the company using the
high-low method.
P6.5. ZTF Corporation accumulated following data for one of its production
activities:
Output Level
(units) Total Costs ($)
13,800 128,000
14,700 131,000
15,500 136,700
12,600 120,900
10,500 109,700
Required
a) Derive a total cost estimating equation using the high-low method
based on given data.
b) Compute the predicted total cost if the output level were 15,000
units.
P6.6. KTG Company accumulated the following data for a delivery truck dur-
ing the first four months of the year.
Distance Driven
(miles) Total Cost ($)
January 8,000 11,100
February 9,000 11,600
March 10,500 12,500
April 11,500 13,550
Required
a) Develop the equation to predict total costs for the delivery truck
using the high-low method.
b) Estimate the total costs of driving the truck for 12,000 miles.
P6.7. Data concerning an operation activity for the first six months of the year
are as follows:
Machine Hours Electrical Cost ($)

January 5,000 5,250
February 5,200 5,360
March 4,900 5,195
April 5,600 5,595
May 5,200 5,400
June 6,500 6,075
Required: Develop a total cost estimating based on the given data using:
a) The high-low method of cost estimation.
b) The least-square regression method of cost estimation.
7 Cost-Volume-
Profit Analysis
LEARNING OBJECTIVES
• Develop cost-volume-profit models.
• Compute and explain contribution margin (CM) and contribution mar-
gin ratio (CMR).
• Prepare a contribution-margin-format income statement.
• Distinguish the contribution-margin-format and the gross-margin format
income statements.
• State the underlying assumptions of basic cost-volume-profit (CVP) analysis.
• Compute and explain the margin of safety for a product.
• Compute break-even sales in quantity and revenue for a single product.
• Compute break-even sales in quantities and revenues for multiple products.
• Compute sales volume required to earn the desired amount of profit.
• Understand operating leverage.
• Explain sales mix and the impact of changes in sales mix on contribution
margin, break-even point, and profit of a firm.
7.1. INTRODUCTION
Cost-volume-profit (CVP) analysis, also known as break-even analysis, is an ana-
lytical approach to determine how changes in the volume (quantity) of an activity
(e.g., production) affect a company’s costs and profit. This analysis is based on the
behavior of costs and expenses as variable costs (varying in direct proportion to pro-
duction volume) or fixed costs (remaining unchanged over a relevant range as defined
in the previous chapter). The components of CVP analysis are:
1) Level or volume of activity.

2) Selling prices (per unit).
3) Variable cost per unit (including direct material costs, direct labor costs,
and any expenses that vary in proportion to the units produced and sold).
4) Total fixed costs (including the cost of goods manufactured and sold, and
all operating period expenses).
DOI: 10.1201/9780429432163-7 171
7.2. LINEAR COST-VOLUME-PROFIT MODELS

FOR A SINGLE PRODUCT
The conventional cost-volume-profit (CVP) analysis is conducted to determine
whether a firm is able to achieve a specific level of profit. It is a powerful tool for
examining the behavior of total revenues, total costs, and net income as changes occur
in activity level, selling price, variable costs per unit, and/or fixed costs. However,
there are factors that can overpower the CVP analysis. Examples of such factors
include general economic conditions, competition, and government regulations.
The profit (before income taxes) can be determined using the following obvious
formula:
Profit ( Loss ) = Sales Revenue - Total Cost (7.1)
Therefore, for a product or service to be profitable, its sales revenue must exceed
its costs. As the total cost is the sum of total variable and fixed costs (including the
operating and finance expenses), we can restate the profit formula as:
Profit = Sales Revenue – Variable costs – Fixed costs
The total costs include the cost of goods sold and operating and financing expenses.
The above formula can be expressed in the following mathematical form:
Z = PQ – VQ – F (7.2)
By combining the sales revenue (PQ) and total variable cost (VQ), we obtain the fol-
lowing formula for computing the before-tax net income (profit):
Z = ( P – V ) Q – F (7.3)
This equation is called the conventional cost-volume-profit (CVP) model or func-

tion. In the CVP model, the expression (P – V) is called the contribution margin per
unit when multiplied by the sales quantity (Q units), and the result will be the total
contribution margin generated by producing and selling Q units. Therefore, we com-
pute the total contribution margin (CMT) using the following formula:
CMT ( total ) = ( P – V ) Q (7.4)
where
P = Sales price ($ per unit);
V = Variable cost per unit ($ per unit);
Q = Sales quantity (units);
PQ = TR = Total revenue by selling Q units;
VQ = TC = Total variable cost of producing Q units.
Cost-Volume-Profit Analysis 173
According to Equation 7.1, a firm can encounter one of the following three
situations:
1) If the Sales Revenue < Total Expenses, then Profit is negative (loss).

2) If the Sales Revenue = Total Expenses, then Profit is zero (break-even point).
3) If the Sales Revenue > Fixed Expenses, then Profit is positive.
The same three situations can occur by examining Equation (7.3):
1) If (P – V)Q < F, then Z < 0 (loss).

2) If (P – V)Q = F, then Z = 0 (break-even point).
3) If (P – V)Q > F, then Z > 0 (profit).
Dividing the total contribution margin (Equation 7.4) by the sales quantity (Q) gives
the contribution margin per unit (CMU), as follows:
CMU ( per unit ) =

( P –V ) Q = P – V
Q
That is,
CMU = P – V (7.5)
The contribution margin per unit represents the incremental net income generated
for each unit sold after deducting the variable unit cost. Basically, it shows how sales
would help a product (or a firm) to cover the fixed costs.
While the CVP analysis cannot really predict how many units of a product will
be sold, it is capable of providing information about the financial consequences of
different courses of action. One of the most important decisions that need to be made
at the beginning of a fiscal period is about the “number of units of a product need
to produce and sell in order to break even or to make a certain amount of profit.”
“Breaking even” simply means covering all variable and fixed costs without making
a profit or incurring a loss.
7.2.1. Underlying Assumptions in CVP Analysis

To present the concepts of the cost-volume-profit analysis, we consider the deter-
ministic CVP models with the following underlying assumptions, regardless of the
complexity of the situation:
• All expenses can be accurately classified into either fixed or variable.

• Selling price, variable cost (expense) per unit, and total fixed expenses per
period are all known and remain constant through the relevant range.
• There will be no changes in the firm’s efficiency or productivity.
• Changes in activity level (production/sales quantity) are the only factor that
changes revenues and costs (i.e., the volume is the only variable in the CVP
model).
• Inventory level does not change from period to period; that is, all units pro-
duced are sold. Thus, beginning inventory = ending inventory.
• In multi-product situations, the product mix (their relative sales propor-
tions) will remain constant at all levels of sales.
• The CVP analysis is used on a short-run basis. Therefore, there is no uncer-
tainty, risks, or inflation. However, if they exist and are known, they are
incorporated in the CVP model.
The assumptions may seem unrealistic in many situations. Nevertheless, they greatly
simplify the CVP analysis. Despite its deficiencies, the CVP analysis provides useful
information for performing the break-even analysis and in short-term goal settings
(such as sales plans, profit targets, production budgets, and pricing strategies).
7.2.2. Marginal Cost and Revenue and Contribution Margin

Recalling that the total cost (TC) is the sum of total variable costs and total fixed
costs, mathematically expressed as:
TC = V × Q + F (7.6)
where
Q = The production quantity (units produced);
F = The total fixed cost;
V·Q = Total variable cost.
The marginal cost is the additional cost incurred to produce an additional unit of
a product, which is the rate of change in the total cost, found by taking the derivative
of the total cost function with respect to production quantity (Q), that is,
dTC
MC = = V (7.7)
dQ
Note that the fixed cost (F) remains unchanged regardless of the changes in the
production volume, but total cost increases by V dollars (variable cost per unit) for
every additional unit produced. That is, the variable cost per unit (V) is the slope of
the cost curve (function).
The total revenue (TR) is the sales price multiplied by the quantity of the product
sold, mathematically expressed as:
TR = P × Q (7.8)
The marginal revenue (MR) is the additional revenue generated by selling an addi-
tional unit of the product, which is the rate of change in the total revenue. It is the
derivative of the revenue function (Equation 7.8) with respect to sales quantity (Q),
that is:
MR = P (7.9)
Taking the derivative of the CVP model (Equation 7.3) or the derivative of the con-
tribution margin formula (Equation 7.4) with respect to the sales quantity (Q) gives
the marginal profit, which is the contribution margin per unit.
dZ
CMU = = P – V (7.10)
dQ
Therefore, the contribution margin per unit (CMU) means that for every (addi-
tional) unit of the product manufactured and sold, it contributes P – V dollars toward
covering the fixed costs and making profit.
The crucial part of CVP analysis is the contribution margin (CM) and the contri-
bution margin ratio (CMR). The contribution margin represents the part of income
or profit the company made before deducting its fixed costs. In other words, it is the
portion of the sales amount available to cover (or contribute to) fixed costs. The con-
tribution margin ratio (CMR) is a percentage of sales revenue available to cover fixed
costs. Once fixed costs are covered, the remainder of sales is the net income (profit).
The CMR is computed as follows:
CMR =
CM
=
( Sales Amount ) - ( Total Variable Cost )
Sales Amount Sales Amount
PQ - VQ P - V
CMR = = (7.11)
PQ P
where
P = Sales price per unit;
Q = the production quantity (units produced);
PQ = Sales value (sales amount in dollars);
VQ = Total variable cost.
Example 7.1
A manufacturing company produces a product that sells for $5.60 per unit,
whereas its variable costs and expenses are $1.40 per unit. The company has an
annual fixed cost of $504,000. The company’s projected sales in the upcoming
year are 180,000 units of its product. Compute the company’s contribution mar-
gin (CM), contribution margin ratio (CMR), and expected profit in the year.
Solution
Contribution margin per unit:
CMU = P – V = $5.60 - $1.40 = $4.20 per unit
Total contribution margin
CMT = ( P – V ) Q = $4.20 (180, 000 ) = $756, 000
Contributing margin ratio using total sales and total contribution margin:
CMR=
CM
=
( P - V ) Q = ($5.60 - $1.40 )(180, 000 ) = 0.75 = 75% of sales
Sales PQ $5.60 (180, 000 )
Contributing margin ratio using sales price and contribution margin per unit:
CM P -V $5.60 -$1.40
CMR = = = = 0.75 = 75% of sales
Sales P $5.60
The expected profit using the CVP equation:
Z = (P – V ) Q - F

Z (180, 000 ) = ($5.60 - $1.40 )(180, 000 ) - $504, 000 = $252
2, 000
7.2.3. Break-even Analysis for a Single Product

A critical part of CVP analysis is the break-even point, the level of activity (pro-
duction level), where the total revenues equal total costs (both fixed and variable
costs). At the break-even point, a company will experience zero profit (i.e., no
profit no loss).
If a company’s costs were all variable, the problem of breakeven would never
arise. However, as usually some costs are variable and others are fixed, the company,
as previously stated, suffers losses up to a certain level of sales (when revenue equals
total costs), beyond which the company would have profit. This type of analysis is
useful for short-term managerial decision-making.
7.2.3.1. Graphical Method for Finding the Break-even Point

The break-even point (BEP) is the volume of sales at which total revenue equals
total cost. That is, at the break-even point, the profit of the company is zero (no profit,
no loss).
The break-even chart is a graphical representation of total revenue and total cost
at various levels of sales as well as the variation of income (or sales, revenue) shown
on the same chart with the variation in the activity level (e.g., production and sales
quantity). Figure 7.1 illustrates the concept of the break-even point.
$
Breakeven Sales Breakeven
Sales and Cost Amount

Amount and costs Point
Fixed Costs
F
Breakeven Quantity
Q
QBE
Production and Sales Quantity
FIGURE 7.1 A graphical illustration of the break-even point.
Example 7.2
A company manufactures a product that sells for $2.00 (per unit) with a variable
cost of $1.20 per unit and a total fixed cost of $40,000 per period. Find the break-
even point for the company using the graphical method.
Solution
As Figure 7.2 shows, up to the break-even point, found at the intersection of the
total-revenue and total-costs curves, the firm suffers losses. Beyond this point, the
firm makes profits. The break-even point is the cross point of the sales revenue
and the total cost lines.
If we use a graph paper, we can find the break-even quantity (QBE = 50,000
units) by drawing a vertical line from the cross points of total revenue and total cost
lines to intercept the horizontal axis, which is scaled to represent the production
and sales volume (units). The break-even sales amount (revenue) is the intercept
Sales and Costs ($1,000s)
BE Point
BE Sales Amount
100
BE Quantity
40
50
Production and Sales Quantity (1,000s units)
FIGURE 7.2 The break-even point chart for Example 7.2.

point on the vertical axis (i.e., the sales and costs axis) by a horizontal line drawn
from the break-even point, which is $100,000 (TRBE = $2.00×50,000 units)
7.2.3.2. Algebraic Method for Finding the Break-even Point

As previously defined, the break-even quantity is the volume of production and sales
at which the total revenue equals total costs; that is, the profit equals zero. Hence, by
setting Z in the CVP model (Equation 7.6) equal to zero and solving it for the unknown
Q (symbolically shown as QBE), we will get the break-even quantity, as follows:
0 = ( P – V ) QBE – F
Then, solving the resulting equation for the unknown QBE provide the following for-
mula for computing the break-even quantity:
F
QBE = (7.12)
( P -V )
Again, the expression in the denominator is the amount contributed by every unit
produced and sold towards covering the fixed costs.
Example 7.3
For the company in Example 7.2, find the break-even point using the algebraic
method.
Solution
We find the break-even quantity to be:
QBE = $40, 000 ($2.00 - $1.20 ) = 50, 000 units
As done in Example 7.2, we can calculate the break-even sales amount (revenue)
as follows:
Breakeven Sales Amount ( or Dollars ) = PQBE = $2.00 ( 50, 000 ) = $100

0, 000.
7.2.4. CVP Analysis for a Target Profit

We can also use the CVP model to determine a sales quantity, Q*, needed to produce
and sell in order to generate a target profit, Z*. We will find the required sales quan-
tity by replacing Z in the CVP model (Equation 7.6) by the desired profit amount,
Z*, as follows:
Z * = ( P - V ) × Q* - F
Then, we solve the equation for the unknown sales quantity, Q*, which not only cov-
ers the total fixed cost (F) but also provides the target profit, Z*, as expressed by the
following formula:
Z* + F
Q* = (7.13)
P -V
Example 7.4
For the scenario given in Examples 7.2 and 7.3, determined the required sales
revenue that provides a desired (target) profit of $20,000.
Solution
We can directly use Equation (7.15) to compute the desired sales quantity as:
Z * + F $20, 000 + $40, 000

Q* = = = 75, 000 units
P -V $2.00 - $1.20
Alternatively, we can set Z = Z* = $20,000 in the CVP model (Equation 7.3) and
compute the required sales quantity as follows:
Z* = ( P - V ) × Q* - F
$20, 000 = ($2.00 - $1.20 ) Q* - $40, 000
Q* = $60, 000 $0.80 = 75, 000 units
Then, we compute the required sales revenue as follows:
TR* = P × Q* = $2 (75, 000 ) = $150, 000
7.2.5. Margin of Safety
The margin of safety (MOS) is the difference between the estimated (or actual) sales
and the level by which the sales amount can decrease before a loss occurs. That is,
it is the excess of the estimated (or actual) revenues over the break-even revenues as
represented by the following formula:
MOS = Actual ( or Estimated ) Sales Amount - Breakeven Sales (7.14)
The margin of safety is usually expressed as a percentage of the estimated sales:
MOS
MOS% = (7.15)
Actual ( or Estimated ) Sales
MOS is an indicator of the risk of loss when there is a possibility of a significant

sales decline. A business with a low margin of safety percentage may attempt
expenses cutting, while a high spread of margin assures a company that it is
protected against sales variability. MOS may be expressed by the sales quantity
(number of units):
MOS in Units = Actual ( or Estimated ) Sales Units

(7.16)
- Breakeven Quantity
Example 7.5
A company expects the sales price for its product in the upcoming year to be
about $70 and its variable costs are approximately $30. The company has esti-
mated annual fixed costs of $250,000. If the company’s projected sales are 10,000
units of the product, what will be its margin of safety?
Solution
Contribution margin per unit: CMU = $70 – $30 = $40
Fixed Cost $250, 000
The break-even quantity: QBE = = = 6, 250 units
CMU $40
The break-even sales amount = $70(6,250) = $437,500
The projected sales amount = $70(10,000) = $700,000
The Margin of Safety: MOS = Projected sales amount – break-even sales
amount
= $700,000 – $437,500 = $262,500
The Margin of Safety percentage: MOS % = $262,500/$700,000 = 0.375 =
37.5%
7.2.6. Operating Leverage
The operating leverage measures the degree to which a firm or product can increase
its profit by increasing revenue. If a firm’s fixed cost is higher in proportion than its
variable cost, it would have high operating leverage and will generate a larger profit
from an incremental sale.
The operating leverage is calculated by dividing the contribution margin by the
difference between the operating income.
Operating Leverage =
Contribution Margin
=
( P - V ) Q (7.17)
Operating Income ( P - V ) Q -F
A firm (or product) with low operating leverage may have high variable costs that
vary directly with the sales volume but has lower fixed costs to cover each period.
Example 7.6
A company sells 45,000 units of its product at $10 each. The company’s costs
are $90,000 fixed costs and $2 variable costs per unit. Determine the company’s
degree of operating leverage.
Solution
ContributionMargin
OperatingLeverage =
Profit

=
($10 - $2) ( 45, 000 ) = 1.33 or 133%
($10 - $2)( 45, 000 ) - $90, 000
An operating leverage of 133% means a 10% sales increase would result in a
13.3% increase in operating income, which is 1.33 × 10%.
7.3. NONLINEAR CVP ANALYSIS FOR A SINGLE PRODUCT

In previous CVP analysis, the assumptions were that the sales price (P), fixed cost
(F), and unit variable cost per unit (V) are all constant at any production level. These
assumptions lead to the linearity of the model developed for CVP analysis. However,
if the sales price varies as a function of quantity supplied to the market; that is,
P = f(Q), which corresponds to the inverse function of the economists’ demand curve,
Q = f−1(P). This function presents the sales quantity as a function of the price, which
decreases as the price increases.
The total cost of production, TC(Q), could also be a nonlinear function of the
production level, in which not only the marginal cost varies but also the fixed cost
can shift to higher levels, beyond certain production levels. In general, the equation
for CVP is written as
Z ( Q ) = Q × f -1 ( P ) - TC ( Q )
Let’s assume that the total cost function takes the form of the following polynomial.
TC ( Q ) = a0 + a1Q + a2Q 2 + a3Q 3 ,
where a0, a1, a2, and a3 are constant coefficients. Then, the marginal-cost function,
MC(Q), is obtained by taking the derivative of the total-cost function:
dTC ( Q )
MC ( Q ) = = a1 + 2a2Q + 3a3Q 2
dQ
Figure 7.3 illustrates how a total cost of a product may fluctuate as the production
quantity changes when the cost is a non-linear function of production level.
TC(Q)
Total Cost
Production Quantity Q
FIGURE 7.3 An example of a nonlinear cost curve.
Assuming that the demand for the products is a linear function of price, that is,
Q = b0 + b1 × P,
where b0 is a constant and b1 < 0 is the slope (also constant). The negativity of b1 is
the indication of that sales decreases as a reaction to the increases in sales price. The
total revenue function, TR(Q), is then given by the following quadratic function.
TR ( Q ) = Q × P = Q ( Q - b0 ) b1
Figure 7.4 illustrates non-linear changes in total-revenue and the total-cost functions
as the level of activity/production changes.
In this example of nonlinear revenue and cost, we see that there are two break-
even points associated with the production levels, where the total-revenue and total-
cost curves intersect; that is, the total cost equals total revenue. Therefore, we can
find the break-even point quantities by solving the following nonlinear equation.
TR ( Q ) = TC ( Q )
$
Revenue and Costs
PEP
TC(Q)
PEP
TR(Q)
QBE1 Q* QBE2 Q
Production and Sales Quantity
FIGURE 7.4 An illustration of nonlinear revenue and cost functions.

Substituting TR(Q) and TC(Q) by their corresponding expressions give the following
nonlinear equation:
(Q 2
)
- mQ n = a + bQ + cQ 2 + dQ 3
Solving this equation for the unknown Q gives the break-even quantity(ies). However,
we may be more interested in finding a production level that maximizes the profited.
For such a problem, there are two general methods for finding the optimal pro-
duction output, which maximizes the firm’s profits. We explain these methods as
follows:
• Economists’ Method: According to the economics principles, when the

marginal revenue equals marginal cost, profit will be at its maximum; that
is,
MR ( Q ) = MC ( Q )
or
b + 2cQ + 3dQ 2 = ( 2Q - m ) n
when solved for Q, the production level (Q*) which provides the maxi-
mum profit (Z*) is found.
• Mathematical Method: By subtracting the cost function from the revenue
function, the profit function, Z(Q), or the CVP model, is obtained. Then, by
setting the first derivative of Z(Q) equal to zero, we find a production level
(Q*) that yields the maximum profit (Z*).
Note that the optimal value of Q* is the number of units that have to be
produced and sold to maximize profits. Substituting Q by Q* in the total
revenue and total cost functions, we find their optimal amount. The dif-
ference between these two values is the maximum profit. We can also be
substitute Q* for Q in the profit function to find the maximum amount of
profits.
Example 7.7
Assume that the total cost, TC(Q), and total-revenue, TR(Q), respectively, are given
as:
TC (Q ) = 504 + 20Q - 3Q 2 + 0.5Q 3
and
TR (Q ) = 564Q - 8Q 2
Then the CVP model is formulated as follows:
Z = TR (Q ) - TC (Q )

(
= 564Q - 8Q 2 – 504 + 20Q - 3Q 2 + 0.5Q 3 )
That is,
Z = -0.5Q 3 - 5Q 2 + 544Q - 504 ( CVP model)

To find the break-even points, we set TR(Q) equal to TC(Q) (or Z = 0). Either
method results in the following equation:
-0.5Q 3 - 5Q 2 + 544Q - 504 = 0
Solving this equation graphically (Figure 7.5) or by trial and error yields the two
break-even points
QBE = 0.94 and QBE = 27.81.
Therefore, the product will be profitable as long as the level of production is in

the following range:
0.94 < Q < 27.81.
The maximum profit is achieved when marginal revenue, MR(Q), equals marginal
cost, MC(Q).
MR (Q ) = 564 - 16Q
MC (Q ) = 20 - 6Q + 1.5Q 2

To maximize the profit, set MR (Q ) = MC (Q )
564 - 16Q = 20 - 6Q + 1.5Q 2
$10,000 Z(Q)
$5,000
$0 Q
0 5 10 15 20 25 30
-$5,000
FIGURE 7.5 Graphical method for finding the break-even points (Example 7.7).
We can rearrange the equation and write it as
1.5Q 2 + 10Q - 544 = 0
Then, solving the quadratic equation for Q (where Q > 0), gives
-10 ± 10 2 - 4 (1.5) ( -544 )

Q* = = 16 units
2 (1.5)
At this point, both marginal revenue and marginal cost are equal to $308 as com-
puted below.
MR (16 ) = 564 – 16 (16 ) = $308
MC (16 ) = 20 – 6 (16 ) + 1.5 (16 ) = $308

2
Then, the maximum profit is computed as follows:
TR (Q ) = 564Q - 8Q 2

TR (16 ) = 564 (16 ) – 8 (16 ) = $6, 976
2
and
TC (Q ) = 504 + 20Q - 3Q 2 + 0.5Q 3

TC (16 ) = 504 + 20 (16 ) - 3 (16 ) + 0.5 (16 ) = $2
2 3
2,104
Then, profit is found to be:
Z * = TR (16 ) - TC (16 ) = $6, 976 - $2,104 = $4, 872
Alternatively, we could maximize profit by setting the first derivative of the CVP
equation equal to zero, as follows:
Z = - 0.5Q 3 - 5Q 2 + 544Q - 504 ( CVP model)
dZ
= -1.5Q 2 - 10Q + 544 = 0
dQ
10 ± 10 2 - 4 ( -1.5)( 544 ) 10 ± 102 - 4 ( -1.5)( 544 ) 10 ± 58

Q* = = =
2 ( -1.5) 2 ( -1.5) -3
Q* = -22.67 < 0 (not acceptable )
Q* = 16
Then, the maximum profit, Z*, is computed using the CVP equation as follows:
( )
Z * = Z Q* = Z (16 ) = - 0.5 (16 ) - 5 (16 ) + 544 (16 ) - 504
3 2

Z * = $4, 872
7.4. COST-VOLUME-PROFIT ANALYSIS FOR MULTIPLE PRODUCTS

In this section, we present the procedures for performing the CVP analysis for multi-
product situations. Multi-product CVP analysis arises when a company sells two or
more products. The procedure of computing the break-even points or required sales
volumes to achieve a target profit in a multiple-product problem can be more compli-
cated than that is used in single-product cases.
A general CVP model for multiple (say n) products can be written as:
n n
Z= å ( Pi -Vi ) Qi - åFi (7.18)

i =1 i =1
subject to the non-negativity constraints on the production volumes, that is,
Qi ³ 0, i = 1, 2,… , n.
where
Pi = Sales price ($/unit) for product i (for i = 1, 2, …, n);
Vi = Variable cost per unit of product i ($/unit) (for i = 1, 2, …, n);
Fi = Fixed cost assigned to product i ($/period) (for i = 1, 2, …, n);
Qi = Production volume (units) for product i (for i = 1, 2, …, n);
(Pi – Vi) = Contribution margin per unit for product i (for i = 1, 2, …, n);
(Pi – Vi)Qi = Total contribution margin for product i (for i = 1, 2, …, n);
Z = Profit (loss).
7.4.1. CVP Analysis for Multiple Products with a Fixed Sales Mix

When the projections of sales are based on the assumption that the same sales mix of
products and contribution margin ratios, the CVP analysis can be performed using
either of the following two methods:
7.4.1.1. Product-Indexing Method for Sales-Mix CVP Analysis

The analyst can use this method following the steps below:
Step 1.1. Choose one of the products as an index product (named as product i)
and express the sales quantity (Q j) of each of other products in terms (i.e., a
multiple) of the sales quantity of the index product based on the sales-mix
quota, as Q j = Kj·Qi.
Step 1.2. Replace each product’s quantity (Q j) in the multiple-product CVP
model with its equivalent in terms of the index product’s quantity (Kj·Qi).
This converts the CVP model into a single-product model.
Step 1.3. Compute the required sales volume (Qi) for the index product to
break even or to achieve a target profit. Then, compute the required sales
volumes for other products by multiplying the index product’s sales volume
by their corresponding multiplier, Kj, determined in Step 1.1, as Q j = Kj·Qi.
7.4.1.2. Weighted-Average Contribution Margin

Method for Sales-Mix CVP Analysis
The analyst can use this method following the steps below:
Step 2.1. Compute the total contribution margin for each product and sum
the totals to determine the combined total contribution margin for all
products.
Step 2.2. Add the sales quantities (units) for all products into the combined
total sales units.
Step 2.3. Divide the combined total contribution margin (from Step 1) by the
combined total sales units (from Step 2) to determine the weighted-average
contribution margin (WACM) per composite unit, as follows:
Combined Contribution Margin

WACM =
Combined Sales Units
Step 2.4. Compute the composite sales volume (Q) required to break even or
to achieve a target profit, as follows:
Break-even Composite Units:
Total Fixed Costs

QBE =
WACM Per Composite Unit
Required Composite Units to Achieve Target Profit:
Q* =
( Target Profit ) + ( Total Fixed Costs )
WACM Per Composite Unit
Step 2.5. Then, compute the required sales volumes for the individual prod-
ucts using their corresponding sales-mix proportion of the overall compos-
ite units.
Example 7.8
A company manufactures and sells three products, A, B, and C. The weekly sales
and variable costs of the products are shown below:
Sales Variable Cost per

Product Sales Units Price Total Sales Unit
A 25,000 $50 $1,000,000 $20
B 10,000 100 1,000,000 50
C 5,000 200 1,000,000 120
Totals 40,000 $3,000,000
If the company’s fixed costs are $495,000 per year and maintain the product-mix
ratios constant, calculate the break-even points for the products using:
a) Product-indexing method.
b) Weighted-average contribution-margin method.
Solution
a) Finding the break-even quantities using the product-indexing method.
The product-mix quotas are 25,000:10,000:5,000 or 5:2:1. Thus,
we should choose product C as the index product use QA = 5QC and
QB = 2QC. in the CVP formulation, as follows:
Z = ( PA – VA ) QA + ( PB – VB ) QB + ( PC – VC ) QC - 495, 000
Z = ( 50 - 20 )( 5QC ) + (100 - 50 )( 2QC ) + ( 200 - 120 ) QC – 495, 000

Z = 150QC + 100QC + 80QC - 495, 000
Z = 330QC - 495, 000
To break even, set Z = 0 and solve for (QC )BE:
0 = 330 (QC )BE - 495, 000
( QC )BE = 1, 500 units
Then, we compute the break-even quantities for products A and B as

follows
( QA )BE = 5 (1, 500 ) = 7, 500 units
( QB )BE = 2 (1, 500 ) = 3, 000 units

b) Finding the break-even quantities using the weighted-average contribu-

tion-margin method.
The computations are presented in the following table:
Sales Variable Cost Contribution Contribution

Product Sales Units Price Total Sales per Unit Margin/Unit Margin
A 25,000 $ 50 $1,250,000 $ 20 $30 $750,000
B 10,000 100 1,000,000 50 50 500,000
C 5,000 200 1,000,000 120 80 400,000
Totals 40,000 $3,250,000 $1,650,000
Combibed Contribution Margi $1,, 650, 000

WACM Ratio = = = 50.77%
Composite Total Sales $3, 250, 000
Combibed Contribution Margin $1, 650, 00

00
WACM = = = $41.25 per unit
Combined Sales Units 40, 000 Units
Using the weighted-average contribution margin (WACM) we can calculate the

composite break-even point quantity as follows:
Fixed Costs $495, 000

Composite Breakeven Point Quantity = = = 12, 000 units
WACM $41.25 / unit
We can compute the break-even sales quantity (in units) required for each product
based on the proportion of each product in the sales mix:
25, 000
( QA )BE = (12, 000 ) = 7, 500 units
40, 000
10, 000
( QB )BE = (12, 000 ) = 3, 000 units
40, 000
5, 000
( QC )BE = (12, 000 ) = 1, 500 units
40, 000
The break-even sales amount (in dollars) for each product depends on the propor-
tion of each product in the sales mix:
Breakeven sales value for Product A = $50 (7, 500 ) = $375, 000
Breakeven sales value for Product B = $100 ( 3, 000 ) = $300, 000
Breakeven sales value for Product C = $200 (1, 500 ) = $300, 000
7.4.2. CVP Analysis for Multiple Products

without Product Interdependencies
In general, in the absence of the interdependency among the products, to determine

a product mix that yields a given targeted profit level, Z* including the break-even
points (Z* = 0), we will seek the feasible solutions to the following CVP Model:
n n
Z* = å j =1
( Pj - V j )Q j - åF (7.19)
j =1
j
subject to the non-negativity constraints on the production volumes, that is,
Q j ³ 0, for j = 1, 2,… , n
However, there would be an infinite number of solutions to Equation (7.19), which

at the same time satisfy the non-negativity constraints. For instance, one solution is:
å
n
Z* + Fj
j =1
Q1* = , Q2* = Q3* = … = Qn* = 0
P1 - V1
and another solution is
å
n
Z* + Fj
j =1
Q1* = 0, Q2* = , Q3* = … = Qn* = 0
P2 - V2
We can find a total of n different solutions in this same fashion. In addition to these n
solutions, any linear combinations of these n solutions would also be another feasible
solution. Therefore, there are an infinite number of solutions that would also yield
the targeted profit level. For example, if the above two basic solutions are shown by
Y(1)and Y(2), that is,
Y ( ) = the first solution vector (Q1, Q2 , Q3 ,… , Qn ) and

1

Y ( ) = the second solution vector (Q1, Q2 , Q3 ,… , Qn ),

2

then
mY ( ) + (1 - m ) Y ( ) where 0 £ m £ 1
1 2

would be a solution to Equation (7.18).

å
n
This means that any linear combination of the n basic solutions i =1
miY (i )
å
n
(where mi ≥ 0 and i =1
mi = 1 ) would also be a solution to Equation (7.18).
Example 7.9
Consider a two-product situation with the following data:
Product Pi Vi Fi
1 $22 $6 $20,000
2 30 10 30,000
The break-even point for each product is given below:
Product 1: Q1,BE = 20, 000 ( 22 - 6 ) = 1, 250 units
Product 2: Q2,BE = 30, 000 ( 30 - 10 ) = 1, 500 units
The profit equation for this problem is found as follows:
Z = éë( 22 - 6 ) Q1 - 20, 000 ùû + éë( 30 - 10 ) Q2 - 30, 000 ùû
Z = 16Q1 - 20, 000 + 20Q2 - 30, 000
Z = 16Q1 + 20Q2 - 50, 000
In order to break even, the sales quantity vector (Q1, Q2) must be selected such
that
16Q1 +20Q2 - 50, 000 = 0

or 16Q1 +20Q2 = 50, 000
Two of the feasible solutions are:
Y(1) : Q1 = 3,125, Q2 = 0
and
Y(2) : Q1 = 0, Q2 = 2, 500
Also, any product mixes of the form m·Y(1) + (1 − m)·Y(2), where 0 < m < 1, will break
even (i.e., Z = 0). For example, if we choose m = 0.4, then another solution is:
0.4Y( ) + (1- 0.4 ) Y( ) = 0.4 ( 3,125, 0 ) + 0.6 ( 0, 2, 500 ) = (1, 250,1, 500 ) .
1 2
That is, we can break even with Q1 = 1,250 and Q2 = 1,500. An infinite number of
product mixes can be found by letting m vary continuously in the range from 0 to
1, which yields zero profits (i.e., breaking even).
For a given targeted profit, Z*, any product mix (Q1, Q2) that satisfies
16Q1 + 20Q2 = 50, 000 + Z *
would be a solution and provide an overall profit level of Z*.

For problems of this type, when there are no production requirements or con-
straints on the resources by which the capacity of production will be limited,
there will be an infinite number of solutions yielding a given targeted profit level
including the break-even point. In the next sections, the impacts of production
constraints are studied.
7.4.3. CVP Analysis for Multiple Products with a Single Constraint

Achieving the maximum profit is usually the most important factor in the mind of
a cost analyst. In the CVP analysis, products with higher contribution margins (Pi
−Vi) are given special attention. The reason for this is that the products with high
contribution margins maximize the overall contribution margin and, automatically,
profit. But, usually, there are constraints on the company’s resources that limit the
production output.
To make a meaningful CVP analysis, one should identify all production con-
straints. Examples of such constraints are the limitations on the availability of
machine time, labor, supervision, materials, storage space, and transportation, as
well as production requirements and the existence of interdependencies among
products.
In this section, we concentrate on the single constraint situation. In such a situa-
tion, the objective is to maximize the production of products that yield the highest
contribution margin per unit of the limited resource.
Example 7.10
In the previous example, assume that only 30,000 hours of machine time are
available. Assume, also, that each unit of Product 1 requires 3 machine hours and
each unit of Product 2 requires 4 machine hours. The situation is summarized in
the following table.
Product Contribution Margin Per Unit Machine Time Required Per Unit
1 $16 3 hours
2 20 4 hours
When considering the contribution margins, per unit of the individual products,
Product 2, with $4 per unit more contribution margin seems to be more profitable
than Product 1. This would have been true if either there were no constraints on
the production outputs due to the number of machine hours available to produce
the two products. However, if the company produces and sells only Product 2, its
maximum production output will be 7,500 units of Product 2 (i.e., 30,000 hours/4
hours per unit), which yields a total contribution margin of $150,000 (i.e., 7,500
units × $20). Whereas, if the company only produces and sells Product 1, it can
produce 10,000 units (i.e., 30,000 hours/3 hours per unit), which generate a total
contribution margin of $160,000 (i.e., 10,000 units × $16). Therefore, Product 1 is
more profitable than Product 2, although it has a lower contribution margin per
unit than does Product 2.
Thus, when there are some constraints on the production resources, ranking
the profitability of the products based on contribution margin as the only criteria
is misleading. The contribution margin per unit of the limited resource provides
a suitable criterion for ranking the products in terms of their profitability. The con-
tribution margin of the products per machine hour is found to be:
For Product 1: $16/3 hours = $5.33 per machine hour;

For Product 2: $20/4 hours = $5.00 per machine hour.
It became obvious that the machine hours would be more profitably used for
manufacturing Product 1.
7.4.4. CVP Analysis for Multiple Products with Multiple

Constraints and Unavoidable Fixed Costs
Business problems in the real world are not always simple. The resources are usually
scarce. In production situations, there are always shortages in capital, time, materi-
als, labor, demand for products, etc. In this section, we focus on the situations in
which there are more than one production constraints.
Assume that a company manufactures and sells n different products while it has
m constraining resources. Let
i = Product index (i = 1, 2, …, n);
j = The jth constraining resource (j = 1, 2, …, m);
Rj = Maximum amount of resource j available;
rij = The fixed amount of resource j required to produce one unit of Product i;
Qi = The amount of product i produced.
Therefore, to produce Q1, Q2, …, and Qn units of products 1, 2, …, and n, respec-

tively, the following total amount of resource j is required:
r1 jQ1 + r2 jQ2 + ... + rnjQn , ( where j = 1, 2,…, m.)

However, there are only Rj units of each resource j available, hence, the production
outputs must satisfy the following constraints:
år Q £ R for all j = 1, 2,…, m; ( where i = 1, 2,…, n )

i =1
ij i j
In order to maximize the overall profit of the company, the total contribution margin
is generated by all products. To do so, the problem must be formulated as the follow-
ing linear programming from:
n n
Maximize: Z = å i =1
( Pi - Vi )Qi - åF
i =1
i ( where i = 1, 2,…, n )
n
Subject to: år Q £ R
i =1
ij i j for all j = 1, 2,… , m; ( where i = 1, 2,… , n )
Qi ³ 0 ( where i = 1, 2,…, n )
In order to have the standard form of a linear programming problem, we eliminate

å
n
the constant term F in the objective function. If we assume that all fixed
i =1 i
costs are unavoidable in case of a product-line shutdown, then maximizing the total
contribution margin will also maximize the overall profit. Under this simplifying
assumption, the problem becomes as follows:
Maximize: Y = å(P - V )Q
i =1
i i i
Subject to: år Q £ R for all j = 1,22,…, m; ( where i = 1, 2,…, n )

i =1
ij i j
Qi ³ 0 ( where i = 1, 2,..., n )
Example 7.11
For the previous example, assume that a maximum of 24,000 gallons of raw mate-
rial is available. Furthermore, the material required to produce one unit of either
product is 3 gallons. The following table summarizes the information given for this
example.
Contribution margin Machine time Raw material

per unit Fixed cost required per unit per unit
Product(i) (Pi − Vi) ($) (Fi) ($) (ri1) (hours) (ri2) (units)
1 16 20,000 3 3
2 20 30,000 4 3
To achieve the optimal solution (product mix), we solve the following linear pro-
gramming problem:
Maximize: Y = 16Q1 + 20Q2
Subject to: 3Q1 + 4Q2 £ 30, 000 (machine time constraint )

3Q1 + 3Q2 £ 24, 000 (material constraint )
Q1, Q2 ³ 0 (non-negativity constraints )
The optimal product-mix solution to this linear programming problem is:
Q1 = 2, 000 units of product 1, and
Q2 = 6, 000 units of product 2.
This product mix will generate a total contribution margin of $152,000, which
results in an overall profit of
Z = 152, 000 - ( 20, 000 + 30, 000 ) = $102, 000
Since there are only two variables (product volumes) in this problem, this optimal
product-mix solution can be obtained using the graphical method of linear pro-
gramming (Figure 7.6).
Q2 (1,000s)
8 Y = 16Q1 + 20Q2 = 80,000
(2,000, 6,000) 3Q1 + 3Q2 = 24,000

6
Y = 16Q1 + 20Q2 = 152,000

4
3Q1 + 4Q2 = 30,000

2
0 Q1(1,000s)
0 2 4 6 8 10
FIGURE 7.6 A graphical solution to the linear program problem, where Q1 = 2,000 and
Q2 = 6,000.
7.4.5. CVP Analysis for Multiple Products with Multiple

Constraints and Avoidable Fixed Costs
In the previous sections, we ignored the fixed costs because the maximum value of
the total contribution margin guarantees the maximum profits. This was true only
if the fixed costs of a product(s) do not disappear by shutting down the production of
the corresponding product(s).
There are situations in which if the production of a product is discontinued, some
part of its fixed costs will diminish, too. This implies that some part of the total
fixed costs is avoidable (or escapable). Here, the linear programming may provide
an improper solution to the problem. For example, the linear programming solution
may include a product mix with a small production volume of a product whose total
contribution margin will not be enough to cover its own avoidable fixed costs, which
can be saved if that product line is entirely eliminated.
Examples of avoidable fixed costs are supervisory compensations, cost of leasing
equipment, costs of product distribution, and advertising and promotional expenses asso-
ciated with a product. When there exist fixed costs that are traceable to a specific product
line and are avoidable in case of the product-line shutdown, they can be incorporated into
the analysis using a more general model. One can determine the optimal product mix by
formulating and solving the following form of linear programming model:
n n
Maximize: Z = åi =1
( Pi - Vi )Qi - åq F
i =1
i i ( i = 1, 2,…, n )
Subject to: år Q £ R
i =1
ij i j ( j = 1, 2,…, m; i = 1, 2,…, n )
Qi £ qi × M ; ( i = 1, 2,…, n )
Qi ³ 0; ( i = 1, 2,…, n )
qi = 0, 1 ( i = 1, 2,…, n )
Where
Pi = Price of Product i;
Vi = Variable cost per unit of Product i;
Qi = Units of Product i produced (output of Product i);
Fi = Fixed costs that can be avoided if Product i is discontinued;
rij = Amount of resource j consumed by each unit of Product i;
Ri = Maximum amount of resource j available;
M = An arbitrary constant that is large enough to be greater than the maximum
sales volume of any of the n products;
qi = A binary variable associated with Product i so that if Qi = 0, then qi = 0,
if Qi > 0, then qi = 1 (the value of qi indicates whether or not Product i is produced.)
The constant M, in the second set of constraints, is an arbitrary large number,

in excess of the maximum sales of any product. The constraint Qi ≤ qi M assures
that whenever Qi ≥ 0 in a solution, then the variable qi must be equal to 1, and the
escapable fixed cost, Fi, associated with the positive production of Product i will be
subtracted from the objective function.
If in a solution Qi = 0, then qi must also be equal to zero (i.e., qi = 0), and the cor-
responding avoidable fixed cost will not be subtracted from the objective function.
The traditional linear programming techniques cannot be applied to the fixed-
cost problems since they cannot force a decision variable (e.g., qi) to take on integer
values only (i.e., 0 or 1 in this case).
The fixed-cost problem is a special case of a class of integer programming models
called mixed-integer programming. The problems are called so because they have
both continuous variables (Qi) and integer (or discrete) variables (qi).
Example 7.12
The ABC Company produces three products (A, B, and C). Its product-line income
statements on a full-cost basis and its projections for the next period are given
below. Sales commissions are paid at the rate of 3% of sales to the company’s
salespersons. Order-processing costs can be considered variable.
Based on the ABC Company’s full-cost system, Products B and C are unprofit-
able, suggesting that overall profits could be increased by dropping both products.
However, this computation avoids a careful analysis of the variable contribution
margin and escapable fixed costs associated with each product.
Product
A B C Total
Sales volume (Units) 400 300 500 --
Sales revenue ($) 4,000 3,000 2,000 9,000
Cost of goods sold:
Direct material $1,200 $900 $1,000 $3,100
Direct labor 1,000 1,000 400 2,400
Factory overhead absorbed 400 400 200 1,000
Total cost of goods sold $2,600 $2,300 $1,600 $6,500
Gross margin $1,400 $700 $400 $2,500
Selling expenses:
Commissions $ 120 $ 90 $ 60 $ 270
Traceable fixed expenses 200 60 60 320
Common fixed expenses 480 360 240 1,080
Administrative expenses:
Order processing 30 30 20 80
General administration 320 240 160 720
Total operating expense $1,150 $780 $540 $2,470
Net income (loss) before tax $250 ($80) ($140) $30
Further examination yields the following analysis of factory overhead and fixed
operating expenses:
Product
A B C
Factory overhead: $150 $200 $160
Variable (with direct labor cost)
Fixed but escapable if shut down 150 100 20
Fixed and inescapable if shut down 100 100 20
Traceable fixed selling expense: 180 60 60
Escapable if shut down 20 0 0
Inescapable
Common fixed selling expense: 200 210 200
Escapable if shut down 280 150 40
Inescapable
General administrative expense: 20 40 100
Fixed but escapable if shut down 300 200 60
Fixed and inescapable
The selling prices, Pi, for the three products are $10, $10, and $4, respectively. The
variable costs and expenses for the three products are:
Product
A B C
Variable Costs and Expenses:
Material $1,200 $900 $1,000
Labor 1,000 1,000 400
Factory overhead 150 200 160
Sales commissions 120 90 60
Order processing 30 30 20
Total variable costs and expenses $2,500 $2,220 $1,640
Variable cost per unit $6.25 $7.40 $3.28
Contribution margin per unit $3.75 $ 2.60 $0.72
The fixed costs associated with the three products are:
Product
A B C
Factory overhead $250 $200 $0
Selling expenses 680 420 300
General administrative 320 240 160
Total fixed costs $1,250 $860 $500
Our multi-product CVP equation is:
Z = 3.75QA + 2.60QB + 0.72QC - (1, 250 + 860 + 500 )
With the projected sales of QA = 400, QB = 300, QC = 500, we obtain:
Z = 1, 500 + 780 + 360 - 2, 610 = $30
which agrees with the profit from the product-line income statement above. With
this traditional CVP analysis, it appears that all three products are generating posi-
tive contribution margins for the company and hence should be retained if sales
will be as projected.
Tracing all fixed costs to the individual products, we can compute the break-
even volumes as the ratio of fixed costs to per-unit contribution margin:
QA,BE = 1,250/3.75 = 333 units
QB,BE = 860/2.60 = 331 units
QC,BE = 500/0.72 = 694 units
We see that the projected sales for both products B and C are below the break-
even volume, which explains why both products show losses on the product-line
income statement. To achieve breakeven, product B must have 10% more sales,
while product C must increase sales by almost 40%.
This analysis, however, is misleading, since a substantial part of the fixed costs
associated with the products would not disappear were these products to be
dropped from the firm’s product line. A more meaningful product-line profitability
analysis would use only the escapable fixed costs, since the excess of contribution
margin over escapable costs helps to cover those (inescapable) costs that will be
incurred regardless of the product-mix decision. The fixed costs must be separated
into escapable and inescapable components as follows:
Product Escapable fixed costs Inescapable fixed costs Total fixed costs
A $550 $700 $1,250
B 410 450 860
C 380 120 500
We now see that shutting down product line B would lower the profits of the firm
since only $410 of the $860 fixed expenses traceable to B would be avoided if
product B were discontinued. Since product B generates a $780 contribution margin
based on projected sales, it contributes $780 − $410 = $370 to cover inescapable
fixed overhead and profit contribution. Product C, on the other hand, is generat-
ing only $360 in contribution margin, which is less than the $380 of fixed costs
that could be avoided were it to be purged from the product line. Thus, the more
detailed analysis of product C’s fixed costs suggests that strong consideration be
given to dropping this product. Based on escapable fixed costs, product C’s sales
would have to increase to 380/0.72 = 528 units (a 5.6% increase from current levels)
before it could break even by covering its traceable and escapable fixed costs.
So far, we have analyzed the three products regardless of production con-
straints. Product A appears to be more profitable than product B since its unit con-
tribution margin is $3.75, whereas product B’s contribution margin is $2.60 per
unit. Product A has higher escapable fixed costs than product B ($550 to $410),
but its higher unit contribution margin enables it to break even at a volume of 147
units (550/3.75), whereas B’s break-even quantity on escapable costs is 158 units
(410/2.60). If we add the fact that sales of Products A and B could be expanded on
a one-for-one basis (we can increase the sales of A by X units by decreasing the
sales of B by X units and vice versa), we would apparently want to promote the
sales of product A at the expense of Product B.
However, if we add a further complication that Products A and B share a com-
mon machine on which Product A requires 3 hours of processing per unit whereas
Product B requires only 2 hours per unit, the situation becomes quite different.
Under such conditions, Product B becomes more profitable since Product A gen-
erates $3.75/3 = $1.25 contribution margin per machine hour whereas Product B
generates $2.60/2 = $1.30. Thus, Product B becomes the more profitable product
to promote. In the limit, if we could completely offset any loss in Product A’s sales
with increased sales of Product B, we would attempt to run product A’s sales
down to zero, avoid $550 of escapable fixed costs, and produce and sell only B.
This example highlights the importance of carefully segregating both fixed
from variable costs and escapable fixed costs from inescapable fixed costs, and
determining when any production interdependencies exist among various prod-
ucts being considered. Basic knowledge of algebra enables us to incorporate the
effects of the fixed versus variable and escapable versus inescapable cost clas-
sifications. However, when production interdependencies exist, we must turn, at
least conceptually, to a mathematical programming formulation of the problem.
Such a formulation permits us to find a product mix that maximizes contribution
margin less escapable fixed costs with a feasible production schedule.
7.5. CVP ANALYSIS FOR A SINGLE PRODUCT

IN MULTIPLE PERIODS
The capital-budgeting analysis is usually performed by comparing the initial cost
of capital investment and the discounted (present worth of) future cash flow from
the invested project. If the discounted cash flows exceed the initial investment, the
project is worthwhile to be considered for investment.
Multi-period break-even analysis is a generalized approach to capital-investment
decision-making. Its general model is derived as follows:
Let C = Initial cost (investment, or first cost) of a project considered for investment;
n = The useful life of the project;
S = Salvage value of the project after n years;
i = The cost of capital (interest rate);
P = Sales price of the product to be manufactured in this project ($/unit);
V = Variable cost of the product ($/unit);
F = Annual fixed cost of the project ($/year);
Q = Annual production and sales volume (units/year);
Z = Net present worth or overall profits (before tax) of the project over its useful
life (it may be written as Z(Q) to indicate that it is a function of the annual
production output).
If we assume that the cash flow occurs at the end of each year, the net pres-
ent worth, Z(Q), of the cash flows of the project over its n-year useful life can be
expressed as follows:
Z ( Q ) = éë( P - V ) Q - F ùû ( P / A, i, n ) + S ( P / F , i, n ) - C
where (P − V)Q − F is the annual profit of the project ignoring its initial cost and
salvage value.
To break even, as usual, Z(Q) is set equal to zero and the equation is solved for Q,
which is shown as QBE:
0 = éë( P - V ) QBE - F ùû ( P /A, i, n ) + S ( P /F , i, n ) - C
C - S ( P /F , i, n ) + F ( P /A, i, n )
QBE =
( P - V )( P /A, i, n )
or
C ( A / P , i, n ) - S ( A / F , i, n ) + F
QBE =
(P -V )
The annual production output of QBE break evens the whole project where the cost of
capital is i (in %) per year.
Of course, an annual output level (Q*) necessary to obtain a targeted present value
of annual profits (Z*) can similarly be calculated:
é Z * + C - S ( P /F , i, n ) ù ( A /P, i, n ) + F
QBE =ë û
(P -V )
or
QBE =
(Z *
+C ) ( A/P, i, n ) - S ( A/F, i, n ) + F
(P -V )
Example 7.13
Hilo Manufacturing Company is considering the purchasing of a new auto-

matic machine for manufacturing its product. The machine has an initial cost of
$80,000, a useful life of 8 years, and a salvage value of $10,000. If the machine is
installed, only one skilled operator will be required to feed the machine at a cost
of $20 per hour. The hourly production of the machine will be 5 units. However,
the annual maintenance and other fixed operating costs are expected to sum to
$5,000. The cost of capital is 12%. Now, the multi-period break-even analysis is
used to answer the following two questions:
a) If the product is sold for $10 per unit, how many units must the annual
production be in order for the company to break even in this project?
b) If the production output is kept as 5,000 per year, at what price will the
company break even in the project?
Solution
C = $80, 000, n = 8 years, S = $10, 000, i = 12%, F = $5, 000,
V = ($20/hour ) / ( 5 units/hour ) = $4/unit
The overall profit (before taxes) of the company, in this project, is the net present
worth of all cash flows, Z(Q),
Z (Q ) = éë( P - V ) Q - F ùû (P/A, i %, n ) + S (P/F, i %, n ) - C
After substituting the corresponding values for the given variables, the CVP model
will be:
Z (Q ) = éë( P - 4 ) Q - 5, 000 ùû ( 4.9676 ) + 10, 000 ( 0.4039 ) - 80, 000
or
Z (Q ) = 4.9676 ( P - 4 ) Q - 100, 799
Now, the questions are answered as follows:
(a) P = $10/unit, QBE =?

To break even, set Z(Q) = 0, that is,
4.9676(10 − 4)QBE − 100,799 = 0

QBE = 3,382 units
(b) Q = 10,000 units, PBE = ?
To break even, again, set Z(Q) = 0:
4.9676(P − 4)Q − 100,799 = 0
4.9676(PBE − 4)(5,000) − 100,799 = 0
24,838(PBE ) − 200,151 = 0
PBE = $8.06
7.6. USEFULNESS AND APPLICATIONS OF CVP ANALYSIS

The cost-volume-profit (CVP) analysis is useful in finding answers to questions such
as the following:
• What is the expected level of profit at a given sales volume?

• What sales amount is needed to cover all costs?
• What additional amount of sales is needed to achieve a desired level of
profit?
• What additional sales amount must be made to meet the additional fixed
costs to be incurred by a proposed plant expansion?
• What additional profit would be gained if the variable cost per unit is
reduced by a given percentage?
• What will be the effect on profit due to a given percentage increase in sales?
• What increase in sales volume is needed to make up for a given reduction
in sales price to maintain the current profit level?
• How much losses could the business incur if it faces a market downturn
(sales loss)?
• How would the profits change if product prices are altered?
• What will be the production remaining capacity beyond the break-
even point, which reflects the maximum amount of profit that can be
achieved?
• What would the impact on the profit level if production automation (mainly
a fixed cost) replaces labor (usually a variable cost)?
Decision-makers should routinely perform the CVP analysis to explore opportunities

to lower the break-even point. A company can lower the break-even point by reduc-
ing fixed costs and increasing its contribution margin. Strategies to do so include:
• Reducing Fixed Cost: Manufacturing companies cut many fixed salaried

positions and close plants that are not fully utilized. They outsource not-
fully-utilized activities that involve fixed costs. Having lower fixed costs
results in lower sales units required to cover them.
• Reducing Variable Costs. Lowering variable costs and expenses per unit
increases contribution margin and, consequently, lowers the break-even
point. Improper material processing or quality can result in unnecessary
waste and rework. Also, improper job assignments may translate into exces-
sive labor costs.
• Increasing Product Price. Raising a product price is another method
for increasing contribution margin and lowering the break-even point. Of
course, price increase incurs some additional expenses associated with
strategies such as increasing advertisement and promotions, enhancing the
product quality, and improving the product packing and labeling. However,
the decision-maker must be cautious that increased selling price may lower
the sales units. Competition, contractual agreements, and government regu-
lations may hinder the pricing strategy.
A decision-maker may be able to implement a combination of reduced fixed and

variable costs, and moderately increased sales prices increases if possible. Some
products might be redesigned to possess unique features that customers would be
willing to pay for and the additional revenue is greater than the variable costs of the
added features.
SUMMARY
Cost-Volume-Profit (CVP) analysis is a procedure to examine the effect of sales vol-
ume variations on costs and operating profit of a business. The analysis is based on
the classification of expenses as variable (expenses that vary in direct proportion to
sales volume) or fixed (expenses that remain unchanged over a relevant range, irre-
spective of the sales volume). Accordingly, the operating income (profit) is defined
as follows:
Operating Income ( Z ) = Sales ( PQ ) – Variable Costs (VQ ) – Fixed Costs ( F )
where
Q = Sales volume (units of the product);
P = Sales price ($ per unit);
F = Fixed per period.
The CVP model can be expressed by the following formula;
Z = (P - V )Q – F
CVP analysis is used to determine the sales volume required to break even or achieve
a specified profit level (also known as target profit). The cost-volume-profit analysis
is an indispensable tool that helps in managerial, financial, and investment decisions.
CVP analysis is used to answer questions such as:
• How changes in variable and fixed costs affect a firm’s profit?

• How much must sell to break even (cover all costs) or reach a target profit?
• How will changes in selling prices affect profits?

• How will a change in the sales mix of products affect income?
CVP analysis makes several assumptions, including that the sales price, fixed, and
variable costs per unit are constant.
The contribution margin is defined as sales minus variable costs. Therefore, the
expression (P – V) in the CVP formula is the contribution margin per unit of the
product on which the CVP analysis is performed, and (P – V)Q is the total contri-
bution margin of selling Q units of the product generates. The contribution margin
(CM) is usually stated as a contribution margin ratio (CMR) or percentage of sales,
which is computed as follows:
Contribution Margin ( P -V ) Q P -V
CMR ( CM% ) = = =
Sales PQ P
CVP analysis can be used to determine a sales level required to achieve the desired
profit (a target profit, Z*). The sales level may be expressed in volume (number of
units) or in dollar amounts. The required sales volume can be as follows:
Target Profit + Fixed Cost Z* + F

( )
Sales Volume Q* =
Contribution Margin Per Unit
=
P -V

Target Profit + Fixed Cost Z* + F

Required Sales = =
Contribution Margin Ratio ( P - V ) P
The break-even point is reached when total costs and total revenues are equal, result-
ing in no gain or loss (i.e., operating income of $0). Businesses use the CVP analysis
to determine the number of units of a product they need to sell at a given price point
to break even, as follows:
( )
Break-even Units Q* =
Fixed Cost
=
F
Contribution Margin Per Unit P - V

Fixed Cost F
Break-even Sales Amount ( $ ) = =
Contribution Margin Ratio ( P - V ) / P
The break-even point computation is equivalent to finding the sales that yield a tar-
geted profit of zero. Once the break-even point is reached, additional sales revenue is
a profit. This CVP analysis is an essential tool in guiding managerial, financial, and
investment decisions for current operations or future business plans.
Operating leverage is how much a firm’s operating income reacts to a change
in sales level. It is determined by a company’s relative use of fixed versus variable
costs. Businesses with high fixed costs relative to variable costs have high operating
leverage. A business with high operating leverage will experience a sharp increase
(decrease) in operating income with an increase (decrease) in sales level. The degree
of operating leverage is determined by dividing the contribution margin by operat-
ing income.
Symbols and equations used in this chapter are listed in the following table:
Term Symbol/Formula
Sales Units (Quantity) Q
Sales (Selling) Price P
Total Fixed Cost F
Variable Cost Per Unit V
Total Variable Cost VC (or TVC) = VQ
Total Cost (Variable and Fixed Costs) TC = VQ + F
Sales Amount (or Total Revenue) TR = PQ
CVP (basic single-product model) Z = (P – V)Q – F
Contribution Margin Per Unit CMU = (P – V)
Contribution Margin (Total) CM (or CMT) = (P – V)Q
Contribution Margin Ratio (or Percentage) CM T ( P - V )Q P - V
CMR = = =
Sales PQ P
Break-even Volume or Quantity (BEP in Units) F
QBE =
P -V
Break-even Value (BEP in Dollars) F

BES = Total Cost BES = P × QBE =
CMR
Margin of Safety (in Dollars) MOS = Sales – Break-even Sales
Margin of Safety Percentage MOS % = 100(MOS/Sales Amount)
(Degree of) Operating Leverage CM
OL =
Operating Income
REVIEW QUESTIONS
R7.1. What are the four components of a single-product CVP model or
analysis?
R7.2 How are costs classified in the income statement for CVP analysis?
R7.3. What is meant by a product’s contribution margin ratio and how is it use-
ful in planning business operations?
R7.4. How is the break-even point determined?
R7.5. What is the formula for computing break-even quantity?
R7.6. What is the formula for computing break-even sales amount (dollars)?
R7.7. How are the required sales to earn the target profit determined?
R7.8. What are the margin of safety and margin of safety ratio?
R7.9. Explain the term sales mix and its effect on break-even sales.
R7.10. What is the difference between the contribution margin ratio and the
margin of safety ratio?
R7.11. Explain how to compute gross profit, operating profit, and net profit.
R7.12. How do changes in volume within the relevant range affect the break-
even point?
R7.13. What important information is provided by the margin of safety as cal-
culated in CVP analysis?
R7.14. The Creek-Water Company sells spring water. The company has
an annual fixed cost of $450,000 but no variable cost. The projected
demand (Q) − price (P) and marginal revenue (MR) functions for spring
water are Q = 6,000 − 5P and MR = 1,200 − 0.4Q. Determine the selling
prices that maximize the company’s annual profit.
PROBLEMS
P7.1. Assume that the CVP model for a company that makes a single product is
Z = $48Q - $48, 000.
Required
a) How many units of the product must the company produce to
break even?
b) How many units of the product must the company produce and sell
in order to have a target profit of $90,000?
P7.2. KZ Company has provided the following data:
Sales Price Per Unit: $40
Variable Cost Per Unit: $15
Fixed Cost: $125,000
Expected Sales: 8,000 units
Required
a) What is the break-even point in sales dollars?
b) What is the expected margin of safety?
c) What is the operating leverage?
d) If the company wants to have a net income of $100,000, how many
units must it sell?
P7.3. A company has provided the following data:
Sales Price Per Unit: $80
Variable Cost Per Unit: $48
Fixed Cost: $240,000
Expected Sales: 10,000 units
Required
a) What is the break-even point in sales dollars?
b) What is the expected margin of safety?
c) If the company wants to have a net income of $144,000, how many
units must it sell?
P7.4. Assume that the total cost, TC(Q), and demand functions for the product
of a company are as follows:
TC ( Q ) = 200 + 60Q - 3Q2 + 0.2Q3 éë Total Cost ùû
Q = 100 - (1 / 3 ) P éë Demand-Price relationship ùû
where Q and P are the production (and sales) quantity and sales price,
respectively.
Required
a) Find the maximum revenue.
b) Find the maximum profit.
c) Find the price that maximizes the profit.
P7.5. The K&K Company produces three products with price (Pi), variable
cost (Vi), fixed cost (Fi), and machine time requirement for each product
as shown below:
Product Pi Vi Fi Machine Hours per Unit

i = 1 $15 $6 $18,000 4
i = 2 25 10 36,000 6
i = 3 30 18 45,000 4
A maximum of 40,000 machine hours is available. Use contribution

margin to answer the following questions:
Required
a) Which product is most profitable? Why?
b) If there were no machine time constraints, which product would
have been most profitable? Why?
c) Assume that only 24,000 hours of supervisory time is available
and supervision time required for products 1, 2, and 3 are 1 hour, 3
hours, and 2 hours, respectively. Formulate the problem for linear
programming to maximize the profit.
P7.6. The DDT Company manufactures two products, A and B. The product-
line income statement for the year 20X1 is given below:
DDT Company
For the Year Ended December 31, 20X1
Product A Product B
Per Total Per Total

Unit Amount Unit Total Amount ($1,000)
Sales $15.00 $ 750,000 $22.50 $2,250,000 $3,000,000
Cost of Goods Sold:
Materials $4.00 200,000 $5.00 $500 $700,000
Direct Labor 2.00 100,000 3.00 300 400,000
Variable Overhead 1.50 75,000 2.50 250 325,000
Fixed Overhead 3.00 150,000 2.00 200 350,000
Cost of Goods Sold $10.50 $525,000 $12.50 $1,250 $1,775,000
Gross Margin $ 4.50 $ 225,000 $10.00 $1,000,000 $1,225,000
Fixed Sell and Adm. 325,000
Exp.
Net Income Before $900,000
Taxes
Income Taxes (50%) 450,000
Net Income $450,000
The sales mix is assumed to be the same at all volume levels from year to
year. The management decided to increase the price of product A from
$15.00 to $15.75 but to reduce the price of product B from $22.50 to
$21.00 for the year 20X2 (the following year). At the same time, the com-
pany allocated $50,000 more for advertising for year 20X2, in which
the material costs have dropped by 15% for both products but the direct
labor increased by 10%. No other changes occurred in the year 20X2.
Required
a) Find the sales volume of each product to break even in 20X2.
b) What volume of sales for each product is required if the company
is to earn a net income in 20X2 equals that earned in 20X1.
c) What volume of sales for each product is required if the company

is to earn $300,000 net income after tax? Assume that the tax rate
is 30%.
P7.7. The income statement of the Palmon Company is given below. Sales com-
missions are 5% of the sales amount. The company has a production capac-
ity of 180,000 units per year. The results for 20XX were not satisfactory.
Palmon Company
Income Statement
For the Year Ended December 31, 20XX
Sales (100,000 units @ $5.00) $500,000
Cost of Goods Sold:
Direct Materials $150,000
Direct Labor 125,000
Factory Overhead:
Variable $20,000
Fixed 95,000 115,000 390,000
Gross Margin $110,000
Operating Expenses:
Selling Expenses:
Variable:
Sales Commission $25,000
Shipping 5,000 $30,000
Fixed:
Advertising, Salaries, etc. 45,000 $75,000
Administrative Expenses:
Variable $9,000
Fixed 26,000 35,000 110,000
Net Income (or Loss) $0
The Sales Manager has studied the market potential and believes that if
the advertising expense is increased by $75,000 and the sales commis-
sion to 10% of the sales amount, the company will be able to sell the full
production capacity without changing the sales price.
Required: Prepare the budgeted income statement, using a contribution
margin format, and write the CVP formula for the company.
P7.8. A manufacturing company has two production machines that can be
used 7 hours a day, 5 days a week for 50 weeks per year to manufacture
its two products, A and B. The following is a summary of the relevant
information about the products.
Product A Product B
Selling price (per unit) $60 $35
Variable cost (per unit) $30 $10
Units that can be manufactured per machine hour on the same 10 6
production line
Estimated demand (units) 15,000 22,000
Required: To maximize its profit, how many machine hours should the
company devote to the manufacturing of each product?
P7.9. The Maldust Company manufactures and sells a product that has a vari-
able cost of $240. The company’s fixed costs are $169,000 per month.
Based on the historical data and marketing research, the company has
developed the following price–demand relationship:
Q = 375 - 0.05P,
where P is the selling price and Q is the demand quantity.

Required
a) Develop a CVP model for the company.
b) Determine the break-even quantity(ies).
c) Determine the selling price that maximizes the company’s
monthly profit.
d) Compute the company’s monthly maximum profit.
P7.10. Bullarson Corporation produces and sells a single product. Information
on its costs follow:
Variable Costs:
Production $4 per unit
Sales, General and Administration $3 per unit
Fixed Costs:
Production $18,000 per month
Sales, General and Administration $15,000 per month
Required
a) Assume the company produced and sold 15,000 units. At this level
of production and sales, it produced a profit of $45,000. What was
the company’s sales price per unit?
b) The projected production and sales in the upcoming month are 16,000
units. The variable costs per unit and the total fixed costs are expected
to be the same as in the current month. However, the company sets its
sales price at $12.50 per unit. What is the projected margin of safety
and the degree of operating leverage for the next month?
P7.11. Sambo Manufacturing has annual fixed costs of $500,000 and is produc-
ing and selling a single product. Its projected sales are 150,000 units.
The management desires an after-tax net income of $90,000. The com-
pany’s income-tax rate is 25%. What is the maximum amount that the
company can incur as variable costs per unit and still meet its target
profit if the sales price is estimated at $10?
P7.12. The Maldar Company manufactures and sells a single product and proj-
ects the following financial information for the upcoming year:
Sales 60,000 units
Variable Costs $6.00 per unit
Fixed Costs $335,000 per year
Unit Sales Price $15.00
Required
a) How many units would the company have to sell to earn a profit
before taxes of $250,000?
b) If Maldar Company achieves its desired, what will be its degree of
operating leverage?
Index
ABC, see Activity-based costing Conventional cost-volume-profit, 172
ABM, see Activity-based management Conversion cost, 41
Abnormal costs, see Nonrecurring costs Cost, 36, 87
Absorption costing, 66 Cost accounting, 2
Account, 2 Cost drivers, 68, 87, 94, 95, 100
Accounting, 1 Cost equation, 154
Accounting equation, 7 Cost estimate relationship (CER), 154
Accrual basis of accounting, 16 Cost estimation, see Manufacturing cost
Accrued expenses, 4 estimation
Accrued revenues, 4 Cost estimation, methods
Accumulated depreciation, 17 account analysis method, 155
Activity-based costing (ABC), 94 high-low method, 159
Activity-based management (ABM), 95 regression method of cost estimation, 162
Adjusting entries, 18 scatter-graph method of cost estimation, 157
Average cost, 43 Cost estimation, types of
Avoidable fixed costs, 40 budget estimate, 152
definitive estimate, 153
Balance sheet, 7 order of magnitude (ROM), 152
Balance sheet accounts, 22 top-down estimate (see Cost estimation,
Bases for overhead allocation, 95 types of, budget estimate)
Book costs, 49 Cost flow, 50
Bookkeeping, 2, 9 Costing, 65, 89
Break-even analysis, 171, 179 Cost of goods manufactured, 3, 54
Breakeven point, 181 Cost of goods manufactured statement, 55, 88
Breakeven quantity, 180, 185, 189 Cost of goods sold (COGS), 2, 26, 36, 87
By-product, 116 Cost of goods sold (COGS) statement, 53
By-products, basis for identifying, 143 Cost of sales, see Cost of goods sold (COGS)
By-products, cost allocation to Cost reallocation
net-realizable value (NRV), 131 direct method, 100
zero-cost method, 135 reciprocal method, 104
step-down method, 102
Cash basis of accounting, 16 Costs classification by, 37
Cash costs, 49 behavior, 37
Cash flow statement, 8 cash flow, 48
CER, see Cost estimate relationship controllability, 40
Chartered Institute of Management decision-making, 43
Accountants (CIMA), 94 external reporting, 47
Chart of accounts, 2, 33 flexibility, 40
Classified balance sheet, 23 time, 49
Closing entries, 18 traceability, 40
Closing entries for a corporation, 19 Cost-volume-profit (CVP), 171, 172
Closing entries for a single-owner company, 19 Credit, 3
COGS, see Cost of goods sold Current assets, 24
Commercial costs, see Period costs Current liabilities, 24
Committed Fixed Costs, 40 CVP, see Cost-volume-profit
Common products, 116
Completing an accounting period, 18 Debit, 3
Contribution margin, 171–212 Depreciation, 2, 17
Contribution margin ratio (CMR), 171, 177 Differential cost, see Incremental cost
Controllable fixed costs, see Avoidable fixed costs Direct costs, 41
213
214 Index
Direct labor, 87 simple-average method (see Joint cost

Direct materials, 87 allocation to main products, physical-
Direct method of reallocating support measures method)
costs, 100 weighted-average method, 124, 145
Double-entry system, 3, 10 Joint costs, 115, 118
Joint products, 116
Expanded accounting equation, 8 Journal, 2
Expense accounts, 6
Expenses, 4, 36 Law of diminishing returns, 46
Explicit costs, 49 Ledger, 2
Liabilities, 24
Final products, 118 Liability accounts, 7
Financial statements, 5 Life-cycle costs, 50
Finished goods, 87 Long-term liabilities, 25
Finished goods inventory, 36, 55, 87
Fixed assets, 24 Main products, 116
Fixed cost per unit, 38 Manufacturing cost estimation, 151
Fixed costs, 38 Manufacturing costs, 36
Formatted income statement, 26 Manufacturing costs, total, 88
Manufacturing overheads, see Indirect costs
General journal, 10 Marginal cost, 44
General ledger, 12 Marginal revenue, 177
Goods flow, 50 Margin of safety (MOS), 183, 185
Gross margin, 27 Materials, 87
Mixed costs, see Semi-variable costs
Historical costs, 49 MOS, see Margin of safety
Multi-product CVP analysis, 192–205
Implicit costs, 49
Income statement, 5 Net income, 4
Incremental cost, 44 Net loss, see Net income
Indirect costs, 41, 87 Net-realizable value (NRV), 118, 131
Indirect labor, 87 Net worth, 25
Indirect materials, 87 Nominal accounts, 22
Intangible assets, 24 Nonlinear CVP analysis, 187
Intermediate products, 118 Non-operating expenses, 3, 27
Inventoriable cost, 36 Non-operating income, 27
Inventory valuation methods, 50 Nonrecurring costs, 50
Average-cost method, 50, 51 Normal costing, 7
First-In, First-Out (FIFO), 50, 52 Normal costs, see Recurring costs
Last-In, First-Out (LIFO), 50, 52 NRV, see Net-realizable value
Specific identification, 50–51
Operating departments, 90
Job costing, see Job-order costing system Operating expenses, 3, 27
Job cost sheet, 69 Operating income, 27
Job-order costing system, 65, 66, 87 Operating leverage, 185, 187
Joint cost allocation to main products, 115, 122 Opportunity costs, 47
constant-gross-margin method, 131, 146 Overhead (OH) rate
net-realizable value (NRV) method, 133 actual, 67, 87
(see also Relative-market value) predetermined, 67, 88
physical-measures method, 120, 145 Overhead accumulation, 93
production method (see Net-realizable Overhead cost pools, 99
value (NRV)) Overheads; see also Indirect costs
quantitative method for joint cost over-applied overhead, 83, 87
allocation, 137 under-applied, 82, 88
relative-market-value method, 128, 145 Owner’s (or stockholders’) equity, 25
sales-value method, 126 Owners’ equity statement, 6
Index 215
Period costs, 48, 87 Single-stage cost allocation, 94

Permanent or real accounts, 22 Split-off point (SOP), 115, 118
Perpetual inventory system, 15 Standard costing, 78
Point of recovery, see Split-off point (SOP) Statement of cost of goods sold, see Cost of
Posting journal entries, 12 goods sold (COGS) statement
Predetermined costs, 49 Step-down method of reallocating support
Predetermined-overhead-rate, 91 costs, 102
Prepaid expenses, 4 Stockholders’ equity accounts, 7
Prime cost, 41 Stores requisition, 67
Process costing, 48, 66, 69 Sunk costs, 47
FIFO method, 73 Support departments, 100
weighted-average method, 70
Product costing, 36, 65 Target costing, 50
Product costs, 48, 88 Target profit, 182
Product-indexing method for CVP analysis, 192 Terms of Sales, 13
Profit, 172 Time ticket, 67
Total costs, 39
Reallocating costs of support departments, 100 Total revenue, 175
direct method, 100 Total variable cost, 172
reciprocal method, 104 Traditional overhead cost allocation, 91
step-down method, 102 Trial balance, 15
step method (see Step-down method) Two-stage system, 94
Reciprocal method of reallocating support Types of accounts, 22
costs, 104 Types of departments, 90
Recording purchases and sales, 14
Recurring costs, 49 Unavoidable fixed costs, 40
Relative-market value, 118 Uncontrollable fixed costs, see Unavoidable
Relevant range, 153 fixed costs
Revenue accounts, 6 Unearned revenues, 5
Revenues, 4 Unit cost, see Average cost
RMV, see Relative-market value
Valuation, 89
Sales mix, 192, 194 Variable costing, 66
Sales revenue, 26, 172, 177, 180, 183 Variable costs, 37
Sales-value at split-off, 145
Semi-variable costs, 38 Work breakdown structure (WBS), 151
Separable costs, 115, 118 Work-in-process (WIP), 48, 53, 88
Service departments, 90 Work-in-process (WIP) inventory, 55

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Cost Analysis for Engineers

Fariborz (Fred) Tayyari

and by CRC Press

© 2022 Taylor & Francis Group, LLC

Library of Congress Cataloging‑in‑Publication Data

Names: Tayyari, F. (Fariborz), author.

ISBN: 978-1-138-36228-4 (hbk)

Access the Support Material: https://www.routledge.com/9781138362284

Chapter 1 Accounting and Cost Information Systems...........................................1

Chapter 2 Cost Analysis Fundamentals............................................................... 35

Chapter 3 Product Costing................................................................................... 65

Chapter 4 Manufacturing Cost Allocation........................................................... 89

Chapter 5 Joint Cost Allocation......................................................................... 115

5.6. Traditional Methods for Joint Cost Allocation to

Chapter 6 Manufacturing Cost Estimation........................................................ 151

Chapter 7 Cost-Volume-Profit Analysis............................................................. 171

7.3. Nonlinear CVP Analysis for a Single Product....................... 181

Fariborz (Fred) Tayyari

1.2. TERMS AND DEFINITIONS

“Accounting is the art of recording, classifying and summarizing in a signifi-

• Accounting is an art: Accounting is an art because it requires skills and

Bookkeeping: Bookkeeping is the means of recording monetary transactions

Depreciation: Depreciation cost or expense is a periodic allocation of the cost

Title of the Account

FIGURE 1.1 An illustration of a T-account.

ASSETS = LIABILITIES + OWNER'S EQUITY

FIGURE 1.2 The effects of debits and credits on account balances.

• A credited entry to a liability or owner’s equity account increases that

Net Income ( Loss ) = Revenues - Costs of Goods Sold and Expenses

1.3.1. The Income Statement

Revenues (Total Sales) $32,000

FIGURE 1.3 An illustration of the income statement.

• Revenue accounts – Examples: Sales of Merchandise, Service Revenues,

1.3.2. Owners’ Equity Statement

FIGURE 1.4 An illustration of a statement of owners’ equity.

Accounting Equation: This is also known as the basic accounting equation

Assets = Liabilities + Owners’ Equity ( or Net Worth )

FIGURE 1.5 A simple balance sheet.

Equation Equation Components

Expanded: Assets = Liabilities + Common Stock + Paid-in Capital – Treasury Stock

1.3.4. Cash Flow Statement

• Receipts from sales of goods and services.

Cash Flow from Operating Activities

FIGURE 1.7 An example of a cash flow statement.

• Salary and wage payments to employees.

Examples of investing activities include:

• Receipts from sales of marketable securities.

Examples of financing activities include:

1.4.1. Double-Entry System of Accounting

1. On January 2, H.T. Ram invested $7,500 to establish his property man-

Cash Accounts Payable H.T. Ram, Capital Accounts Receivable

Prepaid Rent Utility Expense Wages (Expense) Prepaid Insurance

Telephone Expense Office Equipment

FIGURE 1.8 Posting transactions of Example 1.1 in the corresponding T-accounts.

6 Prepaid Insurance 360

FIGURE 1.10 An illustration of a page (a cut out) of a “general ledger.”

1.4.4. Posting Journal Entries into Ledger Accounts

General Journal Page 14

Nov. 18 Accounts Receivable 3,000

1.2. TERMS AND DEFINITIONS

1.3.1. The Income Statement

1.3.2. Owners’ Equity Statement

1.3.4. Cash Flow Statement

1.4.1. Double-Entry System of Accounting

1.4.4. Posting Journal Entries into Ledger Accounts

1.5. RECORDING PURCHASES AND SALES OF MERCHANDISE

1.5.1. Recording Purchases and Sales Using Periodic Inventory System

1.5.2. Recording Purchases and Sales Using Perpetual Inventory System

1.7. CASH AND ACCRUAL BASES OF ACCOUNTING

1.8. DEPRECIATION OF LONG-LIVED ASSETS

1.9. COMPLETING AN ACCOUNTING PERIOD

General Journal Page _914_

1.11. CLASSIFIED BALANCE SHEET AND INCOME STATEMENT

1.11.1. Division of a Balance Sheet

1.11.2. Formatted Income Statement

Feb. 6. Paid $1,000 for advertisement announcing the establishing of

2.2. COSTS AND EXPENSES

2.4.1. Classification of Costs by Behavior

2.4.1.1. Classification of Fixed Costs by Flexibility

2.4.1.2. Classification of Fixed Costs by Controllability

2.4.2. Classification of Costs by Traceability