Chapter 2 – Cost Accounting Cycle

Learning Objectives

After completing this module, you should be able to know the following:
1. Full understanding of the cost accounting cycle
2. What is the difference between merchandising and manufacturing operations
3. How manufacturing costs flow through accounts?
4. What are the components of product costs?
5. What are the overhead cost allocation system?
6. What is predetermined overhead?
7. How to account predetermined overhead?
8. How to prepare financial reports of a manufacturing operations

Difference between merchandising and manufacturing operations

Raw Materials Inventory

These are the costs of raw materials purchased but not yet issued to production. It is
classified into two categories: direct and indirect materials.

On the computation of cost of goods sold, the direct materials are the only materials added
in the computation of the separate line item, "materials used", since indirect materials are
classified as part of the overhead account. However, regardless of its classification,
whether direct and indirect, both of them will be reported as part of the cost of goods sold.
It is important to take note that they only differ on the presentation of the line items in the
cost of goods sold account.
Work-in-process Inventory
These are the costs of a product that is still in the production process. All elements of the
 product costs namely, direct materials, direct labor and overhead are already added but are
not yet completed in the end of a period.

Finished Goods Inventory

Once goods in the work-in-process inventory are completed, they are transferred into
finished goods inventory. These are manufacturing costs of a product that is already
completed and available for sale.

Accounts to be used to record the flow of costs

Accordingly, the following are the ledgers of the aforementioned accounts that shows how
charges are accumulated and how costs go through accounts.
Manufacturing cost flow and how they are reported

In manufacturing industries, before goods are sold to market, such goods undergo to three
stages. The first stage is where elements of a manufacturing cost - direct materials, direct
labor and overhead are being pooled in. Once combined, goods will be processed and at the
end of a period, all goods that were started but not completed are classified as work-in-
process and will be reported as work-in-process inventory. The last phase is the transfer of
completed goods from the work-in-process account to finished goods account. All finished
goods are ready and available for sale and once sold, the costs incurred in manufacturing
those products will be reported under the cost of goods sold account.

Components of Product Costs

Composed of direct material, direct labor and overhead

Ø Direct material
- any material that can be directly traced to a product
- Example: woods used in a furniture set, paper used in publishing a book, foam
cushion of a sofa.

Ø Direct labor
- refers to the disbursements made for the time spent by individuals who work
directly to manufacture a product
- includes basic compensation, product efficiency bonuses, and employer's share
to government agencies' contributions
- NOTE: Overtime premiums are not part of direct labor costs. It is being treated
as overhead
- Example: factory worker who is directly involve in manufacturing the product

Ø Manufacturing Overhead
- these are not directly traceable to a product but are related to manufacturing a
product
 - composed of indirect materials, indirect labor, other indirect production costs
and quality costs
- can be both variable and fixed
- Variable Manufacturing Overhead
■ Indirect materials such as glue, screws, nails, sandpaper, paint used in
manufacturing custom-made furniture
■ Indirect labor paid on an hourly basis such salaries of product
supervisors, plant managers and quality inspector
■ Variable components of utilities expenses such as electricity, water
and communication expenses
■ Depreciation using the methods of units of production and service life
method
- Fixed Manufacturing Overhead
■ Indirect labor, other than those paid on an hourly basis
■ Other costs that are attributable to factory and production but are
indirect in nature such as factory licensing fees, factory insurance,
factory property taxes, depreciation using straight line method
■ Quality costs such as prevention costs (training, of factory workers)
and appraisal costs (monitoring and inspecting goods prior to selling
in the market).

■ Prime Cost - sum of direct material and direct labor

■ Conversion Cost - sum of direct labor and overhead cost

Overhead Cost Allocation System

Ø Cost allocation - the process of assigning indirect costs to a cost object using an
allocation base. The allocation base should be a driver why a cost has been incurred.
Allocation bases are the cause why the cost are being allocated.
Ø Common allocation base are as follows:
- Machine hours used,
- Direct labor hours
- Kilowatt hours consumed
- Square footage occupied
There are two ways to allocate overhead costs to a cost object:
■ Actual Cost System - actual direct material and actual direct labor incurred are
accumulated in Work-in-process inventory. Whereas, actual overhead incurred are
accumulated separately in an Overhead Control Account, then, at the end of a period
or upon completion of the production, it will be further assigned to Work-in-process
inventory

■ Normal Cost System - combination of actual direct material, actual direct labor and
predetermined overhead and assigning them to Work-in-process inventory

As mentioned, normal costing involves using pre-determined overhead. To compute the pre-
determined overhead, total budgeted overhead cost is divided by it related activity level,
known as the activity base. The activity base should be a cost driver that directly caused the
overhead to be incurred.
Pre-determined overhead rate = Budgeted Overhead Cost
Activity Base

Once the pre-determined overhead rate has been calculated, the amount of overhead that will
be assigned to work-in-process inventory is the applied overhead. Applied overhead is
calculated by multiplying the pre-determined overhead rate to the actual activity volume.
Applied overhead = Pre-determined overhead rate x Actual activity volume
It is important to note that both the actual overhead and the applied overhead are being
recorded. Debits to the overhead control account represents the actual overhead incurred
whereas the credits represent the applied overhead.
There are three instances when applied overhead can be applied. First is when goods are
transferred out to work-in-process inventory. Second, at the end of a period when financial
statements are to be prepared. Lastly, it can be applied continuously as production take place.
At the end of a period, total actual overhead is different from applied overhead. Such
difference is called underapplied or overapplied overhead.
Underapplied overhead transpires when actual overhead incurred is more than the overhead
applied to work-in-process inventory.
On the other hand, overapplied overhead occurs when actual overhead cost is less than the
overhead applied to work-in-process inventory.
Cost differences and differences on utilization of capacity caused the overhead to
underapplied or overapplied.

Accordingly, overhead accounts are temporary or nominal accounts. Therefore, these

accounts are being closed at the end of a period. In this manner, closing under- and
overapplied overhead depends on the materiality of amount involved.
If the amount is immaterial, it is closed to cost of goods sold. When overhead is
underapplied, it is to be concluded that the overhead applied is not enough and the closing
process causes cost of goods sold to increase, thus, the closing entry would be a debit to
cost of goods sold and credit to overhead. Otherwise, if overhead is overapplied, it can be
viewed that an excessive overhead has been applied to production, thus, cost of goods sold
will decrease as an effect. Thereby, a debit to overhead and credit to cost of goods sold are
necessary closing entries.
If the amount is material, it is prorated amongst the work-in-process inventory, finished
goods inventory and cost of goods sold.

Illustrative Problem:
On January 1, 20xx, inventory balances of ABC Manufacturing Company are as follows:
Direct material inventory Php 175,000
Work-in-process inventory 245,000
Finished goods inventory 177,800

During the month, the company purchased direct materials amounting to Php370,000. The
warehouse manager then transferred Php378,000 worth of direct materials to production
 department. Wages for hourly-paid factory workers totaled Php633,000, of which
Php523,000 is attributable to direct labor. In addition, Php20,300 has been accrued to
production supervisor. Utility costs are also incurred but are not yet paid at the end of
January. Utility expenses are totaled Php27,500, of which Php23,300 are variable.

Also, indirect materials amounting to Php4,450 were also transferred to production area.
The company also paid factory property taxes (Php9,000) and factory insurance expense
(Php5,000). Depreciation of factory building for month ending January is Phpl3,000

During the month, Phpl,190,500 of goods were completed and transferred to finished goods
inventory. Lastly, goods costing Php961,280 has been sold on account for Php2,441,920.

ABC Manufacturing Company uses separate variable and fixed accounts to record overhead
costs. What would be the journal entries and its presentation if the company uses the
following systems in allocating its factory overhead:
1. Actual cost system
2. Normal cost system

Solution:
Actual Cost System
The following are the journal entries to be used to present the accounting under actual
cost system:
Normal Cost System
Using the same details of the above illustrative problem and the additional data presented
below, shown in the table are the journal entries to be used to present the accounting under
normal cost system:
Financial Reports of a manufacturing operations

Before income statement and balance sheet are prepared as final reporting, a manufacturing
statement which is composed of cost of goods manufactured statement and cost of goods sold
statement are prepared first.

Cost of Goods Manufactured Statement presents the cost of products manufactured in a

period by listing down the details of costs incurred to direct materials, direct labor,
manufacturing overhead and the movement in the work in process account. In fact, cost of
goods manufactured can be extracted from the cost of goods sold computation as shown in
the table above.
Cost of Goods Sold Statement for a manufacturing company shows the costs that are related
to the production of goods that is sold by a company.
Sample Manufacturing Statement

Using the data of the normal cost system as illustrated above, prepare the following financial
reports:
1. Cost of Goods Manufactured Statement
2. Cost of Goods Sold Statement
3. Income Statement
4. Balance Sheet