Chapter 2

Product Costing and Cost Flow

Product Costing

Product costs in manufacturing firm are the sum of direct material, direct labor and overhead cost of
producing a given product. Thus, production cost per unit is the sum of direct material cost per unit, direct
labor cost per unit and overheads cost per unit.

There are two main types of cost accounting systems for product costing: Job order and process costing
systems.
Job order costing system: is a product costing system used by both manufacturing companies
and service organizations that make large, unique, or special order products such as customized
publications, specially built cabinets, custom printing business etc. Under such a system, the costs
of direct materials, direct labor, and manufacturing overhead is traced to a specific job order or a
batch of products. A job order is a customer order for a specific number of specially designed,
made to order products. Job order costing measures the cost of each complete unit. It uses one
work in process inventory account to summarize the cost of all jobs. This account is supported by
job order cost cards or a subsidiary ledger of accounts for each job.
Process costing system: is a product costing system used by companies that produce large
amounts of similar products or liquids, or that have a continuous production flow. Makers of paint,
soft drinks, bricks, milk or paper would use a process costing system. Under such a system, the
cost of direct materials, direct labor and manufacturing overhead are first traced to processes,
departments, or work cells and then assigned to the products manufactured by those processes,
departments or work cells. A process costing system uses several works in process inventory
accounts, one for each process, department or work cell.

Job costing
Job order costing is an accumulation of costs by specific jobs, contracts, or orders. It keeps track of costs
as follows: direct material and direct labor are traced to a particular job and costs not directly traceable-
factory overhead-are applied (allocated) to individual jobs, using a predetermined overhead rate. The
overhead rate is equal to the budgeted annual overhead divided by the budgeted annual activity units
(direct labor-hours, machine-hours, etc.). At the end of the year, the difference between actual overhead
and overhead applied is closed to cost of goods sold, if there is an immaterial difference. On the other
hand, if a material difference exists, work-in-process, finished goods, and cost of goods sold are adjusted
on a proportionate basis based on units or dollars at year-end for the deviation between actual and applied
overhead.

As products are manufactured, the costs of direct materials and direct labor are transferred to the work in
process inventory account and are recorded on the job’s job order cost card. Manufacturing overhead
costs are applied and charged to the work in process inventory account using a predetermined overhead
rate. Those charges are used to reduce the balance in the manufacturing overhead account. They two are
recorded on the job’s job order cost card.
When products and jobs are completed, the costs assigned to them are transferred to the finished goods
inventory account. When the products are sold and shipped; their costs are transferred to the cost of goods
sold account. The summarized journal entries are illustrated as follows:
When the materials are purchased:
Materials control Debited
Accounts payable control Credited.
When materials are sent to manufacturing plant:
Work in Program Control (for direct material) Debited
Manufacturing overhead control (for indirect material) Debited
Materials control Credited

When labor costs are assigned:

Work in process control (direct labor) Debited
Manufacturing overhead control (indirect labor) Debited
Wages payable control Credited
When payment of total manufacturing payroll:
Wages payable control Debited
Cash control Credited.

When manufacturing overhead costs are incurred:

Manufacturing Overhead control Debited
Various Accounts Credited

When manufacturing overheads is allocated:

Work in process control Debited
Manufacturing overhead control Credited

When jobs are completed and transferred to finished goods account:

 Finished goods control Debited
Work in process control Credited

When transferring finished goods to cost of goods sold:

Cost of goods sold Debited
Finished goods control Credited
When marketing and customer service payable and advertising costs accrued:
Marketing and Advertising costs Debited
Customer – service costs Debited
Salaries payable control Credited
Accounts payable control Credited
When sales are made on account:
Accounts receivable control Debited
Sales or Revenues Credited
Job Costing Procedures
The starting point of the job costing system is the production order. Once an order has been accepted, the
production department will make out a production and manufacturing.
Production order is the starting point for the cost accountant to prepare a job cost card/sheet. Job cost
sheet is the basic record form for a job order costing system. In fact, it is a cost sheet on which the cost
accountant records the costs incurred as the job passes through the factory. When job cost sheet is
complete, it shows the total cost of the completed job which is composed of three elements (direct
material cost, direct labor cost and over head cost) as shown at the end of this section.

Accounting for materials in job order costing system

The term “materials” refers to such commodities which are supplied to themanufacturing industry in
original forms. They are raw in nature and have to be processed further to be sold to customers.
In manufacturing enterprises, materials are recorded using a control account called materials. Cost
accounting for materials involves; the purchase of materials and the issuance of materials for production
use
Cost accounting techniques for the purchase of materials are similar to those studied in general
accounting for a perpetual inventory method. As materials are purchased and received, the amount is
debited to materials or materials inventory account as follows:

Materials -------------------------------xxxx
Accounts payable -------------------------xxxx
When a job is orders is started, the necessary material are issued to the factory i.e. materials are
transferred from the store room to the factory in response to material requisitions, which may be issued by
the manufacturing department concerned or by a central scheduling department. .

A summary of the materials requisitions completed during the month serves as the basis for transferring
the cost of the materials from the controlling account in the general ledger account to the controlling
account for work in process and factory overhead. The flow of materials into production is illustrated by
the following entry:

Work in process ( direct material) …………….xxxx

Factory overhead ( indirect material)…………..xxxx
Materials ……………………..………………. xxxx

Accounting for Labor in Job Costing System

In manufacturing process, the raw materials are converted into completed finished goods using labor and
manufacturing facilities. Accounting for labor is critical to determine the proper cost of a job or a product.
Just as it necessary to know the cost of material input in each product or job the organization produces, it
is also necessary to know the amount or cost of the labor and time spent on each product or job as this is
part of the cost of the job or product.
For direct workers, job cards may also be maintained to record the time spent on particular orders as a
basis for cost accounting. A job card is a record of time spent on a job. At regular intervals usually daily
or weekly, the direct labor time and cost for each job are entered on the job order cost sheets. For each
payroll period-weekly, biweekly, or monthly-the summary of employees’ earnings and the liabilities for
payments are journalized and posted to the general ledger.

Journal Entry:
Work-In process (direct labor) -----------------------------xx
Factory overhead (Indirect labor) -------------------------xx
Wages payable ------------------------------------------------xxx

Accounting for Manufacturing Overheads in Job Costing System

Factory overhead includes all manufacturing costs except direct materials and direct labor. Examples of
factory over head costs, in addition to indirect materials and indirect labor, are depreciation, electricity,
fuel, insurance, and property taxes on factory plants.
Budgeted rate in Applying overhead
Management wants to know the overhead cost of producing different products. This will help
management in product pricing, income determination and inventory valuation; they must be timely as
well as accurate.
The actual overhead cost or rate can be determined only at the end of the year, after actual results are
determined. However, this timing would be too late as managers want product cost information
throughout the year for decision making. To meet these needs, accountants usually budget overhead
application rates i.e. they estimate or compute a rate in advance of production and adjustment is made at
year for the difference between actual over head cost and the one allocated to products or jobs based on
estimated rate.
To allocate over head cost to specific job, budgeted factory overhead rate is first computed by dividing
the total budgeted overhead cost by budgeted application base (cost driver) and the application is made by
multiplying the budgeted rate by actual cost driver for each job.
The following entry is made to record manufacturing over head cost applied:
Work in process………..xxxx
Manufacturing overhead…………….xxxx
The actual over head costs are recorded as follows as they are incurred over the year:
Manufacturing overhead………..xxx
Accumulated Depreciation……………..xxxx
Cash…………………………………….xxxx
Prepaid assets…………………………... xxxx

At the end of the year, adjustment is made for any differences between the amount of overhead actually
incurred and the amount of overhead applied (allocated) to products. The amount by which actual
overhead exceeds the applied overhead is called under applied overhead. If actual overhead had been less
than applied overhead, the difference would have been called over applied overhead.

Journal entries for adjustment of over or under application of overhead costs

For under applied:
Cost of goods sold Debited
Manufacturing overhead Credited
For over applied:
Manufacturing overhead Debited
Cost of goods sold Credited
Bilisuma Company Job order No 5574
Shager Street Date ordered: 1/10
For: Finfinne Construction Company Date started: 1/14
PRODUCT:# Maple Drain Boards Date Wanted: 1/22
SPECIFICATION: 12’x 20” x1” clear Finishes Date completed: 1/18
Quantity: 10
Direct Material
Date REQ.NO Amount Total
1/14 516 Br. 1,420.00
1/17 531 780.00
1/18 544 310.00
Br. 2,510.00
Direct Labor
Date Hours Cost
1/14 40 Br. 320.00
1/15 32 256.00
1/16 36 288.00
1/17 40 320.00
1/18 48384.00
196 Br. 1568.00
Factory overhead Applied
Date Rate of application cost
1/14 16.20 Br. 684.00
1/16 10.00 400.00
1/17 3.20128.00
29.40 Br. 1,176.00

Direct materials Br 2,510.00 Selling price Br. 7860.00

Direct labor 1,568.00 less: production cost Br.5254.00
Factory overhead Applied 1,176.00 marketing Expense 776.00
 Admin. Expense 420.00
Total production Cost Br. 5,254.00 Cost to make and sell (6,450.00)
Profit Br. 1,410.00
Example of job card/sheet after the job is completed

Manufacturing cost flow and financial statements

Raw materials purchases are recorded in the Raw Materials inventory account. When raw materials are
used in production, their costs are transferred to the Work in Process inventory account as direct
materials. Direct labor costs are added directly to Work in Process inventory they do not flow through
Raw Materials inventory.
Manufacturing overhead costs are applied to Work in Process by multiplying the predetermined overhead
rate by the actual quantity of the allocation base consumed by each product or job. When goods are
completed, their costs are transferred from Work in Process to Finished Goods.
The amount transferred from Work in Process to Finished Goods is referred to as the cost of goods
manufactured. As goods are sold, their costs are transferred from Finished Goods to Cost of Goods Sold.
Period costs (or selling and administrative expenses) do not flow through inventories on the balance
sheet. They are recorded as expenses on the income statement in the period incurred. These are further
summarized by the following cost flow chart:

Manufacturing costs

Unused
Direct Materials Inventory
Direct Material costs
Used (Balance sheet)

Direct labor cost Work in process Inventory

Manufacturing (Balance sheet)
process

Factory overhead
costs Finished and unsold Finished goods Inventory
(Balance sheet)
Finished and sold
Cost of goods sold
(Income statement)
Non manufacturing
Selling and administration
or period costs
expense
(Income statement)