CHAPTER FOUR

COST ACCOUNTING

Management accounting can be defined as the process of identification,

measurement, accumulation, analysis, preparation, interpretation, and communication of
financial as well as non financial information used by management to plan, evaluate,
control within the organization and to assure appropriate use and accountability for its
resources.
Cost Accounting
Cost accounting is the process of accumulating the cost of manufacturing and other
functional process and identifying these costs with unit produced or some other object.
It measures and reports financial and other information related to the organization’s
acquisition or consumption of resource.
Cost accounting is applied in any type of organization but primarily applied in
manufacturing organization that combine and process raw martial in to finished product.

COST TERMINOLOGY AND CLSSIFICATION

Cost terminologies
Many accounting reports contain several cost terminologies. A good understanding of the
different cost terminology is essential at least for the following two reasons.
 It enables accounting information users to best use the information provided.
 Uses of common terminology avoids confusion and misunderstanding
The following are some of the terms used in cost accounting:

Costs, Expenses and losses: Accountants usually define cost as resource scarified or
forgone to achieve a specific objective. It refers to an out lay or expenditure of money to
acquire goods and services in the course of generating revenue. For instance purchase of
raw martial represent a cost as the raw material is used to produce finished goods that
generate revenue when sold.
How ever some disbursements are not costs .For example, the payment of dividend is
disbursement but it does not help to generate revenue, hence it is not a cost.

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All costs initially represent an asset. As the asset is used in generating revenue, the
amount consumed becomes an expense. There for expense is an expired cost. The cost of
asset used should then be recognized as expense to properly match revenue and expense
in the process of determining the income of the organization over a given period. For
instance, insurance premium paid in advance to serve the coming period are initially
recognized as asset, but as time passes on, the asset is continually converted in to an
expenses. Another example may be a motor vehicle bought for uses for the coming five
years is an asset when initially purchased. How ever, as the asset is used up in the process
of generating revenue, the cost gradually becomes an expense. Thus, expenss are expired
costs or costs used up in the course of generating revenue.
Some times a firm may incur a cost that produces neither immediate nor future benefit.
This is called a loss. For example damage caused by fir or flood on property held is a
loss.
Cost object: is anything for which a separate measurement of cost is desired. In
manufacturing company, the cost object is the unit of finished goods produced.

Cost accumulation and cost assignment: A costing system typically account for costs in
two basic stages, accumulation followed by assignment. Cost accumulation is the
collection of cost data in some organized means of accounting system and cost
assignment is a general term that encompass both (1) tracing accumulated cost that have
direct relationship to the cost object and (2) allocating accumulated costs that have an
indirect relationship to a cost object. For example a publisher that purchase paper rolls for
printing magazines collect the cost of paper bought and used in any one month to obtain
the total monthly cost of paper used. Beyond accumulating costs ,the cost accountant
assign cost to the different magazines the publisher publish to help decision making

Cost driver: is any factor that affects total cost. That is a change in the cost driver will
cause a change in the level of the cost of a related cost object. Example
 Mile driven for transport cost
 Length of time of call for telephone cost
 Meter cub of water consumed for water cost
 Unite sold for cost of goods sold

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Cost management: is the set of actions that a manager takes to satisfy customers while
continuously reducing and controlling cost. Cost reduction efforts frequently focus on
two key areas
 Doing only value added activities, that is, those activities that customers perceive
as adding value to the product or service they purchase
 Efficiently managing the use of the cost drivers in the value added activities.
Classification of cost
Cost may be classified in different ways from different point of view. The same cost may
be included in several or in all of the following classification.

1. Time period point of view

From time period point of view cost are classified in to historical cost and budgeted cost.
Historical cost are costs incurred in the past period where as Budgeted costs are costs
expected to be incurred in the future period. For example, the 8000 birr cost of a
computer acquired in 20005 is a historical cost in the financial statement of 2006. How
ever the 10,000 birr cost to acquire a new computer in 2007 to replace the existing one is
a future cost.

2. Management function point of view

From management function point of view costs are classified in to:
 Manufacturing cost: includes costs from the acquisition of raw material through
production until the product can be turned over to the marketing division to be
sold( material, labor & manufacturing overhead costs)
 Selling cost: are costs associated with marketing and selling a product. They
include all costs incurred by the marketing division from the time the
manufacturing process is completed until the product is delivered to customers.
These costs include advertising, promotion, transport and warehouse cost.
 Administrative cost: are costs associated with the management of the Company
and include expenditures for accounting, legal and administrative activity.

3. Business function ( value chain)point of view

Value chain refers to the sequence of business functions in which usefulness is added
to the product or service of a company
From business function point of view cost is classified as follows
 Research and development cost

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  Product design cost
 Marketing cost
 Distribution cost
 Customer service cost
4. Cost assignment point of view.
From this point of view costs are classified as direct cost and Indirect cost.
Direct costs are costs that are directly traceable to the product. Example:
direct material cost
Direct labor cost
Indirect cost (manufacturing over head or factory over head): are costs which are
not directly traced to the product but allocated to it using some criteria. Example:
Cost of electricity
Depreciation of equipment
Indirect labor
Indirect material
Cost of different utilities
Cost of repair and maintenance
Insurance for the plant

5. Decision making point of view

A decision involves making a choice among alternative courses of actions.
From decision making point of view costs are divided as relevant and irrelevant costs.
Relevant cost is useful for decision making where as irrelevant costs are not uses full for
decision making .Relevant cost is usually future cost which change among alternative
courses of actions, and irrelevant cost is past or sunk cost which was already incurred.
6. Management influence point of view
Management influence refers to the ability of a manager to control a particular cost.
A cost which is under the control of a given manager is controllable cost where as a cost
which is beyond the control of a given manager is uncontrollable.
Controllability of a cost depends on the level of management and time period. All costs
are controllable by some one at some level in the organization if the time period is longer
enough.

7. Cost behavior point of view

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From their behavior point of view, costs are divided in to fixed cost and Variable cost
Fixed cost is a cost which remains constant with in a given relevant range regardless of
change in out put level, where as variable cost is a cost which change when units
produced change .Usually, material and labor cost are variable with out put, where as
some manufacturing overhead cost such as depreciation are fixed in nature regardless of
change in out put.
Total cost is sum of variable cost and fixed cost (TC = VC + FC)

Average cost = Total cost

No. units produced

Example 1: Student association has hired a musical group for graduation party. The
fixed cost of hiring a band for the party is birr 4000.The hall in which the graduation
ceremony is celebrated can afford up to 2000 attendee It has been determined that the
cost of refreshment consumed by each person attending the party will be birr 8.
Required: a) Fill the following table using the information provided.

No of Total Average Total Variable Total cost Total average

attendee fixed cost fixed cost cost cost
500
1000
1500
2000

b) Draw the graph of FC, VC and TC

c) Draw the graph of Average FC, Average VC and Average TC
d) What will happen to the fixed cost if the number of attendee is 3000?
8. Commitment to cost expenditure
Commitment to a cost expenditure focused on fixed cost as opposed to variable cost and
budgeted cost as opposed to historical cost. Budgeted fixed cost can be classified as
committed cost and discretionary cost.
 Committed cost: is one that is an inevitable consequence of a previous
commitment. For example Property tax on ware house budgeted for the coming

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 year is an example of committement cost because it results from decision to
construct the ware house last time.
 Discretionary cost (programmed or managed cost): is one in which the amount
or time of incurrence is a matter of choice.
These are non recurring costs for which a finale commitment has not yet been
made and that can be postponed to future period or canceled entirely.
10. Other cost classification
 Marginal cost: is cost incurred to manufacture one more product.
 Out of pocket cost: is cash expenditure associated with a particular decision
alternative.
 Opportunity cost: is the cost of an opportunity for gone when one course of action
is chosen over another. Opportunity cost is not an out of pocket cost but
represents an opportunity associated with each of the alternatives that are rejected.

Manufacturing cost
There are three types of inventories in manufacturing .These are
 Direct material inventory: are raw materials in stock and waiting to be used in
manufacturing process.
 Work in process inventory: are goods partially processed but not yet completed .
 Finished goods inventory: are goods fully completed but not yet sold.
In manufacturing enterprises production costs are grouped in to three categories.
 Direct material costs: are costs of raw material that can be physically identified
with or traced to the finished product .It is distinguished from indirect material by
the ability to identify it economically with a finished product and is included as an
element of indirect material cost. For example cost of paper used in printing news
paper is direct material cost for the news paper ,how ever, paper used in beer
factory to stamp around a bottle of beer is probably be classified as indirect
material cost because it is significant part of the finished product ( Bottles of
beers).
 Direct labor cost : includes The cost of employee who work directly on the
product and whose efforts can economically be traced to particular unit of
finished product

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  Manufacturing over head (factory over head or indirect manufacturing cost):
are all manufacturing costs that cannot be individually traced to the finished
product but allocated to it using some criteria. Example:
Indirect material( Nail, sand paper, screw, glue)
Indirect labor(supervisors salary)
Electricity and utilities
Plant rent, Plant insurance
Depreciation
Salary of plant manager
Prime cost and conversion costs are two other terms used to describe production cost.
 Prime cost: are the most important or significant costs traceable to
unit of finished product. They include direct material and direct
labor cost.
Prime cost= Direct material cost + Direct labor cost
 Conversion costs are those required to convert raw material in to
finished product and consists of direct labor and manicuring and
manufacturing over head cost.
Conversion cost= Direct labor cost + Manufacturing over head cost
Financial statement for manufacturing company
In order to prepare financial statement for manufacturing company, the following
schedules are necessary
Schedule1: cost of direct material used
Beginning direct material inventory XX
Purchase in The month XX
Direct material available for use XX
Ending direct material inventory (XX)
Direct material cost used XX

Schedule 2: cost of goods manufactured

Direct material used cost----------------------- XX
Direct labor cost ------------------------------- XX
Manufacturing over head cost -----------------XX
Cost incurred in current period ----------------XX

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 Add: Work in process beginning -------------- XX
Total cost incurred to date ----------------------XX
Less: work in process ending ------------------XX
Cost of goods manufactured --------------------XX
Schedule 3: cost of goods sold
Finished goods beginning --------------------- XX
Cost of goods manufactured ------------------- XX
Cost of goods available for sale ----------------XX
Less: Finished goods ending ------------------- XX
Cost of goods sold --------------------------------XX
Schedule 4: Income statement for manufacturing company
Revenues XX
Cost of goods sold XX
Gross profit XX
Operating expense (XX)
Operating income XX
Example2: Consider the following account balance for ABC manufacturing company in
the year 2004.
Beginning balance End balance
Direct material inventory $22,000 $26,000
WIP inventory 21,000 20,000
Finished goods inventory 18,000 23,000
Purchase of direct material 75,000
Direct labor cost 25,000
Indirect labor cost 15,000
Plant insurance 4,000
Insurance- administrative 5,000
Depreciation - plant building and equipment 9,000
Depreciation - administrative building 3,000
Repair and maintenance – factory equipment 4,000
Marketing, distribution and customer service cost 93,000
General and administrative cost 29,000
Required
a) Calculate cost of direct material used
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b) Calculate cost of goods manufactured
c) Calculate cost of goods sold
d) If revenue for the year is $300, 000, prepare income statement for the Company.
Example 3: A fire destroyed XYZ manufacturing company completely on January 29,
2004. Fortunately certain accounting records were kept in another building. It revealed
the following for the period from january1, 2004 to January 29, 2004.
Direct material purchased $160,000
WIP January1 34,000
Direct material january1, 2004 16,000
Finished goods january1, 2004 30,000
MOH cost 40% of conversion cost
Revenue 500,000
Direct labor cost 180,000
Prime cost 294,000
Gross profit based on sales 20%
Cost of goods available for sale 450,000
Requirements
a. Direct material destroyed
b. Cost of goods manufactured
c. Finished goods destroyed
d. WIP destroyed

Cost Accounting Exercise

Problem 1: The cost department of Randall manufacturing company collected the
following cost data for financial statement presentation for the year ended on
December31, 2005.
Inventories January1,2005 December31,2005
Direct material $34,500 $49,300
Work in process $ 81,500 $42,000
Units of Finished goods 300unit 420 units

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 Cost of Finished goods $48,600 ?
Additional information.
 Sales during the year are 3,880 units at $220 per unit
 Direct material purchased ------- $364,000
 Prime cost -------------- $511,700
 MOH cost -------------------- 48% of conversion cost
 Operating expense ---------------- 50%of gross profit
 All units in the ending finished goods inventory are from current period
production.
Requirements:
Compute the following based on the above information.
1. Cost of direct material used
2. Units of goods manufactured
3. Cost of goods manufactured
4. Cost of goods sold
5. Operating income

Problem 2: The following selected data are for ABC plastic company for the month of
January 2004.
Work in process inventory January 1, 2004 $200.000
Direct material inventory January 1, 2004 90,000
Direct material purchased in January 360,000
Direct material used in January 375,000
Variable manufacturing overhead cost 250,000
Total manufacturing overhead cost 480,000
Total manufacturing cost incurred in January 1,600.000
Cost of goods manufactured 1,650,000

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Cost of goods sold in January 1,700,000
Finished goods inventory January 1, 2004 125,000
Gross profit for January 150,000
Operating income for January 50,000
Requirements: For the month of January calculate the following
a) Direct material inventory on January 31, 2004
b) Fixed manufacturing overhead cost for January
c) Direct manufacturing labor cost for January
d) Work in process inventory on January31, 2004
e) Goods available for sale in January
f) Finished goods inventory January 31, 2004
g) Sales revenue
h) Operating expenses
i) Prime cost
j) Conversion cost
Problem 3: Ato Alemu was graduated from Teferi Mekonnen School ten years ago. He
was working in ABC Company for the last seven years under different positions. 15
months ago he started his own furniture factory called JIMER office and House hold
furniture. After 3 months since he started operation, he learnt that maintaining an
accounting record is essential. He thought he know how to establish an accounting
system, maintain an accounting record and prepare financial statements by virtue of his
high school book keeping. He prepared the following income statement at the end of the
current year sene30, 1998
JIMER Office and House hold furniture
Income statement
For the year ended sene 30, 1998
Sales Br.135,000
Cost of goods sold
Beginning inventory
 Direct material 9,000
 Work in process 3.000
 Finished goods 12,000
Direct material purchase 30,000

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 Direct labor 45,000
Rent 14,000
Light, heat, and power 5,000
Telephone 1,500
Depreciation 4,000
Indirect labor 6,000
Marketing and administrative 9,000
Insurance 8,000
Miscellaneous MOH cost 2,000
Miscellaneous marketing and adm. 1,800
Total 143,100
Net loss 8,100

The following additional information is available

The ending inventory of direct material, work in process and finished goods is birr 3,000,
4,500 and 15,000 respectively. The following costs should be allocated
Manufacturing periodic
Rent 60% 40%
Light, heat and 70% 30%
power
telephone 70% 30%
insurance 60% 40%
depreciation 80% 20%
He worried why the loss comes; he doubted his capacity of accountancy, and asked you
to help him prepare the income statement as new.

Problem 4: Supply the missing data for each of the following companies
A B C D
Unit produced 45,000 unit 60,000 unit K 75,000 unit
Total cost E $450,000 $240,000 N
Fixed cost $157,500 H $90,000 O
Fixed cost per unit F $1.2 $9 P
Variable cost per unit $16.5 I L $11.1
Total cost per unit G J M $15.3

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Problem 5: Supply the missing data for each company listed below:
W X Y Z
Sales $300,000 D 390,000 660,000
DM Beginning 27,000 30,000 21,000 J
DM purchased 42,000 45,000 48,000 63,000
DM ending A 24,000 27,000 24,000
Direct labor 75,000 E 51,000 95,500
MOH cost 60,000 54,000 76,500 95,500
WIP beginning 57,000 18,000 G 36,000
WIP ending 48,000 24,000 45,000 30,000
FG beginning 60,000 F 51,000 48,000
FG ending 69,000 33,000 H 54,000
Cost of goods manufactured B 126,000 210,000 K
Cost of goods sold C 132,000 I 300,000
Gross margin 129,000 144,000 162,000 L

Problem 6: Han plc is nine month old since established to manufacture different parts of
a manual irrigation pump. The company owners failed to maintain a formal accounting
record for the nine months of operation with the presumption that the volume of activity
is small and can thus be effectively administered by them. Lately, they have discovered
the importance of maintaining an accounting rescored. Assume that the firm hires you
and your first duty is to prepare a six month income statement covering the period from
January1, to june30. The company management is capable of supplying actual data on
some items but the rest are estimates. You are given the following actual data.
1 Sales for the first six month is Br.240, 000
2. Inventory january1.
Direct material --------------- 12,000
Work in process -------------- 8,800
Finished goods ---------------- 28,500
3. The gross margin is fairly estimated at 40% of sales, and direct labor is estimated to be
one third of conversion cost and one fourth of prime cost.
4. The period cost totally estimated at 54,000 and marketing cost is estimated to be 40%.
5. A physical count of all inventories made as of june30 reveals the following.
Direct material --------------- 9,000

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 Work in process -------------- 7,500
Finished goods ---------------- 52,000
Required
1. Calculate the cost of goods sold
2. Calculate the cost goods manufactured

3. Calculate the direct labor cost

4. Calculate the direct material cost
5. Calculate the direct MOH cost

Problem 7:- The following transaction occurs during the month of January
1. Purchase of material (direct and indirect), $89,000 on account
2. Raw material sent to manufacturing plant floor is $85,000 out of which $4000
is indirect material
3. Manufacturing labor wages liability incurred is $54,000 out of which $15,000
is indirect
4. The actual machine hours used in the period were 1000 machine hours. The
manufacturing over head is allocated using this actual machine hour.
5. Additional manufacturing over head cost incurred during the month is
$75,000.this cost consists of utility and repairs, $23, 000, insurance expired
$2,000, depreciation expense $50,000.
6. Cost of finished goods of eight individual jobs completed and transferred out
is $188,800.
7. Finished goods costing $180,000 was sold for $300,000 on cash.
Required:
a) Journalize the above transactions
b) Post using T-account
c) Compute the under or over applied MOH cost
d) Close the amount using direct write of to cost of goods sold

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