GLOBAL RECIPROCAL COLLEGES

454 GRC Bldg. Rizal Ave. corner 9th Ave., Grace Park Caloocan City

COST ACCOUNTING AND CONTROL J.A. Labay

ACCOUNTING FOR MATERIALS

Cost Classification for Manufacturing/Product Cost

1. Materials – includes the raw materials and other factory supplies used in manufacturing
operation.
a. Direct Materials
b. Indirect Materials

2. Labor – includes salary and wages cost paid to the workers in the factory.
a. Direct Labor
b. Indirect Labor

3. Manufacturing/Factory Overhead – includes all other manufacturing/production costs not

included in direct material and direct labor.

Inventory Methods of Accounting for Materials

1. Perpetual Inventory Method
Perpetual inventory system may be defined as a method of recording stores balances after every
receipt and issue to facilitate regular checking and to obviate closing down for stock taking.” So
perpetual inventory system implies continuous maintenance of stock records and in its broad
sense it covers both continuous stocks taking as well as up to date recording of stores books. The
balance of the same item of store in bin card should correspond with that shown in the materials
or store ledger card and a frequent checking of these two records should be made and compared
with the actual or physical quantity of materials in stock.

2. Periodic Inventory Method

Periodic inventory system is that does not require a day-to-day record of inventory changes.
Costs of materials used and costs of goods sold cannot be calculated until ending inventories,
determined by physical count, are subtracted from the sum of opening inventories and purchases
(or costs of goods manufactured in the case of a manufacturer).

Procedures for Materials

Although production processes and materials requirements vary, the cycle of procurement and
use of materials usually involves the following steps:

1. Engineering and planning determine the design of the product, the materials specifications,
and the requirements at each stage of operations. Engineering and planning not only
determine the maximum and minimum quantities to run and the bill of materials for given
products and quantities but also cooperate in developing standards where applicable.
2. The production budget provides the master plan from which details concerning materials
requirements are eventually developed.
3. The purchase requisition informs the purchasing agent concerning the quantity and type of
materials needed.
4. The purchase order contracts for appropriate quantities to be delivered at specified dates to
assure uninterrupted operations.
5. The receiving report certifies quantities received and may report results of inspection and
testing for quality.
6. The materials requisition notifies the storeroom or warehouse to deliver specified time or is
the authorization for the storeroom to issue material to departments.
7. The materials ledger cards record the receipt and the issuance of each class of materials and
provide a perpetual inventory record.

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 1 of 10
Economic Order Quantity (EOQ) Decision Model
Inventory management is an important part of profit planning for manufacturing and
merchandising companies. It is the planning, coordinating, and control activities related to the
flow of inventory into, through, and from an organization. Cost of goods sold is largest single
cost item for some retailers. Better decisions regarding the purchasing and managing of goods
for sale can cause large percentage increases in net income when net income is small percentage
of revenues.

Five Categories of Costs Associated with Goods for Sale:

1. Purchasing costs – costs of goods acquired from suppliers including incoming freight or
transportation costs.
2. Ordering costs – include costs of preparing purchase orders and receiving goods.
3. Carrying costs – costs of holding inventory of goods for sale.
4. Stockout costs – costs arising when a customer demands a unit of product and that unit is not
on hand.
5. Quality costs – costs of product or service not in conformance with a preannounced or
prespecified standard.

Economic order quantity (EOQ) is a decision model that calculates optimal quantity of inventory
to order under a set of assumptions (balancing ordering and carrying costs). (How much to order
of a given product). The purpose of the EOQ model is to identify the least cost quantity of a
material to be purchased at each order point.

Formula: 2 x annual demand x cost per order

√ carrying cost per unit

Reorder point is the quantity level of the inventory on hand that triggers a new order.
(When to order)

Formula: Reorder point = Number of units sold per unit of time x Purchase-order lead
time

Safety stock is the inventory held at all times regardless of the quantity of inventory ordered
using the EOQ model. It is used as a buffer against unexpected increases in demand, uncertainty
about lead time and unavailability of stock from suppliers. It is computed using demand forecasts
(usually based on experience) to minimize sum of annual relevant stockout costs and carrying
costs.

PROBLEMS

1. Mic Corp. uses 1,000 units of material annually in its production. Order costs consist of P10
for placing a long-distance call to make the order and P40 for delivering the order by truck to the
company warehouse. Each material costs P100, and the carrying costs are estimated at 15.625%
of the inventory cost.

Required:
a. Compute the economic order quantity for material and the total order costs and carrying costs
for the year.
b. Determine the best order quantity if material is purchased only in multiples of 25 units.
(Round answers to the nearest whole dollar.)

2. Bhe Company estimates that it will consume 400,000 units of Part X in the coming year. The
ordering cost for this unit is P3.20. What would be the carrying costs per unit if the EOQ model
indicates that it is optimal to place exactly 50 orders for the upcoming year?

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 2 of 10
3. Bhe Company estimates that it will consume 400,000 units of Part X in the coming year. The
ordering cost for this unit is P3.20. Bhe Company wants to maintain a safety stock of 1,000 units,
and its factory operates 200 days per year. What is the order point if the lead time is 2 days?

4. Chales Company has developed the following data to assist in controlling one of its inventory
items:
Economic order quantity 1000 liters
Average daily use 100 liters
Maximum daily use 120 liters
Working days per year 250 days
Safety stock 140 liters
Cost of carrying inventory P1.00 per liter per year
Lead time 7 working days

Required: Compute the following:

a. Order point
b. Average inventory
c. Maximum inventory assuming normal lead time and usage
d. Cost of placing one order

5. Cart Graphics uses a special purpose paper in 80% of its jobs. The paper is purchased in 100-
sheet packages at a cost of P100 per package. Management estimates that the cost of placing and
receiving a typical order is P15, and the annual cost of carrying a package in inventory is P1.50.
Cart uses 2,600 packages each year (Working days in a year: 250 days). Production is constant,
and the lead time to receive an order is 5 days.

Required:
a. The economic order quantity is approximately:
b. The reorder point is:

6. Peeman carries a part that is popular in the manufacture of automatic sprayers. Demand for
this part is 4,000 units per year; order costs amount to P30 per order, and carrying/holding costs
total P1.50 per unit. Peeman currently places four orders per year with its suppliers.

Management is considering the implementation of an economic order quantity model in an effort

to better manage its inventories.

Required:
a. Compute Peeman's economic order quantity.
b. Compute total annual inventory costs if Peeman follows the EOQ policy.

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 3 of 10
ACCOUNTING FOR LABOR

Basic Methods of Wage Payment (Remuneration)

1. Time Wage System – wages are paid on the basis of time spent on the job regardless of the
amount of work done. The unit of time maybe a day, a week, or a month. The basic formula of
payment is as follows:
Gross Pay = Rate per Hour x No. of Hours Worked

2. Piece Wage System – wages are paid based on the amount of work done or output of work.
Thus, an employee is paid direct proportion on his output. The basic formula of payment is as
follows:
Gross Pay = Rate per Hour x No. of Units Produced

Procedures for Labor

1. Recording of the length and time worked by each laborer.
2. Analyzing how such time was spent by the laborer.
3. Charging the labor cost to the jobs or manufacturing overhead.
4. Preparing the payroll.

Various departments are involved in the accounting for labor, namely: personnel department,
payroll department, and accounting department.

Further Classifications of Labor Costs

1. Idle time − Machine breakdowns, material shortages, power failures and the like, result in idle
time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.
This spreads the costs across all the production rather than the units in process when the
disruptions occur.

2. Overtime − The overtime premiums for all factory workers are usually considered to be part
of manufacturing overhead. This is done to avoid penalizing particular products or customer
orders simply because they happen to fall on the tail end of the daily production schedule.

3. Labor fringe benefits − These costs relate to employment-related costs paid by an employer
such as insurance programs, retirement plans, and supplemental unemployment programs. They
also include the employer’s share of Social Security, Medicare, workers’ compensation, federal
employment tax, and state unemployment insurance.
- These costs often add up to 30% to 40% of an employee’s base pay.
- Some companies include all of these costs in manufacturing overhead. Other companies
opt for the conceptually superior method of treating fringe benefit expenses of direct
laborers as additional direct labor costs.

PROBLEMS

1. A direct labor worker at Gal Corporation is paid P20 per hour for regular time and time and a
half for all work in excess of 40 hours per week. This employee works 44 hours during a week in
which there was no idle time.

Required: Determine how much of the worker's wages for the week would be classified as direct
labor cost and how much would be classified as manufacturing overhead cost.

2. A direct labor worker at Lang Corporation is paid P16 per hour for regular time and time and a
half for all work in excess of 40 hours per week. This employee works 49 hours in a given week
but is idle for 4 hours during the week due to equipment breakdowns.

Required: Determine how much of the worker's wages for the week would be classified as direct
labor cost and how much would be classified as manufacturing overhead cost.

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 4 of 10
3. A direct labor worker at San Corporation is paid P22 per hour for regular time and time and a
half for all work in excess of 40 hours per week. The company's fringe benefits cost P6 for each
hour of employee time (both regular and overtime). Last week this employee worked 43 hours
but was idle for 4 hours due to material shortages. The company treats all fringe benefits as part
of manufacturing overhead.

Required: Determine how much of the worker's wages for the week would be classified as direct
labor cost and how much would be classified as manufacturing overhead cost. Show your work.

4. A direct labor worker at Vor Corporation is paid P14 per hour for regular time and time and a
half for all work in excess of 40 hours per week. The company's fringe benefits cost P6 for each
hour of employee time (both regular and overtime). Last week this employee worked 43 hours
but was idle for 4 hours due to material shortages. The company treats all fringe benefits relating
to direct labor as added direct labor cost and the remainder as part of manufacturing overhead.

Required: Determine how much of the worker's wages for the week would be classified as direct
labor cost and how much would be classified as manufacturing overhead cost.

5. The following labor data for the past week were prepared for Mr. Master, an employee of Boo
Corp.:
Day Units Produced Hours Worked
Monday ................................................... 110 8
Tuesday ................................................... 125 8
Wednesday .............................................. 120 8
Thursday ................................................. 135 8
Friday ...................................................... 130 8
Master's wage rate is P15 per hour, and the standard production rate is 15 units per hour.

Required: Determine the daily wages for Master and the labor cost per unit for units produced
during each day of the week, assuming that the company is on a straight piecework incentive
wage plan and that a worker is guaranteed a wage of P15 per hour. (Round the unit labor cost to
two decimal places.)

6. Mr. X an employee of Mr. Y and Company, submitted the following data for work performed
last week:
Day Units Produced Each Day
Monday .............................................................................. 22
Tuesday .............................................................................. 24
Wednesday ......................................................................... 30
Thursday ............................................................................ 21
Friday ................................................................................. 27
During the week, Mr. X worked 8 hours each day and was paid a flat hourly wage of P10, plus a
bonus based on the 100% bonus plan. Standard production is 3 units per hour. The bonus is
computed on a daily basis.

Required: Prepare a report for Mr. X, showing daily earnings, the daily efficiency ratio, and the
labor cost per unit produced each day. (Round labor cost per unit to two decimal places.)

7. A direct labor worker at Chin Corporation is paid P14 per hour for regular time and time and a
half for all work in excess of 40 hours per week. The company's fringe benefits cost P4 for each
hour of employee time (both regular and overtime). Last week this employee worked 45 hours
but was idle for 3 hours due to material shortages. The company treats all fringe benefits as part
of manufacturing overhead.

Required: Determine how much of the worker's wages for the week would be classified as direct
labor cost and how much would be classified as manufacturing overhead cost.

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 5 of 10
8. A direct labor worker at Kim Corporation is paid P18 per hour for regular time and time and a
half for all work in excess of 40 hours per week. The company's fringe benefits cost P4 for each
hour of employee time (both regular and overtime). Last week this employee worked 42 hours
but was idle for 4 hours due to material shortages. The company treats all fringe benefits relating
to direct labor as added direct labor cost and the remainder as part of manufacturing overhead.

Required: Determine how much of the worker's wages for the week would be classified as direct
labor cost and how much would be classified as manufacturing overhead cost.

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 6 of 10
ACCOUNTING FOR OVERHEAD

Manufacturing/Factory Overhead Account

The Manufacturing/Factory Overhead Account is used to record the actual overhead incurred
and the amount of overhead applied. This account is debited when overhead is incurred. The
amount of overhead applied is credited to overhead account. It is calculated by multiplying the
predetermined overhead rate to the actual level of activity.

In an actual cost system, factory overhead is assigned directly to products and services. In a
normal cost system, factory overhead is assigned to an overhead control account and then
allocated to products and services.

Overhead must be allocated because it is necessary to (1) determine full cost, (2) it can motivate
managers, and (3) it allows managers to compare alternative courses of action.

Predetermined Overhead Rate

During the course of the production cycle, actual overhead costs are incurred. When overhead is
applied to Work in Process, it is commonly applied using a predetermined rate. A predetermined
overhead rate is a budgeted and constant charge per unit of activity. The activity chosen is called
the Overhead Allocation Base or Cost Driver. The commonly used activity bases are: physical
output, direct labor costs, direct labor hours, material costs, and machine hours. (Predetermined
Overhead Rate = Estimated Total Overhead / Estimated Activity Base)

Predetermined overhead rates should be used for three reasons: (1) to assign overhead to Work in
Process during the production cycle instead of at the end of the period; (2) to compensate for
fluctuations in actual overhead costs that have no bearing on activity levels; and (3) to overcome
problems of fluctuations in activity levels that have no impact on actual fixed overhead costs.

The Need for Predetermined Overhead Rate

Instead of using a predetermined overhead rate, a company could wait until the end of the
accounting period to compute an actual overhead rate based on actual total manufacturing costs
and the actual total units in the allocation base for the period. However, managers cite several
reasons for using predetermined overhead rates instead of actual overhead rates:

1. Managers would like to know the accounting system’s valuation of completed jobs
before the end of the accounting period. Suppose, for example a company waits until the end of
the year to compute its overhead rate. Then there would be no way for managers to know the
cost of goods sold for a job until the close of the year. The job may be completed and shipped
before the end of the year. The seriousness of this problem can be reduced to some extent by
computing the actual overhead more frequently, but that immediately leads to another problem as
discussed below.

2. If actual overhead rates are computed frequently, seasonal factors in overhead costs or
in the allocation base can produce fluctuations in the overhead rates. For example, the cost of
heating and cooling a production facility will be highest in the winter and summer months and
lowest in the spring and fall. If an overhead rate were computed each month or each quarter, the
predetermined overhead rate would go up in the winter and summer and down in the spring and
fall. Two identical jobs, one completed in winter and one completed in spring, would be assigned
different costs if the overhead rate were computed on a monthly or quarterly basis. Managers
generally feel that such fluctuations in overhead rates and costs serve no useful purpose and are
misleading.

3. The use of predetermined overhead rate simplifies the record keeping. To determine
the overhead cost to apply t a job, the accounting staff simply multiplies the direct labor hours
recorded for the job by the predetermined overhead rate.

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 7 of 10
Multiple Predetermined Overhead Rates
When a single predetermined overhead rate is used for entire factory it is called plant wide
overhead rate. This is fairly common practice – particularly in smaller companies. But in large
companies, multiple predetermined overhead rates are often used.

In a multiple predetermined overhead rate system, each production department may have its
own predetermined overhead rate. This system, even more complex, is considered to be more
accurate. Since it can reflect differences across departments in how overhead costs are incurred.
For example, overhead might be allocated based on machine-hours in departments that are
relatively machine intensive. When multiple predetermined overhead rates are used, overhead is
applied in each department according to its own overhead rate as a job proceeds through the
department.

Underapplied and Overapplied Overhead

Overhead application at a predetermined rate may cause overhead to be under- or overapplied.
(The peso amount of overhead assigned to work-in-process inventory using a predetermined rate
is known as applied overhead.) If actual overhead is greater than applied overhead, then
underapplied overhead results and a debit balance exists in the overhead account. If applied
overhead is greater than actual overhead, then overapplied overhead results and a credit balance
exists in the overhead account. If the amount of under- or overapplied overhead is immaterial, it
is closed directly to Cost of Goods Sold. If the amount is material, it must be allocated among
Work in Process, Finished Goods, and Cost of Goods Sold.

Over-applied and Underapplied Overhead

Since the predetermined overhead rate is established before a period begins and is based entirely
on estimated data, the overhead cost applied to work in process (WIP) will generally differ from
the amount of overhead cost actually incurred during a period. The difference between the
overhead cost applied to work in process (WIP) and the actual overhead costs of a period is
termed as either underapplied overhead or overapplied overhead.

Causes / Reasons of under applied or over applied overhead

The causes / reasons of under or over-applied overhead can be complex. Nevertheless, the basic
problem is that the method of applying overhead to jobs using a predetermined overhead rate
assumes that actual overhead costs will be proportional to the actual amount of the allocation
base incurred during the period. If, for example, the predetermined overhead rate is P50 per
machine hour, then it is assumed that actual overhead cost incurred will be P50 for every
machine hour that is actually worked. There are actually two reasons why this may not be true.
First, much of the overhead often consists of fixed costs that do not grow as the number of
machine hours incurred increases. Second, spending on overhead items may or may not be under
control. If individuals who are responsible for overhead costs do a good job, those costs should
be less than were expected at the beginning of the period. If they do a poor job, those costs will
be more than expected.

Disposition of Underapplied or Overapplied Overhead Balances

What disposition should be made of an underapplied overhead or overapplied overhead balance
remaining in the manufacturing overhead account at the end of a period?
Generally, any balance in the account is treated in one of the two ways.
1. Closed out to cost of goods sold.
2. Allocated between work in process (WIP), finished goods and cost of goods sold in
proportion to the overhead applied during the current period in the ending balances of these
account.

The second method, which allocates the under or overapplied overhead among ending
inventories and cost of goods sold is equivalent to using an “actual” overhead rate and is for that
reason considered by many to be more accurate than the first method. Consequently, if the

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 8 of 10
amount of underapplied or overapplied overhead is material, many accountants would insist that
the second method be used.

Closed Out to Cost of Goods Sold

Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than
the allocation method. Cost of goods sold is increased by the amount of underapplied and
decreased by the amount of overapplied overhead.
Allocated Between Accounts
Allocation of under or overapplied overhead between work in process (WIP), finished goods and
cost of goods sold (COGS) is more accurate than closing the entire balance into cost of goods
sold. The reason is that allocation assigns overhead costs to where they would have gone in the
first place had it not been for the errors in the estimates going into the predetermined overhead
rate.
If the amount of under-applied or over-applied overhead is significant, it should be allocated
among the accounts containing applied overhead: Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied”
overhead means that the balances in these accounts are quite different from what they would
have been if actual overhead costs had been assigned to production.

PROBLEMS

1. Don Corp. estimates that its production for the coming year will be 10,000 widgets, which is
80% of normal capacity, with the following unit costs: materials, P40; direct labor, P60. Direct
labor is paid at the rate of P24 per hour. The widget shaper, the most expensive piece of
machinery, must be run for 20 minutes to produce one widget. Total estimated overhead is
expected to consist of P400,000 for variable overhead and P400,000 for fixed overhead.

Required: Compute the overhead rate for each of the following bases, using the expected actual
capacity activity level:
a. physical output
b. materials cost
c. direct labor cost
d. direct labor hours
e. machine hours

2. Louis Inc. manufactures sound equipment. The company estimates the following costs at
normal capacity and other items for the coming period:

Direct materials ................................................................... P300,000

Direct labor ......................................................................... 520,000
Factory overhead (fixed) ..................................................... 300,000
Factory overhead (variable) ................................................ 240,000
Normal capacity .................................................................. 100,000 direct labor hours
Expected production ........................................................... 80,000 direct labor hours

Required: Compute the overhead application rate for fixed, variable, and total overhead per
direct labor hour, using both the normal capacity and the expected actual capacity activity levels.

3. The following information is available concerning the inventory and cost of goods sold
accounts of AAA Company at the end of the most recent year:
Work in Finished Cost of Goods
Process Goods Sold
Direct material ............................................... P 5,000 P 8,000 P 11,000
Direct labor .................................................... 6,000 15,000 15,000
Applied overhead ........................................... 4,000 12,000 24,000
Year-end balance ........................................... P 15,000 P 35,000 P 50,000

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 9 of 10
Applied overhead has already been closed to Factory Overhead Control.

Required:
Give the journal entry required to close Factory Overhead Control, assuming:
a. Overapplied overhead of P10,000 is to be allocated to inventories and Cost of Goods Sold in
proportion to the balances in those accounts.
b. Underapplied overhead of P10,000 is to be allocated to inventories and Cost of Goods Sold in
proportion to the amounts of applied overhead contained in those accounts.

4. Dnd Corp. estimates that its production for the coming year will be 10,000 widgets, which is
80% of normal capacity, with the following unit costs: materials, P40; direct labor, P60. Direct
labor is paid at the rate of P24 per hour. The widget shaper, the most expensive piece of
machinery, must be run for 20 minutes to produce one widget. Total estimated overhead is
expected to consist of P400,000 for variable overhead and P400,000 for fixed overhead.

Required: Compute the overhead rate for each of the following bases, using the normal capacity
activity level:
a. physical output
b. materials cost
c. direct labor cost
d. direct labor hours
e. machine hours

Cost Accounting and Control (Accounting for Materials, Labor, and Overhead) Page 10 of 10