CHAPTER ONE

Overview of cost and management accounting

All organizations have two things in common. First, every organization has a set of goals or
objective. Second, in pursuing an organization goal, managers need information.
In pursuing organizations goals, managers engage in the following four basic activities,
- Decision making,
- Planning,
- Directing, and
- Controlling
For all these managerial activity managers needs information.
This information comes from various sources, including:
- Economist,
- Financial expert,
- Marketing and production personnel, and
- Organizations’ managerial and cost accountants
There are also individuals and institutions that need information about the organization:
Example includes:
- Suppliers,
- Creditors,
- Customers
- Investors,
- Taxing authorities etc.

Meaning of Cost Accounting

Previously, cost accounting was simply considered to be a technique for the ascertainment of
costs of products or services on the basis of historical data. In course of time, due to competitive
nature of the market, it was realized that ascertaining of cost is not as important as controlling
costs. Hence, cost accounting started to be considered more as a technique for cost control as
compared to cost ascertainment. Due to the technological advancement in all fields, cost
reduction has also come within the ambit of cost accounting. Cost accounting is, thus, concerned
with recording, classifying and summarizing costs for determination of costs of products or
services, planning, controlling and reducing such costs and providing of information to
management for decision making.

Objectives of Cost Accounting

The main objectives of cost accounting can be summarized as follows:
Ascertainment of cost
• Cost accounting is to ascertain cost of different products, job and services. For example,
cost per kg, cost per meter, cost per liter, cost per ton etc.
Determining selling price

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 • Cost accounting provides detailed information about the composition of total cost for
determining action of the selling price of the product or service under different conditions.
Measure and increasing efficiency
• Cost accounting involves a study of various operations used in manufacturing a product or
providing a service.
• The study facilitates measuring the efficiency of an organization as a whole or
department-wise as well as devising means of increasing efficiency.
Cost Control
• Cost accounting aims at improving the efficiency by controlling and reducing cost.
• Budgetary control and standard costing are the two important techniques used to control
cost.
Facilitating preparation of financial and other statements
• The other objective of cost accounting is to produce statements whenever is required by
management.
• The financial statements are prepared under financial accounting generally once a year or
half-year and are spaced too far with respect to time to meet the needs of management.
• In order to operate a business at a high level of efficiency, it is essential for management
to have a frequent review of production, sales and operating results.
• Cost accounting provides daily, weekly or monthly volumes of units produced and
accumulated costs with appropriate analysis.
• A developed cost accounting system provides immediate information regarding stock of
raw materials, work-in-progress and finished goods. This helps in speedy preparation of
financial statements.
Providing basis for operating policy
Cost accounting helps management to formulate operating policies. These policies may relate to
any of the following matters:
• Determination of a cost-volume-profit analysis
• Shutting down or operating at a loss
• Making for or buying from outside suppliers
• Continuing with the existing plant and machinery or replacing them by improved and
economic ones.

Relationship between CA, FA and MA

• Cost Accounting is a branch of accounting, which has been developed because of the
limitations of financial accounting from the point of view of management control and
internal reporting.
• Sometimes the terms “cost accounting” and “management accounting” are used
interchangeably. This is generally acceptable because the two concepts are interrelated;
one is a subset of the other.

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 • Since the context of cost and management accounting is the same, the information used
from cost accounts is required by management, particularly for pricing decisions, order
assessment and stock valuation, to name a few.
• Technically, the cost function supplements the management accounting function.
• Both C.A and M.A facilitate the planning, controlling and decision-making functions of
management.

Distinction between FA, CA and MA

Management accounting - focuses on accounting information that facilitates decision making
by managers of the organization.
Financial accounting - measures and records business transactions and provides financial
statements that are based on GAAP.
Cost accounting - provides information to facilitate both management accounting and financial
accounting. Its focus is measuring and reporting financial and non-financial information.

Cost Classification concepts and terms

The word ‘cost’ is usually used in our day to day conservation. It is a generic term that anyone
needs to know.
- Cost is the amount of resource given up in exchange for some present and
futurebenefits.
- The resource given up is always expressed in terms of money.

Common Cost Related Terminologies

a. Cost object
- A cost object is anything for which a separate measurement of cost is needed.
Examples:
- a product,
- a service,
- a project,
- a brand category,
an activity and a department
b. Cost driver
• A cost driver is any factor that affects total costs over a given time span.
• A cost driver is variable. i.e., a change in the level of the cost driver will cause a change in
the level of the total cost of a related cost object.
• Any change made in any of the cost drivers will cause a change in the total cost.
Examples of cost Drivers
• Number of units produced
• Number of items distributed
• Number of Customers

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 • Number of advertisements
• Number of sales personnel
• Number of research project

c. Cost accumulation
• It is the collecting of cost data in some organized way (such as material, labor, fuel ec,)
through accounting system.
Example:
• a publisher that purchases paper rolls for printing magazines collects (accumulates) the
cost of individual rolls bought in any one month to obtain the total monthly cost of paper.
d. Cost assignment
- cost assignment is a general term that encompasses both:
1. Tracing accumulated costs that have a direct relationship to a cost object (cost racing).
2. Allocating accumulated costs that have an indirect relationship to a cost object (cost
allocation).
The following table summarizes the relationship between cost assignment, cost racing, and
cost allocation
Cost tracing
Direct
Cost Cost
Cost
assignment
Cost allocation Object
Indirec
t Cost
e. Cost pool
- Is the collection of overhead costs related to a cost object (a product related activity).
f. Expense
- a cost that has given a benefit and is now expired.
- When the benefit of goods and services are received the cost becomes an expense. In
contras the un expired cost is classified as an asset because, benefits are still o be
received.
g. Loss – a cost that occurs when goods or services purchased are determined valueless
revenues.

Classification of Costs
An important step in computation and analysis of cost is the classification of costs into different
types. Classification helps in better control of the costs and also helps considerably in decision
making. Here, classification of costs can be made according to the following basis. However,
you may encounter other classification in practices.
1. Classification according to Elements
Costs can be classified according to the Elements as follows.

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 - Material,
- Labor, and
- Overheads
Elements of costs like material and labor can be classified into direct and indirect.
They are mentioned below.
i. Direct and Indirect Material
Direct Material (DM) -raw materials which can be physically and conveniently associated with
the finished product during the manufacturing process. Cost incurred for DM is known as DM
cost.
Examples of DM
• Steel, plastics and tires are raw material in making Automobiles;
• Flour in the baking of Bread
• Wood in furniture making;
• Cloth in dress making;
• Bricks in building a house etc.
Indirect material (IM) – Material which is used for purposes ancillary to production, and
which cannot be conveniently assigned to specific physical units. Cost incurred for IM is known
as IM cost.
Examples of IM
 Consumable stores,
 Oil and waste,
 Printing and stationery materials,
 Lubricants,
 Fuel, etc.
i. Direct and Indirect Labor
For conversion of materials into finished goods, human effort is needed and such human effort is
called labor. Labor can be direct as well as indirect.
Direct Labor (DL) - workers who are directly engaged in the production processes.
Direct labor can be identified with a given unit of product, e.g., when wages are paid according
to the piece rate, wages per unit can be identified.Cost incurred for DL is known as DL cost.
Examples of DL
 Machine operators and assembly
 Bottlers in soft drink
 Bakers in Bakery
Indirect Labor (IL) - workers who are not directly engaged in the production of goods and
services.Cost incurred for IL is known as IL cost.
Examples of IL
 Sweepers/Janitors
 Gardeners,
 Time keepers

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  Stock keepers
 Maintenance workers
 Supervisors etc
ii. Overheads - includes indirect material, indirect labor costs. Thus, all indirect costs are
overheads.
A manufacturing organization can broadly be divided into the following three divisions:
 Factory or works – where production is done
 Office and administration – where routine as well as policy matters are decided
 Selling and distribution – where products are sold and finally dispatched to customers
2. Classification by degree of tractability to the Product
Direct Costs: Direct costs are costs that are related to the particular cost object and that can be
traced to it. These costs can be conveniently identified with a particular cost unit, process or
department.
Examples:
 Direct materials cost, and
 Direct Labor cost
Indirect costs- costs that are related to the particular cost object but cannot be traced to it.
Indirect costs cannot be conveniently identified with a particular cost unit or cost centre.
Examples:
 Indirect materials cost, and
 Indirect Labor cost
Managers prefer to make decisions based on direct costs rather than indirect costs. Why?
Because they know that direct costs are more accurate than indirect costs. This classification is
important from the point of view of accurate ascertainment of cost. Direct costs of a product
can be conveniently determined while the indirect costs have to be arbitrarily apportioned to
various cost units.
3. Classification according to Behavior
Fixed costs: A fixed cost is a cost that does not change in total despite changes in a cost driver
for a given time period. Fixed costs are commonly described as those which remain fixed in total
amount with increase or decreases in the volume of output for a given period of time. Fixed costs
per unit increases as production declines.
Examples:
 Rents,
 Insurance of Factory building, and
 Factory manager’s salary
Variable Costs:These costs are variable in nature, i.e. they change according to the volume of
production. Their variability is in the same proportion to the production.
Examples:
 Direct labor costs
 Direct material costs

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4. Classification According to Time
Historical Costs
- These are the costs which are incurred in the past, i.e., in the past year, past month or
even in the last week or yesterday.
- The historical costs are ascertained after the period is over.
- In other words, it becomes a post-mortem analysis of what has happened in the past.
- Though, historical costs have limited importance, still they can be used for estimating the
trends of the future, i.e. they can be effectively used for predicting the future costs.
Future Cost
- These costs relating to the product are computed in advance of production, on the basis of
a specification of all the factors affecting cost and cost data.
5. Classification according to Functions
Manufacturing Costs
- Two terms used in manufacturing costs systems are; Prime costs and Conversion costs
Prime Costs (PC) – are all direct manufacturing costs. Prime costs consist of direct material
costs (DM) and direct labor costs (DL).
PC = DM + DL
Conversion Costs (CC) – are all manufacturing costs other than direct material costs.
Conversion costs represent all manufacturing costs incurred to convert direct materials into
finished goods. Conversion costs would comprise Direct Labor costs (DL) and Indirect
manufacturing costs (MOH).
CC = DL + MOH
Manufacturing cost = PC + CC - DL

Or manufacturing costs = DM + DL + MOH

Administrative Costs
- Costs incurred for administration purposes
Examples:
- Office salaries,
- Printing and stationery,
- Office telephone,
- Office rent,
- Office insurance etc.
Selling and Distribution Costs
Selling cost – all costs incurred for procuring an order.
E.g. Market research expenses, advertising, sales staff salary, sales promotion
Distribution costs – all costs incurred for execution of order.
E.g. Transportation expenses incurred on sales, warehouse rent
Research and Development Costs
• In the modern days, research and development has become one of the important functions
of a business organization.

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 • Expenditure incurred for this function can be classified as Research and Development
Costs.
6. Classification of costs for Management Decision Making
Marginal Cost
• It is the change in the aggregate costs due to change in the volume of output by one unit.
Opportunity Costs
• It is the value of benefit sacrificed in favor of an alternative course of action.
Relevant Cost
• The relevant cost is a cost which is relevant in various decisions of management.
• Decision making involves consideration of several alternative courses of action.
• In this process, whatever costs are relevant are to be taken into consideration.
• Relevant cost is a future cost which is different for different alternatives.
Controllable vsun controllable Costs
Controllable costs – costs which can be controlled or influenced by a conscious management
action.
Uncontrollable costs – costs which cannot be subjected to control or influence at any level of
management.
Note:
• All variable costs are controllable and fixed costs are not.
• All direct costs are controllable and indirect costs are not
• All long term costs are controllable
Shutdown Costs
• Costs which are incurred if the operations are shut down and they will disappear if the
operations are continued.

Chapter Two
Cost computation
1. Direct Material Cost Computation

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Formula:
DM used = Beg. DM inventory + DM purchased – Ending DM

Exercise:
Suppose that, the direct materials inventory of BGK Furniture Factory amounts to Birr 248,000
as of January 1, 2013, purchases of Birr 880,000 and freight in costs Birr 3,200 is made during
the year, and the amount of direct materials inventory at the end of the year is Birr 234,900.
The direct material used, therefore, can be computed as follows.
Beginning DM……………………...248,000
Add: Purchase during the period……880,000
Freight in ………………………...3,200
DM available for use…………1,131,200
Deduct: Ending DM …………………234,900
Cost of DM used…………Br. 896,300

The direct material used in production shows the portion of direct material that have already put
in the production process and the ending direct material cost shows that portion of direct material
left in the store at the end of the period or direct material inventory.
2. Cost of Goods Manufactured Computation
Cost of goods manufactured refers to those costs that are added in production process and finally
converted into finished goods during a given production period.
The cost of goods manufactured, consists three cost elements:
a. Cost of direct materials used,
b. Cost of direct labor, and
c. Manufacturing overhead
Extending the same example of BGK Furniture Factory illustrated above, let’s assume the cost
of direct labor employed for the year is Br. 875,000, and the following overhead costs are
incurred.

Indirect labor Br. 179,200

Depreciation of factory equipment 89,200

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Light and power 87,200
Depreciation of Factory building 24,000
Insurance expense on factory properties 19,000
Property tax 39,000
Factory supplies expense 11,600
Miscellaneous factory costs 2,200
Total overheads Br. 475,400

After the information for the three elements of costs of goods manufactured gathered, additional
information about the beginning and ending Wok-In-Process are needed. Let’s assume further
that the beginning and ending Work-In-Process inventory costs for BG Furniture Factory are Br.
220,000 and Br. 236,200 respectively.
Formula:
Cost of Goods Manufactured= Beg. WIP inventory + Mfg. cost - Ending WIP inventory
Where, Mfg. cost = DM + DL + MOH
OR,
Cost of Goods Manufactured= Beg. WIP inventory + (DM used + DL incurred + MOH) -
Ending WIP inventory
The computation of Cost of Goods Manufactured for BG Furniture Factory will take the following
form:
Work in process inventory January 1, 2013 Br. 220,000
Add: DM used (previous computation) 896,000
Direct labor 875,000
Factory overhead 475,400
Manufacturing cost incurred during the year 2,246,700
Total Work In Process inventory during the year (to date) 2,466,700
Deduct: Work In Process inventory December 31, 2013 236,200
Cost of Goods Manufactured (CGM) Br. 2,230,500

3. Cost of Goods Sold Computation

The cost of goods sold represents the cost of goods that are sold during a given year.

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Formula:

Cost of Goods Sold= Beg. Finished Goods inventory + Cost of goods manufactured- Ending
Finished Goods Inventory
Assume that, the finished goods inventory for BGK Furniture Factory as of the beginning of the
year was Birr 314,000 and the ending inventory of finished goods inventory is Birr 364,000.
Cost of goods sold is then computed as follows.
Finished goods inventory, January 1, 2013 Br. 314,000
Add: Cost of goods manufactured(previous computation) 2,230,500
Cost of goods available for sale 2,544,500
Deduct: Ending Finished Goods inventory Dec., 31, 2013 364,000
Cost of Goods Sold Br. 2,908,500

Ordering Quantity

The basic problems of material control are two.

1. What quantity of an item should be ordered at a time and
2. When should an order be placed.
 While deciding economic ordering quantity, the efforts are directed to ascertain the ideal
order size. While deciding the ideal order size, factors such as material carrying charges and
the ordering cost associated with the placement of purchase orders are to be considered; the
total of both has to be minimized.
 The material carrying charges include interest on the capital invested in the stores of
materials, rent for the storage space, salaries and wages of the store-keeping department, any
loss due to pilferage and deterioration, stores insurance charges, stationery, etc. used by the
stores, taxes on inventories, etc.
 Ordering costs may include rent for the space used by the purchasing department, the salaries
and wages of officers and staff in the purchasing department, the depreciation on the
equipment and furniture used by the department, postage, telegraph charges and telephone
bills, the stationery and other consumables required by the purchasing department, any
travelling expenditure incurred, and the costs of inspection etc., on receipt of material.

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 The optimum ordering quantity, i.e., the quantity for which the cost of holding plus the cost
of purchasing is the minimum is known as Economic ordering Quantity and is calculated by
the following formula:

Chapter Three

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Job order costing system
 Job order costing system is used in situations where many different products are
produced each period.
For example clothing factory would typically made many different types of jeans for both
men and women during a month.
 In a job order costing system, costs are traced to the jobs and then the costs of the job are
divided by the number of units in the job to arrive at an average cost per unit.
 Job order costing system is also extensively used in service industries.
 Hospitals, law firms, movie studios, accounting firms, advertising agencies and repair
shops all use a variety of job order costing system to accumulate costs for accounting and
billing purposes.
 The details here deal with a manufacturing firm, the same concept and procedures are
used by many service organizations.
The record keeping and cost assignment problems are more complex in job order costing system
when a company sells many different products and services than when it has only a single
product or service. Since the products are different, the costs are typically different.
Consequently, cost records must be maintained for each distinct product or job. A job order
costing system requires more effort than a process costing system.
Companies classify manufacturing costs into three broad categories:
 Direct materials
 Direct labor and
 Manufacturing overhead

Journal entries for job-order costing

Illustration of a Job-costing in manufacturing company
3. Purchase of materials (direct and indirect) for $89,000 on account.
Materials control 89,000
Accounts payable control 89,000
(To record purchase of materials)
2. Materials sent to manufacturing plant floor; direct materials 81,000 and indirect materials
4,000.

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 Work-in-process control 81,000
Manufacturing overhead control 4,000
Materials control 85,000
(To record issuance of direct and indirect materials to production)
3. Manufacturing labor wages liability incurred, direct 39,000 and indirect 15,000.
Work-in-process control 39,000
Manufacturing overhead control 15,000
Wages payable control 54,000
(To record direct and indirect wages liability)
4. Payment of total manufacturing payroll for the month 54,000.
Wages payable control 54,000
Cash control 54,000
(To record the payment of manufacturing payroll)
4. Additional manufacturing overhead costs incurred during the month $75,000. These costs
consists of utilities and repairs, $23,000, insurance expired $2,000 and depreciation on
equipment $50,000.
Manufacturing overhead control 75,000
Accounts payable control 23,000
Accumulated depreciation control 50,000
Prepaid insurance control 2,000
(To record manufactured overhead costs incurred)
5. Allocation of manufacturing overhead to products $80,000.
Work-in-process control 80,000
Manufacturing overhead allocated 80,000
(To record Transaction allocation manufacturing overhead)
7. Completion and transfer to finished goods of eight individual Jobs $188,800.
Finished goods control 188,800
Work-in-process control 188,800
(To record the transfer from work-in-process to finished goods inventory)
8. Cost of goods sold $180,000
Cost of goods sold 180,000

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 Finished goods inventory 180,000
(To record cost of goods sold)
9. Revenues/sales Birr. 6, 0000
Accounts Receivable (Cash)………………6,000
Sales Revenue…………………………………6,000
(To record sale of goods)
Accounting for Spoilage, Rework, Scrap, and Waste
Generally, manufacturing operations cannot escape the occurrence of certain losses or output
reduction due to scrap, spoilage, or defective units. Sometimes, these are known as the costs of
doing good units.
Defects: are natural to any production process, and thus cannot be totally avoided. In fact, it is
possible to reduce the rate of defect and that is the important point of managing defects.
Reducing defects means reducing cost of products which in turn means adding value on the
products manufactured.
Defective units are of two types:
(1) Rework - defective units that can be reworked and sold at normal prices
(2) Spoilage – defective units that cannot be reworked and cannot be sold at all or can be
sold at less than normal price or cannot be sold at normal prices.

Spoilage: refers to defective units that are unacceptable and as a result cannot be sold for normal
prices. Spoiled units may or may not have any selling price. Spoiled units have selling prices
when the level of defect is insignificant and if it can be used for some purpose with that defect
remain intact. If the level of defect is significant, the defective unit may not serve any purpose,
and therefore, the spoiled units may not have any selling price.
Scrap: refers to materials that are left over from production processes. However, they may be
useful for different purpose.

Waste: are parts of raw materials left over after production that has no further use or resale
value. Sometimes cost may be incurred to dispose waste materials.

Accounting for Spoilage

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As spoilages are integral part of any production process, some level of spoilage is tolerable. The
important point is to determine that level of spoilage that is accepted as normal. There is no hard
and fast rule as to the level of spoilage that is considered as normal. It depends on several factors
like the philosophy of the management, and the nature of the manufacturing process. Some
managers may consider spoilage up to 10% of good units as normal. Another manager may say
any spoilage level beyond 5% of good units is abnormal.
Types of Spoilage
Spoilage can be classified as
1. Normal, and
2. Abnormal
Normal spoilage
Normal spoilages are unacceptable units that arise under an efficient production process. Normal
spoilage is uncontrollable. The problem is the rate of defect that can arise under the most
efficient operation is unknown. Thus, the rate is left to subjective judgment of the management.
The cost of normal spoilage is added to the cost of good units produced because good units
cannot be produced without simultaneous production of spoiled units. In calculating normal
spoilage, the base is the number of good units produced. The total production is not considered
as it includes abnormal spoilage as well.

Abnormal spoilage
Abnormal spoilage refers to unacceptable units that are above the defect level that is considered
as normal. In other words, it is a level of defect that is not expected under an efficient operation
system. Abnormal spoilage represents defects that can be avoided and controlled with increased
level of efficiency. The cost of abnormal spoilage is separately reported as loss from abnormal
spoilage.
Rework
Rework refers to unacceptable units of production that can be repaired and subsequently sold at
normal price. Just like spoilage, rework can be classified as normal rework attributable to a
specific job, normal rework common to all jobs and abnormal rework.
Scrap

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Scraps are often saleable though their selling price is less as compared to the selling price of the
products from which the scrap is produced.
Important considerations in accounting for scrap are:
• When to recognize scrap in the accounting records, and
• How should the revenue from scrap is accounted for
Waste material
As it has been mentioned before, some costs may be incurred to dispose waste materials.

Chapter Four

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Process costing system
• Process costing system is a method for assigning product costs to units of product when all
units of products are virtually the same.
In general, process costing is used:
 In homogeneous products
 In continuous processing
 In mass production techniques
Difference b/n process costing and Job costing
The principal difference is the extent of averaging used to compute unit cost of product or
service. The cost object in a job order costing system is a job that constitutes a distinctly
identifiable product or service. Thus, costs are assigned to each cost object (job) with minimal
averaging. In contrast, in process costing system, the cost object is a processing center which
produces a mass of similar units of a product or service. Unit costs are computed by averaging
total cost of the process over the total number of similar units.
Other differences between the two are the following:
• In process costing, the amount of production is determined to a large extent by supply
and demand for the product, while in job costing it is by a specific order.
• Generally, there are no transfers from one job to another unless there is surplus of work
or excess production. But in process costing transfers from one process to another are
natural and fundamental.
• In job costing, work in progress at the end is rare, but in process costing some balance of
unfinished work in each process is always there.
• Exercise of control over jobs is relatively difficult as each job is separate and unique in
some respects. However, in process costing the exercise of the control is easier since the
processes are repetitive and more or less identical from period to period.
• Process costing is considered as a capital intensive process; whereas job order is
characterized as a labor intensive process.
Classification and assignment of costs to production units
In manufacturing firms, production may take place in several depts. When the units are
transferred from one producing dep’t to another, the accumulated costs are transferred to the

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subsequent dep’t. The cost of materials, labor, and factory overhead are charged to work in
process accounts which are maintained for each dep’t.
• Process costing system separate costs in to cost categories according to when costs are
introduced in to the process.
• Only two cost classifications, direct materials and conversion costs, are necessary to
assign costs to products. Why only two?
Because all direct materials are added to the process at one time and all conversions costs are
generally added to the process evenly through time.
We will use the production of the DG-19 component in the Assembly dep’t of Global Defense
Company to illustrate process costing in three cases, starting with the simplest case.
Case-1 Process costing with zero beginning and zero ending work in process inventory of DG-
19. This case presents the most basic concepts of process costing and illustrates the feature of
averaging of costs.
Case-2 Process costing with zero beginning work in process but some ending work in process
inventory of DG-19 (some units of DG-19 started during the accounting period are incomplete at
the ending of the period). This case introduces the concept of equivalent units.
Case-3 Process costing with both some beginning and some ending work in process inventory of
DG-19
Case-1 Process costing with zero beginning and zero ending work in process inventory
Physical units for January 2004
Work in process, beginning inventory (January 1) 0 units
Start during January 400 units
Completed and transferred out during January 400 units
Work in process, ending inventory (Jan. 31) 0 units
Total costs for January 2004
Direct material costs added during January $ 32,000
Conversion costs added during January 24,000
Total assembly Dep’t costs added during January $ 56,000
By averaging, the assembly cost per unit of DG19 is $56,000 per 400 units= $140 per unit
Direct material cost per unit ($32,000 ÷400 units) $80
Conversion cost per units ($24,000÷400units) -------- 60

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 Assembly Dep’t cost per unit…………………… $140
Case-2 Process costing with zero beginning but some ending work-in process inventory
In February 2004, global defense places another 400 units of DG-19 in to production.
Physical units for February 2004
Work in process, beginning inventory (Feb1)……...…… 0 units
Started during February……………………………….. .400 units
Completed and transferred out…………………………175 units
Work in process, ending inventory (Feb, 29) ……….… 225 units
The 225 partially assembled units as of February 29, 2004 are fully processed with respect to
direct materials. That is because all direct materials in the Assembly Dep’t are added at the
beginning of the assembly Process. Conversion costs, however, are added evenly during
assembly. An Assembly Dep’t supervisor estimates that the partially assembled units are, on
average, 60% complete from the perspective of conversion costs.
Total costs for February 2004
Direct material costs added during February $32,000
Conversion costs added during February 18,600
Total Assembly Dep’t costs added during February 50,600
The point to understand here is that, a partially assembled unit is not the same as a fully
assembled unit. Faced with some fully assembled units and some partially assembled units:
Global Defense calculates in five steps:
1. The cost of fully assembled units in February, 2004(completed), and
2. The cost of the partially assembled units still in process at the end of that month(ending
WIP)
Step 1. Summarize the flow of physical units of output
2. Compute output in terms of equivalent units
3. Compute equivalent unit costs
4. Summarize total costs to account for
5. Assign total costs to units completed and to units in ending work in process
Physical units and Equivalent units (step-1 & 2) -Exhibit 1
Flow of production Physical units Equivalent units
DM CC

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Work in process, beginning 0
Started during current period 400
Total units to be accounted for 400
Completed & transferred out
During current period
175
175
175
Work in process, ending a
(225x100%, 225x60%)
225
225
135

Total units accounted for work done in current period only

400
400
310
a Degree of completion in this department; direct matierials,100%; conversion costs, 60%
Computations of product costs (Step 3, 4 and 5)
Exhibit-2 shows steps 3, 4 and 5
Description TC of
Production Equivalent units
DM CC
Costs added during February $50,600 $32,000 $18,600
Divide by Equivalent units of Work done in current Period(Exhibit-1) 400 310
Cost per equivalent unit (step 3) $80 $60
(Step-4) Total costs to account for $50,600

(Step-5)Assignment of costs:

CMA - I 21
Completed and transferred
Out (175 units)
$24,500 (175unitsx$80)
$14,000 (175 unitsx$60)
$10,500

Work in process, ending (225units):

$26,100 (225unitsx$80)
$18,000 135unitsx$60)
$8,100
Total costs accounted for $50,600
Case-3 Process costing with some beginning and some ending work in process inventory
At the beginning of March 2004, Global Defense had 225 partially assembled DG-19 units in the
Assembly Department. It started production of another 275 units and 400 units are completed
and transferred in March 2004. Data for the Assembly Dep’t for March are:
Physical units for March 2004
Work in process, beginning inventory (March1) ...........225 units
Started during March……………………………..……275 units
Completed and transferred out during March…………..400 units
Work in process, ending inventory (March, 31)………..100 units
Direct materials (100% complete)
Conversion costs (50% complete)
Total costs for March 2004
Work in process, beginning inventory
Direct materials (225 equivalent units x $ 80 per unit) $18,000
Conversion costs (135 equivalent units x $ 60 per unit) 8,100 $26,100
DM costs added during March…………………………………… 19,800
CC added during March………………………………………….. 16,380 26,180
Total costs to account for ……………………………………………..……………..$62,280

CMA - I 22
Global Defense now has incomplete units in both beginning work in process inventory and
ending work in process inventory for March 2004. We use the five steps described earlier to
calculate:
1. The cost of units completed and transferred out, and
2. The cost of ending work in process
To assign costs to each of these categories, however, we need to choose an inventory cost flow
method. We do have two methods to assign the cost to the products. These are (1) Weighted-
Average-Method, and (2) FIFO Method. However, to assign costs the weighted average method
is widely used. So, the following section illustrates cost assignment using weighted average
method.

Weighted average Method

The weighted-average process costing method calculates the equivalent-unit cost of and all the
work done to date assign this cost to equivalent units completed and transferred out of the
process and to equivalent units in ending work in process inventory.
Exhibit-3 Physical units and Equivalent units (step-1& 2)
Flow of production Physical units Equivalent units
DM CC
Work in process, beginning 225

Started during current period 275

Total units to be accounted for 500
Completed & transferred out
during current period
400
400
400
Work in process, ending (100x100%, 100x50% 100 100 50
Total units accounted for Work done in current period only
500

CMA - I 23
500
450
b Degree of completion in this department: direct matierials,100%; conversion costs, 50% )
Computations of product costs (Step 3, 4, and 5)

Description TC of
Production Equivalent units
DM CC
Work in process, beginning $26,100 $18,000 $8,100
Costs added during March $36,180 $19,800 $16,380
Costs incurred to date $37,800
$24,480
Divide by Equivalent units of Work done in current Period (Exhibit-3) 500 450
Cost per equivalent unit (step 3) $75.60 $54.40
(Step-4) Total costs to account for $62,280
(Step-5)Assignment of costs:

Completed and transferred

Out (400 units)
$52,000 (400x$75.60)
$30,240 (400x$54.40)
$21,760

Work in process, ending (100 units):

$10,280 (100 unitsx$75.60)

$7,560 50 unitsx$54.40)
$2,720
Total costs accounted for $62,280
Chapter Five

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Cost Allocation
Cost allocation is a challenge in every organization and nearly in every feature of accounting,
provides information needed for both strategic and operating decisions. For instance, Ambo
University bothers about how costs should be allocated among undergraduate programs, graduate
programs, and research. Hospitals also think how they should allocate costs among expensive
medical equipment, facilities, and staff. Manufacturing companies bother how costs should be
allocated to individual products.

Major purposes of cost allocation

1. To provide information for economic decision
Mangers within an organizational unit should be aware of all the consequences of their decision;
even consequences outside their units. Cost allocation helps managers to predict the economic
effects of planning and control decisions and to provide feedback for performance evaluation.
2. To motivate manager and other employees
Cost allocations often influence management behavior and thus promote goal congruence and
managerial effort. This helps to encourage the design of products that are simpler to manufacture
or less costly to service, and to encourage sales representatives to emphasize high- margin
products or services.
3. To measure income and assets for reporting
Companies allocate costs to products and projects to measure inventory costs and cost of goods
sold.
4. To justify costs or compute reimbursement
5. To encourage managers of operating departments to make wise use of service provided by
service departments
6. To develop overhead rates in the operating departments

5.3 Criteria for cost allocation decision

There is no one best way of allocating cost to cost object. The followings are major criteria for
guiding cost allocation decisions usually used by cost accountants.
1. Cause and effect criteria
- A manger identifies the variables that cause a resource to be consumed.

CMA - I 25
- E.g., cost drivers i.e., unit produced, unit sold( selling costs)
- It is likely to be the most creditable to operating personnel
2. Benefit received criteria
- The higher the revenue the higher the cost allocated to divisions and vice versa.
3. Fairness or Equity
- Often cited in government units
Allocating Costs of Single Support Department
Under allocating costs of a single support department to operating departments, managers face
two questions.
(1) Should fixed costs of support department be allocated to operating departments?
(2) If fixed costs are allocated, should variable and fixed costs be allocated in the same
ways?
Most companies belief that, fixed costs of support department should be allocated, because the
support department needs to incur fixed cost to provide operating divisions with the service they
require.
Methods of allocating costs of support department
Managers use two basic methods of allocating costs of supporting department.
(1) Single Rate, and
(2) Dual Rate
(1) Single Rate method
 Allocates costs in each service department to cost objects using the same rate per unit of
a single allocation base.
 No distinction is made between fixed and variable costs.
(2) Dual Rate method
 Classifies costs into two pools: variable cost pool and fixed cost pool with each pool
different cost allocation base.
When using the single rate method and dual rate method, managers can allocate support
department costs to operating division based on:
1. Budgeted Rate and budgeted hours to be used by operating divisions,
2. Budgeted rate and actual hours used by operating division, and
3. Actual Rate and Actual Hours used by operating divisions.

CMA - I 26
Illustration
Consider BG Electronics Company that manufactures computers and its accessories. The
company has one central department which gives service to other operating departments. This
department has only two users:
1. The microcomputer Division, and
2. Peripheral Equipment Division
The following Data relate to the 2007 Budget
Fixed costs of operating the computer facility
in the 6,000 -18,750 hours relevant Range …………………………Br 3,000,000
Maximum capacity…………………………………………………….18,750 hours
Budgeted long run usage (quantity) in hours:
The microcomputer Division…………………8,000 hours
Peripheral Equipment Division……………….4,000 hours
Total………Br. 12,000 hours
Budgeted variable cost per hour:
in the 6,000 -18,750 hours relevant Range ……Br 200 per hours used
Actual usage in 2007 in hours:
The microcomputer Division………………9,000 hours
Peripheral Equipment Division…………….3,000 hours
Total………Br. 12,000 hours
Required:
Allocate the costs of service department using the two methods:
1. Single- Rate Method
BG Electronics can allocate central computer department’s cost based on the budget rate and
actual hours used by the operating divisions.
Budgeted usage……………………………………………………………12,000 hrs
Budget total cost pool: Br. 3,000,000 + (12,000 hrs x Br. 200/hrs)……Br. 5,400,000
Budgeted total Rate per hour: Br. 5,400,000 ÷ 12,000 hrs = Br. 450

CMA - I 27
  Note that, the budgeted rate of Br. 450 per hour differs significantly from the Br. 200
budgeted variable costs per hour. That’s because the Br. 450 rate includes an allocated
amount of Br. 250 per hour (budgeted fixed costs, Br. 3,000,000 divided by budget
usage, 12,000hrs) for fixed costs of operating the facility.
 These fixed costs will be incurred whether the computer runs at its maximum capacity of
18,750 hrs, or say at its 12,000 hrsbudgeted usage.

The central computer department costs are allocated to the two operating divisions on the
basis of actual hrs used as follows:
The microcomputer Division………9,000 hours x Br. 450 per hr = Br. 4,050,000
Peripheral Equipment Division……3,000 hours x Br. 450 per hr = Br. 1,350,000
Total = Br. 5,400,000
A problem with single rate method is that it makes the Br. 250 allocated FC per hour of the
central computer department appear as a VC to users of the central computer department. This
could leads operating divisions to take actions that could harm BG as a whole. For instance, an
external vendor offer the Micro computer division computer service at a rate of Br 340 per hour
when the central computer department has unused capacity. The micro computer division’s
manages may be attracted to use this vendor because it would appear to decrease costs Br. 340
per hour instead of Br 450 per hour if it uses the central computer department. In the short run
however, BG actual incur an extra Br. 140 per hour i.e., Br 340 external purchase price per hour
minus the savings of Br 200 in internal variable cost per hour from not using the central
computer department because the FC of the central computer department will remain the same.
2. Dual Rate Method
Under this method, allocation bases must be chosen for both the variable and fixed cost pools of
central computer department.
- BG allocates variable costs to each division based on budgeted variable cost per hour of
Br. 200 for actual hrs used by each division.
- BG allocates fixed costs based on budgeted fixed costs per hour and budgeted number of
hours for each division. The central computer department budgets usage of 12,000 hours:
That is:
 8,000 hrs for Microcomputer Division, and

CMA - I 28
  4,000 hrs for  Peripheral Equipment Division
The budgeted fixed cost Rate is Br. 250 per hr (Br. 3,000,000 ÷ budgeted usage, 12,000 hrs).
Cost allocated to Microcomputer Division:
Fixed costs (Br. 250 x 8,000 hrs) = Br. 2,000,000
Variable costs (Br 200 x 9,000 hrs = Br. 1,800,000
Total Br. 3,800,000

Peripheral Equipment Division:

Fixed costs (Br. 250 x 4,000 hrs) = Br. 1,000,000
Variable costs (Br 200 x 3,000 hrs = Br. 600,000
Total Br. 1,600,000

If actual cost of the central computer department differs from allocated costs of Br. 5,400,000
(3,800,000 + 1,600,000) BG would have to dispose of the over allocated or under allocated cost
using methods described in chapter three.
Note that, the difference between the single rate and dual rate methods in the BG Electronics
arises because, the single rate and the dual rate methods allocates only the actual FC resources
used or the budgeted fixed cost resources to be used by the micro computer and peripheral
equipment division.
Benefit and cost of single rate methods
 One benefit of dual rate method is the low cost to implement it. The single rate method
avoids the often –expensive analysis necessary to classify the individual cost items of a
department into variable and fixed categories.
 However, the single rate method makes allocated fixed costs of the support department
appears as variable costs to the operating division.
 Consequently, the single rate method may lead division manager to make outsourcing
decision that is in their own best interest but not in the best interest of the organization as
a whole.
Benefit and cost dual rate methods
 A big befit of dual rate method is that it signals to division managers how variable costs
and fixed costs behave differently.

CMA - I 29
  This information guides division managers to make decisions that benefit the
organization as a whole, as well as each division.
 For instance, using a third party computer provider that more than Br 200 per hour would
result in BG and each division being worse off than if BG own Central computer
department were used, because it has a variable cost of Br 200 per hour.
 That is, because fixed costs of resources budgeted to be used by the division bought the
service inside or outside the company.
Allocating costs of multiple support departments
Companies distinguish operating departments (and operating divisions) from support
departments. An operating department, which is, also called a production department in
manufacturing companies, directly adds value to a product or a service. A support department,
which is also called a service department, provides the service that assists other departments
(operating departments and other support departments) in the company.

For instance, in computer department services are provided to other units like: (Business School
and Engineering School). What if the computer department also provided computer services to
other service units such as administration and Library? These services are called reciprocal or
interdepartmental services.

Consider a manufacturing company with two producing department Molding and Finishing, and
two service departments, Facilities management (rent, heat, and light, Janitorial service and so
on) and personnel. All costs in a given service department are assumed to be caused by, and
therefore vary in proportion to, a single cost driver. The company decided the best-cost driver
for facilities management costs is square footage occupied and the best-cost driver for personnel
is the number of employees.

Exhibit below shows the direct costs, square footage occupied, and number of employees for
each department. Note that facilities management provides services for the personnel department
in addition to providing services for the producing departments, and that personnel aids
employees in facilities management as well as those in production departments.

CMA - I 30
 Service Department Production Department
Facilities Management Personnel Molding Finishing
Direct department costs
126,000 birr 24,000 birr 100,000 birr 160,000 birr
Square feet occupied
3000 9000 15,000 3000
Number of Employees
20 30 80 320
Methods for allocating service department costs
There are three popular methods for allocating service department costs that is:
1. The direct method
2. The step– down method, and
3. The Reciprocal method
1. The Direct Method
As its name implies, the direct method ignores other service departments when allocating any
given service department’s costs to the revenue–producing (operating) departments. In other
words, the direct method ignores the services that facilities management provides for personnel
and the services that personnel provide to facilities management. Facilities management costs are
allocated based on the relative square footage occupied by the production departments only.

Total square footage in production departments = 15,000 + 3,000 = 18,000

 Facilities management cost allocated to Molding =15,000/18,000 x 126000 = Br 105,000
 Facilities management cost allocated to Finishing = 3,000/18000 x 126,000 = Br 21,000
Likewise, personnel department costs are allocated only to the production departments on the
basis of the relative number of employees in production departments,
Total number of Employees in production departments (80 + 320) = 400
 Personnel costs allocated to molding = 80/400 x 24000 = Br 4,800
 Personnel costs allocated to Finishing = 320/400 x 24000 = Br 19,200

CMA - I 31
ServiceDepartments Production Departments

Br. 105,000
Facilities management Molding

Br.126,000 Br.100,000
Br.4800 Br.21000
birr
Personnel
Br.24000 Br 19200 Finishing
Br.160,000

Total cost of molding

Its direct cost ------------------------------------------------Br 100,000
Add: cost allocated from Facility management --------Br 105,000
Add: cost allocated from personnel ----------------------Br 4,800
Total cost ----------------------------------Br 209,800
Total cost of Finishing
Its Direct cost ----------------------------------------------160,000
Add: cost allocated from Facility management --------21,000
Add: cost allocated from personnel ----------------------19,200
Total cost ------------------------------------Br 200,200
2. The Step – Down Method
This method recognizes that some service departments support the activities in other service
departments as well as those in operating departments. A sequence of allocations is chosen,
usually by starting with the service department that renders the greatest service (as measured by
costs) to the greatest number of other service departments. The last service department in the
sequence is the one that renders the least service to the least number of other service
departments. Once a department’s costs are allocated to other departments, no subsequent service
department costs are allocated back to it.
Facilities Management cost should be allocated first because facilities management renders more
support to personnel than personnel provides for facilities management. At this point, I know that
you already raised a question of “how should we determine which of the two service departments

CMA - I 32
provides more service to the other? Pretty student one way is to carry out step 1 of step- down
with facilities management allocated first and then repeat it assuming personnel is allocated first.
With facilities management allocated first Br 42,000 (9,000/27,000 x Br 12,6000) is allocated to
personnel if a personnel is allocated first 1,143 birr (20/420 x 24,000) would have been
allocated to facilities management. Because 1,143is smaller than 42,000 facilities management is
allocated first. Therefore, the total cost of the producing department after service department cost
allocated to it under the step down method is as follow:

Service Departments
Production Department

Molding Br 100,000
Br 70,000
FM Br 126,000

Br 70,000

Br 42,000

14000
Personnel Br 13,200
Finishing
Br. 66,000
Br. 160,000

Br 52,800

Facilities Management cost as mentioned already is the service department cost which should be
allocated first; therefore; it is allocated to personnel department too beside the two producing
departments molding and finishing.
Thus, the total square footage in these three departments is (9,000 + 15,000 + 3,000) = Br 27,000
 Facilities management cost allocated to molding (15000/27000 x 126000) = Br
70,000

CMA - I 33
 Facilities management cost allocated to Finishing (3000/27000 x 126000) = Br
14,000
 Facilities management cost allocated to personnel (9000/27000 x 126000) = Br 42,000
 After allocating Facilities management cost we do not allocates any costs back to facilities
management.
 The personnel cost to be allocated to the production departments includes the amount
allocated to personnel from the facilities management ( Br 42,000) in addition to the direct
personnel department costs of Br 24,000 hence, the total cost of personnel department to be
allocated become Br 66,000.
As before, this personnel department costs are allocated only to production departments on the
basis of the relative number of employees in production departments.
Thus, total number of employees in production departments is (80 + 320) = 400
 Costs allocated from personnel to molding ( 80/400 x 66,000) = Br 13,200
 Costs allocated from personnel to Finishing (320/400 x 66,000) = Br 52,800
So, the total cost of molding:
Its direct cost ------------------------------------------------ 100,000
Add: cost allocated from Facility management --------- 70,000
Add: cost allocated from personnel ------------------------ 13,200
Total cost ---------------------------------- Br 183,200
Total cost of Finishing:
Its direct cost ------------------------------------------------160,000
Add: cost allocated from Facility management ---------14,000
Add: cost allocated from personnel -----------------------52,800
Total cost ---------------------------------Br 226,800
Comparison of the Two Methods –Direct Vs Step – Down
Consider the following table.
Molding Finishing
Direct Step - Down Direct Step – Down
Direct dept cost 100,000 100,00 160,000 160,000

CMA - I 34
Allocated from 105,00 70,000 21,000 14,000
Facilities management
Allocated from 4,800 13,200 19,200 52,800
personnel
Total

209,800 183,200 200,200 226,800

As it can be seen from the above exhibit the method of allocation can greatly affect the costs
molding appears to be a much more expensive operation to a manager using direct method than it
does to one using the step – down method. Conversely, Finishing seems more expensive to a
manager using the step – down method.

Which method do you think is better?

Generally, the step – down method is better, because it recognizes the effects of the most
significant support provided by service departments to other service departments. In our
example, the direct method may ignores the following possible cause – effect link:

 If the cost of the facilities management is caused by the space used (square footage
occupied) then the space used by personnel department causes Br 42,000 of facilities
management cost.
 If the space used in personnel is caused by the number of production department
employees supported, then, the number of production department employees, not the
square footage causes Br 42,000 of the facilities management cost.
 The producing department with the most employees not with the most square footage,
should bear this cost.
 The greatest virtue of the direct methods is its simplicity.
 If the two methods do not produce significantly different results many companies elect to
use the direct method because it is easier for managers to understand.
3. The Reciprocal Method

CMA - I 35
The reciprocal method – also called the reciprocal allocation method – allocate service
department costs to producing departments by fully recognizing the mutual services provided
among all support departments
To implement the reciprocal method you are required to formulate and solve linear equations,
which requires three steps as illustrated below.

Step1. Express service department costs and service department reciprocal relationships in the
form of linear equation.
Let:
 “F” be complete reciprocated costs of Facilities Management(FM), and
 “P” be the complete reciprocated costs of the Personnel Department
Then we express data in previous exhibit as follow:
F = 126,000 + 20/420P --------------(1)
P = 24,000 + 9,000/27,000F --------(2)
 The ratio 20/420 or 4.76% in equation (1) is the percentage of personnel services used
by facilities management.
 The 9,000/27,000 or 33.33% in equation (2) is the percentage of facilities management
used by the personnel department.
 By compete reciprocated costs in equation (1) and (2) we mean the support department’s
own costs plus any interdepartmental cost allocations.
Step2. Solve the set of linear equations to obtain the complete reciprocated costs of each service
departments.
Substituting equation (2) into (1)
F = 126,000 + 0.0476P
F = 126,000 +0.0 476 [24,000 + 0.333(F)]
F = 126,000 + 1143 + 0.0158F
F = 127,143 + 0.0158F
(1- 0.0158) F = 127,143
0.9842F = 127,143
F = 127,143/0.9842
F = 129,184

CMA - I 36
Substituting the amount of “F” in Equation (2)
P = 24000 + 0.333F
P = 24000 + 0.3333(129,184)
= 67,057
Step3. Allocate the complete reciprocated costs of each service department to all other
departments (both service departments and operating departments) on the basis of cost driver
used.
Accordingly: Allocating costs of Facility Mgt
Total square footage in all departments other than the FM = 9,000 + 15,000 + 3,000 = 27,000
 FM complete reciprocated cost allocated to Molding = 15,000/27,000 x 129,184 =
71,769
 FM complete reciprocated cost allocated to Finishing = 3000/27000 x 129,184 =
14,354
 FM complete reciprocated cost allocated to personnel = 9000/27000 x 129,184 =
43,061
Allocating costs of Personnel:
Total number of employees in all departments other than Personnel = 20 +80 +320 = 420
 Personnel Dept complete reciprocated cost allocated to Molding = 80/420 x 67,057 =
12,773
 Personnel Dept complete reciprocated cost allocated to Finishing= 320/420 x 67,057 =
51,091
 Personnel Dept complete reciprocated cost allocated to FM = 20/420 x 67,057 = 3,193
Reciprocal cost allocation graphical presentation Production Department

Service Department

Facilities Management
Molding 100,000
71,768 126,000+3,193= 129,193

12,773

3,193 43,061

14,354
Personnel
CMA - I 37
24,000 + 43,061 = 67,061
 51,097 Finishing 160,000

There is a difference between complete reciprocated costs of the support department and its
direct cost. Consider the following table.
Service Department Complete Direct cost Difference
Reciprocated cost
Facilities management 129,193 126,000 3,193
Personnel 67,061 24,000 43,061

Note:
Each support department’s complete reciprocated cost is greater than the budgeted direct cost
amount to take in to account that the allocation of support costs will be made to all departments
using its services and not just to operating departments. It is this step that ensures that the
reciprocal method fully recognizes all interrelationships among support departments as well as
operating departments. However, the total costs allocated to operating departments always
remain the same amount. That is, the total direct costs of support departments, here (126000 +
24000) = 150,000.

Cost allocation in Joint products and By-products

Several manufacturing firm have a single production process yielding two or more products
simultaneously. For instance, sugar producing companies, such as Fincha Sugar Factory,
produces sugar as a main product and other products like molasses as by products; other
companies may produce different main products as in the case of petroleum companies, which
produce different products: Kerosene, Nafta, Gazoline, Benzene, etc from crude oil, using the
same process. Here, you may raise, the question “why we allocate joint costs to individual
products or by products?, this section will give you an answer for this question, and with the
methods employed by companies in order to do so.

Some Terminologies
1. Joint products: Joint products are products that are produced together and are not
separately identifiable as individual products until a certain point in the production process. Two
or more products simultaneously produced from a single set of inputs are called Joint products.

CMA - I 38
Joint products are produced from the same raw material. They are produced simultaneously by a
common process. They may require further processing after their point of separation.
Some for example:
- Oil industry, Gasoline, fuel oil, lubricants, coal tar, kerosene are all products from crude
oil.
- Dairy products, chemicals, meat products and wood products.

2. Joint Cost: A joint cost is the cost of a single process that yields multiple products
simultaneously. Production costs incurred prior to the split off point are called Joint Costs. This
chapter examines methods for allocating Joint costs to products and services. Joint costs are the
costs of producing joint products before the split off point.

3. Main Product: When a single process yielding two or more products yields only one
product with a relatively high sales value, that product is termed as main product.

4. Split-off point: The split-off point is the Juncture in the process where the Joint products
become separately identifiable. An example is the point where coal becomes coke, gas, tar and
other products.

5. Separable Costs: Separable costs are costs incurred beyond the split-off point that are
assignable to one or more individual products. At or beyond the split-off point decisions can be
made independently. Separable costs are the costs of further processing Joint products after the
split-off point.

Joint costs and separable costs generally incurred as direct materials, direct labor and factory
overhead costs.

6. By-products: There are certain industries where the production of main product is
accompanied by production of one or more by-products. The term By-product is generally used
to denote one or more products of relatively small value that are produced simultaneously with a
product of greater value. The product with the greater value is commonly called the main

CMA - I 39
product. In brief, by-products are products of comparatively small value that are produced
incurred to the main product.
Examples:
- A refinery can not only produce gasoline from crude oil, it also simultaneously produces
kerosene, benzene, and naphtha.
- These minor or secondary products have less commercial importance and are treated as
by-products.
- A by-product has a low sales value compared with the sales value of the main product.

Distinction between Joint & By-products

1. Joint products are major products having high total sales value. By-products have low
total sales value. This can be done due to small output or to low unit selling price or to both.
2. By-products are incidental items that accompany the production of major products. The
process would not be carried on to produce the by-products alone.

Why Allocate Joint costs?

There are several reasons why joint costs are allocated to individual products or services. These
reasons include the following:
1. Computation of inventorial costs and cost of goods sold for financial accounting purposes
and reports for income tax authorities.
2. Computation of inventorible costs and cost of goods sold for internal reporting purposes-
such reports are used in division- profitability analysis, and they affect evaluation of division
managers’ performance.
3. Cost reimbursement under contracts when only a portion of a business’s products or
services is sold or delivered to a single customer, say, government agency.
4. Insurance- settlement computations for damage claims made on the basis of cost
information of jointly produced products.
5. Rate regulations for one or more of the jointly produced products or services that are
subject to price regulation.
Hence, for all these reasons; and of course, of several other reasons joint cost allocation is an
important issue in accounting.

CMA - I 40
Methods of Allocating Joint Costs
The purpose of Joint-product cost allocation is to allocate joint costs to the joint products which
are the cost objectives. The cost allocation base is determined by the joint-product cost allocation
method used. The most frequently used methods involve the use of the following three methods.

1. Sales value at split-off method

2. Physical measure method
3. Estimated Net Realizable value method

1. Sales value at Split-off Method:

The sales value at split-off method allocates Joint costs on the basis of the relative sales value of
each Joint product at the split-off point of the total production. Note that this method uses the
sales value of the entire production of the accounting period. The Joint costs were incurred on all
units produced and not just those sold.
You would compute this value by multiplying the sales price at the split-off point by the units of
production. You would then find each product’s proposition of the total sales value, and you use
this production to allocate the joint costs.
2. Physical Measure Method or physical Units Method
The physical measure method uses same physical measure, such as pounds, gallons of units of
production, as the base for allocating Joint costs to Joint products.

For example; if two joint products can be measured in terms of gallons, you can use the
proposition of gallons for each product to allocate joint costs to the two products. To allocate the
costs, you would multiply the proposition of the total base for each product by the joint costs.

3. Estimated Net Realizable Value Method

The net realizable value method allocates joint cost based on the relative net realizable value of
the joint products at the split-off point. This method is generally used when the sales value at the
split-off point is not known. The net realizable value at the split-off point can be interpreted as an

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estimate of the sales value at the split-off point. You would compute the net realizable value at
the split-off point as follows:

Estimated NRV= Sales Value at Completion - Separable Costs at the split-off point

The separable processing costs must be deducted from the sales value to arrive at the net
realizable value at the split-off point.

EXAMPLE:
Youbdo Micro enterprise purchases raw milk from individual farm and processes it until the split
off point, where two products- cream and liquid skim-emerges. These two products are sold to an
independent company, which markets and distributes them to supermarkets and other retail out
lets.

Summary data for May 2010 are the following

Raw milk processed (having joint costs $ 400,000), 110,000 gallons; 10,000 gallons are lost in
the production process due to evaporation, spoilage, and the like, yielding 25,000 gallons of
cream and 75,000 gallons of liquid skim.

Production Sales
Cream………..25,000 gallons 20,000 gallons at $ 8 per gallon
Liquid skim…...75,000 gallons 30,000 gallons at $ 4 per gallon

Inventory:
Beginning inventory Ending Inventory
Raw milk 0 Gallons 0 gallons
Cream 0 gallons 5,000 gallons
Liquid skim 0 gallons 45,000 gallons

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Cost of purchasing 110,000 gallons of raw milk and processing it until the split off point to yield
cream and liquid skim is $ 400,000.

The above data depicted as shown below.

-----------Joint cost---------

Raw milk
(110,000)

Required:
Allocate the Joint cost using the three cost allocation methods mentioned above.

1. Sales Value at Split off Method

The sales value at split off method allocates joint costs to joint products on the basis of the
relative total sales value at the split off point of the total production of these products during the
accounting period.

Cream Liquid skim Total

Sales value of total production at split- off point (cream, 25,000 gallons x 8/gallon;
75,000 liquid skim,75,000 gallons x $ 4/ gallon)

$200,000

$300,000

$500,000
Weighting ($200,000÷$500,000;
$300,000÷$500,000) 0.40 0.60 100%
Joint costs allocated (cream, 0.4 x $400,000);

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(Liquid skim, 0.6 x $400,000)
$160,000
$240,000
$400,000
Joint production cost per gallon (cream,$160,000÷25,000gallon,liquid skim,
$240,000÷75,000gallon)
$6.4/gallon

$3.2/gallon

Note that, you can now see why the sales value at split off method follows the benefits received
criterion of cost allocation: costs are allocated to products in proportion to their expected
revenues. That is, this method uses the sales value of the entire production of the accounting
period not just the quantity sold; the justification is that the joint costs were incurred on all units
produced, not just the portion sold during the current period.

The product line Income statement can be presented as follows.

Cream Liquid Skim Total

Sales (20,000@8; 30,000@4) 160,000 120,000 280,000
Cost of goods sold:
(20,000@ $6.4; 30,000@$3.2) (128,000) (96,000) (224,000)
Gross Margin: $32,000 24,000 56,000

Cost of ending inventory

The cost ending inventory of the 5,000 gallon of cream and 45,000 gallon of Liquid skim can be
computed as follows.
5,000 gallon of cream 5,000 x 6.4 = $32,000

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 45,000 gallons of Liquid skim 45,000x 3.2 = $144,000
Cost of ending inventory….…$ 176,000
2. Physical Measure Method
It allocates joint costs to joint products on the basis of the relative weight, volume, or other
physical measure at the split off point of the total production of these products during the
accounting period. In the above example, the $400,000 joint costs produced 25,000 gallons of
cream and 75,000 gallons of liquid skim. Using the number of gallons produced as the physical
measure, joint costs are allocated as follows:
Cream Liquid skim Total
Physical measure of total production
(gallons)
25,000
75,000
100,000
Weighting (cream 25,000 gallons ÷100,000 gallons,
Liquid Skim 75,000 gallons ÷100,000 gallons) 0.25
0.75
Joint costs allocated (cream, 0.25 x $400,000,
liquid skim, 0.75 x $400,000)
$100,000

$300,000
$400,000
Joint production cost per gallon (cream,
$100,000 ÷ 25,000Gallons; liquid skim,
$300,000 ÷75,000 gallons)
$4 per gallon
$4per gallon

Note: Because the physical-measure method allocates joint costs on the basis of gallons
produced, cost per gallon is the same for both products.

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The following is product line income statement under this method:
Cream Liquid skims Total
Sale (20,000@8, 30,000@4) 160,000 120,000 280,000
Cost of goods sold
(20,000@4; 30,000@4) (80,000) (120,000) (200,000)
Gross margin $80,000 0 80,000

Cost of ending inventory

The cost ending inventory of the 5,000 gallon of cream and 45,000 gallon of Liquid skim can be
computed as follows.
5,000 gallon of cream 5,000 x 4 = $20,000
45,000 gallons of Liquid skim 45,000x 4 = $180,000
Cost of ending inventory….…$ 200,000

3. Net Realizable Value (NRV) Method

In many cases, products are processed beyond the split off point to bring them to marketable
form or to increase their value above their selling prices at the split off points. Assume the same
data as in example above except that here both cream and liquid skim can be processed further:
• Cream- Cream can be further processed to give butter cream. The 25,000 gallons of
cream yield 20,000 gallons of butter cream at additional processing cost of birr $280,000.
• Liquid skim- Liquid skim is processed further to get condensed milk. The 75,000 gallons
of liquid skim are processed further to yield 50,000 gallons of condensed milk at additional
processing cost of $520,000.
• Sales during the month was 12,000 gallons of butter cream for $25 per gallon and 45,000
gallons of condensed milk for $22 per gallon.

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Graphical Presentation
……………Joint cost……………………………….separable costs……………….

Raw milk

Split off point

The Net realizable value (NRV) method allocates joint costs to joint products on the basis of the
relative NRV-the final sales value minus the separable costs of the total production of the joint
products during the accounting period.

Joint costs in this example are allocated as follows.

Butter cream condensed milk Total
Final sales value of the total production
(butter cream, 20,000 gallons x$25/gal ;
condensed milk 50,000gallonsx$22/gal)

$500,000

$1,100,000

$1,600,000
Deduct: Separable costs to complete and sell (280,000) (520,000) (800,000)
NRV at split off point $220,000 $580, 000
$800,000
Weighting: Butter cream, ($220,000÷$800,000, condensed milk $580,000 ÷$800,000

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0.275
0.725
Joint costs allocated, (butter cream,
0.275x$400,000; condensed milk 0.725x$400,000)

$110,000

$290,000

$400,000
Production cost per gallon (Butter cream, $110,000+$280,000) ÷20,000gal;Condensed milk,
($290,000+$520,000) ÷50,000 gallons
$19.5/gal
$16.2/gal

The Product line income statement using the estimated NRV method is presented below:
Butter cream Condensed Milk Total
Sales (12,000@ 25; 45,000@22) $300,000 990,000 1,290,000
Cost of goods sold:
(12,000@19.5; 45,000@16.20 234,000 729,000 963,000
Gross Margin $ 66,000 261,000 327,000

Cost of ending inventory

Butter cream 8,000@19.5 = 156,000
Condensed Milk 5,000@16.20 = 81, 000
Total $237,000

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 Chapter Six
Activity Costing and management

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CMA - I 50