Cost Accounting Notes

Intro to Cost Accounting

1.1: Define Managerial Accounting

  • Cost accounting is a part of managerial accounting which focuses on understanding and managing costs within a business for informed decision-making.

  • Financial accounting provides information for external decision-makers such as investors, creditors, and government agencies.

    • It focuses on preparing financial statements and reporting monetary transactions.
    • It looks at past activities and results, ensuring information relevance and faithful representation.
    • Emphasis is on the entire business, with adequacy of disclosures prioritized.
    • Behavioral implications are secondary.

  • Managerial accounting involves collecting, analyzing, and using financial information to aid internal decision-making.

    • It's for internal use only, like employees and managers.
    • It primarily looks towards the future, using current information to improve future business.
    • Requires detailed reports on company sections regularly, like daily or weekly.
    • Considers how reports will affect employee behavior.

  • Managerial Functions:

    1. Planning: Setting goals and strategies to achieve them.
      • Operational planning: Short-term focus on daily operations (e.g., yearly budget, sales projections).
      • Strategic planning: Long-term focus (e.g., shifting from a service to a manufacturing company).
    2. Directing: Managing daily operations and implementing plans (e.g., overseeing production, coordinating resources).
    3. Controlling: Measuring performance against the plan and making necessary adjustments (e.g., monitoring operations, analyzing results vs. budget, suggesting improvements).

  • Organizational Charts: Illustrate relationships between departments, divisions, and managers responsible for each section.

1.2: Service, Merchandising, and Manufacturing Companies

  • Typical Organizational Chart:

    1. Board of Directors: Develops strategic goals, elected by stockholders.
    2. Chief Executive Officer (CEO): Ultimate responsibility, implements short and long-term plans.
    3. Line Positions: Directly involved in providing goods or services (e.g., controller, software development manager).
    4. Staff Positions: Support line positions (e.g., sales manager, production manager).

  • Service Companies:

    • Sell services, not physical products, utilizing skills and knowledge (e.g., hair salons, lawyers, consultants).
    • No inventory.

  • Merchandising Companies:

    • Buy finished products and sell them (e.g., H&M, Amazon).
    • Have Merchandise Inventory (goods bought but unsold).
    • Carry merchandise inventory on the balance sheet.

  • Manufacturing Companies:

    • Purchase raw materials, convert them into finished goods using labor, equipment, supplies, and facilities (e.g., Nike, Samsung).
    • Three types of inventory:
      • Raw Materials Inventory: Unused materials (e.g., fabric).
      • Work-in-Process (WIP): Partially finished items.
      • Finished Goods: Products ready to sell.
    • Carry inventory on the balance sheet.

1.3: Classify Costs & 1.4: Prepare Income Statement and Schedule of Cost of Goods Manufactured

  • Costs Classification:

    • Traceability:
      • Direct: Easily traced to a cost object (e.g., product, department).
      • Indirect: Not easily traced to a cost object.
    • Cause: Classify as product cost or period cost.
    • Behavior: Fixed, variable, or mixed.

  • Costs for Service Companies:

    • Direct Costs: Wages of service staff (e.g., haircutting staff).
    • Overhead: Rent, electricity, etc.

  • Costs for Merchandising Companies:

    • Cost of Goods Sold (COGS): What you paid for the product.
    • Example: Buy shirt for €10, sell for €20; cost is €10.

  • Costs for Manufacturing Companies:

    • Product Costs: Used to make the product.
      • Direct Materials: Materials that become part of the finished product and are easily traced (e.g., cotton for a T-shirt).
      • Direct Labor: Labor costs of employees converting raw materials into finished goods (e.g., sewing staff).
      • Manufacturing Overhead: Indirect manufacturing costs (e.g., electricity, machine maintenance, factory supervisors’ salary).
        • Indirect Materials: Raw materials hard to trace.
        • Indirect Labor: Labor costs of factory staff not directly producing the product.
      • These costs are initially inventoried, then expensed when the product is sold.
    • Period Costs: Not related to production (e.g., marketing, administration, office rent).
      • Expensed directly in the income statement when incurred.

  • COGM → COGS → Income Statement

  • Schedule of Cost of Goods Manufactured (COGM):

    • Shows total cost of making products.
    • Components:
      • Direct Materials Used
      • + Direct Labor
      • + Manufacturing Overhead
      • = Total Manufacturing Costs
      • + Beginning Work-in-Process Inventory
      • - Ending Work-in-Process Inventory
      • = Cost of Goods Manufactured (COGM)

  • Income Statement (Manufacturing):

    • Shows profit/loss.
    • Components:
      • Sales Revenue
      • - Cost of Goods Sold (COGS)
      • = Gross Profit
      • - Operating Expenses (Period Costs)
      • = Net Income

  • COGS=BeginningFinishedGoods+COGM−EndingFinishedGoodsCOGS = Beginning Finished Goods + COGM - Ending Finished Goods

  • Calculating cost of goods manufactured

  • Cost Per Item:

    • Costperitem=Numberofunitsproduced/COGMCost per item = Number of units produced / COGM
    • Includes direct materials, direct labor, and manufacturing overhead.
    • Does not include marketing, distribution, or admin costs (period costs).
    • Only finished products are used in COGS and income statements.
    • COGM is based on what’s completed during the period, not sold.

  • Costs in Manufacturing Company:

    1. Raw Materials Inventory:
      • Company purchases raw materials (direct and indirect).
      • Materials recorded as raw materials inventory on the balance sheet.
      • Unused raw materials stay in inventory.
    2. Direct Materials, Direct Labor, and Manufacturing Overhead:
      • Production begins:
        • Direct materials are taken from inventory and used.
        • Direct labor is added (wages for workers directly making the product).
        • Manufacturing overhead is added (includes indirect labor, indirect materials, and other factory-related costs).
        • These three make up the total manufacturing costs, added into WIP Inventory.
    3. Work-In-Process (WIP) Inventory:
      • Products being worked on are part of WIP inventory on the balance sheet.
      • At the end of the period, unfinished goods remain in WIP inventory.
    4. Finished Goods Inventory:
      • Once production is complete, finished products move from WIP to Finished Goods Inventory.
      • These are completed but not yet sold and remain on the Balance Sheet until sold.
    5. Cost of Goods Manufactured (COGM):
      • All costs added to production during the period, plus beginning WIP and minus ending WIP, result in the COGM.
      • COGM is transferred to Finished Goods Inventory and shown on the Income Statement.
    6. Cost of Goods Sold (COGS):
      • When finished products are sold, the cost moves from Finished Goods Inventory to the Income Statement as an expense.
      • This cost is then subtracted from revenue to determine gross profit.

1.5: Calculate Cost per Service/Item

  • Flow of Costs Through Inventory Accounts:

    • Beginning balance + additions - ending balance = amount used, manufactured, or sold.

  • Cost per Service (Service Company):

    • Costperservice=Totalcosts/NumberofservicesprovidedCost per service = Total costs / Number of services provided
    • Helps managers set the price on each service provided.

  • Cost per Item (Merchandising Company):

    • Costperitem=(Purchasecost+shipping)/NumberofitemsboughtCost per item = (Purchase cost + shipping) / Number of items bought
    • Helps managers set appropriate prices/determine which products are most profitable.

  • Cost per Unit (Manufacturing Company):

    • Costperunit=COGM/NumberofunitsproducedCost per unit = COGM / Number of units produced

1.6: Discuss Business Trends

  • Technology & Automation: Machines replace people, shifting costs from labor to equipment.

  • Sustainability: Tracking environmental costs (e.g., carbon emissions, recycling).

  • Real-Time Data: Digital tools track costs instantly.

  • Globalization: Complex cost tracking due to businesses producing/selling in many countries.

  • Lean Production: Reducing waste and increasing efficiency.

  • Time-Based Competition:

    • Enterprise Resource Planning (ERP) systems integrate companies' data.
    • E-commerce allows companies to sell products worldwide.
    • Just-in-time management is an inventory management tool.

  • Total-Quality Management:

    • A philosophy of continuous improvement creating a culture of cooperation.

  • Value Chain: Each step adds value to the end product.

    • R&D → design → production → marketing and sales → distribution → customer support

  • Cost Accounting System:

    • Accumulates product cost information.
    • Helps set selling prices, compute COGS, and compute cost of inventory.
    • Used to plan and control the cost of resources needed to create a product and deliver it to a customer.

  • Job Order Costing System:

    • Used when products are made individually or in small batches with unique characteristics.
    • Accumulates costs by job.
    • Realized by an ERP-system.
    • Examples: accounting firms, healthcare providers, custom furniture manufacturers.

  • Process Costing System:

    • Used for mass production of identical items produced through a series of steps.
    • Accumulates costs by process.
    • Example: soft drink company, surfboard manufacturer.

Chapter 2: Job Order Costing

2.1: Job Order Costing vs. Process Costing

  • Job order: Costs tracked per job or batch

  • Process: Costs tracked per process/department

  • 4-step method to track product costs

    1. Accumulate costs by the accounting system
    2. Assign direct costs to different products or services
    3. Allocate indirect costs (specifically for manufacturing overhead) to jobs or products
    4. Adjust allocated costs for overhead

  • Job cost record: document that shows the direct materials, direct labour, and manufacturing overhead costs for an individual job

  • Cost flow for production

    • Raw materials inventory (balance sheet)
    • WIP inventory (balance sheet)
    • Finished goods inventory (balance sheet)
    • COGS (income statement)

  • Product costs for each job are recorded on individual job cost records

  • Cost flow: balance sheet parts

    1. Costs incurred: costs incurred for each job + WIP with debits
    2. COGM: when job is done, costs are transferred out of WIP with a credit and transferred into FG with a debit
    3. COGS: when job is sold, costs are transferred out of FG with a credit and transferred into COGS with a debit

  • Cost flow of materials → transactions on T diagram

    1. Purchase raw materials: debit raw materials inventory
      • Credit accounts payable
    2. Using raw materials: WIP inventory (debit)

  • General ledger accounts: accounts receivable, raw materials, accounts payable

  • Raw materials subsidiary ledger accounts: a separate record for each type of raw material.

2.2 Record materials and labour costs in a job order costing system
  • Purchased, issued into production, new balance
  • Manufacturing overhead: temporary account used to accumulate costs, equity account
  • Cost flow of labour in production process
    • Most companies use electronic labour/time records
    • Employees use ID cards to swipe and enter job information
    • Labour time record: record used to assign direct labour costs to specific jobs
  • Journal entries and accounting equation
    • Total labour costs: direct labour + indirect labour
    • Effects on accounting equation
      ■ Assets increase = liabilities increase + equity decrease
      ■ WIP increase = wages payable increase + manufacturing overhead decreases
  • Manufacturing overhead journal entries and allocation
    • Debit manufacturing overhead, credit accumulated depreciation
    • Debit manufacturing overhead, credit cash
    • Debit manufacturing overhead, credit prepaid insurance
    • Debit manufacturing overhead, credit property taxes payable
2.3 How do overhead costs flow through the job order costing system

  • 3- step process for allocating overhead costs to specific jobs

    1. Calculating the predetermined overhead rate before the period begins
    2. Allocating overhead during the period
    3. Adjusting overhead at the end of the period

  • Step 1

    • Predetermined overhead allocation rate: estimated overhead cost per unit of the allocation base calculated at the beginning of the accounting period
    • Total estimated overhead costs / total estimated quantity of overhead allocation base
      • Allocation base: a denominator that links indirect costs to cost objects
        ■ Cost driver: primary factor that causes a cost to increase or decrease
        ■ Common production cost drivers
        ■ Cost driver for labour intensive production: labour use
        ■ Cost driver for machine intensive production: machine use

  • Allocation base for labour intensive production direct labour hours (direct labour cost)

  • Allocation base for machine intensive production: machine hours

  • Result: predetermined overhead allocation rate, that tells you how much overhead to apply per unit of the activity base

  • Step 2

    • Allocated manufacturing overhead cost = predetermined overhead allocation rate x actual quantity of allocation base used by each job
2.4 What happens when products are completed and sold

  • Step 3

    • Balance = actual cost - allocated costs
    • Underallocated = need adjustment

  • Transferring costs to finished goods inventory

    • Once jobs are finished, the costs leave the WIP accounts (credit WIP, debit finished goods)
    • Debit accounts receivable, credit sales revenue
    • Debit COGS, credit finished goods inventory

  • Manufacturing overhead

    • includes all indirect production costs like factory rent, indirect labor, depreciation, insurance, and utilities
    • these costs cannot be traced directly to specific jobs, so they are allocated using a predetermined rate
2.5 How is the manufacturing overhead account adjusted

  • Why is overhead adjusted at the end of the period

    • Because the actual overhead costs and the allocated (estimated) costs are rarely the same.

  • What is underallocated overhead

    • actual overhead was higher than what was allocated
    • Adjustment is needed → Debit COGS, Credit MOH

  • What is overallocated overhead

    • actual overhead was less than the allocated amount
    • Adjustment is needed → Debit MOH, Credit COGS

  • What journal entry corrects underallocated MOH?

    • Debit: COGS
    • Credit: Manufacturing Overhead
    • This increases the COGS to reflect the actual higher overhead costs

  • three stages of tracking MOH in job order costing

    1. Before the period: Estimate overhead and calculate the predetermined rate
    2. During the period: Allocate overhead using the rate
    3. After the period: Adjust for under- or overallocation

  • How do you calculate allocated overhead per job?

    • Allocated MOH = POHR × Actual quantity of allocation base used

  • How is MOH shown in a T-account

    • Left side (Debits): Actual overhead costs
    • Right side (Credits): Allocated overhead
    • If the left > right → Underallocated, needs adjusting

  • COGM calculation table

  • Beginning WIP Inventory 80,00080,000

  • + Direct Materials Used 355,000355,000

  • + Direct Labor 169,000169,000

  • + MOH Allocated 67,60067,600

  • = Total Costs Incurred 591,600591,600

  • + Beginning Inventory 80,00080,000

  • - Ending WIP Inventory −27,000-27,000

  • = COGM 644,600644,600

  • COGS calculation table

  • Beginning FG Inventory 00

  • + COGM 644,600644,600

  • = Goods Available for Sale644,600644,600

  • - Ending FG Inventory −60,000-60,000

  • = COGS before Adjustment584,600584,600

2.6 How do service companies use a job order costing system

  • + Underallocated OH Adjustment +15,40015,400

  • = Final COGS600,000600,000

  • Income statement flow calculation table

  • Sales Revenue 1,200,0001,200,000

  • – COGS −600,000-600,000

  • = Gross Profit 600,000600,000

  • – Selling/Admin Expenses −241,000-241,000

  • = Operating Income 359,000359,000

  • – Other Expenses (Interest) −7,600-7,600

  • – Income Tax −53,000-53,000

  • = Net Income 298,400298,400

  • Service company: company that sells services → has no inventory

  • Management question: what did it cost us to provide a service?

  • Cost accounting: helps managers set the price on each service provided

    1. Assign costs
      • Most assigned cost: direct labour
    2. Allocate indirect costs
      • Allocation base: direct labour hours
    • Predetermined overhead allocation rate → estimate
      ■ indirect costs / direct labour hours
    • Allocated indirect costs = $ per direct labour hour x number of labour hours

  • Calculate total costs, total hourly rate, markup, and selling price

    • Total costs = direct labour + indirect cost
    • Total hourly rate for firm = direct labour hours + indirect cost per hour
    • markup = total cost x markup percentage
    • Selling price = total cost = markup

  • Job order costing

    • Manufactures batches of unique products or provides specialised services
    • Cost accumulation by job
    • WIP inventory: one general ledger account with a subsidiary ledger containing individual job cost sheets
    • Record keeping: job cost sheet for each job
    • Cost transfers done when each job is completed

Chapter 3: Process Costing

3.1 How do costs flow through a process costing system

  • Process costing

    • Manufactures identical products through a series of uniform steps/processes
    • Cost accumulation by process
    • WIP inventory: separate WIP inventory accounts for each process or department
    • Record keeping: production cost report for each process or department
    • Cost transfers at the end of the accounting period

  • Flow of costs through process costing system

    • Step 1: accumulated costs for materials, labour, manufacturing overhead
    • Step 2: transferred and accumulated costs for materials, labour, manufacturing overhead

  • Use of cost per unit information

    • Control costs: company can look for ways to cut costs in each process
    • Set selling prices: setting and selling price to cover costs plus make a profit
    • Calculate account balances: need to know for WIP inventory, finished goods inventory, COGS

  • At the end of the period, total production costs incurred in each process must be split between units that are:

    • finished in that process and transferred to the next process, or to finished goods if it’s the last process
    • Any units that are still in process within that department
3.2 What are equivalent units of production and how are they calculated
  • Equivalent units of production (EUP)
    • Used to measure amount of materials added to, or work done on, partially completed units
    • Expressed in terms of fully completed units
    • Prime costs: direct materials
    • Conversion costs: manufacturing overhead
    • Conversion costs = direct labour + manufacturing overhead
    • Combination: direct labour
3.3 How is a production cost report prepared for the first department

  • Production cost report

    • Report prepared by a processing department for equivalent units of production, production costs, and the assignment of those costs to the completed and in process units

  • Steps for production cost report

    1. Summarise the flow of physical units
    2. Compute output in terms of EUP
    3. Compute the cost per EUP
    4. Assign costs to completed units and units in process

  • Steps 1 and 2 units

    • ‘To account for’: amount in process at the beginning + amount started/added during the period
    • ‘Accounted for’: what happened to the amounts to account for → completed and transferred out + in process

  • Step 1: summarise the flow of physical units

    • Units to account for (beginning WIP + started in production)
    • Units accounted for (completed and transferred out + ending WIP)
    • Ending WIP: units, percent complete (direct materials + conversion costs)

  • Step 2: compute output in terms of EUP

    • Adds all direct materials at the beginning of the process
    • Conversion costs: incurred evenly during the process → we must calculate EUP for conversion costs
    • Process costing methods
      ■ weighted-average method: determines the average cost of EUP by combining beginning inventory costs with current period costs
      ■ FIFO method

  • Step 3: compute cost per EUP

    • Cost per EUP for direct materials = total direct material costs / EUP for direct materials
    • Cost per EUP for conversion costs = total conversion costs / EUP for conversion costs

  • Step 4: assign costs to be completed units and units in process

    • Direct materials + conversion costs → total cost accounted for
3.4 How is a production cost report prepared for subsequent departments
  • Transferred in costs: costs that were incurred in a previous process and brought into a later process as part of the product’s cost
  • Conversion costs: incurred evenly during the process
  • Direct materials: added at the end of the process
  • Cost per EUP for transferred in = total transferred in costs / EUP for transferred in
3.5 What journal entries are required in a process costing system
  • 4 step method to track product costs
    1. Accumulate costs
    2. Assign costs → at the end of an accounting period, permanent
    3. Allocate costs → overhead, job, process
    4. Adjust costs → overhead
  • Transactions in journal entries required in a process costing system
    1. Buy raw materials: debit raw materials inventory, credit accounts payable
    2. Use materials in production: debit WIP inventory, credit raw materials inventory
    3. Record direct labour: debit WIP inventory, credit wages payable
    4. Apply manufacturing overhead: debit WIP inventory, credit manufacturing overhead
    5. Record actual overhead costs: debit manufacturing overhead, credit accumulated depreciation and cash
    6. Transfer between departments: debit WIP (receiving dept), credit WIP (sending dept)
    7. Transfer to finished goods: debit finished goods inventory, credit WIP inventory
    8. Sale of goods: debit accounts receivable and COGS, credit sales revenue and finished goods inventory
    9. Adjusting manufacturing overhead: debit manufacturing overhead, credit COGS
  • T-accounts: debits on the left, credits on the right
3.6 How can the production cost report be used to make decisions
  • Production cost report: report prepared by a processing department for equivalent units of production, production costs, and the assignment of those costs to the completed and in process units
  • Used for management decisions and financial statements
  • Management decisions
    • Controlling cost
    • Evaluate performance
    • Pricing products
    • Profitable products
  • Prepare financial statements
3.7 How is a production cost report prepared using the FIFO method
  • Weighted-average method: determines the average cost of EUP by combining beginning inventory costs with and current period costs
    • Cost changes are not exposed
  • FIFO method: determines the cost of EUP by accounting for beginning inventory costs separately from current period costs → it assumes that the first units started in the production process are the first units completed and sold
    • Better month-to-month cost comparison → benefits if a business operates in an industry that experiences significant cost changes