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Prime Cost = Direct Materials Cost + Direct Labor Cost

Conversion Cost = Direct Labor Cost + Factory Overhead Cost
Total Factory/Manuf. Cost = Direct Materials + Direct Labor Cost + Factory
Overhead
COGM = Total Factory Cost + Opening WIP Inventory Ending WIP Inventory
Or
COGM = Direct materials cost + Direct labor cost + Factory overhead cost +
Opening WIP Inventory Ending WIP Inventory
COGS = COGM + Opening finished goods inventory Ending finished goods
inventory
Or
COGS = Direct materials cost + Direct labor cost + Factory overhead cost +
Opening work in process inventory Ending work in process inventory +
Opening finished goods inventory Ending finished goods inventory
# units manufactured = Units sold + Ending Finished Goods units Opening
finished goods units
Per unit cost of goods manufactured = COGM / Units manufactured
Materials used or consumed = Opening inventory or materials + Net
purchases of materials Ending inventory of materials
Gross profit = Net sales COGS
Operating profit = Gross profit Operating expenses
Operating/commercial expenses = Selling/marketing expenses + Gen./admin
expenses
Per unit gross profit = Gross profit / No. of units sold
Per unit net profit = Net profit / No. of units sold
Percentage of GP to sales = (Gross profit / Net sales) 100
Percentage of net profit to sales = (Net profit / Net sales) 100

Manufacturing Overhead Budget Definition:

Manufacturing overhead budget is a detailed plan showing the production costs,
other than direct materials and direct labor, that will be incurred over
a specified time period.

How to Calculate Product Costs for a Manufacturer

Because most businesses produce multiple products, their accounting systems
must be very complex and detailed to keep accurate track of all direct and
indirect (allocated) manufacturing costs.

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The basic equation for calculating product cost is as follows (using the example
of the manufacturer given in the figure below):
$91,200,000 total manufacturing costs 120,000 units production output
= $760 product cost per unit
The equation shown above looks pretty straightforward, doesnt it? Well, the
equation itself may be simple, but the accuracy of the results depends directly
on the accuracy of your manufacturing cost numbers. The business
example shown in the image manufactures one product. Even so, a single
manufacturing process can be fairly complex, with hundreds or thousands of
steps and operations.

Example for determining the product cost of a manufacturer.

In the example, the business manufactured 120,000 units and sold 110,000
units during the year, and its product cost per unit is $760. The 110,000 total
units sold during the year is multiplied by the $760 product cost to compute the
$83.6 million cost of goods sold expense, which is deducted against the
companys revenue from selling 110,000 units during the year.

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The companys total manufacturing costs for the year were $91.2 million, which
is $7.6 million more than the cost of goods sold expense. The remainder of the
total annual manufacturing costs is recorded as an increase in the companys
inventory asset account, to recognize that 10,000 units manufactured this year
are awaiting sale in the future. In the figure, note that the $760 product cost per
unit is applied both to the 110,000 units sold and to the 10,000 units added to
inventory.
The product cost per unit for the example business is determined for the entire
year. In actual practice, manufacturers calculate their product costs monthly or
quarterly. The computation process is the same, but the frequency of doing the
computation varies from business to business.
Product costs likely will vary each successive period the costs are determined.
Because the product costs vary from period to period, the business must choose
which cost of goods sold and inventory costmethod to use. (If product cost
happened to remain absolutely flat and constant period to period, the different
methods would yield the same results.)

How to Determine Cost of Goods Manufactured

Cost of goods manufactured is based on the amount of work-in-process
completed. This work-in-process includes costs of direct materials put into
production, plus direct labor and overhead.
To determine work-in-process, you enter the number of units or costs into the
same outputs formula that you use to calculate direct materials put into
production.

Number of units manufactured

Knowing how many units of direct materials each finished product requires helps
you figure out how many units you manufacture and how much those units cost.

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For example, to make one gallon of chocolate milk, you need 0.950 gallons of
whole milk and 0.05 gallons of chocolate syrup.
To compute the number of units manufactured, start with the number of units of
work-in-process in beginning inventory (Beginning). Add the number of units of
direct materials put into production (Inputs) and then subtract the number of
units of work-in-process in ending inventory (Outputs).
Suppose that your chocolate milk factory started the year with 200 gallons of
unmixed ingredients in the blenders. During the year, another 4,000 gallons of
ingredients were taken out of storage and poured into the blenders. At the end
of the year, 300 gallons of unmixed ingredients were still in the blenders
(planned for production next year). Plug these numbers into the outputs formula:

The factory completed 3,900 gallons of chocolate milk during the period. From
here, youre ready to figure out the total cost of chocolate milk manufactured
and its cost per unit.

Cost of goods manufactured

Direct materials, direct labor, and overhead all get input into the production
process. Therefore, to compute the cost of goods manufactured, think about all
product costs, including not only direct materials but also direct labor and
overhead.
Consider the cost of goods manufactured for the chocolate milk factory. Your
beginning inventory cost $2,000. The factory put $10,000 worth of direct
materials into production and spent $5,000 on direct labor and another $4,000
on overhead. At the end of the year, you counted $3,000 worth of ending
inventory. Feeling overwhelmed? Hang in there! To compute cost of goods
manufactured, just apply the outputs formula:

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This result tells you that the factorys output of chocolate milk during the year
cost $18,000.
Cost Accounting For Dummies Cheat Sheet
To reduce and eliminate costs in a business, you need to know the formulas that
are most often used in cost accounting. When you understand and use these
foundational formulas, youll be able to analyze a products price and increase
profits.

Breakeven Formula:Profit ($0) = sales variable costs fixed costs

Target Net Income = sales variable costs fixed costs
Gross Margin = sale price cost of sales (material and labor)
Contribution Margin:Contribution margin = sales variable costs
Pre-Tax Dollars Needed for Purchase = cost of item (1 - tax rate)
Price Variance = (actual price - budgeted price) (actual units sold)
Efficiency Variance = (Actual quantity budgeted quantity) (standard price
or rate)
Variable Overhead Variance = spending variance + efficiency variance
Ending Inventory = beginning inventory + purchases cost of sales

How to Allocate Fixed Overhead Costs in Cost Accounting

When cost accounting, the more accurately you allocate fixed overhead costs,
the more accurately your products total costs are reflected. If total cost is
accurate, you can add a profit and calculate an accurate sale price. To more
accurately allocate fixed overhead you use cost pools and cost allocations to
compute a cost allocation rate.

Compute a cost allocation rate in cost accounting

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Say you make car tires. Your cost pool for fixed overhead includes machine
depreciation, utility costs, and salary costs for your security guard. The annual
budgeted costs total $120,000, and you have 20,000 total machine hours
budgeted. Use these formulas and these numbers to compute your cost
allocation rate:

Budgeted cost allocation rate = $120,000 cost 20,000 machine hours

Budgeted cost allocation rate = $6 per machine hour
You determine that a budgeted quantity per unit (per tire) is 30 minutes. Here is
your budgeted fixed manufacturing overhead cost per unit:

Fixed overhead cost per unit = .5 hours per tire x $6 cost allocation rate per
machine hour
Fixed overhead cost per unit = $3
Each tire has direct costs (steel belts, tread) and $3 in fixed overhead built into
it.
Next, apply actual costs and the static budget. Take the total cost pool of
$120,000 and simply divide it over 12 months. Your monthly static budget is
$120,000 12 months. Thats $10,000 per month.

Calculate flexible budget variances rate in cost accounting

You can now calculate a fixed overhead flexible-budget variance (sometimes
referred to as a spending variance). A flexible budget changes as activity levels
(sales, production) change. Because fixed costs do not change within a relevant
range, there is no adjustment of budgeted fixed costs from a static to a flexible
budget. This holds true as long as actual costs are within the relevant range.
Bad news. The static budget simply took the annual cost pool amount of
$120,000 and divided by 12 months. But say total actual costs for April are
$11,000. You have a variance, and it is not favorable. Heres the formula:
Fixed overhead flexible budget variance = actual cost static budget
Fixed overhead flexible-budget variance = $11,000 - $10,000

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Fixed overhead flexible-budget variance = $1,000 unfavorable variance
The variance is unfavorable because your actual spending ($11,000) was more
than the static budget ($10,000). If youre dealing with a spending variance, a
positive number is an unfavorable variance. You spent more than planned.

Use production volume variances rate in cost accounting

An efficiency variance means that you used either more or less of the input
(material, labor) than you planned. The variance reflects how efficiently you
used your inputs to create a product or service.
For fixed overhead, there isnt an efficiency variance. The fixed cost is what it is.
You incur the same amount of fixed costs regardless of how efficiently you
produce your goods. If your actual production is higher or lower than planned, it
doesnt change your flexible budget total for fixed overhead variance.
Whatcha gonna do? Instead of efficiency variance, fixed overhead variance uses
something called a production-volume variance. Because fixed costs are fixed,
the production volume variance measures how much output you got for the
fixed costs you put in. The focus is on the output, not the amount of costs you
put in (the input). This variance reveals how efficient you were at producing
goods using a fixed level of budgeted costs.
This variance compares budgeted fixed overhead and allocated fixed overhead,
based on actual output. (Thats a mouthful.) Heres another way of saying it: You
take the budgeted fixed overhead and apply it to actual output.
For fixed overhead analysis only, budgeted fixed overhead, flexible budget, and
static budget all mean the same thing. This is because fixed costs dont changes
as the level of volume changes. That relationship is true when you operate
within the relevant range.
Assume actual tire production for April is 3,500. The table shows budgeted fixed
overhead applied to actual output.

Budgeted Fixed Overhead Applied to Actual Output

Budgeted cost allocation rate (A)
$6 per unit
Budgeted machine hours per tire (B)
0.5 (30 minutes)

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Actual tires produced (C)
Budgeted overhead applied (A x B x C)

5,000
$15,000

Now that you have the budgeted fixed overhead applied, you can compute
production volume variance:
Production volume variance = budgeted fixed overhead - budgeted fixed
overhead applied
Production volume variance = $10,000 - $15,000
Production volume variance = ($5,000) favorable variance
The negative variance is favorable because this is a cost variance. Spending less
is what you want to do.
What this variance tells you is that even though you planned to spend only
$10,000 in fixed costs, you were able to produce more tires for the same
budgeted amount of money. In theory, producing 5,000 tires should have cost
you $15,000 in budgeted fixed costs. However, you made them within the
$10,000 budget. This saved you $5,000, because you were more efficient at
producing your goods than you planned.
What you saw for fixed overhead analysis were two variances: the flexible
budget variance and the production volume variance.
How to Calculate Overhead Allocation
Not all companies manufacture products that require the same amount of
overhead, and as a managerial account, you need to be able to calculate the
overhead allocation. The following example is relatively simple because each
product gets an equal amount of overhead.
Suppose a simple factory makes two products call them Product A and
Product B. The factory needs no direct materials (yes, that means it makes
products out of thin air; please suspend your disbelief). It paid $1,600 in direct
labor to its workers and $400 for overhead, knowing that each product required
half of the direct labor costs $800 each.
The $400 in overhead also gets divided equally $200 to each product. As
shown in this figure, the total cost you need to apply (in this case, $2,000)
equals the total cost that you apply to your products (again, $2,000).

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But not all companies manufacture products that require the same amount of
overhead, and in those cases, the calculations arent quite as simple.
For example, suppose a similar company plans to make two products, Product J
and Product K. It plans to pay $1,600 in direct labor to its workers. Product J
requires 120 hours of that direct labor, while Product K requires 40 hours. The
company also expects to pay $200 for rent, $150 for maintenance, and $50 for
coffee.

To help you keep uneven allocations straight, remember that overhead allocation
entails three steps:
1.

Add up total overhead.

This step requires adding indirect materials, indirect labor, and all
other product costs not included in direct materials and direct labor. Here,
overhead is estimated to include indirect materials ($50 worth of coffee),
indirect labor ($150 worth of maintenance), and other product costs ($200
worth of rent), for a total of $400.

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2.

Compute the overhead allocation rate by dividing total overhead by

the number of direct labor hours.
You know that total overhead is expected to come to $400. Add up the direct
labor hours associated with each product (120 hours for Product J + 40 hours
for Product K = 160 total hours). Now plug these numbers into the following
equation:

For every hour needed to make a product, you need to apply $2.50 worth of
overhead to that product.
Some accountants and managers refer to the overhead allocation rate as the
predetermined overhead allocation rate because it needs to be estimated at
the beginning of a period.
3.

Apply overhead by multiplying the overhead allocation rate by the

number of direct labor hours needed to make each product.
Because Product J requires 120 hours, apply $300 worth of overhead ($120
hours x $2.50) to this product. Product K requires 40 hours, so apply $100 to
that product.

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Activity-Based Costing for Overhead Allocation

Add up total overhead.

Total overhead includes indirect materials, indirect labor, and other
manufacturing costs. Add up indirect materials, indirect labor, and all
other product costs not included in direct materials and direct labor.

Identify one or more cost drivers.

Scrutinize the nature of your overhead to identify different pools of overhead
costs and specific measures that affect them. For example, one overhead pool
may be storage costs. This pool would be affected by the number of square feet
assigned to each department. Ideally, try to identify a single measure that
actually causes each overhead pool to increase.
Research the nature of your overhead to try to find measurable factors that
affect overhead costs. Ideally, try to find a measure that actually causes the
total overhead pool to increase.
Activity-based costing doesnt prohibit using direct labor hours to allocate
overhead. If managers decide direct labor hours are a cost driver, that measure
can function as part of the activity-based costing system.
This process eventually results in breaking total overhead down into several
different cost pools and identifying a single cost driver for each.
Activity-based costing doesnt prohibit using direct labor hours to allocate
overhead. If managers decide direct labor hours are a cost driver, that measure
can function as part of the activity-based costing system.
This process eventually results in breaking total overhead down into several
different cost pools and identifying a single cost driver for each.

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Compute the overhead allocation rate.

Divide total overhead in each cost pool by its cost driver.

Apply overhead.
Multiply the overhead allocation rate for each cost pool by the individual
products cost driver activity level.

How to Allocate Fixed Overhead Costs in Cost Accounting

When cost accounting, the more accurately you allocate fixed overhead costs,
the more accurately your products total costs are reflected. If total cost is
accurate, you can add a profit and calculate an accurate sale price. To more
accurately allocate fixed overhead you use cost pools and cost allocations to
compute a cost allocation rate.
Compute a cost allocation rate in cost accounting
Say you make car tires. Your cost pool for fixed overhead includes machine
depreciation, utility costs, and salary costs for your security guard. The annual
budgeted costs total $120,000, and you have 20,000 total machine hours
budgeted. Use these formulas and these numbers to compute your cost
allocation rate:

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Budgeted cost allocation rate = $120,000 cost 20,000 machine hours
Budgeted cost allocation rate = $6 per machine hour
You determine that a budgeted quantity per unit (per tire) is 30 minutes. Here is
your budgeted fixed manufacturing overhead cost per unit:
Fixed overhead cost per unit = .5 hours per tire x $6 cost allocation rate per
machine hour
Fixed overhead cost per unit = $3
Each tire has direct costs (steel belts, tread) and $3 in fixed overhead built into
it.
Next, apply actual costs and the static budget. Take the total cost pool of
$120,000 and simply divide it over 12 months. Your monthly static budget is
$120,000 12 months. Thats $10,000 per month.

Calculate flexible budget variances rate in cost accounting

You can now calculate a fixed overhead flexible-budget variance (sometimes
referred to as a spending variance). A flexible budget changes as activity levels
(sales, production) change. Because fixed costsdo not change within a relevant
range, there is no adjustment of budgeted fixed costs from a static to a flexible
budget. This holds true as long as actual costs are within the relevant range.
Bad news. The static budget simply took the annual cost pool amount of
$120,000 and divided by 12 months. But say total actual costs for April are
$11,000. You have a variance, and it is not favorable. Heres the formula:
Fixed overhead flexible budget variance = actual cost static budget
Fixed overhead flexible-budget variance = $11,000 - $10,000
Fixed overhead flexible-budget variance = $1,000 unfavorable variance
The variance is unfavorable because your actual spending ($11,000) was more
than the static budget ($10,000). If youre dealing with a spending variance, a
positive number is an unfavorable variance. You spent more than planned.

Use production volume variances rate in cost accounting

P a g e | 14
An efficiency variance means that you used either more or less of the input
(material, labor) than you planned. The variance reflects how efficiently you
used your inputs to create a product or service.
For fixed overhead, there isnt an efficiency variance. The fixed cost is what it is.
You incur the same amount of fixed costs regardless of how efficiently you
produce your goods. If your actual production is higher or lower than planned, it
doesnt change your flexible budget total for fixed overhead variance.
Whatcha gonna do? Instead of efficiency variance, fixed overhead variance uses
something called a production-volume variance. Because fixed costs are fixed,
the production volume variance measures how much output you got for the
fixed costs you put in. The focus is on the output, not the amount of costs you
put in (the input). This variance reveals how efficient you were at producing
goods using a fixed level of budgeted costs.
This variance compares budgeted fixed overhead and allocated fixed overhead,
based on actual output. (Thats a mouthful.) Heres another way of saying it: You
take the budgeted fixed overhead and apply it to actual output.
For fixed overhead analysis only, budgeted fixed overhead, flexible budget, and
static budget all mean the same thing. This is because fixed costs dont changes
as the level of volume changes. That relationship is true when you operate
within the relevant range.
Assume actual tire production for April is 3,500. The table shows budgeted fixed
overhead applied to actual output.

Budgeted Fixed Overhead Applied to Actual Output

Budgeted cost allocation rate (A)
$6 per unit
Budgeted machine hours per tire (B)
0.5 (30 minutes)
Actual tires produced (C)
5,000
Budgeted overhead applied (A x B x C)
$15,000

Now that you have the budgeted fixed overhead applied, you can compute
production volume variance:
Production volume variance = budgeted fixed overhead - budgeted fixed
overhead applied

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Production volume variance = $10,000 - $15,000
Production volume variance = ($5,000) favorable variance
The negative variance is favorable because this is a cost variance. Spending less
is what you want to do.
What this variance tells you is that even though you planned to spend only
$10,000 in fixed costs, you were able to produce more tires for the same
budgeted amount of money. In theory, producing 5,000 tires should have cost
you $15,000 in budgeted fixed costs. However, you made them within the
$10,000 budget. This saved you $5,000, because you were more efficient at
producing your goods than you planned.
What you saw for fixed overhead analysis were two variances: the flexible
budget variance and the production volume variance.

What Is Peanut Butter Costing?

Despite the benefits of activity-based costing (ABC), many business managers
use cost smoothing, orpeanut butter costing, instead, which spreads costs over
a broad range of cost objects.
When you spread peanut butter, you smooth it over the entire slice of bread. You
dont pay much attention to how much cost is assigned to any particular part of
the bread. Likewise, cost smoothing spreads the cost without paying too much
attention to how much cost is assigned to any particular cost object. The trouble
is, costs arent assigned as accurately as they should be.
With activity-based costing (ABC) you incur costs when production and sales
happen. When you take an order over the phone, manufacture a product, or
place a box on adelivery truck, the activities generate costs.
The activity becomes the focus to assign costs. Because youre connecting cost
to the activity that creates the cost, your cost per product is more accurate, and
so is your pricing.
Cost allocation is the process of allocating indirect costs to products and
services. The cost allocation base is the level of activity you use to assign costs.
Maybe you use 1,000 machine hours or 200 labor hours. Also, keep in mind that
direct costs are traced to products and services, not allocated.
To understand the benefits of ABC, you need to see the slippery slope of peanut
butter costing.
Heres the setup: Say youre a food distributor. You have five restaurant clients
that order meat, fish, and poultry every day. You take orders, package them, and
deliver the food to these businesses every day. Your restaurant clients have high
expectations; they expect high-quality, fresh food to be delivered quickly so they
can prepare their meals.
Your order manager handles the details of order processing. Her salary, benefits,
and other costs total $5,000 per month, an indirect cost. The cost must be
charged to the restaurant clients. You cant tracethe cost of the order manager
to your service. Instead, you need to allocate it.

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A single indirect cost allocation uses one cost pool. The food distribution setup
uses one pool of costs order manager costs. With ABC, you end up dividing
the costs of order management into more cost pools, and youre better off for it.
Everybody pretty much starts by creating a predetermined or budgeted
overhead rate. When you plan at the beginning of the year, using a single
indirect cost pool, you come up with an overhead rate for the order managers
cost, such as the following:
Annual budgeted indirect cost rate = Cost / orders = $60,000 / 1,250 = $48 per
order
The order managers cost of $5,000 per month amounts to $60,000 per year.
The five restaurants order nearly every business day of the year. You figure that
total orders will be 1,250 250 orders per year from five customers. (Isnt it
great that in samples all customers order exactly the same number of times?)
The single indirect cost allocation spreads the cost (order manager) uniformly
over the cost object (orders). Thats $48 dollars per order. This is an example of
peanut butter costing, where all services receive the same or similar amounts of
cost.

The Single Rate Cost Allocation Method in Cost Accounting

In cost accounting, the single rate cost allocation method uses one cost rate to
dictate the dollars that are allocated from a cost pool to a unit, batch,
department, or division. In the case of support departments, the rate allocates
dollars to another department or division.
The single rate method doesnt distinguish between fixed and variable costs.
Now, if it strikes you that this kind of allocation doesnt seem very specific,
youre right.
Of course, more specific cost analysis leads to more precise cost allocations (a
recurrent theme in cost accounting). But for now, you use one rate to allocate
costs. The principle is incredibly simple: When you compute the single cost
allocation rate, you multiply it by actual usage (activity) to apply the cost to the
cost object.
Heres an example of figuring out the cost allocation rate.
Say you manage an online tutoring business. Your instructors serve two markets
high school students and adult continuing education students so your firm
has a high school division and an adult ed division. Both company departments
use technology in a big way. Your computer department (calledinformation

P a g e | 17
technology, or IT) installs software, trains staff, backs up data, and repairs
computers.
The IT department has fixed costs that include the salary and benefits for five
employees and the equipment (hardware and software) they use each day. The
department also incurs variable costs, incurred when staff spends time working
on technical issues. The variable expense can include hardware and software
costs, as well as the expense of outside experts.

IT Department Budgeted Cost Pool

Fixed costs
Variable costs
Variable cost per hour

$200

Budgeted hours

3,200

Total variable costs

Total cost pool

$640,000

$2,000,000

$2,640,000

Your single rate budgeted cost allocation rate is

Single rate budgeted cost allocation rate = cost pool budgeted hours
Single rate budgeted cost allocation rate = $2,640,000 3,200
Single rate budgeted cost allocation rate = $825 per hour
The single cost allocation rate is $825 per hour.

Dual Rate Cost Allocations in Cost Accounting

In cost accounting, the dual rate cost allocation method categorizes cost into
two types of cost pools:fixed costs and variable costs. You calculate a different

P a g e | 18
cost allocation rate for each cost pool. A more specific review of costs leads to
more precise cost allocations.
Say you manage an online tutoring business. Your instructors serve two markets
high school students and adult continuing education students so your firm
has a high school division and an adult ed division. Both company departments
use technology in a big way. Your computer department (calledinformation
technology, or IT) installs software, trains staff, backs up data, and repairs
computers.
Assume your IT department with a budgeted fixed cost allocation rate of $625
per unit. Heres a two-step process to calculate the dual rate cost allocation of
the IT department:

Multiply the budgeted fixed cost allocation rate by the budgeted usage

Multiply the budgeted variable cost allocation rate by the actual usage
Note that the cost allocation rates are multiplied by different usage amounts.
Heres a way to keep the difference straight: Its possible that your budgeted
fixed cost come in as planned. In fact, your fixed cost may involve a contract
(lease agreement, insurance premiums) that cannot change after budgeting.
Thats a way of remembering that you use budgeted usage for fixed cost
allocations.
Variable costs are harder to pin down in planning, so you use actual usage for
the variable cost allocations.
The first table shows the total budgeted fixed cost for the IT department.

Dual Rate Allocation

Fixed Allocation Rate
High school division
$625
Adult education division
$625

Total Budgeted Fixed Cost

Budgeted Usage Hours Budgeted Fixed Costs
1,500

$937,500

1,700

$1,062,500

The next step for a dual rate calculation is to compute the variable costs. Using
the IT department example, you see the related info in the second table.

Dual Rate Allocation Total Variable Cost

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Variable Allocation Rate Actual Usage Hours Budgeted Fixed Costs
High school division
$200
1,300
$260,000
Adult education division
$200
1,800
$360,000

Using the dual rate method of allocation, the total IT department cost allocated
to the high school division would be
High school division IT department cost

The FIFO Method for Cost of Goods Sold

With the FIFO (first-in, first-out) method for cost of goods sold, you charge out
product costs to cost of goods sold expense in the chronological order in which
you acquired the goods. Its like the first people in line to see a movie get in the
theater first. The ticket-taker collects the tickets in the order in which they were
purchased.
Suppose that you acquire four units of a product during a period, one unit at a
time, with unit costs as follows (in the order in which you acquire the items):
$100, $102, $104, and $106. By the end of the period, you have sold three of
these units. Using FIFO, you calculate the cost of goods sold expense as follows:
$100 + $102 + $104 = $306

In short, you use the first three units to calculate cost of goods sold expense.
The cost of the endinginventory asset, then, is $106, which is the cost of the
most recent acquisition.
The $412 total cost of the four units is divided between $306 cost of goods sold
expense for the three units sold and the $106 cost of the one unit in ending
inventory. The total cost has been accounted for; nothing has fallen between the
cracks.

FIFO works well for two primary reasons:

P a g e | 20

Products generally move into and out of inventory in a first-in, first-out

sequence. The earlier acquired products are delivered to customers before the
later acquired products are delivered, so the most recently purchased products
are the ones still in ending inventory to be delivered in the future.
Using FIFO, the inventory asset reported in the balance sheet at the end of the
period reflects recent purchase (or manufacturing) costs, which means the
balance in the asset is close to the current replacement costs of the products.

When product costs are steadily increasing, many businesses follow a firstin, first-out sales price strategy and hold off raising sales prices as long as
possible. They delay raising sales prices until they have sold their lower-cost
products. Only when they start selling from the next batch of products,
acquired at a higher cost, do they raise sales prices.

Average Cost Method for Cost of Goods Sold

The average cost method for cost of goods sold expense is an alternative
method to the more commonly used FIFO and LIFO methods. If you were to
make an exhaustive survey of businesses, you would find out that some
businesses use average cost or even other methods besides FIFO and LIFO to
measure cost of goods sold expense and inventory cost.
Compared with the FIFO and LIFO methods, the average cost method for cost of
goods sold expense and inventory cost seems to offer the best of both worlds.
For example:

The costs of many things in the business world fluctuate, and business
managers tend to focus on the average product cost over a time period.

The averaging of product costs over a period of time has a desirable

smoothing effect that prevents cost of goods sold from being overly dependent
on wild swings of one or two acquisitions.

However, to many businesses, the compromise aspect of the average cost

accounting method is itsworst feature. Businesses often want to go one way or
the other and avoid the middle ground. If they want to minimize taxable income,
LIFO gives the best effect during times of rising prices. Why go only halfway with
the average cost method?

P a g e | 21
If the business wants its ending inventory to be as near to current replacement
costs as possible, FIFO is better than the average cost method. Plus,
recalculating averages every time product costs change, even with computers,
is a real pain. But the average cost method is an acceptable method under GAAP
and for income tax purposes.

Comparing Inventory Valuation Methods for a Business

The inventory valuation method you choose for your business such
as FIFO, LIFO, or Averaging has an impact on your businesss profit margin.
You can compare these methods to see what effect each method might have on
the bottom line.
In this example, assume Company A bought the inventory in question at
different prices on three different occasions. Beginning Inventory is valued at
$500 (thats 50 items at $10 each).
Heres the calculation for determining the number of items sold:
BI + Purchases = Goods available for sale EI = Items sold
50 + 500 = 550 75 = 475

Heres what the company paid to purchase the inventory:

Date
April 1
April 15
April 30

Quantity
150
150
200

Unit Price
$10
$25
$30

Example: The Averaging method

Heres an example of how you calculate the Cost of Goods Sold using the
Averaging method:
Beginning Inventory
Purchases

50
150 @ $10

$500
$1,500

P a g e | 22

Total Inventory
Average Inventory Cost
Cost of Goods Sold
Ending Inventory

150 @ $25
200 @ $30
550
$11,750 550 = $21.36
475 $21.36 = $10,146
75 @ $21.36 = $1,602

$3,750
$6,000
$11,750

Remember, the Cost of Goods Sold number appears on the income

statement and is subtracted from Sales. The Ending Inventory number shows up
as an asset on the balance sheet. This is true for all three inventory valuation
methods.

Example: The FIFO method

Heres an example of how you calculate the Cost of Goods Sold using the FIFO
method. With this method, you assume that the first items received are the first
ones sold, and because the first items received here are those in Beginning
Inventory, the table starts with them:
Beginning Inventory
Next in April 1
Then April 15
Then April 30
Cost of Goods Sold
Ending Inventory

50 @ $10
150 @ $10
150 @ $25
125 @ $30
475
75 @ $30

$500
$1,500
$3,750
$3,750
$9,500
$2,250

Only 125 of the 200 units purchased on April 30 are used in the FIFO method.
Because this method assumes that the first items into inventory are the first
items sold (or taken out of inventory), the first items used are those on April 1.
Then the April 15 items are used, and finally the remaining needed items are
taken from those bought on April 30. Because 200 were bought on April 30 and
only 125 were needed, 75 of the items bought on April 30 are left in ending
inventory.

Example: The LIFO method

P a g e | 23
Heres an example of how you calculate the Cost of Goods Sold using the LIFO
method. With this method, you assume that the last items received are the first
ones sold, and because the last items received were those purchased on April
30, the table starts with them:
April 30
Next April 15
Then April 1
Cost of Goods Sold
Ending Inventory

200 @ $30
150 @ $25
125 @ $10
475
75 @ $10

$6,000
$3,750
$1,250
$11,000
$750

Because LIFO assumes the last items to arrive are sold first, the Ending
Inventory includes the 25 remaining units from the April 1 purchase plus the 50
units in Beginning Inventory.
Heres how the use of inventory under the LIFO method impacts the company
profits. Assume the items are sold to the customers for $40 per unit, which
means total sales of $19,000 for the month (thats $40 475 units sold). In this
example, look at the Gross Profit, which is the profit from Sales before
considering expenses incurred for operating the company. Gross Profit is
calculated by the following equation:
Sales Cost of Goods Sold = Gross Profit

Example: Comparing Gross Profit

The following table shows a comparison of Gross Profit for the three methods
used in the example scenario.
Income Statement Line Item
Sales
Cost of Goods Sold
Gross Profit

Averaging
$19,000
$10,146
$8,854

FIFO
$19,000
$9,500
$9,500

LIFO
$19,000
$11,000
$8,000

P a g e | 24
Looking at the comparisons of gross profit, you can see that inventory valuation
can have a major impact on your bottom line. LIFO is likely to give you the
lowest profit because the last inventory items bought are usually the most
expensive. FIFO is likely to give you the highest profit because the first items
bought are usually the cheapest. And the profit produced by the Averaging
method is likely to fall somewhere in between the two.

How to Use Financial Reports to Apply Inventory Valuation Methods

To give you an idea of how inventory can impact the bottom line on financial reports, here is
an inventory scenario to take you through the calculations for cost-of-goods value by using
the three key methods: average costing, FIFO, and LIFO.
In all three cases, the same beginning inventory is used, purchases, and ending inventory
for a one-month accounting period in March.

1.

100 (Beginning inventory) + 500 (Purchases) = 600 (Goods available for sale)

2.

600 (Goods available for sale) 100 (Ending inventory) = 500 (Items sold)

Three inventory purchases were made during the month:

March 1

100 at $10

March 15

200 at $11

March 25

200 at $12

The beginning inventory value was 100 items at $9 each.

Average costing
Before you can use the average costing inventory system, you need to calculate the
average cost per unit.
100 at $9 = $900 (Beginning inventory)
Plus purchases:
100 at $10 = $1,000 (March 1 purchase)
200 at $11 = $2,200 (March 15 purchase)
200 at $12 = $2,400 (March 25 purchase)

P a g e | 25
Cost of goods available for sale = $6,500
Average cost per unit:
$6,500 (Cost of goods available for sale)600 (Number of units)= $10.83 (Average cost/unit)
When you know the average cost per unit, you can calculate the cost of goods sold and the
ending inventory value pretty easily by using the average costing inventory system:
Cost of goods sold
Ending inventory

500 at $10.83 each

100 at $10.83 each

=$5,415
=$1,083

So the value of cost of goods sold using the average costing method is $5,415. This figure
is the one you see as the Cost of goods sold line item on the income statement. The value
of the inventory left on hand, or the ending inventory, is $1,083. This number is the one you
see as the inventory item on the balance sheet.
FIFO
To calculate FIFO, you don't average costs. Instead, you look at the costs of the first units
the company sold. With FIFO, the first units sold are the first units put on the shelves.
Therefore, beginning inventory is sold first, then the first set of purchases, then the next set
of purchases, and so on.
To find the cost of goods sold, add the beginning inventory to the purchases made during
the reporting period. The remaining 100 units at $12 are the value of ending inventory.
Here's the calculation:
Beginning inventory: 100 at $9 = $900
March 1 purchase: 100 at $10 = $1,000
March 15 purchase: 200 at $11 = $2,200
March 25 purchase: 100 at $12 = $1,200
Cost of goods sold = $5,300
Ending inventory:
From March 25: 100 at $12 = $1,200
In this example, the cost of goods sold includes the value of the beginning inventory plus
the purchases on March 1 and 15 and part of the purchase on March 25. The units that
remain on the shelf are from the last purchase on March 25. The cost of goods sold is
$5,300, and the value of the inventory on hand, or the ending inventory, is $1,200.
LIFO

P a g e | 26
To calculate LIFO, start with the last units purchased and work backward to compute the
cost of goods sold. The first 100 units at $9 in the beginning inventory end up being the
same 100 at $9 for the ending inventory. Here's the calculation:
March 25 purchase: 200 at $12 = $2,400
March 15 purchase: 200 at $11 = $2,200
March 1 purchase: 100 at $10 = $1,000
Cost of goods sold = $5,600
Ending inventory:
From beginning inventory: 100 at $9=

$900

So the Cost of goods sold line item that you find on the income statement is $5,600, and
the Value of the inventory line item on the balance sheet is $900.

How to compare inventory methods and financial statements

Income Statement Line Item
Sales
Cost of goods sold
Income

Averaging
$10,000
$5,415
$4,585

FIFO
$10,000
$5,300
$4,700

LIFO
$10,000
$5,600
$4,400

LIFO gives the lowest net income figure and the highest cost of goods sold. Companies that
use the LIFO system have higher costs to write off on their taxes, so they pay less in income
taxes. FIFO gives companies the lowest cost of goods sold and the highest net income, so
companies that use this method know that their bottom line looks better to investors.
Results for the inventory number on the balance sheet also differ using these methods:

Ending inventory

Averaging
$1,083

FIFO
$1,200

LIFO
$900

LIFO users are likely to show the lowest inventory balance because their numbers are
based on the oldest purchases, which, in many industries, cost the least. This situation is
exactly opposite if you look at an industry in which the cost of goods is dropping in price
then the oldest goods can be the most expensive.

P a g e | 27
For example, computer companies carrying older, outdated equipment can have more
expensive units sitting on the shelves if they try to use the LIFO method, even though the
units may not be worth anywhere near what the company paid for them.

A budget is nothing more than a written estimate of how an organization or a particular

project, department, or business unit will perform financially. If you can accurately predict
your company's performance, you can be certain that resources such as money, people,
equipment, manufacturing plants, and the like are deployed appropriately.

Kinds of budgets
When it comes right down to it, you can budget any activity in your organization that has
a financial impact. Two of the most common budgets are

Cash budget: An estimate of a company's cash position for a particular period of

time.

Operating budget: A business's forecasted revenues along with forecasted

expenses, usually for a period of one year or less.
Line items in your operating budget may include:

Labor budget: The total labor cost to be expended for a set period of time calculated
by taking every person in an organization, department, or project and multiplying the
number of hours they are expected to work by their wage rates.
Sales budget: An estimate of the quantity of goods and services that will be sold
during a specific period of time.
Production budget: A forecast thatstarts with the sales budget's estimates of the
total number of units projected to be sold, then translates this information into estimates of
the cost of labor, material, and other expenses required to produce them.
Expense budget: An estimate prepared for travel, utilities, office supplies,
telephone, and many other common business expenses for a given period.
Capital budget: The total costs and maintenance fees planned for your
company's fixed assets.

The best kind of budget is the one that works. You can choose from three key approaches
to developing a budget:

Top down: Budgets are prepared by top management and imposed on the lower
layers of the organization. Top down budgets clearly express the performance goals and
expectations of top management, but can be unrealistic because they do not incorporate
the input of the very people who implement them.

P a g e | 28

Bottom up: Supervisors and middle managers prepare the budgets and then
forward them up the chain of command for review and approval. These budgets tend to be
more accurate and can have a positive impact on employee morale because employees
assume an active role in providing financial input to the budgeting process.
Zero-based budgeting: Each manager prepares estimates of his or her proposed
expenses for a specific period of time as though they were being performed for the first
time. In other words, each activity starts from a budget base of zero. By starting from
scratch at each budget cycle, managers are required to take a close look at all their
expenses and justify them to top management, thereby minimizing waste.
Each has its advantages and disadvantages, and each approach can work well, although
the pendulum is clearly swinging in favor of the bottom up approach.

Budget tricks of the trade

Budgets provide a kind of early warning system that, when compared to actual
results, can inform you when something is going wrong that needs your
immediate attention.

When your expenditures exceed your budget, you can do several things to get back on
track:

Review your budget. Before you do anything else, take a close look at your budget
and make sure that the assumptions on which it is based are accurate and make sense in
your changing market. If your market is growing quickly, you may need to adjust up your
estimates. Sometimes, it's the budget not the spending that is out of line.
Freeze spending. One of the quickest and most effective ways to bring spending
back in line with a budget is to freeze expenses such as pay raises, new staff, and
bonuses.
Postpone new projects. New projects, including new product development,
acquisition of new facilities, and research and development, can eat up a lot of money.
However, if you are too zealous in curbing spending when you need to develop new
products or services to compete, the result can be disastrous for the future growth and
prosperity of the company.
Lay off employees and close facilities. This is the last resort when you're trying to
cut expenses. Although these actions will result in an immediate and lasting decrease in
expenses, you also face an immediate and lasting decrease in the talent available to your
organization. Productivity and morale of remaining employees may also suffer.

P a g e | 29
Over-applied and Underapplied Overhead
1.
Define, explain and calculate under-applied and over-applied overhead
rate.
2.
Give an example.
Definition and Explanation of Over and Underapplied Overhead:
Since the predetermined overhead rate is established before a period begins
and is based entirely on estimated data, the overhead cost applied to work in
process (WIP) will generally differ from the amount of overhead cost actually
incurred during a period.
The difference between the overhead cost applied to work in process
(WIP) and the actual overhead costs of a period is termed as
either underapplied overhead or overapplied overhead.
For example if a company calculates its predetermined overhead rate $6 per
machine hour. 15,000 machine hours are actually worked and overhead
applied to production is therefore $90,000 (15,000 hours $6). If actual
factory overhead is $95,000 then underapplied overhead is $5,000 ($95,000
$90,000). If the situation is reverse and the company applies $95,000 and
actual overhead is $90,000 the overapplied overhead would be $5,000.
Causes / Reasons of under applied or over applied overhead:
The causes / reasons of under or over-applied overhead can be complex.
Nevertheless the basic problem is that the methodof applying overhead to
jobs using a predetermined overhead rate assumes that actual overhead
costs will be proportional to the actual amount of the allocation base incurred
during the period. If, for example, the predetermined overhead rate is $6 per
machine hour, then it is assumed that actual overhead cost incurred will be
$6 for every machine hour that is actually worked. There are actually two
reasons why this may not be true. First, much of the overhead often consists
of fixed costs that do not grow as the number of machine hours
incurred increases. Second, spending on overhead items may or may not be
under control. If individuals who are responsible for overhead costs do a good
job, those costs should be less than were expected at the beginning of the
period. If they do a poor job, those costs will be more than expected.
Example:Suppose that two companies A and B have prepared the
following estimated data for the coming year:
Company
A

Predetermined overhead rate based

on

Machine-hours

Direct
materials cost

Estimatedmanufacturing overhead

$300,000

$120,000

Estimatedmachine-hours

75,000

Estimateddirect materials cost

$80,000

P a g e | 30
Predetermined overhead rate, (a)
(b)

$4 per machine
hour

150% of direct
materials cost

Now assume that because of unexpected changes in overhead spending

and changes in demand for the companies products, the actual overhead
cost and the actual activity recorded during the year in each company
are as follows:
Company
A

Actual manufacturing overhead costs

$290,000

$130,000

Actual machine-hours

68,000

Actual directmaterials costs

$90,000

For each company, note that the actual data for both cost and activity
differ from the estimates used in computing the predetermined overhead
rate. This results in underapplied overhead and overapplied overhead as
follows:
Actual manufacturing overhead costs

$290,000

$130,000

Manufacturing overhead cost applied to work

in process during the year:
68,000 actual machine hours $4 per
machine hour

272,000

$90,000 actual direct materials cost 150% of

direct materials cost
Under-applied (over-applied) overhead

135,000
-

$ 18,000

$ (5,000)

For company A, notice that the amount of overhead cost that has been
applied to work in process ($272,000) is less than the actual overhead
cost for the year ($290,000). Therefore the overhead is under-applied.
Also notice that original estimate of overhead in company A ($300,000) is
not directly involved in this computation. Its impact is felt only through
the $4 predetermined overhead rate that is used.For B company the
amount of overhead cost that has been applied to work in process
(WIP) ($135,000) is greater than the actual overhead cost for the year
($130,000), and so overhead is over-applied. A summary of the concepts
discussed so for is presented below:
At the beginning of the period
Estimated total

Estimated total

Predetermined

P a g e | 31
manufacturing
overhead cost

units in the
allocation base

overhead rate

Actual total units of

the allocation base
incurred during the
period

Total
manufacturing
overhead applied

Under-applied
(over-applied)
overhead

During the period

Predetermined
overhead rate

At the end of the period

Actual total
manufacturing
overhead cost

Total manufacturing
overhead
applied

Variable and Absorption Costing in Cost Accounting

Variable and absorption costing generate different levels of cost and net income in cost
accounting, so its important to understand the differences so you can select a costing
method to use internally for decision-making.
Say your business manufactures handsaws. Here is a summary of production, sales, and
costs in Year 1.
Year 1 Production Sales and Costs
Production (units)
Sales (units)
Sales (at $25 per unit)
Fixed manufacturing costs
All other product costs

3,000
2,500
$62,500
$21,000
$33,000

Because you didnt sell all of your production, you created ending inventory:
Ending inventory = units produced units sold
Ending inventory = 3,000 2,500
Ending inventory = 500
Your fixed manufacturing costs are $7 per unit produced ($21,000 3,000 units).
Absorption costingrequires you to assign $3,500 of fixed manufacturing costs to ending
inventory ($7 x 500 units). The next table outlines the profit in Year 1, comparing variable
and absorption costing.

P a g e | 32

Year 1 Profit Variable Versus Absorption Costing

Variable Costing
Sales (at $25 per unit)
Fixed manufacturing costs
All other costs
Total costs
Profit

Absorption Costing
$62,500
$62,500
$21,000
$17,500
$27,500
$27,500
$48,500
$45,000
$14,000
$17,500

Absorption costing deferred $3,500 of fixed manufacturing costs. The fixed manufacturing
costs are only $17,500. You see that absorption costing has a $3,500 higher profit ($17,500
versus $14,000).
In Year 2, assume that your sales and sales price are the same. You also sell all your
production, plus the 500 units that were in ending inventory. Your sales (2,500 units) are 500
units more than your production (2,000 units). Because you produced less in Year 2, the allother-cost number declines to $22,500. Less production means less cost. Check out this
next table.

Year 2 Production Sales and Costs

Production (units)
Sales (units)
Sales (at $25 per unit)
Fixed manufacturing costs
All other costs

2,000
2,500
$62,500
$21,000
$22,500

Variable and absorption costing are the same if you sell all of your production. You dont
produce any ending inventory, so you dont defer any fixed manufacturing costs into
inventory items. Here is the profit in Year 2.

Year 2 Profit Variable Versus Absorption Costing

P a g e | 33
Variable Costing
Sales (at $25 per unit)
Fixed manufacturing costs
All other costs
Total costs
Profit

Absorption Costing
$62,500
$62,500
$21,000
$24,500
$27,500
$27,500
$48,500
$52,000
$14,000
$10,500

Five hundred units from Year 1 ending inventory are sold in Year 2. In the third table,
production of 2,000 is 500 units less than sales of 2,500. You had 500 units available for
sale at the beginning of Year 2.
Fixed manufacturing costs for Year 2 are the same for both methods ($21,000). However,
absorption costing added the $3,500 fixed manufacturing cost that was deferred in Year 1.
The fixed manufacturing cost is $24,500 ($21,000 + $3,500).
The variable costing profit in Year 2 is $3,500 higher than the absorption costing profit
($14,000 versus $10,500). In Year 1, variable costing profit was $3,500 lower than the
absorption costing. When Year 1 ending inventory is sold in Year 2, absorption picks up the
fixed manufacturing cost that was deferred.
Over two years, all the production is sold. The total profit over two years is the same for both
costing methods.
Youre probably wondering about which method to use. Your profit eventually is the same
under either method. In the long run, there is no advantage to using one method over
another.
You should select a method and stick with it. By doing so, youre applying the principle of
consistency. For a financial statement reader to compare your results year by year, you
need to use the same method. Its the old idea of an apples-to-apples comparison.

Methods of Joint Cost Allocation in Cost Accounting

When cost accounting, you want to select a method to plan and budget for joint
costs. Choosing a method helps you know where you stand during joint
production. You can assess if your actual joint costs are on track with your
budget. If youre off track, you can make changes.

The splitoff method in cost accounting

P a g e | 34
The splitof point is the point when the costs of two or more products can be
separately identified. After splitoff, each product incurs separable (or
independent) costs. Allocating joint costs using sales value at splitoff may be the
most effective method for planning and budgeting for joint costs. Here are
several reasons why:

The method relates the benefit of production (revenue of sales value at

splitoff) to the related expenses.
No information on separable costs is required.
The sales value at splitoff may be the best comparison of the products. At
that point, youre making an apples-to-apples comparison.
Sale value at splitoff isnt affected by other production or costs after splitoff. A
products sales value after separable costs have been incurred may be very
different. If you spend time and money after the splitoff point, you charge a
higher price to recover those costs. So its fair to say that the sales value at
splitoff method is simple, compared with the others.

Other joint costing methods in cost accounting

Theres a possibility that sales values arent available at splitoff. The products
production may not be far enough along to come up with a price. If theres no
price, you cant compute sales value. In that case, consider a different method.
The next best method may be the net realizable value (NRV) method. The net
realizable value method allocates joint costs on the basis of the final sales value
less separable costs. Final sales value is simply the price tag the price paid by
the customer. That price is paid after all production costs, whether they are joint
costs or separable costs incurred after splitoff.
The NRV method also does a good job of matching the benefit received (final
sales value) with the costs incurred (separable costs). The calculation happens
at the end of all production. Contrast that with sales value at splitoff. The
difference is a matter of timing.
Making a calculation after production ends has some other benefits. The NRV
method accounts for all separable costs, regardless of how much higher or lower
they are than your plan. NRV also handles any change to the final sales value

P a g e | 35
(price tag) due to a change in market conditions. NPV captures any changes to
costs and sale price that might occur as products are produced separately.
The other methods have their challenges. The constant gross margin percentage
method assumes that each department has the same level of profitability. The
gross margin percentages and total costs (as a percentage of sales) are the
same for everything produced. In the real world, different products produce
different levels of profit.
Finally, the physical measure method (allocating cost by the weight, volume, or
some other measurement of the product) doesnt relate revenue to expenses at
all. You may find that this method is the least useful.
Many manufacturers make a big array of products. Two classic examples are
automobiles and computer printers. Each manufacturer in each industry offers
many makes and models in order to reach slightly different buyers, usually
through different price points. Some products are high volume/low margin,
while others are low volume/high margin.
Heres a food analogy, you can make money selling 3,000 $1 hamburgers per
day or 100 $30 filet mignon dinners per night. Same sales revenue.

The Net Realizable Value (NRV) Method in Cost Accounting

By Kenneth Boyd from Cost Accounting For Dummies
When cost accounting, separable costs are incurred after you pass the splitoff
point. In many cases, the product wont be sellable at splitoff, because the
product isnt finished yet.
Say you make two types of leather purses. Both purses go through the same
production process. Each product incurs a portion of the joint costs of
production. But the process doesnt end there. In this case, youd expect to have
costs after splitoff. You need to add straps and metal accessories to complete
the product for sale.
Because many products require production after splitoff, its important that you
review the net realizable value (NRV) method.
The net realizable value method allocates joint costs on the basis of the final
sales value less separable costs. Final sales value is simply the price tag the

P a g e | 36
price paid by the customer. That price is paid after all production costs, whether
they are joint costs or separable costs incurred after splitoff.
What you realize on a sale is usually your profit. You see this term used many
times in business. But in this case, realizable value means sale price less
separable costs. That doesnt equal profit. You have to subtract joint costs from
the subtotal to get profit. Its not a perfect comparison, but its close.
Use the leather-purse example for working through the net realizable value
method. Say you sell two types of purses: The Sassy purse line is more
expensive than the Everyday model. The separable costs per unit for Sassy
purses, as you see, are higher than those of Everyday purses.
The following table calculates the net realizable value for each product.

Joint Cost Net Realizable Value Calculation

Purse Type
Sassy
Production
20,000
$50
Unit price
Sales value (A)
$1,000,000
Separable costs (B)
Per unit
$12
Total
$240,000
Net realizable value (A B)
$760,000

Everyday
24,000
$35

Total
44,000

$840,000

$1,840,000

$10
$240,000
$600,000

$480,000
$1,360,000

Work your way down the Sassy purse column. The sales value of $1,000,000 is
based on the production multiplied by the unit price (20,000 x $50). Then heres
the separable cost calculation:
Separable cost = units produced x cost per unit
Separable cost = 20,000 x $12
Separable cost = $240,000
The net realizable value is the $1,000,000 sales value less $240,000 separable
costs = $760,000. Next, you use net realizable value to allocate joint costs. Take
a gander at the next table.

Joint Cost Net Realizable Value Cost Calculation

Purse Type
Sassy
Everyday
Net realizable value (NRV)
$760,000
$600,000

Total
$1,360,000

P a g e | 37
Percent of NRV total
Joint cost allocation
Total costs
Separable costs
Joint costs
Total costs
Cost per unit

55.88
$502,941

44.12
$397,059

$240,000

$240,000
$502,941
$637,059
$26.54

$742,941
$37.15

$900,000

$397,059

This table starts with the net realizable value amounts from the first table.
The Percent of NRV total is the percentage of the total NRV for each product. The
$760,000 of NRV for Sassy purses is 55.88 percent of the total of $1,360,000.
Then you multiply $900,000 in total joint costs by the percentage, and that
allocates joint costs to each purse. Simple, no? No.
What about separable costs? The second table displays the separable costs from
the first table. Add the separable and joint costs to get total costs. It makes
sense that Sassy purses have a higher total cost per unit ($37.15).
The Sassys per unit separable cost of $12 (from the first table) is higher than
that of the Everyday product ($10), so the Everyday units cost is $26.54. The
$502,941 joint costs allocated to the Sassy in the second table are also higher
than the joint costs for Everyday purses.
One issue with the net realizable value (NRV) method is that amounts may
change. For starters, your production process after splitoff may change.
Hopefully, youre able to review variance results and improve the process. If you
change your production after splitoff, your separable cost totals change.
You may not be able to price your product until after production ends. And in a
market with heavy competition, to maintain your sales levels, you have to keep
your price competitive (for the Sassy purses, say $50 per unit or lower). If your
total costs come in lower than expected, maybe you can price the product lower
than $50, and that might increase sales.
If you cant determine a sales price in advance, you cant calculate relative sales
value.

Two Joint Cost Allocation Methods in Cost Accounting

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By Kenneth Boyd from Cost Accounting For Dummies
In cost accounting, the matching principle matches revenue with the expenses
related to it. You tie the revenue from selling a unit to the cost of making a unit.
This concept is also used to allocate joint costs.
You can allocate joint costs based on the revenue the units generate.
Accountants refer to this as themarket-based approach. Market refers to
the market value (sales value) of the product. The market-based method you
see here is the sales value at splitof method. You also see the physical
measures method of allocating joint costs.

The sales value at splitoff method of cost accounting

One method of allocating joint costs is to allocate costs based on the benefits
received from the expense. Revenue is a benefit received from incurring joint
costs. Thats the basis for using a market-based approach.
Say you own a lumber company and mill. Your crews cut down trees and
produces two types of lumber for the construction industry. Both types are twoby-fours (two inches by four inches by eight feet in length). Winter Pine is the
more expensive product; the all-year-use two-by-fours are cheaper. The following
table explains how to allocate $208,000 in joint costs using the relative sales
value method.

Joint Cost Relative Sales Value at Splitof

Winter Pine
All-Year-Use
Production
10,000
16,000
Unit price
$12
$8
Relative sales value
$120,000
$128,000
Percent sales value
48.39
51.61
Cost allocated
$100,645
$107,355
Cost per unit
$10.06
$6.71

Total
26,000
$248,000
100
$208,000

A products relative sales value is unit price x production. The total sales value
for both products is $248,000, and about 48 percent of the sales value is for
Winter Pine. The joint cost allocation for Winter Pine is $100,645 (48.39 percent,
or 0.4839 x $208,000). To check your work, add the two joint cost allocations

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and verify that they sum up to $208,000. Heres the cost per unit for Winter
Pine:
Cost per unit, Winter Pine = cost allocation units produced
Cost per unit, Winter Pine = $100,645 10,000
Cost per unit, Winter Pine = $10.06

The physical measure method of cost accounting

The physical measure method allocates cost by the weight, volume, or some
other measurement of the product thats produced. Its a contrast to relative
sales value. In this case, assume that the weight or volume for each two-by-four
is the same. (Well, yeah. They are both two-by-fours.) So you allocate joint costs
based on the number of units produced. Check out the following table.

Joint Cost Physical Measure at Splitof

Winter Pine
Production
10,000
Percent production
38.46
Cost allocated
$80,000
Cost per unit
$8

All-Year Use
16,000
61.54
$128,000
$8

Total
26,000
100
$208,000

Winter Pines 10,000 units of production are 38.46 percent of the total. The cost
allocated is $80,000 (38.46 percent or 0.3846 x $208,000). The all-year-use
product gets the rest, $128,000. The total cost allocated sums up to $208,000.
The new version of cost per unit for Winter Pine is:
Cost per unit, Winter Pine = cost allocation units produced
Cost per unit, Winter Pine = $80,000 10,000
Cost per unit, Winter Pine = $8
In the table, the cost per unit is the same for both products. Thats because the
joint cost allocation isnt related to cost because it uses the physical measure
method. Because youre allocating based on number of units, the cost attached
to all units is the same. Youre not weighting the cost allocation based on sales
value.

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How to Determine the Standard Cost Per Unit
To find the standard cost, you first compute the cost of direct materials, direct
labor, and overhead per unit. Then you add up these amounts.
The figure applies this approach to Band Book Company. To calculate the
standard cost of direct materials, multiply the direct materials standard price of
$10.35 by the direct materials standard quantity of 28 pounds per unit.

The result is a direct materials standard cost of $289.80 per case. To compute
direct labor standard cost per unit, multiply the direct labor standard rate of $12
per unit by the direct labor standard hours per unit of 4 hours. The standard cost
per unit is $48 for direct labor.
Now multiply the overhead allocation rate of $10 per hour by the direct labor
standard hours of 4 hours per unit to come to a standard cost of overhead per
unit of $40.
Add together direct materials, direct labor, and overhead to arrive at the
standard cost per unit of $289.80 + $48 + $40 = $377.80. Making a single case
of books costs Band Book $377.80.

Compare Process Costing and Job Order Costing

Process costing handles the same types of manufacturing costs as job order
costing. Both systems deal with tracking how manufacturing costs such as direct
materials, direct labor, and overhead flow through work-in-process to finished
goods and finally, when the goods are sold, to cost of goods sold.
Some manufacturers make unique products, such as aircraft, made-to-order
suits, or custom teddy bears. Others mass-produce large numbers of similar or
identical items, such as soft drinks, sheets of paper, and boxes of cereal. To
mass-produce products at a minimal cost, assembly lines move materials and
partially finished goods from one station or department to the next until they get
completed into finished goods.
Job order costing accumulates costs by job, using job order cost sheets that stay
with the inventory as it flows through the production process.
Process costing, on the other hand, accumulates costs by department. Process
costing gives each department its own separate work-in-process (WIP) account
for accumulating costs and tallies costs at the end of each fiscal period; job

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order costing uses only a single WIP account for all unfinished jobs and tallies
the cost of a job when its finished.
Although job order costing measures the cost of each individual job, process
costing measures the cost of work actually done on WIP during a period.
Unlike job order costing, which sends costs directly to individual jobs, process
costing uses a two-step method:

1.

2.

Sending direct materials, direct labor, and overhead costs to

departments
Sending the department costs to the units produced

Basic Approach to Process Costing in Cost Accounting

In cost accounting, you need to trace or allocate all of the costs attached to a
product to know the full cost of the product. After you know the full cost, you can
compute a reasonable profit level and set a sale price for the product. Thats
easy to say, but getting it done takes a little work.

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To fully price the product, each unit must absorb material, labor, and overhead
costs. Because the goods are identical, the costs you eventually assigned to
each unit are identical. Note the word used was eventually; the process takes
time.
Process costing is all about moving costs from one production department to
another. Say you manufacture blue jeans. Denim material goes to the cutting
room and is cut from patterns. The cut material then goes to the sewing
department. After the blue jeans are sewn, they move to the dyeing department
to add color. As the blue jeans move, so do the costs accumulated along the
way.
So as you can see in the blue-jeans example, as a product moves through
production, it accumulates costs. Now consider when the costs are incurred.

Direct material costs in cost accounting

In most cases, material costs go into production before labor and overhead
costs. You need material before you can perform most of your work. The
employee cant run the sewing machine if there isnt any denim to sew. At any
point in production, youll probably see a higher percentage of material costs
incurred, compared with labor and overhead costs.
Material costs are often incurred all at once. Consider the blue jeans. You decide
to put all the denim you need into production at once. Because the first
production area is the cutting department, all of the material cutting happens as
soon as possible. If the denim is brought into production gradually, the cutting
department may have to stop and wait for more denim. That would slow up your
production, and youre unlikely to do that.
Material costs lead most of the time, but not all of the time. Keep your eyes open
for exceptions. For example, auto bodywork is labor-intensive. So is the work of
plumbers.Service businesses, of course, sell services.

Conversion costs in cost accounting

Conversion costs are all costs other than material costs. They are costs you incur
to convert material into a final product. So labor and overhead are conversion
costs.

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Also, keep in mind that conversion costs are put into production gradually.
Maybe your product moves through several stages of production. If you make
baseball gloves, for example, you have a department that cuts the leather for
the baseball gloves and another department that sews the leather. Because
there are workers and machines in each department, you add costs as the
product moves through production gradually.

Cost Accounting: Spoilage and Process Costing

In cost accounting, process costing assumes that all units produced are
identical. When spoilage creates costs in a process-costing environment, you
apply the following methods to account for them.

Cost accounting for abnormal spoilage

Accountants post the cost of abnormal spoilage to a loss for abnormal spoilage
account. The loss isnt related to cost of goods manufactured. Instead, abnormal
spoilage is a separate cost that you cant recover.
As a result, abnormal spoilage isnt included as a product cost. So break it out
first. Your accountant will put the cost in a loss account separate from costs of
manufacturing. When you determine that a cost represents abnormal spoilage,
you recognize a loss and youre all done with that part.

Cost accounting for normal spoilage

Costing normal spoilage takes a little math. You add spoilage costs to cost of
goods manufactured. Now consider how costs are assigned using process
costing.
As units move from one production department to another, the costs move along
with them. Process costing uses equivalent units to account for units that are
partially complete. The percentage of completion for material cost might be
different from conversion costs, and vice versa. Equivalent units even things out.
The goal is for each equivalent unit to have the same amount of costs attached
to it.

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Some of your equivalent units will be spoiled. Maybe youre running production
of 10,000 magazines. As you inspect the magazines for defects, you notice that
10 magazines have pages that were printed incorrectly. Those magazines arent
sellable to customers. Because you expect some spoilage (due to the limits of
your machines capability), the ten magazines are considered normal spoilage.
Normal spoilage adds costs to your goods.
So you have a choice when accounting for normal spoilage. You can include the
spoiled units in your calculation of physical units and equivalent units, or you
can exclude them.