Chapter 5

ACCOUNTING FOR COST FLOWS

Introduction
Every business organization utilizes an accounting system that serves people
both inside and outside the organization. Cost accounting systems are generally
used for cost accumulation and cost assignment to products and services. Cost
accounting is concerned with recording and measuring cost elements as the related
resources flow through the production process. Information gathered from cost
accounting provides data necessary for the preparation of financial statements. This
chapter will introduce us to the cost accounting cycle and to the different methods of
cost accumulation. Though all types of business organizations adopt a cost
accounting system, the focus of the discussions would be for a manufacturing type of
business organization.

Learning Objective:
At the end of the lesson, you should be able to:
1. Discuss the cost accounting cycle.
2. Present and discuss the flow of manufacturing costs.
3. Prepare the cost of goods sold for a manufacturing entity.
4. Distinguish the different kinds of cost systems.

Lesson 1 – The Cost Accounting Cycle

The manufacturing process involves the physical arrangement of the factory

and the decision-making needs of manager constitute the basis for determining how
costs will be accumulated.

The cost accounting cycle started when the entity acquires assets to be used
for in the production. During the production, materials are purchased and held in
Material Inventory. Materials needed in the production are requisitioned to be placed
in process. Some other manufacturing cost such as direct labor and factory overhead
are incurred and are also placed in process. Upon completion of the process, it will
be moved to finished goods inventory and once sold it will be accounted for as Cost
of Goods Sold.

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 Typically, the general ledger accounts for manufacturing costs are Materials,
Payroll, Factory Overhead Control, Work in Process, Finished Goods and Cost of
Goods Sold. These accounts are used to recognize and measure the flow of costs,
from the acquisition of materials, to factory operations to the cost of products sold.

MANUFACTURING COST FLOW

The figure below shows the flow of cost through the accounting system. Each
arrow depicts a specific type of accounting entry. It illustrates relationship between
the general accounts and cost accounts. When assets are purchased, it corresponds
the recognition in the general accounts. As the factory operates, the accumulated
cost of materials, labor and factory overhead are process into work in progress and it
is then transferred to finished goods as the goods are completed. Then it will be
recognized in the cost of goods sold in the general account when the goods are sold.

The transaction below illustrates the arrow in the figure and its accounting
entries:

Transaction Accounting Entries

a. Payments on account Materials
Accounts payable
b. Expenses paid in advance Prepaid Expense
Cash

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c. Purchases and improvements of assets Building and equipment
Cash
d. Various payments for resources Various Expenses
Cash
e. Payments of wages and salaries Payroll
Accrued Expense
f. Purchase of raw materials and factory Raw Materials
supplies on credit Accounts Payable
g. Recording of payroll Payroll
Accrued Payroll
h. Issuing factory supplies Factory overhead Control
Materials/Factory supplies
i. Incurring various indirect manufacturing Factory overhead Control
costs on credit Materials
Payroll
j. Manufacturing portion of any Factory overhead Control
prepayments that have expired Prepaid expense
k. Manufacturing portion of depreciation Factory overhead Control
Accumulated Depreciation
l. Manufacturing portion of various other Factory overhead Control
resources used Various accounts
m. Charging all types of indirect labor cost Work in process
to production Factory overhead Control
n. Issuing direct materials to production Work in process
Materials
o. Charging manufacturing overhead cost Work in process
to production Payroll
p. Charging direct labor cost to production Work in process
Factory overhead Control
q. Charging cost of completed units to Finished Goods Inventory
finished goods account Work in process
r. Charging cost of goods sold units to the Cost of Goods Sold
cost of goods sold account Finished Goods Inventory

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 Lesson 2 – Cost of Goods Sold for a Manufacturing Company

The report of operation in a manufacturing concern is reported in the

statement of comprehensive income. The statement summarizes the period’s
operations and show financial position at the end of the period.
The cost element incurred during the production is reported in the statement
of comprehensive income as Costs of Goods Sold. Below is the pro-forma statement
of the cost of goods sold:
Raw materials, beg xx
Add: Purchases xx
Materials Available for use xx
Less: Indirect materials used xx
Raw materials, ending xx xx
Raw materials used xx
Direct Labor xx
Factory Overhead xx
Total Manufacturing Cost xx
Add: Work in process, beg xx
Cost of Goods placed in process xx
Less: Work in process, end xx
Cost of Goods Completed xx
Add: Finished Goods, beg xx
Goods available for sale xx
Less: Finished Goods, end xx
Cost of Goods Sold xx

The inventories that are left unsold at the end of the period will be reported in
statement of financial position as part of the current assets.

Lesson 3: The Cost Systems and Cost Accumulation Methods

Costs assigned to units of production may be through the actual cost system,
or normal cost system, or standard cost system.

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 In an actual cost system, actual direct material and direct labor costs are
accumulated in Work in Process Inventory as the costs are incurred. Actual
production overhead costs are accumulated separately in an Overhead Control
account and are assigned to Work in Process Inventory at the end of a period or at
completion of production. The use of an actual cost system is generally considered to
be less than desirable because all production overhead information must be available
before any cost allocation can be made to products or services. For example, the
cost of products and services produced in May could not be calculated until the May
electricity bill is received in June.
An alternative to an actual cost system is a normal cost system, which uses
actual direct material and direct labor costs and a predetermined overhead (OH) rate
or rates. A predetermined overhead rate (or overhead application rate) is a budgeted
and constant charge per unit of activity that is used to assign overhead cost from an
Overhead Control account to Work in Process Inventory for the period’s production or
services.
In a standard cost system¸ products, operations, and processes are costed
based on predetermined quantities of resources to be used and predetermined prices
of those resources. The actual costs are compared to the standard costs. If such has
different amounts, a variance will also be recorded and analyzed.

The costs allocated to production may include all manufacturing costs (full
absorption costing) or only the variable manufacturing costs (variable or direct
costing). Full absorption costing includes direct materials, direct labor and factory
overhead whether fixed or variable. Whereas, variable costing includes direct
materials, direct labor and only variable factory overhead.

COST ACCUMULATION
The costs incurred in production may be accumulated based on the following:
1. Job order costing
2. Process costing
3. Blended costing
4. Backflush costing

Job order costing

In job order costing, costs are accumulated for each batch, lot or customer
order. It is used when the products manufactured within a department or cost center
are heterogeneous. It requires that it be practical to physically identify each job

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produced and to charge each job with at least some element(s) of its own cost. It is
applicable to made-to-order work in factories, workshops, and repair shops; to work
by builders, construction engineers, and printers and to service businesses such as
medical, legal, architectural, accounting and consulting firm.

Process costing
In process costing, costs are accumulated by production process or by
department. It is used when all worked within a department or other work area are
homogeneous, or when there is no need to distinguish among units, or when it is not
practical to do so.
It accumulates all costs of operating a process for a period of time and then
divides the cost by the number of units of product that passed through that process
during the period; the result is a unit cost. If the product of one process becomes the
material of the next, a unit cost is computed for each process.
Process costing is applicable to industries such as flour mills, breweries,
chemical plants and textile factories where large quantities of one product or a few
products are produced. It is also applicable to assembly and testing operations
involving large numbers of similar small items such as power tools, electrical parts
and home appliances.

Blended method
In blended method, it is a combination of the above costing method. In some
manufacturing, different units have significantly different direct material costs, but all
units undergo identical conversion in large quantities. In this case, direct materials
costs are accumulated using job order costing, and conversion costs are
accumulated using process costing.

Backflush costing
It is a workable way to accumulate manufacturing costs in a factory or part of
a factory in which processing speeds are extremely fast, such as in a mature Just-in-
Time system.
It is workable because it bypasses the routine cost accounting entries that are
required in subsidiary records for job order and process cost accumulation, thus
saving considerable data processing time.
Where there is insufficient time and insufficient incentive to track the detailed
costs of work in process, backflushing provides a method of cost accumulation by

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working backward through the available accounting information after production is
completed; that is at the end of each accounting period.

Comparison of Cost Accumulation Methods

Aspects of
Typical Job order Blended Process Backflush
System
Cost object to Material, to a A process or
A specific job,
which cost are specific job, to department of a A production
batch, lot or
physically a process or production facility
contract
traced department facility
Amount of
output Thousands or
One job, Material may
produced hundreds of
batch, lot or change for Unlimited
before thousands of
contract each job
processing units of output
may change
Material may
Cost elements All cost
All cost differ
that differ in elements may Only material
elements may dramatically;
one output to differ by small cost differs
differ conversion, by
another degree
small degrees
Amount of Moderate
detailed (summarized
accounting High High for each None
done for work department or
in process process)
Source of
Financial and Financial and Financial and
information Visual
physical data physical data physical data
used to control observation
recorded recorded recorded
processing

Chapter Exercises

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Review Questions
1. Discuss and explain the cost accounting cycle in a manufacturing business
organization.
2. Discuss the complementary relationship between the balance sheet and
income statement.
3. Distinguish actual cost system from normal cost system.
4. Distinguish among the process, job order, blended and backflush cost
accumulation method.

Exercise Problems
1. Marvin Co. has developed the following information for the year ended
December 31, 2018.
Raw materials inventory, January 1 175,000
Purchases 250,000
Raw materials, December 31 125,000
Direct labor 270,000
Factory overhead (120% of direct labor cost)
Work in process inventory, January 1 90,000
Work in process inventory, December 31 120,000
Finished goods inventory, January 1 100,000
Finished goods inventory, December 31 80,000

Required: Prepare a cost of goods sold statement.

2. Ram Co. completed the following transactions for October, 2018.
a) Purchased on account direct materials of P 180,000.
b) The factory payroll was recorded. Direct labor P 60,000; indirect labor P
20,000. Employee payroll deductions were recorded as follows:
Withholding Taxes P 11,200
SSS Premiums 2,400
PhilHealth Contribution 375
Pag-ibig Funds Contribution 1,620
c) Indirect materials of P 20,000 were purchased.
d) Employer payroll tax expense is recorded as follows:
SSS Premiums P 3,600
PhilHealth Contribution 375
Pag-ibig Funds Contribution 1,620
e) Materials issued: Direct materials – P 120,000; indirect materials – P 10,000.

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 f) Defective materials P 5,000 were returned to vendors.
g) Accounts payable totaling P 148,300, including accrued payroll, were paid.
h) Sundry factory expenses of P 24,900 were recorded as liabilities.
i) Factory overhead was charged to production at 120% of direct labor costs.
j) Goods completed with a total cost of P 180,000 were transferred to finished
goods.
k) Sales were P 210,000 and cost P 140,000 to produce.

Required:
1. Journal entries to record the transactions given above.
2. Statement of cost of goods sold.