Chapter 4

Cost Allocation: Joint Products and Byproducts

Definitions of Terminologies

 Joint costs are the costs of a single production process that yields multiple products simultaneously.
 The Split-off point is the juncture in a joint production process where one or more products become separately
identifiable.
 Separable costs are all costs of manufacturing, marketing, distribution, and so on that incurred beyond the split
off point those are assignable to one or more individual products.
At or beyond the split off point, decisions relating to sale or further processing of individual products can be
made independently of decisions about other products.
The outputs of a joint production process can be classified into two general categories:
1. Those with a positive sales value: is any output that has a positive net sales value (or an output that
enables an organization to avoid incurring costs). A joint product has relatively high sales value
compared to other products yielded by a joint production process
2. Those with a zero sales value.

When a joint production process yields only one product with a relatively high sales value, the product is termed
as main product.
A byproduct has a relatively low sales value compared with the sales value of a joint or main product.

Approaches for Allocating Joint Costs

Approach 1: Allocate costs using market based data such as revenues.
 Sales value at splitoff point
 Estimated net realizable value (NRV) method
 Constant gross-margin percentage NRV method
Approach 2: Allocate costs using physical-measure-based data such as weight or volume.
Example1: Farmers Dairy purchases raw milk from individual farms and processes it until the splitoff point,
where two products (cream and liquid skim) emerge. These two products are sold to an independent company,
which markets and distributes them to supermarkets and other retail outlets.
Raw milk processed 100,000 gallons. 10,000 gallons of raw milk are lost in the production process due to
evaporation, spoilage, and the like, yielding 100,000 gallons of good product.

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 Production Sales
Cream 25,000 gallons 20,000 gallons at Br. 8/gallon
Liquid skim 75,000 gallons 30,000 gallons at Br. 4/gallon
Inventories
Beginning Inv Ending Inv
Raw milk 0 gallons 0 gallons
Cream 0 gallons 5,000 gallons
Liquid skim 0 gallons 45,000 gallons
Cost of purchasing 110,000 gallons of raw milk and processing it until the splitoff point to yield 25,000 gallons
of cream and 75,000 gallons of liquid skim, Br. 400,000.
How much of the joint costs of Br.400,000 should be allocated to the cost of goods sold (20,000 gallons of cream
and 30,000 gallons of liquid skim) and to the ending inventory (5,000 gallons of cream and 45,000 gallons of
liquid skim)?

1. Sales value at split off point

Allocates joint costs to joint products on the basis of a relative sales value at the split off point of the total
production of these products during the accounting period

Cream Liquid Skim Total

 Sales value at split off point Br.200,000 Br.300,000 Br.500,000
(Cream, 25,000 gall.*Br.8; liquid skim, 75,000Gall.*Br.4)

 Weighting 0.40 0.60 1

(Br.200, 000/Br.500, 000; Br.300, 000/Br.500, 000)
 Joint cost allocated Br.160, 000 Br.240, 000 Br.400, 000
(Cream, 0.40*Br.400, 000, liquid skim, 0.60*Br.400, 000)

 Joint production cost per gallon, Br. 6.40 Br.3.20

(Cream Br.160, 000/25,000 gall; liquid skim, Br.240, 000/75,000 gall.)

 Cost of goods sold (cream:20,000*6.40, liquid skim:30000*3.20) 128000 96000 224000

 Ending inventories(cream,5000*6.40,liqud skim,45000*3.20 320000 144000 176000

Note that the method uses the sales value of the entire production of the accounting period. The reason is that the
joint costs were incurred on all units produced, not just those sold in the current period.

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2. Physical-Measure Method
Allocates joint costs to joint products on the basis of the relative weight, volume, or other physical measure at
the split off point of the total production of these products during the accounting period
Cream Liquid Skim Total
1. Physical measure of production (gall.) 25, 000 75, 000 100, 000
2. Weighting (25,000gall/100,000 gall; 0.25 0.75
75,000gall/100,000gall)
3. Joint cost allocated (cream, 0.25* Br.100, 000 Br.300, 000 Br.400, 000
Br.400, 000; liquid skim, 0.75*Br.400, 000
4. Joint production cost per gallon (cream, Br. 4 Br.4
Br.100, 000/25,000 gall; liquid skim, Br.300, 000/75,000 gall.)
Cost of goods sold (cream, 20,000*4,liquid cream,30000*4) 80,000 120,000 200,000
Ending inventories (cream 5000*4, liquid cream 45000*4) 20,000 180,000 200,000
3. Estimated Net Realizable Value (NRV) Method
In many cases, products are processed beyond the splitoff in order to bring them to a marketable form or to
increase their value above their selling price at the splitoff point.
The estimated net realizable value is typically used in preference to the sales value at splitoff point method only
when market selling prices for one or more products at the splitoff point are available.

Eample2: Assume the same situation as in Example 1 except that both cream and liquid skim can be processed
further:
Cream Butter cream; 25,000 gallons of cream are further processed to yield 20,000 gallons of butter cream
at additional processing (separable) costs of Br.280, 000. Butter cream, sold for Br.25 per gallon, is used in the
manufacture of butter-based products.
Liquid skim Condensed Milk; 75,000 gallons of liquid skim are further processed to yield 50,000 gallons
of condensed milk at additional processing costs of Br.520,000. Condensed milk is sold for Br.22 per gallon.
Sales during the accounting period were 12,000 gallons of butter cream and 45,000 gallons of condensed milk.
Beginning Inventory Ending Inventory
Raw milk 0 gallons 0 gallons
Cream 0 gallons 0 gallons
Liquid skim 0 gallons 0 gallons

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 Butter cream 0 gallons 8000 gallons
Condensed milk 0 gallons 5,000 gallons

The estimated NRV method allocates joint costs to joint products on the basis of the relative estimated NRV
(expected final sales value in the ordinary course of business minus the expected separable costs) of the total
production of these products during the accounting period. Joint costs would be allocated as follows:

Butter Condensed Total

Cream Milk
Expected final sales value of production
(Butter cream, 20000gall.*Br.25; condensed Milk, 50,000gall*Br.22) Br.500, 000 Br.1, 100,000 Br.1, 600,000
Deduct expected separable costs to Complete and sell Br.280, 000 Br.520, 000 800,000
Estimated NRV at split off point Br.220, 000 Br.580, 000 Br. 800,000
Weighting (220,000/800,000; 580,000/800,000) 0.275 0.725
Joint costs allocated (butter cream, 0.275* Br.110, 000 Br.290, 000 Br.400, 000
400,000; condensed milk, 0.725*400,000)

Production cost per gallon (butter cream, Br.19.50 Br.16.20

[110, 000+280,000]/20,000 gall; condensed
Milk [290,000+520,000]/50,000gall)

4. Constant Gross-Margin Percentage NRV Method

This method allocates joint costs to joint products in such a way that the overall gross margin percentage is
identical for the individual products. This method requires three steps:
Step 1: Compute the overall gross-margin percentage.
Step 2: Use the overall gross margin percentage and deduct the gross margin from the final sales values to obtain
the total costs that each product will bear
Step 3: Deduct the expected separable costs from the total costs to obtain the joint-cost allocation.

Step 1:
Expected final sales value of total production during the accounting period
(20,000gall.*Br.25) + (50,000gall*Br.22) Br.1, 600,000
Deduct joint and separable costs (Br.400, 000+Br.280, 000+
Br.520, 000) 1,200,000

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Gross Margin Br. 400,000
Gross Margin percentage (400,000/1,600,000) 25%
Step 2:
Butter Cream Condensed Milk Total
[

Expected final sales value of production during the accounting period: Br.500, 000 Br.1, 100,000 Br.1, 600,000
(Butter Cream, 20000gall.*Br.25; condensed Milk, 50,000gall*Br.22)
Deduct gross margin, using overall
Gross margin percentage (25%) 125,000 275,000 400,000
Cost of Goods Sold 375,000 825,000 1,200,000

Step 3:
Deduct separable costs to complete and sell 280,000 520,000 800,000
Joint costs allocated Br.95, 000 Br.305, 000 Br.400, 000

Accounting for Byproducts

Joint production process may yield not only joint and main products but byproducts as well. Although
byproducts have much lower sales value than do joint or main products, the presence of byproducts can affect
the allocation of joint costs.
Example 3: The Meatworks Group processes meat from slaughterhouses. One of its departments cuts lamb
shoulders and generates two products:
Shoulder meat (the main product) – sold for Br.60 per pack
Hock meat (the byproduct) - sold for Br.4 per pack.
Both products are sold at splitoff point without further processing. Data (number of packs) for this department in
July 2001 are as follows:
Production Sales Big. Inv. End.Inv.
Shoulder meat 500 400 0 100
Hock Meat 100 30 0 70
The joint manufacturing costs of these products in July 2001 were Br.25, 000 (comprising, Br.15, 000 for direct
materials and Br.10, 000 for conversion costs).
Method A: Byproducts Recognized at the Time Production is Completed

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This method recognizes the byproduct in the financial statements-the 100 packs of hock meat-in the month it is
produced (July 2001). The estimated net realizable value from the byproduct produced is offset against the costs
of the main (or joint) products. The following journal entries illustrate this method:
1. Work in process 15,000
Cash/ Account Payable 15,000
(To record direct materials purchased and used in production during July)
2. Work-in Process 10,000
Various Accounts 10,000
(To record conversion costs in the production process during July; examples include energy,
manuf.supplies, all Manu. labor, and plant maintenance)
3. Byproduct Inventory-Hock Meat (100*Br.4) 400
Finished Goods –Shoulder Meat (Br.25, 000-400) 24,600
Work-in Process (Br.15, 000+10,000) 25,000
(To record cost of goods completed during July)
4a. Cost of Goods Sold [(400/500)*24,600 19,680
Finished Goods-Shoulder Meat 19,680
(To record cost of the main products sold during July)
b. Cash (Account Receivable) 400*Br.60 24,000
Revenues –Shoulder Meat 24,000
(To record the sales of the main product during July)
5. Cash (Account Receivable) 30*Br.4 120
Byproduct Inventory- Hock Meat 120
(To record the sales of the byproduct during July)
This method reports the byproduct inventories of hock meat in the balance sheet at their Br.4/pack selling price
[(100-30)*Br.4 = Br.280].
Method B: Byproducts Recognized at Time of Sale
This method makes no journal entries until sale of the byproduct occurs. Revenues of the byproducts are reported
as a revenue item in the income statement at the time of sale.
In the Meatworks Group example, byproduct revenues in July 2001 would be Br.120 (30*Br.4) because only 30
packs of the hock meat are sold in July (of the 100 packs produced).
The journal entries would be:

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 1. Work in process 15,000
Cash/ Account Payable 15,000
(To record direct materials purchased and used in production during July)
2. Work-in Process 10,000
Various Accounts 10,000
(To record conversion costs in the production process during July; examples include energy, manuf.supplies, all
Manu. labor, and plant maintenance)
3. Finished Goods-Shoulder Meat 25,000
Work-in Process 25,000
(To record cost of goods completed during July)

4a. Cost of Goods Sold [(400/500)*Br.25, 000= 20,000

Finished Goods-Shoulder Meat 20,000
(To record cost of the main products sold during July)
4b. Cash (Account Receivable) 400*Br.60 24,000
Revenues –Shoulder Meat 24,000
(To record the sales of the main product during July)

5. Cash (Account Receivable) 120

Revenues- Hock Meat 120
To record the sales of the byproduct during July)
Method B is rationalized in practice primarily on grounds that the dollar amounts of byproducts are immaterial.
However, this method permits managers to “manage” reported earnings by timing when they sell byproducts.

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 Chapter 5
Product costing systems
There are two types of product costing systems that are commonly practiced in manufacturing and
in many service companies. These are, process costing and job-order costing
1. Process costing is a product costing system that used in situations where the company
produces many units of a single product for long periods at a time. In this system, the cost
object is masses of identical or similar units of a product or service.
2. Job-order costing is used in situations where many different products are produced each
period.
JOB ORDER COSTING SYSTEM
Cost Accounting System
The cost accounting system uses the perpetual inventory system, and achieves greater accuracy in
the determination of product costs than is possible with the general accounting system. There are
two extremes of cost accounting systems for manufacturing operations – job order cost system, and
process cost system.
 A job order cost system provides a separate record of the cost of each particular quantity of
product that passes through the factory. The system accumulates costs for a particular batch of
production, commonly referred as a Job. A job has a definite starting and completion time, for
example, the production of 10 pieces of windows, or 50 coffee tables.
 In job order costing system, costs are accumulated by job. For each job, the firm maintains a
separate job cost sheet, which is a record on which manufacturing costs of the job are accumulated.

Job order costing for manufacturing firms:

An interrelationship exists between the physical flow of production, and the cost accounting cycle.
The flow of costs parallels the flow of work in the production settings.

Work and cost flow in job order costing cycle

The physical flow of production is the sequence of operating activity that begins with the decision
to order direct materials and ends with finished product being sold to customers. The intervening

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 steps may vary from firm to firm, but they share a common thread. The following may show the
steps of the physical flow of production.
1. Purchase requisition – For commonly used direct materials, organizations have a reorder level,
which is the minimum amount of stock that can be on hand at any given time before another
purchase is made to meet the lead time demand. When the stock level reaches such a point, the
storeroom clerk fills a purchase requisition, a form requesting the purchase of the needed material.
After the form is duly filled, it will be sent to the purchasing department.
 No journal entry is required when a purchase requisition is prepared.
2. Purchase order – the purchasing department following purchase requisitions from the storeroom
clerk will prepare a purchase order. A purchase order is a document that authorizes the supplier to
ship the specified merchandise ordered.
 No journal entry is required when a purchase order is filled.
3. Receiving report – when the ordered materials are received, the receiving department prepares a
receiving report, which lists the description, and quantities of goods received. The receiving report,
together with the invoice of the supplier forms the basis for recording the purchase of the materials.
For instance, recording of purchase of lumber on account, would be as follows:

Dr. Cr.
January 15, 2003 Direct material 20,000.00
Account payable 20,000.00

4. Production order – a manufacturer can produce in response to a customer order or just for stock.
Whatsoever, when the decision to produce is made, productions order will be prepared and
approved by the manager in charge.
 No journal entries are required on the company’s books when the production order is issued.
5. Material requisition – to commence production, evidently the production department needs direct
materials. The materials required for production are requested through a document called material
requisition form. The material requisition form should contain specific description of the direct
and indirect materials required for production.

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 At the time the materials are issued from the storeroom, the following entry is made:
Jan. 28, 2003 Work in process 10,000.00
Manufacturing overhead 52.00
Raw materials 10,052.00

 Direct materials that are sent for manufacturing process are no more direct materials since they are
soon to be processed to become finished goods Thus, the cost is charged to work in process
account.

6. Job Cost Sheet

 Right after the materials are received from store, a job cost sheet will be prepared. The job cost
sheet is used to accumulate the manufacturing costs incurred in producing that particular job.
 The key source document in a job costing system is a job cost record, also called a job cost sheet,
a document that records and accumulates all the costs assigned to a specific job. The job cost record
is started as soon as work begins in a particular job.
 After being notified that the production order had been issued, the Accounting Department
prepares a job cost sheet. A job cost sheet is a form prepared for each separate job that records the
materials, labor, and overhead costs charged to the job.
 In addition to serving as a means for charging costs to jobs, the job cost sheet also serves as a key
part of a firm’s accounting records. The job cost sheet form a subsidiary ledger to the Work in
Process account. A separate cost sheet is maintained for each job. Thus, the value of work in
process at any time can be found by adding the different job cost sheet.
7. Job time ticket – the second cost category of manufacturing firms is the direct labor
employed. A job time ticket is used to record how much time is spent on a particular job.
When a particular job is started, the employee fills the time the job is started on the job time
ticket, and he punch out the card and fills the time he stopped when he left the job. Suppose
analysis of the job time ticket showed direct labor of 9,600.00 and indirect labor of 4,800.00,
the journal entry to record the cost of direct and indirect labor looks like the following:
Jan. 28, 2003 Work in process 9,600.00
Manufacturing overhead 4,800.00

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 Wages payable 14,400.00

8. Manufacturing overhead – costs other than direct material and direct labor that are necessary to
transform the raw materials into finished goods are called manufacturing overhead.
 Such Manufacturing costs are common costs – costs shared by more than one cost object- that
should be apportioned among the cost objects sharing the cost.
 However, the total overhead costs cannot be known exactly until the end of the year. Thus,
organizations should wait up to the end of the year if they are to charge the actual amount.
 Yet, many jobs are completed but the job cost sheet remains open waiting for the actual overhead
cost. Thus, interim financial statements are impossible which in turn affect managerial decision
purposes.
 A predetermined overhead rate is determined to allocate such costs to individual jobs, which is
found by dividing estimated overhead cost to the estimated amount of allocation base.
 The allocation base is assumed to be a cost driver of manufacturing overhead costs.
 In other words, there has to be a cause and effect relationship between the allocation base and
manufacturing overhead costs.
 For instance, a labor intensive firm should use a labor oriented base, and a machine base should
use a machine oriented base since most these overhead costs may respond to a change to the
allocation base.
 Such Costs includes factory rent, electricity, and depreciation on machinery.
 Most of these costs are common to more than one batch of job and hence cannot be directly traced
to a specific job.
 Thus, such costs must be assigned to the different cost objects in some way.
 However, assigning MO to units of product is a difficult task; because of three reasons:
1. MO is an indirect cost, it is difficult to trace to a particular job.
2. MO consists of many different items ranging from the grease used in machines to the annual salary
of production manager.
3. MO costs tend to remain relatively constant due to the presence of fixed costs.
 Therefore, the only way to assign overhead costs to products is to use an allocation process. This
allocation overhead cost is accomplished by selecting an allocation base that is common to all of the
company’s products and services.

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 An allocation base is a measure such as direct labor hours (DLH) or machine hours (MH) that is
used to assign overhead costs to products and services. The allocation base is used to compute the
predetermined overhead rate:

Predetermined overhead rate = Estimated total manufacturing overhead cost

Estimated total units in the allocation base
 The predetermined overhead rate is based on estimated rather than an actual figure. This is because
the predetermined overhead rate is computed before the period begins and is used to apply overhead
cost to jobs throughout the period. The process of assigning overhead cost to jobs is called
overhead application.

Overhead applied to a particular job = Predetermined * Amount of the allocation

Overhead rate base incurred by the job
 A predetermined overhead rate is calculated using the projected overhead cost and some activity
base that has a cause and effect relationship with manufacturing overhead costs. For instance,
assume that the projected overhead cost for the upcoming year is Birr 80,000.00, and the direct
labor hour is estimated to be 4,000 hrs, the predetermined overhead rate can thus be calculated as
follows:
Predetermined overhead cost rate = Estimated overhead cost
Estimated activity base (direct labor hr.)

POR = 80,000 = 20 per direct labor hour.

4,000
If we assume that the direct labor hours spent on the job are 90, the manufacturing over head
applied will therefore be 90 X 20 =1800.
The entry to record the manufacturing overhead applied is as follows:
March 18, 2003 Work in process 1,800.00
Manufacturing overhead applied 1,800.00

 The manufacturing overhead applied is a contra account to the actual manufacturing cost.

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  Although actual costs are not assigned, they should be recorded as incurred. Suppose that factory
rent, utilities, and other manufacturing costs totaled Birr 22,000.00. The following entry is required
to record the actual manufacturing cost.
March 20, 2003 Manufacturing over head 22,000.00
Various accounts 22,000.00

9. Finished goods inventory ledger card – when work in process is completed and transferred to the
finished goods inventory warehouse, the following journal entry is required:
March 20, 2003 Finished goods 21,400.00
Work in process 21,400.00
10. Cost of goods sold – two records are maintained when sale is made under the perpetual
inventory system: one for sales and the other for cost of goods sold. Assume that half (75
coffee tables) of the coffee tables produced are sold for birr 180 each on with a 40% down
payment. The entry to record the sales looks the following:
April 10, 2003 Cash 5,400.00
Account receivable 8,100.00
Sales 13,500.00

 The total units produced are 150 as shown in the production order. Half of that amount is 75, and
75 units at 180 is equal to 13,500.00. When we come to the cost of goods sold, the total cost of
goods produced is Birr 21,400.00. Thus, the unit cost of each coffee table is Birr 142.67. The cost
of the 75 units that are sold is Birr 10,700.00.
 The following entry is necessary to record the cost of goods sold.

April 10, 2003 Cost of goods sold 10,700.00

Finished goods 10,700.00

 In general, a firm’s cost accounting system parallels its flow of operation. The nine steps followed
in the previous illustration are summarized below in a concise manner.
1. Procurement – raw materials and supplies needed for manufacturing are ordered, received, and
stored.

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2. Production – raw materials are transferred from storeroom to factory. Labor, tools, machines,
power, and other costs are applied to transform the raw material into finished product.
3. Warehousing – finished goods are moved from the factory to the ware house to be held until they
are sold.
4. Selling – customers are found. Merchandises are shipped from the warehouse, and customer
accounts are charged.

The following diagram shows the above points:

Procurement Production Warehousing Selling

Raw materials Work in process Finished good CGS

In Out In Out In Out In

Direct labor

Out

MOH

Out

As shown in the table cost flow parallels with the physical flow of production.
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 Actual Costing versus Normal costing
The use of an applied overhead instead of an actual overhead has the advantage of timeliness, and
hence relevance for timely decision making. However, the amount may not be as accurate as the
actual overhead cost. But the actual cost is known only at the end of the period, and thus product
costing is impossible before the year ends. Actual costing thus makes product costing untimely, and
this in turn affect decisions like product pricing, and controlling operations. Therefore, most firms
use an applied overhead cost than actual cost for indirect manufacturing costs.
 Normal costing is a costing system where the actual direct material and direct labor are added to
the work in process inventory at the actual amount, and overhead costs are applied to the work in
process inventory using a predetermined overhead rate.
 The term normal comes from the idea that the rate is normalized over a long period of time.
 Actual costing is a costing system where direct material and direct labor costs are traced to the job
at their actual amounts, and overhead costs are allocated using actual overhead rate.
 Since manufacturing overhead costs cannot be directly traced to each job in an economically
feasible way, still the amount charged to each job is simply an allocated amount.
 The difference is simply the use of an actual overhead than an estimated overhead.
The table below shows summary of actual and normal costing

Cost Assignment Actual costing Normal costing

Direct material Tracing Actual Actual
Direct labor Tracing Actual Actual
Manufacturing Allocation Actual over head rate X Estimated overhead rate X
overhead actual cost driver used actual amount of cost driver

Disposition of over and under applied overhead

Under normal costing, the actual amount of manufacturing overhead costs at the end of the period
rarely matches with the applied manufacturing overhead costs during that same period. Often the
applied amount may either be less or more than the actual amount.
 If the amount of applied manufacturing overhead is less than the actual amount, the difference is
said under applied overhead or under absorbed overhead. When the reverse is true, the
difference is said over applied overhead or over absorbed overhead.

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 Under and over applied overhead at the end of one fiscal year should not be carried to the
upcoming periods; rather they should be disposed off in the year the difference occurs. The
disposition of under and over applied overhead costs can take one of the following two ways.
 Closed out to Cost of Goods Sold.
 Allocated between Work in Process, Finished Goods, and Cost of Goods Sold in proportion to the
overhead applied during the current period in the ending balances of these accounts.
1. Closed out to Cost of Goods Sold
Cost of Goods Sold xxx
Manufacturing Overhead xxx
(If the actual cost  overhead applied = under applied)

Manufacturing Overhead xxx

Cost of Goods Sold xxx
(If the actual cost  overhead applied = Over applied
 Suppose that the actual manufacturing overhead – control has a debit balance of Birr 607,500, and
the manufacturing costs applied is Birr 540,000. The under applied manufacturing overhead cost
can thus be disposed to cost of goods sold in the following manner:
Debit Credit
Cost of goods sold 67,500.00
Manufacturing overhead applied 540,000.00
Manufacturing overhead -control 607,500.00
OR

Debit Credit
Cost of goods sold 67,500.00
Manufacturing overhead 67,500

 The applied manufacturing overhead is a contra account to manufacturing overhead control, and
thus, the normal balance for the applied manufacturing overhead is credit.

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 At the end of the period both must be closed. The applied manufacturing overhead is debited and
the manufacturing overhead is credited, and any difference is closed to cost of goods sold.
2. Allocated Between Accounts (Proration Approach)
Under and over applied overhead costs can also be disposed off by prorating to work in process,
finished goods inventory and cost of goods sold.
Assume the following information is pertaining to Awash Manufacturing Company:

End of year balance beforeManufacturing overhead

proration allocated component of
year-end-balances (before proration)
Work in process 11,400.00 3,907.00
Finished good 18,600.00 7,814.00
Cost of goods sold 427,500.00 183,629.00
Total 457,500.00 195,350.00

 Further, assume that the manufacturing overhead control account shows a debit balance of Birr
192,650.00, which shows an over applied balance of Birr 2,700.00. The over applied amount of
manufacturing overhead will be prorated to work in process, finished good, and cost of goods sold.
 The proration base may be on the basis of the manufacturing overhead applied to the three
accounts, or on the respective balance of the three accounts.
 Prorating on the basis of the manufacturing overhead applied is theoretical sound than using the
year-end balance. The table below shows the proration process:

Account Account Manufacturing Proration of the overAccount

balance overhead appliedallocated overhead balance after
(%) proration
Work in process 11,400.00 3,907.00 = 2% 2% X 2,700.00 11,346.00
54
Finished good 18,600.00 7,814.00 = 4% 4% X 2,700.00 18,492.00
108

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 Cost of goods sold 427,500.00 183,629.00=94% 94% X 2,700 424,962.00
2,538.00
Total 457,500.00 195,350.00 2,700.00 454,800.00

The following journal entry is required to show the proration of the over allocated overhead.
Debit Credit
Manufacturing overhead applied 195,350.00
Work in process 54.00
Finished good 108.00
Cost of goods sold 2,538.00
Manufacturing overhead -control 192,650.00

Debit Credit
Manufacturing overhead 2700.00
Work in process 54.00
Finished good 108.00
Cost of goods sold 2,538.00

 The over allocated amount is prorated and the balance of work in process, finished good, and cost
of goods sold is reduced. The amount is reduced because the costs of the three accounts initially
charged higher than the actual, and thus the balance must be reduced.
 The over allocated amount can be prorated on the basis of the year-end balance of the respective
accounts as well. The following table shows the proration of the over allocated cost on the basis of
the year-end balance of the three accounts.

Account Account Proration of the over allocated overhead Account balance

balance after proration
Work in process 11,400.00 11,400/457,500.00 = 2.5% 11,332.50
2.5% X 2,700.00 = 67.5
Finished good 18,600.00 18,600.00/457,500.00 = 4% 18,492.00
4% X 2,700.00 = 108

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Cost of goods sold 427,500.00 427,500.00/457,500.00 = 93.5% 424,975.50
93.5% X 2,700.00 = 2,524.5
Total 457,500.00 2,700.00 454,800.00

The journal entry is the same except that the amount is different. The journal entry looks the
following:
Debit Credit
Manufacturing overhead applied 195,350.00
Work in process 67.50
Finished good 108.00
Cost of goods sold 2,524.50
Manufacturing overhead -control 192,650.00

Debit Credit
Manufacturing overhead 2700.00
Work in process 67.50
Finished good 108.00
Cost of goods sold 2,524.50

Chapter -6
Absorption Costing and Variable Costing
Meaning and Difference between Absorption Costing and Variable Costing
1. Absorption Costing/full costing- under this inventory valuation procedure all manufacturing
costs are assigned to inventory cost (all manufacturing costs: Direct material used, direct
labor cost, variable manufacturing overhead, and Fixed manufacturing overhead-are
inventoriable costs). This is also known as full costing or traditional costing approach. It is
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 used in general purpose financial statements prepared for external users in accordance with
generally accepted accounting principles.
2. Variable (Direct) Costing
This is an inventory valuation procedure that assigns only variable manufacturing (Direct
material used, Direct manufacturing labor cost, and variable manufacturing overhead) to units
produced. All other costs including fixed manufacturing overhead are treated as period costs.

Product cost vs period cost

 Product Costs
o Product costs include all cots that are involved in acquiring or making product- direct
materials, direct labour, and manufacturing overhead.
o Initially product costs are assigned to an inventory account on the balance sheet. When
goods are sold, the costs are released from inventory as expenses (cost of goods sold) and
matched against revenue. For this reason they are also known as inventoriable costs.
o Product costs are not necessarily treated as expenses in the period in which they are
incurred. Rather they are treated as expenses in the period in which the related products are
sold. This means that a product cost such as direct materials or direct labor might be
incurred during one period but not treated as an expense until a following period when the
completed product is sold.
 Period Costs
o Period costs are all the costs that are not included in product costs. These costs are expensed
on the income statement in the period, in which they are incurred, the rules of accrual
accounting.
o Period costs are not included as part of the cost of either purchased or manufactured goods
like sales commissions and office rent and all selling and adminstatrative expenses are
considered to be period costs
Look at the following Exhibit

Absorption Variable (Direct)

Costing Costing

Direct material
used

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 Direct labor cost

Variable
manufacturing
Overhead

Fixed manufacturing
Overhead

Variable Selling and

administrative
Expenses

Fixed Selling and

Administrative
Expenses

Note- the difference between absorption costing and direct costing as you can see from the above
exhibit the treatment of fixed manufacturing overhead which is considered as Product cost under
absorption costing and period cost under variable costing approach.

Income Effect of Alternative Product Costing (Absorption versus Variable Costing

Approaches)
Under absorption costing, all production costs are absorbed into products and the unsold stock is
measured at total cost of production, whereas, in variable costing only variable costs of
production are allocated to products and the unsold stock (inventory) is measured at variable cost
of production. Fixed production costs are treated as a cost of the period in which they are
incurred.
Absorption Variable
Revenues (Sale)--------------------- xx Revenue------ -----------------xx
Less: cost of goods sold------------(xx ) Less :Variable Costs---------(xx)

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Gross Margin-------------------------xx Contribution Margin--------xx
Less: Selling and Less: Fixed Costs------------(xx)
Administrative Expenses-----------(xx) Operating income---------------xx
Operating Income--------------------xx

 The income statements prepared based on the two costing methods differs in their treatment
of fixed manufacturing costs and the classification and presentation of costs on the income
statement.
 On the traditional (absorption) costing method income statement, costs are classified on
the basis of functions: Manufacturing, Selling, Administrative, etc.
 Whereas on a variable (direct) costing method income statement costs are classified on
the basis of behavior pattern: Fixed and Variable.

ILLUSTRATION
Assume that, the business operations plan for Abdi Biya Company for five years periods data
are given bellow. Data regarding budgeted selling price, budgeted variable production cost
per unit and fixed production overhead, variable selling cost per unit and Fixed selling and
Administrative costs per period are given below, together with budgeted volumes of
production and sales over the next five periods of production.

Birr
Selling price per unit 20
Variable production cost per unit 9
Fixed production overhead per period 500
Variable selling cost per unit 2
Fixed selling and Administrative 250
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 2006 2007 2008 2009 2010
Units Produced 230 270 260 240 250
Units Sold 200 210 260 280 300
Ending Inventory Units 30 90 90 50 Nil

Required:
Prepare projected income statement under Absorption and Direct costing approaches.

Solution
1. Absorption Costing
Abdi Biya Company
Projected Income Statement
For Years 2006-2010

2006 2007 2008 2009 2010

Total
Sales (unit sold x price) 4000 4200 5200 5600 6000 25000
Less: Cost of good sols:

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Beginning inventory cost 0 330 990 990 550
Add: cost of production:
Variable 2070 2430 2340 2160 2250
Fixed 500 500 500 500 500
* Less: ending inventory
Cost (330) (990) (990) (550) (0)
Cost of good Sold (2240) (2270) (2840) (3100) (3300) (13750)
Gross profit 1760 1930 2360 2500 2700 11250
Less: Selling and Adm:
Variable (400) (420) (520) (560) (600)
(2500)
Fixed (250) (250) (250) (250) (250)
(1250)
Operating income 1,110 1260 1590 1690 1850 7500
Ending inventory is computed using a cost per unit computed in each period-the cost per unit is
computed nearest to zero decimal place; i.e, Total production cost in each period divided by total
number produced in each period.

2. Variable (Direct) Costing

Abdi Biya Company
Projected Income Statement
For Years 2006-2010

2006 2007
2008 2009 2010 Total
Sales 4000 4200 5200 5600 6000 25000
Less variable cost:
Cost of goods sold (1800) (1890) (2340) (2520) (2700) (11250)

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Selling and Administ. (400) (420) (520) (560) (600) (2500)
Contribution Margin 1800 1890 2340 2520 2700 11250
Less: Fixed costs:
Fixed production cost (500) (500) (500) (500) (500) (2500)
Fixed Selling Adm. (250) (250) (250) (250) (250) (1250)
Operating income 1050 1140 1590 1770 1950 7500

When there is increase in inventory level (2006, 2007, above) operating income under
absorption costing is higher than it is under variable costing; when there is decrease in inventory
level (2009 and 2010 above), operating income under absorption costing is lower than it is under
variable costing and when there is no change in inventory level (2008 above) the operating
income under both approaches is the same.

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