Chapter 5

Accounting for
production expenses,
cost of finished goods
1
 List
List of
of contents
contents

1. Expenses, cost, classification of cost

2. Accounting for manufacturing cost
3. Accounting for cost of finished goods

2
 Expenses
Expenses
Expenses
Expenses areare decreases
decreases in in economic
economic benefits
benefits during
during
the
the accounting
accounting period
period in in the
the form
form of
of outflows
outflows or or
depletions
depletions ofof assets
assets or
or incurrences
incurrences of of liabilities
liabilities that
that
result
result in
in decreases
decreases in in equity,
equity, other
other than
than those
those
relating
relating to
to distributions
distributions to to equity
equity participants
participants (VAS
(VAS
01
01 –– Framework)
Framework)

3
 Cost and Cost Terminology
• Cost is a resource sacrificed or foregone to
achieve a specific objective.
• It is usually measured as the monetary
amount that must be paid to acquire goods
and services.
• An actual cost is the cost incurred (a historical
cost) as distinguished from budgeted costs

4
 Cost and Cost Terminology
• A cost object is anything for which a separate
measurement of costs is desired.
• A cost pool is a group of individual costs that a
company allocates to cost objects using a
single cost-allocation base.
• A cost driver is a factor, such as the level of
activity or volume, that causally affects costs
(over a given time span).

5
 Cost and Cost Terminology
• There are two basic stages of accounting
for costs:
1.Cost accumulation
2.Cost assignment to various cost objects:

6
 Cost and Cost Terminology

Cost Object

Cost
Accumulation Cost Object

Cost Object
Cost Assignment

7
 Cost and Cost Terminology
• Cost accumulation is the collection of cost data
in some organised way by means of an
accounting system.
• Cost assignment is a general term that
encompasses ...
– tracing accumulated costs to a cost object and
– allocating accumulated costs to a cost object.

8
 Classification of costs
Classification of costs can be made on the basis of:
•Business function
•Assignment to a cost object
• Direct vs. Indirect costs
•Behaviour pattern in relation to changes in the level
of a cost driver
• Variable vs. Fixed costs
•Assets or expenses
• Capitalised (product) vs. Revenue (period) costs

9
 Direct vs. Indirect costs
• Direct costs of a cost object are those that are
related to a given cost object (product,
department, etc.) and that can be traced to it in
an economically feasible way.
– Cost-Tracing describes the assignment of direct
costs to the particular cost object.
• Indirect costs are related to the particular
cost object but cannot be traced to it in an
economically feasible way.
– Cost allocation describes the assigning of indirect
costs to the particular cost object. 10
 Variable vs. Fixed costs

• Variable costs change in total in proportion

to changes in the related level of total
activity or volume.
• Fixed costs do not change in total for a
given time period despite wide changes in
the related level of total activity or volume.

11
 Capitalised vs. Revenue Costs
• Capitalised costs are all costs of a product that
are regarded as an asset when they are incurred
and then become cost of goods sold when the
product is sold.
• Revenue costs are all costs in the Profit and loss
account other than cost of goods sold.
– Revenue costs are recorded as expenses of the
accounting period in which they are incurred.

12
 Manufacturing entities
• Manufacturing operations transform raw
materials - the basic materials from which a
product is made - into other goods through
the use of labor and factory facilities.
• In manufacturing companies, products are
frequently the cost object.
• Manufacturing companies classify production
costs as either (1) direct material, (2) direct-
labor, or (3) indirect production costs.
13
 Direct material costs
• Direct-material costs include the acquisition
costs of all materials that a company identifies
as a part of the manufactured products and
that it can trace to the products in an
economically feasible way.

14
 Direct labour costs
• Direct manufacturing labour costs include the
compensation of all manufacturing labour that
can be traced to the cost object in an
economically feasible way.

15
 Indirect Production Costs
(Manufacturing Overhead)
• Manufacturing overhead includes all costs
associated with the production process that the
company cannot trace to the manufactured goods
(the cost object) in an economically feasible way.
• Examples:
– power, supplies, supervisory salaries, property taxes,
rent, insurance, and depreciation, indirect materials
and indirect labour

16
Flows of costs in manufacturing entities
Costs &
Expenses
Product Costs Balance Sheet

Materials
Materials Materials
Materials
Purchases
Purchases Inventory
Inventory
Period
Periodcosts
costsflow
flow
Direct
Direct
directly
directlyto
tothe
the
Work
Workinin
Labor
Labor income
incomestatement
statement
Process
Process
Inventory
Inventory
Factory
Factory
Overhead
Overhead Income Statement
Finished
Finished
Goods Cost
Costofof
Goods
Period Costs Inventory Goods
GoodsSold
Sold
Inventory
Selling
Sellingand Selling
and Sellingand
and
Administrative
Administrative Administrative
Administrative

17
 Categories of Inventory

• The three categories of Inventory found in

many manufacturing companies depict stages
in the conversion process:
– materials
– work-in-progress
– finished goods

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 Categories of Inventory (Cont’d)

• Direct materials capitalised costs are used to

calculate the cost of materials used.
• Opening direct materials stock
+ Purchases of direct materials
– Closing direct materials stock
= Direct materials used

19
 Categories of Inventory (Cont’d)

• Work-in-progress capitalised costs are used to

calculate the cost of goods manufactured.
• Opening work-in-progress stock
+ Manufacturing costs incurred during the
period
– Closing work-in-progress stock
= Cost of goods manufactured

20
 Categories of Inventory (Cont’d)

• Finished goods capitalised costs are used to

calculate the cost of goods sold.
• Opening finished goods stock
+ Cost of goods manufactured
– Closing finished goods stock
= Cost of goods sold

21
 Example

• Kruger Bicycles had $50,000 of direct

materials stock at the beginning of the period.
• Purchases during the period amounted to
$180,000 and ending stock was $30,000.
• How much direct materials were used?
 Example

• Direct labour costs incurred were $105,500.

• Indirect manufacturing costs were $194,500.
• What are the total manufacturing costs
incurred?
 Example
• Assume that the work-in-progress stock
at the beginning of the period was $30,000,
and $35,000 at the end of the period.
• What is the cost of goods manufactured?
 Example

• Assume that the finished goods stock at the

beginning of the period was $10,000,
and $15,000 at the end of the period.
• What is the cost of goods sold?
Flow of Costs in Manufacturing Firm
Work-in-Process Inventory Finished Goods Inventory
Direct material cost Product cost transferred
Direct labor cost
Manufacturing overhead when product is finished

Cost of Goods Sold Income Summary

Expense closed into

Income Summary at end

of accounting period
26
 2.Accounting for manufacturing costs

2.1 Perpetual and Periodic System

2.2 Accounting for direct material costs
2.3 Accounting for direct labour costs
2.4 Accounting for manufacturing overhead

27
2.1 Perpetual and Periodic System
Flow of Costs
Perpetual System

 Maintain detailed records of the cost of

each inventory purchase and sale.
 Records continuously show inventory that
should be on hand.
 Company determines cost of goods sold
each time a sale occurs.
28
 2.1 Perpetual and Periodic
Flow of Costs System
Periodic System
 Do not keep detailed records of the goods
on hand.
 Determine cost of goods sold only at end of
accounting period.
 Physical inventory count to determine cost
of goods on hand.
 Calculation of Cost of Goods Sold
29
2.1 Perpetual and Periodic System
Flow of Costs
Additional Consideration
Perpetual System:
 Traditionally used for merchandise with high
unit values.
 Provides better control over inventories.

 Requires additional clerical work and

additional cost to maintain inventory
records. 30
2.2 Accounting for raw materials cost
• Related documents used
• Account used for raw materials cost
• Recording transactions of raw materials
cost

31
 2.2 Accounting for raw materials cost
* Source documents:
- Material allocation sheet
- VAT invoice, Sale invoice
* Account used: Acc 621 – Direct material cost

Acc 621
• Unused material at the end of the period
• Material used directly for • Scrap collected during the period
production incurred during the • Allocate direct material cost to cost center
period

Detailed account of Acc 621: Acc 6211-PX1; Acc6212-PX2;...

32
Accounting entries flowchart for direct materials costs

Ac. 152 (611) Ac. 621 Ac. 152,111…

(1)
(3)

Ac. 111,112,331.
Ac. 632
(2)
(4)

Ac. 133
Ac. 154(631)

(5)

33
Explanations:
(1) Material used for directly manufacturing products and
supplying services
(2) Purchase of raw material (not through the company’s
warehouse) used for manufacturing product and
supplying services
(3) Returning unused material at the end of accounting
period
(4) Transferring the value of raw material exceeded the
normal rates (abnormal cost)
(5) At the end of accounting period, transfer (or allocate)
cost of raw material to each cost centre
34
2.3 Accounting for direct labor cost
• Related documents used
• Account used for direct labor cost
• Recording transaction of direct labor cost

35
35
 2.3 Accounting for direct labor cost
* Content
* Source document:
- Payroll and payroll related compensation sheet
- -….
* Account used
Acc 622 – Direct labor cost
Acc. 622

Direct labor cost Allocate direct labor

incurred during the cost to cost center
period
2.3 Accounting for direct labor cost
Ac. 334 Ac. 622 Ac. 154 (631)

(1)
(5)

Ac. 338

(2)
Ac. 632

Ac. 335 (6)

Ac. 334

(4) (3)

37
Explanation:
1. Salaries, wages and allowances for direct
employees
2. Recognizing payroll compensations for direct
employees
3. Provision for annual leave
4. Actual benefits payable to employees when leave
is taken
5. At the end of accounting period, transfer (or
allocate) direct labor cost to cost centre for
calculating costs of product and services.
6. Transfer of direct labor cost higher than normal
rate to account 632 38
2.4 Accounting for factory overhead costs

• Related documents used

• Account used for factory overhead costs
• Recognizing transaction of factory
overhead costs

39
39
2.4 Accounting for factory overhead costs

Manufacturing overhead cost includes:

Indirect labor cost Services rendered

outside

Indirect
Other expenses in
material cost
cash
Indirect tool cost Depreciation cost

40
2.4 Accounting for factory overhead costs

* Source documents:
- Salary and social insurance allocation sheet
- Material allocation sheet
- Depreciation allocation sheets
- VAT invoice, sale invoice
- Debit note issued by bank
- ….
* Account used: Acc 627 – Manufacturing overhead cost

41
 2.4 Accounting for factory overhead costs
* Account used: Acc 627 - Manufacturing overhead cost
Acc. 627

- Manufacturing overhead
Manufacturing
overhead cost cost deduction
incurred during the - Allocate manufacturing
period overhead cost to cost
Detaited account centre

Acc 6271: Indirect labor cost Acc 6274: Depreciation cost

Acc 6272: Indirect material cost Acc 6277: Service rendered outside

Acc 6273: Indirect tool cost Acc 6278: Other expenses paid in cash

42
2.4 Accounting for factory overhead costs

Variable manufacturing overhead

cost
Detailed account of Acc627
Fixed manufacturing overhead
cost

+ If actual production < normal capacity ->….

+ If actual production > normal capacity ->….

43
 2.4 Accounting for factory overhead costs
Allocation method

Fixed overhead Total fixed overhead cost incurred

X Actual goods
cost is allocated on = Normal production capacity produced
cost center

•Fixed overhead cost under Total fixed Fixed overhead

_ cost is allocated
normal capacity is not = overhead cost
allocated in cost center incurred on cost center

Example:
44
 Ac. 627

Ac. 334,338
Ac. 111,112,138
(1) (6)

Ac. 152
(611),111,112… (2)
Ac. 154 (631)
(8)
Acc 153 (611), 242…
(3)

Ac. 214 Ac. 632

(4)
(7)

Ac. 112,113,331…

Ac.133
(5) 45
Explanation:
(1) Indirect labor incurred
(2) Indirect materials used
(3) Tools and supplies are used for administrating the
factory
(4) Depreciation cost of fixed asset used in the factory
(5) Services and other expenses used for
administrating the factory
(6) Decrease in factory overhead cost
(7) Amount of fixed overhead costs not allocated
(8) Transfer (or allocate) of factory overhead cost to
cost centre
46
 33 Accounting
Accounting for
for cost
cost of
of finished
finished goods
goods

3.1 Perpetual inventory method

3.2 Periodic inventory method

1.

47
47
 3.1 Perpetual inventory method

Account 154 “Work in progress”

 - Allocation of production  - Value of non-repairable
costs in the period products
 Value of goods and materials,  Actual cost of finished goods
expenses are rendered from  Value of finished goods and
outside processing
materials returned from
outside processing

Costs of work in progress

at the end of period
48
3.1 Perpetual inventory method
Ac. 621 Ac. 154 Ac.152,138,632...

(1) (4)

Ac. 155

Ac. 622 (5)

(2)
Ac. 632

(6
Ac. 627

Ac. 157

(3)
(7)

49
Explanation:
(1) At the end of the period, direct material expenses
are allocated to cost centre
(2) At the end of the period, direct labor expenses are
allocated to cost centre
(3) At the end of the period, factory overhead expenses
are allocated to cost centre
(4) Value of non-repairable products is not counted into
the cost of finished goods
(5) Cost of finished goods put in the store during the
period
(6) Finished goods directly transferred to customers, not
through the warehouse
(7) Finished goods sent on consignment to customers,
not through the warehouse 50
 3.2 Periodic inventory method
*Enterprises using the periodic inventory method:
Accounts used to reflect the total expenses and calculate
the cost of finished products:
Account 154 – Work in progress
Debit: Allocation of the closing balance of work in
progress
Credit: Reallocation of the opening balance of work in
progress
Debit balance: Work in progress at the end of period

51
 3.2 Periodic inventory method

Account 631 “Cost of products manufacture

d”

 - Opening balance of work in  - Value of finished goods and

progress completed services
 - Expenses incurred in the  - Closing balance of work in
accounting period progress

Acc 631 has no ending balances

52
3.2 Periodic inventory method
Ac. 154
Ac. 631
(1)
Ac.138,632...
Ac. 621

(6)

(2)

Ac. 622

(3)
Ac. 632

Ac. 627
(7)
(4)

53
Explanations:
1. Reallocate opening balance of work in progress to
account 631
2. At the end of the period, direct material expenses
are allocated to cost centre
3. At the end of the period, direct labor expenses are
allocated to cost centre
4. At the end of the period, overhead expenses are
allocated to cost centre
5. Allocation of the closing balance of work in progress
to account 154
6. Value of non-repairable products is not counted into
the cost of finished goods
7. The cost of finished goods and completed services54