CHAPTER

Traditional Cost Management

Systems

Central Focus and Learning Objectives

This chapter presents fundamental concepts relating to basic product
costing systems. After studying this chapter, students should be able to:
1. Understand job order costing systems
2. Understand how using job bid sheets is effective for estimating
product costs in a job order costing system
3. Use cost driver rates to apply support activity costs to products
4. Discuss why using cost systems with multiple cost driver rates gives
different estimates of product costs than cost systems with a single
rate
5. Evaluate a cost system to understand whether it is likely to distort
product costs, explain the importance of recording actual costs, and
compare them with estimated costs
6. Appreciate the importance of conversion costs and the measurement
of costs in multistage continuous-processing industries
7. Understand the significance of differences between job order costing
and multistage-process costing systems
8. Understand the two-stage allocation process and service department
allocation methods

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Chapter overview Chapter 34 introduces basic product costing systems. The
construction of job bid sheets, determination of markup rates, and
problems with fluctuating cost driver rates are discussed in the
context of job order costing systems.
Recording actual job costs is considered next, and examples of
materials requisition notes, worker time cards, and job cost sheets
are presented. Determining first- and second-level variances of the
differences between estimated and actual costs follows.
In the final section of the chapter, multi-stage product costing for
continuous processing industries is discussed and the concept of
conversion costs introduced. The issue of service department cost
allocation is addressed in Appendix 43-1.

Teaching tips • Many students have not been inside a manufacturing plant. To
increase student involvement, ask them to list products that are
made in a job shop. Try to elicit a wide range of examples, such
as washing machines, furniture, machined parts for automobiles,
lawn mowers and calculators, thus illustrating the broad range
of industries in which job order costing systems are useful.
Showing one of the videos which focuses on manufacturing
operations should help to enhance students’ familiarity with
manufacturing processes in general.
• Students often have difficulty with the idea that support costs
assigned to a job in a job cost sheet are calculated by
multiplying the actual cost driver quantity (such as direct labor
hours) by the predetermined cost driver rate, and not an actual
cost driver rate. Emphasize that actual support costs are usually
not known until the end of the fiscal period.
• Students often confuse the labor rate with the cost driver rate,
particularly when the driver is direct labor hours. Particular
attention to the difference between these rates may be necessary
to clear up the confusion.
• Note that students are often confused about which costs are
inventoried (charged to production) and written off as cost of
goods sold. I find it necessary to stress the fact that selling and
administrative expenses are never inventoried under GAAP.
• I find that the mechanics of service department allocation are
extremely difficult for students to grasp. Having the students
work through several examples on a computer spreadsheet is
very helpful, as this forces them to think carefully about the
relationships between and among the various parts of the
process.

Traditional Cost Management Systems 2

Recommended 1. Narnia, Inc. is a basic case in product costing and problems
cases with misallocation of support costs. The case is in Rotch,
Allen, & Brownlee, Cases in Management Accounting and
Control Systems, Prentice-Hall, 1995.
2. The Bridgeton Industries case can also be used in this chapter
for a medium difficulty case on determining cost driver rates
and product costs (HBS Case 190-085 and the accompanying
teaching note 5-191-168).
3. Seligram, Inc. Electronic Testing Operations is a good case to
illustrate how a company moved from a poorly designed, single
cost center system to one with multiple cost centers (HBS Case
9-189-084 and teaching note 5-191-020).
4. Colorscope (HBS Case 9-197-040; teaching note 5-198-110
provides an illustration of the impact of cost allocation on job
profitability.
5. Digital Communications (HBS Case 9-189-083; teaching note
5-191-097) provides a comprehensive look at service
department allocation in a more complex setting.
6. For those who want an intensive, hands-on, exposure to the
mechanics and conceptual foundation underlying service
department allocation, the Mayers Tap (A), (B), and (C) series
(HBS cases 9-185-024, 9-185-025, and 9-185-026,
respectively; teaching note 5-185-069) is excellent. Access to
spreadsheet software is required.

Chapter outline 1. Job Order Costing Systems

1 A job order costing system is a system for estimating costs
Learning Objective 1: of products in organizations that produce several different types
Understand job order of products. More specifically, a job order costing system
costing systems. estimates costs of manufacturing products for different jobs
required for customer orders.

Learning Objective 2: 2. A job bid sheet is a format for estimating job costs.
Understand how using 1.1 Review Exhibit 43-1 for an example of a job bid sheet. Note Formatted: Bullets and Numbering
job bid sheets is the inclusion of standard engineering and industrial engineering
effective for specifications.
estimating product
2.2 Job costs are the total of direct material, direct labor, and
costs in a job order
costing system. support activity costs estimated for, or identified with, a job.
3.3 Markup or margin is the amount added to estimated job
costs to arrive at bid price. It must cover the costs not assigned
to jobs (i.e., selling and administrative expenses), and generate
a profit.
4.4 The markup rate may depend on the rate of return that the
organization has specified. The rate of return is the ratio of net
income to investment, also called return on investment.
5 Ask students to discuss the role costs play in bidding on a job

Traditional Cost Management Systems 3

 following an inquiry by a potential customer. Students should
note that the bidder wants the markup over costs to be as high
as possible to increase profit, but not risk bidding so high as to
lose the job. Thus, the bidder does not want to either
underestimate or overestimate the job cost. Encourage students
to identify factors that lead to higher or lower markups for
products like computers, televisions, cameras, and patented
pharmaceuticals.

Learning Objective 3: 3. Determination of cost driver rates requires the specification of

Use cost driver rates cost pools and the identification of an appropriate cost driver.
to apply support 1.1 Cost pools are categories of costs identified with different Formatted: Bullets and Numbering
activity costs to cost drivers and with a separate rate for each category.
products.
2.2 The cost driver rate is the rate at which support activity costs
are applied to individual jobs. It is the ratio of the normal cost
for a support activity accumulated in a cost pool to the normal
level of the cost driver for the activity.
3.3 A general principle in selecting the number of cost pools is
that separate cost pools should be used if the productivity of
resources is different and if the pattern of demand varies across
products.
4 Emphasize that the optimal number of cost pools will change
over time as an organization’s business processes and
competitive environment change. Refining the costing system
is a continuous improvement activity.

Learning Objective 4: 4. Use of budgeted or actual activity levels in determining a cost

Discuss why using a driver rate results in misleading product costs. The correct
cost system with method for determining the cost driver rate is to estimate the
multiple cost driver normal activity level.
rates gives different
1 A critical point to stress here is that firms should not rely on
estimates of product
costs than a cost actual consumption rates to determine cost driver rates because
system with a single the rates will fluctuate with changes in demand, thus leading to
rate. distortions in product costs. See Exhibit 43.2 for an illustration.

Learning Objective 5: 5. When costs are driven by multiple factors, but a single cost
Evaluate a cost system driver rate is used to assign support costs evenly across
to understand whether different jobs based on this one driver alone, it can lead to
it is likely to distort overestimating the costs of some types of jobs, and
product costs, and
underestimating the costs of other types of jobs. As a result, a
explain the
importance of firm may find that profits on individual jobs are distorted.
recording actual costs 1.1 Jobs which are apparently profitable may turn out to be less Formatted: Bullets and Numbering

and comparing them profitable (or even money-losers).

with estimated costs. 2.2 Jobs which appeared to be money-losers or marginally
profitable may turn out to be significantly more profitable.

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 3 A comprehensive illustration for Learning Objective 5 is
provided by the Melissa’s Auto Service example. Review this
example, paying particular attention to Exhibits 43-3 through
43-7.

Learning Objective 6: 6. Reinforce the definition of conversion costs (labor and

Appreciate the overhead). Students may find it helpful to remember that
importance of conversion costs are the cost of converting raw material into a
conversion costs and finished (or partially finished) product.
the measurement of
costs in multistage
continuous-processing
industries

Learning Objective 7: 7. Review the process costing illustration in Exhibits 43-13, 43-
Understand the 1414, and 43-15.
significance of 1 A multi-stage process costing system is a system for
differences between
determining product costs in multi-stage processing industries
job order costing and
such as chemicals, basic metals, and pharmaceuticals.
multistage-process
costing systems 1 With this method, the first step is to assess costs for each
stage of the process and then to assign costs to individual
products.
2 A common feature of process costing is that the products that
are produced are relatively homogeneous.

Learning Objective 8: 8. Work through a detailed (but straightforward) example of

Understand the two- service department allocation. The illustration in the Appendix
stage allocation is a good example, particularly because it links the mechanics
process and service of cost allocation with the mechanics of product costing, a
department allocation
linkage which most texts fail to make sufficiently explicit.
methods.

Traditional Cost Management Systems 5

Chapter quiz

1. Which of the following statements about job order costing systems is false?
a. A job order costing system is a method used for estimating product costs in firms
that have several distinct products.
b. A job order costing system estimates costs of manufacturing products for different
jobs required for customer orders.
c. A job order costing system relies on the concept of conversion costs.
d. A job order costing system provides the means to estimate costs so that bids can
be prepared.

2. From the following information, determine a 20% markup on job H1. For H1, direct
materials are $4,000, direct labor is $5,500 and support activity costs are $7,400.
a. $11,400
b. $20,280
c. $15,480
d. $13,680

3. Carmen Company assigns support costs to final products based on the number of
machine hours required. The normal levels of support costs and machine hours are
$50,000 and 5,000 hours, respectively. Job number 273 required 1,000 machine
hours. Determine the support costs that should be charged to job 473.
a. $50,000
b. $10,000
c. $5,000
d. $1,000

4. A job order costing system is less likely to distort job costs if it assigns support costs
to individual jobs based on:
a. direct labor hours.
b. machine hours.
c. direct material cost.
d. the consumption of different cost drivers.

5. Choose the best answer, given the following scenario. One way to tell whether your
cost accounting system is distorting product costs is if you discover that:
a. the most complex products you produce are overpriced and the simplest to
produce are underpriced.
b. the most complex products you produce are underpriced and the simplest to
produce are overpriced.
c. the most complex products you produce are overpriced as are the simplest to
produce.
d. the most complex products you produce are underpriced as are the simplest to
produce.

Traditional Cost Management Systems 6

6. In a job order costing system, a document that lists the materials required to start
production for a job is referred to as:
a. a materials requisition note.
b. a job cost sheet.
c. a worker time card.
d. a material consumption card.

7. Which of the following is NOT required to record actual job costs?

a. cost estimate for customer job
b. materials requisition note
c. worker time cards
d. job cost sheet

8. Conversion costs are:

a. direct costs.
b. indirect costs.
c. a combination of direct material and direct labor costs.
d. a combination of direct labor and support costs.

9. Which of the following is NOT characteristic of multistage process costing systems?

1.a. Work is carried out continuously in large batches. Formatted: Bullets and Numbering
2.b. The process is homogeneous across products.
3.c. Costs are measured for individual jobs.
d. Costs are measured for individual process stages.

10. Which activity level should be used to determine cost driver rates?
1.a. the
budgeted activity level Formatted: Bullets and Numbering
2.b. the
theoretical activity level
3.c. the
practical activity level
4.d. the
normal activity level

Traditional Cost Management Systems 7

Solutions to chapter quiz
1. c
2. b
3. b
4. d
5. b
6. a
7. a
8. c
9. c
10. d

Traditional Cost Management Systems 8