1.0.

Introduction

In managerial accounting, cost accounting establishes budget and actual cost of operations,
processes, departments or product and the analysis of variances, profitability or social use of
funds. Managers use cost accounting to support decision-making how costs are assigned to
production process and improve profitability. Costing systems are components of a broader
accounting system used by a different company or organization (especially manufacturing
company). The main function of the costing system is to keep a focused eye on expenditures
made by the company. While the data that is collected and generated by the costing system is
also integrated into the overall accounting system, the costing approach allows for easy
extraction of the data for reports to upper management.

1.1. Origin of the report

The preparation of this report has been authorized on 24th February, 2011 by Mohammad Abu
Sayeed, Course instructor of ACT 203: Managerial Accounting 1for the students of 18th batch of
the Institution of Business Administration (IBA), Jahangirnagar University, Savar, Dhaka. A
group of 6 students (ID-917, 935, 1657, 1660, 1661, 1664) of 4th semester of BBA program
have been asked to prepare a report on costing system.

The report has been prepared by our group & the submission date of this report is March 03,
2011. Our course instructor gave us all required instructions. This report is prepared by following
the standard procedures on long formal report writing.

1.2. Objective of the report

The purpose of this report on “Costing System” is to

 To study and analyze what is costing system.

 To analyze process costing.
 To analyze job order costing.
 To analyze activity based costing.

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1.3. Scope of the report

In this report we have covered a brief description about costing system method that is used in a
typical manufacturing company. Our group has also focused on the cost accounting to analyze
various types of costing systems. For this purpose we have discussed process costing, job order
costing and activity-based costing.

1.4. Background Information

Institute of Business Administration, Jahangirnagar University operates BBA program. As a

student of 4th semester of this program we are covering the course ACT 203: Managerial
Accounting. Here we are learning the accounting for the managerial activities of an organization
and this report is the practical implementation of that study. The topic was thoroughly discussed
by our respected instructor at the course and the students were asked to prepare a long formal
business report on that study. For this procedure, our course instructor asked us to form group of
six members for a better research. We studied the topic for better knowledge, surfed internet and
also went the RSRM in Chittagong for better and practical knowledge.

1.5. Methodology

A study has been carried out to analyze “Costing System”. The report is mainly based on
secondary data. The methodology of preparing this report is given below:

Collecting the data: We collected data and information from secondary sources by surfing
internet and studying the book Managerial Accounting, Garrison, Noreen, Brewer, 13th edition.
We tried to collect all the necessary information to analyze the costing system.

Analyzing the data: We processed the collected information and tabulated and analyzed to
present the findings in a logical and subjective manner. First we presented about the costing
system and then focused on different types of costing systems like variable costing system, time
constraint, process costing and job order costing.

Finding the result: After analyzing the collected data we showed out the result of the analysis.
We tried to get to know what is costing system of a company and the details.

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2.0. Manufacturing Company

Manufacturing is the use of machines, tools and labor to produce goods for use or sale. The term
may refer to a range of human activity, from handicraft to high tech, but is most commonly
applied to industrial production, in which raw materials are transformed into finished goods on a
large scale. Such finished goods may be used for manufacturing other, more complex products,
such as aircraft, household appliances or automobiles, or sold to wholesalers, who in turn sell
them to retailers, who then sell them to end users – the "consumers”.

A firm that converts raw materials and component parts into consumer and industrial goods
called a manufacturing company.

3.0. Costing System

Cost accounting has long been used to help managers understand the costs of running a business.
Modern cost accounting originated during the industrial revolution, when the complexities of
running a large scale business led to the development of systems for recording and tracking costs
to help business owners and managers make decisions.

Costing systems are components of a broader accounting system used by a given company or
organization. The main function of the costing system is to keep a focused eye on expenditures
made by the company. While the data that is collected and generated by the costing system is
also integrated into the overall accounting system, the costing approach allows for easy
extraction of the data for reports to upper management.

The information that typically is gathered by a costing system allows owners and managers to
quickly identify the current status of two key factors that are relevant to the success of the
company. Operational costs are often the foundation of the data collected by a costing system.
Here, management is able to get a snapshot of all expenditures that are directly connected with
the general operation of the organization, especially in terms of production costs

3.1. Classification of Cost

All types of organizations incur costs – governmental, not-for-profit, manufacturing, retail and
service. Manufacturing companies are involved in acquiring raw materials, producing finished
goods, marketing, distributing, billing, and almost every other business activity. The major
classification of costs of a manufacturing company is:

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  Manufacturing cost: a. Direct material
b. Direct labor
c. Manufacturing overhead

 Non-Manufacturing cost: a. Selling cost

b. Administrative cost

3.1.1. Manufacturing cost

Manufacturing cost is the cumulative total of resources that are directly used in the process of
making various goods and products. In general, factors such as raw materials, labor, equipment
operation, and the general overhead for maintaining the production facility are common
components that are included in determining the overall manufacturing costs.

1) Direct material: The materials that go into the final product are called raw materials.
Actually, raw materials refer to any materials that are used in the final product; and the
finished product of one company can become the raw material of another company. Raw
materials include both direct and indirect materials.

Direct materials are those materials that become an integral part of the finished product and
whose costs can be conveniently traced to the finished product. Direct material forms an integral
part of the finished product and can be directly identified or included in computing the cost of
such product.

The indirect material cost is the cost incurred by the company in other than core operations of the
company.

2) Direct Labor: Direct labor consists of labor costs that can be easily traced to individual
units of product. Direct labor is sometimes called touch labor, since direct labor workers
typically touch the product while it is being made.

Indirect labor is labor costs that cannot be physically traced to the creation of products, or that
can be traced only at greater cost and inconvenience. Just like indirect materials, indirect labor is
treated as part of manufacturing overhead.

3) Manufacturing Overhead: Manufacturing overhead, the third element of manufacturing

cost, includes all costs of manufacturing except direct materials and direct labor.
Manufacturing overhead includes items such as indirect materials; indirect labor;
maintenance and repairs on production equipment; and heat and light, property taxes,
insurance on manufacturing facilities. A company also incurs costs for heat and light,

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 property taxes, depreciation, insurance, depreciation, and so forth, associated with its
selling and administrative functions, but these costs are not included in manufacturing
overhead. Only those costs associated with operating the factory are included in
manufacturing overhead.

3.1.2. Non-manufacturing Costs:

Nonmanufacturing costs are often divided into two categories:

i) Selling Costs

ii) Administrative Costs.

i) Selling Costs: Selling costs include all costs that are incurred to secure customer
orders and get the finished product to the customer. These costs are sometimes called
order-getting and order-filling costs.
ii) Administrative Costs: Administrative costs include all executive, organizational,
and clerical costs associated with the general management of an organization rather
than with manufacturing or selling.

3.2. Other Classifications of Cost:

Along with the manufacturing and nonmanufacturing costs there are other ways to look at the
costs. For instance, they can also be classified as:

i) Product costs,
ii) Period costs,
iii) Prime costs,
iv) Conversion costs.

i) Product Costs: For financial accounting purposes, product costs include all costs involved in
acquiring and making a product. In the case of manufactured goods, these costs consist of direct
materials, direct labor, and the manufacturing overhead. Product costs “attach” to units of
product as the goods are purchased or manufactured and they remain attached as the goods go

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into inventory awaiting sale. Since product costs are initially assigned to inventories, they are
also known as inventoriable cost.

ii) Period Costs: period costs are all costs that are not product costs. Period costs are not
included as part of the cost of either purchased or manufactured goods; instead, period costs are
expensed on the income statement in the period in which they are incurred using the usual rules
of accrual accounting.

iii) Prime Costs: Prime cost is the sum of direct material l cost and direct labor cost.

Prime cost=Direct material cost + Direct labor cost

iv) Conversion Costs: Conversion cost is the sum of direct labor cost and manufacturing
overhead cost. The term conversion cost is used to describe direct labor and manufacturing
overhead because these cots are incurred to convert materials into finished product.

Conversion cost=Direct labor cost + Manufacturing overhead cost

3.3. Types of Costing:

The costing structure of a company depends on its functions and on the matter that what type of
company it is. There may be four types of costing structure that a firm can use:

i) Process Costing: A process costing system is used in situations where the company produces
many units of a single product for long periods.

ii) Job-order Costing: A job-order costing system is used in situations where many different
products are produced each period.

iii) Variable Costing: In a variable costing system, only those manufacturing costs that vary with
output are considered.

iv) Activity-based Costing: Activity Based Costing (ABC) is a method for developing cost
estimates in which the project is subdivided into discrete, quantifiable activities or a work unit.

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4.0. Process Costing:

4.1. Definition and Explanation of Process Costing System:

Process costing is used when products are manufactured under conditions of continuous
processing or under mass production methods. In fact, process costing procedures are often
termed "continuous or mass production cost accounting procedures". Process costing method is
used for industries producing chemicals, petroleum, textiles, steel, rubber, cement, flour,
pharmaceuticals, shoes, plastics, sugar, and coal. Process costing system is also used by firms
manufacturing items such as rivets, screws, bolts, and small electrical parts. A third type of
industry using process costing system is the assembly type industry which manufactures such
things as typewriters, automobiles, airplanes, and household electric appliances (washing
machines, refrigerators, toasters, irons, radios, television sets, etc.). Finally certain service
industries, such as gas, water, and heat, cost their products by using process costing system.

The type of manufacturing operations performed determines the cost procedures that must be
used. For example, a company manufactures custom machinery will use job order costing,
whereas a chemical company will use process costing. In the case of machinery manufacturer, a
job order cost sheet is prepared for each order, accumulating the costs of materials, labor, and
factory overhead. In contrast the chemical company cannot identify materials, labor, and factory
overhead with each order, since each order is part of a batch or a continuous process. The
individual order identity is lost, and the cost of a completed unit must be computed by dividing
total cost incurred during a period by total units completed. The summarization of the costs takes
place via the cost of production report, which is an extremely efficient, economical, and
timesaving device for the collection of large amounts of data.

4.2. Characteristics and Procedure of Process Costing System:

The characteristics of process costing system:

1) A cost of production report is used to collect, summarize and compute total and unit costs.

2) Production is accumulated and reported by departments.

3) Costs are posted to departmental work in process accounts.

4) Production in process at the end of a period is restated in terms of completed units.

5) Total cost charged to a department is divided by total computed production of the

department in order to determine a unit cost for a specific period.

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 6) Costs of completed units of a department are transferred to the next processing department
in order to arrive at the total costs of the finished products during a period. At the same
time, costs are assigned costs are assigned to units still in process.

4.3. The Cost Flows in Process Costing:

The procedures of process costing are designed to:

1) Accumulate materials, labor, and manufacturing overhead costs by departments and make
the relevant journal entries.

2) Determine equivalent units of production of production and a unit cost for each
department.

3) Transfer costs from one department to the next and to finished goods.

4) Assign costs to the inventory of work in process (WIP)

5.0. Job Order Costing

Job order costing system is used in situations where many different products are produced each
period. In a job order costing system, costs are traced to the jobs and then the costs of the job are
divided by the number of units in the job to arrive at an average cost per unit.

Job order costing system is also extensively used in service industries. Hospitals, law firms,
movie studios, accounting firms, advertising agencies and repair shops all use a variety of job
order costing system to accumulate costs for accounting and billing purposes. The details here
deal with a manufacturing firm, the same concept and procedures are used by many service
organizations.

The record keeping and cost assignment problems are more complex in a job order costing
system when a company sells many different products and services than when it has only a single
product or service. Since the products are different, the costs are typically different.
Consequently, cost records must be maintained for each distinct product or job.

Companies classify manufacturing costs into three broad categories:

(1) Direct materials,

(2) Direct labor,

(3) Manufacturing overhead.

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5.1. Documents used in a job order costing

1) Measuring direct material cost through materials acquisition form.

2) Job cost sheets to determine the materials, labors, manufacturing overhead costs charged to
that job.

3) Measuring direct labor cost by using time ticket.

5.2. The Cost Flows in a Job Order Costing

1) Accumulate materials, labor, and manufacturing overhead costs and make the relevant journal
entries.

2) Applying manufacturing overhead cost and makes the relevant journal entries.

3) Determine the amount of finished goods.

4) Determine the cost of goods sold.

5.3. Identification of Job Order:

Management determines the services or products to be cost schedules work in the production
departments, and forwards the order to cost accounting. A job order number is assigned to each
identified cost object. The job order number is a control feature for identifying each job and is a
means of accumulating departmental labor, material, and overhead cost by job order. As work
progresses production departments report costs incurred by job order number. The information is
forwarded to the cost accounting department where the costs are recorded on separate job order
cost ledgers (subsidiary job cost ledger). A summary work in process cost schedule for all open
job order numbers is prepared and forwarded to the accounting department for posting to the
general ledger control accounts Work-in-Process and Construction-in-Progress. The supporting
detail for these accounts is identified and maintained by the job order number on individual job
order cost ledgers. As production departments complete a job order, the cost accounting
department calculates the total cost for the job and prepares a summary schedule for the
accounting department. The accounting department prepares the general ledger control account
entry transferring the appropriate amount from Work-in-Process and Construction in Progress
accounts to the applicable asset accounts. The detail support for these general ledger accounts is
identified and maintained by job order numbers assigned to completed job order cost sheets.

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6.0. Activity-based Costing

Activity based costing (ABC) is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect capacity and therefore "fixed
cost".

Activity based costing system is used to determine product costs for special management reports.
This system is ordinarily used as a supplement to the company's usual costing system. Most
organizations that use ABC system have two costing systems--the official costing system that is
used for preparing external financial reports and the activity based costing system that is used for
internal decision making and for managing activities.

6.1. Comparison between traditional cost accounting system and the activity-
based system

In traditional cost accounting systems, the objective is to value inventories and cost of goods
sold for external financial reports in accordance with the generally accepted accounting
principles (GAAP). In activity based costing (ABC) system the objective is to understand
overhead and the profitability of products and customers and to manage overhead. As a
consequence of these differences in objectives, "best practice" activity based costing system
differs in a number of ways from traditional cost accounting.

In activity based costing:

1. Non-manufacturing as well as manufacturing costs may be assigned to products.

2. Some manufacturing costs may be excluded from product costs.
3. A number of overhead cost pools are used, each of which is allocated to products and
other costing objects using its own unique measure of activity.
4. The allocation bases often differ from those used in traditional costing system.
5. The overhead rates or activity rates may be based on the level of activity at capacity
rather than on the budgeted level of activity.

These differences from traditional cost accounting systems can dramatically impact the apparent
costs of products and the profitability of products and customers.

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6.2. Activity cost methodology:

For many years, construction firms and industry trade groups have collected cost data from a
multitude of different construction projects. The amount of work associated with that cost was
also collected with the cost data. For example, collected data included the cost of the paint, labor,
equipment, and overhead to paint a room, the amount of surface area painted, and the manpower
required painting the room. This practice allowed construction professionals to obtain a cost per
area and manpower per area. These costs are based on an activity, such as painting, and are
known as ABC. ABCs are discussed in detail in the following sections.

ABC can be defined by the following equation:

C/A = HD + M + E + S

Where C/A = Estimated cost per activity

H = Number of labor hours required to perform the activity one time

D = Wages per labor hour

M = Material costs required to perform the activity one time

E = Equipment costs to perform the activity one time

S = Subcontracting costs to perform the activity one time

6.3. Development of an Activity-based System:

There are three steps necessary to develop an ABC system. The steps are the following:

1. Identifying available resources and resource-consuming activities

2. Assigning costs of available resources to activities

3. Assigning costs of activities to cost objects (i.e. products, batches of products)

6.4. Identifying Available Resources and Resource-consuming Activities:

At first, a company developing an ABC system has to identify the resources consumed by the
company and their cost. Note that a resource is an economic good consumed in performing

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activities. For example, Friends Company, a manufacturer of valves, has the following resources:
manufacturing equipment, supplies, utilities, wages, office expenses, furniture, etc.

In addition to identifying available resources, the company has to determine the activities that
consume the company's resources, or in other words, resource-consumption cost drivers.
Resource-consumption cost drivers can be divided into two categories: Transaction drivers and
Duration drivers.

Transaction drivers count the number of times an activity occurs (e.g. number of orders
processed, number of orders shipped, number of items inspected). Transaction drivers can
accurately measure the activity rate when the activity requires the same amount of time. For
example, the amount of bills processed would be an accurate activity measure when it takes the
same amount of time to process each bill. However, a more accurate type of activity measure is a
duration driver.

Duration drivers measure the time required to perform an activity. For example, duration drivers
measure the amount of time required to inspect items, to process bills, to process orders, etc.
Duration drivers are more accurate measurement of the consumption of resources.

To determine resource-consumption cost drivers, the company collects data concerning the
activities performed in a manufacturing process. Such information can be gathered from the
company's records and documents as well as from observations, interviews of personnel, and
surveys. Some of the questions often asked are: What activities do you do? What resources are
necessary to perform these activities? How much time do you spend performing these activities?

Besides collecting data regarding activities, the company ranks activities according to their level
of resource consumption.

6.5. Activity levels of resource consumption:

A unit-level activity is an activity performed on each individual product or service. At this level,
the cost drivers will be volume-based since the amount of activity will proportionally depend on
the number of units produced. For example, for Friends Company, a manufacturer of valves, the
unit-level activities include inserting piston into piston valves, inspecting each unit, and
providing power to run processing equipment.

A batch-level activity is an activity performed on each batch of products or services regardless of

how many units are in the batch. For instance, the cost of setting up equipment is the same
whether the batch has ten or thousand units. Examples of batch-level activities are: placing
purchase orders, setting up machines (i.e. per batch and not per individual product), conducting

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inspections by batch, arranging for deliveries to customers, etc. At this level, examples of cost
drivers are: orders processed, number (or duration) of set-ups, number of inspections, etc.

A product-level activity (also called, a product- or service-sustaining activity) is an activity

performed to support production of a specific product or service regardless of how many batches
are run or how many items are produced. Examples of product-level activities are: purchasing
product parts, designing, modifying (re-engineering) and testing products, managing inventory,
advertising a product, maintaining a product manager, etc. At the product-level, examples of cost
drivers are: number of categories of product parts, design and testing time, number of
engineering orders, number of inventory categories, etc

A customer-level activity is an activity that relates to specific customers, not specific products.

Examples of customer-level activities are: IT-support, sales calls, sales visits, catalog mailings,
etc. We will talk in greater detail about customer-level costs when we will learn about customer
cost and customer profitability analyses.

A facility-level activity (also called, a business/organization sustaining activity) is an activity

that supports business operations in general and cannot be traced to individual units, batches, or
products. Examples of facility-level activities are: managing factory, heating factory, providing
factory safety and security, maintaining general-purpose equipment, cleaning executive offices,
arranging for loans, closing books each month, preparing annual reports to shareholders,
providing a computer network, etc.

Note, that the activities can be traced in the ascending order and not vice versa. For example, a
unit-level activity can be traced to a batch-level activity, and a batch-level activity can be traced
to a product level activity, but not vice versa. In addition, within each group of activities, the
activity cost centers that use the same cost driver are combined into homogeneous cost pools
(e.g. Customer Orders, Customer relations).

6.6. Steps in implementing Activity-Based Costing

 Define activities, activity cost pools, and activity measures.

 Assign overhead costs to activity cost pools.
 Calculate activity rates.
 Assign overhead costs to cost objects using the activity rates and activity measures.
 Prepare management reports.

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6.7 Advantages of Activity-based Costing system:

An activity-based costing system has the following advantages:

 Accurate product cost and product and customer profitability measurement: An ABC
system provides accurate and detailed product information that can be utilized by
management in decision-making process. It can help to make better-informed
management decisions concerning product pricing, product volumes, market segments,
product lines, and target costing.

 Better-informed strategic decisions: The information about cost drivers for each activity
enables management to make better-informed decisions concerning product design,
customer support, etc.

 Production improvement: An ABC system provides information helpful in improving

production processes.

 Better product cost information: An ABC system provides a lot of information necessary
for strategic budgeting, planning, and product pricing decisions. It also takes into
consideration cost of unused capacity and measures it at all levels (i.e. product, batch, and
facility-levels).

6.8. Disadvantages or Limitations of Activity Based Costing System

Activity based costing system help managers manage overhead and understand profitability of
products and customers and therefore is a powerful tool for decision making. However activity
based costing has a number of limitations or disadvantages.

These limitations or disadvantages are briefly discussed below:

1. Implementing an ABC system is a major project that requires substantial resources. Once

implemented   an activity based costing system is costly to maintain. Data concerning
numerous activity measures must be collected, checked, and entered into the system.

2. ABC produces numbers such as product margins that are odds with the numbers
produced by traditional costing systems. But managers are accustomed to using
traditional costing systems to run theirs operations and traditional costing systems are
often used in performance evaluations.

3.  Activity based costing data can be easily misinterpreted and must be used with care
when used in making decisions. Costs assigned to products, customers and other cost

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 objects are only potentially relevant. Before making any significant decision using
activity based costing data, managers must identify which costs are really relevant for the
decisions at hand.

Reports generated by this system do not conform to generally accepted accounting principles
(GAAP). Consequently, an organization involved in activity based costing should have two cost
systems - one for internal use and one for preparing external reports.

7.0. Conclusion

Cost accounting establishes budget and actual cost of operations, processes, departments or
product and the analysis of variances, profitability or social use of funds. Managers use cost
accounting to support decision-making to cut a company's costs and improve profitability.
Costing systems are components of a broader accounting system used by a different company or
organization. The main function of the costing system is to keep a focused eye on expenditures
made by the company for manufacturing its products. Manufacturing is the use
of machines, tools and labor to produce goods for use or sale. The term may refer to a range of
human activity, from handicraft to high tech, but is most commonly applied
to industrial production, in which raw materials are transformed into finished goods on a large
scale. Costing systems are components of a broader accounting system used by a given company
or organization. The main function of the costing system is to keep a focused eye on
expenditures made by the company. Throughout the report we have seen different types of
costing structure possible in a company. And we have also covered the details of each type. We
think this report will be helpful in determining the appropriate costing system for a certain
company.

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 Appendix

Bibliography

 Garrison R. H., Noreen E. W., Brewer P. C. (2010-11), Managerial Accounting, Ed. 12th,
McGraw Hill, New York.

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