The main topics in this chapter are related to cost accumulation and cost allocation. The authors discuss job order costing and
job cost bit sheets in the first section. The second section describes cost driver rates for activity costs. The traditional term for "cost driver
rates" is "factory overhead rates". They use the newer term to promote the activity based approach, but
the term "cost driver rates" was not used in traditional cost systems. This section includes a discussion of how these overhead or driver rates are
determined and why they believe the rates should be based on the long term capacity made available. This section is followed by an example to show why
multiple rates are frequently needed to prevent cost distortions. The last section in the chapter compares job order costing with process costing or
multistage process costing. Chapter 4 also includes an extensive appendix related to the two stage allocation process for service department costs.
2. What is a Cost Accounting System and How do Job Order costing and Process Costing Fit into the System?
The illustration below shows the various components needed to develop a cost accounting system. One component from each
of the five categories is required for an operational cost system, along with many details such as source documents and general ledger accounts. My purpose
for placing Exhibit 2-1 in this summary is not to introduce all of the terminology included in the exhibit, but to point out that job order costing
and process costing are cost accumulation methods, not complete cost systems. These are subsystems that indicate whether manufacturing costs are accumulated by: 1)
job or order, or 2) department or process. Job order cost accumulation is appropriate where products or services are produced to customer specifications.
Process costing is appropriate where identical products are mass produced in a sequence of processes or departments. Then the costs are allocated to individual
products based on an average that varies depending on the cost flow assumption used. For more discussion on the components in Exhibit 2-1 see What
is a cost accounting system or MAAW's Textbook Chapter 2.
3. Determining Activity, Cost Driver, or Overhead Rates
Purpose: Activity rates, cost driver rates, or overhead rates, are developed for the purpose of assigning indirect
costs or support costs to products. All of these terms have similar meanings. The terms "activity rates" and "cost driver rates" are used
in the activity based costing literature, while the term "overhead rates" is an older term associated with traditional cost accounting
systems. In traditional cost systems the overhead rates were usually determined for each producing department, typically one rate per department. Most of these
rates were based on a single production volume based measurement like direct labor hours or machine hours. These rates were calculated as follows:
Overhead rate = Estimated indirect costs for the period ÷ Estimated activity level
The most popular activity level used in the denominator has been the planned capacity level. The basis for the
denominator in the rate calculations is controversial and ABKY do not agree with the calculation above. They show the following calculation on page 118.
Activity cost driver rate = Normal cost of support activity ÷ Normal level of driver
where normal level is defined as the long run capacity made available.
The activity in their example is machining. Annual cost = $900,000. Normal capacity is 20,000 machine hours. The activity
rate is 900,000 ÷ 20,000 = $45.
Then products are charged with $45 of machining costs per machine hour used.
4. Why use Long Run Capacity as the Denominator?
First, if the activity rates are calculated frequently based on expected demand (e.g., by month, or by quarter as
in the example on page 119), product costs would vary from month to month, or quarter to quarter, and cause bid prices to fluctuate and create problems for
the company. ABKY mention a death spiral on page 119 where high prices created during low volume periods could lead to even lower demand and even
higher prices in subsequent periods.
Second, using long run capacity as the basis for the denominator provides more accurate product costs by allowing for
the separation of costs into the cost of capacity used and the cost of capacity unused. When the activity costs are assigned to products, only the
cost of capacity used is assigned. The death spiral argument also applies here. If annual activity rates are based on planned or expected activity volume,
unused capacity cost will be assigned to products and the potential for over pricing products will exist. But note as indicated above, this is a
5. Why use Multiple Rates?
The reason for using multiple rates is to avoid product cost distortions. ABKY show this with an example that appears on
pages 119-123. When the labor costs for two types of mechanics (expert and regular) are lumped together to determine a single activity rate, the simple
jobs are over charged and the complex jobs are under charged. Using separate rates for the two types of mechanics solves the problem. This is another simple
example of how the activity based approach is used to provide more accurate costs.
Determining the number of cost pools and activity rates is based on the tradeoff between cost and benefit. Increasing the number
of cost pools increases the cost of measurement, but decreases the cost of errors in decisions. This tradeoff is illustrated in ABKY's Exhibit 4-8 on page 125.
6. Recording Actual Costs
The ABKY section on pages 125-127 shows how actual costs are recorded on job cost sheets. In the illustration below (from MAAW's
Textbook Chapter 4), job cost sheets serve as the supporting records (subsidiary accounts) for work in process and finished goods. The illustration shows the
general ledger accounts in T-account form for a normal historical job order cost system. Cost sheets are an important part of this type of system, but
there are many other components. Actual resource costs (direct material, direct labor, and support) are recorded and flow through a set of perpetual inventory
accounts as shown. When the products (jobs) are sold, the costs are transferred from finished goods to cost of goods sold. For a complete explanation of this
illustration, along with an example, click on the Chapter 4 link above.
7. Multistage Process Costing
Process costing is a cost accumulation method used where the work performed on each unit is standardized, or uniform, in a
continuous mass production or assembly operation. Costs are accumulated by departments, operations, or processes. For example, process costing is
used by companies that produce appliances, alcoholic beverages, tires, sugar, breakfast cereals, leather, paint, coal, textiles, lumber, candy, coke,
plastics, rubber, cigarettes, shoes, typewriters, cement, gasoline, steel, baby foods, flour, glass, men's suits, pharmaceuticals and automobiles. Process
costing is also used in meat packing and for public utility services such as water, gas and electricity. ABKY show an illustration on page 131 of a chemical
company process involving several process stages including mixing and blending, reaction chambers, and pulverizing and packing. The illustration below (from
MAAW's Textbook Chapter 5) shows how costs flow from one stage or process to another. Costs assigned to products in one stage are transferred to the next stage so
that product cost accumulate to determine the final product costs that are transferred to finished goods.
8. T-ACCOUNT VIEW OF PROCESS COST FLOW
The main problem in process costing is determining the average product cost for each process. An average cost is needed
so that the cost transferred to the next process can be separated from the cost of the ending inventory that remains in process. How the average is determined
depends on the cost flow assumption chosen. The graphic illustration in Exhibit 5-4 (from MAAW's
Textbook Chapter 5) provides a conceptual
view of the calculations that are involved in process costing. Cost accounting textbooks typically include a lot of detailed process costing illustrations and problems.
Our purpose here is to grasp the general concepts, not the operational details. ABKY's Exhibit 4-12 on page 131 helps distinguish between process costing and job order costing.
9. Flow Chart for process Costing
10. Service Department Cost Allocations
The various functional areas within a manufacturing facility are usually separated into producing departments and
service departments. Producing departments convert raw, or direct materials into finished products. Service departments provide support services to the other
departments in the plant. Some examples of service departments include purchasing, receiving and storage, engineering, power, maintenance, packing,
shipping, inventory control, inspection and quality control. Service department costs must be assigned (applied, allocated, or traced) to the inventory for
product costing purposes. ABKY's Exhibit 4-16 and Exhibit 6-1 below (from MAAW's Textbook
Chapter 6) show conceptual views of the traditional two stage cost allocation approach. Service department costs are allocated to producing departments in
stage one using a convenient basis, e.g., book value of machines for maintenance, (See p. 136). Then producing department cost are allocated to
products using a production volume related measurement such as direct labor costs.
In a service organization, the terms revenue producing and non-revenue producing departments might be used rather than the
terms production departments and service departments. However, the concept of allocating, or tracing cost from non-revenue (support) departments to revenue
producing departments is just as applicable as it is in manufacturing. For example, support costs need to be traced to facilitate strategic decisions such
as introducing new services, discontinuing services, pricing services and outsourcing services.
11. Stage One Allocation Methods
ABKY discuss three methods for allocating service department costs to producing departments. These include: 1) the direct method,
2) the step-down or sequential method and 3) the reciprocal method. A summary of these methods appears below.
First Stage Allocation Method
Recognition of Self Service
Procedure for Allocations
Level of Difficulty
Level of Accuracy
Ignores self services, e.g.,
maintenance of the maintenance department, or power consumed by the power
Ignores services provided from
service departments to other service departments.
Cost are allocated directly from
service departments to producing departments.
Least accurate. Distorts the cost
of the services for outsourcing decisions, as well as product costs.
Sequential or Step-down
Ignores self services.
Partially recognizes reciprocal
services as service departments are closed in a prescribed sequence.
Cost are allocated in a sequence
from service departments to some other service departments and to
Difficult and time consuming to
establish the sequence of allocations. Sequential method problems in textbooks
are the most difficult to solve.
More accurate than the direct
method, but still distorts the cost of the services for outsourcing
decisions, as well as product costs.
Fully recognizes self services.
Fully recognizes reciprocal
Allocations are made based on the
solution to a set of simultaneous equations that represent all the
Fairly easy to write equations
representing relationships. Computer software needed to solve
realistic set of equations.
Most accurate for both outsourcing
decisions and product cost decisions.
12. Two Stage Allocation Cost Distortions
The two stage cost allocation approach does not establish an accurate link between the causes of support costs and the products
produced. The main cost distortions occur in the second stage where indirect costs are allocated to products ignoring the relationships between the products
and the service activities. ABKY illustrate this on page 142. Using setup costs as an example of support cost, they show how a traditional stage two
calculation would assign the cost to two products (A and B) based on a production volume related measurement such as machine hours. Since product A is
a high volume product relative to product B, (800 units of A compared to 200 for B), it generates a larger number of machine hours and is charged with more than
its fair share of the setup costs. The problem is that setup costs are related to the number of batches, not the number of units produced. The solution
according to ABKY is to allocate the setup costs based on a batch related measurement such as setup hours. This is an example of how non-production volume
related measurements are used in activity based costing. ABC is the topic in the next chapter. See ABKY pages 90-93 in Chapter 3 to review the cost hierarchy
* What is a cost accounting system and how do job order costing and process costing fit into the system? (See
item 2 above).
1. Why are costs estimated for individual jobs?
2. What information is presented in a typical job bid sheet?
3. What is the source of the information to estimate the cost of materials?
4. What is the source of the information to estimate the direct labor costs?
9. What problem arises when cost driver rates are based on planned or actual short-term usage instead of normal usage? (See
item 4 above and Problem 4-26).
10. What is the normal cost of a support activity? What is the normal usage of a cost driver? (See item 3 above).
11. Use of a peanut-butter-spreading approach of a single cost driver rate when there are multiple cost drivers leads to
distortions in job costs. Do you agree with this statement? Explain. (See
item 5 above).