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OVERVIEW OF COSTING

Definition of Costing
It refers to the method and process of ascertaining the costs. Costing involves classifying, recording, and
allocating the expenditure of an organization to determine the costs of products or services. Also, it
requires the presentation of suitably arranged data, for management control and guidance. The major
objectives of costing are the following:
• To determine the cost incurred during each operation to control wages;
• To provide information that establishes the selling price of a product and the pricing policies of a
company;
• To provide information about the economic consideration in purchasing materials; and
• To help the management in decision-making, detection of wastages, and reduction of total
manufacturing costs.

Concepts of Costs
The following are the different definitions of cost:
• It is the amount of resource used in exchange for goods or services.
• It is the amount of expenditure incurred on, or attributable to a specified object or activity.
• It is a preceding value, measured in monetary terms, incurred or potentially to be incurred to
achieve a specific objective.

Costs have to be assessed in different aspects as follows:

• Nature of business. A cost has to be studied in relation to its nature of business. For example, a
manufacturing organization is interested in knowing the cost per unit of its product, whereas the
organizations rendering services such as electricity and transport are interested in determining
the costs of services they undertook. The cost per unit can be easily determined by dividing the
total expenditure by the number of units produced or total services rendered.
• Purpose. A cost has to be studied in relation to its purpose. For example, the purpose is fixation
of selling price cost. All items of expenditure relating to production, administration, and selling
will have to be included. But if the purpose is valuation of inventories, only the cost of production
will have to be taken into account. Hence, the concept of cost varies according to the purpose.
• Conditions. A cost has to be determined under different conditions. For instance, while dealing
with inventory, work-in-progress is valued at factory cost, whereas stock of finished goods is
valued at production cost.
• Context. Cost is a generic term which has to be recognized or qualified. It is generally used to
include all the various types of expenditures. However, when the term cost is used specifically, it
is always modified with reference to the context of the different types of cost like fixed cost,
variable cost, and sunk cost, among others. Each type of cost implies a certain attribute which is
important in computing and measuring the cost.

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Classification of Costs
Costs can be classified into different categories for different purposes as follows:
1. According to Management Function
• Manufacturing costs. It refers to the costs incurred in the factory for converting raw materials
into finished goods. It includes the cost of raw materials used, direct labor, and the costs incurred
during the manufacturing process or factory overhead.
• Nonmanufacturing costs. It refers to the unincurred costs in transforming materials to finished
goods. These include selling expenses such as advertising costs, delivery expense, salaries, and
commission. It also includes administrative expenses such as salaries of executives and legal
expenses.

2. According to Ease of Traceability

• Direct costs. It refers to the costs that can be traced directly to a particular object of costing such
as a particular product, department, or branch. Examples include materials and direct labor. Some
operating expenses can also be classified as direct costs, such as advertising cost for a particular
product.
• Indirect costs. It refers to the costs that cannot be traced to a particular object of costing. They
are also called common costs or joint costs. Examples include factory overhead and operating
costs associated with more than one (1) product, department, or branch.

3. According to Timing of Charge Against Revenue

• Product costs. It refers to the costs that form part of inventory and are charged against revenue.
They are also called inventoriable costs. It includes manufacturing costs such as direct materials,
direct labor, and factory overhead.
• Period costs. It refers to the costs that are not inventoriable and are immediately charged against
revenue. It includes nonmanufacturing costs such as selling expenses and administrative
expenses.

4. According to Relevance to Decision-making

• Overhead cost. It refers to the ongoing business expenses not including or related to direct labor
or direct materials used in creating a product or service like rent, utilities, and insurance.
• Standard cost. It refers to the predetermined cost based on some reasonable basis such as past
experiences, budgeted amounts, and industry standards.
• Opportunity cost. It refers to the benefit forgone or given up when an alternative is chosen over
the other/s. For instance, if a business decides to use its building for production rather than
renting it out to its tenants, the opportunity cost would be the rent income that would be earned
had the business decides to rent out the building.
• Sunk costs. It refers to the historical costs that will not make any difference in making a decision.
Examples include the acquisition cost of an office equipment and the manufacturing costs of
finished goods on hand.
• Committed costs. It refers to the costs resulting from an organization’s structure or the use of its
facilities. Examples include property taxes, salaries of management personnel, and cost of renting
facilities.

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• Discretionary costs. It refers to the costs resulting from a management decision to spend a
particular amount of money for a specific purpose. Examples include the amount of money to
spend on research and development, contributions to charitable institutions, and advertising.
• Controllable costs. It refers to the costs that can be influenced or controlled by a supervisor or
manager for a given period of time. An example of this is the control of a supervisor to company
expenditures such as the purchase of office supplies and the maximum overtime a rank and file
employee may render. Another example is the power of a manager to influence equipment
purchases or building acquisitions.

5. According to Accounting Period-Wise Classification of Costs

• Capital expenditure: It refers to the expenditure which results in the acquisition of an asset. It
also pertains to the extension or enhancement of earning capacity at a smaller cost. Capital
expenditure is intended to benefit future periods. It is classified as a fixed asset. Examples of this
include costs of acquiring land, building, and machinery.
• Revenue expenditure: It refers to the expenditure which occurs for the maintenance of assets in
working condition and not intended for increasing the revenue-earning capacity. A revenue
expenditure benefits the current accounting period. It is treated as an expense.

6. According to Behavior in Accordance with Activity

• Fixed costs. These are constant costs which do not change with an increase or decrease in the
number of goods or services produced and sold. The changes in the number of goods and services
produced or sold are classified as the activity with a designated relevant range or boundary of
minimum and maximum activity level. The cost of production or unit cost of goods and services
may vary as the activity level increases or decreases, while the total fixed cost remains constant.
Examples of this include supervision fee, factory rent, insurance, and taxes.

12 Fixed Cost Line

Total cost (Pesos)

10
8
6
4
2
0
1 2 3 4 5 6
Volume of Production (Units)

Figure 1. Fixed Cost

ILLUSTRATION: ABC Manufacturing has the following monthly expenses which present the
breakdown of their factory rent and the cost of production for its three (3) major products: liquid

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detergent, baking soda, and paper towels. The management set the ideal production or relevant
range within 8,000 – 10,000 units for a given month.

Factory Rent (Total Fixed Cost) P100,000

Production in Units:
Liquid detergent 8,000
Baking soda 9,000
Paper towels 9,500
Relevant Range 8,000-10,000 units
Use the following formula to solve for the Fixed Cost (FC) per unit:

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝐹𝐹𝐹𝐹 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

Liquid detergent Baking soda Paper towels

Total Fixed Cost (Rent) P100,000 P100,000 P100,000
Production 8,000 9,000 9,500
Fixed Cost (FC) per Unit P12.50 P11.11 P10.53

ANALYSIS: The factory rent which is the total fixed cost is the same for the three (3) products.
However, the fixed cost per unit decreases as production increases within the relevant range.

• Variable costs. These are costs that vary in total, in direct proportion to changes in the volume of
production. Variable cost is a constant amount on a per unit basis as activity changes within a
relevant range. As activity changes, the total variable cost increases or decreases proportionately
with the change, but the unit variable cost remains the same. Examples of this include direct
materials, direct labor, overtime premium, materials handling costs, and maintenance costs.

120
100 Total Variable Cost Line
Total cost (Pesos)

80
60
40
20
0
1 2 3 4 5 6
Volume of Production (Units)

Figure 2. Variable cost

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ILLUSTRATION: The primary component of the bestselling perfume of Kisses Inc. is the plant
substance of citrus fruits which costs the company P5.00 for each bottle of production. The
perfume production is being handled by the company’s floor workers with an associated piece
rate of P6.00 for each bottle that they produce. Also, the estimated advertising expense or
overhead cost of the company is at P3.00 per bottle. The following is the summary of the
company’s incurred costs of unit production for each perfume line:

Production in Units:
Magical Citrus 8,000
Wild Citrus 9,000
Victoria’s Citrus 9,500

Variable Cost per Unit:

Direct Materials (citrus fruits) P5.00
Direct Labor (salary of floor workers) 6.00
Overhead (advertising expense) 3.00
Total Variable Cost P14.00

Use the following formula to solve for the Total Variable Cost (TVC):

𝑇𝑇𝑇𝑇𝑇𝑇 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑖𝑖𝑖𝑖 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 × 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢

Magical Citrus Wild Citrus Victoria’s Citrus

Production in Units 8,000 9,000 9,500
Variable Cost per Unit P14.00 P14.00 P14.00
Total Variable Cost P112,000 P126,000 P133,000

ANALYSIS: The variable cost per unit is constant at P14.00 per unit, but as the production of each
perfume line increases, the total variable cost increases.

• Mixed Costs. These costs vary in total but not in proportion to activity changes. It includes both
fixed and variable component.

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120 Fixed Cost

100

Total Cost (Pesos)

80
Variable Cost
60
40
20
0
1 Volume
2 of Production
3 4(Units) 5 6

Figure 3. Mixed cost

EXAMPLE: A water company charges a fixed amount of P200.00 for using less than or equivalent
to 500 gallons of water on a given month. Also, the company imposes an additional P1.00 charged
for each gallon consumed more than the 500-gallon base. The fixed component in the given
scenario is the P200.00 charged for consuming less than or equivalent to 500 gallons of water,
while the variable component is the additional P1.00 charge for consuming more than 500 gallons
of water on a given month.

• Step Costs. These costs remain unchanged or constant for a given level of output and then
increase by a fixed amount at a higher level of output, i.e., from one level of output to another
higher level. An example of this is the salary of supervisors in a factory. Depending upon the period
up to which an expense can be kept up to a certain level in spite of the increase in activity, the
height and width of steps vary. If the steps are small and narrow, the behavior of cost is like that
of “pure variable cost.” This is called “step variable cost.” On the other hand, if the steps are wider,
the cost is like that of “fixed cost.” This is called “step fixed cost.”
Total variable cost

Figure 4. Step variable cost

Source: Costing Accounting, 2010

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EXAMPLE: In a goods importing company, where the freight charge of Php 1,000 will have an
additional Php 1,000 for every 1 cubic meter of finished goods in excess each time they deliver.
Thus a volume of 1.8 cubic meter of goods will cost Php 2,000 and the 2.5 cubic meters will be
charged at Php 3,000 then the very narrow cost level increases from one range to next and can
be categorized as Step Variable Cost.

Total fixed cost (Pesos)

Figure 5. Step fixed cost

Source: Costing Accounting, 2010

EXAMPLE: Assume that a supervisor can supervise effectively 20 workers, a second supervisor
would be needed if workers exceed 20, and a third supervisor if workers exceed 40 and so on.
There would be a sudden increase in the salary of the supervisors, if the activity level increases
from one range to next in a wider scope, it can be categorized as Step Fixed Cost.

Separating Mixed Cost

The procedure for separating mixed cost involves the use of high-low method on a given set of data within
the relevant range.
ILLUSTRATION: Machine hours and utility costs for DKNY Industries in year 201A were as follows:
Month Machine Hours Utility Costs
January 2,500 P36,800
February 2,900 42,000
March 1,900 27,000
April 3,100 46,000
May 3,800 56,500
June 3,300 44,000
July 4,100 49,500
August 3,500 45,500
September 2,000 31,000
October 3,700 52,000
November 4,700 62,000
December 4,200 55,500
Table 1. DKNY Industries
Source: Cost Accounting, 2016, p.13

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PROCEDURE:

1. Select the highest and lowest levels of activity and costs within the given set of data.

Machine Hours Utility Costs

Highest 4,700 P62,000
Lowest 1,900 27,000
Difference 2,800 P35,000

2. Compute the variable cost element using the following formula:

𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 (𝑉𝑉𝑉𝑉) 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 =
𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 (𝑉𝑉𝑉𝑉) 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 =
𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑖𝑖𝑖𝑖𝑖𝑖 ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑃𝑃35,000
=
2,800
= 𝑃𝑃12.50 𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑖𝑖𝑖𝑖𝑖𝑖 ℎ𝑜𝑜𝑜𝑜𝑜𝑜

3. Compute the variable cost at the highest and lowest level of activity using the following formula:
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 × 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = 4,700 × 12.50 = 𝑃𝑃58,750

𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = 1,900 × 12.50 = 𝑃𝑃23,750

4. Determine the fixed cost at each level of activity using the following formula:
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑎𝑎𝑎𝑎 𝑒𝑒𝑒𝑒𝑒𝑒ℎ 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = 𝑃𝑃62,000 − 𝑃𝑃58,750 = 𝑃𝑃3,250

𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = 𝑃𝑃27,000 − 𝑃𝑃23,750 = 𝑃𝑃3,250

Inventory Accounts
Most companies particularly in manufacturing industry maintain the following inventory accounts:

• Raw Materials Inventory. This shows the available raw materials to use in the manufacturing
process. It serves as a controlling account if the company maintains only one account for direct
and indirect materials.
• Work-in-Process Inventory. This represents the costs of partially completed goods on which
production activities have been started but not yet completed as of a certain period.
• Finished Goods Inventory. This summarizes the costs of completed job stored in the warehouse
for delivery to the customers.

Raw Materials Inventory System

Manufacturing companies commonly use the following inventory systems:

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• Perpetual Inventory System. This system requires the need to maintain stock cards or records of
the status of the goods held in the inventory for each type of raw materials, which reflects the
summary of the inflow, outflow, and balance of raw materials in quantity and peso amount.
Although the quantity of raw materials is available any time by referring to the stock card, this
system also requires physical counting of raw materials at least once a year to confirm the balance
reflected in the material stock cards.
• Periodic Inventory System. This system does not require a stock card for the raw materials,
however, a physical count of raw materials must be facilitated periodically to determine the units
on hand.

The Flow of Manufacturing Costs

The flow of manufacturing costs is based on the following illustration:

Chart 1. Flow of Costs

Source: Cost Accounting, 2016, p.19

The flow of costs of a manufacturing company is outlined as follows:

1. Purchase of Raw Materials. It involves the acquisition of raw materials needed for production.
Most manufacturing companies use a perpetual inventory system where purchases and issuance
of raw materials are recorded directly in the raw materials inventory account as they occur.
2. Issuance of Raw Materials. It involves the delivery of raw materials to production through a
requisition slip properly accomplished and approved by the production manager. The cost of
issued raw materials can be classified under work-in-process inventory.
3. Return of Excess Materials. It involves the returning of excess raw materials in the storage room.
4. Factory Labor Incurred. It involves temporarily accumulating the compensation of factory
workers and other personnel, in a factory payroll account at the time it is incurred, whether it is
paid immediately or not.
5. Distribution of Factory Labor. It involves sorting the time tickets or written records of the total
hours an employee worked in a given pay period and segregating the direct labor and indirect
labor costs. The salaries of direct laborers or factory workers are classified under work-in-process
account, while the salaries of indirect laborers like the manager, supervisor, clerk, and
maintenance personnel are classified under manufacturing overhead.

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6. Manufacturing Overhead Incurred. It involves charging the actual overhead cost in production to
a manufacturing overhead account at the time it is incurred. Other manufacturing costs such as
expired insurance and depreciation of factory plant and equipment are charged to manufacturing
overhead account only at the end of the year.
7. Actual Factory Overhead Charged to the Job. It involves transferring the actual overhead to the
work-in-process account.
8. Completion of the Job. It involves transferring the accumulated cost of production summarized
in the work-in-process account to the finished goods account.
9. Sale of the Completed Job. It involves setting the price for the completed job. The most common
method in setting price is the Cost-Plus Pricing method. In this method, the costs include not only
production costs but also administrative and selling costs. The desired profit of the firm and the
prices of competitors are the other factors that must be considered in setting the price.

Methods of Accumulating Product Costs

The following are the methods of accumulating product costs:

• Actual Costing System. This method requires that all production overhead is available prior any
cost allocation to the jobs in process. Under this system, the actual costs of direct materials used,
direct labor, and manufacturing overhead incurred in production are charged to the job to
determine the cost of specific products.

Use the following formula to compute for the costs associated in the product using actual costing
system:
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 + 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
EXAMPLE: High Street Manufacturing has the following account balances at the end of their
production cycle for the month of January:

Direct Labor P120,000

Direct Materials 162,000
Manufacturing Overhead 74,000
Total Actual Cost P 356,000

SOLUTION:
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = (𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 + 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀) + 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

= (𝑃𝑃120,000 + 162,000) + 74,000

= 𝑃𝑃282,000 + 74,000

= 𝑃𝑃356,000

KEY POINTS: Based on the illustration, the direct labor and direct materials are added because
they are classified as actual direct costs. Then, by adding the actual direct costs and actual
overhead cost which is the given manufacturing overhead, the total cost or actual cost will be
derived.

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• Normal Costing System. This method requires the costs of direct materials and direct labor to be
charged to the job. Under this system, the manufacturing overhead applied to production differs
in the sense that a predetermined overhead rate is used in computing for the amount of overhead
charged to the job. The predetermined overhead rate is the ratio of the estimated total overhead
to the estimated total of cost driver selected. A company may employ a plant wide rate or
departmental rates. If several rates or departmental rates are used, the budgeted manufacturing
overhead is divided into several cost pools, and uses each driver as the denominator in computing
for the predetermined overhead rate.

Use the following formula to compute for the costs associated in the product using normal costing
system:

𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑂𝑂𝑂𝑂𝑂𝑂𝑟𝑟ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢

EXAMPLE: High Street Manufacturing Company has the following account balances at the end of
their production cycle for the month of February:

Fixed Cost P1,000,000

Variable Cost per Direct Labor Hours (DLH) 40
Budgeted annual Direct Labor Hours (DLH) 125,000
Actual Direct Labor Hours utilized 150,000

SOLUTION:

1. The first step is to get the predetermined overhead rate using the formula:

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜ℎ𝑒𝑒𝑒𝑒𝑒𝑒

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎

𝑃𝑃1,000,000 +(125,000 ×40)

=
125,000 𝐷𝐷𝐷𝐷𝐷𝐷

𝑃𝑃1,000,000 + 5,000,000
=
125,000 𝐷𝐷𝐷𝐷𝐷𝐷

𝑃𝑃6,000,000
=
125,000 𝐷𝐷𝐷𝐷𝐷𝐷

= 𝑃𝑃48 𝑝𝑝𝑝𝑝𝑝𝑝 𝐷𝐷𝐷𝐷𝐷𝐷

KEY POINTS: Take note that the budgeted manufacturing overhead is the sum of the fixed cost
and variable cost multiplied by the budgeted annual direct labor hours. The budgeted production
activity is the budgeted annual direct labor.

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2. In order to get the normal cost, substitute the values to the formula:

𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
= 𝑃𝑃48 × 150,000
= P7,200,000
KEY POINTS: To arrive at the amount of overhead applied to the job through normal costing, the
predetermined overhead rate is multiplied by the number of direct labor hours utilized in the
production.

References
Accountingverse. (n.d.). Types of costs (cost classifications). Retrieved on August 23, 2018, from
https://www.accountingverse.com/managerial-accounting/cost-concepts/types-of-costs.html

Lalitha, R., & Rajasekaran, V. (2010). Costing accounting. India: Pearson.

Nikhila, C. (n.d.). Costing: Meaning, aims and methods. Retrieved on August 23, 2018, from
https://www.businessmanagementideas.com/cost-accounting/costing-meaning-aims-and-
methods-cost-accounting/7265

Rante, G. A. (2016). Cost accounting. Mandaluyong City: Millenium Books, Inc.

Swiftutors. (n.d.). Aims of costing. Retrieved on August 23, 2018, from

http://www.swiftutors.com/estimating/what-is-costing.php

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