Traditional Product and Service Costing Systems

Introduction and context

Traditional costing systems collect direct costs and assign indirect costs to products, jobs, batches, processes or services. They remain important where direct labour, machine usage and production volume explain a substantial part of resource consumption. They also provide the foundation for understanding more advanced systems such as activity-based costing.

The central accounting problem is to measure the cost of output accurately enough for inventory valuation, profit measurement, pricing, budgeting and operational control. The appropriate system depends on whether output is separately identifiable, homogeneous, continuous, or service-based.

Learning objectives

By the end of this chapter, you should be able to:

• distinguish job, batch, process, operation and service costing;
• calculate and apply overhead absorption rates;
• prepare process-costing schedules using weighted-average and FIFO equivalent units;
• account for normal and abnormal spoilage, abnormal gain, rework, joint products and by-products;
• explain the difference between absorption and variable costing profits; and
• evaluate the limitations and governance implications of traditional costing.

1. Costing-system selection

The selection is not arbitrary. Job costing emphasizes traceability to an individual contract; process costing emphasizes average cost per equivalent unit. Operation costing combines features of both: materials may be traced to a product while conversion costs are accumulated by operation.

2. Overhead absorption

Direct material and direct labour are normally traced to output. Indirect production costs—such as supervision, depreciation, factory rent, maintenance and utilities—are accumulated in overhead cost centres and assigned using an absorption rate.

The activity base may be direct labour hours, machine hours, direct labour cost or units. The chosen base should have a credible causal relationship with overhead consumption. The rate has units, such as £ per machine hour.

Worked example: plant-wide absorption

A factory budgets production overhead of £600,000 and 15,000 direct labour hours. Its plant-wide rate is:

A job requiring 120 direct labour hours absorbs:

If actual overhead is £620,000 and actual activity is 15,500 hours, overhead absorbed is £620,000 when the predetermined rate is applied to actual hours. The resulting under- or over-absorption is:

If actual hours had been 14,000, absorbed overhead would be £560,000 and under-absorption would be £40,000. Under-absorption normally reduces profit when closed to cost of sales; over-absorption increases profit, subject to the entity’s accounting policy and materiality.

Departmental rates may be superior where departments use resources differently. A machining department might use machine hours, while an assembly department might use labour hours. A single rate is simpler but can cross-subsidize high-volume and low-volume products.

3. Job and batch costing

A job cost sheet records direct materials, direct labour and absorbed overhead for a separately identifiable job.

If Job 48 uses £8,000 of materials, 200 labour hours at £18 per hour, and a £40 labour-hour overhead rate:

• Direct labour = 200 × £18 = £3,600;
• absorbed overhead = 200 × £40 = £8,000;
• total job cost = £8,000 + £3,600 + £8,000 = £19,600.

Batch costing applies the same logic to a group of identical units. If a batch costs £24,000 and produces 600 good units, unit cost is £40. If 20 units are rejected and the rejection is normal, the cost of good output is commonly calculated over 580 good units: £24,000 ÷ 580 = £41.38 per good unit, unless the organization’s policy treats normal loss through a separate process-account method.

4. Process costing and equivalent units

Process costing is used when units are substantially identical and move continuously through departments. A process account records input costs, completed output, closing work in progress (WIP), normal loss and abnormal loss or gain.

An incomplete unit is converted into an equivalent number of complete units. For each cost category:

Materials may be introduced at the beginning, whereas conversion costs (labour and overhead) accrue evenly. Therefore, material and conversion equivalent units can differ.

Weighted-average method

The weighted-average method combines opening WIP costs with current-period costs. The cost per equivalent unit is:

#### Worked example

A department has 1,000 opening units, 60% complete for conversion, with costs of £2,000 materials and £1,200 conversion. During the month, 9,000 units are introduced. Materials are added at the start; conversion is incurred evenly. There are 8,000 completed units and 2,000 closing WIP units, 50% complete for conversion. There is no loss.

Under weighted average:

Current costs are £18,000 materials and £27,000 conversion. Thus:

• materials cost per equivalent unit = (£2,000 + £18,000) ÷ 10,000 = £2.00;
• conversion cost per equivalent unit = (£1,200 + £27,000) ÷ 9,000 = £3.1333.

Completed output receives 8,000 × (£2.00 + £3.1333) = £41,066.40. Closing WIP receives:

• materials: 2,000 × £2.00 = £4,000;
• conversion: 1,000 equivalent units × £3.1333 = £3,133.30;
• closing WIP ≈ £7,133.30.

The small rounding difference should be controlled by retaining more decimal places in the accounting system.

FIFO method

FIFO keeps opening WIP separate from current-period work. It measures only work performed in the current period.

Using the same data, current-period equivalent units are:

Current-period cost per equivalent unit is therefore:

• materials: £18,000 ÷ 9,000 = £2.00;
• conversion: £27,000 ÷ 8,400 = £3.2142857.

The cost assigned to output is calculated in three parts:

1. Opening WIP completed: its prior cost (£3,200) plus current work: 0 materials + (400 × £3.2142857) = £1,285.71, total £4,485.71.
2. Units started and completed: 7,000 × (£2.00 + £3.2142857) = £36,500.00.
3. Completed output cost = £4,485.71 + £36,500.00 = £40,985.71.

Closing WIP cost is 2,000 × £2.00 + 1,000 × £3.2142857 = £7,214.29. Total assigned cost is £48,200, equal to opening costs (£3,200) plus current costs (£45,000). FIFO is particularly useful for measuring current-period efficiency because it does not blend prior-period work with current performance.

5. Spoilage, abnormal gain and rework

Normal and abnormal spoilage

Normal spoilage is unavoidable under efficient operating conditions. Abnormal spoilage is avoidable or exceeds the expected level. Normal loss is generally absorbed by good output; abnormal loss is separately identified and charged to an abnormal-loss account or the income statement.

#### Process-account example

A process receives 10,000 units costing £50,000. Normal loss is 5% of input and has no scrap value. Actual output is 9,400 units. There is therefore abnormal loss of:

• expected normal loss = 10,000 × 5% = 500 units;
• expected good output = 9,500 units;
• abnormal loss = 9,500 − 9,400 = 100 units.

The cost per good unit before abnormal loss is:

Good output is charged £49,473.68 and abnormal loss is charged £526.32. A typical entry structure is:

• Debit Process account £50,000; credit materials, labour and overhead £50,000.
• Debit Finished output £49,473.68 and debit Abnormal loss £526.32; credit Process account £50,000.

If abnormal loss units have scrap value of £0.40 each, the abnormal-loss account is credited £40 for scrap proceeds, leaving £486.32 as the net abnormal loss.

Abnormal gain

If actual loss is below normal, an abnormal gain arises. Suppose the same input has actual output of 9,700 units. Expected good output is 9,500, so abnormal gain is 200 units. At £5.2632 per unit, abnormal gain is £1,052.64 before considering any scrap-value convention. The process account is credited for 9,700 output and debited for normal loss treatment and abnormal gain; the abnormal-gain account is ultimately transferred to profit or loss, adjusted for relevant scrap value.

The precise journal layout varies by accounting system, but the essential control is that normal loss is included in the cost of good output while abnormal loss or gain is reported separately.

Rework

Rework is the additional work required to bring defective units to specification. Normal rework is treated as a production cost and absorbed by good production. Abnormal rework is charged separately so that inefficiency is visible.

For example, normal rework costs £1,200 and abnormal rework costs £700. The normal amount is debited to production overhead or the relevant process and absorbed into output. The abnormal amount is debited to an abnormal rework-loss account and credited to wages, materials or overhead. This prevents avoidable quality failures from being hidden in inventory cost.

6. Joint products and by-products

Joint products arise from a common process that produces two or more significant outputs up to the split-off point. Joint costs cannot be traced economically to individual products before split-off. Common allocation methods include:

• physical-volume method: allocate in proportion to kilograms, litres or units;
• sales-value-at-split-off method: allocate in proportion to relative selling prices at split-off;
• net-realizable-value method: allocate according to final sales value less separable processing and selling costs.

For example, joint cost of £90,000 produces Product A with split-off sales value £60,000 and Product B with £40,000. Under sales-value allocation, A receives £54,000 and B £36,000. Allocation is useful for inventory valuation and reporting, but joint cost is generally sunk for decisions made after split-off.

A by-product is relatively insignificant compared with the main product. Common treatments are to credit by-product proceeds against joint or process cost, or to recognize net realizable value as other income, depending on the reporting policy and materiality. If by-product sales are £5,000 and further processing and selling costs are £1,200, net realizable value is £3,800. It should not be treated as a major joint product merely because it has a selling price.

7. Service costing

Service costing measures costs against a service unit, such as passenger-kilometres, occupied room-nights, patient-days or meals served. A service unit should reflect the output actually delivered.

A transport operator incurs annual standing costs of £180,000, running costs of £0.08 per passenger-kilometre and administration costs of £40,000. It provides 2,000,000 passenger-kilometres. Total cost is:

• running cost = 2,000,000 × £0.08 = £160,000;
• total service cost = £180,000 + £160,000 + £40,000 = £380,000;
• cost per passenger-kilometre = £380,000 ÷ 2,000,000 = £0.19.

If fares are £500,000, the difference of £120,000 is a margin, not contribution, because standing and administration costs have already been deducted. Contribution would be fares less variable costs only: £500,000 − £160,000 = £340,000. The distinction matters in short-term decisions, where fixed costs may not change.

8. Absorption and variable costing profits

Absorption costing assigns all production costs—including fixed production overhead—to units. Variable costing assigns only variable production costs to units; fixed production overhead is expensed in the period.

When inventory increases, absorption costing usually reports higher profit because some fixed production overhead is carried forward in closing inventory. When inventory decreases, variable costing usually reports higher profit because previously deferred fixed overhead is released under absorption costing.

This formula assumes one product, constant fixed overhead per unit based on normal production, no mix changes, and no under- or over-absorption adjustment. It should not be applied mechanically when production volumes or product mix change materially.

Example: fixed production overhead is £100,000 and normal production is 10,000 units, so fixed overhead is £10 per unit. Opening inventory is 1,000 units and closing inventory is 1,400 units. The increase is 400 units; absorption profit exceeds variable-costing profit by £4,000, assuming all other conditions are unchanged.

Variable costing is often more useful for contribution analysis and short-term decisions. Absorption costing is required for external inventory valuation under widely adopted financial reporting frameworks, subject to applicable standards. Managers should therefore reconcile internal variable-costing information with externally reported absorption-costing results.

9. Integrated illustrative case: Northstar Components

This is a fictional illustrative case.

Background

Northstar manufactures two products, Standard and Specialist. The existing system uses one plant-wide direct-labour-hour rate. The annual budget is:

• production overhead: £600,000;
• direct labour hours: 15,000;
• Standard: 10,000 units requiring 0.5 labour hour each;
• Specialist: 2,000 units requiring 5 labour hours each.

The existing plant-wide rate is correctly calculated as £600,000 ÷ 15,000 = £40 per labour hour. It is not £12.

Problem

The production manager believes the single rate may distort product costs because Specialist requires more machine setups and inspections, while Standard uses relatively routine processing.

Analysis

The current system assigns:

• Standard overhead: 10,000 × 0.5 × £40 = £200,000, or £20 per unit;
• Specialist overhead: 2,000 × 5 × £40 = £400,000, or £200 per unit.

Management collects additional departmental information:

Activity rates are:

• setups: £180,000 ÷ 300 = £600 per setup;
• machine processing: £300,000 ÷ 15,000 = £20 per machine hour;
• inspection: £120,000 ÷ 1,000 = £120 per inspection.

Activity-based assignments are:

• Standard: (60 × £600) + (8,000 × £20) + (200 × £120) = £236,000, or £23.60 per unit;
• Specialist: (240 × £600) + (7,000 × £20) + (800 × £120) = £364,000, or £182 per unit.

The plant-wide system overstates Specialist by £36,000 and understates Standard by £36,000 relative to this activity analysis. The conclusion is not that the plant-wide system is mathematically wrong; it is that its causal basis may be weak. Northstar should assess whether the additional data and maintenance cost justify a departmental or activity-based system.

Outcome and learning points

The corrected rate prevents a major decision error. The case also demonstrates that a costing method can be internally consistent yet strategically misleading. Rates should be reviewed when automation, product diversity, batch size or quality requirements change.

10. Implementation, technology and governance

A robust costing system should:

1. define cost objects and service units clearly;
2. separate direct, indirect, product and period costs;
3. document normal loss, rework and overhead policies;
4. reconcile subsidiary cost records to the general ledger;
5. review rates at least annually and after major process changes;
6. preserve audit trails for labour time, material issues and production quantities; and
7. prevent managerial manipulation of completion percentages or standard loss rates.

Enterprise-resource-planning systems can capture barcode, machine, labour and quality data. Artificial intelligence may identify unusual scrap or predict maintenance needs, but it does not replace managerial judgment about causality, cost classification or financial-reporting requirements. Automated estimates require validation, access controls, version histories and bias monitoring.

Traditional systems have limitations. Volume-based rates may cause cross-subsidization; equivalent units depend on credible completion estimates; joint-cost allocations are partly arbitrary; and reported unit costs may be unsuitable for incremental decisions. Managers should distinguish full cost, avoidable cost, variable cost and opportunity cost rather than treating one accounting measure as universally relevant.

Chapter Summary

Traditional costing systems match cost accumulation with the nature of output. Job and batch costing trace costs to identifiable orders or groups; process costing averages costs across homogeneous output; operation costing focuses on production stages; and service costing measures cost per meaningful service unit. Overhead absorption requires a predetermined rate based on budgeted overhead and a justified activity base. Process costing requires equivalent units, with weighted-average costing blending opening WIP and current costs, while FIFO isolates current-period work. Normal spoilage is absorbed by good output, whereas abnormal loss, abnormal gain and abnormal rework are separately reported. Joint costs may be allocated for reporting, but allocations should not automatically drive post-split-off decisions; by-products are normally treated using their net value or proceeds. Finally, absorption and variable costing differ because fixed production overhead may be included in inventory, requiring careful profit reconciliation.

Key Terms

Cost object: Anything for which cost is measured.

Job costing: Costing system for separately identifiable orders.

Batch costing: Costing a group of similar units.

Process costing: Costing system for continuous homogeneous production.

Operation costing: Cost accumulation by repetitive production operation.

Service costing: Measurement of cost per service unit.

Overhead absorption rate: Predetermined overhead divided by budgeted activity.

Under-absorption: Actual overhead exceeding absorbed overhead.

Equivalent unit: A partially complete unit expressed as completed-unit work.

Weighted-average method: Process method combining opening and current costs.

FIFO method: Process method assigning only current-period work to current costs.

Normal loss: Expected loss under efficient operating conditions.

Abnormal loss: Loss exceeding the expected normal amount.

Abnormal gain: Output exceeding expected good output.

Rework: Additional work needed to correct defective output.

Joint product: Significant product arising from a common process.

By-product: Relatively incidental output of a process.

Contribution: Sales less variable costs.

Margin: Sales less a specified broader set of costs.

Variable costing: Product costing that excludes fixed production overhead from inventory.

Review Questions

Short Answer Questions

1. What factors determine the choice between job and process costing?
2. Define an equivalent unit and explain why materials and conversion may have different equivalent units.
3. Distinguish normal spoilage from abnormal spoilage.
4. Why is a fare surplus after total service cost a margin rather than contribution?
5. State the main reason absorption profit can exceed variable-costing profit when inventory increases.

Long Answer Questions

1. Explain the design and operation of a job-costing system, including overhead absorption and under- or over-absorption.
2. Compare weighted-average and FIFO process costing, using the assumptions and quantitative logic of equivalent units.
3. Discuss accounting treatments for normal loss, abnormal loss, abnormal gain and rework.
4. Evaluate alternative methods for allocating joint costs and explain why allocations may be inappropriate for short-term decisions.
5. Explain how traditional costing systems can distort product costs and how a management accountant should respond.

Analytical / Application Questions

1. A process receives 12,000 units. Normal loss is 10%, actual output is 10,500 units and total process cost is £72,000. Calculate normal output, abnormal loss or gain, and the cost per expected good unit.
2. A company budgets fixed production overhead of £240,000 for 30,000 units. Opening inventory is 2,000 units and closing inventory is 2,600 units. Assuming unchanged conditions, calculate the expected difference between absorption and variable-costing profit.
3. A service has fixed operating costs of £90,000, variable cost of £0.25 per service unit and output of 400,000 units. Revenue is £220,000. Calculate total cost, cost per unit and contribution, and explain why contribution is not revenue less total cost.

Multiple Choice Questions with Answers

Question 1

A factory budgets £600,000 of overhead and 15,000 direct labour hours. What is the predetermined overhead rate?

A. £12 per labour hour

B. £40 per labour hour

C. £600 per labour hour

D. £9,000 per labour hour

Correct Answer: B. £40 per labour hour

Question 2

Which costing system is most appropriate for continuous production of identical chemical units?

A. Job costing

B. Batch costing

C. Process costing

D. Contract costing

Correct Answer: C. Process costing

Question 3

A process has 2,000 closing units that are 50% complete for conversion. How many conversion equivalent units are represented?

A. 500

B. 1,000

C. 1,500

D. 2,000

Correct Answer: B. 1,000

Question 4

Under FIFO process costing, opening work in progress is treated as:

A. Entirely current-period production

B. Separate from current-period work, with only completion work measured currently

C. A period expense

D. Normal loss

Correct Answer: B. Separate from current-period work, with only completion work measured currently

Question 5

Input is 10,000 units, normal loss is 5%, and actual output is 9,400 units. What is the abnormal loss?

A. 100 units

B. 400 units

C. 500 units

D. 600 units

Correct Answer: A. 100 units

Question 6

Which treatment normally makes abnormal rework visible as a separate inefficiency?

A. Include all abnormal rework in finished-goods inventory

B. Charge abnormal rework to a separate abnormal-loss account

C. Ignore the rework cost

D. Treat it as a by-product receipt

Correct Answer: B. Charge abnormal rework to a separate abnormal-loss account

Question 7

Joint costs are £90,000. Products A and B have split-off sales values of £60,000 and £40,000. Using sales-value allocation, how much joint cost is assigned to A?

A. £36,000

B. £45,000

C. £54,000

D. £60,000

Correct Answer: C. £54,000

Question 8

A service earns fares of £500,000 and incurs variable costs of £160,000 plus fixed costs of £220,000. What is contribution?

A. £120,000

B. £160,000

C. £340,000

D. £500,000

Correct Answer: C. £340,000

Question 9

If inventory increases and all other assumptions remain constant, which profit is normally higher?

A. Variable-costing profit

B. Absorption-costing profit

C. Both are always identical

D. Neither can be calculated

Correct Answer: B. Absorption-costing profit

Question 10

A company has fixed production overhead of £100,000 and normal output of 10,000 units. Inventory increases by 400 units. What is the expected absorption-versus-variable profit difference?

A. £400

B. £4,000

C. £10,000

D. £40,000

Correct Answer: B. £4,000