CHAPTER

Traditional Cost Management

Systems

Central Focus and Learning Objectives

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

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Chapter overview Chapter 3 introduces basic product costing systems. The
construction of job bid sheets, determination of markup rates, and
problems with fluctuating cost driver rates are discussed in the
context of job order costing systems.
Recording actual job costs is considered next, and examples of
materials requisition notes, worker time cards, and job cost sheets
are presented. Determining first- and second-level variances of the
differences between estimated and actual costs follows.
In the final section of the chapter, multi-stage product costing for
continuous processing industries is discussed and the concept of
conversion costs introduced. The issue of service department cost
allocation is addressed in Appendix 3-1.

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

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

Chapter outline I. Job Order Costing Systems

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

Learning Objective 2: II.
Understand how
using job bid sheets is
effective for
estimating product
costs in a job order
costing system.
A job bid sheet is a format for estimating job costs.
A. Review Exhibit 3-1 for an example of a job bid sheet.
Note the inclusion of standard engineering and industrial
engineering specifications.
B. Job costs are the total of direct material, direct labor, and
support activity costs estimated for, or identified with, a
job.
C. Markup or margin is the amount added to estimated job
costs to arrive at bid price. It must cover the costs not
assigned to jobs (i.e., selling and administrative
expenses), and generate a profit.
D. The markup rate may depend on the rate of return that
the organization has specified. The rate of return is the
ratio of net income to investment, also called return on
investment.

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Learning Objective 3: III. Determination of cost driver rates requires the specification
Use cost driver rates
to apply support
activity costs to
products.
Learning Objective 4: IV. Use of budgeted or actual activity levels in determining a
Discuss why using a
cost system with
multiple cost driver
rates gives different
estimates of product
costs than a cost
system with a single
rate.
Learning Objective 5: V.
Evaluate a cost
system to understand
whether it is likely to
distort product costs,
and explain the
importance of
recording actual costs
and comparing them
E. Ask students to discuss the role costs play in bidding on a
job following an inquiry by a potential customer. Students
should note that the bidder wants the markup over costs to
be as high as possible to increase profit, but not risk
bidding so high as to lose the job. Thus, the bidder does
not want to either underestimate or overestimate the job
cost. Encourage students to identify factors that lead to
higher or lower markups for products like computers,
televisions, cameras, and patented pharmaceuticals.
of cost pools and the identification of an appropriate cost
driver.
A. Cost pools are categories of costs identified with
different cost drivers and with a separate rate for each
category.
B. The cost driver rate is the rate at which support activity
costs are applied to individual jobs. It is the ratio of the
normal cost for a support activity accumulated in a cost
pool to the normal level of the cost driver for the activity.
C. A general principle in selecting the number of cost pools
is that separate cost pools should be used if the
productivity of resources is different and if the pattern of
demand varies across products.
D. Emphasize that the optimal number of cost pools will
change over time as an organization’s business processes
and competitive environment change. Refining the
costing system is a continuous improvement activity.
cost driver rate results in misleading product costs. The
correct method for determining the cost driver rate is to
estimate the normal activity level.
A. A critical point to stress here is that firms should not rely
on actual consumption rates to determine cost driver rates
because the rates will fluctuate with changes in demand,
thus leading to distortions in product costs. See Exhibit
3.2 for an illustration.
When costs are driven by multiple factors, but a single cost
driver rate is used to assign support costs evenly across
different jobs based on this one driver alone, it can lead to
overestimating the costs of some types of jobs, and
underestimating the costs of other types of jobs. As a result, a
firm may find that profits on individual jobs are distorted.
A. Jobs which are apparently profitable may turn out to be
less profitable (or even money-losers).
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with estimated costs. B. Jobs which appeared to be money-losers or marginally
profitable may turn out to be significantly more
profitable.
C. A comprehensive illustration for Learning Objective 5 is
provided by the Melissa’s Auto Service example. Review
this example, paying particular attention to Exhibits 3-3
through 3-7.

Learning Objective 6: VI. Reinforce the definition of conversion costs (labor and
Appreciate the overhead). Students may find it helpful to remember that
importance of conversion costs are the cost of converting raw material into a
conversion costs and finished (or partially finished) product.
the measurement of
costs in multistage
continuous-
processing industries

Learning Objective 7: VII. Review the process costing illustration in Exhibits 3-13, 3-14,
Understand the and 3-15.
significance of A. A multi-stage process costing system is a system for
differences between determining product costs in multi-stage processing
job order costing and
industries such as chemicals, basic metals, and
multistage-process
costing systems
pharmaceuticals.
1. With this method, the first step is to assess costs for
each stage of the process and then to assign costs to
individual products.
2. A common feature of process costing is that the
products that are produced are relatively
homogeneous.

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

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

Traditional Cost Management Systems 5

Chapter quiz

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

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

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

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

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

Traditional Cost Management Systems 6

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

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

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

8. Conversion costs are:

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

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

a. Work is carried out continuously in large batches.
b. The process is homogeneous across products.
c. Costs are measured for individual jobs.
d. Costs are measured for individual process stages.

10. Which activity level should be used to determine cost driver rates?
a. the budgeted activity level
b. the theoretical activity level
c. the practical activity level
d. the normal activity level

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

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