business statistics chapter 3

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Chapter 3

Systems Design—Job-Order Costing Learning Objectives LO1. Distinguish between process costing and job-order costing and identify companies that

would use each costing method. LO2. Identify the documents used in a job-order costing system. LO3. Compute predetermined overhead rates and explain why estimated overhead costs (rather

than actual overhead costs) are used in the costing process. LO4. Prepare journal entries to record costs in a job-order costing system. LO5. Apply overhead cost to Work In Process using a predetermined overhead rate. LO6. Use T-accounts to show the flow of costs in a job-order costing system, and prepare

schedules of cost of goods manufactured and cost of goods sold. LO7. Compute under- or overapplied overhead cost and prepare the journal entry to close the

balance in Manufacturing Overhead to the appropriate accounts. LO8. (Appendix 3A) Understand the implications of basing the predetermined overhead rate on

activity at capacity rather than on estimated activity for the period. New in this Edition • New In Business boxes have been added. • New shorter exercises that cover a single learning objective have been created. Chapter Overview A. Costing Systems. (Exercise 3-1.) Two major types of costing systems are used in manufacturing and many service companies: process costing and job-order costing. 1. Process Costing. A process costing system is used where a single, homogeneous product

or service is produced. In a process costing system, total manufacturing costs are divided by total number of units produced during a given period. The unit cost that results is a broad, average figure. Process costing is used in industries such as cement, flour, brick, and oil refining.

2. Job-Order Costing. Job-order costing is used when different types of products, jobs, or

batches are produced within a period. In a job-order costing system, direct materials costs and direct labor costs are usually traced directly to jobs. Overhead is applied to jobs using a predetermined rate. Actual overhead costs are not traced to jobs. Examples of industries in which job-order costing is used include special order printing, shipbuilding, construction, hospitals, professional services such as law firms, and movie studios.

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Note that in some situations either job-order costing or process costing could be used, depending on the level of detail needed and the desires of management.

B. Job-Order Costing—An Overview. (Exercises 3-2, 3-3, 3-9, 3-11, 3-12, 3-13, 3-15, and 3-16.) The discussion in the text and below assumes that a paper-based manual system is used for recording costs. Cost and other data are recorded on materials requisition forms, time tickets, and job cost sheets. Of course, many companies now enter cost and other data directly into computer databases and have dispensed with these paper documents. Nevertheless, the data residing in the computer typically consists of a “virtual” version of the manual system. Since a manual system is easy for students to understand, we continue to rely on it when describing a job-order costing system. 1. Job Cost Sheet. Each job has its own job cost sheet on which costs are charged to the job.

The job cost sheet will have some code or descriptive data to identify the particular job and will contain spaces to record costs of materials, labor, and overhead. Exhibit 3-4 provides an illustration of a job cost sheet.

2. Materials Costs. When a job is started, materials that will be required to complete the job

are withdrawn from the storeroom. The document that authorizes these withdrawals and that specifies the types and amounts of materials withdrawn is called the materials requisition form. The materials requisition form identifies the job to which the materials are to be charged. Care must be taken when charging materials to distinguish between direct and indirect materials. An example of a materials requisition form is shown in Exhibit 3-1 in the text.

3. Labor. Labor costs are recorded on a document called a time ticket or a time sheet. Each

employee records the amount of time he or she spends on each job and each task on a time ticket. The time spent on a particular job is considered direct labor and its cost is traced to that job. The cost of time spent on other tasks, not traceable to any particular job, is usually considered part of manufacturing overhead. An example of an employee time ticket is shown in Exhibit 3-3 in the text.

4. Manufacturing Overhead. Manufacturing overhead includes all manufacturing costs that

are not traced to a particular job. In practice, manufacturing overhead usually consists of all manufacturing costs other than direct materials and direct labor. Since manufacturing overhead costs are not traced to jobs, they must be allocated to jobs if absorption costing is used. a. We do not dwell on the reasons for allocating all manufacturing overhead to jobs in this

chapter. What costs should or should not be allocated to jobs and to products remains a controversial issue. In the chapter we confine discussion to absorption costing since that is the approach that is used in the vast majority of organizations for both external and internal reporting.

b. In order to allocate overhead costs, management must choose an allocation base. The

most widely used allocation bases are direct labor-hours, direct labor costs, and machine-hours. (These bases have been severely criticized in recent years. Critics charge that overhead is largely unrelated to, or even negatively correlated with, machine-hours or direct labor-hours.) In the costing system illustrated in the chapter, a predetermined overhead rate is computed by dividing the estimated total overhead for the upcoming period by the estimated total amount of the allocation base.

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c. Ideally overhead cost should be strictly proportional to the allocation base; in other

words, an x% change in the allocation base should cause an x% change in the overhead cost. Only then will the allocated overhead costs be useful in decision-making and in performance evaluation. However, much of the overhead typically consists of costs that are not proportional to any conceivable allocation base and hence any scheme for allocating such costs will inevitably lead to costs that are biased and unreliable for decision-making and performance evaluation. In practice, the overriding concern is to select some basis or bases for allocating all overhead costs and scant attention is paid to questions of causality. These issues are not raised in the text at this point since students will not be ready to understand them until after having studied cost behavior in more depth in later chapters.

d. At any rate, the actual amount of the allocation base incurred by a job is recorded on

the job cost sheet. The actual amount of the allocation base is then multiplied by the predetermined overhead rate to determine the amount of overhead that is applied to the job.

C. Job Order Costing—The Flow of Costs. (Exercises 3-4, 3-10, 3-13, 3-14, 3-15, and 3-17.) Exhibit 3-14 in the text provides a model for the cost flows in a job-order costing system. 1. Overview of Cost Flows. The basic flow of costs in a job-order system begins by

recording the costs of material, labor, and manufacturing overhead. a. Direct material and direct labor costs are debited to the Work In Process account. Any

indirect material or indirect labor costs are debited to the Manufacturing Overhead control account, along with any other actual manufacturing overhead costs incurred during the period. Manufacturing overhead is applied to Work In Process using the predetermined rate. The offsetting credit entry is to the Manufacturing Overhead control account.

b. The cost of finished units is credited to Work In Process and debited to the Finished

Goods inventory account. c. When units are sold, their costs are credited to Finished Goods and debited to Cost of

Good Sold.

2. The Manufacturing Overhead Control Account. Manufacturing Overhead is a temporary control account.

a. As stated above, actual overhead costs are recorded on the debit side of the

Manufacturing Overhead control account. Overhead costs applied to Work in Process using predetermined rates are recorded on the credit side of the account.

b. Any discrepancy between overhead costs incurred and overhead costs applied shows up

as a balance in the Manufacturing Overhead control account at the end of the period. A debit balance is called underapplied overhead and a credit balance is called overapplied overhead.

D. Under- and Overapplied Overhead. (Exercises 3-6, 3-7, 3-8, 3-13, 3-14, 3-16 and 3-17.) Since the predetermined overhead rate is based entirely on estimated data, the actual amount

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of overhead cost incurred will almost always differ from the amount of overhead cost that is applied to the Work In Process account. The difference is termed underapplied or overapplied overhead, and as discussed above, can be determined by the ending balance in the Manufacturing Overhead control account. An underapplied balance occurs when more overhead cost is actually incurred than is applied to the Work In Process account. An overapplied balance results from applying more overhead to Work In Process than is actually incurred. 1. Cause of Under- and Overapplied Overhead. When a predetermined overhead rate is

used, it is implicitly assumed that the overhead cost is variable with (i.e., proportional to) the allocation base. For example, if the predetermined overhead rate is $20 per direct labor-hour, it is implicitly assumed that the actual overhead costs will increase by $20 for each additional direct labor-hour that is incurred. If, however, some of the overhead is fixed with respect to the allocation base, this will not happen and there will be a discrepancy between the actual total amount of the overhead and the overhead that is applied using the $20 rate. In addition, the actual total overhead can differ from the estimated total overhead because of poor controls over overhead spending or because of inability to accurately forecast overhead costs.

2. Disposition of Under- and Overapplied Overhead. Two approaches to dealing with an

under- or overapplied overhead balance in the accounts are illustrated in the text. a. The simplest approach is to close out the under- or overapplied overhead to Cost of

Goods Sold. This is the method that is used in most of the exercises and problems because it is easiest for students to understand and master.

b. The second approach is to allocate the under- or overapplied balance to Cost of Goods

Sold and to the Work In Process and Finished Goods inventory accounts. The basis of allocation is the amount of overhead applied during the period in the ending balance of each of these accounts. This method is equivalent to waiting until the end of the period to allocate the actual overhead costs based on the actual amount of the allocation base incurred.

3. The Effect of Under- and Overapplied Overhead on Net Operating Income.

a. If overhead is underapplied, less overhead has been applied to inventory than has actually been incurred. Enough overhead must be added to Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is increased, underapplied overhead reduces net income.

b. If overhead is overapplied, more overhead has been applied to inventory than has

actually been incurred. Enough overhead must be removed from Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is decreased, overapplied overhead increases net operating income.

E. The Predetermined Overhead Rate and the Level of Activity (Appendix 3A). (Exercise 3-16.) Interest has been recently rekindled in the issue of how to select the denominator level of activity in the predetermined overhead rate. In the main body of the chapter, it is assumed that the denominator is the estimated total amount of the allocation base for the period. While this is the most common method used in practice, it has some serious drawbacks.

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1. Drawbacks of basing the predetermined overhead rate on the estimated level of activity.

a. If overhead contains substantial fixed costs, then as the estimated level of activity

decreases, the predetermined overhead rate will increase. Thus if the company starts losing sales due to a recession or other reason, the company’s unit costs will increase. This could result in some managers increasing prices or dropping products, which is likely to be exactly the wrong thing to do in this situation.

b. Products are charged with resources they don’t use. If a product uses 10% of the

capacity of a fixed resource, it is argued that it should be charged with only 10% of the cost of that resource. If all of the products a company makes use only 50% of the capacity of the fixed resource, the cost of that idle capacity should be separately recognized as a period expense rather than spread over the products that use the resource during the period. Under the conventional approach, products are charged for both their share of the capacity they use and for a share of the idle capacity they do not use. So if a product uses 10% of the capacity of a resource, but 50% of the capacity is idle, then under the conventional approach the product would be charged with 20% of the total cost of the resource.

2. Suggested solution. It has been suggested that predetermined overhead rates should be

based on the amount of the allocation base at capacity rather than on the estimated amount of the allocation base for the upcoming period. This proposal would result in stable unit costs that do not rise and fall with decreases and increases in the expected level of activity. The underapplied overhead that results from the discrepancy between the actual level of activity and the level of activity at capacity can be treated as a period expense and taken directly to the income statement. In the text we suggest the title “Cost of Unused Capacity” for this income statement item, but other names would work as well. By showing this amount separately, the cost of idle capacity is highlighted for management attention. For a good discussion of these issues, we recommend the IMA’s Statement on Management Accounting 4Y, Measuring the Cost of Capacity, March 31, 1996. Even though we have a great deal of sympathy with this proposal, we continue to use the conventional approach in the main body of the text since it still predominates in practice.

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Assignment Materials

Assignment Topic Level of

Difficulty Suggested

Time Exercise 3-1 Process costing and job-order costing ................................... Basic 10 min. Exercise 3-2 Job-order costing documents................................................. Basic 15 min. Exercise 3-3 Compute the predetermined overhead rate............................ Basic 10 min. Exercise 3-4 Prepare journal entries........................................................... Basic 15 min. Exercise 3-5 Apply overhead ..................................................................... Basic 10 min. Exercise 3-6 Applying overhead; cost of goods manufactured .................. Basic 15 min. Exercise 3-7 Prepare T-accounts ................................................................ Basic 20 min. Exercise 3-8 Under- and overapplied overhead ......................................... Basic 10 min. Exercise 3-9 Departmental overhead rates ................................................. Basic 15 min. Exercise 3-10 Journal entries and T-accounts .............................................. Basic 30 min. Exercise 3-11 Applying overhead in a service company.............................. Basic 30 min. Exercise 3-12 Varying predetermined overhead rates.................................. Basic 30 min. Exercise 3-13 Applying overhead; T-accounts; journal entries ................... Basic 30 min. Exercise 3-14 Applying overhead; journal entries; disposition of under-

or overapplied overhead ................................................... Basic 15 min. Exercise 3-15 Applying overhead; journal entries; T-accounts ................... Basic 30 min. Exercise 3-16 (Appendix 3A) Overhead rates and capacity issues .............. Basic 30 min. Exercise 3-17 Applying overhead in a service company; journal entries..... Basic 30 min. Problem 3-18 Comprehensive problem........................................................ Basic 45 min. Problem 3-19 Cost flows; T-accounts; income statements .......................... Basic 60 min. Problem 3-20 Journal entries, T-accounts; cost flows.................................. Basic 60 min. Problem 3-21 T-accounts; applying overhead.............................................. Basic 60 min. Problem 3-22 T-accounts; overhead rates; journal entries ........................... Medium 60 min. Problem 3-23 Multiple departments; applying overhead ............................. Medium 30 min. Problem 3-24 T-account analysis of cost flows ........................................... Medium 45 min. Problem 3-25 Journal entries; T-accounts; disposition of under- or

overapplied overhead; income statement.......................... Medium 90 min. Problem 3-26 Predetermined overhead rate; disposition of under- or

overapplied overhead........................................................ Medium 30 min. Problem 3-27 Schedule of cost of goods manufactured; overhead

analysis ............................................................................. Medium 60 min. Problem 3-28 (Appendix 3A) Predetermined overhead rate and capacity... Medium 60 min. Problem 3-29 Multiple departments; overhead rates; under- or

overapplied overhead........................................................ Medium 30 min. Problem 3-30 Plantwide versus departmental overhead rates; under- or

overapplied overhead........................................................ Difficult 60 min. Problem 3-31 Comprehensive problem; journal entries; T-accounts;

financial statements .......................................................... Difficult 120 min. Problem 3-32 Comprehensive problem; T-accounts; job-order cost

flows; financial statements ............................................... Difficult 120 min. Case 3-33 Critical thinking; interpretation of manufacturing

overhead rates ................................................................... Difficult 45 min. Case 3-34 (Appendix 3A) Ethics; predetermined overhead rate and

capacity............................................................................. Difficult 120 min. Case 3-35 Ethics and the manager.......................................................... Difficult 45 min.

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Essential Problems: Problem 3-18 or 3-20, Problem 3-19 or 3-21, Problem 3-22, Problem 3-23 or 3-29

Supplementary Problems: Problem 3-24, Problem 3-25, Problem 3-26, Problem 3-27, Problem 3-30, Problem 3-31 or 3-32, Case 3-33, Case 3-35

Appendix 3A Essential Problems: Problem 3-28 Appendix 3A Supplementary Problems: Case 30-34

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Chapter 3 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the third segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 3. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Managers need to assign costs to products to facilitate external financial reporting and internal decision making. This chapter illustrates an absorption costing approach (also called a full cost approach) to calculating product costs known as job-order costing.

Helpful Hint: Briefly review the concepts of fixed and variable manufacturing costs to help students grasp the meaning of absorption costing. Mention that total fixed costs are constant and therefore change on a per unit basis. Variable costs are proportional to the number of units produced and are constant on a per unit basis.

I. Process and job-order costing: Two costing systems are

commonly used in manufacturing and many service companies; these two systems are known as process costing and job-order costing.

A. Process costing systems

i. This type of cost system is used when:

1. A company produces many units of a single product.

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2. One unit of product is indistinguishable from other units of product.

3. The identical nature of each unit of product enables assigning the same average cost per unit.

ii. Examples of companies that would use process

costing include:

1. Weyerhaeuser (paper manufacturing) 2. Reynolds Aluminum (refining aluminum

ingots) 3. Coca-Cola (mixing and bottling beverages)

B. Job-order costing systems

i. This type of cost system is used when:

1. Many different products are produced each period.

2. Products are manufactured to order. 3. The unique nature of each order requires

tracing or allocating costs to each job, and maintaining cost records for each job.

ii. Examples of companies that would use job-order

costing include:

1. Boeing (aircraft manufacturing) 2. Bechtel International (large scale

construction) 3. Walt Disney Studios (movie production)

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C. Comparing process costing and job-order costing

i. With job-order costing, many jobs are worked on during the period; with process costing, a single product is produced for a long period of time.

ii. With job-order costing, costs are accumulated by

individual jobs; with process costing, costs are accumulated by departments.

iii. With job-order costing, average unit costs are

computed by job; with process costing, average unit costs are computed for a particular operation or by department.

Helpful Hint: To clarify the difference between process and job-order costing, contrast a company manufacturing standard metal desks with a company manufacturing custom-made hardwood desks. Ask the class, which company would probably use process costing and which company would probably use job-order costing, and why.

Quick Check − job-order vs. process costing

II. Job-order costing−an overview

A. Types of manufacturing costs that are assigned to products using a job-order costing system:

i. Direct costs

1. Direct materials − Traced directly to each

job as the work is performed.

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2. Direct labor − Traced directly to each job as the work is performed.

ii. Indirect costs

1. Manufacturing overhead (including

indirect materials and indirect labor) − These costs are allocated to jobs rather than directly traced to each job.

B. The job cost sheet − The accounting department relies

upon a job cost sheet for tracking the direct and indirect costs associated with a given job.

i. An overview of a job cost sheet for a hypothetical

company called PearCo:

1. A job number uniquely identifies each job. 2. Direct material, direct labor and

manufacturing overhead costs are accumulated for each job.

3. The job cost sheet is a subsidiary ledger to the Work in Process account.

ii. Measuring direct materials cost

1. Once a sales order has been received and a

production order issued, the Production Department prepares a materials requisition form to specify the type, quantity, and total cost of materials (e.g., $116) to be drawn from the storeroom, and the job number (e.g., A-143) to which the cost of the materials is to be charged.

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a. For an existing product, the production department can refer to a bill of materials to determine the type and quantity of each item of materials needed to complete a unit of product.

2. The Accounting Department records the total direct material cost (e.g., $116) on the appropriate job cost sheet. Notice, the material requisition number (e.g., X7-6890) is included on the job cost sheet to provide easy access to the source document.

iii. Measuring direct labor costs

1. Workers use time tickets to record the

amount of time that they spent on each job and the total cost assigned to each job.

2. The Accounting Department records the labor costs from the time tickets (e.g., $88) on to the job cost sheet.

“In Business Insights” The direct labor cost as a percent of a product’s total cost is often very small. For example: “Relation of Direct Labor to Product Cost” (Page 92)

• The National Labor Committee based in New York estimates that the labor cost to assemble a $90 pair of Nike sneakers is only $1.20.

Consequently, many companies have stopped tracking direct labor costs separately. For example: “A More Productive Use of Time” (Page 92)

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• United Electric Controls, Inc., located in Waterton, Massachusetts, converted all direct laborers to salaried workers and stopped producing labor reports.

• The manufacturing vice president decided that he wanted employees spending their time making products rather than filling out labor time tickets.

“In Business Insights” While many companies have stopped tracking direct labor costs separately, others now rely upon computer systems to assign direct labor costs to jobs. For example: “Cleaning Up with Bar Codes” (page 93)

• Bradford Soap Works is a manufacturer of private label bar soap.

• Employees wear identification badges with a bar code that reveals their relevant personal data.

• The bar codes are used to charge workers’ time directly to specific orders.

• The bar codes have decreased clerical errors from 500 errors per 10,000 transactions to just one error per 10,000 transactions.

iv. Manufacturing overhead application:

1. An allocation base, such as direct labor

hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to products. Allocation bases are used because: i. It is impossible or difficult to trace these

costs to particular jobs (i.e.,

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manufacturing overhead is an indirect cost).

a. Manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager’s salary.

b. Many types of manufacturing overhead costs are fixed even though output may fluctuate during the year.

2. The predetermined overhead rate is calculated by dividing the estimated amount of manufacturing overhead for the coming period by the estimated quantity of the allocation base for the coming period. Ideally, the allocation base chosen should be the cost driver of overhead cost.

a. Predetermined overhead rates that rely upon estimated data are often used because:

i. Actual overhead costs for the period are not known until the end of the period, thus inhibiting the ability to estimate job costs during the period.

ii. Actual overhead costs can fluctuate seasonally, thus misleading decision makers.

iii. It simplifies record keeping. 3. Manufacturing overhead is applied to jobs

using the predetermined overhead rate multiplied by the actual amount of the allocation base used completing the job (this is called a normal costing system). For example, assume PearCo:

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a. Applies overhead to jobs based on direct labor hours.

b. Estimated its total overhead for the year to be $640,000.

c. Estimated its total direct labor hours for the year to be 160,000.

d. Calculated its predetermined overhead rate to be $4 per direct labor hour.

i. The amount of overhead that would be applied to the job cost sheet that we have been working with related to Job A-143 is $32, calculated as follows:

1. Eight direct labor hours were worked on Job A-143.

2. The predetermined overhead rate is $4 per direct labor hour.

3. 8 direct labor hours × $4 per hour = $32

v. Completing the job cost sheet

1. The total direct material, direct labor, and

manufacturing overhead costs assigned to Job A-143 is $236. Since this particular job included two units of production, the average cost per unit is $118.

a. The average unit cost should not be interpreted as the costs that would actually be incurred if another unit were produced.

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b. The fixed overhead would not change if another unit were produced,

so the incremental cost of another unit is something less than $118.

Quick Check − job cost accounting

C. Job-order costing: document flow summary

i. A sales order is prepared as a basis for issuing a production order.

ii. A production order initiates work on a job.

iii. A materials requisition is used to draw direct and indirect materials from the storeroom.

1. Direct material costs are charged to specific

jobs. 2. Indirect material costs are included in

manufacturing overhead.

iv. Employee time tickets are used to quantify direct and indirect labor costs.

1. Direct labor costs are charged to specific jobs.

2. Indirect labor costs are included in manufacturing overhead.

v. The predetermined overhead rate is used to apply

manufacturing overhead costs to jobs.

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III. Job-order costing−the flow of costs

Helpful Hint: Sometimes students need a brief review of journal entries and the use of T-accounts before beginning this section of the chapter.

A. The transactions (in T-account and journal entry form) that capture the flow of costs in a job-order costing system are as follows:

i. The purchase and issue of raw materials.

1. In T-account form:

a. The cost of raw material purchases is debited, and although not shown, the credit side of the transaction would be to Accounts Payable.

b. The cost of direct material requisitions is debited to Work in Process and added to the job cost sheets which serve as a subsidiary ledger.

c. The cost of indirect material requisitions is debited to Manufacturing Overhead.

2. In journal entry form: a. Debit Raw Materials and credit

Accounts Payable. b. Debit Work in Process and

Manufacturing Overhead and credit Raw Materials.

ii. The recording of labor costs.

1. In T-account form:

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a. Direct labor costs are debited to Work in Process and added to the job cost sheets which serve as a subsidiary ledger.

b. Indirect labor costs are debited to Manufacturing Overhead.

2. In journal entry form: a. Debit Work in Process and

Manufacturing Overhead and credit Salaries and Wages Payable.

iii. Recording actual manufacturing overhead costs

(other than indirect materials and indirect labor).

1. In T-account form: a. The manufacturing overhead costs

are debited to Manufacturing Overhead.

b. The credit side of the entry is the various liability accounts (e.g., Accounts Payable and Property Taxes Payable), prepaid asset accounts (e.g., Prepaid Insurance) and contra-asset accounts (e.g., Accumulated Depreciation).

2. In journal entry form: a. Debit Manufacturing Overhead and

credit various accounts as shown

iv. Applying manufacturing overhead costs to work in process

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1. In T-account form: a. Work in process is debited and

Manufacturing Overhead is credited by the amount of the actual quantity of the allocation base multiplied by the predetermined rate.

b. Actual manufacturing overhead costs are not debited to Work in Process, nor are they charged to jobs via the job cost sheets.

c. The Manufacturing Overhead account is a clearing account. The actual amount of overhead incurred during the period on the debit side of the account will almost certainly not equal the amount applied to Work in Process as shown on the credit side of the account. This requires a year-end adjusting entry that will be discussed shortly.

2. In journal entry form: a. Debit Work in Process and Credit

Manufacturing Overhead.

Helpful Hint: Students sometimes have difficulty understanding the use of Manufacturing Overhead as a clearing account. Explain that the purpose of the clearing account is to find any discrepancy that exists between the amount of overhead applied to inventory and the amount of overhead actually incurred. Actual overhead incurred is debited to the account. Overhead applied to inventory using the predetermined rate is credited to the account.

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v. Accounting for nonmanufacturing costs

Helpful Hint: Review the concepts of product and period costs at this point. Since period costs are not directly related to the actual manufacture of the products, they are expensed as incurred.

1. Companies that use job-order cost systems to assign manufacturing costs to products also incur nonmanufacturing costs.

2. Nonmanufacturing costs should not go into the Manufacturing Overhead account.

3. Nonmanufacturing costs are not assigned to individual jobs, rather they are expensed in the period incurred. For example:

a. The salary expenses of employees that work in a marketing, selling or administrative capacity are expensed in the period incurred.

b. Advertising expenses are expensed in the period incurred.

vi. Transferring completed units from work in

process to finished goods

1. In T-account form: a. The sum of all amounts transferred

from work in process to finished goods represents the cost of goods manufactured for the period.

b. The Work in Process account is credited and the Finished Goods account is debited.

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2. In journal entry form: a. Debit Finished Goods and credit

Work in Process.

vii. Transferring finished goods to cost of goods sold

1. In T-account form: a. Debit Cost of Goods Sold and credit

Finished Goods. b. If only a portion of the units

associated with a particular job are shipped, then the unit cost figure from the job cost sheet is used to determine the amount of the journal entry.

c. This journal entry is also accompanied by a journal entry that recognizes the sales revenue.

2. In journal entry form: a. Debit Accounts Receivable and credit

Sales. b. Debit Cost of Goods Sold and credit

Finished Goods.

Helpful Hint: As a concluding thought, remind students that all inventory accounts are governed by the same logic: Beginning inventory + Additions = Ending Inventory + Transfers out. In the case of raw materials, transfers out consist of both direct and indirect materials requisitions. Direct materials requisitions are added to Work in Process inventory. Indirect materials requisitions are debited to Manufacturing Overhead. Additions to Work in Process consist of direct materials requisitions, direct labor, and overhead applied. Transfers out of Work in

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Process consist of costs transferred to Finished Goods. Transfers out of Finished Goods consist of Cost of Goods Sold.

IV. Problems of overhead application

A. There are two complications relating to overhead application.

i. Defining and computing underapplied and

overapplied overhead

1. The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is termed either underapplied or overapplied overhead.

a. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period.

b. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period.

Helpful Hint: Students need to understand that factory overhead must be estimated at the beginning of the production period. Therefore, there will most likely be a difference between actual and applied overhead. A debit balance in the Manufacturing Overhead account

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indicates more overhead has been incurred than has been applied to inventory and overhead is underapplied. A credit balance indicates more overhead has been applied than has been incurred and overhead is overapplied.

2. Computing underapplied or overapplied overhead, an example:

a. Assume that PearCo’s actual overhead and direct labor hours for the year are $650,000 and 170,000, respectively.

b. Recall that PearCo’s total estimated overhead and direct labor hours for the year were $640,000 and 160,000, respectively. Therefore, the predetermined overhead rate would be $4 per direct labor hour.

c. The amount of overhead applied to jobs during the year would be 170,000 direct labor hours × $4 per hour = $680,000.

d. In this example, overhead is overapplied by $680,000 − $650,000 = $30,000.

Quick Check − underapplied and overapplied overhead ii. Disposition of under- or overapplied overhead

balances

1. Any remaining balance in the Manufacturing Overhead account, such as PearCo.’s $30,000 of overapplied overhead, is disposed of in one of two ways:

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a. It can be closed out to Cost of Goods Sold.

b. It can be allocated between Work in Process, Finished Goods, and Cost of Goods Sold in proportion to the overhead applied during the current period in the ending balances of these accounts.

2. The journal entry, in T-account form, to close out PearCo.’s $30,000 of overapplied overhead into Cost of Goods Sold would be as follows:

a. Debit Manufacturing Overhead and credit Cost of Goods Sold.

3. Calculating the allocation of under- or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods Sold.

a. Assume the overhead applied in Ending Work in Process Inventory, Ending Finished Goods Inventory, and Cost of Goods Sold is $68,000, $204,000, and $408,000, respectively.

b. In this case, the allocation percentages for Work in Process, Finished Goods, and Cost of Goods Sold would be 10%, 30%, and 60%, respectively.

c. The allocation of the $30,000 of overapplied overhead would be: Work in Process, $3,000; Finished Goods, $9,000; and Cost of Goods Sold, $18,000.

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4. The journal entry to close out the $30,000 of overapplied overhead to each of the three accounts would be:

a. Debit Manufacturing Overhead and credit Work in Process, Finished Goods, and Cost of Goods Sold.

5. In summary, there are two methods for disposing of under- and overapplied overhead.

a. Close out to Cost of Goods Sold b. Allocate between Work in Process,

Finished Goods, and Cost of Goods Sold.

Quick Check − under- and overapplied overhead

V. Selected topics

A. Multiple predetermined overhead rates

i. The chapter discussion assumes that there is a

single predetermined overhead rate for an entire factory called a plantwide overhead rate.

ii. In larger companies, multiple predetermined

overhead rates are often used. For example, each production department may have its own predetermined overhead rate.

iii. While using multiple predetermined overhead rates

is more complex, it is also more accurate because it reflects differences across departments in how overhead costs are incurred.

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B. Job-order costing in services companies

i. Although our attention has focused upon manufacturing applications, it bears re-emphasizing that job-order costing is also used in services industries.

1. For example, in a law firm, each client

represents a “job.” Legal forms and similar inputs represent direct materials. The time expended by attorneys represents direct labor. The costs of secretaries, clerks, rent, depreciation, and so forth, represent the overhead.

C. The use of information technology

i. Previously, the chapter discussed the use of bar

code technology to track direct labor costs; however, bar code technology is being integrated into all areas of business activity.

“In Business Insights” Many companies are integrating bar code technology throughout their organizations. For example: “Managing Diversity with Technology” (Page 113)

• Andersen Windows of Bayport, Minnesota has used technology to customize window configurations to individual customer orders.

• Andersen has installed hundreds of Macintosh-based systems at distributors and retailers around the country.

• Customers can use these systems to customize a standard window design to their individual

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needs. The computer automatically checks to ensure the structural soundness of the newly designed window.

• Once the sale is made, the sales order and all the necessary specifications are electronically transmitted to Andersen.

• Andersen assigns a unique number to the order and tracks it in real time from the assembly line to the warehouse using bar code technology.

• In one year, Andersen offered 188,000 different products, yet fewer than one in 200 van loads contained an order discrepancy.

ii. When combined with Electronic Data

Interchange (EDI) or a web-based programming language called Extensible Markup Language (XML), bar coding eliminates the inefficiencies and inaccuracies associated with manual clerical processes.

“In Business Insights” Many companies are using XML to enhance their ability to compete using the internet. “Using XML to Enhance Web Commerce” (Page 113)

• W.W. Grainger Inc. maintains a web-based catalog of all the maintenance and repair supplies that it sells to customers.

• For an effective web-based catalog, the company needs up-to-date, detailed product descriptions from its own suppliers.

• Grainger uses software from OnDisplay Inc. to add XML tags to product descriptions collected from its vendors’ databases.

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• When Grainger’s customers use the web to request product information, the XML tags ensure that all the information from a diverse number of suppliers is displayed to customers in a standardized format.

• This process cuts in half the amount of time required to post new product information to Grainger’s web catalog.

VI. Appendix 3A: the predetermined overhead rate and

capacity (Slide # 63 is a title slide)

A. Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base

i. This method was used throughout the chapter;

however, recently it has been criticized in two ways:

1. Basing the predetermined overhead rate on budgeted activity results in product costs that fluctuate depending upon the activity level.

2. Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use.

B. Capacity-based overhead rates

i. The aforementioned criticisms can be overcome by using “estimated total units in the allocation base at capacity” in the denominator of the predetermined overhead rate calculation (rather than the

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“estimated total units in the allocation base” in the denominator).

i. The following example will help distinguish

between these two approaches.

1. Assume that a company leases a piece of equipment for $100,000 per year. If run at full capacity, the machine can produce 50,000 units per year.

2. The company estimates that 40,000 units will be produced and sold next year.

3. The predetermined overhead rate, if based on the estimated number of units that will be produced and sold, is $2.50 per unit.

4. The predetermined overhead rate, if based on the number of units produced at capacity, is $2.00.

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Quick Check − estimated units of allocation base vs. capacity of the allocation base 68-75

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C. Income statement preparation

i. Critics suggest that the underapplied overhead that results from idle capacity should be disclosed on the income statement as the cost of unused capacity − a period expense.

1. Using a measure of capacity in the

denominator of the predetermined overhead rate enables this type of disclosure.

2. Using the estimated or budgeted amount of the allocation base in the denominator of the predetermined overhead rate calculation does not enable this type of disclosure.

a. Underapplied overhead is not treated as a period expense rather it is closed out to work in process, finished goods, and/or cost of goods sold.

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Chapter 3 Transparency Masters

TM 3-1

© The McGraw-Hill Companies, Inc., 2006. All rights reserved.

AGENDA: JOB-ORDER COSTING

1. The documents used and the flow of costs in job-order costing.

a. Materials requisition form.

b. Direct labor time ticket.

c. Job cost sheet.

2. Applying overhead using a predetermined overhead rate.

a. Computing the predetermined overhead rate.

b. Applying the predetermined overhead rate to jobs.

3. Underapplied and overapplied overhead. How is it determined? What is it? What is done with it?

4. Journal entries and T-accounts in a job-order costing system.

5. (Appendix) The predetermined overhead rate and capacity.

TM 3-2


THE FLOW OF DOCUMENTS IN A

JOB-ORDER COSTING SYSTEM

PredeterminedOvhd. Rates

Direct LaborTime Ticket

MaterialsRequisition

Job CostSheet

A sales order is preparedas a basis for issuing a ...

A production order initiateswork on a job, whereby costs

are charged through ...

The various costs of production areaccumulated on a form, prepared by theaccounting department, known as a ...

The job cost sheet forms the basis for valuingending inventories and Cost of Goods Sold.

ProductionOrder

SalesOrder

TM 3-3


MATERIALS REQUISITION FORM

(Exhibit 3-1)

TM 3-4


EMPLOYEE TIME TICKET

(Exhibit 3-3)

TM 3-5


JOB COST SHEET

(Exhibit 3-4)

TM 3-6


APPLICATION OF OVERHEAD

• In a job-order costing system, the cost of a job consists of:

1. Actual direct material costs traced to the job.

2. Actual direct labor costs traced to the job.

3. Manufacturing overhead applied to the job using a predetermined overhead rate. Actual overhead costs are not assigned to jobs.

• A predetermined overhead rate is used to assign overhead cost to products and services. It is:

• Based on estimated data.

• Established before the period begins.

• Why use estimated data?

• Waiting until the year is over to determine actual overhead costs would be too late. Managers want cost data immediately.

• Overhead rates, if based on actual costs and activity, would vary substantially from month to month. Much of this variation would be due to random changes in activity.

TM 3-7


PREDETERMINED OVERHEAD RATE FORMULA

The formula for computing a predetermined overhead rate is:

Estimated total manufacturing overhead costPredetermined =overhead rate Estimated total amount of the allocation base

The company in the preceding example applies overhead costs to jobs on the basis of direct labor-hours. In other words, direct labor-hours is the allocation base.

At the beginning of the year the company estimated that it would incur $320,000 in manufacturing overhead costs and would work 40,000 direct labor-hours. The company’s predetermined overhead rate is:

$320,000= $8 per DLH

40,000 DLHs

APPLICATION OF OVERHEAD TO JOBS

The process of assigning overhead to jobs is known as applying overhead.

In the preceding example, Job 2B47 required 27 direct labor-hours. Therefore, $216 of overhead cost was applied to the job as follows:

Predetermined overhead rate .................... $8 per DLH Direct labor-hours required for Job 2B47 .... × 27 DLHs Overhead applied to Job 2B47 ................... $216

TM 3-8


JOB-ORDER COSTING EXAMPLE

In the example appearing on the next few pages, we will trace how costs flow through Reeder Company’s job-order costing system.

1. Summary journal entries for the year for Reeder Company appear below:

a. Raw materials were purchased on account for $150,000.

Raw Materials .................................................... 150,000 Accounts Payable ..................................... 150,000

b. Raw materials that cost $160,000 were issued from the storeroom for use in production. Of this total, $136,000 was for direct materials and $24,000 for indirect materials.

Work in Process ................................................. 136,000 Manufacturing Overhead .................................... 24,000 Raw Materials........................................... 160,000

Note: Actual manufacturing overhead costs incurred are debited to a control account called Manufacturing Overhead.

c. The following costs were incurred for employee services: direct labor, $200,000; indirect labor, $85,000; selling and administrative wages and salaries, $90,000.

Work in Process ................................................. 200,000 Manufacturing Overhead .................................... 85,000 Wage and Salary Expense................................... 90,000 Salaries and Wages Payable ...................... 375,000

TM 3-9


JOB-ORDER COSTING EXAMPLE (cont’d)

d. Utility costs of $40,000 were incurred in the factory.

Manufacturing Overhead .................................... 40,000 Accounts Payable (or Cash) ....................... 40,000

e. Prepaid insurance of $20,000 expired during the year. (80% related to factory operations and 20% to selling and administration.)

Manufacturing Overhead .................................... 16,000 Insurance Expense............................................. 4,000 Prepaid Insurance..................................... 20,000

f. Advertising costs of $100,000 were incurred during the year.

Advertising Expense ........................................... 100,000 Accounts Payable (or Cash) ....................... 100,000

g. Depreciation of $145,000 was accrued for the year on factory assets and $15,000 on selling and administrative assets.

Manufacturing Overhead .................................... 145,000 Depreciation Expense ......................................... 15,000 Accumulated Depreciation ......................... 160,000

TM 3-10



h. Manufacturing overhead was applied to jobs. The company’s predetermined overhead rate was based on the following estimates: manufacturing overhead, $315,000; direct labor cost, $210,000.

$315,000= 1.5 or 150%

$210,000

Since the total direct labor cost incurred was $200,000, the total manufacturing overhead applied to work in process was 150% of this amount or $300,000. The journal entry to record this is:

Work in Process ................................................. 300,000 Manufacturing Overhead ........................... 300,000

i. Goods that cost $650,000 to manufacture according to their job cost sheets were completed and transferred to the finished goods warehouse.

Finished Goods .................................................. 650,000 Work in Process........................................ 650,000

j. Sales for the year (all on credit) were $900,000.

Accounts Receivable........................................... 900,000 Sales ....................................................... 900,000

k. The goods that were sold had cost $600,000 to manufacture according to their job cost sheets.

Cost of Goods Sold............................................. 600,000 Finished Goods......................................... 600,000

TM 3-11



2. T-accounts are provided below for the manufacturing accounts (beginning balances are assumed).

Raw Materials Work in Process Bal. 20,000 Bal. 74,000 (a) 150,000 160,000 (b) (b) 136,000 650,000 (i) Bal. 10,000 (c) 200,000 (h) 300,000 Bal. 60,000

Finished Goods Manufacturing Overhead

Bal. 40,000 (b) 24,000 300,000 (h) (f) 650,000 600,000 (k) (c) 85,000 Bal. 90,000 (d) 40,000 (e) 16,000 (g) 145,000 Bal. 10,000

Cost of Goods Sold (k) 600,000

a) Purchase of raw materials. g) Depreciation of factory assets. b) Issue of materials. h) Apply manufacturing overhead. c) Labor costs. i) WIP completed. d) Factory utility costs. k) Finished Goods sold. e) Factory insurance costs.

TM 3-12


UNDER- AND OVERAPPLIED OVERHEAD

Since predetermined overhead rates are based on estimated data, at the end of an accounting period overhead costs are usually either underapplied or overapplied. In the example, overhead is underapplied by $10,000, which can be determined by examining the balance in the Manufacturing Overhead account:

Manufacturing Overhead (b) 24,000 300,000 (h) Actual (c) 85,000 Applied Overhead (d) 40,000 Overhead Costs (e) 16,000 Costs (g) 145,000 310,000 300,000 Under-applied Bal. 10,000

The difference of $10,000 between the actual overhead costs and the applied overhead costs in this case is called underapplied overhead because actual overhead costs exceeded the overhead costs that were applied to inventory.

Alternatively, the amount of the under- or overapplied overhead can be determined as follows:

Actual overhead costs incurred ...................... $310,000 Applied overhead costs (150% × $200,000) ... 300,000 Underapplied overhead ................................. $ 10,000

TM 3-13



3. Disposition of under- or overapplied overhead.

a. Close the balance in Manufacturing Overhead to Cost of Goods Sold:

Cost of Goods Sold............................................. 10,000 Manufacturing Overhead ........................... 10,000

or

b. Allocate the balance in Manufacturing Overhead among Work in Process, Finished Goods, and Cost of Goods Sold in proportion to the amount of overhead applied during the period in each account at the end of the period. (The figures below are given.)

Overhead applied during the current period in the ending balance of:

Work in Process ................................. $ 24,000 8% Finished Goods .................................. 36,000 12 Cost of Goods Sold............................. 240,000 80 Total ................................................. $300,000 100%

The journal entry to record the allocation of the underapplied overhead of $10,000 would be:

Work in Process (8% of $10,000)........................ 800 Finished Goods (12% of $10,000) ....................... 1,200 Cost of Goods Sold (80% of $10,000).................. 8,000 Manufacturing Overhead ........................... 10,000

TM 3-14



Reeder Company Schedule of Cost of Goods Manufactured

Direct materials: Beginning raw materials inventory.......... $ 20,000 Add: Purchases of raw materials ............ 150,000 Total raw materials available.................. 170,000 Deduct: Ending raw materials inventory.. 10,000 Raw materials used in production........... 160,000 Less: Indirect materials ......................... 24,000 $136,000

Direct labor............................................. 200,000 Manufacturing overhead applied* ............. 300,000 Total manufacturing costs ........................ 636,000 Add: Beginning work in process inventory . 74,000 710,000 Deduct: Ending work in process inventory . 60,000 Cost of goods manufactured..................... $650,000

* Note that manufacturing overhead applied during the period is used to compute the total manufacturing costs on the schedule of cost of goods manufactured, not the actual manufacturing costs.

TM 3-15



4. Reeder Company’s income statement for the year (assuming that the underapplied overhead is closed directly to Cost of Goods Sold) would be:

Reeder Company Income Statement

Sales ..................................................... $900,000Cost of goods sold ($600,000 + $10,000) . 610,000Gross margin.......................................... 290,000Less selling and administrative expenses:

Wage and salary expense ..................... $ 90,000 Insurance expense ............................... 4,000 Advertising expense ............................. 100,000 Depreciation expense ........................... 15,000 209,000

Net operating income.............................. $ 81,000

Reeder Company Schedule of Cost of Goods Sold

Beginning finished goods inventory .......... $ 40,000Add: Cost of goods manufactured ............ 650,000Goods available for sale........................... 690,000Ending finished goods inventory............... 90,000Unadjusted cost of goods sold ................. 600,000Add: Underapplied overhead.................... 10,000Adjusted cost of goods sold ..................... $610,000

TM 3-16


COST FLOWS IN A JOB-ORDER COSTING SYSTEM (Exhibit 3-14)

TM 3-17


THE PREDETERMINED OVERHEAD RATE AND CAPACITY (APPENDIX 3A)

• Difficulties with the traditional approach:

Estimated total manufacturing overhead costPredetermined =overhead rate Estimated total amount of the allocation base

• Manufacturing overhead typically includes large amounts of fixed costs. As activity (and the amount of the allocation base) falls, the predetermined overhead rate increases.

• Products appear to cost more when activity has declined.

• May lead to pressure to increase selling prices.

• Products are charged for resources they don’t use (unused or idle capacity). As activity falls, the increased costs of idle capacity are spread across fewer units.

• Alternative approach:

Estimated total manufacturing overhead costPredetermined =overhead rate Total amount of the allocation base at capacity

• Underapplied overhead resulting from unused capacity is treated as a period expense and is called Cost of Unused Capacity on the income statement.

• Since the denominator is more stable than in the traditional approach, this method results in a more stable predetermined overhead rate. The costs of products will not appear to increase as the activity level falls.

• Products are only charged for the resources they use. They are not charged for the idle capacity they don’t use. If a product uses 10% of the capacity of a machine, it will be charged for only 10% of the costs of the machine regardless of how much capacity is unused.

business statistics chapter 3

Documents

joborder costing system

costing process

process costing

particular job

costs of materials

manufacturing overhead

job cost sheets

absorption costing