There are several methods that can be used to accumulate manufacturing costs and determine unit product cost. One of these methods is known as a job-order cost system.
A process cost system is best used by companies that produce many units of a single product and when one unit of output is indistinguishable from any other unit of output. Because the units of output are identical, the company will probably use an average cost system to determine product cost.
An example of a company that may consider a process cost system is Weyerhaeuser, a manufacturer of paper products. When we think of paper manufacturing, we generally think about continuous production of a single roll of paper that may eventually be cut into sizes needed by customers. Other companies that would benefit from process costing are Reynolds Aluminum and Coca-Cola. Certainly the desire of all three of these companies is to make each unit of output consistent with the quality standards established. Coca-Cola bottled in California should taste identical to the same product bottled in New York City.
A company would use a job order costing system when many different products are produced each period. The products are usually manufactured to customers’ specifications and are unique in nature.
Companies that may benefit from using job order cost systems include Boeing, Bechtel International, and Walt Disney Studios. Bechtel is perhaps the largest international construction company. The company works on huge projects that are unique to customer needs.
This table presents an overview of the differences between a job-order and process costing system. Notice that costs are accumulated by the job in a job-order system and by department in the process system. If you think of building a house, you can see how easy it is to accumulate costs for a particular house even though you may be building more than one house at a time. If you think of mixing Coca-Cola, costs would naturally be accumulated by the department working on the current batch.
See if you can identify those types of companies that would benefit from the use of a job-order cost system. There may be more than one company in the list.
How did you do? The paper and ketchup manufacturers would probably use a process costing system rather than a job-order system.
In a job-order costing system, direct materials and direct labor are both assigned to individual jobs on which the materials were used and the labor incurred.
Manufacturing overhead includes indirect materials and indirect labor as well as other manufacturing costs like the power used to run the machinery in the factory. Manufacturing overhead cannot be traced directly to specific jobs. Rather, it is allocated to jobs on the basis of a predetermined rate.
The job cost sheet is used by the accounting department to track the direct and indirect costs associated with a give job. We will look at a job cost sheet used by a hypothetical company called PearCo. PearCo has a job that calls for the construction of wooden cargo crates. You can see the separate sections for direct materials, direct labor, and manufacturing overhead. In addition, we have a section to summarize total costs of the job. A job number uniquely identifies each job. Direct material, direct labor and manufacturing overhead costs are accumulated for each job. The job cost sheet is a subsidiary ledger to the Work in Process account.
Here is the materials requisition form completed for job A dash 143. The requisition is number X7 dash 6890. The worker has requested twelve two by fours, twelve feet long, and twenty one by sixes, twelve feet long. The unit cost of the lumber is shown in the unit cost column. The quantity requested is multiplied by the unit cost to arrive at the total cost for materials. The person in charge of the store room will issue the lumber once the materials requisition form has been properly authorized.
Once the materials have been issued by the store room, they are charged to the job cost sheet for job number A dash 143. We have a proper reference for the requisition number and the total amount. If we need to look at the details of the one hundred sixteen dollar cost, we can ask to see materials requisition form X7-6890.
The direct materials were posted to the summary section of the job cost sheet.
Here is the time ticket for an employee who worked eight hours on job A dash 143. The employee’s hourly pay rate is eleven dollars, so the total labor cost charged to the job will be eighty-eight dollars. The time ticket, number thirty six, serves as the major source document for labor costs charged to this job.Let’s look at the labor posting to the job cost sheet.
On the job cost sheet we can see that time ticket number thirty-six posted eight hours to job A dash 143. The total amount of direct labor cost is eighty-eight dollars. This amount is also posted to the summary section of the job cost sheet.
Part IManufacturing overhead is applied to all jobs that are in process. We apply overhead using a base we believe causes overhead costs to be incurred. Some companies allocate manufacturing overhead using direct labor hours or machine hours.
Part IIWe must allocate overhead costs to jobs for a variety of reasons. First, it is difficult, if not impossible, to actually trace overhead costs to a particular job. The cost of grease for machinery to manufacture our product is part of our manufacturing costs. It would be impossible to accurately trace the amount of grease consumed to manufacture one unit of output.
Manufacturing overhead also includes a number of different costs and it would be very difficult to gather all of them together in time to charge them to a particular job. A job may be complete and sold before we can determine the actual overhead costs incurred.Finally, many types of overhead are fixed in nature even though output fluctuates during the period.
To facilitate the allocation of manufacturing overhead to each job, we calculate a predetermined overhead rate before the period begins. The rate is calculated by dividing the total estimated manufacturing overhead for the coming period by the estimated total units of the allocation base. If our allocation base is machine hours, we would estimate the total number of machine hours used in production in the coming period.
Ideally, the allocation base should be a cost driver, that is, it causes overhead to be incurred.
Predetermined overhead rates that rely upon estimated data are often used because (1) 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; (2) Actual overhead costs can fluctuate seasonally, thus misleading decision makers; (3) it simplifies record keeping.
We calculate the predetermined overhead rate before the period begins. As we work on a particular job, we apply overhead by multiplying the predetermined rate times the actual level of activity. If overhead is applied on the basis of machine hours, we would apply overhead by multiplying the predetermined rate times the actual number of machine hours used on a particular job.
Part I
Here is our equation for calculating the predetermined manufacturing overhead rate.
Part IIPearCo’s predetermined overhead rate is four dollars per direct labor hour.Part IIISo, at PearCo each job will be charged four dollars of overhead for each one hour of direct labor worked. Let’s see how this works.
Our predetermined overhead rate is four dollars per direct labor hour, so we will apply thirty-two dollars of overhead to job number A dash 143. The computation is shown in the manufacturing overhead section of the job cost sheet and in the summary section.On job A dash 143 we completed two wooden cargo crates at a total cost of two hundred thirty-six dollars. The total cost includes direct materials, direct labor, and manufacturing overhead.
For this particular job the average cost of each crate is one hundred eighteen dollars. We calculated the average by dividing the total cost of two hundred thirty six dollars by the two crates produced.
The total direct material, direct labor, and manufacturing overhead costs assigned to Job A-143 is two hundred thirty six dollars. Since this particular job included two units of production, the average cost per unit is one hundred eighteen dollars.
We cannot say that the average cost per crate in the future will be one hundred and eighteen dollars. If a third crate were to be produced, we would not add any additional fixed overhead cost, so the incremental cost of an additional unit may be somewhat less than one hundred eighteen dollars.
This problem may take a while to solve, but it will be well worth your time to work it carefully.
This problem may take a while to solve, but it will be well worth your time to work it carefully.
Now let’s look at the document flow in a job-order cost system.
The entire accounting process begins when a sales order is received from a customer.Once the sales order is received, a production order is drafted to initiate work on a job.
From the production order, we are able to determine the direct and indirect materials we will need to requisition from the store room. We now know that the materials requisition form is a critical source document in the preparation of the job cost sheet. Direct material costs are charged to specific jobs. Indirect material costs are included in manufacturing overhead.
As employees work on the job covered by the production order, time tickets are prepared for recording both direct and indirect labor costs. Direct labor costs are charged to specific jobs. Indirect labor costs are included in manufacturing overhead.
Indirect materials and indirect labor are parts of manufacturing overhead. Other overhead costs are charged to the manufacturing overhead account as incurred.As we have seen, overhead is applied to the job cost sheet.
Now, let’s see how these amounts flow through the tee accounts of a company.
Part IWhen raw materials are purchased they are debited to the raw materials inventory account and credited to accounts payable.
Part II
The cost of direct material requisitions is debited to Work in Process and added to the job cost sheet which serve as a subsidiary ledger.
Part IIIIndirect materials are removed from raw materials inventory with a credit and debited to the manufacturing overhead account.
Here is an example of the general journal entry to record the purchase of raw materials on account. We debit raw materials and credit accounts payable.
When materials are requisitioned from raw materials inventory, we debit work in process (job cost sheet) for direct materials, and debit manufacturing overhead for indirect materials.
Part IDirect labor is debited to Work in Process and added to the job cost sheet which serves as a subsidiary ledger and credited to salaries and wages payable.
Part IIIndirect labor is debited to Manufacturing Overhead and credited to salaries and wages payable.
Here is an example of the entry to charge direct and indirect labor from the salaries and wages payable account and place the amount in work in process inventory. The credit side of the entry is the various liability accounts, for example, Accounts Payable, Property Taxes Payable and other accounts.
Additional manufacturing overhead amounts are debited to the manufacturing overhead account. The debit side of the manufacturing overhead account represents actual overhead incurred during the period.
This journal entry represents the accumulation of other actual overhead amounts like property taxes on the manufacturing plant, insurance on the plant structure and depreciation of manufacturing assets.
When we apply overhead to a particular job, we debit work in process inventory (through the job cost sheet) and credit the manufacturing overhead account. Amounts on the credit side of the manufacturing overhead account represent overhead applied.
It is not likely that actual and applied overhead will be equal during a period. We normally make an adjusting entry at the end of the period to equalize actual and applied overhead.
This journal entry shows the application of overhead to work in process inventory.
We previously discussed the treatment of selling, general, and administrative salaries expense during the period. Other nonmanufacturing costs are charged as expense in the period incurred.
This journal entry illustrates the expensing of nonmanufacturing costs in the current period.
The sum of all amounts transferred from work in process to finished goods represents the cost of goods manufactured for the period. As a job is completed, its costs are transferred from the work in process inventory to finished goods inventory.
The transfer is accomplished with a debit to finished goods inventory and a credit to work in process inventory.
When a finished job is sold to the customer, the cost of that job is transferred from finished goods inventory to cost of good sold. Recall that cost of goods sold is an income statement account. 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.
Assuming the company uses a perpetual inventory system, two journal entries are required to record the sale.
The first entry is to debit either accounts receivable or cash and credit sales for the selling price of the job completed.
The second entry is to debit cost of goods sold and credit finished goods inventory for the cost incurred to complete the job.
The difference between the selling price and cost is the company’s gross margin on the job.
When we apply overhead on the basis of a predetermined overhead rate, there is always the chance that the amount of overhead applied will be different from the amount of overhead actually incurred during the period. When there is a difference we refer to the amount as either underapplied overhead or overapplied overhead.
Part ILet’s assume that PearCo incurred actual overhead of six hundred fifty thousand dollars during the period and worked a total of one hundred seventy thousand direct labor hours. PearCo applies overhead at the rate of four dollars per direct labor hour worked. How much overhead did PearCo apply to jobs during the period?Part IIPearCo would have applied six hundred eighty thousand dollars of overhead during the period. That is four dollars per direct labor hour times the one hundred seventy thousand direct labor hours actually worked. Can you see our problem?
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. PearCo incurred actual overhead of six hundred fifty thousand dollars and applied six hundred and eighty thousand dollars, so the company overapplied thirty thousand dollars of overhead for the year. How do we dispose of this overapplied overhead?
In this question we ask you to calculate the overapplied or underapplied overhead. Be careful with your intermediate computations.
In this question we ask you to calculate the overapplied or underapplied overhead. Be careful with your intermediate computations.
There are two way to dispose of over- or underapplied overhead. The more complex approach is to allocate a portion of the over- or underapplied overhead to work in process inventory, finished goods inventory, and cost of goods sold. The allocation would be based on the relative dollar value in each of the three accounts involved.
An easier way to deal with the problem, and the way PearCo uses, is to adjust cost of goods sold for the entire amount of the over- or underapplied overhead.
Part IWe know that PearCo applied six hundred eighty thousand dollars of overhead but incurred only six hundred fifty thousand dollars of actual overhead. The manufacturing overhead account has a thirty thousand dollar credit balance, representing the overapplied overhead during the year. PearCo chooses to adjust cost of goods sold for the entire amount.
Part IIThe adjustment necessary at the end of the year is to debit the manufacturing overhead account for thirty thousand dollars and credit, or reduce, cost of goods sold by the same amount.
We may elect to allocate the over- or underapplied overhead to ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold. Let’s assume that at the end of the period PearCo had the following overhead costs in each of the accounts shown.
We will complete the following allocation of the thirty thousand dollars of overapplied overhead. We will reduce ending Work in Process Inventory by three thousand dollars, and the other accounts by the amounts shown.
The journal entry to record the allocation is to debit Manufacturing Overhead for thirty thousand dollars, credit Work in Process Inventory for three thousand dollars, credit Finished Goods Inventory for nine thousand dollars, and credit Cost of Goods Sold for eighteen thousand dollars.
We have provided a good study aid for dealing with overapplied or underapplied overhead. We have shown the impact of both the allocation approach to the solution to the problem and the direct adjustment to cost of goods sold approach. It is a good idea to review this chart before your next exam.
Give this question some thought before deciding on your answer.
How did you do?
Part IWe have assumed that the company has used one single predetermined overhead rate for the entire factory.
Part IIMany large companies use multiple predetermined overhead rates.
Part IIIUsing multiple overhead rates can cause more complexity.
Part IVBut when a company uses multiple rates it promotes accuracy in the allocation process because it gives formal recognition to differences across departments in how overhead costs are incurred.
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.
As in any area of business, technology may play an important role in the accounting process. New, easier to use, programming languages and the mastery of microcomputers help spread technology throughout the organization.
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In this appendix we will look at the relationship between the predetermined overhead rate and capacity utilization.
There are two major criticisms of calculating the predetermined overhead rate based on estimated amounts. The first is that the predetermined rate creates problems when actual levels of activity are different from estimated, or budgeted, amounts. The second is that in some cases basing the predetermined overhead rate on estimated amounts charges products for costs that they do not use.
We can minimize the criticisms by basing estimated total units in the allocation base at capacity levels of activity.
Here is a rather simple example where a company leases a piece of equipment for one hundred thousand dollars per year. Full capacity at the company is fifty thousand units of output. Management estimates that forty thousand units will be produced and sold in the coming year. Let’s calculate the predetermined overhead rate.
Part I
Under the traditional method we have used in this chapter the predetermined overhead rate will be two dollars and fifty cents. We divide the total cost of one hundred thousand dollars by the estimated level of activity, forty thousand units.
Part IIUnder the capacity approach, the predetermined overhead rate is two dollars per unit. We divide the total cost of one hundred thousand dollars by production at capacity, fifty thousand units.
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Based on the information given, what is the predetermined overhead rate using the traditional method?
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The correct answer is four dollars per case. How did you do?
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Now calculate the predetermined overhead rate using the capacity approach.
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Did you get the correct answer of two dollars and fifty cents per case?
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Recall your answers to the previous questions and answer this question about changes in the predetermined overhead rate.
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The predetermined overhead rate stays the same and is not affected by changes in the level of activity.
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Now take that same information and answer this questions assuming the traditional approach is used by the company.
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Now we know that the predetermined overhead rate goes up when activity goes down.
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Look carefully at the income statement prepared using the capacity approach to calculate the predetermined overhead rate. Notice the twenty thousand dollars cost of idle capacity. This cost is incurred because we were not able to fully utilize our capacity.
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Here is the income statement using the traditional approach. Notice that cost of goods sold is charged with the cost of idle capacity.
We have certainly covered a great deal of ground in this chapter. Job order costing is used by many companies and it is important for you, as a potential manager, to understand how the system works.
