College of San Mateo

Accounting 131

Rosemary Nurre


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Chapter 3

Systems Design—Job-Order Costing

Learning Objectives

1. Distinguish between process costing and job-order costing and identify companies that would use each costing method.

2. Identify the documents used in a job-order costing system.

3. Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process.

4. Prepare journal entries to record costs in a job-order costing system.

5. Apply overhead cost to Work In Process using a predetermined overhead rate.

6. 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.

7. Compute under- or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.

Chapter Overview

A. Costing Systems. 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.

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. 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.

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 . 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. Since the predetermined overhead rate is based entirely on estimated data, the actual amount 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.