What adjustment is made for underapplied overhead

Chapter 3 Job-Order Costing

LEARNING OBJECTIVES

After studying Chapter 3 , you should be able to:

· LO1 Compute a predetermined overhead rate.

· LO2 Apply overhead cost to jobs using a predetermined overhead rate.

· LO3 Compute the total cost and average cost per unit of a job.

· LO4 Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.

· LO5 Use T-accounts to show the flow of costs in a job-order costing system.

· LO6 Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement.

· LO7 Compute underapplied 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.

· LO9 ( Appendix 3B ) Properly account for labor costs associated with idle time, overtime, and fringe benefits.

BUSINESS FOCUS: Two Former College Students Succeeding as Entrepreneurs

When the University of Dayton athletic department needed 2,000 customized T-shirts to give away at its first home basketball game of the year, it chose University Tees to provide the shirts. A larger competitor could have been chosen, but University Tees won the order because of its fast customer response time, low price, and high quality.

University Tees is a small business that was started in February 2003 by two Miami University seniors—Joe Haddad and Nick Dadas (see the company's website at www.universitytees.com ). The company creates the artwork for customized T-shirts and then relies on carefully chosen suppliers to manufacture the product.

Accurately calculating the cost of each potential customer order is critically important to University Tees because the company needs to be sure that the price exceeds the cost associated with satisfying the order. The costs include the cost of the T-shirts themselves, printing costs (which vary depending on the quantity of shirts produced and the number of colors printed per shirt), silk screen costs (which also vary depending on the number of colors included in a design), shipping costs, and the artwork needed to create a design. The company also takes into account its competitors’ pricing strategies when developing its own prices. ▪

Source: Conversation with Joe Haddad, cofounder of University Tees.

Understanding how products and services are costed is vital to managers because the way in which these costs are determined can have a substantial impact on reported profits, as well as on key management decisions.

A managerial costing system should provide cost data to help managers plan, control, and make decisions. Nevertheless, external financial reporting and tax reporting requirements often heavily influence how costs are accumulated and summarized on managerial reports. This is true of product costing. In this chapter we use absorption costing to determine product costs. In absorption costing , all manufacturing costs, both fixed and variable, are assigned to units of product—units are said to fully absorb manufacturing costs. In later chapters we look at alternatives to absorption costing such as variable costing and activity-based costing.

Most countries—including the United States—require some form of absorption costing for both external financial reports and for tax reports. In addition, the vast majority of companies throughout the world also use absorption costing in their management reports. Because absorption costing is the most common approach to product costing throughout the world, we discuss it first and then discuss the alternatives in subsequent chapters.

Job-Order Costing—An Overview

Under absorption costing, product costs include all manufacturing costs. Some manufacturing costs, such as direct materials, can be directly traced to particular products. For example, the cost of the airbags installed in a Toyota Camry can be easily traced to that particular auto. But what about manufacturing costs like factory rent? Such costs do not change from month to month, whereas the number and variety of products made in the factory may vary dramatically from one month to the next. Because these costs remain unchanged from month to month regardless of what products are made, they are clearly not caused by—and cannot be directly traced to—any particular product. Therefore, these types of costs are assigned to products and services by averaging across time and across products. The type of production process influences how this averaging is done.

Job-order costing is used in situations where many different products are produced each period. For example, a Levi Strauss clothing factory would typically make many different types of jeans for both men and women during a month. A particular order might consist of 1,000 boot-cut men's blue denim jeans, style number A312. This order of 1,000 jeans is called a job. In a job-order costing system, costs are traced and allocated to jobs and then the costs of the job are divided by the number of units in the job to arrive at an average cost per unit.

Other examples of situations where job-order costing would be used include large-scale construction projects managed by Bechtel International, commercial aircraft produced by Boeing, greeting cards designed and printed by Hallmark, and airline meals prepared by LSG SkyChefs. All of these examples are characterized by diverse outputs. Each Bechtel project is unique and different from every other—the company may be simultaneously constructing a dam in Zaire and a bridge in Indonesia. Likewise, each airline orders a different type of meal from LSG SkyChefs’ catering service.

Job-order costing is also used extensively in service industries. For example, hospitals, law firms, movie studios, accounting firms, advertising agencies, and repair shops all use a variation of job-order costing to accumulate costs. Although the detailed example of job-order costing provided in the following section deals with a manufacturing company, the same basic concepts and procedures are used by many service organizations.

IN BUSINESS: IS THIS REALLY A JOB?

VBT Bicycling Vacations of Bristol, Vermont, offers deluxe bicycling vacations in the United States, Canada, Europe, and other locations throughout the world. For example, the company offers a 10-day tour of the Puglia region of Italy—the “heel of the boot.” The tour price includes international airfare, 10 nights of lodging, most meals, use of a bicycle, and ground transportation as needed. Each tour is led by at least two local tour leaders, one of whom rides with the guests along the tour route. The other tour leader drives a “sag wagon” that carries extra water, snacks, and bicycle repair equipment and is available for a shuttle back to the hotel or up a hill. The sag wagon also transports guests’ luggage from one hotel to another.

Each specific tour can be considered a job. For example, Giuliano Astore and Debora Trippetti, two natives of Puglia, led a VBT tour with 17 guests over 10 days in late April. At the end of the tour, Giuliano submitted a report, a sort of job cost sheet, to VBT headquarters. This report detailed the on the ground expenses incurred for this specific tour, including fuel and operating costs for the van, lodging costs for the guests, the costs of meals provided to guests, the costs of snacks, the cost of hiring additional ground transportation as needed, and the wages of the tour leaders. In addition to these costs, some costs are paid directly by VBT in Vermont to vendors. The total cost incurred for the tour is then compared to the total revenue collected from guests to determine the gross profit for the tour.

Sources: Giuliano Astore and Gregg Marston, President, VBT Bicycling Vacations. For more information about VBT, see www.vbt.com .

Job-Order Costing—An Example

To introduce job-order costing, we will follow a specific job as it progresses through the manufacturing process. This job consists of two experimental couplings that Yost Precision Machining has agreed to produce for Loops Unlimited, a manufacturer of roller coasters. Couplings connect the cars on the roller coaster and are a critical component in the performance and safety of the ride. Before we begin our discussion, recall from the previous chapter that companies generally classify manufacturing costs into three broad categories: (1) direct materials, (2) direct labor, and (3) manufacturing overhead. As we study the operation of a job-order costing system, we will see how each of these three types of costs is recorded and accumulated.

MANAGERIAL ACCOUNTING IN ACTION

The Issue

Yost Precision Machining is a small company in Michigan that specializes in fabricating precision metal parts that are used in a variety of applications ranging from deep-sea exploration vehicles to the inertial triggers in automobile air bags. The company's top managers gather every morning at 8:00 a.m. in the company's conference room for the daily planning meeting. Attending the meeting this morning are: Jean Yost, the company's president; David Cheung, the marketing manager; Debbie Turner, the production manager; and Marc White, the company controller. The president opened the meeting:

· Jean: The production schedule indicates we'll be starting Job 2B47 today. Isn't that the special order for experimental couplings, David?

· David: That's right. That's the order from Loops Unlimited for two couplings for their new roller coaster ride for Magic Mountain.

· Debbie: Why only two couplings? Don't they need a coupling for every car?

· David: Yes. But this is a completely new roller coaster. The cars will go faster and will be subjected to more twists, turns, drops, and loops than on any other existing roller coaster. To hold up under these stresses, Loops Unlimited's engineers completely redesigned the cars and couplings. They want us to make just two of these new couplings for testing purposes. If the design works, then we'll have the inside track on the order to supply couplings for the whole ride.

· Jean: We agreed to take on this initial order at our cost just to get our foot in the door. Marc, will there be any problem documenting our cost so we can get paid?

· Marc: No problem. The contract with Loops stipulates that they will pay us an amount equal to our cost of goods sold. With our job-order costing system, I can tell you the cost on the day the job is completed.

· Jean: Good. Is there anything else we should discuss about this job at this time? No? Well then let's move on to the next item of business.

Measuring Direct Materials Cost

The blueprints submitted by Loops Unlimited indicate that each experimental coupling will require three parts that are classified as direct materials: two G7 Connectors and one M46 Housing. Each coupling requires two connectors and one housing, so to make two couplings, four connectors and two housings are required. This is a custom product that is being made for the first time, but if this were one of the company's standard products, it would have an established bill of materials. A bill of materials is a document that lists the type and quantity of each type of direct material needed to complete a unit of product.

When an agreement has been reached with the customer concerning the quantities, prices, and shipment date for the order, a production order is issued. The Production Department then prepares a materials requisition form similar to the form in Exhibit 3–1 . The materials requisition form is a document that specifies the type and quantity of materials to be drawn from the storeroom and identifies the job that will be charged for the cost of the materials. The form is used to control the flow of materials into production and also for making entries in the accounting records.

EXHIBIT 3–1 Materials Requisition Form

The Yost Precision Machining materials requisition form in Exhibit 3–1 shows that the company's Milling Department has requisitioned two M46 Housings and four G7 Connectors for the Loops Unlimited job, which has been designated as Job 2B47.

Job Cost Sheet

After a production order has been issued, the Accounting Department's job-order costing software system automatically generates a job cost sheet like the one presented in Exhibit 3–2 . A job cost sheet records the materials, labor, and manufacturing overhead costs charged to that job.

EXHIBIT 3–2 Job Cost Sheet

After direct materials are issued, the cost of these materials are automatically recorded on the job cost sheet. Note from Exhibit 3–2 , for example, that the $660 cost for direct materials shown earlier on the materials requisition form has been charged to Job 2B47 on its job cost sheet. The requisition number 14873 from the materials requisition form appears on the job cost sheet to make it easier to identify the source document for the direct materials charge.

Measuring Direct Labor Cost

Direct labor consists of labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced directly to any job are treated as part of manufacturing overhead. As discussed in the previous chapter, this latter category of labor costs is called indirect labor and includes tasks such as maintenance, supervision, and cleanup.

Today many companies rely on computerized systems (rather than paper and pencil) to maintain employee time tickets. A completed time ticket is an hour-by-hour summary of the employee's activities throughout the day. One computerized approach to creating time tickets uses bar codes to capture data. Each employee and each job has a unique bar code. When beginning work on a job, the employee scans three bar codes using a handheld device much like the bar code readers at grocery store checkout stands. The first bar code indicates that a job is being started; the second is the unique bar code on the employee's identity badge; and the third is the unique bar code of the job itself. This information is fed automatically via an electronic network to a computer that notes the time and records all of the data. When the task is completed, the employee scans a bar code indicating the task is complete, the bar code on his or her identity badge, and the bar code attached to the job. This information is relayed to the computer that again notes the time, and a time ticket, such as the one shown in Exhibit 3–3 , is automatically prepared. Because all of the source data is already in computer files, the labor costs can be automatically posted to job cost sheets. For example, Exhibit 3–3 shows $45 of direct labor cost related to Job 2B47. This amount is automatically posted to the job cost sheet shown in Exhibit 3–2 . The time ticket in Exhibit 3–3 also shows $9 of indirect labor costs related to performing maintenance. This cost is treated as part of manufacturing overhead and does not get posted on a job cost sheet.

EXHIBIT 3–3 Employee Time Ticket

IN BUSINESS: BUCKING THE TREND: USING PEOPLE INSTEAD OF MACHINES

For decades, overhead costs have been going up and labor costs have been going down as companies have replaced people with machines. However, at the French automaker Renault, the exact opposite has been happening with its no-frills vehicle called the Logan. The Logan was intentionally stripped of costly elements and unnecessary technology so that the car could be sold for $6,000 in emerging Eastern European markets. The car's simplified design enables Renault's manufacturing plant in Romania to assemble the car almost entirely with people instead of robots. The monthly pay for a line worker at Renault's Romanian plant is $324 versus an average of more than $4,700 per worker in Western European countries. Thanks in part to low-cost labor, Logan's production costs are estimated to be just $1,089 per unit.

The Logan is finding buyers not only in emerging markets but also in more advanced Western European nations where customers have been clamoring for the car. Renault expects sales for the Logan to climb to one million vehicles—adding $341 million to its profits.

Source: Gail Edmondson and Constance Faivre d'Arcier, “Got 5,000 Euros? Need a New Car?”BusinessWeek, July 4, 2005, p. 49.

Computing Predetermined Overhead Rates

LEARNING OBJECTIVE 1

Compute a predetermined overhead rate.

Recall that product costs include manufacturing overhead as well as direct materials and direct labor. Therefore, manufacturing overhead also needs to be recorded on the job cost sheet. However, assigning manufacturing overhead to a specific job involves some difficulties. There are three reasons for this:

· 1. Manufacturing overhead is an indirect cost. This means that it is either impossible or difficult to trace these costs to a particular product or job.

· 2. Manufacturing overhead consists of many different items ranging from the grease used in machines to the annual salary of the production manager.

· 3. Because of the fixed costs in manufacturing overhead, total manufacturing overhead costs tend to remain relatively constant from one period to the next even though the number of units produced can fluctuate widely. Consequently, the average cost per unit will vary from one period to the next.

Given these problems, allocation is used to assign overhead costs to products. Allocation is accomplished by selecting an allocation base that is common to all of the company's products and services. An allocation base is a measure such as direct labor-hours (DLH) or machine-hours (MH) that is used to assign overhead costs to products and services. The most widely used allocation bases in manufacturing are direct labor-hours, direct labor cost, machine-hours and (where a company has only a single product) units of product.

Manufacturing overhead is commonly assigned to products using a predetermined overhead rate.The predetermined overhead rate is computed by dividing the total estimated manufacturing overhead cost for the period by the estimated total amount of the allocation base as follows:

The predetermined overhead rate is computed before the period begins using a four-step process. The first step is to estimate the total amount of the allocation base (the denominator) that will be required for next period's estimated level of production. The second step is to estimate the total fixed manufacturing overhead cost for the coming period and the variable manufacturing overhead cost per unit of the allocation base. The third step is to use the cost formula shown below to estimate the total manufacturing overhead cost (the numerator) for the coming period:

Where,

· Y The estimated total manufacturing overhead cost

· a The estimated total fixed manufacturing overhead cost

· b The estimated variable manufacturing overhead cost per unit of the allocation base

· X The estimated total amount of the allocation base

The fourth step is to compute the predetermined overhead rate. Notice, the estimated amount of the allocation base is determined before estimating the total manufacturing overhead cost. This needs to be done because total manufacturing overhead cost includes variable overhead costs that depend on the amount of the allocation base.

Applying Manufacturing Overhead

LEARNING OBJECTIVE 2

Apply overhead cost to jobs using a predetermined overhead rate.

To repeat, the predetermined overhead rate is computed before the period begins. The predetermined overhead rate is then used to apply overhead cost to jobs throughout the period. The process of assigning overhead cost to jobs is called overhead application . The formula for determining the amount of overhead cost to apply to a particular job is:

For example, if the predetermined overhead rate is $8 per direct labor-hour, then $8 of overhead cost is applied to a job for each direct labor-hour incurred on the job. When the allocation base is direct labor-hours, the formula becomes:

Manufacturing Overhead—A Closer Look

To illustrate the steps involved in computing and using a predetermined overhead rate, let's return to Yost Precision Machining and make the following assumptions. In step one, the company estimated that 40,000 direct labor-hours would be required to support the production planned for the year. In step two, it estimated $220,000 of total fixed manufacturing overhead cost for the coming year and $2.50 of variable manufacturing overhead cost per direct labor-hour. Given these assumptions, in step three the company used the cost formula shown below to estimate its total manufacturing overhead cost for the year:

In step four, Yost Precision Machining computed its predetermined overhead rate for the year of $8 per direct labor-hour as shown below:

The job cost sheet in Exhibit 3–4 indicates that 27 direct labor-hours (i.e., DLHs) were charged to Job 2B47. Therefore, a total of $216 of manufacturing overhead cost would be applied to the job:

EXHIBIT 3–4 A Completed Job Cost Sheet

This amount of overhead has been entered on the job cost sheet in Exhibit 3–4 . Note that this is notthe actual amount of overhead caused by the job. Actual overhead costs are not assigned to jobs—if that could be done, the costs would be direct costs, not overhead. The overhead assigned to the job is simply a share of the total overhead that was estimated at the beginning of the year. A normal cost system , which we have been describing, applies overhead to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the jobs.

The Need for a Predetermined Rate

Instead of using a predetermined rate based on estimates, why not base the overhead rate on theactual total manufacturing overhead cost and the actual total amount of the allocation base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the allocation base can produce fluctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall. If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs. Many managers believe that such fluctuations in product costs serve no useful purpose. To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems.

Choice of an Allocation Base for Overhead Cost

Ideally, the allocation base in the predetermined overhead rate should drive the overhead cost. A cost driver is a factor, such as machine-hours, beds occupied, computer time, or flight-hours, that causes overhead costs. If the base in the predetermined overhead rate does not “drive” overhead costs, product costs will be distorted. For example, if direct labor-hours is used to allocate overhead, but in reality overhead has little to do with direct labor-hours, then products with high direct labor-hour requirements will be overcosted.

Most companies use direct labor-hours or direct labor cost as the allocation base for manufacturing overhead. In the past, direct labor accounted for up to 60% of the cost of many products, with overhead cost making up only a portion of the remainder. This situation has changed for two reasons. First, sophisticated automated equipment has taken over functions that used to be performed by direct labor workers. Because the costs of acquiring and maintaining such equipment are classified as overhead, this increases overhead while decreasing direct labor. Second, products are becoming more sophisticated and complex and are changed more frequently. This increases the need for highly skilled indirect workers such as engineers. As a result of these two trends, direct labor has decreased relative to overhead as a component of product costs.

In companies where direct labor and overhead costs have been moving in opposite directions, it would be difficult to argue that direct labor “drives” overhead costs. Accordingly, managers in some companies use activity-based costing principles to redesign their cost accounting systems. Activity-based costing is designed to more accurately reflect the demands that products, customers, and other cost objects make on overhead resources. The activity-based approach is discussed in more detail in Chapter 7 .

Although direct labor may not be an appropriate allocation base in some industries, in others it continues to be a significant driver of manufacturing overhead. Indeed, most manufacturing companies in the United States continue to use direct labor as the primary or secondary allocation base for manufacturing overhead. The key point is that the allocation base used by the company should really drive, or cause, overhead costs, and direct labor is not always the most appropriate allocation base.

IN BUSINESS: REDUCING HEALTH-DAMAGING BEHAVIORS

Cianbro is an industrial construction company headquartered in Pittsfield, Maine, whose goal is “To be the healthiest company in America.” It introduced a corporate wellness program to attack employee behaviors that drive up health-care costs. The table below summarizes the number of employees in five health risk categories as of 2003 and 2005. The decreases in the number of employees in these high-risk categories are evidence that the wellness program was effective in helping employees make positive lifestyle changes. This should result in reduced health-care costs for the company.

Number of Employees

Health Risk Category

January 2003

March 2005

Decrease

Obesity

432

353

79

High cholesterol

637

515

122

Tobacco use

384

274

110

Inactivity

354

254

100

High blood pressure

139

91

48

Source: Cianbro, WELCOA's Absolute Advantage Magazine, 2006.

LEARNING OBJECTIVE 3

Compute the total cost and average cost per unit of a job.

Computation of Unit Costs

With the application of Yost Precision Machining's $216 of manufacturing overhead to the job cost sheet in Exhibit 3–4 , the job cost sheet is complete except for two final steps. First, the totals for direct materials, direct labor, and manufacturing overhead are transferred to the Cost Summary section of the job cost sheet and added together to obtain the total cost for the job. 1 Then the total product cost ($1,800) is divided by the number of units (2) to obtain the unit product cost ($900). This unit product cost information is used for valuing unsold units in ending inventory and for determining cost of goods sold. As indicated earlier, this unit product cost is an average cost and should not be interpreted as the cost that would actually be incurred if another unit were produced. The incremental cost of an additional unit is something less than the average unit cost of $900 because much of the actual overhead costs would not change if another unit were produced.

MANAGERIAL ACCOUNTING IN ACTION

The Wrap-up

In the 8:00 a.m. daily planning meeting on March 9, Jean Yost, the president of Yost Precision Machining, once again drew attention to Job 2B47, the experimental couplings:

· Jean: I see Job 2B47 is completed. Let's get those couplings shipped immediately to Loops Unlimited so they can get their testing program under way. Marc, how much are we going to bill Loops for those two units?

· Marc: Because we agreed to sell the experimental couplings at cost, we will be charging Loops Unlimited just $900 a unit.

· Jean: Fine. Let's hope the couplings work out and we make some money on the big order later.

IN BUSINESS: ONE-OF-A-KIND MASTERPIECE

In a true job-order costing environment, every job is unique. For example, Purdey manufactures 80–90 shotguns per year with each gun being a specially commissioned one-of-a-kind masterpiece. The prices start at $110,000 because every detail is custom built, engraved, assembled, and polished by a skilled craftsman. The hand engraving can take months to complete and may add as much as $100,000 to the price. The guns are designed to shoot perfectly straight and their value increases over time even with heavy use. One Purdey gun collector said “when I shoot my Purdeys I feel like an orchestra conductor waving my baton.”

Source: Eric Arnold, “Aim High,” Forbes, December 28, 2009, p. 86.

1

Notice, we are assuming that Job 2B47 required direct materials and direct labor beyond the charges shown in Exhibits 3–1 and 3–3 .

Job-Order Costing—The Flow of Costs

LEARNING OBJECTIVE 4

Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.

We are now ready to discuss the flow of costs through a job-order costing system. Exhibit 3–5 provides a conceptual overview of these cost flows. It highlights the fact that product costs flow through inventories on the balance sheet and then on to cost of goods sold in the income statement. More specifically, raw materials purchases are recorded in the Raw Materials inventory account. Raw materials include any materials that go into the final product. When raw materials are used in production, their costs are transferred to the Work in Process inventory account as direct materials. 2 Work in process consists of units of product that are only partially complete and will require further work before they are ready for sale to the customer. Notice that direct labor costs are added directly to Work in Process—they do not flow through Raw Materials inventory. Manufacturing overhead costs are applied to Work in Process by multiplying the predetermined overhead rate by the actual quantity of the allocation base consumed by each job. 3 When goods are completed, their costs are transferred from Work in Process to Finished Goods. Finished goods consist of completed units of product that have not yet been sold to customers. The amount transferred from Work in Process to Finished Goods is referred to as the cost of goods manufactured. The cost of goods manufactured includes the manufacturing costs associated with the goods that were finished during the period. As goods are sold, their costs are transferred from Finished Goods to Cost of Goods Sold. At this point, the various costs required to make the product are finally recorded as an expense. Until that point, these costs are in inventory accounts on the balance sheet. Period costs (or selling and administrative expenses) do not flow through inventories on the balance sheet. They are recorded as expenses on the income statement in the period incurred.

EXHIBIT 3–5 Cost Flows and Classifications in a Manufacturing Company

To illustrate the cost flows through a company's general ledger, we will consider a single month's activity at Ruger Corporation, a producer of gold and silver commemorative medallions. Ruger Corporation has two jobs in process during April, the first month of its fiscal year. Job A, a special minting of 1,000 gold medallions commemorating the invention of motion pictures, was started during March. By the end of March, $30,000 in manufacturing costs had been recorded for the job. Job B, an order for 10,000 silver medallions commemorating the fall of the Berlin Wall, was started in April.

The Purchase and Issue of Materials

On April 1, Ruger Corporation had $7,000 in raw materials on hand. During the month, the company purchased on account an additional $60,000 in raw materials. The purchase is recorded in journal entry (1) below:

As explained in the previous chapter, Raw Materials is an asset account. Thus, when raw materials are purchased, they are initially recorded as an asset—not as an expense.

Issue of Direct and Indirect Materials

During April, $52,000 in raw materials were requisitioned from the storeroom for use in production. These raw materials included $50,000 of direct and $2,000 of indirect materials. Entry (2) records issuing the materials to the production departments.

The materials charged to Work in Process represent direct materials for specific jobs. These costs are also recorded on the appropriate job cost sheets. This point is illustrated in Exhibit 3–6 , where$28,000 of the $50,000 in direct materials is charged to Job A's cost sheet and the remaining $22,000is charged to Job B's cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.)

EXHIBIT 3–6 Raw Materials Cost Flows

The $2,000 charged to Manufacturing Overhead in entry (2) represents indirect materials. Observe that the Manufacturing Overhead account is separate from the Work in Process account. The purpose of the Manufacturing Overhead account is to accumulate all manufacturing overhead costs as they are incurred during a period.

Before leaving Exhibit 3–6 , we need to point out one additional thing. Notice from the exhibit that the job cost sheet for Job A contains a beginning balance of $30,000. We stated earlier that this balance represents the cost of work done during March that has been carried forward to April. Also note that the Work in Process account contains the same $30,000 balance. Thus, the Work in Process account summarizes all of the costs appearing on the job cost sheets of the jobs that are in process. Job A was the only job in process at the beginning of April, so the beginning balance in the Work in Process account equals Job A's beginning balance of $30,000.

2

Indirect material costs are accounted for as part of manufacturing overhead.

3

For simplicity, Exhibit 3–5 assumes that Cost of Goods Sold does not need to be adjusted as discussed later in the chapter.

Labor Cost

In April, the employee time tickets included $60,000 recorded for direct labor and $15,000 for indirect labor. The following entry summarizes these costs:

Only the direct labor cost of $60,000 is added to the Work in Process account. At the same time that direct labor costs are added to Work in Process, they are also added to the individual job cost sheets, as shown in Exhibit 3–7 . During April, $40,000 of direct labor cost was charged to Job A and the remaining $20,000 was charged to Job B.

EXHIBIT 3–7 Labor Cost Flows

The labor costs charged to Manufacturing Overhead ($15,000) represent the indirect labor costs of the period, such as supervision, janitorial work, and maintenance.

Manufacturing Overhead Costs

Recall that all manufacturing costs other than direct materials and direct labor are classified as manufacturing overhead costs. These costs are entered directly into the Manufacturing Overhead account as they are incurred. To illustrate, assume that Ruger Corporation incurred the following general factory costs during April:

The following entry records the incurrence of these costs:

In addition, assume that during April, Ruger Corporation recognized $13,000 in accrued property taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The following entry records these items:

Finally, assume that the company recognized $18,000 in depreciation on factory equipment during April. The following entry records the accrual of this depreciation:

In short, manufacturing overhead costs are recorded directly into the Manufacturing Overhead account as they are incurred.

Applying Manufacturing Overhead

Because actual manufacturing costs are charged to the Manufacturing Overhead control account rather than to Work in Process, how are manufacturing overhead costs assigned to Work in Process? The answer is, by means of the predetermined overhead rate. Recall from our discussion earlier in the chapter that a predetermined overhead rate is established at the beginning of each year. The rate is calculated by dividing the estimated total manufacturing overhead cost for the year by the estimated total amount of the allocation base (measured in machine-hours, direct labor-hours, or some other base). The predetermined overhead rate is then used to apply overhead costs to jobs. For example, if machine-hours is the allocation base, overhead cost is applied to each job by multiplying the predetermined overhead rate by the number of machine-hours charged to the job.

To illustrate, assume that Ruger Corporation's predetermined overhead rate is $6 per machine-hour. Also assume that during April, 10,000 machine-hours were worked on Job A and 5,000 machine-hours were worked on Job B (a total of 15,000 machine-hours). Thus, $90,000 in overhead cost ($6 per machine-hour × 15,000 machine-hours = $90,000) would be applied to Work in Process. The following entry records the application of Manufacturing Overhead to Work in Process:

The flow of costs through the Manufacturing Overhead account is shown in Exhibit 3–8 . The actual overhead costs on the debit side in the Manufacturing Overhead account in Exhibit 3–8 are the costs that were added to the account in entries (2)–(6). Observe that recording these actual overhead costs [entries (2)–(6)] and the application of overhead to Work in Process [entry (7)] represent two separate and entirely distinct processes.

EXHIBIT 3–8 The Flow of Costs in Overhead Application

The Concept of a Clearing Account

The Manufacturing Overhead account operates as a clearing account. As we have noted, actual factory overhead costs are debited to the account as they are incurred throughout the year. When a job is completed (or at the end of an accounting period), overhead cost is applied to the job using the predetermined overhead rate, and Work in Process is debited and Manufacturing Overhead is credited. This sequence of events is illustrated below:

As we emphasized earlier, the predetermined overhead rate is based entirely on estimates of what the level of activity and overhead costs are expected to be, and it is established before the year begins. As a result, the overhead cost applied during a year will almost certainly turn out to be more or less than the actual overhead cost incurred. For example, notice from Exhibit 3–8 that Ruger Corporation's actual overhead costs for the period are $5,000 greater than the overhead cost that has been applied to Work in Process, resulting in a $5,000 debit balance in the Manufacturing Overhead account. We will reserve discussion of what to do with this $5,000 balance until later in the chapter.

For the moment, we can conclude from Exhibit 3–8 that the cost of a completed job consists of the actual direct materials cost of the job, the actual direct labor cost of the job, and the manufacturing overhead cost applied to the job. Pay particular attention to the following subtle but important point: Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the job cost sheet nor do they appear in the Work in Process account. Only the applied overhead cost, based on the predetermined overhead rate, appears on the job cost sheet and in the Work in Process account.

Nonmanufacturing Costs

In addition to manufacturing costs, companies also incur selling and administrative costs. These costs should be treated as period expenses and charged directly to the income statement.Nonmanufacturing costs should not go into the Manufacturing Overhead account. To illustrate the correct treatment of nonmanufacturing costs, assume that Ruger Corporation incurred $30,000 in selling and administrative salary costs during April. The following entry summarizes the accrual of those salaries:

Assume that depreciation on office equipment during April was $7,000. The entry is as follows:

Pay particular attention to the difference between this entry and entry (6) where we recorded depreciation on factory equipment. In journal entry (6), depreciation on factory equipment was debited to Manufacturing Overhead and is therefore a product cost. In journal entry (9) above, depreciation on office equipment is debited to Depreciation Expense. Depreciation on office equipment is a period expense rather than a product cost.

Finally, assume that advertising was $42,000 and that other selling and administrative expenses in April totaled $8,000. The following entry records these items:

The amounts in entries (8) through (10) are recorded directly into expense accounts—they have no effect on product costs. The same will be true of any other selling and administrative expenses incurred during April, including sales commissions, depreciation on sales equipment, rent on office facilities, insurance on office facilities, and related costs.

Cost of Goods Manufactured

When a job has been completed, the finished output is transferred from the production departments to the finished goods warehouse. By this time, the accounting department will have charged the job with direct materials and direct labor cost, and manufacturing overhead will have been applied using the predetermined overhead rate. A transfer of costs is made within the costing system that parallels the physical transfer of goods to the finished goods warehouse. The costs of the completed job are transferred out of the Work in Process account and into the Finished Goods account. The sum of all amounts transferred between these two accounts represents the cost of goods manufactured for the period.

In the case of Ruger Corporation, assume that Job A was completed during April. The following entry transfers the cost of Job A from Work in Process to Finished Goods:

The $158,000 represents the completed cost of Job A, as shown on the job cost sheet in Exhibit 3–8 . Because Job A was the only job completed during April, the $158,000 also represents the cost of goods manufactured for the month.

Job B was not completed by the end of the month, so its cost will remain in the Work in Process account and carry over to the next month. If a balance sheet is prepared at the end of April, the cost accumulated thus far on Job B will appear as the asset “Work in Process inventory.”

Cost of Goods Sold

As finished goods are shipped to customers, their accumulated costs are transferred from the Finished Goods account to the Cost of Goods Sold account. If an entire job is shipped at one time, then the entire cost appearing on the job cost sheet is transferred to the Cost of Goods Sold account. In most cases, however, only a portion of the units involved in a particular job will be immediately sold. In these situations, the unit product cost must be used to determine how much product cost should be removed from Finished Goods and charged to Cost of Goods Sold.

For Ruger Corporation, we will assume 750 of the 1,000 gold medallions in Job A were shipped to customers by the end of the month for total sales revenue of $225,000. Because 1,000 units were produced and the total cost of the job from the job cost sheet was $158,000, the unit product cost was $158. The following journal entries would record the sale (all sales were on account):

LEARNING OBJECTIVE 5

Use T-accounts to show the flow of costs in a job-order costing system.

Entry (13) completes the flow of costs through the job-order costing system. To pull the entire Ruger Corporation example together, journal entries (1) through (13) are summarized in Exhibit 3–9 . The flow of costs through the accounts is presented in T-account form in Exhibit 3–10 .

EXHIBIT 3–9 Summary of Ruger Corporation Journal Entries

EXHIBIT 3–10 Summary of Cost Flows—Ruger Corporation

Schedules of Cost of Goods Manufactured and Cost of Goods Sold

LEARNING OBJECTIVE 6

Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement.

This section uses the Ruger Corporation example to explain how to prepare schedules of cost of goods manufactured and cost of goods sold as well as an income statement. The schedule of cost of goods manufactured contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and it summarizes the portions of those costs that remain in ending Work in Process inventory and that are transferred out of Work in Process into Finished Goods. The schedule of cost of goods sold also contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and it summarizes the portions of those costs that remain in ending Finished Goods inventory and that are transferred out of Finished Goods into Cost of Goods Sold.

Exhibit 3–11 presents Ruger Corporation's schedules of cost of goods manufactured and cost of goods sold. We want to draw your attention to three key aspects of the schedule of cost of goods manufactured. First, three amounts are always added together—direct materials used in production ($50,000), direct labor ($60,000), and manufacturing overhead applied to work in process ($90,000)—to yield the total manufacturing costs ($200,000). Notice, the direct materials used in production ($50,000) is included in total manufacturing costs instead of raw material purchases ($60,000). The direct materials used in production will usually differ from the amount of raw material purchases when the raw materials inventory balance changes or indirect materials are withdrawn from raw materials inventory. Second, the amount of manufacturing overhead applied to Work in Process ($90,000) is computed by multiplying the predetermined overhead rate by the actual amount of the allocation base recorded on all jobs. The actual manufacturing overhead costs incurred during the period are not added to the Work in Process account. Third, total manufacturing costs ($200,000) plus beginning Work in Process inventory ($30,000) minus ending Work in Process inventory ($72,000) equals the cost of goods manufactured ($158,000). The cost of goods manufactured represents the cost of the goods completed during the period and transferred from Work in Process to Finished Goods.

EXHIBIT 3–11 Schedules of Cost of Goods Manufactured and Cost of Goods Sold

The schedule of cost of goods sold shown in Exhibit 3–11 relies on the following equation to compute the unadjusted cost of goods sold:

The beginning finished goods inventory ($10,000) plus the cost of goods manufactured ($158,000) equals the cost of goods available for sale ($168,000). The cost of goods available for sale ($168,000) minus the ending finished goods inventory ($49,500) equals the unadjusted cost of goods sold ($118,500). Finally, the unadjusted cost of goods sold ($118,500) plus the underapplied overhead ($5,000) equals adjusted cost of goods sold ($123,500). The next section of the chapter takes a closer look at why cost of goods sold needs to be adjusted for the amount of underapplied or overapplied overhead

Exhibit 3–12 presents Ruger Corporation's income statement for April. Observe that the cost of goods sold on this statement is carried over from Exhibit 3–11 . The selling and administrative expenses (which total $87,000) did not flow through the schedules of cost of goods manufactured and cost of goods sold. Journal entries 8–10 (page 100) show that these items were immediately debited to expense accounts rather than being debited to inventory accounts.

EXHIBIT 3–12 Income Statement

Underapplied and Overapplied Overhead—A Closer Look

LEARNING OBJECTIVE 7

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

This section explains how to compute underapplied and overapplied overhead and how to dispose of any balance remaining in the Manufacturing Overhead account at the end of a period.

Computing Underapplied and Overapplied Overhead

Because the predetermined overhead rate is established before the period begins and is based entirely on estimated data, the overhead cost applied to Work in Process will generally differ from the amount of overhead cost actually incurred. In the case of Ruger Corporation, for example, the predetermined overhead rate of $6 per hour was used to apply $90,000 of overhead cost to Work in Process, whereas actual overhead costs for April proved to be $95,000 (see Exhibit 3–8 ). The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is called either underapplied or overapplied overhead . For Ruger Corporation, overhead was underapplied by $5,000 because the applied cost ($90,000) was $5,000 less than the actual cost ($95,000). If the situation had been reversed and the company had applied $95,000 in overhead cost to Work in Process while incurring actual overhead costs of only $90,000, then the overhead would have been overapplied.

What is the cause of underapplied or overapplied overhead? Basically, the method of applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount of the allocation base incurred during the period. If, for example, the predetermined overhead rate is $6 per machine-hour, then it is assumed that actual overhead costs incurred will be $6 for every machine-hour that is actually worked. There are at least two reasons why this may not be true. First, much of the overhead often consists of fixed costs that do not change as the number of machine-hours incurred goes up or down. Second, spending on overhead items may or may not be under control. If individuals who are responsible for overhead costs do a good job, those costs should be less than were expected at the beginning of the period. If they do a poor job, those costs will be more than expected.

To illustrate these concepts, suppose that two companies—Turbo Crafters and Black & Howell—have prepared the following estimated data for the coming year:

Note that when the allocation base is dollars (such as direct materials cost in the case of Black & Howell) the predetermined overhead rate is expressed as a percentage of the allocation base. When dollars are divided by dollars, the result is a percentage.

Now assume that because of unexpected changes in overhead spending and in demand for the companies’ products, the actual overhead cost and the actual activity recorded during the year in each company are as follows:

For each company, note that the actual data for both cost and the allocation base differ from the estimates used in computing the predetermined overhead rate. This results in underapplied and overapplied overhead as follows:

For Turbo Crafters, the amount of overhead cost applied to Work in Process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore, overhead is underapplied.

For Black & Howell, the amount of overhead cost applied to Work in Process ($135,000) is greater than the actual overhead cost for the year ($130,000), so overhead is overapplied.

A summary of these concepts is presented in Exhibit 3–13 .

EXHIBIT 3–13 Summary of Overhead Concepts

Disposition of Underapplied or Overapplied Overhead Balances

If we return to the Ruger Corporation example and look at the Manufacturing Overhead T-account in Exhibit 3–10 , you will see that there is a debit balance of $5,000. Remember that debit entries to the account represent actual overhead costs incurred, whereas credit entries represent overhead costs applied to jobs. In this case, the actual overhead costs incurred exceeded the overhead costs applied to jobs by $5,000—hence, the debit balance of $5,000. This may sound familiar. We just discussed in the previous section the fact that the overhead costs incurred ($95,000) exceeded the overhead costs applied ($90,000), and that the difference is called underapplied overhead. These are just two ways of looking at the same thing. If there is a debit balance in the Manufacturing Overhead account of X dollars, then the overhead is underapplied by X dollars. On the other hand, if there is a credit balance in the Manufacturing Overhead account of Y dollars, then the overhead is overapplied by Y dollars. What do we do with the balance in the Manufacturing Overhead account at the end of the accounting period?

The underapplied or overapplied balance remaining in the Manufacturing Overhead account at the end of a period is treated in one of two ways:

· 1. Closed out to Cost of Goods Sold.

· 2. Allocated among the Work in Process, Finished Goods, and Cost of Goods Sold accounts in proportion to the overhead applied during the current period in ending balances.

Closed Out to Cost of Goods Sold

Closing out the balance in Manufacturing Overhead to Cost of Goods Sold is simpler than the allocation method. In the Ruger Corporation example, the entry to close the $5,000 of underapplied overhead to Cost of Goods Sold is:

Note that because the Manufacturing Overhead account has a debit balance, Manufacturing Overhead must be credited to close out the account. This has the effect of increasing Cost of Goods Sold for April to $123,500:

After this adjustment has been made, Ruger Corporation's income statement for April will appear as shown earlier in Exhibit 3–12 .

Note that this adjustment makes sense. The unadjusted cost of goods sold is based on the amount of manufacturing overhead applied to jobs, not the manufacturing overhead costs actually incurred. Because overhead was underapplied, not enough cost was applied to jobs. Hence, the cost of goods sold was understated. Adding the underapplied overhead to the cost of goods sold corrects this understatement.

Allocated between Accounts

Allocation of underapplied or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods Sold is more accurate than closing the entire balance into Cost of Goods Sold. This allocation assigns overhead costs to where they would have gone had the estimates included in the predetermined overhead rate matched the actual amounts.

Had Ruger Corporation chosen to allocate the underapplied overhead among the inventory accounts and Cost of Goods Sold, it would first be necessary to determine the amount of overhead that had been applied during April to each of the accounts. The computations would have been as follows:

Based on the above percentages, the underapplied overhead (i.e., the debit balance in Manufacturing Overhead) would be allocated as shown in the following journal entry:

Note that the first step in the allocation process was to determine the amount of overhead applied in each of the accounts. For Finished Goods, for example, the total amount of overhead applied to Job A, $60,000, was divided by the total number of units in Job A, 1,000 units, to arrive at the average overhead applied of $60 per unit. Because 250 units from Job A were still in ending finished goods inventory, the amount of overhead applied in the Finished Goods Inventory account was $60 per unit multiplied by 250 units or $15,000 in total.

If overhead had been overapplied, the entry above would have been just the reverse, because a credit balance would have existed in the Manufacturing Overhead account.

Which Method Should Be Used for Disposing of Underapplied or Overapplied Overhead?

The allocation method is generally considered more accurate than simply closing out the underapplied or overapplied overhead to Cost of Goods Sold. However, the allocation method is more complex. We will always specify which method you are to use in problem assignments.

A General Model of Product Cost Flows

Exhibit 3–14 presents a T-account model of the flow of costs in a product costing system. This model can be very helpful in understanding how production costs flow through a costing system and finally end up as Cost of Goods Sold on the income statement.

EXHIBIT 3–14 A General Model of Cost Flows

Multiple Predetermined Overhead Rates

Our discussion in this chapter has assumed that there is a single predetermined overhead rate for an entire factory called a plantwide overhead rate . This is a fairly common practice—particularly in smaller companies. But in larger companies, multiple predetermined overhead rates are often used. In a multiple predetermined overhead rate system each production department may have its own predetermined overhead rate. Such a system, while more complex, is more accurate because it can reflect differences across departments in how overhead costs are incurred. For example, in departments that are relatively labor intensive overhead might be allocated based on direct labor-hours and in departments that are relatively machine intensive overhead might be allocated based on machine-hours. When multiple predetermined overhead rates are used, overhead is applied in each department according to its own overhead rate as jobs proceed through the department.

Job-Order Costing in Service Companies

Job-order costing is used in service organizations such as law firms, movie studios, hospitals, and repair shops, as well as in manufacturing companies. In a law firm, for example, each client is a “job,” and the costs of that job are accumulated day by day on a job cost sheet as the client's case is handled by the firm. Legal forms and similar inputs represent the direct materials for the job; the time expended by attorneys is like direct labor; and the costs of secretaries and legal aids, rent, depreciation, and so forth, represent the overhead.

In a movie studio such as Columbia Pictures, each film produced by the studio is a “job,” and costs of direct materials (costumes, props, film, etc.) and direct labor (actors, directors, and extras) are charged to each film's job cost sheet. A share of the studio's overhead costs, such as utilities, depreciation of equipment, wages of maintenance workers, and so forth, is also charged to each film.

In sum, job-order costing is a versatile and widely used costing method that may be encountered in virtually any organization that provides diverse products or services.

IN BUSINESS: MANAGING JOB COSTS IN A SERVICE BUSINESS

IBM has created a software program called Professional Marketplace to match IBM employees with client needs. “Using Marketplace, IBM consultants working for customers can search through 100 job classifications and 10,000 skills, figuring out who inside IBM is available, where they are located and roughly how much it costs the company to use them.” Thus far, the results have been encouraging. IBM has reduced its reliance on outside contractors by 5% to 7% and its consultants spend more of their time in billable work. Furthermore, IBM's senior consultants can search across the globe for available employees with particular niche skills with the click of a mouse instead of having to rely on numerous time-consuming phone calls and emails.

Source: Charles Forelle, “IBM Tool Deploys Employees Efficiently,” The Wall Street Journal, July 14, 2005, p. B3.

Summary

Job-order costing is used in situations where the organization offers many different products or services, such as in furniture manufacturing, hospitals, and legal firms. Materials requisition forms and labor time tickets are used to assign direct materials and direct labor costs to jobs in a job-order costing system. Manufacturing overhead costs are assigned to jobs using a predetermined overhead rate. All of the costs are recorded on a job cost sheet. The predetermined overhead rate is determined before the period begins by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base for the period. The most frequently used allocation bases are direct labor-hours and machine-hours. Overhead is applied to jobs by multiplying the predetermined overhead rate by the actual amount of the allocation base recorded for the job.

Because the predetermined overhead rate is based on estimates, the actual overhead cost incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as underapplied or overapplied overhead. The underapplied or overapplied overhead for a period can be either closed out to Cost of Goods Sold or allocated between Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is underapplied, manufacturing overhead costs have been understated and therefore inventories and/or expenses must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or expenses must be adjusted downwards.