As production takes place, manufacturing costs are tracked in the Work-in-Process Inventory account. Every product is made up of three cost components: direct materials, direct labor, and manufacturing overhead. After products are completed, the corresponding cost leaves the Work-in-Process account and is debited to the Finished-Goods account. (A merchandising firm buys its goods already completed and directly debits the items’ cost to Merchandise Inventory.)
When units are sold, the Finished-Goods Inventory account is credited and Cost of Goods Sold is debited.
A product-costing system must be adapted to match the environment in which it operates.
A job-order costing system is used in an industry where products are made individually, or in relatively small batches, and one product or batch is readily distinguishable from the other.
Candidates for job-costing systems would be custom homebuilding, custom printing, custom furniture construction, legal cases, medical cases, audits, and research projects.
A process-costing system is employed in an environment at the other end of the continuum: the mass production of like units. Users might include manufacturers of chemicals, gasoline, and microchips. This topic is discussed fully in Chapter 4.
4.ACCUMULATING COSTS IN A JOB-ORDER COSTING SYSTEM
A job-cost record is used to accumulate the actual direct materials, actual direct labor, and applied manufacturing overhead costs for each job. The recording of costs on this record and in the general ledger is triggered by various source documents.
Material requisition forms authorize the transfer of direct materials from the warehouse to production. In many firms, the requisitions are based on a bill of materials that lists all of the materials (e.g., parts) needed.
Supply chain—the flow of all goods, services, and information into and out of the organization. The supply chain often has ramifications for materials, as manufacturers work with vendors to achieve improved delivery schedules and reductions in material cost.
Time records are used to gather the amount of direct labor worked on a specific job.
Manufacturing overhead is entered on the job-cost record in the form of applied (i.e., estimated) overhead. Source documents, such as invoices for factory insurance and schedules for factory depreciation, trigger a general-ledger entry that debits the Manufacturing Overhead account.
Overhead accounting involves a number of steps. Chapter 3 focuses on the final step: the application of overhead to jobs and products.
Although overhead cannot be directly traced to the product, the use of an application rate should allocate an equitable amount of cost to each job (known as overhead application).
Step 1: Set a predetermined overhead rate at the beginning of the accounting period. This is done by dividing the period’s estimated (budgeted) overhead by the period’s estimated number of cost-driver units.
Step 2: Use the predetermined overhead rate to apply an equitable portion of overhead to each job. As the actual number of cost-driver units used on a job becomes known, it is multiplied by the predetermined overhead rate.
Actual overhead costs incurred during the year are debited to the Manufacturing Overhead control account. In contrast, applied overhead is debited to Work-in-Process Inventory and credited to Manufacturing Overhead.
The year-end difference between actual and applied amounts is known as over-
or underapplied overhead. This figure is adjusted in the process of closing the Manufacturing Overhead account to zero by either:
Charging or crediting the amount to cost of goods sold. This approach is acceptable if the over- or underapplication is small or if most of the products made during the period have been sold.
Prorating the amount among work in process, finished goods, and cost of goods sold.
Teaching Tip: Emphasize that under- and overapplied overhead is the difference between actual and applied overhead, not actual and budgeted overhead. The budgeted figure is used solely in the determination of the predetermined rate.
6. EXTENDED ILLUSTRATION OF JOB COSTING
As noted earlier, the Work-in-Process Inventory account contains charges for direct materials used, direct labor, and applied manufacturing overhead.
Period costs are expensed and not charged to Manufacturing Overhead.
A sale requires two journal entries: one to record the sales revenue and another to transfer the goods’ cost from Finished-Goods Inventory to Cost of Goods Sold.
Teaching Tip: Although the text illustration appears relatively complicated, it is simply presenting the details that accompany the flow of goods (and costs) from work in process, to finished goods, to cost of goods sold.
7.FINANCIAL SCHEDULES FOR MANAGERS
The schedule of cost of goods manufactured details the activity in the Work-in-Process account (beginning balance, direct materials used, direct labor, applied overhead, and ending balance).
The schedule of cost of goods sold details the activity in the Finished- Goods Inventory account. It is similar to the cost-of-goods-sold schedule as shown in financial accounting courses for merchandising companies, except the “purchases” amount is replaced with cost of goods manufactured.
8.FURTHER ASPECTS OF OVERHEAD APPLICATION
Actual and normal costing
Accountants prefer predetermined application rates, which are used in a normal-costing system. Such rates help to smooth product costs over time and allow users to cost products/jobs upon completion.
In contrast, users of actual-costing systems derive an actual overhead rate at the end of the accounting period. Product-cost information to management is therefore delayed.
Choosing an appropriate cost driver
Direct labor has been a very common and appropriate cost driver. Past processes were labor intensive, and products incurring more labor often produced higher amounts of manufacturing overhead.
Today, many processes are automated and less dependent on labor. Thus, firms now use machine hours, process time, throughput (cycle) time (the average amount of time to convert raw materials into finished goods), and other measures as cost drivers.
Single vs. multiple overhead rates
Companies commonly use multiple (rather than single) application rates. With computerized accounting systems, multiple rates are easily generated, thus lowering the cost of producing highly accurate information.
A single overhead rate is commonly known as a plantwide rate; multiple rates are often known as departmental rates.
Two-stage cost allocation
Stage one: Overhead is first accumulated in production departments. This frequently requires the allocation of service department costs to production departments.
Stage two: As a final step, production department costs are assigned to individual jobs and products via overhead application.
Project costing refers to job costing in a nonmanufacturing environment. “Jobs” in this case refer to cases, contracts, and/or programs.
Costing involves tracking the direct, easily traceable costs and subdividing them by project. Overhead is then applied by using a predetermined rate, with a possible application base being a project’s direct professional labor cost.
Technology such as bar coding may be used to track appropriate costs to projects, although this is just one of many possible applications. Service providers, along with manufacturers, are also making use of:
Electronic data interchange (EDI), which involves the electronic transfer of information from one organization to another by using a computer-to-computer interface.
Extensible markup language (XML), which is web-based and allows users to share structured data such as product order lists and price data.
I begin the topic of job costing by explaining that students should not expect to apply a so-called “textbook system” to any real-world company, because cost systems must be designed to meet a firm’s unique needs. However, the two traditional system models, job order and process costing, give users the ability to build-in various modifications for use in actual situations.
The major difficulty that students encounter in job costing is the concept of manufacturing overhead. The first area needing clarification is terminology, namely:
Estimated = budgeted
Applied = allocatedIncurred = actual
The second area in need of clarification is the sequence of procedures for overhead application: calculating predetermined overhead rates, using the rates, and adjusting the over- or underapplied amount. This problem stems from the fact that students are doing textbook assignments where all the information is given simultaneously. Therefore, the question arises, “Why use an imperfect predetermined overhead rate when I have all the totally correct, actual data in the next paragraph?” It is helpful to be on the lookout for this line of thinking when discussing homework assignments and to remind students how and when information becomes available in the real world. (I suspect this is a problem mainly for undergraduates with limited work experience.)
Based on many years of teaching, I also find that students struggle with the journal entries required to handle a sale. Two entries are needed: one to transfer the cost of units sold from finished goods to cost of goods sold; another is needed to record revenue. Students often forget one or the other or exhibit some creativity, creating a new account entitled Profit on Sale. Be sure to spend a few extra minutes with this issue.
After the preceding issues have been handled, students generally are quite interested in job-costing concepts, particularly those who have worked in a family business or who plan to start their own business. Students are also interested in job costing in a service enterprise (discuss something as basic as the activities of a sports agent who represents clients across the country) and the impact of changing manufacturing techniques (such as the acquisition of new, state-of-the-art production technology) on product-costing procedures.
I recommend Exercise 3-35 (manufacturing overhead) and Problem 3-46 (job costing and journal entries) as lecture demonstration problems.