Job Costing. Product Costing Systems PART I INTRODUCTION TO COST MANAGEMENT. After studying this chapter, you should be able to...

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1 Cost : A C H A P T E R F O U R PART I INTRODUCTION TO COST MANAGEMENT Job Costing After studying this chapter, you should be able to.... Explain the types of costing systems. Explain the strategic role of product costing 3. Explain the flow of costs in a job costing system 4. Explain the application of factory overhead costs in a job costing system 5. Calculate underapplied and overapplied overhead and show how to dispose of it at the end of the period 6. Apply job costing in service industries 7. Explain an operation costing system Determining the accurate cost of a product or service plays a critical role in the success of firms in most industries. For example, Smith Fabrication, Inc. of Kent, Washington ( ), uses a product costing system to estimate costs and to charge customers for the sheet metal products it provides to other manufacturers in the aviation, computer, telecom, and medical products industries. The product costing method it uses provides a competitive edge by providing accurate cost information in a form that customers can easily understand. Similarly, Hammert s Iron Works of St. Louis, Missouri ( ) uses job costing with a real-time labor and materials reporting system to provide the ability to account for materials and labor accurately at any point in the production process important for managing the process of the job and for improving customer service. What these and many companies have found is that a simple yet accurate method for determining product cost is crucial to their competitive success. Another example is home construction and remodeling, where product costing plays a key role in cost estimating and pricing the work ( ). Smith Fabrication, Hammert s Iron Works, and most home builders use a type of product costing called job costing which is explained in this chapter. The following section explains all the different choices a management accountant must make in choosing a cost system, with job costing as one of the possibilities. Product Costing Systems Product costing is the process of accumulating, classifying, and assigning direct materials, direct labor, and factory overhead costs to products or services. LEARNING OBJECTIVE Explain the types of costing systems. 84 Product costing is the process of accumulating, classifying, and assigning direct materials, direct labor, and factory overhead costs to products or services. In developing the particular product costing system to fit a specific firm, the management accountant must make three choices, one for each of the three following categories of costing methods: () the cost accumulation method job costing or process costing; () the cost measurement method actual, normal, or standard costing; and (3) the overhead assignment method volume-based or activity-based. Each product costing system will reflect these three choices. For example, a company may choose to use job costing, normal costing, and activitybased costing, because that combination of choices best fits the firm s operations and strategic goals. Another firm might be better served by a product costing system based on process cost, standard cost, and volume-based costing. The choice of a particular system depends on the nature of the industry and the product or service, the firm s strategy and management information needs, and the costs and benefits of acquiring, designing, modifying, and operating a particular system. Here are the three choices.

2 Cost : A Chapter 4 Job Costing 85 Cost Accumulation: Job or Process Costing? In a job costing system, the jobs or batches of products or services are the cost objects. This means that for the purposes of determining product cost, all manufacturing costs incurred are assigned to jobs. A job costing system is appropriate in a situation in which most costs incurred for the job can be readily identified with specific customers, contracts, or projects. Job costing systems are often found in medium to small firms that produce for customer order. Types of companies that use job costing include those in construction, printing, special equipment manufacturing, shipbuilding, custom furniture manufacturing, professional services, medical services, advertising agencies, and others. Examples of companies using job costing systems include Kinko s ( ), Paramount Pictures ( ), Jiffy Lube International ( ), Accenture ( ), Kaiser Permanente ( ), and Hyatt Corporation ( ). In contrast, process costing is likely to be found in a firm that produces one or a few homogenous products. These firms often have continuous mass production. In this case, it is economically infeasible to trace most costs to individual products. Industries where process costing is common include the chemical industry, bottling companies, plastics, food products, and paper products. Examples of companies using process costing systems include Royal Dutch Shell Group ( ), Ford Motor Company ( ), Coca-Cola ( ), International Paper ( ), and Kimberly-Clark ( ), a consumer products company. This chapter describes job costing systems and operation costing, a variation of job costing. Chapter explains process costing systems. Cost Measurement: Actual, Normal, or Standard Costing? Costs in either a job or process costing system can be measured in their actual, normal, or standard amount. An actual costing system uses actual costs incurred for all product costs including direct materials, direct labor, and factory overhead. Actual costing systems are rarely used because they can produce unit product costs that fluctuate significantly, causing potential errors in pricing, adding/dropping product lines, and for performance evaluations. Also, most actual factory overhead costs are known only at or after the end of the period rather than at the completion of the batch of products. Thus, actual costing systems cannot provide accurate unit product cost information on a timely basis. A normal costing system uses actual costs for direct materials and direct labor and normal costs for factory overhead. Normal costing involves estimating a portion of overhead to be assigned to each product as it is produced. A normal costing system provides a timely estimate of the cost of producing each batch of product. A standard costing system uses standard costs and quantities for all three types of manufacturing costs: direct materials, direct labor, and factory overhead. Standard costs are target costs the firm should attain. Standard costing systems provide a basis for cost control, performance evaluation, and process improvement. This chapter explains actual costing and normal costing systems, and Chapters 3 and 4 present standard costing systems. See Exhibit 4.. Overhead Assignment under Normal Costing: Volume-Based or Activity-Based? Volume-based product costing systems allocate overhead to products or jobs using a volumebased cost driver, such as units produced. This approach relies heavily on the assumption that each product uses the same amounts of overhead, since each product is charged the same amount. Many accountants argue that instead of an equal amount, the overhead in each product should be proportional to the direct labor hours needed to manufacture that unit, because more labor time also means increased overhead costs for equipment, supervision, and other facilities EXHIBIT 4. Cost Measurement Systems Types of Cost Used For Costing System Direct Materials Direct Labor Factory Overhead Actual costing Actual cost Actual cost Actual cost Normal costing Actual cost Actual cost Applied overhead cost (using predetermined rate(s)) Standard costing Standard cost Standard cost Standard cost

3 Cost : A 86 Part One Introduction to Cost The Strategic Role of Product Costing costs. Generally, neither of these assumptions turns out to be sufficiently accurate in many companies, so these firms use an activity-based approach. Activity-based costing (ABC) systems allocate factory overhead costs to products using cause-and-effect criteria with multiple cost drivers. ABC systems use both volume-based and nonvolume-based cost drivers to more accurately allocate factory overhead costs to products based on resource consumption during various activities. Chapter 5 explains ABC systems. LEARNING OBJECTIVE Explain the strategic role of product costing. To compete successfully, firms need accurate product cost information, irrespective of their competitive strategies. And this is even more likely to be true for cost leadership firms that rely on a high level of manufacturing efficiency and quality to succeed. Effective management of manufacturing costs requires timely and accurate cost information. Getting this timely and accurate information requires that the firm choose a cost system that is a good match for its competitive strategy. For example, a cost leadership firm that produces a commodity product is also likely to be in a process industry, such as food or chemical processing, or assembly line manufacturing. Thus, process costing systems are likely to be a good fit. Because accurate costs are important, such firms are likely to use activity-based costing, which is more accurate than the volume-based method for overhead assignment. And finally, this type of firm is likely to choose a standard costing system to provide the cost targets and regular reports on meeting these targets. In sum, the commodity/cost leadership type of firm might very well use a cost system that combines elements of process costing (Chapter ), activity-based costing (Chapter 5), and standard costing (Chapters 3 and 4). In contrast, firms with a wide variety of distinct products often use a job costing system, which is applied to low-volume goods and services. Firms with homogeneous products over a significant time period use the process costing system, which is applied to high-volume goods when individual units cannot be specifically identified and assigned a cost. In practice, many firms appropriately use job costing for some products or departments and process costing for other products or departments. Automobile manufacturing firms are an example; their products not only have many common features but also have unique features. Automakers cannot use either a pure job costing or a pure process costing system. Many firms competitive environments are changing rapidly. To provide meaningful information, a product costing system must keep up with the constantly changing environment. To be competitive, the firm needs accurate cost information for product pricing, profitability analysis of individual products, profitability analysis of individual customers, evaluation of management performance, and refinement of strategic goals. Job Costing: The Cost Flows LEARNING OBJECTIVE 3 Explain the flow of costs in a job costing system. Job costing is a product costing system that accumulates costs and assigns them to specific jobs, customers, projects, or contracts. A job cost sheet records and summarizes the costs of direct materials, direct labor, and factory overhead for a particular job. Job costing is a product costing system that accumulates costs and assigns them to specific jobs, customers, projects, or contracts. The basic supporting document (usually in electronic form) in a job costing system is the job cost sheet. It records and summarizes the costs of direct materials, direct labor, and factory overhead for a particular job. The job cost sheet in Exhibit 4. is started when the production or processing of a job begins. A job cost sheet has spaces for all three cost elements (materials, labor, overhead) and other detailed data management requires. The job cost sheet follows the product as it goes through the production process; all costs are recorded on the sheet as materials and labor are added. On completion of production, the overhead is added based usually on a certain dollar amount per labor hour, as shown in Exhibit 4.. The total of all costs recorded on the job cost sheet is the total cost of the job. The average cost per unit is determined by dividing the number of units in the job by its total cost. All costs shown in the job cost sheet are recorded in the Work-in-Process Inventory account. The subsidiary accounts to the Work-in-Process Inventory account (such as direct materials, direct labor, and various factory overhead accounts) consist of job cost sheets that include the manufacturing costs incurred during or prior to the current period. The total on all job cost sheets equals the total amount on the debit side of the Work-in-Process Inventory

4 Cost : A REAL-WORLD FOCUS Job Costing in the Printing Industry and Home Remodeling Industry Companies use job costing to determine the cost of each job completed. Perhaps more important, the job costing system is used in cost estimating, bidding, and pricing. The printing industry and home remodeling industry are good examples of where cost estimating and pricing (based on cost estimates using job costing) are critical for success. Through job costing, these firms have a systematic way to measure the materials, labor, and overhead costs for each job. To do the job costing effectively means being careful to measure accurately the amount of materials and labor to be used on the job and to use accurate rates for materials and labor costs. Successful firms find that this means updating materials and labor costs frequently and providing incentives to employees to use job costing properly and to complete the work within the job cost estimates. While the printers are more likely to use normal costing, using historical and industry average rates, the remodelers tend to use actual costing. The reports cited below indicate that some printers are moving from the volumebased to the activity-based method. Source: Benefiting from Your Costing and Pricing Tools, Graphic Arts Monthly, July 004, pp. 3 34; Blueprint for Success: Job Costing, Professional Remodeler, June 00, pp account. This total is reported on the statement of cost of goods manufactured (for review, see Exhibits 3.4 and 3.5). Direct Materials Costs When materials are purchased for $,00, for example, the accountant () checks the supporting documents of purchase orders, receiving reports, and invoices and () records the purchase amounts in the Receipts column of the subsidiary ledger, the material ledger. These support the following journal entry: () Materials Inventory,00 Accounts Payable,00 A general ledger control account sums the similar detailed account balances in the related subsidiary ledger. The Materials Inventory amount is the sum of all direct and indirect materials in the subsidiary ledger. EXHIBIT 4. Job Cost Sheet THOMASVILLE FURNITURE INDUSTRIES, INC. Job Cost Sheet Product End Table Job No. 35 Date begun June 6, 007 Quantity 0 Date completed July 5, 007 Unit cost $376.0 Direct Materials Direct Labor Factory Overhead Requisition Labor- Application Total Dept. Date Number Units Cost Date Hours Rate Ticket Amount Hours Rate Amount Cost 6/6 A 0 A 6/6 A $,500 to 00 $0 through $, $5.00 $ 500 $3,000 6/5 A 50 6/6 B 308 B 6/6 B to 60 5 through ,70 6/30 B 30 7/ C 55 C 7/ C to 40 through, ,80 7/5 C 500 Total $,00 $3,580 $,74 $7,5

5 Cost : A 88 Part One Introduction to Cost A materials requisition form is a source document that the production department supervisor uses to request materials for production. A product costing system uses materials requisition forms to document and control all materials issued. A materials requisition form is a source document that the production department supervisor uses to request materials for production. The production department prepares materials requisition forms to request materials from the warehouse; copies are sent to the accounting department. The warehouse releases the materials based on the requisition. The materials requisition indicates the job charged with the materials used. In an online computer environment, the information is entered electronically. A detailed listing of all the materials needed for a given job is often developed in a bill of materials. For example, a bill of materials used by Thomasville Furniture Industries, Inc., ( ) in the manufacture of an end table is shown in Exhibit 4.3. Thomasville Furniture Industries (TFI) is a large manufacturer of high-quality furniture, with dedicated galleries in more than 600 stores worldwide and another 5 company-owned stores. The job cost sheet for the end table order is shown in Exhibit4.. Based on the information in materials requisition forms, costs of direct materials issued to production are recorded on the job cost sheet. The materials requisition form is the source document for determining materials costs for individual jobs. Notice that the materials requisition form in Exhibit 4.4 specifically identifies the job that will use the materials. For example, Thomasville Furniture Industries Department A incurred $,500 of costs for direct materials for Job 35. () Work-in-Process Inventory,500 Materials Inventory,500 Indirect materials are treated as part of the total factory overhead cost. Typical indirect materials are factory supplies and lubricants. They are recorded in the overhead cost sheet EXHIBIT 4.3 Bill of Materials for End Table for Thomasville Furniture Industries, Inc. PLANT STYLE T Thomasville Furniture Industries, Inc. Bill of Materials CHANGES FOR 45 ARTICLE GEORGIAN END TABLE DATE 9 07 SHEET OF L I N E ONLY M NO. FINISH SIZE UL ROUGH SIZE PCS. DESCRIPTION L W T BS T FOOTAGE SKETCH I L W T / TOP TOP CORE TOP CORE SIDE BANDS TOP CORE FRT. & BK. BANDS 6 47/ 0 3/6 3/4 3/ / 47/ 9/6 3/4 4/4 4/ SIDE PANELS SIDE APRON RAIL BACK PANEL BACK APRON RAIL FRONT POST BACK POST 3/8 45/6 3/8 7/8 63/8 45/6 63/8 7/8 3 /4 / 3/4 / 3/4 7/6 3/4 7/6 / / 3/8 3/8 53/8 53/ /8 33/8 77/8 73/8 3 3 /4 33/4 3/4 /8 3/4 /8 3 /4 3/4 5/8 8/4 5/8 8/4 3 pcs 5/4 3 pcs 5/4 4/4 POP CORE 4/4 POP CORE ONLY DRAWER FRONT DWR. SIDES 47/8 0 37/8 3 3/4 7/6 3 67/6 65/6 3/4 5/8 5/8 4/4 POP CORE 5 DWR. BACK 4 /6 7 /8 7/6 6 DWR. BOTTOM 4 /4 9 3 /6 3/6 53/4 0 7 /8 R.C. 7 DWR. GUIDE FEMALE 0/ 3/3 9/6 93/6 / /4 4/4 8 DWR. GUIDE MALE / / 3/ /4 4/4 9 DWR. HOWE PULL 0

6 Cost : A Chapter 4 Job Costing 89 EXHIBIT 4.4 Materials Requisition Form Job Number Department Authorized by MATERIALS REQUISITION FORM 35 Date A Received by Juanita Peres Issued by June 6, 007 Tom Chan Ted Mercer No. A 404 Item Number Description Quantity Unit Cost Total Cost MJI 48 Drawer Pull 0 $.50 $5 subsidiary ledger and the factory overhead general ledger account. The journal entry to record the issue of indirect materials cost of $50 to support departments is (3) Factory Overhead 50 Materials Inventory 50 A time ticket shows the time an employee worked on each job, the pay rate, and the total labor cost chargeable to each job. Exhibit 4.5 describes cost flows for direct materials and indirect materials of transactions (), (), and (3) through related general ledger T-accounts, subsidiary ledgers, and various source documents. Direct Labor Costs Direct labor costs are recorded on the job cost sheet by means of a time ticket prepared daily for each employee. A time ticket shows the amount of time an employee worked on each job, the pay rate, and the total labor cost chargeable to each job. Analysis of the time tickets provides information for assigning direct labor costs to individual jobs. Note the typical time EXHIBIT 4.5 Materials Cost Flows General Ledger Accounts Materials Inventory (),00 (),500 (3) 50 Source Documents Bill of Materials Purchase Orders, Receiving Reports, Approved Invoices Subsidiary Ledgers Receipts (),00 Material Ledger Cards Issues Balance Accounts Payable (),00 Work-in-Process Inventory Materials Requisition Forms Materials () 450 Job Cost Sheets Labor Overhead (),500 (3) 50 Factory Overhead Indirect Materials (3) 50 Overhead Cost Sheets Indirect Labor Other

7 Cost : A 90 Part One Introduction to Cost EXHIBIT 4.6 Time Ticket Employee Number Employee Name Operation 05 Dale Johnson Assembly TIME TICKET Date Job Number Approved by June 6, 007 #35 Juanita Perez Time Started Time Completed Hours Worked Rate Cost 8:00 a.m. :00 a.m $0.00 $30.00 Total Cost $30.00 ticket form in Exhibit 4.6. The cost of the $,000 direct labor incurred in TFI s Department A for Job 35 is recorded by the following journal entry: (4) Work-in-Process Inventory,000 Accrued Payroll,000 In addition to time tickets, clock or time cards are widely used for cost assignment and payroll. The times reported on an employee s time tickets are compared with the related clock cards as an internal check on the accuracy of the payroll computation. Indirect labor costs are treated as part of the total factory overhead cost. Indirect labor usually includes items such as salaries or wages for supervisors, inspectors, rework labor, and warehouse clerks. They are recorded in the Indirect Labor column of the overhead cost sheet subsidiary ledger. The following is a journal entry to record the $00 indirect labor cost incurred: (5) Factory Overhead 00 Accrued Payroll 00 Exhibit 4.7 shows direct labor and indirect labor cost flows through related general ledger T-accounts, subsidiary ledgers, and various source documents. EXHIBIT 4.7 Labor Cost Flows General Ledger Accounts Source Documents Subsidiary Ledgers Work-in-Process Inventory (4),000 Time Tickets, Time Cards Materials Job Cost Sheets Labor Overhead (4),000 Factory Overhead (5) 00 Accrued Payroll (4),000 (5) 00 Indirect Materials Overhead Cost Sheets Indirect Labor (5) 00 Other

8 Cost : A Chapter 4 Job Costing 9 Overhead application is a process of assigning overhead costs to jobs. An actual costing system uses actual costs incurred for direct materials and direct labor and applies actual factory overhead to jobs. Actual factory overhead costs are costs incurred in an accounting period for indirect materials, indirect labor, and other indirect factory costs. Factory Overhead Costs Overhead application is a process of allocating overhead costs to jobs. Allocation is necessary because overhead costs are not traceable to individual jobs. The two approaches to allocating overhead costs are actual costing and normal costing. A third approach, standard costing, is covered in Chapters 3 and 4. Actual Costing An actual costing system uses actual costs incurred for direct materials and direct labor and applies actual factory overhead to the jobs. Actual factory overhead costs are incurred each month for indirect materials, indirect labor, and other indirect factory costs, including factory rent, insurance, property tax, depreciation, repairs and maintenance, power, light, heat, and employer payroll taxes for factory personnel. Different firms use terms such as manufacturing overhead, indirect manufacturing cost, overhead, or burden in referring to factory overhead. Indirect materials of $50 and indirect labor of $00 were discussed in transactions (3) and (5), respectively. In this example, other factory overhead costs such as depreciation, utilities, and insurance are accumulated in an overhead cost sheet subsidiary ledger under the Other column. The documents to support these costs include vouchers, invoices, and memos. This journal entry records the actual overhead costs of factory utilities ($80), depreciation ($50), and insurance ($0) for Department A. (6) Factory Overhead 350 Accounts Payable 80 Accumulated Depreciation Plant 50 Factory Insurance 0 Assume Job 35 is the only job in Department A for the current month. The journal entry to record the overhead application ($50 + $00 + $350 = $500) to Job 35 for TFI s Department A is (7) Work-in-Process Inventory 500 Factory Overhead Applied 500 Exhibit 4.8 illustrates actual factory overhead and applied factory overhead cost flows through related general ledger T-accounts, subsidiary ledgers, and source documents. When Job 35 is complete, the finished products are transferred from the production department to finished goods. The management accountant finds the total cost incurred for Department A and transfers the total $,950 cost (Direct materials $450 + Direct labor $,000 + Factory overhead $500) to the Finished Goods Inventory account from the Work-in-Process Inventory account with this journal entry: (8) Finished Goods Inventory $,950 Work-in-Process Inventory $,950 Normal Costing Actual factory overhead costs are not always readily available to most manufacturers at the end of a production process or period, nor can they be easily traced to individual products. In

9 Cost : A 9 Part One Introduction to Cost EXHIBIT 4.8 Factory Overhead Cost Flows: Actual Costing General Ledger Accounts (6) 350 Factory Overhead Other Accounts A. ACTUAL FACTORY OVERHEAD COST FLOWS Source Documents Vouchers, Invoices, Memos Indirect Materials Subsidiary Ledgers Overhead Cost Sheets Indirect Labor Other (6) 350 (6) 350 B. APPLIED FACTORY OVERHEAD COST FLOWS General Ledger Accounts Work-in-Process Inventory (7) 500 Factory Overhead Applied (7) 500 Materials Subsidiary Ledgers Job Cost Sheets Labor Overhead (7) 500 Normal costing system uses actual costs for direct materials and direct labor and applies factory overhead to various jobs using a predetermined allocation rate. EXHIBIT 4.9 Monthly per-unit Fixed Factory Overhead Cost Fluctuations under Actual Costing practice, many firms adopt a normal costing system that uses actual costs for direct materials and direct labor and applies factory overhead to various jobs using a single rate used throughout the year. The motive for normalizing factory overhead costs is to avoid the fluctuations in cost per unit under actual costing resulting from changes in the month-to-month volume of units produced and overhead costs. Using a predetermined annual factory overhead rate normalizes overhead cost fluctuations, hence, the term normal costing. The fluctuations in unit cost under actual costing are illustrated in Exhibit 4.9. Another reason for firms to favor normal costing is that this procedure allows management to keep product costs current. If, for example, the management of TFI wants to know the cost of tables manufactured on completion of a job, the controller can immediately provide the actual materials and labor costs incurred because this information is readily available. The controller, however, usually could not compute the actual per-unit overhead cost of the tables until the end of the accounting period or until some later time when all bills of factory overhead Steece Machine Tools, Inc., has a monthly total fixed factory overhead of $60,000 and variable manufacturing costs per unit of $0 for its only product. The firm produced 50,000 units in January but only 0,000 units in February because it had a large inventory of unsold goods at the end of January. The unit costs would be as follows if actual costing were used to determine the manufacturing cost per unit: Variable Cost Month Production Units per Unit Fixed Cost per Unit Total Unit Cost January 50,000 $0 $60,000/50,000 = $.0 $.0 February 0, ,000/0,000 = This fluctuation in unit cost arises because total fixed costs do not change, so unit costs change as volume changes, which is not desirable for cost estimation, budgeting, or product profitability analysis. Predetermined overhead rates, used for a year or longer, are easy to apply and reduce monthly fluctuations in job costs caused by changes in the production volume and/or overhead costs throughout the year.

10 Cost : A Chapter 4 Job Costing 93 items arrived from the vendors. The costs for overhead elements such as electricity and repair and maintenance, for example, are most likely not available until the end of the period or later. would not be satisfied with having to wait until the end of the period to review the manufacturing costs if it wants to bill customers promptly. Use of a predetermined factory overhead rate enables the controller to determine the cost of the product in a timely manner. The Application of Factory Overhead in Normal Costing The predetermined factory overhead rate is an estimated factory overhead rate used to apply factory overhead cost to a specific job. Factory overhead applied is the amount of overhead assigned to a specific job using a predetermined factory overhead rate. LEARNING OBJECTIVE 4 Explain the application of factory overhead costs in a job costing system. To apply overhead cost to each job, normal costing requires a per product rate (ratio of total overhead to the output of product), which is often called a predetermined rate since it is calculated at the beginning of the accounting period. The predetermined factory overhead rate is an estimated factory overhead rate used to apply factory overhead cost to a job. The amount of overhead assigned to a job using a predetermined factory overhead rate is called factory overhead applied. To obtain the predetermined overhead rate, follow these four steps: Estimate total factory overhead costs for the operating period, usually a year. Select the most appropriate cost drivers for applying the factory overhead costs. Estimate the total amount or activity level of the chosen cost drivers for the operating period. Divide the estimated factory overhead costs by the estimated activity level of the chosen cost drivers to obtain the predetermined overhead rate. Cost Drivers for Factory Overhead Application The base for applying a predetermined overhead rate can be either a volume- or activity-based cost driver. The best cost driver choice is the activity or output measure that best represents what drives or causes overhead. Direct labor-hours, direct labor costs, and machine-hours are among the most frequently used volume-based cost drivers for applying factory overhead. The proper bases or cost drivers for a labor-intensive firm are probably direct labor-hours, direct labor costs, or some labor-related measure. In contrast, if factory overhead costs are predominantly related to the equipment operation, the proper cost driver is probably machine-hours or a related measure. Surveys of practice show that direct labor (hours or dollars) and machine-hours are the most commonly used cost drivers for overhead application. Applying Factory Overhead Costs The predetermined overhead rate usually is calculated at or before the beginning of the year as follows: Estimated factory overhead amount for the year Predetermined factory overhead rate = Estimated level of cost driver for the year For example, suppose TFI has total estimated factory overhead cost of $00,000 for the coming year. TFI s total overhead costs vary with the total number of machine-hours worked. Thus, management decided to use machine-hours as the cost driver for overhead application. TFI has the following budgeted and actual data. Estimated annual overhead for all departments $00,000 Expected annual machine-hours for all departments 6,000 Actual machine-hours for department A for Job 35 6 Actual labor-hours for department A for Job 35 0 Thus, the predetermined overhead rate is Estimated factory overhead $00,000 Estimated number of machine-hours = = $.50 per machine-hour 6,000

11 Cost : A 94 Part One Introduction to Cost Overapplied overhead is the amount of factory overhead applied that exceeds actual factory overhead cost. Underapplied overhead is the amount by which actual factory overhead exceeds factory overhead applied. The overhead cost applied to Job 35 for Department A is $35, and the overhead cost per unit is $3.50: Overhead applied to Job 35 for Department A is $.50 6 = $35 There is a difference of $75 between the $35 overhead applied for Department A under normal costing versus $500 overhead applied under actual costing (page 9). The $75 difference is due to the fluctuations in volume and overhead costs month by month. Normal costing assures that the unit cost of Department A overhead in each end table will be the same throughout the year. Firms lacking a Factory Overhead Applied account credit the Factory Overhead account. We use the separate Factory Overhead Applied account to clearly distinguish between actual and applied factory overhead costs. Using a predetermined factory overhead rate to apply overhead cost to products can cause total overhead applied to the units produced to exceed the actual overhead incurred in periods when production is higher than expected. Alternatively, applied overhead might exceed incurred overhead if the amount incurred is less than estimated. Overapplied overhead is the amount of factory overhead applied that exceeds the actual factory overhead cost incurred. On the other hand, it is possible that applied overhead will be less than the incurred amount of overhead, due either to the fact that the actual amount of incurred overhead was greater than expected and/or the actual production level was smaller than expected. Underapplied overhead is the amount by which actual factory overhead exceeds factory overhead applied. If the predetermined overhead rate has been determined carefully, and if actual production is similar to expected production, the overapplied or underapplied difference should be small. Departmental Overhead Rates When the production departments in the plant are very similar as to the amount of overhead in each department and the use of cost drivers in the departments, then the use of a plantwide rate (one rate for all production departments taken as a whole) as illustrated above, is appropriate. In many cases, however, the various production departments differ significantly in the amount of cost and cost drivers. Suppose, for example, that TFI has only two production departments, Department A (as referred to above) and Department B, and that the overhead costs, machinehours, and labor-hours in the two departments are shown below. Department A Department B Total Overhead $75,000 $5,000 $00,000 Machine-hours 3,000 3,000 6,000 Labor-hours 5,000 5,000 0,000 Note that the total overhead of $00,000 and total machine-hours of 6,000 hours is the same as in our above calculations for the plantwide rate. However, Department B has more than 4 times the number of machine-hours as Department A, while the total overhead in Department B is less than twice that of Department A. Department B could be more automated, as shown by the lower number of labor-hours in Department B, relative to Department A. Because of the important differences between the two departments, overhead costs will be more accurately allocated if departmental rates are used. If machine-hours is used, then the rates would be as follows: Overhead Rate for Department A: $75,000 /3,000 machine-hours = $5 per machine-hour Overhead Rate for Department B: $5,000 /3,000 machine-hours = $9.6 per machine-hour Using this approach, the overhead cost allocated to TFI s Job 35 for Department A would be 6 machine-hours $5 = $650. The overhead calculated under the departmental approach would be significantly higher than for the plantwide approach, a $35 difference ($650 $35). Looking again at the machine- and labor-hours in the two departments, it would make sense to consider using machine-hours to allocate Department B s overhead cost and labor-hours to

12 Cost : A Cost in Action Job Costing: JIT and Flexible Manufacturing Job costing has a natural application in companies that have a traditional materials flow through work in process to finished goods, and where customer orders of varying sizes are common. The construction industry, furniture manufacturing, professional services, and many other industries continue to rely upon this costing method to conveniently and effectively track direct costs to jobs and customer orders. In contrast, to be competitive many firms in the consumer goods and electronics industries are moving to advanced manufacturing techniques such as flexible manufacturing systems, just-in-time (JIT) inventory management, and mass customization. Such changes in manufacturing processes have led to changes in costing methods for these firms that are putting less effort into tracing costs to jobs. Instead these firms are simplifying the accounting, which will charge some of these costs (especially labor and overhead) directly to cost of goods sold. The reduced levels of work in process and finished goods inventory in these firms do not justify the additional accounting effort of tracing costs to these accounts. Also, in flexible manufacturing systems employees are often available to work on two or more jobs at the same time in order to speed the flow of production and to improve operating efficiency. This makes direct tracing of labor costs difficult or impossible, and is another reason for charging the labor costs directly to cost of goods sold. Some say that an additional operating advantage of these systems is that it will smooth the flow of product through improved overall efficiency. Unfortunately, some firms have seen an increased volatility to the flow of product, due to unexpected customer orders and larger than expected customer orders, because when customers can expect JIT delivery, some will wait until the last minute to place an order, adding to the unpredictability and volatility of the firm s production and sales. As a management accountant, what would you advise a firm that is considering implementation of JIT and flexible manufacturing systems? (Refer to comments on Cost in Action at end of chapter.) LEARNING OBJECTIVE 5 Calculate underapplied and overapplied overhead and show how to dispose of it at the end of the period. allocate Department A s overhead cost. The reason is that Department B is a machine-intensive department, while Department A is more labor-intensive. The overhead rate for Department A based on labor-hours would be Overhead Rate for Department A: $75,000 /5,000 labor-hours = $5.00 per labor-hour Since Job 35 required 00 labor-hours, the overhead charged to Job 35 would now be $ = $500. Disposition of Underapplied and Overapplied Overhead What do we do with the discrepancy between factory overhead applied and the actual amount of overhead incurred? Since actual production costs should be reported in the period they were incurred, total product costs at the end of the accounting period should be based on actual rather than applied overhead. Underapplied or overapplied overhead can be disposed of in two ways:.. Adjust the Cost of Goods Sold account. Adjust the production costs of the period; that is, prorate the discrepancy among the amounts of the current period s applied overhead remaining in the ending balances of the Work-in- Process Inventory, the Finished Goods Inventory, and the Cost of Goods Sold accounts. When the amount of underapplied or overapplied overhead is not significant, it generally is adjusted to Cost of Goods Sold. On the other hand, if the amount is significant, it is often prorated. Adjustment to Cost of Goods Sold Adjusting Cost of Goods Sold is the more expedient of the two methods for disposing of overhead discrepancies. The difference between the actual factory overhead incurred and the amount applied to production is disposed of by adding to or subtracting from the Cost of Goods Sold account for the period, whichever is appropriate. Suppose that TFI applied $00,000 of overhead but found at the end of the year that the actual total amount of overhead incurred was $05,000. The $5,000 discrepancy represents underapplied overhead. The appropriate adjusting entry to the Cost of Goods Sold account is Cost of Goods Sold 5,000 Factory Overhead Applied 00,000 Factory Overhead 05,000 To record the disposition of underapplied overhead.

13 Cost : A 96 Part One Introduction to Cost This entry closes the Factory Overhead and Factory Overhead Applied accounts and increases the cost of the goods sold for the period by $5,000. To dispose of the $5,000 difference only in the Cost of Goods Sold account ignores the fact that some portion of current production costs also can be in ending Work-in-Process Inventory or ending Finished Goods Inventory; so when the overhead difference is significant, a management accountant usually chooses to use proration. Proration is the process of allocating underapplied or overapplied overhead to Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Proration among Inventories and Cost of Goods Sold Proration is the process of allocating underapplied or overapplied overhead to Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Because factory overhead is one of the manufacturing cost elements that entered into the Work-in-Process Inventory account, underapplied or overapplied overhead affects the value of work in process, which, in turn, affects the amount transferred out of the Work-in-Process Inventory account and charged to the Finished Goods Inventory account. Eventually, the amount in the Cost of Goods Sold account for the period is also affected. If all units placed into production are completed and sold at the end of a period, adjusting for any discrepancy between actual overhead and applied overhead can be accomplished with entries to the Cost of Goods Sold account as just explained. If, on the other hand, all units processed are not completed and/or all units completed are not sold at the end of the period, the adjustment made for underapplied or overapplied overhead should affect the Work-in-Process Inventory account and the Finished Goods Inventory account, in addition to the Cost of Goods Sold account. For these ending inventories to reflect the actual cost incurred, the amount of overapplied or underapplied overhead must be prorated among the three accounts. The proration of the difference is based on the current period s applied overhead in the ending inventories of the Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts at the end of the period. The amount of applied overhead in the three accounts may not be directly available but can be approximated from knowledge of the approximate percentage of labor cost and materials cost in total cost. To determine the proration, we compute the sum of the applied overhead in the ending inventories of the Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts at the end of the period. The ratio of each of the components to this sum is the amount of the underapplied or overapplied overhead that should be prorated to the cost of the component. To illustrate the proration of an overhead variance, assume that TFI s accounts had the following applied overhead balances for the end of period: Ending Work-in-process inventory $ 0,000 Ending Finished goods inventory 30,000 Cost of goods sold 50,000 Total factory overhead applied $00,000 Factory overhead incurred (actual) $05,000 Suppose that TFI uses the Factory Overhead account to record the actual overhead incurred and the Factory Overhead Applied account to record the application of overhead to the job. The proration of the $5,000 underapplied factory overhead among the Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts is computed as follows: Percentage Overhead Amount Applied Overhead of Total Prorated Work-in-process inventory $ 0,000 0% $ 500 Finished goods inventory 30, Cost of goods sold 50, ,750 Total $00,000 00% $5,000

14 Cost : A Chapter 4 Job Costing 97 The appropriate adjusting entry is Factory Overhead Applied 00,000 Work-in-Process Inventory 500 Finished Goods Inventory 750 Cost of Goods Sold 3,750 Factory Overhead 05,000 Job Costing in Service Industries Some firms prefer to use the balances of Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts rather than the applied overhead in the accounts to calculate the percentages since these balances are readily available. When a substantial difference between the actual factory overhead incurred and the factory overhead applied occurs, the total manufacturing cost as recorded on the debit side of the Work-in-Process Inventory account is understated (underapplication) or overstated (overapplication). Left unadjusted, the inventory and Cost of Goods Sold accounts would be substantially distorted. No matter which method is used, underapplied or overapplied overhead is usually adjusted only at the end of a year. Nothing needs to be done during the year because the predetermined factory overhead rate is based on annual figures. A variance is expected between the actual overhead incurred and the amount applied in a particular month or quarter because of seasonal fluctuations in the firm s operating cycle. Furthermore, an underapplied factory overhead in one month is likely to be offset by an overapplied amount in another month (and vice versa). LEARNING OBJECTIVE 6 Apply job costing in service industries. Job costing is used extensively in service industries such as advertising agencies, construction companies, hospitals, and repair shops, as well as consulting, architecture, accounting, and law firms. Instead of using the term job, accounting and consulting firms use the term client or project ; hospitals and law firms use the term case, and advertising agencies and construction companies use the term contract or project. Many firms use the term project costing to indicate the use of job costing in service industries. Job costing in service industries uses recording procedures and accounts similar to those illustrated earlier in this chapter except for direct materials involved (there could be none or an insignificant amount). The primary focus is on direct labor. The overhead costs are usually applied to jobs based on direct labor cost. Suppose that Freed and Swenson, a Los Angeles law firm, has the following budget of estimated costs for the year. Compensation of professional staff $ 500,000 Other costs 500,000 Total budgeted costs for 007 $,000,000 Other costs include indirect materials and supplies, photocopying, computer-related expenses, insurance, office rent, utilities, training costs, accounting fees, indirect labor costs for office support personnel, and other office expenses. Freed and Swenson charges overhead costs to clients or jobs at a predetermined percentage of the professional salaries charged to the client. The law firm s recent data show that chargeable hours average 80 percent of available hours for all categories of professional personnel. The nonchargeable hours are regarded as additional overhead. This nonchargeable time might involve training, idle time, inefficiency in resource allocation, and similar factors.

15 Cost : A 98 Part One Introduction to Cost Using these data, the firm s budgeted (that is, estimated) direct labor costs and budgeted overhead costs are:. Budgeted direct labor costs: $500, % = $400,000. Budgeted overhead costs: Other costs $500,000 Salary costs for nonchargeable hours: $500,000 $400,000 = 00,000 $600,000 Operation Costing The predetermined overhead rate is Budgeted overhead costs $ 600, 000 = = 50% Budgeted direct laborcosts $ 400, 000 Exhibit 4.0 presents relevant data and job costs for the law firm s recent client, George Christatos. Operation costing is a hybrid costing system that uses job costing to assign direct materials costs and process costing to assign conversion costs to products or services. LEARNING OBJECTIVE 7 Explain an operation costing system. EXHIBIT 4.0 Job Costing for Freed and Swenson Law Firm Operation costing is a hybrid costing system that uses job costing to assign direct materials costs to jobs, and a departmental approach to assign conversion costs to products or services. Manufacturing operations whose conversion activities are very similar across several product lines, but whose direct materials used in the various products differ significantly use operation costing. After direct labor and factory overhead conversion costs have been accumulated by operations or departments, these costs are then assigned to products. On the other hand, direct materials costs are accumulated by jobs or batches, and job costing assigns these costs to products or services. Industries suitable for applying operation costing include clothing, food processing, textiles, shoes, furniture, metalworking, jewelry, and electronic equipment. For example, sofa manufacturing has two standard operations: cutting and assembling. Different jobs, however, require different wood and fabric materials. Therefore, an operation costing system can be well-suited for this situation. Suppose that Irvine Glass Company manufactures two types of glass for sheets, clear glass and colored glass. Department produces clear glass sheets, some of which are sold as finished goods. Others are transferred to Department, which adds metallic oxides to clear glass sheets to form colored glass sheets, which are then sold as finished goods. The company uses operation costing. Client: George Christatos Employee Charges Hours Salary Rates Billing Rates Partners 0 $00 $50 Managers Associates Total Revenues and Costs for This Client s Job Service revenues ($50 0) + ($00 0) + ($00 00) = $6,500 Cost of services Direct labor ($00 0) + ($80 0) + ($30 00) = $5,600 Overhead $5,600 50% = 8,400 Total costs of services 4,000 Operating income for this client $,500

16 Cost : A Chapter 4 Job Costing 99 Irvine Glass Company finished two jobs: Job A produced 0,000 sheets of clear glass and job B produced 5,000 sheets of colored glass. Manufacturing operations and costs applied to these products follow. Direct materials Job A (0,000 clear glass sheets) $400,000 Job B (5,000 colored glass sheets) Materials for clear glass sheets in Department $00,000 Materials added to clear glass sheets in Department 00, ,000 Total direct materials $700,000 Conversion costs Department $80,000 Department 50,000 Total conversion costs $30,000 Total costs $930,000 Notice in this table that operation costing identifies direct materials by job but that it identifies conversion costs with the two production departments. The unit product cost for each type of glass sheet is computed as follows: Clear Glass Colored Glass Direct materials Job A ($400,000/0,000) $40 Job B ($300,000/5,000) $60 Conversion: Department ($80,000/5,000) Conversion: Department ($50,000/5,000) 0 Total product cost per unit $5 $8 Notice in this table that each glass sheet receives the same conversion costs in Department since this operation is identical for the two products. Total product costs are calculated as follows: Clear glass sheets ($5 0,000) $50,000 Colored glass sheets ($8 5,000) 40,000 Total $930,000 The following journal entries record Irvine Glass Company s flow of costs. Department makes the first entry by recording the requisition of direct materials when Job A entered production: Work-in-Process Inventory: Department 400,000 Materials Inventory 400,000 Department makes the following entry to record the requisition of direct materials when Job B enters production: Work-in-Process Inventory: Department 00,000 Materials Inventory 00,000

17 Cost : A 00 Part One Introduction to Cost Conversion costs are applied in Department with the following journal entry: Work-in-Process Inventory: Department 80,000 Conversion Costs Applied 80,000 The following entry records the transfer of completed clear glass sheets to finished goods: Finished Goods Inventory 50,000 Work-in-Process Inventory: Department 50,000 Direct materials of $400,000 + Conversion ( $ 0,000 ) = $50,000 The following entry for units of colored glass records the transfer of partially completed colored glass sheets to Department : Work-in-Process Inventory: Department 60,000 Work-in-Process Inventory: Department 60,000 Direct materials of $00,000 + Conversion ( $ 5,000 ) = $60,000 The following entry records the requisition of the materials by Department when job B enters production: Work-in-Process Inventory: Department 00,000 Materials Inventory 00,000 Conversion costs are applied in Department with the following journal entry. Work-in-Process Inventory: Department 50,000 Conversion Costs Applied 50,000 Finally, the completed colored glass sheets are transferred to finished goods. Finished Goods Inventory 40,000 Work-in-Process Inventory: Department 40,000 Department work-in-process $60,000 + Materials for colored glass of $00,000 + Conversion ( $0 5,000 ) = $40,000 Summary Product costing is the process of accumulating, classifying, and assigning direct materials, direct labor, and factory overhead costs to products or services. Product costing provides useful cost information for both manufacturing and nonmanufacturing firms for () product and service cost determination and inventory valuation, () management planning, cost control, and performance evaluation, and (3) managerial decisions. Several different product costing systems are available and can be classified as the () cost accumulation method job or processing costing systems, () cost measurement method actual, normal, or standard costing systems, (3) overhead assignment

18 Cost : A Chapter 4 Job Costing 0 method volume- or activity-based costing systems. The choice of a particular system depends on the nature of the industry and the product or service; the firm s strategy and its management information needs; and the costs and benefits to acquire, design, modify, and operate a particular system. Job costing uses several general ledger accounts to control the product cost flows. Direct materials costs are debited to the Materials Inventory account at purchase time and debited to the Work-in-Process Inventory account when production requests materials. Direct labor costs are debited to the Work-in-Process Inventory account when they are incurred. Actual factory overhead costs are debited to the Factory Overhead account when they are incurred. Factory overhead applied using the predetermined factory overhead rate in normal costing is debited to the Work-in-Process Inventory account and credited to the Factory Overhead Applied account. When a job is complete, the cost of goods manufactured is transferred from the Workin-Process Inventory account to the Finished Goods Inventory account. The predetermined factory overhead rate is an estimated factory overhead rate used to apply factory overhead cost to a specific job. The application of a predetermined overhead rate has four steps: () estimate factory overhead costs for an appropriate operating period, usually a year, () select the most appropriate cost drivers for charging the factory overhead costs, (3) estimate the total amount or activity level of the chosen cost drivers for the operating period, and (4) divide the estimated factory overhead costs by the estimated activity level of the chosen cost drivers to obtain the predetermined factory overhead rates. The difference between the actual factory overhead cost and the amount of the factory overhead applied is the overhead variance; it is either underapplied or overapplied. It can be disposed of in two ways: () adjust the Cost of Goods Sold account or () prorate the discrepancy among the Work-in-Process Inventory, the Finished Goods Inventory, and the Cost of Goods Sold accounts. Job costing is used extensively in service industries such as advertising agencies, construction companies, hospitals, repair shops and consulting, architecture, accounting, and law firms. Operation costing is used when most of the plant s products have a similar conversion cycle, but materials costs may differ significantly. In this case, materials costs are traced to jobs, while conversion costs are traced to departments and then to jobs. Appendix A Spoilage refers to an unaccepted unit that is discarded or sold for disposal value. Rework is a produced unit that must be reworked into a good unit that can be sold in regular channels. Scrap is the material left over from the manufacture of the product; it has little or no value. Normal spoilage is waste that occurs under normal operating conditions. Abnormal spoilage is waste that should not arise under normal operating conditions. Spoilage, Rework, and Scrap in Job Costing In today s manufacturing environment, firms adopt various quality-improvement programs to reduce spoilage, rework units, and scrap. Spoilage refers to unacceptable units that are discarded or sold for disposal value. Rework units are units produced that must be reworked into good units that can be sold in regular channels. Scrap is the material left over from the manufacture of the product; it has little or no value. SPOILAGE The two types of spoilage are normal and abnormal. Normal spoilage occurs under normal operating conditions; it is uncontrollable in the short term and is considered a normal part of production and product cost. That is, the cost of spoiled unit costs is absorbed by the cost of good units produced. Abnormal spoilage is in excess over the amount of normal spoilage expected under normal operating conditions; it is charged as a loss to operations in the period detected. Normal spoilage is of two types: () specific normal spoilage, which is particular to a given job, and is not due to factors related to other jobs and () common normal spoilage, which is due to factors that affect two or more jobs, such as a machine malfunction that affected parts used in several jobs. Normal spoilage that is specific to a job is treated as a cost of that job, so that in effect the cost of spoilage is spread over the cost of the good units in the job. Normal spoilage that is common to two or more jobs is charged to factory overhead and, in this way, affects the costs of all jobs. Abnormal spoilage is charged to a special account, such as Loss

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