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1 Chapter 3 Notes Page 1 Job-Order System There are basically two approaches to assign manufacturing costs to products produced or services rendered: Job-Order Costing and Process Costing. The approach that you use depends upon the character of your production operations. In Columbo Goes To College, two students get caught cheating. Naturally, they respond by killing their professor. Unfortunately for them, Lt. Columbo is the guest lecturer that night, and he solves the murder. DON T EVEN THINK ABOUT IT! Products and services are often produced according to a customer's order. Because every job is different, the cost of each product or service will be different. Because of this difference in cost, you have to keep track of the cost of every job separately. This is what occurs with Job- Order Costing (also called Job Costing). Companies that typically use Job-Order Costing include print shops, law firms, accounting firms, doctors, construction companies, and film studios. In all of these cases, the firm keeps track of the cost of each job separately because each order is different. For example, in 1975 Universal Studios made both Jaws and the Columbo television series. The cost of these products differed greatly ($12 million vs. $600,000 per episode). Process Costing is used in assembly-line operations or where the products are standard. Because all of the products are the same, they should all cost the same to make. Therefore, with Process Costing you treat the average cost to produce the products as the cost of each unit. You do not keep track of the cost to make each unit separately. Not all operations are clearly Job-Order Costing or Process Costing. Think of a Nissan Sentra. They all have basic, common features that cost the same to produce (e.g., the body). Different models, however, have different engines, seat fabrics and/or sound systems. To the extent that all the Sentras produced have the same common features, Nissan can use Process Costing. To the extent that different models have different features, then they can use Job-Order Costing to keep track of the costs of the different features by model. This is called Operation Costing (also called Hybrid Costing). A recent survey found that: 51.1% manufacturing firms used Job-Order Costing; 14.2% manufacturing firms used Process Costing; 10.6% manufacturing firms used Operation Costing; and 24.1% manufacturing firms used Standard Costing.

2 Chapter 3 Notes Page 2 With Standard Costing, you use the estimated cost to make a unit as the cost of that unit. There is no need to determine the actual cost to produce your units. We will discuss Standard Costing in a later chapter. Components of Cost If you purchased your inventory (retail business), then all of the costs incurred in order to get the inventory to your place of business and have it ready to sell are included in the cost of the inventory. The same approach is applied when you make your own inventory. Because you need to run the factory in order to make your inventory, then all of the costs to run the factory are treated as the cost of the inventory produced and they are not typically expensed when incurred. All of the costs to run the factory can be divided into three components of the cost of the inventory that you produce: Direct Labor, Direct Materials, and Manufacturing Overhead. Materials that become part of the product being made are Direct Materials (e.g., wood for furniture). Materials that are used in the manufacturing process, but do not become part of the product itself (e.g., sandpaper used to make furniture, lubricants for equipment, cleaning solvents for plant personnel & premises, and other factory supplies) are Indirect Materials. Labor costs incurred by workers who actually make the products (e.g., assembly-line workers or finishing labor) are Direct Labor. Factory labor costs of workers who do not make the products (e.g., security, maintenance, janitorial and supervisory personnel) are Indirect Labor. Manufacturing Overhead consists of all of the costs of the factory that are not Direct Materials and Direct Labor. Manufacturing Overhead includes such things as Indirect Materials, Indirect Labor, depreciation on factory assets, factory utility cost, factory property taxes, factory insurance, and factory landscaping. Manufacturing Overhead is also referred to as Indirect Costs, Overhead and Factory Overhead.

3 Chapter 3 Notes Page 3 Record Keeping With Job-Order Costing, every job (order) has a record of costs called a Job Cost Sheet (also called a Job Cost Record, Card or File), where the costs to make the products are recorded. At any given time, the cost of each job can be found on the Job Cost Sheet. The Job Cost Sheets serve as the subsidiary ledger for the Work In Process account. You can determine the amount in Work In Process by adding up the balances on all of the Job Cost Sheets for jobs in process. (The same is true for Finished Goods.) Some books add the word "Control" to the name of an account to remind you of this. When materials are needed for a job, the workers or supervisors fill out a Materials Requisition Form. The Materials Requisition Form is then sent to the accounting office, which notes the materials cost on the Job Cost Sheet. Factory workers fill out Time Sheets or Time Tickets (noting on what orders or jobs they worked for a given day), or managers fill out Labor Requisition Forms (when they use labor on a job or order). These records are sent to the accounting office, which notes the labor costs on the Job Cost Sheet. The accounting office adds Manufacturing Overhead to the Job Cost Sheet using the selected Cost Driver.

4 Chapter 3 Notes Page 4 Flow of Costs Costs flow through the accounting system as noted below: Journal Entries With few exceptions, factory costs are not expensed. As noted above, they are treated as the cost of the inventory being produced, which is an asset. It is only when the inventory is sold that the cost is expensed as Cost of Goods Sold When doing the journal entries for various factory costs, start with the journal entry that you learned in your introductory accounting class. Do not change the credit side of the journal entry. If you are dealing with what would otherwise be an expense, then change the debit side of the journal entry from an expense to Work In Process (for Direct Materials and Direct Labor), or Manufacturing Overhead (for other factory costs). For example, consider the journal entry for depreciation that you learned in introductory accounting: Dr. Depreciation Expense Cr. Accumulated Depreciation The depreciation on factory equipment would not be expensed. Instead, it would be treated as Manufacturing Overhead. The debit changes, but the credit is unchanged. Dr. Manufacturing Cr. Accumulated Depreciation Keep in mind that if you are not dealing with a cost of the factory, then the journal entry is the same as you learned in your introductory accounting class. The debit can be an expense. Also, keep in mind that when purchasing raw materials, you are acquiring an asset (not incurring what would otherwise be an expense ). Thus, there is no need to modify this journal entry.

5 Chapter 3 Notes Page 5 The General Journal entries for typical manufacturing operations include the following: a. The purchase of raw materials on credit: Dr. Materials Inventory Cr. Accounts Payable Materials Inventory is also called Raw Materials and Raw Materials Inventory. b. The requisition of Direct Materials from the warehouse for Job #301: Dr. Work In Process -- Job #301 Cr. Materials Inventory c. The requisition of Indirect Materials from the warehouse: Cr. Materials Inventory Sometimes, problems combine Direct Materials and Indirect Materials in one journal entry. d. Incur Direct Labor Costs in working on Job #301: Dr. Work In Process -- Job #301 Cr. Wages Payable This is similar to the general journal entry for wages that you learned in your introductory accounting course. Note that the credit does not change, but the debit is no longer Wage Expense. e. Incur Indirect Labor costs: Cr. Wages Payable Some problems combine Indirect Labor Costs and Direct Labor Costs in one journal entry.

6 Chapter 3 Notes Page 6 f. Incur depreciation on factory equipment. Cr. Accumulated Depreciation As noted above, this is similar to the depreciation journal entry you learned in your introductory accounting course. Note that the credit has not changed, but that the debit is no longer depreciation expense. g. Incur factory utility cost: Cr. Utilities Payable This is similar to the utility journal entry you learned in you introductory accounting course. Note that the credit has not changed, but that the debit is no longer utility expense. h. Assume that the firm has prepaid the factory rent for a year. One month has gone by. Cr. Prepaid Rent This is similar to the prepaid rent journal entry you learned in you introductory accounting course. Note that the credit has not changed, but that the debit is no longer rent expense. i. Apply Manufacturing Overhead to Job #301: Dr. Work in Process -- Job #301 Cr. Manufacturing Overhead Manufacturing Overhead is a clearing account. The debits are all the Manufacturing Overhead Costs that the firm has incurred. The credits are all the Manufacturing Overhead Costs that the firm applies to the orders. By applying Manufacturing Overhead Costs, the firm is, in effect, taking the costs that you added to Manufacturing Overhead and putting those costs into Work In Process.

7 Chapter 3 Notes Page 7 Some books use two accounts for Manufacturing Overhead; not just one. All the debits go into Manufacturing Overhead, and all the credits go into Manufacturing Overhead Applied. j. The factory completes Job #301: Dr. Finished Goods -- Job #301 Cr. Work in Process -- Job #301 The cost of all of the goods completed and sent from Work In Process to Finished Goods is called Cost of Goods Manufactured. l. Job #301 is delivered to the customer: Dr. Cost of Goods Sold Cr. Finished Goods Inventory -- Job #301 This only covers the cost side of the sale, don't forget there is also the revenue side of the transaction: Dr. Accounts Receivable (or Cash) Cr. Sales Revenue Predetermined Overhead Rate While you can measure how much Direct Labor and Direct Materials are used to produce an order, it is difficult to measure how much Manufacturing Overhead is used for each job (or order). As a result, firms use a measurable proxy for Manufacturing Overhead. This is the Cost Driver. Typical Manufacturing Overhead Cost Drivers include Direct Labor Hours, Direct Labor Cost, units or machine hours. A recent survey found that more than 60% of the largest companies in America use Direct Labor Hours or Direct Labor Cost as the Cost Driver for Manufacturing Overhead. In the Manufacturing Overhead area, it is difficult to assign actual costs to a product. For example, some Manufacturing Overhead Costs are not known until after the goods are delivered to the customer. Also, seasonal variations in production and Manufacturing Overhead Costs can cause per unit Manufacturing Overhead Costs to vary widely.

8 Chapter 3 Notes Page 8 For example, assume that you own a toy factory that is located in the New York City. Your production will vary because the greatest demand for your toys is at Christmas. Moreover, the weather in New York varies greatly depending upon the season of the year. This variation causes you to experience high air conditioning bills during the summer, high heating bills during the winter, and lower utility costs in the spring and fall. Assume that you have the following Manufacturing Overhead Costs and productions: April July January Actual Manufacturing Overhead $50,000 $70,000 $60,000 Production in Units 40,000 80,000 20,000 Per Unit Manufacturing Overhead Costs $1.25 $.88 $3.00 If you use actual costs, you firm's profits would fluctuate widely depending upon the month in which the units sold were produced. Most firms want to avoid such fluctuation, so they normalize these costs. With normalized costs, in applying Manufacturing Overhead, a Predetermined Overhead Rate is determined at the beginning of the year, as follows: Application Rate = Estimated Manufacturing Overhead for the Year Estimated Cost Driver for the Year For example, if the firm estimates that it will have Manufacturing Overhead of $300,000 for the year, and 100,000 Direct Labor Hours for the year, then Manufacturing Overhead is applied at the rate of $3.00 per Direct Labor Hour. So, if a job has 10 Direct Labor Hours, then the job will be allocated $30 of Manufacturing Overhead. While Predetermined Application Rates can be created for Direct Labor and Direct Materials, this is usually not done because these costs are easily traced to the goods manufactured regardless of the method being used. Actual Costing refers to using only actual costs in calculating the cost of your units. The use of a Predetermined Overhead Rate, but actual costs for Direct Labor and Direct Materials, is called Normal Costing. The use of Predetermined Application Rates for Direct Labor, Direct Materials and Manufacturing Overhead is called Budgeted Costing.

9 Chapter 3 Notes Page 9 Under-Applied and Over-Applied Overhead With Normal Costing, the Manufacturing Overhead is applied to production based upon the Predetermined Overhead Rate. This rate is based on estimates, and it is highly unlikely that the amount of Manufacturing Overhead applied will be equal to actual amount of Manufacturing Overhead incurred during the year (unless you employ a psychic to calculate your application rates). At the end of the year, it is likely that there will be either a debit or a credit balance in the Manufacturing Overhead account. If the debits in Manufacturing Overhead are greater than the credits, then you did not apply enough Manufacturing Overhead to the units produced. (You have a debit balance.) The Manufacturing Overhead is under-applied. If the credits in Manufacturing Overhead are greater than the debits, then you applied too much Manufacturing Overhead to the units produced. (You have a credit balance.) The Manufacturing Overhead is over-applied. The amount that is under-applied or over-applied is called the Manufacturing Overhead Variance. Manufacturing Overhead Manufacturing Overhead $100,000 $90,000 $90,000 $100,000 (Actual Cost) (Applied to WIP) (Actual Cost) (Applied to WIP) $10,000 $10,000 (Under-Applied) (Over-Applied) In order to see what we should do with the Manufacturing Overhead Variance, consider the flow chart that appears below. Assume that the Manufacturing Overhead applied was $10 too low. This results in the amount in Work in Process being $10 too low. Assuming that all of the units in Work in Process were completed, the $10 variance moves with the units to Finished Goods, and the amount in Finished Goods becomes $10 too low. Assuming that all of the units in Finished Goods were sold, then the $10 variance moves with the units to Cost of Goods Sold, and the amount in Cost of Goods Sold becomes $10 too low. Thus, ultimately, the mistake caused by over-applying or under-applying Manufacturing Overhead ends up in the Cost of Goods Sold.

10 Chapter 3 Notes Page 10 This is why your book says that you should close out the Manufacturing Overhead account (the variance) to the Cost of Goods Sold account. This is the appropriate treatment when all of the units produced have been completed and sold. If all of the units have not been completed and sold, this treatment is still appropriate provided that you are dealing with an immaterial Manufacturing Overhead Variance. We will discuss this shortly. If the Manufacturing Overhead was under-applied, then the general journal entry used to close the Manufacturing Overhead account is as follows: Dr. Cost of Goods Sold Cr. Manufacturing Overhead You did not add enough Manufacturing Overhead to the cost of the units produced, and you are now increasing the cost of those units to reflect their true costs. If the Manufacturing Overhead was over-applied, then the general journal entry used to close the Manufacturing Overhead account is as follows: Cr. Cost of Goods Sold You added too much Manufacturing Overhead to the cost of the units produced, and you are now decreasing the cost of those units to reflect their true costs. Material Manufacturing Overhead Variance Previously, we saw that if Manufacturing Overhead was over-applied or under-applied, then the Manufacturing Overhead Variance ultimately ends up in Cost of Goods Sold. Thus, when all of the goods produced by a company have been completed and sold, then all of the variance should be added to Cost of Goods Sold. If, however, you have units that are unfinished (in Work in Process) and/or unsold (in Finished Goods) at the end of the period, then the misapplication of Manufacturing Overhead (that is evidenced by the variance) affects the units in Work In Process and Finished Goods, as well as,

11 Chapter 3 Notes Page 11 Cost of Goods Sold. Previously, we placed the entire Manufacturing Overhead Variance in Cost of Goods Sold even if some of the units were not completed or sold. This treatment is justified under the concept of Materiality. As you will recall from your introductory accounting class, Generally Accepted Accounting Principles (GAAP) include the concept of Materiality. Materiality allows you to use an incorrect accounting treatment provided that the improper treatment would not affect anyone s decision making. For example, it is common to consider the Manufacturing Overhead Variance to be immaterial when the improper treatment changes Net Income by less than 1% or 2%. If the Manufacturing Overhead Variance is material, then the variance should be prorated (allocated) among the units in Cost of Goods Sold, Finished Goods and Work in Process. This allocation of the variance can be accomplished a number of ways. For example, you can apportion the variance between the three accounts: (i) using the relative ending balances of the three accounts (before allocating the variance) or (ii) using the relative amount of Manufacturing Overhead that is retained in each account. The effect on Net Income is often so small that the Manufacturing Overhead Variance is considered immaterial, and it is closed to Cost of Goods Sold. This is because most of the units that are started are, in fact, completed and sold during the current period. For example, assume that Madonna, Inc. had a Net Income of $1,000,000 and a Manufacturing Overhead Variance of $100,000 (underapplied). You might think that a variance that is 10% of Net Income should be considered material. The size of the mistaken accounting treatment (not the size of the variance) is key to determining materiality. If all of the variance were added to Cost of Goods Sold, then Cost of Goods Sold would increase by $100,000. Assume that 90% of units that Madonna began were completed and sold, and the Materiality Girl other 10% are still in Work In Process and/or Finished Goods. As noted above, it is proper to allocate the Manufacturing Overhead Variance among Work In Process, Finished Goods, and Cost of Goods Sold by their relative ending balances. Such an allocation would add $90,000 of the variance to Cost of Goods Sold (90% x $100,000 variance). Note that this accurate allocation of the variance ($90,000) is $10,000 less than the inaccurate allocation described above ($100,000). Thus, only $10,000 was added to Cost of Goods Sold improperly. The $10,000 improper increase in Cost of Goods Sold has the effect of decreasing Net Income by $10,000, which is 1% of Madonna s Net Income. This is probably immaterial.

12 Chapter 3 Notes Page 12 Assuming that there is a material variance where Manufacturing Overhead is underapplied, then the general journal entry used to close the Manufacturing Overhead account is as follows: Dr. Cost of Goods Sold Finished Goods Work In Process Cr. Manufacturing Overhead XXX XXX Assuming that there is a material variance where Manufacturing Overhead is overapplied, then the general journal entry used to close the Manufacturing Overhead account is as follows: Cr. Cost of Goods Sold Finished Goods Work In Process XXX XXX

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