Chapter 3 Notes

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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.
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 JobOrder 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).
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.

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.

DONT EVEN THINK ABOUT IT!

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.

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Chapter 3 Notes

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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.

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Chapter 3 Notes

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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.

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Chapter 3 Notes

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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

$ XXX
$ XXX

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

$ XXX
$ XXX

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.

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Chapter 3 Notes

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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

$ XXX
$ XXX

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

$ XXX
$ XXX

c. The requisition of Indirect Materials from the warehouse:

Dr. Manufacturing Overhead
Cr. Materials Inventory

$ XXX
$ XXX

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

$ XXX
$ XXX

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:
Dr. Manufacturing Overhead
Cr. Wages Payable

$ XXX
$ XXX

Some problems combine Indirect Labor Costs and Direct Labor Costs in one
journal entry.

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Chapter 3 Notes

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f. Incur depreciation on factory equipment.

Dr. Manufacturing Overhead
Cr. Accumulated Depreciation

$ XXX
$ XXX

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:
Dr. Manufacturing Overhead
Cr. Utilities Payable

$ XXX
$ XXX

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.
Dr. Manufacturing Overhead
Cr. Prepaid Rent

$ XXX
$ XXX

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

$ XXX
$ XXX

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.

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Chapter 3 Notes

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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

$ XXX
$ XXX

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

$ XXX
$ XXX

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

$ XXX
$ XXX

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.

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Chapter 3 Notes

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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:

Actual Manufacturing Overhead

Production in Units
Per Unit Manufacturing Overhead Costs

April
$50,000
40,000
$1.25

July
$70,000
80,000
$ .88

January
$60,000
20,000
$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.

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Chapter 3 Notes

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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
$100,000
$90,000
(Actual Cost)
(Applied to WIP)
$10,000
(Under-Applied)

Manufacturing Overhead
$90,000
$100,000
(Actual Cost)
(Applied to WIP)
$10,000
(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.

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Chapter 3 Notes

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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

$ XXX
$ XXX

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:
Dr. Manufacturing Overhead
Cr. Cost of Goods Sold

$ XXX
$ XXX

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,
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Chapter 3 Notes

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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 anyones 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
Materiality Girl
began were completed and sold, and the
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
Madonnas Net Income. This is probably immaterial.

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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
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:
Dr. Manufacturing Overhead
Cr. Cost of Goods Sold
Finished Goods
Work In Process

$ XXX

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$ XXX
XXX
XXX