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Systems Design—Job-Order Costing

Lecture Notes (to be used together with the PowerPoint slides)

A. Costing Systems. Two major types of costing systems are used in manufacturing and
many service firms: process costing and job-order costing.

1. Process Costing. A process costing system is used where a single, homogeneous


product or service is produced. In a process costing system, total manufacturing costs
are divided by total number of units produced during a given period. The unit cost that
results is a broad, average figure. Examples of industries in which process costing is
used include cement, flour, brick, and oil refining.

2. Job-Order Costing. Job-order costing is used when different types of products, jobs, or
batches are produced within a period. In a job-order costing system, direct materials
costs and direct labor costs are usually “traced” directly to jobs. Overhead is applied to
jobs using a predetermined rate. Actual overhead costs are not traced to jobs.
Examples of industries in which job-order costing is used include special order
printing, shipbuilding, construction, hospitals, professional services such as law firms,
and movie studios.

B. Job-Order Costing—An Overview. The discussion will assume that a paper-based


manual system is used for recording costs. Cost and other data are recorded on materials
requisition forms, time tickets, and job cost sheets. Of course, many companies now enter
cost and other data directly into computer databases and have dispensed with these paper
documents. Nevertheless, the data residing in the computer typically consists of a “virtual”
version of the manual system. Since a manual system is easy for students to understand, we
continue to rely on it when describing a job-order costing system.

1. Job Cost Sheet. Each job has its own job cost sheet on which costs are charged to the
job. The job cost sheet will have some code or descriptive data to identify the particular
job and will contain spaces to record costs of materials, labor, and overhead. Slide 9
provides an illustration of a job cost sheet.

2. Materials Costs. When a job is started, materials that will be required to complete the
job are withdrawn from the storeroom. The document that authorizes these withdrawals
and that specifies the types and amounts of materials withdrawn is called the materials
requisition form. The materials requisition form identifies the job to which the
materials are to be charged. Care must be taken when charging materials to distinguish
between direct and indirect materials. An example of a materials requisition form is
shown in Slide 11.

3. Labor. Labor costs are recorded on a document called a time ticket or a time sheet.
Each employee records the amount of time he or she spends on each job and each task
on a time ticket. The time spent on a particular job is considered direct labor and its cost
is “traced” to that job. The cost of time spent on other tasks, not traceable to any
particular job, is usually considered part of manufacturing overhead. An example of an
employee time ticket is shown in Slide 15 in the text.

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4. Manufacturing Overhead. Manufacturing overhead includes all manufacturing costs
that are not traced to a particular job. In practice, manufacturing overhead usually
consists of all manufacturing costs other than direct materials and direct labor. Since
manufacturing overhead costs are not traced to jobs, they must be allocated to jobs if
absorption costing is used.

a. In order to allocate overhead costs, management must choose an allocation base.


The most widely used allocation bases are direct labor-hours, direct labor costs,
and machine-hours. In the costing system illustrated in the chapter, a
predetermined overhead rate is computed by dividing the estimated total overhead
for the upcoming period by the estimated total amount of the allocation base.

b. At any rate, the actual amount of the allocation base incurred by a job is recorded on
the job cost sheet. The actual amount of the allocation base is then multiplied by the
predetermined overhead rate to determine the amount of overhead that is applied to
the job.

REMEMBER!!!! that job costs consist of actual direct materials costs, actual direct labor
costs, but applied overhead costs.

C. Job Order Costing—The Flow of Costs.

1. Overview of Cost Flows. The basic flow of costs in a job-order system begins by
recording the costs of material, labor, and manufacturing overhead.

a. Direct material and direct labor costs are debited to the Work In Process account.

Dr. Work in Process (direct materials) xxx


Manufacturing overhead (indirect materials) xxx
Cr. Raw materials xxx

Any indirect material or indirect labor costs are debited to the Manufacturing
Overhead control account, along with any other actual manufacturing overhead
costs incurred during the period.

Dr. Work in Process (direct labor) xxx


Manufacturing overhead (indirect labor) xxx
Cr. Salaries and wage payable xxx

Manufacturing overhead is applied to Work in Process using the predetermined rate.


The offsetting credit entry is to the Manufacturing Overhead control account.

Manufacturing overhead is an indirect cost and therefore must be allocated in


order to be assigned to units of product. This allocation is usually done with a
predetermined rate. The formula is:

Predetermined overhead rate (POR) = Estimated total manufacturing overhead


cost
Estimated total amount of the allocation base

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An allocation base is a measure of activity, such as direct labor-hours, direct labor
cost or machine hours. The allocation base is something that all jobs have in
common – for example, all of the jobs may require direct labor-hours. Ideally, the
allocation base should actually cause the overhead cost.

For example, suppose direct labour-hours used as the allocation base and that the
estimated total manufacturing overhead cost for next year is RM400,000 and the
estimated total number of direct labour-hours is 10,000. Then the predetermined
overhead rate would be:

RM400,000/10,000 hours = RM40 per direct labour-hours.

To assign overhead costs to a job, the predetermined overhead rate (POR) is


multiplied by the amount of the allocation base incurred by the job.
POR x Actual amount of the allocation base incurred during the period.

For example, supposed that a particular job incurs 20 direct labor hours and the
predetermined overhead rate (POR) is RM40 per direct labour-hours. Then RM800
of overhead cost would be applied to that job.

Applied overhead = 20 direct labor-hours x RM40 per direct labor-hour


= RM800

Dr. Work in process xxx


Cr. Manufacturing overhead xxx

b. The cost of finished units is credited to Worki Process and debited to the Finished
Goods inventory account.
Dr. Finished goods xxx
Cr. Work in Process xxx

c. When units are sold, their costs are credited to Finished Goods and debited to Cost
of Goods Sold.
Dr. Cost of Goods Sold xxx
Cr. Finished goods xxx

2. The Manufacturing Overhead Control Account. Manufacturing Overhead is a


temporary control account.

a. As stated above, actual overhead costs are recorded on the debit side of the
Manufacturing Overhead control account. Overhead costs applied to Work in
Process using predetermined rates are recorded on the credit side of the account.

b. Any discrepancy between overhead costs incurred and overhead costs applied
shows up as a balance in the Manufacturing Overhead control account at the end of
the period. A debit balance is called underapplied overhead and a credit balance is
called overapplied overhead.

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D. Under- and Overapplied Overhead. Since the predetermined overhead rate is based
entirely on estimated data, there will almost always be a difference between the actual
amount of overhead cost incurred and the amount of overhead cost that is applied to the
Work in Process account. This difference is termed underapplied or overapplied overhead,
and as discussed above, can be determined by the ending balance in the Manufacturing
Overhead control account.

An underapplied balance occurs when more overhead cost is actually incurred than is
applied to the Work In Process account. (Actual overhead > applied overhead)

An overapplied balance results from applying more overhead to Work In Process than is
actually incurred. (Actual overhead < applied overhead)

Under or over applied overhead can be computed as follows:


Actual overhead…………………………… RMXXX
Less: Overhead cost applied to Work in Process*………………...xxx
Underapplied (overapplied) overhead
*Overhead applied = POR x Actual amount of the allocation base incurred during the
period.

1. Cause of Under- and Overapplied Overhead. When a predetermined overhead rate is


used, it is implicitly assumed that the overhead cost is variable with (i.e., proportional
to) the allocation base. For example, if the predetermined overhead rate is RM20 per
direct labor-hour, it is implicitly assumed that the actual overhead costs will increase by
RM20 for each additional direct labor-hour that is incurred. If, however, some of the
overhead is fixed with respect to the allocation base, this will not happen and there will
be a discrepancy between the actual total amount of the overhead and the overhead that
is applied using the RM20 rate. In addition, the actual total overhead can differ from the
estimated total overhead because of poor controls over overhead spending or because of
inability to accurately forecast overhead costs.

2. Disposition of Under- and Overapplied Overhead. Two approaches to dealing with


an under- or overapplied overhead balance in the accounts are illustrated in the text.

a. The simplest approach is to close out the under- or overapplied overhead to Cost of
Goods Sold. This is the method that is used in most of the exercises and problems
because it is easiest for students to understand and master.
If overhead has been underapplied:
Dr. cost of goods Sold xxx
Cr. Manufacturing overhead xxx

b. The second approach is to allocate the under- or overapplied balance to Cost of


Goods Sold and to the Work In Process and Finished Goods inventory accounts.
The basis of allocation is the amount of overhead applied during the period in the
ending balance of each of these accounts. This method is equivalent to waiting until
the end of the period to allocate the actual overhead costs based on the actual
amount of the allocation base incurred.
If overhead is underapplied:

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Dr. Work in Process xxx
Finished goods xxx
Cost of goods sold xxx
Cr. Manufacturing overhead xxx

3. The Effect of Under- and Overapplied Overhead on Net Operating Income.

a. If overhead is underapplied, less overhead has been applied to inventory than has
actually been incurred. Enough overhead must be applied retroactively to Cost of
Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since
Cost of Goods Sold is increased, underapplied overhead reduces net income.

b. If overhead is overapplied, more overhead has been applied to inventory than has
actually been incurred. Enough overhead must be removed retroactively from Cost
of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since
Cost of Goods Sold is decreased, overapplied overhead increases net operating
income.

EXAMPLES

Computing POR using different type of bases.

The Mentari Enterprise estimated its factory overhead for the next period at RM160,000. It is
estimated that 40,000 units will be produced at a material costs of RM200,000. Production
will require 40,000 man hours at an estimated wage cost of RM80,000. The machine will
run about 25,000 hours.
Calculate the predetermined overhead rate using the following bases:
(a) Units produced
(b) Direct labor cost
(c) Direct material cost
(d) Machine hours
Answers:
(a) Units produced = RM160,000/40,000 units
= RM4/unit

(b) Direct labor cost = RM160,000/RM80,000


= 200% of DL cost

(c) Direct material cost = RM160,000/RM200,000


= 80% of DM cost

(d) Machine hours = RM160,000/25,000 hours


= RM6.40/machine hours

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Calculate POR and overhead applied.

Bazli Company uses a job-order cost system and applies overhead with a predetermined
overhead rate based on direct labor-hours. At the beginning of the year, the estimated total
manufacturing overhead for the year was RM150,000 and the estimated level of activity was
100,000 direct labor-hours. At the end of the year, cost records revealed that actual costs of
RM160,000 had been incurred and that 105,000 direct labor-hours had been worked.

a. The predetermined overhead rate for the year was RM__________


b. Manufacturing overhead cost applied to work in process during the year was
RM________
c. The amount of underapplied or overapplied cost for the year was RM____________

Answers:
a. POR = RM150,000/100,000 DLHs
= RM1.50 per DLH

b. 105,000 DLHs x RM1.50 = RM157,500 applied

c. Actual overhead cost………………………….RM160,000


Applied overhead cost……………………………..157,500
Underapplied overhead cost…………………..RM2,500

Disposition of Under- and Overapplied Overhead to Cost of Goods Sold and to the
Work In Process and Finished Goods inventory accounts.

Malt Company’s Manufacturing Overhead account showed a RM10,000 underapplied


overhead balance on December 31. Other accounts showed the following amounts of
overhead applied from the current period in their ending balances:
Work in Process 40,000
Finished goods 60,000
Cost of goods sold 100,000

If the company allocates the underapplied overhead among Cost of Goods Sold and to the
Work in Process and Finished Goods, calculate the amounts of allocation for each.

Work in Process RM40,000 20% RM2,000


Finished goods 60,000 30 3,000
Cost of goods sold 100,000 50 5,000
Total cost RM200,000 100% RM10,000

Prepared by Miss Suraya

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