Two costing systems are commonly used in manufacturing and many service companies – process costing and job-order costing. A process cost system is best used by companies that produce many units of a single product and when one unit of output is indistinguishable from any other unit of output. Because the units of output are identical, the company will probably use an average cost system to determine product cost. A company would use a job-order costing system when many different products are produced in each period. The products are usually manufactured to customers’specifications. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job. With job-order costing, many jobs are worked on during the period; with process costing, a single product is produced for a long period of time. With job-order costing, costs are accumulated by individual jobs; with process costing, costs are accumulated by departments. With job-order costing, average unit costs are computed by job; with process costing, average unit costs are computed for a particular operation or by department.
In a job-order costing system, direct materials and direct labor are both assigned to individual jobs on which the materials were used and the labor incurred. Manufacturing overhead includes indirect materials and indirect labor as well as other manufacturing costs, like the power used to run the machinery in the factory. Manufacturing overhead cannot be traced directly to specific jobs; rather, it is allocated to jobs on the basis of a predetermined rate. Overhead is applied to each job that’s in process using the predetermined rate.
The accounting department relies upon a job cost sheet for tracking the direct and indirect costs associated with a given job. In a job cost sheet, a job number uniquely identifies each job. Direct material, direct labor, and manufacturing overhead costs are accumulated for each job. And, the job cost sheet is a subsidiary ledger to the Work in Process account.
Once a sales order has been received and a production order issued, the Production Department prepares a materials requisition form to specify the type, quantity, and total cost of materials to be drawn from the storeroom, and the job number to which the cost of the materials is to be charged. For an existing product, the production department can refer to a bill of materials to determine the type and quantity of each item of materials needed to complete a unit of product. The Accounting Department records the total direct material cost on the appropriate job cost sheet. The material requisition number is included on the job cost sheet to provide easy access to the source document.
Workers use time tickets to record the amount of time that they spent on each job and the total cost assigned to each job. The Accounting Department records the labor costs from the time tickets (e.g., $88) on to the job cost sheet.
Manufacturing overhead is applied to all jobs that are in process. Firms apply overhead using a base which they believe causes overhead costs to be incurred. Some companies allocate manufacturing overhead using direct labor hours, direct labor dollars, or machine hours. Overhead costs must be allocated to jobs for a variety of reasons. First, it is difficult, if not impossible, to actually trace overhead costs to a particular job. The cost of grease for machinery to manufacture our product is part of manufacturing costs. It would be impossible to accurately trace the amount of grease consumed to manufacture one unit of output. Manufacturing overhead also includes a number of different costs and it would be very difficult to gather all of them together in time to charge them to a particular job. A job may be complete and sold before we can determine the actual overhead costs incurred. Finally, many types of overhead are fixed in nature even though output fluctuates during the period.
To facilitate the allocation of manufacturing overhead to each job, organizations calculate a predetermined overhead rate before the period begins. The rate is calculated by dividing the total estimated amount of manufacturing overhead for the coming period by the estimated quantity of the allocation base for the coming period. For example, if allocation base is machine hours, a firm would estimate the total number of machine hours used in production in the coming period. Ideally, the allocation base should be a cost driver, that is, it causes overhead to be incurred. Predetermined overhead rates that rely on estimated data are often used because actual overhead costs for the period are not known until sometime after the end of the period; thereby inhibiting the ability to estimate job costs during the period. Actual overhead costs can fluctuate seasonally, thus misleading decision makers. Therefore, using a predetermined overhead rate simplifies record keeping.
Manufacturing overhead is applied to jobs using the predetermined overhead rate multiplied by the actual amount of the allocation base used completing the job (this is called a normal costing system).
A T-account approach to looking at the cost flows in a job-order cost system is as follows.
When raw materials are purchased, they are debited to the raw materials inventory account and credited to accounts payable. The cost of direct material requisitions is debited to Work in Process and added to the job cost sheet, which serves as a subsidiary ledger. The manufacturing overhead account is debited and the raw materials inventory is credited for the indirect materials used.
As shown below, wages and salaries are initially recorded in a payable account. Direct labor is charged to work in process inventory through the Job-Cost Sheet. Indirect labor is charged to manufacturing overhead.
Other actual manufacturing overhead costs are debited to Manufacturing Overhead. The credit side of the entry is the various liability accounts (e.g., Accounts Payable and Property Taxes Payable), prepaid asset accounts (e.g., Prepaid Insurance) and contra-asset accounts (e.g., Accumulated Depreciation).
Next, as shown below, manufacturing overhead is applied to each job in work in process inventory by debiting Work in Process and crediting Manufacturing Overhead for the amount of applied overhead based on the predetermined overhead rate. Actual manufacturing overhead costs are not debited to Work in Process, nor are they charged to jobs via the job cost sheets.The Manufacturing Overhead account is a clearing account. The actual amount of overhead incurred during the period (debit side of the account) will not be equal to the amount applied to the Work in Process account (credit side of the account). Any variance between actual and applied will be accounted for as a year-end adjusting entry.
Companies that use job-order cost systems to assign manufacturing costs to products also incur nonmanufacturing costs. Nonmanufacturing costs should not go into the Manufacturing Overhead account. Nonmanufacturing costs are not assigned to individual jobs, rather, they are expensed in the period incurred. For example, the salary expense for employees that work in a selling or administrative capacity are expensed in the period incurred. And, advertising expenses are expensed in the period incurred. This journal entry illustrates the expensing of nonmanufacturing costs in the current period.
The sum of all amounts transferred from work in process to finished goods represents the cost of goods manufactured for the period. As shown below, the Work in Process account is credited and the Finished Goods account is debited.
As shown in the following figure, when a finished job is sold to the customer, the cost of that job is transferred from Finished Goods inventory to Cost of Good Sold. Cost of Goods Sold is an income statement account. If only a portion of the units associated with a particular job are shipped, then the unit cost figure from the job cost sheet is used to determine the amount of the journal entry.
Assuming the company uses a perpetual inventory system, two journal entries are required to record the sale. The first entry is to debit either Accounts Receivable or Cash and credit Sales for the selling price of the job completed. The second entry is to debit Cost of Goods Sold and credit Finished Goods inventory for the cost incurred to complete the job. The difference between the selling price and cost is the company’s gross margin on the job.
There are two complications relating to overhead application: defining and computing underapplied and overapplied overhead. When we apply overhead on the basis of a predetermined overhead rate, there is always the chance that the amount of overhead applied will be different from the amount of overhead actually incurred during the period. When there is a difference, we refer to the amount as either underappliedoverhead or overappliedoverhead. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period. As shown below, the simplest way to account for any remaining balance in the Manufacturing Overhead account is to close it out to Cost of Goods Sold.
In larger companies, multiple predetermined overhead rates are often used. For example, each production department may have its own predetermined overhead rate. Using multiple predetermined overhead rates is more complex. When a company uses multiple rates, it promotes greater accuracy in the allocation process because it provides recognition to differences across departments in how overhead costs are incurred.