Chapter 3: Job Order Costing

- Managers need to assign costs to products to facilitate external financial reporting and internal decision
making.
- Job - order costing systems are used when:
o 1. Many different products are produced each period.
o 2. Products are manufactured to order.
o 3. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost
records for each job.
- In a job - order costing system, direct materials and direct labor are traced directly to each job as the work is
preformed.
- Indirect manufacturing costs are referred to as manufacturing overhead. Manufacturing overhead includes
both indirect materials and indirect labor. These costs are allocated to (all) jobs rather than directly traced to
each job.
- The job cost sheet is used by the accounting department to track the direct and indirect costs associated with
a given job. A job number uniquely identifies each job. Direct material, direct labor, and manufacturing
overhead costs are accumulated for each job. The job cost sheet is a subsidiary ledger to the Work in Process
account.
- Measuring Direct Materials Cost
o 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.
o Once the materials have been issued by the storeroom, they are charged to the job cost sheet
- Measuring Direct Labor Costs
o Workers use time tickets to record the amount of time that they spent on each job. A completed time
ticket is an hour - by - hour summary of the employee's activities throughout the day.
o The Accounting Department records the labor costs from each time ticket onto the job cost sheet.

Compute a predetermined overhead rate.
- Manufacturing Overhead Allocation
o Manufacturing overhead is applied to jobs that are in process
o An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign
manufacturing overhead to products.
o Allocation bases are used because:
a. It is impossible or difficult to trace these costs to particular jobs (i.e., manufacturing overhead is an
indirect cost).
b. Manufacturing overhead consists of many different items ranging from the grease used in
machines to the production manager's salary.
c. Many types of manufacturing overhead costs are fixed even though output may fluctuate during
the year. (This means average cost per unit will vary from one period to the next)
o Overhead pool: pools where allocation costs accumulate
o Steps for allocating overhead to different products/jobs/batches:
1- Determine the number of overhead pools and the allocation base (i.e. cost driver such as DLH or
MH) for each pool
2- Divide the total overhead costs into the pools
3- Compute an overhead rate for each pool: OH rate = Total OH / Total cost driver
4- Compute the overhead cost for each product based on its usage of each pool: OH cost = OH rate X
Cost driver used by job or product
- What are the problems associated with actual costing?
o 1. Cost estimates based actual cost numbers will fluctuate with production volume (especially for seasonal
products).
o 2. Actual cost will not reveal until the end of the accounting period, while managers would like to have the
cost estimates at the beginning of the accounting period.
- The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period
begins.
o POHR = estimated amount of manufacturing overhead for the coming period / estimated quantity of
the allocation base for the coming period
o The allocation base chosen should be the cost driver of overhead cost.
o The need for a POHR
Using predetermined rates makes it possible to estimate total job costs sooner-- Actual overhead
costs for the period are not known until the end of the period, thus inhibiting the ability to estimate
job costs during the period
Also, actual overhead costs can fluctuate seasonally, thus misleading decision makers
o Overhead applied = POHR * Actual Activity
POHR is based on estimates, and is determined before the period begins
Actual Activity is the actual amount of allocation based upon the actual level of activity
o Computing Predetermined Overhead Rates (A four step process)calculated before period begins
1. Estimate the total amount of the allocation base (the denominator) that will be required for next
period's estimated level of production.
2. Estimate the total fixed manufacturing overhead cost for the coming period and the variable
manufacturing overhead cost per unit of the allocation base.
3. Use the following equation to estimate the total amount of manufacturing overhead: Y = a + bX
o Where,
o Y = The estimated total manufacturing overhead cost
o a = The estimated total fixed manufacturing overhead cost
o b = The estimated variable manufacturing overhead cost per unit of the allocation base
o X = The estimated total amount of the allocation base.
4. Compute the predetermined overhead rate.
- 3 Types of overhead
o Estimated overhead - Total overhead costs the company expects to incur during a period; used for
calculating the predetermined overhead rate (Estimated OH / Estimated Allocation base) at the beginning
of the period
o Applied overhead Overhead costs that are applied or added to work-in-process inventory for each job
that is being produced; represents the best guess about the overhead cost depending on the units
actually produced (Calculation- POHR * Actual # of allocation base used)
o Actual overhead Total actual overhead costs; determined at the end of the period Calculation: Actual
OH- Applied OH; if negative= overapplied, if positive- underapplied
- Most often, applied overhead (i.e. a companys best guess of actual OH) and actual overhead are different
numbers. The difference is determined at the end of the period - usually long after many of the jobs have
been completed and sold. Hence the companys financial records must be corrected to reflect the actual
overhead cost rather than the applied overhead.

Flow of costs in a job - order costing system

- Work in process consists of units of production that are only partially complete and will require further work
before they are ready for sale to customers.
o Raw materials include any materials that go into the final product.
Raw materials purchases are recorded in the Raw Materials inventory account.
When raw materials are used in production, their costs are transferred to the Work in Process
inventory account as direct materials.
o Direct labor costs are added directly to Work in Process - they do not flow through Raw Materials
inventory.
o Manufacturing overhead costs are applied to Work in Process by multiplying the predetermined overhead
rate by the actual quantity of the allocation base consumed by each job.
- Finished goods consist of completed units of product that have not been sold to customers.
o When goods are completed, their costs are transferred from Work in Process to Finished Goods. The
amount transferred from Work in Process to Finished Goods is referred to as the cost of goods
manufactured.
- Cost of goods manufactured include the manufacturing costs associated with the goods that were finished
o As goods are sold, their costs are transferred from Finished Goods to Cost of Goods Sold.
- Period costs (or selling and administrative expenses) do not flow through inventories on the balance sheet.
They are recorded as expenses on the income statement in the period incurred.

Flow of Costs (T-Account / Journal Entry Form)
- Direct Materials
o When raw materials are purchased, they are debited to the raw materials inventory account and credited
to accounts payable / cash.
o The cost of direct material requisitioned is debited to Work in Process and added to the job cost sheet,
which serves as a subsidiary ledger.
o To account for the indirect materials requisition, the manufacturing overhead account is debited and the
raw materials inventory account is credited.
- Labor Cost
o Direct labor is debited to Work in Process and added to the job cost sheet, which serves as a subsidiary
ledger, and credited to salaries and wages payable.
o Indirect labor is debited to Manufacturing Overhead and credited to salaries and wages payable
- Recording Actual Manufacturing Overhead
o Additional manufacturing overhead amounts are debited to the manufacturing overhead account. The
debit side of the manufacturing overhead account represents actual overhead incurred during the period.
o The credit side of the entry is the various liability accounts, for example, accounts payable and property
taxes payable. The credit side will also include prepaid assets (like prepaid insurance) and contra accounts
for items like depreciation.
- Applying Manufacturing overhead
o The manufacturing overhead account is a clearing account. The actual amount of overhead incurred
during the period on the debit side of the account will almost certainly not equal the amount applied to
work in process on the credit side of the account. This requires a year - end adjustment.
o When we apply overhead to a particular job, we debit work in process inventory (and the job cost sheet)
and credit the manufacturing overhead account. Amounts on the credit side of the manufacturing
overhead account represent overhead applied.
o To Apply MOH, you debit WIP and credit MOH in the amount of Allocation Base * POHR
- Transferring Completed Units
o The sum of all amounts transferred from work in process to finished goods represents the cost of goods
manufactured for the period. As a job is completed, its costs are transferred from the work in process
inventory to finished goods inventory.
o Debit Finished Goods and credit Work in process the amount of jobs completed
- Transferring Units Sold
o When a finished job is sold to the customer, the cost of that job is transferred from finished goods
inventory to cost of goods sold.
o Recall that 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.
o 2 Entriesthe first regarding the sale (ex. Debit A/R, Credit Sales) and the second regarding the cost of
the sale-- Debit Cost of Goods Sold and credit Finished goods
The difference between the selling price and cost is the company's gross margin on the job.
- Accounting for Nonmanufacturing costs
o Period costs are not directly related to the actual manufacture of the products, and so, they are expensed
as incurred.
o Nonmanufacturing costs are charged to the respective expense accounts (marketing, selling,
administrative) in the period the expenses were incurred, and not manufacturing overhead.
o Examples include salary expense of employees who work in marketing, selling or administrative capacity
and advertising expenses.
o Ex. if Smith incurred but has not paid sales salaries of $2,000, and advertising expense of $750. The proper
journal entry is to debit salaries expense for $2,000, advertising expense for $750, credit salaries payable
for $2,000, and accounts payable for $750.


Cost Flows in a manufacturing company
- The Inventory Equation = Beginning Inventory + Additions to Inventory = Ending Inventory + Items Removed
from Inventory
o Allows us to prepare the Schedule of Total Manufacturing Costs (of the period)
o Allows us to prepare the Schedule of Cost of Goods Manufactured
Calculates the cost of raw material, direct labor and manufacturing overhead used in production.
Calculates the manufacturing costs associated with goods that were finished during the period.
- Schedule of Cost of Goods Manufactured
o The schedule of cost of goods manufactured contains the three elements of costs mentioned previously,
namely direct materials, direct labor, and manufacturing overhead. It calculates the cost of raw material,
direct labor, and manufacturing overhead applied to production. It also calculates the manufacturing
costs associated with goods that were finished during the period.
o
o AS RM is used, it is credited to Raw materials inventory and debited to WIP as direct materials.
o As DM, DL, and MOH are added to WIP, the COGM (completed goods) is credited to WIP and debited to
Finished Goods.
o When sale occurs, COGS is credited to Finished Goods and Debited to COGS account.

Under/over Applied Overhead; Closing out MOH
- The difference between the overhead cost applied to Work in Process and the actual overhead costs of a
period is termed either underapplied or overapplied overhead.
o 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.
o 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.
- Disposition of under or over applied overhead (Closing Variance)
o Close it out to COGS.
If overhead is overapplied by 30,000, MOH has a 30,000 credit balance. We can adjust COGS for the
entire amount by debiting MOH account and crediting (Reducing) COGS.
o How does this adjustment affect Net Income? Net income would increase, because we are
decreasing an expense account (COGS)
If underapplied by 30,000, MOH has a 30000 debit balance. We credit MOH and debit COGS
o How does this adjustment affect Net Income? Net income would decrease, because we are
increasing an expense account (COGS)
o Allocation- Prorate the amount among work in process inventory, finished goods inventory, and cost of
goods sold.
We know the overhead costs in WIP, FG, and COGS. Sum these costs up and this should equal the
MOH applied balance. At this point, we determine the percent of each overhead cost from the total
MOH applied (so WIP is 15% of MOH.) With this percentage, we take the under or over applied
amount and multiply this by the percentage. This helps us determine how much should be allocated
to WIP, FG, and COGS.
When underapplied, Debit WIP, FG, and COGS their allocated amounts, and credit MOH in full
When overapplied, Debit MOH in full, credit WIP, FG, and COGS their respective allocated amounts
This method is much more accurate because we are looking at the number of units left and each unit
consumes same MOH. This method looks at directly how much WIP, FG, and COGS is effected.

The Predetermined Overhead Rate and Capacity
- Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has
been criticized because:
o Basing the predetermined overhead rate upon budgeted activity results in product costs that fluctuate
depending upon the activity levels.
o Calculating predetermined rates based upon budgeted activity charges products for costs that they do not
use
- Criticisms can be overcome by using estimated total units in the allocation base at capacity in the denominator
of the predetermined overhead rate calculation (as opposed to the estimated units used)
- Traditional MethodTotal Cost / Estimated Level of activity
- Capacity Method- Total Cost / Production at Capacity
- The difference between Full Capacity and Estimated Capacity Used is the Idle Capacity
o Idle Capacity is multiplied by POHR to determine cost of idle capacityshows up on capacity income
statement as a period expense
o In traditional Income statement, idle Capacity is included part of COGS