CHAPTER 4

Product Costing System

1. Production Cost information:
Management depends on relevant and reliable information about costs in managing their
organizations. The role of management accountant is to develop management information
systems that provide managers with the cost information they need.

2. Product costing system:

Management need extensive information about product related costs. To meet this it is
necessary to develop a highly reliable product costing system that is specifically designed to
record and report the organization’s operation.
A product costing system is a set of procedures used to account for an organizations product
costs and provide timely and accurate unit cost information for pricing, cost planning and
control, inventory valuation and financial statement preparation

3. Types of cost accounting systems:

There are three main types of cost accounting systems for manufacturing operations: Job order,
process and operational cost systems.
Each of the three systems is widely used and any one organization may use more than one type.

(a) Job order costing system: A job order costing system is a product costing system used
by both manufacturing companies and service organizations that make large, unique, or
special order products such as customized publications, specially built cabinets, custom
printing business etc. Under such a system, the costs of direct materials, direct labor,
and manufacturing overhead is traced to a specific job order or a batch of products. A
job order is a customer order for a specific number of specially designed, made to order
products. Job order costing measures the cost of each complete unit. It uses one work in
process inventory account to summarize the cost of all jobs. This account is supported
by job order cost cards or a subsidiary ledger of accounts for each job.
(b) Process costing system: A process costing system is a product costing system used by
companies that produce large amounts of similar products or liquids, or that have a
continuous production flow. Makers of paint, soft drinks, bricks, milk or paper would
use a process costing system. Under such a system the cost of direct materials, direct
labor and manufacturing overhead are first traced to processes, departments, or work
cells and then assigned to the products manufactured by those processes, departments
or work cells. A process costing system uses several works in process inventory
accounts, one for each process, department or work cell.
(c) Operational costing system: In reality, few actual production processes perfectly
match either a job order costing system or a process costing system. Thus, the typical
product costing system combines parts of both job order costing and process costing to
create a hybrid system designed specifically for an organizations particular production
process. An example of a company that would use an operational cost system is an
automobile manufacturer.
An automobile Maker may use process costing to treat the costs of manufacturing basic car
and then use job order costing to track the costs of customized features such as a
convertible or hardtop, an automatic transmission or stick shift.

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 4. Characteristics of job order and process costing systems:

S.No Job order costing system Process costing system

1 Used by companies that
make large, unique or
special- order products
such as customized
publications, built in
cabinets and made to
order draperies.
2 Measures the cost of
each completed unit
3 Collects manufacturing costs
and assigns them to a specific job
order or batch.
4 Uses one work in process
inventory account to summaries
the cost of all jobs orders.
Used by companies that make large amount of
similar products production flow such as
makers of paint, soft drinks, and candy bricks
paper.
Measures costs in terms of units
completed in a specific time
Groups manufacturing costs by process
Department, or work cell, and then
Assigns them to product manufactured.
Uses several works in process inventory
accounts, one for each procces, department or
work cell.

If managers learn the terms and procedures used in both the job order and the process costing
systems, they can adapts to any operating environment and help design product costing system
that fit their specific information needs.

In recent years, approaches to product costing have contained to change because of global
competition, technology and the shifting mix of materials, labor, and overhead in the
manufacturing process. The use of multi disciplinary teams of managers has encouraged the
exploration of new management accounting practice to improve product costing. Those new
practices emphasize the elimination of waste plan the importance of quality, value added
processing and increased customer satisfaction. Some of the new practices including the value
chain, process value analysis, activity-based management and Just in time operating
environment.

Job order costing system

A job order costing system emphasizes cost flow, it is important to understand how costs are
incurred, recorded and transferred within the system. This cost flow along with the job order
cost cards and the subsidiary ledgers for materials and finished goods inventory forms the core
of the job order costing system. Familiarity with the flow of costs enables to fully understand
how system works.

a) Cost flow overview

Costs follow the flow of production, starting with materials, and move through work in
process, finished good and cost of goods sold to completion and sale.
The costs of materials are first charged to the materials inventory account and to the respective
materials accounts in the subsidiary ledger. Labor costs are accumulated in the factory payroll
account. The various manufacturing overhead costs is charged to the manufacturing overhead
account.

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As products are manufactured, the costs of direct materials and direct labor are transferred to
the work in process inventory account and are recorded on the job’s job order cost card.

Manufacturing overhead costs are applied and charged to the work in process inventory
account using a predetermined overhead rate. Those charges are used to reduce the balance in
the manufacturing overhead account. They too are recorded on the job’s job order cost card.
When products and jobs are complete, the costs assigned to them are transferred to the finished
goods inventory account. When the products are sold and shipped, their costs are transferred to
the cost of goods sold account.
b) Journal entries
1. When the materials are purchased:
Materials control Debited
Accounts payable control Credited.
2. When materials are sent to manufacturing plant:
Work in Progress Control (for direct material) Debited
Manufacturing overhead control
(for indirect material) Debited
Materials control Credited
3. When labor costs are assigned:
Work in process control (direct labor) Debited
Manufacturing overhead control (indirect labor) Debited
Wages payable control Credited
4. When payment of total manufacturing payroll:
Wages payable control Debited
Cash control Credited.
5. When manufacturing overhead costs are incurred:
Manufacturing Overhead control Debited
Various Accounts Credited
6. When manufacturing overheads is allocated:
Work in process control Debited
Manufacturing overhead control Credited
7. When jobs are completed and transferred to finished goods account:
Finished goods control Debited
Work in process control Credited
8. When transferring finished goods to cost of goods sold:
Cost of goods sold Debited
Finished goods control Credited
9. When marketing and customer service payable and advertising costs accrued:
Marketing and Advertising costs Debited
Customer – service costs Debited
Salaries payable control Credited
Accounts payable control Credited
10. When sales are made on account:
Accounts receivable control Debited
Sales or Revenues Credited

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 C) Accounting of factory overhead in a job cost system:
Materials requisitions and labor time tickets make it easy to identify direct materials and direct
labor with a specific job. Factory overhead on the other hand, includes a variety of costs that
cannot be linked to a particular job. Overhead costs are recorded as incurred. All the overhead
costs are debited to a single account – factory overhead in the general ledger.

Actual Costing and Normal Costing

1. Actual costing means the aggregate of actual direct material costs, actual direct labor cost
and actual manufacturing overhead. The actual manufacturing overhead can be known only at
the end of the month or year. Therefore, under this method the managers cannot know the cost
of job before completion of the job. Managers often want to close approximation of the
manufacturing costs of various jobs on a timely basis, not just at the end of the year. Managers
want these costs for various ongoing uses, including choosing which job to emphasize or de-
emphasize, pricing jobs, managing costs and preparing interim financial statements. Because
management benefits from having immediate access to the costs of jobs.

2. Normal Costing:
A predetermined or budgeted indirect cost rate is calculated for each cost pool at the
beginning of a fiscal year and overhead costs are allocated to jobs as work in progresses.
Normal costing is a costing method that traces direct costs to a cost object by using the
actual direct cost rate(s) times the actual quantity of the direct cost input(s) and allocates
indirect costs based on the budgeted indirect cost rate(s) times the actual quantity of cost
allocation base(s). Note that both actual costing and normal costing trace direct costs to
jobs in the same way. The only difference between actual costing and normal costing is that
actual costing uses an actual indirect cost rate(s), whereas normal costing uses a budgeted
indirect cost rate(s) to cost jobs.

Distinction between Actual costing and Normal costing

Actual costing Normal costing
Items
Direct Actual direct cost rate(s) X Actual direct cost rate(s) X
costs Actual quantity of direct cost Actual quantity of direct cost
input(s) input(s)
Indire Actual indirect- cost rate(s) X Budgeted indirect cost rate(s) X
ct Actual quantity of cost Actual quantity of cost allocation
costs allocation bases bases

Example: XYZ product uses a job-costing system with two direct cost categories (direct
materials and direct manufacturing Labor) and one manufacturing overhead cost pool. XYZ
allocates manufacturing overheard cost using direct manufacturing Labor costs. Xyz provides
the following information:
Budget for Actual Results for

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 Year 2006 Year 2006

Direct material cost $ 375,000 $362,500

Direct manufacturing labor cost 250,000 245,000
Manufacturing overhead cost 437,500 465,500
Required:
(a) Compute the actual and budgeted manufacturing overall rates for 2006.
(b) During June the job cost record for job No. 205
Contained the following information:
Direct materials used $ 10,000
Direct manufacturing Labor costs 7,500

Compute the cost of job No 205 using (s) actual costing and (b) Normal costing, and c)
At the end of 2006, Compute the under- or over allocated manufacturing overhead
under normal costing why is there no under- or over-allocated overhead under actual
costing?
Solution:
(a) Computation of manufacturing overhead Rate for 2002.
Actual Budgeted

Manufacturing meatheads $ 465,500 $437500

Manufacturing Labor cost 245,000 250,000
Manufacturing overhead $ 465,500x100 $437,500x100
rate 245,000 250,000
= 190 % 175 %
(b) Computation of cost of job No 205 under actual costing and normal costing:
Actual costing Normal costing
Direct Materials used $ 10,000 $ 10,000
Direct manufacturing 7,500 7,500
Labor cost-
Allocated manufacturing 14,250 13,125
Overheads

190
(i) Actual= 7,500x
100
175
(ii) normal= 7,500x
100

Total cost of job 31,750 30,625

c) Computation of under or over allocated manufacturing overhead under normal

costing at the end of 2006:
Actual manufacturing overhead for the year 2002 = $ 465,500
Budgeted or allocated manufacturing for the year 2002 = 437,500
Under allocated manufacturing cost = 28,000

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 Reasons for no under or over allocated overhead under actual costing:

Under actual costing method, allocation of manufacturing overhead costs are based on
actual manufacturing overhead rates

The actual manufacturing overheads and allocated manufacturing overhead costs are
equal. Therefore, there will be no under or over allocation of manufacturing overhead
cost under actual costing methods.

d) Disposing of under or over applied overhead:

The application of factory overhead cost to production will usually not being to zero the
balance in the factory overhead account. This account is debited for actual cost and credited for
applied amounts.
The total debits to factory overhead for the year may not equal the total credits to the account.
Under applied overhead: The amount by which actual overhead exceeds the applied
overhead is called under applied overhead
Over applied overhead: If actual overhead had been less than applied overhead, the
difference would have been called over applied overhead.

Accountants usually ignore over and under applied overhead during the year and dispose of it
at year-end
There are two alternatives for the disposition of under applied or over applied
overhead.
(i) Transfer to cost of goods sold:
If the amount of under or over applied overhead is insignificant (immaterial) it is closed
into cost of goods sold
Journal entries: -
(a) For under applied:
Cost of goods sold Debited
Manufacturing overhead Credited

(b) For over applied:

Manufacturing overhead Debited
Cost of goods sold Credited

(ii) Transfer to working in process, finished goods Inventory and cost of goods
sold.
If the amount of under or over applied overhead is significant (material), it often is
allocated to work in process, Finished goods and Cost of goods sold based on their
relative balances before the allocation. When under or over applied overhead is
allocated among the three accounts shown above, the process is called proration.

Journal entries:
A. For under applied:
Work in process Inventory Debited
Finished goods inventory Debited

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Cost of goods sold Debited
Manufacturing overhead Credited

B. For over applied:

Manufacturing overhead Debited
Work in process inventory Credited
Finished goods inventory Credited
Cost of goods sold Credited
Example 2:
XYZ Company incurred $ 314,000 of manufacturing overhead costs during 2002.
However, only $ 282,000 of overhead was applied to production. At the conclusion, the
following amounts of the year’s applied overhead remained in the various
manufacturing accounts.
2002 Applied overhead remaining
in account on December 31, 2002.
Work in process inventory $ 70,500
Finished goods inventory 98,700
Cost of goods sold 112,800

Required: Prepare a journal entry to close out the balance in the manufacturing
overhead account and prorate the balance to the three manufacturing accounts.

Solution:
Computation of under applied or over applied overhead:
Actual manufacturing overhead to the jobs = $ 314,000
Applied manufacturing overhead to the jobs = $ 282,000
Under applied overhead = 32,000

Statement showing proration of under applied overhead:

Account Amount Percentage Under applied Amount
Overhead x % age Added to Account
25
Work in process $ 70,500 25% 32000 x $ 8,000
100
35
Finished goods 98,700 35% 32000 x 11,200
100
40
Cost of goods sold 112,800 40% 32000 x 12,800
100
282,000 100% 32,000

Journal entries:
Work in process inventory $ 8,000
Finished stock inventory 11,200
Cost of goods sold 12,800
Manufacturing overhead control 32,000
(For under applied overhead charged to work in process, finished goods inventory and
cost of goods sold on proration basis)

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 e) Multiple overhead cost pools

The multiple overhead cost rate may be followed if the existence of multiple overhead
cost pools. Some overhead costs can be allocated to jobs based on labor cost or labor
hour basis if it is labor oriented job. On the other hand, machine hour rate may be used
if the jobs are undertaken automated machines.
To implement a normal costing system with multiple overhead cost pools, it is required
to determine the budgeted total manufacturing labor hours and the budgeted total
machine hours and identity the associated budgeted indirect total cost for each cost
pool. It would then calculate two indirect cost rates, one based on direct manufacturing
labor hours and the other based on machine hours. Indirect costs would be allocated to
jobs using these indirect cost rates and the direct manufacturing labor hours and
machine hours used by various jobs. The general ledger would contain manufacturing
overhead control and manufacturing overhead-allocated amounts for each cost pool.
End of period adjustments for under or over allocated indirect costs would then need be
made separately for each cost pool.
Example:

The Lucas Incorporation uses a job – costing system. The plant has a machining
department and an assembly department. Its job costing system has two direct cost
categories (direct materials and direct manufacturing labor) and two manufacturing
overhead cost pools (the machining department overhead, allocated using actual
machine hours, and the Assembly Department overhead, allocated using actual direct
manufacturing labor cost).

The 2002 budget for the plant is as follows:

Machining Assembly
Department Department
Manufacturing overhead $ 900,000 $ 1,800,000
Direct manufacturing labor Cost $ 700,000 $1,000,000
Direct manufacturing labor Hours 50,000 100,000
Machine hours 25,000 100,000

Required:
(a) Present an overview diagram of Lucas Incorporation’s job – costing system. Compute the
budgeted manufacturing overhead rate for each department

(b) During March 2002, the job cost record for job No. 555 contained the following.
Machining Assembly
Department Department
Direct Materials used $22,500 $ 35,000
Direct manufacturing Labor costs $7,000 $ 7,500
Direct manufacturing Labor – hours 500 750
Machine hours 1,000 500

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Compute the total manufacturing overhead costs of job 555.

c) At the end of 2002, the actual manufacturing overhead costs were $1,050,000 in
machining and $ 1,850,000 in Assembly. Assume that 27,500 actual machine hours
were used in machining and that actual direct manufacturing labor costs in Assembly
were $1,100,000. Compute the over- or- under allocated manufacturing overhead for
each department.
Solution: Job costing overview for determining
(a) Manufacturing costs of jobs ate Lucas Inc.
Indirect- cost pool
Manufacturing overhead
Machining Dept. Assembly
Dept.
$ 900,000 $ 1,800,000

Cost Allocation base

25,000 machine $ 1,000,000 direct
hours Manufacturing labor
cost

$ 36 per machine hour

180% of direct manufacturing
labor cost

Cost object: Jobs

Indirect costs
Direct costs

Direct Direct
Material manufacturing
labor
a)Budgeted Manufacturing overhead rate:

(i) Machining Department: 36 per machine hour [$ 900,000/ 25,000) hours.

(ii) Assembly Department: 180% of direct manufacturing labor cost:
1,800,000
($ 1,000,000 x 100)

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 b) Computation of manufacturing overhead cost of job No. 555 and total job cost No
555:
(i) Total manufacturing cost of job No. 555:

Machining department - ($ 36per machine hour for 1000 machine hours) = $36,000

Assembly department -(180% of direct manufacturing labor cost of $ 7500) = $13,500

Total manufacturing overhead cost of job No. 555 = $ 49,500

Total cost of job No. 555

Machining Assembly Total
Dept. Dept.
Direct material cost $ 22,500 $ 35,000 $ 57,500
Direct manufacturing labor 7,000 7,500 14,500
Manufacturing overhead
Allocated 36,000 13,500 49,500

Total job cost $65,500 $56,000 $121,500

c) Computation of over or under allocated manufacturing overhead of machining and

assembly department:
Machining Assembly
Department Department
Actual manufacturing
Overhead costs $ 1,050,000 $ 1,850,000

Allocated manufacturing
Overhead costs 990,000 1,980,000
(i) Machining – 27500hrs x $36
(ii)Assembly – 180% of 1,100,000
Under or (over) allocated 60,000 (130,000)

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