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Chapter 3 Notes Page 1
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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 Job-Order 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). 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. 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.
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. DONT EVEN THINK ABOUT IT!
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Chapter 3 Notes Page 2
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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 Page 3
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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 Page 4
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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 $ XXX Cr.
Accumulated Depreciation $ 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 $ XXX Cr. Accumulated Depreciation $
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 Page 5
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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 $ XXX Cr. Accounts Payable $ 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 $ XXX Cr. Materials Inventory $
XXX
c. The requisition of Indirect Materials from the warehouse:
Dr. Manufacturing Overhead $ XXX Cr. Materials Inventory $
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 $ XXX Cr. Wages Payable $
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 $ XXX Cr. Wages Payable $ XXX
Some problems combine Indirect Labor Costs and Direct Labor
Costs in one journal entry.
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Chapter 3 Notes Page 6
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f. Incur depreciation on factory equipment.
Dr. Manufacturing Overhead $ XXX Cr. Accumulated Depreciation $
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 $ XXX Cr. Utilities Payable $ 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 $ XXX Cr. Prepaid Rent $ 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 $ XXX Cr. Manufacturing Overhead
$ 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 Page 7
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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 $ XXX Cr. Work in Process -- Job
#301 $ 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 $ XXX Cr. Finished Goods Inventory -- Job
#301 $ 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) $ XXX Cr. Sales Revenue $ 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 Page 8
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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:
April July January Actual Manufacturing Overhead $50,000 $70,000
$60,000 Production in Units 40,000 80,000 20,000 Per Unit
Manufacturing Overhead Costs $1.25 $ .88 $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 Page 9
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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 Manufacturing Overhead $100,000 $90,000
$90,000 $100,000
(Actual Cost) (Applied to WIP) (Actual Cost) (Applied to WIP)
$10,000 $10,000
(Under-Applied) (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 Page 10
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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 $ XXX Cr. Manufacturing Overhead
$ 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 $ XXX Cr. Cost of Goods Sold $ 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 Page 11
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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 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.
Materiality Girl
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Chapter 3 Notes Page 12
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Assuming that there is a material variance where Manufacturing
Overhead is under-applied, then the general journal entry used to
close the Manufacturing Overhead account is as follows: Dr. Cost of
Goods Sold $ XXX Finished Goods XXX Work In Process XXX Cr.
Manufacturing Overhead $ XXX Assuming that there is a material
variance where Manufacturing Overhead is over-applied, then the
general journal entry used to close the Manufacturing Overhead
account is as follows: Dr. Manufacturing Overhead $ XXX Cr. Cost of
Goods Sold $ XXX Finished Goods XXX Work In Process XXX