Chapter 5: System Design: Job Order Costing

Absorbing Costing – A costing method that includes all manufacturing costs – direct materials, direct labour, and both fixed variable and fixed overhead – as part of the cost of the finished unit of product: synonymous with full costing.

1) Distinguish between process costing and job-order costing and identify the production or service processes that fit with each costing method.

Process Costing

  • A costing system used in manufacturing situations where a single, homogenous product flows in a continuous stream out of the production process.
  • i.e. cement, oil, paper towels, bottling beverages.
  • Unit Product Cost (per litre, kilogram, bottle) = Total Manufacturing cost / Total Units produced (litres, kilograms, bottles)
  • Results in a broad average unit cost figure for identical units.

Job Order Costing

  • A costing system used in situations where many different products, jobs, or services are produced each period.
  • i.e. Levi’s jeans for different genders, large-scale construction, Hallmark greeting cards.
  • Used extensively in service industries and NFP organizations.
  • Cost records must be maintained for each distinct job as they vary job to job.

2) Recognize the flow of costs through a job-order costing system.

Measuring Direct Materials Cost

  • Bill of Materials – Record that lists the type and quantity of each major item of the materials required to make a product.
  • Production order – Issued when an agreement has been reached with the customer concerning quantities, process, and shipment date.
  • Materials Requisition Form – Detailed source document that specifies the type and quantity of materials drawn from the storeroom and identifies the job to which the cost of materials are charged.
  • Raw Materials – Ingredients that are converted into a finished product,
  • Direct Materials – Materials directly traced to the product or service.
  • Not all direct materials are raw materials.

Job Cost Sheet

  • A form prepared for each job that records the materials, labour, and overhead costs charged to the job.
  • They are subsidiary ledgers to the Work in Process account because the detailed records provided add up the to the balance.

Image result for job cost sheet

Measuring Direct Labour Cost

  • Direct labour consists of labour charges easily traced to a particular job (indirect labour is mart of manufacturing overhead).
  • Time Ticket – Detailed source document that is used to record an employee’s hour-by-hour activities during a day.
  • Maintained by computerized systems with unique bar codes for employees and jobs.
  • Any indirect labour on the time ticket is not posted the job cost sheet.

3) Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process.

There are four reasons to why assigning Manufacturing Overhead (MOH) to units of product is difficult

  1. MOH costs are indirect – They are hard to trace to particular products/jobs.
  2. MOH consists of many types of costs, ranging from many indirect materials and labour.
  3. MOH remains relatively constant due to the presence of fixed costs – which is different from fluctuating output.
  4. MOH’s timing of payment often varies – Some items may be paid on different intervals but output is year-long.

  • Allocation Process is used to assign costs to product.
  • Allocation Base – Measure of activity, such as direct labour-hours or machine hours, that is used to assign costs to cost objects.
  • Predetermined Overhead Rate – A rate used to charge overhead costs to jobs; the rate is established in advance for each period using estimates of total MOH cost and of the total allocation base for the period.
  • Predetermined Overhead Rate = Estimated total MOH cost / Estimated total units in the allocation base.
  • Based on estimated results as it is computed before the period begins and is used to apply cost to jobs throughout the period.
  • Overhead Application – The process of charging MOH cost to job cost sheets and to the Work in Process account.
  • Overhead applied to a job = Predetermined Overhead Rate x Amount of the allocation base incurred by the job.
  • If the allocation base is direct labour-hours, change allocation base to “Actual direct labour-hours charged to the job”

Using the Predetermined Overhead Rate

Example - ABY Precision Manufacturing

  • Estimated MOH costs = $320 000 / year
  • Total Direct Labour-Hours = $40 000

Predetermined Overhead Rate = Estimated Total MOH / Estimated total units in the allocation base

  • 320 000 / 40 000 = $8 per direct labour-hour.
  • Overhead application to a job = $8 per hour x 27 direct labour hours (find this on the job cost sheet)
  • This is not the actual overhead caused – It cannot be traced because it is indirect.
  • Normal Cost System – A costing system in which overhead costs are applied to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the job.
  • If the job has not been completed, it should be applied to value work in process inventory.

The Need for a Predetermined Rate

  • Managers have reasons for using the predetermined rate rather than an actual overhead rate.
  • Managers want to know the valuation of completed jobs before the end of the accounting period.
  • If MOH rates are computed frequently, seasonable factors in MOH costs or allocation base may produce fluctuations in the rates.
  • Predetermined overhead rate use simplifies record-keeping.

Choice of an Allocation Base

  • Cost Driver – A factor that causes overhead costs, such as machine hours, beds occupied, computer time, or flight hours.
  • Base that doesn’t drive costs produces inaccurate overhead rates and distorted product costs.
  • In the present, sophisticated automated equipment and sophisticated/complex products have caused decreasing direct labour costs.
  • Activity-Based Costing – Reflects more accurately the demands that products, customers, and other cost objects make on MOH resources.

Computation of Unit Costs

  • The totals for direct materials, direct labour, and MOH are transferred to the Cost Summary section of the job cost sheet, added together to receive total cost.
  • Divide total cost by the number of units to obtain the unit cost.
  • This is average cost, not the actual cost.
  • Job Cost Sheet is important for valuing unsold goods in ending inventory and determining COGS.
  • Job-Order Costing System summarized as follows:

4) Record the journal entries that reflect the flow of costs in a job-order costing system.

The Purchase and Issue of Materials

Direct and Indirect Materials

  • Debit Work in Process Inventory and Manufacturing Overhead (for indirect materials) and credit Raw materials inventory.
  • MOH account is separate from the Work in Process account as it accumulates all MOH as they are incurred.
  • Charge the cost of these materials to respective job sheets.
  • Work in Process Account is a control account – contains summarized total of all costs appearing on the individual job cost sheets for all jobs in process at any given point in time.

Image result for labourDirect Materials

  • Debit Work in Process Inventory, credit raw materials inventory.

Labour Cost

  • Time worked is costed according to employee wage rates, and the resulting costs are classified as either direct/indirect labour.
  • Debit Work in Process Inventory and Manufacturing Overhead and Credit Salaries and Wages Payable.

Manufacturing Overhead Costs

  • All costs of operating the factory other than direct materials and direct labour are classified as MOH costs.
  • Debit Manufacturing Overhead and Credit a payable account (i.e. accounts payable, taxes payable), prepaid insurance, or accumulated depreciation.

5) Apply overhead cost to work in process using a predetermined overhead rate.

The Application of Manufacturing Overhead

  • Predetermined overhead rate is used to apply overhead costs to jobs.
  • i.e. Direct labour-hours is the allocation base, so overhead cost would be applied to each job by multiplying the number of hours by the rate.
  • To apply the cost to the job, debit work in process and credit manufacturing overhead.
  • (Like reversing a normal MOH entry)

The Concept of a Clearing Account

  • MOH is a clearing account – when a job is completed, overhead cost is released from the MOH account and applied to Work in Process through the predetermined rate.
  • Debit work in process and credit manufacturing overhead. (As shown above)
  • Actual overhead costs are made of many different types of costs and contain estimates of what they are expected to be, established before the year begins.
  • Only applied overhead costs based on the predetermined overhead rate appear on the job cost sheet and Work in Process account.

Non-Manufacturing Cost

  • Marketing and selling costs are directly expensed to the income statement, and not the MOH account.
  • For selling and administrative salaries, record as follows: Debit salaries expense and credit salaries and wages payable.
  • Operating depreciation is recorded as normal. (Debit Depreciation expense and credit accumulated depreciation)
  • Because selling and administrative costs go directly into expense accounts, they have no effect on product costs.

6) Prepare schedules of cost of goods manufactured and cost of goods sold.

Cost of Goods Manufactured

  • Direct labour, direct materials, and MOH based on the predetermined rate are transferred out of the Work in Process account and into the Finished Goods account.
  • Sum up all these costs to get the Cost of Goods Manufactured (COGM)
  • Debit Finished Goods Inventory and credit Work in Process inventory.
  • Non-completed jobs are left in work in process and carried over when they are done. (They are recorded as Work in Process Inventory under the balance sheet)
  • COGM Schedule: List items under each category DM, DL, and MOH, deducting the unfinished good costs.

Cost of Goods Sold

  • As units of finished goods are shipped to customers, their cost is transferred from Finished Goods to Cost of Goods Sold (COGS)
  • Unit cost must be determined to find out how much product cost to move to COGS if not everything has been sold.
  • Sale: Debit Accounts Receivable and credit Sales.
  • Find COGS: Debit Cost of Goods Sold and Credit Finished Goods Inventory (take price per unit x amount of units sold)
  • COGS Schedule: List inventory at the beginning, adding COGM and deducting unsold inventory.

Summary of Cost Flows

  • Journalize direct costs, direct labour, and MOH from acquisition to finished work.
  • Transfer to the general ledger and cost sheet.
  • Calculate cost of goods manufactured and cost of goods sold. (Put it in the Schedule format)
  • Report expenses from selling/administrative as well as the COGS.
  • Refer to Exhibit 5-9, 5-10, and 5-11 for examples of statements.

7) Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in manufacturing overhead to the appropriate accounts.

Complications of Overhead Application

Underapplied & Overapplied Overhead

  • As predetermined overhead rate is found before the period begins and is based on estimated data, there will be a difference between applied cost and actual incurred cost.
  • Underapplied Overhead – A debit balance in MOH that arises when the amount of overhead cost is greater than the amount of overhead cost applied to Work in Process.
  • Overapplied Overhead – A credit balance in MOH that arises when the amount of overhead cost applied to Work in Process is greater than the amount of overhead cost actually incurred.

Disposition of Underapplied or Overapplied Overhead Balances

  • The balance is treated in one of two ways:
  • Underapplied – Remaining balance is closed out to Cost of Goods Sold.
  • Debit COGS and Credit Manufacturing Overhead
  • Because there is a debit balance in MOH, it must be credited to close – so COGS is higher.
  • Overapplied – Remaining balance is allocated among Work in Process, Finished Goods, and COGS in proportion to the overhead applied during the current period.
  • Calculate proportions of distribution by finding overhead applied in: work in process, finished goods inventory, and COGS and their respective percentages.
  • Total Overhead / number of units in the job to get average overhead applied. Multiply this by # of units in the account.
  • Debit Manufacturing Overhead the full amount and credit Work in Process, Finished Goods, and COGS their respective percentages of that amount.

A General Model of Cash Flows

  • Raw Materials
  • Debit cost of materials purchased
  • Credit direct materials added to Work in Process
  • Credit indirect materials added to MOH
  • Salaries and Wages Payable
  • Credit direct labour added to WIP
  • Credit indirect labour added to MOH
  • Manufacturing Overhead
  • Debit actual overhead costs incurred (Underapplied Overhead Cost)
  • Credit for overhead cost applied to Work in Process (Overapplied Overhead Cost)
  • Work in Process
  • Debit for the cost of DM, DL, MOH applied
  • Credit for the cost of goods manufactured
  • Finished Goods
  • Debit for the cost of goods manufactured
  • Credit for the cost of goods sold.
  • Cost of Goods Sold
  • Debit for the cost of goods sold.

Summary of Overhead Concepts


  • Estimated Total Manufacturing Overhead Cost / Estimated Total Units in the Allocation Base = Predetermined Overhead Rate

During the Period

  • Predetermined Overhead Rate x Actual total units of the allocation base incurred during the period = Total manufacturing overhead applied

At the End of the Period

  • Actual Total manufacturing Overhead Cost – total Manufacturing Overhead Applied = Overapplied/Underapplied Overhead
  • Underapplied – Write off to COGS
  • Overapplied – Allocate among WIP Inventory, Finished Goods Inventory, and COGS

Variations from the General Model of Product Cost Flow

  • Costing systems vary from the general model.
  • Backflush CostingA system variation that permits labour charges to be made directly to manufacturing overhead – the overhead is applied to the cost of completed jobs.
  • Need to keep WIP records can be avoided.

Multiple Predetermined Overhead rates

  • Plantwide Overhead rate – A single predetermined overhead rate used throughout a plant.
  • Multiple Predetermined Overhead Rate – A costing system where there are multiple overhead cost pools with a different predetermined rate for each pool rather than just one.
  • Each production department is its own cost pool, so it is more accurate.
  • Multiple predetermined overhead rates is more informative but more expensive, and should be used when decision making is significantly improved to justify the cost.

Job Costing in Service Companies

  • Most significant cost categories are direct labour (i.e. number of hours) and overhead (i.e. rent, depreciation) – they are blended into a Charge-out Rate for the staff providing service.
  • Cost of producing services in important to pricing and cost control despite the lack of inventory accounts.

Use of Information Technology

  • EDI – A network that lets companies electronically exchange business documents and other info that extends into all areas of business activity.
  • Challenged by HTML (shows on browser) as well as XML and JSON (additional tags such as <price>)
  • Computer utilizes the order file to draw up a list of required raw materials and sends out electronic purchase orders with bar codes to update inventory.
  • Enterprise Resource Planning System (ERP) – Real-time computer system using a single uniform database coupled with modules for accounting, logistics, and HR.

8) Explain the implications of basing the predetermined overhead on activity at full capacity than on estimated activity for the period.

Predetermined Overhead Rate and Capacity

  • Basing predetermined overhead rates on estimated amount of the allocation base for the upcoming period is often criticized.
  • As rates are based on budgeted activity, unit product costs will fluctuate depending on budgeted level of activity.
  • Products are charged for resources that they do not use.
  • IAS pronouncements now prohibit use of predetermined overhead rates based on capacity for external reports. (internal is okay)

Note Created by
Is this note helpful?
Give kudos to your peers!
Wanna make this note your own?
Fork this Note