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Chap 4 CMA
Chap 4 CMA
Process costing is on the other hand, used in industries where there is mass-production of
similar/identical products. This costing system averages costs over large number of nearly
identical products. It is most often found in such industries as chemicals, oils, plastics, rubber,
lumber, food processing, glass mining, cement, meatpacking, etc.
The differences between job order costing and process costing arise from two factors. The first is
that the flow of units in a process costing system is more or less continuous, and the second is
that these units are indistinguishable from one another. Under process costing it makes no sense
to try to identify materials, labor, and overhead costs with a particular order from a customer (as
we do with job order costing ), since each order is just one of many that are filled from a
continuous flow of virtually identical units from the production line. Under process costing, we
accumulate costs by department rather than by order, assign these costs uniformly to all units that
pass through the department during a period.
A further difference between the two costing systems is that the job cost sheet is not used in
process costing, since the focal point of process costing is on departments. Instead of using job
cost sheet a production report is prepared for each department in which work is done on
products. The production report serves several functions. It provides a summary of number of
units moving through a department during a period, and it also provides a computation of unit
costs. In addition it shows what costs were charged to the department and what disposition was
made on these costs. The department production report is a key document in a process costing
system. These differences are summarized below:
Job Order Costing Process Costing
1. Many different jobs are worked on during 1. A single product is produced either on
each period, with each job having different continuous basis or for long periods. All
production requirements. units of product are identical.
2. Costs are accumulated by individual job. 2. Costs are accumulated by departments.
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3. Job cost sheet is the key document 3. The department production report is the key
controlling the accumulation of costs by a document showing the accumulation and
job. disposition of costs.
4. Unit costs are computed by job on the job 4. Unit costs are computed by department on
cost sheet. the department production report.
Assigning Costs
One advantage of job order costing is that it allows managers to calculate the profit earned on
individual jobs, helping them to better ascertain whether specific jobs are desirable to pursue in
the future. This is best for businesses that do highly custom work, such as construction
contractors and consultants. An advantage of process costing is that it allows managers to get
detailed information on the production statistics of individual departments or workgroups. This is
best suited for continuous manufacturing settings, such as factories and utility companies.
Record Keeping
A disadvantage of job order costing is that employees are required to track all materials and labor
used during the job. Process costing simplifies record keeping by relying on statistical
calculations rather than actual inputs. As an example, consider a construction contractor using a
job order costing system. The contractor has to keep track of all the wood, nails, screws,
electrical fixtures, paint and other materials used on the job, as well as tracking workers' lunch
breaks and hours worked. In a factory setting, on the other hand, materials are calculated using
an average of units produced, and salaries expenses are often relatively consistent between pay
periods.
Reporting
Job order costing gives managers the advantage of being able to keep track of individuals' and
teams' performance in terms of cost-control, efficiency and productivity. Process costing, on the
other hand, gives managers the advantage of being able to ascertain the same qualities in entire
departments and compare performance over time.
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Accounting for Job order costing system
Job order costing system is used in situations where many different products are produced each
period. For example clothing factory would typically made many different types of jeans for both
men and women during a month. In a job order costing system, costs are traced to the jobs and
then the costs of the job are divided by the number of units in the job to arrive at an average cost
per unit.
Job order costing system is also extensively used in service industries. Hospitals, law firms,
movie studios, accounting firms, advertising agencies and repair shops all use a variety of job
order costing system to accumulate costs for accounting and billing purposes. The details here
deal with a manufacturing firm, the same concept and procedures are used by many service
organizations.
The record keeping and cost assignment problems are more complex in a job order costing
system when a company sells many different products and services than when it has only a single
product or service. Since the products are different, the costs are typically different.
Consequently, cost records must be maintained for each distinct product or job. For example an
attorney in a large criminal law practice would ordinarily keep separate records of the costs of
advising and defending each of his/her clients. And a clothing factory would keep separate track
of the costs of filling orders for particular styles, sizes, and colors of jeans. A job order costing
system requires more effort than a process costing system. Companies classify manufacturing
costs into three broad categories: 1) direct materials, 2) direct labor, and 3) manufacturing
overhead. As we study the operation of a job costing system, we will see how each of these three
types of costs is recorded and accumulated.
1. Measuring Direct Materials Cost in Job Order Costing System: At the beginning of
production process a document known as bill of materials is used for standard products. "A
bill of materials is a document that lists the type and quantity of each item of materials
needed to complete a unit of standard product".
2. Measuring Direct Labor Cost in Job Order Costing System: Direct labor cost is
handled in much the same way as direct materials cost. Direct labor consists of labor
charges that are easily traced to a particular job. Labor charges that cannot be easily traced
directly to any job are treated as part of manufacturing overhead.
3. Application of Manufacturing Overhead: Manufacturing overhead must be included
with direct labor on the job cost sheet since manufacturing overhead is also a product cost.
However, assigning manufacturing overhead to units of product can be a difficult task.
4. Job Order Costing System - The Flow of Costs: To understand the flow of costs in job
order costing system, we shall consider a single month's activity for a company, say for
instance, a producer of product A and product B.
5. Multiple Predetermined Overhead Rates: When a single predetermined overhead rate is
used for entire factory it is called plant wide overhead rate. This is fairly common practice -
particularly in smaller companies.
6. Under-applied overhead and over-applied overhead calculation: Since the
predetermined overhead rate is established before a period begins and is based entirely on
estimated data, the overhead cost applied to work in process (WIP) will generally differ
from the amount of overhead cost actually incurred during a period.
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7. Disposition of any balance remaining in the manufacturing overhead account at the
end of a period: What disposition should be made of an under-applied overhead or over-
applied overhead balance remaining in the manufacturing overhead account at the end of a
period?
8. Predetermined Overhead Rate and Capacity: Companies typically base their
predetermined overhead rates on the estimated, or budgeted, amount of allocation base for
the upcoming period. This is the method that is used in this chapter, but it is practice that is
recently come under severe criticism. An example will be very helpful anyway.
9. Recording Non - manufacturing Costs: In addition to manufacturing costs, companies
also incur marketing and selling costs. These costs should be treated as period expenses and
charged directly to the income statement and therefore should not go into the
manufacturing overhead account.
10. Recording Cost of Goods Manufactured and Sold: When a job has been completed, the
finished out put is transferred from the production department to the finished
goods warehouse. By this time, the accounting department will have charged the job with
direct materials and direct labor cost and manufacturing overhead will have been applied
using the predetermined overhead rate.
11. Job Order Costing in Services Companies: Job order costing is also used in service
organizations such as law firms, movie studios, hospitals, and repair shops, as well as
manufacturing companies.
12. Use of Information Technology in Job Order Costing: Bar code technology can be
used to record labor time--reducing the drudgery (hard boring work) in that task and
increasing accuracy. Bar codes also have many other uses. In a company with a well-
developed bar code system, the manufacturing cycle begins with the receipt of a customer's
order in electronic form.
To illustrate and understand the flow of costs in job order costing system, we shall consider a
single month's activity for a company; say for instance, a producer of product A and product B.
The company has two jobs in process during April, the first month of its fiscal year. Job 1, of
1000 units of product A was started in March. By the end of March, $30,000 in manufacturing
costs had been recorded for the job 1. Job 2 an order for 10,000 units of product B was started in
April.
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During April, $52,000 in raw materials was requisitioned from the storeroom for use in
production. These raw materials include both direct and indirect materials. Entry (2) records
issuing the materials to the production department.
The materials charged to work in process (WIP) represent direct materials for specific jobs. As
these materials are entered into the work in process account, they are also recorded on the
appropriate job cost sheets. This point is illustrated in Exhibit 4.1; where $28,000 of the $50,000
in direct materials is charged to Job 1 cost sheet and the remaining $22,000 is charged to job 2
cost sheet. (In this example, all data are presented in summary form and the job cost sheet is
abbreviated.)
The $2,000 charged to manufacturing overhead in entry (2) represents indirect materials used in
production during April. Observe that the manufacturing overhead account is separate from work
in process account. The purpose of the manufacturing overhead account is to accumulate all
manufacturing overhead costs as they are incurred during a period.
Before leaving Exhibit 2.1 we need to point out one additional thing. Notice from the exhibit that
the job cost sheet for job 1 contains a beginning balance of $30,000. We stated earlier that this
balance represents the cost of work done during March that has been carried forward to April.
Also note that work in process account contains the same $30,000 balance. The reason the
$30,000 appears in both places is that the work in process account is a control account and the
job cost sheets form a subsidiary ledger. Thus, the work in process account contains a
summarized total of all costs appearing on the individual job cost sheet for all jobs in process at
any given point in time. (Since the company had only job 1 in process at the beginning of April,
job 1's $30,000 balance on that date is equal to the balance in the work in process account.
Exhibit 4.1
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Issue of Direct Materials Only:
Sometimes the materials drawn from the raw materials inventory account are all direct materials.
In this case, the entry to record the issue of the materials into production would be as follows:
Work in process XXX
Raw materials XXX
Labor Cost:
As work is performed each day in various departments of the company, employee time tickets
are filled out by workers, collected, and forward to the accounting department. In the accounting
department, wages are computed and the resulting costs are classified as either direct or indirect
labor. This costing and classification for April resulted in the following summary entry (3):
Only direct labor is added to the work in process account. In this example, direct labor is $60,000
for April.
At the same time the direct labor costs are added to work in process, they are also added to the
individual job cost sheets, as shown in the Exhibit 4.2. During April, $40,000 of direct labor cost
was charged to job 1 and the remaining $20,000 was charged to job 2. The labor cost charged to
manufacturing overhead represent the indirect costs of the period, such as supervision, janitorial
work, and maintenance.
Exhibit 4.2
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Utilities (heat, water, and power) $21,000
Rent on factory equipment 16,000
Miscellaneous factory costs 3,000
Total $40,000
The following entry (4) records the incurrence of these costs:
40,000
Manufacturing overhead
Accounts Payable 40,000
In addition, let us assume that during April, the company recognized $13,000 in accrued property
taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The
following entry (5) records these items:
Finally let us assume that the company recognizes $18,000 in depreciation on factory equipment
during April. The following entry (6) records the accrual of this depreciation:
In short, all manufacturing overhead costs are recorded directly into the manufacturing overhead
account as they are incurred day by day through a period. It is important to understand that
manufacturing overhead is a control account for many--perhaps thousands--of subsidiary
accounts such as indirect materials, indirect labor, factory utilities, and so forth. As the
manufacturing overhead account is debited for costs during a period the various subsidiary
accounts are also debited. In this example, I omit the entries to the subsidiary accounts for the
sake of brevity.
To illustrate assume that the company has used machine hours to compute predetermined
overhead rate and that this rate is $6 per machine hour. Also assume that during April, 10,000
machine hours were worked on Job 1 and 5,000 machine hours were worked on Job 2 (a total of
15,000 machine hours). Thus, $90,000 in overhead cost (15,000 machine x hours $6 per machine
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hour = $90,000) would be applied to work in process. The following entry (7) records the
application of manufacturing overhead to work in process:
Exhibit 4.3
The actual overhead costs in the manufacturing overhead account in Exhibit 4.3 are the costs that
were added to the account in entries (2)-(6). Observe that the incurrence of these actual
overhead costs and the application of overhead to work in process represent two separate and
entirely distinct processes.
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overhead account. This debit balance in manufacturing overhead account is called under-applied
overhead. Any credit balance in manufacturing overhead account is called over-applied
overhead. Any balance in the manufacturing overhead account (under or over-applied overhead)
is treated in one of the following ways:
1. Closed out to cost of goods sold
2. Allocated between work in process, finished goods, and cost of goods sold in proportion
to the overhead applied during the current period in the ending balance of these accounts.
These two methods are illustrated on Disposition of Under- or Over-applied Overhead Balances
page. For the moment, we can conclude by nothing from Exhibit 4.3 that the cost of a completed
job consists of the actual materials cost of the job, the actual labor cost of the job, and the
overhead cost applied to the job. Pay particular attention to the following subtle but important
point: Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the
job cost sheet nor do they appear in the work in process account. Only the applied overhead
cost, based on the predetermined overhead rate, appear on the job cost sheet and in the work in
process account. Study this point carefully.
Finally assume that advertising was $42,000 and that other selling and administrative expenses
during the month were $8,000. The following journal entry (10) records these items:
Since the amounts in entries above all go directly into expense accounts, they will have no effect
on the costing of the company's production for the month. The same will be true of any other
selling and administrative expenses incurred during the month including sales commission,
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depreciation on sales equipment, rent on office facilities, insurance on office facilities, and
related costs.
Let us assume that the job 1 was completed during the period. The following entry (11) transfers
the cost of job 1 from work in process (WIP) to finished goods.
The $158,000 represents the completed cost of job 1, as shown on the job cost sheet in Exhibit
4.3. Since job 1 was the only job completed during April, the $158,000 also represents the cost
of goods manufactured for the month. The job 2 was not completed by month-end, so its cost
will remain in the work in process (WIP) account and carry over to the next month. If a balance
sheet is prepared at the end of April, the cost accumulated thus far on the job 2 will appear as
"work in process inventory" in the assets section.
Assume that the company has completed 1000 units and 750 out of 1000 units have been shipped
to customers for a price of $225,000. The unit product cost is $158. Following journal entries
(12) and (13) would record the sales (all sales are on account).
Accounts receivable 225,000
Sales 225,000
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Summary of Cost Flow:
To pull the entire example together, journal entries (1) through (13), T accounts, and schedules
of cost of goods manufactured and cost of goods sold are presented below:
Journal Entries:
(1)
Raw Materials 60,000
Accounts Payable 60,000
(2)
Work in process 50,000
Manufacturing overhead 2,000
Raw materials 52,000
(3)
Work in process 60,000
Manufacturing overhead 15,000
Salaries and wages 75,000
(4)
Manufacturing overhead 40,000
Accounts payable 40,000
(5)
Manufacturing overhead 20,000
Property taxes payable 13,000
Prepaid insurance 7,000
(6)
Work in process 18,000
Manufacturing overhead 18,000
(7)
Work in process 90,000
Manufacturing overhead 90,000
(8)
Salaries expenses 30,000
Salaries and wages payable 30,000
(9)
Depreciation expense 7,000
Accumulated depreciation 7,000
(10)
Advertising expense 42,000
Other selling and administrative expense 8,000
Accounts payable 50,000
(11)
Finished goods 158,000
Work in process 158,000
(12)
Accounts receivable 225,000
Sales 225,000
(13)
Cost of goods sold 118,500
Finished goods 118,500
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T-Accounts:
Accounts Receivable Accounts Payable Capital Stock
xx xx xx
(12) 225,000 (1) 60,000
(4) 40,000
(10) 50,000
Prepaid Insurance Salaries & Wages Payable Retained Earnings
xx xx xx
(3) 75,000
(5) 7,000 (8) 30,000
Raw Materials Property Taxes Payable Sales
Bal. 7,000(2) 52,000 xx (12) 225,000
(1) 60,000 (5) 13,000
Bal. 15,000
Cost of Goods Sold
Work in Process Salaries expenses (13) 118500
Bal. 30,000(11) 158,000 (8) 30,000
(2) 50,000 Depreciation expenses
(3) 60,000 (9) 7,000
(7) 90,000
Bal. 72,000
Finished Goods Advertising Expenses
Bal. 10,000(13) 118,500 (10) 42,000
(11) 158,000
Bal. 49,000
Manufacturing Overhead
(2) 2000 (7) 90,000
(3) 15,000
(4) 40,000
(5) 20,000
(6) 18,000
Bal. 5,000
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Explanation of entries:
1) Raw materials purchased
2) Direct and indirect materials issued 8) Administrative salaries expenses incurred.
into production.
3) Direct and indirect factory labor cost 9) Depreciation recorded on office equipment.
incurred.
4) Utilities and other factory costs 10) Advertising and other expenses incurred
incurred.
5) Property taxes and insurance incurred 11) CGM transferred into finished goods.
on the factory.
6) Depreciation recorded on the factory 12) Sale of job 1 recorded.
assets.
7) Overhead cost applied to work in 13) Cost of goods sold recorded for job 1.
process.
XX = Normal balance in the account (for example accounts receivable normally carries a debit
balance).
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Predetermined overhead rate)
Actual overhead = $95,000
Under applied overhead = $95,000 (actual) - $90,000 (applied) = $5,000
Entry to close the $5,000 of under applied to cost of goods sold would be as
follows:
Cost of goods sold-------------------------- 5,000
Manufacturing overhead--------------------------- 5,000
Income Statement:
Sales (750 units@$300) $225,000
Less cost of goods sold ($ 118,500 + $5,000) 123,500
-----------
Gross margin/profit 101,500
Less operating expenses:
Salaries $30,000
Depreciation 7,000
Advertising expenses 42,000
Other expense 8,000 87,000
Net operating income $14,500
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much of the overhead often consists of fixed costs that do not grow as the number of machine
hours incurred increases. Second, spending on overhead items may or may not be under control.
If individuals who are responsible for overhead costs do a good job, those costs should be less
than were expected at the beginning of the period. If they do a poor job, those costs will be more
than expected.
Example: Suppose that two companies A and B have prepared the following estimated data for
the coming year:
Company
A B
Predetermined overhead rate based on Machine-hours DM cost
Estimated manufacturing overhead (a) $300,000 $120,000
Estimated machine-hours (b) for A co. 75,000 --
Estimated direct materials cost (b) for B co. -- $80,000
$4 per machine 150% of direct
Predetermined overhead rate, (a) ÷ (b)
hour materials cost
Now assume that because of unexpected changes in overhead spending and changes in demand
for the companies' products, the actual overhead cost and the actual activity recorded during the
year in each company are as follows:
Company
A B
Actual manufacturing overhead costs $290,000 $130,000
Actual machine-hours 68,000 --
Actual direct materials costs -- $90,000
For each company, note that the actual data for both cost and activity differ from the estimates
used in computing the predetermined overhead rate. This results in under-applied overhead and
over-applied overhead as follows:
Company
A B
Actual manufacturing overhead costs $290,000 $130,000
Manufacturing overhead cost applied to WIP during the year:
68,000 actual machine hours × $4 per machine hour 272,000
$90,000 actual direct materials cost × 150% of direct materials
135,000
cost
------------- -------------
Under-applied (over-applied) overhead $ 18,000 $ (5,000)
For company A, notice that the amount of overhead cost that has been applied to work in process
($272,000) is less than the actual overhead cost for the year ($290,000). Therefore the overhead
is under-applied. Also notice that original estimate of overhead in company A ($300,000) is not
directly involved in this computation. Its impact is felt only through the $4 predetermined
overhead rate that is used.
For company B the amount of overhead cost that has been applied to work in process (WIP)
($135,000) is greater than the actual overhead cost for the year ($130,000), and so overhead is
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over-applied. A summary of the concepts discussed so for is presented below:
After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of
goods sold is increased by the amount of under-applied and decreased by the amount of over-
applied overhead.
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2. Allocated Between Accounts:
Allocation of under or over-applied overhead between work in process (WIP), finished goods
and cost of goods sold (CGS) is more accurate than closing the entire balance into cost of goods
sold. The reason is that allocation assigns overhead costs to where they would have gone in the
first place had it not been for the errors in the estimates going into the predetermined overhead
rate.
Example:
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leaving Work in Process Inventory, thus making more difficult the determination of the amount
of overhead in Finished Goods Inventory and Cost of Goods Sold account balances
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