POMA Chapter 2: Job-Order

Costing:
Calculating Unit Product Costs
Companies usually assign costs to their products and services for two main reasons.
First, it helps them fulfill their planning, controlling, and decision-making responsibilities.
Second, it helps them determine the value of ending inventories and cost of goods sold
for external reporting purposes. The costs attached to products that have not been sold
are included in ending inventories on the balance sheet, whereas the costs attached to
units that have been sold are included in cost of goods sold on the income statement.
It is very common for external financial reporting requirements to heavily influence how
companies assign costs to their products and services.
Many companies use some form of absorption costing for product costing purposes.
In absorption costing, all manufacturing costs, both fixed and variable, are assigned to
units of product—units are said to fully absorb manufacturing costs.
Conversely, all nonmanufacturing costs are treated as period costs and they are not
assigned to units of product.

Job-Order Costing—An Overview

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 Job-order costing is used in situations where many different products, each with
individual and unique features, are produced each period.
In a joborder costing system, costs are traced and allocated to 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.

This average cost per unit is also referred to as the unit product cost.

Job-order costing is also used extensively in service industries.

Job-Order Costing—An Example

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 Measuring Direct Materials Cost
A bill of materials is a document that lists the quantity of each type of direct material
needed to complete a unit of product.

When an agreement has been reached with the customer concerning the quantities,
prices, and shipment date for the order, a production order is issued. The Production
Department then prepares a materials requisition form similar to the form in Exhibit 2–1.

The materials requisition form is a document that specifies the type and quantity of
materials
to be drawn from the storeroom and identifies the job that will be charged for the cost of
the
materials.

The form is used to control the flow of materials into production and also for making
journal entries in the accounting records.

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 Job Cost Sheet
After a production order has been issued, the Accounting Department’s job-order
costing software system automatically generates a job cost sheet like the one presented
in Exhibit 2–2.

A job cost sheet records the materials, labor, and manufacturing overhead costs
charged to that job.

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 Measuring Direct Labor Cost
Direct labor consists of labor charges that are easily traced to a particular job.
Labor charges that cannot be easily traced to specific jobs are treated as part of
manufacturing overhead.

Most companies rely on computerized systems to maintain employee time tickets.

A completed time ticket is an hour-by-hour summary of the employee’s activities
throughout the day. One computerized approach to creating time tickets uses bar codes
to capture
data. Each employee and each job has a unique bar code.

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 Computing Predetermined Overhead Rates
Recall that, in absorption costing, product costs include manufacturing overhead as well
as direct materials and direct labor. Therefore, manufacturing overhead also needs to
be
recorded on the job cost sheet. However, assigning manufacturing overhead to a
specific
job is complicated by three circumstances:

1. Manufacturing overhead is an indirect cost. This means that it is either impossible or

difficult to trace these costs to a particular product or job.

2. Manufacturing overhead consists of many different types of costs ranging from the
grease used in machines to the annual salary of the production manager. Some of
these costs are variable overhead costs because they vary in direct proportion to
changes in the level of production (e.g., indirect materials, supplies, and power)
and some are fixed overhead costs because they remain constant as the level of
production fluctuates (e.g., heat and light, property taxes, and insurance).

3. Many companies have large amounts of fixed manufacturing overhead. Therefore,

their total manufacturing overhead costs tend to remain relatively constant from one
period to the next even though the number of units that they produce can fluctuate
widely. Consequently, the average cost per unit will vary from one period to the
next.
Given these circumstances, an allocation method is used to assign overhead costs

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 to products. Allocation is accomplished by selecting an allocation base that is
common to all of the
company’s products and services. An allocation base is a measure such as direct
labor-hours
(DLH) or machine-hours (MH) that is used to assign overhead costs to products and
services.
The most widely used allocation bases in manufacturing are direct labor-hours,
direct labor
cost, machine-hours, and (where a company has only a single product) units of
product.

Manufacturing overhead is commonly assigned to products using a predetermined

overhead rate.

The predetermined overhead rate is computed before the period begins using a four-
step
process.
The first step is to estimate the total amount of the allocation base (the denominator)
that will be required for next period’s estimated level of production.
The second step is to estimate the total fixed manufacturing overhead cost for the
coming period and the variable manufacturing overhead cost per unit of the allocation
base.
The third step is to use the cost formula shown below to estimate the total
manufacturing overhead cost (the numerator) for the coming period:

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 The fourth step is to compute the predetermined overhead rate.
Notice, the estimated amount of the allocation base is determined before estimating the
total manufacturing overhead cost. This needs to be done because total manufacturing
overhead cost includes variable overhead costs that depend on the amount of the
allocation base.
1 When there is more than one production department, each department may have a
different variable manufacturing overhead cost per unit of the allocation base. In that
case, the formula Y = a + bX should be applied to each department separately. These
departmental cost estimates (Y) can be combined in step 4 to calculate one overhead
rate or they can be kept separate to calculate departmental overhead rates

Applying Manufacturing Overhead

Apply overhead cost to jobs using a predetermined overhead rate

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 This approach to overhead application is known as normal costing. A normal cost
system applies overhead costs to jobs by multiplying a predetermined overhead rate by
the actual amount of the allocation base incurred by the jobs

Manufacturing Overhead—A Closer Look

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 The Need for a Predetermined Rate
Instead of using a predetermined rate based on estimates, it may be tempting to
suggest that companies should use the actual total manufacturing overhead cost
and the actual total amount of the allocation base to compute their overhead rates on
a monthly, quarterly, or annual basis.

However, if an actual rate is computed monthly or quarterly, seasonal factors in

overhead costs or in the allocation base can produce fluctuations in the overhead rate

Computation of Total Job Costs and Unit Product Costs

Compute the total cost and the unit product cost of a job using a plantwide
predetermined overhead rate.
First, the totals for direct materials, direct labor, and manufacturing overhead are
transferred to the Cost Summary section of the job cost sheet and added together to
obtain the total cost for the job.

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 Then the total product cost is divided by the number of units to obtain the unit product
cost.
As indicated earlier, this unit product cost is an average cost and should not be
interpreted as the cost that would actually be incurred if another unit were produced.
The incremental cost of an additional unit is something less than the average unit cost
because much of the actual overhead costs would not change if another unit were
produced.

Job-Order Costing—A Managerial

Perspective
Managers use job cost information to establish plans and make decisions. For example,
managers may use job profitability reports to develop sales and production plans for
next
year.
Managers may also use job cost information to make pricing decisions

If a company’s job-order costing system does not accurately assign manufacturing costs
to jobs, it will adversely influence the types of planning and decision-making scenarios
just described.
In other words, distorted job cost data may cause managers to use additional
advertising dollars to pursue certain types of jobs that they believe are profitable, but in
actuality are not. Similarly, inaccurate job costs may cause managers to establish selling
prices that are too high or too low relative to the prices established by more savvy
competitors.
To improve job cost accuracy, the allocation base in the predetermined overhead rate
should drive the overhead cost.
A cost driver is a factor, such as machine-hours, beds occupied, computer time, or
flight-hours, that causes overhead costs.

If the base in the predetermined overhead rate does not “drive” overhead costs, it will
not accurately measure the cost of overhead resources used by each job. Many
companies use job-order costing systems that assume direct labor-hours (or direct labor
cost) is the only manufacturing overhead cost driver.

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 They use a single predetermined overhead rate, or what is called a plantwide overhead
rate, to allocate all manufacturing overhead costs to jobs based on their usage of direct-
labor hours.
However, while direct labor-hours may indeed “drive” some of a company’s
manufacturing overhead costs, it is often overly simplistic and incorrect to assume that
direct-labor hours is a company’s only manufacturing overhead cost driver. When
companies can identify more than one overhead cost driver they can improve job cost
accuracy by using multiple predetermined overhead rates

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 Job-Order Costing Using Multiple
Predetermined Overhead Rates
Job-Order Costing Using Multiple Predetermined Overhead Rates

A cost system with multiple predetermined overhead rates uses more than one
overhead rate to apply overhead costs to jobs.
For example, a company may choose to use a predetermined overhead rate for each of
its production departments.
Such a system, while more complex, is more accurate because it reflects differences
across departments in terms of how jobs consume overhead costs.

For example, in departments that are relatively labor-intensive, their overhead costs
might be applied to jobs based on direct labor-hours and in departments that are
relatively machine-intensive, their overhead costs might be applied to jobs based on
machine-hours.

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 Multiple Predetermined Overhead Rates—A
Departmental Approach
Process Reengineering is generally considered to be a more radical approach to
improvement than Total Quality Management.

Exhibit 2–5 explains how Dickson would compute a selling price for Job 407 using
a five-step process, the first of which is to calculate the estimated total manufacturing
overhead cost in each department using the equation

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 Job-Order Costing—An External Reporting
Perspective

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 job-order costing systems are also often used to create a balance sheet and income
statement for external parties, such as shareholders and lenders.
All of a company’s job cost sheets collectively form a subsidiary ledger.
The job costs sheets provide an underlying set of financial records that explain what
specific jobs comprise the amounts reported in Work-in-Process and Finished
Goods on the balance sheet.

The job costs sheets provide an underlying set of financial records that explain what
specific jobs comprise the amounts reported in Cost of Goods Sold on the income
statement.

Overhead Application and the Income Statement

When a company applies less overhead to production than it actually incurs, it creates
what is known as underapplied overhead. When it applies more overhead to production
than it actually
incurs, it results in overapplied overhead.

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 The adjustment for underapplied overhead increases cost of goods sold and
decreases net operating income, whereas the adjustment for overapplied overhead
decreases
cost of goods sold and increases net operating income.

Job Cost Sheets: A Subsidiary Ledger

A job cost sheet accumulates the total direct materials, direct labor, and manufacturing
overhead costs assigned to a job. When all of a company’s job cost sheets are viewed
collectively they form what is known as a subsidiary ledger. In other words, a company’s
job costs sheets provide an underlying set of financial records that explain what specific
jobs comprise the amounts reported in Work-in-Process and Finished Goods on the
balance sheet as well as Cost of Goods Sold on the income statement.

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 Job-Order Costing in Service Companies

Manufacturing overhead is an indirect cost with respect to units of product.

Labor fringe benefits may be charged to direct labor or manufacturing overhead while
overtime premiums paid usually are considered a part of manufacturing overhead.
If a company closes any under- or overapplied overhead to the Cost of Goods Sold
account, then Cost of Goods Sold will be credited if manufacturing overhead is
overapplied for the period.
When the predetermined overhead rate is based on the level of activity at capacity, the
overhead underapplied may be called the Cost of Unused Capacity and treated as a
period expense.
The absorption cost approach is so named because it provides for the absorption of all
manufacturing costs, fixed and variable, into units of product.

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 Prime cost consists of direct materials and direct labor.
Property taxes on a company's factory building would be classified as a(n):
A) product cost.

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 Appraisal cost, internal failure cost, external failure cost, and preventive cost on a
quality cost report

building depreciation is a fixed cost and manufacturing overhead

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 predetermined overhead rate= Estimated manufacturing overhead/Estimated machine-
hours
applied manufacturing overhead= predetermined overhead rate * actual manufacturing
overhead
finished goods=cost of goods manufactured

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 Actual or Incurred manufacturing cost
Applied or Estimated manufacturing cost
If overhead is overapplied, what adjustment does the company make to Cost of Goods
Sold? Is Cost of Goods Sold increased or decreased? Why?
Level: Easy LO: 8
Answer:
If overhead is overapplied, too much overhead has been applied to inventories and
they are therefore overcosted. Since these excess costs flow through to Cost of Goods
Sold when finished goods are sold, it is necessary to reduce Cost of Goods Sold in
order to eliminate this overstatement of costs.
Actual -applied=
if overapplied….c.o.g.s will be subtracted

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