A 

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 her clients. And a clothing factory would keep
separate track of the costs of filling orders for particular styles, sizes, and colors of jeans.

The job order cost system is used when products are made based on specific customer orders. Each product
produced is considered a job. Costs are tracked by job. Services rendered can also be considered a job. For
example, service companies consider the creation of a financial plan by a certified financial planner, or of an
estate plan by an attorney, unique jobs. The job order cost system must capture and track by job the costs of
producing each job, which includes materials, labor, and overhead in a manufacturing environment. To track
data, the following documents are used:

3 Basic Elements of Job Order Costing System

Under a job order cost system, the three basic elements of cost—direct materials, direct labor, and
factory overhead—are accumulated according to assigned job numbers. The unit cost for each job is
obtained by dividing the total units for the job into the job’s total cost. A cost sheet is used to summarize the
applicable job costs. Selling and administrative expenses, which are based on a percentage of manufacturing
cost, are listed on the cost sheet to arrive at total cost.
In order for a  job order  cost  system  to  function properly,  it must be possible  to  identify  each 
job  physically  and  segregate  its  related  costs.
Direct material requisitions and direct labor costs carry the particular job number; factory overhead is usually
applied to individual jobs based on a predetermined factory overhead application rate. The profit or loss can
be determined for each job and the unit cost computed for purposes of inventory costing. Schedules are
prepared to accumulate the information for the required journal entries.

Element-1. Direct Materials

Purchase of Materials - Raw materials and supplies used in production are ordered by the purchasing
department. These materials are kept in a materials storeroom under the control of a clerk and are issued
only when a properly approved requisition is presented.

Issuance of Materials - The next step in the manufacturing process is to obtain the needed raw materials
from the materials storeroom. There is one source document for the issuance of materials in a job order cost
system—a materials requisition.Any issuance of materials by the materials clerk must be substantiated by a
materials requisition approved by the production manager or the department supervisor. Each requisition form
shows the job order number, the department number, and the quantities and description of materials
requested. The materials  clerk  enters  the  unit  cost  and  total  cost  on  the requisition form.

On a regular basis, perhaps weekly, materials requisitions are sorted by job number and the totals
recorded on a cost summary sheet.

When direct materials are put into production, a journal entry is made to record the addition of materials to
work-in-process inventory. When indirect materials are requisitioned, they are generally charged to a
departmental Factory Overhead Control account. Indirect materials costs are included in the factory overhead
application rate, as it is often impractical to trace these materials to each job.

PearCo Materials Requisition Form

Requisition No. X7 - 6890 Date 3-4-01

Job No. A - 143
Department B3

Description Quantity Unit Cost Total Cost

2 x 4, 12 feet 12 $ 3.00 $ 36.00
1 x 6, 12 feet 20 4.00 80.00
$ 116.00

Authorized
Signature
 PearCo Job Cost Sheet
Job Number A - 143 Date Initiated 3-4-01
Date Completed
Department B3 Units Completed
Item Wooden cargo crate
Direct Materials Direct Labour Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours Rate Amount
X7-6890 $ 116

Cost Summary Units Shipped

Direct Materials $ 116 Date Number Balance
Direct Labour
Manufacturing Overhead
Total Cost
Unit Cost

Element-2. Labor Cost

There are two source documents for labor in a job order cost system—a time card and a labor job ticket:

 Time (or clock) cards are inserted in a time clock by employees each day when they arrive, go to
and return from lunch, take breaks, and leave work for the day. This procedure mechanically shows a
record of total hours worked each day by each employee and thus provides a reliable source for the
computation and recording of payroll.
 Labor job tickets are prepared daily by each employee indicating the job worked on and the number
of hours worked. The wage rate of the employee is inserted by the payroll department. The sum of the
labor cost and hours incurred on various jobs (labor tickets) should be equal to the total labor cost and
total labor hours for the period (time cards).

 At periodic intervals, time cards are summarized to record the payroll,  and  labor  job  tickets  are  summarized 
to  be  charged  to work-in-process inventory or factory  overhead  control.  Time card and job ticket hours
should be reconciled.
PearCo Employee Time Ticket

Time Ticket No. 36 Date 3/5/01

Employee I. M. Skilled Station 42

Starting Ending Hours Hourly

Time Time Completed Rate Amount Job No.
0800 1600 8.00 $ 11.00 $ 88.00 A-143

Totals 8.00 $ 11.00 $ 88.00 A-143

Supervisor C. M. Workman
 
PearCo Job Cost Sheet
Job Number A - 143 Date Initiated 3-4-01
Date Completed
Department B3 Units Completed
Item Wooden cargo crate
Direct Materials Direct Labour Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours Rate Amount
X7-6890 $ 116 36 8 $ 88

Cost Summary Units Shipped

Direct Materials $ 116 Date Number Balance
Direct Labour $ 88
Manufacturing Overhead
Total Cost
Unit Cost

Element-3. Factory Overhead

The third element to be included in determining the total cost in a job order cost system is factory
overhead. There is one source document for the computation of factory overhead costs in a job order cost
system—a departmental factory overhead cost sheet, which each department maintains. This is a subsidiary
ledger of the Factory Overhead Control account. Reconciliation of the control and subsidiary ledgers should be
performed at regular intervals. It should be noted, however, that factory overhead costs may be recorded for
the factory in total and then distributed to production departments for ultimate distribution to jobs. However,
assigning manufacturing overhead to units of product can be a difficult task. There are three reasons for this:

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 items ranging from the grease used in machines to
the annual salary of production manager.
3. Even though output may fluctuate due to seasonal or other factors, manufacturing overhead costs
tend to remain relatively constant due to the presence of fixed costs.

The  distribution  of  factory  overhead  to  jobs  is  based  on  a  predetermined “factory  overhead 
application  rate“.  Factory overhead application rates are expressed in terms of direct labor hours, direct
labor dollars, direct materials dollars, machine hours, or some other reasonable basis. When factory overhead is
not accumulated on a factory wide level for distribution to several departments, each department will generally
have a different rate.

OVERHEAD AND COST DRIVERS:  The application of overhead to specific jobs is mostly an exercise in
algebra.  Jack applied overhead at the rate of $20 for each hour of direct labor.  A similar mathematical exercise
is used to apply overhead in the highly automated factory environment.  Some predetermined scheme is used to
apply the overhead to production.

However, in a highly mechanized environment, one must give careful thought to the "cost driver."  The cost driver
is the factor that is viewed as causing costs to be incurred within an organization; it is best viewed only in an
abstract context, as there are too many individual variables for any single factor to fully explain all cost
incurrence.  For Jack Castle's business, direct labor hours were viewed as the primary cost driver and the basis
for assigning overhead.  Labor hours may not be the most significant cost driver in a mechanized setting. 
Machine hours, number of direct material bar code scans, fuel consumption, spot-welds, or number of assembly
steps could each provide a potentially logical base for allocating overhead.  This choice must be logical, as it will
govern the allocation of total overhead costs to individual products.

It is a bit frightening to consider that product pricing, CVP analysis, inventory values, decisions to discontinue a
product, and so forth are dependent upon costing information that is driven by arbitrary overhead allocation
choices.  This underscores the importance of careful methodology in correctly identifying cost drivers.  To do
otherwise could result in costing some products too high and others too low.  This might lead to overproduction of
unprofitable products and discontinuance of profitable lines.  How is this possible?  Suppose a computer
manufacturer allocated overhead based on the installation of RAM memory chips.  As a result, a machine with 2
GB of memory would absorb twice as much overhead as a machine with 1 GB.  This is probably not a good idea;
there is little difference in the production process needed to manufacture the two machines (save and except the
difference in direct material cost for memory chips).  The faulty overhead allocation could cause management to
conclude that the 2 GB machines were too costly to produce, while the 1 GB machines seem a relative bargain.  
In short, the amount of memory is probably not the leading cost driver.

Management accountants have long fretted about the overhead allocation problem.  With so much at stake, quite
a lot of thought has been put into ways to improve this effort.  In the next chapter, you will discover "activity-based
costing."  ABC seeks to overcome some of the issues just described by dividing production into its component
processes ("activities") and more closely associating overhead with each unique process.   But, ABC has its own
limitations, so do not be too quick to dismiss the merits of the overhead allocation approach introduced in this
chapter.

PearCo Job Cost Sheet

Job Number A - 143 Date Initiated 3-4-01
Date Completed 3-5-01
Department B3 Units Completed 2
Item Wooden cargo crate
Direct Materials Direct Labour Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours Rate Amount
X7-6890 $ 116 36 8 $ 88 8 $ 4 $ 32

Cost Summary Units Shipped

Direct Materials $ 116 Date Number Balance
Direct Labour $ 88
Manufacturing Overhead $ 32
Total Cost $ 236
Unit Cost $ 118

Formula and Calculation of Predetermined Overhead Rate:

[Predetermined Overhead Rate = Estimated total manufacturing overhead cost / Estimated
total units in the allocation base]

PearCo applies overhead based on direct labour hours. Total estimated overhead for the year is $640,000. Total
estimated labour cost is $1,400,000 and total estimated labour hours are 160,000.

What is PearCo’s predetermined overhead rate per hour?

predetermined overhead rate= 640000/160000 = $4 per direct labour hour

The Need for Predetermined Overhead Rate:

Instead of using a predetermined overhead rate, a company could wait until the end of the
accounting period to compute an actual over head rate based on actual total manufacturing costs
and the actual total units in the allocation base for the period. However, managers cite several
reasons for using predetermined over head rates instead of actual overhead rates:

1. Managers would like to know the accounting system's valuation of completed jobs before
the end of the accounting period. Suppose, for example a company waits until the end of
the year to compute its overhead rate. Then there would be no way for managers to know
the cost of goods sold for a job until the close of the year. The job may be completed and
shipped before the end of the year. The seriousness of this problem can be reduced to some
extent by computing the actual overhead more frequently, but that immediately leads to
another problem as discussed below.
2. If actual overhead rates are computed frequently, seasonal factors in overhead costs or in
the allocation base can produce fluctuations in the overhead rates. For example, the cost of
heating and cooling a production facility will be highest in the winter and summer months
and lowest in the spring and fall. If an overhead rate were computed each month or each
quarter, the predetermined overhead rate would go up in the winter and summer and down
in the spring and fall. Tow identical jobs, one completed in winter and one completed in
spring, would be assigned different costs if the overhead rate were computed on a monthly
or quarterly basis. Managers generally feel that such fluctuations in overhead rates and
costs serve no useful purpose and are misleading.
3. The use of predetermined overhead rate simplifies the record keeping. To determine the
overhead cost to apply t a job, the accounting staff simply multiplies the direct labor hours
recorded for the job by the predetermined overhead rate.

The Flow of Documents in a Job Order Costing System

 

Materials The job

      requisition     cost sheet
form is used to
A These compute
productio production unit
A sales
n order costs are product
order is
initiates accumulate costs that
Job
Sales prepare work on a d on a form, in turn are
Orde d as a → Productio job, → Direct labor
prepared by→ cost
used to
basis for n Order time ticket shee
r whereby the value
issuing t
costs are accounting ending
a.....
charged department inventorie
through... known as... s and to
Predetermine determine
      d overhead     cost of
rates goods sold

Job Order Costing - The Flow of Cost:

To understand the flow of costs in job order costing system, we shall consider a single
month's activity for a company, 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.

The Purchase and Issue of Materials:

On April 1, the company had $7,000 in raw materials on hand. During the month, the company
purchased an additional $60,000 in raw materials. The purchase is recorded in journal entry (1)
below:
 (1)

Raw Materials 60,000 Dr.

  Accounts Payable              60,000 Cr.

Raw materials is an asset account. Thus, when raw materials are purchased, they are initially
recorded as an asset--not as an expense.

Issue of Direct and Indirect Materials:

During April, $52,000 in raw materials were 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.

(2)
Work in Process 50,000 Dr.

Manufacturing Overhead 2,000 Dr.

  Raw Materials   52,000 Cr.

The materials charged to work in process (WIP) represents 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 1.1 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 they are as they are incurred during a period.

Before leaving Exhibit 1.1 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 1.1

Issue of Direct Materials Only:

Some times the materials drawn from the raw materials inventory account are all direct materials.
I this case, the entry to record the issue of the materials into production would be as follows:

Work in process XXX Dr.

  Raw materials   XXX Cr.

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)
Work in process 60,000 Dr.

Manufacturing overhead 15,000 Dr.

  Salaries and wages payable   75,000 Cr.

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 1.2. During April, $40,000 of direct labor cost
was charged to job 1 and the remaining $20,000was 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 1.2

Manufacturing Overhead Costs:

All costs of operating the factory other than direct materials and direct labor are classified as
manufacturing overhead costs. These costs are entered directly into the manufacturing overhead
account as they are incurred. To illustrate, assume that the company incurred the following general
factory costs during April:

Utilities (heat, water, and power) $21,000

Rent on factory equipment 16,000

Miscellaneous factory costs 3,000

-----------

Total $40,000

======

The following entry records the incurrence of these costs:

(4)
Manufacturing overhead 40,000 Dr.

  Accounts Payable   40,000 Cr.

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 records these items:
 (5)
Manufacturing overhead 20,000 Dr.

  Property taxes payable   13,000 Cr.

  Prepaid insurance   7,000 Cr.

Finally let us assume that the company recognize $18,000 in depreciation on factory equipment
during April. The following entry records the accrual of this depreciation:

(6)
Manufacturing overhead 18,000 Dr.

  Accumulated Depreciation   18,000 Cr.

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 we omit the entries to the subsidiary accounts for the sake of brevity.

Calculation of Predetermined Overhead Rate and Application of Manufacturing

Overhead to Work in Process (WIP):
Since actual manufacturing costs are charged to the manufacturing overhead control account
rather than work in process account. How are manufacturing costs assigned to work in
process? The answer is, by means of the predetermined overhead rate. A predetermined overhead
rate is established at the beginning of each year. The predetermined overhead rate is
calculated by dividing the estimated total manufacturing overhead cost for the year by
the estimated total units in the allocation base (measured in machine hours, direct labor
hours, or some other base). This rate is then used to apply overhead costs to jobs.

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 hours  $6 per machine
hour = $90,000) would be applied to work in process. The following entry records the application of
manufacturing overhead to work in process:

(7)
Work in process 90,000 Dr.

  Manufacturing overhead   90,000 Cr.

The flow of cost through the manufacturing overhead account in Exhibit 1.3
 Exhibit 1.3

The actual overhead cost in the manufacturing overhead account in Exhibit 1.3 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 represents two separate and
entirely distinct processes.

The Concept of Clearing Account:

The manufacturing overhead account operates as a clearing account. As we have noted, actual
factory overhead costs are debited to the accounts as they are incurred day by day through the
year. A certain intervals during the year, usually when a job is completed, overhead cost is applied
to the job by means of the predetermined overhead rate, and work in process is debited and
manufacturing overhead is credited. This sequence of events is illustrated below:

Manufacturing Overhead
(a clearing account)
Actual overhead costs are charged to this Overhead is applied to work in process using the
account as they are incurred throughout the predetermined overhead rate.
period.

As we emphasized earlier, the predetermined overhead rate is based on estimates of what

overhead costs are expected to be, and it is established before the year begins. As a result, the
overhead cost applied during a year will almost certainly turn out to be more or less than the
overhead cost that is actually incurred. For example, notice from Exhibit 1.3 that the company's
actual overhead costs for the period are $5,000 greater than the overhead cost that has been
applied to work in process (WIP), resulting in a $5,000 debit balance in the manufacturing
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 1.3 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.

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 the manufacturing overhead account. To illustrate the correct treatment of
non-manufacturing costs, assume that the company (in this example) incurred $30,000 in selling
and administrative salary costs during a months, the following entry records these salaries.

(8)
Salaries expense 30,000 Dr

   Salaries and wages payable   30,000 Cr

Depreciation on factory equipment is debited to manufacturing overhead account but depreciation

on office equipment is considered a period expense and is not included in manufacturing overhead.
Assume that depreciation of office equipment during the month was $7,000. The entry is as
follows.

(9)
Depreciation expense 7,000 Dr

    Accumulated depreciation   7,000 Cr

Finally assume that advertising was $42,000 and that other selling and administrative expenses
during the month was $8,000. The following journal entry records these items:

(10)
Advertising expenses 42,000 Dr.

Other selling and administrative expense 8,000 Dr.

   Accounts payable   50,000 Cr.

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,
depreciation on sales equipment, rent on office facilities, insurance on office facilities, and related
costs.

Cost of Goods Manufactured (COGM):

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. A transfer of costs is made within the costing
system that parallels the physical transfer of the goods to the finished goods warehouse. The costs
of the completed jobs are transferred out of the work in process (WIP) account and into
the finished goods account. The sum of all amounts transferred between these two accounts
represents the cost of goods manufactured for the period.

Let us assume that the job 1 was completed during the period. The following entry transfers the
cost of  job 1 from work in process (WIP) to finished goods.

(11)
Finished goods 158,000 Dr.

   Work in process   158,000 Cr

The $158,000 represents the completed cost of job 1, as shown on the job cost sheet in Exhibit
1.3. 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.

Cost of Goods Sold (COGS):

As units in the finished goods are shipped to the customers, their costs are transferred from
the finished goods account into the cost of goods sold account. If complete job is shipped, as in the
case where a job has been done to a customer's specification then it is a simple matter to transfer
the entire cost appearing on the job cost sheet into the cost of goods sold account. In most cases,
only a portion of the units involved in a particular job will be immediately sold. In these situations
the unit cost must be used to determine how much product cost should be removed from finished
goods and charged to cost of goods sold.

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 would
record the sales (all sales are on account).

(12)
Accounts receivable 225,000 Dr.

  Sales   225,000 Cr.

 (13)
Cost of goods sold 118,5000* Dr.

  Finished goods   118,5000 Cr.

($158 × 750units = $118,500*)

With entry (13), the flow of cost through our job order costing system is completed.

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 Dr.

  Accounts Payable   60,000 Cr.

(2)

Work in process 50,000   Dr.

Manufacturing overhead 2,000   Dr.

  Raw materials   52,000 Cr.

(3)    

Work in process 60,000   Dr.

Manufacturing overhead 15,000   Dr.

  Salaries and wages   75,000 Cr.

(4)

Manufacturing overhead 40,000 Dr.

  Accounts payable   40,000 Cr.

(5)    

Manufacturing overhead 20,000   Dr.

  Property taxes payable   13,000 Cr.

  Prepaid insurance   7,000 Cr.

(6)

Work in process 18,000  

  Manufacturing overhead   18,000  

(7)
Work in process 90,000 Dr.

  Manufacturing overhead   90,000 Cr.

(8)    
Salaries expenses 30,000 Dr.

  Salaries and wages payable   30,000 Cr.

(9)    
Depreciation expense 7,000 Dr.

  Accumulated depreciation   7,000 Cr.

(10)    
Advertising expense 42,000 Dr

Other selling and administrative expense 8,000 Dr.

  Accounts payable   50,000 Cr.

(11)    
Finished goods 158,000 Dr.

  Work in process   158,000 Cr.

(12)    

Accounts receivable 225,000  

  Sales   225,000  

(13)    

Cost of goods sold 118,500  

  Finished goods   118,500  

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 and 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 (20)   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
(3)      60,000
Depreciation expenses    
(7)      90,000
(9)    7,000  

Bal.     72,000            

           
Finished Goods   Advertising Expenses     
Bal.     10,000 (13)  118,500   (10)  42,000       
(11)  158,000

Bal.     49,000            

             
Accumulated Depreciation   Other Selling and     
Administrative expenses

                 xx   (10)   8,000       

(6)     18,000
(9)      7,000

             
Manufacturing Overhead          
(2)         2000 (7)     90,000          
(3)      15,000
(4)      40,000
(5)      20,000
(6)      18,000

Bal.       5,000            

             

             
Explanation of entries:  
(1) Raw materials purchased.
(2) Direct and indirect materials issued into (8) Administrative salaries expenses incurred.
production.

(3) Direct and indirect factory labor cost (9) Depreciation recorded on office equipment.
incurred.

(4) Utilities and other factory costs incurred. (10) Advertising and other expenses incurred
(5) Property taxes and insurance incurred on the (11) COGM  transferred into finished goods.
factory.

(6) Depreciation recorded on the factory assets. (12) sale of job 1 recorded.

(7) Overhead cost applied to work in process. (13) Cost of goods sold recorded for job 1.

 
XX = Normal balance in the account (for example accounts receivable normally carries a debit
balance).

Cost of Goods Manufactured:

Direct materials $50,000

Direct labor $60,000

Manufacturing overhead applied to work in process $90,000*

---------------

Total Manufacturing cost $200,000

Add: Beginning work in process $30,000

  ------------

  $230,000

Deduct: Ending work in process inventory $72,000

  -----------

Cost of goods manufactured $158,000

=======

Cost of Goods Sold:

Finished goods inventory beginning $10,000

$158,000

-----------

Goods available for sale $168,000

Deduct: Finished goods inventory ending $49,500

----------

Unadjusted cost of goods sold $118,500

Add: Under applied overhead $5,000*

-----------

Adjusted cost of goods sold $123,500

=======

   
*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 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 Dr

         Manufacturing overhead-------------------------------- 5,000 Cr

Note that the underapplied overhead is added to cost of goods sold. If overhead
were overapplied, it would be deducted from cost of goods sold.

Income Statement:
Sales   $225,000

Les cost of goods sold ($ 118,500 + $5,000)   123,500

    -----------

Gross margin   101,500

Less selling and administrative expenses:    

      Salaries $30,000  

      Depreciation 7,000  

      Advertising expenses 42,000  

      Other expense 8,000 87,000

  -----------
----------

Net operating income   $14,500

    =======

   

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. But in large
companies, multiple predetermined overhead rates are often used.

In a multiple predetermined overhead rate system, each production department may have its
own predetermined overhead rate. Such a system, while more complex, is considered to be more
accurate. Since it can reflect differences across departments in how overhead costs are incurred.
For example, overhead might be allocated based on machine-hours in departments that are
relatively machine intensive. When multiple predetermined overhead rates are used, overhead is
applied in each department according to its own overhead rate as a job proceeds through the
department.
Problems of Overhead Application:
We need to consider two complications relating to overhead application. These are:
A) Under-applied and Over-applied Overhead
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. The difference between the
overhead cost applied to work in process (WIP) and the actual overhead costs of a
period is termed as either underapplied overhead or overapplied overhead. For example if
a company calculates its predetermined overhead rate $6 per machine hour. 15,000 machine hours
are actually worked and overhead applied to production is therefore $90,000 (15,000 hours × $6).
If actual factory overhead is $95,000 then underapplied overhead is $5,000 ($95,000 – $90,000).
If the situation is reverse and the company applies $95,000 and actual overhead is $90,000
the overapplied overhead would be $5,000.

Causes / Reasons of underapplied or overapplied overhead:

The causes / reasons of under or over-applied overhead can be complex. Nevertheless the basic
problem is that the method of applying overhead to jobs using a predetermined overhead
rate assumes that actual overhead costs will be proportional to the actual amount of the allocation
base incurred during the period. If, for example, the predetermined overhead rate is $6 per
machine hour, then it is assumed that actual overhead cost incurred will be $6 for every machine
hour that is actually worked. There are actually two reasons why this may not be true. First, 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 Direct materials cost

Estimated manufacturing overhead $300,000 $120,000

Estimated machine-hours 75,000 --

Estimated direct materials cost   $80,000

150% of direct materials

Predetermined overhead rate, (a) ÷ (b) $4 per machine hour
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 underapplied overhead and
overapplied overhead as follows:
 

                 Company                 

A B
Actual manufacturing overhead costs $290,000 $130,000

Manufacturing overhead cost applied to work in process during the year:

68,000 actual machine hours × $4 per machine hour 272,000

$90,000 actual direct materials cost × 150% of direct materials cost 135,000

------------- -------------

Underapplied (overapplied) 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 underapplied. 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 B company 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 overapplied. A summary of the concepts discussed so for is presented below:

At the beginning of the period

Estimated total manufacturing Estimated total units in the

÷ = Predetermined overhead rate
overhead cost  allocation base

During the period

Actual total units of the allocation Total manufacturing overhead
Predetermined overhead rate × =
base incurred during the period applied

At the end of the period

Actual total manufacturing overhead Total manufacturing overhead Underapplied (overapplied)
– =
cost applied overhead

What disposition should be made of any under or over applied overhead balance
remaining in the manufacturing overhead account at the end of a period? To understand
the procedure of disposing off any under or over applied overhead see disposition of any balance
remaining in the manufacturing overhead account at the end of a period page.
 B) Disposition of Underapplied or Overapplied Overhead Balances:

What disposition should be made of an underapplied overhead or overapplied overhead

balance remaining in the manufacturing overhead account at the end of a period?

Generally any balance in the account is treated in one of the two ways.

1. Closed out to cost of goods sold.

2. Allocated between work in process (WIP), finished goods and cost of goods sold in
proportion to the overhead applied during the current period in the ending balances of these
account.

The second method, which allocates the under or overapplied overhead among ending inventories
and cost of goods sold is equivalent to using an "actual" overhead rate and is for that reason
considered by many to be more accurate than the first method. Consequently, if the amount of
underapplied or overapplied overhead is material, many accountants would insist that the second
method be used.

Closed Out to Cost of Goods Sold:

Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than
the allocation method.

Where the overhead is underapplied following journal entry is made:

Cost of goods sold Dr

Manufacturing overhead Cr

Where the overhead is overapplied the following journal entry is made:

Manufacturing overhead   Dr
Cost of goods sold Cr

After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of
goods sold is increased by the amount of underapplied and decreased by the amount of
overapplied overhead.

Example:

Cost of Goods Manufactured:    

Direct materials $50,000  

Direct labor $60,000  

Manufacturing overhead applied to work in process $90,000*

---------
Total Manufacturing cost $200,000  

Add: Beginning work in process $30,000  

  ----------  

  $230,000  

Deduct: Ending work in process inventory $72,000  

  ----------  

Cost of goods manufactured $158,000  

========

Cost of Goods Sold:

Finished goods inventory beginning $10,000

$158,000

-----------

Goods available for sale $168,000

Deduct: Finished goods inventory ending $49,500

----------

Unadjusted cost of goods sold $118,500

Add: Under applied overhead $5,000*

----------

Adjusted cost of goods sold $123,500

========

     

*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 Predetermined overhead rate)
Actual overhead = $95,000
Under applied overhead = $95,000 - $90,000 = $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 Dr

         Manufacturing overhead------------------------- 5,000 Cr

Allocated Between Accounts:

Allocation of under or overapplied overhead between work in process (WIP),finished goods and cost

of goods sold (COGS) 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:
If the amount of under-applied or over-applied overhead is significant, it should be allocated
among the accounts containing applied overhead: Work in Process Inventory, Finished
Goods Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-
applied” overhead means thatthe balances in these accounts are quite different from what
they would have been if actual overhead costs had been assigned to production.

Allocation restates the account balances to conform more closely to actual historical cost
as required for external reporting by generally accepted accounting principles. The above
figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of
over-applied overhead among the necessary accounts; had the amount been under-applied, the
accounts debited and credited in the journal entry would be the reverse of that presented for over-
applied overhead. A single overhead account is used in this illustration.

Theoretically, under-applied or over-applied overhead should be allocated based on the

amounts of applied overhead contained in each account rather than on total account
balances. Use of total account balances could cause distortion because they contain direct
material and direct labor costs that are not related to actual or applied overhead. In spite of this
potential distortion, use of total balances is more common in practice for two
reasons: First, the theoretical method is complex and requires detailed account analysis. Second,
overhead tends to lose its identity after 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

JOB COSTING IN SERVICE, NOT-FOR-PROFIT, AND GOVERNMENTAL ENVIRONMENTS

THE MANUFACTURING ECONOMY:  The last hundred-plus years have been remarkable.  A primarily
agriculture-based world economy gave way to the industrial revolution.  This revolution took root and continues to
sweep around the globe.  Following the growth in manufacturing has been an even greater proliferation of support
and service roles.  Perhaps as few as 10% of workforce members are now actively producing a tangible end
product.

THE SERVICE SECTOR:  Most employees in the private sector are engaged in nonmanufacturing activities like
accounting, sales, computing, and administration.  New businesses have developed in the areas of law,
healthcare, food services, electronic information delivery, transportation, entertainment, and others.  The not-for-
profit sector is increasing; consider the size and scope of educational institutions, hospitals, foundations, and so
forth.  And, not to be forgotten, is the size and scope of governmental entities.   Cities provide services like
municipal infrastructure, fire, police, water utilities, and code enforcement.  State and provincial governments may
provide for the educational system, highways, and prisons.  At the federal level, governments may provide
military, welfare, transportation, and countless other services.  It is no wonder that most people work in a
nonmanufacturing role.

The job costing model presented in this chapter is generally suggestive of the idea that a "job" can be identified as
some tangible product.  But, that is not necessarily the case.  This chapter opened with an illustration for Castle
Electric.  If you think deeper about that example, you will realize that most of what Jack Castle provided to his
customers was a "service."  But, the utilization of job costing methodologies was still highly relevant.  The cost of
services, whether provided in the private sector, not-for-profit, or governmental arenas, must be determined with
some reasonable degree of accuracy.  The growth, indeed dominance, of these sectors of the economy
underscores the need to extend costing methods beyond the traditional manufacturing setting.

The concept of a "job" gives way to more abstract connotations: "client," "surgical procedure," "seat mile,"
"student credit hour," "fire call," or other measure of output.  Clearly, direct materials become a less significant
part of the overall picture.  But, overhead can take on heightened levels of importance.  Perhaps you have
experienced a costly hospital stay.  The itemized billing that follows usually includes some shocking components
(e.g., $5 for an aspirin).  These prices cannot be justified based on direct material cost alone.  Clearly, the hospital
has tremendous and costly overhead.  In addition, you don't just pop an aspirin in the hospital as you would at
home.  The pill must be administered, documented, and billed; efforts which consume expensive labor time.

If costing methods are not employed correctly, the organization may find that it has underestimated its costs of
services.  This can lead to financial failure.  On the other hand, many will question the cost drivers and methods of
allocations that are used in service type activities.  For instance, a city may determine that the full cost of a fire
department is several hundred thousand dollars per residential house fire.  This type of job costing could lead one
to conclude that a fire department is not cost effective.  The problem with this approach is that it ignores that one
fire would quickly spread to an entire city without a suppression action by the fire department.   And, firefighters
save countless lives for which there can be no rational economic measure.  So, what is the actual "job" and how
are costs to be assigned to that "job?"  This measurement problem is pervasive and challenging in the service
sector

Advantages and Disadvantages of Job Order Costing System:

One of the primary advantages of job order costing system is that the management team has
ready access to all the costs incurred for each job being completed. This allows the team to
examine each cost incurred, finding out why it happened, and determine how it can be controlled
better in the future, thereby contributing to better ongoing levels of profitability. For example, a
proper job record contains any special reworking costs, which a manager can then use to trace
back to the specific reason why the rework was needed. Similarly, overhead allocations based on
machine usage reveal problems with excess use, which might be the result of lengthy machine
setups or break downs as well as longer than expected machine cycle times.

Another reason for using job order costing system is that it yields ongoing results for each job. In
today's world of fully computerized production tracking data bases, one can use a job order costing
system to track costs as they are added rather than waiting until the job has been completed. This
gives a company several advantages. One is that the accounting staff can monitor job accounts to
see if costs are being posted to the wrong accounts and correct them right away, rather than
waiting until the job closes and having to frantically review records to see why the results are
different from expectations. Another advantage is that a company can monitor the costs incurred
for longer jobs and have enough time to make changes before they close, based on the costing
information revealed by the job costing system. For example, a lengthy new product development
project might be over budget after just 25% of the work has been completed; If the management
team is made aware of this costing problem early in the project, it will still have 75% of the project
in which to make corrections and bring costs back down to budgeted levels. Yet a third advantages
is that changes in the cost of a job can result in negotiations with cost-plus customers who are
paying for all the costs incurred, so that they are fully aware of cost overruns well in advance and
are prepared to pay the additional amounts. All these factors are the main advantages of using job
order costing system in a computerized environment.

There are also several problems with job order costing system. One is that it focuses attention
primarily on products rather than on departments or activities. This is not an issue if there are
supplemental systems in place that record information about these other cost categories, but it
leaves management with inadequate information if this is not the case. An other difficulty is that
overhead is generally allocated based on rates that are changed only about once a year.
Considerable fluctuation in overhead costs over the course of a year can result both in over and
under allocation of overhead costs to jobs during that period. Another problem is specific to the use
of normal costing. This practice involves the use of standards overhead rate rather than one that is
based on actual costs and requires adjustment from time to time. If it is management's intention to
charge individual jobs for the variance between standard and actual overhead rates, this may not
be possible if some jobs have already been closed by the time the variance allocation takes place.
This is not just a technical accounting issue, for some jobs are fully reimbursed by customers who
pay on a cost plus basis; if the overhead variance is a positive one, a company may not be able to
charge its customers for the added costs if the related job have already been closed.

Another issue is that job costing has little relevance in some environments. For example, the soft
ware industry have high development costs but almost zero direct costs associated with the sale of
its products. The use of a job order costing system to records these costs makes little sense if the
associated costs represent only a few percent of the total revenue  gained from each one. The
same problem arises in service industries, such as retailing, where there is no discernible product.
These situations limit the most effective use of job order costing system to two areas--production
and professionals services. The first case, production is an obvious use for the concept since there
are high material costs that can be specifically identified with a job. The same is true of
professional services, but here the main cost is direct labor rather than direct materials. In most
other cases job costing does not provide management with sufficient quantity of information to be
useful.

The most important problem with job order costing  is that it requires a major amount of data
entry and data accuracy in order to yield effective results. Data related to materials, labor,
overhead, indirect labor, scrap, spoilage, and supplies must be entered into system capable of
accurately assigning these costs to the correct jobs every time. In reality such systems are rife
with mistakes due to the sheer volume of data transactions, keying errors, misidentification of
jobs, and the like. Problems can be resolved with a sufficient amount of error tracing by the
accounting staff, but there may be so many that there are not enough staff members to keep up
with them. Though these issues can to some degree be resolved through the use of computerized
data entry system outweighs the benefits to be gained from it. A final issue is that a large
proportion of the costs assigned to a job, frequently more 50%, comes from allocated overhead.
When there is no fully proven method for accurately allocating overhead, such as through
an activity based costing system the results of the allocation yield meaningless information. This
has been a particular problems for the companies that persist in allocating overhead costs based on
the direct labor used by each job, Since a small amount of labor is generally being used to allocate
a much larger amount of overhead, resulting in large shifts in overhead allocations based on small
amount of labor is generally being used to allocate a much larger amount of overhead, resulting in
large shifts in overhead allocations based on small changes in labor costs. Some companies avoid
this problem by ignoring overhead for job order costing purposes or by reducing overhead cost
pools to include only overhead directly traceable at the job level. In this way, many costs are not
allocated to jobs at all, but those that are allocated are fully justifiable.

Clearly, one must weigh the pros and cons of using a job order costing system to see if the benefits
outweigh the costs. This system is a complex one that is prone to error, but it does yield good
information about production-specific costs.

When Is Job-Order Costing Appropriate?

Job-order costing is a type of costing that can be used in many different industries, although not
all. Industries that sell items in batches will be able to use job-order costing most effectively. For
example, a T-shirt company that makes batches of T-shirts with company logos on them may use
job-order costing, each company they work for could be classified as an individual job. Job-order
costing would probably not be used in other industries such as general manufacturing, as products
may not be specialized and therefore would not be classified in batches.

Job Order Costing--Journal Entries, T Accounts, Income Statement

Hogle Company is a manufacturing firm that uses job order costing system. On January 1, the beginning of its
fiscal year, the company's inventory balances were as follows:

Raw materials $20,000

Work in process $15,000
Finished Goods $30,000

The company applies overhead cost to jobs on the basis of machine-hours worked. For the current year, the
company estimated that it would work 75,000 machine-hours and incur $450,000 in manufacturing overhead cost.
The following transactions were recorded for the year

1. Raw materials were purchased on account, $410,000.

2. Raw materials were requisitioned for use in production, $380,000 ($360,000 direct materials and $20,000
indirect materials).
3. The following costs were incurred for employee services: direct labor, $75,000; indirect labor, $110,000;
sales commission, $90,000; and administrative salaries, $20,000.
4. Sales travel costs were $17,000.
5. Utility costs in the factory were $43,000.
6. Advertising costs were $180,000.
7. Depreciation was recorded for the year, 350,000 (80% relates to factory operations, and 20% relates to
selling and administrative activities).
8. Insurance expired during the year, $10,000 (70% relates to factory operations, and 30% relates to selling
and administrative activities).
9. Manufacturing overhead was applied to production. Due to greater than expected demand for its
products, the company worked 80,000 machine-hours during the year.
10. Goods costing $9,00,000 to manufacture according to their job cost sheets were completed during the
year.
11. Goods were sold on account to customers during the year at a total selling price of $1,500,000. The
goods cost $870,000 to manufacture according to their job cost sheets.

Required:

1. Prepare journal entries to record the preceding transactions.

2. Post the entries in (1) above to T-accounts (don't forget to enter the beginning balances in the inventory
accounts).
3. Is manufacturing overhead underapplied or overapplied for the year? Prepare journal entry to close any
balance in the manufacturing overhead account to cost of goods sold (COGS). Do not allocate the
balance between ending inventories and cost of goods sold (COGS).
4. Prepare an income statement for the year.

Solution:
1: Journal Entries
1 Raw materials 410,000  
    Accounts payable   410,000
2 Work in process 360,000  
  Manufacturing overhead 20,000  
    Raw materials   380,000
3 Work in process 75,000  
  Manufacturing overhead 110,000  
  Sales commission expense 90,000  
  Administrative salaries expense 200,000  
    Salaries and wages payable   475,000
4 Sales travel expense 17,000  
    Accounts payable   17,000
5 Manufacturing overhead 43,000  
    Accounts payable   43,000
6 Advertising expense 180,000  
    Accounts payable   180,000
7 Manufacturing overhead 280,000  
  Depreciation expense 70,000  
    Accumulated depreciation   350,000
8 Manufacturing overhead 7,000  
  Insurance expense 3,000  
    Prepaid insurance   10,000
9* Work in process 480,000  
    Manufacturing overhead   480,000
10 Finished Goods 900,000  
    Work in process   900,000
11 Accounts Receivable 1,500,000  
    Sales   1,500,000
  Cost of goods sold 870,000  
    Finished goods   870,000

*The predetermined overhead rate for the year would be computed as follows:

Predetermined overhead rate = Estimated total manufacturing overhead cost / Estimated total units in the
allocation base

= $450,000 / 75,000 machine-hours

= $6 per machine-hour

Based on the 80,000 machine-hours actually worked during the year, the company would have applied $480,000
in overhead cost to production: 80,000 machine-hours × $6 per machine-hour = $480,000.

2: T Accounts

Accounts Receivable   Raw Materials   Work in Process

11      1,500,000   Bal.       20,000 (2)          380,000 Bal.     20,000 (10)    900,000
(1)        410,000 (2)     360,000
(3)       75,000
    Bal.       50,000 (9)     480,000  
 
Finished Goods Bal.      30,000  
Bal.       30,000 (11)        870,000
   
10        900,000
    Prepaid Insurance

(8)            10,000 Accumulated Depreciation

Accounts Payable   (7)      350,000
 
  (1)         410,000
(4)           17,000    
(5)           43,000    
(6)         180,000 Salaries and Wages Payable
(3)         475,000 Manufacturing Overhead
 
    (2)       20,000 (9)      480,000
(3)     110,000
Sales     (5)       43,000
(11)     1,500,000 (7)     280,000
  (8)         7,000
Cost of goods sold
(11)        870,000              460,000            480,000
   
      Bal.        20,000
Sales Commissions Expenses
(3)           90,000   Administrative Salary Expense
(3)         200,000    
 
    Insurance Expense
    (8)         3,000  
Advertising expense
(6)         180,000   Depreciation Expenses
(7)           70,000      
Sales Travel Expense
(4)       17,000  

3: Under or Overapplied manufacturing overhead:

Manufacturing overhead is overapplied for the year. The entry to close it out to cost of goods sold is as follows:

Manufacturing overhead 20,000

  Cost of goods sold   20,000

4: Income Statement

HOGLE COMPANY
Income Statement
For the Year Ended December 31
Sales   $1,500,000

Less cost of goods sold ($870,000 - $20,000 overapplied O/H   850,000

    --------------

Gross margin   650,000

Less selling and administrative expenses:    

     Commission expense $90,000  

     Administrative salaries expense 200,000  

     Sales travel expense 17,000  

     Advertising expense 180,000  

     Depreciation expense 70,000  

     Insurance expense 3,000 560,000

  ------------ -------------

Net operating income   $90,000

    ======

CASE STUDIES

Determination of Cost:
The presented of the Nola Cola Company has heard rumblings of dissatisfaction among board of
directors about the relatively low net earnings of the company. Several directors are not satisfied
with the accounting reports being issued.
They believe, it appears, that the shipping and delivery expenses are responsible, that advertising
is in line, and that administrative expenses, although possibly somewhat above normal, are not out
of control. Their primary criticism seems leveled at manufacturing costs.
Consequently, a meeting of the board of directors has been called in order to examine critically the
accounting system is use for determining manufacturing costs; that is, the cost of a Nola Cola
bottle ready for delivery as it comes from the last operation of the bottling process.
Sensing some of the problems involved, the president has adopted a recognized technique of
executive strategy. Before having the controller explain the accounting system in use, the
president has decided to ask for an opinion as to what item should be included in the proper
determination of the cost of a bottle of Nola Cola. For example, the president believes there is
mutual agreement that such items as syrup, water, carbonation, and bottle caps are properly part
of manufacturing costs.
Required: A list of other items that should be included, and to what extent.
Solution:
A number of specific items may be mentioned:

1. Direct labor cost.

2. Wear and breaking of bottles and cases.
3. A share of manufacturing expenses other than direct materials ad direct labor, i.e., factory
overhead.

As these specific items are mentioned, the discussion should be channeled into a consideration of
several "general" problems of cost accounting:

1. The problem of setting up an equitable and economical cost determination system.

2. The need for the system also to provide devices and information for control and decision-
making purposes.
3. The problem of measurement and assignment of overhead costs to work completed.
4. The fact that cost figures are, at best, estimates. Yet, although we may never know what
the exact cost is, we can obtain useful information at a reasonable price.

Improving a Cost Information and Accumulation System:

An examination of costing methods and procedures in the Franklin Printing Company reveals the
following:
 1. Costing formulas and ratios prepared a long time ago are still being used by estimators
even though prices for materials have increased, overhead is higher, and new machinery
has been installed.
2. An estimator in the production department and a cost clerk  in the cost department prepare
estimates independently from one another, resulting in widely divergent cost figures.
3. A profit per individual job or order can never be determined.
4. Each job or order is sold with a definite markup. Yet, instead of a profit of $100,000 as the
president hopped for, the chief accountant prepared an income statement showing only a
$48,000 profit.
5. Determining departmental efficiency and control over expenses is not possible.

Required: A statement outlining:

                A. Possible causes of the existing conditions.

                B. Possible steps to remedy the situation.

Solution:
A. Possible causes of the existing conditions:

1. The printing industry makes use of predetermined rates and pricing tables. At times
advancement of materials labor costs is not incorporated quickly enough. The installation of
new machinery requires individual attention to the cost situation.
2. This situation is unusual. estimator, in many firms, operates with future costs and prices
while the cost department bases its calculations on present or experienced costs. Often the
situation is particularly critical with regard to the overhead rates used by the two parties.
3. This situation is also typical of the printing industry. Generally, a printer has many jobs:
some require only a very short time, others continue over several weeks. Cost
determination becomes a job of averaging costs over the time. Therefore, an individual
profit per job can rarely be calculated on the basis of the books and records.
4. This result can be traced to the fact that cost estimates are based on erroneous and
outdated costs and percentages. It could also be caused by a steady increase of fixed costs
that consume the imaginary profit calculated in the estimates. Overhead rates might be out
of line with actual experience.
5. The company's management might never have considered the delegation of authority and
responsibility to supervisors. With costs so for out of line it may be that no manager has
been asked to contribute ideas and prepare cost estimates for a better performance in his or
her department.

B. Possible steps to remedy the situation:

1. Check industry rates and prices with company's costs. Revise and keep up to date, so that
estimates can be based on realistic figures.
2. Let estimator prepare bids and estimates, but costs and prices used should be set in
collaboration with the cost department. Differences should be explainable and, if possible,
brought into agreement.
3. The determination of profit per job or order depends greatly upon the revisions suggested in
(1) and (2). Also, a job order cost accumulation of actual costs may be practical. Many
factors might still prevent a completely accurate profit determination; however, basing the
estimates on realistic data and company overhead rates and modifying these estimates as
circumstances change will result in a more satisfactory job cost and profit picture.
4. Here, too, rates and costs must be examined in the light of present conditions. It is
important to examine fixed costs that have entered into the cost situation unnoticed. The
 preparation of a budget with a continuous reporting scheme would assist in avoiding the
difficulty of this unpleasant report regarding the final profit.
5. The steps needed in (4) are also part of this answer. Departmental budgets will permit (1)
the calculation of overhead rates and (2) a close watch over actual expenses by supervisors.
Weekly or monthly reports will assist the supervisors in keeping the costs within the budget
limits; that is, within the predetermined profit range.

Installing a Cost Information and Accumulation System:

A textile manufacturer asks advice concerning the installation of a cost system. The manufacturer explains
briefly that many different cloths are produced, starting with scoured wool that passes through the following
processing before becoming finished cloth: picking and blending, carding, spinning, weaving, finishing, and
dyeing. The company's sales representatives take orders considerably  in advice of the actual production of the
cloth, using samples produced during a special period set aside each season for the manufacture of samples.
Competition is keen and the profit margin is low. The financing is received through bank loans.
Required:

1. The principle advantages of installing a cost system.

2. The principle additions or alterations necessary to operate a cost system. (The present
accounting system is designated for the purpose preparing annual financial statements.)
3. An explanation of how matters can be arranged in order to find the cost of the principle
stages of manufacture, such as carding, spinning, weaving, etc. (The carding machines
operate three shifts per day; the spinning machines, two shifts; and the weaving machines,
one shift.)

Solution :

A: The principle advantages of installing a cost system are:

1. The ascertainment of unit costs of the various products. Unit costs are variable in
determining minimum sales prices and in eliminating unprofitable lines.
2. Improvement in efficiency by comparison of cost details at regular intervals.
3. More adequate information, which is available for inventory costing.
4. Establishing control over production

B: To operate a cost system, it would be necessary to amplify the accounting procedure by
providing for:

1. More detailed analysis of disbursements.

2. Perpetual inventory records.
3. Monthly accumulation of detailed figures relating to costs of each operation and product.

C: Divide the factory into departments for cost accumulating purposes corresponding to the       natural
divisions, such as Carding Department, Spring Department, and Weaving Department.     Break down the
analysis of factory overhead according to these department departments. This automatically takes care of the
differences in operating shifts.
Designing Cost Accumulation Procedures:
A client has asked advice as to a satisfactory system of factory costs for a factory that is divided into two main
divisions:
 1. Machine Shop: This division makes steel molds used in the manufacture to plastic articles.
These molds require careful precision work; and frequently, one person is employed at
machining one mold for several weeks. The finished molds are used by the Plastic Division
of the company. In addition, some other machine work is done for customers, although this
forms the smaller portion of the shop's output.
2. Plastic Division: This division manufactures plastic articles including ash trays, buttons,
knobs, etc. The process of manufacture consists of placing chemical powders in a mold,
which is then placed under a steam press where pressure is applied for a few minutes. The
chemical powders are the only materials used and are not processed before being placed in
the mold. After being processed, a certain amount of finishing and inspection labor is
necessary to complete the articles.

It is ascertained that:

 The company has had no previous cost records.

 Production in both divisions is controlled by job order tickets.
 Materials are kept in one place, but no record has been kept of withdrawals.
 Labor is paid at hourly rates, and a time clock at the factory entrance is used for
determining the hours worked in any day.
 Employees have been preparing satisfactory time tickets showing the hours worked on each
job and, in the case of the plastics division, the number of units produced; but this record
has never been balanced against the wages paid nor the record of production.
 Spoilage is a substantial factor in both divisions.
 The machine shop and the plastic division are in separate parts of the one building.
 The company has a satisfactory system of general ledger accounting.

Required: A method or methods for obtaining factory costs, explaining why they are considered the most
satisfactory under the circumstances.
Solution:
Regardless of what cost system is installed, three changes should be made in the company's methods:
 A control should be established over materials. Requisitions should be used.
 Factory overhead should be segregated between the two divisions. Direct departmental
charges should be made as much as possible. Common costs should be apportioned to each
department on an equitable basis.
 Clock cards should be balanced  with employees' time sheets.
If these matters are resolved satisfactorily, the costs might be obtained as follows:
Machine Shop. The product seems to be custom item so that job costing seems appropriate.
Overhead should be charged to the product on some predetermined basis.
Plastic Division. It seems that job order costing system is also possible here. The overhead might
be charged to the product  on different bases if the machine used would suggest different rates.
This might make possible the creation of cost centers.
General. Any cost system should permit comparison with estimated figures