Systems Design: Job-Order Costing Chapter 5 Systems Design: Job-Order Costing Chapter 5: Systems Design: Job-Order Costing Managers need to assign costs to products to facilitate external financial reporting and internal decision making. This chapter illustrates an absorption costing approach (also called a full cost approach) to calculating product costs known as job-order costing. Two costing systems are commonly used in manufacturing and many service companies; these two systems are known as process costing and job-order costing. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Types of Product Costing Systems Process Costing Job-order Costing A company produces many units of a single product. One unit of product is indistinguishable from other units of product. The identical nature of each unit of product enables assigning the same average cost per unit. A process costing system is used when:   A company produces many units of a single product. One unit of product is indistinguishable from other units of product. The identical nature of each unit of product enables assigning the same average cost per unit.

Types of Product Costing Systems Process Costing Job-order Costing Many different products are produced each period. Products are manufactured to order. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job. A job-order costing system is used when: Many different products are produced each period. Products are manufactured to order. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job.

Comparing Process and Job-Order Costing This table presents an overview of the differences between a job-order and process costing system. Note that: With job-order costing, many jobs are worked on during the period; with process costing, a single product is produced for a long period of time. With job-order costing, costs are accumulated by individual jobs; with process costing, costs are accumulated by departments. With job-order costing, average unit costs are computed by job; with process costing, average unit costs are computed for a particular operation or by department.

Job-Order Costing – An Overview Charge direct material and direct labor costs to each job as work is performed. Direct Materials Job No. 1 Direct Labor Job No. 2 In a job-order costing system, direct materials and direct labor are traced directly to each job as the work is performed. Manufacturing Overhead Job No. 3

Job-Order Costing – An Overview Manufacturing Overhead, including indirect materials and indirect labor, are allocated to all jobs rather than directly traced to each job. Direct Materials Job No. 1 Direct Labor Job No. 2 Manufacturing overhead (including indirect materials and indirect labor) represents other manufacturing costs like the power used to run the machinery in the factory. Manufacturing overhead cannot be traced directly to specific jobs. Rather, it is allocated to jobs on the basis of a predetermined rate. Manufacturing Overhead Job No. 3

Why Use an Allocation Base? Manufacturing overhead is applied to jobs that are in process. An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual jobs. We use an allocation base because: It is impossible or difficult to trace overhead costs to particular jobs. Manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager’s salary. Many types of manufacturing overhead costs are fixed even though output fluctuates during the period. Part I An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to apply manufacturing overhead to products. Part II Allocation bases are used because: It is impossible or difficult to trace these costs to particular jobs (i.e., manufacturing overhead is an indirect cost). Manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager’s salary. Many types of manufacturing overhead costs are fixed even though output may fluctuate during the year.

Application of Manufacturing Overhead The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period begins. Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period POHR = To facilitate the allocation of manufacturing overhead to each job, we calculate a predetermined overhead rate before the period begins. The predetermined overhead rate is calculated by dividing the estimated amount of manufacturing overhead for the coming period by the estimated quantity of the allocation base for the coming period. Ideally, the allocation base chosen should be the cost driver of overhead cost. Ideally, the allocation base is a cost driver that causes overhead.

Application of Manufacturing Overhead Predetermined overhead rates are calculated using a three-step process.  Estimate the level of production for the period.  Estimate the total amount of the allocation base in the denominator that would be required for that level of production. Predetermined overhead rates are calculated using a three-step process. (1)  The first step is to estimate the level of production for the period.          (2) The second step is to estimate the total amount of the allocation base in the denominator that would be required for that level of production.        (3) The third step is to estimate the total manufacturing overhead cost in the numerator that would be incurred for the estimated amount of the allocation base.  Estimate the total manufacturing overhead cost in the numerator that would be incurred for the estimated amount of the allocation base.

Application of Manufacturing Overhead The predetermined overhead rate (POHR) is based on estimates and determined before the period begins. Overhead applied = POHR × Actual activity Manufacturing overhead is applied to jobs using the predetermined overhead rate multiplied by the actual amount of the allocation base used completing the job (this is called a normal costing system). Actual amount of the allocation is based upon the actual level of activity.

Job-Order Costing Document Flow Summary Materials used may be either direct or indirect. Direct materials Job Cost Sheets Materials Requisition A materials requisition is used to draw direct and indirect materials from the storeroom. Direct material costs are charged to specific jobs. Indirect material costs are included in manufacturing overhead. Indirect materials Manufacturing Overhead Account

Job-Order Costing Document Flow Summary An employee’s time may be either direct or indirect. Direct Labor Job Cost Sheets Employee Time Ticket Employee time tickets are used to quantify direct and indirect labor costs. Direct labor costs are charged to specific jobs. Indirect labor costs are included in manufacturing overhead. Indirect Labor Manufacturing Overhead Account

Job-Order Costing Document Flow Summary Employee Time Ticket Indirect Labor Other Actual Overhead Charges Manufacturing Overhead Account Applied Overhead Job Cost Sheets Indirect materials and indirect labor are parts of manufacturing overhead. Other overhead costs are charged to the manufacturing overhead account as incurred. The predetermined overhead rate is used to apply manufacturing overhead costs to jobs. Indirect Material Materials Requisition

Underapplied or Overapplied Overhead The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is referred to as either underapplied or overapplied overhead. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period. The difference between the manufacturing overhead cost applied to jobs and the actual manufacturing overhead costs of a period is called either underapplied or overapplied overhead. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period.

Disposition of Under- or Overapplied Overhead We will always assume that underapplied or overapplied overhead is closed out to Cost of Goods Sold. We will always assume that underapplied or overapplied overhead is closed out to Cost of Goods Sold. Overapplied overhead is deducted from Cost of Goods Sold. Underapplied overhead is added to Cost of Goods Sold. Overapplied overhead is deducted from Cost of Goods Sold. Underapplied overhead is added to Cost of Goods Sold.

Predetermined Overhead Rate and Capacity Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has been criticized because: Basing the predetermined overhead rate upon budgeted activity results in product costs that fluctuate depending upon the activity level. Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use. There are two major criticisms of calculating the predetermined overhead rate based on estimated amounts: Basing the predetermined overhead rate on budgeted activity results in product costs that fluctuate depending on the activity level. Calculating predetermined rates based on budgeted activity charges products for costs that they do not use.

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