Chapter 5. Job-Order Costing, Part 1

Chapter 5: Job-Order Costing Learning Objectives 1. Describe the differences between job-order costing and process costing, and identify the types of firms that would use each method. 2. Compute the predetermined overhead rate, and use the rate to assign overhead to units or services produced. 3. Identify and set up the source documents used in job-order costing. 4. Describe the cost flows associated with job-order costing. 5. (Appendix 5A) Prepare the journal entries associated with job-order costing. 6. (Appendix 5B) Allocate support department costs to producing departments. 1 The Differences Between Job-Order and Process Costing ►Companies can be divided into two major types. 1. Those firms producing similar products or services can use a process-costing accounting system. 2. On the other hand, if a company’s products/ services are unique, they require a job-order accounting system. 1 Characteristics of the Job-Order Environment ►Customized or built-to-order products fit into this category, as do services that vary from customer to customer. ►A job is one distinct unit or set of units. ►Common job-order processes include: printing, construction, furniture making, medical and dental services, automobile repair, beautician services ►For job-order production systems, costs are accumulated by job. ►This approach to assigning costs is called a job-order costing system. 1 Process Production and Costing ► Firms in process industries mass-produce large quantities of similar or homogeneous products. This approach to cost accumulation is known as a process-costing system. Examples of process manufacturers include: ►Food canning and manufacturing ►Cement ►Petroleum ►Pharmaceutical and chemical manufacturing ► Process firms accumulate production costs by process or by department for a given period of time. The output for the process for that period of time is measured. ► Unit costs are measured using the following equation: Unit costs = Process Costs ÷ Output The Differences Between 1 Job-Order and Process Costing 2 Normal Costing and Overhead Application ► Unit costs are very important because managers need accurate cost information on materials, labor, and overhead when making decisions. ► For example, when a construction company bills a client at set points throughout the construction, it is important that unit cost be generated in a timely manner. ► Job-order costing using a normal cost system will give the company the unit cost information it needs. 2 Actual Costing ► Two ways are commonly used to measure the costs associated with production: actual costing and normal costing. ► In an actual cost system, only actual costs of direct materials, direct labor, and overhead are used to determine unit cost. ► However, there are several issues involved in using actual costing. ► Defining Overhead Costs: Overhead items do not have the direct relationship with units produced that direct materials and direct labor do. ► Uneven Overhead Costs: Many overhead costs are not incurred uniformly throughout the year. However, waiting until the end of the year to total the actual overhead costs is typically unrealistic. ► Uneven Production: Distortions can occur if when averages are used with uneven production. Strict actual cost systems are rarely used because accurate day-to-day unit cost information is needed on a timely basis. 2 Normal Costing ► Normal costing solves the problems associated with actual costing. ► A normal cost system determines unit cost by adding actual direct materials, actual direct labor, and estimated overhead. ► Overhead can be estimated by approximating the year’s actual overhead at the beginning of the year and then using a predetermined rate throughout the year to obtain the needed unit cost information. ► Virtually all firms use normal costing. 2 Importance of Unit Costs to Manufacturing Firms ► Unit cost is a critical piece of information for a manufacturer. ► Unit costs are essential for valuing inventory, determining income, and making numerous important decisions. ► Disclosing the cost of inventories and determining income are financial reporting requirements that a firm faces at the end of each period. ► In order to report the cost of its inventories, a firm must know the number of units on hand and the unit cost. ► The cost of goods sold (COGS), used to determine income, requires knowledge of the units sold and their unit cost. ► Full cost information is useful as an input for a number of important internal decisions as well as for financial reporting. ► In the long run, for any product to be viable, its price must cover its full cost. 2 Importance of Unit Costs to Service Firms ► Service and nonprofit firms also require unit cost information. ► Conceptually, the way companies accumulate and assign costs is the same whether or not the firm is a manufacturer. ► The service firm must first identify the service ‘‘unit’’ being provided. ► For example, a hospital would accumulate costs by patient, patient day, and type of procedure. ► Because service firms do not produce physical products, they do not need to value work-in-process and finished goods inventories. 2 Ethical Decisions ► Nonprofit firms must track costs to be sure that they provide their services in a cost-efficient way. ► Governmental agencies must track costs to use the funds wisely because they have a fiduciary responsibility to taxpayers. ► A cost accounting system that measures and assigns costs so that the unit cost of a product or service can be determined which is a critical piece of information for both manufacturing and service firms. ► In addition, an important part of bidding and charging for services under Medicaid rules impacts government agencies and is commonly tied to the critical determination of unit cost. 2 Normal Costing and Estimating Overhead ►In normal costing, overhead is estimated and applied to production. The basics of overhead application can be described in three steps: ►Step 1: Calculate the predetermined overhead rate ►Step 2: Apply overhead to production throughout the year ►Step 3: Reconcile the difference between the total actual overhead incurred during the year and the total overhead applied to production. Step 1: Calculating the 2 Predetermined Overhead Rate ► The predetermined overhead rate is calculated at the beginning of the year by dividing the total estimated annual overhead by the total estimated level of associated activity or cost driver: Overhead Rate = Estimated Annual Overhead ÷ Estimated annual activity level ► Notice that the predetermined overhead rate includes estimated amounts in both the numerator and the denominator. ► This estimation is necessary because the predetermined overhead rate is calculated in advance, usually at the beginning of the year. ► Estimated overhead is the firm’s best estimate of the amount of overhead (utilities, indirect labor, depreciation, etc.) to be incurred in the coming year. The number of machine hours could be a good choice of activity level for overhead of a company that has automated production. ► Estimates may be based on last year’s figures adjusted for anticipated changes in the coming year. Step 2: Applying Overhead to 2 Production Throughout the Year ► Once the overhead rate has been computed, the company can begin to apply overhead to production. ► Applied overhead is found by multiplying the predetermined overhead rate by the actual use of the associated activity for the period: Applied overhead = Predetermined overhead rate x Actual activity level ► Once this is calculated, the total cost of product for the period is the actual direct materials and direct labor, plus the applied overhead: Total costs = Actual direct materials + Actual direct labor + Applied overhead 2 Cornerstone 5-1 Calculating The Predetermined Overhead Rate and Applying Overhead to Production Step 3: Reconciling Actual Overhead 2 with Applied Overhead ► Remember that two types of overhead are recorded: ►Actual overhead: Costs are tracked throughout the year in the overhead account. ►Applied overhead: Costs are computed throughout the year and added to actual direct materials and actual direct labor to get total product cost. ► At the end of the year, however, it is time to reconcile any difference between actual and applied overhead and to correct the cost of goods sold account to reflect actual overhead spending. ► Applied overhead will rarely equal actual overhead. Step 3: Reconciling Actual Overhead 2 with Applied Overhead (continued) ► The difference between actual overhead and applied overhead is called an overhead variance. ► If actual overhead is $400,000 for the year but $390,000 was applied to production, we would say that the variance is underapplied overhead. ► If actual overhead is $400,000 for the year but $410,000 was applied to production, we would say that the variance is overapplied overhead. ► If overhead has been underapplied, then product cost has been understated. ► If overhead has been overapplied, then product cost has been overstated. Step 3: Reconciling Actual Overhead 2 with Applied Overhead (continued) ►Something must be done with the overhead variance at year-end to report costs at actual amounts on the financial statements. ►Generally, the entire overhead variance is assigned to Cost of Goods Sold, since the amount is usually small or immaterial. ►Underapplied overhead is added to Cost of Goods Sold. ►Overapplied overhead is subtracted from Cost of Goods Sold. ►If the overhead variance is material, or large, another approach would be taken. That approach is, to allocate the variance among the ending balances of Work in Process, Finished Goods, and Cost of Goods Sold.