JOB ORDER COST SYSTEMS AND OVERHEAD ALLOCATIONS Chapter 17 JOB ORDER COST SYSTEMS AND OVERHEAD ALLOCATIONS Chapter 17: Job Order cost Systems and Overhead Allocations

To explain the purposes of cost accounting systems. Learning Objective To explain the purposes of cost accounting systems. Learning objective number 1 is to explain the purposes of cost accounting systems. LO1

Cost Accounting Systems Determining unit manufacturing costs Planning and control functions Cost accounting systems provide information supporting decisions making the business successful A cost accounting system is designed to provide information to managers to assist them in making decisions. A cost system shows us how to determine the cost to produce our products. It helps us schedule and plan production and meet customer expectations. A quality cost accounting system is important to the long-run success of any company. Assessing the efficiency and effectiveness of operations Providing products or services to customers

Cost Accounting Systems Evaluate and reward employee performance Disclose inventories and cost of goods sold Cost accounting systems are the procedures and techniques used by management All managers are faced with the problem of scarce resources. Cost accounting helps managers deal with the use of these scarce resources. We also use information from our cost accounting system as part of the input in evaluating employee effectiveness. Manage activities that consume resources Track resources consumed by products and services

Learning Objective To identify the processes for creating goods and services that are suited to job order costing. Learning objective number 2 is to identify the processes for creating goods and services that are suited to job order costing. LO2

Job Order Costing Used for production of large, unique, high-cost items. Built to order rather than mass produced. Many costs can be directly traced to each job. Typical job order cost applications: Special-order printing Building construction Also used in service industry Hospitals Law firms Job order costing is typically used by manufacturers of custom products or providers of custom services. The jobs must be large enough in scope and value to justify the accounting effort to trace costs to the jobs.

Receive orders from customers Job Order Costing Receive orders from customers Begin production Schedule jobs The initial event in a job order system is receipt of a customer order. The job is then scheduled, necessary materials are obtained, and the work begins. Order materials

Job Order Costing THE JOB Manufacturing overhead (OH) Applied to each job using a predetermined rate (POHR) Direct materials Traced directly to each job THE JOB All manufacturing costs, direct labor, direct materials, and manufacturing overhead are accumulated by the job. These costs are placed in the work in process inventory. Traced directly to each job Direct labor

Manufacturing Overhead Job Order Costing Charge direct material and direct labor costs to each job as work is performed. Direct Materials Job No. 1 Direct Labor Job No. 2 Direct materials and direct labor are traced to jobs and accumulated in the work in process inventory. Manufacturing Overhead Job No. 3

Job Order Costing Direct Materials Apply overhead to each job using a predeter-mined rate. Job No. 1 Direct Labor Job No. 2 Indirect materials and indirect labor flow through the manufacturing overhead account into the work in process inventory account. Manufacturing Overhead Job No. 3

Learning Objective To explain the purpose and computation of overhead application rates for job order costing. Learning objective number 3 is to explain the purpose and computation of overhead application rates for job order costing. LO3

Overhead Application Rates 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 activity base for the coming period POHR = The term “predetermined” means that the overhead rate is computed before the operating period begins. Overhead costs and labor costs are estimated for the coming period as a part of the company’s budgeting process. The activity chosen for the denominator is known as an allocation base. Ideally, the activity base is a cost driver that causes overhead.

Overhead Application Rates Using a predetermined rate makes it possible to estimate total job costs sooner. Actual overhead for the period is not known until the end of the period. $ We must use a predetermined overhead rate because we will not know our actual overhead costs until the end of the period. Goods that are produced and sold during the period must contain an element of overhead. To make sure current production receives it share of overhead costs, we use a predetermined rate based of informed estimates.

Overhead Application Rates Based on estimates, and determined before the period begins. Overhead applied = POHR × Actual activity Overhead is applied to individual jobs based on the actual level of activity during the period. For example, we may use a predetermined overhead rate based upon the number of direct labor hours required to produce the product. We apply the overhead by multiplying the predetermined overhead rate times the number of actual direct labor hours worked on the job. Let’s look at a specific example of calculating a predetermined overhead rate. Actual amount of the cost driver such as units produced, direct labor hours, or machine hours incurred during the period.

Overhead Application Rates Compuline, Inc., applies overhead based on direct labor hours. Total estimated overhead for the year is $360,000. Total estimated labor hours are 30,000. What is Compuline’s predetermined overhead rate per hour? Compuline applies overhead based on direct labor hours. At the beginning of the current period, the company estimates it will incur three hundred sixty thousand dollars and will need an estimated thirty thousand direct labor hours. Can you determine the company’s predetermined overhead rate?

Overhead Application Rates Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period POHR = POHR = $12.00 per DLH $360,000 30,000 direct labor hours (DLH) POHR = Part I Here is the equation we use to calculate the predetermined overhead rate. Part II The rate for Compuline is twelve dollars per direct labor hour. Part III For each direct hour worked on any particular job, twelve dollars of overhead will be applied. For each direct labor hour worked on a job, $12.00 of manufacturing overhead will be applied to the job.

To describe the purpose and the content of a job cost sheet. Learning Objective To describe the purpose and the content of a job cost sheet. Learning objective number 4 is to describe the purpose and the content of a job cost sheet. LO4

Job Order Costing The primary document for tracking the costs associated with a given job is the job cost sheet. A job cost sheet is used to account for material, labor, and factory overhead costs for each job. The job cost sheet may be a paper record, but most likely it is a computerized file. Let’s investigate

The Job Cost Sheet Here’s an example of a job cost sheet showing the type of product, number of units, job number and relevant dates, along with material, labor, and overhead costs for the job.

The Job Cost Sheet A materials requisition form is used to authorize the use of materials on a job. Materials cost entered on the job cost sheet may be summarized from a materials requisition form.

The Job Cost Sheet Accumulate direct labor costs by means of a work record, such as a time ticket, for each employee. Labor cost entered on the job cost sheet is summarized from an employee’s time ticket.

The Job Cost Sheet Apply manufacturing overhead to jobs using a predetermined overhead rate (POHR) based on direct labor cost. Oak and Glass Furniture Company assigns overhead to jobs using a predetermined overhead rate of 150 percent of direct labor cost.

Job Order Costing Document Flow Summary The materials requisition indicates the cost of direct material to charge to jobs and the cost of indirect material to charge to overhead. Direct Labor Job Cost Sheets Job Cost Sheets Job Cost Sheets Job Cost Sheets Employee Time Ticket Employee Time Ticket Employee Time Ticket Employee Time Ticket When materials are needed for a job, the production manager prepares a materials requisition form and sends it to the materials manager. The materials manager will not release materials from the materials storage facility without this authorization. Direct materials are assigned to the particular job and indirect materials are accumulated in the manufacturing overhead account. These indirect material costs are actual “overhead” incurred during the period. Manufacturing Overhead Account Indirect Labor

Job Order Costing Document Flow Summary Direct Labor Employee time tickets indicate the cost of direct labor to charge to jobs and the cost of indirect labor to charge to overhead. Job Cost Sheets Job Cost Sheets Job Cost Sheets Job Cost Sheets Employee Time Ticket Employee Time Ticket Employee Time Ticket Employee Time Ticket Production managers use employee time tickets to assign labor costs to individual jobs. In addition to the proper signature authorizing the labor cost assignment, the time ticket includes labor time, rate, job number, date, and employee identification. Labor time tickets are the source documents supporting the payroll accounting entries. Indirect labor costs are accumulated in the manufacturing overhead account. Manufacturing Overhead Account Indirect Labor

Job Order Costing Document Flow Summary Employee Time Ticket Indirect Labor Overhead Applied with POHR Other Actual OH Charges Manufacturing Overhead Account Job Cost Sheets In addition to indirect labor and indirect materials, Rose Company will incur other actual overhead costs, like factory utilities. These additional costs will be assigned to the manufacturing overhead account. As we have seen, overhead is applied to specific jobs on the basis of direct labor hours worked. Materials Requisition Indirect Material

To account for the flow of costs when using job order costing. Learning Objective To account for the flow of costs when using job order costing. Learning objective number 5 is to account for the flow of costs when using job order costing. LO5

Flow of Costs in Job Costing Let’s examine the cost flows in a job order costing system. We will use T-accounts and start with materials. T-accounts for a job order system are helpful in visualizing the cost flows.

Flow of Costs in Job Costing Work in Process (Job Cost Sheet) Materials Inventory Direct Material Direct Material Material Purchases Indirect Material Material purchases are entered as debits (left side) in the materials inventory account. A credit entry (right side) in the materials inventory account is recorded when material is withdrawn. Direct materials usage is recorded in the work in process inventory account and on the job cost sheet for an individual job. Indirect material usage is recorded in the manufacturing overhead account. Mfg. Overhead Indirect Material

Flow of Costs in Job Costing Next let’s add labor costs and applied manufacturing overhead to the job order cost flows. Are you with me? Direct labor and applied factory overhead are the remaining product costs that we must record.

Flow of Costs in Job Costing Work in Process (Job Cost Sheet) Labor Direct Labor Direct Material Indirect Labor Direct Labor Overhead Applied Mfg. Overhead Part I Direct labor cost is recorded in the work in process inventory account and on the job cost sheet for each individual job. Indirect labor cost is recorded in the manufacturing overhead account. Manufacturing overhead is applied to jobs in the work in process inventory account using a predetermined overhead rate. Because of the estimating process used in calculating the predetermined overhead rate, the amount of overhead assigned to all jobs in an operating period may differ from the actual overhead costs incurred in the same period. Part II It is not likely that actual manufacturing overhead will exactly equal the overhead applied during the period. When a difference exists, we close the amount to Cost of Goods Sold at the end of the period. the difference is closed to cost of goods sold. When Actual Applied factory factory overhead overhead = / Indirect Material Overhead Applied to Work in Process Indirect Labor

Over- or Underapplied Overhead The end-of-period adjustment for under-applied overhead increases cost of goods sold. The end-of-period adjustment for over-applied overhead decreases cost of goods sold.

Flow of Costs in Job Costing Now let’s complete the goods and sell them. Still with me? Once we have combined the proper amount of direct labor and factory overhead to convert material into a finished product, we will move the product out of the factory and prepare it for sale.

Flow of Costs in Job Costing Work in Process (Job Cost Sheet) Finished Goods Direct Material Cost of Goods Mfd. Cost of Goods Mfd. Cost of Goods Sold Direct Labor Overhead Applied Direct material, direct labor, and manufacturing overhead are combined in work in process. As jobs are completed, they are transferred to finished goods and then sold (delivered to customers). The dollar amount of the transfer from the work in process inventory account to the finished goods inventory account is called cost of goods manufactured. Cost of Goods Sold Cost of Goods Sold

Learning Objective To define overhead-related activity cost pools and provide several examples. Learning objective number 6 is to define overhead-related activity cost pools and provide several examples. LO6

Activity-Based Costing (ABC) One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job. Assigning overhead is difficult. I agree! In an activity based costing system, or ABC system, a company uses a number of allocation bases for assigning costs to products. Each allocation base represents a major activity that the company believes causes overhead costs to be incurred. An ABC system is designed to help more clearly determine the overhead costs we assign to each job or process.

Activity-Based Costing (ABC) Departmental Overhead Rates In the process of allocating overhead to products, we’ve discussed the use of single plant-wide overhead rates and departmental rates, and now we’re going to take a detailed look at ABC. You can see that the level of complexity is much higher with activity based costing than with either of the other systems. Level of Complexity Plantwide Overhead Rate Overhead Allocation

Activity-Based Costing (ABC) In the ABC method, we recognize that many activities within a department drive overhead costs. A B C It is important to remember that in an ABC costing system we recognize the fact that many activities within a department can drive overhead costs.

Activity-Based Costing (ABC) Identify activity cost pools and assign indirect costs to those pools. Central idea . . . Products require activities. Activities consume resources. A B C The key concept of any ABC system is that production requires activities and those activities consume resources. We need an accurate method of assigning overhead costs to our products.

The Benefits of ABC More detailed measures of costs. Better understanding of activities. More accurate product costs for . . . Pricing decisions. Product elimination decisions. Managing activities that cause costs. Benefits should always be compared to costs of implementation. Implementing an ABC system can be very expensive. It is important that the benefits derived from better cost allocation exceed the cost of implementing and maintaining the system. At its core, an ABC system is designed to provide better product cost data. This improved data helps a company set prices, react to competitors, and manage its own costs.

Identifying Cost Drivers Most cost drivers are related to either volume or complexity of production. Examples: machine time, machine setups, purchase orders, production orders. Three factors are considered in choosing a cost driver: Causal relationship. Benefits received. Reasonableness. The first step is identifying and defining activities and cost drivers. We should consider three factors when selecting a cost driver. First, there must be a causal relationship. The overhead costs must be driven by the cost driver. Second, the benefits received from added an additional cost driver must outweigh the costs of using the driver. Finally, it must be reasonable to assume that the cost driver will be significant in the future.

Activity-Based Costing Procedures Identify activities that consume resources. Assign costs to a cost pool for each activity. Identify cost drivers associated with each activity. Compute overhead rate for each cost pool: Assign costs to products: Rate = Estimated overhead costs in activity cost pool Estimated number of activity units We begin the development of our ABC system by identifying activities that consume resources. Next, we assign the costs to a cost pool for each activity identified. Then we determine the association between the cost driver and the activity. Now we compute the overhead rate for each activity. This predetermined rate of each activity is calculated in the same way we used for a single overhead rate. Finally, we assign overhead costs to products based on the actual level of activity. Overhead Actual Rate Activity ×

Learning Objective To demonstrate how activity bases are used to assign activity cost pools to units produced. Learning objective number 7 is to demonstrate how activity bases are used to assign activity cost pools to units produced. LO7

Traditional Costing vs. ABC Example Pear Company manufactures a product in regular and deluxe models. Overhead is assigned on the basis of direct labor hours. Budgeted overhead for the current year is $2,000,000. Other information: Pear Company produces two products, a regular and deluxe model. Estimated overhead for the coming period is $2,000,000. Information about material costs, direct labor costs and time to produce one unit of each model are shown in the table. Pear Company expects to produce 5,000 deluxe models and 40,000 regular models during the period. Let’s begin by applying overhead using a traditional costing system. First, determine the unit cost of each model using traditional costing methods.

Traditional Costing Overhead Estimated overhead costs = Part I Based on projected production and time required to manufacture one unit of each model, Pear Company determines that 40,000 direct labor hours are needed to complete the production. The company uses direct labor hours as the basis for allocating overhead costs to products. Part II Using our predetermined overhead rate equation, Pear Company determines that overhead will be applied at the rate of $50 per direct labor hour worked. Overhead Estimated overhead costs Rate Estimated activity = Overhead $2,000,000 Rate 40,000 DLH = $50 per DLH

ABC will have different overhead per unit. Traditional Costing ABC will have different overhead per unit. Part I It takes 1.6 direct labor hours to manufacture one unit of the deluxe model. At $50 per direct labor hour, $80 of overhead will be assigned to each deluxe model. It requires less labor to produce the regular model, so $40 of overhead will be assigned to each unit produced. Part II Under an ABC system we will arrive at different overhead rates for the two models.

Activity-Based Costing Pear Company plans to adopt activity-based costing. Using the following activity center data, determine the unit cost of the two products using activity-based costing. Pear Company has adopted an activity-based costing system. The ABC team identified four activity cost pools: purchasing, scrap rework, testing, and machine related. The team has placed the $2,000,000 estimated overhead cost into the appropriate activity cost pools. The cost driver for purchasing and scrap rework is the number of orders filled. The cost driver for testing activities is the number of tests conducted. The machine related activity cost driver is the number of machine hours operated. Members of the team have determined that there will be 400 purchase orders issued for the deluxe model and 800 for the regular model. You can see the distribution of cost driver activities between the deluxe and regular models. Let’s calculate the proper overhead rates.

Activity-Based Costing A combined total of 1,200 purchase orders will be issued for the deluxe and regular models. We have combined the totals for scrap rework, testing and machine related activities. 400 deluxe + 800 regular = 1,200 total

Activity-Based Costing The overhead rate for purchasing is $70 per order. We arrive at this amount by dividing the cost pool overhead cost of $84,000 by the total number of purchase orders, 1,200. We complete the same math for the remaining activities.

Activity-Based Costing At $70 per order, how much overhead will be charged to the deluxe and regular models? See if you can calculate these amounts before going to the next screen.

Activity-Based Costing How did you do? The cost allocated to the deluxe model is $28,000, and $56,000 will be allocated to the regular model. Try to complete the schedule before moving on. Let’s complete the table.

Activity-Based Costing We can see that a total of $720,000 of overhead will be allocated to the deluxe model and $1,280,000 will be allocated to the regular model.

Activity-Based Costing Total overhead = $720,000 + $1,280,000 = $2,000,000 Recall that $2,000,000 was the original amount of overhead assigned to the products using traditional overhead costing. The total overhead allocated is equal to our estimate of $2,000,000.

Activity-Based Costing Part I With $720,000 of overhead allocated to the deluxe model and estimated production of 5,000 units, the overhead per unit is $144. The overhead allocated to each unit of the regular model produced is $32. Part II We have the same direct materials and direct labor cost as under the traditional costing system. Next, we add the calculated overhead cost per unit and see that the total unit cost of each deluxe model is $310 and the total cost for each regular model is $152. Let’s compare these costs to those we developed under the traditional costing system.

Activity-Based Costing Part I You can see that we shifted more overhead cost per unit to the deluxe model and less to the regular model under the ABC system. Part II Many companies have determined that low-volume, specialized products like our deluxe model generally receive a greater overhead allocation than the higher-volume, generalized product. This result is not uncommon when activity-based costing is used. Many companies have found that low-volume, specialized products have greater overhead costs than previously realized.

Costs and Cost Drivers in Activity-Based Costing In this table we have identified some common overhead costs and the cost driver used by many companies to allocate overhead costs. The list is not meant to be comprehensive.

Ethics, Fraud, and Corporate Governance In addition to allocating manufacturing overhead costs to products, many companies allocate corporate overhead charges to their segments or divisions. In addition to allocating manufacturing overhead costs to products, many companies allocate corporate overhead charges to their segments or divisions. Failure to allocate corporate overhead properly can result in misleading financial statement information. Failure to allocate corporate overhead properly can result in misleading financial statement information.

End of Chapter 17 End of Chapter 17.