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 best used by companies that produce many units of a single product and when one unit of output is indistinguishable from any other unit of output. Because the units of output are identical, the company will probably use an average cost system to determine product cost.

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. Example companies: 1. Weyerhaeuser (paper manufacturing) 2. Reynolds Aluminum (refining aluminum ingots) 3. Coca-Cola (mixing and bottling beverages) An example of a company that may consider a process costing system is Weyerhaeuser, a manufacturer of paper products. When we think of paper manufacturing, we generally think about continuous production of a single roll of paper that may eventually be cut into sizes needed by customers. Other companies that would benefit from process costing are Reynolds Aluminum and Coca-Cola. Certainly the desire of all three of these companies is to make each unit of output consistent with the quality standards established. Coca-Cola bottled in California should taste identical to the same product bottled in New York City.

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 company would use a job order costing system when many different products are produced each period. The products are usually manufactured to customers’ specifications and are unique in nature. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job.

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. Example companies: 1. Boeing (aircraft manufacturing) 2. Bechtel International (large scale construction) 3. Walt Disney Studios (movie production) Companies that may benefit from using job order costing systems include Boeing, Bechtel International, and Walt Disney Studios. Boeing is an aircraft manufacturer. Bechtel is perhaps the largest international construction company. The company works on huge projects that are unique to customer needs. Walt Disney Studios produces movies.

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 preformed. Manufacturing Overhead Job No. 3

Indirect Manufacturing Costs 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 (i.e., 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

The Job Cost Sheet PearCo Job Cost Sheet Job Number A - 143 Date Initiated 3-4-09 Date Completed Department B3 Units Completed Item Wooden cargo crate Direct Materials Direct Labor Manufacturing Overhead Req. No. Amount Ticket Hours Rate Cost Summary Units Shipped Date Number Balance Total Cost Unit Product Cost The job cost sheet is used by the accounting department to track the direct and indirect costs associated with a given job. A job number uniquely identifies each job. Direct material, direct labor and manufacturing overhead costs are accumulated for each job. The job cost sheet is a subsidiary ledger to the Work in Process account. We will look at a job cost sheet used by a hypothetical company called PearCo. The company has a job that calls for the construction of wooden cargo crates. You can see the separate sections for direct materials, direct labor, and manufacturing overhead. In addition, we have a section to summarize total costs of the job.

Measuring Direct Materials Cost Will E. Delite Once a sales order has been received and a production order issued, the Production Department prepares a materials requisition form to specify the type, quantity, and total cost of materials. Here is the materials requisition form completed for job A - 143. The requisition is number X7 - 6890. The worker has requested twelve 2 x 4s, 12 feet long, and twenty 1 x 6s, 12 feet long. The unit cost of the lumber is shown in the unit cost column. The quantity requested is multiplied by the unit cost to arrive at the total cost for materials. The person in charge of the store room will issue the lumber once the materials requisition form has been properly authorized.

Measuring Direct Materials Cost Once the materials have been issued by the store room, they are charged to the job cost sheet for job number A – 143. The Accounting Department records the total direct cost, $116, on the appropriate job cost sheet. Notice, the material requisition number, X7-6869, is included on the job cost sheet to provide easy access to the source document. We have a proper reference for the requisition number and the total amount. If we need to look at the details of the $116 cost, we can ask to see materials requisition form X7-6890.

Measuring Direct Labor Costs Workers use time tickets to record the amount of time that they spent on each job. Here is the time ticket for an employee who worked eight hours on job A – 143. The employee’s hourly pay rate is $11, so the total labor cost charged to the job will be $88. The time ticket, number 36, serves as the major source document for labor costs charged to this job. Let’s look at the labor posting to the job cost sheet.

Job-Order Cost Accounting The Accounting Department records the labor costs from each time ticket onto the job cost sheet. On the job cost sheet, we can see that time ticket number 36 posted 8 hours to job A – 143. The total amount of direct labor cost is $88. This amount is also posted to the summary section of the job cost sheet.

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 production manager’s salary. Many types of manufacturing overhead costs are fixed even though output fluctuates during the period. Part I Manufacturing overhead is applied to all jobs that are in process. We apply overhead using a base we believe causes overhead costs to be incurred. Some companies allocate manufacturing overhead using direct labor hours or machine hours. Part II We must allocate overhead costs to jobs for a variety of reasons. First, it is difficult, if not impossible, to actually trace overhead costs to a particular job. The cost of grease for machinery to manufacture our product is part of our manufacturing costs. It would be impossible to accurately trace the amount of grease consumed to manufacture one unit of output. Manufacturing overhead also includes a number of different costs and it would be very difficult to gather all of them together in time to charge them to a particular job. A job may be complete and sold before we can determine the actual overhead costs incurred. Finally, many types of overhead are fixed in nature even though output fluctuates during the period.

Manufacturing Overhead Application 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 = Part I To facilitate the allocation of manufacturing overhead to each job, we calculate a predetermined overhead rate before the period begins. The rate is calculated by dividing the total estimated manufacturing overhead for the coming period by the estimated total units of the allocation base. If our allocation base is machine hours, we would estimate the total number of machine hours used in production in the coming period. Part II Ideally, the allocation base should be a cost driver, that is, it causes overhead to be incurred. Ideally, the allocation base is a cost driver that causes overhead.

The Need for a POHR 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. Predetermined overhead rates that rely upon estimated data are often used because: (1) actual overhead costs for the period are not known until the end of the period, thus inhibiting the ability to estimate job costs during the period; and (2) actual overhead costs can fluctuate seasonally, thus misleading decision makers.

Determining Predetermined Overhead Rates Predetermined overhead rates are calculated using a three-step process.  Estimate the level of production for the period.  Estimate total amount of the allocation base for the period.  Estimate total manufacturing overhead costs. The predetermined overhead rate is calculated using a three-step process: We must estimate the level of production for the period, Next, we estimate the total amount of the allocation base in the denominator that would be required for that level of production. Finally, we estimate the total manufacturing overhead cost in the numerator that would be incurred for the estimated amount of the allocation base. So, the predetermined overhead rate is calculated by dividing step 2 by step 3. POHR =  ÷ 

Application of Manufacturing Overhead Based on estimates, and determined before the period begins. Overhead applied = POHR × Actual activity We calculate the predetermined overhead rate before the period begins. As we work on a particular job, we apply overhead by multiplying the predetermined rate times the actual level of activity. If overhead is applied on the basis of machine hours, we would apply overhead by multiplying the predetermined rate by the actual number of machine hours used on a particular job. This is called a normal costing system. Actual amount of allocation is based upon the actual level of activity (normal costing system).

Overhead Application Rate Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period POHR = $640,000 160,000 direct labor hours (DLH) POHR = Part I Recall the equation for calculating the predetermined manufacturing overhead rate. At PearCo, overhead is allocated on the basis of direct labor hours worked on a particular job. PearCo’s predetermined overhead rate is $4 per direct labor hour. Part II At PearCo, each job will be charged $4 of overhead for each hour of direct labor worked. Let’s see how this works. POHR = $4.00 per DLH For each direct labor hour worked on a particular job, $4.00 of factory overhead will be applied to that job.

Job-Order Cost Accounting Recall that an employee worked a total of 8 hours on Job A-143. Our predetermined overhead rate is $4 per direct labor hour, so we will apply $32 of overhead to this job. The computation is shown in the manufacturing overhead section of the job cost sheet and in the summary section.

Job-Order Cost Accounting The total direct material, direct labor, and manufacturing overhead costs assigned to Job A-143 is $236. Since this particular job included 2 units of production, the average cost per unit is $118. We calculated the average cost by dividing the total cost of $236 by the 2 crates produced.

Interpreting the Average Unit Cost The average unit cost should not be interpreted as the costs that would actually be incurred if an additional unit was produced. Fixed overhead would not change if another unit was produced, so the incremental cost of another unit is something less than $118. We cannot say that the average cost per crate, in the future, will be $118. If a third crate was to be produced, we would not add any additional fixed overhead cost, so the incremental cost of an additional unit will be something less than $118.