1. Systems Design: Job-Order Costing
Chapter 3: 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 to calculating product costs known as job-order costing.

2. Learning Objective 1
Distinguish between process costing and job-order costing and identify companies that would use each costing method.
Learning objective number 1 is to distinguish between process costing and job-order costing and identify companies that would use each costing method.

3. 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.

4. 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.

5. 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.

6. 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.

7. Comparing Process and Job-Order Costing
This table presents an overview of the differences between a job-order and process costing system.
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 department.
With job-order costing, average unit costs are computed by job; with process costing, average unit costs are computed for a particular operation of by department.

8. Quick Check  a. Scott Paper Company for Kleenex. b. Architects.
Which of the following companies would be likely to use job-order costing rather than process costing?
a. Scott Paper Company for Kleenex.
b. Architects.
c. Heinz for ketchup.
d. Caterer for a wedding reception.
e. Builder of commercial fishing vessels.
See if you can identify those types of companies that would benefit from the use of a job-order costing system. There may be more than one company in the list.

9. Quick Check  a. Scott Paper Company for Kleenex. b. Architects.
Which of the following companies would be likely to use job-order costing rather than process costing?
a. Scott Paper Company for Kleenex.
b. Architects.
c. Heinz for ketchup.
d. Caterer for a wedding reception.
e. Builder of commercial fishing vessels.
How did you do? The paper and ketchup manufacturers would probably use a process costing system, rather than a job-order system.

10. Identify the documents used in a job-order costing system.
Learning Objective 2
Identify the documents used in a job-order costing system.
Learning objective number 2 is to identify the documents used in a job-order costing system.

11. 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

12. 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

13. The Job Cost Sheet PearCo Job Cost Sheet Job Number A - 143
Date Initiated
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.

14. 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 The requisition is number X 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.

15. 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 X

16. 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.

17. 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.

18. Learning Objective 3
Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process.
Learning objective number 3 is to compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process.

19. 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.

20. 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.

21. 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.

22. 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 =  ÷ 

23. 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).

24. 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.

25. Job-Order Cost Accounting
Recall that an employee worked a total of 8 hours on Job A 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.

26. 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.

27. 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.

28. Quick Check 
Job WR53 at NW Fab, Inc. required $200 of direct materials and 10 direct labor hours at $15 per hour. Estimated total overhead for the year was $760,000 and estimated direct labor hours were 20,000. What would be recorded as the cost of job WR53?
a. $200.
b. $350.
c. $380.
d. $730.
This problem may take a while to solve, but it will be well worth your time to work it carefully. Remember, we are interested in the total cost of the job. To answer this question, we will need all three elements of product cost at NW Fab, Inc.

29. Quick Check 
Job WR53 at NW Fab, Inc. required $200 of direct materials and 10 direct labor hours at $15 per hour. Estimated total overhead for the year was $760,000 and estimated direct labor hours were 20,000. What would be recorded as the cost of job WR53?
a. $200.
b. $350.
c. $380.
d. $730.
How did you do? The correct answer is $730. You can see the costs (direct materials, direct labor, and manufacturing overhead) incurred for job WR53. We begin by calculating the predetermined overhead rate of $38 per direct labor hour. Since we worked 10 hours on the job, we will have $150 ($15 hourly rate times 10 hours) of direct labor and $380 ($38 per direct labor hour times 10 hours worked) of manufacturing overhead.

30. Learning Objective 4
Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.
Learning objective number 4 is to understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.

31. Job-Order Costing Document Flow Summary
A sales order is the basis of issuing a production order.
A production order initiates work on a job.
The entire accounting process begins when a sales order is received from a customer. Once the sales order is received, a production order is drafted to initiate work on a job.

32. Job-Order Costing Document Flow Summary
Materials used may be either direct or indirect.
Direct materials
Job Cost Sheets
Materials Requisition
From the production order, we are able to determine the direct and indirect materials that we will need to requisition from the store room. We now know that the materials requisition form is a critical source document in the preparation of the job cost sheet.
Direct material costs are charged to specific jobs. Indirect material costs are included in manufacturing overhead.
Indirect materials
Manufacturing Overhead Account

33. Job-Order Costing Document Flow Summary
An employee’s time may be either direct or indirect.
Direct Labor
Job Cost Sheets
Employee Time Ticket
As employees work on the job covered by the production order, time tickets are prepared for recording both 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

34. Job-Order Costing Document Flow Summary
Materials Requisition
Indirect Material
POHR rate used to apply overhead
Other Actual OH Charges
Manufacturing Overhead Account
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. As we have seen, the predetermined overhead rate is used to apply manufacturing overhead costs to jobs.
Indirect Labor
Employee Time Ticket

35. Learning Objectives 4 and 7
Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs. Use T-accounts to show the flow of costs in a job-order costing system.
Learning objective number 4 is to understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.
Learning objective 7 is to use T-accounts to show the flow of costs in a job-order costing system.

36. Job-Order Costing: The Flow of Costs
The transactions (in T-account and journal entry form) that capture the flow of costs in a job-order costing system are illustrated on the following slides.
The transactions (in T-account and journal entry form) that capture the flow of costs in a job-order costing system are illustrated on the following slides.

37. The Purchase and Issue of Raw Materials
Work in Process (Job Cost Sheet)
Direct Materials
Material
Purchases
Indirect Materials
Mfg. Overhead
Part I
When raw materials are purchased they are debited to the raw materials inventory account and credited to accounts payable.
Part II
The cost of direct material requisitions is debited to Work in Process and added to the job cost sheet which serve as a subsidiary ledger.
Part III
To account for the indirect materials requisition, the manufacturing overhead account is debited and the raw materials inventory account is credited.
Actual
Applied

38. Cost Flows – Material Purchases
Raw material purchases are recorded in an inventory account.
Here is an example of the general journal entry to record the purchase of raw materials on account. We debit raw materials and credit accounts payable.

39. Cost Flows – Material Usage
Direct materials issued to a job increase Work in Process and decrease Raw Materials. Indirect materials used are charged to Manufacturing Overhead and also decrease Raw Materials.
When materials are requisitioned from raw materials inventory, we debit work in process (job cost sheet) for direct materials, and debit manufacturing overhead for indirect materials.

40. The Recording of Labor Costs
Salaries and Wages Payable
Work in Process (Job Cost Sheet)
Direct Labor
Direct Materials
Indirect Labor
Mfg. Overhead
Part I
Direct labor is debited to Work in Process and added to the job cost sheet which serves as a subsidiary ledger and credited to salaries and wages payable.
Part II
Indirect labor is debited to Manufacturing Overhead and credited to salaries and wages payable.
Actual
Applied
Indirect Materials

41. The Recording of Labor Costs
The cost of direct labor incurred increases Work in Process and the cost of indirect labor increases Manufacturing Overhead.
The cost of direct labor is debited to Work in Process account, while the indirect labor is debited to the Manufacturing Overhead account. The cost of labor (direct and indirect) is credited to the Salaries and Wages Payable account.

42. Recording Actual Manufacturing Overhead
Salaries and Wages Payable
Work in Process (Job Cost Sheet)
Direct Labor
Direct Materials
Indirect Labor
Direct Labor
Mfg. Overhead
Actual
Applied
Indirect Materials
Additional manufacturing overhead amounts are debited to the manufacturing overhead account. The debit side of the manufacturing overhead account represents actual overhead incurred during the period. The credit side of the entry is the various liability accounts, for example, accounts payable and property taxes payable. The credit side will also include prepaid assets (like prepaid insurance) and contra accounts for items like depreciation.
Indirect Labor
Other Overhead

43. Recording Actual Manufacturing Overhead
In addition to indirect materials and indirect labor, other manufacturing overhead costs are charged to the Manufacturing Overhead account as they are incurred.
This journal entry represents the accumulation of other actual overhead amounts like property taxes on the manufacturing plant, insurance on the plant structure and depreciation of manufacturing assets.

44. Learning Objective 5
Apply overhead cost to Work in Process using a predetermined overhead rate.
Learning objective number 5 is to apply overhead cost to Work in Process using a predetermined overhead rate.

45. Applying Manufacturing Overhead
Salaries and Wages Payable
Work in Process (Job Cost Sheet)
Direct Labor
Direct Materials
Indirect Labor
Direct Labor
Mfg. Overhead
Overhead Applied
Overhead Applied to Work in Process
Actual
Applied
Indirect Materials
The manufacturing overhead account is a clearing account. The actual amount of overhead incurred during the period on the debit side of the account will almost certainly not equal the amount applied to work in process on the credit side of the account. This requires a year-end adjustment.
When we apply overhead to a particular job, we debit work in process inventory (and the job cost sheet) and credit the manufacturing overhead account. Amounts on the credit side of the manufacturing overhead account represent overhead applied.
If actual and applied manufacturing overhead are not equal, a year-end adjustment is required.
Indirect Labor
Other Overhead

46. Applying Manufacturing Overhead
Work in Process is increased when Manufacturing Overhead is applied to jobs.
This journal entry shows the application of overhead to work in process inventory. For applied overhead, we debit work in process and credit manufacturing overhead.

47. Accounting for Nonmanufacturing Cost
Nonmanufacturing costs are not assigned to individual jobs, rather they are expensed in the period incurred.
Examples: 1. Salary expense of employees who work in a marketing, selling, or administrative capacity.
2. Advertising expenses are expensed in the period incurred.
We previously discussed the treatment of selling, general, and administrative salaries expense during the period. Nonmanufacturing costs are charged to the respective expense accounts (marketing, selling, administrative) in the period the expenses were incurred.

48. Accounting for Nonmanufacturing Cost
Nonmanufacturing costs (period expenses) are charged to expense as they are incurred.
These journal entries illustrate the expensing of nonmanufacturing costs in the current period.

49. Learning Objective 6
Prepare schedules of cost of goods manufactured and cost of goods sold.
Learning objective number 6 is to prepare schedules of cost of goods manufactured and cost of goods sold.

50. Transferring Completed Units
Work in Process (Job Cost Sheet )
Finished Goods
Cost of Goods Mfd.
Direct Materials
Direct Labor
Overhead Applied
The sum of all amounts transferred from work in process to finished goods represents the cost of goods manufactured for the period. As a job is completed, its costs are transferred from the work in process inventory to finished goods inventory.

51. Transferring Completed Units
As jobs are completed, the Cost of Goods Manufactured is transferred to Finished Goods from Work in Process.
The transfer is accomplished with a debit to finished goods inventory and a credit to work in process inventory.

52. Transferring Units Sold
Work in Process (Job Cost Sheet)
Finished Goods
Cost of Goods Sold
Cost of Goods Mfd.
Direct Materials
Cost of Goods Mfd.
Direct Labor
Overhead Applied
Cost of Goods Sold
When a finished job is sold to the customer, the cost of that job is transferred from finished goods inventory to cost of good sold. Recall that cost of goods sold is an income statement account. If only a portion of the units associated with a particular job are shipped, then the unit cost figure from the job cost sheet is used to determine the amount of the journal entry.

53. Transferring Units Sold
When finished goods are sold, two entries are required: (1) to record the sale, and (2) to record the Cost of Goods Sold.
Assuming the company uses a perpetual inventory system, two journal entries are required to record the sale.
The first entry is to debit either accounts receivable or cash and credit sales for the selling price of the job completed.
The second entry is to debit cost of goods sold and credit finished goods inventory for the cost incurred to complete the job.
The difference between the selling price and cost is the company’s gross margin on the job.

54. Learning Objective 8
Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.
Learning objective number 8 is to compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.

55. Problems of Overhead Application
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.
When we apply overhead on the basis of a predetermined overhead rate, it’s likely that the amount of overhead applied will be different from the amount of overhead actually incurred during the period. When there is a difference, we refer to the amount as either underapplied overhead 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.

56. Overhead Application Example
PearCo’s actual overhead for the year was $650,000 with a total of 170,000 direct labor hours worked on jobs.
How much total overhead was applied to PearCo’s jobs during the year? Use PearCo’s predetermined overhead rate of $4.00 per direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
Part I
Let’s assume that PearCo incurred actual overhead of $650,000 during the period and worked a total of 170,000 direct labor hours. PearCo applies overhead at the rate of $4 per direct labor hour worked. How much overhead did PearCo apply to jobs during the period? Part II
PearCo would have applied $680,000 of overhead during the period. That is $4 per direct labor hour times the 170,000 direct labor hours actually worked. Can you see our problem?

57. Overhead Application Example
PearCo’s actual overhead for the year was $650,000 with a total of 170,000 direct labor hours worked on jobs.
How much total overhead was applied to PearCo’s jobs during the year? Use PearCo’s predetermined overhead rate of $4.00 per direct labor hour.
PearCo has overapplied overhead for the year by $30,000. What will PearCo do?
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is termed either underapplied or overapplied overhead. PearCo incurred actual overhead of $650,000 and applied $680,000, so the company overapplied $30,000 of overhead for the year. How do we dispose of this overapplied overhead?

58. Quick Check 
Tiger, Inc. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine hour. Tiger, Inc. worked 290,000 machine hours during the period. Tiger’s manufacturing overhead is
a. $50,000 overapplied. b. $50,000 underapplied. c. $60,000 overapplied. d. $60,000 underapplied.
In this question, you are asked to calculate the overapplied or underapplied overhead. Be careful with your intermediate computations.

59. Quick Check 
Tiger, Inc. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine hour. Tiger, Inc. worked 290,000 machine hours during the period. Tiger’s manufacturing overhead is
a. $50,000 overapplied. b. $50,000 underapplied. c. $60,000 overapplied. d. $60,000 underapplied.
Overhead Applied $4.00 per hour × 290,000 hours = $1,160,000
Underapplied Overhead $1,210,000 - $1,160, = $50,000
The correct answer is $50,000 underapplied overhead. Tiger incurred $1,210,000 of actual overhead but applied only $1,160,000, thus the company underapplied its overhead costs during the period.

60. Disposition of Under- or Overapplied Overhead
$30,000 may be closed directly to cost of goods sold.
Cost of Goods Sold
PearCo’s Method
Work in Process
Finished Goods
Cost of Goods Sold
$30,000 may be allocated to these accounts. OR
There are two ways to dispose of over- or underapplied overhead. The more complex approach is to allocate a portion of the over- or underapplied overhead to work in process inventory, finished goods inventory, and cost of goods sold. The allocation would be based on the relative dollar value in each of the three accounts involved.
An easier way to deal with the problem, and the method PearCo uses, is to adjust cost of goods sold for the entire amount of the over- or underapplied overhead.

61. Disposition of Under- or Overapplied Overhead
PearCo’s Cost of Goods Sold
PearCo’s Mfg. Overhead
Unadjusted Balance
Actual overhead costs
$650,000
Overhead applied to jobs
$680,000
$30,000
Part I
We know that PearCo applied $680,000 of overhead but incurred only $650,000 of actual overhead. The manufacturing overhead account has a $30,000 credit balance, representing the overapplied overhead during the year.
Part II
PearCo chooses to adjust cost of goods sold for the entire amount. The adjustment necessary at the end of the year is to debit the manufacturing overhead account for $30,000, and credit, or reduce, cost of goods sold by the same amount.
Adjusted Balance
$30,000 overapplied

62. Allocating Under- or Overapplied Overhead Between Accounts
Assume the overhead applied in ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold is shown below:
Let’s assume that at the end of the period PearCo had the following overhead costs in each of the accounts shown. We may elect to allocate the over- or underapplied overhead to ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold.

63. Allocating Under- or Overapplied Overhead Between Accounts
We would complete the following allocation of $30,000 overapplied overhead:
We will complete the following allocation of the $30,000 of overapplied overhead. We will reduce ending Work in Process Inventory by $3,000, Finished Goods Inventory by $9,000, and Cost of Goods Sold for the period by $18,000.
10% × $30,000

64. Allocating Under- or Overapplied Overhead Between Accounts
The journal entry to record the allocation is to debit Manufacturing Overhead for $30,000, credit Work in Process Inventory for $3,000, credit Finished Goods Inventory for $9,000, and credit Cost of Goods Sold for $18,000.

65. Overapplied and Underapplied Manufacturing Overhead - Summary
PearCo’s Method
We have provided a good study aid for dealing with overapplied or underapplied overhead. We have shown the impact of both the allocation approach to the solution to the problem and the direct adjustment to cost of goods sold approach. Alternative 2 is considered more accurate, but it is more complex to apply. It is a good idea to review this chart before your next exam.
More accurate but more complex to compute.

66. Quick Check  a. Net operating income will increase.
What effect will the overapplied overhead have on PearCo’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
Give this question some thought before deciding on your answer.

67. Quick Check  a. Net operating income will increase.
What effect will the overapplied overhead have on PearCo’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
How did you do?

68. Multiple Predetermined Overhead Rates
To this point, we have assumed that there is a single predetermined overhead rate called a plantwide overhead rate.
Large companies often use multiple predetermined overhead rates.
May be more complex but . . .
Part I
We have assumed that the company has used one single predetermined overhead rate for the entire factory.
Part II
Many large companies use multiple predetermined overhead rates.
Part III
Using multiple overhead rates can create more complexity. However, the use of multiple rates promotes greater accuracy in the allocation process because it reflects the differences across departments in how overhead costs are incurred.
May be more accurate because it reflects differences across departments.

69. Job-Order Costing in Service Companies
Job-order costing is used in many different types of service companies.
Although our attention has focused upon manufacturing applications, it bears re-emphasizing that job-order costing is also used in services industries. In a law firm, each client represents a job. Legal forms and similar inputs represent direct materials. The time expended by attorneys represents direct labor. The costs of secretaries, clerks, rent, depreciation, and so forth, represent the overhead.

70. The Use of Information Technology
Technology plays an important part in many job-order cost systems. When combined with Electronic Data Interchange (EDI) or a web-based programming language called Extensible Markup Language (XML), bar coding eliminates the inefficiencies and inaccuracies associated with manual clerical processes.
As in any area of business, technology may play an important role in the accounting process. New, easier to use, programming languages and the mastery of microcomputers help spread technology throughout the organization.

71. The Predetermined Overhead Rate and Capacity
Appendix 3A: The Predetermined Overhead Rate and Capacity.
Appendix 3A

72. Learning Objective 9 (Appendix 3A)
Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.
Learning objective number 9 is to understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.

73. 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. The first is that the predetermined rate creates problems when actual levels of activity are different from estimated, or budgeted, amounts. The second is that in some cases basing the predetermined overhead rate on estimated amounts charges products for costs that they do not use.

74. Capacity-Based Overhead Rates
Criticisms can be overcome by using estimated total units in the allocation base at capacity in the denominator of the predetermined overhead rate calculation.
Let’s look at the difference!
We can minimize the criticisms by basing estimated total units in the allocation base at capacity levels of activity (rather than the estimated total units).

75. An Example
Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. What is the predetermined overhead rate?
Here is a simple example where a company leases a piece of equipment for $100,000 per year. Full capacity at the company is 50,000 units of output. Management estimates that 40,000 units will be produced and sold in the coming year. Let’s calculate the predetermined overhead rate.

76. An Example
Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year.
Traditional Method
= $2.50 per unit
$100,000
40,000 =
Part I
Under the traditional method we have used in this chapter, the predetermined overhead rate will be $2.50. We divide the total cost of $100,000 by the estimated level of activity, 40,000 units.
Part II
Under the capacity approach, the predetermined overhead rate is $2.00 per unit. We divide the total cost of $100,000 by production at capacity, 50,000 units.
Capacity Method
= $2.00 per unit
$100,000
50,000 =

77. Quick Check 
Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
Based on the information given, what is the predetermined overhead rate using the traditional method?

78. Quick Check 
Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
The correct answer is $2.50 per case. How did you do?

79. Quick Check 
Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
Now calculate the predetermined overhead rate using the capacity approach.

80. Quick Check 
Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
Did you get the correct answer of $2.00 per case?

81. Quick Check 
When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
Recall your answers to the previous questions and answer this question about changes in the predetermined overhead rate.

82. Quick Check 
When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
The predetermined overhead rate stays the same because it is not affected by changes in the level of activity.

83. Quick Check 
When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
Now, take that same information and answer this question assuming the traditional approach is used by the company.

84. Quick Check 
When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
Now we know that the predetermined overhead rate goes up when activity goes down.

85. Income Statement Preparation – Capacity
Critics suggest that the underapplied overhead that results from idle capacity should be disclosed on the income statement as the cost of unused capacity  a period expense.
Look carefully at the income statement on this slide prepared using the capacity approach to calculate the predetermined overhead rate. Notice the disclosure of the $20,000 cost of idle capacity that is recorded as a period expense. This cost is incurred because we were not able to fully utilize our capacity. Using a measure of capacity in the denominator of the predetermined overhead rate enables this type of disclosure.

86. Income Statement Preparation – Traditional
Here is the income statement using the traditional approach. Notice that cost of goods sold is charged with the cost of idle capacity. Using the estimated or budgeted amount of the allocation base in the denominator of the predetermined overhead rate calculation does not allow for disclosure of the idle capacity. In this example, underapplied overhead is not treated as a period expense, but instead, it is allocated to the work in process, finished goods, and/or cost of goods sold.

87. End of Chapter 3
End of chapter 3.