1. CHAPTER 3
Product Costing and Cost Accumulation in a Batch Production Environment
Chapter 3: Product Costing and Cost Accumulation in a Batch Production Environment
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2. Learning Objective 1
Learning Objective 1. Discuss the role of product and service costing in manufacturing and nonmanufacturing firms.
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3. Product and Service Costing
Our focus changes from financial
statement costs to operations
Managerial Accounting and Cost Management
Product costs are used for planning, control, directing, and management decision making.
Financial Accounting
Product costs are used to value inventory and to compute cost of goods sold.
Our focus changes from financial statement costs to operations:
Financial Accounting – Products costs are used to value inventory and to compute cost of goods sold.
Managerial Accounting and Cost Management – Product costs are used for planning, control, directing, and management decision making. (LO1)
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4. Learning Objective 2
Learning Objective 2. Diagram and explain the flow of costs through the manufacturing accounts used in product costing.
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5. Flow of Costs in Manufacturing Firm
Manufacturing costs consist of direct material, direct labor, and manufacturing overhead. As production takes place, all manufacturing costs are added to the Work-in-Process Inventory account with a debit. As soon as products are completed, their product costs are transferred from Work-in-Process Inventory to Finished-Goods Inventory with a credit to Work in Process and a debit to Finished Goods. During the time period when products are sold, the product cost of the inventory sold is removed from Finished Goods and added to Cost of Goods Sold, which is an expense of the period in which the sale occurred. A credit to Finished Goods and a debit to Cost of Goods Sold completes this step. Cost of Goods Sold is closed into the Income Summary account at the end of the accounting period, along with all other expenses and revenues of the period. (LO2)
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6. Learning Objective 3
Learning Objective 3. Distinguish between job-order costing and process costing.
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7. Types of Product-Costing Systems
Process Costing
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.
TWO TYPES:
Job-shop operations
Products manufactured in very low volumes or one at
a time.
Batch-production operations
Multiple products in batches of relatively small
quantity.
Job-order costing is used by companies with job-shop operations or batch-production operations. In a job-shop environment, products are manufactured in very low volumes or one at a time. In job-order costing, each distinct batch of production is called a job or job order. The cost-accounting procedures are designed to assign costs to each job. Then the total costs assigned to each job are divided by the units of production in the job to obtain an average cost per unit.
In a batch-production environment, multiple products are produced in batches of relatively small quantity. Examples include furniture manufacture, printing, agricultural equipment, and pleasure boat production. (LO3)
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8. Types of Product-Costing Systems
Process Costing
Job-Order Costing
Typical job-order cost applications:
Special-order printing
Building construction
Also used in the service industry
Hospitals
Law firms
Examples of a job-shop environment include feature film production, custom house building, ship building, aircraft manufacture, and custom machining operations. Job-order costing is also used in the service industry. (LO3)
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9. Types of Product-Costing Systems
Process Costing
Job-Order Costing
Used for production of small, identical, low cost
items.
Mass produced in automated continuous
production process.
Costs cannot be directly traced to each unit of
product.
Typical process cost applications:
Petrochemical refinery
Paint manufacturer
Paper mill
Process costing is used by companies that produce large numbers of identical units. A process-costing system accumulates all the production costs for a large number of units of output, and then these costs are averaged over all of the units.
Firms that produce chemicals, microchips, gasoline, beer, fertilizer, textiles, processed food, and electricity are among those using process costing. In these kinds of firms, there is no need to trace costs to specific batches of production because the products in the different batches are identical. (LO3)
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10. Accumulating Costs in a Job-Order Costing System
The primary document for tracking the costs associated with a given job is the
job-cost record.
In a job-order costing system, costs of direct material, direct labor, and manufacturing overhead are assigned to each production job. These costs comprise the inputs of the product-costing system. As costs are incurred, they are added to the Work-in-Process Inventory account in the ledger. To keep track of the manufacturing costs assigned to each job, a subsidiary ledger is maintained. The subsidiary ledger account assigned to each job is a document called a job-cost record. (LO3)
Let’s look at the Aluminum Fishing Boat Company (AFB).
Let’s investigate using the AFB Company
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11. Job-Order Cost Accounting
Three major sections on the job-cost record are used to accumulate the costs of direct material, direct labor, and manufacturing overhead assigned to the job. The other two sections are used to record the total cost and average unit cost for the job, and to keep track of units shipped to customers. A job-cost record may be a paper document upon which the entries for direct material, direct labor, and manufacturing overhead are written. Increasingly, it is a computer file where entries are made using a computer. (LO3)
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12. Job-Order Cost Accounting
Let’s see one
A materials requisition form is used to authorize the use of materials on a job.
As raw materials are needed for the production process, they are transferred from the warehouse to the production department. To authorize the release of materials, the production department supervisor completes a material requisition form and presents it to the warehouse supervisor. (LO3)
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13. Job-Order Cost Accounting
A copy of the material requisition form goes to the cost accounting department. (LO3)
Timothy Williams
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14. Job-Order Cost Accounting
There it is used as the basis for transferring the cost of the requisitioned material from the Raw-Material Inventory account to the Work-in-Process Inventory account, and for entering the direct-material cost on the job-cost record for the production job in process. (LO3)
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15. Job-Order Cost Accounting
Accumulate direct labor costs by means of a work record, such as a time ticket, for each employee.
The assignment of direct-labor costs to jobs is based on time records filled out by employees. (LO3)
Let’s see one
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16. Employee Time Ticket
A time record is a form that records the amount of time an employee spends on each production job. (LO3)
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17. Job-Order Cost Accounting
The time record is the source document used in the cost accounting department as the basis for adding direct-labor costs to Work-in-Process Inventory and to the job-cost records for the various jobs in process. (LO3)
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18. Job-Order Cost Accounting
Manufacturing overhead is a pool of indirect production costs, such as indirect material, indirect labor, utility costs, and depreciation. These costs often bear no obvious relationship to individual jobs or units of product, but they must be incurred for production to take place. (LO3)
Apply manufacturing overhead to jobs using a predetermined overhead rate based on direct labor hours (DLH).
Let’s do it
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19. Job-Order Cost Accounting
Therefore, it is necessary to assign manufacturing-overhead costs to jobs in order to have a complete picture of product costs. This process of assigning manufacturing-overhead costs to production jobs is called overhead application. A predetermined overhead rate is used to apply overhead on the job-cost record. (LO3)
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20. Job-Order Cost Accounting
Once manufacturing overhead has been applied, the cost summary can be completed. Total direct material costs, total direct labor costs and total manufacturing overhead costs are added together to determine total costs. These costs are divided by the number of units completed to arrive at the unit cost. (LO3)
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21. Job-Order Cost Accounting
The shipping summary is completed when the completed units are shipped to the customer. This summary shows units shipped, units remaining and the cost of the units remaining in inventory. (LO3)
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22. Learning Objective 4
Learning Objective 4. Compute a predetermined overhead rate and explain its use in job-order costing for job-shop and batch-production environments.
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23. Manufacturing Overhead Costs
Overhead is applied to jobs using a predetermined overhead rate (POHR) based on estimates made at the beginning of the accounting period.
POHR =
Budgeted manufacturing overhead cost
Budgeted amount of cost driver (or activity base)
The accounting department chooses some measure of productive activity to use as the basis for overhead application. In traditional product-costing systems, this measure is usually some volume-based cost driver (or activity base), such as direct-labor hours, direct-labor cost, or machine hours. An estimate is made of (1) the amount of manufacturing overhead that will be incurred during a specified period of time and (2) the amount of the cost driver (or activity base) that will be used or incurred during the same time period. (LO4)
Overhead applied = POHR × Actual activity
Based on estimates, and determined before the period begins
Actual amount of the allocation base, such as direct labor hours, incurred during the period
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24. Manufacturing Overhead Costs
Overhead is applied to jobs using a predetermined overhead rate (POHR) based on estimates made at the beginning of the accounting period.
POHR =
Budgeted manufacturing overhead cost
Budgeted amount of cost driver (or activity base)
The predetermined overhead rate of $30 per direct labor hour is multiplied by the actual direct labor hours (600) charged to the job. Therefore, the overhead applied to the job is $18,000. (LO4)
Overhead applied = POHR × Actual activity
Recall the Aluminum Boat example where:
Overhead applied = $30 per DLH × 600 DLH = $18,000
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25. Learning Objective 5
Learning Objective 5. Prepare journal entries to record the costs of direct material, direct labor, and manufacturing overhead in a job-order costing system.
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26. Job-Order Costing Document Flow Summary
Let’s summarize the document flow we have been discussing in a job-order costing system.
Let’s summarize the document flow we have been discussing in a job-order costing system. (LO5)
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27. Production Order for Job
Job-Order Costing Document Flow Summary
Production Order for Job
The production order for the job authorizes the start of the production process.
The materials requisition indicates the cost of direct material to charge to jobs and the cost of indirect material to charge to overhead.
Material Requisition
Employee time tickets indicate the cost of direct labor to charge to jobs and the cost of indirect labor to charge to overhead.
Labor Time Records
The production order for the job authorizes the start of the production process. The materials requisition form identifies the amount of direct material to add to the job-cost records and the amount of indirect materials to add to the manufacturing overhead account.
The employee time tickets identity the amount of direct labor to add to the job-cost records and the amount of indirect labor to add to the manufacturing overhead account.
Overhead is applied to the job-cost records using some cost driver or activity base and a predetermined overhead rate. (LO5)
Actual Cost Driver (or Activity Base)
Apply Manufacturing Overhead X
Predetermined Overhead Rate
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28. Job-Order System Cost Flows
Let’s examine the cost flows in a job-order costing system. We will use T-accounts and start with materials.
Let’s examine the cost flows in a job-order costing system. We will use T-accounts and start with materials. (LO5)
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29. Work in Process (Job-Cost Record)
Job-Order System Cost Flows
Work in Process (Job-Cost Record)
Raw Materials
Direct Material
Direct Material
Material
Purchases
Indirect Material
Mfg. Overhead
Materials purchases are recorded with a debit to the raw materials account. When materials are placed into production, the raw materials account is credited. Work-in-process is increased with a debit for the amount of the raw materials and manufacturing overhead is increased with a debit for the amount of the indirect materials. The amount of direct materials for each job is recorded on the individual job-cost records. (LO5)
Indirect Material
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30. Job-Order System Cost Flows
Next let’s add labor costs and applied manufacturing overhead to the job-order cost flows. Are you with me?
Next let’s add labor costs and applied manufacturing overhead to the job-order cost flows. (LO5)
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31. Work in Process (Job-Cost Record)
Job-Order System Cost Flows
Work in Process (Job-Cost Record)
Wages Payable
Direct Labor
Direct Material
Indirect Labor
Direct Labor
Mfg. Overhead
Direct labor and indirect labor costs are taken from the time tickets and recorded with a credit to wages payable. The direct labor costs are recorded with a debit to work-in-process. Manufacturing overhead is increased with a debit for the amount of the indirect labor. The amount of direct labor for each job is recorded on the individual job-cost records. (LO5)
Indirect Material
Indirect Labor
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32. Work in Process (Job-Cost Record) Overhead Applied to Work in Process
Job-Order System Cost Flows
Work in Process (Job-Cost Record)
Wages Payable
Direct Labor
Direct Material
Indirect Labor
Direct Labor
Overhead Applied
Mfg. Overhead
If actual and applied manufacturing overhead are not equal, a year-end adjustment is required. We will look at the procedure to accomplish this later.
Overhead is applied to each job-cost record based on the predetermined overhead rate and the actual activity for that job. The overhead applied is also recorded in the work-in-process account with a debit. The manufacturing overhead account is decreased by the amount of overhead applied with a credit. The actual and applied overhead may not be equal at the end of the year. This is caused by errors in the estimates of overhead and activity used to compute the predetermined overhead rate. (LO5)
Indirect Material
Overhead Applied to Work in Process
Indirect Labor
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33. Now let’s complete the goods and sell them. Still with me?
Job-Order System Cost Flows
Now let’s complete the goods and sell them. Still with me?
Now we will record the completion of the goods and the sale. (LO5)
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34. Work in Process (Job-Cost Record)
Job-Order System Cost Flows
Work in Process (Job-Cost Record)
Finished Goods
Direct Material
Cost of Goods Mfd.
Cost of Goods Mfd.
Cost of Goods Sold
Direct Labor
Overhead Applied
Cost of Goods Sold
When the goods are completed, the cost of the goods manufactured are transferred to the finished goods inventory with a credit to work-in-process and a debit to finished goods. When goods are sold, the cost becomes an expense in the period of the sale. It is recorded with a debit to cost of goods sold and a credit to finished goods inventory. (LO5)
Cost of Goods Sold
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35. Job-Order System Cost Flows
Let’s return to AFB Company and see what we will do if actual and applied overhead are not equal.
Let’s look at an example when actual and applied overhead are not equal. (LO5)
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36. Overhead Application Example
Actual Overhead costs for the year: $5,050,000
Actual direct labor hours worked for the year: 170,000
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $30.00 per DLH × 170,000 DLH = $5,100,000
AFB’s actual overhead for the year was $5,050,000 and a total of 170,000 direct-labor hours were worked.
AFB’s predetermined overhead rate calculated at the beginning of the year was $30 per direct labor hour. This rate is multiplied by the actual direct labor hours worked to arrive at applied overhead of $5,100,000.
When applied overhead exceeds actual overhead, it is called overapplied overhead. Underapplied overhead occurs when actual overhead exceeds applied overhead. Applied overhead exceeds actual overhead by $50,000, therefore, AFB has overapplied overhead of $50,000. (LO5)
Applied overhead exceeds actual overhead by $50,000
This difference is called overapplied overhead.
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37. Overapplied and Underapplied Manufacturing Overhead
Work in Process
Finished Goods
Cost of Goods Sold
$50,000 may be allocated to these accounts.
$50,000 may be closed directly to cost of goods sold. OR
At the end of an accounting period, the managerial accountant has two alternatives for the disposition of underapplied or overapplied overhead. Under the most common alternative, the underapplied or overapplied overhead is closed into Cost of Goods Sold. The more accurate method allocates underapplied or overapplied overhead to work-in-process, finished goods, and costs of goods sold. (LO5)
AFB Company’s Method
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38. Overapplied and Underapplied Manufacturing Overhead
AFB’s Mfg. Overhead for the year
AFB’s Cost of Goods Sold for the year
Unadjusted Balance
Actual overhead costs
$5,050,000
Overhead Applied to jobs
$5,100,000
The actual overhead costs of $5,050,000 were recorded with a debit to manufacturing overhead. The applied overhead of $5,100,000 was recorded with a credit to manufacturing overhead. This leaves a credit balance of $50,000 which is the overapplied overhead. This amount is closed to cost of goods sold with a debit to manufacturing overhead and a credit to cost of goods sold. (LO5)
$50,000
Adjusted Balance
$50,000
$50,000 overapplied
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39. Overapplied and Underapplied Manufacturing Overhead - Summary
(LO5)
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40. Learning Objective 6
Learning Objective 6. Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer.
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41. Schedule of Cost of Goods Manufactured
The schedule of cost of goods manufactured details the costs of direct material, direct labor, and manufacturing overhead applied to work in process during the period and shows the change in Work-in-Process Inventory. The cost of goods manufactured is shown in the last line of the schedule. This is the amount transferred from Work-in-Process Inventory to Finished-Goods Inventory during the period. (LO6)
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42. Schedule of Cost of Goods Sold
This schedule shows the cost of goods sold for the period and details the changes in Finished-Goods Inventory during the month. The adjusted cost of goods sold appears as an expense on the income statement. (LO6)
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43. Actual direct material and direct labor combined with actual overhead.
Actual and Normal Costing
Actual direct material and direct labor combined with actual overhead.
Actual direct material and direct labor combined with predetermined overhead.
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.
Most firms use a predetermined overhead rate. When direct material and direct labor are added to Work-in-Process Inventory at their actual amounts, but overhead is applied to Work-in-Process Inventory using a predetermined overhead rate, the product-costing system is referred to as normal costing. A few companies use actual costing, a system in which direct material and direct labor are added to work in process at their actual amounts, and actual overhead is allocated to work in process using an actual overhead rate computed at the end of each accounting period.
Many companies combine all of the firm’s manufacturing overhead into a single cost pool. Then the overhead is applied to products using a single predetermined overhead rate based on labor hours. This is known as a plantwide overhead rate.
In some production processes, the relationship between overhead costs and the firm’s products differs substantially across production departments. In such cases, the firm may use departmental overhead rates, which differ across production departments. This usually results in a more accurate assignment of overhead costs to the firm’s products. (LO6)
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44. Learning Objective 7
Learning Objective 7. Describe the two-stage allocation process used to assign manufacturing overhead costs to production jobs.
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45. Two-Stage Cost Allocation
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
When a company uses departmental overhead rates, the assignment of manufacturing overhead costs to production jobs is accomplished in two stages, comprising what is called two-stage cost allocation. In the first stage, all manufacturing-overhead costs are assigned to the production departments, such as machining and assembly. (LO7)
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46. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Stage Two:
Costs applied
to products
In the second stage, all of the manufacturing-overhead costs accumulated in each production department are assigned to the production jobs on which the department has worked. This process is called overhead application. In stage two, each production department has its own predetermined overhead rate. These rates often are based on different cost drivers. (LO7)
Products
Departmental Allocation Bases
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47. Learning Objective 8
Learning Objective 8. Describe the process of project costing used in service industry firms and non-profit organizations.
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48. Job-Order Costing in Nonmanufacturing Organizations
THE JOB
Contracts
Missions
Programs
Cases
Job-order costing is also used in service industry companies and other nonmanufacturing organizations. However, rather than referring to production “jobs,” such organizations use terminology that reflects their operations. For example, hospitals may assign costs to “cases,” and consulting firms might track “contract” costs. Law firms assign costs to cases, while government agencies typically refer to “programs” or “missions.” The need for cost accumulation exists in these and similar organizations for the same reasons found in manufacturing firms. (LO8)
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49. Changing Technology in Manufacturing Operations
Computerized data interchange has eliminated much of the paperwork associated with job-order cost systems.
Scanning devices have simplified data entry to record material and labor use.
Electronic data interchange (or EDI) is the direct exchange of data between organizations via a computer-to-computer interface. EDI is used to transmit such documents as purchase orders, shipping notices, receiving notices, invoices, and a host of other production-related data. This eliminates the need for paperwork, speeding up the flow of information and substantially reducing errors. EDI is now in widespread use. An alternative to EDI is extensible markup language (XML) which is web based and less expensive to implement. (LO8)
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50. End of Chapter 3
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