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Chapter 3 Outline

Product Costing and Job-Order Costing Systems


  1. Product and Service Costing
    1. Product-costing system accumulates and assigns: A product-costing system accumulates the costs incurred in a production process and assigns those costs to the organization’s final products.
    1. Use varies: Product costs are needed for a variety of purposes in both financial and managerial accounting.
    1. Inventory valuation in financial accounting: Product costs are used to value inventory on the balance sheet and to compute cost-of-goods-sold expense on the income statement.
    2. Decision-facilitating function in managerial accounting: Product costs are needed for planning, cost control, and decision-making.
    1. Example: Decisions about product prices, the mix of products to be produced, and the quantity of output are examples of decisions made using product costs information.
    1. Product costs determining sales price: There is an ever-growing need for product cost information in relationships between firms and various outside organizations.
    1. Example: Many defense contracts for military equipment base the compensation amount for the manufactured goods upon the product costs (i.e., the contract may provide for cost plus 20%).
    1. Product Costing in Nonmanufacturing Firms: The need for product costing is not limited to manufacturing firms.
    1. Identical role: The role of product costs in nonmanufacturing firms is identical to that in manufacturing firms.
    1. Example: Merchandising companies include the costs of buying and transporting merchandise in their product costs.
    1. Inventoriable items valued at product costs: Inventoriable items are valued at their product costs on the balance sheet until sold, then they become a cost-of-goods-sold expense on the income statement.
    1. Service and Nonprofit Firms: The product of service and nonprofit firms consists of services that are consumed as produced.
    1. Valuing service production: The service and nonprofit firms need accurate information about the costs of producing services.
    2. Use information for pricing: The service and nonprofit firms compile the costs of producing their service for planning, cost control and decision-making.
    1. Flow of Costs in Manufacturing Firms:



Direct Material



Direct Labor Work-in-Process Finished-Goods


Inventory Inventory




Overhead Cost-of-Goods Sold



Income Summary


    1. Work-in-Process Inventory: Work-in-process product costs are transferred to the Finished-Goods Inventory when product is finished.
    2. Finished-Goods Inventory: Product costs are transferred to cost-of-goods sold when product is sold.
    3. Cost-of-Goods Sold: Product cost expenses are closed into income summary at the end of the accounting period.
    1. Product-costing systems are industry specific: The type of product-costing system used is industry specific.
    1. Job-Order Costing: Job-order costing is used by companies where goods are produced in distinct batches and there are significant differences among the batches (e.g., airplane manufacturers and firms specially in custom manufacturing).
    1. Real world example: Market researchers estimate that 100,000 small, no-name person computer manufacturers still control 25% of the market share despite the big, brand-name companies’ massive advertising and price-cutting. Small PC manufacturers offer to build customized that range from cutting-edge machine with Pentium Pro microprocessors to older, less powerful, and cheaper components for budget-minded buyers. Small PC manufacturers would use job-order costing systems to trace the costs of different systems they manufacture.
    2. Batches termed jobs: In job-order costing, each distinct batch of production is called a job or job order.
    3. Costs assigned to distinct batches: The cost-accounting procedures are designed to assign costs to each job. The costs are then average over the units of the job or batch to obtain an average cost per unit.
    4. Service industries use quasi job-order costing: Procedures similar to those used in job-order costing are also used in many service industry firms, although these firms have no work-in-process or finished-goods inventories.
    1. Process-costing systems for homogenized goods: Companies producing large numbers of identical units use process costing.
    1. Averaged over entire production run: 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 the units.
    1. Alternative product-costing systems: The distinction between job-order and process costing hinges on the type of production process involved.
    1. Costs assigned to individualized units: Job-order costing systems assign costs to distinct production jobs that are significantly different. Then, an average cost is computed for each unit of product in each job.
    2. Process-costing systems for homogenized units: Process-costing systems average costs over a large number of identical (or very similar) units of production.
    1. Accumulating Costs in a Job-Order Costing System
    1. Generally: 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.
    2. Job-cost sheets accumulate costs: Three sections on the job-cost sheet are used to accumulate the costs of direct material, direct labor, and manufacturing overhead assigned for 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.
    1. Modern job costs sheets computerized: More frequently, a job-cost sheet is stored in a computer accounting program as a computer file.
    1. Direct-Material Costs: As raw materials are needed for the production process, they are transferred from the warehouse to the production department.
    1. Modern material requisitions are electronic: To authorize the release of materials, the production department supervisor completes a material requisition form and presents it to the warehouse supervisor. In most factories that are sophisticated enough to keep detailed account of their production, material requisitions are entered directly into a computer terminal by the production department supervisor. The requisition is then automatically transmitted to terminals in the warehouse and in the cost-accounting department.
    2. Automation reduces paperwork: Such automation reduces the flow of paperwork, minimizes clerical errors, and speeds up the production process.
    3. Source documents used as a basis for accounting: A document such as a material requisition form, which is used as a basis for an accounting entry is called a source document.
    4. Material-Requirements Planning (MRP) for predictable products: For products and product components that are produced routinely, the required materials are known in advance. For these products and components, material requisitions are based on a bill of materials that lists all of the materials needed.
    1. Typically used in complex manufacturing: In complex manufacturing operations, in which production takes place in several stages, material-requirements planning (or MRP) may be used.
    2. Operations tool assisting in scheduling: MRP is an operations-management tool that assists managers in scheduling production at each stage of the manufacturing process.
    3. Careful planning ensures continuity: Careful planning ensures that at each stage of the production process, the required subassemblies, components, or partially processed materials are ready for the next stage.
    4. MRP generally computerized: MRP systems, which are generally computerized, include files that list all of the component parts and materials in inventory and all of the parts and materials needed at each stage of the production process.
    1. Direct-Labor Costs
    1. Time tickets track production costs: A time ticket is a form that records the amount of time spent on each production job.
    2. Assignment based on time tickets: The assignment of direct-labor costs to jobs is based on time tickets filled out by employees.
    3. Time tickets serves as source document: The time ticket is a 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 sheets for various jobs in process.
    1. Manufacturing-overhead costs’ "catch all" status makes assignment difficult: By definition manufacturing overhead (M.0.) is a heterogeneous pool of indirect production costs, such as indirect material, indirect labor, utility costs, and depreciation.
    1. M.O. costs often bear no relationship to jobs: The M.O. costs often bear no obvious relationship to individual jobs, or units of production, but they must be incurred to production to take place.
    2. Overhead application assigns costs: To get a complete picture of product costs manufacturing overhead must be assigned to jobs. This assignment process is called overhead application (or overhead absorption).
    3. Timing crucial: For product-costing information to be used, it must be provided to managers on a timely basis.
    1. Predetermined overhead rate solves timeliness: The solution to this problem is to apply overhead to products based on the estimates made at the beginning of the accounting period.
    2. Previous productive activity estimates: The accounting department chooses some measure of productive activity to use as the basis for overhead application.
    3. Traditionally volume-based cost drivers are used: In traditional product-costing systems, this measure is usually some volume-based cost driver (or activity base), such as direct-labor hours, direct-labor hour cost, or machine hours.
    4. Estimates control rate: An estimate is made of (1) the amount of manufacturing overhead that will be incurred during a specific period of time and (2) the amount of cost driver (or activity base) that will be used or incurred during the same period.
    5. Prediction overhead rate formula:

Predetermined Budgeted manufacturing-overhead cost

Overhead rate = Budgeted amount of cost driver

    1. Applying overhead costs: The predetermined overhead rate is used to apply manufacturing overhead costs to production jobs.
    1. Formula:
    2. Predetermined overhead rate X (times) volume-based cost driver

    3. Example:
    4. Predetermined overhead rate……………….. $ 9.00

      Machine hours required by job……………... x $ 3.00


    5. Applied manufacturing overhead: The amount of manufacturing-overhead costs added to Work-in-Process Inventory during an accounting period is applied manufacturing overhead.
    1. Summary of Overhead Accounting: Three concepts are used in overhead accounting. Overhead is budgeted at the beginning of the accounting period, it is applied during the period, and actual overhead is measured at the end of the period.
    2. Selling and Administrative Costs: These costs are not manufacturing costs and are not added to Work-in-Process Inventory. Therefore, these period costs must be added in as an expense in the accounting period incurred.
    3. Completion of Production Job: Upon the completion of production the job costs are transferred from Work-in-Process Inventory to Finished-Goods Inventory.
    4. Underapplied and Overapplied Overhead:
    1. Actual exceeds estimated: The amount by which actual overhead exceeds applied overhead is called underapplied overhead.
    2. Formula:

Actual manufacturing overhead*

Underapplied overhead

*Sum of the Manufacturing-Overhead account:

^Applied overhead

    1. Actual less than applied is overapplied overhead: If actual overhead has been less than applied overhead, the difference would have been called overapplied overhead.
    2. Inaccurate estimates cause: Underapplied or overapplied overhead is caused by errors in the estimates of overhead and activity used to compute the predetermined overhead rate.
    3. Disposition of underapplied or overapplied overhead: At the end of the accounting period the managerial accountant has two alternatives for the disposition of the overhead.
    1. Most common disposition: The most common alternative is to close (or move) the amount into Cost of Goods Sold.
    2. Simplest: Most companies close into the Cost of Good Sold account because it is simple and the amount is usually small.
    1. Proration more precise but more complex: Some companies use a more accurate procedure to dispose of underapplied or overapplied overhead.
    1. Recognizes inaccuracies of other accounts: This approach recognized that underestimation or overestimation of the predetermined overhead rate affects Cost of Goods Sold, Work-in-Process Inventory and Finished-Goods Inventory.
    2. Required by Cost Accounting Standards Board (CASB): Proration of underapplied and overapplied overhead is used by a small number of firms that are required to do so under the rules specified by the CASB. This agency was chartered by Congress to develop cost-accounting standards for large government contractors.
    3. See example in Text on page 81.
    1. Schedule of Costs of Goods Manufactured: The schedule of cost of goods manufactured details the manufacturing costs incurred during an accounting period and shows the change in Work-in-Process Inventory.
    1. Example: See Text Exhibit 3-9 (page 82).
    2. Cost of goods manufactured: The cost of good manufactured is the cost of direct labor, direct material, and manufacturing overhead transferred from Work-in-Process Inventory during an accounting period.
    1. Schedule of Cost of Good Manufactured: The schedule of cost of goods sold shows the cost of goods sold and the change in finished-goods inventory during an accounting period.

(a) Example: See Text Exhibit 3-10 (page 83).

    1. Further Aspect of Overhead Application
    1. Accuracy versus Timeliness of Information: A Cost-Benefit Issue
    1. Cost-benefit theme prevails: One of the major themes of managerial accounting is the cost versus the benefit of information.
    2. Actual overhead rate defined: The actual overhead rate is the rate at which overhead costs are actually incurred during an accounting period.
    1. Predetermined Overhead Formula:

Actual Actual overhead for the accounting period

overhead rate = Actual amount of cost driver (activity base)


    1. Actual overhead rate more accurate, but untimely: A product-costing system could be designed to use an actual overhead rate instead of a predetermined overhead rate.
    1. Trade-off: A trade-off exists between accuracy and timeliness.
    2. Use of accuracy: Accurate information is useful when decisions are based on the information. Better pricing or cost-control decisions may result from more accurate product costs.
    3. Late information creates opportunity costs: Late information entails a cost in terms of missed opportunities and late responses to events. Therefore, managers and managerial accountants must weigh the costs and benefits of the following choices.
    1. More accuracy, but untimely: An actual overhead rate can only be computed at the end of the accounting period. Thus, actual overhead rates are more accurate but untimely.
    2. Less accuracy, but more timely: Predetermined overhead rates are less accurate but more timely.
    3. Each system has its own distinct costs and benefits: When designing a overhead allocation system the unique costs and benefits of each system must be carefully evaluated.
    1. Predetermined generally recommended: When designing product-costing systems, accountants generally recommend predetermined overhead rates.
    2. Frequent recomputing tempting: It might be tempting to solve the overhead rate problem by using an actual rate and recomputing the rate frequently to provide more timely information.
    1. Frequent recomputation may distort product cost: The problem with frequent recomputing is that some manufacturing-overhead costs are seasonal. These overhead costs are incurred unevenly throughout the year, and the monthly overhead rate will fluctuate widely.
    2. Volume-based cost driver may vary widely: The level of a volume-based cost driver, used as the denominator of the overhead rate, also may vary from period to period.
    3. Varying number of workdays and volume: The fluctuations in the number of workdays in a month and seasonal fluctuations in production volume can cause such variations.
    4. Resulting inconsistency misleading: The resulting inconsistency in product costs could give misleading information signals for product pricing and other decisions that may depend on product cost information.
    5. Fluctuations smoothed: Accountants generally choose to smooth out fluctuations in the predetermined overhead rate by computing the rate over a longer period of time.
    1. Common periods: One, two, or three year periods are common.
    2. Normalized rates are smoothed: A predetermined overhead rate computed over a relatively longer period of time is called a normalized overhead rate.
    1. Cost-benefit trade-off: The use of a relatively longer period of time forces the accountant to face the trade-off between accuracy and timeliness that was discussed above.
    1. Actual & Normal Costing: Most firms use a predetermined overhead rate, based on overhead and activity estimates for a relatively long time period.
    1. Normal costing uses actual and estimates: When direct materials 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.
    2. Actual costing use only actual rate: A system used by a few companies where actual direct-material, actual direct labor, and actual manufacturing-overhead costs are added to Work-in-Process Inventory.
    1. Amount still allocated: Note that even though an actual overhead rate is used, the amount of overhead assigned to each production job is still an allocated amount. Overhead costs, which are by definition indirect costs, cannot be traced easily to individual production jobs.
    2. Allocation of costs:
    1. Actual Costing = Actual direct-material costs + actual direct-labor costs + overhead allocated (Actual overhead rate (computed at the end of period) X Actual amount of cost driver (e.g. direct-labor hours)).
    2. Normal Costing = Actual direct-material costs + actual direct-labor costs + overhead allocated (Predetermined overhead rate (computed at the beginning of the period) X Actual amount of cost driver used (e.g., direct-labor hours)).
    3. Difference between methods: Essentially, the only difference between actual and normal costing is that actual costing uses an actual overhead rate computed at the end of the period. While normal costing uses the predetermined overhead rate computed at the beginning of the period.
    1. Choosing the Cost Driver for Overhead Application: Manufacturing overhead includes various indirect manufacturing costs that vary greatly in their relationship to the production process.
    1. Single volume-based cost driver common to all products: If a single, volume-based cost driver (or activity base) is used in calculating the predetermined overhead rate, it should be some product input that is common across all the firm’s product.
    2. Choose drivers that vary directly with overhead: In selecting a volume-based cost driver (or activity base), the goal is to choose an input that varies in a pattern that is most similar to the pattern with which overhead costs vary.
    1. Correlation between overhead and cost driver: Thus, there should be a correlation between overhead costs and the cost driver.
    1. Limitation of Direct Labor as a Cost Driver: In traditional product-costing systems, the most common volume-based cost drivers are direct-labor hours and direct-labor cost.
    1. Trend away from using direct labor: There is a trend away from using direct labor as the overhead application base.
    1. Trend results from automation: Many production processes are becoming increasingly automated, through the use of robotics and computer-integrated manufacturing systems
    2. Increased automation causes:
    1. M.O.’s proportion larger: Manufacturing-overhead costs to represent a larger proportion of total production costs.
    2. Direct labor less important: Direct labor decreases in importance as a factor of production.
    3. Firms switch away from labor as cost driver: As direct labor decreases in importance as a productive unit, it becomes less appropriate as a cost driver. For this reason, some firms have switched to machine hours, process time, or throughput time as cost drivers that better reflect the pattern of overhead costs.
    1. Throughput time averages conversion: Throughput time (or cycle time) is the average amount of time required to convert raw materials into finished goods ready to be shipped to customers.
    1. Includes time until competition: Throughput time includes the time required for material handling, production processing, inspection, and packaging.
    1. Plantwide overhead rates: Only one overhead rate is used for the entire factory, so it is known as a plantwide overhead rate.
    2. Departmental overhead rates: In some production processes, the relationship between overhead costs and the firm’s products differ substantially across production departments.
    1. Individualized rates: In a departmental overhead rate a single production rate is calculated for each department.
    2. More accurate assignment: This usually results in a more accurate assignment of overhead costs to the firm’s products.
    1. Two-Stage Cost Allocation: When a company uses departmental overhead rates, the assignment of manufacturing-overhead costs to production jobs is accomplished in two stages.
    1. First Stage—Departmental assignment: In the first stage all manufacturing-overhead costs are assigned to the firm’s production departments.
    1. Two different allocations: Stage one often involves two types of allocation processes.
    1. Cost assigned: First, all manufacturing-overhead costs are assigned to departmental overhead centers. This step is called cost distribution (or sometimes cost allocation).
    2. Service departments: These departments are not directly involved in producing the organization’s output of goods and services.
    3. Service departments reassigned: All service department costs are redesigned to the production departments through a process called service department cost allocation. In this step, an attempt is made to allocate service department costs on the basis of the relative proportion of each service department’s output that is used by the various production departments.
    1. Second Stage—Job assignment: In the second stage all of the manufacturing-overhead costs accumulated in each production department are assigned to production jobs on which the department has worked.
    1. Overhead application: This process is sometimes called overhead application (or sometime overhead absorption).
    2. Unique department’s rate: In stage two, each production department has its own predetermined overhead rate.
    3. Cost drivers differ: These rates often are based on different cost drivers.
    1. Activity-Based Costing: An Introduction
    1. Great accuracy with activity focus: While departmental overhead rates provide more accurate product costs than a single plantwide rate, it is possible to achieve even greater accuracy by focusing on the many activities that comprise the production process.
    2. ABC defined: A two-stage procedure for assigning overhead costs to products, which focuses on the major activities performed in the production process is a activity-based costing (or ABC) system.
    3. Cost assignment: After assigning costs to the activity cost pools in stage one, cost drivers are identified that are appropriate for each cost pool. Then, in stage two the overhead costs are allocated from each activity cost pool to each production job in proportion to the amount of activity consumed by the job.
    4. Costs and benefits: The theme of costs and benefits arises again with respect to using a single, plantwide overhead rate, departmental overhead rates, or an activity costing system.
    5. Trends: The trend in today’s highly automated manufacturing environments is toward greater use of multiple cost drivers for overhead application. Activity-based costing systems are coming into greater use as mangers see the strategic importance of having highly accurate production information.
    1. Project Costing: Job-Order Costing in Nonmanufacturing Organizations
    1. Generally: Job-order costing is used in nonmanufacturing organizations.
    2. Terminology operation specific: Rather than referring to production "jobs," such organizations use terminology that reflects their operations.
    1. Examples: Hospitals and law firms assign costs to "cases," consulting firms and advertising agencies have "contracts," and governmental agencies often refer to "programs" or "missions."
    1. Identical needs: The need for cost accumulation exists in these and similar organizations for the same reasons found in manufacturing firms.
    2. Main point: The main point is that job-order costing systems are used in a wide variety of organizations, and these systems provide important information to managers for planning, decision-making and control.
    3. Budgeted overhead rate:

Budgeted overhead

Budgeted direct professional labor

    1. Changing Technology in Manufacturing Operations:
    1. Generally: Technological changes often affect the managerial accounting procedures used to collect data and transmit information to the intended users.
    2. Electronic Data Interchange: The direct exchange of data between organizations via a computer-to-computer interface is known as electronic data interchange (or EDI).
    1. Example in Press: Recently, financial EDI has become available for customer to send an electronic remittance advice to a financial institution. Integrated financial EDI and EFT (electronic funds transfer) systems eliminate considerable check-payment paperwork between customers and suppliers.
    2. All types of use: EDI is used to transmit such documents as purchase orders, shipping notices, receiving notices, invoices, and a host of other production-related data.
    3. Reduces paperwork and errors: EDI eliminates the need for paperwork, speeding up the flow of information, and substantially reducing errors.
    1. Bar Codes: Bar codes represent one more instance where technology is changing both the production environment and the procedures used in accounting for production operation.
    1. Manufacturer’s use: Many manufacturers use bar code technology to track orders through every stage of production process, from requisitioning raw materials to shipping finished goods.


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