Chapter-Three

Costing System
Part: I: - Job order costing

Job order costing systems-is a traditional volume based approach, used by companies
in situations where many distinct products, jobs, or batches of products are being
produced each period and where there are significant differences among the batches.
Examples of firms that use job-order costing are aircraft manufacturers, printers, furniture
manufacturers, ship-building, equipment manufacturing, and the like. In job-order
costing, each distinct batch of production is called a job or job order. The cost accounting
system is designed to assign costs to each job. Then the costs assigned to each job are
averaged over the units of production in the job to obtain an average cost per unit.
E.g. Suppose that Doni-printing Company worked on two printing jobs, job-A and job-
B during February, and the following costs were incurred.

Job-A Job-B
(1000 campaign posters) (100 weeding invitations card)

Direct material ----------------$100-----------------------------------------$36

Direct labor--------------------250--------------------------------------------40
Manufacturing overhead-----150--------------------------------------------24
Total manufacturing cost----$500-----------------------------------------$100

The cost per campaign poster is $.50 per poster ($500 divided by 1,000 posters), and the
cost per wedding invitation is $1.00 ($ 100 divided by 100 invitations.)
Procedures similar to those used in job-order costing are also used in many service
industry firms that have no work-in-process or finished goods inventories. In public
accounting firm, for example, costs are assigned to audit engagements in much the same
way they are assigned to a batch of products by furniture manufacturers. Similar
procedures are used to assign costs to “cases” in health care facilities, to “programs” in
government agencies, to research “projects” in universities, and to “contracts” in
consulting and architectural firms.

 Material and cost flows (manufacturing companies)

Manufacturing costs consists of direct material, direct labor, and manufacturing

overhead. The product costing system used by companies employ several
manufacturing accounts. As production takes place, all manufacturing costs are added
to the work- in-process inventory accounts. Work in process is partially completed
inventory. A debit to the account increases the cost-based valuation of the asset
represented by the unfinished products. As soon as products are completed, their
product costs are transferred from Work-in-Process Inventory to Finished-Goods
Inventory. This is accomplished 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, which is an expense of the period in which the sales occurred. A
credit to finished goods and a debit to cost of goods sold completes this step. Cost of

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 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.(see exhibit 3-7)

Exhibit 3-7 : Material and cost flow manufacturing companies

Work-in-process Inventory Finished Goods Inventory

Direct-material cost Product cost is transferred

Direct-labor cost
Manufacturing overhead when product is finished

Product cost are transferred when product is sold

Cost of Goods Sold Income Summary

Expense closed into

Income Summary at end

of accounting period

 Accounting treatment

Job cost sheet-To keep track of the manufacturing costs assigned to each job, a
subsidiary ledger is maintained. The subsidiary ledger assigned to each job is a document
called a job-cost-sheet. It is used to accumulate the cost of direct material, direct labor,
and manufacturing overhead assigned to the job.

Direct material cost-As raw material are needed for 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. A copy of the material requisition form goes
to the cost- accounting department where it is used a base for transferring the cost of the
requisitioned material from the Raw-Material Inventory account to the work –in-Process
Inventory account, and to enter the direct- material cost on the job-cost sheet for the
production job in process.

Direct-Labor cost-The assignment of direct labor costs to jobs is based on time tickets
filled out by employees. A time ticket is a form that records the amount of time an
employee spends on each production job. It is used as a source document by cost
accounting department as the basis for adding direct –labor cost to work-in- process
Inventory and to the job-cost sheets for the various jobs in process.
Manufacturing-Overhead costs-It is relatively simple to trace direct-material and direct
labor costs to production jobs, but manufacturing overhead is not easily traced to jobs. By

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definition, manufacturing overhead is a heterogeneous pool of indirect production costs,
which bears no obvious relationship to individual jobs or units of products, but must be
incurred for production to take place. 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 /or overhead allocation / or sometimes overhead absorption/

Exhibit 3-8: Summary of overhead concepts

The amount of overhead cost that management
Estimated overhead cost estimate to be incurred. This estimate is made
Before the period or at the beginning of the period
in order to compute predetermined overhead rate.

Actual overhead cost The amount of overhead cost

that is actually incurred during
a period (as shown by payments The deference
for utilities, rents, and so on.) between these
amounts
Applied overhead The amount of overhead cost represents
that is added(applied)to work under or
in process. This amount is over applied
computed by applying overhead
actual activity during
the period by the predetermined
overhead rate

Actual costing- Allocate direct material and direct labor costs to cost objects on the bases
of actual direct-cost rate(s) and actual quantity of direct-cost input(s). Overhead costs are
allocated to cost object on the basis of actual overhead rate computed at the end of the
period and actual amount of cost deriver used
Normal costing- allocate direct material and direct labor cost on the bases of actual
direct cost rate(s) and actual quantity of direct-cost input(s). Overhead costs are allocated
to cost object on the basis of predetermined /budgeted/ overhead rate computed at the
beginning of the period and actual quantity of cost-allocation base(s).The summary is
given as follows.

Actual costing Normal costing

Direct costs - Actual direct-cost rate(s) × - Actual direct-cost rate(s) ×
Actual quantity of direct-cost Actual quantity of direct-cost
Input(s) input(s)

Indirect costs -Actual indirect-cost rate(s) × - Budgeted indirect-cost rate(s) ×

Actual quantity of cost-allocation Actual quantity of cost-allocation
base(s). base(s)

Allocation of overhead costs- for product costing to be useful, information must be

provided to managers on a timely basis. Suppose the cost-accounting department waited
until the end of an accounting period so that the actual costs of manufacturing overhead

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could be determined before applying overhead costs to the firm’s products. The result
would be very accurate overhead application and decision based in such information
could be better i.e. better pricing and control decisions may result from more accurate
product costs. However, the information might be useless because it was not available to
managers for planning, control, and decision making at the appropriate time. Do to this
fact many opportunities may be missed and late responses may be given to events. Thus,
managers and management accountants must weigh the costs and benefits of this
information.
- It might be tempting to solve the overhead rate problem by using an actual rate and
recomputed the rate frequently to provide more timely information. This is generally
because of the numerator and denominator factors such as the following.

Numerator factors (indirect cost pools)

- The shorter the period, the greater the influence of seasonal patters
eg Cost of heating is higher in the winter than it is in the summer.
Cost of ventilator is higher in the summer than in winter.
- Non seasonal erratic costs such as cost incurred in a particular month that
benefit operation during future months e.g. Repair and
maintenance of equipment, vacation and holiday pay.
The denominator reason (quantity of the allocation base)
- Some indirect costs such as costs of supplies may be variable with respect
to the cost-allocation base, whereas other indirect costs are
fixed( for example, property taxes and rent)
Thus, it is possible to smooth out fluctuation in the overhead rate and the
numerator and denominator related variations by computing the rate over a long time
such as one year period and so.

Actual overhead rate Predetermined overhead rate

- More accurate, but - Less accurate, but more
untimely information timely information

Each entails costs and benefits

that must be considered

Predetermined overhead rate-As most management accountants recommend, and as

most organizations do, the best solution to the above said problem is to apply overhead to
products on the basis of estimates made at the beginning of the accounting period. The
accounting department chooses some measure of productive activity to use as the basis
for overhead application. In the case of traditional approaches, this could be volume
based cost drive (or activity base) such direct labor hours, direct-labor cost, machine
hours, number of miles traveled and the like

As estimate is made of (1) the amount of manufacturing overhead costs that will be
incurred during a specified period of time and (2) the amount of the cost driver that will

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be used or incurred during the same time period, then a predetermined overhead rate is
computed as follows:
Predetermined = Budgeted total manufacturing overhead cost for the period
Overhead rate Budgeted total amount of cost driver (activity base)

For example, suppose that R-printing co. has chosen machine hours as its cost driver
(activity- base), and estimated that its total overhead cost to work on two distinct jobs,
job-1,and job-2 for the next year will amount to $90,000 and that the total machine hours
required for the two jobs will be 10,000 hours. Then, its predetermined overhead rate is
computed as follows:

Predetermined overhead rate = $90,000 = $9.00 per machine hours.

10,000 hours
Applying overhead costs- The predetermined overhead rate is used to apply
manufacturing overhead costs to production jobs/ normal costing/. The actual quantity of
the cost driver (or activity base) required by a particular job is multiplied by the
predetermined overhead rate to determine the amount of overhead cost applied to the job.
For example, suppose that R-printing co. job number one (Job-1), consists of 1,000
brochures that requires a total of three machine hours. The overhead applied to the job is
computed as follows:

Predetermined overhead rate---------------------------------$9

Machine hours required by job-1------------------- --------×3
Overhead applied to job-1-----------------------------------$27

The $27 of applied overhead will be added to Work-in-Process Inventory and recorded
on the job-cost sheet for job-1. The accounting entry made to add manufacturing
overhead to Work-in-Process Inventory may be made daily, weekly, monthly and so,
depending on the time required to process production jobs. Before the end of the
accounting period, entries should be made to record all manufacturing costs incurred to
date in Work-in-Process Inventory. This is necessary to properly value work in process
on the balance sheet.

Work-in-process control-is the account used to record direct material and direct labor
cost used / put/ in to production. As direct materials are used, they are charged to
individual job records, which are subsidiary ledger accounts for the Work-in Process
control account in the general ledger account. Its balance increases when indirect costs
are applied to production.
Manufacturing overhead control- is the account used to record the actual costs incurred
during the period in all the individual overhead categories such as indirect material,
indirect labor, and other indirect costs. It has a normal debit balance i.e. it increases when
actual indirect costs are incurred and decreases when indirect costs are applied to
production process on the basis of the predetermined overhead rate.
Manufacturing overhead applied-is the account used to record the manufacturing
overhead allocated during the period to individual jobs on the bases of the budgeted rate

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multiplied by actual amount /number/unit/ allocation base such as direct manufacturing
labor-hours. It is a contra-account to manufacturing overhead account.
Disposing of factory overhead balances-If the actual overhead had been less than or
more than the applied overhead, then, there will be overhead balances that should be
disposed as of the end of the accounting period.
If actual overhead is less than applied overhead, the difference would have been called
over applied overhead or over allocated overhead.
If the actual overhead is more than applied overhead, then, the difference is called under
applied overhead or under allocated overhead.
In any ways, companies have three alternatives to dispose the overhead balances at the
end of the period. These are:
(1) Adjusted allocation rate approach- this approach restate all entries
in the general and subsidiary ledgers by using actual cost rates than
budgeted cost rates. First the indirect cost rate is computed at the end
of the year. Then, every job to which indirect costs were allocated
during the year has its amounts recomputed using the actual indirect-
cost rate rather than the budgeted indirect cost rate. This will give the
best accuracy, and decisions based on accurate information could be
sound and more important. But unless computer system is applied, it
will be complicated and costly.
(2) Write-off to cost of Goods sold Approach-as in the case of most
companies, the over or under applied overhead costs may be closed
into cost of goods sold.
a) For under applied overhead balance, by debiting Cost of Goods sold
accounts and crediting Manufacturing overhead account by the amount
of the difference or by debiting cost of goods sold by the amount of the
difference and debiting Manufacturing overhead applied account by its
balance and crediting Manufacturing overhead control account by the
total amount of its balance i.e.

Cost of goods sold----------------------------------x

Manufacturing overhead applied-----------------xx
Manufacturing overhead control--------------xxx

b)For over applied overhead balance, by crediting Cost of Goods sold

account and debiting to manufacturing overhead applied account by the
amount of the difference or by crediting cost goods sold by the amount of
the difference, crediting manufacturing overhead control account by its
balance and debit manufacturing overhead applied account by its balance.
i.e. Manufacturing over head applied-------------------------xxx
Cost of goods sold------------------------------------------------x
Manufacturing overhead control-------------------------------xx

(3) Proration Approach-is the distribution of overhead balances among

ending work in process, finished goods, and cost of goods sold
accounts. Materials inventories are not allocated any manufacturing

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 overhead costs, so they are not included in this spreading of under-or
over allocated overhead among proration. To this effect, companies
may use the amount of the current period’s applied overhead
remaining in each account as the base for the proration procedure.
Suppose that AB-Manufacturing company produces two products X and Y.
Assume that the total actual overhead costs incurred by the company and the total
overhead costs applied by the company during the year 2002 were $19,400 and
$18,000 respectively. The current period before adjustment overhead balance
allocated to Work-in-Process, Finished Goods Inventory and Cost of Goods sold
accounts are $9,000,$3,000 and $6,000 respectively.
The under applied overhead balance = $19,400- $18,000 = $400

The company can prostate the balance of $400 among the three accounts as follows.
Total year end overhead balances of the three accounts (before adjustment) = $9,000 +
$3,000 + $6,000 = $18,000
Thus, the amount allocated to each account should be:
Work-in process = $9,000 × $400 = $200
$18,000
Finished goods inventory = $3,000 × $400 = $66.67
$18,000
Cost of goods sold = $6,000 × $400 = $133.33
$18,000
The entry for this case should be:
Work-in process inventory------------------200
Finished goods inventory-----------------66.67
Cost of goods sold------------------------133.33
Manufacturing overhead control--------------400
This approach gives us a more accurate figure of work in process, finished goods, and
cost of goods sold, but it is still not as simple as write off to cost of goods sold methods.

NB-In all of the above cases /approaches/, the balances of manufacturing Overhead
control and Manufacturing Overhead applied accounts should be reduced to zero after
the factory overhead balances are removed through adjustment and ready to accumulate
the overhead costs of the next accounting period.
 In choosing among the three approaches, managers should be guided by how the
resulting information will be used.
-If managers desire to develop the most accurate records of individual job costs for
profitability analysis purposes, the adjustment allocation-rate approach is preferred.
- If the purpose is confined to reporting the most accurate inventory and cost of goods
sold figures, proration approach on the manufacturing overhead-allocated component in
the ending balances should be used.
-If the amount of under or over allocated balances is small-in comparison to total
operating income, or some other measure of materiality, the write off to cost of goods
sold method(the simples method) could be used. This approach can be reliable in today’s
business environment where the concept of JIT is applicable.

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 Illustration of job order costing

To illustrate the procedures used in job-order costing, we will examine the accounting
entries made by Alpha-manufacturing co. during November 2003. The company uses
machine hours to allocate overhead costs to the individual jobs. It has worked on two
production jobs during the month.
Job-1: 80 deluxe wooden canoes
Job-2: 80 deluxe aluminum fishing boats
The company undertaken the following activities/transaction during the month of
November

Transaction-1: Acquisition of direct materials

4000-square feet of rolled aluminum sheet metal were purchased on account for $10,000.
The purchase is recorded with the following journal entry.

Raw-material Inventory----------------------10,000
Accounts payable------------------------------10,000

Transaction-2: Use of direct material

On November -1, the following material requisitions were filed.

Requisition number-001 (for job-1) ---------8,000 board feet of lumber, at $2 per

board foot, for a total of $16,000
Requisition number-002 (for job-2) --------7,200 square feet of aluminum sheet metal,
at $2.50 per square foot, for a total of
$18,000

The following journal entry records the release of these raw materials to production.

Work-in-process inventory---------------34,000
Raw-material inventory--------------------34,000

Transaction-3: Use of indirect material

On November 15, the following material requisition was filed.
Requisition-003: 5-gallons of bonding glue, at $10 per gallon, for a total cost of $50

Manufacturing overhead-------------------50
Manufacturing supplies inventory----------50

Since only small amounts of bonding glue are used in the production of all classes of
boats manufactured by the company, the costs incurred is small, and no attempt is made
to trace the cost of glue to specific jobs. Instead, glue is considered an indirect material,
and its cost is included in manufacturing overhead. The company accumulates all
manufacturing-overhead cost in Manufacturing Overhead account. All actual overhead
cost are recorded by debiting the account when indirect materials are requisitioned, when

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indirect-labor costs are incurred , when utility bills are paid, when depreciation is
recorded on manufacturing equipment, and so on.
Transaction-4: Use of direct labor
At the end of November, the cost-accounting department used the labor time tickets
filed during the month to determine the following direct-labor costs of each job.
Direct labor: Job-1----------------$9,000
Direct labor: Job-2--------------12,000
Total direct labor-----------------$21,000
The journal entry used to record these costs should be

Work-in-process Inventory---------------21,000
Wages payable--------------------------------21,000

Transaction-5: Use of indirect labor

The analysis of large time card undertaken on November-30 also revealed the following
use of indirect labor that is not charged to either of the products specifically amounts to
$14,000.
This cost is comprised of the production supervisor’s salary and the wages of various
employees who spent some of their time on maintenance, general cleanup duties and
salary of guards and store keepers during November.

Manufacturing overhead--------------------14,000
Wages Payable------------------------------------14,000

No entry is made on any job cost sheet, since indirect-labor costs are not traceable to any
particular job. In practice, journal entries (4) and (5) are usually combined into one
compound entry as follows:

Work in process inventory------------------21,000

Manufacturing overhead---------------------14,000
Wages payable------------------------------------35,000

Transaction-6: Other manufacturing over head costs

During November, the company incurred the following other manufacturing overhead
cost besides the indirect materials and indirect labors costs.
Rent on factory building (expired prepaid rent) ------------$3,000
Depreciation on equipment-------------------------------------5,000
Utilities (electricity, water, telephone) -----------------------4,000
Property taxes-----------------------------------------------------2,000
Insurance (amount expire during the month) -----------------1,000
Total --------------------------------------------------------------$15,000
The following compound entry is made on November-30, to record these costs.

Manufacturing overhead------------------------15,000
Prepaid Rent----------------------------------------------3,000
Accumulated depreciation-Equipment----------------5,000
Accounts Payable (utilities and property tax) --------6,000

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 Prepaid Insurance-----------------------------------------1,000
Application of manufacturing overhead
Various manufacturing-overhead costs were incurred during November, and these costs
were accumulated by debiting the Manufacturing-Overhead accounts. However, no
manufacturing-overhead cost have yet been added to Work- in-Process Inventory or
recorded on the job-cost sheets. The application of overhead to the firm’s products is
based on a predetermined overhead rate. This rate computed by the accounting
department at the beginning of the period. (Refer to page-14 to 15)
Transaction-7: Allocation of overhead costs
Factory machine-usage records indicate the following usage of machine hours during
November.
Machine hour used: Job-1 -----------------------------1, 200 hours
Machine hour used: Job-2-------------------------------2,000 hours
Total machine hours--------------------------------------3,200 hours
The total manufacturing overhead applied to Work-in Process Inventory during
November is calculated as follows:
The total manufacturing overhead applied to Work-in-Process Inventory during
November is calculated as follows:
Machine hour Predetermined Manufacturing
Overhead rate overhead applied
Job-1 1,200 × $9.00 = $10,800
Job-2 2,000 × $9.00 = $18,000
Total manufacturing overhead applied $28,800
The following journal entry is made to apply manufacturing overhead to Work-in-Process
Inventory.

Work-in-Process Inventory ----------------------28,800

Manufacturing overhead---------------------------------28,800

NB. As the following time line shows, three concepts are used in accounting for
overhead. 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.

Beginning of End of
Accounting period accounting period
TIME

Budgeted overhead
(and calculation of Applied Actual
Predetermined overhead overhead
Overhead rate)
Transaction-8: Selling and administrative costs
During November, Alpha-manufacturing co. incurred the following selling and
administrative costs.
Rental of sales and administrative offices--------------------------$1,500
Salaries of sales personnel---------------------------------------------4,500

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 Salaries of management------------------------------------------------8,000
Advertising---------------------------------------------------------------1,000
Office supplies used------------------------------------------------------ 300
Total---------------------------------------------------------------------$14,800
Since these are not manufacturing costs, they are not added to Work-in-Process Inventory. Selling
and administrative costs are period costs, not product costs. They are treated as expenses of the
accounting period. The following journal entry is made

Selling and Administrative Expenses---------------------14,800

Wages Payable---------------------------------------------------12,000
Accounts payable-------------------------------------------------1,000
Prepaid Rent-------------------------------------------------------1,500
Office Supplies inventory------------------------------------------300
Transaction-9: Completion of production job
Job-2 was completed during November, whereas job-1 remained in process. The job sheet
indicates that the total cost of job-2 was $48,000. The following journal entry records the transfer
of these job costs from Work-in-Process Inventory to finished goods inventory.

Finished goods inventory--------------------48,000

Work-in- Process inventory-------------------48,000

Transaction-10: Sales of goods

Sixty deluxe aluminum fishing boats manufactured in job-2 were sold for $900 each during
November. The cost of each unit sold was $600 as shown on the job cost sheet. The following
journal entries were made

a) Accounts Receivable------------------54,000
Sales Revenue-----------------------------54,000

b) Cost of goods sold-----------------------36,000

Finished goods inventory-----------------36,000
The reminder of the manufacturing cost of job-2 remains in Finished –goods inventory until some
subsequent accounting period when the units are sold. Therefore the cost balance for job-2
remaining in inventory is $12,000 (20 units remaining times $600 per unit.)
Transaction-11: Disposition of overhead balances
During November, Alpha-Manufacturing co. incurred total actual manufacturing-overhead costs
of $29,050, but only $28,800 of overhead was applied to Work-in-Process Inventory. The amount
by which the company’s actual overhead exceeds applied overhead, called under applied
overhead, is calculated below.
Actual manufacturing overhead*----------------------------------$29,050
Applied manufacturing overhead+-------------------------------- 28,800
Under applied overhead---------------------------------------------$ 250

The company disposes its overhead balances at the end of the year by directly writing the amount
to cost goods sold during the period. Accordingly, the following journal entry is made by the
company. This entry reduces the balance of Manufacturing Overhead accounts to zero and
increase the balance of cost of goods sold account by $250.

Cost of goods sold------------------------------250

Manufacturing Overhead control--------------250

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