job order
TRANSCRIPT
A job order costing system is used in situations where many different products are produced each period. For example clothing factory would typically made many different types of jeans for both men and women during a month. In a job order costing system, costs are traced to the jobs and then the costs of the job are divided by the number of units in the job to arrive at an average cost per unit.
Job order costing system is also extensively used in service industries. Hospitals, law firms, movie studios, accounting firms, advertising agencies and repair shops all use a variety of job order costing system to accumulate costs for accounting and billing purposes. The details here deal with a manufacturing firm, the same concept and procedures are used by many service organizations.
The record keeping and cost assignment problems are more complex in a job order costing system when a company sells many different products and services than when it has only a single product or service. Since the products are different, the costs are typically different. Consequently, cost records must be maintained for each distinct product or job. For example an attorney in a large criminal law practice would ordinarily keep separate records of the costs of advising and defending each of her clients. And a clothing factory would keep separate track of the costs of filling orders for particular styles, sizes, and colors of jeans.
The job order cost system is used when products are made based on specific customer orders. Each product produced is considered a job. Costs are tracked by job. Services rendered can also be considered a job. For example, service companies consider the creation of a financial plan by a certified financial planner, or of an estate plan by an attorney, unique jobs. The job order cost system must capture and track by job the costs of producing each job, which includes materials, labor, and overhead in a manufacturing environment. To track data, the following documents are used:
3 Basic Elements of Job Order Costing SystemUnder a job order cost system, the three basic elements of cost—direct materials, direct labor, and factory overhead—are accumulated according to assigned job numbers. The unit cost for each job is obtained by dividing the total units for the job into the job’s total cost. A cost sheet is used to summarize the applicable job costs. Selling and administrative expenses, which are based on a percentage of manufacturing cost, are listed on the cost sheet to arrive at total cost.In order for a job order cost system to function properly, it must be possible to identify each job physically and segregate its related costs.
Direct material requisitions and direct labor costs carry the particular job number; factory overhead is usually applied to individual jobs based on a predetermined factory overhead application rate. The profit or loss can be
determined for each job and the unit cost computed for purposes of inventory costing. Schedules are prepared to accumulate the information for the required journal entries.
Element-1. Direct Materials
Purchase of Materials - Raw materials and supplies used in production are ordered by the purchasing
department. These materials are kept in a materials storeroom under the control of a clerk and are issued only
when a properly approved requisition is presented.
Issuance of Materials - The next step in the manufacturing process is to obtain the needed raw materials
from the materials storeroom. There is one source document for the issuance of materials in a job order cost
system—a materials requisition.Any issuance of materials by the materials clerk must be substantiated by a
materials requisition approved by the production manager or the department supervisor. Each requisition form
shows the job order number, the department number, and the quantities and description of materials
requested. The materials clerk enters the unit cost and total cost on the requisition form.
On a regular basis, perhaps weekly, materials requisitions are sorted by job number and the totals
recorded on a cost summary sheet.
When direct materials are put into production, a journal entry is made to record the addition of materials to
work-in-process inventory. When indirect materials are requisitioned, they are generally charged to a
departmental Factory Overhead Control account. Indirect materials costs are included in the factory overhead
application rate, as it is often impractical to trace these materials to each job.
Element-2. Labor CostThere are two source documents for labor in a job order cost system—a time card and a labor job ticket:
Time (or clock) cards are inserted in a time clock by employees each day when they arrive, go to
and return from lunch, take breaks, and leave work for the day. This procedure mechanically shows a
record of total hours worked each day by each employee and thus provides a reliable source for the
computation and recording of payroll.
Labor job tickets are prepared daily by each employee indicating the job worked on and the number
of hours worked. The wage rate of the employee is inserted by the payroll department. The sum of the
labor cost and hours incurred on various jobs (labor tickets) should be equal to the total labor cost and
total labor hours for the period (time cards).
At periodic intervals, time cards are summarized to record the payroll, and labor job tickets are summarized to be charged to work-in-process inventory or factory overhead control. Time card and job ticket hours should be reconciled.
PearCo Employee Time Ticket
Time Ticket No. 36 Date 3/5/01
Employee I. M. Skilled Station 42
Starting Ending Hours HourlyTime Time Completed Rate Amount Job No.0800 1600 8.00 11.00$ 88.00$ A-143
Totals 8.00 11.00$ 88.00$ A-143
Supervisor C. M. Workman
Element-3. Factory Overhead
The third element to be included in determining the total cost in a job order cost system is factory overhead. There is one source document for the computation of factory overhead costs in a job order cost system—a departmental factory overhead cost sheet, which each department maintains. This is a subsidiary ledger of the Factory Overhead Control account. Reconciliation of the control and subsidiary ledgers should be performed at regular intervals. It should be noted, however, that factory overhead costs may be recorded for the factory in total and then distributed to production departments for ultimate distribution to jobs. However, assigning manufacturing overhead to units of product can be a difficult task. There are three reasons for this:
1. Manufacturing overhead is an indirect cost. This means that it is either impossible or difficult to trace these costs to a particular product or job.
2. Manufacturing overhead consists of many different items ranging from the grease used in machines to the annual salary of production manager.
3. Even though output may fluctuate due to seasonal or other factors, manufacturing overhead costs tend to remain relatively constant due to the presence of fixed costs.
The distribution of factory overhead to jobs is based on a predetermined “factory
overhead application rate “. Factory overhead application rates are expressed in terms of direct labor hours, direct labor dollars, direct materials dollars, machine hours, or some other reasonable basis. When factory overhead is not accumulated on a factory wide level for distribution to several departments, each department will generally have a different rate.
OVERHEAD AND COST DRIVERS: The application of overhead to specific jobs is mostly an exercise in algebra. Jack applied overhead at the rate of $20 for each hour of direct labor. A similar mathematical exercise is used to apply overhead in the highly automated factory environment. Some predetermined scheme is used to apply the overhead to production.
However, in a highly mechanized environment, one must give careful thought to the "cost driver." The cost driver is the factor that is viewed as causing costs to be incurred within an organization; it is best viewed only in an abstract context, as there are too many individual variables for any single factor to fully explain all cost incurrence. For Jack Castle's business, direct labor hours were viewed as the primary cost driver and the basis for assigning overhead. Labor hours may not be the most significant cost driver in a mechanized setting. Machine hours, number of direct material bar code scans, fuel consumption, spot-welds, or number of assembly
steps could each provide a potentially logical base for allocating overhead. This choice must be logical, as it will govern the allocation of total overhead costs to individual products.
It is a bit frightening to consider that product pricing, CVP analysis, inventory values, decisions to discontinue a product, and so forth are dependent upon costing information that is driven by arbitrary overhead allocation choices. This underscores the importance of careful methodology in correctly identifying cost drivers. To do otherwise could result in costing some products too high and others too low. This might lead to overproduction of unprofitable products and discontinuance of profitable lines. How is this possible? Suppose a computer manufacturer allocated overhead based on the installation of RAM memory chips. As a result, a machine with 2 GB of memory would absorb twice as much overhead as a machine with 1 GB. This is probably not a good idea; there is little difference in the production process needed to manufacture the two machines (save and except the difference in direct material cost for memory chips). The faulty overhead allocation could cause management to conclude that the 2 GB machines were too costly to produce, while the 1 GB machines seem a relative bargain. In short, the amount of memory is probably not the leading cost driver.
Management accountants have long fretted about the overhead allocation problem. With so much at stake, quite a lot of thought has been put into ways to improve this effort. In the next chapter, you will discover "activity-based costing." ABC seeks to overcome some of the issues just described by dividing production into its component processes ("activities") and more closely associating overhead with each unique process. But, ABC has its own limitations, so do not be too quick to dismiss the merits of the overhead allocation approach introduced in this chapter.
Formula and Calculation of Predetermined Overhead Rate:
[Predetermined Overhead Rate = Estimated total manufacturing overhead cost / Estimated total units in the allocation base]
PearCo applies overhead based on direct labour hours. Total estimated overhead for the year is $640,000. Total estimated labour cost is $1,400,000 and total estimated labour hours are 160,000.
What is PearCo’s predetermined overhead rate per hour?
predetermined overhead rate= 640000/160000 = $4 per direct labour hour
The Need for Predetermined Overhead Rate:
Instead of using a predetermined overhead rate, a company could wait until the end of the accounting period to compute an actual over head rate based on actual total manufacturing costs
and the actual total units in the allocation base for the period. However, managers cite several reasons for using predetermined over head rates instead of actual overhead rates:
1. Managers would like to know the accounting system's valuation of completed jobs before the end of the accounting period. Suppose, for example a company waits until the end of the year to compute its overhead rate. Then there would be no way for managers to know the cost of goods sold for a job until the close of the year. The job may be completed and shipped before the end of the year. The seriousness of this problem can be reduced to some extent by computing the actual overhead more frequently, but that immediately leads to another problem as discussed below.
2. If actual overhead rates are computed frequently, seasonal factors in overhead costs or in the allocation base can produce fluctuations in the overhead rates. For example, the cost of heating and cooling a production facility will be highest in the winter and summer months and lowest in the spring and fall. If an overhead rate were computed each month or each quarter, the predetermined overhead rate would go up in the winter and summer and down in the spring and fall. Tow identical jobs, one completed in winter and one completed in spring, would be assigned different costs if the overhead rate were computed on a monthly or quarterly basis. Managers generally feel that such fluctuations in overhead rates and costs serve no useful purpose and are misleading.
3. The use of predetermined overhead rate simplifies the record keeping. To determine the overhead cost to apply t a job, the accounting staff simply multiplies the direct labor hours recorded for the job by the predetermined overhead rate.
The Flow of Documents in a Job Order Costing System
A sales order is prepared as a basis for issuing a.....
A production order initiates work on a job, whereby costs are charged through...
→
Materials requisition form
These production costs are accumulated on a form, prepared by the accounting department known as...
The job cost sheet is used to compute unit product costs that in turn are used to value ending inventories and to determine cost of goods sold
Sales Order
→ Production Order
Direct labor time ticket →
Job cost sheet
Predetermined overhead rates
Job Order Costing - The Flow of Cost: To understand the flow of costs in job order costing system, we shall consider a single month's activity for a company, a producer of product A and product B. The company has two jobs in process during April, the first month of its fiscal year. Job 1, of 1000 units of product A was started in march. By the end of march, $30,000 in manufacturing costs had been recorded for the job 1. Job 2 an order for 10,000 units of product B was started in April.
The Purchase and Issue of Materials:
On April 1, the company had $7,000 in raw materials on hand. During the month, the company purchased an additional $60,000 in raw materials. The purchase is recorded in journal entry (1) below:
(1)
Raw Materials 60,000 Dr.
Accounts Payable 60,000 Cr.
Raw materials is an asset account. Thus, when raw materials are purchased, they are initially recorded as an asset--not as an expense.
Issue of Direct and Indirect Materials:
During April, $52,000 in raw materials were requisitioned from the storeroom for use in production. These raw materials include both direct and indirect materials. Entry (2) records issuing the materials to the production department.
(2)
Work in Process 50,000 Dr.
Manufacturing Overhead 2,000 Dr.
Raw Materials 52,000 Cr.
The materials charged to work in process (WIP) represents direct materials for specific jobs. As these materials are entered into the work in process account, they are also recorded on the appropriate job cost sheets. This point is illustrated in Exhibit 1.1 where $28,000 of the $50,000 in direct materials is charged to Job 1 cost sheet and the remaining $22,000 is charged to job 2 cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.)
The $2,000 charged to manufacturing overhead in entry (2) represents indirect materials used in production during April. Observe that the manufacturing overhead account is separate from work in process account. The purpose of the manufacturing overhead account is to accumulate all manufacturing overhead costs they are as they are incurred during a period.
Before leaving Exhibit 1.1 we need to point out one additional thing. Notice from the exhibit that the job cost sheet for job 1 contains a beginning balance of$30,000. We stated earlier that this balance represents the cost of work done during march that has been carried forward to April. Also note that work in process account contains the same $30,000 balance. The reason the $30,000 appears in both places is that the work in process account is a control account and the job cost sheets form a subsidiary ledger. Thus, the work in process account contains a summarized total of all costs appearing on the individual job cost sheet for all jobs in process at any given point in time. (Since the company had only job 1 in process at the beginning of April, job 1's $30,000 balance on that date is equal to the balance in the work in process account.
Exhibit 1.1
Issue of Direct Materials Only:
Some times the materials drawn from the raw materials inventory account are all direct materials. I this case, the entry to record the issue of the materials into production would be as follows:
Work in process XXX Dr.
Raw materials XXX Cr.
Labor Cost:
As work is performed each day in various departments of the company, employee time tickets are filled out by workers, collected, and forward to the accounting department. In the accounting department, wages are computed and the resulting costs are classified as either direct or indirect labor. This costing and classification for April resulted in the following summary entry:
(3)
Work in process 60,000 Dr.
Manufacturing overhead 15,000 Dr.
Salaries and wages payable 75,000 Cr.
Only direct labor is added to the work in process account. In this example, direct labor is $60,000 for April.
At the same time the direct labor costs are added to work in process, they are also added to the individual job cost sheets, as shown in the Exhibit 1.2. During April, $40,000 of direct labor cost was charged to job 1 and the remaining $20,000was charged to job 2. The labor cost charged to manufacturing overhead represent the indirect costs of the period, such as supervision, janitorial work, and maintenance.
Exhibit 1.2
Manufacturing Overhead Costs:
All costs of operating the factory other than direct materials and direct labor are classified as manufacturing overhead costs. These costs are entered directly into the manufacturing overhead account as they are incurred. To illustrate, assume that the company incurred the following general factory costs during April:
Utilities (heat, water, and power) $21,000
Rent on factory equipment 16,000
Miscellaneous factory costs 3,000
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Total $40,000
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The following entry records the incurrence of these costs:
(4)
Manufacturing overhead 40,000 Dr.
Accounts Payable 40,000 Cr.
In addition, let us assume that during April, the company recognized $13,000 in accrued property taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The following entry records these items:
(5)
Manufacturing overhead 20,000 Dr.
Property taxes payable 13,000 Cr.
Prepaid insurance 7,000 Cr.
Finally let us assume that the company recognize $18,000 in depreciation on factory equipment during April. The following entry records the accrual of this depreciation:
(6)
Manufacturing overhead 18,000 Dr.
Accumulated Depreciation 18,000 Cr.
In short, all manufacturing overhead costs are recorded directly into the manufacturing overhead account as they are incurred day by day through a period. It is important to understand that manufacturing overhead is a control account for many--perhaps thousands--of subsidiary accounts such as indirect materials, indirect labor, factory utilities, and so forth. As the manufacturing overhead account is debited for costs during a period the various subsidiary accounts are also debited. In this example we omit the entries to the subsidiary accounts for the sake of brevity.
Calculation of Predetermined Overhead Rate and Application of Manufacturing Overhead to Work in Process (WIP):
Since actual manufacturing costs are charged to the manufacturing overhead control account rather than work in process account. How are manufacturing costs assigned to work in process? The answer is, by means of the predetermined overhead rate. A predetermined overhead rate is established at the beginning of each year. The predetermined overhead rate is calculated by dividing the estimated total manufacturing overhead cost for the year by the estimated total units in the allocation base (measured in machine hours, direct labor hours, or some other base). This rate is then used to apply overhead costs to jobs.
To illustrate assume that the company has used machine hours to compute predetermined overhead rate and that this rate is $6 per machine hour. Also assume that during April, 10,000 machine hours were worked on Job 1 and 5,000 machine hours were worked on Job 2 (a total of 15,000 machine hours). Thus, $90,000 in overhead cost (15,000 machine hours $6 per machine hour = $90,000) would be applied to work in process. The following entry records the application of manufacturing overhead to work in process:
(7)
Work in process 90,000 Dr.
Manufacturing overhead 90,000 Cr.
The flow of cost through the manufacturing overhead account in Exhibit 1.3
Exhibit 1.3
The actual overhead cost in the manufacturing overhead account in Exhibit 1.3 are the costs that were added to the account in entries (2)--(6). Observe that the incurrence of these actual overhead costs and the application of overhead to work in process represents two separate and entirely distinct processes.
The Concept of Clearing Account:
The manufacturing overhead account operates as a clearing account. As we have noted, actual factory overhead costs are debited to the accounts as they are incurred day by day through the year. A certain intervals during the year, usually when a job is completed, overhead cost is applied to the job by means of the predetermined overhead rate, and work in process is debited and manufacturing overhead is credited. This sequence of events is illustrated below:
Manufacturing Overhead(a clearing account)
Actual overhead costs are charged to this account as they are incurred throughout the period.
Overhead is applied to work in process using the predetermined overhead rate.
As we emphasized earlier, the predetermined overhead rate is based on estimates of what overhead costs are expected to be, and it is established before the year begins. As a result, the overhead cost applied during a year will almost certainly turn out to be more or less than the overhead cost that is actually incurred. For example, notice from Exhibit 1.3 that the company's actual overhead costs for the period are $5,000 greater than the overhead cost that has been applied to work in process (WIP), resulting in a $5,000 debit balance in the manufacturing overhead account. This debit balance in manufacturing overhead account is called under-applied overhead. Any credit balance in manufacturing overhead account is called over-applied overhead. Any balance in the manufacturing overhead account (under or over-applied overhead) is treated in one of the following ways:
1. Closed out to cost of goods sold
2. Allocated between work in process, finished goods, and cost of goods sold in proportion to the overhead applied during the current period in the ending balance of these accounts.
These two methods are illustrated on Disposition of Under- or Over-applied Overhead Balances page.
For the moment, we can conclude by nothing from Exhibit 1.3 that the cost of a completed job consists of the actual materials cost of the job, the actual labor cost of the job, and the overhead cost applied to the job. Pay particular attention to the following subtle but important point: Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the job cost sheet nor do they appear in the work in process account. Only the applied overhead cost, based on the predetermined overhead rate, appear on the job cost sheet and in the work in process account. Study this point carefully.
Non-manufacturing Costs:
In addition to manufacturing costs, companies also incur marketing and selling costs. These costs should be treated as period expenses and charged directly to the income statement and therefore should not go into the the manufacturing overhead account. To illustrate the correct treatment of non-manufacturing costs, assume that the company (in this example) incurred $30,000 in selling and administrative salary costs during a months, the following entry records these salaries.
(8)
Salaries expense 30,000 Dr
Salaries and wages payable 30,000 Cr
Depreciation on factory equipment is debited to manufacturing overhead account but depreciation on office equipment is considered a period expense and is not included in manufacturing overhead. Assume that depreciation of office equipment during the month was $7,000. The entry is as follows.
(9)
Depreciation expense 7,000 Dr
Accumulated depreciation 7,000 Cr
Finally assume that advertising was $42,000 and that other selling and administrative expenses during the month was $8,000. The following journal entry records these items:
(10)
Advertising expenses 42,000 Dr.
Other selling and administrative expense 8,000 Dr.
Accounts payable 50,000 Cr.
Since the amounts in entries above all go directly into expense accounts, they will have no effect on the costing of the company's production for the month. The same will be true of any other selling and administrative expenses incurred during the month including sales commission, depreciation on sales equipment, rent on office facilities, insurance on office facilities, and related costs.
Cost of Goods Manufactured (COGM):
When a job has been completed, the finished out put is transferred from the production department to the finished goods warehouse. By this time, the accounting department will have charged the job with direct materials and direct labor cost and manufacturing overhead will have been applied using the predetermined overhead rate. A transfer of costs is made within the costing system that parallels the physical transfer of the goods to the finished goods warehouse. The costs of the completed jobs are transferred out of the work in process (WIP) account and into the finished goods account. The sum of all amounts transferred between these two accounts represents the cost of goods manufactured for the period.
Let us assume that the job 1 was completed during the period. The following entry transfers the cost of job 1 from work in process (WIP) to finished goods.
(11)
Finished goods 158,000 Dr.
Work in process 158,000 Cr
The $158,000 represents the completed cost of job 1, as shown on the job cost sheet in Exhibit 1.3. Since job 1 was the only job completed during April, the $158,000 also represents the cost of goods manufactured for the month.
The job 2 was not completed by month-end, so its cost will remain in the work in process (WIP) account and carry over to the next month. If a balance sheet is prepared at the end of April, the cost accumulated thus far on the job 2 will appear as "work in process inventory" in the assets section.
Cost of Goods Sold (COGS):
As units in the finished goods are shipped to the customers, their costs are transferred from the finished goods account into the cost of goods sold account. If complete job is shipped, as in the case where a job has been done to a customer's specification then it is a simple matter to transfer the entire cost appearing on the job cost sheet into the cost of goods sold account. In most cases, only a portion of the units involved in a particular job will be immediately sold. In these situations the unit cost must be used to determine how much product cost should be removed from finished goods and charged to cost of goods sold.
Assume that the company has completed 1000 units and 750 out of 1000 units have been shipped to customers for a price of $225,000. The unit product cost is $158. Following journal entries would record the sales (all sales are on account).
(12)
Accounts receivable 225,000 Dr.
Sales 225,000 Cr.
(13)
Cost of goods sold 118,5000* Dr.
Finished goods 118,5000 Cr.
($158 × 750units = $118,500*)
With entry (13), the flow of cost through our job order costing system is completed.
Summary of Cost Flow:
To pull the entire example together, journal entries (1) through (13), T accounts, and schedules of cost of goods manufactured and cost of goods sold are presented below:
Journal Entries:
(1)
Raw Materials 60,000 Dr.
Accounts Payable 60,000 Cr.
(2)
Work in process 50,000 Dr.
Manufacturing overhead 2,000 Dr.
Raw materials 52,000 Cr.
(3)
Work in process 60,000 Dr.
Manufacturing overhead 15,000 Dr.
Salaries and wages 75,000 Cr.
(4)
Manufacturing overhead 40,000 Dr.
Accounts payable 40,000 Cr.
(5)
Manufacturing overhead 20,000 Dr.
Property taxes payable 13,000 Cr.
Prepaid insurance 7,000 Cr.
(6)
Work in process 18,000
Manufacturing overhead 18,000
(7)
Work in process 90,000 Dr.
Manufacturing overhead 90,000 Cr.
(8)
Salaries expenses 30,000 Dr.
Salaries and wages payable 30,000 Cr.
(9)
Depreciation expense 7,000 Dr.
Accumulated depreciation 7,000 Cr.
(10)
Advertising expense 42,000 Dr
Other selling and administrative expense 8,000 Dr.
Accounts payable 50,000 Cr.
(11)
Finished goods 158,000 Dr.
Work in process 158,000 Cr.
(12)
Accounts receivable 225,000
Sales 225,000
(13)
Cost of goods sold 118,500
Finished goods 118,500
T Accounts:
Accounts Receivable Accounts Payable Capital Stock
xx(12) 225,000
xx (1) 60,000 (4) 40,000 (10) 50,000
xx
Prepaid Insurance Salaries and Wages Payable Retained Earnings
xx
(5) 7,000
xx(3) 75,000(8) 30,000
xx
Raw Materials Property Taxes Payable Sales
Bal. 7,000(1) 60,000
(20) 52,000
xx(5) 13,000
(12) 225,000
Bal. 15,000
Cost of Goods Sold
Work in Process Salaries expenses (13) 118500
Bal. 30,000(2) 50,000(3) 60,000(7) 90,000
(11) 158,000 (8) 30,000
Depreciation expenses (9) 7,000
Bal. 72,000
Finished Goods Advertising Expenses
Bal. 10,000(11) 158,000
(13) 118,500 (10) 42,000
Bal. 49,000
Accumulated Depreciation Other Selling and Administrative expenses
xx(6) 18,000(9) 7,000
(10) 8,000
Manufacturing Overhead
(2) 2000(3) 15,000(4) 40,000(5) 20,000(6) 18,000
(7) 90,000
Bal. 5,000
Explanation of entries:
(1) Raw materials purchased.
(2) Direct and indirect materials issued into production.
(8) Administrative salaries expenses incurred.
(3) Direct and indirect factory labor cost incurred.
(9) Depreciation recorded on office equipment.
(4) Utilities and other factory costs incurred. (10) Advertising and other expenses incurred
(5) Property taxes and insurance incurred on the factory.
(11) COGM transferred into finished goods.
(6) Depreciation recorded on the factory assets. (12) sale of job 1 recorded.
(7) Overhead cost applied to work in process. (13) Cost of goods sold recorded for job 1.
XX = Normal balance in the account (for example accounts receivable normally carries a debit balance).
Cost of Goods Manufactured:
Direct materials $50,000
Direct labor $60,000
Manufacturing overhead applied to work in process $90,000*
---------------
Total Manufacturing cost $200,000
Add: Beginning work in process $30,000
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$230,000
Deduct: Ending work in process inventory $72,000
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Cost of goods manufactured $158,000
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Cost of Goods Sold:
Finished goods inventory beginning $10,000
$158,000
-----------
Goods available for sale $168,000
Deduct: Finished goods inventory ending $49,500
----------
Unadjusted cost of goods sold $118,500
Add: Under applied overhead $5,000*
-----------
Adjusted cost of goods sold $123,500
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*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 Predetermined overhead rate)Actual overhead = $95,000Under applied overhead = $95,000 (actual) - $90,000 (applied) = $5,000
Entry to close the $5,000 of under applied to cost of goods sold would be as follows:
Cost of goods sold--------------------------------- 5,000 Dr Manufacturing overhead-------------------------------- 5,000 Cr
Note that the underapplied overhead is added to cost of goods sold. If overhead were overapplied, it would be deducted from cost of goods sold.
Income Statement:
Sales $225,000
Les cost of goods sold ($ 118,500 + $5,000) 123,500
-----------
Gross margin 101,500
Less selling and administrative expenses:
Salaries $30,000
Depreciation 7,000
Advertising expenses 42,000
Other expense 8,000 87,000
----------
-----------
Net operating income $14,500
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Multiple Predetermined Overhead Rates:
When a single predetermined overhead rate is used for entire factory it is called Plant wide overhead rate. This is fairly common practice--particularly in smaller companies. But in large companies, multiple predetermined overhead rates are often used.
In a multiple predetermined overhead rate system, each production department may have its own predetermined overhead rate. Such a system, while more complex, is considered to be more accurate. Since it can reflect differences across departments in how overhead costs are incurred. For example, overhead might be allocated based on machine-hours in departments that are relatively machine intensive. When multiple predetermined overhead rates are used, overhead is
applied in each department according to its own overhead rate as a job proceeds through the department.
Problems of Overhead Application:We need to consider two complications relating to overhead application. These are:
A) Under-applied and Over-applied Overhead
Since the predetermined overhead rate is established before a period begins and is based entirely on estimated data, the overhead cost applied to work in process (WIP) will generally differ from the amount of overhead cost actually incurred during a period. The difference between the overhead cost applied to work in process (WIP) and the actual overhead costs of a period is termed as either underapplied overhead or overapplied overhead. For example if a company calculates its predetermined overhead rate $6 per machine hour. 15,000 machine hours are actually worked and overhead applied to production is therefore $90,000 (15,000 hours × $6). If actual factory overhead is $95,000 then underapplied overhead is $5,000 ($95,000 – $90,000). If the situation is reverse and the company applies $95,000 and actual overhead is $90,000 the overapplied overhead would be $5,000.
Causes / Reasons of underapplied or overapplied overhead:
The causes / reasons of under or over-applied overhead can be complex. Nevertheless the basic problem is that the method of applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount of the allocation base incurred during the period. If, for example, the predetermined overhead rate is $6 per machine hour, then it is assumed that actual overhead cost incurred will be $6 for every machine hour that is actually worked. There are actually two reasons why this may not be true. First, much of the overhead often consists of fixed costs that do not grow as the number of machine hours incurred increases. Second, spending on overhead items may or may not be under control. If individuals who are responsible for overhead costs do a good job, those costs should be less than were expected at the beginning of the period. If they do a poor job, those costs will be more than expected.
Example:
Suppose that two companies A and B have prepared the following estimated data for the coming year:
Company
A B
Predetermined overhead rate based on Machine-hours Direct materials cost
Estimated manufacturing overhead $300,000 $120,000
Estimated machine-hours 75,000 --
Estimated direct materials cost $80,000
Predetermined overhead rate, (a) ÷ (b) $4 per machine hour150% of direct materials cost
Now assume that because of unexpected changes in overhead spending and changes in demand for the companies' products, the actual overhead cost and the actual activity recorded during the year in each company are as follows:
Company
A B
Actual manufacturing overhead costs $290,000 $130,000
Actual machine-hours 68,000 --
Actual direct materials costs -- $90,000
For each company, note that the actual data for both cost and activity differ from the estimates used in computing the predetermined overhead rate. This results in underapplied overhead and overapplied overhead as follows:
Company
A B
Actual manufacturing overhead costs $290,000 $130,000
Manufacturing overhead cost applied to work in process during the year:
68,000 actual machine hours × $4 per machine hour 272,000
$90,000 actual direct materials cost × 150% of direct materials cost 135,000
------------- -------------
Underapplied (overapplied) overhead $ 18,000 $ (5,000)
For company A, notice that the amount of overhead cost that has been applied to work in process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore the overhead is underapplied. Also notice that original estimate of overhead in company A ($300,000) is not directly involved in this computation. Its impact is felt only through the $4 predetermined overhead rate that is used.
For B company the amount of overhead cost that has been applied to work in process (WIP) ($135,000) is greater than the actual overhead cost for the year ($130,000), and so overhead is overapplied. A summary of the concepts discussed so for is presented below:
At the beginning of the period
Estimated total manufacturing overhead cost
÷ Estimated total units in the allocation base
= Predetermined overhead rate
During the period
Predetermined overhead rate × Actual total units of the allocation base incurred during the period
= Total manufacturing overhead applied
At the end of the periodActual total manufacturing overhead cost
– Total manufacturing overheadapplied
= Underapplied (overapplied)overhead
What disposition should be made of any under or over applied overhead balance remaining in the manufacturing overhead account at the end of a period? To understand the procedure of disposing off any under or over applied overhead see disposition of any balance remaining in the manufacturing overhead account at the end of a period page.
B) Disposition of Underapplied or Overapplied Overhead Balances:
What disposition should be made of an underapplied overhead or overapplied overhead balance remaining in the manufacturing overhead account at the end of a period?
Generally any balance in the account is treated in one of the two ways.
1. Closed out to cost of goods sold.
2. Allocated between work in process (WIP), finished goods and cost of goods sold in proportion to the overhead applied during the current period in the ending balances of these account.
The second method, which allocates the under or overapplied overhead among ending inventories and cost of goods sold is equivalent to using an "actual" overhead rate and is for that reason considered by many to be more accurate than the first method. Consequently, if the amount of underapplied or overapplied overhead is material, many accountants would insist that the second method be used.
Closed Out to Cost of Goods Sold:
Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than the allocation method.
Where the overhead is underapplied following journal entry is made:
Cost of goods soldManufacturing overhead
DrCr
Where the overhead is overapplied the following journal entry is made:
Manufacturing overhead Cost of goods sold
DrCr
After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of goods sold is increased by the amount of underapplied and decreased by the amount of overapplied overhead.
Example:
Cost of Goods Manufactured:
Direct materials $50,000
Direct labor $60,000
Manufacturing overhead applied to work in process $90,000*
---------
Total Manufacturing cost $200,000
Add: Beginning work in process $30,000
----------
$230,000
Deduct: Ending work in process inventory $72,000
----------
Cost of goods manufactured $158,000
========
Cost of Goods Sold:
Finished goods inventory beginning $10,000
$158,000
-----------
Goods available for sale $168,000
Deduct: Finished goods inventory ending $49,500
----------
Unadjusted cost of goods sold $118,500
Add: Under applied overhead $5,000*
----------
Adjusted cost of goods sold $123,500
========
*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 Predetermined overhead rate)Actual overhead = $95,000Under applied overhead = $95,000 - $90,000 = $5,000
Entry to close the $5,000 of under applied to cost of goods sold would be as follows:
Cost of goods sold-------------------------- 5,000 Dr Manufacturing overhead------------------------- 5,000 Cr
Allocated Between Accounts:
Allocation of under or overapplied overhead between work in process (WIP),finished goods and cost of goods sold (COGS) is more accurate than closing the entire balance into cost of goods sold. The reason is that allocation assigns overhead costs to where they would have gone in the first place had it not been for the errors in the estimates going into the predetermined overhead rate.
Example:
If the amount of under-applied or over-applied overhead is significant, it should be allocated among the accounts containing applied overhead: Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied” overhead means thatthe balances in these accounts are quite different from what they would have been if actual overhead costs had been assigned to production.
Allocation restates the account balances to conform more closely to actual historical cost as required for external reporting by generally accepted accounting principles. The above figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of over-applied overhead among the necessary accounts; had the amount been under-applied, the accounts debited and credited in the journal entry would be the reverse of that presented for over-applied overhead. A single overhead account is used in this illustration.
Theoretically, under-applied or over-applied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they contain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion, use of total balances is more common in practice for two reasons: First, the theoretical method is complex and requires detailed account analysis. Second, overhead tends to lose its identity after leaving Work in Process Inventory, thus making more difficult the determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances
JOB COSTING IN SERVICE, NOT-FOR-PROFIT, AND GOVERNMENTAL ENVIRONMENTS
THE MANUFACTURING ECONOMY: The last hundred-plus years have been remarkable. A primarily agriculture-based world economy gave way to the industrial revolution. This revolution took root and continues to sweep around the globe. Following the growth in manufacturing has been an even greater proliferation of support and service roles. Perhaps as few as 10% of workforce members are now actively producing a tangible end product.
THE SERVICE SECTOR: Most employees in the private sector are engaged in nonmanufacturing activities like accounting, sales, computing, and administration. New businesses have developed in the areas of law, healthcare, food services, electronic information delivery, transportation, entertainment, and others. The not-for-profit sector is increasing; consider the size and scope of educational institutions, hospitals, foundations, and so
forth. And, not to be forgotten, is the size and scope of governmental entities. Cities provide services like municipal infrastructure, fire, police, water utilities, and code enforcement. State and provincial governments may provide for the educational system, highways, and prisons. At the federal level, governments may provide military, welfare, transportation, and countless other services. It is no wonder that most people work in a nonmanufacturing role.
The job costing model presented in this chapter is generally suggestive of the idea that a "job" can be identified as some tangible product. But, that is not necessarily the case. This chapter opened with an illustration for Castle Electric. If you think deeper about that example, you will realize that most of what Jack Castle provided to his customers was a "service." But, the utilization of job costing methodologies was still highly relevant. The cost of services, whether provided in the private sector, not-for-profit, or governmental arenas, must be determined with some reasonable degree of accuracy. The growth, indeed dominance, of these sectors of the economy underscores the need to extend costing methods beyond the traditional manufacturing setting.
The concept of a "job" gives way to more abstract connotations: "client," "surgical procedure," "seat mile," "student credit hour," "fire call," or other measure of output. Clearly, direct materials become a less significant part of the overall picture. But, overhead can take on heightened levels of importance. Perhaps you have experienced a costly hospital stay. The itemized billing that follows usually includes some shocking components (e.g., $5 for an aspirin). These prices cannot be justified based on direct material cost alone. Clearly, the hospital has tremendous and costly overhead. In addition, you don't just pop an aspirin in the hospital as you would at home. The pill must be administered, documented, and billed; efforts which consume expensive labor time.
If costing methods are not employed correctly, the organization may find that it has underestimated its costs of services. This can lead to financial failure. On the other hand, many will question the cost drivers and methods of allocations that are used in service type activities. For instance, a city may determine that the full cost of a fire department is several hundred thousand dollars per residential house fire. This type of job costing could lead one to conclude that a fire department is not cost effective. The problem with this approach is that it ignores that one fire would quickly spread to an entire city without a suppression action by the fire department. And, firefighters save countless lives for which there can be no rational economic measure. So, what is the actual "job" and how are costs to be assigned to that "job?" This measurement problem is pervasive and challenging in the service sector
Advantages and Disadvantages of Job Order Costing System:
One of the primary advantages of job order costing system is that the management team has ready access to all the costs incurred for each job being completed. This allows the team to examine each cost incurred, finding out why it happened, and determine how it can be controlled better in the future, thereby contributing to better ongoing levels of profitability. For example, a proper job record contains any special reworking costs, which a manager can then use to trace back to the specific reason why the rework was needed. Similarly, overhead allocations based on machine usage reveal problems with excess use, which might be the result of lengthy machine setups or break downs as well as longer than expected machine cycle times.
Another reason for using job order costing system is that it yields ongoing results for each job. In today's world of fully computerized production tracking data bases, one can use a job order costing system to track costs as they are added rather than waiting until the job has been completed. This gives a company several advantages. One is that the accounting staff can monitor job accounts to see if costs are being posted to the wrong accounts and correct them right away, rather than waiting until the job closes and having to frantically review records to see why the results are different from expectations. Another advantage is that a company can monitor the costs incurred for longer jobs and have enough time to make changes before they close, based on the costing information revealed by the job costing system. For example, a lengthy new product development project might be over budget after just 25% of the work has been completed; If the management team is made aware of this costing problem early in the project, it will still have 75% of the project in which to make corrections and bring costs back down to budgeted levels. Yet a third advantages is that changes in the cost of a job can result in negotiations with cost-plus customers who are paying for all the costs incurred, so that they are fully aware of cost overruns well in advance and are prepared to pay the additional amounts. All these factors are the main advantages of using job order costing system in a computerized environment.
There are also several problems with job order costing system. One is that it focuses attention primarily on products rather than on departments or activities. This is not an issue if there are supplemental systems in place that record information about these other cost categories, but it leaves management with inadequate information if this is not the case. An other difficulty is that overhead is generally allocated based on rates that are changed only about once a year. Considerable fluctuation in overhead costs over the course of a year can result both in over and under allocation of overhead costs to jobs during that period. Another problem is specific to the use of normal costing. This practice involves the use of standards overhead rate rather than one that is based on actual costs and requires adjustment from time to time. If it is management's intention to charge individual jobs for the variance between standard and actual overhead rates, this may not be possible if some jobs have already been closed by the time the variance allocation takes place. This is not just a technical accounting issue, for some jobs are fully reimbursed by customers who pay on a cost plus basis; if the overhead variance is a positive one, a company may not be able to charge its customers for the added costs if the related job have already been closed.
Another issue is that job costing has little relevance in some environments. For example, the soft ware industry have high development costs but almost zero direct costs associated with the sale of its products. The use of a job order costing system to records these costs makes little sense if the associated costs represent only a few percent of the total revenue gained from each one. The same problem arises in service industries, such as retailing, where there is no discernible product. These situations limit the most effective use of job order costing system to two areas--production and professionals services. The first case, production is an obvious use for the concept since there are high material costs that can be specifically identified with a job. The same is true of professional services, but here the main cost is direct labor rather than direct materials. In most other cases job costing does not provide management with sufficient quantity of information to be useful.
The most important problem with job order costing is that it requires a major amount of data entry and data accuracy in order to yield effective results. Data related to materials, labor, overhead, indirect labor, scrap, spoilage, and supplies must be entered into system capable of accurately assigning these costs to the correct jobs every time. In reality such systems are rife with mistakes due to the sheer volume of data transactions, keying errors, misidentification of jobs, and the like. Problems can be resolved with a sufficient amount of error tracing by the accounting staff, but there may be so many that there are not enough staff members to keep up with them. Though these issues can to some degree be resolved through the use of computerized data entry system outweighs the benefits to be gained from it. A final issue is that a large proportion of the costs assigned to a job, frequently more 50%, comes from allocated overhead. When there is no fully proven method for accurately allocating overhead, such as through an activity based costing system the results of the allocation yield meaningless information. This has been a particular problems for the companies that persist in allocating overhead costs based on the direct labor used by each job, Since a small amount of labor is generally being used to allocate a much larger amount of overhead, resulting in large shifts in overhead allocations based on small amount of labor is generally being used to allocate a much larger amount of overhead, resulting in large shifts in overhead allocations based on small changes in labor costs. Some companies avoid this problem by ignoring overhead for job order costing purposes or by reducing overhead cost pools to include only overhead directly traceable at the job level. In this way, many costs are not allocated to jobs at all, but those that are allocated are fully justifiable.
Clearly, one must weigh the pros and cons of using a job order costing system to see if the benefits outweigh the costs. This system is a complex one that is prone to error, but it does yield good information about production-specific costs.
When Is Job-Order Costing Appropriate?
Job-order costing is a type of costing that can be used in many different industries, although not all. Industries that sell items in batches will be able to use job-order costing most effectively. For example, a T-shirt company that makes batches of T-shirts with company logos on them may use job-order costing, each company they work for could be classified as an individual job. Job-order costing would probably not be used in other industries such as general manufacturing, as products may not be specialized and therefore would not be classified in batches.
Job Order Costing--Journal Entries, T Accounts, Income Statement
Hogle Company is a manufacturing firm that uses job order costing system. On January 1, the beginning of its fiscal year, the company's inventory balances were as follows:
Raw materialsWork in processFinished Goods
$20,000$15,000$30,000
The company applies overhead cost to jobs on the basis of machine-hours worked. For the current year, the company estimated that it would work 75,000 machine-hours and incur $450,000 in manufacturing overhead cost. The following transactions were recorded for the year
1. Raw materials were purchased on account, $410,000.
2. Raw materials were requisitioned for use in production, $380,000 ($360,000 direct materials and $20,000 indirect materials).
3. The following costs were incurred for employee services: direct labor, $75,000; indirect labor, $110,000; sales commission, $90,000; and administrative salaries, $20,000.
4. Sales travel costs were $17,000.
5. Utility costs in the factory were $43,000.
6. Advertising costs were $180,000.
7. Depreciation was recorded for the year, 350,000 (80% relates to factory operations, and 20% relates to selling and administrative activities).
8. Insurance expired during the year, $10,000 (70% relates to factory operations, and 30% relates to selling and administrative activities).
9. Manufacturing overhead was applied to production. Due to greater than expected demand for its products, the company worked 80,000 machine-hours during the year.
10.Goods costing $9,00,000 to manufacture according to their job cost sheets were completed during the year.
11.Goods were sold on account to customers during the year at a total selling price of $1,500,000. The goods cost $870,000 to manufacture according to their job cost sheets.
Required:
1. Prepare journal entries to record the preceding transactions.
2. Post the entries in (1) above to T-accounts (don't forget to enter the beginning balances in the inventory accounts).
3. Is manufacturing overhead underapplied or overapplied for the year? Prepare journal entry to close any balance in the manufacturing overhead account to cost of goods sold (COGS). Do not allocate the balance between ending inventories and cost of goods sold (COGS).
4. Prepare an income statement for the year.
Solution:1: Journal Entries1 Raw materials 410,000 Accounts payable 410,0002 Work in process 360,000 Manufacturing overhead 20,000 Raw materials 380,0003 Work in process 75,000
Manufacturing overhead 110,000 Sales commission expense 90,000 Administrative salaries expense 200,000 Salaries and wages payable 475,0004 Sales travel expense 17,000 Accounts payable 17,0005 Manufacturing overhead 43,000 Accounts payable 43,0006 Advertising expense 180,000 Accounts payable 180,0007 Manufacturing overhead 280,000 Depreciation expense 70,000 Accumulated depreciation 350,0008 Manufacturing overhead 7,000 Insurance expense 3,000 Prepaid insurance 10,0009* Work in process 480,000 Manufacturing overhead 480,00010 Finished Goods 900,000 Work in process 900,00011 Accounts Receivable 1,500,000 Sales 1,500,000 Cost of goods sold 870,000 Finished goods 870,000
*The predetermined overhead rate for the year would be computed as follows:
Predetermined overhead rate = Estimated total manufacturing overhead cost / Estimated total units in the allocation base
= $450,000 / 75,000 machine-hours
= $6 per machine-hour
Based on the 80,000 machine-hours actually worked during the year, the company would have applied $480,000 in overhead cost to production: 80,000 machine-hours × $6 per machine-hour = $480,000.
2: T Accounts
Accounts Receivable11 1,500,000
Finished GoodsBal. 30,00010 900,000
(11) 870,000
Accounts Payable
(1) 410,000(4) 17,000(5) 43,000(6) 180,000
Raw MaterialsBal. 20,000(1) 410,000
(2) 380,000
Bal. 50,000
Prepaid Insurance
(8) 10,000
Salaries and Wages Payable
(3) 475,000
Work in ProcessBal. 20,000(2) 360,000(3) 75,000(9) 480,000
(10) 900,000
Bal. 30,000
Accumulated Depreciation
(7) 350,000
Manufacturing Overhead
Sales
(11) 1,500,000
Sales Commissions Expenses(3) 90,000
Advertising expense(6) 180,000
Cost of goods sold(11) 870,000
Administrative Salary Expense(3) 200,000
Depreciation Expenses(7) 70,000
(2) 20,000(3) 110,000(5) 43,000(7) 280,000(8) 7,000
(9) 480,000
460,000 480,000
Bal. 20,000
Insurance Expense(8) 3,000
Sales Travel Expense(4) 17,000
3: Under or Overapplied manufacturing overhead:
Manufacturing overhead is overapplied for the year. The entry to close it out to cost of goods sold is as follows:
Manufacturing overhead 20,000
Cost of goods sold 20,000
4: Income Statement
HOGLE COMPANYIncome Statement
For the Year Ended December 31Sales $1,500,000
Less cost of goods sold ($870,000 - $20,000 overapplied O/H 850,000
--------------
Gross margin 650,000
Less selling and administrative expenses:
Commission expense $90,000
Administrative salaries expense 200,000
Sales travel expense 17,000
Advertising expense 180,000
Depreciation expense 70,000
Insurance expense 3,000 560,000
------------ -------------
Net operating income $90,000
======
CASE STUDIES
Determination of Cost:The presented of the Nola Cola Company has heard rumblings of dissatisfaction among board of directors about the relatively low net earnings of the company. Several directors are not satisfied with the accounting reports being issued.They believe, it appears, that the shipping and delivery expenses are responsible, that advertising is in line, and that administrative expenses, although possibly somewhat above normal, are not out of control. Their primary criticism seems leveled at manufacturing costs.Consequently, a meeting of the board of directors has been called in order to examine critically the accounting system is use for determining manufacturing costs; that is, the cost of a Nola Cola bottle ready for delivery as it comes from the last operation of the bottling process.Sensing some of the problems involved, the president has adopted a recognized technique of executive strategy. Before having the controller explain the accounting system in use, the president has decided to ask for an opinion as to what item should be included in the proper determination of the cost of a bottle of Nola Cola. For example, the president believes there is mutual agreement that such items as syrup, water, carbonation, and bottle caps are properly part of manufacturing costs.Required: A list of other items that should be included, and to what extent.Solution:A number of specific items may be mentioned:
1. Direct labor cost.
2. Wear and breaking of bottles and cases.
3. A share of manufacturing expenses other than direct materials ad direct labor, i.e., factory overhead.
As these specific items are mentioned, the discussion should be channeled into a consideration of several "general" problems of cost accounting:
1. The problem of setting up an equitable and economical cost determination system.
2. The need for the system also to provide devices and information for control and decision-making purposes.
3. The problem of measurement and assignment of overhead costs to work completed.
4. The fact that cost figures are, at best, estimates. Yet, although we may never know what the exact cost is, we can obtain useful information at a reasonable price.
Improving a Cost Information and Accumulation System:An examination of costing methods and procedures in the Franklin Printing Company reveals the following:
1. Costing formulas and ratios prepared a long time ago are still being used by estimators even though prices for materials have increased, overhead is higher, and new machinery has been installed.
2. An estimator in the production department and a cost clerk in the cost department prepare estimates independently from one another, resulting in widely divergent cost figures.
3. A profit per individual job or order can never be determined.
4. Each job or order is sold with a definite markup. Yet, instead of a profit of $100,000 as the president hopped for, the chief accountant prepared an income statement showing only a $48,000 profit.
5. Determining departmental efficiency and control over expenses is not possible.
Required: A statement outlining:
A. Possible causes of the existing conditions. B. Possible steps to remedy the situation.
Solution:A. Possible causes of the existing conditions:
1. The printing industry makes use of predetermined rates and pricing tables. At times advancement of materials labor costs is not incorporated quickly enough. The installation of new machinery requires individual attention to the cost situation.
2. This situation is unusual. estimator, in many firms, operates with future costs and prices while the cost department bases its calculations on present or experienced costs. Often the situation is particularly critical with regard to the overhead rates used by the two parties.
3. This situation is also typical of the printing industry. Generally, a printer has many jobs: some require only a very short time, others continue over several weeks. Cost determination becomes a job of averaging costs over the time. Therefore, an individual profit per job can rarely be calculated on the basis of the books and records.
4. This result can be traced to the fact that cost estimates are based on erroneous and outdated costs and percentages. It could also be caused by a steady increase of fixed costs that consume the imaginary profit calculated in the estimates. Overhead rates might be out of line with actual experience.
5. The company's management might never have considered the delegation of authority and responsibility to supervisors. With costs so for out of line it may be that no manager has been asked to contribute ideas and prepare cost estimates for a better performance in his or her department.
B. Possible steps to remedy the situation:
1. Check industry rates and prices with company's costs. Revise and keep up to date, so that estimates can be based on realistic figures.
2. Let estimator prepare bids and estimates, but costs and prices used should be set in collaboration with the cost department. Differences should be explainable and, if possible, brought into agreement.
3. The determination of profit per job or order depends greatly upon the revisions suggested in (1) and (2). Also, a job order cost accumulation of actual costs may be practical. Many factors might still prevent a completely accurate profit determination; however, basing the estimates on realistic data and company overhead rates and modifying these estimates as circumstances change will result in a more satisfactory job cost and profit picture.
4. Here, too, rates and costs must be examined in the light of present conditions. It is important to examine fixed costs that have entered into the cost situation unnoticed. The preparation of a budget with a continuous reporting scheme would assist in avoiding the difficulty of this unpleasant report regarding the final profit.
5. The steps needed in (4) are also part of this answer. Departmental budgets will permit (1) the calculation of overhead rates and (2) a close watch over actual expenses by supervisors. Weekly or monthly reports will assist the supervisors in keeping the costs within the budget limits; that is, within the predetermined profit range.
Installing a Cost Information and Accumulation System:
A textile manufacturer asks advice concerning the installation of a cost system. The manufacturer explains briefly that many different cloths are produced, starting with scoured wool that passes through the following processing before becoming finished cloth: picking and blending, carding, spinning, weaving, finishing, and dyeing. The company's sales representatives take orders considerably in advice of the actual production of the cloth, using samples produced during a special period set aside each season for the manufacture of samples. Competition is keen and the profit margin is low. The financing is received through bank loans.Required:
1. The principle advantages of installing a cost system.
2. The principle additions or alterations necessary to operate a cost system. (The present accounting system is designated for the purpose preparing annual financial statements.)
3. An explanation of how matters can be arranged in order to find the cost of the principle stages of manufacture, such as carding, spinning, weaving, etc. (The carding machines operate three shifts per day; the spinning machines, two shifts; and the weaving machines, one shift.)
Solution :
A: The principle advantages of installing a cost system are:
1. The ascertainment of unit costs of the various products. Unit costs are variable in determining minimum sales prices and in eliminating unprofitable lines.
2. Improvement in efficiency by comparison of cost details at regular intervals.
3. More adequate information, which is available for inventory costing.
4. Establishing control over production
B: To operate a cost system, it would be necessary to amplify the accounting procedure by providing for:
1. More detailed analysis of disbursements.
2. Perpetual inventory records.
3. Monthly accumulation of detailed figures relating to costs of each operation and product.
C: Divide the factory into departments for cost accumulating purposes corresponding to the natural divisions, such as Carding Department, Spring Department, and Weaving Department. Break down the analysis of factory overhead according to these department departments. This automatically takes care of the differences in operating shifts.Designing Cost Accumulation Procedures:A client has asked advice as to a satisfactory system of factory costs for a factory that is divided into two main divisions:
1. Machine Shop: This division makes steel molds used in the manufacture to plastic articles. These molds require careful precision work; and frequently, one person is employed at machining one mold for several weeks. The finished molds are used by the Plastic Division of the company. In addition, some other machine work is done for customers, although this forms the smaller portion of the shop's output.
2. Plastic Division: This division manufactures plastic articles including ash trays, buttons, knobs, etc. The process of manufacture consists of placing chemical powders in a mold, which is then placed under a steam press where pressure is applied for a few minutes. The chemical powders are the only materials used and are not processed before being placed in
the mold. After being processed, a certain amount of finishing and inspection labor is necessary to complete the articles.
It is ascertained that:
The company has had no previous cost records. Production in both divisions is controlled by job order tickets. Materials are kept in one place, but no record has been kept of withdrawals. Labor is paid at hourly rates, and a time clock at the factory entrance is used for
determining the hours worked in any day. Employees have been preparing satisfactory time tickets showing the hours worked on each
job and, in the case of the plastics division, the number of units produced; but this record has never been balanced against the wages paid nor the record of production.
Spoilage is a substantial factor in both divisions. The machine shop and the plastic division are in separate parts of the one building. The company has a satisfactory system of general ledger accounting.
Required: A method or methods for obtaining factory costs, explaining why they are considered the most satisfactory under the circumstances.Solution:Regardless of what cost system is installed, three changes should be made in the company's methods:
A control should be established over materials. Requisitions should be used.
Factory overhead should be segregated between the two divisions. Direct departmental charges should be made as much as possible. Common costs should be apportioned to each department on an equitable basis.
Clock cards should be balanced with employees' time sheets.If these matters are resolved satisfactorily, the costs might be obtained as follows:Machine Shop. The product seems to be custom item so that job costing seems appropriate. Overhead should be charged to the product on some predetermined basis.Plastic Division. It seems that job order costing system is also possible here. The overhead might be charged to the product on different bases if the machine used would suggest different rates. This might make possible the creation of cost centers.General. Any cost system should permit comparison with estimated figures