Chapter 03 – Lecture Notes
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Chapter 3
Lecture Notes
Chapter theme: Managers need to assign costs to products
to facilitate external financial reporting and internal
decision making. This chapter illustrates an absorption
costing approach to calculating product costs known as
job-order costing.
Helpful Hint: Briefly review the concepts of fixed and
variable manufacturing costs to help students grasp the
meaning of absorption costing. Mention that total fixed
costs are constant and therefore change on a per unit
basis. Variable costs are proportional to the number of
units produced and are constant on a per unit basis.
I. Job-order costing: an overview
A. Job-order costing systems are used when:
i. Many different products are produced each
period.
ii. Products are manufactured to order.
iii. The unique nature of each order requires tracing or
allocating costs to each job, and maintaining cost
records for each job.
B. Examples of companies that would use job-order
costing include:
i. Boeing (aircraft manufacturing)
ii. Bechtel International (large scale construction)
iii. Walt Disney studios (movie production)
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II. Job-order costing−an example
A. Types of manufacturing costs that are assigned to
products using a job-order costing system:
i. Direct costs
1. Direct materials − Traced directly to each
job as the work is performed.
2. Direct labor − Traced directly to each job as
the work is performed.
ii. Indirect costs
1. Manufacturing overhead (including
indirect materials and indirect labor). These
costs are allocated to jobs rather than
directly traced to each job.
B. The job cost sheet − The accounting department relies
upon a job cost sheet for tracking the direct and
indirect costs associated with a given job.
i. An overview of a job cost sheet for a hypothetical
company called PearCo:
1. A job number uniquely identifies each job.
2. Direct material, direct labor, and
manufacturing overhead costs are
accumulated for each job.
3. The job cost sheet is a subsidiary ledger to
the Work in Process account.
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ii. Measuring direct materials cost
1. Once a sales order has been received and a
production order issued, the Production
Department prepares a materials requisition
form to specify the type, quantity, and total
cost of materials (e.g., $116) to be drawn
from the storeroom, and the job number (e.g.,
A-143) to which the cost of the materials is
to be charged.
a. For an existing product, the
production department can refer to a
bill of materials to determine the
type and quantity of each item of
materials needed to complete a unit
of product.
2. The Accounting Department records the total
direct material cost (e.g., $116) on the
appropriate job cost sheet. Notice, the
material requisition number (e.g., X7-
6890) is included on the job cost sheet to
provide easy access to the source document.
iii. Measuring direct labor costs
1. Workers use time tickets to record the
amount of time that they spent on each job
and the total cost assigned to each job.
2. The Accounting Department records the
labor costs from the time tickets (e.g., $88)
on to the job cost sheet.
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iv. Computing predetermined overhead rates
Learning Objective 1: Compute a predetermined
overhead rate.
1. An allocation base, such as direct labor
hours, direct labor dollars, or machine hours,
is used to assign manufacturing overhead to
products. Allocation bases are used because:
a. It is impossible or difficult to trace
these costs to particular jobs (i.e.,
manufacturing overhead is an
indirect cost).
b. Manufacturing overhead consists of
many different items ranging from
the grease used in machines to the
production manager’s salary.
c. Many types of manufacturing
overhead costs are fixed even though
output may fluctuate during the year.
2. The predetermined overhead rate is
calculated by dividing the estimated amount
of manufacturing overhead for the coming
period by the estimated quantity of the
allocation base for the coming period.
Ideally, the allocation base chosen should be
the cost driver of overhead cost.
a. Predetermined overhead rates that
rely upon estimated data are often
used because:
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(1). Actual overhead costs for the
period are not known until the
end of the period, thus
inhibiting the ability to estimate
job costs during the period.
(2). Actual overhead costs can
fluctuate seasonally, thus
misleading decision makers.
3. Predetermined overhead rates are calculated
using a four-step process.
(1). The first step is to estimate the
total amount of the allocation
base required for next period’s
estimated level of production.
(2). The second step is to estimate
the total fixed manufacturing
overhead cost for the coming
period and the variable
manufacturing overhead cost
per unit of the allocation base.
(3). The third step is to use a cost
formula to estimate the total
manufacturing overhead cost
for the coming period.
(4). The fourth step is to compute
the predetermined overhead
rate.
v. Applying manufacturing overhead
Learning Objective 2: Apply overhead cost to jobs
using a predetermined overhead rate.
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1. Manufacturing overhead is applied to jobs
using the predetermined overhead rate
multiplied by the actual amount of the
allocation base used completing the job (this
is called a normal costing system). For
example, assume PearCo:
a. Applies overhead to jobs based on
direct labor hours.
b. Estimated that 160,000 direct labor
hours would be required to support
the planned production for the year.
c. Estimated $200,000 of total fixed
overhead cost and $2.75 of variable
overhead per direct labor-hour.
d. Used a cost formula to estimate its
total manufacturing overhead cost of
$640,000.
e. Calculated its predetermined
overhead rate of $4 per direct labor
hour.
(1). The amount of overhead that
would be applied to the job cost
sheet that we have been
working with related to Job A-
143 is $32, calculated as
follows:
(a). Eight direct labor hours
were worked on Job A-
143.
(b). The predetermined
overhead rate is $4 per
direct labor hour.
(c). 8 direct labor hours $4
per hour = $32.
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Learning Objective 3: Compute the total cost and
average cost per unit of a job.
vi. Completing the job cost sheet
1. The total direct material, direct labor, and
manufacturing overhead costs assigned to
Job A-143 is $236.
a. Since this job included two units, the
average cost per unit is $118. The
average unit cost should not be
interpreted as the costs that would
actually be incurred if another unit
was produced.
b. The fixed overhead would not change
if another unit were produced, so the
incremental cost of another unit is
something less than $118.
Quick Check
−
job cost accounting
III. Job-order costing−the flow of costs
Learning Objectives 4 and 5: Understand the flow of
costs in a job-order costing system and prepare
appropriate journal entries to record costs. Use
T-accounts to show the flow of costs in a job-order
costing system.
Helpful Hint: Sometimes students need a brief review of
journal entries and the use of T-accounts before
beginning this section of the chapter.
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A. Key definitions
i. Raw materials include any materials that go into
the final product.
ii. Work in process consists of units of production
that are only partially complete and will require
further work before they are ready for sale to
customers.
iii. Finished goods consist of completed units of
product that have not yet been sold to customers.
iv. Cost of goods manufactured includes the
manufacturing costs associated with the goods that
were finished during the period.
B. Flow of cost: a conceptual overview
i. Raw materials purchases are recorded in the Raw
Materials inventory account.
ii. When raw materials are used in production, their
costs are transferred to the Work in Process
inventory account as direct materials.
iii. Direct labor costs are added directly to Work in
Process—they do not flow through Raw Materials
inventory.
iv. Manufacturing overhead costs are applied to
Work in Process by multiplying the predetermined
overhead rate by the actual quantity of the
allocation base consumed by each job.
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v. When goods are completed, their costs are
transferred from Work in Process to Finished
Goods.
vi. The amount transferred from Work in Process to
Finished Goods is referred to as the cost of goods
manufactured.
vii. As goods are sold, their costs are transferred from
Finished Goods to Cost of Goods Sold.
viii. Period costs (or selling and administrative
expenses) do not flow through inventories on the
balance sheet. They are recorded as expenses on the
income statement in the period incurred.
C. The transactions (in T-account and journal entry form)
that capture the flow of costs in a job-order costing
system are as follows:
i. The purchase and issue of raw materials
1. In T-account form:
a. The cost of raw material purchases is
debited, and although not shown, the
credit side of the transaction would
be to Accounts Payable.
b. The cost of direct material
requisitions is debited to Work in
Process and added to the job cost
sheets which serve as a subsidiary
ledger.
c. The cost of indirect material
requisitions is debited to
Manufacturing Overhead.
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2. In journal entry form:
a. Debit Raw Materials and credit
Accounts Payable.
b. Debit Work in Process and
Manufacturing Overhead and credit
Raw Materials.
ii. The recording of labor costs
1. In T-account form:
a. Direct labor costs are debited to
Work in Process and added to the job
cost sheets which serve as a
subsidiary ledger.
b. Indirect labor costs are debited to
Manufacturing Overhead.
2. In journal entry form:
a. Debit Work in Process and
Manufacturing Overhead and credit
Salaries and Wages Payable.
iii. Recording actual manufacturing overhead costs
(other than indirect materials and indirect labor)
1. In T-account form:
a. The manufacturing overhead costs
are debited to Manufacturing
Overhead.
b. The credit side of the entry is the
various liability accounts (e.g.,
Accounts Payable and Property
Taxes Payable), prepaid asset
accounts (e.g., Prepaid Insurance),
and contra-asset accounts (e.g.,
Accumulated Depreciation).
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