Discussion module 3 MC

Chapter 3: Product Costing and Cost Accumulation in a Batch Production Environment

Learning Objective 3-1. Discuss the role of product and service costing in manufacturing and nonmanufacturing firms.

Product costing is the assignment of production costs to all output of the organization. A product-costing system accumulates the costs incurred in a production process and assigns those costs to the organization’s outputs. Product costing produces data that are needed for a variety of purposes in financial accounting, managerial accounting, and cost management.

Use in Financial Accounting – Product costs are used to value inventory on the balance sheet and to compute the cost of goods sold on the income statement.

Use in Managerial Accounting – Product costs are needed to help management plan, control, and direct operations. In addition, they are needed to help with management decision making.

Use in Reporting to Interested Organizations – Product cost information is often required between firms and outside organizations. Public utilities, hospitals, and governmental agencies are a few examples. (LO 3-1)

Learning Objective 3-2. Diagram and explain the flow of costs through the manufacturing accounts used in product costing.

Manufacturing costs consist of direct material, direct labor, and manufacturing overhead. As production takes place, all manufacturing costs are added to the Work-in-Process Inventory (WIP) account with a debit. As soon as products are completed, their product costs are transferred from Work-in-Process Inventory to Finished-Goods Inventory with a credit to Work in Process and a debit to Finished Goods. During the time period when products are sold, the product cost of the inventory sold is removed from Finished Goods and added to Cost of Goods Sold, which is an expense of the period in which the sale occurred. A credit to Finished Goods and a debit to Cost of Goods Sold completes this step. Cost of Goods Sold is closed into the Income Summary account at the end of the accounting period, along with all other expenses and revenues of the period. We will look at this in more detail and go through each journal entry recorded as the costs progress through the accounting system. (LO 3-2)

Learning Objective 3-3. Distinguish between job-order costing and process costing.

Job-order costing is used by companies with job-shop operations or batch-production operations. In a job-shop environment, products are manufactured in very low volumes or one at a time. In job-order costing, each distinct batch of production is called a job or job order. The cost-accounting procedures are designed to assign costs to each job. Then the total costs assigned to each job are divided by the units of production in the job to obtain an average cost per unit. Examples of job-shop environments include film production, custom home building, and aircraft manufacturing.

In a batch-production environment, multiple products are produced in batches of relatively small quantity. Examples include furniture manufacture, printing, agricultural equipment, and pleasure boat production. (LO 3-3)

Process costing is used by companies that produce large numbers of identical units. A process-costing system accumulates all the production costs for a large number of units of output, and then these costs are averaged over all of the units.

Process costing is used by companies that produce large numbers of identical units in a continuous-flow manufacturing process. In addition, some batch-production environments use process costing when the manufacturing process requires that the product be produced in discrete batches, but batch after batch of identical products are produced.

Firms that produce chemicals, microchips, gasoline, beer, fertilizer, textiles, processed food, and electricity are among those using process costing. In these kinds of firms, there is no need to trace costs to specific batches of production because the products in the different batches are identical. (LO 3-3)

Three major sections on the job-cost record are used to accumulate the costs of direct material, direct labor, and manufacturing overhead assigned to the job. The other two sections are used to record the total cost and average unit cost for the job, and to keep track of units shipped to customers. (LO 3-3)

As raw materials are needed for the production process, they are transferred from the warehouse to the production department. To authorize the release of materials, the production department supervisor completes a material requisition form and presents it to the warehouse supervisor. (LO 3-3)

A copy of the material requisition form goes to the cost accounting department. (LO 3-3)

There it is used as the basis for transferring the cost of the requisitioned material from the Raw-Material Inventory account to the Work-in-Process Inventory account, and for entering the direct-material cost on the job-cost record for the production job in process. (LO 3-3)

The assignment of direct-labor costs to jobs is based on time records filled out by employees. (LO 3-3)

A time record is a form that records the amount of time an employee spends on each production job. (LO 3-3)

The time record is the source document used in the cost accounting department as the basis for adding direct-labor costs to Work-in-Process Inventory and to the job-cost records for the various jobs in process. (LO 3-3)

Manufacturing overhead is a pool of indirect production costs, such as indirect material, indirect labor, utility costs, and depreciation. These costs often bear no obvious relationship to individual jobs or units of product, but they must be incurred for production to take place. Therefore, it is necessary to assign manufacturing-overhead costs to jobs in order to have a complete picture of product costs. (LO 3-3)

This process of assigning manufacturing-overhead costs to production jobs is called overhead application. A predetermined overhead rate is used to apply overhead on the job-cost record. (LO 3-3)

Once manufacturing overhead has been applied, the cost summary can be completed. Total direct material costs, total direct labor costs, and total manufacturing overhead costs are added together to determine total costs. These costs are divided by the number of units completed to arrive at the unit cost. (LO 3-3)

The shipping summary is completed when the completed units are shipped to the customer. This summary shows units shipped, units remaining, and the cost of the units remaining in inventory. (LO 3-3)

Learning Objective 3-4. Compute a predetermined overhead rate and explain its use in job-order costing for job-shop and batch-production environments.

The accounting department chooses some measure of productive activity to use as the basis for overhead application. In traditional product-costing systems, this measure is usually some volume-based cost driver (or activity base), such as direct-labor hours, direct-labor cost, or machine hours. An estimate is made of (1) the amount of manufacturing overhead that will be incurred during a specified period of time and (2) the amount of the cost driver (or activity base) that will be used or incurred during the same time period. (LO 3-4)

So if we assume that the company has budgeted manufacturing overhead for the period of $360,000 and it expects to use a total of 40,000 machine hours over that same period, then the pre-determined rate would be computed by taking the estimated overhead of $360,000 and dividing it by the number of machine hours to be used over that same period – in this case 40,000 hours. This equates to a rate of $9 per machine hour that will be used to charge overhead to all of the jobs. If one specific job took 30 machine hours to complete, then a total of $270 or 30 hours multiplied by $9 per hour would be charged to the job. (LO 3-4)

Learning Objective 3-5. Prepare journal entries to record the costs of direct material, direct labor, and manufacturing overhead in a job-order costing system.

The production order for the job authorizes the start of the production process. The material requisition form identifies the amount of direct material to add to the job-cost records and the amount of indirect materials to add to the manufacturing overhead account.

The employee time tickets identity the amount of direct labor to add to the job-cost records and the amount of indirect labor to add to the manufacturing overhead account.

Overhead is applied to the job-cost records using some cost driver or activity base and a predetermined overhead rate.

Let’s examine the cost flows in a job-order costing system. We will use T-accounts and start with materials. (LO 3-5)

Materials purchases are recorded with a debit to the raw materials account. When materials are placed into production, the raw materials account is credited. Work-in-process is increased with a debit for the amount of the raw materials and manufacturing overhead is increased with a debit for the amount of the indirect materials. The amount of direct materials for each job is recorded on the individual job-cost records. Now let’s review the resulting journal entries for these transactions. (LO 3-5)

A company worked on two jobs during the accounting cycle. During the month, the company purchased, on account, $38,000 worth of materials and parts to be used in the manufacturing operation. The journal entry to record the purchase of the materials on account is shown. (LO 3-5)

During the month, materials were requisitioned for use to manufacture the products. One job (Job D42) requisitioned $34,000 of direct materials and the second job (Job S116) requisitioned $28,000 of direct materials. The journal entries record the release of the materials requested into production. (LO 3-5)

Since the cost of indirect materials incurred is relatively small and it affects all units, no attempt is made to trace the costs to specific jobs. The company accumulates all manufacturing-overhead costs in the Manufacturing Overhead account. All actual overhead costs are recorded by debiting this account. The account is debited when indirect materials are requisitioned, when indirect-labor costs are incurred, when utility bills are paid, when depreciation is recorded on manufacturing equipment, and so forth. (LO 3-5)

Direct labor and indirect labor costs are taken from the time tickets and recorded with a credit to wages payable. The direct labor costs are recorded with a debit to work-in-process. Manufacturing overhead is increased with a debit for the amount of the indirect labor. The amount of direct labor for each job is recorded on the individual job-cost records. Let’s take a look at the journal entry to record labor costs. (LO 3-5)

The cost accounting department uses the labor time records filed during the month to determine the following direct labor costs of all jobs. One job (Job D42) used $19,000 worth of direct labor costs and the other job (Job S116) used $12,000 of direct labor costs. The journal entry to record these costs is shown. (LO 3-5)

The analysis of labor time records also revealed that the company incurred $14,000 of labor costs that were not charged out to any particular job. This labor cost comprises some production supervisor time and wages of various employees who spent some of their time on maintenance and general clean up of the factory. This journal entry records the indirect labor costs to manufacturing overhead. (LO 3-5)

In a previous slide, we saw how overhead costs were incurred or accumulated on the debit side of the manufacturing overhead account. Overhead must be applied to each job-cost record based on the predetermined overhead rate and the actual activity for that job. The overhead applied is also recorded in the work-in-process account with a debit. The manufacturing overhead account is decreased by the amount of overhead applied with a credit. The actual overhead cost incurred and the amount of applied overhead rarely will match. This is caused by errors in the estimates of overhead and activity used to compute the predetermined overhead rate. Let’s see how overhead is applied through the journal entry process. (LO 3-5)

The company incurred various overhead costs or indirect production costs provided during the month. After analyzing the costs, the compound entry is made to record these overhead costs. (LO 3-5)

Recall that we discussed the pre-determined overhead rate earlier. The rate was computed by taking the company’s estimated manufacturing overhead and dividing by the total budgeted machine hours. We computed the rate per machine hour to be $9.00.

The company reviewed factory machine usage records that indicated that the actual machine usage was as shown. Now let’s make a journal entry to reflect the application of the overhead costs to the jobs. Job number D42 used 1,800 machine hours and so that job will be charged with $16,200 in overhead costs. Job S116 used 2,000 machine hours and so that job will be charged with $18,000 in overhead costs. The journal entry to show how the overhead is applied will be shown next. (LO 3-5)

The journal entry to add applied manufacturing overhead to Work-in-Process using the previous computations includes a debit to WIP and a credit to Manufacturing Overhead. (LO 3-5)

This slide summarizes the accounting procedures used for manufacturing overhead. The left side of the Manufacturing Overhead account is used to accumulate actual manufacturing-overhead costs as they are incurred throughout the accounting period. The right side is used to record overhead applied to the Work-In-Process account. The two sides of the account rarely equal. The balance of the account is usually relatively small. We will talk about how to dispose of the balance later in the chapter. (LO 3-5)

During the month, the company incurred some typical selling and administrative costs as shown. Remember that these costs are period costs, not product costs. They are NOT manufacturing costs and so they do NOT go through the WIP account. They are instead treated as expenses of the accounting period in which they are incurred. Take a moment to review the costs incurred and the resulting journal entry. (LO 3-5)

When the goods are completed, the cost of the goods manufactured are transferred to the finished goods inventory with a credit to work-in-process and a debit to finished goods. When goods are sold, the cost becomes an expense in the period of the sale. It is recorded with a debit to cost of goods sold and a credit to finished goods inventory. (LO 3-5)

Job Number S116 was completed during the period, whereas Job umber D42 remained in process at the end of the period. As the job-cost record (or Cost Summary) for Job S116 indicates, the total cost of job S116 was $48,000. Since this job was completed, the cost of $48,000 is transferred out of the WIP account and into Finished-Goods. (LO 3-5)

Sixty of the standard product in job number S116 were sold for $900 each during the period. The cost of each unit sold was $600 as shown in the job record. The following journal entries are made. The first one for $54,000 records the revenue generated by the sale and can be computed by taking the sixty units sold multiplied by the selling price of $900 each. Next, the per unit cost associated with the sale was $600 each. So the $36,000 or $600 multiplied by 60 units was taken out of the Finished-Goods inventory and charged to Cost of Goods Sold. The remaining unsold units are still in Finished Goods account and will remain there until the units are sold. (LO 3-5)

Remember that the company incurred actual manufacturing overhead of $34,450, but only applied $34,200 to the jobs in Work-in-Process. The amount by which the actual overhead exceeded the applied overhead was $250 as shown. This is referred to as underapplied overhead. This means that the pre-determined overhead rate was underestimated by just a small amount. If the actual overhead had been less than the applied overhead, then we would have overapplied overhead. If the amount is immaterial, you can close it to cost of goods sold. In this case, the $250 would be disposed of by the journal entry shown. (LO 3-5)

This table summarizes the disposition of underapplied or overapplied overhead. (LO 3-5)

Sheet1

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet7

Sheet8

Sheet9

Sheet10

Sheet11

Sheet12

Sheet13

Sheet14

Sheet15

Sheet16

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Learning Objective 3-6 – Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer.

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Schedule of Cost of Goods Manufactured

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Schedule of Cost of Goods Sold

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The Income Statement

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Further Aspects of Overhead Application

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Learning Objective 3-7– Describe the two-stage allocation process used to assign manufacturing overhead costs to production jobs.

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Cost pools

Stage One:

Costs assigned

to pools

Indirect

Labor

Indirect

Materials

Other

Overhead

Department

1

Department

2

Department

3

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Two-Stage Cost Allocation

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Departmental Overhead Rates

Department

1

Department

2

Department

3

Products

Cost pools

Direct

Labor

Hours

Machine

Hours

Raw

Materials

Cost

Stage One:

Costs assigned

to pools

Stage Two:

Costs applied

to products

Departmental Allocation Bases

Indirect

Materials

Other

Overhead

Indirect

Labor

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Learning Objective 3-8 – Describe the process of project costing used in service industry firms and nonprofit organizations.

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THE JOB

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Job-Order Costing in Nonmanufacturing Organizations

Contracts

Missions

Programs

Cases

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End of Chapter 3

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