Cost Accumulation System

Chapter 3 Job-Order Costing

LEARNING OBJECTIVES

After studying  Chapter 3 , you should be able to:

· LO1 Compute a predetermined overhead rate.

· LO2 Apply overhead cost to jobs using a predetermined overhead rate.

· LO3 Compute the total cost and average cost per unit of a job.

· LO4 Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.

· LO5 Use T-accounts to show the flow of costs in a job-order costing system.

· LO6 Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement.

· LO7 Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.

· LO8 ( Appendix 3A ) Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.

· LO9 ( Appendix 3B ) Properly account for labor costs associated with idle time, overtime, and fringe benefits.

BUSINESS FOCUS: Two Former College Students Succeeding as Entrepreneurs

When the University of Dayton athletic department needed 2,000 customized T-shirts to give away at its first home basketball game of the year, it chose University Tees to provide the shirts. A larger competitor could have been chosen, but University Tees won the order because of its fast customer response time, low price, and high quality.

University Tees is a small business that was started in February 2003 by two Miami University seniors—Joe Haddad and Nick Dadas (see the company's website at  www.universitytees.com ). The company creates the artwork for customized T-shirts and then relies on carefully chosen suppliers to manufacture the product.

Accurately calculating the cost of each potential customer order is critically important to University Tees because the company needs to be sure that the price exceeds the cost associated with satisfying the order. The costs include the cost of the T-shirts themselves, printing costs (which vary depending on the quantity of shirts produced and the number of colors printed per shirt), silk screen costs (which also vary depending on the number of colors included in a design), shipping costs, and the artwork needed to create a design. The company also takes into account its competitors’ pricing strategies when developing its own prices. ▪

 

Source: Conversation with Joe Haddad, cofounder of University Tees.

Understanding how products and services are costed is vital to managers because the way in which these costs are determined can have a substantial impact on reported profits, as well as on key management decisions.

A managerial costing system should provide cost data to help managers plan, control, and make decisions. Nevertheless, external financial reporting and tax reporting requirements often heavily influence how costs are accumulated and summarized on managerial reports. This is true of product costing. In this chapter we use absorption costing to determine product costs. In absorption costing , all manufacturing costs, both fixed and variable, are assigned to units of product—units are said to fully absorb manufacturing costs. In later chapters we look at alternatives to absorption costing such as variable costing and activity-based costing.

Most countries—including the United States—require some form of absorption costing for both external financial reports and for tax reports. In addition, the vast majority of companies throughout the world also use absorption costing in their management reports. Because absorption costing is the most common approach to product costing throughout the world, we discuss it first and then discuss the alternatives in subsequent chapters.

Job-Order Costing—An Overview

Under absorption costing, product costs include all manufacturing costs. Some manufacturing costs, such as direct materials, can be directly traced to particular products. For example, the cost of the airbags installed in a Toyota Camry can be easily traced to that particular auto. But what about manufacturing costs like factory rent? Such costs do not change from month to month, whereas the number and variety of products made in the factory may vary dramatically from one month to the next. Because these costs remain unchanged from month to month regardless of what products are made, they are clearly not caused by—and cannot be directly traced to—any particular product. Therefore, these types of costs are assigned to products and services by averaging across time and across products. The type of production process influences how this averaging is done.

Job-order costing  is used in situations where many different products are produced each period. For example, a Levi Strauss clothing factory would typically make many different types of jeans for both men and women during a month. A particular order might consist of 1,000 boot-cut men's blue denim jeans, style number A312. This order of 1,000 jeans is called a job. In a job-order costing system, costs are traced and allocated to 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.

Other examples of situations where job-order costing would be used include large-scale construction projects managed by Bechtel International, commercial aircraft produced by Boeing, greeting cards designed and printed by Hallmark, and airline meals prepared by LSG SkyChefs. All of these examples are characterized by diverse outputs. Each Bechtel project is unique and different from every other—the company may be simultaneously constructing a dam in Zaire and a bridge in Indonesia. Likewise, each airline orders a different type of meal from LSG SkyChefs’ catering service.

Job-order costing is also used extensively in service industries. For example, hospitals, law firms, movie studios, accounting firms, advertising agencies, and repair shops all use a variation of job-order costing to accumulate costs. Although the detailed example of job-order costing provided in the following section deals with a manufacturing company, the same basic concepts and procedures are used by many service organizations.

IN BUSINESS: IS THIS REALLY A JOB?

VBT Bicycling Vacations of Bristol, Vermont, offers deluxe bicycling vacations in the United States, Canada, Europe, and other locations throughout the world. For example, the company offers a 10-day tour of the Puglia region of Italy—the “heel of the boot.” The tour price includes international airfare, 10 nights of lodging, most meals, use of a bicycle, and ground transportation as needed. Each tour is led by at least two local tour leaders, one of whom rides with the guests along the tour route. The other tour leader drives a “sag wagon” that carries extra water, snacks, and bicycle repair equipment and is available for a shuttle back to the hotel or up a hill. The sag wagon also transports guests’ luggage from one hotel to another.

Each specific tour can be considered a job. For example, Giuliano Astore and Debora Trippetti, two natives of Puglia, led a VBT tour with 17 guests over 10 days in late April. At the end of the tour, Giuliano submitted a report, a sort of job cost sheet, to VBT headquarters. This report detailed the on the ground expenses incurred for this specific tour, including fuel and operating costs for the van, lodging costs for the guests, the costs of meals provided to guests, the costs of snacks, the cost of hiring additional ground transportation as needed, and the wages of the tour leaders. In addition to these costs, some costs are paid directly by VBT in Vermont to vendors. The total cost incurred for the tour is then compared to the total revenue collected from guests to determine the gross profit for the tour.

 

Sources: Giuliano Astore and Gregg Marston, President, VBT Bicycling Vacations. For more information about VBT, see  www.vbt.com .

Job-Order Costing—An Example

To introduce job-order costing, we will follow a specific job as it progresses through the manufacturing process. This job consists of two experimental couplings that Yost Precision Machining has agreed to produce for Loops Unlimited, a manufacturer of roller coasters. Couplings connect the cars on the roller coaster and are a critical component in the performance and safety of the ride. Before we begin our discussion, recall from the previous chapter that companies generally classify manufacturing costs into three broad categories: (1) direct materials, (2) direct labor, and (3) manufacturing overhead. As we study the operation of a job-order costing system, we will see how each of these three types of costs is recorded and accumulated.

MANAGERIAL ACCOUNTING IN ACTION

The Issue

Yost Precision Machining is a small company in Michigan that specializes in fabricating precision metal parts that are used in a variety of applications ranging from deep-sea exploration vehicles to the inertial triggers in automobile air bags. The company's top managers gather every morning at 8:00 a.m. in the company's conference room for the daily planning meeting. Attending the meeting this morning are: Jean Yost, the company's president; David Cheung, the marketing manager; Debbie Turner, the production manager; and Marc White, the company controller. The president opened the meeting:

· Jean: The production schedule indicates we'll be starting Job 2B47 today. Isn't that the special order for experimental couplings, David?

· David: That's right. That's the order from Loops Unlimited for two couplings for their new roller coaster ride for Magic Mountain.

· Debbie: Why only two couplings? Don't they need a coupling for every car?

· David: Yes. But this is a completely new roller coaster. The cars will go faster and will be subjected to more twists, turns, drops, and loops than on any other existing roller coaster. To hold up under these stresses, Loops Unlimited's engineers completely redesigned the cars and couplings. They want us to make just two of these new couplings for testing purposes. If the design works, then we'll have the inside track on the order to supply couplings for the whole ride.

· Jean: We agreed to take on this initial order at our cost just to get our foot in the door. Marc, will there be any problem documenting our cost so we can get paid?

· Marc: No problem. The contract with Loops stipulates that they will pay us an amount equal to our cost of goods sold. With our job-order costing system, I can tell you the cost on the day the job is completed.

· Jean: Good. Is there anything else we should discuss about this job at this time? No? Well then let's move on to the next item of business.

Measuring Direct Materials Cost

The blueprints submitted by Loops Unlimited indicate that each experimental coupling will require three parts that are classified as direct materials: two G7 Connectors and one M46 Housing. Each coupling requires two connectors and one housing, so to make two couplings, four connectors and two housings are required. This is a custom product that is being made for the first time, but if this were one of the company's standard products, it would have an established bill of materials. A  bill of materials  is a document that lists the type and quantity of each type of direct material needed to complete a unit of product.

When an agreement has been reached with the customer concerning the quantities, prices, and shipment date for the order, a production order is issued. The Production Department then prepares a materials requisition form similar to the form in  Exhibit 3–1 . The  materials requisition form  is a document that specifies the type and quantity of materials to be drawn from the storeroom and identifies the job that will be charged for the cost of the materials. The form is used to control the flow of materials into production and also for making entries in the accounting records.

EXHIBIT 3–1 Materials Requisition Form

The Yost Precision Machining materials requisition form in  Exhibit 3–1  shows that the company's Milling Department has requisitioned two M46 Housings and four G7 Connectors for the Loops Unlimited job, which has been designated as Job 2B47.

Job Cost Sheet

After a production order has been issued, the Accounting Department's job-order costing software system automatically generates a job cost sheet like the one presented in  Exhibit 3–2 . A  job cost sheet  records the materials, labor, and manufacturing overhead costs charged to that job.

EXHIBIT 3–2 Job Cost Sheet

After direct materials are issued, the cost of these materials are automatically recorded on the job cost sheet. Note from  Exhibit 3–2 , for example, that the $660 cost for direct materials shown earlier on the materials requisition form has been charged to Job 2B47 on its job cost sheet. The requisition number 14873 from the materials requisition form appears on the job cost sheet to make it easier to identify the source document for the direct materials charge.

Measuring Direct Labor Cost

Direct labor consists of labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced directly to any job are treated as part of manufacturing overhead. As discussed in the previous chapter, this latter category of labor costs is called indirect labor and includes tasks such as maintenance, supervision, and cleanup.

Today many companies rely on computerized systems (rather than paper and pencil) to maintain employee time tickets. A completed  time ticket  is an hour-by-hour summary of the employee's activities throughout the day. One computerized approach to creating time tickets uses bar codes to capture data. Each employee and each job has a unique bar code. When beginning work on a job, the employee scans three bar codes using a handheld device much like the bar code readers at grocery store checkout stands. The first bar code indicates that a job is being started; the second is the unique bar code on the employee's identity badge; and the third is the unique bar code of the job itself. This information is fed automatically via an electronic network to a computer that notes the time and records all of the data. When the task is completed, the employee scans a bar code indicating the task is complete, the bar code on his or her identity badge, and the bar code attached to the job. This information is relayed to the computer that again notes the time, and a time ticket, such as the one shown in  Exhibit 3–3 , is automatically prepared. Because all of the source data is already in computer files, the labor costs can be automatically posted to job cost sheets. For example,  Exhibit 3–3  shows $45 of direct labor cost related to Job 2B47. This amount is automatically posted to the job cost sheet shown in  Exhibit 3–2 . The time ticket in  Exhibit 3–3  also shows $9 of indirect labor costs related to performing maintenance. This cost is treated as part of manufacturing overhead and does not get posted on a job cost sheet.

EXHIBIT 3–3 Employee Time Ticket

IN BUSINESS: BUCKING THE TREND: USING PEOPLE INSTEAD OF MACHINES

For decades, overhead costs have been going up and labor costs have been going down as companies have replaced people with machines. However, at the French automaker Renault, the exact opposite has been happening with its no-frills vehicle called the Logan. The Logan was intentionally stripped of costly elements and unnecessary technology so that the car could be sold for $6,000 in emerging Eastern European markets. The car's simplified design enables Renault's manufacturing plant in Romania to assemble the car almost entirely with people instead of robots. The monthly pay for a line worker at Renault's Romanian plant is $324 versus an average of more than $4,700 per worker in Western European countries. Thanks in part to low-cost labor, Logan's production costs are estimated to be just $1,089 per unit.

The Logan is finding buyers not only in emerging markets but also in more advanced Western European nations where customers have been clamoring for the car. Renault expects sales for the Logan to climb to one million vehicles—adding $341 million to its profits.

 

Source: Gail Edmondson and Constance Faivre d'Arcier, “Got 5,000 Euros? Need a New Car?”BusinessWeek, July 4, 2005, p. 49.

Computing Predetermined Overhead Rates

LEARNING OBJECTIVE 1

Compute a predetermined overhead rate.

Recall that product costs include manufacturing overhead as well as direct materials and direct labor. Therefore, manufacturing overhead also needs to be recorded on the job cost sheet. However, assigning manufacturing overhead to a specific job involves some difficulties. 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 the production manager.

· 3. Because of the fixed costs in manufacturing overhead, total manufacturing overhead costs tend to remain relatively constant from one period to the next even though the number of units produced can fluctuate widely. Consequently, the average cost per unit will vary from one period to the next.

Given these problems, allocation is used to assign overhead costs to products. Allocation is accomplished by selecting an allocation base that is common to all of the company's products and services. An  allocation base  is a measure such as direct labor-hours (DLH) or machine-hours (MH) that is used to assign overhead costs to products and services. The most widely used allocation bases in manufacturing are direct labor-hours, direct labor cost, machine-hours and (where a company has only a single product) units of product.

Manufacturing overhead is commonly assigned to products using a predetermined overhead rate.The  predetermined overhead rate  is computed by dividing the total estimated manufacturing overhead cost for the period by the estimated total amount of the allocation base as follows:

The predetermined overhead rate is computed before the period begins using a four-step process. The first step is to estimate the total amount of the allocation base (the denominator) that will be required for next period's estimated level of production. 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. The third step is to use the cost formula shown below to estimate the total manufacturing overhead cost (the numerator) for the coming period:

Where,

· Y The estimated total manufacturing overhead cost

· a The estimated total fixed manufacturing overhead cost

· b The estimated variable manufacturing overhead cost per unit of the allocation base

· X The estimated total amount of the allocation base

The fourth step is to compute the predetermined overhead rate. Notice, the estimated amount of the allocation base is determined before estimating the total manufacturing overhead cost. This needs to be done because total manufacturing overhead cost includes variable overhead costs that depend on the amount of the allocation base.

Applying Manufacturing Overhead

LEARNING OBJECTIVE 2

Apply overhead cost to jobs using a predetermined overhead rate.

To repeat, the predetermined overhead rate is computed before the period begins. The predetermined overhead rate is then used to apply overhead cost to jobs throughout the period. The process of assigning overhead cost to jobs is called  overhead application . The formula for determining the amount of overhead cost to apply to a particular job is:

For example, if the predetermined overhead rate is $8 per direct labor-hour, then $8 of overhead cost is applied to a job for each direct labor-hour incurred on the job. When the allocation base is direct labor-hours, the formula becomes:

Manufacturing Overhead—A Closer Look

To illustrate the steps involved in computing and using a predetermined overhead rate, let's return to Yost Precision Machining and make the following assumptions. In step one, the company estimated that 40,000 direct labor-hours would be required to support the production planned for the year. In step two, it estimated $220,000 of total fixed manufacturing overhead cost for the coming year and $2.50 of variable manufacturing overhead cost per direct labor-hour. Given these assumptions, in step three the company used the cost formula shown below to estimate its total manufacturing overhead cost for the year:

In step four, Yost Precision Machining computed its predetermined overhead rate for the year of $8 per direct labor-hour as shown below:

The job cost sheet in  Exhibit 3–4  indicates that 27 direct labor-hours (i.e., DLHs) were charged to Job 2B47. Therefore, a total of $216 of manufacturing overhead cost would be applied to the job:

EXHIBIT 3–4 A Completed Job Cost Sheet

This amount of overhead has been entered on the job cost sheet in  Exhibit 3–4 . Note that this is notthe actual amount of overhead caused by the job. Actual overhead costs are not assigned to jobs—if that could be done, the costs would be direct costs, not overhead. The overhead assigned to the job is simply a share of the total overhead that was estimated at the beginning of the year. A  normal cost system , which we have been describing, applies overhead to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the jobs.

The Need for a Predetermined Rate

Instead of using a predetermined rate based on estimates, why not base the overhead rate on theactual total manufacturing overhead cost and the actual total amount of the allocation base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the allocation base can produce fluctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall. If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs. Many managers believe that such fluctuations in product costs serve no useful purpose. To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems.

Choice of an Allocation Base for Overhead Cost

Ideally, the allocation base in the predetermined overhead rate should drive the overhead cost. A cost driver  is a factor, such as machine-hours, beds occupied, computer time, or flight-hours, that causes overhead costs. If the base in the predetermined overhead rate does not “drive” overhead costs, product costs will be distorted. For example, if direct labor-hours is used to allocate overhead, but in reality overhead has little to do with direct labor-hours, then products with high direct labor-hour requirements will be overcosted.

Most companies use direct labor-hours or direct labor cost as the allocation base for manufacturing overhead. In the past, direct labor accounted for up to 60% of the cost of many products, with overhead cost making up only a portion of the remainder. This situation has changed for two reasons. First, sophisticated automated equipment has taken over functions that used to be performed by direct labor workers. Because the costs of acquiring and maintaining such equipment are classified as overhead, this increases overhead while decreasing direct labor. Second, products are becoming more sophisticated and complex and are changed more frequently. This increases the need for highly skilled indirect workers such as engineers. As a result of these two trends, direct labor has decreased relative to overhead as a component of product costs.

In companies where direct labor and overhead costs have been moving in opposite directions, it would be difficult to argue that direct labor “drives” overhead costs. Accordingly, managers in some companies use activity-based costing principles to redesign their cost accounting systems. Activity-based costing is designed to more accurately reflect the demands that products, customers, and other cost objects make on overhead resources. The activity-based approach is discussed in more detail in  Chapter 7 .

Although direct labor may not be an appropriate allocation base in some industries, in others it continues to be a significant driver of manufacturing overhead. Indeed, most manufacturing companies in the United States continue to use direct labor as the primary or secondary allocation base for manufacturing overhead. The key point is that the allocation base used by the company should really drive, or cause, overhead costs, and direct labor is not always the most appropriate allocation base.

IN BUSINESS: REDUCING HEALTH-DAMAGING BEHAVIORS

Cianbro is an industrial construction company headquartered in Pittsfield, Maine, whose goal is “To be the healthiest company in America.” It introduced a corporate wellness program to attack employee behaviors that drive up health-care costs. The table below summarizes the number of employees in five health risk categories as of 2003 and 2005. The decreases in the number of employees in these high-risk categories are evidence that the wellness program was effective in helping employees make positive lifestyle changes. This should result in reduced health-care costs for the company.

	Number of Employees
Health Risk Category	January 2003	March 2005	Decrease
Obesity	432	353	79
High cholesterol	637	515	122
Tobacco use	384	274	110
Inactivity	354	254	100
High blood pressure	139	91	48
Source: Cianbro, WELCOA's Absolute Advantage Magazine, 2006.

LEARNING OBJECTIVE 3

Compute the total cost and average cost per unit of a job.

Computation of Unit Costs

With the application of Yost Precision Machining's $216 of manufacturing overhead to the job cost sheet in  Exhibit 3–4 , the job cost sheet is complete except for two final steps. First, the totals for direct materials, direct labor, and manufacturing overhead are transferred to the Cost Summary section of the job cost sheet and added together to obtain the total cost for the job. 1  Then the total product cost ($1,800) is divided by the number of units (2) to obtain the unit product cost ($900). This unit product cost information is used for valuing unsold units in ending inventory and for determining cost of goods sold. As indicated earlier, this unit product cost is an average cost and should not be interpreted as the cost that would actually be incurred if another unit were produced. The incremental cost of an additional unit is something less than the average unit cost of $900 because much of the actual overhead costs would not change if another unit were produced.

MANAGERIAL ACCOUNTING IN ACTION

The Wrap-up

In the 8:00 a.m. daily planning meeting on March 9, Jean Yost, the president of Yost Precision Machining, once again drew attention to Job 2B47, the experimental couplings:

· Jean: I see Job 2B47 is completed. Let's get those couplings shipped immediately to Loops Unlimited so they can get their testing program under way. Marc, how much are we going to bill Loops for those two units?

· Marc: Because we agreed to sell the experimental couplings at cost, we will be charging Loops Unlimited just $900 a unit.

· Jean: Fine. Let's hope the couplings work out and we make some money on the big order later.

IN BUSINESS: ONE-OF-A-KIND MASTERPIECE

In a true job-order costing environment, every job is unique. For example, Purdey manufactures 80–90 shotguns per year with each gun being a specially commissioned one-of-a-kind masterpiece. The prices start at $110,000 because every detail is custom built, engraved, assembled, and polished by a skilled craftsman. The hand engraving can take months to complete and may add as much as $100,000 to the price. The guns are designed to shoot perfectly straight and their value increases over time even with heavy use. One Purdey gun collector said “when I shoot my Purdeys I feel like an orchestra conductor waving my baton.”

 

Source: Eric Arnold, “Aim High,” Forbes, December 28, 2009, p. 86.

1

Notice, we are assuming that Job 2B47 required direct materials and direct labor beyond the charges shown in  Exhibits 3–1  and  3–3 .

Job-Order Costing—The Flow of Costs

LEARNING OBJECTIVE 4

Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs.

We are now ready to discuss the flow of costs through a job-order costing system.  Exhibit 3–5 provides a conceptual overview of these cost flows. It highlights the fact that product costs flow through inventories on the balance sheet and then on to cost of goods sold in the income statement. More specifically, raw materials purchases are recorded in the Raw Materials inventory account. Raw materials  include any materials that go into the final product. When raw materials are used in production, their costs are transferred to the Work in Process inventory account as direct materials. 2   Work in process  consists of units of product that are only partially complete and will require further work before they are ready for sale to the customer. Notice that direct labor costs are added directly to Work in Process—they do not flow through Raw Materials inventory. 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. 3  When goods are completed, their costs are transferred from Work in Process to Finished Goods.  Finished goods consist of completed units of product that have not yet been sold to customers. The amount transferred from Work in Process to Finished Goods is referred to as the cost of goods manufactured. The  cost of goods manufactured  includes the manufacturing costs associated with the goods that were finished during the period. As goods are sold, their costs are transferred from Finished Goods to Cost of Goods Sold. At this point, the various costs required to make the product are finally recorded as an expense. Until that point, these costs are in inventory accounts on the balance sheet. 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.

EXHIBIT 3–5 Cost Flows and Classifications in a Manufacturing Company

To illustrate the cost flows through a company's general ledger, we will consider a single month's activity at Ruger Corporation, a producer of gold and silver commemorative medallions. Ruger Corporation has two jobs in process during April, the first month of its fiscal year. Job A, a special minting of 1,000 gold medallions commemorating the invention of motion pictures, was started during March. By the end of March, $30,000 in manufacturing costs had been recorded for the job. Job B, an order for 10,000 silver medallions commemorating the fall of the Berlin Wall, was started in April.

The Purchase and Issue of Materials

On April 1, Ruger Corporation had $7,000 in raw materials on hand. During the month, the company purchased on account an additional $60,000 in raw materials. The purchase is recorded in journal entry (1) below:

As explained in the previous chapter, 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 included $50,000 of direct and $2,000 of indirect materials. Entry (2) records issuing the materials to the production departments.

The materials charged to Work in Process represent direct materials for specific jobs. These costs are also recorded on the appropriate job cost sheets. This point is illustrated in  Exhibit 3–6 , where$28,000 of the $50,000 in direct materials is charged to Job A's cost sheet and the remaining $22,000is charged to Job B's cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.)

EXHIBIT 3–6 Raw Materials Cost Flows

The $2,000 charged to Manufacturing Overhead in entry (2) represents indirect materials. Observe that the Manufacturing Overhead account is separate from the Work in Process account. The purpose of the Manufacturing Overhead account is to accumulate all manufacturing overhead costs as they are incurred during a period.

Before leaving  Exhibit 3–6 , we need to point out one additional thing. Notice from the exhibit that the job cost sheet for Job A 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 the Work in Process account contains the same $30,000 balance. Thus, the Work in Process account summarizes all of the costs appearing on the job cost sheets of the jobs that are in process. Job A was the only job in process at the beginning of April, so the beginning balance in the Work in Process account equals Job A's beginning balance of $30,000.

2

Indirect material costs are accounted for as part of manufacturing overhead.

3

For simplicity,  Exhibit 3–5  assumes that Cost of Goods Sold does not need to be adjusted as discussed later in the chapter.

Labor Cost

In April, the employee time tickets included $60,000 recorded for direct labor and $15,000 for indirect labor. The following entry summarizes these costs:

Only the direct labor cost of $60,000 is added to the Work in Process account. At the same time that direct labor costs are added to Work in Process, they are also added to the individual job cost sheets, as shown in  Exhibit 3–7 . During April, $40,000 of direct labor cost was charged to Job A and the remaining $20,000 was charged to Job B.

EXHIBIT 3–7 Labor Cost Flows

The labor costs charged to Manufacturing Overhead ($15,000) represent the indirect labor costs of the period, such as supervision, janitorial work, and maintenance.

Manufacturing Overhead Costs

Recall that all manufacturing costs 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 Ruger Corporation incurred the following general factory costs during April:

The following entry records the incurrence of these costs:

In addition, assume that during April, Ruger Corporation 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:

Finally, assume that the company recognized $18,000 in depreciation on factory equipment during April. The following entry records the accrual of this depreciation:

In short, manufacturing overhead costs are recorded directly into the Manufacturing Overhead account as they are incurred.

Applying Manufacturing Overhead

Because actual manufacturing costs are charged to the Manufacturing Overhead control account rather than to Work in Process, how are manufacturing overhead costs assigned to Work in Process? The answer is, by means of the predetermined overhead rate. Recall from our discussion earlier in the chapter that a predetermined overhead rate is established at the beginning of each year. The rate is calculated by dividing the estimated total manufacturing overhead cost for the year by the estimated total amount of the allocation base (measured in machine-hours, direct labor-hours, or some other base). The predetermined overhead rate is then used to apply overhead costs to jobs. For example, if machine-hours is the allocation base, overhead cost is applied to each job by multiplying the predetermined overhead rate by the number of machine-hours charged to the job.

To illustrate, assume that Ruger Corporation's predetermined overhead rate is $6 per machine-hour. Also assume that during April, 10,000 machine-hours were worked on Job A and 5,000 machine-hours were worked on Job B (a total of 15,000 machine-hours). Thus, $90,000 in overhead cost ($6 per machine-hour × 15,000 machine-hours = $90,000) would be applied to Work in Process. The following entry records the application of Manufacturing Overhead to Work in Process:

The flow of costs through the Manufacturing Overhead account is shown in  Exhibit 3–8 . The actual overhead costs on the debit side in the Manufacturing Overhead account in  Exhibit 3–8  are the costs that were added to the account in entries (2)–(6). Observe that recording these actual overhead costs [entries (2)–(6)] and the application of overhead to Work in Process [entry (7)] represent two separate and entirely distinct processes.

EXHIBIT 3–8 The Flow of Costs in Overhead Application

The Concept of a Clearing Account

The Manufacturing Overhead account operates as a clearing account. As we have noted, actual factory overhead costs are debited to the account as they are incurred throughout the year. When a job is completed (or at the end of an accounting period), overhead cost is applied to the job using the predetermined overhead rate, and Work in Process is debited and Manufacturing Overhead is credited. This sequence of events is illustrated below:

As we emphasized earlier, the predetermined overhead rate is based entirely on estimates of what the level of activity and 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 actual overhead cost incurred. For example, notice from  Exhibit 3–8  that Ruger Corporation's actual overhead costs for the period are $5,000 greater than the overhead cost that has been applied to Work in Process, resulting in a $5,000 debit balance in the Manufacturing Overhead account. We will reserve discussion of what to do with this $5,000 balance until later in the chapter.

For the moment, we can conclude from  Exhibit 3–8  that the cost of a completed job consists of the actual direct materials cost of the job, the actual direct labor cost of the job, and the manufacturing 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, appears on the job cost sheet and in the Work in Process account.

Nonmanufacturing Costs

In addition to manufacturing costs, companies also incur selling and administrative costs. These costs should be treated as period expenses and charged directly to the income statement.Nonmanufacturing costs should not go into the Manufacturing Overhead account. To illustrate the correct treatment of nonmanufacturing costs, assume that Ruger Corporation incurred $30,000 in selling and administrative salary costs during April. The following entry summarizes the accrual of those salaries:

Assume that depreciation on office equipment during April was $7,000. The entry is as follows:

Pay particular attention to the difference between this entry and entry (6) where we recorded depreciation on factory equipment. In journal entry (6), depreciation on factory equipment was debited to Manufacturing Overhead and is therefore a product cost. In journal entry (9) above, depreciation on office equipment is debited to Depreciation Expense. Depreciation on office equipment is a period expense rather than a product cost.

Finally, assume that advertising was $42,000 and that other selling and administrative expenses in April totaled $8,000. The following entry records these items:

The amounts in entries (8) through (10) are recorded directly into expense accounts—they have no effect on product costs. The same will be true of any other selling and administrative expenses incurred during April, including sales commissions, depreciation on sales equipment, rent on office facilities, insurance on office facilities, and related costs.

Cost of Goods Manufactured

When a job has been completed, the finished output is transferred from the production departments 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 goods to the finished goods warehouse. The costs of the completed job are transferred out of the Work in Process 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.

In the case of Ruger Corporation, assume that Job A was completed during April. The following entry transfers the cost of Job A from Work in Process to Finished Goods:

The $158,000 represents the completed cost of Job A, as shown on the job cost sheet in  Exhibit 3–8 . Because Job A was the only job completed during April, the $158,000 also represents the cost of goods manufactured for the month.

Job B was not completed by the end of the month, so its cost will remain in the Work in Process 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 Job B will appear as the asset “Work in Process inventory.”

Cost of Goods Sold

As finished goods are shipped to customers, their accumulated costs are transferred from the Finished Goods account to the Cost of Goods Sold account. If an entire job is shipped at one time, then the entire cost appearing on the job cost sheet is transferred to the Cost of Goods Sold account. In most cases, however, only a portion of the units involved in a particular job will be immediately sold. In these situations, the unit product cost must be used to determine how much product cost should be removed from Finished Goods and charged to Cost of Goods Sold.

For Ruger Corporation, we will assume 750 of the 1,000 gold medallions in Job A were shipped to customers by the end of the month for total sales revenue of $225,000. Because 1,000 units were produced and the total cost of the job from the job cost sheet was $158,000, the unit product cost was $158. The following journal entries would record the sale (all sales were on account):

LEARNING OBJECTIVE 5

Use T-accounts to show the flow of costs in a job-order costing system.

Entry (13) completes the flow of costs through the job-order costing system. To pull the entire Ruger Corporation example together, journal entries (1) through (13) are summarized in  Exhibit 3–9 . The flow of costs through the accounts is presented in T-account form in  Exhibit 3–10 .

EXHIBIT 3–9 Summary of Ruger Corporation Journal Entries

EXHIBIT 3–10 Summary of Cost Flows—Ruger Corporation

Schedules of Cost of Goods Manufactured and Cost of Goods Sold

LEARNING OBJECTIVE 6

Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement.

This section uses the Ruger Corporation example to explain how to prepare schedules of cost of goods manufactured and cost of goods sold as well as an income statement. The  schedule of cost of goods manufactured  contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and it summarizes the portions of those costs that remain in ending Work in Process inventory and that are transferred out of Work in Process into Finished Goods. The  schedule of cost of goods sold  also contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and it summarizes the portions of those costs that remain in ending Finished Goods inventory and that are transferred out of Finished Goods into Cost of Goods Sold.

Exhibit 3–11  presents Ruger Corporation's schedules of cost of goods manufactured and cost of goods sold. We want to draw your attention to three key aspects of the schedule of cost of goods manufactured. First, three amounts are always added together—direct materials used in production ($50,000), direct labor ($60,000), and manufacturing overhead applied to work in process ($90,000)—to yield the total manufacturing costs ($200,000). Notice, the direct materials used in production ($50,000) is included in total manufacturing costs instead of raw material purchases ($60,000). The direct materials used in production will usually differ from the amount of raw material purchases when the raw materials inventory balance changes or indirect materials are withdrawn from raw materials inventory. Second, the amount of manufacturing overhead applied to Work in Process ($90,000) is computed by multiplying the predetermined overhead rate by the actual amount of the allocation base recorded on all jobs. The actual manufacturing overhead costs incurred during the period are not added to the Work in Process account. Third, total manufacturing costs ($200,000) plus beginning Work in Process inventory ($30,000) minus ending Work in Process inventory ($72,000) equals the cost of goods manufactured ($158,000). The cost of goods manufactured represents the cost of the goods completed during the period and transferred from Work in Process to Finished Goods.

EXHIBIT 3–11 Schedules of Cost of Goods Manufactured and Cost of Goods Sold

The schedule of cost of goods sold shown in  Exhibit 3–11  relies on the following equation to compute the unadjusted cost of goods sold:

The beginning finished goods inventory ($10,000) plus the cost of goods manufactured ($158,000) equals the cost of goods available for sale ($168,000). The cost of goods available for sale ($168,000) minus the ending finished goods inventory ($49,500) equals the unadjusted cost of goods sold ($118,500). Finally, the unadjusted cost of goods sold ($118,500) plus the underapplied overhead ($5,000) equals adjusted cost of goods sold ($123,500). The next section of the chapter takes a closer look at why cost of goods sold needs to be adjusted for the amount of underapplied or overapplied overhead

Exhibit 3–12  presents Ruger Corporation's income statement for April. Observe that the cost of goods sold on this statement is carried over from  Exhibit 3–11 . The selling and administrative expenses (which total $87,000) did not flow through the schedules of cost of goods manufactured and cost of goods sold. Journal entries 8–10 (page 100) show that these items were immediately debited to expense accounts rather than being debited to inventory accounts.

EXHIBIT 3–12 Income Statement

Underapplied and Overapplied Overhead—A Closer Look

LEARNING OBJECTIVE 7

Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.

This section explains how to compute underapplied and overapplied overhead and how to dispose of any balance remaining in the Manufacturing Overhead account at the end of a period.

Computing Underapplied and Overapplied Overhead

Because the predetermined overhead rate is established before the period begins and is based entirely on estimated data, the overhead cost applied to Work in Process will generally differ from the amount of overhead cost actually incurred. In the case of Ruger Corporation, for example, the predetermined overhead rate of $6 per hour was used to apply $90,000 of overhead cost to Work in Process, whereas actual overhead costs for April proved to be $95,000 (see  Exhibit 3–8 ). The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is called either underapplied or  overapplied overhead . For Ruger Corporation, overhead was underapplied by $5,000 because the applied cost ($90,000) was $5,000 less than the actual cost ($95,000). If the situation had been reversed and the company had applied $95,000 in overhead cost to Work in Process while incurring actual overhead costs of only $90,000, then the overhead would have been overapplied.

What is the cause of underapplied or overapplied overhead? Basically, 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 costs incurred will be $6 for every machine-hour that is actually worked. There are at least two reasons why this may not be true. First, much of the overhead often consists of fixed costs that do not change as the number of machine-hours incurred goes up or down. 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.

To illustrate these concepts, suppose that two companies—Turbo Crafters and Black & Howell—have prepared the following estimated data for the coming year:

Note that when the allocation base is dollars (such as direct materials cost in the case of Black & Howell) the predetermined overhead rate is expressed as a percentage of the allocation base. When dollars are divided by dollars, the result is a percentage.

Now assume that because of unexpected changes in overhead spending and in demand for the companies’ products, the actual overhead cost and the actual activity recorded during the year in each company are as follows:

For each company, note that the actual data for both cost and the allocation base differ from the estimates used in computing the predetermined overhead rate. This results in underapplied and overapplied overhead as follows:

For Turbo Crafters, the amount of overhead cost applied to Work in Process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore, overhead is underapplied.

For Black & Howell, the amount of overhead cost applied to Work in Process ($135,000) is greater than the actual overhead cost for the year ($130,000), so overhead is overapplied.

A summary of these concepts is presented in  Exhibit 3–13 .

EXHIBIT 3–13 Summary of Overhead Concepts

Disposition of Underapplied or Overapplied Overhead Balances

If we return to the Ruger Corporation example and look at the Manufacturing Overhead T-account in  Exhibit 3–10 , you will see that there is a debit balance of $5,000. Remember that debit entries to the account represent actual overhead costs incurred, whereas credit entries represent overhead costs applied to jobs. In this case, the actual overhead costs incurred exceeded the overhead costs applied to jobs by $5,000—hence, the debit balance of $5,000. This may sound familiar. We just discussed in the previous section the fact that the overhead costs incurred ($95,000) exceeded the overhead costs applied ($90,000), and that the difference is called underapplied overhead. These are just two ways of looking at the same thing. If there is a debit balance in the Manufacturing Overhead account of X dollars, then the overhead is underapplied by X dollars. On the other hand, if there is a credit balance in the Manufacturing Overhead account of Y dollars, then the overhead is overapplied by Y dollars. What do we do with the balance in the Manufacturing Overhead account at the end of the accounting period?

The underapplied or overapplied balance remaining in the Manufacturing Overhead account at the end of a period is treated in one of two ways:

· 1. Closed out to Cost of Goods Sold.

· 2. Allocated among the Work in Process, Finished Goods, and Cost of Goods Sold accounts in proportion to the overhead applied during the current period in ending balances.

Closed Out to Cost of Goods Sold

Closing out the balance in Manufacturing Overhead to Cost of Goods Sold is simpler than the allocation method. In the Ruger Corporation example, the entry to close the $5,000 of underapplied overhead to Cost of Goods Sold is:

Note that because the Manufacturing Overhead account has a debit balance, Manufacturing Overhead must be credited to close out the account. This has the effect of increasing Cost of Goods Sold for April to $123,500:

After this adjustment has been made, Ruger Corporation's income statement for April will appear as shown earlier in  Exhibit 3–12 .

Note that this adjustment makes sense. The unadjusted cost of goods sold is based on the amount of manufacturing overhead applied to jobs, not the manufacturing overhead costs actually incurred. Because overhead was underapplied, not enough cost was applied to jobs. Hence, the cost of goods sold was understated. Adding the underapplied overhead to the cost of goods sold corrects this understatement.

Allocated between Accounts

Allocation of underapplied or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods Sold is more accurate than closing the entire balance into Cost of Goods Sold. This allocation assigns overhead costs to where they would have gone had the estimates included in the predetermined overhead rate matched the actual amounts.

Had Ruger Corporation chosen to allocate the underapplied overhead among the inventory accounts and Cost of Goods Sold, it would first be necessary to determine the amount of overhead that had been applied during April to each of the accounts. The computations would have been as follows:

Based on the above percentages, the underapplied overhead (i.e., the debit balance in Manufacturing Overhead) would be allocated as shown in the following journal entry:

Note that the first step in the allocation process was to determine the amount of overhead applied in each of the accounts. For Finished Goods, for example, the total amount of overhead applied to Job A, $60,000, was divided by the total number of units in Job A, 1,000 units, to arrive at the average overhead applied of $60 per unit. Because 250 units from Job A were still in ending finished goods inventory, the amount of overhead applied in the Finished Goods Inventory account was $60 per unit multiplied by 250 units or $15,000 in total.

If overhead had been overapplied, the entry above would have been just the reverse, because a credit balance would have existed in the Manufacturing Overhead account.

Which Method Should Be Used for Disposing of Underapplied or Overapplied Overhead?

The allocation method is generally considered more accurate than simply closing out the underapplied or overapplied overhead to Cost of Goods Sold. However, the allocation method is more complex. We will always specify which method you are to use in problem assignments.

A General Model of Product Cost Flows

Exhibit 3–14  presents a T-account model of the flow of costs in a product costing system. This model can be very helpful in understanding how production costs flow through a costing system and finally end up as Cost of Goods Sold on the income statement.

EXHIBIT 3–14 A General Model of Cost Flows

Multiple Predetermined Overhead Rates

Our discussion in this chapter has assumed that there is a single predetermined overhead rate for an entire factory called a  plantwide overhead rate . This is a fairly common practice—particularly in smaller companies. But in larger 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 more accurate because it can reflect differences across departments in how overhead costs are incurred. For example, in departments that are relatively labor intensive overhead might be allocated based on direct labor-hours and in departments that are relatively machine intensive overhead might be allocated based on machine-hours. When multiple predetermined overhead rates are used, overhead is applied in each department according to its own overhead rate as jobs proceed through the department.

Job-Order Costing in Service Companies

Job-order costing is used in service organizations such as law firms, movie studios, hospitals, and repair shops, as well as in manufacturing companies. In a law firm, for example, each client is a “job,” and the costs of that job are accumulated day by day on a job cost sheet as the client's case is handled by the firm. Legal forms and similar inputs represent the direct materials for the job; the time expended by attorneys is like direct labor; and the costs of secretaries and legal aids, rent, depreciation, and so forth, represent the overhead.

In a movie studio such as Columbia Pictures, each film produced by the studio is a “job,” and costs of direct materials (costumes, props, film, etc.) and direct labor (actors, directors, and extras) are charged to each film's job cost sheet. A share of the studio's overhead costs, such as utilities, depreciation of equipment, wages of maintenance workers, and so forth, is also charged to each film.

In sum, job-order costing is a versatile and widely used costing method that may be encountered in virtually any organization that provides diverse products or services.

IN BUSINESS: MANAGING JOB COSTS IN A SERVICE BUSINESS

IBM has created a software program called Professional Marketplace to match IBM employees with client needs. “Using Marketplace, IBM consultants working for customers can search through 100 job classifications and 10,000 skills, figuring out who inside IBM is available, where they are located and roughly how much it costs the company to use them.” Thus far, the results have been encouraging. IBM has reduced its reliance on outside contractors by 5% to 7% and its consultants spend more of their time in billable work. Furthermore, IBM's senior consultants can search across the globe for available employees with particular niche skills with the click of a mouse instead of having to rely on numerous time-consuming phone calls and emails.

 

Source: Charles Forelle, “IBM Tool Deploys Employees Efficiently,” The Wall Street Journal, July 14, 2005, p. B3.

Summary

Job-order costing is used in situations where the organization offers many different products or services, such as in furniture manufacturing, hospitals, and legal firms. Materials requisition forms and labor time tickets are used to assign direct materials and direct labor costs to jobs in a job-order costing system. Manufacturing overhead costs are assigned to jobs using a predetermined overhead rate. All of the costs are recorded on a job cost sheet. The predetermined overhead rate is determined before the period begins by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base for the period. The most frequently used allocation bases are direct labor-hours and machine-hours. Overhead is applied to jobs by multiplying the predetermined overhead rate by the actual amount of the allocation base recorded for the job.

Because the predetermined overhead rate is based on estimates, the actual overhead cost incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as underapplied or overapplied overhead. The underapplied or overapplied overhead for a period can be either closed out to Cost of Goods Sold or allocated between Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is underapplied, manufacturing overhead costs have been understated and therefore inventories and/or expenses must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or expenses must be adjusted downwards.

Review Problem: Job-Order Costing

Hogle Corporation is a manufacturer that uses job-order costing. On January 1, the beginning of its fiscal year, the company's inventory balances were as follows:

Raw materials	$20,000
Work in process	$15,000
Finished goods	$30,000

The company applies overhead cost to jobs on the basis of machine-hours worked. For the current year, the company's predetermined overhead rate was based on a cost formula that estimated $450,000 of total manufacturing overhead for an estimated activity level of 75,000 machine-hours. The following transactions were recorded for the year:

· a. Raw materials were purchased on account, $410,000.

· b. Raw materials were requisitioned for use in production, $380,000 ($360,000 direct materials and $20,000 indirect materials).

· c. The following costs were accrued for employee services: direct labor, $75,000; indirect labor, $110,000; sales commissions, $90,000; and administrative salaries, $200,000.

· d. Sales travel costs were $17,000.

· e. Utility costs in the factory were $43,000.

· f. Advertising costs were $180,000.

· g. Depreciation was recorded for the year, $350,000 (80% relates to factory operations, and 20% relates to selling and administrative activities).

· h. Insurance expired during the year, $10,000 (70% relates to factory operations, and the remaining 30% relates to selling and administrative activities).

· i. Manufacturing overhead was applied to production. Due to greater than expected demand for its products, the company worked 80,000 machine-hours on all jobs during the year.

· j. Goods costing $900,000 to manufacture according to their job cost sheets were completed during the year.

· k. Goods were sold on account to customers during the year for a total 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 a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Do not allocate the balance between ending inventories and Cost of Goods Sold.

· 4. Prepare an income statement for the year.

Solution to Review Problem

· 1.

· 2.

· 3. Manufacturing overhead is overapplied for the year. The entry to close it out to Cost of Goods Sold is as follows:

· 4.

Glossary

Absorption costing

A costing method that includes all manufacturing costs—direct materials, direct labor, and both variable and fixed manufacturing overhead—in the cost of a product. (p. 84)

Allocation base

A measure of activity such as direct labor-hours or machine-hours that is used to assign costs to cost objects. (p. 89)

Bill of materials

A document that shows the quantity of each type of direct material required to make a product. (p. 86)

Cost driver

A factor, such as machine-hours, beds occupied, computer time, or flight-hours, that causes overhead costs. (p. 91)

Cost of goods manufactured

The manufacturing costs associated with the goods that were finished during the period. (p. 93)

Finished goods

Units of product that have been completed but not yet sold to customers. (p. 93)

Job cost sheet

A form that records the materials, labor, and manufacturing overhead costs charged to a job. (p. 86)

Job-order costing

A costing system used in situations where many different products, jobs, or services are produced each period. (p. 84)

Materials requisition form

A document that specifies the type and quantity of materials to be drawn from the storeroom and that identifies the job that will be charged for the cost of those materials. (p. 86)

Multiple predetermined overhead rates

A costing system with multiple overhead cost pools and a different predetermined overhead rate for each cost pool, rather than a single predetermined overhead rate for the entire company. Each production department may be treated as a separate overhead cost pool. (p. 107)

Normal cost system

A costing system in which overhead costs are applied to a job by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the job. (p. 90)

Overapplied overhead

A credit balance in the Manufacturing Overhead account that occurs when the amount of overhead cost applied to Work in Process exceeds the amount of overhead cost actually incurred during a period. (p. 103)

Overhead application

The process of charging manufacturing overhead cost to job cost sheets and to the Work in Process account. (p. 89)

Plantwide overhead rate

A single predetermined overhead rate that is used throughout a plant. (p. 107)

Predetermined overhead rate

A rate used to charge manufacturing overhead cost to jobs that is established in advance for each period. It is computed by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base for the period. (p. 89)

Raw materials

Any materials that go into the final product. (p. 93)

Schedule of cost of goods manufactured

A schedule that contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and that summarizes the portions of those costs that remain in ending Work in Process inventory and that are transferred out of Work in Process into Finished Goods. (p. 102)

Schedule of cost of goods sold

A schedule that contains three elements of product costs—direct materials, direct labor, and manufacturing overhead—and that summarizes the portions of those costs that remain in ending Finished Goods inventory and that are transferred out of Finished Goods into Cost of Goods Sold. (p. 102)

Time ticket

A document that is used to record the amount of time an employee spends on various activities. (p. 87)

Underapplied overhead

A debit balance in the Manufacturing Overhead account that occurs when the amount of overhead cost actually incurred exceeds the amount of overhead cost applied to Work in Process during a period. (p. 103)

Work in process

Units of product that are only partially complete and will require further work before they are ready for sale to the customer. (p. 93)

Questions

· 3–1. Why aren't actual manufacturing overhead costs traced to jobs just as direct materials and direct labor costs are traced to jobs?

· 3–2. Explain the four-step process used to compute a predetermined overhead rate.

· 3–3. What is the purpose of the job cost sheet in a job-order costing system?

· 3–4. Explain how a sales order, a production order, a materials requisition form, and a labor time ticket are involved in producing and costing products.

· 3–5. Explain why some production costs must be assigned to products through an allocation process.

· 3–6. Why do companies use predetermined overhead rates rather than actual manufacturing overhead costs to apply overhead to jobs?

· 3–7. What factors should be considered in selecting a base to be used in computing the predetermined overhead rate?

· 3–8. If a company fully allocates all of its overhead costs to jobs, does this guarantee that a profit will be earned for the period?

· 3–9. What account is credited when overhead cost is applied to Work in Process? Would you expect the amount applied for a period to equal the actual overhead costs of the period? Why or why not?

· 3–10. What is underapplied overhead? Overapplied overhead? What disposition is made of these amounts at the end of the period?

· 3–11. Provide two reasons why overhead might be underapplied in a given year.

· 3–12. What adjustment is made for underapplied overhead on the schedule of cost of goods sold? What adjustment is made for overapplied overhead?

· 3–13. What is a plantwide overhead rate? Why are multiple overhead rates, rather than a plantwide overhead rate, used in some companies?

· 3–14 What happens to overhead rates based on direct labor when automated equipment replaces direct labor?

Multiple-choice questions are provided on the text website at  www.mhhe.com/garrison14e .

 Applying Excel

LEARNING OBJECTIVES 1, 4, 7

Available with McGraw-Hill's Connect™ Accounting.

The Excel worksheet form that appears below is to be used to recreate part of the example on page 104. Download the workbook containing this form from the Online Learning Center at www.mhhe.com/garrison14e . On the website you will also receive instructions about how to use this worksheet form.

You should proceed to the requirements below only after completing your worksheet.

Required:

· 1. Check your worksheet by changing the estimated total amount of the allocation base in the Data area to 60,000 machine-hours, keeping all of the other data the same as in the original example. If your worksheet is operating properly, the predetermined overhead rate should now be $5.00 per machine-hour. If you do not get this answer, find the errors in your worksheet and correct them. How much is the underapplied (overapplied) manufacturing overhead? Did it change? Why or why not?

· 2. Determine the underapplied (overapplied) manufacturing overhead for a different company with the following data:

Allocation base	Machine-hours
Estimated manufacturing overhead cost	$100,000
Estimated total amount of the allocation base	50,000 machine-hours
Actual manufacturing overhead cost	$90,000
Actual total amount of the allocation base	40,000 machine-hours

· 3. What happens to the underapplied (overapplied) manufacturing overhead from part (2) if the estimated total amount of the allocation base is changed to 40,000 machine-hours and everything else remains the same? Why is the amount of underapplied (overapplied) manufacturing overhead different from part (2)?

· 4. Change the estimated total amount of the allocation base back to 50,000 machine-hours so that the data looks exactly like it did in part (2). Now change the actual manufacturing overhead cost to $100,000. What is the underapplied (overapplied) manufacturing overhead now? Why is the amount of underapplied (overapplied) manufacturing overhead different from part (2)?

 Exercises

All applicable exercises are available with McGraw-Hill's Connect™ Accounting.

EXERCISE 3–1 Compute the Predetermined Overhead Rate [LO1]

Logan Products computes its predetermined overhead rate annually on the basis of direct labor-hours. At the beginning of the year, it estimated that 40,000 direct labor-hours would be required for the period's estimated level of production. The company also estimated $466,000 of fixed manufacturing overhead expenses for the coming period and variable manufacturing overhead of $3.00 per direct labor-hour. Logan's actual manufacturing overhead for the year was $713,400 and its actual total direct labor was 41,000 hours.

Required:

Compute the company's predetermined overhead rate for the year.

EXERCISE 3–2 Apply Overhead [LO2]

Westan Corporation uses a predetermined overhead rate of $23.10 per direct labor-hour. This predetermined rate was based on a cost formula that estimated $277,200 of total manufacturing overhead for an estimated activity level of 12,000 direct labor-hours.

The company incurred actual total manufacturing overhead costs of $266,000 and 12,600 total direct labor-hours during the period.

Required:

Determine the amount of manufacturing overhead that would have been applied to all jobs during the period.

EXERCISE 3–3 Computing Job Costs [LO3]

Weaver Company's predetermined overhead rate is $18.00 per direct labor-hour and its direct labor wage rate is $12.00 per hour. The following information pertains to Job A-200:

Direct materials	$200
Direct labor	$120

Required:

· 1. What is the total manufacturing cost assigned to Job A-200?

· 2. If Job A-200 consists of 50 units, what is the average cost assigned to each unit included in the job?

EXERCISE 3–4 Prepare Journal Entries [LO4]

Kirkaid Company recorded the following transactions for the just completed month.

· a. $86,000 in raw materials were purchased on account.

· b. $84,000 in raw materials were requisitioned for use in production. Of this amount, $72,000 was for direct materials and the remainder was for indirect materials.

· c. Total labor wages of $108,000 were incurred. Of this amount, $105,000 was for direct labor and the remainder was for indirect labor.

· d. Additional manufacturing overhead costs of $197,000 were incurred.

Required:

Record the above transactions in journal entries.

EXERCISE 3–5 Prepare T-Accounts [LO5, LO7]

Granger Products recorded the following transactions for the just completed month. The company had no beginning inventories.

· a. $75,000 in raw materials were purchased for cash.

· b. $73,000 in raw materials were requisitioned for use in production. Of this amount, $67,000 was for direct materials and the remainder was for indirect materials.

· c. Total labor wages of $152,000 were incurred and paid. Of this amount, $134,000 was for direct labor and the remainder was for indirect labor.

· d. Additional manufacturing overhead costs of $126,000 were incurred and paid.

· e. Manufacturing overhead costs of $178,000 were applied to jobs using the company's predetermined overhead rate.

· f. All of the jobs in progress at the end of the month were completed and shipped to customers.

· g. Any underapplied or overapplied overhead for the period was closed out to Cost of Goods Sold.

Required:

· 1. Post the above transactions to T-accounts.

· 2. Determine the cost of goods sold for the period.

EXERCISE 3–6 Schedules of Cost of Goods Manufactured and Cost of Goods Sold [LO6]

Parmitan Corporation has provided the following data concerning last month's manufacturing operations.

Required:

· 1. Prepare a schedule of cost of goods manufactured for the month.

· 2. Prepare a schedule of cost of goods sold for the month.

EXERCISE 3–7 Underapplied and Overapplied Overhead [LO7]

Cretin Enterprises uses a predetermined overhead rate of $21.40 per direct labor-hour. This predetermined rate was based on a cost formula that estimated $171,200 of total manufacturing overhead for an estimated activity level of 8,000 direct labor-hours.

The company incurred actual total manufacturing overhead costs of $172,500 and 8,250 total direct labor-hours during the period.

Required:

· 1. Determine the amount of underapplied or overapplied manufacturing overhead for the period.

· 2. Assuming that the entire amount of the underapplied or overapplied overhead is closed out to cost of goods sold, what would be the effect of the underapplied or overapplied overhead on the company's gross margin for the period?

EXERCISE 3–8 Schedules of Cost of Goods Manufactured and Cost of Goods Sold; Income Statement [LO6]

The following data from the just completed year are taken from the accounting records of Eccles Company:

Sales	$643,000
Direct labor cost	$90,000
Raw material purchases	$132,000
Selling expenses	$100,000
Administrative expenses	$43,000
Manufacturing overhead applied to work in process	$210,000
Actual manufacturing overhead costs	$220,000

Required:

· 1. Prepare a schedule of cost of goods manufactured. Assume all raw materials used in production were direct materials.

· 2. Prepare a schedule of cost of goods sold.

· 3. Prepare an income statement.

EXERCISE 3–9 Apply Overhead to a Job [LO2]

Winston Company applies overhead cost to jobs on the basis of direct labor cost. Job X, which was started and completed during the current period, shows charges of $18,000 for direct materials, $10,000 for direct labor, and $15,000 for overhead on its job cost sheet. Job Q, which is still in process at year-end, shows charges of $20,000 for direct materials, and $8,000 for direct labor.

Required:

Should any overhead cost be added to Job Q at year-end? If so, how much? Explain.

EXERCISE 3–10 Applying Overhead; Computing Unit Product Cost [LO2, LO3]

A company assigns overhead cost to completed jobs on the basis of 120% of direct labor cost. The job cost sheet for Job 413 shows that $12,000 in direct materials has been used on the job and that $8,000 in direct labor cost has been incurred. A total of 200 units were produced in Job 413.

Required:

What is the total manufacturing cost assigned to Job 413? What is the unit product cost for Job 413?

EXERCISE 3–11 Journal Entries and T-Accounts [LO2, LO4, LO5]

Foley Company uses a job-order costing system. The following data relate to the month of October, the first month of the company's fiscal year:

· a. Raw materials purchased on account, $210,000.

· b. Raw materials issued to production, $190,000 (80% direct and 20% indirect).

· c. Direct labor cost incurred, $49,000; and indirect labor cost incurred, $21,000.

· d. Depreciation recorded on factory equipment, $105,000.

· e. Other manufacturing overhead costs incurred during October, $130,000 (credit Accounts Payable).

· f. The company applies manufacturing overhead cost to production on the basis of $4 per machine-hour. A total of 75,000 machine-hours were recorded for October.

· g. Production orders costing $510,000 according to their job cost sheets were completed during October and transferred to Finished Goods.

· h. Production orders that had cost $450,000 to complete according to their job cost sheets were shipped to customers during the month. These goods were sold on account at 50% above cost.

Required:

· 1. Prepare journal entries to record the information given above.

· 2. Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant information above to each account. Compute the ending balance in each account, assuming that Work in Process has a beginning balance of $35,000.

EXERCISE 3–12 Computing Predetermined Overhead Rates and Job Costs [LO1, LO2, LO3, LO7]

Kody Corporation uses a job-order costing system with a plantwide overhead rate based on machine-hours. At the beginning of the year, the company made the following estimates:

Machine-hours required to support estimated production	150,000
Fixed manufacturing overhead cost	$750,000
Variable manufacturing overhead cost per machine-hour	$4.00

Required:

· 1. Compute the predetermined overhead rate.

· 2. During the year Job 500 was started and completed. The following information was available with respect to this job:

Direct materials requisitioned	$350
Direct labor cost	$230
Machine-hours used	30

· Compute the total manufacturing cost assigned to Job 500.

· 3. During the year the company worked a total of 147,000 machine-hours on all jobs and incurred actual manufacturing overhead costs of $1,325,000. What is the amount of underapplied or overapplied overhead for the year? If this amount were closed out entirely to Cost of Goods Sold, would the journal entry increase or decrease net operating income?

EXERCISE 3–13 Applying Overhead; Cost of Goods Manufactured [LO2, LO6, LO7]

The following cost data relate to the manufacturing activities of Black Company during the just completed year:

The company uses a predetermined overhead rate to apply overhead cost to jobs. The rate for the year was $5 per machine-hour; a total of 10,000 machine-hours was recorded for the year. All raw materials ultimately become direct materials—none are classified as indirect materials.

Required:

· 1. Compute the amount of underapplied or overapplied overhead cost for the year.

· 2. Prepare a schedule of cost of goods manufactured for the year.

EXERCISE 3–14 Varying Predetermined Overhead Rates [LO1, LO2, LO3]

Javadi Company makes a single product that is subject to wide seasonal variations in demand. The company uses a job-order costing system and computes predetermined overhead rates on a quarterly basis using the number of units to be produced as the allocation base. Its estimated costs, by quarter, for the coming year are given below:

Management finds the variation in quarterly unit product costs to be confusing and difficult to work with. It has been suggested that the problem lies with manufacturing overhead because it is the largest element of total manufacturing cost. Accordingly, you have been asked to find a more appropriate way of assigning manufacturing overhead cost to units of product.

Required:

· 1. Using the high-low method, estimate the fixed manufacturing overhead cost per quarter and the variable manufacturing overhead cost per unit. Create a cost formula to estimate the total manufacturing overhead cost for the fourth quarter. Compute the total manufacturing cost and unit product cost for the fourth quarter.

· 2. What is causing the estimated unit product cost to fluctuate from one quarter to the next?

· 3. How would you recommend stabilizing the company's unit product cost? Support your answer with computations that adapt the cost formula you created in requirement 1.

EXERCISE 3–15 Departmental Overhead Rates [LO1, LO2, LO3]

Diewold Company has two departments, Milling and Assembly. The company uses a job-order costing system and computes a predetermined overhead rate in each department. The Milling Department bases its rate on machine-hours, and the Assembly Department bases its rate on direct labor-hours. At the beginning of the year, the company made the following estimates:

Required:

· 1. Compute the predetermined overhead rate to be used in each department.

· 2. Assume that the overhead rates you computed in (1) above are in effect. The job cost sheet for Job 407, which was started and completed during the year, showed the following:

Compute the total manufacturing cost assigned to Job 407.

· 3. Would you expect substantially different amounts of overhead cost to be charged to some jobs if the company used a plantwide overhead rate based on direct labor-hours instead of using departmental rates? Explain. No computations are necessary.

EXERCISE 3–16 Applying Overhead; Journal Entries; Disposition of Underapplied or Overapplied Overhead [LO4, LO5, LO7]

The following information is taken from the accounts of FasGrow Company. The entries in the T-accounts are summaries of the transactions that affected those accounts during the year.

The overhead that had been applied to production during the year is distributed among the ending balances in the accounts as follows:

For example, of the $80,000 ending balance in Work in Process, $32,800 was overhead that had been applied during the year.

Required:

· 1. Identify the reasons for entries (a) through (d).

· 2. Assume that the company closes any balance in the Manufacturing Overhead account directly to Cost of Goods Sold. Prepare the necessary journal entry.

· 3. Assume instead that the company allocates any balance in the Manufacturing Overhead account to the other accounts in proportion to the overhead applied during the year that is in the ending balance in each account. Prepare the necessary journal entry, with supporting computations.

EXERCISE 3–17 Applying Overhead; T-Accounts; Journal Entries [LO1, LO2, LO4, LO5, LO7]

Medusa Products uses a job-order costing system. Overhead costs are applied to jobs on the basis of machine-hours. At the beginning of the year, management estimated that 85,000 machine-hours would be required for the period's estimated level of production. The company also estimated $106,250 of fixed manufacturing overhead expenses for the coming period and variable manufacturing overhead of $0.75 per machine-hour.

Required:

· 1. Compute the company's predetermined overhead rate.

· 2. Assume that during the year the company actually works only 80,000 machine-hours and incurs the following costs in the Manufacturing Overhead and Work in Process accounts:

Copy the data in the T-accounts above onto your answer sheet. Compute the amount of over-head cost that would be applied to Work in Process for the year, and make the entry in your T-accounts.

· 3. Compute the amount of underapplied or overapplied overhead for the year, and show the balance in your Manufacturing Overhead T-account. Prepare a journal entry to close out the balance in this account to Cost of Goods Sold.

· 4. Explain why the manufacturing overhead was underapplied or overapplied for the year.

EXERCISE 3–18 Plantwide and Departmental Overhead Rates; Job Costs [LO1, LO2, LO3]

Smithson Company uses a job-order costing system and has two manufacturing departments—Molding and Fabrication. The company provided the following estimates at the beginning of the year:

During the year, the company had no beginning or ending inventories and it started, completed, and sold only two jobs—Job D-75 and Job C-100. It provided the following information related to those two jobs:

Smithson had no overapplied or underapplied manufacturing overhead during the year.

Required:

· 1. Assume Smithson uses a plantwide overhead rate based on machine-hours.

· a. Compute the predetermined plantwide overhead rate.

· b. Compute the total manufacturing costs assigned to Job D-75 and Job C-100.

· c. If Smithson establishes bid prices that are 150% of total manufacturing costs, what bid price would it have established for Job D-75 and Job C-100?

· d. What is Smithson's cost of goods sold for the year?

· 2. Assume Smithson uses departmental overhead rates based on machine-hours.

· a. Compute the predetermined departmental overhead rates.

· b. Compute the total manufacturing costs assigned to Job D-75 and Job C-100.

· c. If Smithson establishes bid prices that are 150% of total manufacturing costs, what bid price would it have established for Job D-75 and Job C-100?

· d. What is Smithson's cost of goods sold for the year?

· 3. What managerial insights are revealed by the computations that you performed in this problem? (Hint: Do the cost of goods sold amounts that you computed in requirements 1 and 2 differ from one another? Do the bid prices that you computed in requirements 1 and 2 differ from one another? Why?)

EXERCISE 3–19 Applying Overhead; Journal Entries; T-Accounts [LO1, LO2, LO3, LO4, LO5]

Custom Metal Works produces castings and other metal parts to customer specifications. The company uses a job-order costing system and applies overhead costs to jobs on the basis of machine-hours. At the beginning of the year, the company used a cost formula to estimate that it would incur $4,320,000 in manufacturing overhead cost at an activity level of 576,000 machine-hours.

The company had no work in process at the beginning of the year. The company spent the entire month of January working on one large order—Job 382, which was an order for 8,000 machined parts. Cost data for January follow:

· a. Raw materials purchased on account, $315,000.

· b. Raw materials requisitioned for production, $270,000 (80% direct and 20% indirect).

· c. Labor cost incurred in the factory, $190,000, of which $80,000 was direct labor and $110,000 was indirect labor.

· d. Depreciation recorded on factory equipment, $63,000.

· e. Other manufacturing overhead costs incurred, $85,000 (credit Accounts Payable).

· f. Manufacturing overhead cost was applied to production on the basis of 40,000 machine-hours actually worked during January.

· g. The completed job was moved into the finished goods warehouse on January 31 to await delivery to the customer. (In computing the dollar amount for this entry, remember that the cost of a completed job consists of direct materials, direct labor, and applied overhead.)

Required:

· 1. Prepare journal entries to record items (a) through (f) above. Ignore item (g) for the moment.

· 2. Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant items from your journal entries to these T-accounts.

· 3. Prepare a journal entry for item (g) above.

· 4. Compute the unit product cost that will appear on the job cost sheet for Job 382.

EXERCISE 3–20 Applying Overhead in a Service Company [LO1, LO2, LO3]

Pearson Architectural Design began operations on January 2. The following activity was recorded in the company's Work in Process account for the first month of operations:

Pearson Architectural Design is a service firm, so the names of the accounts it uses are different from the names used in manufacturing companies. Costs of Subcontracted Work is comparable to Direct Materials; Direct Staff Costs is the same as Direct Labor; Studio Overhead is the same as Manufacturing Overhead; and Completed Projects is the same as Finished Goods. Apart from the difference in terms, the accounting methods used by the company are identical to the methods used by manufacturing companies.

Pearson Architectural Design uses a job-order costing system and applies studio overhead to Work in Process on the basis of direct staff costs. At the end of January, only one job was still in process. This job (the Krimmer Corporation Headquarters project) had been charged with $13,500 in direct staff costs.

Required:

· 1. Compute the predetermined overhead rate that was in use during January.

· 2. Complete the following job cost sheet for the partially completed Krimmer Corporation Head-quarters project.

Problems 

All applicable problems are available with McGraw-Hill's Connect™ Accounting.

PROBLEM 3–21 Predetermined Overhead Rate; Disposition of Underapplied or Overapplied Overhead [LO1, LO7]

Savallas Company is highly automated and uses computers to control manufacturing operations. The company uses a job-order costing system and applies manufacturing overhead cost to products on the basis of computer-hours. The following estimates were used in preparing the predetermined overhead rate at the beginning of the year:

During the year, a severe economic recession resulted in cutting back production and a buildup of inventory in the company's warehouse. The company's cost records revealed the following actual cost and operating data for the year:

Computer-hours	60,000
Manufacturing overhead cost	$1,350,000
Inventories at year-end:
Raw materials	$400,000
Work in process	$160,000
Finished goods	$1,040,000
Cost of goods sold	$2,800,000

Required:

· 1. Compute the company's predetermined overhead rate for the year.

· 2. Compute the underapplied or overapplied overhead for the year.

· 3. Assume the company closes any underapplied or overapplied overhead directly to Cost of Goods Sold. Prepare the appropriate entry.

· 4. Assume that the company allocates any underapplied or overapplied overhead to Work in Process, Finished Goods, and Cost of Goods Sold on the basis of the amount of overhead applied during the year that remains in each account at the end of the year. These amounts are $43,200 for Work in Process, $280,800 for Finished Goods, and $756,000 for Cost of Goods Sold. Prepare the journal entry to show the allocation.

· 5. How much higher or lower will net operating income be for the year if the underapplied or overapplied overhead is allocated rather than closed directly to Cost of Goods Sold?

PROBLEM 3–22 Schedules of Cost of Goods Manufactured and Cost of Goods Sold; Income Statement [LO6]

Valenko Company provided the following account balances for the year ended December 31 (all raw materials are used in production as direct materials):

Selling expenses	$215,000
Purchases of raw materials	$260,000
Direct labor	?
Administrative expenses	$160,000
Manufacturing overhead applied to work in process	$340,000
Total actual manufacturing overhead costs	$350,000

Inventory balances at the beginning and end of the year were as follows:

The total manufacturing costs for the year were $675,000; the cost of goods available for sale totaled $720,000; the unadjusted cost of goods sold totaled $665,000; and the net operating income was $35,000. The company's overapplied or underapplied overhead is closed entirely to cost of goods sold.

Required:

Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement. (Hint: Prepare the income statement and schedule of cost of goods sold first followed by the schedule of cost of goods manufactured.)

PROBLEM 3–23 T-Account Analysis of Cost Flows [LO1, LO5, LO6, LO7]

Selected T-accounts for Rolm Company are given below for the just completed year:

Required:

· 1. What was the cost of raw materials put into production during the year?

· 2. How much of the materials in (1) above consisted of indirect materials?

· 3. How much of the factory labor cost for the year consisted of indirect labor?

· 4. What was the cost of goods manufactured for the year?

· 5. What was the cost of goods sold for the year (before considering underapplied or overapplied overhead)?

· 6. If overhead is applied to production on the basis of direct materials cost, what rate was in effect during the year?

· 7. Was manufacturing overhead underapplied or overapplied? By how much?

· 8. Compute the ending balance in the Work in Process inventory account. Assume that this balance consists entirely of goods started during the year. If $32,000 of this balance is direct materials cost, how much of it is direct labor cost? Manufacturing overhead cost?

PROBLEM 3–24 Schedule of Cost of Goods Manufactured; Overhead Analysis [LO1, LO2, LO3, LO6, LO7]

The Pacific Manufacturing Company operates a job-order costing system and applies overhead cost to jobs on the basis of direct labor cost. Its predetermined overhead rate was based on a cost formula that estimated $126,000 of manufacturing overhead for an estimated allocation base of $84,000 direct labor dollars. The company has provided the following data in the form of an Excel worksheet:

Required:

· 1.

· a. Compute the predetermined overhead rate for the year.

· b. Compute the amount of underapplied or overapplied overhead for the year.

· 2. Prepare a schedule of cost of goods manufactured for the year. Assume all raw materials are used in production as direct materials.

· 3. Compute the unadjusted cost of goods sold for the year. (Do not include any underapplied or overapplied overhead in your cost of goods sold figure.) What options are available for disposing of underapplied or overapplied overhead?

· 4. Job 137 was started and completed during the year. What price would have been charged to the customer if the job required $3,200 in materials and $4,200 in direct labor cost, and the company priced its jobs at 40% above the job's cost according to the accounting system?

· 5. Direct labor made up $8,000 of the $40,000 ending Work in Process inventory balance. Supply the information missing below:

PROBLEM 3–25 Journal Entries; T-Accounts; Financial Statements [LO1, LO2, LO3, LO4, LO5, LO6, LO7]

Southworth Company uses a job-order costing system and applies manufacturing overhead cost to jobs on the basis of the cost of direct materials used in production. Its predetermined overhead rate was based on a cost formula that estimated $248,000 of manufacturing overhead for an estimated allocation base of $155,000 direct material dollars. The following transactions took place during the year (all purchases and services were acquired on account):

· a. Raw materials purchased, $142,000.

· b. Raw materials requisitioned for use in production (all direct materials), $150,000.

· c. Utility bills incurred in the factory, $21,000.

· d. Costs for salaries and wages were incurred as follows:

Direct labor	$216,000
Indirect labor	$90,000
Selling and administrative salaries	$145,000

· e. Maintenance costs incurred in the factory, $15,000.

· f. Advertising costs incurred, $130,000.

· g. Depreciation recorded for the year, $50,000 (90% relates to factory assets, and the remainder relates to selling and administrative assets).

· h. Rental cost incurred on buildings, $90,000 (80% of the space is occupied by the factory, and 20% is occupied by sales and administration).

· i. Miscellaneous selling and administrative costs incurred, $17,000.

· j. Manufacturing overhead cost was applied to jobs, .

· k. Cost of goods manufactured for the year, $590,000.

· l. Sales for the year (all on account) totaled $1,000,000. These goods cost $600,000 according to their job cost sheets.

The balances in the inventory accounts at the beginning of the year were as follows:

Required:

· 1. Prepare journal entries to record the above data.

· 2. Post your entries to T-accounts. (Don't forget to enter the opening inventory balances above.) Determine the ending balances in the inventory accounts and in the Manufacturing Overhead account.

· 3. Prepare a schedule of cost of goods manufactured.

· 4. Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Prepare a schedule of cost of goods sold.

· 5. Prepare an income statement for the year.

· 6. Job 218 was one of the many jobs started and completed during the year. The job required $3,600 in direct materials and 400 hours of direct labor time at a rate of $11 per hour. If the job contained 500 units and the company billed at 75% above the unit product cost on the job cost sheet, what price per unit would have been charged to the customer?

PROBLEM 3–26 Multiple Departments; Applying Overhead [LO1, LO2, LO3, LO7]

WoodGrain Technology makes home office furniture from fine hardwoods. The company uses a job-order costing system and predetermined overhead rates to apply manufacturing overhead costto jobs. The predetermined overhead rate in the Preparation Department is based on machine-hours, and the rate in the Fabrication Department is based on direct labor-hours. At the beginning of the year, the company's management made the following estimates for the year:

Job 127 was started on April 1 and completed on May 12. The company's cost records show the following information concerning the job:

Required:

· 1. Compute the predetermined overhead rate used during the year in the Preparation Department. Compute the rate used in the Fabrication Department.

· 2. Compute the total overhead cost applied to Job 127.

· 3. What would be the total cost recorded for Job 127? If the job contained 25 units, what would be the unit product cost?

· 4. At the end of the year, the records of WoodGrain Technology revealed the following actualcost and operating data for all jobs worked on during the year:

What was the amount of underapplied or overapplied overhead in each department at the end of the year?

PROBLEM 3–27 Comprehensive Problem [LO1, LO2, LO4, LO5, LO6, LO7]

Sovereign Millwork, Ltd., produces reproductions of antique residential moldings at a plant located in Manchester, England. Because there are hundreds of products, some of which are made only to order, the company uses a job-order costing system. On July 1, the start of the company's fiscal year, inventory account balances were as follows:

Raw Materials	£10,000
Work in Process	£4,000
Finished Goods	£8,000

The company applies overhead cost to jobs on the basis of machine-hours. Its predetermined overhead rate for the fiscal year starting July 1 was based on a cost formula that estimated £99,000 of manufacturing overhead for an estimated activity level of 45,000 machine-hours. During the year, the following transactions were completed:

· a. Raw materials purchased on account, £160,000.

· b. Raw materials requisitioned for use in production, £140,000 (materials costing £120,000 were chargeable directly to jobs; the remaining materials were indirect).

· c. Costs for employee services were incurred as follows:

Direct labor	£90,000
Indirect labor	£60,000
Sales commissions	£20,000
Administrative salaries	£50,000

· d. Prepaid insurance expired during the year, £18,000 (£13,000 of this amount related to factory operations, and the remainder related to selling and administrative activities).

· e. Utility costs incurred in the factory, £10,000.

· f. Advertising costs incurred, £15,000.

· g. Depreciation recorded on equipment, £25,000. (£20,000 of this amount was on equipment used in factory operations; the remaining £5,000 was on equipment used in selling and administrative activities.)

· h. Manufacturing overhead cost was applied to jobs, £?. (The company recorded 50,000 machine-hours of operating time during the year.)

· i. Goods that had cost £310,000 to manufacture according to their job cost sheets were completed.

· j. Sales (all on account) to customers during the year totaled £498,000. These goods had cost £308,000 to manufacture according to their job cost sheets.

Required:

· 1. Prepare journal entries to record the transactions for the year.

· 2. Prepare T-accounts for inventories, Manufacturing Overhead, and Cost of Goods Sold. Post relevant data from your journal entries to these T-accounts (don't forget to enter the opening balances in your inventory accounts). Compute an ending balance in each account.

· 3. Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold.

· 4. Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the journal entries and T-accounts you have prepared.)

PROBLEM 3–28 Cost Flows; T-Accounts; Income Statement [LO1, LO2, LO5, LO6, LO7]

Fantastic Props, Inc., designs and fabricates movie props such as mock-ups of star-fighters and cybernetic robots. The company's balance sheet as of January 1, the beginning of the current year, appears below:

Because each prop is a unique design and may require anything from a few hours to a month or more to complete, Fantastic Props uses a job-order costing system. Overhead in the fabrication shop is charged to props on the basis of direct labor cost. The company's predetermined overhead rate for the year is based on a cost formula that estimated $80,000 in manufacturing overhead for an estimated allocation base of $100,000 direct labor dollars. The following transactions were recorded during the year:

· a. Raw materials, such as wood, paints, and metal sheeting, were purchased on account, $80,000.

· b. Raw materials were issued to production, $90,000; $5,000 of this amount was for indirect materials.

· c. Payroll costs incurred and paid: direct labor, $120,000; indirect labor, $30,000; and selling and administrative salaries, $75,000.

· d. Fabrication shop utilities costs incurred, $12,000.

· e. Depreciation recorded for the year, $30,000 ($5,000 on selling and administrative assets; $25,000 on fabrication shop assets).

· f. Prepaid insurance expired, $4,800 ($4,000 related to fabrication shop operations, and $800 related to selling and administrative activities).

· g. Shipping expenses incurred, $40,000.

· h. Other manufacturing overhead costs incurred, $17,000 (credit Accounts Payable).

· i. Manufacturing overhead was applied to production. Overhead is applied on the basis of direct labor cost.

· j. Movie props that cost $310,000 to produce according to their job cost sheets were completed.

· k. Sales for the year totaled $450,000 and were all on account. The total cost to produce these movie props was $300,000 according to their job cost sheets.

· l. Collections on account from customers, $445,000.

· m. Payments on account to suppliers, $150,000.

Required:

· 1. Prepare a T-account for each account on the company's balance sheet, and enter the beginning balances.

· 2. Make entries directly into the T-accounts for transactions (a) through (m). Create new T-accounts as needed. Determine an ending balance for each T-account.

· 3. Was manufacturing overhead underapplied or overapplied for the year? Assume that the company allocates any overhead balance between the Work in Process, Finished Goods, and Cost of Goods Sold accounts. Prepare a journal entry to show the allocation. (Round allocation percentages to one decimal place.)

· 4. Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the T-accounts.)

 Cases

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Case 3–29 Plantwide versus Departmental Overhead Rates; Underapplied or Overapplied Overhead [LO1, LO2, LO3, LO7]

“Don't tell me we've lost another bid!” exclaimed Sandy Kovallas, president of Lenko Products, Inc. “I'm afraid so,” replied Doug Martin, the operations vice president. “One of our competitors underbid us by about $10,000 on the Hastings job.” “I just can't figure it out,” said Kovallas. “It seems we're either too high to get the job or too low to make any money on half the jobs we bid anymore. What's happened?”

Lenko Products manufactures specialized goods to customers’ specifications and operates a job-order costing system. Manufacturing overhead cost is applied to jobs on the basis of direct labor cost. The following estimates were made at the beginning of the year:

Jobs require varying amounts of work in the three departments. The Hastings job, for example, would have required manufacturing costs in the three departments as follows:

The company uses a plantwide overhead rate to apply manufacturing overhead cost to jobs.

Required:

· 1. Assuming the use of a plantwide overhead rate:

· a. Compute the rate for the current year.

· b. Determine the amount of manufacturing overhead cost that would have been applied to the Hastings job.

· 2. Suppose that instead of using a plantwide overhead rate, the company had used a separate predetermined overhead rate in each department. Under these conditions:

· a. Compute the rate for each department for the current year.

· b. Determine the amount of manufacturing overhead cost that would have been applied to the Hastings job.

· 3. Explain the difference between the manufacturing overhead that would have been applied to the Hastings job using the plantwide rate in question 1(b) and using the departmental rates in question 2(b).

· 4. Assume that it is customary in the industry to bid jobs at 150% of total manufacturing cost (direct materials, direct labor, and applied overhead). What was the company's bid price on the Hastings job? What would the bid price have been if departmental overhead rates had been used to apply overhead cost?

· 5. At the end of the year, the company assembled the following actual cost data relating to all jobs worked on during the year:

Compute the underapplied or overapplied overhead for the year (a) assuming that a plantwide overhead rate is used, and (b) assuming that departmental overhead rates are used.

CASE 3–30 Ethics and the Manager [LO1, LO2, LO7]

Cristin Madsen has recently been transferred to the Appliances Division of Solequin Corporation. Shortly after taking over her new position as divisional controller, she was asked to develop the division's predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any overapplied or underapplied overhead is closed out to Cost of Goods Sold at the end of the year. Solequin Corporation uses direct labor-hours in all of its divisions as the allocation base for manufacturing overhead.

To compute the predetermined overhead rate, Cristin divided her estimate of the total manufacturing overhead for the coming year by the production manager's estimate of the total direct labor-hours for the coming year. She took her computations to the division's general manager for approval but was quite surprised when he suggested a modification in the base. Her conversation with the general manager of the Appliances Division, Lance Jusic, went like this:

· Madsen: Here are my calculations for next year's predetermined overhead rate. If you approve, we can enter the rate into the computer on January 1 and be up and running in the job-order costing system right away this year.

· Jusic: Thanks for coming up with the calculations so quickly, and they look just fine. There is, however, one slight modification I would like to see. Your estimate of the total direct labor-hours for the year is 110,000 hours. How about cutting that to about 105,000 hours?

· Madsen: I don't know if I can do that. The production manager says she will need about 110,000 direct labor-hours to meet the sales projections for next year. Besides, there are going to be over 108,000 direct labor-hours during the current year and sales are projected to be higher next year.

· Jusic: Cristin, I know all of that. I would still like to reduce the direct labor-hours in the base to something like 105,000 hours. You probably don't know that I had an agreement with your predecessor as divisional controller to shave 5% or so off the estimated direct labor-hours every year. That way, we kept a reserve that usually resulted in a big boost to net operating income at the end of the fiscal year in December. We called it our Christmas bonus. Corporate headquarters always seemed as pleased as punch that we could pull off such a miracle at the end of the year. This system has worked well for many years, and I don't want to change it now.

Required:

· 1. Explain how shaving 5% off the estimated direct labor-hours in the base for the predetermined overhead rate usually results in a big boost in net operating income at the end of the fiscal year.

· 2. Should Cristin Madsen go along with the general manager's request to reduce the direct labor-hours in the predetermined overhead rate computation to 105,000 direct labor-hours?

Appendix 3A: The Predetermined Overhead Rate and Capacity

Companies typically base their predetermined overhead rates on the estimated, or budgeted, amount of the allocation base for the upcoming period. This is the method that is used in the chapter, but it is a practice that has come under severe criticism. 1  The criticism centers on how fixed manufacturing overhead costs are handled under this traditional approach. As we shall see, the critics argue that, in general, too much fixed manufacturing overhead cost is applied to products. To focus on this issue, we will make two simplifying assumptions in this appendix: (1) we will consider only fixed manufacturing overhead; and (2) we will assume that the actual fixed manufacturing overhead at the end of the period is the same as the estimated, or budgeted, fixed manufacturing overhead at the beginning of the period. Neither of these assumptions is entirely realistic. Ordinarily, some manufacturing overhead is variable and even fixed costs can differ from what was expected at the beginning of the period, but making those assumptions enables us to focus on the primary issues the critics raise.

An example will help us to understand the controversy. Prahad Corporation manufactures music CDs for local recording studios. The company's CD duplicating machine is capable of producing a new CD every 10 seconds from a master CD. The company leases the CD duplicating machine for $180,000 per year, and this is the company's only manufacturing overhead cost. With allowances for setups and maintenance, the machine is theoretically capable of producing up to 900,000 CDs per year. However, due to weak retail sales of CDs, the company's commercial customers are unlikely to order more than 600,000 CDs next year. The company uses machine time as the allocation base for applying manufacturing overhead to CDs. These data are summarized below:

If Prahad follows common practice and computes its predetermined overhead rate using estimated or budgeted figures, then its predetermined overhead rate for next year would be $0.03 per second of machine time computed as follows:

LEARNING OBJECTIVE 8

Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.

Because each CD requires 10 seconds of machine time, each CD will be charged for $0.30 of overhead cost.

Critics charge that there are two problems with this procedure. First, if predetermined overhead rates are based on budgeted activity and overhead includes significant fixed costs, then the unit product costs will fluctuate depending on the budgeted level of activity for the period. For example, if the budgeted output for the year was only 300,000 CDs, the predetermined overhead rate would be $0.06 per second of machine time or $0.60 per CD rather than $0.30 per CD. In general, if budgeted output falls, the overhead cost per unit will increase; it will appear that the CDs cost more to make. Managers may then be tempted to increase prices at the worst possible time—just as demand is falling.

Second, critics charge that under the traditional approach, products are charged for resources that they don't use. When the fixed costs of capacity are spread over estimated activity, the units that are produced must shoulder the costs of unused capacity. That is why the applied overhead cost per unit increases as the level of activity falls. The critics argue that products should be charged only for the capacity that they use; they should not be charged for the capacity they don't use. This can be accomplished by basing the predetermined overhead rate on capacity as follows:

It is important to realize that the numerator in this predetermined overhead rate is the estimated total manufacturing overhead cost at capacity. In general, the numerator in a predetermined overhead rate is the estimated total manufacturing overhead cost for the level of activity in the denominator. Ordinarily, the estimated total manufacturing overhead cost at capacity will be larger than the estimated total manufacturing overhead cost at the estimated level of activity. The estimated level of activity in this case was 600,000 CDs (or 6 million seconds of machine time), whereas capacity is 900,000 CDs (or 9 million seconds of machine time). The estimated total manufacturing overhead cost at 600,000 CDs was $180,000. This also happens to be the estimated total manufacturing overhead cost at 900,000 CDs, but that only happens because we have assumed that the manufacturing overhead is entirely fixed. If manufacturing overhead contained any variable element, the total manufacturing overhead would be larger at 900,000 CDs than at 600,000 CDs and, in that case, the predetermined overhead rate should reflect that fact.

At any rate, returning to the computation of the predetermined overhead rate based on capacity, the predetermined overhead rate is $0.02 per second and so the overhead cost applied to each CD would be $0.20. This charge is constant and would not be affected by the level of activity during a period. If output falls, the charge would still be $0.20 per CD.

This method will almost certainly result in underapplied overhead. If actual output at Prahad Corporation is 600,000 CDs, then only $120,000 of overhead cost would be applied to products ($0.20 per CD × 600,000 CDs). Because the actual overhead cost is $180,000, overhead would be underapplied by $60,000. Because we are assuming that manufacturing overhead is entirely fixed and that actual manufacturing overhead equals the manufacturing overhead as estimated at the beginning of the year, the underapplied overhead represents the cost of unused capacity. In other words, if there had been no unused capacity, there would have been no underapplied overhead. The critics suggest that the underapplied overhead that results from unused capacity should be separately disclosed on the income statement as the Cost of Unused Capacity—a period expense. Disclosing this cost as a lump sum on the income statement, rather than burying it in Cost of Goods Sold or ending inventories, makes it much more visible to managers. An example of such an income statement appears below:

Note that the cost of unused capacity is prominently displayed on this income statement.

Official pronouncements do not prohibit basing predetermined overhead rates on capacity for external reports. 2  Nevertheless, basing the predetermined overhead rate on estimated or budgeted activity is a long-established practice in industry, and some managers and accountants may object to the large amounts of underapplied overhead that would often result from using capacity to determine predetermined overhead rates. And some may insist that the underapplied overhead be allocated among Cost of Goods Sold and ending inventories—which would defeat the purpose of basing the predetermined overhead rate on capacity.

IN BUSINESS: RESOURCE CONSUMPTION ACCOUNTING

Clopay Plastic Products Company, headquartered in Cincinnati, Ohio, recently implemented a pilot application of a German cost accounting system known in the United States as Resource Consumption Accounting (RCA). One of the benefits of RCA is that it uses the estimated total amount of the allocation base at capacity to calculate overhead rates and to assign costs to cost objects. This makes idle capacity visible to managers who can react to this information by either growing sales or taking steps to reduce the amount and cost of available capacity. It also ensures that products are only charged for the resources used to produce them.

Clopay's old cost system spread all of the company's manufacturing overhead costs over the units produced. So, if Clopay's senior managers decided to discontinue what appeared to be an unprofitable product, the unit costs of the remaining products would increase as the fixed overhead costs of the newly idled capacity were spread over the remaining products.

 

Source: B. Douglas Clinton and Sally A. Webber, “Here's Innovation in Management Accounting with Resource Consumption Accounting,” Strategic Finance, October 2004, pp. 21–26.

1

Institute of Management Accountants, Measuring the Cost of Capacity: Statements on Management Accounting, Number 4Y, Montvale, NJ; Thomas Klammer, ed., Capacity Measurement and Improvement: A Manager's Guide to Evaluating and Optimizing Capacity Productivity (Chicago: CAM-I, Irwin Professional Publishing); and C. J. McNair, “The Hidden Costs of Capacity,” The Journal of Cost Management (Spring 1994), pp. 12–24.

2

Institute of Management Accountants, Measuring the Cost of Capacity, pp. 46–47.

  Appendix 3A  Exercises and Problems

All applicable exercises and problems are available with McGraw-Hill's Connect™ Accounting.

EXERCISE 3A–1 Overhead Rates and Capacity Issues [LO1, LO2, LO7, LO8]

Estate Pension Services helps clients to set up and administer pension plans that are in compliance with tax laws and regulatory requirements. The firm uses a job-order costing system in which over-head is applied to clients’ accounts on the basis of professional staff hours charged to the accounts. Data concerning two recent years appear below:

“Professional staff hours available” is a measure of the capacity of the firm. Any hours available that are not charged to clients’ accounts represent unused capacity. All of the firm's overhead is fixed.

Required:

· 1. Jennifer Miyami is an established client whose pension plan was set up many years ago. In both 2010 and 2011, only five hours of professional staff time were charged to Ms. Miyami's account. If the company bases its predetermined overhead rate on the estimated overhead cost and the estimated professional staff hours to be charged to clients, how much overhead cost would have been applied to Ms. Miyami's account in 2010? In 2011?

· 2. Suppose that the company bases its predetermined overhead rate on the estimated overhead cost and the estimated professional staff hours to be charged to clients as in (1) above. Also suppose that the actual professional staff hours charged to clients’ accounts and the actual overhead costs turn out to be exactly as estimated in both years. By how much would the overhead be underapplied or overapplied in 2010? In 2011?

· 3. Refer back to the data concerning Ms. Miyami in (1) above. If the company bases its predetermined overhead rate on the professional staff hours available, how much overhead cost would have been applied to Ms. Miyami's account in 2010? In 2011?

· 4. Suppose that the company bases its predetermined overhead rate on the professional staff hours available as in (3) above. Also, suppose that the actual professional staff hours charged to clients’ accounts and the actual overhead costs turn out to be exactly as estimated in both years. By how much would the overhead be underapplied or overapplied in 2010? In 2011?

EXERCISE 3A–2 Overhead Rate Based on Capacity [LO8]

Wixis Cabinets makes custom wooden cabinets for high-end stereo systems from specialty woods. The company uses a job-order costing system. The capacity of the plant is determined by the capacity of its constraint, which is time on the automated bandsaw that makes finely beveled cuts in wood according to the preprogrammed specifications of each cabinet. The bandsaw can operate up to 180 hours per month. The estimated total manufacturing overhead at capacity is $14,760 per month. The company bases its predetermined overhead rate on capacity, so its predetermined overhead rate is $82 per hour of bandsaw use.

The results of a recent month's operations appear below:

Sales	$43,740
Beginning inventories	$0
Ending inventories	$0
Direct materials	$5,350
Direct labor (all variable)	$8,860
Manufacturing overhead incurred	$14,220
Selling and administrative expense	$8,180
Actual hours of bandsaw use	150

Required:

· 1. Prepare an income statement following the example in  Appendix 3A  in which any underapplied overhead is directly recorded on the income statement as an expense.

· 2. Why is overhead ordinarily underapplied when the predetermined overhead rate is based on capacity?

PROBLEM 3A–3 Predetermined Overhead Rate and Capacity [LO1, LO2, LO7, LO8]

Skid Road Recording, Inc., is a small audio recording studio located in Seattle. The company handles work for advertising agencies—primarily for radio ads—and has a few singers and bands as clients. Skid Road Recording handles all aspects of recording from editing to making a digital master from which CDs can be copied. The competition in the audio recording industry in Seattle has always been tough, but it has been getting even tougher over the last several years. The studio has been losing customers to newer studios that are equipped with more up-to-date equipment and that are able to offer very attractive prices and excellent service. Summary data concerning the last two years of operations follow:

	2010	2011
Estimated hours of studio service	1,000	750
Estimated studio overhead cost	$90,000	$90,000
Actual hours of studio service provided	900	600
Actual studio overhead cost incurred	$90,000	$90,000
Hours of studio service at capacity	1,800	1,800

The company applies studio overhead to recording jobs on the basis of the hours of studio service provided. For example, 30 hours of studio time were required to record, edit, and master the Slug Fest music CD for a local band. All of the studio overhead is fixed, and the actual overhead cost incurred was exactly as estimated at the beginning of the year in both 2010 and 2011.

Required:

· 1. Skid Road Recording computes its predetermined overhead rate at the beginning of each year based on the estimated studio overhead and the estimated hours of studio service for the year. How much overhead would have been applied to the Slug Fest job if it had been done in 2010? In 2011? By how much would overhead have been underapplied or overapplied in 2010? In 2011?

· 2. The president of Skid Road Recording has heard that some companies in the industry have changed to a system of computing the predetermined overhead rate at the beginning of each year based on the hours of studio service that could be provided at capacity. He would like to know what effect this method would have on job costs. How much overhead would have been applied using this method to the Slug Fest job if it had been done in 2010? In 2011? By how much would overhead have been underapplied or overapplied in 2010 using this method? In 2011?

· 3. How would you interpret the underapplied or overapplied overhead that results from using studio hours at capacity to compute the predetermined overhead rate?

· 4. What fundamental business problem is Skid Road Recording facing? Which method of computing the predetermined overhead rate is likely to be more helpful in facing this problem? Explain.

CASE 3A–4 Ethics; Predetermined Overhead Rate and Capacity [LO2, LO7, LO8]

Melissa Ostwerk, the new controller of TurboDrives, Inc., has just returned from a seminar on the choice of the activity level in the predetermined overhead rate. Even though the subject did not sound exciting at first, she found that there were some important ideas presented that should get a hearing at her company. After returning from the seminar, she arranged a meeting with the production manager, Jan Kingman, and the assistant production manager, Lonny Chan.

· Melissa: I ran across an idea that I wanted to check out with both of you. It's about the way we compute predetermined overhead rates.

· Jan: We're all ears.

· Melissa: We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year, which is all a fixed cost, by the estimated total units produced for the coming year.

· Lonny: We've been doing that as long as I've been with the company.

· Jan: And it has been done that way at every other company I've worked at, except at most places they divide by direct labor-hours.

· Melissa: We use units because it is simpler and we basically make one product with minor variations. But, there's another way to do it. Instead of basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity.

· Lonny: Oh, the Marketing Department will love that. It will drop the costs on all of our products. They'll go wild over there cutting prices.

· Melissa: That is a worry, but I wanted to talk to both of you first before going over to Marketing.

· Jan: Aren't you always going to have a lot of underapplied overhead?

· Melissa: That's correct, but let me show you how we would handle it. Here's an example based on our budget for next year.

Traditional approach to computing the predetermined overhead rate:

· Jan: Whoa!! I don't think I like the looks of that “Cost of unused capacity.” If that thing shows up on the income statement, someone from headquarters is likely to come down here looking for some people to lay off.

· Lonny: I'm worried about something else, too. What happens when sales are not up to expectations? Can we pull the “hat trick”?

· Melissa: I'm sorry, I don't understand.

· Jan: Lonny's talking about something that happens fairly regularly. When sales are down and profits look like they are going to be lower than the president told the owners they were going to be, the president comes down here and asks us to deliver some more profits.

· Lonny: And we pull them out of our hat.

· Jan: Yeah, we just increase production until we get the profits we want.

· Melissa: I still don't understand. You mean you increase sales?

· Jan: Nope, we increase production. We're the production managers, not the sales managers.

· Melissa: I get it. Because you have produced more, the sales force has more units it can sell.

· Jan: Nope, the marketing people don't do a thing. We just build inventories and that does the trick.

Required:

In all of the questions below, assume that the predetermined overhead rate under the traditional method is $25 per unit, and under the new method it is $20 per unit. Also, assume that under the traditional method any underapplied or overapplied overhead is taken directly to the income statement as an adjustment to Cost of Goods Sold.

· 1. Suppose actual production is 80,000 units. Compute the net operating incomes that would be realized under the traditional and new methods if actual sales are 75,000 units and everything else turns out as expected.

· 2. How many units would have to be produced under each of the methods in order to realize the budgeted net operating income of $210,000 if actual sales are 75,000 units and everything else turns out as expected?

· 3. What effect does the new method based on capacity have on the volatility of net operating income?

· 4. Will the “hat trick” be easier or harder to perform if the new method based on capacity is used?

· 5. Do you think the “hat trick” is ethical?

Appendix 3B: Further Classification of Labor Costs

Idle time, overtime, and fringe benefits associated with direct labor workers pose particular problems in accounting for labor costs. Are these costs a part of the costs of direct labor or are they something else?

Idle Time

Machine breakdowns, materials shortages, power failures, and the like result in idle time. The labor costs incurred during idle time may be treated as a manufacturing overhead cost rather than as a direct labor cost. This approach spreads such costs over all the production of a period rather than just the jobs that happen to be in process when breakdowns or other disruptions occur.

LEARNING OBJECTIVE 9

Properly account for labor costs associated with idle time, overtime, and fringe benefits.

To give an example of how the cost of idle time may be handled, assume that a press operator earns $12 per hour. If the press operator is paid for a normal 40-hour workweek but is idle for 3 hours during a given week due to breakdowns, labor cost would be allocated as follows:

Overtime Premium

The overtime premium paid to factory workers (direct labor as well as indirect labor) is usually considered to be part of manufacturing overhead and is not assigned to any particular order. At first glance this may seem strange because overtime is always spent working on some particular order. Why not charge that order for the overtime cost? The reason is that it would be considered unfair and arbitrary to charge an overtime premium against a particular order simply because the order happened to fall on the tail end of the daily production schedule.

To illustrate, assume that two batches of goods, order A and order B, each take three hours to complete. The production run on order A is scheduled early in the day, but the production run on order B is scheduled late in the afternoon. By the time the run on order B is completed, two hours of overtime have been logged. The necessity to work overtime was a result of the fact that total production exceeded the regular time available. Order B was no more responsible for the overtime than was order A. Therefore, managers feel that all production should share in the premium charge that resulted. This is considered a more equitable way of handling overtime premium because it doesn't penalize one run simply because it happens to occur late in the day.

Let us again assume that a press operator in a plant earns $12 per hour. She is paid time and a half for overtime (time in excess of 40 hours a week). During a given week, she works 45 hours and has no idle time. Her labor cost for the week would be allocated as follows:

Observe from this computation that only the overtime premium of $6 per hour is charged to the overhead account—not the entire $18 earned for each hour of overtime work ($12 regular rate per hour × 1.5 hours = $18).

Labor Fringe Benefits

Labor fringe benefits are made up of employment-related costs paid by the employer and include the costs of insurance programs, retirement plans, various supplemental unemployment benefits, and hospitalization plans. The employer also pays the employer's share of Social Security, Medicare, workers’ compensation, federal employment tax, and state unemployment insurance. These costs often add up to as much as 30% to 40% of base pay.

Many companies treat all such costs as indirect labor by adding them to manufacturing overhead. Other companies treat the portion of fringe benefits that relates to direct labor as additional direct labor cost. This approach is conceptually superior because the fringe benefits provided to direct labor workers clearly represent an added cost of their services.

  Appendix 3B  Exercises and Problems

All applicable exercises and problems are available with McGraw-Hill's Connect™ Accounting.

EXERCISE 3B–1 Allocations of the Cost of Idle Time [LO9]

Chris Shannon is employed by Acme Company and is paid $18 per hour. Last week she worked 36 hours assembling one of the company's products and was idle 4 hours due to material shortages. Acme's employees are engaged at their workstations for a normal 40-hour week.

Required:

Allocate Ms. Shannon's earnings for the week between direct labor and manufacturing overhead.

EXERCISE 3B–2 Allocations of Overtime Pay [LO9]

Barry DeJay operates a stamping machine on the assembly line of Clinton Manufacturing Company. Last week Mr. DeJay worked 46 hours. His basic wage rate is $16 per hour, with time and a half for overtime (time worked in excess of 40 hours per week).

Required:

Allocate Mr. DeJay's earnings for the week between direct labor and manufacturing overhead.

EXERCISE 3B–3 Classification of Overtime Cost [LO9]

Several weeks ago you called Jiffy Plumbing Company to have some routine repair work done on the plumbing system in your home. The plumber came about two weeks later, at four o'clock in the afternoon, and spent two hours completing your repair work. When you received your bill from the company, it contained a $75 charge for labor—$30 for the first hour and $45 for the second.

When questioned about the difference in hourly rates, the company's service manager explained that the higher rate for the second hour contained a charge for an “overtime premium,” because the union required that plumbers be paid time and a half for any work in excess of eight hours per day. The service manager further explained that the company was working overtime to “catch up a little” on its backlog of work orders, but still needed to maintain a “decent” profit margin on the plumbers’ time.

Required:

· 1. Do you agree with the company's computation of the labor charge on your job?

· 2. The company pays its plumbers $20 per hour for the first eight hours worked in a day and $30 per hour for any additional time worked. Show how the cost of the plumber's time for the day (nine hours) should be allocated between direct labor and general overhead on the company's books.

· 3. Under what circumstances might the company be justified in charging an overtime premium for repair work on your home?

EXERCISE 3B–4 Classification of Labor Costs [LO9]

Fred Austin is employed by White Company where he assembles a component part for one of the company's products. Fred is paid $12 per hour for regular time, and he is paid time and a half (i.e., $18 per hour) for all work in excess of 40 hours per week.

Required:

· 1. Assume that during a given week Fred is idle for two hours due to machine breakdowns and that he is idle for four more hours due to material shortages. No overtime is recorded for the week. Allocate Fred's wages for the week between direct labor and manufacturing overhead.

· 2. Assume that during a following week Fred works a total of 50 hours. He has no idle time for the week. Allocate Fred's wages for the week between direct labor and manufacturing overhead.

· 3. Fred's company provides an attractive package of fringe benefits for its employees. This package includes a retirement program and a health insurance program. Explain two ways that the company could handle the costs of its direct laborers’ fringe benefits in its cost records.

PROBLEM 3B–5 Classification of Labor Costs [LO9]

Lynn Bjorland is employed by Southern Laboratories and is directly involved in preparing the company's leading antibiotic drug. Lynn's basic wage rate is $24 per hour. The company pays its employees time and a half (i.e., $36 per hour) for any work in excess of 40 hours per week.

Required:

· 1. Suppose that in a given week Lynn works 45 hours. Compute Lynn's total wages for the week. How much of this cost would the company allocate to direct labor? To manufacturing overhead?

· 2. Suppose in another week that Lynn works 50 hours but is idle for 4 hours during the week due to equipment breakdowns. Compute Lynn's total wages for the week. How much of this amount would be allocated to direct labor? To manufacturing overhead?

· 3. Southern Laboratories has an attractive package of fringe benefits that costs the company $8 for each hour of employee time (either regular time or overtime). During a particular week, Lynn works 48 hours but is idle for 3 hours due to material shortages. Compute Lynn's total wages and fringe benefits for the week. If the company treats all fringe benefits as part of manufacturing overhead cost, how much of Lynn's wages and fringe benefits for the week would be allocated to direct labor? To manufacturing overhead?

· 4. Refer to the data in (3) above. If the company treats that part of fringe benefits relating to direct labor as added direct labor cost, how much of Lynn's wages and fringe benefits for the week will be allocated to direct labor? To manufacturing overhead?