Accounting 204 Notes PDF

Financial Accounting ==================== Financial accounting is concerned with reporting financial information to external parties, such as stockholders, creditors, and regulators. It must comply with rules (GAAP/IFRS). It emphasizes financial consequences of past transactions. It also emphasizes...

Financial Accounting ==================== Financial accounting is concerned with reporting financial information to external parties, such as stockholders, creditors, and regulators. It must comply with rules (GAAP/IFRS). It emphasizes financial consequences of past transactions. It also emphasizes companywide reports, as well as precision and verifiability. Managerial Accounting ===================== Managerial accounting is concerned with providing information to people within an organization, such as senior managers, middle managers, and front-line employees. It is not mandatory; used to create reports deemed cost beneficial by employees. It does not have to comply with rules. It emphasizes improving future performance through planning, controlling, and decision making. It also emphasizes segment reports, as well as timely and credible judgements, assumptions, and estimates. [Planning] involves establishing goals and specifying how to achieve them. [Controlling] involves gathering feedback to ensure to plan is being properly executed or modified as circumstances change. [Decision making] involves selecting a course of action from competing alternatives. Now, let's take a closer look at these three pillars of managerial accounting. Chapter 1: Managerial Accounting and Cost Concepts Different definitions of cost could exist depending on accounting management needs. For instance, the prologue mentioned that financial accounting reports financial information to external parties, such as stockholders, creditors, and regulators. In this sense, costs are classified such that externally imposed rules enable the preparation of financial statements. Conversely, Managerial Accounting provides information to employees within an organization so they can come up with plans, control operations, and make decisions. In these contexts, costs are classified in varying ways, enabling managers to predict future costs, compare actual costs to budgeted costs, assign costs to segments of business (such as product lines, geographic regions, and distributed channels), and contrast costs associated with competing alternatives. The notion of different cost classifications for different purposes is the most important unifying theme of this chapter and one of the key foundational concepts of the entire textbook. Cost classification for assigning costs to objects ================================================== Understand cost classifications used for assigning costs to cost objects: direct and indirect costs Costs are assigned to costs objects for a variety of purposes, including pricing, preparing profitability studies, and controlling spending. A cost object is anything for which cost data are desired-including products, customers, plants, office locations, and departments. For purposes of assigning costs to cost objects, costs are classified as either direct or indirect. Direct Cost A direct cost can be easily traced to a specified cost object. For example, if Adidas is assigning costs to its various regional and national sales offices, then the salary of the sales manager in its Tokyo office would be a direct cost office. If a printing company made 10,000 brochures for a specific customer, then the cost of the paper used to make the brochures would be a direct cost of that customer. Indirect Cost An indirect cost cannot be easily traced to a specific cost object. For example, Amy's Kitchen may produce a variety of organic soups in one factory. The factory manager's salary would be an indirect cost of a particular variety, such as chunky vegetable soup, because it is incurred to run the entire factory---not to produce a specific flavor of soup. To be traced to a cost object such as a particular product, the cost must be caused by the cost object. The factory manager's salary is called a common cost of producing the various products of the factory. A common cost is a cost incurred to support a number of cost objects but cannot be traced to them individually. A common cost is a type of indirect cost. A particular cost may be direct or indirect, depending on the cost object. While the Amy's Kitchen factory manager's salary is an indirect cost of manufacturing chunky vegetable soup, it is a direct cost of the manufacturing department. In the first case, the cost object is chunky vegetable soup. In the second case, the cost object is the entire manufacturing department. Cost classifications for manufacturing companies ================================================ Manufacturing companies such as Samtec, Mack Trucks, and 3M separate their costs into two broad categories---manufacturing and nonmanufacturing costs. Manufacturing Costs Most manufacturing companies further separate their manufacturing costs into two direct cost categories, direct materials and direct labor, and one indirect cost category, manufacturing overhead. A discussion of these three categories follows. Direct Materials Materials used in the final product are called raw materials. This term is somewhat misleading because it implies unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials used in the final product; and the finished product of one company can become the raw materials of another company. For example, the plastics produced by DuPont are a raw material used by HP in its personal computers. Direct materials refers to raw materials whose costs can be easily traced to finished products. Examples include the seats Airbus purchases from subcontractors to install in its commercial aircraft, the electronic components Samsung uses in its cell phones, and the doors Whirlpool installs on its refrigerators. Direct Labor Direct labor includes labor costs easily traceable to finished products. Direct labor is sometimes called touch labor because direct labor workers typically touch the products being made. Examples of direct labor include assembly-line workers at Tesla, carpenters at the home builder KB Home, and electricians who install equipment on aircraft at Bombardier Learjet. Managers occasionally refer to direct manufacturing costs as prime costs. Prime cost is the sum of direct materials cost and direct labor cost. Manufacturing Overhead Manufacturing overhead, the third manufacturing cost category, includes all manufacturing costs except direct materials and direct labor. From a product costing standpoint, manufacturing overhead costs are indirect costs because they cannot be readily traced to specific products. For example, manufacturing overhead includes a portion of raw materials known as indirect materials as well as indirect labor. Indirect materials are raw materials, such as the solder used to make electrical connections in a Toshiba HDTV and the glue used to assemble an Ethan Allen chair, whose costs cannot be easily traced to finished products. Indirect labor refers to employees, such as janitors, supervisors, materials handlers, maintenance workers, and night security guards, who play an essential role in running a manufacturing facility; however, the cost of compensating these people cannot be easily traced to finished products. Because indirect materials and indirect labor are difficult to trace to specific products, their costs are included in manufacturing overhead. Manufacturing overhead also includes other production costs, such as depreciation of manufacturing equipment and the utility costs, property taxes, and insurance premiums incurred to operate a manufacturing facility. Although companies also incur depreciation, utility costs, property taxes, and insurance premiums to sustain their nonmanufacturing operations, these costs are not included as part of manufacturing overhead. Only those indirect costs associated with operating the factory are included in manufacturing overhead. In practice, managers use various names for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonyms for manufacturing overhead. Another term managers frequently use is conversion cost. Conversion cost is the sum of direct labor and manufacturing overhead, which are the two costs incurred to convert direct materials into finished products. Nonmanufacturing Costs Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs. Selling costs include all costs incurred to secure customer orders and get the finished product to the customer. These costs are sometimes called ordergetting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses. Selling costs can be either direct or indirect costs. For example, the cost of an advertising campaign dedicated to one specific product is a direct cost of that product, whereas the salary of a marketing manager who oversees numerous products is an indirect cost with respect to individual products. Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, legal counsel, secretarial, public relations, and similar costs involved in the administration of the organization as a whole. Administrative costs can be either direct or indirect costs. For example, the salary of an accounting manager in charge of accounts receivable collections in the East region is a direct cost of that region, whereas the salary of a chief financial officer who oversees all of a company's regions is an indirect cost with respect to individual regions. Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or just selling and administrative costs Cost Classifications for Preparing Financial Statements ======================================================= When preparing a balance sheet and an income statement, companies need to classify their costs as product costs or period costs. To understand the difference between product costs and period costs, we must first discuss the matching principle from financial accounting. Generally, costs are recognized as expenses on the income statement in the period benefitting from the cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is not an expense of the year when the payment is made. Instead, one-half of the cost would be recognized as an expense each year. The reason is both years---not just the first year---benefit from the insurance payment. The unexpensed portion of the insurance payment is reported on the balance sheet as an asset called prepaid insurance. The matching principle is based on the accrual concept that costs incurred to generate a particular revenue should be recognized as expenses in the same period the revenue is recognized. This means if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place---that is, when the benefit occurs. Such costs are called product costs. Product Costs For financial accounting purposes, product costs include all costs involved in acquiring or making a product. Product costs "attach" to products as they are purchased or manufactured and they remain attached to those products while in inventory awaiting sale. Once sold, their costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales on the income statement. Because product costs are initially assigned to inventories, they are also known as inventoriable costs. For manufacturing companies, product costs include direct materials, direct labor, and manufacturing overhead.1 A manufacturer's product costs flow through three inventory accounts on the balance sheet---Raw Materials, Work in Process, and Finished Goods---prior to being recorded in cost of goods sold on the income statement. Raw materials include any materials used in the final product. Work in process includes units of product that are only partially complete and will require further work before they are ready for sale to the customer. Finished goods consist of completed units of product that have not been sold to customers. When direct materials are used in production, their costs are transferred from Raw Materials to Work in Process. Direct labor and manufacturing overhead costs are added to Work in Process to convert direct materials into finished goods. Once units of product are completed, their costs are transferred from Work in Process to Finished Goods. When a manufacturer sells its finished goods to customers, the costs are transferred from Finished Goods to Cost of Goods Sold. We want to emphasize product costs are not necessarily recorded as expenses on the income statement in the period incurred. Rather, as explained above, they are recorded as expenses when the related products are sold. Period Costs Period costs include all the costs that are not product costs. All selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, executive salaries, public relations, and the rental costs of administrative offices are all period costs. Period costs are not included in inventory; instead, they are expensed on the income statement in the period incurred using the usual rules of accrual accounting. Keep in mind the period incurred is not necessarily the same period cash changes hands. For example, as discussed earlier, the cost of liability insurance is spread across the periods benefitting from the insurance---regardless of when the insurance premium is paid. Exhibit 1--2 summarizes the product and period cost flows for manufacturers. Notice product costs flow through three inventory accounts on the balance sheet before being recognized as cost of goods sold in the income statement. Conversely, period costs do not flow through inventory on the balance sheet and are not included in cost of goods sold in the income statement. Instead, they are recorded as selling and administrative expenses in the income statement during the period incurred.  Cost Classifications for Predicting Cost Behavior ================================================= For planning purposes, managers need to predict cost behavior. Cost behavior refers to how a cost reacts to changes in the level of activity. This section defines three types of cost behavior---variable, fixed, and mixed. The relative proportion of each type of cost in an organization is known as its cost structure. For example, an organization might have many fixed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs. Variable Cost A variable cost varies, in total, in direct proportion to changes in the level of activity. Common examples of variable costs include cost of goods sold for a merchandising company; direct materials; direct labor; variable elements of manufacturing overhead, such as indirect materials, supplies, and power; and variable elements of selling and administrative expenses, such as commissions and shipping costs. For a cost to be variable, it must vary with respect to something. That "something" is its activity base. An activity base is a measure of whatever causes the incurrence of a variable cost. An activity base is sometimes referred to as a cost driver. Some of the most common activity bases are direct labor-hours, machine-hours, units produced, and units sold. Other examples of activity bases (cost drivers) include the number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls handled by technical support staff at a software company, and the number of beds occupied in a hospital. While there are many activity bases within organizations, throughout this textbook, unless stated otherwise, you should assume the activity base under consideration is the total volume of goods and services provided by the organization. We will specify the activity base only when it differs from total output. To provide an example of a variable cost, consider Nooksack Expeditions, a small company that provides daylong whitewater rafting excursions on rivers in the North Cascade Mountains. The company provides all of the necessary equipment and experienced guides, and it serves gourmet meals to its guests. The meals are purchased from a caterer for \$30 a person for a daylong excursion. The behavior of this variable cost, on both a per-unit and a total basis, is shown below: While total variable costs change as the activity level changes, a variable cost is constant if expressed on a per-unit basis. For example, the per-unit cost of the meals remains constant at \$30 even though the total cost of the meals increases and decreases with activity. The graph on the left-hand side of Exhibit 1--3 illustrates how total variable cost rises and falls as the activity level rises and falls. At an activity level of 250 guests, the total meal cost is \$7,500. At an activity level of 1,000 guests, the total meal cost rises to \$30,000.  Fixed Cost A fixed cost remains constant, in total, regardless of changes in the level of activity. Manufacturing overhead usually includes various fixed costs such as depreciation, insurance, property taxes, rent, and supervisory salaries. Similarly, selling and administrative costs often include fixed costs such as administrative salaries, advertising, and depreciation of nonmanufacturing assets. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total fixed costs remain constant unless influenced by some outside force, such as a landlord increasing your monthly rent. To continue the Nooksack Expeditions example, assume the company rents a building for \$500 per month to store its equipment. The total amount of rent paid is the same regardless of the number of guests the company takes on its expeditions during any given month. The concept of a fixed cost is shown graphically on the right-hand side of Exhibit 1--3. Because total fixed costs remain constant for large variations in the level of activity, the average fixed cost per unit becomes progressively smaller as the level of activity increases. If Nooksack Expeditions has only 250 guests in a month, the \$500 fixed rental cost would amount to an average of \$2 per guest. If there are 1,000 guests, the fixed rental cost would average only 50 cents per guest. The table below illustrates this aspect of the behavior of fixed costs. Note as the number of guests increases, the average fixed cost per guest drops. As a general rule, we caution against expressing fixed costs on an average per-unit basis in internal reports because it creates the false impression fixed costs are like variable costs and actually change as the level of activity changes. For planning purposes, fixed costs can be viewed as either committed or discretionary. Committed fixed costs represent organizational investments with a multiyear planning horizon that can't be significantly reduced even for short periods of time without making fundamental changes. Examples include investments in facilities and equipment, as well as real estate taxes, insurance premiums, and salaries of top management. Even if operations are interrupted or cut back, committed fixed costs remain largely unchanged in the short term because the costs of restoring them later are likely to be far greater than any short-run savings that might be realized. Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend on certain fixed cost items. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students. Discretionary fixed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization The Linearity Assumpitiom and the Relevant Range Management accountants ordinarily assume costs are strictly linear; that is, the relation between cost on the one hand and activity on the other can be represented by a straight line within a narrow band of activity known as the relevant range. The relevant range is the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid. The concept of the relevant range is important in understanding fixed costs. For example, suppose the Mayo Clinic rents a machine for \$20,000 per month that tests blood samples for the presence of leukemia cells. Furthermore, suppose the capacity of the leukemia diagnostic machine is 3,000 tests per month. The assumption the rent for the diagnostic machine is \$20,000 per month is only valid within the relevant range of 0 to 3,000 tests per month. If the Mayo Clinic needed to test 5,000 blood samples per month, then it would need to rent another machine for an additional \$20,000 per month. It would be difficult to rent half a diagnostic machine; therefore, the step pattern depicted in Exhibit 1--4 is typical for such costs. This exhibit shows the fixed rental cost is \$20,000 for a relevant range of 0 to 3,000 tests. It increases to \$40,000 within the relevant range of 3,001 to 6,000 tests. The rental cost increases in discrete steps or increments of 3,000 tests, rather than increasing in a linear fashion per test.  This step-oriented cost behavior pattern can also be used to describe other costs, such as some labor costs. For example, the cost of compensating salaried employees can be characterized using a step pattern. Salaried employees are paid a fixed amount, such as \$40,000 per year, for providing the capacity to work a prespecified amount of time, such as 40 hours per week for 50 weeks a year (= 2,000 hours per year). In this example, the total salary cost is \$40,000 within a relevant range of 0 to 2,000 hours of work. The total salary cost increases to \$80,000 (or two employees) if the organization's work requirements expand to a relevant range of 2,001 to 4,000 hours of work. Cost behavior patterns, such as salaried employees, are often called step-variable costs. Step-variable costs can often be adjusted quickly as conditions change. Furthermore, the width of step-variable costs is generally so narrow these costs can be treated as variable costs for most purposes. The width of step-fixed costs, on the other hand, is so wide these costs should be treated as entirely fixed within the relevant range. Exhibit 1--5 summarizes four key concepts related to variable and fixed costs. Mixed Costs A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semivariable costs. To continue the Nooksack Expeditions example, the company incurs a mixed cost called fees paid to the state. It includes a license fee of \$25,000 per year plus \$3 per rafting party paid to the state's Department of Natural Resources. If the company runs 1,000 rafting parties this year, then the total fees paid to the state would be \$28,000, made up of \$25,000 in fixed cost plus \$3,000 in variable cost. Exhibit 1--6 depicts the behavior of this mixed cost.  Even if Nooksack fails to attract any customers, the company will still have to pay the license fee of \$25,000. This is why the cost line in Exhibit 1--6 intersects the vertical cost axis at the \$25,000 point. For each rafting party the company organizes, the total cost of the state fees will increase by \$3. Therefore, the total cost line slopes upward as the variable cost of \$3 per party is added to the fixed cost of \$25,000 per year. Because the mixed cost in Exhibit 1--6 is represented by a straight line, the following equation for a straight line can be used to express the relationship between a mixed cost and the level of activity: Because the variable cost per unit equals the slope of the straight line, the steeper the slope, the higher the variable cost per unit. In the case of the state fees paid by Nooksack Expeditions, the equation is written as follows: This equation makes it easy to calculate the total mixed cost for any activity level within the relevant range. For example, suppose the company expects to organize 800 rafting parties next year. The total state fees would be calculated as follows: Cost Terminology---A Closer Look To improve your understanding of the definitions and concepts introduced so far, consider the following costs and expenses for the most recent month:  These costs and expenses can be categorized in a number of ways, some of which are shown below: Cost Classifications for Decision Making ======================================== Every decision involves choosing from among at least two alternatives. The key to choosing among alternatives is distinguishing between relevant and irrelevant costs and benefits. Relevant costs and relevant benefits should be considered when making decisions and irrelevant costs and benefits should be ignored. The remainder of this section expands on these concepts by defining the terms differential cost and revenue, incremental cost, opportunity cost, and sunk cost. Differential Cost and Revenue A future cost that differs between any two alternatives is known as a differential cost. Differential costs are always relevant costs. Future revenue that differs between any two alternatives is known as differential revenue. Differential revenue is an example of a relevant benefit. Any future cost or benefit that does not differ between the alternatives is irrelevant and should be ignored. A differential cost is also known as an incremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another, whereas decreases in cost should be referred to as decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives. The accountant's differential cost concept can be compared to the economist's marginal cost concept. In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue. The revenue obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit is called marginal cost. The economist's marginal concept is basically the same as the accountant's differential concept applied to a single unit of output. Differential costs can be either fixed or variable. To illustrate, assume that Natural Cosmetics, Inc., is thinking about changing its marketing method from distribution through retailers to distribution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the following table: According to the above analysis, the differential revenue is \$100,000 and the differential costs total \$85,000, leaving a positive differential net operating income of \$15,000 in favor of using sales representatives. In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives can be ignored. For example, in the Natural Cosmetics, Inc., example above, the "Other expenses" category, which is \$60,000 under both alternatives, can be ignored because it has no effect on the decision. If it were removed from the calculations, the sales representatives would still be preferred by \$15,000. This is an extremely important principle in management accounting that we will revisit in later chapters. Opportunity Cost and Sunk Cost Opportunity cost is the potential benefit given up when one alternative is selected over another. For example, assume you have a part-time job while attending college paying \$200 per week. If you spend one week at the beach during spring break without pay, then the \$200 in lost wages would be an opportunity cost of taking the week off to be at the beach. Opportunity costs are not usually found in accounting records, but they are relevant costs that must be explicitly considered in every decision a manager makes. Virtually every alternative involves an opportunity cost. A sunk cost has already been incurred and cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs are irrelevant and should always be ignored. To illustrate a sunk cost, assume a company paid \$50,000 several years ago for a special-purpose machine. The machine was used to make a product that is now obsolete and no longer being sold. Even though in hindsight purchasing the machine may have been unwise, the \$50,000 cost has already been incurred and cannot be undone. It would be folly to continue making the obsolete product in a misguided attempt to "recover" the original cost of the machine. In short, the \$50,000 originally paid for the machine is a sunk cost that should be ignored in current decisions. Before moving to the next section, we want to emphasize managers can use cost classifications for other purposes besides those described thus far. For example, managers may wish to classify costs as controllable or uncontrollable for employee performance evaluation purposes. A controllable cost can be influenced by the manager being evaluated. An uncontrollable cost cannot be influenced by the manager being evaluated. A company's managers may also wish to classify costs as value-added or non-value-added for process improvement purposes. A value-added cost increases the value of products and services provided to the company's stakeholders, whereas a non-value-added cost does not provide any benefit to the company's stakeholders. The overarching theme of the chapter is to first identify the needs of management and then classify costs accordingly. Using different cost classifications for different purposes =========================================================== This section discusses how to prepare traditional and contribution format income statements for a merchandising company.3 Merchandising companies do not manufacture the products they sell to customers. For example, Lowe's and Home Depot are merchandising companies because they buy finished products from manufacturers and then resell them to end consumers. Contrasting these two types of income statements enables us to illustrate the chapter's unifying theme of different cost classifications for different purposes. Traditional income statements are prepared primarily for external reporting purposes. They rely on cost classifications for preparing financial statements (product and period costs) to depict the financial consequences of past transactions. Contribution format income statements are prepared for internal management purposes. They use cost classifications for predicting cost behavior (variable and fixed costs) to better inform decisions affecting the future. The two different purposes served by these income statements highlight what is arguably the most important difference between financial accounting and managerial accounting---an emphasis on recording past performance versus an emphasis on making predictions and decisions affecting future performance. The Traditional Format Income Statement The left-hand side of Exhibit 1--7 shows a traditional income statement format for merchandising companies. This type of income statement organizes costs into two categories---cost of goods sold and selling and administrative expenses. Sales minus cost of goods sold equals the gross margin. The gross margin minus selling and administrative expenses equals net operating income.  The cost of goods sold reports the product costs attached to the merchandise sold during the period. The selling and administrative expenses report all period costs expensed as incurred. The cost of goods sold for a merchandising company can be computed directly by multiplying the number of units sold by their unit cost or indirectly using the equation below: For example, let's assume the company depicted in Exhibit 1--7 purchased \$3,000 of merchandise inventory during the period and had beginning and ending merchandise inventory balances of \$7,000 and \$4,000, respectively. The equation on the previous page could be used to compute the cost of goods sold as follows:  Although the traditional income statement is useful for external reporting purposes, it has serious limitations when used for internal purposes. It does not distinguish between fixed and variable costs. For example, under the heading "Selling and administrative expenses," both variable administrative costs (\$400) and fixed administrative costs (\$1,500) are lumped together (\$1,900). Internally, managers need cost data organized by cost behavior to aid in planning, controlling, and decision making. The contribution format income statement has been developed in response to these needs. The Contribution Format Income Statement The right-hand side of Exhibit 1--7 shows a contribution format income statement for merchandising companies. The contribution approach separates costs into fixed and variable categories, first deducting all variable expenses from sales to obtain the contribution margin. For a merchandising company, cost of goods sold is a variable cost that gets included in the "Variable expenses" portion of the contribution format income statement. The contribution margin is the amount remaining from sales revenues after all variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits. The contribution margin can also be stated on a per-unit basis. For example, if the company depicted in Exhibit 1--7 sold 500 units, then its contribution margin per unit would be \$10 per unit ( = \$ 5 , 000 ÷ 500 units). The contribution format income statement is used as an internal planning and decision-making tool. Its emphasis on cost behavior aids cost-volume-profit analysis, management performance appraisals, and budgeting. Moreover, the contribution approach helps managers organize data pertinent to numerous decisions such as product-line analysis, pricing, use of scarce resources, and make or buy analysis. All of these topics are covered in later chapters. Summary ======= This chapter discusses ways managers classify costs. How the costs will be used---for assigning costs to cost objects, preparing external reports, predicting cost behavior, or decision making---dictates how they are classified. For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or indirect. Direct costs can be easily traced to cost objects, whereas indirect costs cannot. For external reporting purposes, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In contrast, period costs are taken directly to the income statement as expenses in the period in which they are incurred. For purposes of predicting cost behavior, costs are classified into three categories---variable, fixed, and mixed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant. Fixed costs, in total, remain the same as the activity level changes within the relevant range. The average fixed cost per unit decreases as the activity level increases. Mixed costs have variable and fixed elements and can be expressed in equation form as 𝑌 = 𝑎 + 𝑏 𝑋 , where Y is the total mixed cost, a is the total fixed cost, b is the variable cost per unit of activity, and X is the activity level. When making decisions, managers distinguish between relevant and irrelevant costs and benefits. Differential costs and revenues are relevant because they differ between alternatives. Opportunity costs are also relevant because they consider the benefits of the forgone alternative. Sunk costs are irrelevant because they have already occurred in the past and cannot be altered. Different cost classifications for different purposes is the unifying theme of this chapter, and it can be highlighted by contrasting traditional and contribution format income statements. The traditional income statement format is used primarily for external reporting purposes. It organizes costs using product and period cost classifications. The contribution format income statement aids decision making because it organizes costs using variable and fixed cost classifications. Companies usually assign costs to their products and services for two main reasons. First, it helps them with planning, controlling, and decision making. For example, a company may use product cost information to better understand each product's profitability or to establish each product's selling price. Second, it helps them value ending inventories and cost of goods sold for external reporting purposes. The costs attached to products that have not been sold are included in ending inventories on the balance sheet, whereas the costs attached to units that have been sold are included in cost of goods sold on the income statement. It is very common for external financial reporting requirements to heavily influence how companies assign costs to their products and services. Because most countries (including the United States) require some form of absorption costing for external financial reports, many companies use some form of absorption costing for product costing purposes. In absorption costing, all manufacturing costs, both fixed and variable, are assigned to units of product---units are said to fully absorb manufacturing costs. Conversely, all nonmanufacturing costs are treated as period costs and not assigned to products. This chapter and the next explain a common type of absorption costing system known as job-order costing. In this chapter, we'll discuss the role of job-order costing systems in planning, control, and decision making. Our focus will be on assigning manufacturing costs to individual jobs. In the next chapter, we will explain how job-order costing systems can be used to prepare the schedules of cost of goods manufactured and cost of goods sold and an income statement for external reporting purposes. Job-Order Costing: An Overview ============================== Job-order costing is used by companies that make many different products, each with unique features. For example, a Diesel clothing factory would typically make many different types of jeans for both men and women. 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, also called the unit product cost. Other examples where job-order costing would be used include large-scale construction projects managed by Bechtel International; commercial aircraft produced by Boeing; business cards designed, printed, and shipped by Vistaprint; and airline meals prepared by LSG SkyChefs. All of these companies have diverse outputs. Each Bechtel project is unique and different from every other---the company may be simultaneously constructing a dam in Nigeria 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 example of job-order costing provided in the following section deals with a manufacturing company, the same procedures are used by many service organizations. 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, it bears reemphasizing 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 product costs is assigned to jobs for computing unit product costs. Measuring Direct Material Costs The blueprints submitted by Loops Unlimited indicate each experimental coupling requires three parts classified as direct materials: two G7 Connectors and one M46 Housing. Because each coupling requires two connectors and one housing, the production of two couplings requires four connectors and two housings. This is a custom product 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 quantity of each type of direct material needed to complete a unit of product. When 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 2--1. The materials requisition form specifies the type and quantity of materials to be drawn from the storeroom and identifies the job charged for the cost of the materials. The form is used to control the flow of materials into production and also for making journal entries in the accounting records (as will be demonstrated in the next chapter).  The Yost Precision Machining materials requisition form in Exhibit 2--1 shows the company's Milling Department requisitioned two M46 Housings and four G7 Connectors for the Loops Unlimited job, which is designated as Job 2B47. Job Cost Sheet After a production order is issued, the Accounting Department's job-order costing software automatically generates a job cost sheet like the one shown in Exhibit 2--2. A job cost sheet records the materials, labor, and manufacturing overhead costs charged to that job. After direct materials are issued, the cost of these materials are automatically recorded on the job cost sheet. Note from Exhibit 2--2, for example, 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 As the name implies, direct labor costs can be directly traced to particular jobs. Most companies tabulate labor costs using computerized employee time tickets. A time ticket provides an hour-by-hour summary of the employee's activities throughout the day. For example, Exhibit 2--3 shows an employee time ticket that assigns \$90 of direct labor cost to Job 2B47. The company's computerized system automatically posts this labor charge to Job 2B47's job cost sheet, as shown in Exhibit 2--2. The time ticket in Exhibit 2--3 also shows \$18 of indirect labor cost related to performing maintenance. This cost is treated as part of manufacturing overhead and does not get directly posted on a job cost sheet.  Computing Predetermined Overhead Rates Recall that, in absorption costing, 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 is complicated by three circumstances: 1. 2. 3. Given these circumstances, companies use one or more allocation bases to assign overhead costs to products. An allocation base is a measure, such as direct labor-hours (DLH) or machine-hours (MH), that is common to all products and used to assign overhead costs to them. 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 allocated 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) 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:  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 The predetermined overhead rate is computed before the period begins and is 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 \$20 per direct labor-hour, then \$20 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:  Note the amount of overhead applied to a particular job is not the 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 allocated to the job is simply a share of the total overhead estimated at the beginning of the year. This approach to overhead application is known as normal costing. A normal cost system applies overhead costs to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the jobs. 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 40,000 direct labor-hours would be required to support the production planned for the year. In step two, it estimated \$640,000 of total fixed manufacturing overhead cost for the coming year and \$4.00 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 \$20 per direct labor-hour as shown below:  The job cost sheet in Exhibit 2--4 indicates that 27 direct labor-hours (i.e., DLHs) were charged to Job 2B47. Therefore, a total of \$540 of manufacturing overhead cost would be applied to the job: This amount of overhead has been entered on the job cost sheet in Exhibit 2--4.  The Need for a Predetermined Rate Instead of using a predetermined rate based on estimates, it may be tempting to suggest companies should use the actual total manufacturing overhead cost and the actual total amount of the allocation base to compute their overhead rates on a monthly, quarterly, or annual basis. However, 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. To avoid such confusing fluctuations, companies could compute actual overhead rates on an annual basis. However, with this approach, 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. Computation of Total Job Costs and Unit Product Costs With the application of Yost Precision Machining's \$540 of manufacturing overhead to the job cost sheet in Exhibit 2--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 (\$2,390) is divided by the number of units (2) to obtain the unit product cost (\$1,195). 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 \$1,195 because much of the actual overhead costs would not change if another unit were produced. Job-Order Costing--A Managerial Perspective =========================================== Managers use job costs for planning and decision-making purposes. For example, they may rely on job profitability reports to influence sales and production plans. If certain types of jobs, such as low-volume engineering-intensive jobs, seem highly profitable, managers may dedicate future advertising expenditures to growing sales of these types of jobs. Conversely, if other types of jobs, such as high-volume labor-intensive jobs, seem unprofitable, managers may reduce the projected sales and production of these types of jobs. Managers may also use job costs for pricing decisions. For example, if Job A has a total manufacturing cost of \$100, managers often use a predefined markup percentage, say 50%, to establish a markup of \$ 50 ( = \$ 100 × 50 % ) and a selling price of \$ 50 ( = \$ 100 + \$ 50 ). Under this approach, known as cost-plus pricing, the managers establish a markup percentage they believe generates enough revenue to cover all of a job's manufacturing costs and a portion of the company's nonmanufacturing costs, while generating some residual profit. If a company's job-order costing system does not accurately assign manufacturing costs to jobs, it will adversely influence the types of planning and decision-making scenarios just described. In other words, distorted job cost data may cause managers to use additional advertising dollars to pursue certain types of jobs they believe are profitable, but in actuality, are not. Similarly, inaccurate job costs may cause managers to establish selling prices that are too high or too low relative to the prices established by more savvy competitors. At this point, you may be wondering, how can this happen? How can a job-order costing system inaccurately assign costs to jobs? The key to answering this question is focusing on indirect manufacturing costs, also called manufacturing overhead costs. While job-order costing systems accurately trace direct materials and direct labor costs to jobs, they often fail to accurately allocate manufacturing overhead costs to jobs. The root cause of these inaccuracies often relates to the choice of an allocation base.  Choosing an Allocation Base--A Key to Job Cost Accuracy Imagine going to a restaurant with three of your friends. The group orders an extra-large pizza for \$20 cut into ten slices. One of your friends eats five slices of pizza, your other two friends eat two slices each, and you eat one slice. When the bill arrives, the friend who ate five slices recommends paying the bill using "number of people seated at the table" as the allocation base, thereby requiring you to contribute \$ 5 ( = \$ 20 ÷ 4 ) toward paying the bill. How would you feel about the accuracy of this cost allocation base? In all likelihood, you'd suggest distributing the bill among the four diners using another allocation base called "number of slices eaten." This approach requires each person to pay \$ 2 ( = \$ 20 ÷ 10 ) per slice consumed, thereby requiring you to contribute \$2 toward paying the bill. While the distortion caused by using "number of people seated at the table" as the allocation base seems obvious, job-order costing systems often make the same error---they use allocation bases that do not reflect how jobs actually use overhead resources. To improve job cost accuracy, 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, it will not accurately measure the cost of overhead resources used by each job. Many companies use job-order costing systems that assume direct labor-hours (or direct labor cost) is the only manufacturing overhead cost driver. They use a single predetermined overhead rate, or what is called a plantwide overhead rate, to allocate all manufacturing overhead costs to jobs based on their usage of direct-labor hours. However, while direct labor-hours may "drive" some of a company's manufacturing overhead costs, it is often incorrect to assume that direct-labor hours is a company's only manufacturing overhead cost driver. When companies can identify more than one overhead cost driver, they can improve job cost accuracy by using multiple predetermined overhead rates. A cost system with multiple predetermined overhead rates uses more than one overhead rate to apply overhead costs to jobs. For example, a company may choose to use a predetermined overhead rate for each of its production departments. Such a system, while more complex, is more accurate because it reflects differences across departments in terms of how jobs consume overhead costs. For example, in labor-intensive departments, their overhead costs might be applied to jobs based on direct labor-hours. However, in machine-intensive departments, their overhead costs might be applied to jobs using machine-hours. Multiple Predetermined Overhead Rates--A Departmental Approach Dickson Company has two production departments, Milling and Assembly. The company uses a job-order costing system and computes a predetermined overhead rate in each department. The predetermined overhead rate in the Milling Department is based on machine-hours, and in the Assembly Department, it is based on direct labor-hours. The company uses cost-plus pricing to establish selling prices for its products. Cost-plus pricing is a pricing method in which a predetermined markup is applied to a cost base to determine the target selling price. In this instance, Dickson Company uses a markup percentage of 75% of total manufacturing cost to establish selling prices for all of its jobs. At the beginning of the year, the company made the following estimates: During the current month, the company started and completed Job 407. It wants to use its predetermined departmental overhead rates and the information pertaining to Job 407 shown below to establish a selling price for this job:  Exhibit 2--5 explains how Dickson would compute a selling price for Job 407 using a five-step process, the first of which is to calculate the estimated total manufacturing overhead cost in each department using the equation As shown in step 1 in Exhibit 2--5, this equation provides the Milling Department's estimated total manufacturing overhead cost of \$510,000 and the Assembly Department's estimated total overhead cost of \$800,000.  The second step is to calculate the predetermined overhead rate for each department using the following formula: Per step 2 in Exhibit 2--5, this formula results in predetermined overhead rates in the Milling and Assembly Departments of \$8.50 per machine-hour and \$10.00 per direct labor-hour, respectively. The third step is to use the general equation shown below to calculate the amount of overhead applied from each department to Job 407.  As depicted in the middle of Exhibit 2--5, \$765 of manufacturing overhead is applied from the Milling Department to Job 407, whereas \$200 is applied from the Assembly Department to this same job. Finally, Exhibit 2--5 summarizes steps 4 and 5, which calculate the total job cost for Job 407 (\$2,485) and the selling price of Job 407 (\$4,348.75) using the markup percentage of 75%. It is important to emphasize using a departmental approach to overhead application results in a different selling price for Job 407 than would have been derived using a plantwide overhead rate based on either direct labor-hours or machine-hours. The appeal of using predetermined departmental overhead rates is they presumably provide a more accurate accounting of the costs caused by jobs, which, in turn, should enhance management planning and decision making. Multiple Predetermined Overhead Rates---An Activity-Based Approach Using departmental overhead rates is one approach to creating a job-order costing system with multiple predetermined overhead rates. Another approach is to create overhead rates related to the activities performed within departments. This approach usually results in more overhead rates than a departmental approach because each department may perform more than one activity. When a company creates overhead rates based on the activities it performs, it is employing an approach called activity-based costing. For now, our goal is to simply introduce you to the idea of activity-based costing---an alternative approach to developing multiple predetermined overhead rates. Managers use activity-based costing systems to more accurately measure the demands that jobs, products, customers, and other cost objects make on overhead resources. Appendix 2A provides an in-depth discussion of activity-based absorption costing and contrasts it with the plantwide approach described earlier in this chapter. Chapter 7 describes a more refined approach to activity-based costing that better serves the needs of management than the activity-based absorption costing approach discussed in Appendix 2A. Job-Order Costing---An External Reporting Perspective ===================================================== However, job-order costing systems are also often used to create a balance sheet and income statement for external parties, such as shareholders and lenders. In this section, we explain how a company's job cost sheets provide a subsidiary ledger that summarizes the specific jobs that comprise the amounts reported in Work-in-Process and Finished Goods on the balance sheet as well as Cost of Goods Sold on the income statement. To illustrate, assume Dixon Company worked on six jobs during May: Jobs A, B, C, D, E, and F. At the end of May, the job cost sheets for these six jobs contained the following data: Jobs C, D, E, and F were completed during May. Jobs A and B were incomplete at the end of May. There was no finished goods inventory on May 1, and the company's total manufacturing overhead applied equals its total actual manufacturing overhead. Given this information, the job cost sheets can be used to calculate Work in Process for the May 31 balance sheet by identifying the jobs that still have units in process at the end of the month (Jobs A and B) and summing their total job costs as follows:  The job cost sheets can also be used to calculate Cost of Goods Sold for May's income statement using a two-step process. First, calculate the unit product costs for all jobs completed during May (Jobs C, D, E, and F) as follows: Next, calculate the Cost of Goods Sold by multiplying each job's unit product cost by the number of units sold:  The Finished Goods inventory for the May 31 balance sheet can also be calculated using a two-step process. First, calculate the number of units in ending finished goods inventory: Second, multiply the units in finished goods inventory by each job's respective unit product cost:  Overhead Application and the Income Statement For simplicity, the example we just completed assumes Dixon Company's total manufacturing overhead applied equals its total actual manufacturing overhead. However, in reality, when a company uses predetermined overhead rates to apply overhead cost to jobs, it is almost a certainty that the amount of overhead applied to all jobs will differ from the actual amount of overhead cost. When a company applies less overhead to production than it actually incurs, it creates what is known as underapplied overhead. When it applies more overhead to production than it actually incurs, it results in overapplied overhead. The existence of underapplied or overapplied overhead has implications for how a company prepares its financial statements. For example, the cost of goods sold reported on a company's income statement must be adjusted to reflect underapplied or overapplied overhead. The adjustment for underapplied overhead increases cost of goods sold and decreases net operating income, whereas the adjustment for overapplied overhead decreases cost of goods sold and increases net operating income. Nonetheless, all forthcoming exercises and problems pertaining to this learning objective will assume the amounts of applied and actual overhead are the same. Job-Order Costing in Service Companies ====================================== This chapter focused on manufacturing companies; however, job-order costing is also used in service organizations, such as law firms, movie studios, hospitals, and repair shops. 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 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 and props) 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 summary, 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. Summary ======= Job-order costing is used when organizations offer many different products or services, such as in furniture manufacturing, hospitals, and legal firms. When used in a manufacturing context, job-order costing systems accumulate a job's direct materials, direct labor, and manufacturing overhead costs on a job cost sheet. Selling and administrative costs are not assigned to jobs because they are treated as period costs. Job-order costing systems use materials requisition forms and labor time tickets to trace direct materials and direct labor costs to jobs. Because manufacturing overhead costs are indirect costs, they must be allocated to jobs. Ideally, the allocation base used to allocate overhead costs to jobs should be a cost driver---it should cause the consumption of overhead costs. The most frequently used allocation bases in job-order costing systems are direct labor-hours and machine-hours. Normal costing systems allocate overhead costs to jobs using predetermined overhead rates estimated before the period begins. A predetermined overhead rate is computed by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base. Job-order costing systems can use only one predetermined overhead rate (also called a plantwide rate) or multiple predetermined overhead rates. Throughout the period, overhead is applied to jobs by multiplying the predetermined overhead rate by the actual amount of the allocation base recorded for each job. The total manufacturing costs assigned to a job (including direct materials, direct labor, and applied overhead) divided by the number of units within that job equals the unit product cost. A company's job cost sheets form a subsidiary ledger that can be used to summarize the amounts of work in process and finished goods on the balance sheet and the cost of goods sold in the income statement. Chapter 3: Job-Order Costing; Cost Flows and External Reporting Chapter 2 discussed how companies use job-order costing to assign manufacturing costs to individual jobs. This chapter describes how companies use job-order costing to prepare a balance sheet and income statement for external reporting purposes. Exhibit 3--1 summarizes seven vocabulary terms introduced in the previous chapter. Please review these terms, each of which is included in the Glossary at the end of this chapter, because it will help you understand the forthcoming learning objectives. Job-Order Costing--The Flow of Costs ==================================== In Chapter 1, we used Exhibit 1--2 to illustrate the cost flows and classifications in a manufacturing company. Now we are going to use a similar version of that exhibit, as shown in Exhibit 3--2, to introduce the cost flows and classifications in a manufacturing company that uses job-order costing.  Exhibit 3--2 shows in job-order costing a company's product costs flow through three inventory accounts on the balance sheet and then 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 as direct materials, their costs are transferred to Work in Process inventory.1 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. To transform direct materials into completed jobs, direct labor cost is added to Work in Process and manufacturing overhead cost is applied to Work in Process by multiplying the predetermined overhead rate by the actual quantity of the allocation base consumed by each job.2 When jobs are completed, their costs are transferred from Work in Process to Finished Goods inventory. 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 units of product finished during the period. As jobs are sold, their costs are transferred from Finished Goods to Cost of Goods Sold. At this point, the various costs attached to each job are finally recorded as an expense on the income statement. 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. To illustrate the cost flows within a job-order costing system, we will record Ruger Corporation's transactions for the month of April. Ruger is a producer of gold and silver commemorative medallions and it worked on only two jobs in April. Job A, a special minting of 1,000 gold medallions commemorating the invention of motion pictures, was started during March and completed in April. As of March 31st, Job A had been assigned \$30,000 in manufacturing costs, which corresponds with Ruger's Work in Process balance on April 1st of \$30,000. Job B, an order for 10,000 silver medallions commemorating the fall of the Berlin Wall, was started in April and was incomplete at the end of the month. 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: Remember that Raw Materials is an asset account. Thus, when raw materials are purchased, they are initially recorded as an asset---not as an expense. The Issue of Direct and Indirect Materials During April, materials requisition forms were prepared to authorize withdrawing \$52,000 in raw materials 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--3, where \$28,000 of the \$50,000 in direct materials is charged to Job A's cost sheet and the remaining \$22,000 is charged to Job B's cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.) The \$2,000 charged to Manufacturing Overhead in entry (2) is indirect materials. The debit side of the Manufacturing Overhead account always records actual manufacturing overhead costs, such as indirect materials used during the period. The credit side of this account, as you will see in transaction (7), always records manufacturing overhead applied to work in process. Notice in Exhibit 3--3 Job A has a beginning balance of \$30,000. This balance represents the cost of work done during March that has been carried forward to April. Also note the Work in Process account contains the same \$30,000 balance. Thus, the Work in Process account summarizes all costs appearing on the job cost sheets for jobs still 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. Labor Cost In April, the employee time tickets (which provide hourly summaries of each employee's activities throughout the day) included \$60,000 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 direct labor costs are added to Work in Process, they are also added to individual job cost sheets, as shown in Exhibit 3--4. During April, \$40,000 of direct labor was charged to Job A and the remaining \$20,000 was charged to Job B. The \$15,000 charged to Manufacturing Overhead represents indirect labor costs, 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 recorded in the Manufacturing Overhead account when incurred. To illustrate, assume Ruger Corporation incurred the following general factory costs during April:  The following entry records these costs: In addition, assume during April, Ruger Corporation recorded \$13,000 in accrued property taxes and \$7,000 in expired prepaid insurance on factory buildings and equipment as follows: Finally, assume the company recorded \$18,000 in depreciation on factory equipment as follows: In short, all actual manufacturing overhead costs are debited to the Manufacturing Overhead account when incurred. Applying Manufacturing Overhead Because actual manufacturing overhead costs are charged to the Manufacturing Overhead account rather than Work in Process, it begs the question how are manufacturing overhead costs assigned to Work in Process? The answer is, they are assigned using a predetermined overhead rate---which is calculated by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base. For example, if we assume machine-hours is the allocation base, then overhead cost would be applied to jobs by multiplying the predetermined overhead rate by the number of machine-hours charged to each job. To illustrate, assume Ruger Corporation's predetermined overhead rate is \$6 per machine-hour. Also assume 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 as follows:  Exhibit 3--5 shows the flow of costs through the Manufacturing Overhead account. The actual overhead costs on the debit side of the Manufacturing Overhead account were recorded in entries (2)--(6), whereas the application of overhead to Work in Process occurs in entry (7). The Concept of a Cleairng Account The Manufacturing Overhead account operates as a clearing account. Actual manufacturing overhead costs are debited to the account as incurred throughout the year. When jobs are completed (or at the end of an accounting period), overhead cost is applied to the jobs using the predetermined overhead rate---Work in Process is debited and Manufacturing Overhead is credited. This sequence of events is illustrated below:  The predetermined overhead rate is based 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 differ from the actual overhead cost incurred. For example, notice from Exhibit 3--5 Ruger Corporation's actual overhead costs are \$5,000 greater than the overhead cost 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--5 the cost of a completed job includes 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 are 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 Ruger Corporation incurred \$30,000 in selling and administrative salary costs during April. The following entry summarizes the accrual of those salaries: Assume depreciation on office equipment during April was \$7,000. The entry is as follows:  Notice the difference between this entry and entry (6) where we recorded depreciation on factory equipment. In entry (6), depreciation on factory equipment was debited to Manufacturing Overhead and is therefore a product cost. In entry (9), depreciation on office equipment is debited to Depreciation Expense because it's a period expense rather than a product cost. Finally, assume advertising was \$42,000 and 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, and insurance on office facilities. Cost of Goods Manufactured When a job is completed, the finished output is transferred from the production departments to the finished goods warehouse. By this time, the accounting department has charged the job with direct materials and direct labor cost and applied overhead 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. In the case of Ruger Corporation, remember that Job A was completed during April and Job B was incomplete at the end of the month. Thus, the following entry transfers the cost of Job A from Work in Process to Finished Goods:  The \$158,000, which appears on Job A's cost sheet in Exhibit 3--5, represents the cost of goods manufactured for the month. Because Job B was not completed by the end of the month, its costs remain in Work in Process and carry over to the next month. If a balance sheet were prepared at the end of April, Job B's cost (\$72,000) would appear in the asset account Work in Process. Cost of Goods sold As completed jobs are shipped to customers, their costs are transferred from Finished Goods to Cost of Goods Sold. If an entire job is shipped at one time, then its entire cost is transferred to Cost of Goods Sold. However, sometimes only a portion of the units involved in a particular job will be immediately sold. In these situations, the unit product cost is 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 record the sale (all sales were on account): 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--6. In addition, Exhibit 3--7 presents the flow of costs through the accounts in T-account form.    Schedules of Cost of Goods Manufactured and Cost of Goods Sold ============================================================== 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 remaining in ending Work in Process inventory and transferred out to Finished Goods. The schedule of cost of goods sold also contains three product costs---direct materials, direct labor, and manufacturing overhead---and summarizes the portions of those costs remaining in ending Finished Goods inventory and transferred out to Cost of Goods Sold. Schedule of Cost of Goods Manufactured Exhibit 3--8 presents Ruger Corporation's schedule of cost of goods manufactured, which is based on three underlying equations. First, as shown in the left-hand column of numbers, the raw materials used in production are computed using the following equation: Schedule of Cost of Goods Sold The schedule of cost of goods sold shown in Exhibit 3--9 uses the following equation to compute the unadjusted cost of goods sold: The beginning finished goods inventory (\$0) plus the cost of goods manufactured (\$158,000) equals the cost of goods available for sale (\$158,000). The cost of goods available for sale (\$158,000) minus the ending finished goods inventory (\$39,500) 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. Income Statement Exhibit 3--10 presents Ruger Corporation's income statement for April. Notice the cost of goods sold on this statement carries over from Exhibit 3--9. 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 show these items were immediately debited to expense accounts rather than inventory accounts.  Underapplied and Overapplied Overhead--A Closer Look ==================================================== 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 machine-hour was used to apply \$90,000 of overhead cost to Work in Process, whereas actual overhead costs for April were \$95,000 (see Exhibit 3--5). The difference between overhead cost applied to Work in Process and actual overhead costs is called either underapplied overhead 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 cost 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 actual overhead costs will be proportional to the actual amount of the allocation base incurred during the period. So, if the predetermined overhead rate is \$6 per machine-hour, it is assumed actual overhead costs will equal \$6 for every machine-hour actually worked. There are at least two reasons why this may not be true. First, many overhead costs are fixed costs that do not change as the number of machine-hours incurred goes up or down. Second, overhead spending may or may not be under control. If the individuals responsible for overhead costs do a good job, those costs should be less than estimated at the beginning of the period. If they do a poor job, those costs will be more than expected. To illustrate, suppose two companies---Turbo Crafters and Black & Howell---prepared the following estimates for the coming year: Note 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 because of unexpected changes in overhead spending and unit sales, the actual overhead cost incurred and the actual amount of the allocation base used during the year in each company are as follows:  Given this actual data and each company's predetermined overhead rate, the manufacturing overhead applied to Work in Process during the year would be computed as follows: This results in underapplied and overapplied overhead as shown below:  For Turbo Crafters, the overhead cost applied to Work in Process of \$272,000 is less than the actual overhead cost for the year of \$290,000; therefore, overhead is underapplied by \$18,000. For Black & Howell, the overhead cost applied to Work in Process of \$135,000 is greater than the actual overhead cost for the year of \$130,000, so overhead is overapplied by \$(5,000). A summary of these concepts is presented in Exhibit 3--11. Disposition of underapplied or overapplied overhead balances The Turbo Crafters and Black & Howell examples show one way to calculate underapplied or overapplied overhead. However, another equivalent method of determining the amount of underapplied or overapplied overhead is to properly analyze the Manufacturing Overhead T-account. Explaining this second method also enables us to discuss the topic of preparing a journal entry to dispose of underapplied or overapplied overhead for financial reporting purposes. If we return to the Ruger Corporation example and look at the Manufacturing Overhead T-account in Exhibit 3--7, you will see there is a debit balance of \$5,000. Remember debit entries to this account represent actual overhead costs, whereas credit entries represent applied overhead costs. In this case, the applied overhead costs (the credits) are less than the actual overhead costs (the debits) by \$5,000---hence, manufacturing overhead is underapplied. In other words, 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. Once we have quantified the underapplied or overapplied overhead, it must be disposed of in one of two ways: 1. 2. Closed to Cost of Goods Sold Closing the balance in Manufacturing Overhead to Cost of Goods Sold is the simpler of the two methods. In the Ruger Corporation example, the entry to close the \$5,000 of underapplied overhead to Cost of Goods Sold is:  Because the Manufacturing Overhead account has a debit balance, it must be credited to close out the account. This increases April's Cost of Goods Sold by \$5,000 as shown below: Ruger Corporation's adjusted cost of goods sold of \$123,500 as shown here agrees with the company's income statement shown in Exhibit 3--10. Keep in mind unadjusted cost of goods sold is based on the manufacturing overhead cost applied to jobs, not the amount of actual manufacturing overhead cost incurred. So, when overhead is underapplied it means two things---not enough overhead cost was applied to jobs and the cost of goods sold is understated. Adding the underapplied overhead to the cost of goods sold corrects this understatement. Closed Proportionally to Work in Process, Finished Goods, and Cost of Goods Sold Closing underapplied or overapplied overhead proportionally to Work in Process, Finished Goods, and Cost of Goods Sold is more accurate than closing the entire balance into Cost of Goods Sold; however, it is also more complex. We'll explain the proportional allocation of underapplied or overapplied overhead using a three-step process. The first step is to break the overhead cost applied to production into three pieces---the portion included in ending Work in Process, the portion included in ending Finished Goods, and the portion applied to Cost of Goods Sold during the period. The second step is to state each of these three amounts as a percent of the total overhead cost applied to production. The third step is to derive the amounts needed for the journal entry by multiplying the percentages from step two by the amount of underapplied or overapplied overhead. Exhibit 3--12 illustrates this three-step process for Ruger Corporation. As you may remember, Ruger worked on only two jobs in April---Job A and Job B. Job A consisted of 1,000 gold medallions, 750 of which were sold to customers and 250 of which remained in Finished Goods at the end of the month. Job B consisted of 10,000 silver medallions and it was incomplete at the end of April.  In step one of Exhibit 3--12, Ruger takes its total manufacturing overhead applied to production from Exhibit 3--5 (\$90,000) and splits it between Job A (\$60,000) and Job B (\$30,000). Because Job B was incomplete at the end of April, all of its applied overhead cost (\$30,000) resides in Work in Process at the end of the month, whereas the \$60,000 of overhead cost applied to Job A needs to be split into two accounts. A total of 25% of Job A's gold medallions ( = 250 ÷ 1 , 000 ) were in Finished Goods at the end of April; therefore, 25% of Job A's applied overhead cost, or \$ 15 , 000 ( = \$ 60 , 000 × 25 % ) , also remains in Finished Goods. Similarly, 75% of Job A's gold medallions ( = 750 ÷ 1 , 000 ) were sold during April; thus, 75% of Job A's applied overhead cost, or \$ 45 , 000 ( = \$ 60 , 000 × 75 % ) , is included in Cost of Goods Sold. In step 2 of Exhibit 3--12, the amounts of applied overhead cost in Work in Process (\$30,000), Finished Goods (\$15,000), and Cost of Goods Sold (\$45,000) are each stated as a percent of the total manufacturing overhead cost applied to production during the (\$90,000). In other words, 33.33% of the period's total applied overhead cost resides in Work in Process at the end of April. Similarly, 16.67% of the total remains in Finished Goods and 50% is included in Cost of Goods Sold. Step 3 from Exhibit 3--12 uses the percentages from step 2 to proportionally allocate the \$5,000 of underapplied overhead to Work in Process, Finished Goods, and Cost of Goods Sold. Work in Process is allocated \$1,666.50 of underapplied overhead, whereas Finished Goods and Cost of Goods Sold are allocated \$833.50 and \$2,500, respectively. Using these dollar amounts, the journal entry is recorded as follows: Note the \$5,000 credit to Manufacturing Overhead ensures this account ends the month with a zero balance. Furthermore, it bears emphasizing if Ruger's overhead had been overapplied rather than underapplied, the entry above would have been just the reverse. The Manufacturing Overhead account would have had a credit balance, thus necessitating a reversal of the debits and credits shown above. Comparing the Two Methods for Disposing of Underapplied or Overapplied Overhead Closing the underapplied or overapplied overhead to Work in Process, Finished Goods, and Cost of Goods Sold is more accurate than the simpler approach of closing it out to Cost of Goods Sold. For example, the simpler approach overstates Ruger Corporation's Cost of Goods Sold by \$ 2 , 500 ( = \$ 5 , 000 − \$ 2 , 500 ) and understates its net operating income by the same amount. A General Model of Product Cost Flows Exhibit 3--13 presents a T-account model of the flow of manufacturing costs in a job-order costing system. This model can be very helpful in understanding how manufacturing costs flow through a normal costing system and finally end up as Cost of Goods Sold on the income statement.  Summary ======= The most important concept to understand in this chapter is the flow of costs for manufacturers. Raw materials purchased from suppliers are stored in raw materials inventory until requisitioned for use in production. Direct materials are added to work in process along with direct labor and applied overhead. Once units of production are complete, their manufacturing costs are transferred from Work in Process to Finished Goods. When units of production are sold, their associated costs are transferred from Finished Goods to Cost of Goods Sold. Selling and administrative expenses are not attached to units of production. Instead, they are recorded as expenses on the income statement as incurred. Manufacturing overhead costs are applied to jobs using a predetermined overhead rate. 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---resulting in underapplied or overapplied overhead. Underapplied or overapplied overhead can be closed to Cost of Goods Sold or closed proportionally to 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 cost of goods sold must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or cost of goods sold must be adjusted downwards.