Hello class and welcome to our lecture on chapter 5, which will be looking at job order costing. So just to summarize what it is, so job order costing is a system used in management accounting to track and assign costs to specific jobs or orders. So in particular, industries with products and services that are unique or customized are those that use this system mostly.
It's a pretty simple and straightforward system, but can get complicated when we look at things like the overhead cost allocation and handling over and under applied overhead. So in this system, the costs are accumulated for each job separately, which allows businesses to accurately determine the cost of each individual product or service. So that's especially important when you have... unique items and you're performing a service for one group or person in particular at a time. So let's look at our learning objectives for this chapter.
So first we're going to distinguish between process costing and job order costing and we'll identify the production and service processes that fit with each costing method. So we're just going to briefly touch on process costing. It's actually good.
would have been chapter 6 but we're not covering it in this course. It will be covered in the next more advanced managerial accounting course. Second, we're going to recognize the flow of cost through the job order costing system.
Third, we'll compute a predetermined overhead rate and we're going to learn how to apply that overhead using that rate. And then we're going to record some journal entries and look at T accounts as costs flow through the system. Like I said, we're going to be applying overhead using that predetermined overhead rate that we calculated in the previous step.
We're going to prepare some schedules of cost of goods manufactured. So that's part of Chapter 2. We won't be preparing it during the slides here, but you may have a question related to it in your homework. We're going to compute the over and under applied overhead cost and prepare the journal entries to close that balance out.
And we'll spend a few slides on that. And then finally, Appendix 5A, we're not going to actually cover this week. So we won't be worrying about the implications of basing predetermined overhead rate on activity at full capacity rather than estimated activity. So we're going to not worry about Appendix 5A for this week. OK, so let's get right into the content of what job order costing is.
So this chapter, we're looking at job order costing. So it's a type of product costing system. It's used when there are many different products or unique products that are produced within an accounting period. The products are manufactured to order. So essentially, the company doesn't start working on the product until the order comes in.
And the unique nature of each order requires tracing or allocating costs to each job. and maintaining the cost records for each job accurately. So we'll see how direct materials, direct labor, and manufacturing overhead are applied to each of the jobs and how they're tracked according to those jobs.
So some of the examples of companies that use this type of costing system are aircraft manufacturers because each aircraft is such a large project. It'll have its own unique costs associated with it. Companies like construction companies will have their costs associated to that specific job.
And then a company like Hallmark, who works on unique greeting card designs, would have a somewhat job order costing system. Although if they're producing multiples of the same card design, then that becomes a process costing system. And we'll explain why that is in a second.
But... If you're looking at the actual design of the greeting card, it would have a unique, it would be a unique job up to the point where it's mass produced. Okay, and some, this is an example of a car garage, which is essentially a perfect kind of job order costing system.
So in this case, the cost object is the car and all the costs associated with it. Modifications to the car or repairs are tracked according to a unique job number. So think about an auto mechanic.
They will have specific costs associated with the work that's performed on your car and it will be shown in their work order and invoice what kind of work was done. So they'll have labor and materials. They usually generally don't show you their overhead allocation because that's usually worked into...
the cost per hour for labor and markup on their parts. But if you're working in a company that is doing custom jobs or creating custom automobile modifications, they would have that cost in the background to be able to charge the correct value or correct price to the consumer to cover those costs. Okay, so quickly we'll talk about process costing. So if the company produces many units of a single product, and the biggest way to distinguish this is whether you can tell between the first product and the 100th product. So if you can't tell the difference between the various products, that means that they're all identical.
That means it's usually a process costing system. So the identical nature of each unit of product enables assigning the same average cost per unit. So you're not going to be having major differences between each of the iterations of the product.
So the costing can just be divided by the number of products that are produced. Okay, and some different companies that might use this type of system are a cement manufacturer. So you can't tell between the first bag of cement and the 100th bag, a oil refinery, and then a Coca-Cola mixing and bottling facility. This is just an example of a bottling facility. So you see that all the bottles look identical.
And so therefore, the costs associated with production can just be taken as the total manufacturing cost divided by the number of products that are produced. So each bottle will be assigned the same costs so that it's easier to price and easier to manage the distribution of costs. Okay, and this is just a little quick check just to double check that we know what we're talking about. So which of the following types of companies would be likely to use a job order costing rather than a process costing system? So let's look at the first one, Scott Paper Company for Kleenex.
So every box of Kleenex has produced pretty much looked the same, the exact same. So we can say that their process costing system, an architect, they would work on a job. basis because each job will have different requirements in terms of the labor and overhead needed so they would be working on a job order system.
Heinz for ketchup each bottle of ketchup would be the same so that would be a process costing system. A caterer for a wedding reception every wedding reception is different so they would have to work on a job to job basis so that'd be a job order costing system and then a builder of commercial fishing vessels. So they wouldn't be producing the same fishing vessel over and over again. So they're likely going to be using a job order costing system, especially if they're larger commercial fishing vessels.
A good example, if you can think about cruise ships, cruise ships are each unique. So each cruise ship has to have its own, has to be its own cost object tracking costs at that for each of the ships that are produced. Okay, so this just reiterates what we just talked about, the three types of manufacturers that are using job costing systems.
Okay, so let's look at how a job order costing system works. So starting from the order, the company receives an order and a unique job number is assigned to track the costs. So we'll accumulate our costs, meaning the direct materials, direct labor, and...
overhead at that job number or for that job number. So direct materials and direct labor can be charged right to that specific job but overhead because it's such a large portion of the cost and also is not directly tied to the activities we need to use a predetermined overhead rate to be able to apply that overhead to the jobs according to some activity base. So a common one is labor hours because usually these types of jobs are labor intensive so they would be a good estimation of the amount of overhead that would be used.
Once the job is finished then the total costs that we accumulated so materials labor and overhead are totaled and that'll basically give us the total cost for the job. And then we price the total job depending on what markup the company wants to charge to the end consumer. So let's look at what these look like in terms of a visualization.
So we have first the The job order costing direct materials and direct labor. So direct materials are usually the raw materials used specifically for a particular job. So the cost of these materials are directly traceable to the job. Also directly traceable is labor, direct labor.
So this refers to the wages paid to the workers that are directly involved in producing a specific product or completing a specific service. So for instance, a lawyer. So like materials, these labor costs are usually traceable to the particular job.
So for manufacturing overhead, this would include your indirect materials and indirect labor, as well as other overheads such as factory utilities, rent, equipment depreciation. So those costs are allocated to the jobs using a predetermined overhead rate. So let's go back to direct materials and talk about how that is performed and how those costs are traced to each job.
So we want to measure the direct materials or raw materials that we're acquiring through a materials requisition form. So this specifies the type and quantity of materials that we're going to be using. and what's going to be withdrawn from our storeroom. So it identifies the job that these materials are going to and how much is going to be used for them.
So it controls the flow of materials into production, but also makes or allows us to track the flow of costs as well. So let's see what one of those looks like. So this is just a simple example taken from the textbook.
So for materials requisition, they each have their own unique identifier. date, what job number they were going to be charged to, and what department is taking that charge. So we can describe the material that we're taking, how many of the items are being taken, what's the unit cost for each, and then what's the total cost for all of the materials that we're using.
So that amount, the $660 that we see here, that'll be moved to a job cost sheet. So the job cost sheet will track materials, labor, and overhead for the overall job. So let's see what that will look like. So this is the job cost sheet. So right now this is showing the direct materials and the direct labor which we haven't talked about yet.
But let's focus on the direct materials. This just shows what the requisition number was that we associated with this direct materials and the amount that's been charged. Okay so let's talk about the direct labor next. And for direct labor, the cost is handled in a similar way, except we don't use a requisition form. We use basically a timesheet.
So these are all the labor charges that are easily traced to a particular job, not the indirect labor, but the direct labor. And so they get posted to the job cost sheet through a time card or time ticket. which they refer to here.
So let's see what the time ticket looks like. So the time ticket has a unique identifier, it has the employee name, the date, and what station they worked in, and then these hours that this employee works are traced to specific job numbers that they're working on. So for instance from 7 a.m to 12 30 they're working on job 2B47.
From 1230 to 230, they're working on, sorry, the first one was 7 to 12. And then 1230 to 230, they're working on 2B50. And then from 230 to 330, they're working on maintenance. So that would be more of a general work. So that would be an indirect labor amount.
So the two direct labor amounts can be put onto a job cost sheet. And we saw that in the previous slide where it showed the direct labor hours. and the cost associated with that.
So the next step would be to calculate the overhead amounts that are going to be charged to each job. So to compute this predetermined overhead, or this overhead, we need to come up with a predetermined overhead rate. So this is the amount that each allocation base unit will cause in terms of costs for each specific job. So we need to know what the allocation base is. And usually, like I said, that's direct labor hours when you're dealing with a job order costing system.
You can also measure by labor hours or machine hours. So that's what's used to assign the manufacturing overhead. So the allocation base, we're going to use that to first calculate and predetermine overhead rate. And then we use that allocation base again to apply it. So we do this because it's not possible or it's too difficult to trace overhead costs to specific jobs.
So that's things like... electricity, rent, smaller materials like indirect materials, and labor that works generally throughout the factory. So the manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager's salary.
So lots of types of manufacturing overhead costs are fixed even though output fluctuates during the period and the timing of payment of manufacturing overhead costs often varies. So we can't get an accurate estimation of a cost of a job during an accounting period because we don't have all of the manufacturing overhead costs measured in terms of what the actual amount is. So that's why we need that applied amount.
That applied amount is an estimation of the overhead at a particular time during the accounting period. Okay, so this slide shows... our calculation of the predetermined overhead rate. This calculation takes place prior to the accounting period starting and it is made up of the estimated total manufacturing overhead cost.
So that'll be predicted at the beginning of the accounting period and then they'll also predict the total units in the allocation base. So for example, if we had a total manufacturing overhead cost estimation of a million dollars for the upcoming year then we would have an estimated total number of labor hours as say 100,000 then that predetermined overhead rate can be calculated as $10 per labor hour so then during the accounting period we can calculate how many direct labor hours actually are recorded and that actual amount of direct labor hours will be calculated by or multiplied by that ten dollars per labor hour to give us an applied overhead amount which is an estimation of the amount of overhead that is going to be applied or allocated to our jobs so for instance the one job where we had say it was uh 10 labor hours for one particular job, then we multiply that by the rate, predetermined overhead rate of $10 per labor hour. And that means that we would have $100 of applied overhead for that specific job.
So that occurs over many, many jobs. And by the end of the year, we will have a total amount for both the actual overhead that's measured and the applied overhead that we are estimating. So let's look at another example.
Here we have our calculation again for predetermined overhead rate. In this case, we are estimating that we will have $320,000 worth of manufacturing overhead, and we're also estimating that we'll have 40,000 direct labor hours for the upcoming accounting period. So when we perform this calculation we get $8 per direct labor hours for each direct labor hour. And if we had a total of 27 direct labor hours charged to a specific job, in this case to be 47, then a total of $216 of overhead would be allocated to that job. So let's see how that looks on our updated job cost sheet.
So here we can see that we have the direct labor and direct materials amounts. here and our direct labor was calculated according to the 27 hours that are allocated to it and then direct materials were based on our requisition sheet and then we use the 27 hours of direct labor to calculate our total manufacturing overhead that's allocated to this job so that's performed here and you can see that our cost Driver is the direct labor and the manufacturing overhead is calculated based on that and our predetermined overhead rate, which we calculate at the beginning of the accounting period. So why do we need this predetermined overhead rate?
So we use this rate because we need to estimate the total job costs. at any point during the accounting period. The actual overhead for the period is not known until the end of the accounting period, whatever it happens to be. It could be a month, it could be a year.
And the predetermined overhead rate is based on estimates rather than actual results. But that allows us to get timely information that will allow us to make decisions. So the predetermined overhead rate is computed before the period begins and used to apply overhead costs to jobs throughout the year. So because these are estimates, there's going to be a difference between the applied amount of overhead or estimation and the actual results that we'll see at the end of the accounting period.
So in this type of system, it's very important to choose the correct allocation base for the overhead cost allocation. So we want to make sure that the cost driver that we're picking is. It has a causal relationship with the amount of overhead costs that's being accumulated. So the allocation base used for predetermined overhead rate should drive the overhead cost.
So in an environment like a custom job shop, we will see that a lot of the overhead is driven by direct labor hours. If you're in a manufacturing environment that uses a lot of machinery, then machine hours might be the better allocation base. But the cost driver is a factor that causes overhead costs to occur. So that causal relationship is very important.
If the base use doesn't drive the cost, then the results will be inaccurate overhead rates and distorted product costs. So in our case, the most common allocation base is direct labor hours for. these type of job costs. You can also use direct labor costs as your cost driver, but both of them are related to the use of labor and the fact that labor is very intensive in terms of custom job work, especially in the service industry. So let's look at how this affects the computation of the unit cost.
So the average unit cost should not be interpreted as the cost that would be actually occurred if we had an additional unit that were produced. So the average unit cost means that the total cost to produce all the units divided by the number of units. That's what it means. But this average cost doesn't reflect what it would cost to produce one additional unit. And this is because if you make one more unit, fixed costs like rent, equipment, etc. won't increase.
So the cost of producing that extra unit will be less than the average unit cost. So therefore, the extra cost is only from things like materials and labor, not from overhead costs that are already covered. And we'll see that in our short term decision making chapter when we're looking at special orders. So we can actually quote a lower than expected price to.
potential customers because we don't have to worry about covering fixed costs again. So in simpler terms producing one more item usually costs less than the average up to that point because fixed costs don't change when we produce that one additional item. So this just goes through a little quick check in terms of calculating the cost of a job. So for job WR53 at NWFAB Incorporated, they require $200 of direct materials and 10 labor hours at $25 per hour. So that's $250.
The estimated total overhead for the year was $760,000 and the estimated direct labor hours were $20,000. So the overhead is allocated based on labor hours, so what would be recorded as the cost for this job? So very quickly, we know that we're looking at the individual job, so we have $200 in material and $250 in labor right away. And then we first, to get the overhead, must calculate a predetermined overhead rate, which would be the $760,000 divided by $20,000, so $38 per hour.
And since we have 10 direct labor hours associated with this job, we can multiply that by the $38 to get $380. And so that should give us $830 total dollars for this job. So this is how that breakdown looks. So again, starting with the predetermined overhead rate.
So $760,000 divided by 20,000 hours gets you $30 to $8 per hour. Direct materials were given. Direct labor we multiply by 20. we multiply 25 by 10 hours and then finally for manufacturing overhead we multiply 38 by 10 hours so that gives you the total cost for that specific job okay and this slide just summarizes the flow of documents so some of the documents we've already talked about on the left hand side we see that there's a sales order so the sales order is prepared as a basis for issuing a production order the production order initiates the work on the job And then the costs are flowing through our next three documents.
So we have the materials requisition form, which we saw. That'll be associated to a specific job. Direct labor, time ticket. So time tickets will involve many jobs and that the employees will work and those jobs will be associated with a specific job.
So those costs will be tied to that. Then we have our predetermined overhead rate calculation. So these are accumulated on our job cost sheet altogether, and they're prepared for the accounting period.
And the job cost sheet is the form basically that accumulates these three costs according to these three documents. So the documents contain the amount of information. or the information specific to that type of cost but everything is linked based on that job order number okay so uh from the document flow we see that there was uh some flow of costs that were occurring so in terms of tracking flow of costs it's best to look at them in terms of t accounts so we'll start off with the raw materials inventory and where the direct and indirect materials go.
So first we have our raw materials inventory so you're going to debit that amount or that account because it's inventory which is an asset and it accumulates or increases on the debit side so we purchase some materials and we're filling up our raw materials inventory so when we're ready to use some of that raw materials for our production of whatever we're making. We want to credit the raw materials inventory, so reduce it and then increase our inventory account for work in process by whatever amount we are subtracting from the raw materials inventory. So that raw materials now becomes direct materials.
We also have indirect materials that we're going to take out of the raw materials inventory as as well so that's going to decrease our raw materials inventory but increase our manufacturing overhead account so those are going to be actual amounts so that indirect material now becomes part of the manufacturing overhead so looking at that from a journal entry we can see that the The first purchase of raw materials were debited and we credited accounts payable, which is a liability. We could have also paid for it in cash, which would also have been a credit. That would reduce our cash amount on the credit side. So either way or however you want to record it, but in general, most companies will not pay in cash.
They'll pay in accounts payable and then pay the accounts payable later. so when we move the direct material or raw materials to our direct materials then we are going to increase our work and process account and our manufacturing overhead for indirect and then we're going to sorry increase our manufacturing overhead increase our work in process and decrease our raw materials inventory so that'll keep take care of both the direct and indirect amounts for both of those transfers. So next we'll look at labor costs. So we have just like with direct materials and indirect materials, we'll have direct labor and indirect labor.
So the direct labor will be basically credited from the salaries and wages payable since that's a liability and it'll be debited to our working process. So we can see that here. The indirect labor will again be credited to our salaries and wages payable and then debited to our manufacturing overhead.
OK, so then that is what that will look like. So from a general ledger point of view, we are going to be debiting our. work in process inventory and our manufacturing overhead to increase them.
And then we're going to credit our accounts payable, which is our liability. That will increase that liability for our salaries and wages payable. And then eventually we'll pay those salary and wages payable in cash. So that'll debit the payable account and credit the cash account to reduce it.
Okay, so from that, we can now move on to the manufacturing overhead amounts. So in the allocation base, we have a direct labor amount, and that amount will be usually our cost driver for how manufacturing overhead is going to be allocated, and we're going to call that amount other overhead. So the other overhead includes... All sorts of stuff that is measured, including things like property taxes, insurance, depreciation, etc. So those amounts are accumulated on the debit side, which is our actual amounts.
So remember, most of those we won't know officially what those will be until the end of the accounting period. So this is what that looks like in terms of. Our journal entries, so we have our manufacturing overhead increasing in terms of the actual amounts, and then we're crediting our different overheads that we're accumulating into that overhead account.
So once we have, this actually is occurring throughout the accounting period, it doesn't happen just at once, so those other overhead amounts are being applied all the way through the accounting period. Same with the applied amount. So this is what it would look like on a T account. And for the overhead application, we're applying throughout the accounting period.
And so that accumulates from the first day to the last day of that accounting period. And that overhead is then applied to our working process. So remember that overhead applied is an estimate. And that estimate will have to be compared to our actual amount later on. So the journal entry for this is fairly straightforward.
We're just simply going to debit our work in process inventory account and credit our manufacturing overhead. So that's what this looks like. And so when we look at the manufacturing overhead account, we have actual amounts on the left.
hand side and applied amounts on the right hand side. So those amounts are not going to be equal. So we'll look at what we do with those amounts later on because we want that account to be zero at the end of the accounting period. It's what we call a clearing account. So we need to, once we know the difference between the actual and the applied, we need to basically zero out the account so that we can start over.
at the beginning of the next accounting period. Okay, so before we get to the completion of the cost flow, we should talk about non-manufacturing costs. So these are the costs that are not related to the production itself. So these are the costs that will be expensed for the period that they're incurred.
So that means they're going directly to the income statement. So things like salary expense of employees who work in marketing, selling and admin capacities. Those are non-manufacturing employees.
Advertising expenses and things like depreciation of administrative office equipment. So again, the non-product related costs. So what happens with those in terms of our journal entries? We are simply going to expense them. So expense again is a debit account.
So it increases on the debit side and we're crediting salaries payable here when we expense our salaries. And that just means that we're going to pay it later. If it was cash, we would simply credit cash and then that would reduce the cash amount. And then same for something like an advertising expense, which would increase on the debit side and then we would increase a liability or payable and then that's your double entry accounting with that.
So those expenses will accumulate and then eventually be moved to the income statement under our salary or our selling and admin expenses. So let's go back to our manufacturing costs and look at what happens at the point where we complete the work. So here we have the T account for work in process. On the debit side or left hand side we've accumulated the direct materials, direct labor and manufacturing overhead. Once they are complete we can move those costs to the finished goods inventory.
So what we're doing is reducing the value of the work in process inventory according to those items that are complete and remember the cost associated with those completed items is called the cost of goods manufactured. Those cost of goods manufactured increase the finished goods inventory value on the debit side or left-hand side. What that looks like in terms of a journal entry is that we increase our finished goods inventory by the same amount that we decrease the work in process inventory. So as it says on the top, as the jobs are completed, the cost of goods manufactured is transferred to finished goods from work in process. The sum of all amounts transferred from work in process to finished goods represents the cost of goods manufactured for the period.
So it could be related to a single product that's completed or could be an accumulation of multiple products that are completed. So then the final stage is when we sell our items. And because it's usually a job order system, a lot of those items are already prepaid.
So think about something like a custom motorcycle. It's already sold to the customer. They may have not paid the full amount yet, but in most instances we don't have to worry about items sitting in inventory. We're not going to create unique items just to have them sit there.
So when the item is moved from the finished goods to the cost of goods sold, we are going to decrease the finished goods amount and increase the cost of goods sold amount. And of course, the cost of goods sold is the amount that goes to our income statement. So we have the completed job now.
Once the job is finished, the total cost for the job, materials, labor, and overhead is added together. We transfer the cost from our finished goods inventory to our cost of goods sold, and that goes to our income statement. So what does that look like in terms of journal entries?
So we have the journal entry for accounts receivable and sales. So that means that's the customer paying for their amount or paying the amount to have the product delivered. So they may pay with cash.
So if they paid with cash, we would simply replace accounts receivable with cash and that would increase on the debit side. And then sales is a revenue. So that increases on the credit side.
Then we have our cost of goods sold, which increases like we saw in the T accounts. and then our finished goods inventory decreases by that same amount. So the cost of goods sold amount is what's going to be appearing on our income statement. So here are some, we'll talk about quickly some complications with overhead application and that's related to our overhead costs. And that's because our actual and our applied overhead costs are rarely the same amount.
Okay, so the difference between the overhead cost applied which is on the credit side of the overhead clearing account and the actual overhead cost, which is the debit side of the overhead clearing account. We have to do something about that because it'll either be over applied or under applied. So what it means when it says over applied, that means that the credit side is higher than the debit side. So that means the applied amount is higher than the actual amount.
If it's underapplied, that means that the credit side is lower than the debit side. So that means that the applied amount is lower than the actual amount. So again, just to summarize, the underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of actual overhead. Overapplied.
is the opposite case when the applied amount according to our predetermined overhead rate is greater than the actual amount. So what do we do in these instances? So let's look at an example where we have an actual overhead for the year of $650,000 and the total of $170,000 direct labor hours that were worked on jobs. And our rate for... applying overhead to the jobs is $4 per direct labor hour.
So if we perform that calculation, we end up with $680,000 of applied overhead. So when we compare the actual overhead with the applied overhead, we end up with a $30,000 difference. And because the applied overhead is higher, we can say that it's over applied.
by $30,000. And on the bottom right hand side, you can see the manufacturing overhead clearing account where the actual amount paid out is $650,000. And that's always going to be on the credit or sorry, the debit side. So the left hand side, and then the amount applied is $680,000, which will always be on the credit side or right hand side. So in this case, because the applied amount is higher than the actual amount, we have we can say that is over applied.
So what does this mean? It means that that $30,000 can't just be left as is. Because this is a clearing account, we want to make sure that its balance is zero at the end of the month, or whatever the accounting period is. So that means we have to credit that manufacturing overhead account by $30,000. So if we're going to credit that T account, then what account are we going to debit?
And there's a couple of different options. But we'll talk about quickly why this disposition is important, and it's actually related to accounting standards. So according to current accounting standards applicable in Canada, so this is International Accounting Standard 2, it states that the unallocated overheads are recognized as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost. So this is related to external reporting and in particular the valuation of inventory.
So when a company has overhead costs that aren't assigned to products, these costs are recorded as expenses in the period that they happen. Also when production levels are unusually high, the company reduces the overhead cost per product to avoid making the inventory appear more expensive than it actually is. So let's see how we are going to dispose of this.
So the balance of the The manufacturing overhead account must be treated in one of two ways. So if the overhead is underapplied or overapplied by a small amount, the remaining balance can be closed out to the cost of goods sold alone. So that just means adjusting the cost of goods sold amount by whatever the over or under application is. If it's a very large amount, then you may have to remove the balance and allocate it among three different accounts, including cost of goods sold. but also including work in process and finished goods your other two inventory accounts related to production in the proportion to the overhead applied during the current period in those accounts so let's look at that quickly of how let's look at both of them both methods first we'll look at the simpler method which is the uh applying the or allocating sorry disposing of the over or under applied overhead to the cost of goods sold amount account.
So this is the simplest method and is often used when the amount of over or under applied overhead is relatively small or doesn't have a significant impact on financial reporting. So for over applied overhead we debit or reduce the manufacturing overhead. So over applied means that there's a higher amount on the credit side.
So we're debiting the manufacturing overhead and crediting cost of goods sold. So this adjustment reduces cost of goods sold which increases your gross margin and in turn your net income because what happened when we over applied is that we made the cost of goods sold appear higher than it actually is so we want to reduce that amount. For under applied that means that we are making the cost of goods sold appear lower than it actually is we need to increase that cost of goods sold.
And then we will credit the manufacturing overhead account, the amount that it's underapplied, and that will bring it back down to zero. So that adjustment increases cost control, which decreases your net income. And you can see how if you left it as it is, you would have an inflated net income that actually isn't true to what your business actually did.
So that would be an overstatement on financial reporting, and that could cause... an audit. It could cause other issues with external stakeholders.
So you want to make sure that your accounting is sound. So this method is straightforward and corrects the overall profitability for the period by adjusting that cost of goods sold. So what does that look like in terms of T-accounts? We'll just look at the over-applied instance. So in this case, we would have an over applied amount of $30,000.
So we want to debit the manufacturing overhead by $30,000. And then in turn credit the cost of goods sold by $30,000. So what that does is it, because it was over applied, we want to reduce the cost of goods sold amount.
So we reduce that amount by crediting it. So that unadjusted balance now decreases to an adjusted balance. which will in turn cause you to have a higher gross margin than you thought you did, and also a higher net income than you thought you did.
So let's look at the other method, which is allocating it among three different accounts. So the three accounts we're looking at are work in process, finished goods, and cost of goods sold. So when the value of over-applied or under-applied overhead is large, so we say that it's material, and that...
A materiality test is set by the corporation or organization or company, whatever the instance may be. They may set a rule that says if it's greater than 1% of revenue, then it's material. So that means it's going to have a significant impact on financial reporting. So it's better to distribute the amount or prorate it over these three accounts. rather than have it disposed of directly to cost of goods sold.
So the accounts we're working with are shown here working process finished goods and cost of goods sold. So what we want to do is take each of these accounts and find out what percent of the total amount of applied overhead is that they incurred. So in this case we had 10 percent of the applied overhead was allocated to work in process, 30% to finish goods, and 60% to cost of goods sold. So when we allocate the $30,000, we multiply that percentage by $30,000 to get the amount that will be allocated to each of those accounts.
And because this is an over-applied amount, we're going to, again, debit our manufacturing overhead and credit these three accounts. So when we do that in terms of our journal entry, we end up with higher values for all three or for the two inventory counts plus our cost of goods sold. So that means that we will still have a reduction. So we're crediting cost of goods sold. We'll still have a reduction in the value of cost of goods sold by $18,000 this time rather than the $30,000 that we would have if we use the other method.
And again, this is... if the amount that you're dealing with in terms of over or under applied is a large amount. So that means it's material.
And in any questions that we do related to this type of stuff, I will tell you whether the amount of over or under applied overhead is material or not. So you won't have to worry about determining that yourself. It will be given to you in each question. So the other thing to note about the allocation through using the prorated method is that the method is more precise and ensures that the inventory accounts are not misstated. Especially this is especially important for financial reporting purposes.
So let's look at a quick example of a over or under applied amounts. So we have a we have Tiger Inc. They had actual manufacturing overhead of 1.21 million. So actual goes on the left hand or debit side of the account.
The overhead rate was $4 per machine hour and they work 290,000 machine hours. So in order to get the applied amount, we're going to multiply $4 by 290,000 machine hours. So that amount will be about 1.16 million.
So that means that it's the applied amount will be lower than the actual amount. So it'll be under applied. So we can already see that it's going to be either B or D. So let's look at the calculations for this and see what we end up with. So when we look at the calculation, we're taking the predetermined overhead rate, multiplying it by 290,000 hours to get the 1.16 million of applied overhead.
And again, that's the amount that goes on the right hand or debit. or sorry, right hand or credit side of the T account. When we look at the comparison, we see that we are underapplied.
And in this case, we're underapplied by $50,000. So that's your answer for this quick check question. Okay, and this chart just shows a summary of the overhead costs and what we've talked about so far.
So at the beginning of the... accounting period we want to take the total estimated manufacturing overhead cost and divide it by the total estimated units in our allocation base so remember that's usually going to be direct labor hours that'll give you your predetermined overhead rate you use your predetermined overhead rate and multiply by the actual total units of the allocation base that incurred that were incurred during the period and that'll get you your applied manufacturing overhead So that manufacturing overhead at the end of the accounting period is compared with the actual manufacturing overhead to get you whether get you your over or under applied overhead amount. If that overhead amount is material, then you will allocate across the three accounts. And if it's immaterial, then you'll write it off to the cost of goods sold. So this chart is a little different than what we talked about.
It's basically saying that if it's. over applied you go to the three accounts but we want to make sure that if it's not material that we're not applying it across the three because that's just extra work so you can write it off to cost of goods sold in both instances so this one cube should be asking whether it's material or not. So this chart just summarizes the cost flows.
So we're talking from the raw materials, we'll see that we're crediting out our direct and indirect materials. Indirect is going to manufacturing overhead and direct is going to work in process. We're doing the same for salaries and wages payable. Indirect salary and wages goes to manufacturing overhead and direct goes to work in process.
When we look at the manufacturing overhead account, we have an actual amount of manufacturing overhead on the debit side. So remember that amount doesn't, we won't know that exact amount until the end of the accounting period. And then we're crediting the applied amount on the right hand side or credit side. And that's the amount we use to calculate product cost.
So that's the amount that goes into our work in process. The work in process indirectly becomes our cost of goods sold through our finished goods account. And that cost of goods sold will be adjusted after, depending on whether we use the prorated method or the direct to cost of goods sold method, it'll be adjusted according to our over or under applied overhead at the end of the accounting period. So when we look at, again, I basically talked through all these, but the next few slides just shows each different account that I talked about. So the raw materials first, the salaries and wages payable first, and then the manufacturing overhead.
And then that becomes your work in process, which then becomes your finished goods. And then finally, your cost of goods sold, which is. the one that we adjust according to our over or under applied amount. Okay, so what happens when there's multiple predetermined overhead rates? So what we've talked about so far is a plant-wide overhead rate.
So that means that a single rate is used across all departments within a plant or a large company. But because large companies have different departments, each department might not need or want the same predetermined overhead rate. So that can be adjusted according to the department that you're working with.
And they may have different cost drivers that they want to use. They may have different allocation bases and different overhead amounts. So it's more accurate to use a specific departmental rate rather than using a plant wide rate when there's multiple departments. I believe we have at least one or two questions that look at departmental rates over plant wide rates in our example problems.
OK, next, we'll just quickly look at job order costing and service companies. And as you can see, they are something that fits really well with these type of organizations. So accounting firms, hospitals, airlines and repair shops are what they are referring to. But if you think about something like a repair shop for a car, like a mechanic, or an accounting, or sorry, or a lawyer, any one of those service companies would be looking at the client as the cost object, and then usually the number of labor hours as the cost driver. So you In an accounting firm, for example, services provided to each client are classified as a job, and then the costs of providing services are accumulated day by day on a job cost sheet as the services are provided.
In a service firm, the most significant cost categories are obviously labor and overhead, so things like the cost of rent, depreciation on office equipment, salaries, etc. There's two... These two cost categories are often blended into the charge out rate.
So this is what we see as well in a mechanic shop, where they have the rate for the mechanic to perform work. That includes their salary as well as the overhead costs. So what we see in terms of the amount that's on our invoice, that's not what the mechanic is getting paid.
That includes the mechanic's salary, but... It also includes the overhead coverage of the overhead costs as well. So in these type of job order costing systems, technology is pretty important. So that is used to track costs and if you can remember back to our documents that we talked about like the requisition forms, the time sheets and the overhead cost sheets, those are all integrated into the cost, the job cost sheet and how everything is tracked in one place. And that just makes it easier to track the jobs and make sure the costs are staying associated with the right job number.
So looking at an example of a job order costing system, we'll look at a lawyer's office. So the client case is considered the job. So it's a contract, in this case, a contract dispute case for a corporate client.
The direct costs are the attorney spending or attorney salary of $400 per hour. Sorry, that's not just their salary. That includes the overhead. charge rate as well.
Paralegal services are $100 per hour and then filing fees are $500. So those fees all include both the salary of these individuals plus the overhead rate. The indirect costs that are charged to the client are $30 per direct labor hour and then the attorney and paralegal combined hours are 30 hours.
So the overhead applied is $900. So the salary that we're seeing above is actually the salary of each of these individuals, the attorney and paralegal. So the total cost of the job, you have the direct cost, which are the salaries for each of the individuals, plus the filing fees. And then the overhead applied is the $900 below. So on an invoice, the client will likely not see the.
the breakdown of the salary and the overhead they'll likely see just the total cost of the job and then a charge out rate that combines both the salary and the overhead so the client would be billed based on these costs typically with a markup for profit or based on agreed upon hourly rates so the real hourly rate say this is um ten thousand four hundred dollars in total might be much higher than the four hundred dollars that is seen by the as the lawyers per hour rate. Okay, so just to summarize what we talked about, we talked about job order costing, obviously, and how it's used in situations where organizations offer many different unique products or services. So here's some examples, some more examples. So a custom furniture manufacturer, a hospital, and then legal firms like we just talked about. Process costing is different because it's basically many different products that look the same.
So essentially one product replicated over and over again. We won't be discussing process costing any further than that. So you won't be working on Chapter 6. We'll be skipping to Chapter 7. Then manufacturing overhead costs are assigned to each of the jobs using a predetermined overhead rate. And that rate is established.
Before the accounting period starts and it's based on an estimated total manufacturing overhead divided by an estimated total allocation base, that overhead is applied to jobs by multiplying that rate by the actual amount of the allocation base that occurs during the accounting period. So this amount is accumulated over the accounting period. It's not done all at once. And as the accounting period goes on, you can tell. what the product cost is at any given period because you'll know what the estimated overhead cost is and that's why it's used so you can have that timely information to make decisions and then since the predetermined overhead rate is based on estimates the actual overhead will be different and that way that's why you'll have an over under applied overhead amounts that amount has to be disposed of so you have two methods one is straight to cost of goods sold for immaterial and then prorated over your work in process completed goods and or sorry finished goods if you want to go that name of that and your cost of goods sold and then we didn't really cover the schedule cost goods sold our goods manufactured in the slides but it is covered in the chapter so make sure you review that We have finally any over or under applied overhead of the period can be closed at the cost of goods sold.
Again, like I said, allocated amongst work in process, finished goods and cost of goods sold. And then it is reported on your at the end of the accounting period on your income statement as an adjustment to your inventory accounts and your cost of goods sold account. OK, so that concludes our lecture on Chapter 5. So make sure you're completing the exercises, the smart book exercises and the quiz for the end of the week and don't forget to complete your chapter test which is due at 7 p.m.
on Thursday.