CHAPTER FOUR

JOB ORDER COSTING SYSTEM

In order to be successful and survive, business must employ some type of product costing
system. In other words, they need to track the cost of making a product or furnishing a service.
This chapter will discuss one of the two broad product costing system; job-order costing system,
in the next chapter (chapter 5) the other product costing; process costing system will be
discussed. For now, let’s begin by distinguishing between the two systems.

Difference between Job Order and Process Costing:

As mentioned above, the two common product costing systems are: Job order costing and
Process costing systems. Job order costing system is a system of cost accumulation where there
is identifiable activity for which costs may be collected. The activity is usually specified in terms
of job work or group of tasks contributing to a stage in the production or service process. Job
order costing system allocates costs to products that are readily identifiable by individual units or
batches each of which requires varying degree of attention and skill. It is used by companies
where products are identifiable individual or batches; thus, costs attributable to a particular job
are assigned directly to it. Industries that use commonly job order costing system include:
construction, auto-repair, printing aircraft, furniture, special-purpose machinery, tax-return
preparation, and so on.

Process costing is on the other hand, used in industries where there is mass-production of
similar/identical products. This costing system averages costs over large number of nearly
identical products. It is most often found in such industries as chemicals, oils, plastics, rubber,
lumber, food processing, glass mining, cement, meatpacking, etc.

The differences between job order costing and process costing arise from two factors. The first is
that the flow of units in a process costing system is more or less continuous, and the second is
that these units are indistinguishable from one another. Under process costing it makes no sense
to try to identify materials, labor, and overhead costs with a particular order from a customer (as
we do with job order costing ), since each order is just one of many that are filled from a
continuous flow of virtually identical units from the production line. Under process costing, we
accumulate costs by department rather than by order, assign these costs uniformly to all units that
pass through the department during a period.

A further difference between the two costing systems is that the job cost sheet is not used in
process costing, since the focal point of process costing is on departments. Instead of using job
cost sheet a production report is prepared for each department in which work is done on
products. The production report serves several functions. It provides a summary of number of
units moving through a department during a period, and it also provides a computation of unit
costs. In addition it shows what costs were charged to the department and what disposition was
made on these costs. The department production report is a key document in a process costing
system. These differences are summarized below:
Job Order Costing Process Costing
1. Many different jobs are worked on during 1. A single product is produced either on
each period, with each job having different continuous basis or for long periods. All
production requirements. units of product are identical.
2. Costs are accumulated by individual job. 2. Costs are accumulated by departments.

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3. Job cost sheet is the key document
controlling the accumulation of costs by a
job.
4. Unit costs are computed by job on the job
cost sheet.
3. The department production report is the key
document showing the accumulation and
disposition of costs.
4. Unit costs are computed by department on
the department production report.

Advantages & Disadvantages of Job Order Costing & Process Costing

Costing is an accounting technique used to determine the exact expenses for materials, labor and
overhead incurred in operations. Job order costing records the actual materials and labor
expenses for specific jobs, and assigns overhead to jobs at a pre-determined rate. Process costing
applies costs to departments based on the average number of units produced per day. Job order
and process costing have unique advantages and disadvantages that make them best suited for
specific situations.

Assigning Costs
One advantage of job order costing is that it allows managers to calculate the profit earned on
individual jobs, helping them to better ascertain whether specific jobs are desirable to pursue in
the future. This is best for businesses that do highly custom work, such as construction
contractors and consultants. An advantage of process costing is that it allows managers to get
detailed information on the production statistics of individual departments or workgroups. This is
best suited for continuous manufacturing settings, such as factories and utility companies.

Record Keeping
A disadvantage of job order costing is that employees are required to track all materials and labor
used during the job. Process costing simplifies record keeping by relying on statistical
calculations rather than actual inputs. As an example, consider a construction contractor using a
job order costing system. The contractor has to keep track of all the wood, nails, screws,
electrical fixtures, paint and other materials used on the job, as well as tracking workers' lunch
breaks and hours worked. In a factory setting, on the other hand, materials are calculated using
an average of units produced, and salaries expenses are often relatively consistent between pay
periods.

Reporting
Job order costing gives managers the advantage of being able to keep track of individuals' and
teams' performance in terms of cost-control, efficiency and productivity. Process costing, on the
other hand, gives managers the advantage of being able to ascertain the same qualities in entire
departments and compare performance over time.

Unit Cost Calculation

Job order and process costing are adequate to determine the average cost of each unit produced.
The formula for unit cost calculation in a job order costing system is: Unit Cost = Total Job
Cost / Number of Units Produced in Job. In many cases, such as the construction contractor
example, only one unit is technically being produced per job—in this case one deck or one
bathroom remodeling. The formula for unit cost calculation in a process cost system is: Unit Cost
= Department's Periodic Cost / Number of Units Produced in the Period. Unit cost considerations
are generally more relevant in situations suited for process costing.

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Accounting for Job order costing system
Job order costing system is used in situations where many different products are produced each
period. For example clothing factory would typically made many different types of jeans for both
men and women during a month. In a job order costing system, costs are traced to the 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.

Job order costing system is also extensively used in service industries. Hospitals, law firms,
movie studios, accounting firms, advertising agencies and repair shops all use a variety of job
order costing system to accumulate costs for accounting and billing purposes. The details here
deal with a manufacturing firm, the same concept and procedures are used by many service
organizations.

The record keeping and cost assignment problems are more complex in a job order costing
system when a company sells many different products and services than when it has only a single
product or service. Since the products are different, the costs are typically different.
Consequently, cost records must be maintained for each distinct product or job. For example an
attorney in a large criminal law practice would ordinarily keep separate records of the costs of
advising and defending each of his/her clients. And a clothing factory would keep separate track
of the costs of filling orders for particular styles, sizes, and colors of jeans. A job order costing
system requires more effort than a process costing system. Companies 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 costing system, we will see how each of these three
types of costs is recorded and accumulated.

1. Measuring Direct Materials Cost in Job Order Costing System: At the beginning of
production process a document known as bill of materials is used for standard products. "A
bill of materials is a document that lists the type and quantity of each item of materials
needed to complete a unit of standard product". 
2. Measuring Direct Labor Cost in Job Order Costing System: Direct labor cost is
handled in much the same way as direct materials cost. Direct labor consists of labor
charges that are easily traced to a particular job. Labor charges that cannot be easily traced
directly to any job are treated as part of manufacturing overhead.
3. Application of Manufacturing Overhead: Manufacturing overhead must be included
with direct labor on the job cost sheet since manufacturing overhead is also a product cost.
However, assigning manufacturing overhead to units of product can be a difficult task. 
4. Job Order Costing System - The Flow of Costs: To understand the flow of costs in job
order costing system, we shall consider a single month's activity for a company, say for
instance, a producer of product A and product B. 
5. Multiple Predetermined Overhead Rates: When a single predetermined overhead rate is
used for entire factory it is called plant wide overhead rate. This is fairly common practice -
particularly in smaller companies. 
6. Under-applied overhead and over-applied overhead calculation: Since the
predetermined overhead rate is established before a period begins and is based entirely on
estimated data, the overhead cost applied to work in process (WIP) will generally differ
from the amount of overhead cost actually incurred during a period. 

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 7. Disposition of any balance remaining in the manufacturing overhead account at the
end of a period: What disposition should be made of an under-applied overhead or over-
applied overhead balance remaining in the manufacturing overhead account at the end of a
period?
8. Predetermined Overhead Rate and Capacity: Companies typically base their
predetermined overhead rates on the estimated, or budgeted, amount of allocation base for
the upcoming period. This is the method that is used in this chapter, but it is practice that is
recently come under severe criticism. An example will be very helpful anyway.
9. Recording Non - manufacturing Costs: In addition to manufacturing costs, companies
also incur marketing and selling costs. These costs should be treated as period expenses and
charged directly to the income statement and therefore should not go into the
manufacturing overhead account. 
10. Recording Cost of Goods Manufactured and Sold: When a job has been completed, the
finished out put is transferred from the production department to the finished
goods warehouse. By this time, the accounting department will have charged the job with
direct materials and direct labor cost and manufacturing overhead will have been applied
using the predetermined overhead rate.
11. Job Order Costing in Services Companies: Job order costing is also used in service
organizations such as law firms, movie studios, hospitals, and repair shops, as well as
manufacturing companies. 
12. Use of Information Technology in Job Order Costing: Bar code technology can be
used to record labor time--reducing the drudgery (hard boring work) in that task and
increasing accuracy. Bar codes also have many other uses. In a company with a well-
developed bar code system, the manufacturing cycle begins with the receipt of a customer's
order in electronic form.

To illustrate and understand the flow of costs in job order costing system, we shall consider a
single month's activity for a company; say for instance, a producer of product A and product B.
The company has two jobs in process during April, the first month of its fiscal year. Job 1, of
1000 units of product A was started in March. By the end of March, $30,000 in manufacturing
costs had been recorded for the job 1. Job 2 an order for 10,000 units of product B was started in
April.

The Purchase and Issue of Materials:

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

Raw Materials 60,000

Accounts Payable              60,000
Raw materials are an asset account. Thus, when raw materials are purchased, they are initially
recorded as an asset-not as an expense.

(1) Issue of Direct and Indirect Materials:

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During April, $52,000 in raw materials was requisitioned from the storeroom for use in
production. These raw materials include both direct and indirect materials. Entry (2) records
issuing the materials to the production department.

Work in Process 50,000

Manufacturing Overhead 2,000
  Raw Materials   52,000

The materials charged to work in process (WIP) represent direct materials for specific jobs. As
these materials are entered into the work in process account, they are also recorded on the
appropriate job cost sheets. This point is illustrated in Exhibit 4.1; where $28,000 of the $50,000
in direct materials is charged to Job 1 cost sheet and the remaining $22,000 is charged to job 2
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) represents indirect materials used in
production during April. Observe that the manufacturing overhead account is separate from work
in process account. The purpose of the manufacturing overhead account is to accumulate all
manufacturing overhead costs as they are incurred during a period.

Before leaving Exhibit 2.1 we need to point out one additional thing. Notice from the exhibit that
the job cost sheet for job 1 contains a beginning balance of $30,000. We stated earlier that this
balance represents the cost of work done during March that has been carried forward to April.
Also note that work in process account contains the same $30,000 balance. The reason the
$30,000 appears in both places is that the work in process account is a control account and the
job cost sheets form a subsidiary ledger. Thus, the work in process account contains a
summarized total of all costs appearing on the individual job cost sheet for all jobs in process at
any given point in time. (Since the company had only job 1 in process at the beginning of April,
job 1's $30,000 balance on that date is equal to the balance in the work in process account.
Exhibit 4.1

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Issue of Direct Materials Only:
Sometimes the materials drawn from the raw materials inventory account are all direct materials.
In this case, the entry to record the issue of the materials into production would be as follows:
Work in process XXX
  Raw materials   XXX

Labor Cost:
As work is performed each day in various departments of the company, employee time tickets
are filled out by workers, collected, and forward to the accounting department. In the accounting
department, wages are computed and the resulting costs are classified as either direct or indirect
labor. This costing and classification for April resulted in the following summary entry (3):

Work in process 60,000

Manufacturing overhead 15,000
  Salaries and wages payable   75,000

Only direct labor is added to the work in process account. In this example, direct labor is $60,000
for April.

At the same time the direct labor costs are added to work in process, they are also added to the
individual job cost sheets, as shown in the Exhibit 4.2. During April, $40,000 of direct labor cost
was charged to job 1 and the remaining $20,000 was charged to job 2. The labor cost charged to
manufacturing overhead represent the indirect costs of the period, such as supervision, janitorial
work, and maintenance.
Exhibit 4.2

Manufacturing Overhead Costs:

All costs of operating the factory other than direct materials and direct labor are classified as
manufacturing overhead costs. These costs are entered directly into the manufacturing overhead
account as they are incurred. To illustrate, assume that the company incurred the following
general factory costs during April, on account:

6
 Utilities (heat, water, and power) $21,000
Rent on factory equipment 16,000
Miscellaneous factory costs 3,000
Total $40,000
The following entry (4) records the incurrence of these costs:
40,000
Manufacturing overhead
  Accounts Payable   40,000

In addition, let us assume that during April, the company recognized $13,000 in accrued property
taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The
following entry (5) records these items:

Manufacturing overhead 20,000

  Property taxes payable   13,000
  Prepaid insurance   7,000

Finally let us assume that the company recognizes $18,000 in depreciation on factory equipment
during April. The following entry (6) records the accrual of this depreciation:

Manufacturing overhead 18,000

  Accumulated Depreciation   18,000

In short, all manufacturing overhead costs are recorded directly into the manufacturing overhead
account as they are incurred day by day through a period. It is important to understand that
manufacturing overhead is a control account for many--perhaps thousands--of subsidiary
accounts such as indirect materials, indirect labor, factory utilities, and so forth. As the
manufacturing overhead account is debited for costs during a period the various subsidiary
accounts are also debited. In this example, I omit the entries to the subsidiary accounts for the
sake of brevity.

Calculation of Predetermined Overhead Rate and Application of

Manufacturing Overhead to Work in Process (WIP)
Since actual manufacturing costs are charged to the manufacturing overhead control account
rather than work in process account. How are manufacturing costs assigned to work in
process? The answer is, by means of the predetermined overhead rate. A predetermined
overhead rate is established at the beginning of each year. The predetermined overhead rate is
calculated by dividing the estimated total manufacturing overhead cost for the year by the
estimated total units in the allocation base (measured in machine hours, direct labor hours,
or some other base). This rate is then used to apply overhead costs to jobs.

To illustrate assume that the company has used machine hours to compute predetermined
overhead rate and that this rate is $6 per machine hour. Also assume that during April, 10,000
machine hours were worked on Job 1 and 5,000 machine hours were worked on Job 2 (a total of
15,000 machine hours). Thus, $90,000 in overhead cost (15,000 machine x hours $6 per machine

7
hour = $90,000) would be applied to work in process. The following entry (7) records the
application of manufacturing overhead to work in process:

Work in process 90,000

  Manufacturing overhead   90,000
The flow of cost through the manufacturing overhead account in Exhibit 2.3

Exhibit 4.3

The actual overhead costs in the manufacturing overhead account in Exhibit 4.3 are the costs that
were added to the account in entries (2)-(6).  Observe that the incurrence of these actual
overhead costs and the application of overhead to work in process represent two separate and
entirely distinct processes.

The Concept of Clearing Account:

The manufacturing overhead account operates as a clearing account. As I have noted, actual
factory overhead costs are debited to the accounts as they are incurred day by day through the
year. A certain intervals during the year, usually when a job is completed, overhead cost is
applied to the job by means of the predetermined overhead rate, and work in process is debited
and manufacturing overhead is credited. This sequence of events is illustrated below:

Manufacturing Overhead (a clearing account)

Actual overhead costs are charged to this Overhead is applied to work in process using
account as they are incurred throughout the the predetermined overhead rate.
period.

As we emphasized earlier, the predetermined overhead rate is based on estimates of what

overhead costs are expected to be, and it is established before the year begins. As a result, the
overhead cost applied during a year will almost certainly turn out to be more or less than the
overhead cost that is actually incurred. For example, notice from Exhibit 4.3 that the company's
actual overhead costs for the period are $5,000 greater than the overhead cost that has been
applied to work in process (WIP), resulting in a $5,000 debit balance in the manufacturing

8
overhead account. This debit balance in manufacturing overhead account is called under-applied
overhead. Any credit balance in manufacturing overhead account is called over-applied
overhead. Any balance in the manufacturing overhead account (under or over-applied overhead)
is treated in one of the following ways:
1. Closed out to cost of goods sold
2. Allocated between work in process, finished goods, and cost of goods sold in proportion
to the overhead applied during the current period in the ending balance of these accounts.

These two methods are illustrated on Disposition of Under- or Over-applied Overhead Balances
page. For the moment, we can conclude by nothing from Exhibit 4.3 that the cost of a completed
job consists of the actual materials cost of the job, the actual labor cost of the job, and the
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, appear on the job cost sheet and in the work in
process account. Study this point carefully.

(8) Non-manufacturing Costs:

In addition to manufacturing costs, companies also incur marketing and selling costs. These costs
should be treated as period expenses and charged directly to the income statement and therefore
should not go into the manufacturing overhead account. To illustrate the correct treatment of
non-manufacturing costs, assume that the company (in this example) incurred $30,000 in selling
and administrative salary costs during a months, the following entry (8) records these salaries.

Salaries expense 30,000

   Salaries and wages payable   30,000

Depreciation on factory equipment is debited to manufacturing overhead account but

depreciation on office equipment is considered a period expense and is not included in
manufacturing overhead. Assume that depreciation of office equipment during the month was
$7,000. The entry (9) is as follows.
7,000
Depreciation expense
    Accumulated depreciation   7,000

Finally assume that advertising was $42,000 and that other selling and administrative expenses
during the month were $8,000. The following journal entry (10) records these items:

Advertising expenses 42,000

Other selling and administrative expense 8,000
   Accounts payable   50,000

Since the amounts in entries above all go directly into expense accounts, they will have no effect
on the costing of the company's production for the month. The same will be true of any other
selling and administrative expenses incurred during the month including sales commission,

9
depreciation on sales equipment, rent on office facilities, insurance on office facilities, and
related costs.

Cost of Goods Manufactured (CGM):

When a job has been completed, the finished out put is transferred from the production
department to the finished goods warehouse. By this time, the accounting department will have
charged the job with direct materials and direct labor cost and manufacturing overhead will have
been applied using the predetermined overhead rate. A transfer of costs is made within the
costing system that parallels the physical transfer of the goods to the finished goods warehouse.
The costs of the completed jobs are transferred out of the work in process (WIP) account and
into the finished goods account. The sum of all amounts transferred between these two accounts
represents the cost of goods manufactured for the period.

Let us assume that the job 1 was completed during the period. The following entry (11) transfers
the cost of job 1 from work in process (WIP) to finished goods.

Finished goods 158,000

   Work in process   158,000

The $158,000 represents the completed cost of job 1, as shown on the job cost sheet in Exhibit
4.3. Since job 1 was the only job completed during April, the $158,000 also represents the cost
of goods manufactured for the month. The job 2 was not completed by month-end, so its cost
will remain in the work in process (WIP) account and carry over to the next month. If a balance
sheet is prepared at the end of April, the cost accumulated thus far on the job 2 will appear as
"work in process inventory" in the assets section.

Cost of Goods Sold (CGS):

As units in the finished goods are shipped to the customers, their costs are transferred from the
finished goods account into the cost of goods sold account. If complete job is shipped, as in the
case where a job has been done to a customer's specification then it is a simple matter to transfer
the entire cost appearing on the job cost sheet into the cost of goods sold account. In most cases,
only a portion of the units involved in a particular job will be immediately sold. In these
situations the unit cost must be used to determine how much product cost should be removed
from finished goods and charged to cost of goods sold.

Assume that the company has completed 1000 units and 750 out of 1000 units have been shipped
to customers for a price of $225,000. The unit product cost is $158. Following journal entries
(12) and (13) would record the sales (all sales are on account).
Accounts receivable 225,000
  Sales   225,000

Cost of goods sold 118,5000*

  Finished goods   118,5000
($158 × 750units = $118,500*)
 With entry (13), the flow of cost through our job order costing system is completed.

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Summary of Cost Flow:
To pull the entire example together, journal entries (1) through (13), T accounts, and schedules
of cost of goods manufactured and cost of goods sold are presented below:
Journal Entries:
(1)
Raw Materials 60,000
Accounts Payable 60,000
(2)
Work in process 50,000
Manufacturing overhead 2,000  
Raw materials   52,000
(3)    
Work in process 60,000
Manufacturing overhead 15,000  
Salaries and wages   75,000
(4)
Manufacturing overhead 40,000
Accounts payable   40,000
(5)
Manufacturing overhead 20,000  
Property taxes payable   13,000
Prepaid insurance   7,000
(6)
Work in process 18,000  
Manufacturing overhead   18,000  
(7)
Work in process 90,000
Manufacturing overhead   90,000
(8)    
Salaries expenses 30,000
Salaries and wages payable   30,000
(9)
Depreciation expense 7,000
Accumulated depreciation   7,000
(10)    
Advertising expense 42,000
Other selling and administrative expense 8,000
Accounts payable   50,000
(11)    
Finished goods 158,000
  Work in process   158,000
(12)    
Accounts receivable 225,000  
  Sales   225,000  
(13)    
Cost of goods sold 118,500  
Finished goods 118,500

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T-Accounts:
Accounts Receivable Accounts Payable Capital Stock
         xx                  xx            xx
(12)  225,000  (1)      60,000
 (4)      40,000
 (10)    50,000

              
Prepaid Insurance   Salaries & Wages Payable   Retained Earnings
              xx                     xx               xx
(3)       75,000
(5)       7,000 (8)       30,000
              
Raw Materials   Property Taxes Payable   Sales
Bal.      7,000(2)   52,000        xx    (12) 225,000
(1)     60,000  (5)  13,000   
Bal.    15,000            
           Cost of Goods Sold
Work in Process Salaries expenses (13)  118500
Bal.    30,000(11)  158,000 (8)  30,000
(2)      50,000 Depreciation expenses
(3)      60,000 (9)    7,000
(7)      90,000
Bal.    72,000              
             
Finished Goods   Advertising Expenses      
Bal.     10,000(13)  118,500   (10)  42,000        
(11)  158,000

Bal.    49,000

Other Selling &

Accumulated Depreciation Administrative expenses
               xx (10)   8,000
(6)     18,000
(9)      7,000

Manufacturing Overhead
(2)        2000 (7)     90,000
(3)     15,000
(4)     40,000
(5)     20,000
(6)     18,000
Bal.      5,000

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Explanation of entries:
1) Raw materials purchased
2) Direct and indirect materials issued 8) Administrative salaries expenses incurred.
into production.
3) Direct and indirect factory labor cost 9) Depreciation recorded on office equipment.
incurred.
4) Utilities and other factory costs 10) Advertising and other expenses incurred
incurred.
5) Property taxes and insurance incurred 11) CGM transferred into finished goods.
on the factory.
6) Depreciation recorded on the factory 12) Sale of job 1 recorded.
assets.
7) Overhead cost applied to work in 13) Cost of goods sold recorded for job 1.
process.
 
XX = Normal balance in the account (for example accounts receivable normally carries a debit
balance).

Cost of Goods Manufactured:

Direct materials $50,000
Direct labor $60,000
Manufacturing overhead applied to work in process $90,000*
------------
Total Manufacturing cost incurred $200,000
Add: Beginning work in process $30,000
  ------------
  $230,000
Deduct: Ending work in process inventory $72,000
  -----------
Cost of goods manufactured $158,000
=======

Cost of Goods Sold:

Finished goods inventory beginning $10,000
Cost of goods manufactured $158,000
-----------
Goods available for sale $168,000
Deduct: Finished goods inventory ending $49,500
----------
Unadjusted cost of goods sold $118,500
Add: Under applied overhead $5,000*
-----------
Adjusted cost of goods sold $123,500
=======
*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00

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Predetermined overhead rate)
Actual overhead = $95,000
Under applied overhead = $95,000 (actual) - $90,000 (applied) = $5,000
Entry to close the $5,000 of under applied  to cost of goods sold would be as
follows:
Cost of goods sold-------------------------- 5,000
Manufacturing overhead--------------------------- 5,000

Note that the under-applied overhead is added to cost of goods sold. If

overhead were over-applied, it would be deducted from cost of goods sold.

Income Statement:
Sales (750 units@$300) $225,000
Less cost of goods sold ($ 118,500 + $5,000)   123,500
    -----------
Gross margin/profit 101,500
Less operating expenses:    
      Salaries $30,000  
      Depreciation 7,000  
      Advertising expenses 42,000  
      Other expense 8,000 87,000
Net operating income   $14,500

Under-applied and Over-applied Overhead

Exercise1: Define, explain and calculate under-applied and over-applied overhead rate. Give an
example.

Definition and Explanation of Over and Under-applied Overhead:

Since the predetermined overhead rate is established before a period begins and is based entirely
on estimated data, the overhead cost applied to work in process (WIP) will generally differ from
the amount of overhead cost actually incurred during a period. The difference between the
overhead cost applied to work in process (WIP) and the actual overhead costs of a period is
termed as either under-applied overhead or over-applied overhead. For example if a company
calculates it’s predetermined overhead rate $6 per machine hour. 15,000 machine hours are
actually worked and overhead applied to production is therefore $90,000 (15,000 hours × $6). If
actual factory overhead is $95,000 then under-applied overhead is $5,000 ($95,000 – $90,000). If
the situation is reverse and the company applies $95,000 and actual overhead is $90,000 the
over-applied overhead would be $5,000.

Causes / Reasons of under applied or over applied overhead:

The causes / reasons of under or over-applied overhead can be complex. Nevertheless the basic
problem is that the method of applying overhead to jobs using a predetermined overhead rate
assumes that actual overhead costs will be proportional to the actual amount of the allocation
base incurred during the period. If, for example, the predetermined overhead rate is $6 per
machine hour, then it is assumed that actual overhead cost incurred will be $6 for every machine
hour that is actually worked. There are actually two reasons why this may not be true. First,

14
much of the overhead often consists of fixed costs that do not grow as the number of machine
hours incurred increases. Second, spending on overhead items may or may not be under control.
If individuals who are responsible for overhead costs do a good job, those costs should be less
than were expected at the beginning of the period. If they do a poor job, those costs will be more
than expected.
Example: Suppose that two companies A and B have prepared the following estimated data for
the coming year:
             Company            
A B
Predetermined overhead rate based on Machine-hours DM cost
Estimated manufacturing overhead (a) $300,000 $120,000
Estimated machine-hours (b) for A co. 75,000 --
Estimated direct materials cost (b) for B co. -- $80,000
$4 per machine 150% of direct
Predetermined overhead rate, (a) ÷ (b)
hour materials cost

Now assume that because of unexpected changes in overhead spending and changes in demand
for the companies' products, the actual overhead cost and the actual activity recorded during the
year in each company are as follows:
                Company             
  A B
Actual manufacturing overhead costs $290,000 $130,000
Actual machine-hours 68,000 --
Actual direct materials costs -- $90,000

For each company, note that the actual data for both cost and activity differ from the estimates
used in computing the predetermined overhead rate. This results in under-applied overhead and
over-applied overhead as follows:
Company
A B
Actual manufacturing overhead costs $290,000 $130,000
Manufacturing overhead cost applied to WIP during the year:
68,000 actual machine hours × $4 per machine hour 272,000
$90,000 actual direct materials cost × 150% of direct materials
135,000
cost
------------- -------------
Under-applied (over-applied) overhead $ 18,000 $ (5,000)

For company A, notice that the amount of overhead cost that has been applied to work in process
($272,000) is less than the actual overhead cost for the year ($290,000). Therefore the overhead
is under-applied. Also notice that original estimate of overhead in company A ($300,000) is not
directly involved in this computation. Its impact is felt only through the $4 predetermined
overhead rate that is used.

For company B the amount of overhead cost that has been applied to work in process (WIP)
($135,000) is greater than the actual overhead cost for the year ($130,000), and so overhead is

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over-applied. A summary of the concepts discussed so for is presented below:

At the beginning of the period

Estimated total
Estimated total units in the Predetermined overhead
manufacturing overhead ÷ =
allocation base rate
cost 
During the period
Actual total units of the
Total manufacturing
Predetermined overhead rate × allocation base incurred =
overhead applied
during the period
At the end of the period
Total manufacturing Under-applied (over-
Actual total manufacturing
– overhead = applied)
overhead cost
applied overhead

What disposition should be made of an under-applied overhead or over-applied overhead

balance remaining in the manufacturing overhead account at the end of a period?
Generally any balance in the account is treated in one of the two ways.
1. Closed out to cost of goods sold.
2. Allocated between work in process (WIP), finished goods and cost of goods sold in
proportion to the overhead applied during the current period in the ending balances of
these account.
The second method, which allocates the under or over-applied overhead among ending
inventories and cost of goods sold is equivalent to using an "actual" overhead rate and is for that
reason considered by many to be more accurate than the first method. Consequently, if the
amount of under-applied or over-applied overhead is material, many accountants would insist
that the second method be used.

1. Closed Out to Cost of Goods Sold:

Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than
the allocation method.

Where the overhead is under-applied following journal entry is made:

Cost of goods sold   XX
Manufacturing overhead XX

Where the overhead is over-applied the following journal entry is made:

Manufacturing overhead   XX
Cost of goods sold XX

After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of
goods sold is increased by the amount of under-applied and decreased by the amount of over-
applied overhead.

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2. Allocated Between Accounts:
Allocation of under or over-applied overhead between work in process (WIP), finished goods
and cost of goods sold (CGS) is more accurate than closing the entire balance into cost of goods
sold. The reason is that allocation assigns overhead costs to where they would have gone in the
first place had it not been for the errors in the estimates going into the predetermined overhead
rate.
Example:

If the amount of under-applied or over-applied overhead is significant, it should be allocated

among the accounts containing applied overhead: Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied”
overhead mean that the balances in these accounts are quite different from what they would have
been if actual overhead costs had been assigned to production.
Allocation restates the account balances to conform more closely to actual historical cost as
required for external reporting by generally accepted accounting principles. The above
figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of
over-applied overhead among the necessary accounts; had the amount been under-applied, the
accounts debited and credited in the journal entry would be the reverse of that presented for over-
applied overhead. A single overhead account is used in this illustration.
Theoretically, under-applied or over-applied overhead should be allocated based on the amounts
of applied overhead contained in each account rather than on total account balances. Use of total
account balances could cause distortion because they contain direct material and direct labor
costs that are not related to actual or applied overhead. In spite of this potential distortion, use of
total balances is more common in practice for two reasons: First, the theoretical method is
complex and requires detailed account analysis. Second, overhead tends to lose its identity after

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leaving Work in Process Inventory, thus making more difficult the determination of the amount
of overhead in Finished Goods Inventory and Cost of Goods Sold account balances

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