Chapter 3

Job and process costing

Building-Block Concepts of Costing Systems
Before we begin our discussion of costing systems, let’s review cost-related terms and introduce
the new terms that we will need for our primary discussion.
1. Cost object—anything for which a measurement of costs is desired—for example, a
product, such as a DELL computer, or a service, such as the cost of repairing a DELL
computer.
2. Direct costs of a cost object—costs related to a particular cost object that can be traced to
that cost object in an economically feasible (cost-effective) way—for example the cost of
purchasing the main computer board or the cost of parts used to make a DELL computer.
3. Indirect costs of a cost object—costs related to a particular cost object that cannot be
traced to that cost object in an economically feasible (cost-effective) way—for example,
the costs of supervisors who oversee multiple products, or the rent paid for the repair
facility that repairs many different DELL computer products. Indirect costs are allocated
to the cost object using a cost allocation method.
Recall that cost assignment is a general term for assigning costs, whether direct or indirect, to a
cost object. Cost tracing is a specific term for assigning direct costs; cost allocation refers to
assigning indirect costs.
4. Cost pool. A cost pool is a grouping of individual indirect cost items. Cost pools can
range from broad, such as all manufacturing-plant costs, to narrow, such as the costs of
operating metal-cutting machines. Cost pools are often organized in conjunction with
cost-allocation bases.
5. Cost-allocation base. How should a company allocate costs to operate metal-cutting
machines among different products? One way to allocate costs is based on the number of
machine-hours used to produce different products. The cost-allocation base (number of
machine-hours) is a systematic way to link an indirect cost or group of indirect costs
(operating costs of all metal-cutting machines) to cost objects (different products). For
example, if indirect costs of operating metal-cutting machines is $500,000 based on
running these machines for 10,000 hours, the cost allocation rate is $500,000 ÷ 10,000
hours = $50 per machine-hour, where machine-hours is the cost allocation base. If a
product uses 800 machine-hours, it will be allocated $40,000; $50 per machine-hour and
800 machine-hours. The ideal cost-allocation base is the cost driver of the indirect costs,
because there is a cause-and-effect relationship between the cost allocation base and the
indirect costs. A cost-allocation base can be either financial (such as direct labor costs) or
nonfinancial (such as the number of machine-hours). When the cost object is a job,
product, or customer, the cost-allocation base is also called a cost-application base.
 Job-Costing and Process-Costing Systems
Companies frequently adopt one of two basic types of product costing system to assign costs to
products or services: A product costing system is a set of procedures used to account for an
organization’s product costs and to provide timely and accurate unit cost information for pricing,
cost planning and control, inventory valuation, and financial statement preparation.
 The product costing system enables managers to track costs throughout the management
process.
 It provides a structure for recording the revenue earned from sales and the costs incurred
for direct materials, direct labor, and overhead.
1. Job-costing system. In this system, the cost object is a unit or multiple units of a distinct
product or service called a job. Each job generally uses different amounts of resources. The
product or service is often a single unit, such as a specialized car made at Ford, a construction
project managed by Afro Tsion, a repair job done at Local mobile maintenance, or an
advertising campaign produced by Serawit Fikrie Promotion. Each special car made by Ford
is unique and distinct. An advertising campaign for one client at Serawit Fikrie Promotion is
unique and distinct from advertising campaigns for other clients. Job costing is also used by
companies such as Furniture producers to cost multiple identical units of distinct furniture
products. Because the products and services are distinct, job-costing systems accumulate costs
separately for each product or service.
2. Process-costing system. In this system, the cost object is masses of identical or similar units
of a product or service. For example, Dashen bank provides the same service to all its
customers when processing customer deposits. Dashen Beer and MOHA soft drinks produce
identical beer and soft drinks, respectively. In each period, process-costing systems divide the
total costs of producing an identical or similar product or service by the total number of units
produced to obtain a per-unit cost. This per-unit cost is the average unit cost that applies to
each of the identical or similar units produced in that period.
Comparison between Job costing and Process costing
Job costing Process Costing
Wide Variety of Distinct Products Homogeneous products
Costs accumulated by jobs Costs accumulated by processes or departments
Unit cost is computed by dividing total job costs by Unit cost is computed by dividing total process costs of
units produced in that job the period by the number of units produced in the period

Examples of job costing and process costing in the service, merchandising and manufacturing
sectors
Service Sector Merchandising Manufacturing
Sector Sector
Job Costing System  Accounting Firm  Sending a catalogue  Aircraft assembly
audits to a mailing list  House Construction
 Advertising agency  Special promotion
campaign of a new store
product
Process Costing  Deposit processing  Grain dealing  Oil refining
System  Postal delivery  Processing new  Beverages
magazine production
subscriptions
Features of Job Costing System
 Each job has its own characteristics and need a separate treatment.
 Each job is taken as a job unit.
 For each job, a distinct number is assigned and a separate job cost sheet if used.
 The costing department keeps a separate work in process account for each job.
 Profit or loss is determined for each job.
 The cost of production of every job is ascertained or known after the completion of each
job.
Steps to be involved in Job costing System
Step 1: Identify the Job That Is the Chosen Cost Object:
Step 2: Identify the Direct Costs of the Job.
Step 3: Select the Cost-Allocation Bases to Use for Allocating Indirect Costs to the Job.
Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base.
Step 5: Compute the Rate per Unit of Each Cost-Allocation Base Used to Allocate Indirect Costs
to the Job.
Step 6: Compute the Indirect Costs Allocated to the Job.
Step 7: Compute the Total Cost of the Job by Adding All Direct and Indirect Costs Assigned to
the Job.
 Actual Costing Vs Normal costing
Actual costing is a costing system that:
1) Traces direct costs to a cost object by using the actual direct cost rates times the
actual quantities of the direct-cost inputs.
2) It allocates indirect costs based on the actual indirect-cost rates times the actual
quantities of the cost-allocation bases. The actual indirect-cost rate is calculated by
dividing actual total indirect costs by the actual total quantity of the cost-allocation base.

As its name suggests, actual costing systems calculate the actual costs of jobs.
Yet, actual costing systems are not commonly found in practice because actual
costs cannot be computed in a timely manner. The problem is not with
computing direct-cost rates for direct materials and direct manufacturing
labor.
Normal costing is a costing system that
1) Traces direct costs to a cost object by using the actual direct-cost rates times the actual
quantities of the direct-cost inputs and;
2) Allocates indirect costs based on the budgeted indirect-cost rates times the actual
quantities of the cost-allocation bases.
The budgeted indirect-cost rate for each cost pool is computed as follows:

Budgetd Annual Indirect Costs

Budgeted Indirect Cost Rate=
Budgetd annual quantity of cost allocation base
Note:- Manufacturing Overhead application
MOH must be included with direct materials and direct labor on the job cost sheet since it is a product cost. However,
assigning MOH to units of product can be a difficult task. There are three reasons for this:-
 MOH is an indirect cost. This is to mean that it is either impossible of difficult to trace these costs to a
particular job or product.
 MOH consists of many different items.
 Although output may fluctuate due to seasonal or other factors, most MOH costs tend to remain relatively
constant due to the presence of fixed costs.
Source Documents
These are the original records that support journal entries in accounting system. The key source
document in job costing system is job cost sheet or job cost record. It is a form prepared for each
separate job that records the direct materials, direct labor, and manufacturing overheads. This
document assigned to a specific job.
Illustration on job order costing system in manufacturing company
Assume that XYZ Company is a manufacturing firm that uses job costing system. Consider the
company has two direct cost categories; that is direct materials and direct labor, and one indirect
cost pool; that is manufacturing overhead. The company applies overhead cost to jobs on the
basis of machine-hours worked. For the current year, the company estimated that it would work
for 75,000 hours and incur Br. 450,000 in manufacturing overhead costs.
The following transactions were completed during the year:
a. Raw materials were purchased on account 410,000.
b. Raw materials were requisitioned for use in production 380, 000 (360, 000 direct materials
and 20,000 indirect materials).
c. The following costs were incurred for employee services; direct labor, 75,000; indirect labor,
110,000; sales commission, 90,000; and administrative salaries, 200,000.
d. Utility costs were incurred in the factory, 43,000.
e. Advertising costs were incurred, 180,000.
f. Depreciation expenses were recorded for the year, 350,000 (80% to factory equipment, and
20 % selling and administrative activities).
g. Insurance expired during the year, 10,000 (70% relates to factory operations, and 30% for
selling and administrative activities).
h. Manufacturing overhead was applied to production. Due to greater demand than expected
for its products, the company worked 80,000 machine hours during the year.
i. Goods costing 900,000 to manufacture according to their job cost sheet were completed
during the year.
j. Goods were sold on account to customers during the year at a total selling price of
1,500,000. The goods cost 870,000 to manufacture according to their job cost sheets.
Required :- Prepare journal entries to record the preceding transactions.
Solution
a Raw Materials 410,000
Accounts payable 410,000
b Work in process 360,000
Manufacturing Overhead 20,000
Raw Materials 380,000
c Work in Process 75,000
Manufacturing Overhead 110,000
Sales commission expense 90,000
Admin. Salary Expense 200,000
Wages payable 475,000
d Manufacturing Overhead 43,000
Accounts payable 43,000
e Advertising expense 180,000
 Accounts payable 180,000
f Manufacturing Overhead 280,000
Depreciation expense 70,000
Accumulated depreciation 350,000
g Manufacturing Overhead 7,000
Insurance Expense 3,000
Prepaid insurance 10,000
h Budgetd Annual Indirect Costs
Budgeted Indirect Cost Rate=
Budgetd annual quantity of cost allocation base

450,000
¿
75,000
= Br. 6 per machine hour
Manufacturing Overhead Applied = 6 x 80,000 = Br. 480,000
Work in process 480,000
MOH Allocated 480,000
i Finished Goods 900,000
Work in process 900,000
j Accounts Receivable 1,500,000
Sales 1,500,000
Cost of goods Sold 870,000
Finished goods 870,000

Problem of Overhead Application and the concept of Under/Over Applied Overhead

Since the predetermined overhead rate is established based on entirely estimated data, generally,
there will be a difference between the amount of overhead cost which is applied to work in
process and the actual overhead costs. Budgeted/estimated indirect manufacturing costs rate have
the advantage of being timeliness than actual indirect manufacturing cost rate.
Indirect costs can be assigned to individual jobs on ongoing basis rather than waiting until the
end of the accounting period when actual costs will be known. But, the disadvantage of
budgeted/predetermined rate is that they likely will be inaccurate. Hence, we should consider
adjustments when the indirect costs allocated differ from actual indirect cost incurred. The
difference between the overhead cost applied to work in process and actual overhead costs
incurred are termed as either under applied or over applied overhead cost. Under allocated
indirect costs occur when the allocated amount of indirect costs in an accounting period is less than
the actual (incurred) amount. Over allocated indirect costs occur when the allocated amount of
indirect costs in an accounting period is greater than the actual (incurred) amount .
Under allocated (over allocated) indirect costs = Actual indirect costs incurred - Indirect costs allocated
There are two indirect-cost accounts in the general ledger that have to do with manufacturing
overhead:
 Manufacturing Overhead account: - the record of the actual costs in all the individual
overhead categories (such as indirect materials, indirect manufacturing labor, supervision,
engineering, utilities, and plant depreciation).
  Manufacturing Overhead Allocated: - the record of the manufacturing overhead
allocated to individual jobs on the basis of the budgeted rate multiplied by actual quantity
of cost allocation base.

Generally, the difference, actual with allocated, is resulted from the computation of the
predetermined rate; i.e.
 Budgeted allocation base vary from actual allocation base.
 Budgeted indirect cost rate vary from actual indirect cost rate.
There are three approaches to dispose/clear any balance in the manufacturing overhead account
at the end of an accounting period.
I. Proration Approach
Proration spreads under allocated/over allocated overhead costs among ending work in process,
finished goods and cost of goods sold balances.
II. Adjusted allocation rate approach
The adjusted allocation-rate approach restates all overhead entries in the general ledger and
subsidiary ledgers using actual cost rates rather than budgeted cost rates. First, the actual
manufacturing overhead rate is computed at the end of the fiscal year. Then, the manufacturing
overhead costs allocated to every job during the year are recomputed using the actual
manufacturing overhead rate (rather than the budgeted manufacturing overhead rate). Finally,
end-of-year closing entries are made. The result is that at year-end, every job-cost record and
finished goods record—as well as the ending Work-in-Process Control, Finished Goods Control,
and Cost of Goods Sold accounts—represent actual manufacturing overhead costs incurred.
The adjusted allocation-rate approach yields the benefits of both the timeliness and convenience
of normal costing during the year and the allocation of actual manufacturing overhead costs at
year-end.
III.Write-off to cost of goods sold approach
In this case, the total under/over applied/allocated overhead cost is included in the current year’s
cost of goods sold amount.
Illustration
ABC company uses a normal costing with a single manufacturing overhead cost pool and
machine hours as cost allocation base. The following data were for 2013:
Budgeted MOH Br. 4,800,000
Overhead allocation base Machine hours
Budgeted machine hours 80,000
MOH Incurred Br. 4,900,000
Actual machine hours 75,000

Machine hours data and the ending balances (before proration of under/over allocated overhead)
are as follows:
Actual Machine hours 2013, end of year balances
Cost of goods sold 60,000 Br. 8,000,000
 Finished goods 11,000 Br. 1,250,000
Work in process 4,000 Br. 750,000
Required:-
1. Compute the predetermined allocation rate for 2013.
2. Compute the under/over allocated MOH for 2013 and dispose the amount using:
a. Proration approach
1. If allocated MOH cost of Finished goods, cost of goods sold, and work in
process is the base for proration.
2. If ending balance of Finished goods, cost of goods sold, and work in process
is the base for proration.
b. Write –off to cost of goods sold approach
Solutions
Budgetd Annual Indirect Costs
1. Predetermined Indirect Cost Rate=
Budgetd annual quantity of cost allocationbase
4,800,000
¿ = Br. 60/machine hour
80,000
2. MOH allocated = Predetermined allocation rate x actual allocation base
= 60 x 75,000 = Br. 4,500,000
Under/ over applied MOH = Actual MOH incurred – MOH allocated
= 4,900,000 – 4,500,000
= Br. 400,000 (MOH under applied)
MOH applied for the three items will be:-
Cost of goods sold = 60,000 x 60 = Br. 3,600,000
Finished goods = 11,000 x 60 = Br. 660,000
Work in process = 4,000 x 60 = Br. 240,000
Total MOH applied = Br. 4,500,000
a. Proration approach
Item Account balance Proration Base Proration Proration Account balance
before Proration amount after proration
CGS 8,000,000 3,600,000 3.6 320,000 8,320,000
x 400,000
4.5
Finished goods 1,250,000 660,000 0.66 58,667 1,308,667
x
4.5
400,000
WIP 750,000 240,000 0.24 21,333 771,333
x
4.5
400,000
Total 10,000,000 4,500,000 100% 400,000 10,400,000

MOH allocated 4,500,000

CGS 320,000
Finished goods 58,667
WIP 21,333
 MOH, Control 4,900,000
(To record allocation and proration of MOH)

NB: - Some Companies base the ending balance of finished goods, CGS, and WIP to prorate
the under/over applied MOH.

Item Account balance Proration Base Proration Proration Account balance

before Proration amount after proration
CGS 8,000,000 8,000,000 8 320,000 8,320,000
x 400,000
10
Finished goods 1,250,000 1,250,000 1.25 50,000 1,300,000
x
10
400,000
WIP 750,000 750,000 0.75 30,000 780,000
x
10
400,000
Total 10,000,000 10,000,000 100% 400,000 10,400,000
MOH allocated 4,500,000
CGS 320,000
Finished goods 50,000
WIP 30,000
MOH, Control 4,900,000
(To record allocation and proration of MOH)

b. Write off to cost of goods sold approach

Cost of goods sold = 8,000,000 + 400,000 = 8,400,000

MOH allocated 4,500,000

CGS 400,000
MOH, Control 4,900,000
(To record allocation and proration of MOH)