Glossary

Allocation Base. A measure of activity such as direct labor-hours or machine hours that is used to assign
costs to cost objects.

Job-order costing. A costing system used in situations where many different products, jobs, or services are
produced each period.

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

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

JOB-ORDER COSTING USING 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. But in large companies, multiple predetermined
overhead rates are often used.
In a multiple predetermined overhead rate system, each production department may have its own
predetermined overhead rate. Such a system, while more complex, is considered to be more accurate. Since it can
reflect differences across departments in how overhead costs are incurred. For example, overhead might be
allocated based on machine-hours in departments that are relatively machine intensive. When multiple
predetermined overhead rates are used, overhead is applied in each department according to its own overhead rate
as a job proceeds through the department.

Multiple Predetermined Overhead Rates – A Departmental Approach

Ex. Dickson Company has two production departments, Milling and Assembly. The company uses a job-order costing
system and computes a predetermined overhead rate in each production department. The predetermined overhead
rate in the Milling Department is based on machine-hours and in the Assembly Department it is based on direct
labor-hours. The company uses cost-plus pricing (and a markup percentage of 75% of total manufacturing cost to
establish selling prices for all of its jobs. At the beginning of the year, the company made the following estimates:

Department
Milling Assembly
Machine-hours 60,000 3,000
Direct labor-hours 8,000 80,000
Total fixed manufacturing overhead cost $390,000 $500,000
Variable manufacturing overhead per machine-hour $2.00 -
Variable manufacturing overhead per direct labor-hour - $3.75

During the current month the company started and completed Job 407. It wants to use its predetermined
departmental overhead rates and the information pertaining to Job 407 that is shown below to establish a selling
price for this job:

JOB 407 Department

Milling Assembly
Machine-hours 90 4
Direct labor-hours 5 20
Direct materials $800 $370
Direct labor cost $70 $280
This explains how Dickson would compute a selling price for Job 407 using a five-step process.

Step 1. Calculate the estimated total manufacturing overhead cost for each department.
The first of which is to calculate the estimated total manufacturing overhead cost in each department using the
equation:
Y = a + bX
Where:
Y = The estimated total manufacturing overhead cost
a = The estimated total fixed manufacturing overhead cost
b = The estimated variable manufacturing overhead cost per unit of the allocation base
X = The estimated total amount of the allocation base.

Milling Department Overhead Cost (Y) Assembly Department Overhead Cost (Y)
= $390,000 + ($2.00 per MH x 60,000 MHs) = $500,000 + (3.75 per DLH x 80,000 DLHs)
= $390,000 + $120,000 = $500,000 + $300,000
= $510,000 = $800,000
This equation provides the Miling Deparment’s estimated total manufacturing overhead cost of $510,00 and the
Assembly Department’s estimated total overhead cost of $800,000.

Step 2. Calculate the predetermined overhead rate in each department.

The second step is to calculate the predetermined overhead rate for each department using the following
formula:

Predetermined overhead rate = Estimated total manufacturing overhead cost

Estimated total amount of the allocation base

Milling Department Overhead Rate Assembly Department Overhead Rate

= $510,000 = $800,000
600,000 machine-hours 80,000 direct labor-hours
= $8.50 per machine-hours = $10.00 per direct labor-hours

This formula results in predetermined overhead rates in the Milling and Assembly Departments of $8.50 per
machine-hour and $10.00 per direct labor-hour, respectively.

Step 3. Calculate the amount of overhead applied from both departments to Job 407.

The third step is to use the general equation shown below to calculate the amount of overhead applied from
each department to Job 407.

Overhead applied to Job 407 = Predetermined overhead rate x Actual amount of the allocation base used by Job 407

Milling Department Overhead Applied to Job 407 Assembly Department Overhead Applied to Job 407
= $8.50 per MH x 90 MHs = $10.50 per DLH x 20 DLHs
= $765 = $200

As depicted in this computation, $765 of manufacturing overhead would be applied from the Milling Department to
Job 407m whereas $200 would be applied from the Assembly Department to this same job.

Step 4. Calculate the total job cost for Job 407

Milling Assembly Total

Direct Materials $800 $370 $1,170
Direct Labor $70 $280 $350
Manufacturing overhead applied $765 $200 $965
Total Cost of Job 407 $2,485
Step 5. Calculate the selling price for Job 407

Total cost of Job 407 $2,485.00

Markup ($2,485 x 75%) $1,863.75
Selling price of Job 407 $4,348.75
Steps 4 and 5 calculate the total job cost for job 407 ($2,485) and the selling price of Job 407 ($4,348.75) using the
markup percentage of 75%.

Glossary

Job cost sheet. A form that records the direct materials, direct labor, and manufacturing overhead cost
charged to a job.

Overhead Application. The process of assigning overhead cost to specific jobs.

JOB-ORDER COSTING – AN EXTERNAL REPORTING PERSPECTIVE

This focuses on using job-order costing systems to compute unit product costs for internal management
purposes. However, job-order costing system are also often used to create a balance sheet and income statement
for external parties, such as shareholders and lenders.

Overhead Application and the Income Statement

When a company uses predetermined overhead rates to apply overhead cost to jobs, it is almost a certainty
that the amount of overhead applied to all jobs during a period will differ from the actual amount of overhead costs
incurred during the period. When a company applies less overhead to production than it actually incurs, it creates
what is known as underapplied overhead. When it applies more overhead to production than it actually incurs, it
results in overapplied overhead.

The existence of underapplied or overapplied overhead has implications for how a company prepares its
financial statements. For example, the cost of goods sold reported on a company’s income statement must be
adjusted to reflect underapplied or overapplied overhead. The adjustment for underapplied overhead increases cost
of goods sold and decreases net operating income, whereas the adjustment for overapplied overhead decreases cost
of goods sold and increases net operating income.

Job Cost Sheets: A Subsidiary Ledger

A job cost sheet accumulates the total direct materials, direct labor, and manufacturing overhead cost
assigned to a job. When all of a company’s job cost sheet are viewed collectively, they form what is known as a
subsidiary ledger. In other words, a company’s job costs sheets provide an underlying set of financial records that
explain what specific jobs comprise the amounts reported in Work-in-process and Finished Goods on the balance
sheet as well as Cost of Goods Sold on the income statement.
Illustration:

Assume Dixon Company started six jobs during its first month of operations and incurred no underapplied or
overapplied manufacturing overhead. Jobs A and B were incomplete at the end of the month, Job C was finished, but
unsold, and Jobs D, E and F had been produced and sold during the month. In addition, assume the job cost sheets
for these six jobs reported the following costs at the end of the month (in thousands):

Jobs
A B C D E F
Direct Materials $100 $90 $140 $110 $180 $160
Direct Labor $80 $60 $90 $70 $120 $100
Manufacturing overhead $96 $72 $108 $84 $144 $120
applied
Total product cost $276 $222 $338 $264 $444 $380

These six job costs would comprise Work in Process and Finished Goods on the balance sheet and Cost of Goods Sold
on the income statement as follows:

Work in Process Finished Goods Cost of Goods Sold

Job A $276 Job C $338 Job D $264
Job B $222 Total $338 Job E $444
Total $498 Job F $380
Total $1,088

This brief example illustrates the interrelationship between a company’s job cost sheets and its financial
statements. For example, the combined costs of Jobs A and B equal Work in Process ($498) on the balance sheet,
whereas the combined costs of Jobs D, E and F equal Cost of Goods Sold (#1,088) on the income statement.

JOB-ORDER COSTING IN SERVICE COMPANIES

This focused on manufacturing companies; however, job-order costing is also used in service organizations such as
law firms, movie studios, hospitals, and repair shops. In a law firm, for example, each client is a “job”, and the costs
of that job are accumulated day by day on a job cost sheet as the client’s case is handled by the firm. Legal forms and
similar inputs represent the direct materials for the job; the time expended by attorneys is like direct labor; and the
costs of secretaries and legal aids, rent, depreciation, and so forth, represent the overhead.
In a movie studio such as Columbia Pictures, each film produced by the studio is a “job”, and costs of direct
materials (costumes, props, film, etc.) and direct labor (actors, directors, and extras) are charged to each film’s job
cost sheet. A share of the studio’s overhead costs, such utilities, depreciation of equipment, wages of maintenance
workers, and so forth, is also charged to each film.
In sum, job-order costing is a versatile and widely used costing method that may be encountered in virtually
any organization that provides diverse products or services.