MODULE 1

INTRODUCTION TO MANAGERIAL ACCOUNTING

If accounting is the language of business, then managerial accounting is the language inside a

business. Accountants establish very specific definitions for terms such as revenue, expense, net

income, assets, and liabilities. Everyone uses these same definitions when they announce and

discuss these attributes, so that when a company reports sales revenue, for example, investors and

other businesspeople understand how that figure was calculated. This way, companies, investors,

managers, and everyone else in the business community speak the same language, a language for

which accountants wrote the dictionary. Managerial accounting allows a company’s managers to

understand how their business operates and gives them information needed to make decisions. It

helps them plan their business’s activities and control its operations. For example, suppose a

marketing executive needs to set a price for a new product. To set that price, the executive needs

to understand how much the product costs; that’s where managerial accounting comes in.

Furthermore, the price needs to be set at such a level that at the end of the year, when the company

sells all the products it’s supposed to sell at whatever prices it sets, it earns the profit and cash flow

that it has projected for itself. That, too, is where managerial accounting comes in. This module

aims to introduce you to managerial accounting.

MODULE OBJECTIVES

After successful completion of this module, you should be able to understand the:

 Definition and branches of accounting

 Difference between managerial accounting and financial accounting
 Objectives of managerial accounting
 Management functions
 Organizational structure
 Basic accounting terms
 Managerial cost concepts

Accounting is a service activity which function is to provide quantitative information, primarily financial
in nature, about economic entities that is intended to be useful in making economic decisions.
Accounting is also considered the language of business.
Branches of Accounting

 Financial Accounting. This branch of accounting is more focused on the recording of business
transactions and preparation of financial statements to communicate the results of operation
and the financial condition of the enterprise to the external users.
 Managerial Accounting. It is an internally-based accounting that helps managers make decisions
(aligned with organizational objectives) through the use of economic and financial information
and it is also used to measure the results of those decisions.

Financial Accounting VS Managerial Accounting

The main differences of the two branches of accounting are summarized below:

Managerial Accounting Financial Accounting

Primary Users
Types & Frequency of Reports
Purpose of Reports
Content of Reports
Verification Process
Internal users: officers and
managers
Internal reports Historical &
Future-Oriented As frequently
as needed
Special-purpose for specific
decisions
Pertains to subunits of the
business Very detailed Extends
beyond double-entry
accounting to any relevant data
Not governed by standard, as
long as relevant to decision
No independent audits
External users: stockholders,
creditors, and regulators.
Financial statements Historical
Quarterly and annually
General-purpose
Pertains to business as a whole
Highly aggregated (condensed)
Limited to double-entry
accounting and cost data
Governed by GAAP
Audited by a CPA

Objectives of Management Accounting

The main goal of management accounting is to quantify information that can be used to make informed
business decisions. Specifically, it aims to:

1. Provide management with information for decision-making and planning.

2. Assist managers in directing and controlling operations.
3. Motivate managers toward achieving organization’s goals.
4. Measure performance of managers and sub-units within the organization.

Management Functions
 Managers’ activities and responsibilities can be classified into three broad functions as presented below.
In performing these functions, managers make decisions that have significant impact on the
organization.

1. Planning. This involves looking ahead and establishing objectives. These objectives are often
diverse: maximizing short-term profits and market share, maintaining a commitment to
environmental protection, and contributing to social programs.
2. Directing. This function relates to implementing planned objectives and providing necessary
incentives to motivate employees. It also involves coordinating a company’s diverse activities
and human resources to produce smooth-running operation. Directing also involves selecting
executives, appointing managers and supervisors, and hiring and training employees.
3. Controlling is the process of keeping the company’s objectives on track, and determining
whether planned goals are being met. Where there are deviations from targeted objectives,
managers must decide what changes are needed to get back on track.
a. Performance Evaluation is the process of determining the degree of success in
accomplishing the plan whether it is effective or efficient. Effectiveness is the
measure of how well a goal is achieved while efficiency is functioning in the best
possible manner with the least waste of time and effort.

NOTE: Decision-making is not a separate management accounting function. Rather, it is the outcome of
the exercise of good judgement in planning, directing and controlling.

Organizational Structure

An organizational structure is a system that outlines the delegation of authority, responsibility and how
certain activities are directed in order to achieve the goals of an organization. It also determines how
information flows between levels within the company. The typical organizational structure of a corporate
form of business is presented below:

Stockholders

Board of Directors

CEO and President

Corporate VP for Finance / VP for VP for Human

VP for Marketing
Secretary CFO Operations Resources

Internal Audit
Treasurer Controller
Staff
Stockholders own the corporation, but they manage it indirectly through the board of directors they
elect which is in charge of formulating operating policies for the company. The board formulates the
operating policies for the company or organization. The board also selects the officers, such as president
and one or more vice presidents, to execute policy and to perform daily management functions.

The Chief Executive Officer (CEO) has the overall responsibility for managing the business and for the
delegation of responsibilities. The responsibility could either be (1) line position (or those who are
directly involved in the company’s revenue-generating operating activities) or (2) staff position (who are
involved in activities that support the efforts of the line employee).

The Chief Financial Officer (CFO) or VP of Finance is responsible for all accounting and finance issues the
company faces. It is supported by the controller, the treasurer and the internal audit staff. The
controller’s responsibilities include (1) maintaining accounting records, (2) maintaining an adequate
system of internal control, and (3) preparing financial statements, tax returns, and internal reports. The
treasurer has the custody of the corporation’s funds and is responsible for maintaining the company’s
cash position. The internal audit staff’s responsibilities include (1) reviewing the reliability and integrity
of financial information provided by the controller and treasurer, (2) ensuring that internal control
systems are functioning properly to safeguard company’s assets, (3) investigating compliance with
policies and regulations and (4) whether resources are being used in the most economical and efficient
fashion.

The VP of Operations oversees employees with line positions. For example, the company might have
multiple plant managers, each of whom would report to the vice president of operations. Each plant
would also have department managers, such as fabricating, painting, and shipping, each of whom would
report to the plant manager.

The Other Vice Presidents oversees the related function under their responsibility such as marketing and
human resource.

The Corporate Secretary plays a leading role in governance as an officer who provides advice and
counsel on board responsibilities and logistics, in addition to recording minutes and other
documentation that meets legal requirements.

Basic Accounting Terms

 Elements of Balance Sheet or Statement of Financial Position

o Assets. These are resources controlled by the enterprise as a result of past events and
from which future economic benefits are expected to flow to the enterprise. The future
economic benefits embodied in an asset are their potential to contribute directly or
indirectly, to the flow of cash and cash equivalents to the enterprise. An asset may or
 may have no physical form. Examples of assets are: inventories, supplies, office
equipment, furniture and fixtures, accounts receivable, copyrights, etc.
o Liabilities. These are present obligations of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits. Examples of liabilities are: accounts payable, notes
payable, utilities payable, etc.
o Equity or Capital. Equity is defined as the residual interest in the assets of an entity that
remains after deducting all its liabilities. In a corporate type of business, equity includes
the funds invested by the shareholders, retained earnings, reserves representing
appropriations of retained earnings.
 Elements of Income Statement
o Revenue. These are increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities (or a combination of
both) from delivery or production of goods, rendering of services, or other activities that
constitute the enterprise’s major operations. Examples of revenue accounts are: sales,
professional fees earned, interests, dividends, royalties, and rent revenue.
o Costs or Expenses. These are decreases in economic benefits during the period in the
form of outflows or using up of assets or incurrence of liabilities (or a combination of
both) that results in decreases in equity, other than those relating to distributions to
equity participants. Examples of expenses are: cost of sales, and operating expenses.

Managerial Accounting Setup

The concepts, tools and techniques to be discussed in this course would revolve around the
manufacturing type of business and the corporate form. Although these concepts can be applied to any
business type and form, the manufacturing and corporate type are the most complex among these.

Managerial Cost Concepts

In order for managers at a company to plan, direct, and control operations effectively, they need good
information. One very important type of information is related to costs. Managers should ask questions
such as the following:

1. What costs are involved in making a product or providing a service?

2. If we decrease production volume, will costs decrease?
3. What impact will automation have on total costs?
4. How can we best control costs?

To answer these questions, managers need reliable and relevant cost information. We now explain and
illustrate the various cost categories that companies use.

Cost defined
Cost is an amount that has to be paid or given up in order to get something. In business, cost is usually a
valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risk incurred, and
(6) opportunity foregone in production and delivery of goods or services.

Classification of Costs

Depending on the decision being made, data or costs must be classified appropriately in order to be
useful. Inaccurate data classification might result to a misleading or wrong decision that could negatively
affect the business. For purposes of decision making, costs are classified as follows:

Product and Period Costs

 Product Costs (Manufacturing Costs). This is the sum of the costs incurred to manufacture a
product. It includes the cost of raw materials used, labor paid and other costs consumed to make
the product ready for sale. These costs are first charged to inventory and subsequently expensed
when the products are sold.
 Elements of Product Costs
o Materials. These include the raw materials and other factory supplies used in
manufacturing operation.
 Direct Materials. These are materials that can be directly traced to the
product being produced without undue cost or effort.
 Indirect Materials. These are materials that are necessary to manufacture
the product but are not directly included in or not a significant part of the
product. These materials cannot be traced without undue cost or effort.
o Labor. This represents the compensation and other benefits paid to the workers in
the factory.
 Direct Labor. This include compensation and benefits paid to those who are
directly involved in converting the raw materials into the finished product.
 Indirect Labor. This represents wages of personnel other than the direct
laborers, which are necessary to manufacture the product but are not
directly involved in converting the raw materials into the finished product.
o Overhead. This includes production costs other than direct material and direct labor.
These are costs indirectly associated with the manufacture of the product. Examples
of overhead are depreciation on factory buildings and machines, and insurance,
taxes, and maintenance on factory facilities.

Direct materials and direct labor are also called prime costs, while direct labor and overhead are called
conversion costs.

 Period Costs. These are costs that are matched with the revenue of a specific time period rather
than included as part of the cost of a salable product. These are non-manufacturing costs. Period
costs can be further classified as to:
 o Selling Expenses. These are the costs associated with distributing, marketing and selling
a product or service. Selling expenses can include: (1) distribution costs such as logistics,
shipping and insurance costs; (2) marketing costs such as advertising, website
maintenance and spending on social media; and (3) selling costs such as wages,
commissions and out of-pocket expenses.
o General and Administrative Expenses. These are incurred in the day-to-day operations
of a business and may not be directly tied to a specific function or department within
the company. General expenses pertain to operational overhead expenses that impact
the entire business. Administrative expenses are expenses that cannot be directly tied to
a specific function within the company such as manufacturing, production, or sales. G&A
expenses include rent, utilities, insurance, legal fees, and certain salaries.

Joint costs are costs incurred in a single process that yields two or more products. They are production
costs incurred up to the point where the products are separately identified.

Separable Costs. These are costs that are separately incurred by a product. They are incurred after the
joint products are separated in the split-off point.

Opportunity Costs. These represents the benefits foregone because one course of action is chosen over
the other.

Sunk Costs. These are costs that have already been incurred and will not be changed or avoided by any
future decision.

Relevant Costs. A cost is considered relevant if it will affect the decision of the manager. For a cost to be
relevant it must be both future and differential.

Irrelevant Costs. These are costs that will not change the decision of the manager across alternative
courses of actions. These costs are not future or differential or both.

Budgeted Costs. These costs refer to planned or predetermined costs stated on a formal budget
developed by the company.

Out of Pocket Costs. These are expenditures not included as part of the budget but must be incurred in
order to complete a proposed project or to extend an activity undertaken.

Committed Costs. These are costs that cannot be eliminated from the budget without affecting the
operations and/or incurring a legal obligation.

Discretionary Costs. These are costs that can be eliminated temporarily from the budget based on
management’s discretion to do so.
Controllable Costs. These are costs that are primarily subject to the influence of a given manager for a
certain period of time.

Non-controllable Costs. These are costs that cannot be controlled or influenced by a particular manager.

Fixed Costs. These are costs that are constant in total but vary on a per unit basis within the relevant
range of activity. As the activity level increases the total fixed costs remain the same, but the fixed cost
per unit decreases, and vice versa.

Variable Costs. These are costs that vary in total but remains constant on a per unit basis within the
relevant range of activity. As the activity level increases the total variable costs increases, but the
variable cost per unit remains the same, and vice versa.
MODULE 2
FLOW OF INVENTORY COSTS

To earn money, manufacturers must make products for less money than they can sell them for. Similarly,
retailers must buy products for less money than they can sell them for. Therefore, measuring the cost of
products manufactured or purchased is critically important to understanding a business’s profitability.
This concept explains why cost of goods sold usually appears as the first and largest expense on a
manufacturer or retailer’s income statement. How well a company can make or buy goods and then sell
them at a profit is fundamentally important to the company’s profitability and success. This fact applies
to businesses across the spectrum, from mass-market retailers to elite, high-end retailers to
manufacturers. In this module, we will study how goods and their costs flow through a business and
understand how to calculate cost of goods manufactured and cost of goods sold. All this information
gives you a crucial understanding of your business.

MODULE OBJECTIVES

After successful completion of this module, you should be able to:

 Understand the flow of inventory costs in a manufacturing company

 Prepare the statement of cost of goods manufactured and sold
Tracking Inventory Costs

Manufacturing companies purchase raw materials and convert them into finished goods by adding the
necessary labor and overhead. Product costs flow through the manufacturer’s books just as the goods or
products themselves flow through a manufacturer’s operations. Products flow through a manufacturer
inRaw
the following
materials,order, shown in Figure 2.1:
Labor, Work in Process Finished Goods Cost of Goods
Overhead Sold

1. Manufacturers purchase raw materials.

2. Manufacturers pay for labor and overhead to work on those raw materials. After they go into
production, raw materials become work-in process inventory.
3. When completed, work-in-process inventory becomes finished goods.
4. When the goods are sold, they go to the customer.

The first step in the manufacturing process is purchasing of inputs (raw materials). The ‘Raw Materials’
account is increased for purchases and decreased for materials issued or used in the production. In order
to convert raw materials into finished products, labor and overhead costs must also be incurred. Once
the production has started, all the raw materials, labor and overhead costs will be charged to the ‘Work-
in-Process Inventory’ account. Once the goods are completed, it will be transferred to the ‘Finished
Goods Inventory’ account. Lastly, once the goods are sold it will be charged to the ‘Cost of Goods Sold’
account. This flow of costs in the accounting records is illustrated in Figure 2.2.

Labor Overhead

Purchases Sales
Inventory Accounts of a Manufacturing Company

previous section, the productionFactory

As discussed in theSupplier Customers
costs of a manufacturer flow through different types
of inventory, as follows:

 Raw Materials Inventory. This account shows the raw materials available for use in the
manufacturing process. This account includes both direct and indirect materials.
 Work in Process Inventory. This account represents the costs of partially completed goods on
which production activities have started but not yet completed as of a certain period.
 Finished Goods Inventory. This account summarizes the costs of completed jobs stored in the
warehouse ready for delivery to customers.

Example 1:
To illustrate the flow of costs in a manufacturing company, assume the following transaction for the
month of July, gathered from the accounting records Maka-Tea Manufacturing Company, a manufacturer
of powdered milk teas:

a) Purchased tea leaves, sugar, milk and other supplies on account amounting to P240,000.
b) The raw materials used in production for the month is P180,000 of which P12,000 is
indirect materials.
c) Factory payroll for the month was P150,000.
d) The indirect labor from the factory payroll amounts to P30,000.
e) Depreciation on factory plant and equipment for the month is P12,000.
f) Factory taxes amounted to P1,500.
g) Factory insurance amounted to P4,320.
h) Factory utilities for the month amounted to P5,000.
i) The actual amount of overhead is charged to the job.

Additional information:

j) Only 75% of the jobs put into process were completed.

k) 80% of the goods completed were sold at a 50% mark-up.

Required:

1. In tabular form, show the flow of cost from the Manufacturing Cost accounts to the Cost of
Goods Sold account for the month of July.
2. Compute for the amount of Sales and Gross Profit for the period.
Activity 1.

Bayo Dress Shop makes evening dresses. The following information has been gathered from the
company records during the current year:

a) Raw materials purchased on account P2,350,000.

b) Raw materials used in production P2,500,000. 25% of this is indirect material.
c) Factory payroll is P1,350,000.
d) 80% of factory payroll is direct labor, while 20% is indirect labor.
e) Depreciation of sewing equipment, P80,000.
 f) Factory utilities paid, P320,000.
g) Factory insurance is P17,500.
h) Factory rent is P910,000.
i) The actual amount of overhead is charged to the job.

Additional information:

j) The beginning and ending inventory balances are as follows:

Beginning Ending
Raw materials 350,000 ?
Work in process 100,000 565,000
Finished goods 60,000 780,000
k) The company’s mark-up is 40% of cost.

Required:

1. In tabular form, compute for the following:

a. Ending inventory of raw materials
b. The cost of goods transferred from Work in process account to Finished goods account
c. The cost of goods transferred from Finished goods account to Cost of goods sold account
2. Compute for the amount of Sales and Gross Profit for the period. 3. Prepare the Statement of
Cost of Goods Manufactured and Sold.
Activity 2.
Christine Shop produces custom designed dresses for retail sales. Costs during the month of December
in the manufacture of its top-of-the-line dresses include the following:

a) Purchased fabric amounting to P750,000, on account.

b) The cost of fabric used in production is P600,000. P50,000 of indirect materials were also
incurred.
c) The total factory payroll is P185,000.
d) The breakdown of the factory payroll is as follows:

Wages of fabric cutters Total

Wages of tailors P50,000

Wages of quality assurance 90,000

inspectors
40,000
Wages of sewing machine
5,000
technicians
P185,000

e) Utilities paid for the factory, P35,000

f) Cost of factory rent, P65,000
g) Actual amount of overhead is charged to the job.

Additional information:

h) The beginning and ending inventory balances are as follows:

Beginning Ending
Raw materials 50,000 ?
Work in process 75,000 70,000
Finished goods 100,000 105,000
a) The company’s mark-up is 65% of cost.

Required:

1. In tabular form, compute for the following:

a. Ending inventory of raw materials
b. The cost of goods transferred from Work in process account to Finished goods
account
c. The cost of goods transferred from Finished goods account to Cost of goods
sold account
2. Compute for the amount of Sales for the period. 3. Prepare the Statement of Cost of
Goods Manufactured and Sold.
MODULE 3
JOB ORDER COSTING

Looking for a teddy bear? Most people would go no farther than their local department store. There,
they can usually choose from a few different colors and sizes in order to find the bear they like.
Department store bears are usually manufactured on assembly lines, often in batches of thousands of
identical bears. To measure the cost of the products made, companies use process costing, which we will
cover in Module 4. More-discriminating bear aficionados, however, have their teddy bears made to
order. This way, they can choose their bears’ size, fur color, eye color, paw pads, and even tattoos. They
can also choose from a wide selection of clothing or have clothing made to order in any theme they can
imagine. When craftspeople sew and assemble these custom bears, they use a system called job order
costing to track the exact cost of each bear. Information about product cost helps managers to set and
adjust prices and to decide how to best utilize limited production capacity. In this chapter, we will discuss
how companies accumulate costs in a job order costing system and how they apply overhead to the
individual products made.

MODULE OBJECTIVES

After successful completion of this module, you should be able to:

 Understand the classification of production systems and cost accounting systems

  Apply the accounting procedures under a job order costing system
 Account for any under or overapplied manufacturing overhead

Classification of Production Systems

1. Job Shop Production. Job shop production are characterized by manufacturing of one or few
quantities of products designed and produced as per the specification of customers within
prefixed time and cost. The distinguishing feature of this is low volume and high variety of
products. An example of this is the production of a movie by Disney, or the car repair and
maintenance services of an auto shop.
2. Batch Production. Batch production is defined by American Production and Inventory Control
Society (APICS) “as a form of manufacturing in which the job passes through the functional
departments in lots or batches and each lot may have a different routing.” It is characterized by
the manufacture of limited number of products produced at regular intervals using the same
sets of equipment at different times. An example of a batch is the printing of 225 wedding
invitations by a local print shop, or the production of cookies and muffins of a bakery.
3. Mass Production. Manufacture of discrete parts or assemblies using a continuous process are
called mass production. Mass production is the manufacturing of large quantities of
standardized products, often using assembly lines or automation technology. Mass production
facilitates the efficient production of a large number of similar products. It has the ability to
produce a variety of different items all at the same time. Different sets of machineries dedicated
specifically to each product line are used in mass production. An example of a mass production is
the manufacture of cars by Toyota or the concurrent manufacturing of different flavored juices of
Zest-O.
4. Continuous Production. Continuous production is a type of production system in which the
materials being processed are continuously in motion. Continuous production, like mass
production, is a flow production method. During continuous processing, distinct parts flow from
one machine to the next to make a finished product. There are no interruptions between the
stages of production. With continuous manufacturing, operations run 24/7. Companies must
have high capital to run a continuous production operation. Continuous production requires a
large floor space and advanced machinery. Examples of industries or companies that use
continuous production process are oil refineries, paper manufacturers, and cement
manufacturers.

Cost Accounting Systems

The cost accounting system that must be adapted by a manufacturer must depend on the type or
classification of production system that currently uses. There are two basic types of cost accounting
systems: (1) a job order cost system and (2) a process cost system. Although cost accounting systems
differ widely from company to company, most involve one of these two traditional product costing
systems.

Job Order Cost Systems

A job order cost system is used for job shop and batch production systems. Under a job order cost
system, the company assigns costs to each job or to each batch of goods. Since each job or batch has its
own distinguishing characteristic, the objective is to first compute for the cost per job or batch to
determine the cost per product. At each point in manufacturing a product or providing a service, the
company can identify the job and its associated costs. A job order cost system measures cost for each
completed job, rather than for set time periods. Illustration 3.1 shows the recording of costs in a job
order cost system.

Process Cost Systems

For companies using mass and continuous production systems, process costing system is adapted. Since
the products manufactured have the same characteristics, process costing accumulates product-related
costs for a period of time (such as a week or a month) instead of assigning costs to specific batches or
job orders. In process costing, companies assign the costs to departments or processes for the specified
period of time. Illustration 3.2 shows examples of the use of a process cost system. We will discuss the
process cost system further in Module 4.

Can a company use both types of cost systems? Yes. For example, car manufacturers uses process cost
accounting for its standard model cars, and job order cost accounting for custom-made cars. The
objective of both cost accounting systems is to provide unit cost information for product pricing, cost
control, inventory valuation, and financial statement presentation.
Job Order Cost Flow

The flow of costs (direct materials, direct labor, and manufacturing overhead) in job order cost
accounting parallels the physical flow of the materials as they are converted into finished goods. As
shown in Illustration 3.3, companies assign manufacturing costs to the Work in Process Inventory
account. When a job is completed, the company transfers the cost of the job to Finished Goods
Inventory. Later when the goods are sold, the company transfers their cost to Cost of Goods Sold. This
flow of inventory costs were already discussed in Module 2.

Assigning Manufacturing Costs to Work-in-Process

Job Cost Sheets

An essential accounting record in assigning costs to jobs is a job cost sheet, as shown in Illustration 3.4. A
job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total
and unit costs of the completed job.

Companies keep a separate job cost sheet for each job. The job cost sheets constitute the subsidiary
ledger for the Work in Process Inventory account. A subsidiary ledger consists of individual records for
each individual item—in this case, each job. The Work in Process account is referred to as a control
account because it summarizes the detailed data regarding specific jobs contained in the job cost sheets.
Each entry to Work in Process Inventory must be accompanied by a corresponding posting to one or
more job cost sheets. In reality, the entries to the Work in Process Inventory account are made
periodically (usually on a monthly basis), therefore, it is already summarized. On the other hand, the
postings on the job cost sheets must be made every time that a raw material, labor or overhead cost is
incurred or used.

Raw Materials Cost

The raw materials issued may be used directly on a job, or they may be considered indirect materials.
The company will charge direct materials to Work in Process Inventory account, and indirect materials to
Manufacturing Overhead account. After the company has completed all postings, the sum of the direct
materials columns of the job cost sheets (the subsidiary accounts) should equal the direct materials
debited to Work in Process Inventory (the control account).

Factory Labor Costs

For factory labor costs, the account Work in Process Inventory is charged for direct labor and
Manufacturing Overhead is charged for indirect labor. As in the case of direct materials, the postings to
the direct labor columns of the job cost sheets should equal the posting of direct labor to Work in
Process Inventory.

Manufacturing Overhead Costs

In the previous module, we assumed that the actual amount of overhead is being charged to the work in
process account. Although that approach is relatively simpler, it is seldom used in actual practice.
Overhead relates to production operations as a whole. To know what “the whole” is, the logical thing is
to wait until the end of the year’s operations. At that time the company knows all of its costs for the
period. As a practical matter, though, managers cannot wait until the end of the year. To price products
accurately, they need information about product costs of specific jobs completed during the year.
Because of these reasons, overhead costs cannot be assigned to specific jobs on the basis of actual costs
incurred. Instead, companies assign manufacturing overhead to work in process and to specific jobs on
an estimated basis through the use of a predetermined overhead rate.

The predetermined overhead rate is based on the relationship between estimated annual overhead
costs and expected annual operating activity, expressed in terms of a common activity base. The
company may state the activity in terms of direct labor costs, direct labor hours, machine hours, or any
other measure that will provide an equitable basis for applying overhead costs to jobs. Companies
establish the predetermined overhead rate at the beginning of the year. Small companies often use a
single, company-wide predetermined overhead rate. Large companies often use rates that vary from
department to department. The formula for a predetermined overhead rate is as follows.
At the end of each period, the balance in Work in Process Inventory should equal the sum of the costs
shown on the job cost sheets of unfinished jobs.

Assigning Manufacturing Costs to Finished Goods

When a job is completed, the associated costs are transferred from the Work in Process Inventory
account to the Finished Goods account. The amount transferred to the finished goods represents the
total costs of all jobs completed during the period.

Manufacturing Overhead Variance

Since the amount of manufacturing overhead charged to the jobs are based on an estimate, oftentimes,
this would not be in agreement with the actual overhead cost incurred by the company. As a result, this
creates an overhead variance. Any manufacturing variance must be closed to the Cost of Goods Sold
account.

 Underapplied overhead (Applied < Actual). This occurs when the overhead charged or applied
to the jobs are less than the actual overhead incurred. It is said to be an “unfavorable” outcome,
because not enough jobs were produced to absorb all of the overhead incurred. This might
result from below normal levels of output or overspending. In any event, the fact remains that
more was spent than allocated. Any underapplied overhead must be added to the Cost of Goods
Sold.
 Overapplied overhead (Applied > Actual). Conversely, when the overhead charged or applied to
the jobs are greater than the actual overhead incurred, it is said to be overapplied. This is usually
viewed as a favorable outcome, because less has been spent than anticipated for the level of
achieved production. Any overapplied overhead is deducted from to the Cost of Goods Sold.

Example 1

To illustrate a job order cost system, we will use the January transactions of Wallace Manufacturing
Company, which makes machine tools. The following jobs were started by Wallace during the month:

Job No. Quantity (units)

101 1,000
102 1,500
103 2,000
a) Wallace Manufacturing purchases 2,000 handles (Stock No. AA2746) at P5 per unit (P10,000)
and 800 modules (Stock No. AA2850) at P40 per unit (P32,000) for a total cost of P42,000.
b) During the month, Wallace used P24,000 of direct materials and P6,000 of indirect materials.
The direct material costs are charged to the jobs, as follows: Job No. 101 – P12,000, Job No. 102
– P7,000, and Job No. 103 – P5,000.
 c) Wallace Manufacturing incurs P32,000 of factory labor costs.
d) The P32,000 total factory labor cost consists of P28,000 of direct labor and P4,000 of indirect
labor. The labor costs chargeable to Wallace’s three jobs are P15,000, P9,000, and P4,000,
respectively.
e) The actual amount of other overhead costs incurred for the month totaled P15,000.
f) The overhead cost applied to the jobs are determined using direct labor cost as the activity base.
For the current year, the company expects annual overhead costs to be P280,000 and direct
labor costs for the year to be P350,000.
g) During the period, the status of the jobs: Job No. 101 – 100% complete, Job No. 102 – 75%
complete, Job No. 103 – 80% complete.
h) Out of the units completed from each job, the following units were sold: Job No. 101 – 800 units,
Job No. 102 – 625 units, Job No. 103 – 1,000 units. All jobs were sold at a 30% markup.
i) Any under or overapplied overhead is closed to the Cost of Goods Sold account.

Required:

1. In tabular form, show the flow of total costs from the Manufacturing Cost accounts to the Cost
of Goods Sold account for the month of January.
2. Post the manufacturing costs to the separate job cost sheets of individual jobs.
3. Determine any over or underapplied overhead and the balance of Cost of Goods sold after
adjustment for variance.
4. Determine the amount of sales and gross profit for January.
Activity 1.

Phillips Manufacturing uses a job order cost system and applies overhead to production on the basis of
direct labor costs. On January 1, Job No. 50 was the only job in process. The costs incurred prior to
January 1 on this job were as follows: direct materials P20,000, direct labor P12,000, and manufacturing
overhead P16,000. As of January 1, Job No. 49 had been completed at a cost of P90,000 and was part of
finished goods inventory. There was also a P15,000 balance in the Raw Materials Inventory account.
During the month of January, Phillips Manufacturing began production on Jobs 51 and 52. The following
additional events occurred during the month:

a) Purchased additional raw materials of P90,000 on account.

b) Raw materials amounting to P96,000 were charged to the job. Of this amount, P79,000 are
direct materials, while P17,000 are indirect. Assigned direct materials to the jobs as follows: Job
No. 50 – P10,000, Job. No. 51 – P39,000, Job No. 52 – P30,000.
c) Incurred factory labor costs of P65,000.
d) The P65,000 total factory labor cost consists of P50,000 of direct labor and P15,000 of indirect
labor. The direct labor assigned to the jobs are as follows: Job No. 50 – P5,000, Job. No. 51 –
P25,000, Job No. 52 – P20,000.
e) Incurred manufacturing overhead costs as follows: depreciation expense P19,000, and various
other manufacturing overhead costs on account P20,000.
f) Phillips Manufacturing estimates total manufacturing overhead costs of P1,050,000, direct labor
costs of P700,000, and direct labor hours of 20,000 for the year.
g) Jobs 50 and 51 were both completed during the period.
h) Jobs 49 and 50 were also sold on account during the month for P122,000 and P158,000,
respectively.

Required:

1. In tabular form, show the flow of total costs from the Manufacturing Cost accounts to the Cost
of Goods Sold account for the month of January.
2. Post the manufacturing costs to the separate job cost sheets of individual jobs.
3. Determine any over or underapplied overhead and the balance of Cost of Goods sold after
adjustment for variance.
4. Determine the amount of sales and gross profit for January.