A noted earlier, all product costs are charged to inventory. To facilitate this process,
manufacturers break inventory into three categories: RM inventory, WIP inventory, and FG
inventory. There are two categories of direct cost (DL & DM) and then there is overhead,
which is a catch-all term for everything except DL and DM. Raw materials are charged to
RM inventory when purchased and transferred to WIP inventory when it is used. DL is
charged directly to WIP. Indirect product costs are charged to an overhead account. Then
just one number is transferred from OH to WIP.
In a company that produces a variety of products in specific batches, the total costs that are
charged this way are made up of a series of jobs. Think of Kinko’s. They do thousands of
jobs – each of them has some DM (paper mainly), some DL (the operator), and a lot of OH
(store rent, electricity, supplies etc and etc.)
Each job is numbered – the number you see on your invoice. They know how much paper
was used on a job and how much time it took.
For each individual job: DM = Pages used x cost of paper per page
DL = Time taken by operator x hourly wage of operator
Then, for the year as a whole – or for a day, a week, a month – they just add up the costs of
all the individual jobs to see how much cost they incurred for that period.
The big problem is how to charge overhead costs to an individual job. These accumulate
over a year and are all indirect costs i.e., they aren’t collected on an individual job like
paper and wages. These indirect costs need to be spread out over the individual jobs or
share among the individual jobs. Most businesses use the following method to achieve this
“spreading out” process that is called “applying overhead.” They start by computing an
“overhead rate” using a “base” like direct labor hours (DLH).
Overhead rate = Total overhead/Hours worked by operators during the year.
This rate is then multiplied by the DLH on an individual job and gives the share of
overhead applied to that job. If total overhead for the year is $800,000 and total DLH
worked during the year is 40,000 hours then the overhead rate will be $20 per direct labor
hour. If a job takes 5 hours, say, then it will get charged with 5 x $20 or $100. Clearly
added up over a year, the shares applied to individual jobs will add back to the total
overhead. (Note that we could also have used something like machine hours as a base.)
The problem with this method is that we have to wait to the end of the year before we can
figure out the cost of any job during the year. Almost all businesses, therefore, work on an
estimated basis. They figure an overhead rate in advance using DL hours (say):
Predetermined overhead rate
= Total estimated overhead/Estimated hours to be worked during the year
This is the rate that is used to transfer overhead from the OH account to the WIP account.
Obviously, there are many times when the estimates don’t work out. Sometimes some
overhead is left over in the OH account – we then say that overhead was under applied;
sometimes too much overhead is applied when we say it was over applied. That’s it!!
An illustrative example:
The Boston Computer Service Computer repairs computers for corporate clients. They
expect the following overhead costs during 1999 (these are just a subset to illustrate):
Salaries for supervisors $120,000
Depreciation of equipment 70,000
Cafeteria costs 110,000
Equipment insurance 20,000
They expect to work a total of 20,000 direct labor hours at an average wage of $16 per
DLH during the year.
Predetermined overhead rate = 420,000/20,000 = $21/DLH
They have a major job for Searings Retailers that takes 300 hours of direct labor and
involves the use of $27,000 in new parts.
The job cost equals: DM 27,000
DL 4,800 = 300 x 16
OH 6,300 = 300 x 21
The job cost $38,100 = 27,000 + 4,800 + 6,300.
GN E3-3 Computing job costs for one month in a year
The Polaris Company uses a job-order costing system. The following data relate to
October, the first month of the company’s fiscal year.
a. Raw materials purchased on account, $210,000
b. Raw materials issued to production $190,000 ($178,000 direct materials and
$12,000 indirect materials)
c. Direct labor cost incurred, $90,000; indirect labor cost incurred, $110,000
d. Depreciation recorded on factory equipment, $40,000
e. Other manufacturing costs incurred during October, $70,000 (credit Accounts
f. The company applies manufacturing overhead cost to production on the basis of $8
per machine-hour. There were 30,000 machine hours recorded for October.
g. Production orders costing $520,000 according to their job cost sheets were
completed during October and transferred to Finished Goods.
h. Production orders that had cost $480,000 to complete according to their job cost
sheets were shipped to customers during the month. These goods were sold at 25%
above cost. The goods were sold on account.
All of these problems begin with the three inventories plus overhead and cogs. (I am using
spreadsheet format because it is easier to type!)
RM WIP FG COGS OH
(190) 178 12
Balance 20 30 40 472 0
Note that the only difference between this and the problems that you were doing in Chapter
2 is that overhead is applied using a predetermined overhead rate with whatever balance
there is left being transferred to Cogs.
GN E3-7 Same stuff but involving two departments – also machine hours for one
White Company has two departments, Cutting & Finishing. The company uses a job-order
costing system and computes a predetermined overhead rate in each department. The
Cutting Department bases its rate on machine hours, and the Finishing Department bases its