CHAPTER 8

SYSTEM DESIGN: JOB ORDER COSTING AND PROCESS COSTING

Although cost accounting and management accounting differ in their objectives, they share a
common database as well as sure basic concepts.

Cost accounting is the subfield or accounting records, measures, and reports information
about costs. We then say costs are used for managerial/management accounting purposes when it
is used inside the organization by managers to evaluate the performance of operations or
personnel, or as basis for decision making. We also say that cost are used for Financial
accounting purposes when costs are used by outsiders, such as shareholders or creditors to
evaluate the performance of top management and make investment decisions about the
organization.

Flow of Costs in a Merchandizing Company

Merchandizing companies such as computer stores, department stores, drug stores and
retail markets, purchase the merchandise they sell to customers. Their product costs are the
purchase price of the merchandise.

Figure 8.1 Merchandise the basic flow of Costs in Merchandise Company

Costs Statement of Financial Position Income Statement

Expenses

Merchandise purchases Merchandise Inventory Cost of Goods Sold

Profit Expenses
Selling and Administrative Selling and Administrative

Flow of Cost in a Manufacturing company

The most complex cost classification systems are found in manufacturing organizations,
where a special statement must be prepared to determine the cost of goods sold. Figure 8.2 shows
the basis flow of costs in a manufacturing company while figure 8.3 illustrates the flow of
manufacturing costs through manufacturing accounts.

Figure 8.2 Flow of Costs in a Manufacturing Company

 Costs Statement of Financial Position Income Statement
Inventories Expenses

Material Purchases Raw Material

Direct labor Work in Process

Manufacturing Overhead Finished Goods Cost of Goods Sold

Period Expenses
Selling and Administrative Selling and Administrative

Figure 8.3 Manufacturing Cost Flows

A General Model of Cost Flows

Raw Materials
Debited for Credited for
the cost of Direct Materials
materials added to work in
purchased process

Credited for Work in Process

indirect material Debited for the cost Credited for the
added to manufacturing of direct materials, cost of goods
overhead direct labor, and manufactured
manufacturing overhead
applied
Salaries and Wages Payable
Credited for the
direct labor added
to WIP
Finished Goods
Credited for indirect Debited for the Credited for the
labor added to cost of goods cost of goods
manufacturing Overhead manufactured

Manufacturing Overhead
Debited for Credited for overhead Cost of Goods Sold
actual cost applied to WIP Debited for the
overhead costs Cost of Goods sold
incurred
UnderappliedOverapplied overhead cost
Notice that costs move from one account to another in same sequence as products flow through
to the customer, the starting point is the purchase of direct materials, which is recorder as an
asset in the Raw Materials account. As materials are used, their cost is removed from the Raw
Materials account and placed in the Work in Process account. The cost of direct materials still on
hand in either account in period end will appear as an asset in their respective accounts on the
statement of financial position.

Manufacturing Cost Accounting System

In designing any cost accounting system, accountants are required to make four
decisions.

1. Will the system use historical costs or standard costs?

2. Will the system be a job order or a process cost accounting system?

3. Will the system be based on full absorption or direct costing of inventory?

4. What system will be used to assign overhead costs to products? Will the company use plant
wide or activity-based predetermined overhead rates? What and how many cost drivers should be
used?

Cost accounting system can vary greatly depending on these decisions. For example, a standard
process costing system might be based on full absorption costing and a plantwide overhead rate.
A standard job order costing system might be based on direct costing and a departmental
overhead rate. To completely described a cost accounting system , all four decisions must be
made.

Job Order Costing System

Concept and application

Job order cost system, cost are assigned to each job. A job may be an order, a contract, a unit of
production, or a batch performed to meet customers’ specifications. Accountants also use job
order costing in the construction of commercial and residential buildings, ships, and machines.
Job order costing is appropriate for companies making different components for inventory.
 Figure 8.4. Flow of Documents in a Job Order Costing System

Materials These The job cost

requisition form production sheet is used to
compute unit
costs are
Customer’s Sales Production Direct labor accumulated Production
PO Order Order
time ticket on a form, Order
prepared by the product costs
A Sales Order A Production that in turn are
Predetermined accounting
sales order is order initiates used to value
overhead rates department,
prepared as a work on a job, ending
known as a
basis for issuing a whereby cost inventories and
are charged to determine cost
through of goods sold.

Figure 8.5 Flow of costs in Job Order Costing

The work in process account

consists of individual jobs in a
Direct Materials job-order system.

Finished
Direct Labor Jobs goods

Manufacturing Cost of Goods

Overhead Sold

Summary of Accounting Procedures using Job Order Costing to a manufacturing

Company

1. Record the purchase and issue of materials with journal entries.

2. Record labor costs with journal entries.

3. Calculate a predetermined overhead rate and use it to assign overhead cost to a job.
 4. Record applied manufacturing overhead cost with journal entries.

5. Complete a job cost sheet and calculate the average cost per unit of a job.

6. Record actual manufacturing overhead costs with journal entries.

7. Compute over and under applied overhead.

8. Calculate cost of goods manufactured and cost of goods sold.

Process Costing System

Concept and Application

Using a process costing system, accountants accumulated cost for each department for a time
period and allocate them among all the products manufactured during the period. They use
process costing in ice cream processing, petroleum refining and other industries where there is a
continuous production process. Direct material, direct labor and applied factory overhead are
accumulated for each department for a period, usually a month. At the end of the period,
departmental cost is divided by the number of units produced to obtain a cost per unit.

Figure 8.6 Flow of Costs- Process Costing System

The work in process account

consists of individual
Direct Materials products in a process cost
system.

Direct Labor Products Finished goods

Manufacturing
Overhead Cost of Goods
Sold
Figure 8.7 T- account Model for Process Costing Flows
 Raw Materials

Wages Payable

Manufacturing
Overhead

Work in Process Work in Process

-Department A -Department B
xxx xxx

xxx Finished Goods

xxx
COGS
xxx

Summary of Accounting Procedures using Process Costing in a Manufacturing Company

1. Cost are accumulated and cost per unit is calculated.

2. Prepare journal entries to record manufacturing costs and transfer.

3. Calculate equivalent units when resources are added uniformly.

4. Calculate equivalent units when resources are added in a lump.

5. Using equivalent units, Calculate the unit cost for all types of costs and record them on
a cost summary report.

6. Calculate unit cost using the moving average method and use it to compute the cost of
completed units and ending work in process.

7. Calculate unit cost using the FIFO method, and the use it to compute the cost of
completed units and ending work in process.
 Figure 8.8 Comparison of Job Order Costing against Process Costing

Job Order Costing

Job 101

Direct materials
Direct labor Job 102 Finished goods Cost of goods
Factory overhead sold
Job 103

Work in Process- Job 101

Material Cost
Labor Transferred
Overhead
Work in Process- Job 102
Material Cost Finished Good Cost of
Goods sold
Labor Transferred xxx xxx xxx
Overhead
Work in Process- Job 103
Material Cost
Labor Transferred
Overhead

Process Costing

Direct Materials Finished Cost of goods

Direct Labor Department A Department B Department C Goods sold
Factory
Overhead

Work in Process Work in Process Work in Process Finished Goods COGS

Department A Department B Department C
Dept. A Cost xx Cost xx cost xxx xxxxxx
Material Transferred Dept. B Transferred Dept. C Transferred
Labor Material Material
Overhead Labor Labor
Overhead Overhead
System Choice: Job Costing vs. Process Costing

In job costing, costs are collected for each unit produced. In process costing costs are
accumulated in a department for an accounting period then spread evenly or averaged, over all
units produced that month. Process costing assumes each unit produced is relatively uniform.

Process costing has less detailed recordkeeping; hence, if company was choosing between job
and process costing, it would generally find that recordkeeping cost are lower under process
costing. Process costing does not provide as much information as job costing because records of
the cost of each unit produced are not kept using process costing. The choice of process versus
job costing system involves a comparison of the costs and benefits of each system.

As a general rule, job systems are usually more costly than process system. Managers and
accountants must decide whether there are enough additional benefits from knowing the actual
cost of each unit, which is available in a job costing system, to justify additional recordkeeping
costs. If recordkeeping costs were equal under job and process systems for the units in a product
line, then the job systems are better because they provide all of the data that process system do.

Operation Costing

Concept and Application

Many companies employ an operation costing system in the manufacture of goods that have
some common characteristics plus some individual characteristics. An operation is a routine
production method, technique or step that is respectively performed. An operation costing
system represents a hybrid method having some of the characteristics of both process and job
order costing. Companies use operation costing when manufacturing goods that have some
common characteristics plus some individual characteristics. Operation costing meets the needs
of a batch manufacturer whose products has variations of a single design and requires a varying
sequence of standardized operations. Job costing continues to be the best alternative for
accumulating the cost of contracts and customized manufacturing. However, the trend is toward
process costing systems and cost systems that are custom designed such as operation costing.

SummaryofAccountingProceduresusingProcessCostinginaManufacturingCompany

1.Costisaccumulatedandcostperunitiscalculated.
Processcostingisusedwhenproductsareproducedcontinuously,thatis,whentherearenodistinguishabl
estartingandstoppingpointintheproductionprocess.Costperunitiscalculatedbydividingactivitycosts
byunitsprocessed.

2.PrepareJournalentriestorecordmanufacturingcostandtransfers.
Thejournalentriestransfercostsbetweenactivitiesinprocesscostingarebasicallythesameasthoseusedi
njobordercosting.Thewayyoucalculatetheunitcostsneededtomakethejournalentries,however,isdiff
erent.

3.Calculateequivalentunitswhenresourcesareaddeduniformly.
Partiallycompletedunitsareoftenininventoryattheendofaperiod.Sincesomeoftheperiod’sproduction
costsbelongtothosepartiallycompletedunits,theircostsmustbecalculatedaccordingtoequivalentunits
ratherthanphysicalunits.

4.Calculateequivalentunitswhenresourcesareaddedinlump.
Whenaresourceisaddedinalump,100percentoftheresourceisaddedataspecifiedtimeintheproduction
process,oftenatthestart.Priordepartmentcostsanddirectmaterialscostsareusuallyaddedthisway.Whe
ntheyare,equivalentunitsequalthenumberofphysicalunitsthathavepassedthispoint.

5.Usingequivalentunits,calculatetheunitcostsforalltypesofcostsandrecordthemonacostsumm
aryreport.

Thefirststepincalculatingunitcostistoanalyzetheflowofphysicalunits.Thistaskcanbedonebyusingab
ardiagram.Next,equivalentunitmustbecalculatedforeachcategory.Thisisdonebymultiplyingthenum
berofphysicalunitsbythepercentageofcompletioneachcategory.

6.Calculateunitcostusingthemovingaveragemethodanduseittocomputethecostofcompletedun
itsandendingworkinprocess.
Whenanactivityusingamovingaveragehaspartiallycompletedunitsonhandatboththebeginninganden
dofthemonth,thecostofthebeginninginventoryareaveragedwiththecurrentmonth’sproductioncosts.

7.CalculateunitcostusingtheFIFOmethod,anduseittocomputethecostsofcompletedunitsande
ndingworkinprocess.
WhentheFIFOmethodisused,thecostsofbeginningworkinprocessareseparatedfromcurrentcosts.Usi
ngthecurrentmonth’scostsandequivalentunits,aunitcostiscalculatedforeachcostcategory.Theunitco
stsareusedtocalculate(1)thecostofcompletingbeginningworkinprocessand(2)thecostofunitsstarteda
ndcompletedduringthemonth.

SystemsChoice:JobCostingversusProcessCosting

Injobcosting,costsarecollectedforeachunitproduced.Theyareusuallymorecostlythanprocesssystem.
Thusmanagersandaccountantsmustdecidewhetherthereareenoughadditionalbenefitsfromknowingt
heactualcostofeachunit,whichisavailableinajobcostingsystem,tojustifyadditionalrecordkeepingcos
ts.

Inprocesscosting,costsareaccumulatedinadepartmentforanaccountingperiod,thenspreadevenlyora
veraged,overallunitsproducedthatmonth.Itassumesthateachunitproducedisrelativelyuniform.Proce
sscostinghaslessdetailedrecordkeeping.
Thechoiceofprocessversusjobcostingsystemsinvolvesacomparisonofthecostsandbenefitsofeachsys
tem.Ifrecordkeepingcostswereequalunderjobandprocesssystemsfortheunitsinaproductline,thenthej
obsystemsarebetterbecausetheyprovideallofthedatathatprocesssystemsdo.

OperationCosting:ConceptandApplication

Manycompaniesemployanoperationcostingsysteminthemanufactureofgoodsthathavesomecomm
onandindividualcharacteristics.Anoperationisaroutineproductionmethod,techniqueorstepthatisrep
etitivelyperformed.Distinctionsaremadebetweenbatchesofproduct,suchasStyleAladies’suitsandSt
yleBladies’suits.

Anoperationcostingsystemrepresentsahybridmethod,havingsomeofthecharacteristicsofbothproces
sandjobordercosting.Forexample,inoperationcosting,accountantsallocatedirectmaterialsspecificall
ytothebatches,justlikejobordercosting.Theyapplylaborandoverheadtoallphysicalunitspassingthrou
ghtheoperationbyusingasingleaverageunitconversioncostfortheoperation,inthesamemannerasproc
esscosting.

Operationcostingmeetstheneedsofthebatchmanufacturerwhoseproductshasvariationsofasingledesi
gnandrequiresavaryingsequenceofstandardizedoperations.Jobcostingcontinuestobethebestalternat
iveforaccumulatingthecostofcontractsandcustomizedmanufacturing.Howeverthetrendistowardpro
cesscostingsystemsandcostsystemsthatarecustomdesigned,suchasoperationcosting.