Systems Design: Job-Order Costing Chapter Three McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-2 Learning Objective 1 Distinguish between process costing and joborder costing and identify companies that would use each costing method. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-3 Types of Product Costing Systems Process Costing Job-order Costing A company produces many units of a single product. One unit of product is indistinguishable from other units of product. The identical nature of each unit of product enables assigning the same average cost per unit. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-4 Types of Product Costing Systems Process Example companies: Costing Job-order Costing 1. Weyerhaeuser (paper manufacturing) 2. Reynolds Aluminum (refining aluminum ingots) 3. Coca-Cola (mixing and bottling beverages) A company produces many units of a single product. Continuous production of a single roll of paper that One unit of product is indistinguishable from may eventually be cut into sizes needed by customers other units of product. The of all three ofofthese is enables to make desire The identical nature each companies unit of product assigning the same average cost per unit. each unit of output consistent with the quality standards established. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-5 Types of Product Costing Systems Process Costing Job-order Costing Many different products are produced each period. Products are manufactured to order. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-6 Types of Product Costing Systems Process Costing Job-order Costing Many different products are produced each period. Example companies: Products manufactured to order. 1.Boeing (aircraftare manufacturing) 2.Bechtel (large scale construction) TheInternational unique nature of each order requires tracing or to each maintaining cost Works allocating on huge costs projects thatjob, areand unique to customer records for each job. needs 3. Walt Disney Studios (movie production) McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-7 Comparing Process and Job-Order Costing Job-Order Number of jobs worked Cost accumulated by Average cost computed by Process Many Individual Job Single Product Job Department Department While building a house, it is easy to accumulate costs for a particular house, even though you may be building more than one house at a time. If you think of mixing Coca-Cola, costs would naturally be accumulated by the department working on the current batch. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-8 Quick Check Which of the following companies would be likely to use job-order costing rather than process costing? a. Scott Paper Company for Kleenex. b. Architects. c. Heinz for ketchup. d. Caterer for a wedding reception. e. Builder of commercial fishing vessels. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-9 Quick Check Which of the following companies would be likely to use job-order costing rather than process costing? a. Scott Paper Company for Kleenex. b. Architects. c. Heinz for ketchup. d. Caterer for a wedding reception. e. Builder of commercial fishing vessels. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-10 Learning Objective 2 Identify the documents used in a job-order costing system. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-11 Job-Order Costing – An Overview Direct Materials Job No. 1 Direct Labor Manufacturing Overhead McGraw-Hill/Irwin Job No. 2 Job No. 3 Charge direct material and direct labor costs to each job as work is performed. Copyright © 2008, The McGraw-Hill Companies, Inc. 3-12 Direct Manufacturing Costs Direct Materials Job No. 1 Direct Labor Manufacturing Overhead McGraw-Hill/Irwin Job No. 2 Job No. 3 Manufacturing Overhead, including indirect materials and indirect labor, are allocated to all jobs rather than directly traced to each job. Copyright © 2008, The McGraw-Hill Companies, Inc. 3-13 Actual and Applied Factory Overhead • Actual: Actual indirect manufacturing expenses • Applied: Based on pre determined rate normally on basis of labour • Apply overhead using a base believed to cause the overhead costs. E.g direct labor hours or machine hours • Hint: ALWAYS use applied FOH • Compare both overheads and then close the difference (add/subtract) in Cost of Goods Sold McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-14 The Job Cost Sheet Used by the accounting department to track the direct and indirect costs associated with a given job PearCo Job Cost Sheet Job Number A - 143 Department B3 Item Wooden cargo crate Direct Materials Req. No. Amount Direct Labor Manufacturing Overhead Ticket Hours Amount Hours Rate Amount Cost Summary Direct Materials Direct Labor Manufacturing Overhead Total Cost Unit Product Cost McGraw-Hill/Irwin Date Initiated 3-4-05 Date Completed Units Completed Units Shipped Date Number Balance Copyright © 2008, The McGraw-Hill Companies, Inc. 3-15 Measuring Direct Materials Cost Will E. Delite McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-16 Measuring Direct Materials Cost McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-17 Measuring Direct Labor Costs McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-18 Job-Order Cost Accounting McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-19 Learning Objective 3 Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-20 Why Use an Allocation Base? Manufacturing overhead is applied to jobs that are in process. An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual jobs. We use an allocation base because: 1. It is impossible or difficult to trace overhead costs to particular jobs. 2. Manufacturing overhead consists of many different items ranging from the grease used in machines to production manager’s salary. A job may be complete and sold before the actual overhead costs incurred is determined. 3. Many types of manufacturing overhead costs are fixed even though output fluctuates during the period. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-21 Manufacturing Overhead Application The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period begins. POHR = Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period Ideally, the allocation base is a cost driver that causes overhead. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-22 The Need for a POHR Using a predetermined rate makes it possible to estimate total job costs sooner. $ Actual overhead for the period is not known until the end of the period. Actual overhead costs can fluctuate seasonally, thus misleading decision makers and it simplifies record keeping McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-23 Application of Manufacturing Overhead Based on estimates, and determined before the period begins. Overhead applied = POHR × Actual activity Actual amount of the allocation based upon the actual level of activity. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-24 Overhead Application Rate POHR = POHR = Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period $640,000 160,000 direct labor hours (DLH) POHR = $4.00 per DLH For each direct labor hour worked on a particular job, $4.00 of factory overhead will be applied to that job. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-25 Job-Order Cost Accounting McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-26 Job-Order Cost Accounting McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-27 Interpreting the Average Unit Cost The average unit cost should not be interpreted as the costs that would actually be incurred if an additional unit were produced. Fixed overhead would not change if another unit were produced, so the incremental cost of another unit may be somewhat less than $118. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-28 Quick Check Job WR53 at NW Fab, Inc. required $200 of direct materials and 10 direct labor hours at $15 per hour. Estimated total overhead for the year was $760,000 and estimated direct labor hours were 20,000. What would be recorded as the cost of job WR53? a. $200. b. $350. c. $380. d. $730. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-29 Quick Check Job WR53 at NW Fab, Inc. required $200 of direct materials and 10 direct labor hours at $15 per hour. Estimated total overhead for the year was $760,000 and estimated direct labor hours were 20,000. What would be recorded as the cost of job WR53? Pred. ovhd. rate $760,000/20,000hours $38 a. $200. materials $200 b. $350. Direct Direct labor $15 x 10 hours $150 c. $380. Manufacturing overhead $38 x 10 hours $380 Total cost $730 d. $730. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-30 Learning Objective 4 Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. Job-Order Costing Document Flow Summary 3-31 A sales order is the basis of issuing a production order. McGraw-Hill/Irwin A production order initiates work on a job. Copyright © 2008, The McGraw-Hill Companies, Inc. 3-32 Job-Order Costing Document Flow Summary Materials used may be either direct or indirect. Direct materials Job Cost Sheets Materials Requisition Indirect materials McGraw-Hill/Irwin Manufacturing Overhead Account Copyright © 2008, The McGraw-Hill Companies, Inc. 3-33 Job-Order Costing Document Flow Summary An employee’s time may be either direct or indirect. Direct Labor Job Cost Sheets Employee Time Ticket Indirect Labor McGraw-Hill/Irwin Manufacturing Overhead Account Copyright © 2008, The McGraw-Hill Companies, Inc. 3-34 Job-Order Costing Document Flow Summary Employee Time Ticket Other Actual OH Charges Materials Requisition McGraw-Hill/Irwin Indirect Labor Manufacturing Applied Overhead Overhead Account Job Cost Sheets Indirect Material Copyright © 2008, The McGraw-Hill Companies, Inc. 3-35 Learning Objectives 4 & 7 Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs. Use T-accounts to show the flow of costs in a job-order costing system. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-36 Job-Order Costing: The Flow of Costs The transactions (in Taccount and journal entry form) that capture the flow of costs in a joborder costing system are illustrated on the following slides. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-37 The Purchase and Issue of Raw Materials Raw Materials Material Direct Purchases Materials Indirect Materials Work in Process (Job Cost Sheet) Direct Materials Mfg. Overhead Actual Applied Indirect Materials McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-38 Cost Flows – Material Purchases Raw material purchases are recorded in an inventory account. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-39 Cost Flows – Material Usage Direct materials issued to a job increase Work in Process and decrease Raw Materials. Indirect materials used are charged to Manufacturing Overhead and also decrease Raw Materials. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-40 The Recording of Labor Costs Salaries and Wages Payable Direct Labor Indirect Labor Work in Process (Job Cost Sheet) Direct Materials Direct Labor Mfg. Overhead Actual Indirect Materials Indirect Labor McGraw-Hill/Irwin Applied Copyright © 2008, The McGraw-Hill Companies, Inc. 3-41 The Recording of Labor Costs The cost of direct labor incurred increases Work in Process and the cost of indirect labor increases Manufacturing Overhead. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. Recording Actual Manufacturing Overhead 3-42 Additional manufacturing overhead amounts are debited to the manufacturing overhead account. The credit side of the entry is various liability accounts Or prepaid assets (e.g prepaid insurance) and contra accounts (e.g depreciation) Salaries and Wages Payable Direct Labor Indirect Labor Work in Process (Job Cost Sheet) Direct Materials Direct Labor Mfg. Overhead Actual Applied Indirect Materials Indirect Labor Other Overhead McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-43 Recording Actual Manufacturing Overhead In addition to indirect materials and indirect labor, other manufacturing overhead costs are charged to the Manufacturing Overhead account as they are incurred. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-44 Learning Objective 5 Apply overhead cost to Work in Process using a predetermined overhead rate. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-45 Applying Manufacturing Overhead Salaries and Wages Payable Direct Labor Indirect Labor Mfg. Overhead Actual Applied Indirect Materials Overhead Indirect Applied to Labor Work in Other Process Overhead McGraw-Hill/Irwin Work in Process (Job Cost Sheet) Direct Materials Direct Labor Overhead Applied If actual and applied manufacturing overhead are not equal, a year-end adjustment is required. Copyright © 2008, The McGraw-Hill Companies, Inc. 3-46 Applying Manufacturing Overhead Work in Process is increased when Manufacturing Overhead is applied to jobs. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-47 Accounting for Nonmanufacturing Cost Nonmanufacturing costs are not assigned to individual jobs; rather they are expensed in the period incurred. Examples: 1. Salary expense of employees who work in a marketing, selling, or administrative capacity. 2. Advertising expenses are expensed in the period incurred. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-48 Accounting for Nonmanufacturing Cost Nonmanufacturing costs (period expenses) are charged to expense as they are incurred. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-49 Learning Objective 6 Prepare schedules of cost of goods manufactured and cost of goods sold. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-50 Transferring Completed Units Work in Process (Job Cost Sheet) Direct Materials Direct Labor Overhead Applied Finished Goods Cost of Goods Mfd. Cost of Goods Mfd. The sum of all amounts transferred from work in process to finished goods represents the cost of goods manufactured for the period. As a job is completed, its costs are transferred from the work in process inventory to finished goods inventory McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-51 Transferring Completed Units As jobs are completed, the Cost of Goods Manufactured is transferred to Finished Goods from Work in Process. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-52 Transferring Units Sold Work in Process (Job Cost Sheet) Direct Materials Direct Labor Overhead Applied Finished Goods Cost of Goods Mfd. Cost of Goods Mfd. Cost of Goods Sold Cost of Goods Sold Cost of Goods Sold McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-53 Transferring Units Sold When finished goods are sold, two entries are required: (1) to record the sale, and (2) to record COGS and reduce Finished Goods. The difference between the selling price and cost is the company’s gross margin on the job McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-54 Learning Objective 8 Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-55 Problems of Overhead Application The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is referred to as either underapplied or overapplied overhead. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period. McGraw-Hill/Irwin Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period. Copyright © 2008, The McGraw-Hill Companies, Inc. 3-56 Overhead Application Example PearCo’s actual overhead for the year was $650,000 with a total of 170,000 direct labor hours worked on jobs. How much total overhead was applied to PearCo’s jobs during the year? Use PearCo’s predetermined overhead rate of $4.00 per direct labor hour. Overhead Applied During the Period Applied Overhead = POHR × Actual Direct Labor Hours Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-57 Overhead Application Example PearCo’s actual overhead for the year was $650,000 with a total of 170,000 direct labor hours worked on jobs. PearCo has overapplied How much total overhead was applied to overhead for the year PearCo’s jobs during the year? Use by $30,000. What will PearCo’s predetermined overhead rate of PearCo do? $4.00 per direct labor hour. Overhead Applied During the Period Applied Overhead = POHR × Actual Direct Labor Hours Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-58 Quick Check Tiger, Inc. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine hour. Tiger, Inc. worked 290,000 machine hours during the period. Tiger’s manufacturing overhead is a. $50,000 overapplied. b. $50,000 underapplied. c. $60,000 overapplied. d. $60,000 underapplied. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-59 Quick Check Tiger, Inc. had actual manufacturing overhead costs of $1,210,000 and a predetermined Overhead Applied overhead rate of $4.00 per machine Tiger, $4.00 per hour hour. × 290,000 hours = $1,160,000 Inc. worked 290,000 machine hours during the Underapplied Overhead is period. Tiger’s manufacturing overhead a. $50,000 overapplied. $1,210,000 - $1,160,000 = $50,000 b. $50,000 underapplied. c. $60,000 overapplied. d. $60,000 underapplied. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-60 Disposition of Under- or Overapplied Overhead PearCo’s Method $30,000 may be allocated to these accounts. $30,000 may be closed directly to cost of goods sold. OR Work in Process Finished Goods Cost of Goods Sold McGraw-Hill/Irwin Cost of Goods Sold Copyright © 2008, The McGraw-Hill Companies, Inc. 3-61 Disposition of Under- or Overapplied Overhead PearCo’s Cost of Goods Sold Actual Overhead overhead applied costs to jobs Unadjusted Balance $30,000 Adjusted Balance McGraw-Hill/Irwin PearCo’s Mfg. Overhead $650,000 $30,000 $680,000 $30,000 overapplied Copyright © 2008, The McGraw-Hill Companies, Inc. 3-62 Allocating Under- or Overapplied Overhead Between Accounts Assume the overhead applied in ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold is shown below: Work in process Finished Goods Cost of Goods Sold Total McGraw-Hill/Irwin Amount $ 68,000 204,000 408,000 $ 680,000 Percent of Total 10% 30% 60% 100% Allocation of $30,000 $ 3,000 9,000 18,000 $ 30,000 Copyright © 2008, The McGraw-Hill Companies, Inc. 3-63 Allocating Under- or Overapplied Overhead Between Accounts We would complete the following allocation of $30,000 overapplied overhead: Work in process Finished Goods Cost of Goods Sold Total McGraw-Hill/Irwin Amount $ 68,000 204,000 408,000 $ 680,000 Percent of Total 10% 30% 60% 100% Allocation of $30,000 $ 3,000 9,000 18,000 $ 30,000 Copyright © 2008, The McGraw-Hill Companies, Inc. 3-64 Allocating Under- or Overapplied Overhead Between Accounts Work in process Finished Goods Cost of Goods Sold Total McGraw-Hill/Irwin Amount $ 68,000 204,000 408,000 $ 680,000 Percent of Total 10% 30% 60% 100% Allocation of $30,000 $ 3,000 9,000 18,000 $ 30,000 Copyright © 2008, The McGraw-Hill Companies, Inc. 3-65 Overapplied and Underapplied Manufacturing Overhead - Summary PearCo’s Method If Manufacturing Overhead is . . . UNDERAPPLIED Alternative 1 Close to Cost of Goods Sold Alternative 2 INCREASE Cost of Goods Sold INCREASE Work in Process Finished Goods Cost of Goods Sold DECREASE Cost of Goods Sold DECREASE Work in Process Finished Goods Cost of Goods Sold (Applied OH is less than actual OH) OVERAPPLIED (Applied OH is greater than actual OH) McGraw-Hill/Irwin Allocation Copyright © 2008, The McGraw-Hill Companies, Inc. 3-66 Quick Check What effect will the overapplied overhead have on PearCo’s net operating income? a. Net operating income will increase. b. Net operating income will be unaffected. c. Net operating income will decrease. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-67 Quick Check What effect will the overapplied overhead have on PearCo’s net operating income? a. Net operating income will increase. b. Net operating income will be unaffected. c. Net operating income will decrease. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-68 Multiple Predetermined Overhead Rates To this point, we have assumed that there is a single predetermined overhead rate called a plantwide overhead rate. Large companies often use multiple predetermined overhead rates. McGraw-Hill/Irwin May be more complex but . . . May be more accurate because it reflects differences across departments. Copyright © 2008, The McGraw-Hill Companies, Inc. 3-69 Job-Order Costing in Service Companies Job-order costing is used in many different types of service companies. In a law firm, each client represents a job. Legal forms and similar inputs represent direct materials. The time expended by attorneys represents direct labor. The costs of secretaries, clerks, rent, depreciation, and so forth, represent the overhead. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-70 The Use of Information Technology Technology plays an important part in many job-order cost systems. When combined with Electronic Data Interchange (EDI) or a webbased programming language called Extensible Markup Language (XML), bar coding eliminates the inefficiencies and inaccuracies associated with manual clerical processes. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. The Predetermined Overhead Rate & Capacity Appendix 3A McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-72 Learning Objective 9 (Appendix 3A) Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-73 Predetermined Overhead Rate and Capacity Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has been criticized because: 1. Basing the predetermined overhead rate upon budgeted activity results in product costs that fluctuate depending upon the activity level. 2. Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-74 Capacity-Based Overhead Rates Criticisms can be overcome by using estimated total units in the allocation base at capacity in the denominator of the predetermined overhead rate calculation. Let’s look at the difference! McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-75 An Example Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. What is the predetermined overhead rate? McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-76 An Example Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. What is the predetermined overhead rate? McGraw-Hill/Irwin Traditional = Method $100,000 40,000 = $2.50 per unit Capacity Method $100,000 50,000 = $2.00 per unit = Copyright © 2008, The McGraw-Hill Companies, Inc. 3-77 Quick Check Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. If run at full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-78 Quick Check Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. If run at full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-79 Quick Check Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. If run at full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-80 Quick Check Crest Winery in Woodinville leases an automatic corking machine for $100,000 per year. If run at full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-81 Quick Check When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a. The predetermined overhead rate goes up when activity goes down. b. The predetermined overhead rate stays the same; it is not affected by changes in activity. c. The predetermined overhead rate goes down when activity goes down. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-82 Quick Check When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a. The predetermined overhead rate goes up when activity goes down. b. The predetermined overhead rate stays the same; it is not affected by changes in activity. c. The predetermined overhead rate goes down when activity goes down. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-83 Quick Check When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a.The predetermined overhead rate goes up when activity goes down. b.The predetermined overhead rate stays the same; it is not affected by changes in activity. c.The predetermined overhead rate goes down when activity goes down. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-84 Quick Check When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a.The predetermined overhead rate goes up when activity goes down. b.The predetermined overhead rate stays the same; it is not affected by changes in activity. c.The predetermined overhead rate goes down when activity goes down. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-85 • Critics suggest that the underapplied overhead that results from idle capacity should be disclosed on the income statement as the cost of unused capacity a period expense. The disclosure of the $20,000 cost of idle capacity is recorded as a period expense. This cost is incurred because we were not able to fully utilize our capacity. Using a measure of capacity in the denominator of the predetermined overhead rate enables this type of disclosure. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-86 Income Statement Preparation Actual volume Selling price Variable production cost Fixed manufacturing overhead Capacity Predetermined overhead rate Fixed selling and admin. expense Revenue Cost of goods sold Gross margin Cost of idle capacity Selling and admin. expense Net operating income McGraw-Hill/Irwin 40,000 $40.00 $24.00 $100,000 50,000 $2.00 $500,000 cases per case per case per year cases per case per year $ 1,600,000 1,040,000 560,000 20,000 500,000 $ 40,000 Copyright © 2008, The McGraw-Hill Companies, Inc. 3-87 Income Statement Preparation Actual volume Selling price Variable production cost Fixed manufacturing overhead Capacity Predetermined overhead rate Fixed selling and admin. expense Revenue Cost of goods sold Gross margin Cost of idle capacity Selling and admin. expense Net operating income McGraw-Hill/Irwin 40,000 $40.00 $24.00 $100,000 40,000 $2.50 $500,000 cases per case per case per year cases per case per year $ 1,600,000 1,060,000 540,000 500,000 $ 40,000 Copyright © 2008, The McGraw-Hill Companies, Inc. 3-88 • In income statement using the traditional approach cost of goods sold is charged with the cost of idle capacity. Using the estimated or budgeted amount of the allocation base in the denominator of the predetermined overhead rate calculation does not allow for disclosure of the idle capacity. In this example, underapplied overhead is not treated as a period expense, but instead, it is allocated to the work in process, finished goods, and/or cost of goods sold. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 3-89 End of Chapter 3 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.
