Chapter 3 : Overhead Analysis

TABLE OF CONTENTS
• Summary
• Understand the flow of costs in the 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.
• Prepare schedules of cost of goods manufactured and cost of
goods sold and an income statement.
• Compute underapplied or overapplied overhead cost and
prepare the journal entry to close the balance in
Manufacturing Overhead to the appropriate accounts.

SUMMARY
• If actual manufacturing overhead cost is applied to jobs, then the company
must wait until the end of the accounting period to apply overhead and to cost
jobs. If the company computes the actual overhead rates more frequently to get
around this problem, the rates may fluctuate widely. Overhead cost tends to be
incurred somewhat evenly from month to month (due to the presence of fixed
costs), whereas production activity often fluctuates. The result would be high
overhead rates in periods with low activity and low overhead rates in periods
with high activity. For these reasons, most companies use predetermined
overhead rates to apply overhead cost to jobs.
• The measure of activity used as the allocation base should drive the overhead
cost; that is, the base should cause the overhead cost. If the allocation base does
not really cause the overhead, then costs will be incorrectly attributed to
products and jobs and their product costs will be distorted.
• Assigning overhead costs to jobs does not ensure a profit. The units produced
may not be sold and if they are sold, they may not in fact be sold at prices
sufficient to cover all costs. It is a myth that assigning costs to products or jobs
ensures that those costs will be recovered. Costs are recovered only by selling to
customers—not by allocating costs.

SUMMARY
• The Manufacturing Overhead account is credited when overhead
cost is applied to Work in Process. Generally, the amount of
overhead applied will not be the same as the amount of actual cost
incurred, since the predetermined overhead rate is based on
estimates.
• Underapplied overhead occurs when the actual overhead cost
exceeds the amount of over-head cost applied to Work in Process
inventory during the period.
• Overapplied overhead occurs when the actual overhead cost is less
than the amount of overhead cost applied to Work in Process
inventory during the period. Under- or over-applied overhead is
disposed of by either closing out the amount to Cost of Goods Sold
or allocating the amount among Cost of Goods Sold and ending
inventories in proportion to the applied overhead in each account.
The adjustment for underapplied overhead increases Cost of Goods
Sold (and inventories) whereas the adjustment for overapplied
overhead decreases Cost of Goods Sold (and inventories).

SUMMARY
• Overhead may be underapplied for several reasons. Control
over overhead spending may be poor. Or, some of the
overhead may be fixed and the actual amount of the
allocation base was less than estimated at the beginning of
the period. In this situation, the amount of overhead applied
to inventory will be less than the actual overhead cost
incurred.
• Underapplied overhead implies that not enough overhead
was assigned to jobs during the period and therefore cost of
goods sold was under-stated. Therefore, underapplied
overhead is added to cost of goods sold. Likewise,
overapplied over-head is deducted from cost of goods sold.

UNDERSTAND THE FLOW OF COSTS IN THE JOB-ORDER COSTING SYSTEM
AND PREPARE APPROPRIATE JOURNAL ENTRIES TO RECORD COSTS.
Section 1 & 2

IMPORTANT VOCABULARY TERMS
• Job-order costing – A
costing system used
in situations where
many different
products, jobs, or
services are produced
each period.
• Absorption costing –
A costing method that
includes all
manufacturing
costs—direct
materials, direct labor,
and both variable and
fixed manufacturing
overhead—in the cost
of a product.
Direct materials Those materials that are included in a
finished product.
Direct labor The factory labor costs required to
construct a product.
Variable manufacturing overhead The costs to operate a manufacturing
facility, which vary with production
volume. Examples are supplies and
electricity for production equipment.
Fixed manufacturing overhead The costs to operate a manufacturing
facility, which do not vary with
production volume. Examples are rent
and insurance.

• Allocation base – A measure of
activity such as direct labor-hours or
machine-hours that is used to assign
costs to cost objects.
• Predetermined overhead rate – A
rate used to charge manufacturing
overhead cost to jobs that is
established in advance for each
period. It is computed using the
following equation:
• Predetermined overhead rate =
Estimated total manufacturing
overhead cost ÷ Estimated total
amount of the allocation base

Overhead application – the process
of assigning overhead costs to
specific jobs using the following
formula:
Normal costing – A costing system in
which overhead costs are applied to a job
by multiplying a predetermined overhead
rate by the actual amount of the
allocation base incurred by the job.
Job cost sheet – A form that records the
direct materials, direct labor, and
manufacturing overhead cost charged to
a job.
Overhead applied to a particular job =
Predetermined overhead rate x Amount
of allocation base incurred by the job

FLOW OF COSTS: KEY DEFINITIONS
1. Raw materials include any
materials that go into the final
product.
2. Work in process consists of
units of production that are
only partially complete and
will require further work
before they are ready for sale
to customers.
3. Finished goods consist of
completed units of product
that have not been sold to
customers.
4. Cost of goods manufactured
includes the manufacturing
costs associated with the
goods that were finished
during the period.

FLOW OF COSTS: A CONCEPTUAL OVERVIEW

CHARACTERISTICS OF JOB ORDER COSTING
• In general, companies match the flow of costs to the physical
flow of products through the production process. They place
materials received from suppliers in the materials storeroom
and record the cost of those materials when purchasing them
to raw materials inventory. As they are needed for production,
the materials move from the materials storeroom (raw
materials inventory) to the production departments with their
cost as shown below.

• During production, the materials
processed by workers and machines
become partially manufactured
products. At any time during
production, these partially
manufactured products are collectively
known as work in process (or goods in
process). For example, if accountants
compute the inventory when the
company has partially finished products
at the end of the year, this inventory is
work in process inventory.
• Completed products are finished goods.
When the products are completed and
transferred to the finished goods
storeroom, the company removes their
costs from Work in Process Inventory
and assigns them to Finished Goods
Inventory. As the goods are sold, the
company transfers related costs from
Finished Goods Inventory to Cost of
Goods Sold

• The accounting flow of costs follows the
physical flow of the manufacturing
process in most companies. In
discussing product costing, we
described how accountants and
managers assign costs to products.
Products can be either goods or
services, so this discussion applies to
service and merchandising companies
as well as to manufacturing companies.
• What kinds of companies would use job
costing? The chart below shows how
various companies choose different
accounting systems, depending on their
products.
• First, companies producing individual,
unique products known as jobs use job
costing (also called job order costing).
Companies such as construction
companies and consulting firms,
produce jobs and use job costing.

Type of production Accounting system Type of product
Job shop
Hospital, custom home
builder, consulting firm
Job costing Customized
Batch production
Furniture manufacturer,
winery
Mostly job costing Several different
products
Repetitive manufacturing
Computer manufacturer,
bicycle manufacturer
Mostly process costing
(operations)
Few new products
Continuous flow processing
Oil refinery, paint
manufacturer
Process costing Standardized

• Second, some companies, like furniture
manufacturers, produce batches of products.
They produce all of the components of a single
product (e.g. coffee tables) in one batch. They
would then produce the components of another
product (e.g. dining room sets) in a new batch.
Companies such as these use job costing methods
to accumulate the cost of each batch.
• Repetitive manufacturing in use process costing.
Repetitive manufacturing lends itself to the use
of automated equipment that minimizes the
amount of manual material handling. Automobile
assembly plants, bicycle assembly plants, and
computer assembly plants use repetitive
manufacturing.
• Continuous flow processing is the opposite of job
shops. Companies using this process continuously
mass-produce a single, homogeneous product.
Companies might use process cost systems in
manufacturing paint, grinding flour, and refining
oil.

JOB-ORDER COSTING: THE FLOW OF COSTS
• To illustrate the cost flows within a job-order costing system, we will record Ruger
Corporation’s transactions for the month of April. Ruger is a producer of gold and
silver commemorative medallions and it worked on only two jobs in April.
• Job A, a special minting of 1,000 gold medallions commemorating the invention of
motion pictures, was started during March and completed in April. As of March 31,
Job A had been assigned $30,000 in manufacturing costs, which corresponds with
Ruger’s Work in Process balance on April 1 of $30,000.
• Job B, an order for 10,000 silver medallions commemorating the fall of the Berlin
Wall, was started in April and was incomplete at the end of the month.
1. Raw materials
2. Work in Process
3. Manufacturing Overhead

PURCHASE OF RAW MATERIALS – T ACCOUNTS
Purchase of raw materials in T-account form.
Raw Materials
Material
Purchases
Mfg. Overhead
Work in Process
(Job Cost Sheet)
Actual Applied
Direct
Materials Direct
Materials
Indirect
Materials
Indirect
Materials
Indirect materials are materials used in
the production process, but which cannot
be linked to a specific product or job i.e.
Cleaning supplies, disposable safety
equipment etc.

PURCHASE OF RAW MATERIALS – JOURNAL ENTRY
Purchase of raw materials in journal entry form -- On April 1, Ruger
Corporation had $7,000 in raw materials on hand. During the month, the
company purchased on account an additional $60,000 in raw materials.
Raw Materials 60,000
Accounts Payable 60,000
(1)
When a company purchases goods on credit
which needs to be paid back in a short period
of time, it is known as Accounts Payable

THE DIFFERENCE BETWEEN ACTUAL OVERHEAD
AND APPLIED OVERHEAD?
• In accounting, overhead usually refers to the
indirect manufacturing costs. These are the
manufacturing costs other than direct
materials and direct labor.
• The actual overhead refers to the indirect
manufacturing costs actually occurring and
recorded. These include the manufacturing
costs of electricity, gas, water, rent, property
tax, production supervisors, depreciation,
repairs, maintenance, and more.
• The applied overhead refers to the indirect
manufacturing costs that have been assigned
to the goods manufactured. Manufacturing
overhead is usually applied, assigned, or
allocated by using a predetermined annual
overhead rate.
• For example, a manufacturer might estimate
that in its upcoming accounting year there will
be $2,000,000 of manufacturing overhead and
40,000 machine hours. As a result, this
manufacturer sets its predetermined annual
overhead rate at $50 per machine hour.

ISSUE OF DIRECT AND INDIRECT MATERIALS
Work in Process 50,000
Manufacturing Overhead 2,000
Raw Materials 52,000
(2)
During April, materials requisition forms were prepared to authorize withdrawing
$52,000 in raw materials from the storeroom for use in production. These raw
materials included $50,000 of direct and $2,000 of indirect materials. Entry (2)
records issuing the materials to the production departments.
Materials requisition forms - A materials requisition form is a
source document that the production department uses to
request materials for manufacturing process
Work in process consists of units of production that are only
partially complete and will require further work before they
are ready for sale to customers

RECORDING LABOR COST: T-ACCOUNT
Mfg. Overhead
Salaries and Wages
Payable
Work in Process
(Job Cost Sheet)
Direct
Materials
Direct
Labor
Direct
Labor
Indirect
Materials
Actual Applied
Indirect
Labor
Indirect
Labor
Indirect labor is the cost of any labor that
supports the production process, but
which is not directly involved in the active
conversion of materials into finished
products i.e. Production supervisor

RECORDINGLABORCOST:JOURNALENTRY
In April, the employee time tickets (which provide hourly summaries of
each employee’s activities throughout the day) included $60,000
recorded for direct labor and $15,000 for indirect labor. The following
entry summarizes these costs:
Salaries and Wages Payable 75,000
(3)

RECORDING ACTUAL MANUFACTURING
OVERHEAD COSTS: T-ACCOUNT
Mfg. Overhead
Salaries and Wages Payable Work in Process
(Job Cost Sheet)
Direct
Materials
Direct
Labor
Direct
Labor
Indirect
Materials
Actual Applied
Indirect
Labor
Indirect
Labor
Other
Overhead

RECORDING ACTUAL MANUFACTURING
OVERHEAD COSTS: JOURNAL ENTRY
Assume that Ruger Corporation incurred the following general factory
costs during April:
1. Utilities (heat, water, and power) $21,000
2. Rent on factory equipment $16,000
3. Miscellaneous factory overhead costs $3,000
Accounts Payable* 40,000
*Accounts such as Cash may also be credited.
(4)

APPLYING MANUFACTURING OVERHEAD COSTS
TO WORK IN PROCESS: T-ACCOUNT
Mfg. Overhead
Salaries and Wages Payable Work in Process
(Job Cost Sheet)
Direct
Materials
Direct
Labor
Direct
Labor
Indirect
Materials
Actual Applied
Indirect
Labor
Indirect
Labor
Other
Overhead
Overhead
Applied
Overhead
Applied to Work
in
Process
If actual and applied
manufacturing overhead
are not equal, a year-end
adjustment is required.

APPLYING MANUFACTURING OVERHEAD COSTS
TO WORK IN PROCESS: JOURNAL ENTRY
Assume that Ruger Corporation’s predetermined overhead rate is $6 per
machine-hour. Also assume that during April, 10,000 machine-hours were
worked on Job A and 5,000 machine-hours were worked on Job B (a total of
15,000 machine-hours). Thus, $90,000 in overhead cost ($6 per machine-hour
× 15,000 machine-hours = $90,000) would be applied to Work in Process. The
following entry records the application of Manufacturing Overhead to Work in
Process:
(5)

ACCOUNTING FOR NONMANUFACTURING COSTS
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 are expensed in the period incurred.
2. Advertising expenses are expensed in the period incurred.

NONMANUFACTURING COSTS
Ruger Corporation incurred $30,000 in selling and administrative salary costs during
April. The following entry summarizes the accrual of those salaries:
Depreciation on office equipment during April was $7,000. The entry is as follows:
Advertising was $42,000 and other selling and administrative expenses in April
totaled $8,000. The following entry records these items:
(6)
(7)
(8)

TRANSFERRING COMPLETED JOBS FROM WORK
IN PROCESS TO FINISHED GOODS: T-ACCOUNT
Finished GoodsWork in Process
(Job Cost Sheet)
Direct
Materials
Direct
Labor
Overhead
Applied
Cost of
Goods
Manufactured
Cost of
Goods
Manufactured
Cost of goods manufactured is based on
the amount of work-in-process
completed

TRANSFERRING COMPLETED JOBS FROM WORK IN
PROCESS TO FINISHED GOODS: JOURNAL ENTRY
Job A was completed during April and Job B was incomplete at the end of
the month. Thus, the following entry transfers the cost of Job A from Work
in Process to Finished Goods:
Finished Goods 158,000
(9)
Because Job B was not completed by the end of the month, its assigned costs will
remain in Work in Process and carry over to the next month. If a balance sheet
were prepared at the end of April, the cost accumulated thus far on Job B
($72,000) would appear in the asset account Work in Process.

TRANSFERRING FINISHED GOODS TO COST OF
GOODS SOLD: T ACCOUNT
Finished Goods
Cost of Goods Sold
Work in Process
(Job Cost Sheet)
Direct
Materials
Direct
Labor
Overhead
Applied
Cost of
Goods
Mfd.
Cost of
Goods
Mfd.
Cost of
Goods
Sold
Cost of
Goods
Sold

TRANSFERRING FINISHED GOODS TO COST OF
GOODS SOLD: JOURNAL ENTRY
For Ruger Corporation, we will assume 750 of the 1,000 gold medallions in Job A were
shipped to customers by the end of the month for total sales revenue of $225,000.
Because 1,000 units were produced and the total cost of the job from the job cost
sheet was $158,000, the unit product cost was $158. The following journal entries
would record the sale (all sales were on account):
(10)
Accounts Receivable 225,000
Sales 225,000
(11)
Cost of Goods Sold 118,500
Finished Goods 118,500

PREPARE SCHEDULES OF COST OF GOODS MANUFACTURED AND COST OF
GOODS SOLD AND AN INCOME STATEMENT.
Section 3

SCHEDULES OF COST OF GOODS
MANUFACTURED AND COST OF GOODS SOLD
The schedules contains three types of costs:
1. direct materials
2. direct labor
3. manufacturing overhead
The schedules calculate:
1. the cost of raw material and direct labor used in production and
the amount of manufacturing overhead applied to production.
2. the manufacturing costs associated with goods that were finished
during the period.

PRODUCT COST FLOWS – PART 1
Raw material purchases made during the period are added to beginning raw
materials inventory. The ending raw materials inventory is deducted to arrive at
the raw materials used in production.
As items are removed from raw materials inventory and placed into the production
process, they are called direct materials.

Direct labor used in production and manufacturing overhead
applied to production are added to direct materials to arrive at
total manufacturing costs.

Total manufacturing costs are added to the beginning work in
process to arrive at total work in process.

The ending work in process inventory is deducted from the total work in
process for the period to arrive at the cost of goods manufactured.

The cost of goods manufactured is added to the beginning finished goods
inventory to arrive at cost of goods available for sale. The ending finished
goods inventory is deducted from this figure to arrive at cost of goods sold.

COMPUTE UNDERAPPLIED OR OVERAPPLIED OVERHEAD COST AND PREPARE
THE JOURNAL ENTRY TO CLOSE THE BALANCE IN MANUFACTURING
OVERHEAD TO THE APPROPRIATE ACCOUNTS.
Section 4

KEY CONCEPTS
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.
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.

OVERHEAD APPLICATION – PART 1
PearCo’s actual overhead for the year was $650,000 with a
total of 170,000 direct labor hours worked on jobs.
PearCo’s predetermined overhead rate (POHR) is $4.00 per
direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours (DLH)
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000

Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
PearCo’s actual overhead for the year was $650,000 with a total of 170,000
direct labor hours worked on jobs.
PearCo’s predetermined overhead rate is $4.00 per direct labor hour.
OVERHEAD APPLICATION – PART 2
PearCo has overapplied
overhead for the year
by $30,000. What will
PearCo do?

DISPOSITION OF OVERAPPLIED AND
UNDERAPPLIED OVERHEAD – PART 1
Any remaining balance in the Manufacturing Overhead account, such
as PearCo’s $30,000 of overapplied overhead, is disposed of in one of
two ways:
1. It can be closed to Cost of Goods Sold.
2. It can be closed proportionally to Work in Process, Finished Goods,
and Cost of Goods Sold.

PearCo’s
Mfg. Overhead
Actual
overhead costs
$650,000
$30,000
overapplied
PearCo’s Cost
of Goods Sold
Unadjusted
Balance
Adjusted
Balance
$30,000
$30,000
Overhead
applied
to jobs
$680,000
The journal entry, in T-account form, to close out PearCo’s $30,000 of
overapplied overhead into Cost of Goods Sold

Calculating the allocation of underapplied or overapplied overhead
between Work in Process, Finished Goods, and Cost of Goods Sold:
Let’s assume the overhead applied in Ending Work in Process
Inventory, Ending Finished Goods Inventory, and Cost of Goods Sold is
$68,000, $204,000, and $408,000, respectively (total value of
accounts $680,000).

In this case, the allocation percentages for Work in Process (WIP),
Finished Goods, and Cost of Goods would be:
Ending WIP Inventory = $68,000 ÷ $680,000 = 10%
Ending Finished Goods Inventory = $204,000 ÷$680,000 = 30%
Cost of Goods Sold = $408,000 ÷$680,000 = 60%

The allocation of the $30,000 of overapplied overhead would be:
Amount
Percent of
Total
Allocation of
$30,000
Work in process 68,000$ 10% 3,000$
Finished Goods 204,000 30% 9,000
Cost of Goods Sold 408,000 60% 18,000
Total 680,000$ 100% 30,000$

Work in Process Inventory 3,000
Finished Goods Inventory 9,000
Cost of Goods Sold 18,000
Amount
Percent of
Total
Allocation of
$30,000
Work in process 68,000$ 10% 3,000$
Finished Goods 204,000 30% 9,000
Cost of Goods Sold 408,000 60% 18,000
Total 680,000$ 100% 30,000$

In summary, there are two methods for disposing of
underapplied and overapplied overhead:
1.Close out to Cost of Goods Sold.
2.Allocate between Work in Process, Finished Goods, and Cost
of Goods Sold.
The latter method is considered
more accurate, but it is more
complex to compute.

Chapter 3 : Overhead Analysis

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Chapter 3 : Overhead Analysis