Difficulty: Introductory to Intermediate | Prerequisites: Understanding of basic cost classifications (direct vs. indirect costs, fixed vs. variable costs) from Chapters 1–3.
This chapter is where cost accounting moves from classifying costs to assigning them to specific products and services. You are learning the mechanics of how companies figure out what a single job or product costs to produce, which matters for pricing, profitability analysis, and inventory valuation. The two core systems here, job costing and process costing, are the backbone of every costing topic that follows. If you are coming in cold, make sure you are comfortable with the distinction between direct and indirect costs before reading on.
Companies need to assign costs to their products. Job costing tracks costs to individual, distinct jobs; process costing averages costs across masses of identical units. Because indirect costs cannot be traced directly, companies use either actual or budgeted (normal) rates to allocate them, then adjust for any over- or underallocation at year end.
Cost pool
A grouping of individual indirect cost items. Think of it as a bucket where you collect similar overhead costs before spreading them across products.
Cost allocation base
A systematic way to link an indirect cost (or group of indirect costs) to cost objects. In simple terms, this is the measure you use to distribute overhead, such as direct labour hours or machine hours.
Job costing system
A costing system in which the cost object is a distinct product or service called a "job." Each job is often a single unit or a small batch, and costs are tracked to that specific job.
Process costing system
A costing system in which the cost object is masses of identical or similar units. Total costs for the period are divided by the total number of units produced to get an average per-unit cost.
Actual costing
A method that traces direct costs to a cost object using actual direct cost rates multiplied by actual quantities, and allocates indirect costs using actual annual indirect cost rates. The catch: you cannot compute it until the year is over.
Normal costing
A method that traces direct costs using actual rates and actual quantities (same as actual costing), but allocates indirect costs using budgeted (predetermined) rates multiplied by actual quantities of the allocation base. This gives companies timely cost information throughout the year.
Budgeted indirect cost rate
A predetermined overhead rate calculated at the beginning of the fiscal year for each cost pool. It is an estimate, so allocated overhead in any given month is unlikely to match actual overhead exactly.
Source document
The original document that supports journal entries, such as a materials requisition record or a labour time sheet.
Job cost sheet
A record that accumulates all costs assigned to a specific job: direct materials (DM), direct labour (DL), and manufacturing overhead (MOVH), starting when work begins.
Materials requisition record
The source document authorising the release of materials from inventory and recording which job those materials are assigned to.
Manufacturing overhead allocated
The amount of manufacturing overhead assigned to individual jobs, calculated as the budgeted overhead rate multiplied by the actual quantity of the allocation base used.
Manufacturing overhead control
The account that records actual overhead costs incurred across all categories: indirect materials, indirect manufacturing labour, supervision, engineering, utilities, and so on.
Underallocated overhead
The situation where the allocated amount of indirect costs is less than the actual amount incurred. The budget underestimated relative to reality.
Overallocated overhead
The situation where the allocated amount exceeds the actual amount incurred. The budget overestimated relative to reality.
Adjusted allocation rate approach
A year-end method that restates all overhead entries in the general ledger and subsidiary ledgers using actual cost rates rather than budgeted rates. It gives you the timeliness of normal costing during the year and the accuracy of actual costing at year end.
Proration approach
A year-end method that spreads underallocated or overallocated overhead among ending Work in Process (WIP) inventory, Finished Goods inventory, and Cost of Goods Sold (COGS), typically in proportion to the overhead balance in each account.
Write-off approach
A year-end method that writes the entire under- or overallocated manufacturing overhead balance directly to Cost of Goods Sold. The simplest approach, and acceptable when the variance is immaterial.
Job costing suits businesses producing distinct, often customised products or services (construction, consulting, film production).
The cost object is the individual job.
Each job gets its own cost sheet tracking DM, DL, and overhead.
Process costing suits businesses producing large volumes of identical or near-identical units (oil refining, food processing, chemicals).
The cost object is the batch or run of identical units.
Per-unit cost = total costs for the period / total units produced in that period.
Both methods trace direct costs identically: actual direct cost rates × actual quantities used.
The difference is in how indirect costs are handled:
Actual costing uses actual indirect cost rates, calculated at year end.
Normal costing uses budgeted indirect cost rates, set at the start of the year, applied to actual quantities of the allocation base.
Normal costing exists because companies need cost information throughout the year, not only after the books close.
Two reasons, commonly called the numerator reason and the denominator reason:
Numerator reason: shorter periods are more susceptible to seasonal fluctuations in costs (e.g. heating costs spike in winter), which would distort monthly overhead rates.
Denominator reason: monthly output and monthly quantities of the allocation base fluctuate, so spreading fixed indirect costs over a short, variable base produces erratic per-unit costs.
Using an annual period smooths both effects.
Identify the job that is the chosen cost object. Open a job cost sheet.
Identify the direct costs of the job: direct materials (via materials requisition records) and direct labour (via time records).
Select the cost allocation bases for allocating indirect costs to the job (e.g. direct labour hours, machine hours).
Identify the indirect costs associated with each cost allocation base (i.e. which cost pool links to which base).
Compute the budgeted rate per unit of each cost allocation base (budgeted indirect costs / budgeted quantity of allocation base).
Compute indirect costs allocated to the job (budgeted rate × actual quantity of allocation base used by the job).
Compute total job cost by adding all direct and indirect costs assigned.
Actual indirect cost rate:
Actual indirect cost rate = Actual annual indirect costs / Actual annual quantity of the cost allocation base
Budgeted indirect cost rate (normal costing):
Budgeted indirect cost rate = Budgeted annual indirect costs / Budgeted annual quantity of the cost allocation base
Manufacturing overhead allocated to a job:
MOH allocated = Budgeted indirect cost rate × Actual quantity of the allocation base used by the job
Because normal costing uses estimates, actual overhead incurred will nearly always differ from overhead allocated. At year end, the company must deal with this gap.
Underallocated: allocated < actual. You have assigned too little overhead to products.
Overallocated: allocated > actual. You have assigned too much.
Three approaches to fix it:
Adjusted allocation rate approach: restate every overhead entry using the actual rate. Most accurate, most work.
Proration approach: spread the variance across WIP, Finished Goods, and COGS in proportion to their overhead balances. A reasonable middle ground.
Write-off approach: dump the entire variance into COGS. Simplest, appropriate when the amount is immaterial.
Job costing is the system behind every custom manufacturer, law firm, and advertising agency that needs to know what a specific project cost. When a construction company bids on a new contract, it uses historical job cost data to estimate the price.
Process costing is how a petroleum refinery, a brewery, or a paper mill assigns costs, because every barrel of oil or case of beer coming off the line is essentially the same product.
Students often confuse the cost allocation base with the cost pool. The pool is the collection of costs; the base is the measure used to distribute them. They are not the same thing.
Students sometimes think actual costing is always more accurate than normal costing. At the individual job level during the year, actual costing is not available at all, because you need the full year's data. Normal costing trades some precision for timeliness.
It is common to forget that normal costing still uses actual rates and quantities for direct costs. The "budgeted" part applies only to indirect cost allocation.
Students sometimes treat underallocated overhead as an error to fix. It is a normal consequence of using estimates. The year-end adjustment is a planned step, not a correction of a mistake.
⚠️ Know the difference between actual and normal costing cold. The distinction (budgeted vs. actual indirect cost rates) is a staple exam question.
⚠️ Be able to walk through all seven steps of job costing in a problem. Exams frequently give you raw data and ask for the total cost of a job.
⚠️ Understand all three year-end adjustment methods (adjusted allocation rate, proration, write-off) and when each is appropriate.
⚠️ The numerator and denominator reasons for using annual rates are a common short-answer or multiple-choice target.
⚠️ Make sure you can compute a budgeted indirect cost rate and then use it to allocate overhead to a specific job. This is the most-tested calculation in the chapter.
True or False: In normal costing, both direct and indirect costs use budgeted rates.
Fill in the blank: A ________ is a grouping of individual indirect cost items.
True or False: The write-off approach spreads the overhead variance across WIP, Finished Goods, and COGS.
Fill in the blank: The ________ reason for using annual overhead rates relates to seasonal fluctuations in costs.
True or False: Underallocated overhead means the company allocated more overhead than it actually incurred.
Answers:
False. Direct costs use actual rates; only indirect costs use budgeted rates.
Cost pool.
False. That is the proration approach. The write-off approach sends the entire variance to COGS.
Numerator.
False. Underallocated means the allocated amount is less than actual. Overallocated is the reverse.
Q: What is the key difference between job costing and process costing?
A: Job costing assigns costs to individual, distinct jobs (often custom or unique products). Process costing averages total costs across masses of identical or similar units to get a per-unit cost.
Q: A company budgets $600,000 in manufacturing overhead and 50,000 direct labour hours for the year. Job 101 uses 120 direct labour hours. What is the overhead allocated to Job 101 under normal costing?
A: Budgeted rate = $600,000 / 50,000 hours = $12 per direct labour hour. Overhead allocated to Job 101 = $12 × 120 hours = $1,440.
Q: At year end, a company has allocated $580,000 in overhead but incurred $600,000. Is overhead underallocated or overallocated, and by how much?
A: Underallocated by $20,000 ($600,000 actual minus $580,000 allocated).
Q: Name the three approaches for dealing with under- or overallocated overhead at year end.
A: Adjusted allocation rate approach, proration approach, and write-off approach.
Q: Why do companies use annual periods rather than monthly periods to calculate indirect cost rates?
A: Two reasons. The numerator reason: shorter periods amplify seasonal cost fluctuations. The denominator reason: monthly output and allocation base quantities vary, causing erratic per-unit rates when fixed costs are spread over a small, unstable base.
Q: Under normal costing, which costs use actual rates and which use budgeted rates?
A: Direct costs (materials and labour) use actual rates multiplied by actual quantities. Indirect costs use budgeted rates multiplied by the actual quantity of the cost allocation base.
This material connects directly to Chapter 5 (Activity-Based Costing), which refines how indirect costs are allocated by using multiple, more precise cost drivers instead of a single allocation base. It also sets up the process costing methods in later chapters, where equivalent units replace completed units in the denominator. If you go on to study standard costing, the variance analysis there builds on the same logic of comparing budgeted rates to actual outcomes.
cost pool, cost allocation base, cost driver, job costing, job-order costing, process costing, actual costing, normal costing, budgeted overhead rate, predetermined overhead rate, manufacturing overhead, overhead allocation, underallocated overhead, underapplied overhead, overallocated overhead, overapplied overhead, job cost sheet, source document, materials requisition, adjusted allocation rate, proration, write-off to COGS, indirect cost rate, cost object, direct materials, direct labour, manufacturing overhead control, manufacturing overhead allocated, year-end overhead adjustment, cost accounting chapter 4