Introduction to Management Accounting | Source: Week 2 Lecture Notes
Difficulty: Intermediate | Prerequisites: Week 1 (cost classifications, direct vs indirect costs, cost behaviour basics)
This week moves from classifying costs (Week 1) into tracking them through the production process in a job-order costing system. Job-order costing is the method manufacturers and service firms use when each product or engagement is distinct, so costs need to be traced to individual jobs rather than averaged across identical units. You will learn how direct materials, direct labour and manufacturing overhead flow through the inventory accounts (Raw Materials, Work in Process, Finished Goods) and onto the income statement as Cost of Goods Sold. The week also introduces the predetermined overhead rate, the mechanism for assigning indirect costs to jobs before actual overhead figures are known, and covers how to deal with the inevitable gap between applied and actual overhead at year end.
Job-order costing tracks costs per individual job (or batch) rather than per process. Direct materials and direct labour are traced to jobs using requisition forms and time tickets; manufacturing overhead is applied using a predetermined rate (estimated overhead divided by estimated activity). At year end, any difference between applied and actual overhead is closed, usually to Cost of Goods Sold.
Job-order costing
A costing system that assigns manufacturing costs to individual jobs or batches, each of which may be unique. In simple terms, every job gets its own running tab of what it cost to make.
Product costs
Costs tied to manufacturing a product: direct materials, direct labour and manufacturing overhead. These are capitalised into inventory and only hit the income statement as an expense when the goods are sold (as COGS). Think of it as costs that "travel with" the product until it leaves the building.
Period costs
Costs not tied to production, primarily selling and administrative expenses. These are expensed on the income statement in the period they are incurred, regardless of sales. In simple terms, they show up as expenses straight away.
Direct materials (DM)
Raw materials that can be physically and conveniently traced to a specific product or job. Think wood in a custom cabinet, or fabric in a bespoke suit.
Direct labour (DL)
Wages of workers whose time can be directly traced to a specific job. The carpenter building that cabinet, for example.
Manufacturing overhead (MOH)
All manufacturing costs that are not direct materials or direct labour. This includes indirect materials, indirect labour, factory rent, utilities, depreciation on factory equipment and so on. In simple terms, everything else it costs to run the factory.
Predetermined overhead rate (POHR)
A rate computed at the start of the period to apply overhead to jobs: estimated total manufacturing overhead divided by the estimated total allocation base. It lets you assign overhead costs to jobs as work happens, rather than waiting until year end.
Allocation base
The activity measure used to assign overhead to jobs, such as direct labour hours, machine hours or units produced. The base should be the cost driver, the factor that most closely causes overhead costs to be incurred.
Job cost sheet
A document (or record) that accumulates all costs, direct materials, direct labour and applied manufacturing overhead, attributable to a particular job. Think of it as the job's receipt.
Materials requisition form
A source document authorising the release of raw materials from the storeroom for use in production on a specific job.
Cost of goods manufactured (COGM)
The total production cost of goods completed during a period. Calculated from the Work in Process account: beginning WIP + DM used + DL used + MOH applied, minus ending WIP.
Cost of goods sold (COGS)
The cost assigned to units that have been sold and delivered to customers during the period. Calculated from the Finished Goods account: beginning FG + COGM, minus ending FG.
Under-applied overhead
Occurs when the overhead applied to jobs (using the POHR) is less than the actual overhead incurred. Shows up as a debit balance in the Manufacturing Overhead account. In simple terms, you did not charge enough overhead to the jobs.
Over-applied overhead
Occurs when the overhead applied to jobs exceeds the actual overhead incurred. Shows up as a credit balance in the Manufacturing Overhead account. In simple terms, you charged the jobs more overhead than was actually spent.
Manufacturing costs break into three buckets:
Direct materials (DM)
Direct labour (DL)
Manufacturing overhead (MOH), which is indirect by definition
Product vs period costs
Product costs (DM + DL + MOH) are capitalised into inventory. They become expenses (COGS) only when the finished goods are sold.
Period costs (selling and admin) are expensed immediately in the period incurred.
Cost behaviour follows the equation Y = a + bX
Fixed costs (a): stay the same in total regardless of activity level
Variable costs (bX): change in direct proportion to activity
Mixed costs: contain both a fixed and a variable component
Income statement formats
Traditional: groups costs by function (COGS vs selling and admin)
Contribution format: groups costs by behaviour (variable vs fixed)
When to use it: situations where many products, each with unique features, are produced each period. Also common in service organisations where each client engagement is different.
Examples: custom furniture, construction projects, film production, legal or consulting engagements, advertising campaigns.
How costs are traced to jobs:
Direct materials: tracked via a materials requisition form submitted to the storeroom, specifying which job the materials are for.
Direct labour: assigned to jobs based on time tickets (records of hours each worker spends on each job).
Manufacturing overhead: cannot be traced directly, so it is applied using a predetermined overhead rate (see next section).
The job cost sheet is the central record. It accumulates DM, DL and applied MOH for each job. When the job is complete, the total on the sheet is the cost of the finished unit or batch.
Why we need it: overhead costs are indirect; they cannot be physically traced to a specific job the way materials and labour can. We need a systematic way to allocate them.
How it is calculated:
POHR = Estimated total manufacturing overhead / Estimated total amount of the allocation base
The allocation base is chosen based on what drives overhead costs. Common choices: direct labour hours, machine hours, units produced, direct labour dollars.
How it is applied to jobs:
As a job consumes units of the allocation base, the POHR is multiplied by the actual consumption of that base on the job.
Applied overhead for a job = POHR x actual allocation base consumed by the job
Why "predetermined": the rate is set at the beginning of the period, using estimates for both the numerator and denominator. This lets the company assign overhead to jobs throughout the year rather than waiting for actual figures, which are only available after the period ends.
Choosing the allocation base: look at the company's past activities and identify which activity measure best correlates with overhead costs. In a labour-intensive operation, direct labour hours are typical. In a capital-intensive operation, machine hours are more appropriate.
Costs move through inventory accounts in a specific sequence. The key journal entries to understand:
Purchase of raw materials
Debit: Raw Materials Inventory
Credit: Accounts Payable (or Cash)
Requisition of materials to production
Direct materials: Debit WIP Inventory, Credit Raw Materials Inventory
Indirect materials: Debit Manufacturing Overhead, Credit Raw Materials Inventory
Recording labour costs
Direct labour: Debit WIP Inventory, Credit Wages Payable
Indirect labour: Debit Manufacturing Overhead, Credit Wages Payable
Applying manufacturing overhead to jobs
Debit: WIP Inventory (at the predetermined rate)
Credit: Manufacturing Overhead
Completing jobs (transferring to finished goods)
Debit: Finished Goods Inventory
Credit: WIP Inventory
Selling finished goods
Debit: Cost of Goods Sold
Credit: Finished Goods Inventory
The pattern: costs accumulate in WIP as production happens, move to Finished Goods when the job is complete, and finally land in COGS when the goods are sold.
Because the POHR uses estimates, applied overhead will almost never equal actual overhead. At year end, the Manufacturing Overhead account will have a balance:
Debit balance = under-applied overhead. Less overhead was charged to jobs than was actually incurred. The company under-costed its jobs.
Credit balance = over-applied overhead. More overhead was charged to jobs than was actually incurred. The company over-costed its jobs.
Closing the balance (standard approach):
Over-applied (credit balance): Debit Manufacturing Overhead, Credit COGS. This decreases COGS because we charged too much.
Under-applied (debit balance): Debit COGS, Credit Manufacturing Overhead. This increases COGS because we did not charge enough.
Alternative approach for material amounts:
If the balance in WIP and Finished Goods is substantial, the company may distribute the adjustment proportionally across WIP, Finished Goods and COGS rather than dumping it all into COGS. This gives a more accurate picture when significant inventory remains on hand.
Schedule of COGM is an analysis of the Work in Process account. It tells you how much it cost to complete all the jobs finished during the period.
COGM = Beginning WIP + DM used + DL used + MOH applied - Ending WIP
The result is the amount credited out of WIP and debited into Finished Goods.
Schedule of COGS is an analysis of the Finished Goods account. It tells you the cost of the goods that were sold to customers.
COGS = Beginning Finished Goods + COGM - Ending Finished Goods
The result is the amount credited out of Finished Goods and debited into Cost of Goods Sold on the income statement.
After computing unadjusted COGS, add any under-applied overhead (or subtract over-applied overhead) to arrive at adjusted COGS.
Cost behaviour equation
Y = a + bX
Where Y = total cost, a = total fixed costs, b = variable cost per unit of activity, X = level of activity.
Predetermined overhead rate
POHR = Estimated total manufacturing overhead / Estimated total allocation base
Applied overhead (per job)
Applied MOH = POHR x Actual allocation base consumed by the job
Cost of goods manufactured
COGM = Beginning WIP + DM used + DL used + MOH applied - Ending WIP
Cost of goods sold
COGS = Beginning FG + COGM - Ending FG
Adjusted COGS
Adjusted COGS = Unadjusted COGS + Under-applied overhead (or - Over-applied overhead)
Cost flow sequence (diagram summary)
Raw Materials --> WIP (as DM) --> Finished Goods --> COGS
Wages --> WIP (as DL) --> Finished Goods --> COGS
MOH (indirect materials + indirect labour + other factory costs) --> Applied to WIP --> Finished Goods --> COGS
Selling and Admin --> Expensed immediately as period costs
Job-order costing is the system behind any business that prices and tracks work by project or engagement. Law firms, accounting firms and consultancies use it to bill clients for the specific hours and expenses incurred on their matter. Construction companies use it to track costs per building project. Film studios accumulate costs per movie. Even hospitals may use it to track costs per patient procedure. Whenever the output is not identical from one unit to the next, job-order costing is the natural fit.
Confusing product costs with period costs. Students often think selling expenses are part of product cost because they relate to the product. They do not. Only manufacturing costs (DM, DL, MOH) are product costs. Selling and admin are always period costs.
Thinking the predetermined overhead rate uses actual figures. The POHR is computed from estimates at the start of the period. Actual overhead and actual activity are not known until after the period ends, which is the whole reason we estimate.
Assuming over-applied overhead is always bad. Over-applied simply means you applied more than actual. It is a normal result of estimation. At year end it is corrected. Under-applied is not "worse" than over-applied; both are just differences between estimates and reality.
Forgetting that indirect materials and indirect labour go through the Manufacturing Overhead account, not WIP directly. Only direct materials and direct labour are debited straight to WIP. Indirect costs pass through MOH first and reach WIP only via the overhead application entry.
⚠️ Be able to compute the predetermined overhead rate and apply it to a specific job given the allocation base consumed.
⚠️ Know the full cost flow sequence: Raw Materials to WIP to Finished Goods to COGS, and which account is debited and credited at each step.
⚠️ Understand the difference between under-applied and over-applied overhead, including which direction COGS moves when each is closed out.
⚠️ Be prepared to calculate COGM and COGS from beginning and ending inventory balances.
⚠️ Know when indirect costs (indirect materials, indirect labour) go to the MOH account versus when direct costs go straight to WIP.
True or false: Selling expenses are product costs. (False. Selling expenses are period costs.)
True or false: The predetermined overhead rate is calculated using actual overhead figures. (False. It uses estimated overhead and estimated activity.)
Fill in the blank: COGM = Beginning WIP + DM used + DL used + MOH applied - ________. (Ending WIP)
True or false: Under-applied overhead results in a credit balance in the Manufacturing Overhead account. (False. Under-applied overhead leaves a debit balance.)
Fill in the blank: The document that accumulates all costs for a particular job is called a ________. (Job cost sheet)
Q: A company estimates total manufacturing overhead of $600,000 and total machine hours of 40,000 for the year. What is the predetermined overhead rate?
A: $600,000 / 40,000 machine hours = $15 per machine hour.
Q: Job 101 used 120 machine hours. Using the rate above, how much overhead is applied to Job 101?
A: 120 machine hours x $15 = $1,800 applied to Job 101.
Q: At year end, actual manufacturing overhead was $580,000 and total overhead applied to all jobs was $600,000. Is overhead under-applied or over-applied, and by how much?
A: Over-applied by $20,000 ($600,000 applied - $580,000 actual). The MOH account has a $20,000 credit balance.
Q: How is the $20,000 over-applied overhead closed under the standard approach?
A: Debit Manufacturing Overhead $20,000, Credit Cost of Goods Sold $20,000. This decreases COGS.
Q: Beginning WIP is $30,000. During the period, DM used is $80,000, DL is $50,000, and MOH applied is $40,000. Ending WIP is $25,000. What is COGM?
A: $30,000 + $80,000 + $50,000 + $40,000 - $25,000 = $175,000.
Q: Beginning Finished Goods is $45,000 and ending Finished Goods is $35,000. Using the COGM above, what is COGS?
A: $45,000 + $175,000 - $35,000 = $185,000.
This material connects directly to process costing (likely Week 3 or 4), which is the alternative system used when products are identical and costs are averaged across units. Understanding job-order costing first makes the contrast clearer. The cost behaviour concepts (Y = a + bX) will return in cost-volume-profit analysis, where the contribution format income statement becomes central. The overhead allocation discussion also sets the stage for activity-based costing (ABC), a more refined method of assigning indirect costs that uses multiple cost pools and cost drivers instead of a single plantwide rate.
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