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In managerial accounting, there are two general types of costing systems to assign costs to products or services that the company provides: “job order costing” and “process costing.” Job order costing is used in situations where the company delivers a unique or custom job for its customers. Every customer is treated uniquely and delivered products to specifically suit their individual needs.
As an example, law firms or accounting firms use job order costing because every client is different and unique.
Process costing, on the other hand, is used when companies offer a more standardized product. No matter who the customer is, they all end up receiving the same product.
For example, Coca-Cola may use process costing to track its costs to produce its beverages. In job order costing, the company tracks the direct materials, the direct labor, and the manufacturing overhead costs to determine the cost of goods manufactured (COGM).
One type of job order costing is called actual costing. The actual costing system, like the name implies, is a costing system that traces direct and indirect costs to a cost object by using the actual costs incurred in the job.
Although this system is much more simplistic, actual costing systems are not commonly found in real-world situations because actual costs cannot usually be determined in a timely manner because they are often not known until long after the job has been completed.
Due to the practical difficulties of using actual costing, many companies instead use a normal costing system to obtain a close approximation of the costs on a timelier basis, especially manufacturing overhead costs. Direct materials and direct labor are much more feasible in terms of access to actual costs from materials requisition forms and labor time sheets, while manufacturing overhead costs pose difficulties in determining actual costs.
Due to the need for immediate access to job costs, many companies use a predetermined, or budgeted, manufacturing overhead rate to estimate manufacturing overhead costs.
The manufacturing overhead rate is a rate that allocates overhead costs to the production of a good or service based on an allocation formula.
Commonly, the overhead rate may be derived by applying overhead costs on the basis of labor hours or machine hours. This means that the company uses labor hours or machine hours (i.e., the primary cost driver) to reasonably estimate manufacturing overhead costs.
Overhead Rate = Estimated Manufacturing Overhead / Estimated Cost Allocation Base
Where the cost allocation base refers to the estimated machine hours or estimated labor hours, depending on which one the company chooses to estimate its overhead costs by.
XYZ Company estimates that for the current year, it will work 75,000 machine hours and incur $450,000 in manufacturing overhead costs. The company applies overhead cost on the basis of machine hours worked.
This means that the company would estimate $6 in manufacturing overhead costs for every one machine hour worked ($450,000 divided by 75,000 machine hours). So, if the company actually worked 5000 machine hours, the estimated overhead costs would be $30,000.
The WIP inventory asset account is where the actual direct materials cost, actual direct labor cost, and estimated manufacturing overhead costs are recorded in order to determine the COGM. This can be clearly seen through a WIP Inventory T-account.
The T-account would look like this:
| Work in Process (WIP) Inventory | |
| Beginning Balance a | |
Direct Materials b
Manufacturing Overhead (estimated) d
On the credit side of the T-account is COGM. By knowing the opening and closing balances of the inventory account in addition to the actual DM and DL costs and the estimated MOH costs, the COGM can be calculated.
The estimated manufacturing overhead value can be compared to the actual manufacturing overhead value in a separate manufacturing T-account to determine any significant differences.
Because the predetermined overhead rate used by companies is purely based on estimates, the actual overhead cost incurred during the year may be higher or lower than the amount estimated. This is referred to as “under- or overapplied overhead.”
When overhead is underapplied, manufacturing overhead costs have been understated and upward adjustments need to be made to inventory and/or expense accounts, depending on which method the company decides to use.
In contrast, when overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or expenses need to be adjusted downward. There are two ways to adjust for the under- or overapplied overhead amounts.
| Method 1 | Method 2 | |
| Process | Difference is closed out to Cost of Goods Sold (COGS) | Difference is prorated between Work in Process Inventory, Finished Goods Inventory, and COGS |
| Frequency | More commonly used | Rarer |
| Journal Entry: Situation where MOH is overapplied by $10,000 | DR MOH 10,000 |
CR Cost of Goods Sold 10,000
CR Cost of Goods Sold 10,000/x
CR WIP Inventory 10,000/y
CR FG Inventory 10,000/z
Value of x, y, z depends on the company
