Managerial Accounting

🧭 Overview

🧠 One-sentence thesis

Managerial accounting provides detailed, forward-looking, and segment-specific information to help managers plan and control operations, unlike financial accounting which focuses on historical, GAAP-compliant reports for external users.

📌 Key points (3–5)

• Managerial vs financial accounting: managerial accounting serves internal managers with future projections and detailed segments; financial accounting serves external users with historical, GAAP-compliant statements.
• Planning function: managers establish goals and communicate them through budgets (profit plans, capital budgets, cash flow budgets).
• Control function: managers evaluate whether plans were implemented effectively by comparing actual results to budgets.
• Common confusion: not all accounting reports are the same—quarterly projections by division and defect percentages are managerial; income statements and balance sheets prepared under GAAP are financial.
• Why it matters: effective planning and control using managerial accounting can be critical to organizational survival in today's business environment.

🔍 Distinguishing managerial from financial accounting

📊 Core differences

Characteristic	Managerial Accounting	Financial Accounting
Audience	Internal managers	External owners/stakeholders
Time focus	Future projections	Historical information
Detail level	Segments, divisions, departments	Whole organization
Rules	No required format	Must follow U.S. GAAP
Frequency	As needed (e.g., monthly, quarterly)	Annual/quarterly standard reports

🧩 Examples from the excerpt

Managerial accounting reports include:

• Projected net income for next quarter by division (future + segment-specific)
• Defective goods as percentage of all goods produced (nonfinancial detailed measure)
• Monthly sales broken down by geographic region (detailed + frequent)
• Production department budget for next quarter (future projection + segment)

Financial accounting reports include:

• Income statement for current year prepared in accordance with U.S. GAAP (historical + compliant)
• Balance sheet at end of current year prepared in accordance with U.S. GAAP (historical + compliant)

⚠️ Don't confuse

The same organization uses both types of accounting, but for different purposes. A balance sheet goes to owners; a departmental budget goes to managers planning operations.

📋 Planning function

🎯 What planning means

Planning is the process of establishing goals and communicating these goals to employees of the organization.

• Organizations formalize plans by creating budgets.
• A budget is a series of reports used to quantify an organization's plans for the future.
• Planning is not just "hoping it works out"—it involves projecting needs and scheduling resources.

📑 Types of budgets

The excerpt identifies several budget forms:

• Budgeted income statement: indicates a profit plan for the future
• Capital budget: shows long-term investments planned for the future
• Cash flow budget: outlines cash inflows and outflows for the future

💼 Real-world planning example

The excerpt describes Ernst & Young (an international accounting firm):

• Creates a budget indicating labor hours required to perform specific services for each client
• Projects future staffing needs based on these budgets
• Hires accounting staff based on projections
• Schedules staff required for each client

Example: An organization might budget that a project will require 100 labor hours next quarter, then hire and schedule staff accordingly rather than reacting after the fact.

🎛️ Control function

🔎 What control means

The control function is the process of evaluating whether the organization's plans were implemented effectively.

• Control happens after plans are implemented.
• It often leads to recommendations for the future.
• Many organizations compare actual results with the initial plan (budget) to evaluate performance.

🔄 How control works in practice

The excerpt illustrates the control process using Ernst & Young:

1. Planning phase: Create a budget indicating labor hours needed to perform tax services for a client
2. Implementation: Perform the work
3. Control phase: Compare actual labor hours used to budgeted labor hours
4. Evaluation: Assess whether employees completed work within budgeted time
5. Recommendations: Might include adding more labor hours to future budgets or obtaining better support documents from the client

🔗 Planning and control together

• The two functions work as a continuous cycle.
• Control evaluates the plan's implementation and generates insights for future planning.
• The excerpt emphasizes that in today's business environment, effective planning and control can be "the key to survival."

Example: If a personal budget (planning) allocates a certain amount for food expenses, the control function at month-end compares actual food spending to the budget, identifies deviations, and helps adjust future budgets or spending behavior.

🧭 Overview

🧠 One-sentence thesis

Planning and control are critical managerial functions where planning establishes organizational goals and control evaluates whether those goals were achieved, forming a continuous cycle that drives organizational survival and performance improvement.

📌 Key points (3–5)

• Planning function: establishing goals and communicating them to employees throughout the organization.
• Control function: assessing whether goals were achieved and evaluating performance of employees, departments, and the organization as a whole.
• The cycle: control findings lead to recommendations that refine future planning (e.g., adjusting budgets or processes).
• Common confusion: planning is not just setting targets—it requires communication; control is not just measurement—it drives future action.
• Why it matters: in today's business environment, effective planning and control can be the key to organizational survival.

🎯 The Planning Function

🎯 What planning involves

Planning involves establishing goals and communicating these goals to employees of the organization.

• Planning is forward-looking: it sets targets before work begins.
• It requires two components: (1) defining what should be achieved, and (2) making sure employees know what is expected.
• Example: A personal budget plans income sources (wages, scholarships, loans) and expense categories (rent, textbooks, food, entertainment, transportation) for the coming month.

📋 Planning provides guidelines

• Planned expenditures are clearly outlined and provide guidelines for making decisions throughout the period.
• Without clear guidelines, resources might be spent on items that are not needed.
• The planning process helps identify potential deviations before they occur.

🔍 The Control Function

🔍 What control involves

The control function assesses whether goals were achieved and is often used to evaluate the performance of employees, departments, and the organization as a whole.

• Control is backward-looking: it happens after the period ends.
• It compares actual results with budgeted/planned targets.
• Example: In a labor budget scenario, actual labor hours used to complete work are compared to budgeted labor hours to evaluate whether employees completed work within the budgeted time.

📊 Control leads to evaluation and recommendations

• The control function identifies which goals were achieved and which were not.
• Example: Food expenditures might be close to budget (goal achieved) while transportation expenditures might exceed budget (goal not achieved).
• This analysis often results in recommendations for the future, such as:
  • Adding more labor hours to the budget
  • Obtaining better support documents
  • Carpooling to save on transportation costs
  • Working additional hours to earn more income

🔄 Control refines future planning

• Don't confuse control with just "checking results"—it actively feeds back into the planning cycle.
• The control function leads to refined goals in the future based on what was learned.
• This creates a continuous improvement loop: plan → execute → control → refine plan.

💼 Real-world application

💼 Personal budget example

The excerpt uses a personal budget to illustrate both functions:

Function	What it does	Benefit
Planning	Establish income and expense goals for next month	Provides clear guidelines for spending decisions
Control	Compare actual vs. budgeted income/expenses after month ends	Identifies areas for improvement and leads to better future goals

💼 Labor budget example

• Actual labor hours are compared to budgeted labor hours after work is completed.
• This evaluates whether employees were able to complete work within budgeted time.
• Results drive specific recommendations (adjust budget or improve processes).

⚠️ Critical importance

⚠️ Survival in today's environment

• The excerpt emphasizes that planning and controlling operations are critical functions within most organizations.
• In today's business environment, effective planning and control by managers can be the key to survival.
• This is not optional or merely helpful—it is presented as essential for organizational continuity.

🧭 Overview

🧠 One-sentence thesis

Organizations structure their finance and accounting functions based on their size, resources, and reporting needs, with smaller entities often using creative staffing solutions while larger organizations maintain formal hierarchies led by the CFO.

📌 Key points (3–5)

• Formal vs. flexible structures: Large organizations have formal positions (CFO, controller, treasurer, internal auditor), while smaller entities adapt creatively due to financial constraints.
• CFO's central role: The chief financial officer oversees all accounting and finance personnel, including the controller, treasurer, and internal auditor.
• Controller's responsibilities: The controller manages managerial, financial, and tax accounting staff.
• Common confusion: Not all organizations have the same structure—financial limitations may require combining roles or using part-time/volunteer staff instead of full-time employees.
• Functional specialization: Different personnel handle distinct tasks (tax accountant for taxes, financial accountant for reports, managerial accountant for projections, treasurer for financing, internal auditor for controls).

🏢 Organizational structure variations

🎻 Small not-for-profit example

The excerpt describes a California symphony with nearly $200,000 in annual revenues that cannot afford full-time finance staff:

• Part-time bookkeeper: processes and records all financial transactions, inputs budget information, provides monthly reports to the treasurer.
• Volunteer treasurer: a board member responsible for establishing the annual budget and providing monthly financial reports to the board.
• Outside firm: prepares tax filings, assembles annual financial statements, performs year-end review of accounting operations.

This organization lacks the formal positions shown in a typical organization chart (except the treasurer), illustrating how financial constraints require creative organizational structures.

🔑 Key takeaway about structure

Organizations must balance:

• Financial limitations (what they can afford)
• Reporting requirements (what they must produce)
• Operational needs (what functions must be performed)

Don't confuse: The absence of formal titles doesn't mean the functions disappear—they are simply redistributed among available personnel.

👔 Typical corporate hierarchy

👔 Chief Financial Officer (CFO)

The CFO oversees all accounting and finance personnel.

• Top finance position in the organization
• Supervises controller, treasurer, and internal auditor
• Coordinates all financial functions

📊 Controller

The controller is responsible for the managerial, financial, and tax accounting staff.

Manages three types of accounting:

• Managerial accounting: internal decision-making information
• Financial accounting: external reporting (annual reports, financial statements)
• Tax accounting: tax compliance and filings

💰 Treasurer

Handles financing decisions and cash management.

🔍 Internal Auditor

Evaluates the effectiveness of internal controls.

🎯 Functional responsibilities by role

🎯 Who does what

The excerpt provides specific examples from a review problem about Sportswear Company:

Question	Responsible Personnel	Why
Income taxes to government agencies	Tax accountant	Handles tax compliance
Net income in annual report	Financial accountant	Prepares external financial statements
Financial projections for new segment	Managerial accountant (with input from financial accountant)	Creates forward-looking estimates; financial accountant provides historical data as basis
Financing decisions	Treasurer	Manages funding and capital structure
Detailed internal financial information	Managerial accountants	Provides information beyond external reporting requirements
Evaluating internal controls	Internal auditors	Assesses control effectiveness

🤝 Collaboration note

Multiple personnel often work together—for example, the managerial accountant creates projections but may rely on historical information from the financial accountant.

Don't confuse: While roles have distinct primary responsibilities, they frequently collaborate and share information to support organizational decision-making.

🧭 Overview

🧠 One-sentence thesis

Professional accounting organizations provide structured ethical standards and conflict-resolution procedures that guide accountants through ethical dilemmas they encounter in their careers.

📌 Key points (3–5)

• Four ethical standards for accountants: competence, confidentiality, integrity, and credibility form the foundation of professional conduct.
• Structured resolution process: ethical conflicts should be escalated systematically through organizational hierarchy, starting with company policies and moving upward through management levels.
• Multiple resource channels: accountants can access guidance from internal company policies, professional organizations (IMA, AICPA), and governmental bodies (SEC).
• Common confusion: when your immediate supervisor is involved in the ethical conflict, skip that level and escalate to higher management or oversight bodies like the audit committee or board of directors.
• Final options: if internal resolution fails, consult objective advisors (ethics counseling services, attorneys) or consider resignation when unethical behavior persists at the top.

📜 The Four Ethical Standards

🎓 Competence

Members of the IMA must maintain an adequate level of skill to perform duties in an accurate and professional manner.

• This standard focuses on professional capability and accuracy.
• Accountants must keep their skills current to perform work properly.
• It's not just about having credentials—it's about maintaining the ability to do the job well.

🔒 Confidentiality

Members of the IMA must not disclose confidential information for any reason unless legally obligated to do so.

• Accountants handle sensitive financial information that must be protected.
• The only exception is when legal obligations require disclosure.
• Example: An accountant cannot share a company's financial details with outsiders, even friends or family, unless a court order or regulation requires it.

⚖️ Integrity

Members of the IMA must avoid any actual or apparent conflict of interest, including receiving gifts or favors, and must not engage in any activity that would discredit the profession.

• This standard covers both actual conflicts and situations that merely appear problematic.
• Specific prohibitions include accepting gifts or favors that could influence judgment.
• The scope extends beyond personal gain to any activity that would harm the profession's reputation.

📊 Credibility

Members of the IMA must disclose all relevant information fairly and objectively.

• Accountants must present information in a fair and objective manner.
• This means reporting all relevant information, not selectively sharing only favorable data.
• Example: If financial results include both positive and negative trends, both must be disclosed, not just the good news.

🛠️ Resolving Ethical Conflicts

📋 Step-by-step escalation process

The IMA recommends a systematic approach when ethical conflicts arise:

Step	Action	When to use
1	Follow organization's policies	First course of action
2	Discuss with immediate supervisor	If policies don't resolve the issue
3	Present to next higher management level	If supervisor cannot resolve or is involved
4	Escalate to reviewing authority	If management levels fail to resolve
5	Consult objective advisor	When internal channels are exhausted

🚨 When your supervisor is involved

• Don't confuse: The normal chain of command doesn't apply when your immediate supervisor is part of the ethical problem.
• Skip the compromised level and go directly to higher authorities.
• Acceptable reviewing authorities include:
  • Audit committee
  • Executive committee
  • Board of directors
  • Board of trustees
  • Owners

🆘 External resources

When internal resolution fails, accountants can turn to:

• IMA ethics counseling service: Professional guidance from the organization itself.
• Legal counsel: An attorney can clarify legal obligations and rights.
• Other professional organizations: AICPA and SEC provide additional guidance frameworks.

🏢 Real-world application

🏠 Corporate ethics codes

The excerpt highlights two companies with formal ethics policies:

Home Depot, Inc.

• Provides "basic principles for associates to make business decisions consistent with how Home Depot operates"
• Forms "the groundwork for our ethical behavior"

Hewlett-Packard Company

• Established "business ethics guided by enduring values"
• Committed to seven principles: honesty, excellence, responsibility, compassion, citizenship, fairness, and respect

💼 The Drive Write scenario

The excerpt references an ongoing case study where:

• The accountant faces an ethical conflict
• The president (immediate supervisor) is involved in the problem
• Multiple resolution paths are available, but the situation may ultimately require resignation

Key insight from the excerpt: "Many would argue that regardless of the outcome, one would not want to work for a company where this type of unethical behavior occurs at the top, or anywhere within the organization, and that resigning is the best course of action."

🎯 Practical takeaways

📚 Use available resources

• Internal company policies should be your first reference point.
• Professional organizations (IMA, AICPA) provide structured guidance.
• Governmental organizations (SEC) offer regulatory frameworks.

🔄 The resolution process is iterative

• Start with the least disruptive option (company policies).
• Escalate systematically through appropriate channels.
• Document your efforts at each level.
• Don't skip steps unless the situation requires it (e.g., supervisor involvement).

⚠️ Know when to seek outside help

• If internal channels fail to resolve the conflict satisfactorily, external advisors become necessary.
• Legal consultation may be needed to understand your obligations and rights.
• Sometimes the ethical choice is to leave an organization that tolerates unethical behavior.

🧭 Overview

🧠 One-sentence thesis

Computerized accounting systems enable organizations to export financial data to spreadsheet software for efficient analysis and projection, but the decision to upgrade to more complex systems like ERP must weigh benefits against implementation costs.

📌 Key points (3–5)

• Spreadsheet integration: Most computerized accounting systems can export data to spreadsheet programs like Excel for easier analysis and manipulation.
• Practical workflow: Users can import current data, create projections, collaborate with personnel, and make iterative changes without manual recalculation.
• Cost-benefit principle: Before implementing a new system (especially ERP), organizations must ensure the benefits exceed the costs of implementation.
• Common confusion: Not every organization needs an advanced ERP system—basic accounting systems may suffice if the need is only for simple functions like checks, invoices, and payroll.
• Required skills: Organizations increasingly require accounting and finance personnel to have advanced computer spreadsheet skills.

💻 Spreadsheet integration and data analysis

💻 How systems export data

• Most computerized accounting systems are designed to export data to spreadsheet software programs such as Excel.
• This design choice reflects how managers extensively use spreadsheets to organize and analyze data.
• Example: A spreadsheet can import data directly from an annual report, allowing users to see trends like total operating revenue increases over multiple years.

🔍 Analysis capabilities

• Once data is in a spreadsheet, users can quickly perform calculations that would be time-consuming manually.
• Example: Excel can determine the exact percentage increase in revenue from one year to the next.
• The excerpt emphasizes "analyze the data more easily" as the core advantage.

📊 Practical workflow for projections

📊 Building financial projections

The excerpt describes a typical workflow for preparing an income statement with revenue and expense projections:

1. Start with current data: Export this year's results from the accounting system to an Excel spreadsheet.
2. Set up projection columns: Create a new column to show estimates for next year.
3. Collaborate and iterate: Discuss different aspects of the income statement with various personnel in the organization, making changes as you go.
4. Finalize: Complete your projections after incorporating feedback.

⏱️ Time savings vs. manual methods

• Without computers, users would have to write information down by hand.
• Any changes would require time-consuming manual calculations.
• After finalizing data, users would face manual preparation of formal reports.
• Key point: "With the relatively recent advances in business technology, the days of preparing information manually are over."

🎯 Decision framework for system upgrades

🎯 The cost-benefit test

Key Takeaway: Before deciding to implement a new system, ask yourself: Will the benefits derived from a new system, such as an ERP system, exceed the costs of putting the system in place?

• If the answer is "yes," then proceed with implementation.
• If the answer is "no," consider other alternatives.
• This principle applies throughout different methods of recording, sorting, analyzing, and reporting financial information for internal users.

🏢 Case example: Electronics consulting firm

The excerpt provides a scenario to illustrate the decision framework:

Factor	Details
Company size	$30,000,000 in annual revenues; $5,000,000 in annual profit
Current system	Basic functions: issuing checks, creating invoices, processing payroll
Consideration	Upgrading to an ERP system

Analysis factors:

• The company is midsized (though some would argue it's small).
• An ERP system is "probably not appropriate" if management only needs a few reports beyond what basic financial accounting systems provide.
• A low-end ERP system "might be appropriate" if management needs more detailed and complex financial information beyond basic processing.
• Critical rule: The benefits derived from such a system must outweigh the costs.

🚫 Don't confuse: When ERP is unnecessary

• Not every organization needs an advanced ERP system.
• If the current system handles basic functions adequately and management doesn't need complex reporting, upgrading may not be justified.
• The decision depends on the specific information needs, not just company size or revenue.

🎓 Skill requirements

🎓 Modern workplace expectations

• Most organizations require their accounting and finance personnel to have advanced computer spreadsheet skills.
• The excerpt's goal is to provide opportunities to use spreadsheets "in a way that mirrors the real world."
• This reflects a fundamental shift in how financial work is performed in modern organizations.

🧭 Overview

🧠 One-sentence thesis

Manufacturing costs attach to inventory as assets until goods are sold, while nonmanufacturing costs are expensed immediately in the period incurred, making the distinction critical for financial statement presentation.

📌 Key points (3–5)

• Two broad categories: manufacturing costs (product costs) attach to inventory; nonmanufacturing costs (period costs) are expensed when incurred.
• Three manufacturing cost components: direct materials (easily traced raw materials), direct labor (easily traced worker time), and manufacturing overhead (all other production costs).
• Two nonmanufacturing cost components: selling costs (obtaining orders and delivering products) and general/administrative costs (overall management).
• Common confusion: small items like glue or nails seem "direct" but are classified as indirect materials (overhead) because tracing cost outweighs benefit.
• Why it matters: the category determines whether a cost appears on the balance sheet (as inventory) or income statement (as immediate expense), affecting financial reporting.

🏭 Manufacturing costs (product costs)

🪵 Direct materials

Raw materials used in the production process that are easily traced to the product.

• What qualifies: materials that are both significant in cost and easy to track to the finished product.
• Custom Furniture example: wood (cherry, maple, oak, mahogany) and hardware (drawer handles) used to build tables.
• What does NOT qualify: small, inexpensive items like glue, nails, masking tape—these go into overhead instead.
• Why the distinction: the cost of tracing minor items to each product outweighs the benefit of having precise cost data.

Don't confuse: Not all materials are direct materials; if tracing is impractical or the item is too minor, it becomes indirect material (part of overhead).

👷 Direct labor

Workers who convert materials into a finished product and whose time is easily traced to the product.

• What qualifies: production workers whose time can be directly linked to specific units.
• Custom Furniture example: workers who cut, plane, glue, fill, sand, stain, and finish tables.
• MasterCraft example: production workers who assemble boats and test them before shipping.
• Key criterion: "easily traced" means you can identify which worker spent time on which product.

🏗️ Manufacturing overhead

All costs associated with the production process other than direct material costs and direct labor costs.

Synonyms: factory overhead, factory burden, overhead.

Three subcategories:

Subcategory	Definition	Examples at Custom Furniture
Indirect materials	Materials necessary for production but not easily/worthily traced to product	Glue, screws, nails, sandpaper, stain, lacquer
Indirect labor	Workers involved in production whose time cannot easily be traced to product	Factory supervisors who oversee multiple products, hire/schedule employees, order materials
Other manufacturing costs	All other factory-related costs	Equipment maintenance, equipment depreciation, factory utilities, factory insurance, factory building depreciation, factory property taxes

Example scenario: A production supervisor at Custom Furniture oversees several different table designs and handles hiring—this person's salary cannot be easily split among individual tables, so it's indirect labor (overhead), not direct labor.

🛒 Nonmanufacturing costs (period costs)

📢 Selling costs

Costs incurred to obtain customer orders and provide customers with a finished product.

Also called: marketing costs or selling and advertising costs.

Custom Furniture examples:

• Advertising
• Sales commissions
• Salaries for marketing and advertising personnel
• Office space for marketing/advertising staff
• Finished goods storage costs
• Shipping costs paid by the seller to deliver products to customers

PepsiCo example: Television advertising (the largest component of $22.8 billion in selling/administrative expenses), promotional coupons, shipping to customers, salaries of marketing personnel.

🏢 General and administrative costs

Costs related to the overall management of an organization.

Also called: administrative costs.

Custom Furniture examples:

• Personnel and support staff in: accounting, human resources, legal, executive, information technology
• Depreciation of office equipment and buildings for these departments

PepsiCo example: Salaries and bonuses of top executives, costs of administrative departments (personnel, accounting, legal, IT).

⚠️ Gray areas and flexibility

• Ambiguous cases: If legal staff works on production issues or HR hires assembly workers, is the cost manufacturing or nonmanufacturing?
• Organization's choice: Each organization decides how to handle such costs for product costing purposes.
• Managerial accounting advantage: Costs can be organized in any manner that helps managers make decisions, unlike financial accounting which must follow U.S. GAAP.
• Assigning period costs to products: Managers may assign some nonmanufacturing costs (e.g., sales commissions, shipping for a specific product) to products for decision-making, even though U.S. GAAP prohibits this for external reporting.

📊 Financial statement presentation

💰 Timing of expense recognition

Cost category	When recorded as expense	Where it appears first
Manufacturing costs (product costs)	Expensed when goods are sold	Balance sheet as inventory (asset), then transferred to cost of goods sold on income statement
Nonmanufacturing costs (period costs)	Expensed in the time period incurred	Income statement immediately

🔄 The flow for manufacturing costs

1. During production: All manufacturing costs (direct materials + direct labor + manufacturing overhead) are attached to inventory.
2. On the balance sheet: These costs appear as an asset (inventory) until the goods are sold.
3. When goods sell: Costs transfer from inventory to cost of goods sold on the income statement as an expense.

Example scenario: Custom Furniture builds a table in January using $500 of wood, $300 of labor, and $200 of overhead. The $1,000 total sits on the balance sheet as inventory. When the table sells in March, the $1,000 moves to cost of goods sold on the March income statement.

📉 The flow for nonmanufacturing costs

• Immediate expensing: Selling and general/administrative costs are recorded as expenses on the income statement in the same period they are incurred.
• No inventory attachment: These costs never appear on the balance sheet as assets.

Example scenario: Custom Furniture pays $2,000 in advertising in February. The $2,000 appears as a selling expense on the February income statement, regardless of when any tables are sold.

🎯 Why the distinction is critical

• Financial reporting accuracy: U.S. GAAP requires manufacturing costs to be capitalized (held as assets) until sale, while period costs must be expensed immediately.
• Profit measurement: Misclassifying costs changes when expenses are recognized, affecting reported profit in each period.
• Inventory valuation: Only manufacturing costs are included in inventory value on the balance sheet.

Don't confuse: "Product cost" and "manufacturing cost" are interchangeable terms, as are "period cost" and "nonmanufacturing cost."

🧭 Overview

🧠 One-sentence thesis

Product costs move through three inventory accounts on the balance sheet as goods progress from raw materials to completion, then transfer to cost of goods sold on the income statement when the goods are sold.

📌 Key points (3–5)

• Three inventory accounts track production stages: raw materials (not yet used), work-in-process (incomplete), and finished goods (complete but unsold)—all are balance sheet assets.
• Cost of goods sold records sold product costs: when finished goods are sold, their costs transfer from finished goods inventory to cost of goods sold, an income statement expense.
• Cost of goods manufactured: the total cost of goods completed and transferred from work-in-process to finished goods inventory.
• Common confusion—inventory vs. expense: product costs remain assets (inventory) until goods are sold; only then do they become expenses (cost of goods sold).
• Why it matters: understanding this flow clarifies where manufacturing costs appear in financial statements and how they affect reported profit.

📦 The three inventory accounts

📦 Raw materials inventory

Raw materials inventory: the cost of materials not yet put into production.

• Records materials purchased but not yet used in manufacturing.
• Example: a furniture company's wood, brackets, screws, nails, glue, lacquer, and sandpaper sit in this account until workers begin using them.
• This is a balance sheet asset account.

🔧 Work-in-process inventory

Work-in-process (WIP) inventory: the cost of products that have not yet been completed.

• Accumulates all manufacturing costs—direct materials, direct labor, and manufacturing overhead—for goods still in production.
• Example: eight tables still being built at year-end; all costs incurred on them stay in WIP inventory.
• Once goods are completed, their costs transfer to finished goods inventory.
• Cost of goods manufactured: the total cost of completed goods transferred out of WIP into finished goods.

✅ Finished goods inventory

Finished goods inventory: the manufacturing costs of products that are completed and ready to sell.

• Holds the total production cost of items ready for sale but not yet sold.
• Example: five completed tables waiting for delivery; their direct materials, direct labor, and manufacturing overhead costs remain here until sold.
• This is also a balance sheet asset account.

💸 From inventory to expense

💸 Cost of goods sold

Cost of goods sold: an expense account on the income statement that represents the product costs of all goods sold during the period.

• When finished goods are sold, their costs leave finished goods inventory and enter cost of goods sold.
• Example: a table that cost $3,000 to produce is sold; finished goods inventory decreases by $3,000, and cost of goods sold increases by $3,000.
• This is the moment product costs become an expense on the income statement.

🔄 The flow from balance sheet to income statement

Stage	Account	Financial Statement	Status
Materials purchased	Raw materials inventory	Balance sheet (asset)	Not yet used
Production started	Work-in-process inventory	Balance sheet (asset)	Incomplete
Production completed	Finished goods inventory	Balance sheet (asset)	Complete, unsold
Goods sold	Cost of goods sold	Income statement (expense)	Sold

• Don't confuse: product costs are assets while goods remain in inventory; they become expenses only when goods are sold.

🏢 Real-world example

🏢 Advanced Micro Devices (AMD)

The excerpt provides AMD's financial statement presentation:

• Balance sheet inventory accounts (in millions):

  • Raw materials: $28 million (materials not yet in production)
  • Work-in-process: $441 million (incomplete microprocessors and flash memory devices)
  • Finished goods: $163 million (completed products ready to sell)
  • Total inventory: $632 million

• Income statement:

  • AMD calls cost of goods sold "cost of sales," which appears below net sales and above other operating expenses.

• This illustrates how a manufacturing company with $6.5 billion in annual revenue tracks product costs through the three inventory stages and reports them in financial statements.

🧭 Overview

🧠 One-sentence thesis

Manufacturing companies require more complex accounting systems than service or merchandising companies because they must track production costs through multiple inventory stages before calculating cost of goods sold.

📌 Key points (3–5)

• Why manufacturing accounting is complex: Manufacturing companies must track costs throughout the entire production process, from raw materials through work-in-process to finished goods, unlike service companies (no inventory) or merchandising companies (only buy and resell).
• The inventory cost flow equation: Beginning balance + Transfers in – Ending balance = Transfers out; this equation applies to all three inventory accounts and drives the three supporting schedules.
• Three required schedules: (1) Schedule of raw materials placed in production, (2) Schedule of cost of goods manufactured, and (3) Schedule of cost of goods sold—each feeds into the next.
• Common confusion: Merchandising vs. manufacturing terminology—merchandisers use "merchandise inventory" and "net purchases" instead of "finished goods inventory" and "cost of goods manufactured."
• Sequential flow: Each schedule provides information required for the next schedule, ultimately arriving at cost of goods sold for the income statement.

📋 The three inventory schedules

📋 Schedule of raw materials placed in production

Raw materials used in production: the cost of direct and indirect materials placed into the production process.

• Purpose: Calculate how much raw material was transferred from raw materials inventory into production.
• The cost flow equation applied: Beginning raw materials inventory + Raw materials purchases – Ending raw materials inventory = Raw materials placed in production.
• What happens next: This total (minus indirect materials) becomes "direct materials" in the next schedule.
• Example: If a company starts with $10,000 in raw materials, purchases $100,000, and ends with $8,000, then $102,000 was placed in production.

🏭 Schedule of cost of goods manufactured

Cost of goods manufactured: the cost of goods completed and transferred out of work-in-process inventory into finished goods inventory.

• Purpose: Calculate the total cost of products that were completed during the period.
• The cost flow equation applied: Beginning work-in-process inventory + Manufacturing costs added (direct materials + direct labor + manufacturing overhead) – Ending work-in-process inventory = Cost of goods manufactured.
• Three cost components: Direct materials (from the previous schedule), direct labor, and manufacturing overhead.
• What happens next: This total becomes "cost of goods available for sale" in the next schedule.

📦 Schedule of cost of goods sold

Cost of goods sold: the cost of goods that are sold and transferred out of finished goods inventory.

• Purpose: Calculate the expense to be reported on the income statement.
• The cost flow equation applied: Beginning finished goods inventory + Cost of goods manufactured – Ending finished goods inventory = Cost of goods sold.
• What happens next: This amount appears as an expense on the income statement, directly reducing gross profit.
• Example: If finished goods inventory starts at $410,000, cost of goods manufactured is $795,000, and ending inventory is $350,000, then cost of goods sold is $855,000.

🔄 The inventory cost flow equation

🔄 The universal formula

Beginning balance (BB) + Transfers in (TI) – Ending balance (EB) = Transfers out (TO)

• Applies to any balance sheet account: Cash, accounts receivable, inventory, etc.
• Used three times in manufacturing: Once for each inventory account (raw materials, work-in-process, finished goods).
• Why it matters: This equation is the backbone of all three schedules; understanding it means understanding how costs flow through manufacturing.

🔍 How the equation connects the schedules

• First use (raw materials): Transfers out = raw materials placed in production.
• Second use (work-in-process): Transfers out = cost of goods manufactured.
• Third use (finished goods): Transfers out = cost of goods sold.
• Each "transfers out" becomes part of "transfers in" for the next stage.

🏪 Manufacturing vs. merchandising income statements

🏪 Key terminology differences

Manufacturing Company	Merchandising Company	Explanation
Finished goods inventory	Merchandise inventory	Merchandisers don't produce goods, so they simply hold "merchandise"
Cost of goods manufactured	Net purchases	Merchandisers buy goods instead of making them
Three schedules required	Schedule of COGS often included in income statement	Simpler process means fewer supporting schedules
Raw materials, WIP, finished goods	Only merchandise inventory	No production process means no WIP or raw materials

🏪 What merchandisers skip

• No schedule of raw materials placed in production: Merchandisers don't manufacture, so they don't use raw materials.
• No schedule of cost of goods manufactured: They purchase finished goods from suppliers.
• Simpler inventory tracking: Only one inventory account (merchandise inventory) instead of three.
• Net purchases line: Includes purchases, purchase returns and allowances, purchase discounts, and freight in.

🏪 What stays the same

Both manufacturing and merchandising companies use these terms:

• Sales
• Cost of goods available for sale
• Cost of goods sold
• Operating expenses
• Selling, general and administrative expenses
• Operating profit

🚨 Real-world application: fraud detection

🚨 The Rite Aid inventory fraud case

The excerpt describes how Rite Aid executives allegedly committed fraud by failing to record $9,000,000 in inventory shrinkage (physical deterioration or theft).

How the cost flow equation reveals the fraud:

• If ending inventory is overstated (too high), then cost of goods sold is understated (too low).
• Using the equation: Beginning balance + Purchases – Ending balance = Cost of goods sold.
• By not reducing ending inventory by $9,000,000, cost of goods sold was $9,000,000 too low.
• Lower expenses = higher reported profit (by $9,000,000).

Consequences mentioned:

• Net income was restated downward by $1,600,000,000.
• Former CEO sentenced to eight years in prison.
• Former CFO sentenced to 28 months in prison.
• Stock fell from $50 to $5 per share.

Don't confuse: This is about failing to record a loss, not about inventing inventory—the fraud was in the omission, not fabrication.

💡 Perpetual inventory systems

💡 How perpetual systems differ

• Real-time updates: Perpetual systems update inventory records immediately when inventory transfers occur.
• Formal schedules may not be prepared: Because the system tracks everything automatically.
• Physical counts still required: Companies periodically verify accuracy.
• Cost flow equation still used: To ensure perpetual system balances are accurate during physical counts.

🧭 Overview

🧠 One-sentence thesis

Manufacturing companies choose between job costing and process costing systems based on whether they produce unique, distinguishable products or identical units in batches.

📌 Key points (3–5)

• Job costing tracks revenues and costs for each unique product or service that can be easily distinguished from others.
• Process costing tracks costs for batches of identical units produced through a consistent process.
• Common confusion: The choice depends on the product's uniqueness—custom furniture needs job costing, but soft drinks need process costing.
• Why it matters: Managers use these systems to assess cost estimate accuracy, evaluate job profitability, and identify unexpected cost changes early.
• Key distinction: Ask "Can this product be easily distinguished from others?" to determine which system to use.

🏭 Job Costing Systems

🎯 What defines a job

A job is an activity that produces a unique product—one that can be easily distinguished from other products.

• The product must be unique and distinguishable from other products.
• Example: Building a custom home is a job because each home is unique and easy to distinguish from other homes.
• Example: An accounting firm providing tax services to a client is a job.
• Custom Furniture Company produces high-quality custom wood tables (priced $1,000–$30,000), making each table a separate job.

📊 How job costing systems work

A job costing system records revenues and costs for each individual job.

Why companies use job costing:

• Cost estimate accuracy: Managers can compare actual costs to estimates, especially important when prices are based on estimated costs.
• Profitability assessment: Managers review actual revenues and costs to determine if each job is profitable.
• Early problem detection: Comparing actual costs with estimates throughout a project helps identify unexpected changes early.

Example: If mahogany wood costs increase by 50 percent mid-project, Custom Furniture might renegotiate the current job's price or build the increase into future job pricing.

🔧 When to use job costing

Job costing fits companies that produce unique products with different material and labor requirements for each unit.

Products and services requiring job costing:

• Custom homes
• Custom vans
• House painting services
• Movies
• Airplanes
• Bridges
• Legal services
• Custom campers
• Tax services

🏭 Process Costing Systems

🔄 What defines process costing

Companies that produce identical units of product in batches using a consistent process track costs with a process costing system.

• Used when products are identical and produced in batches.
• Tracking costs for each individual unit would be impractical.
• Example: Tracking costs for each can of soda produced would not make sense—a job costing system would be inappropriate.

📦 When to use process costing

Process costing fits companies that produce standardized, identical products through consistent manufacturing processes.

Products requiring process costing:

• Oil
• Chemicals
• Paint
• Lumber
• Milk
• Pencils
• Paper
• Soft drinks

Don't confuse: The same company might use different systems for different product lines—a paint manufacturer uses process costing for standard paint, but a house painting service uses job costing for each client project.

🔍 Choosing the Right System

🧩 The decision framework

Factor	Job Costing	Process Costing
Product type	Unique, distinguishable	Identical units
Production method	Varies by job	Consistent batch process
Cost tracking	Per individual job	Per batch or process
Examples	Custom furniture, bridges, movies	Chemicals, milk, pencils

⚖️ Understanding the company's context

To decide which system to use, managers must understand:

• The company's products
• The company's production processes

The key question: "Can this product be easily distinguished from other products?"

• Yes → Job costing
• No → Process costing

Example: Boeing produces custom airplanes (job costing), while Michelin produces standardized tires (process costing).

🧭 Overview

🧠 One-sentence thesis

A job costing system tracks production costs by recording direct materials and direct labor for each unique job through materials requisition forms, timesheets, and job cost sheets that serve as subsidiary ledgers to the work-in-process inventory account.

📌 Key points (3–5)

• When job costing fits: appropriate for companies producing unique, custom products (like custom furniture sold for varying prices).
• How materials flow: raw materials purchased → moved to production via materials requisition forms → costs recorded on job cost sheets.
• How labor is tracked: workers complete timesheets showing hours per job → direct labor costs recorded on job cost sheets.
• Common confusion: the work-in-process inventory account shows total manufacturing costs, but individual job cost sheets (subsidiary ledgers) track costs per job—the sum of all job cost sheets must match the WIP inventory account balance.
• Why subsidiary ledgers matter: job cost sheets accumulate all manufacturing costs for each specific job, enabling precise cost tracking.

📋 Raw materials purchasing and tracking

💰 Recording raw material purchases

• Raw materials are items needed to build a product (wood, brackets, screws, nails, glue, lacquer, sandpaper for furniture).
• Purchases are recorded in the raw materials inventory account (an asset account).
• Example: Custom Furniture purchased $4,500 in raw materials on account on May 2—debit raw materials inventory, credit accounts payable.

📝 Materials requisition form

A materials requisition form tracks materials taken out of raw materials inventory and placed in production.

• The form specifies: type, quantity, cost of materials, and the job number where materials will be used.
• This document triggers the journal entry to transfer costs from raw materials inventory to work-in-process inventory.
• Example: A form showed $370 in direct materials moved to production for a specific job—debit work-in-process inventory, credit raw materials inventory.

👷 Direct labor cost assignment

⏱️ Timesheet tracking

A timesheet (also called time card, time ticket, or job ticket) tracks the hours workers spend on each job.

• Workers complete the timesheet with: date, job number, and hours worked on each job.
• Direct labor is defined as workers who convert materials into finished product and whose time is easily traced to the job.
• Example: A timesheet showed $120 in direct labor costs for jobs 50 and 51—debit work-in-process inventory, credit wages payable (or cash).

🔗 Posting to job cost sheets

• After recording the journal entry, timesheet information is posted to the appropriate job cost sheet.
• This mirrors the process used for direct materials.
• Both direct materials and direct labor must be recorded on job cost sheets because they are easily traceable to specific jobs.

📊 Job cost sheets as subsidiary ledgers

📑 What a job cost sheet does

A job cost sheet accumulates manufacturing costs incurred for each job.

• It serves as the subsidiary ledger for the work-in-process inventory account.
• Each job has its own cost sheet; the total of all job cost sheets equals the WIP inventory account balance on the balance sheet.

🔄 Information flow

Source document	What it tracks	Where it's posted
Materials requisition form	Direct materials moved to production	Job cost sheet + WIP inventory account
Timesheet	Direct labor hours and costs	Job cost sheet + WIP inventory account

🎯 Why this system works

• The WIP inventory account shows total manufacturing costs across all jobs.
• Individual job cost sheets show costs for each specific job.
• Don't confuse: the general ledger account (WIP inventory) is the control account; job cost sheets are the detailed breakdown that must reconcile to the control account total.

🔢 Account flow and double-entry rules

📚 Account categories

• Increased with debits (decreased with credits): assets, dividends, expenses.
• Increased with credits (decreased with debits): liabilities, stockholders' equity, revenues.
• Inventory accounts (raw materials, work-in-process) are asset accounts, so increases are debits.

🔄 Cost flow pattern

1. Raw materials purchased → debit raw materials inventory (asset increases).
2. Materials moved to production → debit work-in-process inventory, credit raw materials inventory (one asset increases, another decreases).
3. Labor incurred → debit work-in-process inventory, credit wages payable (asset increases, liability increases).
4. Each transaction is also recorded on the relevant job cost sheet to maintain detailed job-level tracking.

🧭 Overview

🧠 One-sentence thesis

Manufacturing overhead costs are assigned to jobs using a predetermined overhead rate calculated from estimated annual costs and activity levels, rather than waiting for actual costs, because this approach provides timely cost information and smooths out monthly fluctuations.

📌 Key points (3–5)

• Predetermined overhead rate: calculated before the year begins by dividing estimated overhead costs by estimated activity in the allocation base (e.g., direct labor hours, machine hours).
• Normal costing vs. actual costing: companies prefer normal costing (using predetermined rates) because actual overhead fluctuates monthly, data arrives late, and bookkeeping is simpler.
• Overhead applied vs. actual overhead: the amount assigned to jobs (overhead applied) rarely equals actual costs incurred, creating underapplied or overapplied overhead.
• Common confusion: underapplied means actual costs exceeded applied costs (debit balance); overapplied means applied costs exceeded actual costs (credit balance).
• Closing the overhead account: at period end, the manufacturing overhead clearing account is closed to cost of goods sold (if immaterial) or allocated proportionally across work-in-process, finished goods, and cost of goods sold (if material).

🧮 The predetermined overhead rate mechanism

🧮 How the rate is calculated

Predetermined overhead rate = Estimated overhead costs ÷ Estimated activity in allocation base

• Numerator: estimate all overhead costs for the coming year (indirect materials, indirect labor, factory utilities, etc.).
• Denominator: estimate the total activity level in the chosen allocation base for the year.
• Example from the excerpt: Custom Furniture Company estimates $1,140,000 overhead costs and 38,000 direct labor hours, yielding a rate of $30 per direct labor hour.

🏷️ Overhead applied

Overhead applied: the assignment of overhead costs to jobs based on a predetermined overhead rate.

• This is not actual overhead incurred; it is a portion of estimated overhead assigned to a specific job.
• Example: if a job uses 6 direct labor hours and the rate is $30 per hour, $180 in overhead is applied to that job.
• The applied amount is recorded on the job cost sheet alongside direct materials and direct labor.

📝 Journal entry for applying overhead

When overhead is applied to a job:

• Debit: Work-in-Process Inventory
• Credit: Manufacturing Overhead

This entry moves estimated overhead costs into the job's total manufacturing cost.

🎯 Choosing an allocation base

🎯 What drives overhead costs

Companies select an allocation base that drives overhead costs (a cost driver):

Production process	Likely cost driver	Allocation base
Labor intensive	Direct labor hours/costs	Direct labor hours or direct labor costs
Highly mechanized	Machine usage	Machine hours

• The goal: find the activity that causes overhead to increase.
• Don't confuse: the allocation base is not overhead itself; it is the activity measure used to distribute overhead.

📏 Ease of measurement

The allocation base must be:

• Linked to overhead costs (as above)
• Measurable in practice

Common bases are easy to track:

• Direct labor hours and costs: measured via timesheets
• Machine hours: measured with hour meters on machines

🔀 Multiple allocation bases

• Some companies use activity-based costing with several allocation bases and rates for more accuracy.
• This approach is noted but detailed in a later chapter.

⚖️ Why use normal costing instead of actual costs

⚖️ Advantages of predetermined rates

Companies prefer normal costing (using predetermined rates) over actual costing for several reasons:

1. Smooths fluctuations: Actual overhead costs vary month to month (e.g., higher utilities in winter/summer, higher maintenance during slow periods). A predetermined rate averages costs over the year.
2. Timely information: Actual overhead data are only available at period end. Managers want job costs during or immediately after production, not weeks later.
3. Pricing support: Prices are often negotiated based on cost estimates. A predetermined rate helps estimate costs before a job is complete.
4. Simpler bookkeeping: One rate is used throughout the period instead of going back to assign actual costs after the fact.

🧾 The manufacturing overhead clearing account

Clearing account: used to hold financial data temporarily and closed out at period end before preparing financial statements.

The manufacturing overhead account tracks two things:

• Debits: actual overhead costs incurred (e.g., indirect materials, factory utilities, supervisor salaries)
• Credits: overhead applied to jobs using the predetermined rate

Example debit entry (actual cost incurred):

• Debit: Manufacturing Overhead
• Credit: Raw Materials Inventory (for indirect materials placed into production)

Example credit entry (overhead applied):

• Debit: Work-in-Process Inventory
• Credit: Manufacturing Overhead

🔄 Underapplied and overapplied overhead

🔄 Definitions and account balances

Because the predetermined rate is based on estimates, applied overhead rarely equals actual overhead.

Underapplied overhead: actual overhead costs (debits) are higher than overhead applied to jobs (credits).

• The manufacturing overhead account has a debit balance.
• Interpretation: not enough overhead was charged to jobs.

Overapplied overhead: actual overhead costs (debits) are lower than overhead applied to jobs (credits).

• The manufacturing overhead account has a credit balance.
• Interpretation: too much overhead was charged to jobs.

🔄 Don't confuse the direction

Situation	Actual vs. Applied	Account balance	Meaning
Underapplied	Actual > Applied	Debit	Jobs were undercharged
Overapplied	Actual < Applied	Credit	Jobs were overcharged

🔚 Closing the manufacturing overhead account

🔚 Immaterial balance: close to cost of goods sold

If the overhead difference is immaterial (small relative to company size), close the entire balance to cost of goods sold.

• Underapplied (debit balance of $2,000):
  • Debit: Cost of Goods Sold $2,000
  • Credit: Manufacturing Overhead $2,000
• Overapplied (credit balance of $3,000):
  • Debit: Manufacturing Overhead $3,000
  • Credit: Cost of Goods Sold $3,000

🔚 Material balance: allocate proportionally

If the balance is material (large), allocate it proportionally to:

• Work-in-Process Inventory
• Finished Goods Inventory
• Cost of Goods Sold

Based on the percentage each account represents of the total.

Example from the excerpt: $2,000 underapplied overhead with account balances totaling $10,000:

• WIP Inventory: $6,000 (60%) → receives $1,200
• Finished Goods Inventory: $3,000 (30%) → receives $600
• Cost of Goods Sold: $1,000 (10%) → receives $200

Journal entry:

• Debit: Work-in-Process Inventory $1,200
• Debit: Finished Goods Inventory $600
• Debit: Cost of Goods Sold $200
• Credit: Manufacturing Overhead $2,000

🔚 Why the difference matters

• Immaterial: simpler to close entirely to cost of goods sold.
• Material: more accurate to spread the adjustment across all accounts that absorbed overhead during the period.

🧭 Overview

🧠 One-sentence thesis

Service organizations use job costing systems similar to manufacturing companies, but they typically track fewer materials and often organize costs by customer rather than by product.

📌 Key points (3–5)

• Core similarity: Service organizations use the same job costing framework as manufacturers—tracking direct materials, direct labor, and overhead on job cost sheets.
• Key difference in materials: Many service firms (accountants, lawyers) have negligible material costs and include supplies in overhead instead of tracking them by job; others (auto mechanics, electricians) track significant material costs just like manufacturers.
• Direct labor dominance: Direct labor is typically the most significant cost category for service organizations.
• Common confusion: Not all service companies use a work-in-process account; some charge costs directly to expense accounts instead.
• Overhead allocation: Service firms commonly use direct labor hours or direct labor cost as the allocation base because overhead is typically driven by labor.

🏢 Account structure differences

📋 Account name variations

Service organizations use slightly different account names compared to manufacturers:

Manufacturing Account	Service Organization Account	Financial Statement
Raw materials inventory	Parts inventory or supplies	Balance sheet (asset)
Work-in-process inventory	Work in process*	Balance sheet (asset)
Finished goods	(Not applicable)	Balance sheet (asset)
Cost of goods sold	Cost of services (or other expense accounts)	Income statement (expense)
Manufacturing overhead	Overhead (or service overhead)	None (clearing account)

*Note: Some service companies skip the work-in-process account entirely and charge costs directly to expense accounts.

🎯 Job tracking focus

• Service organizations often track costs by customer (e.g., an individual client or corporation) rather than by physical product.
• Examples: accountants track by client, electricians by project, auto mechanics by repair job.

💰 Direct materials handling

🔧 When materials are insignificant

• Many service providers (accountants, attorneys) use low-cost materials like binders and paper.
• These materials are called supplies and are included in overhead rather than tracked separately by job.
• This simplifies the accounting process when material costs are negligible.

🔩 When materials are significant

• Some service organizations (auto mechanics, electricians) use costly materials that must be tracked.
• Examples: auto parts for repairs, wiring materials for new buildings.
• Materials may be requisitioned from parts inventory/supplies or purchased directly from suppliers.
• Recording process: Exactly the same as manufacturing companies—materials are recorded in the journal and on the job cost sheet.

Don't confuse: The decision to track materials depends on their significance to total job cost, not on whether the organization is a service or manufacturing firm.

👷 Direct labor tracking

⏱️ Labor as the primary cost driver

Direct labor tends to be the most significant cost for service organizations.

• Unlike manufacturing, where materials and overhead may dominate, service firms are typically labor-intensive.
• This makes accurate labor tracking critical for profitability analysis.

📝 Tracking methods

• Service organizations use timesheets to record hours worked on each job.
• Labor costs are recorded in the journal and on the job cost sheet.
• Process: Identical to manufacturing companies—no differences in the mechanics of tracking and recording.

Example: An accountant records hours spent on each client's tax return; an electrician logs hours spent wiring each building section.

🏭 Overhead application

📊 Common allocation bases

Because overhead is typically driven by direct labor hours in service organizations:

• Most common bases: Direct labor hours or direct labor cost.
• This differs from manufacturing, where machine hours or other bases may be more appropriate.
• The choice reflects the labor-intensive nature of service work.

🔄 Application process

• Service firms use a predetermined overhead rate to apply overhead to jobs.
• The calculation and recording process is exactly the same as for manufacturing companies.
• Overhead is recorded in the journal and on the job cost sheet using the same methods.

🎬 Real-world example: Movie studios

The excerpt describes how movie studios (20th Century Fox, Universal Studios, Warner Brothers) use job costing:

• Direct labor: Actors, directors, editors, film crew.
• Direct materials: Costumes, sets, props.
• Overhead: Depreciation of film equipment, studio utilities, executive salaries for those overseeing multiple films.
• Why it matters: Actors and directors are often compensated based on a percentage of profits, so accurate cost tracking is essential.
• Controversy: Some studios have been accused of allocating too much overhead to individual films to reduce reported profitability and lower profit-sharing payments.

Don't confuse: Overhead allocation in service firms follows the same principles as manufacturing, but the drivers (what causes overhead costs) are often different.

🧭 Overview

🧠 One-sentence thesis

Job costing systems enable companies to track all manufacturing and nonmanufacturing costs through journal entries and T-accounts, then compare actual job costs against estimates to identify profitability problems and improve future pricing decisions.

📌 Key points (3–5)

• Why correct classification matters: Companies must classify and record all manufacturing and nonmanufacturing costs correctly to evaluate profitability at both the job level and company level.
• How transactions flow: Manufacturing costs move through inventory accounts (raw materials → work-in-process → finished goods) via journal entries, with each debit to work-in-process also recorded on individual job cost sheets.
• Profitability analysis: Comparing estimated costs (used for pricing) with actual costs from job cost sheets reveals where estimates went wrong and guides future pricing adjustments.
• Common confusion: A company can price at a 70% markup over estimated costs but still earn low profits if actual costs significantly exceed estimates—the markup percentage alone doesn't guarantee target profit margins.
• Action from variance analysis: When actual costs differ from estimates (e.g., direct materials running higher), managers must investigate root causes (waste, price increases, inexperienced workers) to fix processes or revise future bids.

📒 Recording cost flows through journal entries

📝 Why proper recording is essential

Companies like Custom Furniture Company must correctly classify and record costs to evaluate:

• Profitability of each individual job
• Overall company profitability

This requires tracking both manufacturing costs (direct materials, direct labor, overhead) and nonmanufacturing costs (selling, administrative) through the general journal.

🔄 How transactions are recorded

The excerpt shows Custom Furniture Company's May transactions recorded in two formats:

• Journal entries: summarized monthly totals rather than individual daily transactions
• T-accounts: showing the flow of costs through inventory accounts

Key principle: If you understand how to make a summarized monthly entry, you know how to make each individual transaction entry.

📦 Inventory account flow

Beginning balances for May:

• Raw materials inventory: $25,000
• Work-in-process inventory: $35,000
• Finished goods inventory: $90,000

Important detail: Every debit to work-in-process inventory must also be recorded on the appropriate job cost sheet—this dual recording links the general ledger to individual job tracking.

💰 Evaluating company and job profitability

📊 Company-level income statement

Custom Furniture Company's May results:

• Operating profit: $11,000
• Cost of goods sold: $135,000

The income statement includes an adjustment for underapplied overhead (the amount of overhead underapplied to jobs, closed out to cost of goods sold at month-end).

🎯 Expected vs. actual profitability

The pricing formula: Custom Furniture prices at 70% above estimated production costs (170% markup).

What this should produce:

• If cost of goods sold = $135,000
• Sales revenue should be: $229,500 ($135,000 × 170%)
• Gross profit should be: $94,500 ($135,000 × 70%)

Don't confuse: A 70% markup means gross profit should equal 70% of production costs, not 70% of sales revenue.

🔍 Job-level profitability analysis

The accountant (Leslie) examined the three highest-cost tables produced in May, comparing:

• Original cost estimates (used to set prices)
• Actual costs from job cost sheets

Cost category	Finding
Direct materials	Significantly higher than estimated (the problem area)
Direct labor	Pretty close to estimates
Manufacturing overhead	Pretty close to estimates

Example: The analysis revealed that direct material costs were the culprit—wood costs had increased over recent months, but not to the extent shown in actual results.

🔎 Root cause investigation and corrective action

🧩 Potential causes for cost variances

Leslie identified several possible reasons for higher-than-estimated direct materials costs:

• Materials wasted due to machine problems
• Inexperienced employees causing waste
• Price increases from suppliers (Dan recalled wood costs increasing)

🛠️ Management response

Immediate actions:

1. Investigate why estimates are so far off
2. Research the direct materials cost problem
3. Determine whether changes can be made to the production process

Future planning:

• If production process improvements can reduce costs → implement changes
• If costs cannot be reduced → revise estimates and raise prices on future jobs

📈 How job costing supports decision-making

Job costing systems can do more than simply track the costs of each job. Companies also use these systems to track revenue and the resulting profit for each job.

The comparison process:

• Cost estimate prepared before starting the job (used for pricing)
• Information on the completed job cost sheet (actual costs)
• Analysis of differences → leads to changes in production process and revised estimates for future jobs

Goal: Provide enough information for the company to make informed decisions about areas of concern and how much to charge for future jobs.

⚠️ Why markup alone isn't enough

Common confusion: Custom Furniture set prices at 170% of estimated costs but still earned only $11,000 profit because:

• Actual costs exceeded estimates (especially direct materials)
• The 70% markup applied to estimated costs, not actual costs
• When actual costs are higher, the fixed sales price yields lower profit margins

Lesson: Regular comparison of estimates vs. actuals is essential to maintain target profitability—pricing formulas only work when estimates are accurate.