FMGT-2294 Chapter 5 - Notes from the Textbook

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Garrison, R. H., Webb, A., & Libby, T. (2024). Managerial Accounting (13th Canadian ed.). McGraw-Hill Ryerson.

Garrison, R. H., Noreen, E. W., Libby, T., Brewer, P. C., & Webb, A. (2015). Managerial accounting (10th ed.). McGraw Hill Ryerson.

Note on Organization

This note reorganizes the textbook’s LOs to follow a more natural learning progression. The core question this chapter answers is: How do costs flow through a job-order system, and how does the MOH clearing account work?

Textbook LO	Section Here
LO1 (Process vs job-order)	§1
LO2 (Flow of costs)	§2 + §3
LO3 (Compute POHR)	§4
LO4 (Journal entries)	§2 + §5
LO5 (Apply overhead)	§3 + §4
LO6 (COGM/COGS schedules)	§6
LO7 (Under/overapplied)	§7
LO8 (Full capacity POHR)	§8

1. Choosing a Costing System

What is absorption costing?

Absorption costing = ALL manufacturing costs get assigned to products

Before asking how to assign costs to products, we need to answer which costs get assigned. Absorption costing answers that question.

Approach	What Gets Assigned to Products	What Gets Expensed Immediately
Absorption costing	ALL manufacturing costs (DM + DL + MOH, both fixed and variable)	Non-manufacturing costs (selling, admin)
Variable costing	Only VARIABLE manufacturing costs	Fixed MOH + non-manufacturing costs

The metaphor: Think of the product as a sponge. Under absorption costing, the product “absorbs” all manufacturing costs—both the variable costs that change with production AND the fixed costs (like factory rent) that stay constant regardless of how much you make.

Terminology

Absorption costing = Full costing — same thing, two names.

How do we choose between process and job-order costing?

Choose the cost object that matches your production environment—the system follows from that choice.

Both process costing and job-order costing are absorption costing methods. The difference is how costs get accumulated and assigned, which depends on what cost object makes sense.

Production Environment	Most Useful Cost Object	System
Distinct, custom outputs	The job (order, project, client)	Job-order
Homogeneous, continuous flow	The process/department	Process

The key test:

"If a customer said 'give me a different one,' would it matter?"

• No → units are interchangeable → process costing
• Yes → units are distinct → job-order costing

What is process costing?

Process costing = costs accumulated by department/time period, then averaged across identical units

Used when a company produces homogeneous, interchangeable units in a continuous flow.

$\text{Unit Cost}=\frac{\text{Total Manufacturing Cost}}{\text{Total Units Produced}}$

Industries: Oil refining, paper manufacturing, cement mixing, beverage bottling, chemical production—anywhere output is a commodity.

What is job-order costing?

Job-order costing = costs traced and allocated to distinct jobs, then averaged within each job

Used when a company produces different products or services, where each job is distinguishable.

$\text{Unit Cost}=\frac{\text{Total Job Cost}}{\text{Units in Job}}$

Industries: Construction, custom manufacturing, law firms, hospitals, accounting firms, advertising agencies, movie studios.

Job-order costing is used by more than half of manufacturers in North America.

The Trap

Identical within a batch ≠ Process costing

A print shop producing 10,000 identical business cards for Company X uses job-order costing—because the next run (for Company Y) will be different. The test is whether ALL production is interchangeable, not whether one batch is internally identical.

What about service industries?

Service firms use job-order costing—just without raw materials. The mechanics are identical: accumulate costs by job (client, patient, case, project), then calculate cost per job.

Service Industry	Job/Cost Object	Main Cost Elements
Law firm	Client/case	Direct labour (attorney hours), overhead
Hospital	Patient admission	Direct labour (staff time), overhead, some supplies
Accounting firm	Client engagement	Direct labour (staff hours), overhead

For more on how service firms bundle labour and overhead into billing rates, see Charge-Out Rates in Service Industries.

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2. The Physical and Accounting Flow

Foundation

This builds directly on Inventory Flow in Manufacturing from Chapter 2. Costs remain assets on the balance sheet until the product is sold—only then do they become expenses.

How do costs flow through the system?

Costs flow through three inventory accounts before becoming an expense

Raw Materials Inventory     (asset - storeroom)
        ↓ materials requisitioned
        
Work in Process Inventory   (asset - factory floor)
        ↑ Direct Labour added
        ↑ Manufacturing Overhead applied
        ↓ job completed
        
Finished Goods Inventory    (asset - warehouse)
        ↓ job sold
        
Cost of Goods Sold          (expense - income statement)

What triggers each cost movement?

Event	Document	Entry
Purchase materials	Purchase order / invoice	Dr. Raw Materials / Cr. AP
Requisition materials for job	Materials requisition form	Dr. WIP or MOH / Cr. Raw Materials
Workers log time on job	Time ticket	Dr. WIP or MOH / Cr. Wages Payable
Apply overhead to job	POHR × activity	Dr. WIP / Cr. MOH
Job completed	Job cost sheet totaled	Dr. Finished Goods / Cr. WIP
Job sold	Sales invoice	Dr. COGS / Cr. Finished Goods

What is a job cost sheet?

Job cost sheet = the bucket that catches all costs for one specific job

Each job gets its own job cost sheet that accumulates:

Cost Type	Source Document	Actual or Applied?
Direct Materials	Materials requisition form	Actual
Direct Labour	Time tickets	Actual
Manufacturing Overhead	POHR calculation	Applied

The job cost sheets form a subsidiary ledger to Work in Process. The sum of all job cost sheets must equal the WIP control account balance.

What source documents trigger cost flows?

Document	Purpose
Sales order	Agreement with customer
Production order	Authorizes work to begin
Bill of materials	Lists materials needed
Materials requisition form	Authorizes release of materials from storeroom
Time ticket	Records employee hours by job
Job cost sheet	Accumulates all costs for one job

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3. The Manufacturing Overhead Clearing Account

MOH is a clearing account with two distinct processes: recording actual costs (debits) and applying estimated costs to jobs (credits)

This is the core conceptual challenge of the chapter. Understanding the MOH account unlocks everything else.

Why can’t we charge actual overhead directly to jobs?

Overhead costs (factory rent, utilities, supervisor salaries) benefit all jobs, but we can’t trace them directly to any specific job. We need:

1. A place to collect actual overhead costs as they occur
2. A method to distribute those costs to jobs fairly
3. A way to reconcile when estimates don’t match reality

The MOH account solves #1 and #3. The predetermined overhead rate solves #2.

What are the “two separate and entirely distinct processes”?

Process	What Happens	Entry	Based On
Recording actual overhead	Collect real costs as incurred	Dr. MOH / Cr. Various	Actual dollars spent
Applying overhead to jobs	Charge jobs using POHR	Dr. WIP / Cr. MOH	POHR × actual activity

These happen independently throughout the year. That’s why MOH can end up with a balance—the debits (actual) and credits (applied) don’t automatically match.

Manufacturing Overhead (T-account)
┌─────────────────────────┬─────────────────────────┐
│     DEBIT (Actual)      │     CREDIT (Applied)    │
├─────────────────────────┼─────────────────────────┤
│ Indirect materials      │ POHR × activity         │
│ Indirect labour         │ charged to jobs         │
│ Factory utilities       │                         │
│ Factory depreciation    │                         │
│ Factory insurance       │                         │
└─────────────────────────┴─────────────────────────┘

What’s the difference between direct/indirect and actual/applied?

These are two independent classification systems

Distinction	Question It Answers
Direct vs Indirect	Can you trace the cost to a specific job?
Actual vs Applied	Are you using real dollars or estimated dollars?

How they interact:

Cost Type	Traceable?	What Goes on Job Cost Sheet
Direct materials	Yes	Actual dollars from requisition forms
Direct labour	Yes	Actual dollars from time tickets
Manufacturing overhead	No	Applied dollars (POHR × activity)

The Trap

Thinking actual overhead costs go on job cost sheets.

They don’t. Only applied overhead (POHR × actual activity) appears on job cost sheets and in WIP. Actual overhead sits in the MOH account until year-end disposal.

Why doesn’t manufacturing overhead go straight to expense?

Under absorption costing, manufacturing overhead is a product cost—it must attach to units and flow through inventory before becoming an expense.

The MOH clearing account is just the first stop:

Manufacturing Overhead  →  Work in Process  →  Finished Goods  →  Cost of Goods Sold
   (clearing account)       (on the job)        (job complete)       (EXPENSE)

See Product vs Period Costs for why factory costs attach to products while office costs expense immediately.

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4. Computing and Applying the Predetermined Overhead Rate

How is POHR computed?

POHR = Estimated overhead ÷ Estimated allocation base, calculated BEFORE the period begins

$\text{POHR}=\frac{\text{Estimated Total Manufacturing Overhead}}{\text{Estimated Total Units in the Allocation Base}}$

Component	What It Means
Numerator	Total overhead you expect to incur for the year
Denominator	Total units of the allocation base you expect to use

What units is POHR expressed in?

POHR units depend on the allocation base—when the base is dollars, POHR is a percentage.

Allocation Base	POHR Units	Example
Direct labour hours	$ per DLH	$320,000÷40,000DLH=$8/DLH
Machine hours	$ per MH	$320,000÷16,000MH=$20/MH
Direct materials cost	Percentage	$320,000÷$800,000 = 40%
Direct labour cost	Percentage	$320,000÷$400,000 = 80%

The Trap

Misreading a percentage-based POHR as a dollar rate.

When the allocation base is dollars, a POHR of “0.40” means 40%—not $0.40 per something.

How do you apply POHR to a specific job?

$\text{Overhead Applied to Job}=\text{POHR}\times \text{Actual Activity on the Job}$

Component	Estimated or Actual?
The rate (POHR)	Based on estimates (set at year start)
The activity base	Actual activity on the job

Applying overhead to Job 2B47

Job 2B47 used 27 direct labour-hours. POHR = $8/DLH.

Overhead applied = $8/DLH\times 27DLH=\ast \ast$216**

What is an allocation base?

Allocation base = the measure we use to spread indirect costs across jobs

Allocation Base	Logic
Direct labour hours (DLH)	Jobs using more worker time absorb more overhead
Machine hours (MH)	Jobs using more equipment time absorb more overhead
Direct labour cost ($)	Jobs with higher labour cost absorb more overhead

Ideally, the allocation base should drive overhead costs—there should be a causal relationship. If machine usage causes most overhead (power, maintenance, depreciation), use machine hours.

For analysis of plantwide vs. departmental rates and the cost-accuracy trade-off, see Plantwide vs Departmental Overhead Rates.

Why do we use estimated costs instead of actual?

Three reasons:

Reason	Explanation
Timeliness	Managers need job costs before year-end
Smoothing	Actual overhead varies by season; a monthly rate would make identical products cost different amounts
Simplicity	One predetermined rate is easier than real-time allocation

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5. Journal Entries for the Full Cycle

Materials: Purchase and Requisition

Purchase raw materials:

Account	Debit	Credit
Raw Materials	X
Accounts Payable		X

Requisition materials into production:

Account	Debit	Credit
Work in Process	(direct)
Manufacturing Overhead	(indirect)
Raw Materials		(total)

One Raw Materials Account

There is only one Raw Materials account. The direct/indirect distinction affects where the cost goes (the debit side), not where it comes from (the credit side).

Labour: Direct and Indirect

Account	Debit	Credit
Work in Process	(direct labour)
Manufacturing Overhead	(indirect labour)
Wages Payable		(total)

The Trap

Crediting “Direct Labour Hours” instead of Wages Payable.

Direct labour hours is an allocation base—a measure. The liability for wages goes to Wages Payable.

Other Overhead Costs

Account	Debit	Credit
Manufacturing Overhead	X
Various (Cash, AP, Accum Depr, etc.)		X

Applying Overhead to Jobs

Account	Debit	Credit
Work in Process	(applied amount)
Manufacturing Overhead		(applied amount)

Terminology: Record vs Apply vs Transfer

Term	Meaning	Entry
Record	Collect actual costs as incurred	Dr. MOH / Cr. Various
Apply	Charge jobs using POHR	Dr. WIP / Cr. MOH
Transfer	Move completed/sold job costs	Dr. FG / Cr. WIP or Dr. COGS / Cr. FG

Job Completion and Sale

Job completed (factory → warehouse):

Account	Debit	Credit
Finished Goods	X
Work in Process		X

Job sold (two entries):

Entry	Account	Debit	Credit
Revenue	Cash/AR	(selling price)
	Sales Revenue		(selling price)
Cost	Cost of Goods Sold	(job cost)
	Finished Goods		(job cost)

The Trap

Forgetting the cost entry when recording a sale.

A sale requires TWO entries: one for revenue and one for cost. The revenue entry alone doesn’t remove the inventory.

Non-Manufacturing Costs

Factory = Product, Office = Period

Non-manufacturing costs never go into MOH. They expense immediately:

Cost	Location	Entry
Factory depreciation	Factory	Dr. MOH / Cr. Accum Depr
Office depreciation	Office	Dr. Depreciation Expense / Cr. Accum Depr

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6. COGM and COGS Schedules

How does COGM connect to journal entries?

COGM = sum of all costs transferred from WIP to Finished Goods

Every time a job completes, we make this entry:

Account	Debit	Credit
Finished Goods	X
Work in Process		X

COGM for the period = total of all those credits to WIP.

The COGM Formula

$\text{COGM}=\text{Beginning WIP}+\text{Total Manufacturing Costs}-\text{Ending WIP}$

Component	What It Captures
Beginning WIP	Costs from last period on jobs now finishing
Total Manufacturing Costs	DM + DL + MOH spent this period
Ending WIP	Costs on jobs still in progress

The Trap

Confusing Total Manufacturing Costs with COGM.

Total Manufacturing Costs = everything spent this period. COGM = only costs attached to jobs that finished this period.

See COGM vs Total Manufacturing Costs.

The COGS Formula

$\text{COGS}=\text{Beginning FG}+\text{COGM}-\text{Ending FG}$

Schedule	Shows Flow From → To
COGM Schedule	WIP → Finished Goods
COGS Schedule	Finished Goods → Income Statement

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7. Closing the MOH Variance

How do we compute whether overhead is underapplied or overapplied?

At year-end, MOH typically has a balance because Applied ≠ Actual:

Situation	Relationship	MOH Balance	What Happened
Underapplied	Actual > Applied	Debit balance	Didn’t charge jobs enough
Overapplied	Applied > Actual	Credit balance	Charged jobs too much

Memory Aid

• Underapplied = charged under what we should have → COGS goes up
• Overapplied = charged over what we should have → COGS goes down

How do we close the MOH balance?

Two methods exist. Choice depends on materiality.

Method 1: Close to COGS (Simpler)

Underapplied (debit balance in MOH):

Account	Debit	Credit
Cost of Goods Sold	X
Manufacturing Overhead		X

Overapplied (credit balance in MOH):

Account	Debit	Credit
Manufacturing Overhead	X
Cost of Goods Sold		X

Method 2: Allocate to WIP, FG, and COGS (More Accurate)

Allocate proportionally based on how much applied overhead is in each account:

$10,000 underapplied, allocated proportionally

Account	Applied OH	%	Allocation
WIP	$24,000	30%	$3,000
Finished Goods	$16,000	20%	$2,000
COGS	$40,000	50%	$5,000
Total	$80,000	100%	$10,000

Account	Debit	Credit
Work in Process	3,000
Finished Goods	2,000
Cost of Goods Sold	5,000
Manufacturing Overhead		10,000

For overapplied, reverse the debits and credits.

Why does allocation reduce WIP, FG, and COGS (when overapplied)?

All three accounts have debit balances. Crediting any of them reduces the balance—correcting the overcharge that inflated them.

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8. IAS 2 Treatment (Appendix)

How does IAS 2 treat overhead when production is abnormal?

Under IAS 2, unallocated overhead from abnormally low production is expensed immediately—it cannot inflate inventory values.

Production Level	IAS 2 Requirement
Abnormally LOW	Unallocated overhead → expense in current period
Abnormally HIGH	Decrease fixed overhead per unit

Abnormally low production

Item	Amount
Normal capacity	100,000 units
Actual production	60,000 units
Fixed MOH	$500,000
POHR (normal capacity)	$5 per unit
Applied overhead	60,000 × $5=$300,000
Unallocated overhead	$200,000 → expensed immediately

Scope

IAS 2 is a financial reporting standard. Most companies use consistent treatment for both external and internal reporting to avoid maintaining two systems.