Learning objectives
By the end of this chapter, you will be able to:
- Distinguish between job costing and batch costing and select an appropriate approach for different production settings.
- Compile the full production cost of a job or batch using direct materials, direct labour and absorbed production overhead.
- Calculate and apply a predetermined overhead absorption rate using a sensible activity base.
- Explain and quantify under- and over-absorption of overheads and show how they are handled in financial reporting.
- Perform cost-plus pricing calculations and correctly convert between mark-up and margin.
Overview & key concepts
Many organisations need a reliable way to measure the cost of what they make or deliver. Product costing supports:
- Pricing and quotation decisions
- Profitability analysis (jobs, batches, customers, products)
- Inventory valuation (work in progress and finished goods) and cost of sales in the financial statements
Two common approaches are job costing and batch costing. Both accumulate production costs, but they differ in the cost object (what you are costing) and the way costs are assigned to units.
Job costing
Job costing is used when work is performed to a customer’s specification and each job is distinguishable. Costs are recorded separately for each job, typically on a job cost sheet.
Where goods are manufactured for sale, costs move through inventory as follows:
- Costs incurred on a job are collected in work in progress (WIP).
- On completion, the job’s cost moves from WIP to finished goods.
- On sale, the cost moves from finished goods to cost of sales.
Batch costing
Batch costing is used when similar units are produced together in a production run (a “batch”). Costs are accumulated for the batch and converted into a unit cost by dividing by the number of units of output (with separate treatment of losses where relevant).
Direct costs
Direct materials and direct labour are costs that can be traced economically to a specific job or batch.
- Direct materials: materials that become part of the finished product (or are consumed specifically for it).
- Direct labour: wages of staff directly engaged in production work.
Direct costs are charged to WIP as they are incurred.
Production overheads
Production overheads are indirect manufacturing costs (for example: factory rent, factory utilities, production supervisors’ salaries, depreciation of manufacturing equipment). These costs cannot be traced neatly to individual jobs/batches, so they are absorbed using a rational basis.
Not all overheads are production overheads. Selling, distribution, and many head-office administration costs are typically treated as period costs and charged to profit or loss when incurred, rather than included in inventory.
Core theory and frameworks
1) Cost collection and source documents
A costing system relies on clear documentation:
- Materials requisition note: records materials issued from stores to a specific job/batch
- Labour time record / job card: records time spent on jobs/batches
- Job cost sheet / batch cost record: summarises direct materials, direct labour and absorbed overhead
2) The flow of costs through inventory accounts
For manufactured goods, costs typically move through:
- Raw materials inventory
- Work in progress (WIP)
- Finished goods inventory
- Cost of sales (when sold)
This matters because inventory is an asset until sale; only then does it become an expense.
3) Predetermined overhead absorption rate and activity base selection
Because indirect factory costs cannot be traced directly to one job, organisations often apply overhead using a predetermined rate for the period. The logic is to spread expected production overhead across expected activity.
Predetermined overhead absorption rate (OAR)
- OAR = Budgeted production overhead ÷ Budgeted activity level
“Activity level” is chosen to reflect the main driver of overhead in that environment. Common guidance:
- Labour hours: often suitable where work is labour-intensive
- Machine hours: often suitable where production is machine-intensive
- Units of output: only sensible where output is highly uniform and overhead is broadly proportional (often not the best driver for overhead)
Once the rate is set, overhead is absorbed into each job/batch using the activity it actually consumes:
- Overhead absorbed = Actual activity used × Predetermined OAR
4) Under- and over-absorption of overheads
Actual overhead incurred rarely equals overhead absorbed using a predetermined rate:
- Under-absorption: actual overhead incurred exceeds absorbed overhead
- Over-absorption: absorbed overhead exceeds actual overhead incurred
Financial reporting treatment (exam-aware): If the difference is not material, it is commonly written off to profit or loss (often through cost of sales). If it is material, it may be apportioned between WIP, finished goods, and cost of sales, typically in proportion to closing balances or based on the absorbed overhead content of each balance.
Inventory valuation nuance for external reporting (normal capacity concept): Absorption is a costing technique used to attach overhead to production. For external reporting, inventory must not be overstated. Fixed production overhead is spread using a level of output that reflects normal operating conditions; if production is unusually low, not all fixed overhead is included in inventory values. The unallocated portion is charged as an expense in the period.
5) Defects and abnormal waste in batch production (simplified treatment)
If a batch produces unusable units beyond what would normally be expected, the cost of that avoidable waste should not be carried in inventory values.
In a simplified, exam-friendly approach:
- Calculate a batch unit cost (as directed in the question).
- Charge the cost of abnormal defective units to profit or loss as an expense.
- Transfer only the cost of good output into finished goods.
This ensures inventory reflects items expected to generate future economic benefit, while the period’s performance includes the cost of abnormal waste.
In practice, defective units may have a scrap or disposal value. Where relevant, entries would reflect any proceeds or recoverable value.
6) Cost-plus pricing: mark-up and margin (with conversions)
Cost-plus pricing sets a selling price by adding a profit element to cost.
- Mark-up is profit as a percentage of cost: Selling price = Cost × (1 + mark-up)
- Margin is profit as a percentage of selling price: Margin = Profit ÷ Selling price
Conversion (frequent exam requirement):
Let margin = m and mark-up = u.
- If margin is known: mark-up = m ÷ (1 − m)
- If mark-up is known: margin = u ÷ (1 + u)
(Use decimal form for m and u, e.g. 20% = 0.20.)
Worked example
Narrative scenario
A custom furniture manufacturer, Artisan Creations, produces bespoke furniture and small batches of similar items. The company uses job costing for custom orders and batch costing for small production runs.
Artisan Creations has the following transactions for January 2026:
- Received an order for a custom dining table (Job 101) with an estimated cost of $2,500 (used for internal quotation and planning).
- Issued materials worth $1,000 for Job 101.
- Recorded 20 labour hours for Job 101 at $25 per hour.
- Applied overheads to Job 101 using a predetermined rate of $15 per labour hour.
- Completed Job 101 and transferred it to finished goods.
- Produced a batch of 100 chairs (Batch 201) with materials costing $3,000.
- Recorded 50 labour hours for Batch 201 at $25 per hour.
- Applied overheads to Batch 201 using the same predetermined rate.
- Identified 5 chairs as defective (abnormal waste) and wrote off the cost (assume no scrap value).
- Transferred the completed batch to finished goods.
- Sold Job 101 for $3,500 and Batch 201 for $6,000.
- Recorded actual production overheads of $1,500 for the month.
Required
- Calculate the total cost for Job 101 and Batch 201.
- Determine the unit cost for Batch 201.
- Identify the under- or over-absorption of overheads.
- Prepare journal entries for the transactions.
- Explain the impact on the financial statements.
Solution
1) Total cost for Job 101 (actual)
Direct materials: $1,000
Direct labour: 20 hours × $25 = $500
Overhead absorbed: 20 hours × $15 = $300
Total cost (Job 101) = 1,000 + 500 + 300 = $1,800
Comment on the estimate: The $2,500 estimate is a planning/quotation figure. The actual cost recorded by the costing system is $1,800, so the job was completed $700 below estimate. Estimates are useful for pricing and budgeting, but the financial statements use actual costs (with overhead absorbed using the chosen rate, subject to the external reporting constraint on fixed overhead noted earlier).
2) Total cost for Batch 201
Direct materials: $3,000
Direct labour: 50 hours × $25 = $1,250
Overhead absorbed: 50 hours × $15 = $750
Total cost (Batch 201) = 3,000 + 1,250 + 750 = $5,000
3) Unit cost for Batch 201 (before abnormal waste write-off)
Units produced = 100
Unit cost = 5,000 ÷ 100 = $50 per chair
4) Abnormal waste write-off and finished goods transfer (Batch 201)
Defective chairs (abnormal waste) = 5
Cost per chair = $50
Abnormal waste expense = 5 × 50 = $250
Good output transferred to finished goods = 95 chairs
Cost transferred to finished goods = 5,000 − 250 = $4,750
5) Under- or over-absorption of overheads
Absorbed overheads:
- Job 101: $300
- Batch 201: $750
- Total absorbed = $1,050
Actual production overhead incurred = $1,500
Under-absorption = 1,500 − 1,050 = $450
Journal entries
(Entries shown in a simplified form. Sales are assumed to be on credit. If sales are for cash, replace trade receivables with cash.)
(A) Direct materials issued to production
Dr Work in progress (WIP) 4,000
Cr Raw materials inventory 4,000
(1,000 for Job 101 and 3,000 for Batch 201)
(B) Direct labour recorded
Dr Work in progress (WIP) 1,750
Cr Wages payable / Cash 1,750
(500 for Job 101 and 1,250 for Batch 201)
(C) Actual production overheads incurred
Dr Overhead control (manufacturing overhead) 1,500
Cr Cash / Payables 1,500
(D) Overheads absorbed into production
Dr Work in progress (WIP) 1,050
Cr Overhead control (manufacturing overhead) 1,050
(E) Job 101 completed and transferred to finished goods
Dr Finished goods inventory 1,800
Cr Work in progress (WIP) 1,800
(F) Batch 201 completed, with abnormal waste written off (no scrap value)
Dr Finished goods inventory 4,750
Dr Abnormal waste expense (profit or loss) 250
Cr Work in progress (WIP) 5,000
(If scrap value existed, proceeds would be recorded separately and would reduce the net expense.)
(G) Sales recorded
Dr Trade receivables 9,500
Cr Revenue 9,500
(Job 101: 3,500; Batch 201: 6,000)
(H) Cost of sales recorded (inventory derecognised)
Dr Cost of sales 6,550
Cr Finished goods inventory 6,550
(1,800 for Job 101 + 4,750 for Batch 201)
(I) Under-absorbed overhead written off (not material assumption)
Dr Cost of sales (or separate overhead variance expense) 450
Cr Overhead control (manufacturing overhead) 450
Terminology note: Some texts present the overhead account as a “control” or “clearing” account, and the debit/credit layout may appear reversed depending on the convention used. Focus on the logic: actual overhead is accumulated, absorbed overhead is transferred into WIP, and the remaining balance is the variance to be adjusted.
Impact on the financial statements
Statement of financial position (balance sheet)
- WIP increases as materials, labour and absorbed overhead are charged, then reduces when jobs/batches are completed.
- Finished goods increases when completed output is transferred in (excluding abnormal waste), then reduces when goods are sold.
- Trade receivables (or cash) increases by the selling prices when sales are recorded.
Inventory values reflect production costs carried forward for future sale. Abnormal waste is excluded from inventory and charged to the period.
Statement of profit or loss
- Revenue increases by $9,500.
- Cost of sales includes:
- Abnormal waste expense of $250 is recognised in the period.
Common pitfalls and misunderstandings
- Treating a batch like a job (or vice versa): the cost object determines how costs are accumulated and how unit costs are derived.
- Choosing an unsuitable absorption base: match the base to the main overhead driver (labour hours vs machine hours).
- Forgetting the inventory flow: production costs sit in WIP/finished goods until sale; they do not become cost of sales immediately.
- Ignoring external reporting constraints: fixed overhead allocation must avoid inflating inventory when output is unusually low.
- Confusing under/over-absorption: compare actual overhead incurred with overhead absorbed, not with total production cost.
- Treating abnormal waste as part of unit cost: abnormal waste is expensed and not carried in inventory values (simplified approach).
- Recording sales without cost of sales: leaving out the inventory credit overstates assets and profit.
- Mixing up mark-up and margin: apply the correct base and convert where required.
Summary and further reading
Job costing measures the cost of distinct customer-specific work, while batch costing measures the cost of a production run of similar units. In both systems, total production cost comprises direct materials, direct labour and absorbed production overhead.
Predetermined overhead absorption rates provide a practical way to charge overhead to jobs and batches, but they create under- or over-absorption when estimates differ from actual results. If the variance is immaterial it is often written off to profit or loss; if material it may be apportioned between WIP, finished goods and cost of sales.
Batch costing may require separate treatment of abnormal waste, which is charged to profit or loss rather than carried in inventory. For external reporting, inventory must not be overstated, and fixed production overhead is allocated using a level of activity consistent with normal operating conditions.
FAQ
What is the main difference between job costing and batch costing?
Job costing collects costs for a specific, identifiable piece of work, such as a custom order. Batch costing collects costs for a run of similar units and then converts the batch cost into a unit cost by dividing by output.
How do predetermined overhead absorption rates work?
A predetermined rate is calculated from budgeted overhead and a budgeted activity level. Each job or batch then absorbs overhead based on actual activity used. The difference between absorbed and actual overhead is a variance that is adjusted in reporting.
What does under-absorbed overhead mean?
Under-absorption means absorbed overhead is lower than actual overhead incurred. If written off to profit or loss, it reduces profit for the period. Over-absorption has the opposite effect.
Why is abnormal waste written off instead of included in inventory?
Because abnormal waste does not represent items expected to be sold or used to generate future benefit. Carrying it in inventory can overstate assets and delay recognition of avoidable costs. In practice, any scrap value would be accounted for separately.
How do I convert between mark-up and margin?
Let margin = m and mark-up = u (decimal form):
- mark-up = m ÷ (1 − m)
- margin = u ÷ (1 + u)
Glossary
Job costing
A method of costing where costs are accumulated for a distinct job or customer order and recorded separately from other work.
Batch costing
A method of costing where costs are accumulated for a production run of similar units, then converted into a unit cost by dividing by output.
Cost object
Anything for which a cost is measured separately, such as a job, batch, product, service, or customer.
Direct materials
Materials traceable to a job or batch that form part of the finished output (or are consumed specifically for it).
Direct labour
Labour cost of production staff that can be traced to a particular job or batch.
Production overhead
Indirect manufacturing costs that support production but cannot be traced economically to individual units, jobs, or batches.
Predetermined overhead absorption rate
A rate set from budgeted overhead and a budgeted activity level, used to absorb overhead into production during the period.
Under-absorption (of overhead)
Where actual overhead incurred exceeds overhead absorbed into production.
Over-absorption (of overhead)
Where overhead absorbed into production exceeds actual overhead incurred.
Abnormal waste
Avoidable or unexpected production losses treated as an expense of the period rather than included in inventory values.
Job cost sheet
A record summarising the direct materials, direct labour, and absorbed overhead for a specific job.
Materials requisition note
A document authorising and recording the issue of materials from stores to production for a specific job or batch.