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Job Order Costing

This lesson shows the use of several major types of cost accounting systems. All companies have to accumulate and allocate costs. Each company has to decide how it is going to do that. Companies pick a method that works well for them, and is cost effective.

Accounting isn't hard; students just like to make it seem that way. Accounting is simply a way to organize information, and make it useful for the people who have to manage a business, and make decisions. Managerial accounting reports don't have to follow GAAP because they are prepared for managers, not outside investors or creditors.

A well designed accounting system should generate reports for a large variety of uses. Of course, it must provide the necessary information for annual financial statements; and it should also help in the preparation of special reports, like sales tax and payroll reports. It should help managers track and manage inventories, open orders, accounts receivable and accounts payable.

Managers must make decisions on a daily basis. Annual financial statements are prepared well after the end of the year, and are useless for managing a businesses daily affairs. Managers must look forward to the near future, usually the coming week, month and year. Annual financials look backwards in time.

The basic concepts and terms you learned in the management accounting lesson will carry over through this chapter and the remainder of the course. Businesses use these concepts to prepare managerial reports, and analyze their business activities.

There are two main types of cost accounting systems. Companies select a method that best matches the flow of work in their business. These methods are used to allocate all production costs: labor, materials and overhead.

Job order costing - work is broken into jobs; each job is tracked separately auto mechanics, carpenters, painters, print shops, computer repair
Process costing - a large quantity of identical or similar products are mass produced auto assembly plants, hot dog manufacturing, any large mechanized production facility

Each cost accounting system gathers and reports on the same information. The method used depends on the needs of the business.

Job Order Costing Systems

A job order costing system is used when a job or batch is significantly different from other jobs or batches. Cost accounting is usually fairly simple in these systems. Labor and materials are entered on a job ticket. Overhead is usually added to the amount the customer will be charged for labor and materials.

If you go to an auto repair shop, they will start a job ticket just for the work to be done on your car. Your job ticket will show charges for labor and materials, just for your job. Let's say they charge you $35 per hour for labor. That charge includes the mechanic's payroll cost. But it also includes an overhead charge - which is generally not stated separately. The overhead charge covers the costs of operating the garage - tools and equipment, rent, insurance, maintenance, utilities, etc. It is a way to allocate overhead (discussed below), and build it in to the amount charged to customers.

The garage will also make a gross profit on the parts they use to repair your car. This gross profit covers the cost of buying and maintaining a parts inventory, including department employee wages, insurance and warehousing costs.

Allocating Overhead

Overhead is a large mixed group of costs that can't be directly traced to products. There are several methods of allocating overhead costs in a cost accounting system. ABC costing is one method. There are other, simpler methods as well.

Activity-based costing (ABC) - overhead costs are tracked activities that consume resources used primarily for allocating overhead that is hard to track to specific products or departments

ABC Costing is covered in the process costing lesson.

Cost Flow in an Accounting System

We say that costs flow through an accounting system. That is because they accumulate as the product progresses through the various stages of production. Let's look at a typical product.

Before a product is started, no costs have been incurred. Workers stand ready to make the product, inventory waits patiently in the warehouse, and the manufacturing plant contains all the resources necessary to perform the manufacturing operation.

We first add materials into production, from the inventory. At the same time the accounting department transfers the cost of inventory items to the Work in Process account, and the product or job now has a value.

Next the workers start to convert the raw inventory into a product. As labor is added, the accounting department transfers payroll costs to the Work in Process account, increasing the value of the product or job.

Overhead costs are allocated to the product or job, based on the costing method used. As work progresses on the product or job, it accumulates labor, materials and overhead costs. Finally, the total finished product or job cost is transferred to Finished Goods, and when it is sold the cost is transferred to Cost of Goods Sold.

Accounting Overhead Costs

Overhead is allocated to products or jobs using a reasonable allocation method. We try to find some part of the manufacturing process that is regular and predictable. We call this a cost driver.

Labor hours used is the most popular allocation method. The number of labor hours in a year are fairly predictable. Differences in employees pay rates are not relevant when using hours. The information is readily available from existing payroll records. There is usually a direct correlation between labor and the production process.

Labor dollars is the second most popular allocation method. It is used by very large companies, with large work forces operating under labor contracts. The labor costs are fairly predictable, and are closely linked to production. Because of the large number of employees, labor dollars tends to be a very stable and predictable measure of the progress of production.

Other overhead methods include:

  • number of units produced,
  • machine hours use (jet engines, diesel locomotives),
  • square footage of floor space (heating, cooling & janitorial costs),
  • miles (taxis, trucking)

Some companies use a sophisticated method involving service departments such as maintenance and computer processing. These departments provide services to other departments. Service departments are widely used in hospital accounting.

Simple Overhead Allocation

The simplest form of overhead allocation is to treat all annual overhead as a single cost pool, and allocate it to one annual cost driver.

Assume Johnson's Bakery produces 2,000,000 loaves of bread per year, and incurs $60,000 in annual overhead cost. How much overhead cost must Johnson allocate to each loaf of bread?

Total Annual Overhead = one $ unit of cost driver
Units of Cost Driver

$60,000 = 3 cents per loaf
2,000,000 loaves

In addition to direct costs (labor & materials), Johnson will allocate 3 cents per loaf to overhead costs.

Decision Making Using Overhead Costs

Assume Johnson's Bakery must lease a new oven for $20,000 per year, to replace an old oven. Direct costs per loaf will not change. Johnson charges all Lease costs to the Overhead account. All other overhead costs will stay the same. How will the new oven lease change Johnson's overhead costs?

$60,000 + $20,000 = 4 cents per loaf
2,000,000 loaves

Johnson's overhead cost per loaf will increase 1 cent, from 3 cents to 4 cents.

Another Example

Wilson's Garage has 6 mechanics working full time, 2,000 hours per year each, for a total of 12,000 hours that will be billed to jobs. They incur $60,000 per year in overhead costs. Wilson allocates overhead costs to car repair jobs, based on the number of hours worked on each job. How much will Wilson allocate per labor hour?

$60,000 = $5.00 overhead per labor hour
12,000 hours

Wilson's Garage will allocate $5.00 per labor hour for overhead.

Example of Overhead Allocation to a Job

Wilson's Garage works on the delivery truck belonging to Johnson's Bakery. The job takes 2 hours. How much overhead cost will Wilson's allocate to this job?

overhead per labor hour X labor hours on job = overhead allocated to job

$5.00 x 2 = $10.00

Wilson's Garage will allocate $10.00 in overhead costs to the repair job.

Why don't you see Overhead costs listed separately on repair tickets?

Customers usually don't understand what overhead costs are, or why they are important for a business. Overhead costs are generally "built in" to other costs. Wilson's Garage will add the overhead cost to it's regular labor rate. Since overhead is allocated by labor hour, this is an easy method for a garage, or similar types of businesses. Overhead costs are generally "hidden" from customers in this way, but the company must charge the customer for these costs in some way.

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