Job order costing
There are several costing methods that can be used to accumulate costs. Costing methods are affected by the type of production operation as well as the degree of information required by the management. Remember that costing is part of the management accounts that are used for internal decision making purposes. Some of the costing methods include job order costing, process costing, back flush and hybrid methods. (Garrison Ray H, 2008)
Under job order costing, the costs are allocated to jobs, orders or contracts to which are done according to the requirements specified by the customer. The effect of this is that each job is usually different because of the different customer specifications. This method is most appropriate for companies that make goods in batches or if a service provider, provide customized services e.g. accounting, law etc. These products or services utilize different quantity of resources such that the cost assigned to a particular product or service should reflect all the resources consumed by that product or service
All the costs are monitored as they move along the production process hence direct costs e.g. labor or materials are normally allocated using either actual or standard usage rates known in advance. Indirect costs e.g. factory overheads which cannot be directly attributed to any given product or service is allocated using a pre determined overhead rate which is calculated.
Pre determined overhead rate
In the production process, there are those costs or expenses that are incurred but cannot be attributed to the generation of profits. These expenses are normally called overheads. Examples include depreciation, insurance, telephone expenses etc. Although these costs cannot be directly attributed to any specific product or service or job, they cannot be ignored because they are incurred anyway. Therefore the tricky part is how to subdivide these costs among the units produced in such a way that no one group of products are overpriced or underpriced. This is where the concept of using a standard rate comes about. This standard rate is called a pre determined overhead absorption rate (Siegel Joel G, 2006)
The pre determined overhead rate is calculated by taking total manufacturing overheads divided by the amount of activity base e.g. direct labor cost, direct labor or even machine hours. The total manufacturing overheads are usually estimated or budgeted at the start of the production process. Likewise to the activity base (direct labor hours or machine hours)
Therefore the pre determined overhead rate
= budgeted annual overheads
Budgeted annual activity units (direct labor hours, machine hours etc.)
Example
ABC Ltd’s budgeted manufacturing overhead for the year is $1,000,000 while the budgeted machine hours are estimated to be 50,000 hours. Calculate the pre determined overhead rate and allocate the overheads to jobs orders if job order A and B used 1,000 and 800 machine hours respectively.
Overhead rate=1,000,000
50,000 hrs. =$20 per machine hour
The actual allocation will be
Actual machine hours used pre determined overhead rate manufacturing overheads used
Job A 1,000 $20 20,000
Job B 800 $20 16,000
1,800 $20 $36,000
Why use pre determined overhead rate
The main reason why manufacturing companies us a pre determined overhead absorption rate is because the overhead at times cannot be uniform throughout the year such that in one season more overheads are incurred than in another season. Therefore this may result in different product costs which may lead to erratic product prices. Hence there should be a way of avoiding the occurrence of this and one of the ways is the use of a standard pre determined rate (Shim J K, 2000)
Pre determined overhead rate also normalizes the allocation overheads to jobs hence achieve normal costs in which direct materials and labor are charged to actual costs while manufacturing overheads are applied sing a pre determined rate
The other reason why a pre determined overhead absorption rate is used to allocate overheads over products or jobs is that it helps the management to approximate the total cost of each product or job before the year ends. Consequently it helps the management in their pricing decisions (Garrison Ray H, 2008)
Job cost sheet
The accumulation of costs in job order costing is usually done using job cost sheet. This is a subsidiary record for the entire work in progress inventory. If a company has several jobs, a separate job cost sheet has to be used for each job. The job cost sheet shows the cost of direct labor, materials and how the factory overhead was applied. Total costs can also be obtained from a job cost sheet (Shim J K, 2000).
The information on the job sheet can be extracted from the daily time sheets and materials requisition sheet. The information on the daily time sheet will show the number of hours that each employee spends on any given job. The daily time sheet also shows the hours that were spent doing other tasks which are not directly related to the job.
Information on materials can be obtained from materials requisition sheet. This sheet shows the quantity and price of each materials requisitioned for the various jobs that have to be undertaken. The materials requisition sheet will provide information on direct materials that will be taken to the job cost sheet.
The applied overheads will be calculated using the pre determined overhead absorption rate calculated multiplied by the number of labor hours (direct). If the applied overheads is not equal to the actual overheads incurred, then, there is an over absorption or under absorption. If the applied overheads is more than the actual overheads, then the overheads is said to be over applied. This over application is taken to the cost of goods sold as a gain because less overhead were incurred than had been anticipated initially. However if the applied overheads is less than the actual overheads, then, an under application has occurred. The under application is unfavorable because this portends extra costs. The under applied overheads are taken to the debit side of the cost of goods sold account (Walther, 2009)
Cost flow through accounting system
The flow of cost of production in a manufacturing entity starts with product, period and conversion costs which flows through the work in progress to finished goods and then finally to either balance sheet or income statement.
Prime cost is direct labor and direct materials. These costs are direct in nature while conversion cost is arrived at by adding direct labor and manufacturing overheads. Product cost on the other hand is direct materials, direct labor and factory overheads all added together. Period costs are those non manufacturing costs that should be accounted for within the period it was incurred (Walther, 2009)
The costs that go to the manufacturing process are the direct materials, direct labor, and manufacturing overheads which will be work in progress. Direct materials are sourced from the available materials. Any unused available materials are taken to the balance sheet as part of raw materials inventory. At the end of the production period/year, the work in progress will have been turned to either finished goods or still in the production process as work in progress inventory. The work in process inventory is taken to the balance sheet as closing WIP. This WIP will represent opening WIP in the next period.
Work in progress that turned into finished goods at the end of the production process will have either been sold or would still be in stock. The sold finished goods will be taken to the income statement as cost of goods sold while the unsold finished goods will be recorded in the balance sheet as inventory for finished goods (Siegel Joel G, 2006)
Non manufacturing overheads are costs that cannot be directly attributed to the manufacturing process. These costs are taken to the income statement as part of the selling, general, and administrative expense.
The information on how costs flow through the accounting system is important in that under FASB external reporting rules, the production overheads must be allocated to inventory. The IRS also requires that under the uniform capitalization rules, inventory must absorb all direct costs as well as indirect costs (Garrison Ray H, 2008).
References
Garrison Ray H, N. E. (2008). Managerial Accounting 12th ed. New York: Mc Graw Hill/Irwin.
Shim J K, S. J. (2000). Job order costing. In S. J. Shim J K, Modern Cost management and Analysis (p. 25). New York: Barrons.
Siegel Joel G, S. J. (2006). Cost accumulation Systems. In S. J. Siegel Joel G, Accounting Handbook (p. 33). New York: Barrons.
Walther, L. M. (2009, January 09). Job Costing and Modern Cost Management Systems. Retrieved March 09th, 2009, from Principles Of Accounting: http://www.principlesofaccounting.com/chapter%2019.htm
