Cost estimation methods such as the high-low method are useful for estimating total costs. However, managers often need to understand how total costs relate to specific cost objects on an individual unit level. There are two main cost systems that are useful for estimating these unit costs. These are job-order and process.
Manufacturing and service firms that produce unique products or services require a job-order accounting system. Firms that produce similar products or services can use a process-costing accounting system. The characteristics of a company's actual production process determines whether it needs a job-order or process-costing accounting system.
Job-Order Production and Costing
Firms that operate in job-order industries produce a wide-variety of services or products that are different from each other. The key feature is that the cost of one job differs from that of another job and must be kept track of separately. Customized or built-to-order products fit into this category. Also, services that vary from customer to customer do as well. A job is one distinct unit or set of units. Often a job is associated with a particular customer order. For job-order production, costs are accumulated by job. This approach to assigning costs is called a job-order costing system.
Process production and Costing
Firms that mass produce large quantities of similar or homogeneous products are in process industries. The key feature is that the cost of one unit of a product is identical to the cost of another. Service firms can also use a process-costing approach. Process firms accumulate production costs by process or by department for a given period of time. Output for that period of time is measured. Unit costs are computed by dividing the process costs for the given period by the output of the period. This approach to cost accumulation is known as a process-costing system. It will be examined in detail in the next article.
Production Costs in Job-Ordering Costing
Production costs consist of direct materials, direct labor and overhead. Direct material and labor are typically fairly easy to trace to individual jobs. Overhead is not so easy to trace to individual jobs. By definition, overhead is all production costs other than direct material and direct labor. Some might be easily traced to jobs, but most cannot. Therefore, overhead is applied to production.
Normal Costing and Overhead Application
Unit costs are important because managers need accurate costs information on materials, labor and overhead when making decisions. Job-order costing using a normal cost system will give the company the unit cost information it needs. Two ways commonly used are actual costing and normal costing.
Actual requires the firm to use the actual cost of all direct materials, direct labor and overhead used in production to determine the unit cost. While intuitively it would make sense to use actual costing, it does have drawbacks. First, many overhead costs are not incurred uniformly through the year. Also, uneven production levels give rise to fluctuating unit overhead costs. A solution would be to wait until the end of the year to total the actual overhead costs and divide by the total actual production. Unfortunately waiting until the end of the year is unacceptable. A company needs unit cost information throughout the year. It is needed on a timely basis both for interim financial statements and to help managers make decisions such as pricing. Managers must react to day=to=day conditions in the marketplace in order to maintain a sound competitive position.
Normal costing solves the problems associated with actual costing. A normal costing system determines unit cost by adding the actual direct materials and direct labor to an estimated overhead. Overhead is estimated by approximating the year's actual overhead at the beginning of the year, and then using a predetermined rate throughout the year to obtain the needed unit cost information. Virtually all firms use normal costing.
Unit costs are essential for valuing inventory, determining income and making a number of important decisions. Disclosure of cost of inventories and determining income are requirements in financial reporting for a firm each period. In order to report cost of inventories, a firm must know the number of units on hand and the unit cost. Cost of goods sold, used to determine income, also requires knowing the units sold and their unit cost.
For service firms, unit costs are used to determine profitability and the feasibility of introducing new services.
Normal Costing and Estimating Overhead
Applying overhead is a three step process. The first is calculating the predetermined overhead rate. This is done at the beginning of the year by dividing the total estimated annual overhead by the total estimated level of associated activity, or cost driver. The estimates of overhead are often based on the previous year's data. The associated activity level depends on which activity is best associated with overhead. Often this is the number of direct labor hours or the direct labor cost. The predetermined overhead rate is calculated using the following formula:
Overhead rate= Estimated annual overhead / Estimated annual activity level
The second step is to apply the overhead to production throughout the year. Applied overhead is found by multiplying the predetermined overhead rate by the actual use of the associated activity for the period. For example, a company has an overhead rate of $5 per machine hour, and in the first week of January, used 9,000 machine hours. The overhead applied to the week's production is $5 times 9,000 machine hours, or $45,000. The total cost of production for that first week is the actual direct materials, plus the direct labor, plus the applied overhead. This concept is the same for any time period.
The third step is to reconcile the difference between the total actual overhead incurred during the year and the total overhead applied to production. Actual overhead is tracked throughout the year, as is the applied overhead. At the end of the year, the two numbers are compared. Suppose that a company had an actual overhead of $400,000, but had applied only $390,000 to production. Since the predetermined overhead rate is based on estimated data, applied overhead will rarely equal actual overhead. In this example, the firm has under applied overhead by $10,000. If applied overhead had been $410,000, then the firm would have over applied overhead by $10,000.
The difference between actual and applied overhead is called an overhead variance. If actual overhead is greater than applied variance, then the variance is called under applied overhead. If actual is less than applied, then the variance is called over applied overhead. At the end of the year, the actual overhead costs are reported on the financial statements. The overhead variance is applied to the cost of goods sold.
Departmental Overhead Rates
So far, the description of overhead rates have emphasized a plantwide overhead rate. A plantwide overhead rate is a single overhead rate calculated by using all estimated overhead for a factory divided by the estimated activity level across the entire factory. However, some companies use multiple overhead rates, as they believe that this gives more accurate costing information. A departmental overhead rate is simply estimated overhead for a department divided by the estimated activity level for the same department. The same steps for calculating plantwide overhead rate is used in determining departmental overhead rates. A company will have as many departmental overhead rates as it has departments.
Unit Costs in the Job-Order System
Unit cost of a job is simply the total cost of materials used on the job, labor worked on the job, and applied overhead.
Job-Order Cost Sheet
Every time a new job is started, a job-order cost sheet is prepared. It is subsidiary to the work-in-process account and is the primary document for accumulating all costs related to a particular job. It contains all information pertinent to a job (description, cost of materials, labor and overhead). Jobs are either named or numbered. The total of all unfinished job-order cost sheets should equal the ending balance of the Work-In-Process account.
Materials Requisition Form
The materials requisition form is a source document used to assign the cost of direct materials to a job. The form asks for the type, quantity and unit price of the direct materials issued, and the name or number of the job. This is useful for maintaining proper control over a firm's inventory of direct materials.
Job Time Tickets
Employees fill out a time ticket that identifies their name, wage rate and hours worked on each job. The cost accounting department posts the cost of direct labor to individual jobs. Time tickets are used for direct laborers only. Since indirect labor is common to all jobs, these costs belong to overhead and are allocated using one or more predetermined overhead rates.
Flow of Costs Through Accounts
The principle interest in a job-order costing system is the flow of manufacturing costs.
Accounting for Materials
When accounting for materials, purchases are added to the Raw Materials Inventory account. As they are used in production, direct materials are moved from the Raw Materials account to the Work In Process account. Materials used in production are classified by job and recorded in job order cost sheets.
Accounting for Direct Labor Costs
The time tickets indicate the amount of labor spent on each job. These labor costs are added to the job-order cost sheets. The total of all the direct labor from all the jobs is recorded as a debit in the Work-In-Process account, along with the direct materials.
Accounting for Overhead
When accounting for overhead, normal costing is used. Actual overhead is not assigned directly to jobs. Overhead is applied to each job using a predetermined rate. The Applied overhead is added to the WIP account as a debit along with the direct materials and direct labor. Overhead costs can bee assigned using a single plantwide overhead rate or departmental rates.
Accounting for Actual Overhead Costs
Actual overhead costs never enter the WIP account. Costs are recorded as debits in the Manufacturing Overhead control account. At the end of the period, the actual overhead is reconciled with the applied overhead.
Accounting for Finished Goods
Costs of completed jobs are transferred from the WIP account to the Finished Goods account. The direct materials, direct labor and applied overhead amounts are totaled to arrive at the manufacturing cost of the job.
Accounting for Cost of Goods Sold
Once a job is sold, it is moved from the Finished Goods to the Cost of Goods Sold account. The Cost of Goods sold is reported on the Income Statement. To ensure the accuracy in computing these costs, a cost of goods manufactured statement is prepared. The cost of goods sold before an adjustment for overhead variance is called the normal cost of goods sold. After adjustment, the result is called the adjusted cost of goods sold.
Accounting for Nonmanufacturing Costs
Manufacturing costs are not the only costs incurred by a firm. Selling and general administrative are period costs. These period costs are shown on the Income Statement.