Begin to develop an understanding of job costing by thinking about a simple illustration. Jack Castle owns an electrical contracting company, Castle Electric. Jack provides a variety of products and services to clientele. Jack has four employees, maintains a neat (rented) shop, a broad inventory of parts and equipment, and a fleet of five service trucks. On a typical day, Jack will arrive at the shop early and line out the day's work assignments for his four electricians. Around 8:00 a.m., his electricians begin to arrive, and he gives them their assignments, as well as the necessary parts and equipment they will need. They are then dispatched to the various job sites.
One of Jack's electricians is Donnie Odom. On July 14, Donnie arrived at the shop at 8:00 a.m. He first spent thirty minutes getting his assignments and loading a service truck with necessary items to complete the day's work. His three tasks for the day included:
Job A: Cleaning and reconnecting the electrical connections and replacing a flood light atop a billboard (materials required include one lamp at $150).
Job B: Replacing the breakers on an old electrical distribution panel at an office building (materials required include 20 breakers at $20 each).
Job C: Pulling wire for a new residence under construction (materials required include 500 feet of wire at $0.14 per foot).
Donnie successfully completed all three tasks on July 14. He spent 1 hour on the billboard, 2 hours on the electrical panel, and 3 hours on the residential installation. The other 2 hours of his 8-hour day were spent on indirect job administration and travel. During the day, Donnie also used a roll of electrical tape ($3) and a box of wire nuts (60 nuts at $0.05 each). Donnie is paid $18 per hour. Donnie drove the truck 100 miles on July 14, and he used a variety of tools, ladders, and other specialized equipment. Jack is paid $25 per hour, and he does not usually work on any specific job. Instead, his time is spent doing spot inspections of work, getting permits, managing inventory, and tending to the various other tasks associated with these jobs.
Now, the "job costing" question is: How much did it "cost" to change the light on the billboard, etc.?
The job cost included the direct costs of the job; specifically, Donnie's direct labor time (1 hour) and the direct material (one lamp at $150). But, the job could not have gotten done without the shop, equipment, trucks, indirect labor time, Jack's efforts, tape and wire nuts, and so forth. These latter items constitute the indirect costs, or overhead, for the job. How then, to assign costs to a specific job?
TRACKING DIRECT LABOR
A logical starting point for job costing is to track the direct labor to specific jobs. Donnie, and the other electricians, fill out a time report documenting time spent on each job, as well as the time spent on tasks that cannot be traced to a specific job:
Not only will this time sheet form the basis for payroll, but it will also allow cost assignment to specific jobs. The direct labor for the billboard task (Job A) was one hour of Donnie's time (at $18 per hour). The "direct labor" for Job A will be compiled by reference to the above time sheet.
TRACKING DIRECT MATERIALS
Jack keeps detailed records of the material released to each job. When Donnie gathered up the light bulbs, breakers, wire, tape, and wire nuts on the morning of the 14th, some system needed to be in place to "check out" this material. The document that is used for this process is called a "materials request" or "materials requisition" form. This form will show what material is leaving the available raw materials stock and being put into production.
This form provides essential documentation to safeguard and track inventory. It also reveals that the "direct material" for the billboard task (Job A) was $150 (the light bulb). The wire nuts and tape that might have been used on the billboard will be dealt with as overhead which is discussed later.
TRACKING OVERHEAD
Tracking overhead is tricky. One way this is done is by using a predetermined overhead rate. Assume Jack sat down at the beginning of the year with his accountant. Together they carefully considered all of the production overhead that was anticipated during the year -- the cost of Jack's time, the rent, the cost of vehicles, insurance, taxes, utilities, indirect labor, indirect materials, depreciation of long-lived assets, and so forth. The expected total came to $150,000. Jack figures that his four electricians will work a total of 7,500 direct labor hours during the year. By comparing these two numbers ($150,000 and 7,500 hours), it is now possible to "model" that overhead is $20 per direct labor hour. The "overhead application rate" is thus determined.
Now, two things should be made clear. First, overhead application is arbitrary. Second, expect differences between the actual overhead and the amount applied to production. For instance, Jack will likely discover that actual overhead is more or less than $150,000. Jack will also find that his electricians will probably work more or less than the anticipated 7,500 hours. When all is said and done, Jack will need to deal with the actual cost. The difference between the amount of overhead applied to production and the actual amount spent must be accounted for
JOB COST SHEET: The preceding information can be logically transferred to a job cost sheet that is a compilation of cost data for a specific job:
EXPANDING THE ILLUSTRATION
The next graphic shows separate job cost sheets for all three of Donnie's jobs. All direct material and direct labor must be transferred to specific jobs. The indirect labor (admin hours) and indirect material is not directly transferred to a specific job; its cost is instead represented through the applied overhead.
ANOTHER EXPANSION OF THE ILLUSTRATION
Thus far, the illustration has focused only on Donnie's activities. He had relatively simple assignments on the 14th and was able to complete three separate jobs by himself. But, remember that Jack has three other electricians and many other jobs. Some of these jobs may require multiple employees and extend over days and weeks. One such job was the new home of Aba Obekie. This job took two electricians (Andy Axom and Bev Bentson) three full days to complete. The resulting job cost sheet appeared as follows:
TRACKING JOB COSTS WITHIN THE CORPORATE LEDGER
DIRECT MATERIALS
Begin by considering how a job cost travels through the accounting system by focusing on direct materials. Below is an illustration for a company that buys unfinished pipe from a steel mill. The manufacturing process entails a specialized heat treating, welding, and polishing process that readies the pipe for intense use by gas pipeline transmission companies.
The flow of direct materials occurs in the following four steps:
1. Raw material is purchased from a supplier and placed in the raw materials inventory.2. Raw material is transferred to the production process.3. Upon completion of processing, the material is transferred to finished goods inventory.4. A customer takes delivery of the product, and it is removed from finished goods inventory.
For purposes of this illustration, assume the stack of pipe in the first picture cost $10,000. This expenditure must be captured in inventory and eventually transferred to cost of goods sold when the product is delivered to an end customer. At the time it is acquired, the Raw Materials Inventory needs to be increased by $10,000, as shown in the T-Account.
The second step will result in a reduction in the Raw Materials Inventory and a corresponding increase in the Work in Process Inventory.
Upon completion, that cost is transferred from Work in Process Inventory to Finished Goods Inventory.
When the product is sold, the cost moves out of Finished Goods Inventory. In general journal form, the preceding flow of costs is:
DIRECT LABOR
The following entries assume that the pipe required 200 hours of direct labor at $15 per hour:
APPLIED FACTORY OVERHEAD
Assume the pipe factory applies overhead at the rate of $25 per direct labor hour. Remember that 200 hours were needed for the job in question. Thus, $5,000 ($25 x 200) is the amount of applied factory overhead. The following entries are similar to those that were used to record the direct labor; compare them, and pick out the account that differs:
OVERVIEW
The preceding information can be combined and summarized as follows:
This graphic illustrates how the total job cost was measured as $18,000. The general journal would include the following entries:
FINANCIAL STATEMENT IMPACT SCENARIOS
How job cost data appears on the financial statements depends on its condition at the financial statement date. Considering the pipe illustration:
If the raw pipe had not yet started into production, its $10,000 cost would appear in the raw materials inventory category on the balance sheet:
If the pipe was in production but not complete, the total cost in the Work in Process account as of the balance sheet date would be aggregated and presented as work in process inventory on the balance sheet. For example, assume all of the raw material was in process, but only half of the necessary labor tasks had been performed; in this case, the Work in Process Inventory account would include $14,000 ($10,000 direct material + $1,500 labor + $2,500 applied overhead):
If the drill pipe was completed but unsold, the finished goods inventory would be carried at $18,000 on the balance sheet:
If the drill pipe was sold for $25,000, the income statement would include sales ($25,000) and cost of goods sold ($18,000), netting to the $7,000 gross profit:
COST FLOWS TO THE FINANCIAL STATEMENTS:
ACCOUNTING FOR ACTUAL AND APPLIED OVERHEAD
In this case, the applied overhead equaled the actual overhead, leaving a zero balance. This means that the predetermined allocation rate was exactly what was incurred during the period.
UNDERAPPLIED OVERHEAD
A more likely outcome is that the applied overhead will not equal the actual overhead. The following graphic shows a case where $100,000 of overhead was actually incurred, but only $90,000 was applied.
This situation is called "underapplied" overhead. It is said to be an "unfavorable" outcome, because not enough jobs were produced to absorb all of the overhead incurred. This might result from below normal levels of output, or overspending. In any event, the fact remains that more was spent than allocated. Because the Factory Overhead account is just a clearing account (not a financial statement account), the remaining balance must be transferred out. Several options are available for disposing of this amount, but one approach is to remove (credit) the underapplied amount and charge (debit) Cost of Goods Sold:
This entry has the effect of reducing income for the excessive overhead.
OVERAPPLIED OVERHEAD
If the applied overhead exceeds the actual amount incurred, overhead is said to be "overapplied." This is usually viewed as a favorable outcome, because less has been spent than anticipated for the level of achieved production.
The next journal entry shows the reduction of cost of goods sold to offset the amount of overapplied overhead:
6-30 Factory Overhead 10,000
Cost of Goods Sold 10,000
To reduce cost of goods sold for the overapplied overhead
Always keep in mind that the goal is to "zero out" the Factory Overhead account and measure the actual cost incurred. In this last example, $100,000 was actually spent and accounted for: $110,000 charged to specific jobs and $10,000 offset as a reduction in cost of goods sold.