CHAPTER 4

Job Costing

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Indirect costs of a cost object
Costs related to a particular cost object that cannot be
traced to that cost object in an economically feasible
(cost-effective) way—for example, the costs of
supervisors who oversee multiple products, one of
which is the iMac, or the rent paid for the repair
facility that repairs many different Apple computer
products besides the iMac.

Indirect costs are allocated to the cost object using a

cost-allocation method.
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Recall that cost assignment is a general term for
assigning costs, whether direct or indirect, to a cost
object. Cost tracing is a specific term for assigning
direct costs; cost allocation refers to assigning indirect
costs.

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Cost-allocation base.
The cost-allocation base is a systematic way to link
an indirect cost or group of indirect costs to cost
objects.

How should a company allocate costs to operate

metal-cutting machines among different products?

One way to allocate costs is based on the number of

machine-hours used to produce different products.

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Cost-allocation base example
if indirect costs of operating metal-cutting machines
is $500,000 based on running these machines for
10,000 hours, the cost allocation rate is $500,000 ÷
10,000 hours = $50 per machine-hour, where machine-
hours is the cost allocation base.

If a product uses 800 machine-hours, it will be

allocated $40,000, $50 per machine-hour * 800
machine-hours.

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The ideal cost-allocation base
The ideal cost-allocation base is the cost driver of the
indirect costs, because there is a cause-and-effect
relationship between the cost allocation base and the
indirect costs.

A cost-allocation base can be either financial (such as

direct labor costs) or nonfinancial (such as the number of
machine-hours).

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Job-Costing and Process-Costing Systems
1. Job-costing system. In this system, the cost object
is a unit or multiple units of a distinct product or
service called a job.

Each job generally uses different amounts of

resources.

Because the products and services are distinct, job-costing

systems accumulate costs separately for each product or
service.
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2. Process-costing system.
In this system, the cost object is masses of identical or
similar units of a product or service.

For example, Citibank provides the same service to all its

customers when processing customer deposits.

Intel provides the same product (say, a Core i7 chip) to each of its
customers.

This per-unit cost is the average unit cost that applies to each of
the identical or similar units produced in that period.

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Exhibit 4-1 presents examples of job costing and process costing
in the service, merchandising, and manufacturing sectors.

These two types of costing systems are best considered as

opposite ends of a continuum; in between, one type of system
can blur into the other to some degree.

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Many companies have costing systems that are neither pure
job costing nor pure process costing but have elements of
both. Costing systems need to be tailored to the underlying
operations.

For example, Kellogg Corporation uses job costing to

calculate the total cost to manufacture each of its
different and distinct types of products—such as Corn
Flakes, Crispix, and Froot Loops—and process costing to
calculate the per-unit cost of producing each identical
box of Corn Flakes.
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Job Costing: Evaluation and Implementation
 Robinson Company, a company that manufactures and installs
specialized machinery for the paper-making industry.

 In early 2011, Robinson receives a request to bid for the manufacturing

and installation of a new paper-making machine for the Western Pulp
and Paper Company (WPP).

 Robinson had never made a machine quite like this one, and its
managers wonder what to bid for the job. Robinson’s management
team works through the five-step decision-making process

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1. Identify the problems and uncertainties.
The decision of whether and how much to bid for
the WPP job depends on how management
resolves two critical uncertainties:

what it will cost to complete the job and the prices

that its competitors are likely to bid.

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2. Obtain information.
 Robinson’s managers first evaluate whether doing the WPP job is
consistent with the company’s strategy.

 Do they want to do more of these kinds of jobs?

 Is this an attractive segment of the market?

 Will Robinson be able to develop a competitive advantage over its

competitors and satisfy customers?

 Robinson’s managers conclude that the WPP job fits well with the
company’s strategy.

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Robinson’s managers study the drawings and
engineering specifications provided by WPP and
decide on technical details of the machine.

They compare the specifications of this machine to

similar machines they have made in the past, identify
competitors who might bid on the job, and gather
information on what these bids might be.

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3. Make predictions about the future.
Robinson’s managers estimate the cost of direct
materials, direct manufacturing labor, and
overhead for the WPP job.

They also consider qualitative factors and risk

factors and think through any biases they might
have.

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4. Make decisions by choosing among
alternatives.
Robinson bids $15,000 for the WPP job. This bid is based
on a manufacturing cost estimate of $10,000 and a markup
of 50% over manufacturing cost.

The $15,000 price takes into account likely bids by

competitors, the technical and business risks, and
qualitative factors.

Robinson’s managers are very confident that they have

obtained the best possible information in reaching their
decision.
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5. Implement the decision, evaluate
performance, and learn.
Robinson wins the bid for the WPP job. As Robinson
works on the WPP job, it keeps careful track of all the
costs it has incurred.

Ultimately, Robinson’s managers compare the

predicted amounts against actual costs to evaluate
how well they did on the WPP job.

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In its job-costing system, Robinson accumulates
costs incurred on a job in different parts of the
value chain, such as manufacturing, marketing,
and customer service.

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We focus here on Robinson’s manufacturing function
(which also includes product installation).

To make a machine, Robinson purchases some components

from outside suppliers and makes others itself.

Each of Robinson’s jobs also has a service element:

installing a machine at a customer’s site, integrating it with
the customer’s other machines and processes, and ensuring
the machine meets customer expectations.

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Actual costing
One form of a job-costing system that Robinson can use is
actual costing.

Actual costing is a costing system that traces direct

costs to a cost object by using the actual direct-cost
rates times the actual quantities of the direct-cost
inputs.

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Actual indirect-cost
It allocates indirect costs based on the actual indirect-cost
rates times the actual quantities of the cost-allocation
bases.

The actual indirect-cost rate is calculated by dividing

actual total indirect costs by the actual total quantity
of the cost-allocation base.

As its name suggests, actual costing systems calculate the

actual costs of jobs.

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Problem with actual costing
Yet, actual costing systems are not commonly found in
practice because actual costs cannot be computed in a
timely manner.

The problem is not with computing direct-cost rates for

direct materials and direct manufacturing labor.

For example, Robinson records the actual prices paid for

materials. As it uses these materials, the prices paid serve
as actual direct-cost rates for charging material costs to
jobs.
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Problem with actual costing
Calculating actual indirect-cost rates on a timely basis
each week or each month is, however, a problem.

Robinson can only calculate actual indirect-cost rates

at the end of the fiscal year and Robinson’s managers
are unwilling to wait that long to learn the costs of
various jobs.

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Time Period Used to Compute Indirect-Cost
Rates
 There are two reasons for using longer periods, such as a year, to
calculate indirect-cost rates.

 1. The numerator reason (indirect-cost pool). The shorter the

period, the greater the influence of seasonal patterns on the amount of
costs.

 For example, if indirect-cost rates were calculated each month, costs of

heating (included in the numerator) would be charged to production
only during the winter months.

 An annual period incorporates the effects of all four seasons into a

single, annual indirect-cost rate.
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 Levels of total indirect costs are also affected by non-seasonal erratic
costs. Examples of non-seasonal erratic costs include costs incurred in
a particular month that benefit operations during future months, such
as costs of repairs and maintenance of equipment, and costs of
vacation and holiday pay.

 If monthly indirect-cost rates were calculated, jobs done in a month

with high, non-seasonal erratic costs would be charged with these
costs.

 Pooling all indirect costs together over the course of a full year and
calculating a single annual indirect-cost rate helps smooth some of the
erratic bumps in costs associated with shorter periods.

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2. The denominator reason (quantity of the
cost-allocation base).
Another reason for longer periods is to avoid
spreading monthly fixed indirect costs over
fluctuating levels of monthly output and
fluctuating quantities of the cost-allocation base.

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Example
Reardon and Pane are tax accountants whose work follows
a highly seasonal pattern with very busy months during tax
season and less busy months at other times.

Assume the following mix of variable indirect costs (such

as supplies, food, power, and indirect support labor) that
vary with the quantity of the cost-allocation base (direct
professional labor-hours) and fixed indirect costs
(depreciation and general administrative support) that do
not vary with short-run fluctuations in the quantity of the
cost-allocation base:
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You can see that variable indirect costs change in
proportion to changes in direct professional labor-hours.

Therefore, the variable indirect-cost rate is the same in

both the high-output months and the low-output months
($40,000 ÷ 3,200 labor-hours = $12.50 per labor-hour;
$10,000 ÷ 800 labor-hours = $12.50 per labor-hour).
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Sometimes overtime payments can cause the variable
indirect-cost rate to be higher in high-output months.

In such cases, variable indirect costs will be allocated

at a higher rate to production in high-output months
relative to production in low-output months.

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 Consider now the fixed costs of $60,000. The fixed costs cause
monthly total indirect-cost rates to vary considerably—from $31.25
per hour to $87.50 per hour.

 Few managers believe that identical jobs done in different months

should be allocated indirect-cost charges per hour that differ so
significantly ($87.50 ÷ $31.25 = 2.80, or 280%) because of fixed costs.

 Furthermore, if fees for preparing tax returns are based on

costs, fees would be high in low-output months leading to lost
business, when in fact management wants to accept more
bids to utilize idle capacity.

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Annual indirect costs to the total annual
level of output
An average, annualized rate based on the relationship of
total annual indirect costs to the total annual level of
output smoothes the effect of monthly variations in output
levels and is more representative of the total costs and total
output that management considered when choosing the
level of capacity and, hence, fixed costs.

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Monday-to-Friday workdays
Another denominator reason for using annual overhead
rates is that the calculation of monthly indirect-cost rates is
affected by the number of Monday-to-Friday workdays in a
month.

The number of workdays per month varies from 20 to 23

during a year. If separate rates are computed each month,
jobs in February would bear a greater share of indirect costs
(such as depreciation and property taxes) than jobs in
other months, because February has the fewest workdays
(and consequently labor-hours) in a month.
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Many managers believe such results to be an
unrepresentative and unreasonable way to assign
indirect costs to jobs.

An annual period reduces the effect that the

number of working days per month has on unit
costs.

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Normal Costing
The difficulty of calculating actual indirect-cost rates
on a weekly or monthly basis means managers cannot
calculate the actual costs of jobs as they are
completed.

However, managers, including those at Robinson,

want a close approximation of the costs of various jobs
regularly during the year, not just at the end of the
fiscal year.

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Managers want to know manufacturing costs (and other
costs, such as marketing costs) for ongoing uses, including
pricing jobs, monitoring and managing costs, evaluating
the success of the job, learning about what worked and
what didn’t, bidding on new jobs, and preparing interim
financial statements.

Because of the need for immediate access to job costs, few

companies wait to allocate overhead costs until year-end
when the actual manufacturing overhead is finally known.

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Instead, a predetermined or budgeted indirect-cost rate is
calculated for each cost pool at the beginning of a fiscal
year, and overhead costs are allocated to jobs as work
progresses.

For the numerator and denominator reasons already

described, the budgeted indirect-cost rate for each cost
pool is computed as follows:

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Normal costing is a costing system that
(1) traces direct costs to a cost object by using the
actual direct-cost rates times the actual quantities of
the direct-cost inputs and

(2) allocates indirect costs based on the budgeted

indirect-cost rates times the actual quantities of
the cost-allocation bases.

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General Approach to Job Costing
Step 1: Identify the Job That Is the Chosen Cost
Object.

The cost object in the Robinson Company example is

Job WPP 298, manufacturing a paper-making machine
for Western Pulp and Paper (WPP) in 2011.

Robinson’s managers and management accountants

gather information to cost jobs through source
documents.
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A source document is an original record (such as a
labor time card on which an employee’s work hours are
recorded) that supports the entries in an accounting
system.

The main source document for Job WPP 298 is a job-

cost record. A job-cost record, also called a job-cost
sheet, records and accumulates all the costs assigned
to a specific job, starting when work begins. (see Ehibit
4-2)
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Sample
Job
Cost
Document

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Step 2: Identify the Direct Costs of the Job.
Robinson identifies two direct-manufacturing cost categories:
direct materials and direct manufacturing labor.

Direct materials: On the basis of the engineering specifications

and drawings provided by WPP, a manufacturing engineer
orders materials from the storeroom.

The order is placed using a basic source document called a

materials-requisition record, which contains information
about the cost of direct materials used on a specific job and in a
specific department.

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Example: Part Number MB 468-A, metal
brackets
See how the record in Exhibit 4-3 specifies the job for
which the material is requested (WPP 298), the
description of the material (Part Number MB 468-A,
metal brackets), the actual quantity (8), the actual
unit cost ($14), and the actual total cost ($112).

The $112 actual total cost also appears on the job-cost

record in Exhibit 4-2. If we add the cost of all material
requisitions, the total actual

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Sample Job Cost Source Documents

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Step 3: Select the Cost-Allocation Bases to
Use for Allocating Indirect Costs to the Job.
 Indirect manufacturing costs are costs that are necessary to do a job
but that cannot be traced to a specific job. It would be impossible to
complete a job without incurring indirect costs such as supervision,
manufacturing engineering, utilities, and repairs.

 Because these costs cannot be traced to a specific job, they must be

allocated to all jobs in a systematic way. Different jobs require different
quantities of indirect resources.

 The objective is to allocate the costs of indirect resources in a

systematic way to their related jobs.

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Companies often use multiple cost-allocation bases to
allocate indirect costs because different indirect costs have
different cost drivers.

For example, some indirect costs such as depreciation and

repairs of machines are more closely related to machine-
hours.

Other indirect costs such as supervision and production

support are more closely related to direct manufacturing
labor-hours.
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Robinson, however, chooses direct manufacturing labor-hours
as the sole allocation base for linking all indirect manufacturing
costs to jobs.

That’s because, in its labor-intensive environment, Robinson

believes that the number of direct manufacturing labor-hours
drives the manufacturing overhead resources (such as salaries
paid to supervisors, engineers, production support staff, and
quality management staff) required by individual jobs.

In 2011, Robinson budgets 28,000 direct manufacturing labor-

hours.
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Step 4: Identify the Indirect Costs
Associated with Each Cost-Allocation Base
Because Robinson believes that a single cost-allocation
base—direct manufacturing labor-hours—can be used to
allocate indirect manufacturing costs to jobs.

Robinson creates a single cost pool called manufacturing

overhead costs. This pool represents all indirect costs of the
Manufacturing Department that are difficult to trace
directly to individual jobs.

In 2011, budgeted manufacturing overhead costs total

$1,120,000.
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Step 5: Compute the Rate per Unit of Each
Cost-Allocation Base Used to Allocate
Indirect Costs to the Job. For each cost pool, the budgeted
indirect-cost rate is calculated by dividing budgeted total
indirect costs in the pool (determined in Step 4) by the budgeted
total quantity of the cost-allocation base (determined in Step 3).

Robinson calculates the allocation rate for its single

manufacturing overhead cost pool as follows:

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Step 6: Compute the Indirect Costs
Allocated to the Job.
The indirect costs of a job are calculated by multiplying
the actual quantity of each different allocation base (one
allocation base for each cost pool) associated with the
job by the budgeted indirect cost rate of each allocation
base (computed in Step 5).

Recall that Robinson’s managers selected direct

manufacturing labor-hours as the only cost-allocation
base.

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Robinson uses 88 direct manufacturing labor-hours
on the WPP 298 job.

Manufacturing overhead costs allocated to WPP 298

equal $3,520 ($40 per direct manufacturing labor-hour
88 hours) and appear in the Manufacturing Overhead
panel of the WPP 298 job-cost record in Exhibit 4-2.

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Sample
Job
Cost
Document

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Step 7: Compute the Total Cost of the Job by Adding All
Direct and Indirect Costs Assigned to the Job.
Exhibit 4-2 shows that the total manufacturing costs
of the WPP job are $9,705.

Recall that Robinson bid a price of $15,000 for the job. At that
revenue, the normal-costing system shows a gross margin of
$5,295 ($15,000 – $9,705) and a gross- margin percentage of
35.3% ($5,295 ÷ $15,000 = 0.353).

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Profitability of different jobs
Robinson’s manufacturing managers and sales managers can use
the gross margin and gross-margin percentage calculations to
compare the profitability of different jobs to try to understand the
reasons why some jobs show low profitability.

Have direct materials been wasted? Was direct manufacturing

labor too high? Were there ways to improve the efficiency of these
jobs? Were these jobs simply underpriced? Job-cost analysis
provides the information needed for judging the performance of
manufacturing and sales managers and for making future
improvements.

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The symbols in Exhibit 4-4 are
used consistently in
the costing-system overviews
presented in this book.

A triangle always identifies a

direct cost, a rectangle
represents the indirect-cost
pool, and an octagon
describes the cost-allocation
base.

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Actual Costing
 How would the cost of Job WPP 298 change if Robinson had used
actual costing rather than normal costing?

 Both actual costing and normal costing trace direct costs to jobs in the
same way because source documents identify the actual quantities and
actual rates of direct materials and direct manufacturing labor for a job
as the work is being done.

 The only difference between costing a job with normal costing

and actual costing is that normal costing uses budgeted indirect-
cost rates, whereas actual costing uses actual indirect-cost rates
calculated annually at the end of the year.

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Costing Approaches Summarized

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The following actual data for 2011 are for Robinson’s
manufacturing operations:

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 Steps 1 and 2 are exactly as before: Step 1 identifies WPP 298 as the cost
object;

 Step 2 calculates actual direct material costs of $4,606, and actual

direct manufacturing labor costs of $1,579.

 Recall from Step 3 that Robinson uses a single cost-allocation base,

direct manufacturing labor-hours, to allocate all manufacturing
overhead costs to jobs. The actual quantity of direct manufacturing
labor-hours for 2011 is 27,000 hours.

 In Step 4, Robinson groups all actual indirect manufacturing costs of

$1,215,000 into a single manufacturing overhead cost pool.

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In Step 5, the actual indirect-cost rate is calculated by dividing
actual total indirect costs in the pool (determined in Step 4) by
the actual total quantity of the cost-allocation base (determined
in Step 3). Robinson calculates the actual manufacturing
overhead rate in 2011 for its single manufacturing overhead cost
pool as follows:

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In Step 6, under an actual-costing system,

The manufacturing cost of the WPP 298 job is higher by

$440 under actual costing ($10,145) than it is under normal
costing ($9,705) because the actual indirect-cost rate is $45
per hour, whereas the budgeted indirect-cost rate is $40 per
hour. That is, ($45 – $40) 88 actual direct manufacturing
labor-hours = $440.

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In Step 7, the cost of the job under actual costing is
$10,145, calculated as follows:

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Underallocated and Overallocated Direct
Costs
 Under-allocated indirect costs occur when the allocated amount of
indirect costs in an accounting period is less than the actual (incurred)
amount.

 Over-allocated indirect costs occur when the allocated amount of

indirect costs in an accounting period is greater than the actual
(incurred) amount.

 Underallocated (overallocated) indirect costs are also called under-

applied (over-applied) indirect costs and under-absorbed (over-
absorbed) indirect costs.
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 Consider the manufacturing overhead cost pool at Robinson Company.
There are two indirect-cost accounts in the general ledger that have to
do with manufacturing overhead:

 1. Manufacturing Overhead Control, the record of the actual costs in all

the individual overhead categories (such as indirect materials, indirect
manufacturing labor, supervision, engineering, utilities, and plant
depreciation)

 2. Manufacturing Overhead Allocated, the record of the

manufacturing overhead allocated to individual jobs on the basis of the
budgeted rate multiplied by actual direct manufacturing labor-hours

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At the end of the year, the overhead accounts show the
following amounts.

The $1,080,000 credit balance in Manufacturing

Overhead Allocated results from multiplying the
27,000 actual direct manufacturing labor-hours
worked on all jobs in 2011 by the budgeted rate of $40
per direct manufacturing labor-hour.
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The $135,000 ($1,215,000 – $1,080,000) difference (a net
debit) is an under-allocated amount because actual
manufacturing overhead costs are greater than the
allocated amount.

This difference arises from two reasons related to the

computation of the $40 budgeted hourly rate:

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