Chapter 1

Estimating Costs with Job Costing

In This Chapter

Going over how job costing works

Identifying cost objects

Using job costs to price a product or service

Reviewing the flow of costs through a manufacturing system

Job costing is a methodology you use when the costs to manufacture a product or provide a service vary according to each customer's unique needs. Job costing allows you to provide detailed price estimates based on the product or service provided. A roofing business, for example, uses job costing, because the cost varies according to the customer's needs. The amount of material depends on the type of roof and the square footage. Labor time varies, depending on the roof's size, pitch, and unique angles.

A cost object is the product, activity, or process that causes your company to incur costs. In this chapter, you see how to assign costs to the cost object. You also find out how to follow the flow of manufacturing costs as a product moves through the production process.

Understanding How Job Costing Works

For some businesses, nearly every customer job has different costs, and that's where job costing asserts its value. You need a job costing estimate in order to get the customer's business, and you need to track costs accurately so you generate a reasonable profit.

The different costs for different jobs are often self-evident. Material costs, labor hours, mileage cost, and type of equipment used are likely to vary. For example, a tree trimming company incurs more costs to remove a 30-foot tree than to remove a small stump. The big tree takes more labor and different equipment.

Some factors could lower costs and make a business more competitive in price (or improve its bottom line). For example, a tree trimming company working on a job in a certain neighborhood may distribute a flyer offering free estimates to other homes in the neighborhood. It's a smart business move. If the tree-trimming services already stands to incur the cost to locate its employees and equipment in a certain area, why not perform as much work as possible while it's there? The business can spread some costs (mileage, for example) over several jobs. As a result, its cost per job in that neighborhood is lower, boosting its profit.

The business lesson is that a little bit of flyer can go a long way.

Cost objects: The sponges that absorb money

A cost object is anything that causes you to incur costs. Think about a cost object as a sponge that absorbs your money. The object can be a customer, job, product line, or company division. Carefully identifying cost objects helps you cost your product or service accurately.

Assume you manage a group of plumbers. You're reviewing the month's mileage expense (the equivalent of gasoline) for your staff and notice a 20 percent increase from the prior month. Why? You start asking questions. As it turns out, the customer demand for plumbing work required your staff to drive more miles. The average customer lived farther away.

You grumble, “That driving ran up a lot of costs!” Yes, it did, and you do the driving to meet the needs of your customers. In this example, the cost object was the group of customers for the month. Without any customers, you wouldn't have paid for all the gas. (Well, you wouldn't have had any income either, but never mind that.) No cost object means no costs incurred.

Direct costs are traced to the cost object, and indirect costs are allocated to the cost object.

Indirect costs can be fixed or variable. Insurance costs on vehicles are a fixed indirect cost. The premiums are fixed, and the cost is indirect to the job because you can't trace the vehicle insurance cost directly to a specific job. Utility costs for the office (such as heating and cooling) are variable indirect costs. Costs vary with the weather, but as with the insurance premiums, you can't trace them directly to any one job.

Here's how fixed and variable costs are assigned to cost objects:

• Direct costs
  • Variable direct costs, such as denim material, where denim jeans are the cost object
  • Fixed direct costs, such as a supervisor salary at an auto plant, where an automobile produced is the cost object
• Indirect costs
  • Variable indirect costs, such as utility costs for a television plant, where a television produced is the cost object
  • Fixed indirect costs, such as insurance for a plumbing vehicle, where a plumbing job is the cost object

Charging customers for direct and indirect costs

To bill a customer and calculate a profit, you add up all the costs for that customer, whether they're direct or indirect costs.

If, for example, you manufacture kitchen countertops, you include all direct and indirect costs of a custom countertop installation in order to bill the customer. A direct cost may be marble (for material). To find the total cost of material for the job, you compute direct material cost as Marble × Square footage used × Cost per square foot.

Indirect costs are different. If your kitchen countertop business makes lease payments on an office building, the cost is indirect. You can't know the exact amount of indirect costs for the client. You also can't trace the cost directly to a specific customer, but you can allocate it by using a cost allocation base.

For job costs to be accurate, you need to collect information before you bill the client. You also need to consider the difference between your cost estimate and the final bill. Your client needs to understand how costs higher than the estimate will be handled. Should the customer expect to pay it, or will you absorb the cost (and lower your profit)? If this isn't handled correctly, the customer may be upset. Unforeseen things happen, of course, and you should explain when you hand the customer the estimate that the final bill may be different. A customer is likely to accept additional labor costs. That's because the exact cost of labor is probably hard for you to predict.

Allocating indirect costs

Think about allocating indirect costs this way: You need to allocate a dollar amount of cost (say, $100). You spread that cost over a group of customers, a level of production, or some other activity level. In this section, you see how that may work.

A carpenter owns trucks that require repair and maintenance expense. That cost can't be traced to specific customers; instead, these indirect costs are allocated to a cost object. You find a “best” method to assign repair and maintenance expense to clients, perhaps labor hours worked for the customer.

The logic is that if you work more hours for a specific customer, you probably use your truck more. If you use the truck more, that customer should absorb more of your truck's repair and maintenance cost.

Tracing the repair and maintenance cost of the truck back to a specific customer is virtually impossible. So you make your best educated guess to distribute the cost.

Defining cost allocation

Cost allocation is the process of connecting an indirect cost to a cost object. A cost pool is a grouping of similar costs. You can think of a cost pool as a bunch of similar cost objects thrown together. In this case, the cost object is a specific job.

A cost driver is an item that changes the total costs. If you drive the trucks more, they require more repair and maintenance. An activity (driving to see customers) drives up your costs (repair and maintenance).

Just to clarify: The cost object is the “sponge” that absorbs the cost. The cost driver adds to the size of the sponge. A bigger sponge absorbs more cost.

Assume the total repair and maintenance expense for three carpentry trucks is $3,000. During the month, your workers provide service to 300 clients. Each customer is allocated $10 of repair and maintenance expense ($3,000 ÷ 300 clients).

If the cost driver increases to 400 clients per month, the carpenters drive more miles. As a result, the trucks require more maintenance and possibly repairs. Your monthly repair and maintenance expense is higher.

At 400 customers for the month, assume total repair and maintenance expense for three carpentry trucks is $3,600. Now each customer is allocated repair expense of $9 ($3,600 ÷ 400 clients). The cost driver increase (number of customers) changes your total cost to $3,600. Because you also have an increase in total customers (400), the $3,600 is spread over a larger group. The total cost increases, but the cost allocated per customer declines.

You can see how the cost allocation process can get complicated.

Grouping similar costs into the same cost pool is often beneficial when the cost driver is the same. Consider a cost pool for the indirect costs for the carpentry trucks. In addition to repair and maintenance expense, the company pays for insurance and depreciation on the three trucks. None of these costs can be traced to a specific customer; instead, you need to allocate these costs. A good cost pool includes depreciation, insurance, and repair costs on the trucks. This cost pool can be allocated in the same way as the repair and maintenance costs in the previous example.

Implementing job costing in manufacturing: An example

To implement job costing in a manufacturing company, first think about dividing your costs into two piles: direct costs and indirect costs. In a manufacturing setting, you have direct materials and direct labor you can trace directly to any given job. So far, so good. Next, think about what's driving indirect costs. You spread those indirect costs to the work you perform.

As an example, Reliable Fencing manufactures and installs wooden fences for the residential market. Reliable has a manufacturing component and a service component.

Reliable provides the customer a cost estimate. The estimate is based on the type of fence, fence height and length, and labor hours needed for installation. Because nearly every job has a different set of costs, Reliable Fencing uses job costing. This system allows Reliable to compute costs accurately. And from that, Reliable can calculate a selling price that generates a reasonable profit.

Imagine that you're the manager of Reliable Fencing. The Johnsons have requested an estimate for a fence in their backyard. To provide the estimate, you discuss the fence models and types with them. You measure the length needed for the fence and the height requested. Finally, you consider any extra labor costs you may incur. For example, the Johnsons want the fence to jog around several trees so the fence doesn't damage the tree trunks.

The Johnsons’ fence is the cost object. Reliable will incur costs if the client orders a fence and work starts on the project. But before getting an order, you have to provide a cost estimate.

Figuring out direct costs

Reliable combines the cost of wood, paint, and a waterproofing treatment for the wood. That combined cost represents direct materials. As the manager, you compute direct material costs:

Direct materials = Quantity of materials × Unit price paid for material

You buy material measured in square feet. The unit cost is the price per square foot. Here's the amount of material needed and the cost:

• Direct materials = 600 square feet of material needed × $5 per square foot
• Direct materials = $3,000

Your other direct cost is direct labor. Your staff must cut the wood, paint it, waterproof it, and build the fence. Thinking through it further, your staff must measure and dig postholes. They then fill the area around the posts and nail the fence boards onto the posts, all while keeping everything level. Not easy! It takes real skill and planning. As a result, the owners of Reliable Fencing know it's best to hire skilled people and pay them a reasonable hourly rate.

Your experience as Reliable's manager allows you to estimate the labor time needed based on several factors. You consider the square footage of material needed; the length and height of the fence; and any extra work, such as going around those tree trunks. Here's your formula for direct labor costs:

Direct labor = Hours of labor × Rate paid for labor

Note a difference in terms: Price is used for materials, and rate is the term used for labor. That distinction comes up in the world of cost variances.

You estimate that 2 people working 20 hours can complete the job. Using these numbers, you determine the labor cost:

• Direct labor = Number of workers × Hours of labor per worker × Hourly rate paid for labor
• Direct labor = 2 workers × 20 hours × $20 per hour
• Direct labor = $800

Consider one more direct cost. You see a discussion of mileage expense earlier in chapter. That formula is also used here:

• Cost per mile = Cost per gallon of gas ÷ Miles per gallon for the vehicle
• Mileage costs = Miles needed for client × Cost per mile

You calculate 15 miles (round trip) from your office to the job site. However, the work will be completed over several days, so you estimate 45 total miles.

Your trucks get 20 miles to the gallon, and your fuel cost is $4 per gallon. It's not much, but here is the direct cost for mileage:

• Cost per mile = $4 gallon of gas ÷ 20 miles per gallon
• Cost per mile = $0.20 per mile
• Mileage costs = 45 miles needed for client × $0.20 per mile
• Mileage costs = $9.00

So you have three direct costs: materials, labor, and mileage. They're direct costs because they can be traced to the cost object: the Johnsons’ fence.

Calculating indirect costs

To allocate indirect costs, you decide on two cost pools. One pool is your vehicle and equipment costs, which includes depreciation, maintenance, repair, and insurance costs. The other pool is office cost, which includes salary, benefits, accounting costs, and legal costs for your company. The cost object for allocating these indirect costs is the customer base:

After you resolve how to allocate costs, try to keep it simple. You combine the indirect costs into one amount: $4,000 + $7,000 = $11,000. You then divide the indirect cost total by the number of clients for the month:

• Indirect cost allocation rate = $11,000 ÷ 200 customers = $55 per customer
• Indirect cost allocation rate = $55 per customer

Your office assistant asks a question: “Is that really fair? What if one client has a $3,000 job, and another's project is only $500? Should we be charging the same amount of costs to both?” You think about the issue over lunch.

After lunch, you stop by your office assistant's desk and say: “You know, a client should expect that if we show up for a job of any size we're going to incur some office and vehicle costs. I don't think a client will be surprised by those fees.”

The assistant thinks for a minute. “Yeah, that's fair. If they showed up at my house for a job, those indirect costs seem okay. I guess I'd expect to pay for it somehow. As long as the cost charged to a small job isn't huge, I think charging a rate per customer is reasonable.”

The discussion with your office assistant may convince you that your indirect cost allocation should be more specific. If you could show the client how the specific job generates indirect costs, he or she would be more inclined to agree with your billing.

You need to weigh the cost and time needed to allocate costs with the benefit of knowing more specific information. If customers generally accept the $55 allocation rate as reasonable, great. Probably no reason to dig further into your indirect costs.

If the majority of your customers have a problem with the rate, you should consider more detailed analysis and present a more detailed indirect cost billing. If not, you may lose the opportunity to do more work with the same group of clients.

Presenting total job costs

Table 1-1 shows the total costs for the Johnsons’ fence job.

Taking a Closer Look at Indirect Costs by Using Normal Costing

In this section, you apply indirect costs to your product or service. You also plan direct and indirect costs by using a normal costing system. Actual costs represent what comes out of your checkbook. You determine actual costs after the work is completed. Normal costing instead uses budgeted data, which is generated before the work is completed. Normal costing uses a budgeted price or rate multiplied by the actual quantity used.

Planning your work without some budgeted rates of cost is difficult. Normal costing creates budgeted rates that you can use to plan your work. Although normal costs may not equal your actual costs, they do give you a basis for planning your spending each period.

Suppose you operate a landscaping company. Changes in costs can make planning difficult. Maybe the costs you pay for materials, labor, and other costs change as the year progresses. The cost of grass seed may go up, increasing your material costs. Or your labor costs decline because the economy slows. More people with the needed skills are looking for landscaping work, so you can offer a lower pay rate.

If you use actual costs, which change over time, pricing your product to generate a reasonable profit is difficult. For example, if you had a 15 percent profit above costs, a cost increase would eat away at your profit. Maybe higher costs lower your profit to 10 percent.

Planning your cash needs is also more challenging. If you need to buy $10,000 of grass seed in the next 30 days, what if the price goes up? Maybe a shortage increases your grass seed cost to $12,000. That means that the check you need to write will be $12,000, not $10,000. Now you need to have $2,000 more cash available.

Budgeting and cash management is similar to planning a vacation. First, you determine the costs (airline, car rental, hotel, gas). Next, you plan your cash flow to pay for the vacation cost. If the prices are constantly fluctuating, planning is difficult. Many people try to book a vacation trip well in advance, so at least airfare and lodging costs are fixed for the trip!

Budgeting for indirect costs

When you budget for indirect costs, you spread those costs to cost objects based on a cost driver (refer to the section “Cost objects: The sponges that absorb money”). Before you spread the indirect cost, you come up with a rate to allocate the costs to the product or service. The indirect cost rate allows you to price your product to produce a reasonable profit.

As the manager for the landscaping company, you decide on a cost pool for indirect costs. Your only indirect cost is for vehicles and equipment (depreciation, insurance, and repair costs). Your company is new, with virtually no office costs to consider yet.

Many companies have planning meetings around the end of their fiscal (business) year. In the meetings, they make assumptions about many issues, including next year's costs. This is when a company plans predetermined or budgeted indirect cost rate. The predetermined overhead rate depends on total indirect costs and the cost driver you select. Indirect costs are also referred to as overhead costs.

During a planning session, you consider the prices and rates you paid last year. You think about how prices and rates have changed and consider your estimates of miles driven each month. Based on that analysis, here is your budgeted indirect cost rate:

Predetermined or budgeted indirect cost rate = $7,500 ÷ 1,400 miles = $5.36 per mile

Not until the end of the year does the company know what the actual total indirect costs and the actual miles driven will be. Here's the actual indirect cost rate for the vehicles and equipment (using miles driven for the month as the cost object). The formula is explained in the section “Computing direct costs and indirect costs”:

Indirect cost allocation rate = $8,000 ÷ 1,300 miles = $6.15 per mile

Predetermined or budgeted means planned in advance. Your budgeted monthly rate has a lower monthly cost level ($7,500 versus $8,000) but more monthly miles (1,400 versus 1,300). As a result, the budgeted overhead rate is lower. You use this rate to apply indirect costs to every job during the year.

At the end of the year, you realize that you didn't allocate enough costs to your jobs. As a result, your actual profit will be lower than what you budgeted. Because actual costs aren't known until the end of the year, you almost always have a difference between budgeted and actual results.

Following a normal job costing system

Put together your budgeting process for indirect costs with a plan for direct costs. Think of the combined process as normal costing. This chapter keeps hammering away at this point, but it's important: You trace direct costs and allocate indirect costs.

Normal costing combines indirect cost rate with actual production. The process gets you closer to actual total costs for your product.

Computing direct costs and indirect costs

To implement normal costing, you compute direct and indirect costs:

• Direct costs: Traced to the cost object by multiplying actual prices and/or rates × actual quantity for a specific job object
• Indirect costs: Allocated to the cost object by multiplying predetermined or budgeted indirect cost rate × actual quantity for a specific job object

Note that both direct and indirect costs use actual quantity in the formula. While you come up with an indirect cost rate in planning, the rate is multiplied by actual quantities. In this case, the quantity is jobs for the month.

Introducing the job cost sheet

A job cost sheet lists every cost incurred for a particular job, including direct material, direct labor, and all indirect costs. The job cost sheet is your basis for computing your sale price and your profit. You use this document to prepare a cost estimate for a client. Table 1-2 shows a job cost sheet using normal costing for a landscaping job. Because some job costs are based on budgets and estimates, many businesses round the calculations. You see that total costs are rounded in Table 1-2.

The indirect cost calculation (vehicle and equipment costs) uses the actual quantity (miles driven) and the estimated rate per mile. The other direct costs on the job sheet use actual quantities and actual prices/rates.

Following the Flow of Costs through a Manufacturing System

Costs flow through a manufacturing system, from buying materials for a product all the way to the customer sale. When you envision the flow of costs, you find it easier to collect all the product costs you need to price a product. When you know all the steps, you remember all the costs related to those steps!

The manufacturing process described in the following sections assumes the company uses process costing. Process costing assumes that each product manufactured is similar to the others, maybe even identical. As a result, you can track costs as they move from one production department to another. You don't need to track costs by each customer or each customer job.

Control starts with control accounts

Control accounts are temporary holding places for costs. Managing costs has to start somewhere, and in accounting, that process most often starts with control accounts.

Labor, materials, and indirect costs start off in control accounts. It may sound strange, but these accounts and their balances don't appear in the financial statements. That's because the balances are eventually moved to other accounts. All the checks you write for manufacturing costs are posted first to control accounts.

For many manufacturers and retailers, inventory is the biggest investment; more cash is spent on inventory than any other asset. Because of that, a big part of operating a profitable business is to control the costs of inventory.

Inventory is an asset you eventually sell to someone. (That's a little different, of course, from buildings and equipment.) For manufacturers, inventory has three components: raw materials, work-in-process, and finished goods, whereas retailers just have finished goods. Raw materials inventory is, broadly, products not yet started; work-in-process inventory is partially completed products; and finished goods inventory is completed products.

The three kinds of inventory are assets, because you eventually sell the goods to a customer. When you do, the inventory asset becomes an expense — cost of goods sold. Managing inventory starts in a control account.

Following are the three major categories of control accounts. The amounts in each of these accounts are eventually moved into production.

• Materials: You buy materials (such as wood for making kitchen cabinets) in advance of making your products. Materials control is the term for the control account for material costs.
• Labor: Consider labor costs. Employees report the hours they work on time cards each week. Those cards list hours worked on various projects. For custom cabinets, the time cards list customer jobs that employees completed, and the hours worked. Wages payable control is the term for the control account for labor.
• Indirect costs: A business (such as the kitchen cabinet business) has indirect costs (for example, machine repair and maintenance). Your firm has some method to allocate those costs to clients (see “Budgeting for indirect costs”). However, you may not get to the allocation until after you write checks for the cost. Overhead control is the term for the control account for indirect costs.

Control accounts (materials, labor, and overhead), work-in-process, and finished goods are inventory accounts, which are assets. Cost of goods sold (COGS) is an expense account. When you make a sale to a customer, you “use up” the asset. The asset becomes an expense. Debiting increases all these accounts, and crediting decreases all these accounts. The balance for any of these accounts is equal to debit balance less credit balance. For more about debits and credits, see Book I, Chapter 2.

Walking through a manufacturing cost example

Say you're the manager of Homewood Custom Cabinets. You order $20,000 in lumber. You then take $5,000 of the lumber and start making cabinets for a customer.

When you buy the lumber, cash (an asset) goes down, but the material control account (as asset) goes up. The material control account is increased (debited) when you buy the lumber.

The material control account balance is decreased (credited) when you take $5,000 in lumber to start using the material for a customer. Now how does your material control account look?

Material control account

If the month ends with no other activity, the ending material control balance is $15,000 ($20,000 – $5,000).

But the $5,000 doesn't just vanish. When you put materials into production, you reduce (credit) the material control account and increase (debit) the work-in-process control account.

Work-in-process control account

You reduce one asset (material control account) and increase another asset (work-in-process control account).

Now assume that the people on the shop floor finish some cabinets and move $2,000 of the $5,000 work-in-process to finished goods.

Work-in-process control account

You reduce one asset (work-in-process control account) and increase another asset (finished good control account). If the month ends with no other activity, the ending balance in work-in-process is $3,000 ($5,000 – $2,000).

Again, no money disappears. The “other side” of the transaction hits the finished goods control account.

Finished goods control account

So one more time, you reduce one asset (work-in-process control account) and increase another asset (finished goods control account).

At some point, you sell what you made. You have $2,000 in finished goods. Because you make custom cabinets, you have one customer identified as the buyer. That customer “raised her hand” and placed an order. The finished goods control account shows this:

Finished goods control account

You're almost home. When goods are sold, you reduce (credit) the finished goods account and increase (debit) cost of goods sold. And that's an expense account. At last!

Cost of goods sold

The difference between your sale price and the cost of goods sold is your profit.

The reason you do this exercise is to fully track where your inventory money is. For custom cabinets, it can be a big deal if you're building for, say, 20 customers at once. For off-the-shelf cabinets, it can be a very big deal. You may be delivering 2,000 cabinets per month.

The flow lets you see where the inventory money is and spot production logjams. Too much in the material control account suggests that you're overbuying or not producing at the rate you expected. Too much in the work-in-process control account suggests that you're not producing completed product as planned. Too much in the finished goods control account suggests that you're not selling and you have “dead inventory.”

Applying the methodology to other control accounts

Use the same flow process for labor and indirect costs. Labor costs accumulate in the control account until they're traced to a customer or product line. At that point, the cost moves to work-in-process. When the goods are completed, the costs move to finished goods. When goods are sold, the cost moves to cost of goods sold. The labor cost process mirrors the system for material costs described in the previous section.

For more about cost allocation see the “Budgeting for indirect costs” section earlier in this chapter. For example, you're recognizing depreciation expense and repair costs on vehicles. Those costs are in an overhead account. You plan a budgeted rate to apply indirect costs to products. As those costs are incurred, the overhead control account is increased (debited).

When you allocate indirect costs to a customer or product line, you reduce (credit) the overhead account and increase (debit) work-in-process control account. After that, the process is the same as with the other control accounts. Costs move from work-in-process to finished goods to cost of sales.