Job-order costing

When every product or service is different, each one must be costed separately. A furniture maker building a boardroom table to a customer's drawings, a print shop producing a wedding order, a law firm handling a case and a construction company building a warehouse all face the same problem: what did this particular job cost, and was it profitable? Job-order costing answers it by accumulating direct materials, direct labour and an applied share of overhead on a record for each job. This lesson applies job-order costing to Cedar Ridge's custom shop. It explains predetermined overhead rates, the flow of costs through the accounts, the treatment of underapplied and overapplied overhead, and the choice between plantwide and departmental rates. CON-300 and CON-310 apply the same logic to construction estimates and cost control; this lesson provides the general framework.

When to use job-order costing

Costing systems sit on a spectrum. At one end, job-order costing suits organizations that produce distinct, identifiable units or batches to customer specifications: custom furniture, aircraft, films, audits, hospital stays. At the other end, process costing (lesson 6) suits organizations that make large volumes of identical units in a continuous flow, such as Cedar Ridge's Classic chair line, a bakery or a refinery. Many companies use both: Cedar Ridge costs custom orders by job and standard chairs by process. Hybrid systems, sometimes called operation costing, track materials by batch while treating conversion costs as a process.

The job cost sheet and source documents

The heart of the system is the job cost sheet, a record (today usually a screen in the ERP system) for each job. It accumulates three kinds of cost. Direct materials come from materials requisitions, the documents authorizing the storeroom to release materials to a job. Direct labour comes from time tickets or digital time records, showing the hours each employee worked on each job. Manufacturing overhead is applied using a predetermined rate, because actual overhead for the year is not known until the year ends. The open job cost sheets together make up the work in process subsidiary ledger; completed jobs move to finished goods and then to cost of goods sold.

Predetermined overhead rates

Direct materials and direct labour can be traced to jobs as they are used, but overhead cannot. The custom shop's electricity, the foreman's salary and the depreciation on the wide-belt sander relate to all jobs together. Waiting until year end to divide actual overhead among jobs would be too late for pricing and would give seasonal distortions: heating costs in January would make winter jobs look more expensive than identical summer jobs. So overhead is applied using a predetermined overhead rate, set before the year begins.

The allocation base should be a cost driver that causes overhead to be incurred, such as direct labour hours in a labour-intensive shop or machine hours in an automated one. Cedar Ridge's custom shop budgets $150,000 of overhead for the year and 6,000 direct labour hours, giving a rate of $25 per direct labour hour. Each job is then charged $25 for every direct labour hour it uses. This approach, actual direct materials and direct labour plus overhead applied at a predetermined rate, is called normal costing.

# Custom shop: predetermined overhead rate and a job cost (illustrative)
budget_moh, budget_dlh = 150_000, 6_000
rate = budget_moh / budget_dlh

job = {"materials": [3_600, 600], "dl_hours": 120, "dl_rate": 28}
dm = sum(job["materials"])
dl = job["dl_hours"] * job["dl_rate"]
moh = job["dl_hours"] * rate
total = dm + dl + moh

print(f"Predetermined overhead rate: ${rate:.2f} per DL hour")
print(f"Job CS-2614  DM {dm:,}  DL {dl:,}  MOH {moh:,.0f}  total {total:,.0f}")
markup = 0.40
print(f"Quoted price at {markup:.0%} markup on cost: ${total * (1 + markup):,.0f}")

Predetermined overhead rate: $25.00 per DL hour
Job CS-2614  DM 4,200  DL 3,360  MOH 3,000  total 10,560
Quoted price at 40% markup on cost: $14,784

The flow of costs through the accounts

Job costing follows the flow of physical production. Materials are bought into raw materials inventory. When requisitioned, direct materials move to work in process and indirect materials to a manufacturing overhead control account. Factory labour is recorded the same way: direct labour to work in process, indirect labour to overhead. Other actual overhead costs, such as utilities and depreciation, are debited to manufacturing overhead as incurred. Overhead is applied to work in process at the predetermined rate, crediting manufacturing overhead. When a job is finished, its total cost moves from work in process to finished goods, and when it is delivered, from finished goods to cost of goods sold.

Underapplied and overapplied overhead

Because the predetermined rate is based on estimates, applied overhead rarely equals actual overhead. If actual overhead exceeds applied overhead, overhead is underapplied (the manufacturing overhead account has a debit balance), and jobs have been undercosted. If applied exceeds actual, overhead is overapplied (a credit balance), and jobs have been overcosted. The difference arises because actual overhead spending differed from the budget, because actual activity differed from budgeted activity, or both.

At year end the balance must be cleared. If it is immaterial, the simplest approach is to close it to cost of goods sold: underapplied overhead increases cost of goods sold, overapplied overhead decreases it. If it is material, it is prorated among work in process, finished goods and cost of goods sold in proportion to the overhead applied in each (or to their total balances), which approximates what the job costs would have been had the actual rate been known.

# Disposing of underapplied overhead (illustrative)
underapplied = 156_300 - 6_140 * 25
applied_in = {"Work in process": 12_280, "Finished goods": 9_210, "Cost of goods sold": 132_010}
total = sum(applied_in.values())

print(f"Underapplied overhead: ${underapplied:,}")
print("Option 1: debit cost of goods sold", f"${underapplied:,}")
print("Option 2: prorate on applied overhead")
for acct, amt in applied_in.items():
    share = amt / total
    print(f"  {acct:<20}{share:>7.1%}  ${underapplied * share:>8,.0f}")

Underapplied overhead: $2,800
Option 1: debit cost of goods sold $2,800
Option 2: prorate on applied overhead
  Work in process        8.0%  $     224
  Finished goods         6.0%  $     168
  Cost of goods sold    86.0%  $   2,408

Under either option, the accounts end the year as if actual overhead had been charged. Proration keeps inventory closer to actual cost; closing everything to cost of goods sold is simpler and is acceptable when the amount is small. A large or persistent balance is a signal to managers that the budget or the allocation base needs attention. Note also that financial reporting frameworks require inventory to absorb fixed overhead based on normal capacity, so unusually low production should not inflate inventory cost; unallocated fixed overhead in that case is expensed (lesson 8 returns to this).

Plantwide versus departmental rates

A single plantwide rate is simple, but it can distort job costs when departments use different drivers. Cedar Ridge's custom shop has two departments. Machining, dominated by the CNC router and sanders, incurs overhead driven by machine hours. Finishing, where staff sand, stain and lacquer by hand, incurs overhead driven by labour hours. A job that spends many hours on the router but few in finishing should carry more machining overhead and less finishing overhead than a plantwide labour-hour rate would give it.

# Plantwide versus departmental rates for two jobs (illustrative)
budget = {"Machining": {"moh": 90_000, "base": 1_500, "unit": "machine hour"},
          "Finishing": {"moh": 60_000, "base": 4_000, "unit": "DL hour"}}
rates = {d: b["moh"] / b["base"] for d, b in budget.items()}
plantwide = 150_000 / 6_000          # per DL hour

jobs = {  # machine hours in Machining, DL hours (total and in Finishing)
    "CS-2614 table":     {"mh": 40, "dlh": 120, "fin_dlh": 70},
    "CS-2620 bookcases": {"mh": 6,  "dlh": 110, "fin_dlh": 95},
}
for d, r in rates.items():
    print(f"{d} rate: ${r:.2f} per {budget[d]['unit']}")
for name, j in jobs.items():
    pw = j["dlh"] * plantwide
    dept = j["mh"] * rates["Machining"] + j["fin_dlh"] * rates["Finishing"]
    print(f"{name:<18} plantwide ${pw:>6,.0f}   departmental ${dept:>6,.0f}")

Machining rate: $60.00 per machine hour
Finishing rate: $15.00 per DL hour
CS-2614 table      plantwide $ 3,000   departmental $ 3,450
CS-2620 bookcases  plantwide $ 2,750   departmental $ 1,785

With departmental rates the table, which uses 40 router hours, carries $3,450 of overhead rather than $3,000, while the hand-finished bookcases carry $1,785 rather than $2,750. Under the plantwide rate, the bookcases subsidize the table. If Cedar Ridge priced from plantwide costs, it would tend to underprice machine-heavy work and overprice hand work, losing profitable hand-finishing orders to competitors while winning machine-heavy jobs that earn less than it thinks. Lesson 7 extends the idea from departments to activities.

Job costing in service organizations

Service firms use job costing for engagements, cases and projects. The main direct cost is professional labour, recorded through timesheets; materials are usually minor; and overhead (office rent, administrative staff, technology) is applied using a rate per professional hour. A consulting firm with $1.2 million of budgeted overhead and 24,000 budgeted billable hours applies $50 of overhead per hour. Comparing each engagement's cost with its fee shows which clients and services are profitable. Hospitals cost procedures in a similar way, and government contracts that reimburse costs specify which costs may be charged.

Federal government contracts in Canada that reimburse costs follow contract cost principles set out in Public Services and Procurement Canada's standard clauses (often referred to by the code 1031-2), which define allowable and unallowable costs and how indirect costs may be allocated. Contractors on such work need job-costing systems that can support these rules.