Job-Order Cos�ng: Calcula�ng Unit Product Costs

Companies assign costs to their products and services for two main reasons:

• it helps them fulfil their planning, controlling, and decision-making responsibili�es.

• it helps them determine the value of ending inventories and cost of goods sold for
external repor�ng purposes.

The costs atached to products that have not been sold are included in ending inventories on
the balance sheet.

The costs atached to units that have been sold are included in cost of goods sold on the
income statement.

In absorp�on cos�ng, all manufacturing costs, both fixed and variable, are assigned to units
of product—units are said to fully absorb manufacturing costs.

All nonmanufacturing costs are treated as period costs and they are not assigned to units of
product.

Job-order cos�ng is used in situa�ons where many different products, each with individual
and unique features, are produced each period.

In a job-order cos�ng system, costs are traced and allocated to jobs and then the costs of the
job are divided by the number of units in the job to arrive at an average cost per unit. This
average cost per unit is also referred to as the unit product cost.

Companies generally classify manufacturing costs into three broad categories: (1) direct
materials, (2) direct labor, and (3) manufacturing overhead.

A bill of materials is a document that lists the quan�ty of each type of direct material
needed to complete a unit of product.

When an agreement has been reached with the customer concerning the quan��es, prices,
and shipment date for the order, a produc�on order is issued. The Produc�on Department
then prepares a materials requisi�on form. The materials requisi�on form is a document
that specifies the type and quan�ty of materials to be drawn from the storeroom and
iden�fies the job that will be charged for the cost of the materials. The form is used to
control the flow of materials into produc�on and also for making journal entries in the
accoun�ng records.
A job cost sheet records the materials, labor, and manufacturing overhead costs charged to
that job.

A�er direct materials are issued, the costs of these materials are recorded on the job cost
sheet.

Direct labor consists of labor charges that are easily traced to a par�cular job.

Labor charges that cannot be easily traced to specific jobs are treated as part of
manufacturing overhead. This later category of labor cost is called indirect labor and
includes tasks such as maintenance, supervision, and cleanup.

A completed �me �cket is an hour-by-hour summary of the employee’s ac�vi�es

throughout the day.

In absorp�on cos�ng, product costs include manufacturing overhead as well as direct

materials and direct labor. Therefore, manufacturing overhead also needs to be recorded on
the job cost sheet.
A normal cost system applies overhead costs to jobs by mul�plying a predetermined
overhead rate by the actual amount of the alloca�on base incurred by the jobs.

If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in

the alloca�on base can produce fluctua�ons in the overhead rate. As a result, two iden�cal
jobs, one completed in the winter and one completed in the spring, would be assigned
different manufacturing overhead costs. To avoid such confusing fluctua�ons, companies
could compute actual overhead rates on an annual basis. However, with this approach, the
manufacturing overhead assigned to any par�cular job would not be known un�l the end of
the year. For these reasons, most companies use predetermined overhead rates rather than
actual overhead rates in their cost accoun�ng systems.
With the applica�on of manufacturing overhead to the job cost sheet, the job cost sheet is
complete except for two final steps. First, the totals for direct materials, direct labor, and
manufacturing overhead are transferred to the Cost Summary sec�on of the job cost sheet
and added together to obtain the total cost for the job. Then the total product cost is divided
by the number of units to obtain the unit product cost. As indicated earlier, this unit product
cost is an average cost and should not be interpreted as the cost that would actually be
incurred if another unit were produced. The incremental cost of an addi�onal unit is
something less than the average unit cost, because much of the actual overhead costs
would not change if another unit were produced.

While job-order cos�ng systems can accurately trace direct materials and direct labor costs
to jobs, they o�en fail to accurately allocate the manufacturing overhead costs used during
the produc�on process to their respec�ve jobs. The root cause of the problem o�en relates
to the choice of an alloca�on base. To improve job cost accuracy, the alloca�on base in the
predetermined overhead rate should drive the overhead cost. A cost driver is a factor, such
as machine-hours, beds occupied, computer �me, or flight-hours, that causes overhead
costs. If the base in the predetermined overhead rate does not “drive” overhead costs, it will
not accurately measure the cost of overhead resources used by each job. Many companies
use job-order cos�ng systems that assume direct labor-hours (or direct labor cost) is the only
manufacturing overhead cost driver. They use a single predetermined overhead rate, or
what is called a plantwide overhead rate, to allocate all manufacturing overhead costs to
jobs based on their usage of direct-labor hours. However, while direct labor-hours may
indeed “drive” some of a company’s manufacturing overhead costs, it is o�en overly
simplis�c and incorrect to assume that ‘direct-labor hours’ is a company’s only
manufacturing overhead cost driver.

When companies can iden�fy more than one overhead cost driver, they can improve job
cost accuracy by using mul�ple predetermined overhead rates. A cost system with mul�ple
predetermined overhead rates uses more than one overhead rate to apply overhead costs to
jobs. Such a system, while more complex, is more accurate because it reflects differences
across departments in terms of how jobs consume overhead costs. The appeal of using
predetermined departmental overhead rates is that they presumably provide a more
accurate accoun�ng of the costs caused by jobs, which in turn, should enhance management
planning and decision making.

Using departmental overhead rates is one approach to crea�ng a job-order cos�ng system
that includes mul�ple predetermined overhead rates. Another approach is to create
overhead rates related to the ac�vi�es performed within departments. This approach
usually results in more overhead rates than a departmental approach because each
department may perform more than one ac�vity. When a company creates overhead rates
based on the ac�vi�es that it performs, it is employing an approach called ac�vity-based
cos�ng. Managers use ac�vity-based cos�ng systems to more accurately measure the
demands that jobs, products, customers, and other cost objects make on overhead
resources.
When a company applies less overhead to produc�on than it actually incurs, it creates what
is known as underapplied overhead. When it applies more overhead to produc�on than it
actually incurs, it results in overapplied overhead. The existence of underapplied or
overapplied overhead has implica�ons for how a company prepares its financial statements.
For example, the cost of goods sold reported on a company’s income statement must be
adjusted to reflect underapplied or overapplied overhead. The adjustment for underapplied
overhead increases cost of goods sold and decreases net opera�ng income, whereas the
adjustment for overapplied overhead decreases cost of goods sold and increases net
opera�ng income.

When all of a company’s job cost sheets are viewed collec�vely, they form what is known as
a subsidiary ledger. In other words, a company’s job costs sheets provide an underlying set
of financial records that explain what specific jobs comprise the amounts reported in Work-
in-Process and Finished Goods on the balance sheet as well as Cost of Goods Sold on the
income statement.
Summary:

Job-order cos�ng is used in situa�ons where the organiza�on offers many different products
or services, such as in furniture manufacturing, hospitals, and legal firms. When used in a
manufacturing context, job-order cos�ng systems accumulate a job’s direct materials, direct
labor, and manufacturing overhead costs on a job cost sheet. Selling and administra�ve costs
are not assigned to jobs because they are treated as period costs.

Job-order cos�ng systems use materials requisi�on forms and labor �me �ckets to trace
direct materials and direct labor costs to jobs. Because manufacturing overhead costs are
indirect costs, they must be allocated to jobs. Ideally, the alloca�on base used to allocate
overhead costs to jobs should be a cost driver—it should cause the consump�on of
overhead costs. The most frequently used alloca�on bases in job-order cos�ng systems are
direct labor-hours and machine-hours.

Normal cos�ng systems allocate overhead costs to jobs using predetermined overhead rates
that are es�mated before the period begins. A predetermined overhead rate is computed by
dividing the es�mated total manufacturing overhead cost for the period by the es�mated
total amount of the alloca�on base for the period. Job-order cos�ng systems can use only
one predetermined overhead rate (also called a plantwide rate) or mul�ple predetermined
overhead rates.

Throughout the period, overhead is applied to jobs by mul�plying the predetermined

overhead rate by the actual amount of the alloca�on base recorded for each job. The total
manufacturing costs assigned to a job (including direct materials, direct labor, and applied
overhead) divided by the number of units within that job equals what is known as the unit
product cost.