Chapter 2 - Job-order Costing
Summary :Job-order costing is the accounting system organizations use to track manufacturing costs when what they produce is unique or made to order rather than identical units rolling off a single line. A custom home builder, a specialty printer, or a machine shop building one-off parts all need to know the actual cost of each individual job, not just an average cost across everything they make in a period. Job-order costing assigns direct material, direct labor, and manufacturing overhead to each specific job as it moves through production, giving managers a real cost figure to compare against the price they charge.
What Job-Order Costing Is and When It Fits
Job-order costing assigns product costs directly to the specific job, project, or batch that consumes them, rather than spreading costs evenly across a continuous, standardized production run. It suits organizations that make distinct, identifiable units of output: a construction company building different homes, a custom furniture shop, or a print shop running distinct orders. Because each job can differ in size, materials, and labor required, the system has to trace costs to the individual job rather than assuming every unit produced costs the same amount.
The alternative, process costing, fits organizations producing large volumes of identical or near-identical units, such as a beverage bottler, where tracking cost by individual unit would be both impractical and unnecessary. Recognizing which situation an organization is in determines which costing system its accountants should use.
Product Costs and the Four Inventory Accounts
Product costs, also called inventory costs, consist of direct material, direct labor, and manufacturing overhead, the three categories of cost incurred to actually make something. These costs accumulate in a sequence of inventory asset accounts as a job moves through production: Raw Materials, Manufacturing Overhead, Work in Process, and Finished Goods.
Costs sit in these accounts as assets because the organization still owns the partially or fully completed product and it still has future value. Only once a finished product is sold do its accumulated costs leave the asset side of the books and move to Cost of Goods Sold, an expense account, at which point the related sales revenue is also recorded and gross profit can be calculated as revenue minus that cost of goods sold.
How Raw Materials and Labor Flow Through the System
When raw materials are purchased, their cost is recorded in the Raw Materials account. When those materials are requisitioned for production, the cost leaves Raw Materials and splits based on traceability: direct materials, the ones that can be economically traced to a specific job, move into Work in Process, while indirect materials, things like glue, fasteners, or shop supplies that touch many jobs and are not worth tracing individually, move into Manufacturing Overhead instead.
Labor follows the same traceability logic. Direct labor, the wages of workers actually building the product, is recorded into Work in Process. Indirect labor, such as a production supervisor's salary or quality-control staff whose time cannot be cleanly tied to one job, is recorded into Manufacturing Overhead. Labor spent on office or administrative functions is neither direct nor indirect manufacturing labor; it is a period cost, expensed in the period incurred rather than attached to any job at all.
Manufacturing Overhead: Why It Needs a Separate Rate
Manufacturing overhead covers every production cost that is not direct material or direct labor: indirect materials, indirect labor, and costs like factory rent, utilities, insurance, and property taxes on the production facility. Unlike direct material and direct labor, these costs generally cannot be traced to a specific job as it happens, and they are often not incurred evenly across the year; a property tax bill that arrives twice a year still has to be spread fairly across every job produced during the whole year, not just the jobs in process when the bill happens to be paid.
Because of this timing and traceability problem, actual overhead cannot simply be assigned to jobs as it's incurred the way direct material and labor can. Instead, organizations estimate their overhead in advance and apply it to jobs throughout the year using a predetermined rate, described in the next section, reconciling the estimate against actual overhead once the year closes.
Computing the Predetermined Manufacturing Overhead Rate
An organization-wide predetermined manufacturing overhead rate is calculated before the period begins by dividing total estimated manufacturing overhead for the period by the total estimated amount of whatever allocation base or cost driver the organization has chosen, commonly direct labor hours, machine hours, direct labor dollars, or direct material dollars. A labor-intensive operation typically bases its rate on labor hours, while a machine-intensive operation typically bases its rate on machine hours, whichever activity best explains why overhead costs rise and fall.
In a worked example, a microchip manufacturer estimated it would run 2,080 machine hours in the coming year, with total estimated overhead built from a fixed component plus a variable per-machine-hour component, producing a predetermined rate of roughly $95 per machine hour once the fixed and variable pieces were combined and divided by the estimated machine hours. That single rate is then used throughout the year to apply overhead to every job as it consumes machine hours, without waiting to know the actual overhead figure until year-end.
Applying Overhead to Jobs and the Job Cost Sheet
Once the predetermined rate is set, it is applied to each job based on that job's actual use of the allocation base, machine hours or labor hours actually consumed by that specific job. In the same microchip example, a job that used 3.5 machine hours would be charged $95 multiplied by 3.5 hours in applied overhead, regardless of what the organization's actual total overhead turns out to be for the year.
All of a job's costs, direct material, direct labor, and applied manufacturing overhead, are recorded together on a job cost sheet, which typically also computes total job cost, the number of units produced, cost per unit, and the selling price. A job cost sheet is the underlying record that makes it possible to answer, for any single job, exactly what it cost to produce and whether the price charged actually covered that cost with room for profit.
From Work in Process to Cost of Goods Sold
While a job is in production, its direct material, direct labor, and applied overhead accumulate in the Work in Process account. Once the job is finished, its total accumulated cost moves out of Work in Process and into Finished Goods, where it sits as an asset until the product is actually sold.
When the finished job is sold, its cost moves one final time, out of Finished Goods and into Cost of Goods Sold, an expense account, at the same moment the sale itself is recorded as revenue. Because job-order costing assigns cost to specific, identifiable jobs, the cost of goods sold for a job-order producer directly reflects the actual production costs of whatever specific units were sold, not an average blended across dissimilar units.
Multiple Predetermined Overhead Rates
A single organization-wide overhead rate is simple, but it can distort job costs when different departments or processes consume overhead very differently. A labor-intensive department and a machine-intensive department within the same company do not generate overhead the same way, so a single company-wide rate can overcharge overhead to jobs that spend most of their time in the cheaper department and undercharge jobs that spend most of their time in the more overhead-intensive one.
To correct for this, an organization can calculate separate predetermined overhead rates for each department or process, assigning overhead costs to the specific department that generates them and dividing by that department's own allocation base, such as labor hours in a labor-intensive fabrication department and machine hours in a machine-intensive finishing department. Multiple rates take more record-keeping to maintain than a single organization-wide rate, but they generally produce a more accurate picture of what each job actually cost to build, especially in an organization where departments differ significantly in how they consume overhead resources.
Quick revision summary
- Job-order costing assigns direct material, direct labor, and manufacturing overhead to specific, identifiable jobs, unlike process costing for identical mass-produced units.
- Costs flow through Raw Materials, Manufacturing Overhead, Work in Process, and Finished Goods before landing in Cost of Goods Sold once the job is sold.
- Direct material and direct labor trace to a job directly; indirect material and indirect labor route through the Manufacturing Overhead account instead.
- A predetermined manufacturing overhead rate = estimated total overhead ÷ estimated allocation base (e.g., machine hours), set before the period begins.
- Overhead is applied to each job using its actual use of the allocation base multiplied by the predetermined rate, not the job's actual overhead cost.
- Multiple departmental overhead rates give a more accurate job cost than one organization-wide rate when departments consume overhead very differently.