Job Costing involves the calculation of costs involved in a construction "job" or the manufacturing of goods done in discrete batches.

These costs are recorded in ledger accounts throughout the life of the job or batch and are then summarized in the final trial balance before the preparing of the job cost or batch manufacturing statement.

Job Costing vs Process Costing

Job costing (known by some as job order costing) is fundamental to managerial accounting. It differs from Process costing in that the flow of costs is tracked by job or batch instead of by process. The distinction between job costing and process costing hinges on the nature of the product and, therefore, on the type of production process:

Process costing is used when the products are more homogeneous in nature. Conversely, job costing systems assign costs to distinct production jobs that are significantly different. An average cost per unit of product is then calculated for each job. Process costing systems assign costs to one or more production processes. Because all units are identical or very similar, average costs for each unit of product are calculated by dividing the process costs by the number of units produced. Many businesses produce products with some unique features and some common processes. These businesses use costing systems that have both job and process costing features ]

Using Job Costing

In a job costing system, costs may be accumulated either by job or by batch. For a typical job, direct material, labor, subcontract costs, equipment, and other direct costs are tracked at their actual values. These are accrued until the job or batch is completed. Overhead or "burden" may be applied either by using a rate based on direct labor hours or by using some other Activity Based Costing (ABC) cost driver. In either case, once overhead/burden is added, the total cost for the job can be determined. If the accountant is using a general ledger accounting system, which lacks true job costing functionality, the costs must be manually transferred out of Work in Process to Finished Goods (Cost of Goods Sold for service industries). Of course, in the days of computerized job costing software, journaling costs manually is an obsolete process. Such handjournaling is mandatory for companies that continue to use general accounting software to do job costing. Enlightened accountants are moving forward and using job costing software, thereby improving cost control, reducing risk, and increasing the chance of profitability.

Using Cost Codes in Budgeting

In a true job cost accounting system, a Budget is set up in advance of the job. As actual costs are accrued, they are compared to budgeted costs, to determine variances for each phase of each job. Cost Codes are used for each phase, allowing "mini-budgets" to be generated and tracked. In the construction industry, the Construction Specifications Institute (CSI) has established an industry

standard Cost Coding system.job costing system consists of various cost driver that drives job cost,

Measuring Direct Materials Cost in Job Order Costing System:

Bill of Materials:
At the beginning of production process a document known as bill of materials is used for standard products. "A bill of materials is a document that lists the type and quantity of each item of materials needed to complete a unit of standard product". In case where it is not possible to use a bill of materials, the production staff determines the materials requirements from the blueprints submitted by the customer.

Materials Requisition Form:

When an agreement is reached with the customer concerning the quantities, price and shipment date for the order, a production order is issued. The production department then prepares a materials requisition form. "The materials requisition form is a detailed source document that specifies the type and quantity of materials to be drawn from the storeroom, and identifies the job to which the costs of the materials are to be charged". The form is used to control the flow of materials into production and also for making entries in the accounting records. The completed form is presented to the storeroom clerk who then issues the necessary raw materials. The storeroom clerk is not allowed to release materials without such a form bearing an authorized signature. Following is an example of a materials requisition form.

Sample of materials requisition form:

Materials Requisition Number14873 Job Number to Be Charged 2B47 Department Milling Description M46 Housing G7 Connector Quantity 2 4 Date March 2

Unit Cost $124 103

Total Cost $248 412 ------$660

Authorized Signature Bill White

Job Cost Sheet:

After being notified that the production order has been issued, the Accounting Department prepares a job cost sheet. A job cost sheet is a form prepared for each separate job that

records the materials, labor and overhead costs charged to the job. After direct materials are issued , the Accounting department records their costs directly on the job cost sheet. In addition to serving as a means for charging costs to jobs, the job cost sheet also serves as a key part of a firm's accounting records. The job cost sheets form a subsidiary ledger to the work in process (WIP) account. They are detailed records for the jobs in process that add up to the balance in the work in process (WIP). Following is an example of a job cost sheet.

Example of Job Cost Sheet:

JOB COST SHEET

Job Number 2B47 Department Milling Item For Stock

Date Initiated March 2 Date Completed Units Completed

Direct Materials Req. No. 14873 Amount $660 Ticket

Direct Labor Hours Amount

Manufacturing Overhead Hours Rate Amount

Cost Summary Direct Materials Direct Labor Manufacturing Overhead Total Cost $ $ $ $ $ Date

Units Shipped Number Balance

Unit Product Cost

Measuring Direct Labor Cost in Job Order Costing System:

Labor Time Ticket:

Direct labor cost is handled in much the same way as direct materials cost. Direct labor consists of labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced directly to any job are treated as part of manufacturing overhead. The later category of labor cost is known as indirect labor and includes tasks such as maintenance, supervision, and cleanup. Workers use time tickets to record the time they spend on each job and task. A completed labor time ticket is an hour by hour summary of the employees activities throughout on a specific job, the employee enters the job number on the time ticket and notes the amount of time spent on that job. When not assigned to a particular job, the employee records the nature of the indirect labor task (such as cleanup and maintenance) and the amount of time spent on the task. The daily time tickets are also used as the basis for labor cost entries into the accounting records. Following is an example of employees time ticket.

Sample of Employee Time Ticket:

Time Ticket No. 843 Employee Mary Holden Date March 3 Station 4

Started 7:00 12:30 2:30

Ended 12:00 2:30 3:30

Time Completed 5.0 2.0 1.0

Rate $9 9 9

Amount $45 18 9

Job Number 2B47 2B50 Maintenance

Job Cost Sheet:

At the end of the day, the time tickets are gathered and accounting department enters the direct labor hours and costs on individual job cost sheets. Following is an example of a job cost sheet.

Example of Job Cost Sheet:

JOB COST SHEET

Job Number 2B47 Department Milling Item For Stock

Date Initiated March 2 Date Completed Units Completed

Direct Materials Req. No. 14873 Amount $660 Ticket 843

Direct Labor Hours 5 Amount $45

Manufacturing Overhead Hours Rate Amount

Cost Summary Direct Materials Direct Labor Manufacturing Overhead Total Cost $ $ $ $ $ Date

Units Shipped Number Balance

Unit Product Cost

The system we have just described is a manual method for recording and posting labor costs. Many companies now rely on computerized system and no longer record labor time by hand on sheet of paper. One computerized approach uses bar codes to enter the basic data into the computer. Each employee and each job has a unique bar code. When an employee begins work on a job, he or she scans three bar codes using a hand-held device much like the bar code readers at grocery store check-out stands. The first bar code indicates that a job is being started; the second is the unique bar code on his or her identity badge; and the third is the unique bar code of the job itself. This information is fed automatically via an electronic network to a computer that notes the time and then records

all of the data. When the employee completes the task, he or she scans a bar code attached to the job. This information is relayed to the computer that again notes the time, and a time ticket is automatically prepared. Since all of the source data is already in computer files, the labor costs can be automatically posted to job cost sheets (or their electronic equivalents). Computers, coupled with technology such as bar codes, can eliminate much of the drudgery involved in routine bookkeeping activities while at the same time increasing timeliness and accuracy.

Application of Manufacturing Overhead Cost in Job Order Costing:

Predetermined Overhead Rate:

Manufacturing overhead must be included with direct labor on the job cost sheet since manufacturing overhead is also a product cost. However, assigning manufacturing overhead to units of product can be a difficult task. There are three reasons for this:

1. Manufacturing overhead is an indirect cost. This means that it is either impossible or

difficult to trace these costs to a particular product or job.

2. Manufacturing overhead consists of many different items ranging from the grease
used in machines to the annual salary of production manager.

3. Even though output may fluctuate due to seasonal or other factors, manufacturing

overhead costs tend to remain relatively constant due to the presence of fixed costs.

Given these problems, about the only way to assign overhead costs to production is to use an allocation process. This allocation of overhead cost is accomplished by selecting an allocation base that is common to all of the company's products and services. An allocation base is a measure such as direct labor hours or machine hours that is used to assign overhead costs to products and services. The most widely used allocation bases are direct labor hours, and direct labor cost, with machine hours and even units of product (where a company has only a single product) also used to some extent. The allocation base is used to compute "predetermined overhead rate" in the following formula or equation.

Formula and Calculation of Predetermined Overhead Rate:

Predetermined Overhead Rate = Estimated total manufacturing overhead cost / Estimated total units in the allocation base

Example:
If a company has estimated that its total manufacturing overhead cost will be $320,000 for the year and its total direct labor hour will be 40,000. Its predetermined overhead rate for the year will be $8 per direct labor hour, as calculated below: $320,000 / 40,000 = $8 per direct labor hour predetermined overhead rate is based on estimates rather than actual results. This is because the predetermined overhead rate is computed before the period begins and is used to apply overhead cost throughout the period. The process of assigning overhead cost to

jobs is called overhead application. The formula for determining the amount of overhead cost to apply to a particular job is: Overhead applied to a particular job = Predetermined overhead rate Amount of allocation incurred by the job Note that the job cost sheet in the example below indicates that 27 labor hours have been worked. Therefore a total of $216 of manufacturing overhead cost would be applied to the job. See the following calculation: Overhead applied to job 2B47 = Predetermined overhead rate Actual direct labor hours charged to job 2B47 = $8 per DLH 27 DLHs = $216 of overhead applied to job 2B47

Example of Job Cost Sheet

JOB COST SHEET

Job Number 2B47 Department Milling

Date Initiated March 2 Date Completed March 8

Direct Materials Req. No. 14873 14875 14912 Amount $660 506 238 --------$1,404 ===== Ticket 843 846 850 851

Direct Labor Hours 5 8 4 10 -------27 ===== Amount $45 60 21 54 -------$180 =====

Manufacturing Overhead Hours 27 Rate $8/DLH Amount $216

Cost Summary Direct Materials Direct Labor $1,404 180 Date March 8

Units Shipped Number -Balance 2

Manufacturing Overhead Total Cost

216 1800 900

Unit Product Cost

The amount of overhead has been entered on the job cost sheet above. Note that this is not the actual amount of overhead caused by the job. There is no attempt to trace actual overhead costs to jobs--if that could be done, the costs would be direct costs, not overhead costs. Overhead assigned to the job is simply a share of the total overhead that was estimated at the beginning of the year. When a company applies overhead cost to jobs as we have done--it is called normal cost system. The overhead may be applied as direct laborhours are charged to jobs, or all of the overhead can be applied at once when the job is completed. The choice is up to the company. If a job is not completed at the year-end, however, overhead should be applied to value the work in process inventory.

The Need for Predetermined Overhead Rate:

Instead of using a predetermined overhead rate, a company could wait until the end of the accounting period to compute an actual over head rate based on actual total manufacturing costs and the actual total units in the allocation base for the period. However, managers cite several reasons for using predetermined over head rates instead of actual overhead rates:

1. Managers would like to know the accounting system's valuation of completed jobs

2.

3.

before the end of the accounting period. Suppose, for example a company waits until the end of the year to compute its overhead rate. Then there would be no way for managers to know the cost of goods sold for a job until the close of the year. The job may be completed and shipped before the end of the year. The seriousness of this problem can be reduced to some extent by computing the actual overhead more frequently, but that immediately leads to another problem as discussed below. If actual overhead rates are computed frequently, seasonal factors in overhead costs or in the allocation base can produce fluctuations in the overhead rates. For example, the cost of heating and cooling a production facility will be highest in the winter and summer months and lowest in the spring and fall. If an overhead rate were computed each month or each quarter, the predetermined overhead rate would go up in the winter and summer and down in the spring and fall. Tow identical jobs, one completed in winter and one completed in spring, would be assigned different costs if the overhead rate were computed on a monthly or quarterly basis. Managers generally feel that such fluctuations in overhead rates and costs serve no useful purpose and are misleading. The use of predetermined overhead rate simplifies the record keeping. To determine the overhead cost to apply t a job, the accounting staff simply multiplies the direct labor hours recorded for the job by the predetermined overhead rate.

The Flow of Documents in a Job Order Costing System

Materials requisition form A production order initiates work on a job, whereby costs are charged through... These production costs are accumulated on a form, prepared by the accounting department known as... The job cost sheet is used to compute unit Job product costs that in cost turn are used to value sheet ending inventories and to determine cost of goods sold

A sales order is Sales prepared Production Order Order as a basis for issuing a.....

Direct labor time ticket

Predetermined overhead rates

Job Order Costing The Flow of Cost:

- To understand the flow of costs in job order costing system, we shall consider a single
month's activity for a company, a producer of product A and product B. The company has two jobs in process during April, the first month of its fiscal year. Job 1, of 1000 units of product A was started in march. By the end of march, $30,000 in manufacturing costs had been recorded for the job 1. Job 2 an order for 10,000 units of product B was started in April.

The Purchase and Issue of Materials:

On April 1, the company had $7,000 in raw materials on hand. During the month, the company purchased an additional $60,000 in raw materials. The purchase is recorded in journal entry (1) below: (1) Raw Materials Accounts Payable 60,000 60,000 Dr. Cr.

Raw materials is an asset account. Thus, when raw materials are purchased, they are initially recorded as an asset--not as an expense.

Issue of Direct and Indirect Materials:

During April, $52,000 in raw materials were requisitioned from the storeroom for use in production. These raw materials include both direct and indirect materials. Entry (2) records issuing the materials to the production department.

(2)

Work in Process Manufacturing Overhead Raw Materials

50,000 2,000 52,000

Dr. Dr. Cr.

The materials charged to work in process (WIP) represents direct materials for specific jobs. As these materials are entered into the work in process account, they are also recorded on the appropriate job cost sheets. This point is illustrated in Exhibit 1.1 where $28,000 of the $50,000 in direct materials is charged to Job 1 cost sheet and the remaining $22,000 is charged to job 2 cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.) The $2,000 charged to manufacturing overhead in entry (2) represents indirect materials used in production during April. Observe that the manufacturing overhead account is separate from work in process account. The purpose of the manufacturing overhead account is to accumulate all manufacturing overhead costs they are as they are incurred during a period. Before leaving Exhibit 1.1 we need to point out one additional thing. Notice from the exhibit that the job cost sheet for job 1 contains a beginning balance of $30,000. We stated earlier that this balance represents the cost of work done during march that has been carried forward to April. Also note that work in process account contains the same $30,000 balance. The reason the $30,000 appears in both places is that the work in process account is a control account and the job cost sheets form a subsidiary ledger. Thus, the work in process account contains a summarized total of all costs appearing on the individual job cost sheet for all jobs in process at any given point in time. (Since the company had only job 1 in process at the beginning of April, job 1's $30,000 balance on that date is equal to the balance in the work in process account.

Exhibit 1.1

Issue of Direct Materials Only:

Some times the materials drawn from the raw materials inventory account are all direct materials. I this case, the entry to record the issue of the materials into production would be as follows: Work in process Raw materials XXX XXX Dr. Cr.

Labor Cost:
As work is performed each day in various departments of the company, employee time tickets are filled out by workers, collected, and forward to the accounting department. In the accounting department, wages are computed and the resulting costs are classified as either direct or indirect labor. This costing and classification for April resulted in the following summary entry:

(3)
Work in process Manufacturing overhead Salaries and wages payable 60,000 15,000 75,000 Dr. Dr. Cr.

Only direct labor is added to the work in process account. In this example, direct labor is $60,000 for April. At the same time the direct labor costs are added to work in process, they are also added to the individual job cost sheets, as shown in the Exhibit 1.2. During April, $40,000 of direct labor cost was charged to job 1 and the remaining $20,000 was charged to job 2. The labor cost charged to manufacturing overhead represent the indirect costs of the period, such as supervision, janitorial work, and maintenance.

Exhibit 1.2

Manufacturing Overhead Costs:

All costs of operating the factory other than direct materials and direct labor are classified as manufacturing overhead costs. These costs are entered directly into the manufacturing overhead account as they are incurred. To illustrate, assume that the company incurred the following general factory costs during April: Utilities (heat, water, and power) Rent on factory equipment Miscellaneous factory costs $21,000 16,000 3,000 -------Total $40,000 ======

The following entry records the incurrence of these costs:

(4)
Manufacturing overhead Accounts Payable 40,000 40,000 Dr. Cr.

In addition, let us assume that during April, the company recognized $13,000 in accrued property taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The following entry records these items:

(5)
Manufacturing overhead Property taxes payable Prepaid insurance 20,000 13,000 7,000 Dr. Cr. Cr.

Finally let us assume that the company recognize $18,000 in depreciation on factory equipment during April. The following entry records the accrual of this depreciation:

(6)
Manufacturing overhead Accumulated Depreciation 18,000 18,000 Dr. Cr.

In short, all manufacturing overhead costs are recorded directly into the manufacturing overhead account as they are incurred day by day through a period. It is important to understand that manufacturing overhead is a control account for many--perhaps thousands-of subsidiary accounts such as indirect materials, indirect labor, factory utilities, and so forth. As the manufacturing overhead account is debited for costs during a period the various subsidiary accounts are also debited. In this example we omit the entries to the subsidiary accounts for the sake of brevity.

Calculation of Predetermined Overhead Rate and Application of Manufacturing Overhead to Work in Process (WIP):
Since actual manufacturing costs are charged to the manufacturing overhead control account rather than work in process account. How are manufacturing costs assigned to work in process? The answer is, by means of the predetermined overhead rate. A predetermined overhead rate is established at the beginning of each year. The predetermined overhead rate is calculated by dividing the estimated total manufacturing overhead cost for the year by the estimated total units in the

allocation base (measured in machine hours, direct labor hours, or some other base). This rate is then used to apply overhead costs to jobs. To illustrate assume that the company has used machine hours to compute predetermined overhead rate and that this rate is $6 per machine hour. Also assume that during April, 10,000 machine hours were worked on Job 1 and 5,000 machine hours were worked on Job 2 (a total of 15,000 machine hours). Thus, $90,000 in overhead cost (15,000 machine hours $6 per machine hour = $90,000) would be applied to work in process. The following entry records the application of manufacturing overhead to work in process:

(7)
Work in process Manufacturing overhead 90,000 90,000 Dr. Cr.

The flow of cost through the manufacturing overhead account in Exhibit 1.3

Exhibit 1.3

The actual overhead cost in the manufacturing overhead account in Exhibit 1.3 are the costs that were added to the account in entries (2)--(6). Observe that the incurrence of these actual overhead costs and the application of overhead to work in process represents two separate and entirely distinct processes.

The Concept of Clearing Account:

The manufacturing overhead account operates as a clearing account. As we have noted, actual factory overhead costs are debited to the accounts as they are incurred day by day through the year. A certain intervals during the year, usually when a job is completed, overhead cost is applied to the job by means of the predetermined overhead rate, and work in process is debited and manufacturing overhead is credited. This sequence of events is illustrated below: Manufacturing Overhead (a clearing account) Actual overhead costs are charged to this Overhead is applied to work in process using account as they are incurred throughout the the predetermined overhead rate. period.

As we emphasized earlier, the predetermined overhead rate is based on estimates of what overhead costs are expected to be, and it is established before the year begins. As a result, the overhead cost applied during a year will almost certainly turn out to be more or less than the overhead cost that is actually incurred. For example, notice from Exhibit 1.3 that the company's actual overhead costs for the period are $5,000 greater than the overhead cost that has been applied to work in process (WIP), resulting in a $5,000 debit balance in the manufacturing overhead account. This debit balance in manufacturing overhead account is called under-applied overhead. Any credit balance in manufacturing overhead account is called over-applied overhead. Any balance in the manufacturing overhead account (under or over-applied overhead) is treated in one of the following ways:

1. Closed out to cost of goods sold 2. Allocated between work in process, finished goods, and cost of goods sold in

proportion to the overhead applied during the current period in the ending balance of these accounts.

These two methods are illustrated on Disposition of Under- or Over-applied Overhead Balances page. For the moment, we can conclude by nothing from Exhibit 1.3 that the cost of a completed job consists of the actual materials cost of the job, the actual labor cost of the job, and the overhead cost applied to the job. Pay particular attention to the following subtle but important point: Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the job cost sheet nor do they appear in the work in process account. Only the applied overhead cost, based on the predetermined overhead rate, appear on the job cost sheet and in the work in process account. Study this point carefully.

Non-manufacturing Costs:
In addition to manufacturing costs, companies also incur marketing and selling costs. These costs should be treated as period expenses and charged directly to the income statement and therefore should not go into the the manufacturing overhead account. To illustrate the correct treatment of non-manufacturing costs, assume that the company (in this example)

incurred $30,000 in selling and administrative salary costs during a months, the following entry records these salaries.

(8)
Salaries expense Salaries and wages payable 30,000 30,000 Dr Cr

Depreciation on factory equipment is debited to manufacturing overhead account but depreciation on office equipment is considered a period expense and is not included in manufacturing overhead. Assume that depreciation of office equipment during the month was $7,000. The entry is as follows.

(9)
Depreciation expense Accumulated depreciation 7,000 7,000 Dr Cr

Finally assume that advertising was $42,000 and that other selling and administrative expenses during the month was $8,000. The following journal entry records these items:

article Accounting isn't hard; students just like to make it seem that way. Accounting is simply a way to organize information, and make it useful for the people who have to manage a business, and make decisions. Managerial accounting reports don't have to follow GAAP because they are prepared for managers, not outside investors or creditors. A well designed accounting system should generate reports for a large variety of uses. Of course, it must provide the necessary information for annual financial statements; and it should also help in the preparation of special reports, like sales tax and payroll reports. It should help managers track and manage inventories, open orders, accounts receivable and accounts payable. Managers must make decisions on a daily basis. Annual financial statements are prepared well after the end of the year, and are useless for managing a businesses daily affairs. Managers must look forward to the near future, usually the coming week, month and year. Annual financials look backwards in time. The basic concepts and terms you learned in Chapter 16 will carry over through this chapter and the remainder of the course. Businesses use these concepts to prepare managerial reports, and analyze their business activities. There are two main types of cost accounting systems. Companies select a method that best matches the flow of work in their business. These methods are used to allocate all production

costs: labor, materials and overhead.

Job order costing - work is broken into jobs; auto mechanics, carpenters, painters, print shops, each job is tracked separately computer repair Process costing - a large quantity of identical auto assembly plants, hot dog manufacturing, any or similar products are mass produced large mechanized production facility

Each cost accounting system gathers and reports on the same information. The method used depends on the needs of the business.

Job Order Costing A job order costing system is used when a job or batch is significantly different from other jobs or batches. Cost accounting is usually fairly simple in these systems. Labor and materials are entered on a job ticket. Overhead is usually added to the amount the customer will be charged for labor and materials. If you go to an auto repair shop, they will start a job ticket just for the work to be done on your car. Your job ticket will show charges for labor and materials, just for your job. Let's say they charge you $35 per hour for labor. That charge includes the mechanic's payroll cost. But it also includes an overhead charge - which is generally not stated separately. The overhead charge covers the costs of operating the garage - tools and equipment, rent, insurance, maintenance, utilities, etc. It is a way to allocate overhead (discussed below), and build it in to the amount charged to customers. The garage will also make a gross profit on the parts they use to repair your car. This gross profit covers the cost of buying and maintaining a parts inventory, including department employee wages, insurance and warehousing costs.

Allocating Overhead Overhead is a large mixed group of costs that can't be directly traced to products. There are several methods of allocating overhead costs in a cost accounting system. ABC costing is one method. We will learn other, simpler methods as well.

Activity-based costing (ABC) - overhead costs are tracked activities that consume resources ABC Costing is covered in Chapter 18.

used primarily for allocating overhead that is hard to track to specific products or departments

Cost flow in an accounting system We say that costs flow through an accounting system. That is because they accumulate as the product progresses through the various stages of production. Let's look at a typical product. Before a product is started, no costs have been incurred. Workers stand ready to make the product, inventory waits patiently in the warehouse, and the manufacturing plant contains all the resources necessary to perform the manufacturing operation. We first add materials into production, from the inventory. At the same time the accounting department transfers the cost of inventory items to the Work in Process account, and the product or job now has a value. Next the workers start to convert the raw inventory into a product. As labor is added, the accounting department transfers payroll costs to the Work in Process account, increasing the value of the product or job. Overhead costs are allocated to the product or job, based on the costing method used. As work progresses on the product or job, it accumulates labor, materials and overhead costs. Finally, the total finished product or job cost is transferred to Finished Goods, and when it is sold the cost is transferred to Cost of Goods Sold.

Accounting Overhead Costs Overhead is allocated to products or jobs using a reasonable allocation method. We try to find some part of the manufacturing process that is regular and predictable. We call this a cost driver. Labor hours used is the most popular allocation method. The number of labor hours in a year are fairly predictable. Differences in employees pay rates are not relevant when using hours. The information is readily available from existing payroll records. There is usually a direct correlation between labor and the production process. Labor dollars is the second most popular allocation method. It is used by very large companies, with large work forces operating under labor contracts. The labor costs are fairly predictable, and are closely linked to production. Because of the large number of employees, labor dollars tends to be a very stable and predictable measure of the progress of production. Other overhead methods include: number of units produced, machine hours use (jet engines, diesel locomotives), square footage of floor space (heating, cooling & janitorial costs), miles (taxis, trucking)

Some companies use a sophisticated method involving service departments such as maintenance and computer processing. These departments provide services to other departments. Service

departments are widely used in hospital accounting.

Simple Overhead Allocation The simplest form of overhead allocation is to treat all annual overhead as a single cost pool, and allocate it to one annual cost driver. Assume Johnson's Bakery produces 2,000,000 loaves of bread per year, and incurs $60,000 in annual overhead cost. How much overhead cost must Johnson allocate to each loaf of bread?

Total Annual Overhead -----------------------Units of Cost Driver $60,000 -----------------------2,000,000 loaves

= one $ unit of cost driver

= 3 cents per loaf

In addition to direct costs (labor & materials), Johnson will allocate 3 cents per loaf to overhead costs. Decision making using overhead costs Assume Johnson's Bakery must lease a new oven for $20,000 per year, to replace an old oven. Direct costs per loaf will not change. Johnson charges all Lease costs to the Overhead account. All other overhead costs will stay the same. How will the new oven lease change Johnson's overhead costs?

$60,000 + $20,000 ------------------------ = 4 cents per loaf 2,000,000 loaves Johnson's overhead cost per loaf will increase 1 cent, from 3 cents to 4 cents.

Another Example Wilson's Garage has 6 mechanics working full time, 2,000 hours per year each, for a total of 12,000 hours that will be billed to jobs. They incur $60,000 per year in overhead costs. Wilson allocates overhead costs to car repair jobs, based on the number of hours worked on each job. How much will Wilson allocate per labor hour?

$60,000 = $5.00 overhead per labor hour

-----------------------12,000 hours Wilson's Garage will allocate $5.00 per labor hour for overhead. Example of Overhead Allocation to a Job Wilson's Garage works on the delivery truck belonging to Johnson's Bakery. The job takes 2 hours. How much overhead cost will Wilson's allocate to this job? overhead per labor hour X labor hours on job = overhead allocated to job $5.00 x 2 = $10.00 Wilson's Garage will allocate $10.00 in overhead costs to the repair job. Why don't you see Overhead costs listed separately on repair tickets? Customers usually don't understand what overhead costs are, or why they are important for a business. Overhead costs are generally "built in" to other costs. Wilson's Garage will add the overhead cost to it's regular labor rate. Since overhead is allocated by labor hour, this is an easy method for a garage, or similar types of businesses. Overhead costs are generally "hidden" from customers in this way, but the company must charge the customer for these costs in some way.