A Job-order Costing System That Relies On Normal Costing Will

A Job-Order Costing System That Relies on Normal Costing: A Comprehensive Guide

Job-order costing is a method used to track the costs associated with individual projects or jobs. It's particularly useful for businesses that produce unique or customized products or services, such as construction companies, advertising agencies, or custom furniture makers. Within job-order costing, normal costing offers a streamlined approach, balancing accuracy with efficiency. This article delves deep into a job-order costing system that relies on normal costing, exploring its mechanics, advantages, limitations, and practical applications.

Understanding Job-Order Costing

At its core, job-order costing assigns costs to specific projects. Each job receives a unique identifier, allowing for meticulous tracking of all direct materials, direct labor, and manufacturing overhead incurred. This detailed breakdown enables precise cost analysis for each individual project, providing valuable insights for pricing, profitability analysis, and performance evaluation. Think of it like keeping a detailed ledger for every single project undertaken.

Key Components of Job-Order Costing:

• Direct Materials: These are the raw materials directly used in producing a particular job. This is easily traceable, like the lumber used in a custom-built cabinet.
• Direct Labor: This comprises the wages and salaries of employees directly involved in the production process. This includes the carpenter's wages for the same cabinet.
• Manufacturing Overhead: This encompasses all indirect costs associated with production, including factory rent, utilities, depreciation of equipment, and indirect labor (like the factory supervisor's salary). This isn't directly traceable to a single job but is still crucial to the overall cost.

Integrating Normal Costing into the Job-Order System

Normal costing streamlines the job-order costing process by using predetermined overhead rates. Instead of calculating the actual overhead costs for each job after completion, a predetermined rate is applied throughout the production process. This simplifies accounting and provides more timely cost information.

Calculating the Predetermined Overhead Rate (POHR):

The POHR is calculated at the beginning of the accounting period (usually annually) based on anticipated overhead costs and a chosen allocation base (like direct labor hours, machine hours, or direct materials cost). The formula is:

Predetermined Overhead Rate (POHR) = Budgeted Manufacturing Overhead Costs / Budgeted Allocation Base

For example, if a company budgets $100,000 in manufacturing overhead and expects 10,000 direct labor hours, the POHR would be $10 per direct labor hour ($100,000 / 10,000 hours).

Applying the POHR:

Throughout the production process, the predetermined overhead rate is applied to each job based on its actual consumption of the allocation base. So, if a job consumes 500 direct labor hours, the manufacturing overhead assigned to that job would be $5,000 (500 hours * $10/hour).

The Job Cost Sheet: The Heart of the System

The job cost sheet is a crucial document in a job-order costing system. It serves as a detailed record of all costs associated with a particular job. The sheet typically includes:

• Job Number: A unique identifier for each job.
• Description of the Job: A clear description specifying the nature of the work undertaken.
• Direct Materials Used: A detailed list of all direct materials and their respective costs.
• Direct Labor Hours: The total number of direct labor hours spent on the job.
• Direct Labor Cost: The total cost of direct labor used on the job.
• Manufacturing Overhead Applied: The overhead cost applied using the predetermined overhead rate.
• Total Job Cost: The sum of all direct materials, direct labor, and applied manufacturing overhead costs.

Advantages of Using Normal Costing in Job-Order Costing

• Timeliness of Information: The use of a predetermined overhead rate allows for the calculation of job costs during production, rather than waiting until the end of the accounting period. This provides managers with timely information for decision-making, pricing, and monitoring project profitability.
• Simplicity and Efficiency: Normal costing simplifies the accounting process by eliminating the need for complex calculations for overhead allocation for each individual job. It is more efficient than actual costing, especially for businesses with numerous projects.
• Improved Cost Control: By comparing actual overhead costs to the budgeted amount at the end of the period, variances can be identified and investigated. This leads to better cost control and efficiency improvements.
• Cost Estimation for Future Projects: The POHR, derived from careful budgeting, provides a basis for estimating costs for future projects, leading to more accurate bidding and pricing.

Limitations of Using Normal Costing in Job-Order Costing

While offering significant advantages, normal costing isn't without its drawbacks:

• Potential for Inaccuracy: The accuracy of the job costs depends on the accuracy of the budgeted overhead costs and the chosen allocation base. Significant deviations between budgeted and actual overhead costs can lead to inaccurate job costs.
• Over- or Under-Applied Overhead: At the end of the accounting period, the actual overhead costs are compared to the overhead costs applied using the POHR. If there's a difference, it's known as over- or under-applied overhead. This requires adjustment, which can complicate the accounting process.
• Lack of Granularity: Normal costing provides less detailed cost information compared to actual costing. The detailed cost analysis associated with each job is less precise.

Addressing Over- or Under-Applied Overhead

The presence of over- or under-applied overhead indicates a discrepancy between budgeted and actual overhead costs. This discrepancy needs to be addressed at the end of the accounting period through one of the following methods:

• Proration: This involves distributing the over- or under-applied overhead proportionately among work-in-process (WIP), finished goods, and cost of goods sold (COGS). This is often the most common approach, but it can introduce inaccuracies depending on how significantly each account has been affected.
• Direct Write-Off: This method simply writes off the over- or under-applied overhead to cost of goods sold. This is simpler than proration but can distort the cost of goods sold if the variance is significant.

The choice between proration and direct write-off depends on the materiality of the over- or under-applied overhead. If the amount is small and insignificant, a direct write-off may be preferred for its simplicity. For larger variances, proration offers a more accurate allocation.

Practical Application and Examples

Let’s illustrate normal costing within a job-order costing system with an example:

ABC Construction Company undertakes two jobs during the year:

• Job 1: Building a small residential house
• Job 2: Renovating a commercial building

Budgeted Data:

• Budgeted manufacturing overhead: $200,000
• Budgeted direct labor hours: 10,000 hours

Calculated POHR: $20 per direct labor hour ($200,000 / 10,000 hours)

Actual Data:

Job	Direct Materials	Direct Labor Hours	Direct Labor Cost
Job 1	$50,000	1,000	$20,000
Job 2	$100,000	2,000	$40,000
Total	$150,000	3,000	$60,000

Applying Overhead:

• Job 1: 1,000 hours * $20/hour = $20,000
• Job 2: 2,000 hours * $20/hour = $40,000

Job Cost Sheets:

• Job 1: $50,000 (Direct Materials) + $20,000 (Direct Labor) + $20,000 (Overhead) = $90,000 (Total Job Cost)
• Job 2: $100,000 (Direct Materials) + $40,000 (Direct Labor) + $40,000 (Overhead) = $180,000 (Total Job Cost)

Actual Overhead: Let's assume the actual overhead incurred was $65,000. This results in $15,000 of under-applied overhead ($65,000 - $60,000). This under-applied overhead would then need to be allocated using either proration or direct write-off.

Conclusion: Choosing the Right Costing System

The decision of whether to use a job-order costing system relying on normal costing depends on the specific needs and characteristics of a business. While it offers advantages in terms of timeliness and efficiency, its reliance on estimations means there's a potential for inaccuracies. Businesses should carefully weigh the advantages against the limitations and choose the system that best aligns with their operational characteristics and tolerance for potential errors. A thorough understanding of the system's mechanics, limitations, and the methods for addressing overhead variances is crucial for effective implementation and accurate cost management. Regular review and refinement of the budgeting process and allocation base are essential for improving the accuracy and reliability of the job costing system.