2.1: Introduction to Job Order Costing

Job order costing is a method of keeping track of the costs of manufactured items. Once products are completed, their overall costs are marked up and sold at a profit to customers.

Job order costing is a method of cost accumulation that is used for items or batches of items that are unique – that is, each customer’s order is different. Custom-made kitchen cabinets are an example of a manufactured product that is often customer-specific. Each order is based on different sizes, layouts, wood choices, finishes, hardware, installation costs, customer preferences, etc. No two orders are alike, so the total cost of each order will differ as a result. A single order might involve a homeowner updating her kitchen for a new look. A batch order might be processed for a home builder who is constructing 10 identical homes and therefore requires 10 of the same sets of cabinets. Each single or batch order is referred to as a job and is assigned a unique identification number, such as “Job 15”.

Costs accumulate on manufactured goods while they are in production. The three costs of production are direct materials, direct labor, and factory overhead. For unique products, each job accumulates different amounts of each of these three costs. An analogy would be several patients in a doctor’s office - each person has different symptoms and therefore receives different treatments, medications, and tests from the same doctor. Each person’s total medical bill is like a “tab” that the patient has run up with the doctor.

The three costs of production accumulate in an account called Work in Process, which is like the ‘tab” for the manufactured item. There are three debits to Work in Process - one for direct materials, one for direct labor, and one for factory overhead – as a result. The total of these three costs equals the cost of producing the item.

The following Work in Process ledger for a single order assumes there is no beginning inventory and illustrates the three debits that represent the three costs of production.

Work in Process

Date	Item	Debit	Credit	Debit	Credit
1.	Materials moved to production	5,000		5,000
2.	Labor added to production	4,000		9,000
3.	Overhead added to production	1,100		10,100

The total cost of this job is $10,100, as is shown in the final debit balance in Work in Process ledger.

A manufacturer may work on many jobs simultaneously. Even if several jobs are started at once, it does not necessarily mean that they will all be completed at the same time. In job order costing, each job is typically worked on at its unique location on the production floor as material and labor come to the products, which remain in place.

The following series of journal entries describe and illustrate job order costing transactions that are specific to accumulating the three costs of production: materials, labor, and factory overhead.

1. Direct materials become an integral part of a manufactured product that is sold to a customer. They are requisitioned (asked for) and brought from the stockroom to the production area so that they can be worked on.

   Materials that cost $5,000 are requisitioned from the stockroom. This journal entry represents the first of the three debits to the Work in Process account.

   Account	Debit	Credit	First debit to Work in Process
   Work in Process	5,000		▲ Work in Process is an asset (inventory) account that is increasing
   Materials		5,000	▼ Materials is an asset (inventory) account that is decreasing

   The wood, hinges, etc. that are considered direct materials are moved from the Materials account (by crediting and reducing it) to the Work in Process account (by debiting it and increasing it.) Work in Process is the asset account in which the cost of the manufactured item accumulates, and materials is the first of the three production costs.

2. Direct labor involves work done directly by factory laborers on manufactured items that are sold to customers. This journal entry represents the second of the three debits to the Work in Process account. In this case, direct labor is $4,000.

   Account	Debit	Credit	Second debit to Work in Process
   Work in Process	4,000		▲ Work in Process is an asset (inventory) account that is increasing
   Wages Payable		4,000	▲ Wages Payable is a liability account that is increasing

   Labor in the factory includes the hourly wages paid to production workers. It is considered direct if a production employee is working on a product that will be sold to a customer. Direct labor costs are added to Work in Process by debiting that account and increasing it. Work in Process is the asset account in which the cost of the manufactured item accumulates, and labor is the second of the three production costs.

   FACTORY OVERHEAD INCURRED

   The following six entries represent transactions that are recorded as debits to the Factory Overhead account. This account is used to record all factory expenses except direct materials and direct labor. Rather than Supplies Expense,Maintenance Expense, Depreciation Expense, Insurance Expense, Wages Expense (indirect), etc., the Factory Overhead account is used to substitute for any expense incurred in the factory. Factory overhead costs are indirect because they cannot be specifically traced to particular jobs, but are instead incurred in the factory as a whole. Factory Overhead is debited (increased) for any actual overhead cost incurred. While these expenses are in the Factory Overhead account, they are not yet part of any of the manufactured items.

3. The company uses $400 of its raw materials to build a closet in the factory.

   Account	Debit	Credit	Recording an expense in the factory as Factory Overhead
   Factory Overhead	400		▲ Factory Overhead is an expense account that is increasing
   Materials		400	▼ Materials is an asset (inventory) account that is decreasing

   Materials, such as wood, may be requisitioned for general factory use. These materials are considered an indirect cost since they do not become part of a manufactured item. Materials is credited just like it was for the requisition of direct materials. In this case, Factory Overhead is debited for the indirect materials rather than Work in Process.

   Supplies Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for a Factory Overhead.

4. Wages of $300 are incurred for production employees building a closet in the factory.

   Account	Debit	Credit	Recording an expense in the factory as Factory Overhead
   Factory Overhead	300		▲ Factory Overhead is an expense account that is increasing
   Wages Payable		300	▲ Wages Payable is a liability account that is increasing

   If the same production employees also perform some general factory work, such as hanging the wood shelves, the labor is considered indirect since the time is not spent working on an actual manufactured item. Wages Payable is credited just like it was for the direct labor. In this case, Factory Overhead is debited for the indirect labor rather than Work in Process.

   Wages Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for a Factory Overhead.

5. The company pays $350 cash for one of its utility bills.

   Account	Debit	Credit	Recording an expense in the factory as Factory Overhead
   Factory Overhead	350		▲ Factory Overhead is an expense account that is increasing
   Cash		350	▼ Cash is an asset account that is decreasing

   Factory Overhead is debited rather than Utilities Expense since the expense occurs in the factory.

6. The company receives an invoice for $200 from a repairman who fixed a leak in the factory building.

   Account	Debit	Credit	Recording an expense in the factory as Factory Overhead
   Factory Overhead	200		▲ Factory Overhead is an expense account that is increasing
   Accounts Payable		200	▲ Accounts Payable is a liability account that is increasing

   Factory Overhead is debited rather than Maintenance Expense since the expense occurs in the factory.

7. $150 of the prepaid insurance that the company paid in advance expires.

   Account	Debit	Credit	Recording an expense in the factory as Factory Overhead
   Factory Overhead	150		▲ Factory Overhead is an expense account that is increasing
   Prepaid Insurance		150	▼ Prepaid Insurance is an asset account that is decreasing

   Factory Overhead is debited rather than Insurance Expense since the expense occurs in the factory.

8. The company records depreciation on factory equipment.

   Account	Debit	Credit	Recording an expense in the factory as Factory Overhead
   Factory Overhead	150		▲ Factory Overhead is an expense account that is increasing
   Accumulated Depreciation		150	▲ Accumulated Depreciation is a contra asset account increasing

   Factory Overhead is debited rather than Depreciation Expense since the expense occurs in the factory.

   Factory expenses accumulate in the Factory Overhead account, as just shown in the journal entries (3) through (8). Notice that the Work in Process was not used at all in these transactions, so at this point the third cost of manufacturing has not been added to the cost of any job yet.

   Assuming there were no previous balances in the Work in Process or Factory Overhead accounts, their ledgers would appear as follows based on the previous eight transactions:

   Work in Process

   Date	Item	Debit	Credit	Debit	Credit
   1.	Materials moved to production	5,000		5,000
   2.	Labor added to production	4,000		9,000

   Factory Overhead

   Date	Item	Debit	Credit	Debit	Credit
   3.	For indirect materials	400		400
   4.	For indirect labor	300		700
   5.	For utilities	350		1,050
   6.	For maintenance	200		1,250
   7.	For insurance	150		1,400
   8.	For depreciation	100		1,500

   So far there are only two entries in the Work in Process ledger account. The third cost of production, factory overhead, must be added (or “applied”) to Work in Process to arrive at the total cost of the job(s). This final debit to Work in Process allocates an estimated amount of the factory expenses from the Factory Overhead account to the cost of each unit manufactured.

   Since all expenses associated with the period may not yet be determined and all bills not yet received, actual factory overhead is not yet known. The running balance of $1,500 shown may be incomplete since more bills may be outstanding. The company needs timely information about the cost of each job, so factory overhead is estimated at the time it is applied to Work in Process.

   Also, since factory overhead cannot be specifically traced to a particular job, it is instead allocated to jobs using an activity base that estimates its consumption. Each company uses a method of estimating that makes sense for them, so the process can vary among companies. Three common activity bases used to allocate factory overhead costs are (1) a percentage of direct labor cost (such as $1,500 x 20%) or the (2) number of direct labor hours or (3) number of machine hours. When units such as hours are used, a predetermined factory overhead rate is multiplied by the number of hours. The predetermined factory overhead rate equals estimated total factory overhead costs divided by the estimated number of hours in the activity base.

   In this example, assume total estimated factory overhead is $2,000. It will be allocated, or applied to jobs, using a predetermined factory overhead rate that uses an activity base of an estimated 200 direct labor hours. Therefore, $2,000 / 200 = a factory overhead rate of $10 per direct labor hour.

   If 110 direct labor hours were actually used in this period’s operations, factory overhead applied to Work in Process would be $1,100 (110 hours x $10 per direct labor hour). The journal entry that follows reflects this third cost of production being added to the Work in Process and removed from the Factory Overhead account using this estimating process.

   1. The company applied $1,100 of factory overhead to jobs in production.

      Account	Debit	Credit	Second debit to Work in Process
      Work in Process	1,100		▲ Work in Process is an asset (inventory) account that is increasing
      Factory Overhead		1,100	▼ Factory Overhead is an expense account that is decreasing

      The Factory Overhead account is reduced by crediting it, and that expense amount is moved into the Work in Process (asset) account by debiting it.

      This journal entry represents the third of the three debits to the Work in Process account.

      As shown in the ledger accounts that follow, there are now three entries in the Work in Process ledger account. The third cost of production, factory overhead, has been added (or “applied”) to Work in Process to arrive at the total cost of the job(s).

      Work in Process

      Date	Item	Debit	Credit	Debit	Credit
      1.	Materials moved to production	5,000		5,000
      2.	Labor added to production	4,000		9,000
      3.	Overhead added to production	1,100		10,100

      Factory Overhead

      Date	Item	Debit	Credit	Debit	Credit
      3.	For indirect materials	400		400
      4.	For indirect labor	300		700
      5.	For utilities	350		1,050
      6.	For maintenance	200		1,250
      7.	For insurance	150		1,400
      8.	For depreciation	100		1,500
      3.	Overhead added to production		1,100	400

      The total cost of this manufactured item is the three debits to Work in Process: $5,000 for direct materials plus $4,000 for direct labor plus $1,100 for factory overhead, totaling $10,100.

      ANALOGY

      Assume three people go out on a Friday night (separately). Each will eat dinner, have some drinks, and enjoy some entertainment – the three costs of going out. Yet the food, beverages, and entertainment will be different for each person, and, therefore, the costs will not be the same. Each person has a “tab” – first the food, then the drinks, then the entertainment – that adds up to the final cost of the night out.

      Similarly, different products manufactured under job order costing each have a “tab” on which their three costs – direct materials, direct labor, and factory overhead – accumulate. The costs are different for each product, so the final total for each is different as well.