What is Job Order Costing? Definition & How to Calculate
Every business needs a way to track how much it costs to develop its products or deliver its services, which in turn helps the business determine how to price the products and services for profitability.
One of the methods used to keep track of product costs is job order costing. In this article, we’re going to look at the definition of job order, its importance, how to calculate job order costs, and everything else you need to know about job order costing.
Definition of Job Order Costing
Job order costing is a bookkeeping method that is used to determine how much it costs a business to manufacture an individual unit of output.
For instance, if your company does outdoor branding for businesses, job order costing allows you to determine the cost of creating every single billboard, banner, signboard, or art installment.
Job order costing is used primarily by businesses that produce products or services that are significantly different from each other based on the customer’s requirements, resulting in significantly different production costs for each.
For instance, when producing an animation film, a movie producer needs computer programmers, voice over artists, animation professionals, musical composers, and so on. When producing an action thriller, they’ll need actors, shooting locations, stuntmen, set design, and so on.
While both of these jobs are film productions, their requirements are completely different. In such a situation, job order costing is the best system for tracking the cost of production.
Job order costing usually considers three factors – direct material costs, direct labor costs, and overhead costs.
Importance of Job Order Costing
Job order costing provides a lot of benefits to businesses, including…
1. Determining Profitability
By helping businesses keep track of all the costs involved in getting a particular job done, job order costing makes it possible for businesses to determine the profit margin they are getting for that particular job.
With job order costing, it becomes easy for a company to quote prices that ensure profitability for the company, but low enough to give the company an edge over its competitors.
2. Performance Monitoring
Since job order costing looks at all aspects of production, including labor costs, it can help a business determine the productivity and performance levels of individual employees.
For instance, if one employee takes 10 hours to get a task done, while another employee takes 15 hours to get a similar task done, this is an indicator that the second employee is not working at optimum productivity.
Armed with this information about performance and productivity, it becomes possible to lower production costs by coming up with plans to improve the productivity of employees who do not meet performance expectations.
3. Making Data-Driven Decisions
The job order costing system provides businesses with tons of data about what goes into getting each job done. Over time, this data can be analyzed to derive insights on how the company can make its production processes more efficient and cost-effective.
4. Keep Track of Indirect Costs
While some costs do not go directly into creating a product or delivering a service, they still need to be taken care of. Without a good system for tracking these costs, they don’t get factored into the price, which then means that they’ll have to be deducted from profits.
Using the job order costing method makes it possible for businesses to keep track of these indirect costs, such as the salaries of employees working on the project, electricity costs, and so on.
When you know the value of these costs, it becomes possible to factor them when setting your prices.
5. Allows Real-Time Monitoring
Job order costing allows businesses to monitor the process of production in real-time. This way, any potential issues, such as going over the budget can be identified and corrected while production is still ongoing.
How To Calculate Job Order Costs
The process of calculating job order costs involves the following 6 steps:
1. Job Identification
The job order costing process starts with the identification of requirements for a particular job. This step lays the foundation that will be used as a basis for estimating the costs of getting the job done.
For instance, let’s say you are printing banners for a customer. First, you need to know the number of banners your client wants.
This will inform the number of canvas sheets needed, how much time you need to print that number of banners, the amount of ink required, and the number of employees who will be involved in this job.
You’ll also need to be aware of the capacity of your printing machines, how much electricity each machine consumes with each run, and any other necessities, such as ink cartridges and printing heads.
2. Cost Calculation
Once you know what is required for the job, you can then go ahead and calculate the expected costs for the job. The costs here will fall under two categories – direct and indirect costs.
The direct costs are those that are directly involved in this particular job. These include things like the cost of canvas sheets, ink, and the labor costs of employees who are directly involved in the project.
The indirect costs are those that are not directly involved in this particular job, such as the rent paid on the premises, labor costs of personnel not directly involved in the project (such as sales people, HR, etc.), utility costs, and so on.
Combining both direct and indirect costs will give you a fairly accurate estimation of how much it will cost you to complete this job for your client.
3. Determine The Allocation Base
Determining the indirect costs of a job before it is done can be very difficult, since these costs will vary from one job to the next.
To make it easier to calculate total cost, the indirect costs are given as an estimate based on previous jobs that were similar to the current job. The exact costs can then be adjusted after the job has been done.
The indirect costs estimated here include utility costs, electricity costs, cost of acquiring machines, as well as machine depreciation costs.
4. Receiving The Order
Having calculated the expected costs for the project, you can now go ahead and come up with a quote for the job and share it with your client.
Once the client confirms that they are comfortable with the quote and goes ahead to place the order, you can now start working on the job.
To keep track of a particular job and the costs associated with this job, you need to assign a unique production number to the project, which will be used until the project is completed.
5. Keeping Record of Job Cost Sheets
The source documents for the job cost sheet are material requisition slips, labor time tickets, and the predetermined overhead rate.
Keeping track of the expenses will help you determine whether the actual job costs are significantly different from your projections.
A huge difference between estimated costs and actual costs is an indicator that you have an ineffective cost estimation process, or an inefficient production process.
The good thing is that by comparing your estimated cost to the costs on your job cost sheet, you can easily identify what is costing more than you expected and make changes to bring down the costs, or make changes to your cost estimation process.
6. Revising The Costs
Finally, after you have completed the job, it’s now time to make adjustments to your initial estimations based on the actual cost spent on the project. Remove any inaccurate estimations and replace them with the actual amounts spent.
Once you’re done with this step, you’ll have an accurate idea of the final cost of production. With this, you can then determine whether the job was profitable or not based on your quote to the client.
You’ll also have a better idea of the costing for such a project, which will help you come up with more accurate estimations for similar projects in future.
Job Order Costing vs Process Costing
Very often, job order costing is confused with process costing. This is because both are systems used to determine the cost of producing a product or delivering a service. However, these two do not refer to the same thing.
The main difference between job order costing and process costing is the situations in which they are applied. Job order costing is used in situations where clients require customized products, which means that each product or each unit of output is unique.
Process costing, on the other hand, is used in situations where all the products being manufactured are similar.
For instance, when manufacturing the iPhone 12, the production costs for Apple are the same for each unit of the iPhone. In such situations, the best method for tracking production costs is process costing.
Another key difference between process costing and job order costing is the level of record keeping. Job order costing requires that the cost of each aspect of production is recorded separately.
With process costing, on the other hand, since the cost doesn’t keep changing from one product to the next, there isn’t need for such a high level of record keeping.
Actual Costing vs Normal Costing
Actual costing is a form of job order costing where all the direct and indirect costs of a job or project are tracked based on the actual costs incurred in the job.
Each cost is tracked as the project progresses. If an item is taken out of storage and used on the job, the item’s cost is noted down as the actual cost.
Labor costs are calculated based on the number of hours each employee has worked on the project so far and their hourly rate, while overhead costs are calculated as the project progresses.
Actual costing is a simplistic and accurate way of keeping track of job costs. However, this type of job order costing is not commonly applied in the business world due to the difficulty of determining the actual costs of a project in real-time, especially for overhead costs.
In most cases, the actual costs of a job order or project are only known after the job has been completed.
Due to how difficult it is to use actual costing, most businesses opt for a different system known as normal costing. Normal costing allows businesses to come up with a close approximation of the project costs in a timely manner.
When using normal costing, the business keeps track of the direct material costs and direct labor costs just like they would under actual costing. However, the overhead costs, which are difficult to track in real-time, are calculated using predetermined estimates that are based on previous projects.
Job Order Costing FAQ
Job order costing is used by companies that are required to produce unique, customized outputs every single time.
Examples of companies that use job order costing include construction companies, law businesses, accounting firms, consulting firms, hospitals, movie producers, and so on.
For each of these companies, the requirements of one client will differ significantly from those of the next client, making it impossible for such companies to use process costing.
Job order costing is an accounting technique that allows managers to compare the revenue gained from a job against the labor, material, and overhead costs incurred during the production process.
This, in turn, helps managers to determine the profit earned from individual jobs and makes it easier for them to make decisions on whether specific jobs should be pursued in future or not.
Despite all its benefits, job order costing is not without its drawbacks. First, it involves a lot of paperwork, since every single expense has to be tracked. This creates the need for more clerical staff to deal with this paperwork, which in turn results in more overheads for the company.
Second, applying job order costing can be difficult in practice because of how difficult it is to accurately measure all expenses incurred on a particular job.
Job order costing also makes mistakes very expensive. Since job order costing relies on previous jobs to make cost estimates for overhead costs, a mistake made on one job will be carried on to the next job, resulting in inaccurate projections on multiple jobs.
Job order costing should be used when each product being manufactured is unique, or when each customer has specific requirements on how they want the job done. In such situations, each unit produced is considered to be considered to be a new job.