Job Costing: Evaluation and Implementation

Learning Objective 3 Describe the approaches to evaluating and implementing job-costing systems

• to determine costs of jobs in a timely manner

We will illustrate job costing using the example of the Robinson Company, which manufactures and installs specialized machinery for the paper-making industry. In early 2020, Robinson receives a request to bid on the manufacturing and installation of a new paper-making machine for the Western Pulp and Paper Company (WPP). Robinson has never made a machine quite like this one, and its managers wonder what to bid for the job. In order to make decisions about the job, Robinson’s management team works through the five-step decision-making process.

1. IDENTIFY THE PROBLEMS AND UNCERTAINTIES. The decision of whether and how much to bid for the WPP job depends on how management resolves two critical uncertainties: (1) what it will cost to complete the job and (2) the prices Robinson’s competitors are likely to bid.
2. OBTAIN INFORMATION. Robinson’s managers first evaluate whether doing the WPP job is consistent with the company’s strategy. Do they want to do more of these kinds of jobs? Is this an attractive segment of the market? Will Robinson be able to develop a competitive advantage over its competitors and satisfy customers such as WPP? After completing their research, Robinson’s managers conclude that the WPP job fits well with the company’s strategy and capabilities.

1. Robinson’s managers study the drawings and engineering specifications provided by WPP and decide on the technical details of the machine. They compare the specifications of this machine to similar machines they have made in the past, identify competitors that might bid on the job, and gather information on what these bids might be.

3. MAKE PREDICTIONS ABOUT THE FUTURE. Robinson’s managers estimate the cost of direct materials, direct manufacturing labor, and overhead for the WPP job. They also consider qualitative factors and risk factors and evaluate any biases they might have. For example, do engineers and employees working on the WPP job have the necessary skills and technical competence? Would they find the experience valuable and challenging? How accurate are the cost estimates, and what is the likelihood of cost overruns? What biases do Robinson’s managers have to be careful about?
4. MAKE DECISIONS BY CHOOSING AMONG ALTERNATIVES. Robinson’s managers consider several alternative bids based on what they believe competing firms will bid, the technical expertise needed for the job, business risks, and other qualitative factors. Ultimately Robinson decides to bid $15,000. The manufacturing cost estimate is $9,800, which yields a markup of more than 50% on the manufacturing costs.
5. IMPLEMENT THE DECISION, EVALUATE PERFORMANCE, AND LEARN. Robinson wins the bid for the WPP job. As Robinson works on the job, management accountants carefully track all of the costs incurred (which are detailed later in this chapter). Ultimately, Robinson’s managers will compare the predicted costs against actual costs to evaluate how well the company did on the WPP job.

In its job-costing system, Robinson accumulates the costs incurred for a job in different parts of the value chain, such as manufacturing, marketing, and customer service. We focus here on Robinson’s manufacturing function (which also includes the installation of the paper-making machine at the customer site). To make a machine, Robinson purchases some components from outside suppliers and makes other components itself. Each of Robinson’s jobs also has a service element: installing a machine at a customer’s site and integrating it with the customer’s other machines and processes.

One form of job-costing that Robinson can use is actual costing where direct costs are traced to a cost object based on the actual direct-cost rates times the actual quantities of the direct-cost inputs used. Indirect costs are allocated based on the actual indirect-cost rates times the actual quantities of the cost-allocation bases used or incurred. An actual indirect-cost rate is calculated by dividing the actual annual indirect costs by the actual (total) annual quantity of the cost-allocation base.

As its name suggests, actual costing systems calculate the actual costs of jobs. Yet actual costing systems are not commonly found in practice because actual costs can usually not be computed in a timely manner.^* The problem is not with computing direct-cost rates for direct materials and direct manufacturing labor. For example, Robinson records the actual prices paid for materials. As it uses these materials, the prices paid serve as actual direct-cost rates for charging material costs to jobs. As we discuss next, calculating actual indirect-cost rates on a timely basis each week or each month is, however, a problem. Robinson can only calculate accurate actual indirect-cost rates at the end of the fiscal year. However, the firm’s managers are unwilling to wait that long to learn the costs of various jobs because they need cost information to monitor and manage the costs of jobs while they are in progress. Ongoing cost information about current jobs also helps managers estimate the costs of and prepare competitive bids for new jobs.

Time Period Used to Compute Indirect-Cost Rates

There are two reasons for using longer periods, such as a year, to calculate indirect-cost rates.

1. THE NUMERATOR REASON (INDIRECT-COST POOL). The shorter the period, the greater the influence of seasonal patterns on the amount of costs in a cost pool. For example, if indirect-cost rates were calculated each month, the costs of heating (included in the numerator) would be charged to production only during the winter months. Collecting indirect costs over an annual period incorporates the effects of all four seasons into a single, annual indirect-cost rate.

1. Levels of total indirect costs are also affected by nonseasonal erratic costs. Nonseasonal erratic costs are costs incurred in a particular month that benefit operations in future months, such as equipment-repair costs and the costs of vacation and holiday pay for employees. If monthly indirect-cost rates were calculated, the jobs done in a month in which there were high, nonseasonal erratic costs would be charged with these higher costs. Pooling all indirect costs together over the course of a full year and calculating a single annual indirect-cost rate helps smooth some of the erratic short-term bumps in costs.

2. THE DENOMINATOR REASON (QUANTITY OF THE COST-ALLOCATION BASE). Another reason for calculating indirect-cost rates over longer periods is to avoid spreading monthly fixed indirect costs over fluctuating levels of monthly output and fluctuating quantities of the cost-allocation base. Consider the following example.

Reardon and Pane is a firm of tax accountants whose work follows a highly seasonal pattern. Tax season (January–April) is very busy. Other times of the year are less busy. The firm has both variable indirect costs and fixed indirect costs. Variable indirect costs (such as supplies, power, and indirect support labor) vary with the quantity of the cost-allocation base (direct professional labor-hours). Monthly fixed indirect costs (depreciation and general administrative support) do not vary with short-run fluctuations in the quantity of the cost-allocation base:

Variable indirect costs change in proportion to changes in the number of direct professional labor-hours worked. Therefore, the variable indirect-cost rate is the same in both the high-output months and the low-output months ($12.50 in both as the table shows). (At times, overtime payments could cause the monthly variable indirect-cost rate to be higher in high-output months.)

Now consider the fixed costs of $60,000. Reardon and Pane chooses this level of monthly fixed costs for the year recognizing that it needs to support higher professional labor-hours during some periods of the year and lower professional labor-hours during other periods. The fixed costs cause monthly total indirect-cost rates to vary considerably—from $31.25 per hour to $87.50 per hour. Few managers believe that identical jobs done in different months should be allocated such significantly different indirect-cost charges per hour ( $\$\mathrm{87.50\; \ }÷\; \ \$\mathrm{31.25\; \ }=\ \mathrm{2.80\; \ }$, or 280%). Furthermore, if fees for preparing tax returns are based on calculated costs, fees would be high in low-output months leading to lost business, when in fact management wants to accept more business to use the idle capacity during these months (for more details, see Chapter 9). Reardon and Pane chose a specific level of capacity based on a time horizon far beyond a mere month. An average, annualized indirect-cost rate based on the total annual indirect costs and the total annual level of output smoothes the effect of monthly variations in output levels. This rate is more representative of the total costs and total output the company’s managers considered when choosing the level of capacity and, therefore, the level of fixed costs.

Another denominator reason for using annual indirect-cost rates is that the number of Monday-to-Friday workdays in a month affects the calculation of monthly indirect-cost rates. The number of workdays per month varies from 20 to 23 during a year. Because February has the fewest workdays (and consequently labor-hours), if separate rates are computed each month, jobs done in February would bear a greater share of the firm’s fixed indirect costs (such as depreciation and property taxes) than identical jobs done in other months. Calculating indirect-cost rates over an annual period reduces the effect of the number of workdays per month on calculated unit costs.