Job order costing: system overview and cost flows

Learning outcome statements

The learning outcome statements relevant for this section are:

1. define the nature of the system, understand the cost flows of the system, and identify its appropriate use
2. calculate inventory values and cost of goods sold
3. demonstrate an understanding of the proper accounting for normal and abnormal spoilage
4. discuss the strategic value of cost information regarding products and services, pricing, overhead allocations, and other issues
5. identify and describe the benefits and limitations of each cost accumulation system

Introduction

In managerial and cost accounting, the costing system you choose depends on how customized the production process is. Job order costing tracks costs separately for each distinguishable job, batch, or contract - unlike process costing, which fits continuous, homogeneous production - and it’s common in industries such as construction, aerospace, consulting, advertising, custom furniture manufacturing, and legal services, where each contract or batch demands its own combination of materials, labor, and overhead.

Definition and nature of the system

Definitions

Job order costing

A cost accounting system used to assign and accumulate costs to individual jobs or batches of products.

Under this system, each job is treated as a unique cost object, and all costs (i.e., direct materials, direct labor, and a portion of manufacturing overhead) are recorded separately for that job. This enables organizations to determine the cost (actual direct materials and direct labor plus overhead applied at a predetermined rate) of fulfilling a specific customer order or completing a particular project.

Job order costing is appropriate when:

• Production is customized, non-repetitive, or performed in distinct batches.
• Jobs vary significantly in scope, materials used, and labor requirements.
• Accurate cost traceability to individual products or clients is essential.

Each job is assigned a unique job number, and costs are documented on a job cost sheet. This cost sheet serves as the basis for inventory valuation, billing, performance assessment, and profitability analysis.

Job order costing provides management with highly detailed cost data. This allows the company to achieve some strategic relevance through:

• Accurate quoting and bidding on future projects
• Monitoring of job profitability
• Informed resource allocation and pricing decisions
• Enhanced budget control and operational transparency

Job order costing isn’t without drawbacks, though:

• Tracking costs separately for every job is time-consuming and increases recordkeeping and clerical costs.
• Applied overhead relies on a predetermined (estimated) rate, which can leave overhead over- or under-applied until it’s reconciled.
• The system is a poor fit for continuous, homogeneous production, where process costing is more efficient.

Cost flows and accounting entries

In a job order costing system, costs are tracked and accumulated as they flow through the production process: from raw materials to work-in-process (WIP), then to finished goods, and finally into cost of goods sold (COGS) once the goods are delivered or sold.

The cost flow typically is as follows:

1. Raw materials inventory
   Direct and indirect materials are purchased and stored in inventory.

2. Work-in-process (WIP)
   When production for a specific job begins, direct materials and direct labor costs are transferred to WIP. Overhead is applied to the job using a predetermined rate.

3. Finished goods inventory
   When the job is completed, the total cost of the job is moved from WIP to finished goods inventory.

4. Cost of goods sold (COGS)
   When the finished goods are delivered to the customer or sold, the cost is transferred from finished goods to COGS.

Each job is assigned a Job cost sheet, where all direct materials, direct labor, and applied overhead are recorded. This sheet becomes the central source of cost tracking for managerial review and financial reporting.

The following shows the journal entries in a job order costing system. You will see that they follow the standard journal entries except that costs are tracked per job. We will discuss the application of overhead (Journal entry 7) in the next section about cost computations under the job order costing.

Transaction	Debit	Credit
1. Purchase of raw materials	Raw materials inventory	Accounts payable / cash
2. Issuance of direct materials to a job	Work-in-process (WIP) inventory (Job specific)	Raw materials inventory
3. Issuance of indirect materials	Manufacturing overhead	Raw materials inventory
4. Direct labor costs assigned to a job	Work-in-process (WIP) inventory (Job specific)	Wages payable
5. Indirect labor costs	Manufacturing overhead	Wages payable
6. Other actual overhead incurred (utilities, depreciation, insurance)	Manufacturing overhead	Cash, accumulated depreciation, prepaid insurance, etc.
7. Application of overhead to jobs	Work-in-process (WIP) inventory (Job specific)	Manufacturing overhead applied
8. Completion of a job	Finished goods inventory	Work-in-process (WIP) inventory (Job specific)
9. Sale of completed job (cost portion)	Cost of goods sold (COGS)	Finished goods inventory

Example: Tracing job 101 through the system

ABC metalworks accepts a custom order, job 101. By the time the job is finished, its job cost sheet shows direct materials of $3,000, direct labor of $2,000, and applied overhead of $1,500 (based on a predetermined overhead rate).

• Total cost of job 101: $3,000 + $2,000 + $1,500 = $6,500
• When job 101 is finished: debit finished goods inventory $6,500 / credit WIP inventory (job 101) $6,500
• When job 101 is delivered to the customer: debit COGS $6,500 / credit finished goods inventory $6,500

Answer: Job 101’s total cost of $6,500 moves from WIP to finished goods to COGS as the job is completed and sold.

Job order costing revolves around assigning costs to individual jobs. Therefore, when recording entries for:

• Direct materials
• Direct labor
• Applied overhead
• Job completion

You must indicate which job the entry pertains to, either in the journal entry description, job cost sheet, or subledger.

We cover the proper accounting for normal and abnormal spoilage in a later chapter, job order costing: accounting for spoilage.