Every company is duty bound to keep accounting records to prepare annual accounts.  Besides, a company has to watch its performance and to take corrective action to keep itself on the right path. For this purpose, it needs both operational and financial information.  The latter is provided by a sound accounting system which is nothing but a formal arrangement by which a company develops its financial database eventually turning into financial statements.

Cost accounting system is part of the main accounting system to provide useful information for planning and control. It collects raw information from accounting records, process them and segregates them into various cost components.  An ideal costing system can easily provide any cost information about a process, product, project, or technique. It can generate and compare financial performance across product lines and different processes for producing the same products. It helps minimize waste, use resources in a productive way and weed out money losing products or services.

Basically, there are two costing systems: (i) Job-order costing and (ii) Process costing. Another is called hybrid which is blend of the two. Still there is one more system called Backflush.

Some words about Backflush

Traditional costing system are sequential in nature as they track costs when raw materials move to working in process to finished goods and finally to sales. Backflush works backwards. No costing is done until goods are finished. Standards costs are then flushed backward through the system to assign costs to products. But this system is used where operating cycle is short and inventory levels are low or negligible.

The type of costing system that is right for your business can be determined firstly by what you do or make. If you manufacture a homogeneous product (meaning you do not have differentiated products), then process costing would probably be most appropriate. If you manufacture products that come in differentiated batches, job-order costing would be more appropriate than process costing. Hybrid costing (also called operational costing) is a combination of these two types of costing that is used for products that are similar but produced in batches. For example, a printing press is publishing 10,000 diaries which are similar in nature. It must start from process costing where the work would be departmentalized into to paper cutting, printing and gluing. The final product may be in different bindings such as paper, plastic, hardboard, leather and cloth. Here the printing press would be dealing in batches and job order costing would be most suitable.

The system accumulates cost by jobs. It may be for one unit like a custom-made luxury boat or a dozen boats of the same design termed as a batch. Each job or each batch is unique. If not, it is better to use process costing.

As shown in the diagram, materials and labor are directly added to work-in-process inventory for each job. This work in process is in fact a control account and when an amount is added, the same is also debited to cost sheet relating to a particular job.

Actual overheads costs are not allocated to any specific job since these represent indirect costs or shared costs or common costs. These are allocated using a pre-determined rate (which would be discussed later). From work-in-process, completed jobs are transferred to finished goods and on delivery to customers, the relevant cost is added to cost of goods sold.

Job Costing is used in shipbuilding, service industries like hospital, constructions, special order printing, movie studios and professional services as audit firms.

All material purchases are entered in raw material account.  This includes direct materials like fabric and indirect materials like button, stitching yarn etc. For each job, materials requirements are ascertained and the requisite quantity is obtained from the storeroom. Material Requisition Form is the main document which identifies specific job, types and quantity of material required. 

While direct materials are allocated to work in process, the requisite indirect materials are transferred to Manufacturing Overheads.  (Later, these would be prorated to different jobs).

An account is maintained for labor cost. It can be named as Manufacturing Wages or simply Labor. At the same time, another document is used known as Time Sheet or Time ticket is maintained by each employee in which he or she record time spent on each job and each task.

The time-sheets are consolidated and total wages payable are recorded in manufacturing wages, as shown in the side diagram. Side by side, each time sheet is studied and any time spent on a job is transferred to work in process while the time spent on task is transferred to manufacturing overhead. (Entries in accounts are always in monetary term. The time spent by an employee is multiplied by applicable wage rate and amount is transferred in wage or manufacturing overhead account as the case maybe.)

Manufacturing Overheads consist of all manufacturing costs other than direct materials and direct labor. Since these are not traceable to jobs, there must be a way to allocate the same.

At the time of production planning, a company would decide how much would be produced in the plan period. Next using standard rate, variable manufacturing overhead would be calculated based on production level and added in “estimated overheads”. The fixed manufacturing overheads represent fixed cost like depreciation, rental, salaries of permanent staff, minimum utility cost like fixed power charges, line rent for telephone. This fixed also  would be added in the estimated overheads. When all possible future costs have been added, a total is obtained and divided by estimated units of production. This gives us Overhead Applied Rate which is the same as Standard Rate.

These rates are applied to individual jobs using some base like Direct Labor Hours or  Machine Hours, Raw Material Quantity or Costs. Once a particular base is selected, the same is applied for each job. Which particular base would be selected depends upon (i) industrial practices or (ii) cause and effect relationship.

If it is decided to use Direct Labor Hours as base and a job has taken 200 labor hour, the applied overheads would be 200 x 20 (rate)=400.Similarly, all jobs would be charged with some overheads. At the end, the applied overheads may exceed the actual or be less than actual. Necessary adjustment are made either by transferring the balance to Cost of Goods Sold or dividing the balance, whether positive or negative, among Work in Process Inventory, Finished Goods Inventory and Cost of Good Sold according to quantum of each account.

A step by step approach has been narrated in the foregoing paragraphs. The rest of the procedure is standard and not restricted to job-order costing i.e. transferring costs  from work in process to finished inventory when completed  and to cost of good sold when sold.  Any difference between sale revenues and cost of goods sold would represent gross profit.