Tracking Direct Labor
A logical starting point for job costing is to track the direct labor to specific jobs. Donnie, and the other electricians, fill out a time report documenting time spent on each job, as well as the time spent on tasks that cannot be traced to a specific job:
Not only will this time sheet form the basis for payroll, but it will also allow cost assignment to specific jobs. The direct labor for the billboard task (Job A) was one hour of Donnie's time (at $18 per hour). The "direct labor" for Job A will be compiled by reference to the time sheet on the previous page.
Tracking Direct Materials
Jack keeps detailed records of the material released to each job. When Donnie gathered up the light bulbs, breakers, wire, tape, and wire nuts on the morning of the 14th, some system needed to be in place to "check out" this material. The document that is used for this process is called a "materials request" or "materials requisition" form. This form will show what material is leaving the available raw materials stock and being put into production. Sometimes a separate form is prepared for each item, and sometimes a running list similar to the following is used:
This form provides essential documentation to safeguard and track inventory; a manager that fails to control and monitor inventory does so at great peril! It also reveals that the "direct material" for the billboard task (Job A) was $150 (the light bulb). The wire nuts and tape that might have been used on the billboard will be dealt with as overhead which is discussed later.
Before moving on to overhead, you need to know one more thing about a "materials requisition" form; although the illustrated form lists the material cost, that will not always be the case. Sometimes, a business will not be particularly interested in letting employees see cost information, or cost information may not be readily available. In either case, the form will instead include a part or serial number. A subsequent clerical task will be to identify the cost of the particular parts that were put into production. Great care must always be taken to match the right cost to the right item, and in the right quantity. For example, the 500 feet of wire may be on one roll, but it is priced by the foot, and the quantity should be 500 feet, not 1 roll; the job cost calculation would be incorrect if only $0.14 were assigned to one roll of wire!
Jack would have a huge task at hand if he tried to daily trace all items of overhead. For instance:
o How hard would it be to track the "indirect material"? How many wire nuts were used on the billboard? How many inches of electrical tape were used? What was the cost of these items?
o What about indirect labor? Donnie spent two hours on job-related administration and travel issues for the six hours of direct labor time on the 14th. Should the cost of the 2 hours be spread over the three jobs equally, pro-rata based on hours, or some other basis? On the 15th, Donnie may spend the entire day on the residential wiring job and have little administrative and travel time. How does this impact the cost per hour of output on the 15th versus the 14th? What about Jack's time? He is supervising 4 electricians. Should the cost of his time be allocated 1/4 to each, or based on some other formula?
o Then, one must consider the cost of rent, equipment, trucks, and so forth. Donnie needed a ladder to scale the billboard. A ladder will eventually wear out - but how much is the "ladder cost" for one trip up and down a billboard? Now, repeat this question for every item of cost incurred in running Castle Electric.
Tracking overhead is tricky. One way this is done is by using a predetermined overhead rate. Assume Jack sat down at the beginning of the year with his accountant. Together they carefully considered all of the production overhead that was anticipated during the year - the cost of Jack's time, the rent, the cost of vehicles, insurance, taxes, utilities, indirect labor, indirect materials, depreciation of long-lived assets, and so forth. The expected total came to about $150,000. Jack figures that his four electricians will work a total of about 7,500 direct labor hours during the year. By comparing these two numbers ($150,000 and 7,500 hours), it is now possible to "model" that overhead is $20 per direct labor hour. The "overhead application rate" is thus determined.
Now, two things should be made clear. First, overhead application is arbitrary. Jack decided to apply overhead based on direct labor hours; this is a common choice, but not the only choice. Some other systematic and rational approach could have been developed. Ordinarily, one would try to establish some correlation between the application base and overall cost incurrence. For instance, feet of wire used (instead of direct labor hours) could have been selected as the application base; but, feet of wire would be hard to defend since two of Donnie's three jobs did not use any wire and would not be assigned any of the business overhead! The point is that some logical method needs to be used to attach overhead costs to output, but no single choice is absolute. Cost allocation necessarily involves some degree of arbitrary methodology; this is neither bad nor good, it is just reality. In some ways, costing is more of an "art" than "science" - despite its outward appearance of mathematical precision.
Second, expect differences between the actual overhead and the amount applied to production. For instance, Jack will likely discover that actual overhead is more or less than $150,000. Jack will also find that his electricians will probably work more or less than the anticipated 7,500 hours. When all is said and done, Jack will need to deal with the actual cost. The difference between the amount of overhead applied to production (i.e., direct labor hours x the $20 per hour rate) and the actual amount spent must be accounted for! We will see how to deal with this later in the chapter.