How is direct cost developed? Why use job or process costing? We answer your questions here.

1. Operations Cost Management
www.costmgmt.org
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2. Intro
• In this presentation, we provide you with the
basics of terminology so that you can understand
what tools you can use to cost a product.
– Work Centers
– Job Costing and Process Costing
– Direct Cost and Indirect Cost
• If you are not in manufacturing, think of ways to
use these techniques to fit your industry, the
methodology is the same.
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3. The Layout
• The cost methodology depends on the physical
layout of the plant, the product being made, and
sometimes even the customer.
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4. Work Centers
• A work center is a unique labor or machine driven
work station that performs a specific function(s).
• A work center should have a unique cost structure,
based on the type of labor and/or machine. It should
be possible to develop an average rate for each work
center.
• The layout could be an assembly line, each worker
performing a step in the function, but the workers are
interchangeable. The entire assembly line would be a
work center.
• The layout could be a machine shop with each
machine performing a unique operation, operators
trained specifically to each machine. Each machine
and operator would be a work center.
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5. Work Centers
• A Work Center could be an assembly line or it
could be clusters of people and/or machines,
each of which perform a unique function.
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6. Job Costing
• A method whereby products are run in discrete
‘batches’.
– For example, a company manufactures 10
different varieties of widgets. They are modified
slightly depending on the customer and market
they are intended for.
– 10,000 of widget ‘easy’ are going to be made
beginning Monday morning, following this 7,000 of
widget ‘difficult’ will be made.
• Discrete batches for widgets ‘easy’ and ‘difficult’
are run, there is cost visibility for each, the direct
material and labor for each.
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7. Process Costing
• A methodology whereby a product is made
continuously, there is no way to determine the
exact cost of specific units, raw material is
continuously being added at varying cost.
• Examples of process costing are a chemical
plant, a petroleum refinery, and a food processing
center.
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8. Hybrid Methods
• In some instances a combination of process and
job costing may be appropriate.
– I worked at a small manufacturer of pressure washers
which we sold to home improvement stores. Since we
produced several different models, our normal
production used job costing. The home improvement
stores would also return machines to us, these we
repaired and sold to a specialized retailer. We only
repaired one type of washer at a time, but the amount of
raw material and labor that went into each unit varied.
So rather than trying to cost each washer, we kept track
of the cost going into one batch, which was more like
process costing.
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9. Direct Cost
• Direct costs are the labor and material that are
directly traceable to a product.
• It is generally a good practice to make as much of
the input direct as possible. Moving cost to
overhead is easy but not as accurate.
– The cost of inspection is usually in overhead, but
inspections can be directly traceable to a product.
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10. Standard Cost
• Standard cost is used when large discrete batches are run
periodically. This gives us enough data to update the
standards.
– A standard cost is set for each raw material, the price
we expect to pay for this raw material throughout a
given period (year, quarter).
– A standard cost is also set for labor at each work
station, covering the same time period.
• Standard cost can be used in a process or job costing
setting.
• Approximately 80-85% of manufacturing companies use
standard cost, and most do not follow good practices.
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11. Actual Cost
• Best used when not enough batches of discrete
product are run to obtain good historical
information, or when the product changes
composition frequently.
• Also used by contractors for the US government.
• Actual cost can be used in job costing, but in
process costing the actual cost is not known for a
discrete product.
• Actual cost is most accurate.
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12. Costing the Product
• For there to be consistency, the way the product
is made and what it is made of should have a
written plan.
– Think of baking a cake, we have the list of ingredients,
and the instructions.
• Whether a product is made in a job costing or
process costing environment, it should still have
a list of required ingredients and a plan of
manufacture.
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13. Bill of Material
• The list of ingredients are know as a Bill of
Material.
• The Bill of Material (BOM) tells us what raw
materials are required to make the product.
• It should include anything that may affect the
quantity of required material.
– For example, one of the raw materials is especially
brittle, we therefore end up breaking three pieces
out of every 1,000 pieces. In order to make 1,000
units of finished product then we would need to
start with 1,003 pieces of this brittle raw material.
• The BOM is the list of ingredients for our cake.
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14. Route
• The instructions to make the product are known
as the router.
• The router tells us what work station the product
should be at for each stage of production and
how much time it should be there. It also
includes other information, such as inspections
required.
• The Route contains the instructions to bake our
cake.
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15. Indirect Cost
• The manufacturing overhead can be applied to
the direct cost using a number of different
methods, in some cases not at all.
• Most businesses still apply overhead using one
cost pool and percentage. This ‘peanut butter’
approach to applying overhead is the least
accurate.
• Activity Based Costing is a more accurate
method of applying overhead using many cost
pools each with its own activity drivers.
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16. Usage in Other Industries
• You can see how nicely job and process costing
fit with manufacturing.
• But what if a job were a different kind of product,
say a broken leg. It would still be possible to
create a standard BOM and Router for costing
purposes.
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17. Summary
• For questions or criticisms, please feel free to
email us at info@costmgmt.org
• Process costing vs. job costing, discrete batches
vs. continuous run.
• We also discussed the direct cost, standard vs.
actual and when each is appropriate.
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