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Job Order Costing

Job Order Costing in Service Companies

Job Order Costing as It Relates to Service Companies

Manufacturers and service organizations often use job order costing to track direct labor costs.

Job order costing is a system companies use when they can trace costs to a specific product or service. It allows managers to accumulate costs by jobs instead of departments. A job could refer to a service performed or a customer. Job order costing gives companies in all industries the ability to evaluate costs accurately and price services correctly.

At a manufacturing facility, direct materials—the raw materials that workers use to create products—are likely to be expensive and require highly specific tracking and inventory. But in a service business, such as an accounting or legal firm, direct materials may not be significant expenses. Most materials that the accountants or lawyers and their support staff use will have insignificant cost that an accountant would allocate to the job as overhead. This is not true in all service firms, though. An auto repair shop is a service business, since it is providing a service rather than producing a product. While a significant cost for an auto repair shop is labor, the costs of parts can also be significant. So the accountant for an auto repair shop would include direct materials in job costing.

A service firm uses a job cost sheet to accumulate all costs related to a specific job. In a white-collar firm where labor may be the only direct cost, employees would fill out a time sheet as the costing document. A time sheet, or time ticket, is a paper form or spreadsheet that employees use to record the amount of time they spent working on a job. Members of a CPA firm would use a time sheet to indicate start and stop times where they worked on projects for clients. CPA firms classify employees into groups, such as partner, auditor, senior accountant, and junior accountant. The firm's cost accountant would calculate the costs associated with each employee based on the employee's classification. The cost accountant would apply overhead based on the allocation base and rate. Most service organizations use direct labor as the allocation base.

Time Sheet for Service Firm Job Costing

Companies use time sheets (or time tickets) for information on hours employees work. In service companies, the time sheet may represent all direct costs.
The challenge in a service organization occurs when trying to determine how to bill for 100% of an employee's cost. While employees do not work 100% of the time on a job, the company needs to cover 100% of the cost of the employee in its billing. The time that employees are paid for work not directly related to a customer or job needs to be considered in determining the rate of pay associated with the work performed. The challenges in this area differ based on the type of service organization.

All organizations need to determine a reasonable percentage of employees' time that is spent as direct labor. In an accounting firm, where most of the labor costs are fixed, staffing must align customer demand and capacity. For situations in which customer demand and capacity do not align, the company will have to pay employees their salaries even though there is little or no work available for them to perform.

Service organizations do not always use salaried employees to perform direct labor. Employees doing direct labor work in service companies can be paid hourly. Some examples of service industry workers who are hourly are those who work for cleaning businesses and repair services. Also, social service agencies often pay social workers and other caseworkers on an hourly basis. When service workers are hourly, management can align hours worked versus the hours on a job by the workers' schedule. If demand decreases, then the person works fewer hours and earns less.

Comparison of Service Allocation to Manufacturing Allocation

Manufacturing firms and service organizations allocate costs differently because of differences in cost centers and direct materials.

Historically, manufacturing firms were the primary user of job order costing—in fact, it was designed for them. It is useful in controlling costs for companies in all business sectors, but managers should understand modifications for specific industries.

Both manufacturing and service firms need to have a method to apply costs to a specific job. Firms use a job cost sheet to accumulate related costs under the appropriate job. This sheet may look different from one firm to another. In some service companies, only direct labor costs are collected, while manufacturing firms collect direct materials and direct labor. Some companies use a manual (paper) form, and others use a computer program to collect the information. In all cases, the general concept of collecting job-related costs remains the same.

Jobs in a service organization may be defined differently than in a manufacturing firm. In a manufacturing firm, a job usually refers to a product or group of products being manufactured. In a service organization, on the other hand, the definition of a job depends on the industry. In an accounting or law firm, the job may mean the client. In a cleaning company, the job could be a customer's home or office.

One of the more interesting uses of job order costing in a service organization is its use in casinos. Casinos are heavily labor dependent. The costs of jobs—each job could be a certain game—need to be analyzed. Cost information on these jobs provides information that casino owners and managers use as they make decisions about staffing and technology.

One of the major differences between using job costing in a service organization versus a manufacturing firm involves the cost center of direct materials. A cost center is a department, unit, or section within a business that requires money to operate but does not always directly contribute to the business's profits. Direct materials are items used in a production process that can easily be traced to a product; for instance, steel and bolts are direct materials in car manufacturing. In a manufacturing firm, the largest cost center is usually the costs of direct materials. In a service firm, direct material costs may be close to zero and allocated to the job as overhead.

Another difference between manufacturing and services is the percentage of fixed versus variable costs. A variable cost is an expense that increases or decreases with the level of production. This is especially noticeable in white-collar service industries, such as accounting and law firms. When a service company depends on salaried employees to provide services, its total direct labor costs are a fixed expense. When direct labor costs are based on hourly employees, the costs are variable, and managers are better able to manage labor costs.

In an hourly wage environment, when orders are low, managers reduce employees' hours. When orders increase, managers add overtime to meet demand. If most direct labor hours come from salaried employees, then labor costs will be fixed even if workload is low. However, if work increases and salaried employees are working extra hours without additional compensation, then the cost per unit will be less than estimated. To manage an environment where fixed labor costs are high, managers continuously evaluate customer demand, staffing needs, and related costs. In contrast, service companies that primarily use hourly workers for direct labor use the same approach as manufacturing firms in analyzing and managing their direct labor costs.

Comparison of Service and Manufacturing Costing

Process Manufacturing Firm Service Firm
Examples: toy maker, surgical instrument maker, clothing manufacturer Examples: accounting firm, law firm, auto repair shop, cleaning service
Definition Financial Statement Impact Definition Financial Statement Impact
Raw materials inventory Items received from vendors; usually high-dollar inventory amount Balance sheet May not maintain a raw materials inventory or may have a small-dollar-value inventory of parts and supplies Balance sheet
Work in process (WIP) inventory Inventory value based on accumulated costs while the product is in production Balance sheet Inventory value based on accumulated costs while the service is in process Balance sheet
Finished goods inventory Inventory value when product is finished Balance sheet Not applicable Not applicable
Direct materials Entered to product cost as used in production process; makes up a high percentage of product cost Income statement/ balance sheet Jobs may not include direct materials; they are likely to be a low-dollar amount if included in cost of service. Income statement/ balance sheet
Direct labor Applied to product cost as production is performed Income statement/ balance sheet Applied to job as service is performed Income statement/ balance sheet
Overhead application Allocated to job, based on allocation base Income statement/ balance sheet Allocated to job, based on allocation base Income statement/ balance sheet
Cost of goods manufactured Calculation of the cost to manufacture products during an accounting period Not applicable— included in cost of goods sold Not applicable Not applicable— included in cost of goods sold
Cost of goods sold Expense related to products sold Income statement Expense related to the billable services performed Income statement