Job, Batch and Process Costing

1 Introduction

This chapter looks at how products are costed, depending on whether they are unique products or one of many identical products.

2 Job costing

Job costing is where a unique item is being made and costs can be specifically traced into that item.

The job could be large (such as building a house or a ship) or small (such as constructing a set of shelving for a room).

Often jobs are given identifying numbers, such as contract numbers or simply job numbers.

All relevant costs are labelled with that number and the total costs can be accumulated.

• Material costs: either invoices for specially bought material or requisitions from stores can be labelled with the job number so that material costs can be accounted for.
  

• Labour costs: time sheets can be filled in using the job number to track time spent on the job.
  

• Other expenses: if direct, then the job number will be noted against that cost; if indirect then expenses are often charged to a job on the basis of time and an overhead absorption rate.
  

Controlling the cost of a job

Collecting costs against a job number tells you what the job cost. Control means finding out while the job is still running that it is going to cost more than you told the customer it would.

The job is estimated before it is quoted, and that estimate becomes the control document. As work proceeds, the costs collected on the job cost sheet are compared with the estimate line by line — material, labour hours, subcontract work, overheads absorbed — and the comparison is reviewed at set stages rather than at the end. A job that has used 70% of its estimated labour hours when it is half built is in trouble, and the time to act is then: put more experienced staff on it, change the method, or go back to the customer about the scope.

Two things distort job costs if they are not controlled. Rectification work — putting right faulty work — should be recorded separately, not quietly absorbed, so that the cost of poor quality is visible. And material returned unused should be credited back to the job on a returns note, or every job will look more expensive than it was.

At the end, the actual cost is compared with the original estimate and the differences are fed back into the way the next job is estimated. In batch costing the same applies, with one addition: if part of a batch is scrapped, the good units left have to absorb the batch cost, so the cost per unit rises and the scrap rate needs watching.

3 Cost plus pricing

A job is unique, so there is no market price to look up. The usual answer is cost plus pricing: work out the cost of the job and add a set percentage to arrive at the price to quote.

There are two ways of expressing the addition and they are not the same thing. A mark-up is a percentage of cost. A margin is a percentage of selling price. Read the question carefully, because the two give different prices from the same cost.

Which cost you start from also matters. Adding a mark-up to marginal cost only makes sense if the mark-up is big enough to cover the fixed overheads as well as give a profit; adding it to total absorption cost is safer for a quotation, because the fixed overheads are already in the figure. Cost plus is quick and easy to defend to a customer, but it takes no account of what competitors are charging or what the customer is willing to pay, so it is a starting point for a quotation rather than the end of the argument.

4 Batch costing

In batch costing several identical items are produced as a batch. Each batch will be given a number so that costs can be traced into the batch. The batch costs can be averaged over the units produced.

5 Process costing - introduction

Process costing deals with manufacturing that takes place as a continuous process.

Examples of industries using process costing are:

• Oil refining
  

• Chemical works
  

Because work carries on continuously, there are no batches as creating a batch implies that you know when it starts and stops, and therefore what costs have gone into it.

In process costing, costs are worked out for periods: measure the costs that are used in a period and the output produced in the period and you have a way of working out the cost per unit.

6 Joint and by-products

There are some manufacturing processes in which it is inevitable that more than one product is made. For example, an oil refinery buys crude oil and this is then split (‘cracked’) into kerosene, diesel, petroleum and many other chemicals. Or a dairy buys milk and this is separated into skimmed milk and cream.

If the various products that are made are of comparable value or are material, then they are called joint products.

Any unimportant products of small value are called by-products.

The process can be shown as:

To be able to value inventory, it is necessary to take all costs into account that were responsible in getting the product to its present location and condition. So, to value Product A, its separate costs plus a share of the joint (common) costs have to be used. There is no problem with the separate costs as they are clearly only to do with specific products, but the joint costs have to be split in some way.

There is no single correct way to split joint costs, but common approaches are:

• Physical (weight/volume)
  

• Net realisable value of the final product (sales value less separate costs)
  

• Equal profit margins
  

• Sales value of the final product
  

This syllabus asks you to deal with only the first two methods.

Note that the costs of the products change under the two methods. This does not mean that the company’s overall profit changes: whatever way the joint costs are split and apportioned to products they are still the same total costs to the business.

Joint products are important and material to a business’s results, so care is taken to work out their costs. By-products are not material and are a bit of a nuisance. Joint costs are never apportioned into by-products; nor are sales of by products separately accounted for. Instead, the sales proceeds are deducted from the joint costs and the net amount split over the joint products. In effect, the sale proceeds of a by-product are treated as a reduction of the cost of the main process rather than as revenue in their own right.

7 Further processing decisions

Look at these results:

Note that this does not mean that Product B should be discontinued because it seems to make a loss. If a different basis were used to apportion the joint costs so that they, for example, were split equally between the two products, then both products would show a profit:

Profit for A: 100,000 – 40,000 – 55,000 = 5,000

Profit for B: 150,000 – 90,000 – 55,000 = 5,000

Overall the total profit is unchanged at $10,000.

If the business wants to make product A it has to incur all of the joint costs. There can be a choice, however, as to whether to incur the post separation costs. For example, instead of incurring $40,000 to complete Product A it might be possible to sell its pre-cursor just after split off.

8 Service costing

This looks at costing services, such as providing transport or haulage.

Characteristics of a service

A service is not a product, and that is why costing one is different. Five characteristics between them explain almost everything you need to say about service costing.

• Intangibility. There is nothing physical to point at. You cannot weigh an audit or measure a train journey off a drawing, so the unit of output has to be defined before anything can be costed.
  

• No inventory. A service is consumed as it is produced, so there is nothing to value at the period end. An empty hotel room tonight is revenue that is gone for good — it cannot be stored and sold tomorrow.
  

• Simultaneity. Production and consumption happen at the same time and usually in the customer's presence, so there is no chance to inspect and reject before delivery.
  

• Heterogeneity. No two deliveries are identical. The same hairdresser, the same accountant and the same taxi journey vary from one occasion to the next, so an average cost hides more variation than it would in a factory.
  

• A high proportion of indirect cost. Most service costs are staff and premises, and relatively little can be traced directly to one unit of service, so the answer depends heavily on how overheads are apportioned.
  

A particular characteristic of service costing is that it often requires the use of composite cost units. For example, if costing a bus service you would be interested in the cost per passenger kilometre; if costing haulage you would be interested in cost per tonne kilometre. Composite units are essential because if you wanted to estimate, say a haulage cost that should be charged, it will depend on both weight and distance.

Where service costing is used

Service costing is used in two quite different situations, and the exam asks about both.

The first is a business whose product is a service and which sells it to outside customers: transport and haulage, hotels, hospitals and clinics, schools and colleges, restaurants and catering, banks and insurers, and professional firms such as accountants, solicitors and consultants. In each case the business needs a cost per unit of service to set fees, to bid for contracts and to judge whether a branch, route or department is worth keeping.

The second is a service cost centre inside an ordinary manufacturing business — the canteen, the maintenance department, the internal transport fleet, the IT helpdesk, the payroll office. These do not sell anything, but they still have a cost and still produce a measurable output: meals served, maintenance hours, kilometres driven, calls handled. Costing them that way turns the apportionment you met in the overheads chapter into something management can question: it is the difference between “the canteen cost $35,100” and “a meal costs $1.50, and outside caterers quote $1.35”.

Cost units for different services

The cost unit has to be something the service genuinely produces and that somebody counts anyway. Learn a handful of these — questions very often simply ask which unit fits which service.

Notice how many of these are composite — two measures combined, such as tonne kilometre, passenger kilometre, room-night or student-hour. A single measure is used where one factor drives the cost on its own; a composite unit is used where two do, and a cost per tonne alone would price a 10 kilometre delivery the same as a 500 kilometre one.

The practical problems of costing a service

Service costing looks like an easy sum — total cost divided by units of service — but each half of that sum causes trouble in practice.

• Defining the unit. A hotel could cost a room-night, a guest-night or a booking, and the three give different answers. A hospital could cost a patient, a patient-day or a procedure. Whichever is chosen must then be used consistently, or no comparison over time means anything.
  

• Measuring the output. Nobody counts what nobody has to count. Passenger kilometres, chargeable hours and meals served all need a recording system, and staff have to be persuaded to keep it up accurately.
  

• Tracing staff time. Staff are usually the biggest cost, and the time they spend on one unit of service is rarely recorded exactly. Time sheets are completed after the event, and the time that goes on travelling, waiting or administration has to be recharged somehow.
  

• A mostly indirect cost base. Premises, supervision, equipment and administration cannot be traced to a single unit of service at all, so the cost per unit depends on an apportionment that is, in the end, someone's judgement.
  

• Variable quality. Two deliveries of the same service are not identical, so an average cost per unit can conceal a wide spread — the average cost of an operation says nothing about the difficult one.
  

• Spare capacity. Because there is no inventory, unused capacity is lost immediately. The cost per occupied room rises sharply when occupancy falls, even though nothing has changed about the hotel, which makes the cost per unit unstable and a poor basis for pricing unless volumes are steady.
  

More service cost calculations

Whatever the service, the method is the same: total the costs for the period, count the units of service delivered in that period, and divide. The only real work is deciding what the unit is.

If occupancy fell to 50% the costs would barely change, but the room-nights would fall to 9,125 and the cost per occupied room-night would rise to $59.18. That is the spare-capacity problem in a single line of arithmetic.