alt="Remember"/> This list explains how fixed and variable costs are assigned to cost objects:
Direct costsVariable direct costs, such as denim material, where denim jeans is a cost objectFixed direct costs, such as a supervisor salary at an auto plant, where an automobile produced is the cost object
Indirect costsVariable indirect costs, such as utility costs for a television plant, where a television produced is the cost objectFixed indirect costs, such as insurance for a plumbing vehicle, where a plumbing job is a cost object
Charging customers for direct and indirect costs
To bill a customer and calculate a profit, you must add up all the costs for that customer, whether they are direct or indirect costs.
If, for example, you manufacture kitchen countertops, you would want to include all direct and indirect costs of a custom countertop installation in order to bill the customer. A direct cost might be marble (for material). To find the total cost of material for the job, you’d compute direct material cost as (marble) × (quantity used).
Indirect costs are different. If your kitchen countertop business makes lease payments on an office building, the cost is indirect. You can’t know the exact amount of indirect costs for the client. You also can’t trace the cost directly to a specific customer, but you can allocate it using a cost allocation base.
Think about allocating indirect costs this way: There’s a dollar amount of cost to allocate (say, $100). You spread that cost over a group of customers, a level of production, or some other activity level. In this section, you see how that might work.
A carpenter owns trucks that require repair and maintenance expense. That cost can’t be traced to specific customers; instead, these indirect costs are allocated to a cost object. You find a “best” method to assign repair and maintenance expense to clients, perhaps labor hours worked for the customer.
The logic is that if you worked more hours for a specific customer, you probably used your truck more. If you used the truck more, that customer should absorb more of your truck’s repair and maintenance cost.
It’s virtually impossible to trace the repair and maintenance cost of the truck back to a specific customer. So you make your best educated guess to distribute the cost.
Cost allocation is the process of connecting an indirect cost to a cost object (see Chapter 2 for more). A cost pool is a grouping of similar costs. You can think of a cost pool as a bunch of similar cost objects thrown together. In this case, the cost object is a specific customer job.
Just to clarify: The cost object is the “sponge” that absorbs the cost. The cost driver adds to the size of the sponge. A bigger sponge absorbs more cost.
Assume the total repair and maintenance expense for three carpentry trucks is $3,000. During the month, your workers provide service to 300 clients. Each customer is allocated $10 of repair and maintenance expense ($3,000 ÷ 300 clients).
If the cost driver increased to 400 clients per month, the carpenters would drive more miles. As a result, the trucks would require more maintenance and possibly repairs. Your monthly repair and maintenance expense would be higher.
At 400 customers for the month, assume total repair and maintenance expense for three carpentry trucks is $3,600. Now each customer is allocated repair expense of $9 ($3,600 ÷ 400 clients). The cost driver increase (number of customers) changed your total cost to $3,600. Because you also have an increase in total customers (400), the $3,600 is spread over a larger group. The total cost increased, but the cost allocated per customer declined.
You can see how the cost allocation process can get complicated.
It’s often beneficial to group similar costs together into the same cost pool when the cost driver is the same. Consider a cost pool for the indirect costs for the carpentry trucks. In addition to repair and maintenance expense, the company pays for insurance and depreciation on the three trucks. None of these costs can be traced to a specific customer; instead, you need to allocate these costs. A good cost pool would include depreciation, insurance, and repair costs on the trucks. This cost pool can be allocated just like the repair and maintenance in the previous example.
Implementing job costing in manufacturing: An example
To implement job costing in a manufacturing company, first think about dividing your costs into two piles: direct costs and indirect costs. In a manufacturing setting, you have direct materials and direct labor you can trace directly to the job. So far, so good. Next, think about what’s driving indirect costs. You spread those indirect costs to the work you perform.
As an example, Reliable Fencing manufactures and installs wooden fences for the residential market. Reliable has a manufacturing component and a service component.
Reliable provides the customer a cost estimate. The estimate is based on the type of fence, fence height and length, and labor hours needed for installation. Because nearly every job has a different set of costs, Reliable Fencing uses job costing. This system allows Reliable to compute costs accurately. And from that, Reliable can calculate a selling price that generates a reasonable profit.
Imagine that you’re the manager of Reliable Fencing. The Johnsons have requested an estimate for a fence in their backyard. To provide the estimate, you discuss the fence models and types with them. You measure the length needed for the fence and the height requested. Finally, you consider any extra labor costs you might incur. For example, the Johnsons would like the fence to jog around several trees so the fence doesn’t damage the tree trunks.
The Johnsons’ fence is the cost object. Reliable will incur costs if the client orders a fence and work starts on the project. But before getting an order, you have to provide a cost estimate.
Computing direct costs
Reliable combines the cost of wood, paint, and a waterproofing treatment for the wood. That combined cost represents direct materials. As the manager, you compute direct material costs:
Direct materials = quantity of materials × unit price paid for material
You buy material measured in square feet. The unit cost is the
