Important Decisions Influenced by Cost Modeling
In the previous article, we studied the cost modeling process. We understood the various steps which have to be undertaken in order to model costs. However, we also need to understand that cost modeling is an iterative process. This means that a company creates a cost model, runs the numbers, compares those numbers with their […]
Inverted Yield Curve
Most investors across the world are aware of the fact that yield curves are generally upward sloping. This is because, under normal circumstances, yields for bonds with longer maturities tend to be higher. However, it is possible for the opposite scenario to play out. This means that it is possible for bonds with lower maturities […]
Types of Costs to be Allocated in Job Order Costing
Companies incur a variety of costs in their day to day operation. These costs are very different from one another and need to be treated differently by the accountants to give a fair picture of the organization. Here is a list of the different types of costs that are usually incurred by an organization as […]
The Case for Index Funds
People who invest their money in stocks can be split up into two categories. One category of people actively decide which stock they want to invest their money in. This means that these investors spend their time and money doing research on individual stocks. On the other hand, the other category of people invests their […]
Free Cash Flow to the Firm vs. Free Cash Flow to Equity
Free cash flow models can be further categorized into two types. There are certain kinds of models which pertain to free cash flow that the firm as a whole will generate whereas there are others that pertain solely to the perspective of equity shareholders. These models are quite different from each other. It is therefore […]
In earlier time, prices used to be driven by costs. This meant that the firms would consider the amount of money that they had spent in manufacturing a product. They would add a profit margin to it and then sell it at this “cost plus” price. This system had some issues. Even if the company was inefficient in its production, it could just pass on the costs to the consumer.
However with the advent of competition, pricing became a strategic issue. Companies could no longer charge on “cost-plus” basis. Rather they had to accept the price determined by the marketplace. Thus it became important to control costs and the job order costing system was amongst the first pricing system to be created.
A job order system is used by very specific type of companies. These companies do not manufacture standard products and stock them to sell to customers. Rather they take orders. This means that the product is custom built as per the requirements of the customers. This makes job order costing difficult since in a company that manufactures standard products, the production can be known in advance and overheads can be allocated amongst products. But in case of job order costing, determining what the overheads will be for the next accounting period is extremely subjective and prone to errors.
Companies that follow job order costing cannot determine the exact amount of costs that they will incur. Some of their overheads may be standard and required to run the business while some others may be dependent on the job being performed. Companies that perform these jobs cannot know the exact costs before the job is actually completed.
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-->One of the major problems in job order costing is the mismatch between when the quotation is made and when the costs actually become known. Prices need to be quoted before beginning production. However, the costs are known only after the job is completed.
Labour and material charges can be accurately known. However, overheads are an estimate. Hence the estimation needs to be spot on. If the overheads are not correctly known the company may quote too low and take a loss or the company may quote too high and lose customers to cheaper competitors.
Examples:
Not all types of companies follow job order costing. There are some businesses which are known to follow this technique since it is almost a pre-requisite for their business. Here are a couple of famous examples:
Builders usually do not produce standard units. Even if they do, the location, the logistics and many other factors are different. Thus the costs incurred are different too. Hence, job order costing iis very popular.
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