HOWE AND HALLING Job Costing in a Service Firm Howe and Halling, a CPA firm, uses a job cost system similar to many professional service firms, such as management consultants, law firms, and professional engineering firms. A client is served by various professionals who hold positions in the hierarchy from partners, to seniors, to staff. In addition, Howe and Halling employ secretaries and other administrative assistants. Howe and Halling have the following budget: Total compensation of professional auditors $4,000,000 Other costs 2.400.000 Total budgeted costs $6,400,000 Each professional uses software to track the time spent on each job. Howe and Halling use these time reports to assign costs to individual clients, or jobs. The software summarizes all the professional auditors' time reports for each client. The software reports the following total professional labor hours for the Ramirez client: Employees Charged Partners Seniors Staff Total Hours Week of Jan 8 Jan. 15 4 4 4 10 48 70 56 84 Total Hours 8 14 118 140 The firm uses the variation of normal costing described on pages 133-134 of the text. The budgeted weekly compensation (based on a budgeted 40-hour week) of the auditors working on this job is: partners, $4,000; seniors, $2,000; staff, $1,000 Howe and Halling allocate indirect costs to jobs at a budgeted percentage of the professional labor cost traced to the job. Chargeable hours average 80% of available hours for all categories of professional personnel. (Chargeable hours are the hours that professionals report spending on a particular client.) The non-chargeable hours (for training, recruiting, and so on) are additional indirect costs. Required: 1. What is the indirect cost allocation rate as a percentage of the "direct labor," the chargeable professional compensation cost? (Hint: Compute an annual indirect cost allocation rate.) 2. Compute the total cost of the Ramirez job for the two weeks that began January 8. 3. The Ramirez job record includes only the labor time, but no costs. You computed the labor and indirect costs assigned to the Ramirez job in Requirement 2. Now use the costs you computed in Requirement 2 to figure out how much Howe and Halling should charge (or bill) the Ramirez client. Howe and Halling compute their revenue, or fees billed to the client, by multiplying the professional labor cost by the billing rate (which is of course a higher hourly rate than the firm pays its professionals) for that class of personnel. Howe and Halling's partners want to earn operating income amounting to 20% of the total costs budgeted. What percentage of the professional labor cost traced to the jobs should Howe and Halling charge to achieve a total billing (i.e., total revenues) that will provide the target income? That is what is the billing rate as a percentage of "direct labor" cost? 4. In addition to billing, how might Howe and Halling use the data compiled on the job records? VARIATIONS FROM NORMAL COSTING: A SERVICE-SECTOR EXAMPLE 133 combination of the write-off and proration methods. For example, the portion of the un derallocated overhead cost that is due to inefficiency (say, because of excessive spending or idle capacity) and that could have been avoided should be written off to the Cost of Goods Sold account, whereas the portion that is unavoidable should be prorated. Unlike full proration, this approach avoids making the costs of inefficiency part of inventory assets As our discussion suggests, choosing which method to use and determining the amount to be written off is often a matter of judgment. The method managers choose affects the operat ing income a company reports. In the case of underallocated overhead, the method of writing off to cost of goods sold results in lower operating income compared to proration. In the case of overallocated overhead, proration results in lower operating income compared to writing the overhead off to cost of goods sold. Do managers prefer to report lower or higher operating income? Reporting lower operating income lowers the company's taxes, saving the company cash and increasing company value. But managers are often compensated based on operating income and so favor reporting higher operating incomes even if it results in higher taxes. Managers of companies in financial difficulty also tend to report higher incomes to avoid violating financial covenants. Shareholders and boards of directors seek to motivate managerial actions that increase company value. For this reason, many compensation plans include metrics such as after-tax cash flow, in addition to operating income. At no time should managers make choices that are illegal or unethical. We discuss these issues in more de tail in Chapter 23. Robinson's managers believed that a single manufacturing overhead cost pool with direct manufacturing labor hours as the cost-allocation base was appropriate for allocating all manufacturing overhead costs to jobs. Had Robinson's managers felt that different manufacturing departments (for example, machining and assembly) used overhead resources differently, they would have assigned overhead costs to each de partment and calculated a separate overhead allocation rate for cach department based on the cost driver of the overhead costs in each department. The general ledger would contain Manufacturing Overhead Control and Manufacturing Overhead Allocated ac counts for each department, resulting in end-of-year adjustments for underallocated or overallocated overhead costs for each department Instructors and students interested in exploring these more detailed allocations can go to Chapter 15, where we continue the Robinson Company example of 2017 Goods DECISION POINT How should managers dispose of under or overallocated manufacturing overhead costs at the end of the accounting year? rallo.com sidere ethod 8 ood Variations from Normal Costing: A Service-Sector Example LEARNING Job costing is also very useful in service organizations such as accounting and consulting OBJECTIVE firms, advertising agencies, auto repair shops, and hospitals. In an accounting firm, cach audit Understand variations from is a job. The costs of each audit are accumulated in a job-cost record, much like the docu- normal costing ment used by Robinson Company, based on the seven-step approach described earlier. On the basis of labor-time sheets, direct labor costs of the professional staff--audit partners, audit ...some variations from nor- mal costing use budgeted managers, and audit staff are traced to individual jobs. Other direct costs, such as travel direct contrats out of town meals and lodging, phone, fax, and copying, are also traced to jobs. The costs of secretarial support, office staff, rent, and depreciation of furniture and equipment are indirect costs because these costs cannot be traced to jobs in an economically feasible way. Indirect costs are allocated to jobs, for example, using a cost-allocation base such as number of profes sional labor hours. In some service organizations, a variation from normal costing is helpful because actual direct-labor costs, the largest component of total costs, can be difficult to trace to jobs as they are completed. For example, the actual direct-labor costs of an audit may include bo nuses that become known only at the end of the year (a numerator reason). Also, the hours worked cach period might vary significantly depending on the number of working days cach method 134 CHAPTER 4 JOE COSTING month and the demand for services (a denominator reason) while the direct-labor costs te main largely fixed. It would be inappropriate to charge a job with higher actual direct labor costs simply because a month had fewer working days or demand for services was low in the month. Using budgeted rates gives a better picture of the direct labor cost per hour that the company had planned when it hired the workers. In situations like these, a company needing timely information during the progress of an audit will use budgeted rates for some direct costs and budgeted rates for other indirect costs. All budgeted rates are calculated at the stan of the fiscal year. In contrast, normal costing uses actual cost rates for all direct costs and bud. geted cost rates only for indirect costs. The mechanics of using budgeted rates for direct costs are similar to the methods en ployed when using budgeted rates for indirect costs in normal costing. We illustrate this for Donahue and Associates, a public accounting firm. For 2017, Donahue budgets total direct labor costs of $14,400,000, total indirect costs of $12,960,000, and total direct (professional labor-hours of 288.000. In this case, w Budgeted direct labor costrud Budgeted total direct-labor costs Budgeted total direct labor hours $14.400.000 288.000 direct labor-hours $50 per direct labor-hour 1 Assuming only one indirect-cost pool and total direct-labor costs as the cost-allocation base, Budgeted indirect coste a Budgeted total costs in indirect cost pool Budgeted total quantity of cost-allocation base (direct-labor costs) $12.360,000 $14.400,000 -0.90.90% of direct labor costs b. Suppose that in March 2017, an audit of Hanley Transport, a client of Donahue, uses so direct labor-hours. Donahue calculates the direct labor costs of the audit by multiplying the bodgeted direct labor cost rate, 550 per direct labor-hour, by 800, the actual quantity of direct labor-hours. The indirect costs allocated to the Hanley Transport audit are determined by multiplying the budgeted indirect cost rate 90%) by the direct-labor costs assigned to the job (540,000). Assuming no other direct costs for travel and the like, the cost of the Hankey Transport andit is Direct-labor costs, 550 X 800 Indirect costs allocated, 90% x $40,000 Total $40,000 35,000 $76.000 Cala At the end of the fiscal year, the direct costs traced to jobs using budgeted rates will get erally not equal actual direct costs because the actual rate and the budgeted rate are developed at different times using different information. End-of-year adjustments for under allocated or overallocated direct costs would need to be made in the same way that adjustments are made for underallocated or overallocated indirect COSTS The Donahue and Associates example illustrates that all costing systems do not exactly match either the actual-costing system of the normal-costing system described carlier in the chapter. As another example, engineering consulting firms, such as Tata Consulting Engineer in India and Terracon Consulting Engineers in the United States, often use budgeted rates allocate indirect cones (such as engineering and office support costs) as well as some diced costs (such as professional labor-hours) and trace some actual direct costs (such as the cost of making blueprints and fees paid to outside experts). Users of costing systems should be awan of the different systems that they may encounter ameron 1. 2 3 4. 5 6 7. DECISION POINT What are some tions of roma cong? Solu Amou 1. 2. 5 HOWE AND HALLING Job Costing in a Service Firm Howe and Halling, a CPA firm, uses a job cost system similar to many professional service firms, such as management consultants, law firms, and professional engineering firms. A client is served by various professionals who hold positions in the hierarchy from partners, to seniors, to staff. In addition, Howe and Halling employ secretaries and other administrative assistants. Howe and Halling have the following budget: Total compensation of professional auditors $4,000,000 Other costs 2.400.000 Total budgeted costs $6,400,000 Each professional uses software to track the time spent on each job. Howe and Halling use these time reports to assign costs to individual clients, or jobs. The software summarizes all the professional auditors' time reports for each client. The software reports the following total professional labor hours for the Ramirez client: Employees Charged Partners Seniors Staff Total Hours Week of Jan 8 Jan. 15 4 4 4 10 48 70 56 84 Total Hours 8 14 118 140 The firm uses the variation of normal costing described on pages 133-134 of the text. The budgeted weekly compensation (based on a budgeted 40-hour week) of the auditors working on this job is: partners, $4,000; seniors, $2,000; staff, $1,000 Howe and Halling allocate indirect costs to jobs at a budgeted percentage of the professional labor cost traced to the job. Chargeable hours average 80% of available hours for all categories of professional personnel. (Chargeable hours are the hours that professionals report spending on a particular client.) The non-chargeable hours (for training, recruiting, and so on) are additional indirect costs. Required: 1. What is the indirect cost allocation rate as a percentage of the "direct labor," the chargeable professional compensation cost? (Hint: Compute an annual indirect cost allocation rate.) 2. Compute the total cost of the Ramirez job for the two weeks that began January 8. 3. The Ramirez job record includes only the labor time, but no costs. You computed the labor and indirect costs assigned to the Ramirez job in Requirement 2. Now use the costs you computed in Requirement 2 to figure out how much Howe and Halling should charge (or bill) the Ramirez client. Howe and Halling compute their revenue, or fees billed to the client, by multiplying the professional labor cost by the billing rate (which is of course a higher hourly rate than the firm pays its professionals) for that class of personnel. Howe and Halling's partners want to earn operating income amounting to 20% of the total costs budgeted. What percentage of the professional labor cost traced to the jobs should Howe and Halling charge to achieve a total billing (i.e., total revenues) that will provide the target income? That is what is the billing rate as a percentage of "direct labor" cost? 4. In addition to billing, how might Howe and Halling use the data compiled on the job records? VARIATIONS FROM NORMAL COSTING: A SERVICE-SECTOR EXAMPLE 133 combination of the write-off and proration methods. For example, the portion of the un derallocated overhead cost that is due to inefficiency (say, because of excessive spending or idle capacity) and that could have been avoided should be written off to the Cost of Goods Sold account, whereas the portion that is unavoidable should be prorated. Unlike full proration, this approach avoids making the costs of inefficiency part of inventory assets As our discussion suggests, choosing which method to use and determining the amount to be written off is often a matter of judgment. The method managers choose affects the operat ing income a company reports. In the case of underallocated overhead, the method of writing off to cost of goods sold results in lower operating income compared to proration. In the case of overallocated overhead, proration results in lower operating income compared to writing the overhead off to cost of goods sold. Do managers prefer to report lower or higher operating income? Reporting lower operating income lowers the company's taxes, saving the company cash and increasing company value. But managers are often compensated based on operating income and so favor reporting higher operating incomes even if it results in higher taxes. Managers of companies in financial difficulty also tend to report higher incomes to avoid violating financial covenants. Shareholders and boards of directors seek to motivate managerial actions that increase company value. For this reason, many compensation plans include metrics such as after-tax cash flow, in addition to operating income. At no time should managers make choices that are illegal or unethical. We discuss these issues in more de tail in Chapter 23. Robinson's managers believed that a single manufacturing overhead cost pool with direct manufacturing labor hours as the cost-allocation base was appropriate for allocating all manufacturing overhead costs to jobs. Had Robinson's managers felt that different manufacturing departments (for example, machining and assembly) used overhead resources differently, they would have assigned overhead costs to each de partment and calculated a separate overhead allocation rate for cach department based on the cost driver of the overhead costs in each department. The general ledger would contain Manufacturing Overhead Control and Manufacturing Overhead Allocated ac counts for each department, resulting in end-of-year adjustments for underallocated or overallocated overhead costs for each department Instructors and students interested in exploring these more detailed allocations can go to Chapter 15, where we continue the Robinson Company example of 2017 Goods DECISION POINT How should managers dispose of under or overallocated manufacturing overhead costs at the end of the accounting year? rallo.com sidere ethod 8 ood Variations from Normal Costing: A Service-Sector Example LEARNING Job costing is also very useful in service organizations such as accounting and consulting OBJECTIVE firms, advertising agencies, auto repair shops, and hospitals. In an accounting firm, cach audit Understand variations from is a job. The costs of each audit are accumulated in a job-cost record, much like the docu- normal costing ment used by Robinson Company, based on the seven-step approach described earlier. On the basis of labor-time sheets, direct labor costs of the professional staff--audit partners, audit ...some variations from nor- mal costing use budgeted managers, and audit staff are traced to individual jobs. Other direct costs, such as travel direct contrats out of town meals and lodging, phone, fax, and copying, are also traced to jobs. The costs of secretarial support, office staff, rent, and depreciation of furniture and equipment are indirect costs because these costs cannot be traced to jobs in an economically feasible way. Indirect costs are allocated to jobs, for example, using a cost-allocation base such as number of profes sional labor hours. In some service organizations, a variation from normal costing is helpful because actual direct-labor costs, the largest component of total costs, can be difficult to trace to jobs as they are completed. For example, the actual direct-labor costs of an audit may include bo nuses that become known only at the end of the year (a numerator reason). Also, the hours worked cach period might vary significantly depending on the number of working days cach method 134 CHAPTER 4 JOE COSTING month and the demand for services (a denominator reason) while the direct-labor costs te main largely fixed. It would be inappropriate to charge a job with higher actual direct labor costs simply because a month had fewer working days or demand for services was low in the month. Using budgeted rates gives a better picture of the direct labor cost per hour that the company had planned when it hired the workers. In situations like these, a company needing timely information during the progress of an audit will use budgeted rates for some direct costs and budgeted rates for other indirect costs. All budgeted rates are calculated at the stan of the fiscal year. In contrast, normal costing uses actual cost rates for all direct costs and bud. geted cost rates only for indirect costs. The mechanics of using budgeted rates for direct costs are similar to the methods en ployed when using budgeted rates for indirect costs in normal costing. We illustrate this for Donahue and Associates, a public accounting firm. For 2017, Donahue budgets total direct labor costs of $14,400,000, total indirect costs of $12,960,000, and total direct (professional labor-hours of 288.000. In this case, w Budgeted direct labor costrud Budgeted total direct-labor costs Budgeted total direct labor hours $14.400.000 288.000 direct labor-hours $50 per direct labor-hour 1 Assuming only one indirect-cost pool and total direct-labor costs as the cost-allocation base, Budgeted indirect coste a Budgeted total costs in indirect cost pool Budgeted total quantity of cost-allocation base (direct-labor costs) $12.360,000 $14.400,000 -0.90.90% of direct labor costs b. Suppose that in March 2017, an audit of Hanley Transport, a client of Donahue, uses so direct labor-hours. Donahue calculates the direct labor costs of the audit by multiplying the bodgeted direct labor cost rate, 550 per direct labor-hour, by 800, the actual quantity of direct labor-hours. The indirect costs allocated to the Hanley Transport audit are determined by multiplying the budgeted indirect cost rate 90%) by the direct-labor costs assigned to the job (540,000). Assuming no other direct costs for travel and the like, the cost of the Hankey Transport andit is Direct-labor costs, 550 X 800 Indirect costs allocated, 90% x $40,000 Total $40,000 35,000 $76.000 Cala At the end of the fiscal year, the direct costs traced to jobs using budgeted rates will get erally not equal actual direct costs because the actual rate and the budgeted rate are developed at different times using different information. End-of-year adjustments for under allocated or overallocated direct costs would need to be made in the same way that adjustments are made for underallocated or overallocated indirect COSTS The Donahue and Associates example illustrates that all costing systems do not exactly match either the actual-costing system of the normal-costing system described carlier in the chapter. As another example, engineering consulting firms, such as Tata Consulting Engineer in India and Terracon Consulting Engineers in the United States, often use budgeted rates allocate indirect cones (such as engineering and office support costs) as well as some diced costs (such as professional labor-hours) and trace some actual direct costs (such as the cost of making blueprints and fees paid to outside experts). Users of costing systems should be awan of the different systems that they may encounter ameron 1. 2 3 4. 5 6 7. DECISION POINT What are some tions of roma cong? Solu Amou 1. 2. 5