Sparklin Automotive Company (SAC) is a leader in the spark plug business and has now developed a revolutionary new product that will enhance that leadership position. The new product allows the company to offer special-order spark plugs for the auto racing industry. The company needs to determine the best method of accounting for this product. The current accounting system is a basic costing system that delivers only basic information to the company's managers. Other systems have also been recommended for adoption to enhance the company's costing knowledge and improve managerial decisions. This memo will discuss some of the options for the new custom spark plug product in particular, taking the approach of comparing the new product with the normal spark plugs the company offers, and explaining why a different accounting system for the new custom plugs would be beneficial.
SAC currently utilizes the process costing method for its spark plugs. Process costing is a system commonly used when a company produces a large quantity of identical or similar products, as is the current situation at Sparklin Automotive (White, 2010). Process costing accumulates direct costs, and allocates indirect costs. Costs are assigned on a large batch basis, often over time period (Ibid). So for the current product, SAC examines its costs on a macro basis, using daily, weekly or monthly production as the basis, then working backwards to calculate an average cost per unit. There is little consideration of the cost of different products under this system.
Job Order Costing
For companies that break their work down into jobs, a system called job order costing is often utilized. These companies typically perform work that varies with each order. Examples of firms that would use job order costing are auto mechanics, print shops, accounting firms and plumbers. The new custom spark plugs at SAC are an example of the type of product that would normally be subject to a job order costing system. Each set of custom spark plugs will have different specs, and as a result the cost structure for each will be different.
The mechanics of job order costing are more complicated than for process costing. Record-keeping and cost assignment issues are more complex and harder to manage under a job order costing system, for example (Accounting for Management, 2011). Job order costing does not aggregate costs for any time period, but for each job. This means that overhead and other indirect costs utilized for that particular job must be measured and included in the cost. This process can be difficult and arbitrary, but ultimately the objective is to understand exactly what costs are going into the job. One complicating factor is that the overhead costs may be incurred anyway -- if there are no incremental new overhead costs then no overhead may be charged to the project. However, if the project is taking time away from management, or uses some factory space that is part of the overhead, then this needs to be accounted for. These decisions can be made at a later date, but they complicate the process of conducting job order costing.
There are a few ramifications of selecting job order costing for the custom spark plugs over process costing. The first is that because job order costing allows the company to better understand its cost structure, the company is in a better position to set prices for the project. This is important, because the price is typically going to vary by job. In this situation, the prices may even be contracted, or contracted within a range, to each racing team. Thus, it is critical that SAC understand what the costs for each order are, so that they can set prices effectively. In addition, job order costing provides specific cost information that the company can use to manage its cost structure.
Another benefit of job order costing is that it is congruent with this type of work. The company has not used job order costing because its work has not been conducive. However, job order costing is used for most custom work. The company can analyze its cost data in multiple ways if this system is used -- it can analyze on a project-by-project basis or the different jobs can be aggregated. The different jobs can be analyzed for trend as well. A final benefit is that the company is in a better…