Do you really know how to price your product or service?
What assumptions are you making about your costs? Are you pricing your product so low that you’re not making a consistent profit?
As Entrepreneur.com explains: “Generally, the more you know, the less risk you perceive. From that perspective, pricing is all about getting as much information as you can about your market, your customers and your own internal numbers that drive your profit.”
One way that owners get pricing information is by planning their costs, and investigating differences between budgeted costs and actual spending.
Assigning costs to your product is more difficult when each customer job is different. If you work in an industry that provides an estimate to each customer, you must use job costing.
If you’re not familiar with job costing, and you don’t know the full cost of your product or service, read on.
Meet Jean, who needs to use job costing for her catering business
Jean owns Elegant Catering, a firm that provides catering services to corporate customers.
Elegant offers a menu of food and dessert items for lunch and dinner events.
The caterer provides staff to set up, serve, clean up, and remove food, and Elegant determines the number of staff members that are needed, based on the number of people served at each event.
Jean has operated her business profitability for 10 years, and she has not used job costing to manage the operation.
Like many successful business owners, Jean uses her industry experience and knowledge about competitors to estimate her costs and price her services. She knows her food costs, because many items that have been on her menu for years. Jean plans her staffing based on information she knows about her competitors.
However, Jean’s knowledge about her costs may be incomplete.
Based on a recommendation from her accountant, Jean has decided to use job costing to more accurately plan her costs and her sale prices.
Why Elegant must use job costing
Jean needs to use job costing, because each customer order is different.
The number and type of menu items selected is different for each order, along with staff members attending event, and the mileage to and from the venue.
In addition, Elegant changes the items on its menu periodically, based on client preferences and the season. As a result, a party booked in June will order from a different menu than events planned in December.
Process costing, on the other hand, is used when each product or service is identical, or close to identical, and this costing method does not apply to Jean’s business.
Take a look at your business, and decide if job costing applies to your operation.
Considering prior year results
To start the job costing process, Jean considers her income statement results for the prior year:
|Elegant Catering Income Statement
For period ended 12/31/20XX
The vast majority of Jean’s costs are tied up in food costs, and in labor costs to prepare food, deliver meals, and to cater events.
She also incurs costs for mileage and packaging.
Elegant owns ovens, refrigerators, and kitchen equipment to prepare food, as well as warmers, serving dishes, plates, and silverware for use at client events. Jean’s staff delivers food using two company vans. All of these assets incur depreciation expense.
Finally, Elegant incurs a number of office-related costs, including the building lease, computers, office furniture, marketing costs, insurance, utilities, and a $50,000 salary for Steve, Elegant’s office manager.
Jean’s job costing goal is to ensure that every cost incurred is recovered by a catering sale. This goal requires Elegant to “attach” every dollar of spending to a catering job.
If every cost is accounted for, Jean knows the true cost to operate her business, and can price her catering sales to generate a specific level of profit.
Use your prior year income statement to identify each type of cost that your business incurs.
Understanding direct and indirect costs
To set up an effective job costing system, you need to differentiate between direct costs and indirect, or overhead costs.
Overhead costs are the most difficult costs to assign to a product, and business owners frequently have difficulty analyzing these costs. Overhead costs cannot be directly traced to a product or service- insurance premiums and utility costs are two good examples.
On the other hand, direct costs can be easily traced to a product or service. If a customer orders 15 Cobb salads, for example, Jean knows the dollar amount of food costs that go into each meal. She also can easily compute the labor rate and hours worked for three staff people who work a particular catering event.
As a result, material and labor costs are frequently classified as direct costs.
To determine the true cost of your product or service, you need a method to assign costs to each job you complete.
Allocating overhead costs
Overhead costs can be allocated to each job, based on a level of activity.
The logic here is that a business incurs costs based on activities, such as the number of labor hours worked, total miles driven, or total units produced. If your company didn’t produce or sell anything during a particular month, many costs would not be incurred.
Your next step is to decide on an activity level that causes you to incur each overhead cost.
In some cases, the connection is obvious. Elegant can allocate mileage costs based on the number of miles driven to and from a particular customer’s location, for example.
Make your best effort to connect each overhead costs to a related (or somewhat related) activity.
Connecting an activity to overhead costs incurred
Here are three of Elegant’s overhead costs, and the activity level used to allocate the costs:
|Type of overhead cost||Activity level|
|Mileage costs||Miles driven|
|Office salary||Direct labor hours worked|
|Insurance expense||Direct labor hours worked|
Mileage costs have an obvious connection to miles driven, but the other two costs are harder to allocate. When there is not an obvious connection to an activity level, companies most often use direct labor hours worked.
In Elegant’s case, direct labor hours worked include wages paid for food preparation, delivery, and for staffing a catering event. As explained above, these costs can be directly traced to a particular client’s event.
Wages paid to Steve, the office manager, are indirect (overhead) costs that cannot be easily traced to a client, and overhead hours worked should not be used to allocate an overhead cost.
Why using direct labor hours makes sense
Here’s the rationale for using direct labor hours worked:
If a Job A required more labor hours than Job B, it makes sense to assign more overhead costs to Job A. Job A simply takes more effort, and should be assigned more costs. It’s not a perfect allocation, but it’s an accepted approach that many companies use.
Here’s an allocation example:
Assume that Elegant’s annual forecast for direct labor hours worked is 12,000 hours, and that office salary costs are projected to be $50,000. Office salary costs will be allocated at a rate of ($50,000 / 12,000 hours), or $4.17 per labor hour worked on a catering job.
Every overhead cost is allocated using this same process, and these costs must be included in each job estimate.
Budgeting your costs
Once you determine an activity rate to allocate each overhead cost, you need to budget for both direct cost and overhead costs.
This step is important, in order to generate job estimates that are as close to your actual costs as possible.
Sure, your actual costs may be different than what you budget. A labor shortage, for example, may require you to pay more for labor costs than you planned. But thinking carefully and creating budgeted costs minimizes the differences between budgeted and actual costs.
As a business owner, that’s the best you can do.
Plan your overhead costs
To create a budget, start by reviewing your income statement for the prior year. For Elegant Catering, Jean should scan the expense categories and note each overhead cost, and the amount spent in the prior year.
Some overhead costs, such as insurance premiums or a building lease, are fixed costs, and those can be used to allocate overhead in the current year.
Other overhead costs must be estimated for budgeting purposes. Mileage costs, for example, will vary, depending on the number of catering jobs Elegant completes, and the distance between each job and the office.
To budget for variable overhead costs, consider the prior year expense, and your expected change in sales for the year. If, for example, mileage costs totaled $5,000 in the prior year, and you expect a 10% increase in sales, you can budget for a 10% increase in mileage, or $5,500.
Your goal is to decide on a budgeted dollar amount of annual overhead cost for each cost category.
Budget for direct costs
Elegant’s two big direct costs for a contractor are direct labor and food costs. As explained above, direct costs can be traced to a product or service.
Jean should keep a record of the total food costs by menu item, so that she can properly estimate direct costs for each meal.
To create a budget for direct labor costs, Jean must estimate the number workers and hours needed for a typical catering event, and adjust the total based on travel time and other factors.
Once you have budgeted costs for both direct costs and overhead, you can create useful job estimates.
Creating useful job estimates
Jean uses her budget to generate a job estimate for the Smith’s graduation party. This estimate is an internal document that Elegant uses to manage the work:
Smith Graduation Party Event
Jean budgets a profit of 15% of total cost ($180 profit / $1,200 revenue), and profit is added to costs to produce a $1,200 sales price for the customer.
The job estimate given to the customer won’t list the profit as a line item. Instead, the dollar amount of profit is added to each cost category, and the total adds up to the $1,200 sales price.
When the customer approves the estimate, Elegant Catering generates an event contract that is signed by both parties.
At the end of each month, Jean should compare her job estimates to the actual cost incurred for every catering job. Comparing budgeted to actual costs is referred to as variance analysis, and it’s important to understand these differences to make changes in your business.
Changing customer behavior- and increasing profits
Some customers don’t know how to behave…
Many owners have to deal with clients who demand more than is agreed to in the contract.
A catering customer, for example, might expect the catering staff to do far more cleaning than the contract outlines. If a client changes the time of the event at the last minute, Elegant may incur costs to reheat food, or to prepare a second batch of meals.
These situations cost the business time and money, and Jean’s firm will earn less on the job, or even lose money.
So, what to do?
Business owners should explain how they handle these potential issues with the client, and include language in the contract that assesses more costs if needed.
What you’re really doing is coaching the customer, and motivating them to avoid behavior that may cost your business money. If customers ask you for more catering business down the road, these issues will be less of a problem- because the customer has been trained.
Action items for job costing
To operate your business successfully using job costing, implement these steps:
- Annually: Create budgeting costs for both direct cost and overhead costs.
- Monthly: Review each completed job, and compare budgeting costs (in your job estimate) to actual costs, and investigate the differences that you find and document your findings.
- Each job estimate: Use your budgeted assumptions for each job estimate you generate.
If you notice actual costs that are more than 10% higher than your budget, you need to use that information in your job estimates going forward. This is the real benefit of job costing: you use what you learn during the year to generate more accurate job estimates.
If, for example, you have to pay an hourly wage rate for a worker that is 15% higher than your budget, you need to increase your budgeted wage rate. Now, this takes self-discipline, because you have to change your budget assumptions to recognize the benefit.
Work smarter, and gain peace of mind
If you understand job costing and use it to generate job estimates, you can make informed decisions and increase company profits.
Make the commitment to review each completed job’s cost, and make changes to your budget assumptions as you move forward. This strategy will help you maintain profitability, and you can avoid jobs that won’t be profitable for you.
Work smarter using job costing, and you’ll gain confidence and peace of mind.