Do you clearly understand all of the costs you incur to create your product or deliver your service?
Now, that question may sound odd to you.
You scan your accounting transactions all the time, and you carefully review expenses in your income statement each month. Of course, you know your total costs.
However, if you operate in an industry that uses job costing, understanding your costs is more complicated. Job costing assumes that every customer job is slightly different and that you must track your costs by job, in order to assess profitability.
Contractors, including homebuilders and remodelers, operate using job costing, and properly accounting for job costs can be a huge challenge for a business owner. If you don’t manage your costs properly, you can’t determine the actual profit on each job, and your bids on new jobs won’t be accurate.
If you’re a contractor who’s concerned about profitability, read on.
Learn the definition of job costing, how it works, and how you can apply the concepts to your business and increase profits.
The pros and cons of the contracting industry
The contracting industry has its own unique set of pros and cons, and you need to understand these tradeoffs to succeed in the industry.
The contracting industry’s profitability is closely related to the overall economy, which has performed well in recent years. Due to new technology, changes in logistics, and other improvements in productivity, the construction industry has experienced steady growth.
However, operating your contracting business also presents big challenges. Rising material and labor costs, labor woes, increased competition, and shrinking profit margins are some of the challenges construction firms face.
Many contractors are doing more business in the current economy, but generating less profit per job. This survey points out that 29% of construction firms surveyed earned less than they originally estimated.
Perhaps the biggest challenge for contractors is the scope of the project. Scope refers to the tasks to be performed, costs incurred, staffing, and the timeline for a given project. The contractor and the customer sign a written agreement on the scope details.
Problems come up when the scope changes.
Maybe the client decides that they want two ovens in the new kitchen, so they can cook for large groups of friends. Or, your company starts to install a tile floor in the bathroom, and the homeowner decides on a different tile design.
You and your client can agree on scope changes, but they change the labor costs, material costs, and timeframe for the project. It can be a huge reason why projects end up delayed or over budget.
Ask yourself: Are you willing to accept the challenges of managing your contractor business?
If the answer is yes, keep reading.
Understanding job costing
If you’re going to operate a contracting business, you must understand the differences between job costing and process costing.
This is particularly important if you’re new to the industry, and your previous work involved process costing.
Job costing assumes that you complete work on a project basis and that the total costs required for each job are different. People who work in the trades, such as carpenters, plumbers, and tree services companies use job costing, and they provide each customer with a job estimate.
It’s important to get it right when it comes to job costing for construction. Contractors and construction firms spend large amounts of cash upfront for materials, and project managers must hire tradespeople for the project in advance. If you don’t know the true costs involved, you may lose money on the job.
If you need a tree removed, for example, the tree service company will estimate the labor costs, equipment, and materials required for the project, add a profit margin, and provide an estimate. Each job is different, given the size and location of the tree, and the distance required to drive to your home.
Process costing, on the other hand, is used when each product or service you produce is identical or close to identical.
Imagine a company that manufactures black plastic combs, for example. Making the combs is a process that requires material and labor costs, and costs are incurred as the product moves from one department to another. Plastic material is cut into the proper shape, then each comb is painted black, and finally the combs are packaged for shipment.
Process costing is easier for the owner, because the business only has to track costs for a particular batch of combs. Job costing, on the other hand, requires the owner to manage dozens, or even hundreds of individual projects.
To work efficiently in a job costing business, you need a reliable system to track costs. Make the commitment of time and resources needed to carefully monitor your job costs- it can make of break a contracting business.
Reviewing types of 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 you manufacture baseball gloves, for example, you can compute the amount of leather material you use in each glove, and the amount of labor cost it takes to run the machines. 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.
Manage costs for a contracting business
Meet Susie, she owns and operates Premier Contracting, a business that provides home remodeling and additions.
When she provides a bid to a potential customer, her direct costs are labor expenses and materials. Premier must also assign overhead costs, including the costs related to running the office, insurance premiums, and the company’s building lease.
How does Susie properly assign overhead costs to each job?
Use a level of activity
Overhead costs can be allocated 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. You 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 Premier Contracting’s overhead costs, and the activity level used to allocate the costs:
|Type of overhead cost||Activity level|
|Mileage costs||Miles driven|
|Office salaries||Direct labor hours worked|
|Home office costs||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.
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 Premier’s annual forecast for direct labor hours worked is 6,000 hours, and that home office costs are projected to be $30,000. Home office costs will be allocated at a rate of ($30,000 / 6,000 hours), or $5 per labor hour worked.
If the Johnson kitchen addition, for example, requires 50 labor hours, the customer would be allocated (50 hours X $5), or $250 in home office costs.
Every overhead cost is allocated using this same process, and these costs must be included in each job estimate.
Budgeting your costs
Now that you’re determined 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 about 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. Scan the expense categories and note each overhead cost and the amount you 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 projects Susie 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 Susie expects a 10% increase in sales, she 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
The two big direct costs for a contractor are direct labor and direct materials. As explained above, direct costs can be traced to a product or service.
The Johnson kitchen addition, mentioned above, requires 50 labor hours, and Susie needs to decide on a labor rate per hour. She also needs to budget for all materials, including a cost per square foot for lumber.
To create a budget for direct costs, Susie should review prior year jobs and note the labor rates paid and the costs she incurred for specific materials. Direct costs are budgeted based on rates, such as a labor rate, or a rate paid per square feet of material.
Once you have budgeted costs for both direct costs and overhead, you can create useful job estimates.
Create Job Estimates
Susie uses her budget to generate a job estimate for the Johnson kitchen addition. This estimate is an internal document that Premier uses to manage the project:
|Project:||Johnson Kitchen Addition|
|Home office costs||$250|
|Profit (15% of costs)||$3,808|
Direct labor costs are based on the wage rate and number of hours required for the project. In addition, direct materials are budgeted based on the amount of wood, steel, and other materials needed, and the rate paid for materials (per square foot, etc.).
Susie budgets a profit of 15% of the total cost, and profit is added to costs to produce a sale 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 $29,198 sales price.
Finally, Susie may also list all of her overhead as a single dollar amount on the customer’s job estimate.
Action items for job costing
To operate your contracting business 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 carpenter that is 15% higher than your budget, you need to increase your budgeted wage rate for carpenters. Now, this takes self-discipline, because you have to change your budget assumptions to recognize the benefit.
Earn higher profits
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 in your contracting business by using job costing.