Do you control your business, or is your business controlling you?
Gino Wickman, an author and business consultant, finds this lack of control as a common frustration with entrepreneurs. Gaining control over your business requires time, and there’s often not enough hours in the day.
Money is also a big source of anxiety for business owners.
A 2019 survey finds that the top challenge for small businesses is a lack of capital or cash flow. If you make mistakes and lose money, you have less cash to operate, and finding additional capital is even more difficult. As an example, this recent construction industry survey found that 29% of respondents had a lower actual profit than planned.
So, how can you manage your time and generate a higher profit?
Successful business owners use cost accounting to gain control over company operations, make better decisions, and to maintain profitability. Read on to find out more.
Understanding differences in costing methods
The costing system you choose, however, depends on the type of business you operate. Think about which of these explanations applies to your business:
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.
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.
Now, most companies produce more than one product, and they use process costing by making batches of identical products. Batch A might be 1,000 black combs, and batch B is 2,000 pink combs.
The batches are slightly different, and the manufacturer makes adjustments to switch from one product to another. In fact, the cost incurred to change machine settings and to move in different materials is part of each product’s overhead cost.
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.
Reviewing types of 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 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 the product or service you sell.
Meet Susie, who uses a job costing system
Susie owns and operates Premier Contracting, a business that provides home remodeling and additions. You’ll find that job costing is used frequently in the construction industry.
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 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 office salary 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 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. 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.
If the Johnson kitchen addition, as 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 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.
Susie may also list all of her overhead as a single dollar amount on the customer’s job estimate.
If you think a job costing system applies to you, follow the steps above to capture all of your costs and to price your product.
On the other hand, if you don’t operate using job estimates, you’ll need to use process costing.
Meet Jill, who uses process costing in her manufacturing business
Jill owns Alpine Clothing a business that makes apparel for hikers, bikers, and other outdoor activities. One of Jill’s most popular items is the Sierra line of men’s shirts. These cotton shirts are made with reinforced stitching and extra layers of fabric to prevent tearing.
Compute the cost per unit produced
To implement a process costing system, the first step is to compute the cost per unit produced. Each type of product you produce will have a slightly different cost total.
Just as with job costing, Jill must create a budget with assumptions about costs. Alpine must budget for the cost of materials, and make assumptions about wage rates to determine labor costs.
Here are the budgeted costs to produce a Sierra shirt (size large), the profit generated, and the sale price:
|Sierra Men’s Shirt||Cost per shirt|
|* Cotton fabric|
|* Buttons, thread|
|* Cutting, sewing, packaging|
|Profit (25% of costs)||$17.50|
Alpine purchases cotton fabric by the square yard, and each shirt also requires buttons and thread for assembly.
Jill’s staff runs machinery to cut the cotton fabric, sew each shirt, and to package the shirts once they are completed.
Finally, Alpine assigns overhead to each product, and the process of allocating overhead is the same process used in job costing. Jill determines her overhead costs, decides on an activity level, and allocates overhead costs.
While the overhead allocation process is the same, the types of overhead costs differ by company. Alpine, for example, allocates the cost to lease its manufacturing facility based on the number of total clothing units (shirts, pants, etc.) produced. A carpenter or plumber, on the other hand, must allocate overhead costs for mileage driven to work for clients.
Each Sierra shirt is allocated overhead for the building lease, and other items, totaling $10 per shirt.
Tracking material costs moved into production
The first dollars spent in a process costing system are for materials. That’s because you purchase materials (cotton fabric, thread) before you pay workers to do something with the materials (cut and sew shirts).
Accountants use control accounts to track costs that eventually go into the manufacturing process, and you can think of control accounts as a “parking place” for costs.
If, for example, Alpine buys $1,000 in cotton fabric to make shirts, a cotton material control account is increased by $1,000.
Using timecards to track labor costs
Alpine Clothing’s staff uses a timecard system to track each worker’s total hours worked. At the end of each day, the gross wages (labor rate X hours worked) for each worker is posted to the labor control account, which “parks” labor costs until they are assigned to production.
Using work in process
When Alpine starts production on a particular batch of shirts, the company tracks the costs used in production in the work in process account.
It’s important to note that the costs that go into work in process are actual costs, and the actual costs may differ from your budget. Accounting software packages allow you to input your budget assumptions, post your actual costs, and keep track of any differences.
Say, for example, that Alpine starts batch #210 to make 500 large Sierra shirts. Here is work in process account for the batch, using the cost descriptions explained above:
|Sierra Men’s Shirt: Batch #210||Total Cost for Batch|
|Direct material control||$13,500|
|($27 X 500 shirts)|
|Direct labor control|
|($32 X 500 shirts)||$16,000|
|($10 X 500 shirts)||$5,000|
You see that the actual material cost per shirt is $27 ($2 more than budgeted), and that the labor cost per shirt is $32 ($3 less than budgeted).
Now, this is the tough part of process costing: Jill’s firm needs to precisely track the material costs and labor costs that are needed to make a particular batch of shirts.
When a worker pulls a new roll of cotton fabric off the shelf to make shirts, the cost must be moved out of material control and into work in process. If a worker incurs three hours of time working on batch #210, the gross wages must be reclassified from labor control in work in process.
To track these costs accurately, you need to use technology that allows your staff to easily record this activity. Jill also needs to hold her staff accountable for using these systems everyday. If not, Alpine can’t track product costs.
Accounting for finished goods
When a batch of shirts is completed, the total costs (materials, labor, and overhead) are moved from work in process to finished goods. As the account name implies, these products are finished and ready for sale.
Knowing all costs at any point in time
When Jill shuts the doors of her factory at the end of the day, her material costs are posted to one of three accounts: material control, work in process, or finished goods.
The same is true of labor costs and overhead. Process costing allows you to monitor costs for products that are not in production yet (control account), products that are partially completed (work in process), and goods that are ready for sale (finished goods).
If you manage process costing accurately, you’ll know all your costs at any point in the production process.
Finally, the value of using a process costing system is to collect data to make improvements in your business.
Jill can make changes in her production process by investigating the differences between actual costs and budgeted costs, a process referred to as variance analysis.
If the actual material cost per shirt is $2 more than budgeted, Alpine may have paid a higher rate for cotton fabric than planned. Jill can contact her supplier and try to negotiate a lower rate per square yard of fabric, and possibly lower costs.
Batch #210 also had a labor cost per shirt is $3 less than budgeted. Alpine may have paid a lower wage rate than planned, or workers simply worked more productively and took less time. Either way, Alpine was below budget, which is a good thing.
If you can implement an effective process costing system, you can calculate the full cost of your product, and decide on a sale price that generates a reasonable profit.
Action items for job costing and process costing
To get the most out of your costing system, implement these steps:
- Annually: Create budgeting costs for both direct cost and overhead costs.
- Monthly: For job costing, review each completed job, and compare the budgeted costs (in your job estimate) to actual costs, and investigate the differences that you find. If you use process costing, review your costs by batch, rather than by job.
If you notice actual costs that are more than 10% higher than your budget, you need to determine whether to not you budget assumptions are still reasonable.
Assume, for example, you have to pay an hourly wage rate that is 15% higher than your budget. You investigate and determine that the current labor market will force you to pay the higher wage rate for the rest of the year.
Rather than use a budgeted wage rate that is artificially low, increase your wage rate as you budget moving forward. Now, this takes self-discipline, because you have to change the budget assumptions in your accounting software.
Making the budget change is worth the effort, because you’ll operate based on a budget assumption that is closer to reality, and that will help you make better management decisions.
Beat your competitors
What’s the real payoff for implementing a product costing system?
You may end up with better information than your competitors.
If you understand all of the actual costs that are required to deliver your product or service, you’ll know exactly where you stand financially. You can be confident that the sale price you select for a particular item generates the profit you expect.
You’re not flying blind, and that’s a huge competitive advantage.
Many of your competitors may not have a handle on their true costs, and they may be losing money- without knowing it. Owners that don’t use cost accounting often get to the end of the month and wonder why they operated at a loss.
Don’t be that type of owner! Use cost accounting to outperform your competitors, gain market share, and to increase profits.