The most popular tool to create a cost code is the universal product code, the unique number and bar coding with retail products sold. This same system is also used in manufacturing of complex products comprising multiple parts (think of autos, mowers, tools, appliances etc.).
In small business, it is actually done differently. Here, item codes are unique identifiers to identify certain services or functions of production. This article will explain this from the perspective of labor and a construction contract. For both, cost codes are used to evaluate the outcome against an original estimate. The difference between the two is evaluated by management to discover what works and any shortcomings that may exist.
To illustrate, let’s look at the two different perspectives and learn the value of cost codes in small business.
The primary purpose of cost costs in the service based industries is to track manpower based on skill levels against the revenue generated by that particular skill set. Other cost costs may track the physical materials used, but in general, cost codes with service are designed to track labor.
Here is an illustration to drive home the value.
CX Technology is a computer network installation and maintenance firm. The company has two divisions, installations and maintenance. The maintenance division generally has the more advanced skilled technicians as they have to deal with a wide array of issues and variety of systems. The maintenance division has one type of technician which is highly skilled and costs the most to the company. In general, they cost $45 an hour including all burden costs (payroll taxes, benefits, safety, training etc.). CX codes this level as a T1.
Over in the installation division, there are three types of technicians. The T1 technician exists here too, but their sole purpose is to conduct the final quality control and tests of systems built and installed. There are two other levels, T2 which are the primary technicians, they generally have more than one year of experience and are knowledgeable about the various hardware and network software. T3 is the lowest level and is the entry level tech, usually an intern or somebody fresh out of college/technology school. They are responsible to do the physical work of mounting hardware, running cables, setting up printers/copiers/scanners etc.
The owner usually does the estimating for the respective projects. The owner determines the total number of manhours based on the various levels and the corresponding costs of hardware and software licenses the company purchases to install the system. In general, the estimate looks like this:
Direct Costs of Install
Network System for a Small Office/Warehouse
. Computers/Monitors/Mobile $49,740
. Peripherals 37,218
. Supplies/Hardware 2,780
. Sub-Total Hardware $87,228
. Microsoft Products $11,787
. Office Management 4,691
. Accounting/Document Management 3,485
. Communication/Interfaces 1,216
. Inventory/Warehouse System 3,314
. Retail 1,684
. Engineering 7,492
. Sub-Total Software $33,669
. Speciality Tools $403
. Supplies (Rags/Cleaning/Connectors Etc.) 307
. Sub-Total Other $710
Total Direct Costs of Installation $136,252
This estimate is an internal report and is not what the customer sees. The customer’s estimate is a total price presentation including a list of actual equipment/software they will end up with along with the inclusive overhead and profit desired. This is purely the direct costs estimate for the purpose of comparing initial estimate against the final outcome.
All the costs are tracked with cost codes. Labor reports their respective time based on their actual levels for this project. After the project was completed, the labor section of the comparative report looks like this:
Naturally, the owner reviews this report and wants to know why labor costs are more than expected. To discover the answer he goes to the subjective elements and discovers that the T3 guys had a brand new guy in that group that was just hired, essentially it was his first project. So his lack of experience cost more time and the T2 technician had to do additional work to train and ensure the new T3 guy was doing his job properly.
The above illustrates that the reporting and initial estimating is typically done assuming that performance is normal when in reality, every employee is different in their abilities and knowledge. In the future, the owner will slightly increase the T3 estimates of time for similar projects and also increase the T2 estimates thus keeping his estimated costs in line with the actual costs.
Unlike service based cost codes which focus on the labor element of delivery, construction cost codes are usually driven by functions or phases of work.
Functional Based Cost Codes
Another form of a cost code is based on a group of costs (labor, material, equipment) for a particular function (phase) or time period of a project. For example, in manufacturing many products go through stages or steps for assembly. In baking, the first step is mixing of ingredients, the second step is of course baking, then there is preparation and finally packaging. Each of these steps involve labor, materials and in some instances equipment costs.
The same is true with residential construction. In this case, a home goes through multiple phases to acquire a certificate of occupancy. Each of these phases involve labor, materials, subcontractors and the use of equipment to successfully complete that phase. Here are the standard nine phases of building a home:
- Management/Project Intangibles – Includes the cost of the project manager, interest paid bank loans, governmental compliance (permits, inspections, environmental controls), utilities, real estate taxes during construction, homeowner association fees and debris removal. Even the port-a-potty is coded to this phase.
- Site Development – The purchase of the land and corresponding clearing of the site is included in this phase. This may include installation of drainage, temporary driveway, and the staking out of the home’s footprint. Once the home is completed, the landscaping items are posted here too.
- Footer/Foundation – Depending on the nature of the structure, this phase includes the digging out of the footer, concrete pours, any first floor flatwork including the garage floor and initial underground plumbing to the home. In addition, this phase of construction includes the CMU’s laid along with any facia brick on that foundation. Those homes with basements have the initial basement walls and sealing included in this phase.
- Structure – This phase is the one that identifies the greatest change related to the home. The actual framing, installation of exterior doors/windows, the garage door, roof and exterior siding is included here. Think of this as the drying in step of construction.
- Trades – Electrical, plumbing, mechanical and home entertainment is customarily posted here.
- Walls – Insulation, sheetrock, trim, and painting are included in this phase; in addition interior doors, hardware and customized trim work.
- Fixtures – Tile work, kitchen cabinets, vanities, countertops, appliances are customarily posted to this phase.
- Floors – Floor tile, carpet, hardwood flooring and other custom selections are included in this phase.
- Other – Decks to out buildings are customarily posted here. This phase often includes change orders, warranty type work performed and incidentals.
Some contractors break out the phases into more distinctive sections and will have phases or cost codes upwards of 50 to 60 items. Again, the codes will include labor, materials and subcontractor bills.
When the initial estimation of costs is generated, the contractor/estimator groups these individual estimates into a pool which is referred to as the phase of construction making the development of the total estimate manageable. As the respective labor hours are posted to the phases of work and the corresponding bills for materials/subs are posted to the phases, the final costs of that phase can be compared to the original estimated cost of that phase. I have written several articles about this aspect of accounting and using cost codes for construction and if you need more information please read the following:
- Use Phase Accounting in Construction
- Project Accounting Principles for Residential Contractors
- Phase Codes and Cost Codes with QuickBooks and Construction Accounting
- Job Cost Reports – Balance Sheet Set
Summary – Cost Codes
Cost codes are customarily unique identifiers for inventory items or labor. In addition they can be functional based around a step in a product’s development or a time period to make the end product. Functional based cost codes include all the attributes of labor, materials and other costs in this one grouping. When developing your cost codes for your business, think about whether you are service based, retail or involved in manufacturing and develop your codes with this in mind. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.