Bookkeeping – Project (Job) Costing (Lesson 72)

Job Costing

Another tool used by accountants to evaluate financial performance is project costing. It is also referred to as contract or job costing. This lesson uses the term ‘job’ throughout. Job costing focuses on a specific long-term project customarily associated with a contract signed with a customer. It is never used in retail or rarely used with any homogenous industry (manufacturing, entertainment, service or food service). The most common use is in the following industries:

  • Construction (from site development to commercial fabrication)
  • Engineering
  • Shipbuilding and Repair
  • Government Contracts
  • Technology
  • Farming

Job costing is very similar to departmental accounting but is more narrowly defined to a particular customer and that customer’s purchase. This lesson explains the fundamentals of job costing and its advantages. There are only a few drawbacks. Another section describes the actual bookkeeping process including the two widely used versions – percentage of completion and completed contract. The final section illustrates a set of reports customarily prepared with this method of accounting.

 

Fundamentals of Job Costing

The primary purpose of job costing is answering the question of profitability from the respective project. A project’s revenue and direct costs are mixed with other project in a general income statement (profit and loss statement). Even if the company uses departmental accounting the project’s earnings are still mixed with projects of a similar nature. Job costing is more refined in scope to one single contract. Other advantages include:

  1. Identification of successful aspects and areas that need work
  2. Comparison of actual results to estimations
  3. Historical Database for future comparisons to similar projects
  4. Excellent tool to evaluate project managers

There are a few drawbacks and they include:

  1. More documentation requirements
  2. A greater dependency on accuracy by the bookkeeper
  3. A single error can create misleading outcomes
  4. Not a pure costing concept

Ideally, only the contracted earnings and the associated direct costs are included in job costing. Shared costs of contracts are excluded and include:

  • Project management salaries and benefits, specifically those managers that handle more than one contract at a time;
  • Insurance costs for projects are generally purchased in the aggregate and not for a particular project;
  • Transportation expenses are for all vehicles used in contracts and it is unusual to have a particular vehicle assigned to a single contract;
  • Communications are also general costs spread across several jobs; and,
  • Tooling and equipment depreciation are rarely purchased for a single job, therefore their costs are spread over several jobs.

In order for job costing to work, the costs of sales section must be divided into two broad categories. One is called ‘Direct Costs’ which are costs that are identifiable to a particular job. The second is called ‘Indirect Costs’ which are costs spread over several jobs.  Indirect costs are not overhead expenses as overhead expenses occur whether work is performed or not. Here is some helpful delineation between the two.

Indirect Costs – Expenses paid in order to get the work done. These expenses would not exist unless there were ongoing jobs. Examples include:

  • Project management salaries and benefits
  • Project manager’s truck and fleet vehicles servicing all projects
  • General liability insurance, bonding, property and worker’s compensation insurance
  • Field communications including radios, cell phones and land lines
  • Tooling including general supplies (rags, cleaning agents, safety gear, protective clothing).

Expenses (Overhead) – Those expenditures paid from gross margin of all revenue sources are referred to operating expenses. These include:

  • Management – Front and back office payroll, taxes and benefits
  • Facilities – Rent, real estate taxes, maintenance, repairs, utilities, CAM fees
  • Insurance – Professional, life, disability, general overall insurance
  • Office – Technology, office supplies, marketing and advertising, postage, meals
  • Taxes and Licenses
  • Other
  • Capital Expenses – General depreciation, amortization, interest, leases

A typical job costing income statement will look like this:

                                      York Tank Systems Inc.
                        Income Statement (by Job and in Summary Format)
                           For the Month Ending August 31, 2017

                                     Project ‘A’       Project ‘B’        Project ‘C‘          Total
Contracted Sales           $108,201         $241,796         $79,803         $429,800
Costs of Construction
Direct Costs:

  Materials                        18,612              33,155             4,602             56,369
  Engineering                     9,740              12,127             1,207             23,074
  Labor                             10,344              16,805            13,911             41,060
  Subcontractors                    –                    7,200                 –                    7,200
  Other                               6,516              11,887              4,201              22,604

  Sub-Total Direct            45,212             81,174            23,921            150,307
Project Profits                $62,989         $160,622         $55,882           $279,493
Indirect Costs:                
  Project Management                                                                             17,410
  Transportation                                                                                       12,071
  Insurance                                                                                               16,403
  Communications                                                                                     4,222
  Tooling                                                                                                    6,909
  Equipment                                                                                             14,712
Gross Profit                                                                                           207,766
Expenses
  Management                                                                                         28,401

  Facilities                                                                                                 9,617
  Office                                                                                                      4,141
  Insurance                                                                                               10,313
  Taxes and Licenses                                                                               22,842
  Other                                                                                                     13,911
Operational Profit                                                                                 118,541
Capital Expenses
  Depreciation                                                                                         19,618
  Amortization                                                                                          2,440
  Interest                                                                                                   7,649
  Leases                                                                                                    6,102
  Capital (Gains)/Losses                                                                           4,110
Net Profit                                                                                              $78,622

One of the drawbacks sighted above is the fact that job costing is not a pure concept. This means indirect costs to fulfill the contract cannot be directly allocated to the respective jobs. In the above example, there are $71,727 of indirect costs on $429,800 of contract sales. This is 16.7% of total sales which is a significant percentage. But without some form of allocation per line item, there is no genuine way to say that project ‘A’ incurred certain indirect costs. The income statement’s cost of contracts section is divided into direct and indirect costs. This format will exist in any job costing operation unless management is willing to pay the high cost of professional help to create allocation formulas for indirect costs.

The real value of job costing is identifying the dollars the particular job generates. In the above example project ‘C’ generates a 70% direct profit margin. Management will spend time identifying the characteristics of this job that allows for greater margins. Whereas project ‘A’ with a 58% margin will be bid higher when a similar job is requested in the future. Just in this case alone the dollar value of  ‘C’s characteristics over the other jobs equate to $2,873 per month. That is a significant value. If all jobs where similar it would equal $15,500 per month or $185,673 per year of additional profit.

Job costing will easily pay for itself!

Accounting Process for Job Costing

Job costing is relatively easy to set up and use with most accounting software programs. In a similar manner as departmental accounting and additional field is added to the journal entry screen. To illustrate here are the fields customarily found in a traditional entry system, a departmental accounting system and with job costing.

  Traditional                    Departmental                    Job
      Entry                          Accounting                    Costing
     Date                             Date                                Date
     Transaction ID             Transaction ID               Transaction ID
     Ledger Account           Ledger Account              Ledger Account
     Control ID                   Control ID                       Control ID
        ——-                         Department                    Department (if applicable)
        ——-                          ———-                         Job Identifier
     Description                  Description                     Description
     Debit                            Debit                               Debit
     Credit                           Credit                              Credit

As a bookkeeper transitioning to accounting I hope you spotted a couple of interesting aspects of a job costing entry journal entry.

First, notice that departmental accounting can be used with job costing. How so? Well jobs are a subset of either the company or as a subset of a department. For example, residential contractors may have three departments: New Home, Remodeling and Additions. It is quite logical that a contractor can have several projects within one or more of the respective departments. Yes, a job can be classed (QuickBooks term) to a department; but only if departmental accounting is used.

The second item of interest is the control identifier field. Why can’t the job be a control identifier? The answer is simple. Often the control identifier and the job identifier are needed. Control accounts are used mostly with balance sheet accounts. Remember the two most common control accounts are accounts receivable and payable. A customer or vendor is usually inserted in the control identification field and a customer may have more than one job in progress with the business.  As an example, I had a client that ran an electrical repair and installation business, his best customer was a hospital. This one customer would have upwards of 10 projects ongoing at the same time in various stages of construction. In addition, just like departmental accounting, job costing is an income statement driven concept. With the exception of using the completed contract method of accounting (explained below), most job costs and revenue are recorded directly to the income statement.

Notice that as the accounting method gets more selective, from general to job specific, the data entry at the source requires more fields of data. This is really taken to the extreme in the next article related to phase accounting (Lesson 73).

Before continuing, the accountant needs to be introduced to two more terms – percentage of contract completion method and completed contract method of job costing. This is covered in more detail with Lesson 74.

Percentage of Contract Completion

With job costing there is often a significant time delay between costs incurred for a job and the actual billing of the job. At billing, the revenue is recognized and it is not uncommon to incur costs in a prior interim period before recognizing income. Job costing can greatly distort financial information especially with interim reporting. To alleviate this, accountants use percentage of contract method to recognize the approximate amount of revenue actually earned but not yet invoiced to the customer. For example, if 23% of the job is complete at the end of the first interim reporting period, the company will recognize 23% of the contract value by debiting a temporary receivable and crediting sales as illustrated with this entry.

Sales Journal
Date          ID      Ledger     Control       Job             Description                      DR            CR
08/31/17   1042  Sales        St. Mary’s   ENDO-04   18% of Rewiring Lab                    65,400
                 1042  A/R          St. Mary’s   ENDO-04  18% of Rewiring Lab    65,400           –    
                                                                                                                        65,400      65,400

This allows for proper matching of direct costs to a source of earnings for evaluation purposes.

Completed Contract

The alternative is to wait to recognize revenue until the job is complete. This is a really good an effective approach if a business has several long-term jobs that are relatively high dollar amounts in comparison to the total sales volume for the accounting period. With this approach, revenue is recorded at job completion along with the associated costs to the income statement. Most accountants accumulate costs under this method in a work in process account on the balance sheet (similar to inventory) and then transfer all costs and revenue upon completion. This is explained in more detail in Lesson 74.

A Set of Reports – Comprehensive Example

Marty is the managing partner in an eight employee computer technology services company named Mayberry Technology. He has three distinct departments: Retail Sales, Maintenance/Service and Engineering. The engineering section’s goal is to generate a 20% gross profit margin. This gross profit does not cover this department’s share of the general overhead expenses. But Marty provides this service to get access to the very lucrative maintenance and service agreements he has with customers.

The engineering department designs and installs computer networks and technology systems (phone, retail/inventory monitoring, security and facilities monitoring). Every contract is managed as a project and so Marty uses job costing within this department.  Marty pulls his departmental income statement during August to review performance and finds the following results.

                                   Mayberry Technology Ltd.
                            Departmental Income Statement
                        For the Month Ending August 31, 2017

                          Engineering     Maint/Service      Retail         Total
Sales                    $110,700            $48,327             $21,006     $180,033
Cost of Sales
Direct Costs:
   Hardware             67,418                3,209                 4,811         75,438
   Software              23,902                 5,901              12,644         42,447
   Accessories           9,617                 2,016                1,753         13,386
   Labor                  16,610                 7,281                 1,072         24,963
   Other                    2,344                    761                      85           3,190
Direct Profit           (9,191)             29,159                    641         20,609
Indirect Costs:
   Management        2,110                 1,440                    700           4,250
   Transportation        481                    763                      -0-           1,244
   Insurance                257                    344                    105              706
   Communications    363                    406                    204              973
   Tools                      144                      82                      -0-              226
Gross Profit      ($12,546)            $26,124                ($368)       $13,210

Marty realizes the engineering department lost money and it should have earned around $23,000 as its gross profit. This is a $35,500 difference. Marty wants to understand why. Therefore, he pulls his job costing report for engineering and gets the following results:

                                       Mayberry Technology Ltd.
                      Job Costing Report (Engineering Department)
                           For the Month Ending August 31, 2017
                              Mid-Town Auto        Dr. Moore       Ace Hardware
                          Computer Network    EMR System     Phone System       Total
Contracted Sales         $36,190                   $63,200              $11,310            $110,700
Cost of Sales 
Direct Costs:
  Hardware                    56,193                        9,233                 1,992                67,418
  Software                       9,562                      11,693                  2,647                23,902
  Accessories                  4,920                        2,536                  2,161                  9,617
  Labor                            6,532                       7,677                  2,401                16,610
  Other                            1,890                          348                     106                   2,344
Direct Profit              ($42,907)                  $31,713                $2,003                 (9,191)   
Indirect Costs:
  Management                                                                                                      2,110
  Transportation                                                                                                      481
  Insurance                                                                                                              257
  Communications                                                                                                  363
  Tools                                                                                                                    144
Gross Profit (Departmental Profit)                                                               ($12,546)

The Mid-Town Auto job has a huge loss and Marty shakes his head in disbelief. What is going on, he wonders?

Marty then realizes two problems with that particular job. First is the lead engineer. It turns out he was out of the office for vacation for three weeks in August. The lead engineer’s salary was charged to the job but he didn’t do much work. The lead engineer got married, honeymooned and was out for the third week because he got sunburned on his honeymoon.  All the systems were installed but the lead engineer has yet to configure and test the network for release to the customer. The second problem, per the contract, Mayberry earns one-third of the contract price once all the hardware and software is installed. Once the system is configured and tested, Mayberry is allowed to bill for the remaining two-thirds. Marty understands he will earn another $72,380 once the lead engineer has configured and tested the system. At this point, the month of August looks poor solely due to this one job.

As a side note to this scenario, Mayberry could use the percentage of completion method to recognize additional revenue. Marty estimates the job as 75% complete. The contract value is $108,570 ($36,190 is 1/3rd).  Therefore actual revenue earned on this job is $81,427 which generates a $2,330 direct profit for this job. This is a $45,237 increase in this department’s gross profit. The final net departmental profit is $32,691. This is a 20.95% margin for the engineering department. Here are the modified results.

Engineering Department
Sales                 $155,937 ($110,700 original calculation plus $45,237 earned on the Mid-Town Auto contract)
Direct Costs        119,891  No Change
Indirect Costs         3,355  No Change
Gross Profit         $32,691

The 20.95% gross margin is very close to what Marty desires from this department. To address this issue and prevent future misleading results, Marty should incorporate the percentage of completion method with job costing. Again, percentage of completion is explained in Lesson 74.

There is more information for Marty related to the above engineering job costing report. For one, why did the phone system install perform so poorly? Why did the EMR system install do so well? These questions are answered by breaking the job down into components called phases. Phase costing is customarily used with job costing and is explained in Lesson 73.

Summary – Job Costing

A more focused form of accounting used to evaluate financial performance is called job costing. It is a very effective tool for business operations producing or servicing non-homogeneous operations. It is used with contract driven operations like construction, shipbuilding and engineering. It helps to identify problems areas to compare against the original estimates and make corrections for future similar work. The only drawback of importance is the need for accuracy including using the percentage of completion method to record sales and costs.

The reports only include sales and indirect costs of the job. Costs that are spread over several jobs are excluded in order to prevent misleading results. These types of costs are referred to as ‘Indirect Costs’. Job cost reports are a part of the management set of reports used in accounting. By continuously monitoring results management is able to make improvements to the bottom line. Act on Knowledge. 

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