Job Costing

Job costing is one of the forms of cost accounting. It is used in conjunction with financial accounting to alert management about profitability with production. Those organizations with revenues greater than $25,000,000 per year generally separate their financial accounting from their job costing system and hire a cost accountant to augment the accounting staff. Companies with revenues less than $25M per year generally use a combined accounting system that can provide both job costing reports and financial reports. This article is an introduction to job costing, why it exists and how it ties to financial accounting. Other articles on this site go into greater detail related to job costing, especially for specific industries such as construction, manufacturing and service based operations. For the reader, this article is merely an introduction to job costing.

Introduction to Job Costing

Job costing is a process of tracking costs for a single function or product. In general, those end products requiring multiple inputs of labor, materials, outsourced labor, equipment rental/utilization and government compliance. These resources are tracked to assist the company in identifying discrepancies or errors against a set standard (an estimate, contract or established norm) used with job costing. It is an accounting tool that quickly points to any mistakes. It is used by very few industries and does require some sophistication in the accounting department to get it set up and operating properly.

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There are generally four groupings of business models. They utilize a sales volume against sales margin (sales less cost of goods sold as a percentage of sales), they are:

High Volume, High Margin
High Volume, Low Margin
Low Volume, High Margin
Low Volume, Low Margin

Companies with high volume of sales are commonly found in the retail, food and human services industries. Good examples of high sales volume businesses include traditional retailers, restaurants, fast-food eateries, hair salons, medical practices, lawn maintenance, cleaning services, entertainment venues, hospitality (hotels, resorts etc.), equipment rental, auto repair services, fueling depots, and transportation. The most common theme among these groups are low dollar transactions, i.e. it is rare that a sales transaction is greater than $1,000. Thus, any business falling within groups one and two above generally do not apply job costing as alternative systems are used to evaluate performance.

Those business entities that are low volume high margin based operations such as subcontractors, auto collision shops, medical specialists, professional services, and certain retail (furniture, jewelry, electronics) may implement job costing to track margins but don’t because there exist patterns within the business model and its easy to determine discrepancies. This doesn’t mean they don’t have to, some do, but because the particular product/service is repetitive it is easy to identify errors and fix them. However…

Those operations that commit large volumes of resources such as manpower, equipment utilization or capital resources must use job costing to track the total costs involved to compared against the sale value related to the particular project. A common thread that binds job costing is a signed contract. Contracts customarily exist for large dollar based projects (jobs) and thus the company wants to track actual costs against the final value derived. Job costing is designed to eliminate or reduce errors and this is really essential with low volume, low margin operations. The following industries (low volume/low margin) make it a custom to use job costing:

Site Developers
Road/Utility Contractors
Residential Builders
Shipbuilders/Shipyards
Engineering Projects
Government Contracted Work
Farming

From above, the reader should recognize two common characteristics of companies that use job costing:

Contracted Work
Large dollar investments from multiple resources (labor, materials, equipment, out-sourced labor, compliance costs).

The goal is to accumulate costs into a single value, like filling up a bucket with water. How many drops did it take?

But why does a company really need to know this?

Why Implement Job Costing?

The answer can be said in one word – PROFIT. Remember from above, the most common industries that implement this concept are doing low volume (physical count) of sales with low profit margins (less than 35%). Since the dollar value of the item sold is typically high, even with low profit margins, the entrepreneur will still earn a substantial amount of absolute dollars. Here are some common industry results for margins:

Home Builders – 27 to 34%
Road/Utility Contractors – 19 to 23%
Shipbuilders – 11 to 17%

Assume a custom home builder closes 15 contracts per year and averages $12,000,000 in sales from these 15 jobs. If his profit margin is 23%, his total direct profit from production is $2,760,000. This is a significant sum of money. From this amount, the home builder must pay for indirect costs and overhead as follows:

Indirect Costs:
– Project Management including the owner’s salary
– Transportation (trucks for the management team)
– General Insurance including workers’ compensation insurance
– Tooling/Training/Compliance (licensing, revenue taxes etc.)
Overhead:
– Office Staff
– Office Operations including rent
– Marketing/Advertising
– Professional Fees
– Taxes

For a typical home builder, the two groups of costs above will range from $2.1M to $2.5M depending on his own salary and the project manager compensation packages. This leaves a mere $250,000 to $600,000 as actual bottom line profit for the risk the home builder takes on. Those risks include market value fluctuations for home prices, employee mistakes and customer grievances. Thus a mere 1% change in cost over what was expected will cost the home builder $120,000; this is a significant portion of his/her bottom line return from this business venture.

Job costing identifies mistakes and makes it easier for the entrepreneur to prevent those mistakes with future contracts. A good job costing program allows an entrepreneur to maximize profit margins related to the respective industry.

Job Costing’s Connection to Financial Accounting

The key is to earn a bottom line profit net of taxes to offset the associated risk related to the respective business. Low volume, low margin businesses are exposed to certain inherent risks that demand attention to costs. Here is just some of the risks involved:

Market price fluctuations – because contracted work takes time to complete, the market value may change significantly related to the end product thus exposing the company to a reduction in revenue; this is also true related to costs of completing the product. Nobody today knows the price of aluminum 6 months from now. Thus, a company building a cell tower will sign a contract thinking the cost of aluminum is X when it is quite possible the price could increase 20%.
Cost of capital – as with market price fluctuations, most large contracts are financed with borrowed money. The Federal Reserve meet every two months and adjust the borrowing rate. The longer it takes to complete a project the greater the exposure to interest rates.
Experience – the most common risk is the lack of experience with the end product. The brain pool in a company must have many years of experience to reduce errors which often are costly. Think of an engineering task such as aligning two pieces of a bridge or digging and damaging existing underground utilities. It is essential to have experience when involved in contract work.
Lack of control with outside forces – from governmental compliance, weather, logistics and others; contracted work is exposed to third-party issues thus increasing the end cost of the project. The more complex the contract, the greater the risk exposure to third-party influence. A good example recently witnessed by the author is a solar company. The contract had a penalty for delays, it turns out the market demand for solar panels is very high and the supply is practically non-existent. The company had to spend a significant sum of money to find the proper modules and then paid a premium for the respective units to timely finished the project.

Any slight deviation in the cost structure for a low volume, low margin business operation causes a dramatic change in the bottom line. Look at how a 3.66% change ($850k/$820k) in costs for this company’s financial report causes the net profit to decrease 67% (two -thirds).

ABC Site Development
Profit & Loss Statement Comparison
Same Time Period
Standard Ratio Adjusted Ratio
Contracted Revenues $1,000,0000 100% $1,000,000 100%
Costs of Construction 820,0000 82% 850,000 85%
Job Margin 180,0000 18% 150,000 15%
Indirect Costs 85,000 8.5% 85,000 8.5%
Overhead (Office Ops) 50,000 5.0% 50,000 5.0%
Net Profit 45,000 4.5% 15,000 1.5%

This business principle is referred to as inverse leverage. Unlike high volume transaction operations whereby a single transaction within thousands of transactions with a cost issue will not greatly affect the bottom line, low volume/low margin operations hinge on costs. The beauty of this is that it works in reverse too! Any slight cost savings can create big profits. Look at the same company, same project but instead of 3.66% increase in costs, there is a 3.66% savings.

ABC Site Development
Profit & Loss Statement Comparison
Same Time Period
Standard Ratio Adjusted Ratio
Contracted Revenues $1,000,0000 100% $1,000,000 100%
Costs of Construction 820,0000 82% 789,906 79%
Job Margin 180,0000 18% 210,094 21%
Indirect Costs 85,000 8.5% 85,000 8.5%
Overhead (Office Ops) 50,000 5.0% 50,000 5.0%
Net Profit 45,000 4.5% 75,094 7.5%

Notice now that the job margin increases 66.67%.

For an owner of a low volume/low margin business operation, tracking costs is the primary purpose of accounting. The owner needs to know what the cost overrun is and its dollar value to determine the impact on the bottom line of the company. Any deviation will cause volatile outcomes with financial reports. You can imagine the same change with a much larger company, even a half percent change in costs for a $25M company will cause more than $100,000 of change in the net profit.

The only tool in the business arsenal to monitor and quickly address the issues is job costing. Read other articles on this site to learn how to set up job costing and implement systems and processes to see results in a timely manner. ACT ON KNOWLEDGE.