Using Job Costing to Monitor and Earn Better Margins
Precisely, to ensure that its income is substantially higher than its spendings within a particular financial period.
To make this happen, the company must properly track its finances. It must be able to do a proper accounting of how much it earns and where the earnings come from. It must also report how much it spends and the activities, events, or items it spends on.
This forms the basis of what is known as bookkeeping. Although it has a simple definition, the practice of bookkeeping is far from simple. In turn, over time, businesses and accountants have developed various methods to help them track their finances more effectively. One of such is job costing.
However, apart from aiding better bookkeeping, job costing also offers many benefits for a company’s finances. We bet you are curious about how job costing can improve your business finances. Well, we have got you covered. In this article, we will discuss the concept and practice of job costing and detail everything you need to know about it. Enjoy!
What is Job Costing?
At its basics, job costing is an accounting process in which companies record financial transactions by “job” – rather than collectively. In essence, job costing is a bookkeeping method involving a company tracking its finances based on each “job” or project it undertakes. The company knows how much it earns in revenue; it also knows how much it has expended on such a job.
In accounting, job costing is also known as job order costing, while some refer to it as activity-based costing. Ideally, it works best for companies whose business models involve taking up jobs, projects, or tasks from customers or clients. This makes it easy for the company to break down its financial report for each of the projects.
There is the common notion that job costing as an accounting process only, or better still, mainly pertains to tracking expenses. But that is not the case as many businesses now factor in revenue. Job costing functions to help a company record both revenue and spending on each project it undertakes.
Financial Accounting vs. Managerial Accounting
We should note that job costing is not a component of financial accounting. This means that companies do not use job counting when preparing the financial statements that they will present to the public. Job costing is a component of managerial accounting; that is, companies use job costing internally to understand the profitability of their projects, products, or services.
Applications of Job Costing
Job costing can be applied to different types of businesses and business models. Firstly, companies whose business models require working on projects after projects will find job costing easy to apply. Companies that typically will use job costing will include businesses like construction firms, software engineering, outsourcing companies, law firms, consulting businesses, artisans, medical service businesses, and many more. These companies can simply record their revenue and expenses transactions based on each project that they take up.
However, this does not mean that companies with other business models cannot implement job costing in their financial reporting. A company will adopt the job costing system to separate products or services into categories and then track financial transactions about each product or service individually. This includes financial services firms like banks, manufacturing companies, and a host of Software-as-a-Service (SaaS) firms.
Process Costing vs. Job Costing
Many accountants see process costing as the direct opposite of job costing. Process costing simply entails lumping up the sum of all costs incurred and then using the units produced to get the average cost per unit.
In other words, the total cost of production is taken, and by dividing it by the total units produced, a company can arrive at the average unit cost. Just like with job costing, process costing has started to apply to revenue as well.
This method is not always efficient as it does not consider the peculiarities of each product line. Furthermore, it largely denies the company crucial insight into how each product performed, the way the job costing concept does. This is why job costing is generally regarded as more effective when it comes to monitoring the financial situation of a company.
Job Costing in Practice
As we pointed out above, companies whose business model involves taking on specific jobs and projects will find job costing most appropriate. Let us look at some instances, starting with the construction firm.
Construction businesses will have multiple projects and contracts that they are working on at a particular time. Different clients will likely award each job with different project specifications. As a result, they will have different cost outlays and considerations.
For example, we have ABC Construction LLC, a medium-sized construction business with offices in Queens, New York. It completed different projects during the financial year, including a 5km-road, a terrace of duplexes and a small over-water bridge, and a handful of other projects. These projects have different costs and, thus, different profitability rates.
To understand which project returned more profits, ABC Construction cannot create a financial statement lumping all the projects together. It has to create individual statements for each project. This underscores the idea of job costing.
The same scenario plays out in XYZ Law Practice. The law firm has several clients with different legal needs, and therefore different charges. The company seeks to understand each client’s profitability concerning the number of efforts that the client’s work requires. To do so, the firm draws a financial statement reflecting how much it earned from each client and the amount of human, financial, and managerial resources it expended on them.
However, as we pointed out above, it is not only companies with “jobs” or project-based business models that can make use of job costing in their accounting. Other companies can adapt the idea to their business models as well. For instance, we have manufacturing companies.
A manufacturing company can apply job costing accounting in reporting the finances of its different divisions or product lines. For example, Tesla Inc. can separately report its vehicle models’ finances (revenue, expenses, and profits). This is better than summing up all revenue and expenses together without understanding the details.
Components of Job Costing
In arriving at the cost of a particular job, there are key elements or components that we must include; they are direct labor costs, direct materials costs, and overheads. Noteworthy, this is how companies maximize job costing to monitor business finances. In turn, through this clarity, they can determine how best to earn better margins.
Well, now that we have cleared that up, let us get straight to these components.
1. Direct Labour Costs
Direct labor costs here involve the monetary value of the human efforts involved in delivering the project. In other words, labor costs refer to the compensation and remuneration given to the workers involved in the project for the period they were involved in the project.
This can become a bit tricky and somewhat complicated. For one, we should note that the labor costs here must be “direct.” As such, the labor costs we are calculating pertain to the labor directly involved in the project.
Accountants usually calculate this per hour of work that employees put into the project directly. This is quite straightforward for a business like that of the law firm or construction business but can be difficult for a manufacturing business.
2. Direct Materials Costs
Regardless of the company’s business model, we can agree that this is the easiest to arrive. Direct materials costs refer to the cost of materials – both physical and otherwise – that were involved in developing the product or service.
For a construction business, the direct materials cost refers to the cost of all the materials that went into the construction project. The calculation is somewhat easy for the manufacturing business; all we need to do is sum up all the inputs that went into manufacturing the product.
However, calculating direct materials costs for service businesses, especially internet-based, can be somewhat tricky. In service businesses, the physical products are not usually dedicated to the product solely but can be reused. In the case of virtual materials, however, it is very easy.
We refer to both direct labor and material costs as direct costs. The last of the three, overhead cost, is an indirect cost.
3. Overhead Costs
Overhead Costs refer to “operational” expenses needed for the smooth running of the project or product. It is complex because putting a price tag on it is not straightforward, at least when we compare it with the others.
To solve this, accountants make guesses based on several factors, such as how long the project took. Items under “Overhead Costs” will typically include the cost of business premises where the project was carried out, depreciation of equipment used during the project, as well as administrative fees.
Thus, from the above, the formula for Job Costing will be:
Job Costing = Direct Labour Costs + Direct Materials Costs + Overhead Costs
Importance of Job Costing
Job costing holds many potential benefits for businesses that properly incorporate it. We have to note that the importance of job costing does not lie in applying it to develop financial statements but in the insights and data that the business will derive from it. These insights will bring about an efficient and, above all, profitable business, precisely, earning better margins.
So, what are these benefits?
Often, a company’s finances are a good tell of whether the company is making the right decisions or not. For instance, declining revenue might be pointing to the fact that the business is not focusing on its areas of strengths. Or that the company is directing its attention at unprofitable ventures.
However, there is no way the company will have these all-important insights if the finances are not broken down and detailed based on projects or divisions. For the law firm, applying the concept of job costing in preparing its finances will help it discover which clients or practice areas it has to direct its attention and focus less on.
A financial report reflecting the job costing concept for the manufacturing company will give the decision-makers access to crucial data. It will inform them about which products to produce more of and those that might require scaling back. This will reveal that this method proves more helpful than the process costing that lumps all the revenue and expenses and then calculate the average per product line or project.
Applying job costing in a company’s accounting can also help boost the efficiency of the business. This is because it can generate important insights to guide decision-makers in restructuring its business processes.
For instance, when a company is spending too much on a particular project or product that is necessary, it can be a pointer to the fact that they are not doing things efficiently enough. For instance, the manufacturing company might have three (3) product lines, A, B, and C. Product B might be generating a lot of expenses, much more than A and B, but yet does not yield as much revenue as the others.
It might point out that employees working on Product A are not as productive as those working on others. This might bring up the need to introduce a new machine, for instance, to boost productivity.
A similar instance can come up in a law firm, where the firm commits more human and financial resources to a task or project, but it does not generate as much return as others. This might point to the fact that the particular staff in charge of the task or project might not be best suited for it. Thus, the firm might need to re-assign the project or task.
In turn, the reality is that through job costing, a business can better monitor its activities. Following this, by identifying areas of business inefficiency, it can improve on it and consequently improve its margins.
This goes without saying. Implementing a job costing approach to reporting its financial statements will give a company insight into its price or services. It does often happen that companies undercharge for their products or services without knowing, all because there is no breakdown to make them realize so.
However, by using job costing, they will know how much each product or service costs and the price tags they should assign to the product or service. This level of information will ensure that the business can make better financial decisions.
If a company adopts job costing, the combination of all the above factors should reasonably drive the business towards profitability. With job costing, the company will become better informed about which product or service to focus on. They will know which business areas to optimize for maximum efficiency, and above all, they will be informed as to which price to assign to their products or service.
The gross margin will improve, which will eventually affect and reflect in the net margin.
The concept and practice of job costing is not without its limitations. At least for one, it cannot be applied in many industries. However, we have to acknowledge its potential to help businesses monitor their spending and grow their margins.
In this article, we have discussed the benefits of job costing and how these benefits are inherent for a business to monitor its finances and earn better margins. So, read up and, where necessary, move towards adopting job costing.