What is a job costing system?
The construction industry is a unique business model. There is no ‘standard’ product. The services offered vary greatly and no two jobs are the same.
One week a contractor may be putting in a head gate to a water system, the next they may be building a retaining wall or patio. Each construction job has its own unique deliverables, timing, and scope.
Because of all the variables in the actual project, the cost has to be calculated and quoted on a bid by bid basis. A job costing system and method is critical for the owner when bidding on a job. Bid too high on a job and they might not get the job. Bid too low and they may not cover their cost.
While a job costing system is traditionally used in the construction industry, this method is also used in other industries that work on a project by project basis. Industries such as Software as a Service (SaaS) and digital marketing to name a few.
In this post, we’ll define job costing, show an example of how it’s used, and provide the 5 best practices for getting started with job costing system.
What is job costing?
Job costing is the method of calculating and recording all direct and indirect cost related to a specific job or project. The elements that make up job costing are direct labor, materials, and overhead. This system is used to determine the appropriate bid price to cover cost and a reasonable profit margin.
Job Cost Accounting
There are three main cost drivers that need to be considered to when calculating and recording a job cost. Those drivers are:
- Direct Labor
If any item is necessary or earmarked specifically for a project, then that cost is assigned to the project. Some complexity comes up when bulk materials are purchased and used for multiple jobs.
In this situation, the accounting department will have to calculate the cost of the materials used on each job and assign as considered appropriate.
Factors such as the experience level and availability of the workers can cause swings in the hours budgeted.
When the project is ongoing, all the labor hours need to be assigned to the respective job. Complexity can arise if one of the workers pulls off the job in the middle of the day to work on another job.
Therefore, it is important to have work or project codes for each job. While not fool proof, the project codes help with the accuracy of the labor cost to specific jobs.
Overhead costs are a combination of all costs a business incurres but cannot be directly traced to a specific project. Overhead costs range from depreciation on equipment to administrative expenses, rental costs, and professional fees.
The allocation of overhead cost to a project can range from a set percentage, such as 10%, to an indirect labor rate or ‘shop rate’.
Many companies who utilize an indirect labor rate will calculate the rate at the beginning of the year. They will accumulate all the indirect, or overhead costs, from the prior year and calculate the indirect rate for the current year.
The indirect rate is then applied based on direct labor hours per job. The key is that the overhead costs are being covered by the contract bid price
Assume CCC Construction is bidding on a job. The job estimate is for $10,000 in materials and 55 direct labor hours, with an expected profit margin on all costs of 20%. The following would be the initial bid and entered into the job costing system.
As the job progresses, the respective costs are identified and entered into the system. Usually the costs will be entered with a respective job or project code. At the completion of the job the tracked costs will indicate:
- How well the estimator did on the initial bid.
- The true profit margin on the job.
In the example, we assume the materials didn’t cost as much as expected and there was an overage on total direct labor hours. Here is how the job looks as compared to the budget:
Because all costs were properly tracked in the system, the owner can quickly determine if the job was profitable and whether there are inefficiencies in the labor. This knowledge is then be applied to the next job.
In the above example, the profit margin expected was 20% and the final profit margin was 16%. Another key factor to the system is that the cost should be tracked and monitor frequently.
For small projects the costs need to be monitored daily at a minimum. The owner or project manager needs to know if there will be cost overruns and ask if those costs should be billed in change orders.
If the project isn’t monitored, then inefficiencies can cause a job to lose money quickly. Also, if the overages are due to client issues, then getting a change order before the project is completed will be easier then trying to get one once the project is done.
When setting up a job costing system, there are some best practices to consider.
- Software – There are multiple software vendors that can track the costs for a job. The complexity of the services offered will often dictate how sophisticated the software needs to be. For example, if a business constructs bridges for interstate highways they will need more sophisticated software as opposed to a business that builds single family homes. For the small business, software such as Xero is sufficient. The big key is to make sure the software can integrate with your accounting software or, in the case of Xero, be all-inclusive.
- Job Codes – Job codes are the identifier for where to assign costs. When setting up job codes, it is a good practice to put as part of the job code the year and, often, even the month. This makes it easier for management when they are reviewing expenses by jobs. They can quickly grasp when a job started based on the code. For example, if a job started in March 2020, the job code may look like 202003XXXX. This is also valuable if there is a job that straddles a year-end.
- Gain/Fade – Implementing a job costing system also allows management to perform a gain-fade analysis. This analysis compares the gross profit by job and can be utilized to better understand operational issues, estimating problems, or both.
- Budget to Actual – Similar to the gain-fade analysis, the budget to actual analysis should be done on a job by job basis. This analysis should be done daily for small jobs and at least weekly for larger jobs. Cost overruns can cause cash flow issues quickly. Keeping a pulse on each job, and identifying inefficiencies as they happen, will keep cash in the company.
- Automate Cost Entry – The sooner that costs are entered into a specific job, the faster management can react to cost overruns. Automate as much of the cost identification process as possible. Time entry from phones in the field, notification to the accounting department on were to assign materials, and automated indirect cost based on direct labor hours entered will help facilitate faster entry of expenses.
Tips and Reminders
- Track the direct materials, labor, and overhead by project/job code.
- Set up an indirect billing rate to allow for quick allocation of overhead to each job.
- Monitor job costs daily, especially for small jobs.
- Learn why jobs do not obtain the preferred profit margin and apply that knowledge to future jobs.
A job costing system takes a while to perfect, but once fine tuned the benefits mean more profit and cash in your company.
Need assistance in setting up a job costing system? Contact Hovland Forensic & Financial to set-up a job cost accounting system for your company.
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