When a customer approaches you with a custom order, how do you decide how much to charge? If your answer involves staring at the wall for 30 seconds and spitting out a number, you need job order costing.
Overview: What is job costing?
Charging the right amount for your products and services is integral to building a profitable business, and that requires knowing your exact business costs. Job costing, also called job order costing, is a cost accounting system used to track expenses by project.
From construction to consulting, many businesses use job costing, but it only works when you can easily distinguish your products from each other. When you think of job costing, custom orders should come to mind.
A bobby pin manufacturer doesn’t use job costing, since one bobby pin is indistinguishable from another. For identical units production, use process costing, where you apply direct costs to batches of products instead of individual products.
A furniture maker uses job costing since they can readily tell how much raw material and labor went into producing an armchair or sofa. Consultants use job costing to charge their clients by the number of hours they dedicated to the project, called billable hours.
Job costing can help you accurately price your products and services. Upon completing a project, for example, accountants will draw up job cost sheets to compare actual costs with an initial estimate or bid to make sure they’re maintaining profitability.
How to calculate job cost
Project costs have three components: direct material, direct labor, and overhead. Together, they make up the cost of goods sold or cost of services. Here’s how job costing works.
1. Calculate direct material
Direct materials are all the raw materials that go into your product. Tools and cleaning supplies, on the other hand, are called indirect materials, which are included in overhead costs.
If your product is a wheelbarrow, steel and wood are direct materials. You might’ve used a hammer and blowtorch to make the wheelbarrow, but they’re not considered direct materials because they aren’t attached to the final product.
It’s not always easy to ascertain the cost of direct materials for a specific product. However, you can choose an inventory costing method to estimate the cost of materials in each project.
Service jobs, like a consulting project, don’t have direct material costs.
2. Calculate direct labor
Direct labor costs are the wages of workers with hands-on roles in your project. For example, factory workers are direct laborers in manufacturing businesses.
Service businesses consider direct laborers anyone whose work directly affects the client. For example, a hairstylist is a direct laborer at a hair salon.
Workers in supervisory and maintenance positions don’t qualify as direct laborers. Instead, their compensation gets counted as indirect labor, a part of overhead costs.
3. Determine overhead rate
Overhead costs are all the indirect costs that go into the project. Manufacturing businesses would include factory rent, utilities, supervisory salaries, and machine repairs in overhead. Check out our guide to overhead costs to learn more.
It’s unlikely you’re tracking the kilowatt hours each project draws. Since it’s impossible to trace a project’s precise responsibility for your overhead costs, you calculate an overhead rate to split indirect costs among projects.
You can use either the traditional or activity-based costing (ABC) methods to allocate overhead. Most small businesses should choose the standard method. Why? Because ABC might have you crying SOS because of its complexity.
To calculate your company’s overhead rate, you need your total overhead costs and an activity driver, like labor hours or machine hours. Your activity driver should be a measure used in every project and roughly correlates with overhead resources.
The traditional overhead rate formula is:
Overhead Rate = Overhead Costs ÷ Activity Driver
Let’s say a consulting business uses direct labor hours as an activity driver, and it incurred $100,000 in overhead costs last month. If employees logged 50,000 hours last month, the overhead rate is $2 per direct labor hour ($100,000 overhead costs ÷ 50,000 direct labor hours). The business should tack on $2 for every hour spent on a project.
4. Allocate overhead
Now that you have an overhead rate, apply it to your project using the following formula.
Project Overhead = Overhead Rate ✕ Activity Driver
Continuing the consulting business example, say one project required 300 direct labor hours. The overhead allocation is $600 ($2 overhead rate ✕ 300 direct labor hours).
5. Sum direct material, direct labor, and overhead
Let’s finish with a little arithmetic. Add up your direct material, direct labor, and overhead costs to arrive at the job cost.
Job Cost = Direct Material + Direct Labor + Overhead
An example of job costing
Let’s say I own a dog toy manufacturing business. I have two employees, Alexa and Charles, who make bespoke toys for high-end clients, and I supervise them when I’m not conducting quality control tests with my dog. According to my accounting software, I incurred these expenses over the last month.
During the month, I received and fulfilled a special order for two toys that resemble the customers’ puppies. My employees spent 10 hours each creating the intricate toys.
Calculate direct material
Fabric and stuffing comprise direct material costs. You might think of adding machinery cleaning supplies to direct material, but it’s considered an indirect cost because it doesn’t end up in the final product.
My business incurred $2,000 in total direct material costs, but I only care about the direct material used for one job. Since I had to buy unique materials for the custom project, I know the puppy look-alike toys cost me $200 in direct material.
Calculate direct labor
Only include the wages of workers who create the product. I don’t make the toys, so my salary should be excluded from direct labor. Only Alexa’s and Charles’s wages count in the direct labor calculation.
Alexa and Charles worked 320 hours last month and earned $8,000, meaning they earned $25 per hour ($8,000 wages ÷ 320 direct labor hours).
Alexa and Charles each spent 10 hours working on this project, bringing the direct labor cost to $500.
$25 Wage Per Hour ✕ 20 Direct Labor Hours = $500 Direct Labor
Determine overhead rate
The first step in creating an overhead rate is totaling the company’s overhead costs. My salary, factory rent, factory utilities, machinery repairs, and machinery cleaning supplies all get counted in the overhead calculation. My company’s overhead comes to $7,400 ($5,000 salary + $2,000 rent + $100 utilities + $200 machinery repairs + $100 machinery cleaning supplies).
My business uses the traditional overhead allocation method, and I use direct labor hours as the activity driver. My employees worked 320 hours last month, giving me an overhead rate of $23.13 per direct labor hour.
$7,400 Overhead Costs ÷ 320 Direct Labor Hours = $23.13 Overhead Rate
Alexa and Charles spent a combined 20 hours on this project. Multiply direct labor hours by the overhead rate to arrive at an allocated overhead of $402.60.
$23.13 overhead rate ✕ 20 direct labor hours = $402.60 Project Overhead
Sum direct material, direct labor, and overhead
Let’s bring it all together. Adding direct material, direct labor, and overhead, the job cost comes out to $1,102.60. Only the finest toys for these dogs.
$200 Direct Material + $500 Direct Labor + $402.60 Overhead = $1,102.60 Job Cost
Job well done
Building a robust costing system can only benefit your business. When you know how much it costs to complete a project, you can develop competitive bids, keeping profitability top of mind.
View more information: https://www.fool.com/the-blueprint/job-costing/