Cost Knowledge – Job Costing Can Play an Important Role for Small Business
January 18, 2017
By Larry Ventimiglio
Small businesses often get themselves into financial difficulty simply because small business owners tend to have difficulty distinguishing between what the business “needs” versus what the owner “wants”. A lack of fiscal discipline is one of the top “preventable” reasons for small business failures. People start small businesses for many reasons. They hate their job, need some side money or always wanted to open a shoe store or cupcake shop. The trouble is that too many people do not take the time to really think objectively about what their life would be like as an entrepreneur. In business, whether large or small, “balance” needs to be a core stabilizer in management decisions and actions when it comes to spending. Costs ARE controllable. Sales are less so. As a result, fiscal responsibility and accountability need to begin at the top of the organizational chart, and cascade downward through the management and worker levels.
Small business owners don’t need to be accountants, but they do need to understand costs, what drives them, and the consequences of “out of control” spending.
Types of Cost
The two types of cost in business are fixed and variable costs. Fixed costs are those that are not impacted by the amount of sales or production. They usually include, rent, certain types of insurance, utilities, salaries, etc. Fixed costs CAN change over time, although the change (either upward or downward) is not connected to production, or sales activities. Variable costs are solely driven by business activities. Categories like direct hourly labor, overtime, and temporary support, raw materials, and transportation are good examples of activity-based variable costs.
Cost Drivers
In simple terms, a small business needs to control spending on the major cost drivers of the business – labor, materials, and overhead. Obviously, labor and materials are the primary components of variable costs. Let’s break this down a bit further:
Labor – Headcount is generally the most expensive resource employed in a business. The number of people employed needs to be at the level “required” to support sales volume. Wages and benefits need to be “competitive” with the industry and with other local businesses competing for the same resources. Additionally, this resource needs to be managed to an acceptable productivity level.
Materials – Vendors for materials need to be evaluated on a competitive and quality basis. Additionally, adequate controls must be in place to avoid both waste and theft. Inventory quantities need to be monitored and controlled at levels to support business needs-no more and no less.
Overhead – Business owners need to avoid over expansion – in terms of both facilities, as well as over extending geographic expansion. Over extended fixed costs can kill a business. Earnings must be able to absorb fixed overhead. Additionally, small business owners need to guard against overstaffing in the areas of SG & A on the income statement. These costs tend to not be variable.
Job Costing in a Small Batch Environment
Job costing is often used in a small business environment to accumulate costs at a small unit level. For example, it is appropriate for deriving the cost of constructing a custom machine, designing a software program, constructing a building, or manufacturing a small batch of products.
This method of cost reporting involves the accumulation of the costs of materials, labor, and overhead for a specific job, and it is an excellent tool for tracing specific costs to individual jobs, or batches, and examining them to determine if the costs can be reduced in later jobs. Let’s take a second look at labor, materials, and overhead from a job costing perspective:
Allocation of Labor – In a job costing environment, direct labor may be charged directly to individual jobs based on work order identification. All other non-specific manufacturing –related labor (indirect labor) can be recorded in an overhead cost pool to be allocated to all jobs processed during the accounting period. When a job is completed, the job costs are shifted from WIP (Work In Process) to Finished Goods Inventory. When the goods are sold, the cost is relieved from Finished Goods Inventory and charged to the Cost of Goods Sold section of the P & L Statement.
Allocation of Materials – Materials to be used in manufacturing a product or project are recorded in the Raw Materials category of Inventory when they enter the facility. When a Job/Work Order is created to manufacture a batch, the material is picked from stock and assigned to the specific Job/Work Order shifting it from the Raw Materials Inventory category to the WIP (Work In Process) Inventory category. If scrap is created, it may be charged to an overhead cost pool for allocation to jobs or when excess amounts of scrap is created it may be charged directly to the Cost of Goods Sold in the form of unfavorable material manufacturing variances. When work on the job is completed, the job costs are shifted from WIP (Work In Process) to Finished Goods Inventory. When the goods are sold, the cost is relieved from Finished Goods Inventory and charged to the Cost of Goods Sold section of the P & L Statement.
Allocation of Overhead – Non-direct manufacturing costs are captured into overhead cost pools to be allocated to open jobs based on a selected measure of cost usage. Consistency is required in charging the same types of cost to overhead, and applying these costs to jobs in all reporting periods. Otherwise, it will be extremely difficult for the cost accountant to explain why overhead cost allocations vary from one month to the next.
The accumulation of actual costs into overhead pools and allocation to jobs can be a time-consuming process that can interfere with the monthly closing. To expedite the process, many businesses allocate standard costs that are based on historical cost performance. Since these standards will never be exactly the same as actual costs, variances can be:
- Charged to Cost of Goods Sold.
- Allocated to Cost of Goods Sold, Finished Goods Inventory, and WIP Inventory based on ending account balances.
- Charged to jobs that were open during the reporting period.
Since the allocation of an overhead cost pool is by definition inherently inaccurate, it is best to remain practical and keep it simple. Most businesses select to charge overhead variances to Cost of Goods Sold in the reporting period
Financial Control Reporting
Financial control reports are informational reports that tell management about a company’s activities. Job Costing is one of the tools that can facilitate this reporting. The financial department provides management with a format designed to detect variations versus budget, or standards. These reports act as “decision support” tools to guide management toward positive impactful actions which should improve future performance. On a more global level, management also relies on conventional financial reporting comprised of the balance sheet, income statement, and cash flow statement to report on the financial condition of the company to outside parties.
Additionally, financial control reports need to provide adequate level of information for management to determine “root-cause” for sales and/or cost variations versus budget. Good financial control reporting highlights relevant information by focusing management’s attention on those line categories where actual performance significantly differs from budget.
What about YOUR organization?
Do you need to get a better handle on your business costs?
What does “success” mean to YOU?
For more information on how I may be able to help you achieve greater business success, please visit my website www.LJVBusinessSolutions.com or call me @ 843-245-9753.
Larry Ventimiglio
LJV Business Solutions,LLC
843-245-9753
