WE GUIDE ORGANIZATIONS SELLING TO THE FEDERAL GOVERNMENT

Budgeting in a Job Cost Environment

by Linda Mahnke

What is Job Costing?

A new-construction developer must distinguish the cost of developing Apple Orchard Place separate from Business Park West, separate from Commercial Office Landings. An advertising firm must distinguish the cost of developing television commercials for Darling Diapers separate from the mail campaign for Eduardo's Restaurant, separate from development of a logo and branding for Fantasy Amusement Park. Many businesses benefit from job, or project, costing - even if the benefits are less obvious.

If sales result from a process, such as mass production of widgets, job costing is not appropriate. If revenue must, by law, be budgeted and encumbered before cash goes out the door, job costing is not appropriate. If sales are connected to individual projects, each having a beginning and an end, then job costing is vital.

Most business owners, even small business owners, recognize a need to track income and expenses. They periodically evaluate the net profit or net loss of the business as a whole. Knowing the television picks up 127 channels is not enough; knowing which channels receive picture and sound - and maybe even the type of programs provided by each of these channels - is far more valuable.

Tracking costs by job is more work than just tracking costs for the company as a whole. Small businesses have limited resources. The most persuasive argument for job costing is that small businesses have less "fluff". Small businesses have proportionately less company resources to supplement an unprofitable project. If one particular job (or project) nets a significant loss, it will affect the company as a whole. The organization must minimize the loss on this job, and similar future jobs. This is especially critical for a small business. Without tracking costs on each, individual job, there is no channel line-up to demonstrate which job, or type of job, is the big loser.

Also, without job costing, nothing demonstrates which job, or type of job, is especially profitable.

From Information Technology consulting projects to government contracts, each task, delivery, or statement of work with a beginning and end is recorded separately in the general ledger. The Income Statement or Profit and Loss for each job is evaluated, in addition to the results for the organization as a whole. Continual evaluation of costs for each job determines which channel - or job - to watch.

Ready, Set, Ummm

How does one start a budget for job costing?

The nice, neat method is to predict all future jobs for the year and total cash receipts for each job. Where is that crystal ball when it's needed? Because this step is more complex, the process is discussed later in this article. Keep in mind that doing this step first, will make developing the remainder of the budget much easier.

Business owners, financial management, and project managers usually have a much better handle on the materials and labor required to accomplish a project. With knowledge of what and how much material and labor each project needs, the costs of these elements can be estimated. Let's explore how that can be done.

Cost of Goods Sold Versus Expenses

The budget includes all bill payments to vendors. Costs are broken into two sections. Cost of Goods Sold is payment for material and labor that is a component of, or directly related to, the goods and services sold to the customer. The Expenses section is for payments of items that benefit the company as a whole.

Cost of Goods Sold

Costs for items that are required to accomplish a job are in the Cost of Goods Sold. For example, an employee goes to a client's offices and re-establishes the connection to the Internet Service Provider. The labor of that technician, while performing that service, is salary or wages (Direct Labor) in the Cost of Goods Sold.

Beads are purchased from a wholesaler and used to make unique necklaces, by hand. The whole necklace is sold; the purchase price of the beads used to make the necklace (Direct Material) is in the Cost of Goods Sold.

If an item is both significant and used up (or gone) when the goods are shipped or the services complete, the cost of the item is in the Cost of Goods Sold. These "gray area" or judgmentally labeled Cost of Goods Sold items might include:

  • Wages for making extensive travel arrangements
  • Reams of paper for assembling binder handouts
  • High-quantity and/or expensive equipment lubricant used in processing
  • Specially made cartons or other unique shipping containers
  • Employment advertising for scarce, specially trained candidates applicable to a particular job

Remember that these costs are only assigned directly to a job (Cost of Goods Sold) if they are both significant and used only for that job (or prorated among a few jobs). Also, no item that is a Cost of Goods Sold may also be in the Expenses section. Management clearly defines these items, such as:

  • Not arrangements for occasional travel, but for extensive travel to meet requirements of the job
  • Not all photocopy and printer paper, but paper in excess of X reams required for a job
  • Not normal shop supplies, but special lubricant required for a particular job

Expenses

Rent, electric, building maintenance, bottled water, and janitorial service benefit the whole organization, not any particular job. Costs for these items are in the Expenses section.

Salary and wages for the following services are also Expenses:

  • Negotiating salaries (Indirect Labor), ensuring compliance with labor laws, and other Human Resources activities
  • Recording vendor bills and payments, customer invoices and receipts, and payroll
  • Creating a mission statement, communicating expected ethics, plus writing policies and procedures
  • General marketing/networking with potential customers or within their industry
  • Developing a company-wide budget

Because these tasks benefit the company as a whole, they are Expenses. If these tasks are accomplished by independent contractors or outsourced, the purchase price is still an Expense.

Expenses also include routine shop/office supplies and wages for occasionally making travel arrangements, especially travel in support of a function that is an Expense.

Estimating Budget Costs

Separating payments into these two sections assists budget development. Cost of Goods Sold items are budgeted based directly upon budgeted jobs in Income. One hundred percent of Cost of Goods Sold costs for every anticipated (potential) job are estimated. For each job in budgeted Income, estimate the labor, material, and other direct costs required to complete the job. After all direct costs are estimated, apply the same probability factor used for Income; arrive at the cost multiplied by the probability of cost. (See the application of probabilities in Income by Job, below.) For example, the Project Manager's $20,000 salary on a prospective job with a 50% chance of resulting in a sale is $10,000. The sum, of cost budgets for all jobs, is the organization-wide Cost of Goods Sold budget.

Expense items are budgeted based on history, recent trends, and current knowledge of the market. Originally, the budget is for the company as a whole. After the organization-wide Expenses are budgeted, indirect rates can be calculated for allocation among specific jobs.

If management anticipates that the organization will have little growth over the budget year, the wages paid to the Accounting Clerk throughout the most recent year - plus some reasonable percentage raise - are the best basis for next year's budget. History is a valid basis for most budget estimates.

If recent trends for bottled water show that competition is driving the price down, then last year's cost should be adjusted for next year's budget. A weighted average of each month's cost (for the most recent 12 months) is a valid indicator. Bottled water payments for January, February, and March might each be multiplied by one; April through September payments are each multiplied by two; and October, November, and December payments are each multiplied by 3. Sum the results. The sum is divided by 24 (3 months times 1 plus 6 months times 2 plus 3 months times 3) for a monthly weighted average. Multiply by 12 to calculate annual costs for the budget.

The price of some items greatly fluctuate. Airfare for executive management to attend meetings of the board of directors can be estimated by researching competitive quotes for a typical fare. If board meetings are scheduled with only a week for planning, obtain quotes for flights one week in the future; if management wants no-penalty tickets that can be fully refunded in case the meeting is rescheduled, obtain such quotes. Obtain a range of two or three representative (or typical circumstances) quotes; use the lowest fare for a conservative budget. Market quotes might be applicable for:

  • Precious metals, gems, and other scarce materials
  • Salaries, especially those of highly technical employees
  • Consultants with skills in limited supply
  • Goods and services with market prices that change in both directions

Employment Expenses

Indirect costs related to employee labor are often labeled "overhead". Technically, overhead costs should follow the labor costs that caused them. In other words, the portion of Employee A's salary in Cost of Goods Sold (for performing direct labor on Task Order 1) should match the portion of Employee A's overhead that is allocated to Cost of Goods Sold (on Task Order 1). The portion of Employee B's wages for performing Human Resources tasks should match the portion of Employee B's overhead in Expenses. For ease of calculations, all overhead may be (originally) budgeted as Expenses; all Expenses can, later, be allocated among specific jobs based on an Indirect Cost Rate such as an Overhead and a General and Administrative rate.

Examples of Labor Overhead (usually called Overhead) expenses include the company's portion of Social Security and Medicare, the company contribution to retirement plans, unemployment compensation premiums, the company-paid portion of health insurance premiums, and other fringe benefits.

Income by Job

If the crystal ball is murky, remember the first rule of budgeting: the fifty-one percent best guess. Historical sales, recent trends, and market research are used to estimate future income. Budgeting in a job cost environment requires a listing of every job and potential job that might produce income. Notice this includes jobs, which have little probability of transforming into an actual sale. For every job, known at the time of budget development, which does not result in an actual sale - there will be a replacement job, not imagined at the time of budget development, which does result in a sale. Based on this "replacement" theory, all jobs (even unlikely sales) are included in budget income.

After listing 100% of jobs and potential jobs, estimate the total (gross) income anticipated from each job. This cash-in estimate represents all value received, including in-kind receipts (of goods or services, for which the company would otherwise have to pay) and non-monetary donations (at the price for which the company can sell the donated item, minus the cost of converting the item to cash). Note that the cost the company would have paid for in-kind goods or services is included in Cost of Goods Sold and/or Expenses. For example, a retailer of tablecloths sells 200 tablecloths to a hotel in exchange for $200.00 plus free use of a meeting room for an up-coming conference. The room rental would have been $350.00. The sale is valued at $550.00. The Expense of room rental is $350.00. The Cost of Goods Sold is $125.00. Net Profit is $75.00.

After listing 100% of all jobs and potential jobs and estimating the total income for each job, assess probabilities. Begin with jobs with which the Marketing and/or Project Manager are most familiar. There will likely be some jobs, which have a 100% probability of resulting in an actual sale.

Next, make an objective assessment of the remaining jobs. Assign the probability, for each job, that it will result in a sale. Remember the first rule. These assessments are not etched in concrete or signed in blood. They represent a 51% best guess, at the time of budget preparation. Budgets are usually adjusted, as new information becomes known. Review the budget during the year, making supportable adjustments as new knowledge is gained.

Finally, multiply the income times the probability for each job. The sum of the probable income for all jobs is the company-wide budgeted income. The same jobs and probabilities are used to develop the Cost of Goods Sold budget.

Profit or Loss and Return on Investment

The primary reason for developing an objective, best-guess budget, is to predict the net profit or loss for the organization. The Income minus the Cost of Goods Sold, minus the Expenses tallies to the budgeted net profit or loss for the budget year. Based on the preliminary results, sections and (more likely) specific items are re-visited. The method of calculation (more heavily weighting December and ignoring January), the premise of the basis (history, trends, or market), or additional research can all contribute to changes. After the channel line-up is complete, specific shows (or items) can be evaluated further.

The budget might initiate:

  • A hiring freeze or a search for new employment candidates
  • A request for bids for (more expensive than realized) material or a volume discount from a supplier for orders (in higher than realized quantities)
  • A revised (or new) bonus program as both incentives and rewards
  • Other long-term changes to the way the organization does business

The primary reason for developing a job cost budget is to predict which jobs are attracting Income to cover, not only Cost of Goods Sold but also, their fair share of Expenses. Without job costing, the "fair share" for any particular job is not known. Depending upon what causal/beneficial methods are used to allocate Expenses, a low-dollar job could carry a disproportionately large amount of Expense. Even though Income on this job absorbs all of the Cost of Goods Sold, it can produce a net loss.

Alternatively, a large job with Income that covers Cost of Goods Sold plus a relatively small percentage of gross profit (Income minus Cost of Goods Sold), could carry relatively small Expenses and provide a high-dollar net profit.

For example, a good rule-of-thumb for employment-related overhead is 35% of salary and wages. Because most of these items are not paid for independent contractors, this example allocates a 40% overhead to labor costs only for employees.

Account Costs (Rounded)
Project A Project B
Salaries $102,000 $10,000
Wages 30,000 0
Overhead 53,000 3,000
Direct Material 15,000 15,000
Independent Contractors 0 150,000
Subtotal $200,000 $178,000
General & Administrative 50,000 44,000
Total Cost (not including profit $250,000 $222,000

A budget that shows particular jobs, and types of jobs, that show a projected net profit - and jobs that show a projected net loss - is vital information in developing business strategy. For organizations selling deliveries and/or tasks with a beginning and end, development of a job cost budget is a crucial management tool for accepting or rejecting new work and overseeing cash flow.

Especially for small businesses - differences among total job costs guide management in seeking specific jobs, or types of jobs, with the best return on the organization's investment in employees, equipment, facilities, and relationships.