Where should a small business owner turn when they need to decide whether to lay off a customer, expand the sales force, or price a bid?
To make such decisions, a business owner must be able to predict and measure the potential profitability of the decision. An owner/manager cannot forecast profits by simply studying the income statement and balance sheet – that’s financial accounting based on historical performance.
Management Accounting
Management accounting is internal accounting that helps business owners use their numbers to make data-driven business decisions. Management accounting uses unit economics, the breakdown of a business into its most basic units, to understand profitability and measure success.
In a service business, where people are the product, that unit is the employees. In this case, management accounting means capturing the cost of your people. It’s about knowing the true cost of your employees’ labor to ensure you can make as much money as possible when pricing a job.
Also visit: outsourced accounting services.
True job costing
The most important decision you will ever make as a small business owner is how to price jobs and services. Job costing involves determining the actual cost of providing a service or job so that a business can charge the right price to meet its target gross profit margin.
Service businesses, where employee labor is the product, can benefit most from job costing because they have these characteristics:
– Payroll is the company’s largest cost.
– Time can easily be lost and services can be given away.
– They need access to real-time metrics to make daily pricing decisions.
To understand the job costing process, we first need to delve into a little accounting 101.
Balance Sheet
A balance sheet is a snapshot of your company’s financial position at a given point in time. In contrast, an income statement is like a video – the cumulative picture of your business over a period of time.
A balance sheet is made up of your assets, liabilities, and equity. Assets are your property and consist of cash, accounts receivable, office furniture, equipment, etc. Liabilities are your debts, including accounts payable, taxes, bank debt, and credit card bills.
When assets (what you own) are reduced by liabilities (what you owe), the result is equity, the net asset value of your business. By tracking the growth of total equity, a CEO can quickly assess whether a company’s value is growing.
Income Statement
To see how equity is changing each month, an owner/manager needs to review the income statement. This document reflects revenue or income minus expenses and shows the net profit or loss over a period of time, usually one month. Profits result in an increase in equity; losses result in a decrease in equity.
To understand the profitability of their business, many business managers only look at the income statement at the end of each month. And why? Because the income statement tells them what they want to see – total revenue and profit. But those lines of an income statement don’t give the whole picture of a company’s profitability. To see more detail, you need to change the way you look at expenses on the income statement.
Expenditures: Direct vs. Indirect
Direct expenses are the costs incurred by working directly on a customer’s job or project. Indirect expenses are overhead costs, expenses that are not directly related to generating revenue.
In QuickBooks, the Expenses section of an income statement defaults to a list of expenses in alphabetical order. To create job costs, the QuickBooks Chart of Accounts must be manually set up to separate direct expenses from indirect expenses.
Direct costs are referred to as cost of goods sold (COGS) in the chart of accounts. Cost of goods sold is an important variable in job costing because it is used to calculate the gross profit on a job.
Revenue or sales – cost of goods sold = gross profit
Cost of goods sold is made up of only two types of costs. They are direct labor costs and direct material costs. In a service business, direct labor costs are the wages of the employees who worked on a particular job. Direct material costs are the invoices and labor costs that are attributable to the job.
Overhead
Overhead is the other cost category we have yet to address. These are the costs that are necessary to run your business, but cannot be directly allocated to a customer or a job. Overhead costs are considered “below the gross profit line.” These costs are subtracted from gross profit to calculate your net profit.
There are four possible overhead departments or cost centers:
- Sales and Marketing
- General and administrative
- Product or industry
- Administration
Gross Profit
The best way to assess the profitability of your business is to look at profit not as a dollar amount, but as a percentage of revenue. It may be that your revenue is increasing while your gross profit is shrinking, but you can only determine that by looking at the ratio between the two as a percentage.
(Gross profit $ divided by revenue $) X 100 = % gross profit margin.
Once you know how to calculate gross profit, you understand the accounting behind job costing. You are now able to set up the business systems that will quickly and easily give you the costs and expenses that you can assign to jobs and projects.
Allocation of labor costs
Job costing used to be a difficult task that required a lot of manual effort to compile expenses. However, with QuickBooks and the off-the-shelf technology available today, companies can easily determine gross profit for each job, customer, service and employee.
QuickBooks makes job costing easier because it has a built-in project accounting feature (the Pro in QuickBooks Pro stands for a project) and automatic labor costing.
The best-run companies use their accounting systems to record direct labor costs and expenses for providing services. To efficiently allocate labor costs, a company must automate and integrate employee timekeeping, expense management, and payroll into the accounting system.
With this system integration, an employee can use a smartphone to record the time spent on each job, customer, product or service and automatically feed this information into the accounting system. The time tracking data is then used to invoice customers, generate payroll, and automatically allocate labor costs to match revenue from a job.
Why allocate labor costs?
If a company’s financial, timekeeping and payroll systems are not integrated, time and costs are likely to go undetected and unbilled.
When a project-oriented company loses track of project management, travel time, and other non-billable time, a company can often go months without knowing it is underwater on a job or project. By the time the lost expenses are discovered, it’s too late to charge the client an additional fee.
Job costing works best when it is used to capture and manage all costs incurred in the execution of a job. Even internal tasks, such as non-billable meetings, should be billed as a job so you can keep a close eye on the cost of each business function.
Why job costing?
Job costing is especially important for service organizations that need to optimize employee time because of pressures such as
– Limited resources of skilled labor
– Increased competition for customers
– Less time to complete projects
– The need to anticipate market fluctuations
Using job costing, a company can identify the opportunities with the highest gross profit potential and direct its workforce toward those great opportunities. With custom job costing reports and clear gross profit goals, a small business owner can make data-driven decisions to answer the company’s most pressing questions.
– Are we on budget with our orders?
– Are we within our target margins?
– Who are the most and least profitable customers?
– Which customers do we need to recalculate? Or lay them off?
– Do we have operational inefficiencies?
– Who are the most productive people, employees, teams and departments?
– When is the right time to hire more staff?
– Where should I invest my marketing dollars?
– Where should I focus our sales staff?
