An income statement or profit and loss statement can reveal a lot of important information about your business...but what are you missing?
From this single financial statement, you can determine whether your company made or lost money over a particular period of time. You can see your overall expenses and total revenue. You can also calculate your company's profit margins to see whether or not you are truly profitable. But that doesn't actually help you make decisions.
Your business's income statement, cannot show you which of your company's jobs, products, services, employees or clients was the most or the least profitable. It cannot show what drives the greatest portion of your company's income or expenses. Your P&L cannot show you how to improve your profit margins.
All of that information, including the keys to expanding profit margins, can be found through job costing or project accounting.
Why Profit Margins Reveal More about Your Business Than Profits
Profit margins show how much your company cost you to generate a dollar of profit. For example, consider two businesses that each show $100,000 in profit. If one spent $400,000 to generate that profit, while the other business spent $900,000 to generate the same amount of profit, which company is more profitable? The one which spent less to generate its profit. The business that spent less not only has greater profit margins, it is also less likely to struggle in the face of expense increases. Whereas the smaller profit margins of the larger business make the company extremely vulnerable even to minor cost increases.
Calculating and tracking both gross profit margins (margin calculated after subtracting direct expenses) and contribution margins (margin calculated after subtracting variable indirect expenses) in your business will help you keep a bead on profitability, while also actively managing costs to increase your profits.
Job Costing and How It Applies to Service Businesses
Calculating your business's profit margins from your income statement shows your company’s overall profitability. Job costing, however, provides the financial data which allows you to calculate profit margins for each of the categories within your business to determine which functions of your business are the most profitable.
Calculating specific profit margins by using job costing allows you to make specific adjustments to your operations in order to increase your company's overall margins and profitability.
What Is Job Costing?
Job costing, or project accounting, is the practice of allocating both direct and indirect expenses to particular "jobs" (products or services) to determine their true cost. Job costing can include only direct labor and direct materials (above the line costs) or it can go further and can also include an appropriate percentage of indirect expenses (such as utilities, rent and office supplies).
Either way, Job costing enables business owners to see the true cost of the products or services they provide and then to calculate profit margins not only for the entire business, but individually for any type of job category.
Calculating, tracking and comparing profit margins by individual jobs will give you a clear, data-based understanding of which jobs, services, clients, employees or products are most profitable.
How Can a Service Business Utilize Job Costing?
According to our friends at The Strategic CFO, "Job costing, generally, means a specific accounting methodology used to track the expense of creating a unique product." Job costing, however, can be used quite effectively in service businesses, as well.
In a company whose main objective is selling products, the principle of job costing is fairly straightforward. Simply calculate how much it cost you to develop, manufacture, distribute and market a specific product and for what percentage of total sales does that particular product accounted. The total cost of that product is your job cost.
If your business doesn't sell consumer products (i.e. leather boots, baked goods, furnishings, cosmetics, etc.), then it can at first seem unclear how to properly allocate expenses.
In nonprofits and service businesses such as engineering and architecture firms, nonprofit organizations, digital agencies, marketing companies, construction businesses and more, your products are your people and the work they provide. Jobs can be broken down as individual clients, project types, events, and even by employee.
In a service business, job costing enables you to calculate and track your profit margins in each of these categories (and more) in order to determine which types of projects, clients, events, and even which employees are the most profitable. As a result, you can focus your company's marketing and development efforts on the most profitable pieces of your business.
You can also use job costing to identify strategies to increase profit margins on specific jobs or projects. When you implement job costing, you might find, for example, that a particular ad campaign has more traction through a certain channel.
How to Job Cost in a Nutshell
The goal of job costing is to have the ability to break down your entire business into unit economics, so you can calculate the cost of a single unit of any product, service or employee time. To achieve this, you have to be able to calculate and allocate your costs.
Your direct expenses (above-the-line costs) include both direct materials and direct labor. These are the materials needed to provide a service and the labor “directly” associated with delivering the service. These are the costs you incurred in order to earn the income.
Calculating direct material costs is straightforward, but calculating direct labor can be more difficult because it is tricky to parse out exactly how each employee spends each minute of the workday.
We recommend leveraging technology to streamline the tracking of employee time, such as TSheets. This software will allow you to allocate the proper percentage of direct labor costs (payroll, taxes, insurance, benefits, paid time off and training) to specific jobs based on how people filled out their time sheet.
Overhead expenses, such as rent, utilities and office supplies typically cannot be allocated to any one job costing category.
To incorporate indirect expenses (below-the-line costs) into your job costing and categorized profit margin calculations, you will first need to total all of these expenses and then determine the correct percentage of total indirect expenses to allocate to each category.
If you choose to take the extra step of allocating overhead to jobs, you can base this calculation many different ways. The easiest way is to allocate overhead based off of the percentage of direct labor hours associated with each job. This way you simply add up the total overhead and divide it by the utilized (direct) labor hours to get an overhead rate per hour.
Boost Profit Margins with Management Accounting and the Right Technology for Accurate Job Costing
With the right technology and accounting systems in place, you can easily allocate costs to different jobs inside your business. You can then pull profit and loss statements individually by job or category to determine your profit margins for each category or unit. Small and medium-sized businesses partnered with GrowthForce have access to well organized, time-tested technology and accounting systems that facilitate job costing and unit economics with ease.
With these types of financial insights into your company, you will be able to adjust operations, focus on your company's strengths and strategically reduce expenses to expand your profit margins and allow your business to soar.