In Part 1 of our article on accurate job costing, we discussed the importance of regularly reviewing the actual costs of your jobs when you are a job shop or contract manufacturer and what to look for in job shop software solutions to help you do so. In this week’s article, we will discuss one element specifically, and that is how to determine the appropriate labor and overhead rates to charge to your jobs.
Manufacturing shop owners today may still not charge labor and overhead as separate cost elements to their jobs. Many owners may simply charge a flat shop rate or perhaps two or three different work center rates where all the cost elements and a provision for profit is “lumped together.” Usually this rate (or rates) have no basis in fact and are simply based on “what the market will bear” or the selling rate the shop can get for their work based in whole or in part on what shops that do the same type of work charge out.
The problem with this method of costing is that it tends to hide the true profitability of the job and has an “averaging effect.” Jobs which run on more expensive machines are charged out at the same rate as jobs which are run on much less expensive machines which require little or no maintenance or upkeep, are completely paid for, or do not consume the amount of tooling or utilities as their counterparts. The risk for costing jobs using a single flat rate or only several lump sum rates is that if there is a shift in type of work your shop does you might see a dramatic negative impact to your bottom line.
So what’s the solution?
In short, shop owners and other managers responsible for the financial health of the business should consider “Activity Based Costing” as a method for correctly allocating fixed and variable costs to their jobs. Simply, activity based costing is a method of costing jobs based on the costs that are directly incurred when running those jobs.
Direct and Indirect Labor Costs
In general, it is easy for most shops to correctly cost the direct labor costs incurred when running a job. Many shops are already (or should be) collecting the specific employee time (either electronically in their shop management solution or manually) and posting it to the job. In an automated shop floor system, it is easy to then see the actual direct labor cost for all of the hours by employee that went into that job. In addition, to the actual hourly pay of the employee, the job should “absorb” a portion of that employee’s indirect costs. These indirect costs would include all costs paid by the employer for having that employee on staff such as vacation pay, sick pay, payroll taxes, insurance paid by employer, etc. and are readily available on your annual payroll reports either from your payroll service or from your payroll software. To correctly determine the hourly figure to “absorb” on each job, the total indirect costs for the year for that employee should be divided by the actual hours worked by the employee in that same time period. For most job shops, these indirect costs would amount to approximately 20-25% of the employee’s hourly direct labor rate.
A more difficult figure to arrive at, but no less important is the amount of cost associated with manufacturing expense or overhead to correctly cost to the job. Manufacturing overhead is the cost directly attributable to the manufacturing process such as machine lease payments, maintenance costs, tooling consumption, utilities and rent associated specifically to the shop floor space, etc. This may require several steps to arrive at. In general, a manufacturing shop owner, bookkeeper, or finance manager will now want to evaluate the income statement and begin to allocate and break out those direct manufacturing costs at a minimum to the department level and hopefully down to the work center group level. Once you have your annual or semi-annual department (work center group) expenditures determined, the total costs should be divided by the total machine hours of output for the same period. Notice that the “driver” for this calculation is MACHINE HOURS and not direct labor hours since this will allow you to factor in for unattended or partially attended hours.
Selling, General, Administrative Overhead
The rest of the cost of doing business is categorized as your shop’s “SG&A” expense or selling, general, and administrative overhead. The challenge in determining your selling, general, and administrative overhead is that many shop owners will “shortcut” their calculation for manufacturing overhead and simply lump ALL of their costs beyond direct labor and direct labor overhead into this category. This type of overhead should truly represent ONLY the overall cost of doing business and would include items such as owner and management salaries and benefits, sales and marketing expenditures, rent and utilities allocated to the front office, etc. You will then want to determine the hourly SG&A overhead rate for each work center by the number of hours worked in each work center group for the same period.
But what about overtime and how should its associated premium be costed to the job? In short, overtime is often a factor of many things and cannot often be DIRECTLY attributable to a specific job. In general, overtime should probably be allocated to ALL of the jobs that go through a work center WHERE the overtime occurred. ONLY in those cases where a specific job caused overtime to occur should that specific job be “penalized” with the overtime cost.
Just like any business decision, the choice to move toward more accurate job costing needs to be a thoughtful one. In addition, once the labor and overhead rates are established, they should be “tied out” periodically to the general ledger. You should review the total overhead costed to jobs for a specific period against the expenses and costs incurred as detailed on the income statement for the same period and they should be (within a margin of error) the same.
In this day of tighter margins for job shops and contract manufacturers, it is important for every shop (large or small) to correctly and accurately cost their work. Determining the correct costs that should be allocated and absorbed by your jobs isn’t a daunting task with the right shop floor management (ERP Software) solution in combination with automated real-time data collection from the shop floor. When the owner or manager of a shop has this information available in real-time, they can quote more accurately and make proactive decisions when jobs are projected to overrun costs. In the end, these shops can drive more profit directly to the bottom line by knowing which type of work to take on. Accurate job costing really can be as easy as A-B-C.