Running a manufacturing company is stressful in the best of circumstances, but when your business handles custom orders with varying costs, it can be overwhelming.
But it doesn't have to be. If you have a strong job order costing process, you can be sure that each order you accept is sufficiently profitable to justify the time and expense you spend on it.
This gives you the confidence to take on the right orders and the courage to turn down the ones that won't help — and may even hurt — your business.
Determining the cost of goods manufactured is literally the difference between being a profitable business and going under after taking losses on orders you shouldn’t have accepted. This guide will help you understand the basics of job order costing and how to implement it in your business.
Overview: What is job order costing?
Job order costing is the process of estimating the total expenses for producing or manufacturing an individual unit. It is used when a manufacturer is producing items that significantly differ from each other in cost.
Job order costing is different from process costing, which refers to estimating how much it costs to produce identical units rolling off an assembly line. In job order costing, a different estimate is drawn up for each job or special order.
Companies that create custom-built products that differ with each customer use job order costing to determine the profitability of each order.
What goes into calculating cost?
In manufacturing, four basic elements go into the overall cost of a product: the materials used to create the product, the labor necessary for the product, the equipment and facilities to produce the unit, and the miscellaneous overhead costs associated with every order.
The materials are any of the raw parts used in the creation of a product. Manufacturers must know how much of each part is needed to complete the order. Using this information, the manufacturer calculates the material cost of the order based on current pricing for those parts.
The job will be more expensive in terms of material costs if the company has to place a special order for the parts rather than using parts the firm already has because the parts are commonly used in other jobs. The more unique the order is, the more expensive the unit may be in terms of material costs.
The labor cost is the number of work-hours it takes to build the project multiplied by the hourly wage paid to the employees who do the work. For example, if it takes 100 work-hours to construct a unit and workers are paid $30 per hour, the labor cost to the company to produce that unit would be $3,000.
Manufacturers frequently seek to incorporate machines and robots to reduce the amount of labor necessary to do a job since this is often the most expensive part of manufacturing. However, this is more difficult for manufacturers who do custom work rather than operate an assembly line.
3. Equipment and facilities
Equipment and facilities are necessary for workers to complete the work and must be calculated into the cost of the unit.
While this is already a sunk cost for the manufacturer, meaning one that can’t be recovered, producing the unit will still incur some expenses such as maintenance of the equipment, fuel, electricity, repair, and so on.
Manufacturers should keep detailed records of equipment usage in order to better predict unforeseen costs such as equipment hitting certain milestones that necessitate special maintenance work.
Overhead is all of the miscellaneous costs that come with running a manufacturing firm. It may include rent for office space and the cost of an executive to manage this project and many others.
This is typically the most difficult cost to estimate because it doesn't have a direct relationship to the production of an individual unit. As a result, you must use your best judgment to estimate overhead.
How to calculate job order costs for your business
Once you know the individual costs associated with manufacturing a unit, the actual job order costing is straightforward and just involves adding all of those costs together. Here’s the five-step process, along with how a hypothetical business would calculate it.
Step 1: Estimate materials cost
Acme Inc. estimates that it has $1,000 worth of parts to build the custom widget requested by the customer, thanks to a strong inventory control system that tells the company what safety stock it has on hand at any given time.
The company also estimates it will have to spend an additional $1,500 to have the other necessary parts delivered. The total materials cost is therefore an estimated $2,500 for this order.
Step 2: Estimate labor cost
Acme knows it will take approximately 120 work-hours to build the widget based on an examination of company records for similar orders. Because Acme pays its employees $25 per hour, the total labor cost for this order will be $3,000.
Step 3: Estimate equipment/facilities cost
Based on detailed equipment records, Acme knows that between fuel and maintenance, it will cost the company about $2.50 per hour to operate a necessary piece of machinery over the course of the project. Therefore, based on 120 hours of work, the equipment costs for the order will come to $300.
Step 4: Estimate overhead cost
Based on the salaries of executive leadership, an executive assistant, the monthly rental cost of the warehouse in which units are produced, and other overhead costs, Acme attaches a flat rate of $1,000 to each project to reflect general overhead.
Step 5: Create job order costing estimate
With all four elements of the job order estimated, it's easy to create a job order costing estimate — simply add the four costs together. Since Acme expects to spend $2,500 on materials, $3,000 on labor, $300 on equipment and facilities, and $1,000 on overhead, the total cost for this job order will be $6,800.
The 3 benefits of job order costing
Job order costing provides three main benefits to the manufacturer, which all have a direct impact on the bottom line.
1. Prevents you from taking on a bad job
In the example above, Acme can use its job costing analysis to perform a profitability assessment and determine whether to take on this order. If the customer is willing to pay $10,000, for example, this makes the job profitable to the tune of $3,200.
If the customer will pay $5,000, then taking on this job is a bad idea because it would result in a loss of $1,800. If the customer is willing to pay $7,000, it may result in a small profit, but Acme may decide to forego the order because of the low profit margin that might be wiped out by unforeseen problems.
And even if everything goes well, doing such a low-profit job takes away scarce resources that could be applied to a more profitable order.
2. Makes it easier to budget
If you have no idea how much money you'll make (or even if you'll make money) on each job order that comes in, budgeting is next to impossible.
You've got to guess how much profit you'll make over the next quarter based on previous quarters, which is not an accurate way to budget, particularly when you're in the business of custom manufacturing and don't have the consistency of assembly-line production.
Through job order costing, you'll know exactly how much you're likely to make based on current job orders.
3. Improves your efficiency
Job order costing is an important part of good planning, which results in running your business more efficiently (and driving costs down in the process).
For example, if you do a good job of costing some upcoming orders, you'll see that you can combine multiple orders for parts you'll need into one, allowing you to negotiate some bulk order discounts with your supplier.
Use software to improve your job costing process
The actual job costing formula you see above is simple and can be done with a calculator, but it's not so simple to gather all of the data you need to come up with a good estimate. You'll need to have detailed records of your equipment usage, your employees, your carrying costs, and so on. For that, you'll need software.
Check out inventory management software options to find one that fits your business. With good inventory management comes more accurate job order estimates, so if you don't have software doing that now, find a good platform right away.
Such software isn’t only good for creating a job order costing system. It will assist you with inventory costing, general management, finances, and anything else related to your inventory.