Small Business Management: Costing – Part 1
Small Business Management: Job Costing & Estimating Part I
Making a profit is what business is all about. Finding the right price to sell at is as important to your success as the product (or service) itself.
Basically, finding the right price is a matter of adding up all your business outgoings and then allocating a proportion of the total to each product you make, sell and/or service you provide, together with an additional amount as your profit margin.
If you produce only one product or provide only one service, this does not pose very much of a problem. But, if as most do, you provide a range of goods and/or services, deciding what they cost can be more difficult. Calculating how much you spend on “direct” labour or materials for each job is the first, and the simplest, step. But you must also take into account your “overheads”. That is, all your costs, such as rent, fuel, supervision and even your morning cup of tea, which keep your business running smoothly, but which don’t contribute directly to any single job. Allocating overhead costs is not so simple, but it must be done properly if poor profit returns, or worse – losses, are to be avoided and a satisfactory return is to be generated on the capital invested in your business.
Many small firms like OPE Dealerships and mowing/gardening contractors strike problems calculating what it costs them to produce their goods and/or services. The purpose of this series is to assist you to estimate and cost jobs and/or services more accurately.
Groups that will particularly benefit include: small manufacturers, small retailers, repair businesses and contractors. All of whom are important parts of the Outdoor Power Equipment Industry.
The articles describe how three different types of businesses could cost their work:
The first is a one-man service-repair operation where no parts are used.
The second describes an approach that could be taken by a service and repair business employing a few people using parts and materials.
Thirdly we describe the more involved way a manufacturing firm should cost jobs.
While the third example will be of most direct interest to small manufacturers and large retail/service/repair businesses, all owner/managers will benefit from a careful study of the more detailed approach it involves.
The Importance of costing
Costing is a technique which enables you to know your costs and thus:
Decide on selling prices which will make a profit
Exercise more effective cost control of the running of your business.
A business which fixes its prices without knowing its true costs may, without being aware of it, be giving money away to every customer. The more customers – the larger the deficit when the costs are finally added up. By then the business may have gone broke!
It is therefore important to know your costs; once this has been determined you can safely set selling prices, prepare realistic estimates and quotations for customers, and be aware, from week-to-week (or day-to-day) of how your business is faring.
Some common failings of firms which do not bother enough in this area include:
Not preparing a detailed estimate of costs-plus-profit margin before pricing a job
Overlooking some costs like sub-contractors; delivery costs; sick-pay, holiday-pay, minor materials (eg oil, nuts, bolts washers); wages of employees not directly involved in each job (eg apprentices, supervisors, administrators).
Inadequate system of recording actual time and actual materials used against each job.
Not calculating profit on each job.
Not retaining the above data for future use.
Not comparing estimated and actual costs.
The use of fairly simple costing techniques will not only ensure you do not overlook any costs when you prepare estimates and quotations, it will also save you valuable time.
When later you may compile an estimate for a similar job, you can quickly refer to your records for guidance. Costing records also enable you to analyse your work and see where costs can be saved, thus boosting future profits. Do not be misled into believing that costing is too complicated for the small operator. A simple form of costing can be used be very small firms as the following example demonstrates.
Costing & Estimating
A One Man Band
If you provide specialist labour service only (eg repairer or mowing contractor) you still need to calculate your overhead expenses and include them in your charges. The easiest way to do this is to include them in your hourly rate.
An example is shown below for Joe Blow, a one-man mowing contractor:
Gross return including profit required by owner: $1,050 per week
Actual hours of Productive Work: 35h
Wage Rate: $1050/35h = $30.00/h
Cost of running business (eg Rent, Rates, Electricity, Interest, Depreciation on Vehicle, Tools & Equipment, Insurance) $29 400 per annum
4 Weeks Holiday for Joe Blow $4 200
Overhead per week worked (ie 48 working weeks) $34 600/48 = $612.50 per week
Overhead rate per hour: $612.50/35 = $20.00
Total Hourly rate required: Wage Rate $30.00
A total hourly rate of $50.00 will cover expenses and give Joe Blow a return of $1050.00 per week all year (including four weeks holiday) providing he is ensures that he puts in at least the 35 hours of chargeable work each week for 48 weeks and he has accurately calculated his overheads.
Many small mowing contractors like Joe Blow do most of their work on a “turn-up-work-and-charge” basis. However, it may also be necessary for him to prepare quotations, in which case he would have to estimate the time required to compete a job and submit his quotes on that basis, ideally in writing.
By keeping a simple diary in which he records his time on each job, Joe Blow would be able to write up his invoices and also retain a record that will assist him quoting for future work.
Parts & Labour Operation
A slightly more complicated situation exists where material costs are involved and labour is employed (such as an OPE Servicing Dealership workshop). Often parts or materials are ordered specially for a particular job and are therefore be costs directly attributable to that job (“Direct Costs”).
However, such operations often maintain stocks of such materials and/or parts. This involves storage and other expenses such as waste, losses, packing and funds employed.
The first step is to identify and calculate the overhead expenses for the year. We will address this in greater depth in a later series. For the time being you should be able to extract the relevant figures from your most recent Financial Statements or Income Tax Returns/Business Activity Statements.
Secondly, you should establish a profit target for the year based on obtaining a satisfactory return on the funds invested in the business.
Next calculate a method for recovering the overheads and obtaining a profit on each job. This can be done in a number of ways but we shall concentrate on two:
Calculating an all-up hourly rate
Calculating a mark-up on direct costs (ie labour, materials etc)
The detailed steps involved to calculate an all-up hourly rate on labour for a small firm Joe Blows’ Mowers employing three people:
Estimate total number of chargeable hours for a year:
3 staff @ 35 hours/wk x 46 weeks = 4830h
Estimate total overheads (say, $150,000)
Planned profit (say, $50,000 )
Divide overheads + Profit by chargeable hours to give rate:
$100,000 + $50,000 / 4830 = $31.05
Add actual hourly rate paid for labour (plus a margin for sick and holiday pay etc)
(say, nominal wage $30.00/h)
$30.00 x 40h x 52wk = $62 400pa
Productive time worked: 35h x 46wks = 1610h
Actual hourly Direct Labour cost: $62,400/1610h = $38.75/h
All-up labour Rate required to achieve Projected Profit of $50,000pa:
Overhead/Profit Rate + Real Labour Rate:
$31.05 + $38.75 = $69.80/h
A: Repair of a chainsaw: Direct Materials $100.00; Labour 3 Hours.
B: Service of a lawnmower: Labour 1 Hour (Small quantities of parts – not costed separately but included in overheads).
C: Repair of a Ride-on Mower: Direct Materials $250.00; Labour 6 Hours; Sub-contractors $150.00.
A B C
Materials $100.00 $250.00
Labour @ $69.80 $209.40 $69.80 $418.80
Total $309.40 $69.80 $818.80
The “Mark-up” approach to costing is, in some ways, closer to that employed by a retailer. The steps involved are as follows:
1 Assess the cost of direct or chargeable hours for a year:
3 staff @ 35 hours/wk x 46 weeks = 4830h
4830h x $38.75 = $187,162.50 (say, $188,000)
2 Assess estimated cost of materials used and other direct expenses (say, $250,000)
3 Divide overheads ($150,000) + Profit desired ($50,000) by Direct costs (ie, $428,000) to arrive at required mark-up:
$150,000 + $50,000 / $438,000 x 100% = 45%
If Joe Blow’s Mowers costed this way Jobs A, B, and C would be as follows:
A B C
Materials $100.00 $250.00
Direct Labour @ $38.75 $116.25 $38.75 $232.50
$216.25 $38.75 $632.50
Plus Mark-Up 45% $97.30 $17.45 $284.65
Total (Method 2) $313.55 $56.20 $917.15
(Compare Method 1 $309.40 $69.80 $818.80)
NB: This method yields higher profits for Jobs A & C than method 1)
The estimates could be prepared in a simple duplicate book, or pre-printed forms could be used for a more professional approach.
A simple job “cost card” should be kept to record the actual time on each job and any materials used to provide a cross-check on the estimate. In cases where the work was on a “do-and-charge” basis, the job card would provide the basis for preparing an invoice.
These days the above information can be easily calculated, collected and recorded using Business Management Computer Stofware.
Next Issue: Costing & Estimating for the Larger Service Firm