Within any business, it’s vital to understand profitability surrounding output. This allows for better decision-making, so profits can be maximised and inefficiencies minimised.
Job costing and process costing allow you to do this.
These methods mean you can work out the cost per unit of output – that is, for each item you produce or provide. They can be used for both manufacturing and for service sector businesses.
Without this level of understanding, your business is almost certain to struggle and achieving growth will be tough.
How to perform job and process costing is a straightforward process, as we explain below.
Here’s what we cover in this article:
What is job costing?
Job costing is a way of working out the cost for each unique product your business produces, or ‘units’. A unit might be an item manufactured, or it might be a particular service offering.
Job costing formula
The basic formula for job costing is:
Unit cost = direct costs for the unit + a portion/fraction of indirect costs
Direct costs might include the labour involved in producing or providing the unit, and the cost of materials used to manufacture the unit or provide the service.
Indirect costs might include costs for warehouse storage for the manufactured goods, or the cost of lighting for the manufacturing plant.
There might also be indirect labour costs too, such as paying for a warehouse manager.
The difference between direct and indirect costs is that direct costs relate only to that particular unit, while indirect costs cannot be measured just for that unit.
For example, a warehouse stores all products a manufacturer produces, so is an indirect cost because it can’t be costed to just that one unit.
Similarly, the warehouse manager’s labour is an indirect cost.
Let’s say a business creates bespoke curtains for clients. The business owner should use job costing.
To create a job costing they first need to discover the direct costs, covering the likes of the following:
- The cost for 30 minutes of labour for a worker operating the sewing machine
- The cost of the fabrics
- The cost of posting out the curtains to the homeowner.
Indirect costs might include apportioned shares of costs for the following:
- Factory and warehouse rent
- Depreciation costs of the machinery
Or let’s look at a mobile phone repair shop.
Direct costs include electronic components used in the repairs, and the labour cost for each repair.
Indirect costs might include apportioned costs for the shop rent, internet costs for communicating with the customer, and heat/lighting for the shop.
What is process costing?
Job costing might seem like a perfect solution to working out the cost for each unit of output your business produces.
But if you have a business that’s responsible for mass quantities of the same thing or service, process costing makes more sense.
Examples include chemical processing plants that produce nothing but the same chemical, or a courier service where thousands of packages are delivered each week.
In these cases, it’s futile attempting to work out the individual job costing for each drum of chemical that’s shipped, or for each package pushed through a letterbox.
They’ll always be broadly the same, or certainly close enough that producing an average cost figure makes sense.
Process costing formula
The basic formula for process costing is:
Cost per unit of output = total cost of output, divided by the number of units produced
This sounds simple but care needs to be taken around accounting periods.
For example, the chemical plant won’t shut down and then start up again cleanly at the end of each month – even though you might start a new accounting period at that point. Manufacturing will be continuous.
This means some of the direct or indirect costs – such as raw ingredients or electricity to power the machinery – may ‘roll over’ from a previous period into the following period.
The solution is to make adjustments each month to take this into account.
Should you use process costing or job costing?
The clue is right there in the name.
If what you do involves continuous processes (such as manufacturing the same chemical, or distributing packages) then process costing is probably best.
Why job costing or process costing is important
The curtain manufacturer mentioned previously learns a competitor is undercutting their prices. Because of this, sales figures are falling. They must at least match the competitor’s prices.
They look to their job costing figures.
In most examples of job costing, the direct costs are higher than indirect costs. So they start there.
They contact suppliers and learn they can source fabric in larger quantities, reducing the cost to £8 per unit, compared to the existing £12.
They also realise they can introduce manufacturing efficiencies that reduce the labour cost by a quarter.
The mobile phone repair shop faces equivalent competition from a new shop that opens up a few doors away.
Their direct costs are already pared to the bone because the parts are sourced directly from manufacturers in China, although they switch to online invoicing to avoid the direct costs of paper and a printer.
Labour costs are also essentially impossible to reduce.
However, indirect costs can be reduced by negotiating with the landlord to reduce the rent, and seeking more competitive utility providers as well as lower internet costs.
How to calculate job costing
To calculate a job costing, you might use a job costing form, or you might already have a job costing system perhaps as part of your cloud accounting software solution.
You may need to speak to your finance function or even your accountant to find out what specific information they want to see costed, although generally six things are recorded:
- Direct materials used
- Indirect materials used
- Direct labour
- Indirect labour
- Other direct costs
- Other indirect costs.
There might be a prime cost part of the form that tallies the direct costs separately, and a total overheads section too.
- The job cost form should be headed by its own unique record number to identify it. Also in the heading should be the product description and/or code, and potentially a reference to the client or customer.
- Direct materials used should be listed according to the measures used in their initial purchase, such as kilogram or litre. You can source this information easily from existing purchase agreements, but the goal is to list the quantity used only in production or creating of this particular unit. You might want to record not just the quantity but also the cost. If, for example, you purchased 100 litres of paint for £100 and 10 litres is used in the job then you would list 10 litres with a cost of £10.
- Direct labour is recorded as hours worked, and you also might want to record the wage costs associated with this. For example, if an employee earns £15 per hour and works for two hours then you would record two hours at a cost of £30.
- Other direct costs should also be specified. These might include the cost of shipping for the item if it’s sent out individually, for example. You may need to really dig into these costs because some might not be obvious.
- Indirect costs and labour will need to be based on a portion of costs. There are several different ways of doing this and no standard way will fit all kinds of job costings. For example, if you want to include warehouse costs and your business produces 10 products that are warehoused then you might want to work out 1/10th of the cost and then pro rata it for the length of time the goods are in the warehouse. Or if your company produces five items then you might simply take the total cost of overheads and divide it by that number.
Other forms of costing
There are other forms of costing that can be used instead of job or process costing.
Batch costing is used if you produce batches of something, but the costs vary between batches. For example, if your business manufactures trousers then the cost of material may vary according to the design.
Or you may repair electronics and be servicing a recurrent fault with a particular piece of equipment that will keep your field engineers busy for a certain amount of time.
Batch costing formula
The basic formula for batch costing is:
Cost of batch (both direct and indirect costs) divided by number of units in the batch
Final thoughts on job costing and process costing
Minimising your company’s inefficiencies and aiming to maximise your profits is important. Managing your costs in the right way will help you go a long way to achieving these goals.
Now you understand the difference between job costing and process costing, you can use the appropriate method to make better business decisions and achieve the growth you desire.
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