In an uncertain economy, accurate and actionable job cost accounting is more important than ever. If you haven’t already, consider using activity-based costing (ABC) to obtain more precise and useful information.
Done right, ABC helps you use your resources more efficiently by allocating expenditures — especially overhead and indirect costs — more realistically than traditional job costing. As a result, you can better determine the actual cost of each project.
ABC 101
Traditional job costing typically allocates overhead and indirect costs based on labor hours or a similar volume-based measure. This can result in over- or under-costing.
In contrast, ABC generally allocates overhead costs based on the performance of specific activities that generate costs. Each activity is clearly defined to prevent overlap. Examples include:
- Sourcing and ordering materials and supplies
- Preparing equipment for use
- Doing cleanup
ABC allows you to capture all the costs associated with each activity in a project with overhead incorporated into each as appropriate. These include labor, equipment, materials, subcontractors, and depreciation. It eliminates overly broad cost classifications, such as overhead or operating expenses.
Essentially, you calculate the costs associated with each activity and assign them to jobs based on the extent to which each project uses the respective activities. The allocation is determined by applying so-called cost drivers — basically anything that incurs a variable indirect cost or uses a resource. Examples of cost drivers include equipment usage (for equipment maintenance costs) and the number of purchase orders (for procurement costs).
Overhead and indirect costs are assigned to specific activities and, in turn, allocated to jobs based on their utilization of the activities. So, a project that requires a high number of purchase orders, for example, will be assigned a larger portion of the procurement activity’s costs.
This type of cost accounting is an ongoing process. Activities and the supply of various resources are adjusted throughout each project phase based on variances between budgeted and actual costs. ABC doesn’t replace a traditional cost accounting system, but it provides valuable additional data for evaluating how efficiently your construction business is operating.
Pros and cons
Unlike businesses that manufacture or sell goods, construction companies can’t simply divide up their expenses equally among a set number of units. Because jobs consume different resources in varying amounts over various time periods, the traditional approach to allocating overhead and indirect costs can present a distorted financial picture of your individual projects.
With ABC, you can more easily identify why some jobs take more time or money than expected, as well as which activities consume the most resources. You can also uncover where waste might be occurring and pinpoint spending overruns.
On a more positive note, ABC also helps you determine the kinds of jobs and activities that are most profitable. It can lead to improved strategic planning, decision making, budgeting, and pricing. It enhances estimators’ accuracy and allows for simpler revisions if a project’s scope expands.
That said, establishing ABC can be challenging, partly because of the comprehensive employee training required. Project managers and others may need to provide more detailed, granular information than they have in the past. The greater the number of people adding data, the higher the likelihood of inaccurate inputs that skew the numbers and undermine their value.
Additionally, some employees may grumble about the hassle or take a lackadaisical approach to recording and reporting data. While it’s easy for them to understand how clocking in and out benefits them directly, the rewards of this additional layer of tracking may not be so apparent.
Trial project
Implementing ABC can be a daunting process. However, bear in mind that you don’t have to do it all at once. Consider using it on a trial project and assessing the results. If satisfied, you can expand ABC to more jobs from there.
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