Cost Accounting For Dummies. Kenneth W. Boyd
to forecast the exact number of hours of labor required.
If you work in a consultant role, provide a range of hours required for the job, based on your best estimate. In this example, Julie forecasts 800 to 1,000 total hours, and hours greater than 1,000 require prior approval from Everest. This approach prevents any client surprises, if more hours are needed to complete the work. As long as you document how the hours were used and what work remains, you can justify the extra hours needed to complete the project.
Prestige will have other variable costs, including travel, office supplies, and possible subscription fees for specialized software used for the project.
There may also be a small amount of fixed costs related to the project. For example, Prestige may purchase a commercial liability insurance policy, to protect the firm against a client lawsuit. While many firms have these policies in place, Prestige may need to pay an additional premium for the Everest project risk exposure.
SEPARATING DIRECT COSTS AND INDIRECT COSTS
To this point, Prestige has analyzed direct costs, meaning costs that can be traced to the project (both fixed and variable). To determine total costs, Julie must allocate indirect cost. You’ll find a fascinating discussion of direct costs and indirect costs in Chapter 2.
Here are Prestige’s largest indirect costs:
Home office costs: Salary and benefits paid to office support staff, and the lease payment on the office building.
Asset depreciation expense: Prestige purchases hardware and software for use on many customer projects, and buys office furniture. Each of these assets incurs depreciation expense.
Prestige also incurs marketing and advertising costs, which are indirect costs. These costs are allocated, based on a level of activity (labor hours, number of customer projects, and so on.) You can allocate indirect costs more precisely using activity-based costing, which is explained in Chapter 5.
Taking a Closer Look at Indirect Costs using Normal Costing
In this section, you apply indirect costs to your product or service. You also plan direct and indirect costs using a normal costing system. Actual costs represent what comes out of your checkbook. You determine actual costs after the work is completed. Normal costing instead uses budgeted data, which is generated before the work is completed. Normal costing uses a budgeted price or rate and multiplies that rate by the actual quantity used.
It’s difficult to plan your work without some budgeted rates of cost. That’s the purpose of normal costing. The process creates budgeted rates that you can use to plan your work. You don’t have to wait until the end of the job and determine your actual costs. You can find more on budgeting in Chapter 6.
Let’s say you operate a landscaping company. Changes in costs can make planning difficult, and the changes may be higher or lower. Maybe the costs you pay for materials, labor, and other costs change as the year goes on. The cost of grass seed may go up, increasing your material costs. Or your labor costs decline because the economy slows. More people with the needed skills are looking for landscaping work, so you can offer a lower pay rate.
If you use actual costs, which change over time, it’s difficult to price your product to generate a reasonable profit. For example, if you had a 15 percent profit above costs, a cost increase will eat away at your profit. Maybe higher costs lower your profit to 10 percent.
It’s also harder to plan your cash needs. If you need to buy $10,000 of grass seed in the next 30 days, what if the price goes up? Maybe a shortage increases your grass seed cost to $12,000. That means that the check you need to write will be $12,000, not $10,000. Now you need to have $2,000 more cash available.
Budgeting for indirect costs
When you budget for indirect costs, you spread those costs to cost objects, based on a cost driver (refer to the section “Cost objects: The sponges that absorb money”). Before you spread the indirect cost, you come up with a rate to allocate the costs to the product or service. The indirect cost rate allows you to price your product to produce a reasonable profit.
As the manager for the landscaping company, you decide on a cost pool for indirect costs. Your only indirect cost is for vehicles and equipment (depreciation, insurance, and repair costs). Your company is new, with virtually no office costs to consider yet.
Many companies have planning meetings around the end of their fiscal (business) year. In the meetings, they make assumptions about many issues, including next year’s costs. This is when a company plans predetermined or budgeted indirect cost rate. The predetermined overhead rate depends on total indirect costs and the cost driver you select.
During a planning session, you consider the prices and rates you paid last year. You think about how prices and rates have changed, and consider your estimates of miles driven each month. Based on that analysis, here is your budgeted indirect cost rate:
Predetermined or budgeted indirect cost rate = $7,500 ÷ 1,400 miles
Predetermined or budgeted indirect cost rate = $5.36 per mile
It isn’t until the end of the year that the company knows what the actual total indirect costs will be and the actual miles driven. Here is the actual indirect cost rate for the vehicles and equipment (using miles driven for the month as the cost object). The formula is explained in the section “Computing direct costs and indirect costs”:
Indirect cost allocation rate = $8,000 ÷ 1,300 miles
Indirect cost allocation rate = $6.15 per mile
At the end of the year, you realize that you didn’t allocate enough costs to your jobs. As a result, your actual profit will be lower than what you budgeted. Because actual costs aren’t known until the end of the year, you almost always have a difference between budgeted and actual results.
Following a normal job costing system
Put together your budgeting process for indirect costs with a plan for direct costs. Think of the combined process as normal costing. I’ll keep hammering away at this point, but it’s important: You trace direct costs and allocate indirect costs.