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Methodology for indirect cost planning

Category: Budgeting Methodology

The methodology presented in the following summarises solutions which have been developed in several Ukrainian companies faced with problems of indirect cost planning, allocation of indirect cost to the productive activities and product pricing.

The problem of how to adequately plan and calculate indirect cost stems from the fact that indirect costs are not causally tied to individual products, orders or services like direct costs. Indirect cost planning and allocation, therefore, has to be done on the basis of certain assumptions. If these assumptions do not fit the operating environment, inaccuracies of process and product cost are the result reducing management’s ability to take management action and causing competitive disadvantages.

Indirect costs are predominantly personnel costs. Due to comparatively low wages and salaries in Ukraine, indirect costs represent in most companies only about 30% of total cost. This fact is often used as an excuse for the low level of attention which in many companies is paid to this subject. However, due to inadequate indirect cost distribution practices, the indirect cost for certain products and /or product lines can be easily misstated by 30%. This results in product costs which are over- or understated by up to 9%. An example which compares a wrong indirect cost allocation on the basis of labour cost with a correct one based on the effective use of indirect activities can be accessed through.

Because customers under free market conditions make their buying decisions by opting for the lowest price and because competing companies in a free market will have similar cost structures (and as a result, similar prices), products A and B will be sold at respectively 17.60 and 13.20 and not product C where the price proposal, based on the false calculation, lies over the market price. However, in producing A and B, the margins finally achieved will be 0.60 and 0.20 per item only instead of the 1.60 and 1.20 calculated originally. No sales of C will be made.

In knowing the true cost, it would have been wiser to sell in the first place as much as possible of C for which a margin of 1.00 per unit can be achieved and to sell A and B only to the extent required to reach a reasonable utilization of plant capacity.

The example is simplistic. However, such a situation can be observed very often and is one of the most frequent reasons for sub-optimal sales performance.

Indirect cost planning and distribution systems which perform poorly as far as their ability to calculate precise cost for individual products and services are concerned are a legacy of the former command economy. In the command economy no attention was devoted to this problem. Prices were set centrally and did not reflect the offer and demand situation in the market place. The knowledge of the precise cost was considered of secondary importance as long as the total cost of an the operation was recouped.

The features which make traditional systems perform poorly under market economy conditions are

  • oversimplified indirect cost allocation, generally as a plant-wide percentage on labour cost;
  • no tracing possibility within the indirect cost distribution and allocation system making clear to what extent auxiliary activities are caused by what products/services and vice versa;
  • no clarity as to the share which the different manufacturing-assisting functions contribute to the product cost;
  • no splitting of indirect cost into fixed and variable elements. The systems, due to this, offer no basis for flexed budgeting, direct costing and for pricing taking into account the actual order situation of the company.

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