• (a) should provide for visibility as to how types of cost (e.g. employee salaries) spent for an assisting function (e.g. mechanical repairs) serve the production activities.
• (b) should, if changes occur in the productive activity (e.g. productive activity 1 increases or decreases), be able to at least approximately determine the impact on the assisting functions, and on the individual cost categories (e.g. what is the impact on the mechanical repair function and on the headcount in this function, if productive activity 1 increases, or decreases by 10%).
• (c) should clearly indicate what contribution an individual product (symbolized in the example as output from an activity) makes to recoup the cost of the assisting functions.

Due to confidentiality reasons, the Excel indirect manufacturing cost budgeting for the two sample companies does not reproduce the full detail of the manufacturing overhead planning process, but only the resulting summary sheets.

In planning this way, the quantities, simultaneously, represent the planned capacity utilization, i.e. the use which is planned to be made of the available equipment. The degree of capacity utilization, as can be easily understood, influences the amount and structure of indirect cost which has to be planned.

Indirect cost planning, as in the example on Excel sheet TB, is therefore only valid for the capacity utilization planned.

The decision which costs at the given capacity utilization level behave “variable” and which behave “fixed” requires the design of a model which should not be too complicated. Such models are generally built assigning a certain variable/fixed behaviour to cost categories and using this assigned behaviour across the board for all functions. The example uses such a concept: costs have been assigned as 100% fixed, 50% variable/50% fixed or 100% variable (marked through colours) and the split has been calculated accordingly.

All those costs are associated with 17 activities/functions– 4 productive activities, 10 assisting functions, other costs, sales/marketing and administration.

Through the function to which they are related (e.g. UAH 376,000 are related to auxiliary function 2), indirect cost can be budgeted in assessing the contribution which the subject assisting function has to make in order to permit the realization of the production plan.

In the case of mechanical repairs for instance, this analysis would consist of an assessment of the number, and kind of repair jobs which the repair manager deems necessary to keep the production running at the budgeted activity level of 36,000 machine hours in production activity 1, of 90,000 m2 in production activity 2, of 180,000 kg in production activity 3, and of 18,000 operator hours in production activity x. during. The total budgeted mechanical repair cost (i.e. repair material, repair labour, and repair department overheads) can then be distributed in accordance with the material and labour cost planned to be spent for the four productive activities. The distribution base in this case is the sum of direct repair material cost and direct repair labour cost.

It has to be noted that this methodology can be used only if the mechanical repair cost structure for the different production activities is similar. Should the mechanical repair activity be characterized by the situation that repairs for one production activity consist primarily of unproblematic replacement of expensive material, whereas the other production activities require complex manual repair work using insignificant and inexpensive material, such a distribution practice could not be applied because it would overly burden the material-intensive repairs with indirect repair cost. Another distribution method would have to be selected in this case.

The general message which this discussion of alternative methods wants to convey is that there is no simple and uniform way for distributing indirect cost to the productive activities. The correct distribution method is the one which distributes the indirect cost in a way that the distributed costs most closely reflect the effective use caused by the production process.

Generally, the following distribution bases can be expected to lead to an adequate distribution of the cost of auxiliary functions:

Auxiliary services performed within the assisting functions area should be consolidated, and only the services leaving the auxiliary function area should be shown in the distribution.

Because the different products cause different labour cost in the workshops which contribute to the manufacturing process, the planning has to be done by workshop. The technical documentation as to the work to be carried out – how many minutes of direct work have to be spent in the different work shops, and at what rate – serves as basis for calculating the direct labour cost budget in using the formula:

Attention has to paid to the fact that in the case of work which is not paid “by piece”, the time per unit (the norm) might be over-, or understated, i.e. not be established in accordance with the principle of “attainable performance under efficient operating conditions”. Using such norms for budgeting will automatically lead to a wrong direct material cost budget.

In the case of the sample company Eurotransform, the direct labour budget calculation is carried out for 14 workshops by month in accordance with the planned delivery date of the final product, and in splitting the labour cost into “incentive paid work” (paid per piece), and “straight paid work” (paid by hour). This calculation shows which direct labour cost are caused in the different workshops by the final products due for delivery in January, February, March, etc. The calculation, however, does not indicate at what point in time of the production cycle the labour cost becomes cash outflow effective. (for example, in the case of delivery by the end of June, production has to be launched for category II – III products in April, for category IV – VI products in March). A direct labour payment pattern, therefore, has to be assumed similar to the one used for direct materials (%age distribution of cash outflows during the production cycle time for transformer sizes II-III, and IV-VI).

The problem of budgeting overheads (or indirect cost) stems from the fact that overhead cost are not connected directly to individual products, orders or services, as are the direct cost.

Some indirect costs, however, are still relatively close to direct costs. The labour cost caused by a workshop supervisor, certainly, cannot be related to individual work operations, as can the labour cost of direct workers. Each workshop, carrying out productive work has to bear such indirect cost of its own. But the supervisor’s cost, and other indirect cost incurred, can be related to the productive work done by the workshop, and via the productive work, to the products.

Other indirect cost are spent in departments which only carry out indirect activities, e.g. building maintenance and repair. These functions are referred to as auxiliary functions. The costs of auxiliary functions, too, have to be put in relation to the productive functions in order to relate them to products. This putting in relation is referred to as “distribution” and “allocation”

• the cost of auxiliary activities, recorded in accounting by type of cost and by organizational function, are distributed to the direct activities who have to carry them in an accordance with the contribution they make to their work.
• the total indirect cost identified as belonging to one productive activity (i.e. the indirect cost of the productive activity plus the distributed cost of the auxiliary activities) are then allocated to products, or processes.

This is explained in more detail in the following.

To be useful, the material budget has to be established in some detail using material consumption standards denominated in quantities (i.e. so much g, kg, m, items etc. are needed to manufacture a certain quantity of product). These material consumption standards should be engineered and be realistic (i.e. reflect attainable performance under efficient operating conditions). The quantities so obtained are then multiplied by the purchase prices which the company, realistically, can expect to obtain on the market.

A material budget which is built up in this way lists, by month, the main materials, by item, the quantities needed and the purchase prices which the company wants to achieve to purchase them. The advantages which such a material budget offers to management are evident: because a material budget prepared in this way is a detailed simulation of the future purchase activity and of the future material consumption, the budget numbers can be directly used to measure during the year the performance of the purchasing function and the efficiency of manufacturing as far as material usage is concerned. The establishment of a material budget which fully covers the above mentioned two aspects – income forecasting and management controlling with regard to purchasing efficiency and material usage – however, is a relatively complex and time consuming task going beyond the immediate objective to obtain information as to the monthly balance sheet and cash flow data which prevails here. The methodology described, due to this, is not paying particular attention to the task to establish budget data for measuring the efficiency of purchasing and material utilization.

In the case of Eurotransform, all transformers are being planned as customer specific versions. The direct material lists (bills of material) compiled when working out the proposal for the customer, therefore can be used to budget the material requirements. These lists show the needed quantities and “LIFO” – purchase prices. This information, in accordance with the planned delivery dates, is collected by month, and classified in accordance with six raw material categories (2 types of copper wire, magnetic steel, oil, isolation paper, others). Direct materials are loaded with material acquisition cost which cover purchasing, incoming inspection, and the transportation to the workshop.

An further important material cost element of transformers are the purchased components, as they are often imposed by the customer. These components are planned specifically too, classified in accordance with the components type as listed below, and shown with the planned transformer type to which they belong.

In order to determine the points in time when materials, and components become due for payment during the production cycle (and, consequently, cause cash outflows), a consumption pattern has to be established. The scenario developed for this purpose links the payments for materials to the transformer size (2 classes: size II-III, and size IV-VII); to the types of raw materials, and purchased components, to the production cycle time (3 months for size II-III, 4 months for size IV-VI), and to an assumed typical payment pattern indicating at what point in time of the production cycle payments are made. The production cycle is counted backwards from the planned delivery date.

Essentially, the same methodology has been used to prepare the material budget for the tannery business. The material consumption standards are here related to the 15 planning units used for sales planning.

The following assumptions have been made with regard to raw material inventories and the cash out flows caused by material purchases:

• material inventory at end of each month should be equal to the next month’s consumption;
• 50% of the monthly purchases are paid in the same month, the remaining 50% in the following months.

The use of such a calculation scheme has the advantage that order particularities can be taken into account when making the proposal. If a request, for instance, reaches the company later in the year when it is already certain that the budgeted capacity utilisation will be met and that consequently all fixed costs are already covered, part of the calculated fixed cost (in the example 9.56, i.e. 19.75% of the calculated price) can be used for strengthening the company’s competitive position.

The company further, for instance, in the case of minimum marketing cost for an order, can take this fact into account in reducing the calculated cost share for marketing.

Such practice, however, presupposes that the opposite is done too i.e. excessive marketing/quality/development costs etc. are added when the order significantly lies over the calculated amounts for those cost items.

• (a) provides for clarity as to how the different types of cost (e.g. employee salaries) spent for an auxiliary function (e.g. assisting activity 2) serve production activities.
• (b) must be capable of estimating the effect on the assisting functions and on the individual cost categories of changes in the productive activity (e.g. productive activity 1 increases or decreases). For examle, what is the impact on assisting function 2 and on the headcount employed in this function if activity 1 increases, or decreases by 10%.

(c) indicates clearly what contribution an individual product (symbolised in the example as output from an activity) makes to recoup the costs of the assisting functions.

In planning this way, the quantities, simultaneously, represent the planned capacity utilisation, i.e. the use which is planned to be made of the available equipment. The degree of capacity utilisation, as can be easily understood, influences the amount and structure of indirect cost which has to be planned.

Indirect cost planning, as in the example on Excel sheet TB, is therefore valid for this planned capacity utilisation only.

The decision which cost at a given capacity utilization level behave as “variable” and which behave as “fixed” requires the designing of a model which should not be too complicated. Such models are generally built assigning a certain variable/fixed behaviour to cost categories. Then, this assigned behaviour is used across the board for all functions. The example uses such a concept. The types of cost have been assigned as 100% fixed, 50% variable/50% fixed or 100% variable (marked by colours) and the split has been calculated accordingly.

If the activity of an operation consists of assembling piece parts essentially through manual labour, the labour time spent on assembling, generally, is an adequate allocation base. This is the case because it can be considered that the products cause indirect cost (energy cost, workshop administration, use of tools, machines, building space materialized through amortization, maintenance, use of utilities etc.) proportional to the time which is needed to perform the assembling work. Operator hours have been selected in the example for productive activity 4 (budgeted volume 18,000 operator hours, i.e. 10 direct workers in one shift). One labour hour, in the example, carries 120.46 indirect cost.

With increasing mechanization, labour hours or labour cost are less and less suitable for allocating indirect cost to products. This is due to the fact that the “human work”, even where it still exists, less and less determines the pace of the production process and increasingly has merely an assisting function. If this situation applies, machine hours should be used for indirect cost allocation. This has been done for production activities 1 and 2 in the example. The example shows for the two activities 36,000 and 9,000 budgeted machine hours respectively. This corresponds to an active machine pool of approximately 15 machines in the case of activity 1, and of 3 or 4 machines in the case of activity 2. In the example, the machine hour calculation carries 355.05 respectively 441.64 indirect cost.

As an example of a more simple allocation base, metres have been chosen in the case of activity 3. Such a basis assumes that a product is produced and the output is measured in metres (e.g. rope). Whether indirect cost allocation on the basis of metres is possible in such a case depends on the manufacturing process. If the metre output per machine hour is constant independent of the type of rope which is produced, metres can be used as the absorption base. If this is not the case, machine hours have to be applied.

All these costs, simultaneously, are associated with activities and functions adding up to 17 – 4 productive activities, 10 auxiliary functions, other costs, sales/marketing, and administration – listed in the columns of the/

Through the function to which they are related (e.g. UAH 376,000 are related to auxiliary function 2), the indirect cost can be budgeted by assessing the contribution which the auxiliary function has to make in order to realise the production plan.

In the case of mechanical repairs, for instance, this analysis would consist of an assessment of the number and kind of repair jobs which the repair manager deems necessary to keep production at the budgeted activity level of 36,000 machine hours in production activity 1, of 9,000 machine hours in production activity 2, of 180,000 m in production activity 3, and of 18,000 operator hours in production activity 4 during the budget period. The total budgeted mechanical repair cost (i.e. repair material, repair labour and the repair department overheads) would then be distributed in accordance with the material and labour cost planned to be spent for the four productive activities. The distribution base in this case is the sum of direct repair material cost and direct repair labour cost. In applying this method, 199UAH are distributed to activity 1, 120 to activity 2, 49 to activity 3 and 8 to activity 4.

It has to be noted that this methodology can only be used if the mechanical repair cost structure for the different production activities is similar. Should the mechanical repair activity be characterised by the situation that repairs for one production activity consist primarily of unproblematic replacement of expensive material, whereas the other production activities require complex manual repair work using insignificant and inexpensive material, such a distribution methodology could not be applied because it would overly burden the material intensive repairs with indirect repair cost. Another distribution method would have to be selected in this case.

The general message is that there is no simple and uniform way for distributing indirect costs to production activities. The correct distribution method is the one which distributes the indirect cost in a way which most closely reflects the effective use caused by the production process. Here are some examples of frequently used distribution bases:

Auxiliary services performed within the assisting functions area should be consolidated and only the services leaving the assisting functions area should be distributed.