• (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.

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.

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.

Some indirect costs, however, are still relatively close to direct cost: the salary of a workshop supervisor, certainly, cannot be related to individual work operations, as can the labour cost of direct workers. The supervisor’s cost, however, and any other indirect cost incurred by the workshop in which the direct worker works, can be attached to the productive work done by the workers, and via the productive work, to the products.

Other indirect costs are spent in departments which only carry out indirect activities, e.g. building maintenance and repair, equipment maintenance and repair, internal transport, quality control etc. These functions are referred to as auxiliary functions.

A third category of indirect cost is incurred by purely administrative functions such as marketing/sales, accounting, general administration etc.

All these indirect costs have to be put in relation to the productive work performed which can have the form of operator hours or of machine hours. The way this is done can be described schematically as follows:

• the cost of auxiliary activities and general administrative activities recorded in accounting by type of cost and by organizational function are distributed to the direct activities who have to carry them in 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. It is recommended to read this explanation in conjunction with the Excel sheets which have been developed to illustrate the indirect cost distribution and allocation methodology

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.