Different methods of allocating costs

First, we will start with Direct Costs. In the previous article I indicated that it is advisable to allocate direct or (known) costs to the product or service whenever possible.

There are a number of methods used. The most common one being used by service type industries such as the local mechanic:-

DIRECT COSTS

Job Costing

For some, this takes the form of a docket book in which they write down each expense relative to the job being undertaken. In larger workshops and small factories there is often a job sheet or card that follows the product along the assembly line. These can be specially printed, or with many of the Small to Medium Enterprises (SME) the accounting package used may print one.

On jobs that extend over a longer period if these cards are collected and entered into the accounting program then the value of Work in Progress for each job may be obtained. It is also possible to see how actual costs compare with those in the quotation.

One of these expenses is of course Workshop Labour. Few firms are ever able to track each employee's direct labour cost as the employee often is shifted from one job to another too frequently for this to be practicable. The clerical cost of this recording of labour is also prohibitive.

Once a firm has been able to establish a cost history for labour the most sensible way of allocating this is to establish how many different categories of employee are on the payroll. That is, an average cost may be established for a supervisor, another average cost for leading hands, another for permament tradesmen and yet another for casual employees. With apprentices, there may be different average rates based on years of training.

All these labour rates should take into account not only gross wages paid, but also such extra costs as employer superannuation contribution, WorkCover levy, any regular tool or car allowances, and any salary sacrifice costs that affect the employer.

Process or Batch Costing.

The theory here is not much different to Job Costing except that instead of the costs being allocated to a specific job to be charged out, they are being allocated to a production run of some product. The end result is that an average cost can be established for one of a number of products being processed at one time.

Standard Costs

These are established by larger firms such as automotive manufacturers. When a production run is scheduled the costs are accumulated at standard contract rates as soon as Purchase Orders are issued. A detailed analysis is subsequently undertaken of the costs of over or under supply of materials and labour. Even the costs of wear and tear of plant are charged against the run based on standard machine hours that should occur. I consider that it is unlikely that any SME would need to consider seven variable Standard Cost reporting.

INDIRECT COSTS

These are usually associated with the cost of running the front office, sales team costs, advertising and any other cost that can not be reasonably allocated direct to the Job or Process Cost.

As mentioned in the previous article all costs have to be recovered, and provision made for replacement of plant (as distinct from depreciation of historic cost by the Tax Agent), and of course a profit for the investors. The most usual method of applying these indirect or on-costs is as a percentage to be added to the Direct or known costs.

Modern accounting software for SME provides for Plussage to be added to purchase cost e.g. in MoneyWorks Gold, and when the selling price is shown, the percentage mark-up can be set to also show on the screen. This then enables the salesperson to know how much they can safely reduce the price if bargaining is practiced.

A future article will deal with the concepts of budget setting in more detail.