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.
Normal costing combines indirect cost rate with actual production. The process gets you closer to actual total costs for your product.
Computing direct costs and indirect costs
Here are the two steps to implement normal costing:
Direct costs: Traced to the cost object by multiplying (actual prices/rates) × (actual quantity for a specific job object)
Indirect costs: Allocated to the cost object multiplying (predetermined or budgeted indirect cost rate) × (actual quantity for a specific job object)
Note that both direct and indirect costs use actual quantity in the formula. While you come up with an indirect cost rate in planning, the rate is multiplied by actual quantities. In this case, the quantity is jobs for the month.
Introducing the job cost sheet
A job cost sheet lists every cost you’ve incurred for a particular job. That includes direct material, direct labor, and all indirect costs. The job cost sheet is your basis for computing your sale price and your profit. You use this document to prepare a cost estimate for a client. Table 4-2 shows a job cost sheet using normal costing for a landscaping job.
The indirect cost calculation (vehicle and equipment costs) uses the actual quantity (miles driven) and the estimated rate per mile. The other direct costs on the job sheet use actual quantities and actual prices/rates.
TABLE 4-2 Normal Job Cost Sheet — Landscaping Job
| Type of Cost | Amount or Quantity | Price or Rate | Total Cost (Rounded) |
|---|---|---|---|
| Direct material | 100 square feet of grass seed | $12 per square foot | $1,200 |
| Direct labor | 15 hours of labor | $15 per hour | $225 |
| Mileage | 30 miles driven | $0.18 per mile | $5 |
