de 11.1 4E1 Project Management Costing – 2 Marginal Costing, ABC and Depreciation
Dec 20, 2015
Slide 11.2
Key Concepts
Marginal/decision costing
Sunk costs and other excluded costs
Activity-based costing
Calculating labour and machine costs
Depreciation and amortisation
Slide 11.3
Marginal (Decision) Costing
Also known as variable, direct and decision costing• Basic principle: cost = direct costs only
Direct costs:• Salaries/wages
• Raw materials
• Plant hire
Other costs are generally omitted:• Overheads
• Money spent before the project starts (“sunk costs”)
• Indirect costs
Slide 11.4
Period 1 2 3 4 5Project 1 Labour hours 100 100 100 75 75 Rate/hour 25 25 25 27 27 Labour cost 2,500 2,500 2,500 2,025 2,025 Materials 1,000 1,200 1,000 - 2,000 Total Cost 3,500 3,700 3,500 2,025 4,025 Project 2 Labour hours 200 150 150 100 150 Rate/hour 30 30 28 28 32 Labour cost 6,000 4,500 4,200 2,800 4,800 Materials 5,000 6,000 3,000 600 600 Subtotal 11,000 10,500 7,200 3,400 5,400 Overhead 4,000 4,000 4,000 4,000 4,000
Marginal Costing Example
Marginal costing is usually (though not always) straightforward. Unlike the previous example, we simply ignore overheads.
Slide 11.5
Marginal Costing: Pros & Cons
Advantages• Simple
Data relatively easy to collect or estimate
Easy to compute
• Avoids allocation problem
• Forward-looking
• Tends to be less controversial with users
• Avoids distortions due to incorrect absorption
Disadvantages• Ignores many realities,
e.g. Sunk costs
Indirect and knock-on costs
• Understates the true cost
• Can lead to bad decisions e.g. “throwing good money
after bad”
Slide 11.6
Marginal Cost: Weaknesses
Startup/Preacquisition
Costs
Post completionCosts
SecondaryCosts
DisruptionCosts
Opportunity Costs
DisplacementCosts
Start Finish
Marginal Cost
Slide 11.7
Activity-Based Costing
Basic principle:
cost = direct cost + indirect driven cost
Overhead is allocated according to:• labour hours/costs
• machine hours/costs
• materials cost
• direct costs
ABC is offered as more accurate/meaningful• A better basis for decisions
Slide 11.8
ABC Versus Absorption
Illustration using an industrial example• A company produces two products X and Y
• Using traditional cost accounting:
X Y
Units 1,000 1,500Materials/unit (€) 25 30Labour hour/unit 0.5 1.0Labour cost/hour €20
Overhead €50,000
Hours 500 1,500Overhead allocation €12,500 €37,500Per unit €12.50 €25.00Cost/unit €47.50 €75.00
Slide 11.9
ABC Versus Absorption
ABC considers what drives the overheads• Assume these are made up as follows:
The following data are gathered:
Task Cost Cost driver
Machine set-ups €10,000 Number of set-ups
Quality inspections €25,000 Number of inspections
Plant cleaning €10,000 Time required to clean after production
Packaging € 5,000 Number of customers for product
Slide 11.10
ABC Versus Absorption
Activity Cost (€)
ProductX
ABC(€)
Product Y
ABC (€)
Set-ups 2,000 4 8,000 1 2,000
Inspections 2,500 7 17,500 3 7,500
Cleaning 1,000 8 8,000 2 2,000
Packaging 1,000 1 1,000 4 4,000
Total 34,500 15,500
Units 1,000 1,500
Per unit 34.50 10.33
Cost per unit 69.50 60.33
Absorption cost/unit 47.50 75.00
Slide 11.11
Costing Detail: PeopleImportant to cost labour accurately
• e.g. how much does an engineer cost per hour?
Total cost includes:• Salary• Social welfare cost• Pension cost• Office costs (if relevant)• Other non-people support costs• Training, etc.
We also need to know time worked, based on:• Standard hours per year• Non-working time: holidays, training time, illness, etc.
Slide 11.12
Costing People - Example
Joe is paid €36,400 p.a. and works a 35-hour week (1,820 hours/year)
• Gives an hourly cost of €20
But:• Joe’s pension, social welfare and perks add another €4,000
• Joe works only 1,155 hours a year 4 weeks annual leave plus 10 days of public holiday
one week’s sick leave
one week’s training
and Joe effectively works about 6 hours in every 8
1155 hours @ €40,400 ≈ €35 per working hour
Slide 11.13
Maximum time available
Planned time available
Available time
Normal time available Not worked
Planned running time Changeovers
Actual running timeMachine down time
Obviously, this does not matter if it is a fixed cost.
Costing Detail: Machine Hire
Slide 11.14
Depreciation/AmortisationRationale
• Assets cost money• Physical assets will be used up through wear and tear,
depletion, loss of value, etc.
This usage is known as:• “depreciation” (for equipment)• “amortisation” (for wasting assets e.g. mines, quarries)
Basic methods:• Straight line• Declining balance• Sum of digits• Double declining balance
Slide 11.16
Straight Line Depreciation
Based on no. years over which asset will be written off• Machine press bought for €200,000, written off over 4 years
• Therefore, depreciation charge is 25% per year
Pros: simple to compute; writes off assets cleanly (no residual balance problem)
Cons: not always realistic
Year Charge Balance
1 €50,000 €150,000
2 €50,000 €100,000
3 €50,000 € 50,000
4 €50,000 € 0
Slide 11.17
Declining Balance DepreciationWrite off same % of residual balance each year
• press may be written off over infinite no. of years• may therefore need a termination year
e.g. write down press over 4 years at 25% p.a.
Pros: relatively easy to compute; realistic for many assets
Cons: Problem of residual balances
Year Charge Balance1 €50,000 €150,0002 €37,500 €112,5003 €28,100 € 84,4004 €21,100 € 63,300
Slide 11.18
Sum of Digits DepreciationCombines exponential and a clean write-down
Example: assume 4-year write-down• Add the digits in the no. of years: 1 + 2 + 3 + 4 = 10• Take the write-down in order: 4/10, 3/10, 2/10, 1/10
Pros: Approximates declining balance; no residual balance problem
Cons: More complicated to compute
Year Charge Balance 1 €80,000 €120,000 2 €60,000 € 60,000 3 €40,000 € 20,000 4 €20,000 € 0
Slide 11.19
Double Declining Balance Depreciation
Start with a straight line (say four years)
• Compute % depreciated (10%) and double it (20%)
• Depreciate with declining balance method at this rate until charge is less that it would be using straight line
• Use straight line value from there on
SL DDB
Year Balance Charge Balance Charge
0 200,000 20,000 200,000 40,000
1 180,000 20,000 160,000 32,000
2 160,000 20,000 128,000 25,600
3 140,000 20,000 102,400 20,480
4 120,000 20,000 81,920 20,000
5 100,000 20,000 61,920 20,000
6 80,000 20,000 41,920 20,000
7 60,000 20,000 21,920 20,000
8 40,000 20,000 920 920
9 20,000 20,000 0 0
10 0 0
Slide 11.20
Shared Costs
Costs shared with other activities• e.g. Machines used part of the time
• Part-time staff
Shared overheads• e.g. Management
• Insurance
Not always clear how to account for shared costs
Slide 11.21
Case Study 1: New Building
How is the cost overrun to be accounted for?
Completion due early 2003
Funding problems during design• Number of floors reduced to six
• Atrium design change - chimneys on adjacent building need to be raised
• Makes change of occupancy necessary; new occupants need existing wall to be knocked down to put in equipment
Delays: building handed over late 2004
Later, power system fails and must be repaired at considerable expense
Slide 11.22
Case Study 2: System Development
What complications arise in computing project cost?
Large public sector computer system development
Personnel• Some staff full-time, some part-time. Consultants hired for part
of the project period. Some changes of internal personnel
Equipment• Used existing servers, PCs and peripherals. Existing network
had to be upgraded for project team. Existing servers also used for ongoing production systems. Bought some additional servers and PCs
Timescale: 30 months (no overrun)
Slide 11.23
SummarySeveral costing approaches
• Arguments for and against each approach• There are times when each is appropriate• Different methods can give quite different results • Understand the limitations of each
There are issues that arise in costing labour, machinery and other fixed assets
Asset costs must be spread appropriately
Depreciation/amortisation is often a material cost
Project have their own costing problems