The problem of indirect cost distribution – relating indirect functions to the productive tasks performed
Category: Budgeting Methodology
Indirect costs, independent from the purpose they serve, are incurred as types of cost such as salaries, salary related contributions, energy, communication, amortization, utilities, purchased services etc.
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:
| Dispatching department: | Time spent by dispatching dept. employees |
| Energy/energy repairs: | Consumed electrical energy |
| Steam production: | Consumed steam |
| Internal transports | Tonnes of material moved |
| Building repairs: | Repair orders |
| Equipment repairs: | Repair orders |
| Quality control: | Effective quality control efforts as estimated by the quality manager |
| Purchasing | % on material value, if necessary different %ages for different value classes |
| Sales/marketing: | Effective sales/marketing efforts as estimated by the marketing manager |
| Administration/Other cost: | Mark — up on all other cost |
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.