ENGR 510

Engineering Project
Management
LECTURE 6 – MONEY IN THE ORGANIZATION
PART 2
Cost Determination
 Management accounting is the name given to the allocation and control of internal costs
within an organization.
 We need to understand how costs arise and vary to determine how to set them against
products and services.
 As we mentioned in Part 1 on investment appraisal, a business has one main aim – to earn
more than it pays out over as short a time as possible.
 The incoming revenue is based on the price we receive for products, or services. Profit is
what is left after deducting all money spent.
 Therefore to ensure that we do receive more money than we spend we have to ensure that
prices more than cover all the costs involved.

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Classifying Costs: Type of Costs
Costs can be described in two main ways.
 Direct costs. This is a cost for any material or activity that is used directly in making the
product. These costs include:
 Raw materials which go into the product.
 The labour operating machines, or assembling a product.
 Power and other consumables used up when making the product.
The easiest way to decide if a cost is direct is to ask the question – ‘If we make one more
of this product, what actual money will need to be spent?’
 Indirect costs. These are all the costs which do not directly go into the making of the
product. They include items such as supervision, general heating and lighting,
administration, sales, etc.

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Classifying Costs: Behavior of Costs
 Fixed costs. These do not vary as the amount of product made varies – at least in the short
term as in Figure 5.2.1. In the long term they actually do vary – e.g. rent and business rates,
supervision, administration, etc.

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Classifying Costs: Behavior of Costs
(Cont’d)
 Variable costs. These should vary directly in relation to the products being made as in
Figure 5.2.2. These can be seen as similar to direct costs.

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Classifying Costs: Behavior of Costs
(Cont’d)
 Semi-variable costs. These are costs which do not vary in relation to slight variations in
activity, but do in relation to significant changes. An example of this would be supervisors:
One supervisor may suffice to oversee 10 operatives, but if the number of operatives rose
to 20, then an extra supervisor may have to be appointed. This behavior is often stepped
as in Figure 5.2.3.

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Costing: Labour
 Labour costs are often thought of as easy. Just set the wages paid against product costs. In
reality, it is more complex than that.
 For example, it is difficult to employ part of an employee. We normally have to employ
people for a set time period and may not have sufficient orders to keep them working for
all the time we pay for. Their wage cost is then behaving as a fixed cost, or at least as a
stepped cost.
 Similarly an organization may have a human resource policy of not hiring and firing as trade
fluctuates, making labour costs act very much like a fixed cost. Some organizations attempt
to get round this by employing flexible part-time workers, but these are not always easy to
find with the required skills.
 Similarly the cost per hour of operatives can vary according to premiums for overtime, shift
working and degree of skill. It is common within some industries to pay people a premium
for having the capability of performing more than one skill e.g. being capable of operating
more than one type of machine.

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Costing: Labour - Labour Cost
Elements
 Labour costs must include more than just the basic pay that an employee receives. The
extra costs involved are:
 National Insurance
 Contribution to pension funds
 Holidays
 Sick pay

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Costing: Labour - Labour Cost
Elements (Cont’d)
 In addition, every minute of an employee’s time is not spent directly working on a product.
There will be:
 Tea breaks
 Meetings
 Training
 Receiving instruction
 Idle time due to:
◦ Machine breakdowns
◦ Shortage of work or material
◦ Awaiting decisions

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Costing: Labour - Labour Cost
Elements (Cont’d)
 Everything done may not result in good products – some defective items will be produced
involving either scrapping of work done, or reworking – which may be done by the same
employee or a different one.
 Finally there are overheads which are determined by the number of employees such as
supervision, and wages calculations.

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Example 5.2.1

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Example 5.2.1 (Cont’d)

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Costing: Labour - Labour Cost
Elements (Cont’d)
 As we can see from Example 5.2.1, the actual cost rates per hour for employees are more
than they are paid per hour. In this case, almost 44% more.
 Note that this rate further assumes that all available time is actually spent on producing
work.
 When allowing for non-productive time, cost per hour can readily approach double what
an operative is paid for basic work time. If the employee in Example 5.2.1 was only 80%
producing then the applied cost per hour would rise to £10.76–80% above his paid rate.

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Costing: Labour - Material Costs
 Similar to labour, at first sight determining material costs should be simple. Again, however,
there are complications when we get down to details.
 All material purchased does not leave the premises in the form of product:
 All processes have waste associated with them and this has to be included in any
cost set against the product.
 There are losses due to scrap.
 Some materials are used in a process, but do not end up in the product – example
include emery powder (used for polishing), gas consumed in heat treatment etc.

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Valuation of Stock Material
 In times when the prices of raw material fluctuate even determining the cost of standard
stock material becomes more complex. This is because there are several methods of
valuing stock material as it is withdrawn.
 To demonstrate the differences, we shall look at the following material stock movements
under four different valuation methods:

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3000

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Valuation of Stock Material (Cont’d)

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Costing: Comparison of Methods

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Costing: Process costs
 We should build up a true picture of all the costs involved in operating an item of plant in a
similar manner to that used to build up the cost of an operative-hour.
 First we have to determine what items of cost are caused by our operating that particular
plant item.
 We then have to determine the monetary value to be set against the plant (see Example
5.2.2) for the budgeted number of running hours.
 A cost setter is an entity that has the ability to set its own prices, because its products are
sufficiently differentiated from those of competitors. A firm is better able to set prices
when it has a significant amount of market share and follows a clear pricing strategy.

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Example 5.2.2 (Cont’d)
 Note that the figure used for the operative rate was that calculated for the worker being
available 100% of the time. However, only an 80% utilization has been used to calculate the
overhead rate per hour. The remaining 20% could be set against a different cost area for
control purposes. It should also be included in the machine hour rate, in which case this
would rise to £18.93/hour.
 Only 10% of a machine setter’s hourly cost rate has been set against the machine as that
was calculated to be the amount of time the setter spent on the machine.
 Where tooling is required specifically for a product then that cost should be set against the
quantity to be produced by each tool.

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END OF PART 2

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