How to Budget for Indirect Costs in Cost Accounting
When you budget for indirect costs in cost accounting, you spread those costs to cost objects, based on a cost driver. A cost driver is an item that changes the total costs. 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
Predetermined or budgeted means planned in advance. Your budgeted monthly rate has a lower monthly cost level ($7,500 versus $8,000) but more monthly miles (1,400 versus 1,300). As a result, the budgeted overhead rate is lower. You use this rate to apply indirect costs to every job during the year.
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.