Charging Customers for Direct and Indirect Costs
To bill a customer and calculate a profit, you add up all the costs for that customer, whether they’re direct or indirect costs. If, for example, you manufacture kitchen countertops, you include all direct and indirect costs of a custom countertop installation in order to bill the customer.
A direct cost may be marble (for material). To find the total cost of material for the job, you compute direct material cost as Marble x Square footage used x Cost per square foot.
Indirect costs are different. If your kitchen countertop business makes lease payments on an office building, the cost is indirect. You can’t know the exact amount of indirect costs for the client. You also can’t trace the cost directly to a specific customer, but you can allocate it by using a cost allocation base.
For job costs to be accurate, you need to collect information before you bill the client. You also need to consider the difference between your cost estimate and the final bill. Your client needs to understand how costs higher than the estimate will be handled.
Should the customer expect to pay it, or will you absorb the cost (and lower your profit)? If this isn’t handled correctly, the customer may be upset. Unforeseen things happen, of course, and you should explain when you hand the customer the estimate that the final bill may be different. A customer is likely to accept additional labor costs. That’s because the exact cost of labor is probably hard for you to predict.
Allocating indirect costs
Think about allocating indirect costs this way: You need to allocate a dollar amount of cost (say, $100). You spread that cost over a group of customers, a level of production, or some other activity level.
A carpenter owns trucks that require repair and maintenance expense. That cost can’t be traced to specific customers; instead, these indirect costs are allocated to a cost object. You find a “best” method to assign repair and maintenance expense to clients, perhaps labor hours worked for the customer.
The logic is that if you work more hours for a specific customer, you probably use your truck more. If you use the truck more, that customer should absorb more of your truck’s repair and maintenance cost.
Tracing the repair and maintenance cost of the truck back to a specific customer is virtually impossible. So you make your best educated guess to distribute the cost.
Defining cost allocation
Cost allocation is the process of connecting an indirect cost to a cost object. A cost pool is a grouping of similar costs. You can think of a cost pool as a bunch of similar cost objects thrown together. In this case, the cost object is a specific job.
A cost driver is an item that changes the total costs. If you drive the trucks more, they require more repair and maintenance. An activity (driving to see customers) drives up your costs (repair and maintenance).
Just to clarify: The cost object is the “sponge” that absorbs the cost. The cost driver adds to the size of the sponge. A bigger sponge absorbs more cost.
Assume the total repair and maintenance expense for three carpentry trucks is $3,000. During the month, your workers provide service to 300 clients. Each customer is allocated $10 of repair and maintenance expense ($3,000 / 300 clients).
If the cost driver increases to 400 clients per month, the carpenters drive more miles. As a result, the trucks require more maintenance and possibly repairs. Your monthly repair and maintenance expense is higher.
At 400 customers for the month, assume total repair and maintenance expense for three carpentry trucks is $3,600. Now each customer is allocated repair expense of $9 ($3,600 / 400 clients). The cost driver increase (number of customers) changes your total cost to $3,600. Because you also have an increase in total customers (400), the $3,600 is spread over a larger group. The total cost increases, but the cost allocated per customer declines.
You can see how the cost allocation process can get complicated.
Grouping similar costs into the same cost pool is often beneficial when the cost driver is the same. Consider a cost pool for the indirect costs for the carpentry trucks. In addition to repair and maintenance expense, the company pays for insurance and depreciation on the three trucks. None of these costs can be traced to a specific customer; instead, you need to allocate these costs.
A good cost pool includes depreciation, insurance, and repair costs on the trucks. This cost pool can be allocated in the same way as the repair and maintenance costs in the previous example.