Share of indirect costs, both departmental and enterprise-wide, in the total cost of the company is big and shows still increasing trends, which is why it is important to control and analyze them.
The need to properly include the issue of indirect cost in cost accounting every company is a result of both management demands for information regarding decision-making (assessment of product profitability or effectiveness of responsibility centers management) as well as information allowing motivating and controlling managers on different levels of management within the firm. Traditional procedures of calculating indirect costs have been for decades the only procedures enabling assigning an indirect cost to a product. Those methods were appropriate during times when the company was manufacturing a limited amount of products, and costs of materials and direct wages had in manufacturing expenses much more share than indirect costs. Indirect costs constituted a small part of the product’s cost, nobody paid much attention to their calculation, and distortions created as a result of calculation weren’t significant (for example, if in a certain company indirect cost would constitute 10% of the total cost and their allocation to specific products would be distorted about 10%, then an error would occur in a valuation of the product cost in the amount of 1% of this cost).
Nowadays, traditional methods of calculating indirect costs aren’t appropriate anymore for the majority of companies, and information generated via those systems are often considered to be biased and unsuitable to the needs of managing a modern firm – a changed one, operating in a different environment than dozens of years ago.
One of the factors affecting the informational needs of a modern company is the development of the competition, which leads to changes in the area of technology, automation of manufacturing process, an extension of the product range offered by the company, and reduction of their life span. Using new and fast-changing technologies caused significant changes in the cost structures of the majority of the companies. It found an expression in decline in the share of direct wages in manufacturing costs and transformation of their character – meaning, on the one hand, work of people has been replaced by the work of machines, but on the other hand, direct wages that used to be a variable element, gained the character of fixed costs or have been replaced by manufacturing indirect costs. There also has been a decrease in the share of the firm’s costs regarding indirect material costs in favor of increasing the departmental costs and costs of supporting processes, like costs of marketing and advertising, research and development, quality, storage and so on. Meanwhile, in the past, costs of indirect materials constituted about 50% of all company’s costs, costs of direct labor 35%, and indirect costs merely 15%, today those proportions have dramatiacally changed – material costs constitute about 45% of the company’s costs, direct wages just 10%, and indirect costs as much as 45% (and in extreme cases even up to 80-90%).
Application of this solution enables, among others:
- Improvement of information about costs for making pricing decisions
- Improvement of profitability analysis in cross-section of products, clients, distribution channels, sales regions, and so on
- Improvement of knowledge about reasons of creation of costs
An increase of the indirect costs in the product costs led to mistakes in calculating indirect costs that were acceptable before, now inadmissible. On the other hand, it is worth noting that for modern companies, the basis of calculating indirect costs based on the production size turns out to be inadequate, because more and more often there’s a loosening of a cause-effect relation between production size and indirect costs.
The traditional cost accounting system can cause significant distortions in calculating the cost of the products and services, incorrect estimation of their profitability, and as a result, making wrong decisions.
Activity-based costing has become an answer for infirmities of traditional cost accounting.
Has been working with the implementation of IT systems supporting management for 15 years. He specializes in Business and Workflow solutions. Enthusiast of using AI to support business processes. Archman’s CEO and chancellor of College of Economics And Computer Science in Cracow.