Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

16.1.1 Actual Costs, Direct Costs, and Overhead Costs

Intended learning outcomes: Describe actual costs. Differentiate between direct costs and overhead costs.

The actual costs of an item are the costs that were incurred when that item was last produced or procured. They refer to the item’s unit of measure.

The revenue generated by a customer order can be compared against its costs. This allows determination of the profitability of the order. This is particularly useful if the sales price fluctuates greatly or the cost of pro­cured materials used in production varies — such as when the purchasing department takes advantage of large quantity discounts or special offers.

In contrast to costs, the revenue generated by a sale is often easy to identify. Cost accounting subdivides expenditures into a number of alternative pairs, such as direct and overhead costs.

Direct costs are the costs that can be identified specifically with or traced to a given cost object (a product, service, or order, for example).

Direct costs are, for example, costs for direct labor, such as wages or external operations, or for direct material, such as purchased components needed to produce the order.

Overhead costs cannot be identified specifi­cally with or traced to a given cost object. Such costs must be allocated across the various cost objects (e.g. products, services, or orders).

Typical examples include the costs of plant and operating equipment (machinery, devices, tools), depreciation, rent, lighting and heating, and management and administration costs.

In practice, actual costs may change frequently over the course of a year. Irregularities in procurement (breakdowns, scrap, discounts, special promotions) cause the actual costs to fluctuate considerably. There are also fundamental problems associated with calculating the cost of a sales order on the basis of the actual costs:

Firstly, many of the costs incurred within an organization are of an in­di­rect nature, even overhead costs. To allocate overhead costs to the individual products or orders, we need some sort of “fair” distribution formula as a basis for apportionment. This is often a percentage of sales, measured against direct costs. An alternative is to base allocation on cost rates per labor or machine hours, based on forecasts.

Secondly, when items are issued for sale or for assembly in a higher-level end product, it is important to specify the associated production or procurement order to allow further calculation of the actual costs of the orders. To be able to do this, inventory management must keep accoun­ting records according to production or procurement batch or charge. Issues are then always allocated to a particular batch. Lot control will provide the necessary documen­tation (indeed, this procedure is mandatory in the process industry).

Thirdly, job-order costing must be carried out as soon as possible after the order is completed. Invoices, the source of information on actual costs for external operations and for components purchased directly for the order, must be received within a reasonable peri­od. Analysis of variances from budgeted costs becomes more difficult as more time elapses between the cost event and cost control. Various data regarding the event, particularly infor­mal data, are often not registered and are thus no longer available at the time of the analysis.

Course section 16.1: Subsections and their intended learning outcomes