The following article was prepared by Mike Taylor, C.P.M., for distribution to ISM affiliate newsletters.


All costs are not created equal

February 2007

When I purchase a valve or hire a contractor to clean the HVAC systems in our office, the direct costs are generally very obvious. There is a the cost of the castings which become valve parts, the machining processes which make the threads, hardware, paint, testing, packaging, etc. When cleaning the HVAC system I can see the people working, hear the big truck run, observe the filters being installed, etc. These direct costs elements either become part of the end product or are incurred by the seller directly as a result of my order. Obviously I expect to pay for the castings, machining, filters and labor hours needed to clean my HVAC ducts.

Direct costs are generally easy to identify and relatively easy to calculate – even in the case of costs which I should only pay a small share of. The paint on my valve is only a fraction of the 5-gallon can of paint and the screw is only one piece from a much larger box of screws. Regardless, I can see the paint and know that I will have to pay for it. Likewise, the wages of a craftsman or laborer who builds my product are easy to track. Direct costs are those expenses that a seller can directly allocate to my contract and/or would not have incurred if he wasn’t working on my contract.

Direct Costs are obvious targets for cost reduction. Change the design to leave the screw out and save the cost of the screw. Use a new, faster machining process and reduce the labor cost. When trying to reduce direct costs, the sky is the limit. The more creative we can be in avoiding the direct costs, the bigger the possible reduction.

But, don’t forget that sellers also incur indirect expenses in order to provide products and services. The laborer, who gets paid $9.00 per hour, also receives fringe benefits in the form of insurance, vacation and sick leave. Obviously I owe the supplier $9.00 for each hour the laborer works on my job, but it certainly isn’t fair for me to pay the whole value of the laborer’s fringe benefit package. The seller may also be incurring expenses for a foreman, union dues, uniforms, training and certification in order to have the laborer available to work on my contract. In the case of the screw, there is the expense of storing and inventorying the box of screws and even the salary of the Buyer who purchased the box. These indirect expenses are not just part of my contract; they become indirect costs in every valve  produced or HVAC duct cleaned.

Indirect costs are those costs which are part of multiple contracts. If the seller only charged us for the direct costs (the casting or screw to put in the valve) then the seller would soon go broke. So how can sellers accurately allocate  the portion of a Buyer’s time which should be charged to me as opposed to other customers? One answer is by using indirect cost pools. An indirect cost pool is a grouping of similar expenses that gets allocated equally across all of the work performed during the accounting period.

So in our example; if the seller’s purchasing department cost him $90,000/year to operate,  then the seller can recover the cost of the purchasing department by splitting the $90,000 equally between the direct material costs of all of the valves he makes for the year. That is, if the total direct material cost (screws, castings, paint and hardware ) sold in a year works out to $ 4.5 Mil then the seller can recover the cost of his purchasing department by adding 2% to the cost of materials on each order. (2% of $4.5 Mil = $90,000) So if the materials in my valve cost $20 the seller would charge me $2.40 [$20+ (2% of $ 20)]. Thus a share of the material overhead expense gets allocated as an indirect cost to each order for the year.

There are also other types of overhead expenses which can be associated with a specific cost in the production process. The laborer’s fringe benefit package generally is allocated as a labor overhead rate. So while the laborers machining and assembling the valve may only be paid $9.00/hour, I would be charged $9.00 plus a percentage of their fringe benefit expense. So the bill would read 5 hours @ $9.00 = $45.00 plus .35% (fringe allocation) that is  $45.00 +15.75 =$60.75

In addition to purchasing departments, sellers also have many other General and Administrative (G&A) expenses required to support the overall operation of the business which are pooled together and charged to each customer. The G&A expense pool usually includes elements such as utilities, the accounting & marketing department and the CEO’s salary.

General expense pools are usually charged as a percentage of the total of all the other direct and indirect overhead costs. Even though this is an incomplete picture, let’s assume that the total of all direct and overhead costs in a year is $10 Mil and the total of the G&A pool is $1 Mil. So our G&A adder rate then needs to be 10% in order to make sure we have fully recovered the G&A pool by the end of the year.

To reiterate;  even if the seller charges me exactly what it costs him to make the valve – he will go broke unless he also recovers all of his other indirect costs as part of the selling price. The corollary is also true - when I purchase a valve - I pay for much more than just the cost of the materials and labor to make the valve.

Using our example above, the selling price of the valve would be calculated this way:

Cost Element Value Extension Running Total
Material $200 $200 $200
Material Overhead  2% * $200 $4 $204
Labor 5 hrs @ $9.00 $45 $249
Labor Overhead 35% * $45 $15.75 $309.75
Subtotal   $309.75 $309.75
G & A $10% * $309.75 $30.98 $340.73
Subtotal   $340.73 $340.73
Profit 15% * $340.75 $51.11 $391.83
Total Selling Price     $391.84
       

O.K. so you can see how this all starts to add up. Instead of $245 for materials and labor we end up paying $309.75 (give or take a few tenths of a cent.)

There is much more to talk about with respect to costs – and we’ll leave that for another article, but there are a few points I want to make now.

1- Notice how indirect costs get lumped together on top of the direct costs. What this means to a negotiator is that a dollar saved in direct cost can save much more at the bottom line. In our example above a dollar of direct material is worth $1.29 at the bottom line ($1.00 + 2% +10%+15%) [materials + material overhead + G&A + profit].  Saving one hour of direct labor ends up saving $15.36 on the bottom line ($9+35%+10%+15%).

2- Companies use different accounting methods for gathering and liquidating indirect cost pools. Not all companies use the same indirect cost pools.  Key points are consistency, grouping similar types of expenses and ensuring that expenses which should be shared across multiple customers are not charged to just one. Companies can have different accounting practices – within certain limits.

3- There could be other indirect costs pools added on top of direct costs. Example: Acquisition and inventorying costs are sometimes added as a separate pool. Might make sense for a company that has a large procurement organization for their regular business, but wants to be more cost effective when quoting on consulting services.

4- Companies set up an accounting system based on how they want to best recover their expenses and ensure they make a profit. By understanding how the supplier’s accounting system is allocating costs, buyers have the opportunity to make more significant impacts in their negotiation strategy. 

5 – The examples above are not intended to recreate accounting 101 – just to demonstrate the basic principles involved.

6- If want to learn more precisely about accounting – sorry, it won’t be from me. This is where the lawyers would insert extensive small-print disclaimers.


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