4E1 Project Management

1. 4E1 Project Management Costing – 2 Marginal Costing, ABC and Depreciation

2. Key Concepts • Marginal/decision costing • Sunk costs and other excluded costs • Activity-based costing • Calculating labour and machine costs • Depreciation and amortisation

3. Marginal (Decision) Costing • Also known as variable, direct and decision costing • Basic principle: cost = direct costs only • Direct costs: • Salaries/wages • Raw materials • Plant hire • Other costs are generally omitted: • Overheads • Money spent before the project starts (“sunk costs”) • Indirect costs

4. Marginal Costing Example Marginal costing is usually (though not always) straightforward. Unlike the previous example, we simply ignore overheads.

5. Advantages Simple Data relatively easy to collect or estimate Easy to compute Avoids allocation problem Forward-looking Tends to be less controversial with users Avoids distortions due to incorrect absorption Disadvantages Ignores many realities, e.g. Sunk costs Indirect and knock-on costs Understates the true cost Can lead to bad decisions e.g. “throwing good money after bad” Marginal Costing: Pros & Cons

6. Opportunity Costs Displacement Costs Startup/ Preacquisition Costs Post completion Costs Disruption Costs Secondary Costs Marginal Cost: Weaknesses Marginal Cost Finish Start

7. Activity-Based Costing • Basic principle: cost = direct cost + indirect driven cost • Overhead is allocated according to: • labour hours/costs • machine hours/costs • materials cost • direct costs • ABC is offered as more accurate/meaningful • A better basis for decisions

8. ABC Versus Absorption • Illustration using an industrial example • A company produces two products X and Y • Using traditional cost accounting:

9. ABC Versus Absorption • ABC considers what drives the overheads • Assume these are made up as follows: • The following data are gathered:

10. ABC Versus Absorption

11. Costing Detail: People • Important to cost labour accurately • e.g. how much does an engineer cost per hour? • Total cost includes: • Salary • Social welfare cost • Pension cost • Office costs (if relevant) • Other non-people support costs • Training, etc. • We also need to know time worked, based on: • Standard hours per year • Non-working time: holidays, training time, illness, etc.

12. Costing People - Example • Joe is paid €36,400 p.a. and works a 35-hour week (1,820 hours/year) • Gives an hourly cost of €20 • But: • Joe’s pension, social welfare and perks add another €4,000 • Joe works only 1,155 hours a year • 4 weeks annual leave plus 10 days of public holiday • one week’s sick leave • one week’s training • and Joe effectively works about 6 hours in every 8 • 1155 hours @ €40,400 ≈ €35 per working hour

13. Not worked Normal time available Planned running time Changeovers Actual running time Machine down time Costing Detail: Machine Hire Maximum time available Planned time available Available time Obviously, this does not matter if it is a fixed cost.

14. Depreciation/Amortisation • Rationale • Assets cost money • Physical assets will be used up through wear and tear, depletion, loss of value, etc. • This usage is known as: • “depreciation” (for equipment) • “amortisation” (for wasting assets e.g. mines, quarries) • Basic methods: • Straight line • Declining balance • Sum of digits • Double declining balance

15. Plant and Machinery Costing Total cost Depreciation Maintenance

16. Straight Line Depreciation • Based on no. years over which asset will be written off • Machine press bought for €200,000, written off over 4 years • Therefore, depreciation charge is 25% per year • Pros: simple to compute; writes off assets cleanly (no residual balance problem) • Cons: not always realistic

17. Declining Balance Depreciation • Write off same % of residual balance each year • press may be written off over infinite no. of years • may therefore need a termination year • e.g. write down press over 4 years at 25% p.a. • Pros: relatively easy to compute; realistic for many assets • Cons: Problem of residual balances Year Charge Balance 1 €50,000 €150,000 2 €37,500 €112,500 3 €28,100 € 84,400 4 €21,100 € 63,300

18. Sum of Digits Depreciation • Combines exponential and a clean write-down • Example: assume 4-year write-down • Add the digits in the no. of years: 1 + 2 + 3 + 4 = 10 • Take the write-down in order: 4/10, 3/10, 2/10, 1/10 • Pros: Approximates declining balance; no residual balance problem • Cons: More complicated to compute

19. Double Declining Balance Depreciation • Start with a straight line (say four years) • Compute % depreciated (10%) and double it (20%) • Depreciate with declining balance method at this rate until charge is less that it would be using straight line • Use straight line value from there on

20. Shared Costs • Costs shared with other activities • e.g. Machines used part of the time • Part-time staff • Shared overheads • e.g. Management • Insurance • Not always clear how to account for shared costs

21. Case Study 1: New Building How is the cost overrun to be accounted for? • Completion due early 2003 • Funding problems during design • Number of floors reduced to six • Atrium design change - chimneys on adjacent building need to be raised • Makes change of occupancy necessary; new occupants need existing wall to be knocked down to put in equipment • Delays: building handed over late 2004 • Later, power system fails and must be repaired at considerable expense

22. Case Study 2: System Development What complications arise in computing project cost? • Large public sector computer system development • Personnel • Some staff full-time, some part-time. Consultants hired for part of the project period. Some changes of internal personnel • Equipment • Used existing servers, PCs and peripherals. Existing network had to be upgraded for project team. Existing servers also used for ongoing production systems. Bought some additional servers and PCs • Timescale: 30 months (no overrun)

23. Summary • Several costing approaches • Arguments for and against each approach • There are times when each is appropriate • Different methods can give quite different results • Understand the limitations of each • There are issues that arise in costing labour, machinery and other fixed assets • Asset costs must be spread appropriately • Depreciation/amortisation is often a material cost • Project have their own costing problems