When the term "Directors" is used below, it means those owners or partners who are rewarded by a distribution of profit and not a salary or wage.

1. Establishing a Cost Rate.
   Information required
   1. An estimate of productive hours
   2. An analysis of estimated expenditure

2. Estimate of productive hours
   1. Estimate the hours which will be spent by labour over a period (usually a year) spent making product.

   2. Include in this figure the estimated hours the Directors will spend on productive work.

   3. Estimate the number of hours that each of the different machine types will actually work, over the same period

   4. Exclude time elements such as, machine cleaning; tea breaks; etc.

3. Analysis of Estimated Expenditure
   Analyse expenditure into:-

    

   1. Direct labour - that is the cost of employees, plus a reasonable charge for the hours the Directors will spend on productive work.

   2. Variable overheads - that is, expenses which will vary according to the amount of work activity of the factory.
      Examples are: Consumables stores(such as oils, greases, rags), power etc.
      Analyse separately items specifically related to different machine types from expenditure of a general nature

   3. Fixed Overheads - that is expenses which do not vary irrespective of the amount of work activity. Examples are: Rent, Rates, Depreciation, Accountants fees, General Administration Expenses etc. In this category, include a reasonable charge, for the time the Directors spend on supervision, planning and administration.
      Again analyse separately items specifically related to different machine types, for example depreciation.

   4. Allocate overheads of a general nature, both variable and fixed, to cost centres/machines on an equitable basis. For example, Power on the basis of Kilowatt Hours; Rent on the basis of Floor Area.

4. Calculation of Cost Rates.

    

   1. From the above analysis, cost rates are calculated as follows:-
      (Hypothetical figures are included to illustrate more clearly the calculations)

      		Hand Work	Machine Group _One_	Machine Group _Two_	Machine Group Three
      1.	Production Hours	5,700	1,200	1,100	950
      		$	$	$	$
      2.	Direct Labour	94,000	N/A	N/A	N/A
      3.	Variable Overhead	_10,000	4,000	2,000	3,000
      4.	Total Variable Cost	104,000	4,000	2,000	3,000
      5.	Fixed Overhead	_35,000	2,500	1,500	1,300
      6.	Total Labors	139,000	6,500	3,500	4,300
      	Cost Rates per Hour
      7.	Variable Cost Rate   (line 4 ÷ line 1)	18.246	3.333	1.818	3.158
      8.	Fixed Overhead Cost Rate   (line 5 ÷ line 1)	6.140	2.084	1.364	1.368
      9.	Total Cost Rate	24.386	5.417	3.182	4.526

   2. The estimated total conversion Labors, (that is total Labors excluding direct materials), of this hypothetical company are $153,300 (139,000+6.500+3,500+4,300).

   3. The conversion cost of a job, taking (say) 5 hours hand work and 2 attended hours on Machine Group One would be:-

      		Cost	Conversion Cost
      	Hrs	Rates   $	Variable    $	Fixed   $
      Hand Work	5	18.246	91.23
      		6.140		30.73
      Machine Group One
      Labour	2	18.246	36.49
      		6.140		12.28
      Machine	2	3.333	6.66
      		2.084	_____	_4.17
      		Total	134.38	47.15
      Total Conversion Cost			181.53

      
       

5. Addition for Profit Required.
   
   1. As the labour input of the Directors to the Company has been included in the Labors, the addition for profit is confined to the return required on the Directors' investment in the Company.

   2. On the principle that the Company is selling its skills, the addition of profit should be related mainly to conversion Labors.

   3. A return of twice the borrowing Labors is recommended. Assuming that the current borrowing cost is 14% and the investment in the Company is around $40,000 for fixed assets and working capital (excluding stocks of raw materials), the formula would result in target profit of $11,200 (40,000 x 14% x 2).

   4. Applied to the total conversion Labors in the example above, this would be an addition of 7.3% (11,200 as a percentage of 153,300).

   5. In addition the Company will have an investment in stocks of materials. An addition to cover this should be made, by adding a percentage to direct material Labors. Based on the hypothetical figures below, this should be calculated as follows:-

      Investment in stocks			 $4,000
      Stock turnover				  15 times per annum
      Direct material consumed		$60,000 (4,000 x 15)
      

      Using the same parameter of requiring twice the borrowing cost, the return required is $1120per annum. ($4,000 x 14% x 2)

      The percentage addition to direct material Labors is therefore 1.9% (1120 as a percentage of 60,000)

   6. If it is assumed that the direct material cost of the job example above is $71. The total estimated cost of the job and the required price is calculated as follows:-

      		$
      Direct Material Cost		71.00
      Variable Conversion Cost		134.38
      Total Variable Cost		205.38
      Fixed Conversion Cost		_47.15
      Total Cost		252.53
      Add:	Target Profit Materials   (71.00 x 1.9%)	1.35
      	Conversion Cost   (181.53 x 7.3%)	_13.25
      Required Selling Price		267.13

E-mail us your queries and comments.

Reproduced with Permission
Copyright Len Bainbridge (Unregistered)