Principles of Management Cost Modeling and Estimating

Lecture Sessions 7-9

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Principles of Management Cost Modeling and Estimating

Costs, Cost Modelling and Estimating

Costing

Any project will fail if the costs exceed the revenue. It makes commercial sense for this to be
the case the difference between cost and revenue provides a basic profit indication. While
the imperative of the organisation is to make a profit, the project manager is often
constrained by issues of cost. Budgets are often required by engineers as part of the process
of project development. This process of budgets is taken a stage further when companies
are required to price their services, tender for work, etc. This series of notes examine the
nature of construction costs and their allocation.

Direct and Indirect Costs

The provision of service or a product will have a number of costs attributable to it. Cost is
normally divided into two areas, direct costs and indirect costs.

Direct costs relate to the factors that are a direct input to the product, such as material,
components and labour. If no production or service is performed no costs arise.

Certain costs are created whether a service or product is achieved. These are classified as
indirect costs. These costs may be associated with the value of buildings and equipment,
consumables, heating and lighting, salaries of support and supervisory staff. In considering
the cost of the service or product these items of expenditure have to be recovered. If a firm
fails to take these items into consideration then it would be under-pricing and not recovering
all its costs and would lose profit.

In each of these cost categories they may be fixed or variable in nature. A direct fixed cost
will not vary with production. For example, 60 standard bricks are needed to build one m2 of
wall. This is a fixed direct cost of the wall. On the other hand the fuel used power the mortar
mixer will vary depending on how long the machine is needed to mix the mortar. The fuel is a
direct cost but it varies with use.

The costs of paying taxes on a building, the company uses, are fixed on a year to year basis.
This is an indirect cost that is fixed. On the other hand, the heating and lighting bills for the
building will vary depending on use. This is an indirect cost that is variable.

In cost control and planning, the objective is to recover all costs direct or indirect, fixed or
variable. In concession/ operational cost planning there are other costs to consider. These
are costs in use. (operational costs) They relate to costs created during the operation of
infrastructure. They will also have the same characteristics of other costs. The difficulty in
predicting and calculating cost in use (life-cycle costs) is the uncertainty of the future. For
example what is the length of time before you need to replace a lightbulb or how long will it
be before you need to repair a road through normal use. Even in longer term arrangements
we still have to predict the costs.

A “price” will contain all the various costs of the project and service and an allowance for
profit. The profit element is normally dictated by the prevailing market conditions in the
industry. A simple definition of “gross profit” is the difference between the sale price and the
direct costs attributable to production. The “net profit” is the residual value when all costs,
both direct and indirect are recovered.

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Principles of Management Cost Modeling and Estimating

Measuring the costs of materials and components

Of all the costs, materials are the most clearly identifiable as a direct cost. If material is used
in a product its cost can be directly attributed to its final price. If this material is not used then
no cost arises. In the production of a service, such as design, there are direct consumable
materials.

Stock Valuation

In estimating the price of the product or service forecasts of the usage of the materials have
to be made. This allows for forward planning. Where material is drawn from an existing stock
the conventions for pricing are slightly different. What happens when a company has an
existing stock of ventilation grilles purchased over a long duration? Before the pricing of the
product can proceed there must be decisions taken as to how the product is to be priced.

The two most common methods used to value stock are first in first out (FIFO) and last in
first out (LIFO)

Example: Assume that the company has purchased the following ventilation grilles over the
following period as part of its normal stock:

February 300 @ £20

March 400 @ £21
April 350 @£20
May 300 @£22

At the start of June the company needs to install 800 grilles. What should the company
charge if it is unable to determine the difference between the various grilles

Using First in First out (FIFO)

300 @£20 = £6000

400 @£21 = £8400
100 @£20 = £2000
Total Cost = £16 400

Using Last in First out (LIFO)

300 @£22 = £6600

350 @£20 = £7000
150 @£21 = £3150
Total Cost = £16 750

This has two possible implications for the firm. Using FIFO means that the firm can charge a
lower price due to the lower cost. It also means the value of the remaining stock will be
different LIFO (£11250) and FIFO (£11600). The LIFO valuation may eventually lead to a
build-up of old stock valuation.

Other Methods

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Although LIFO and FIFO are the normally used method for calculation of prices other
methods have gained popularity. Average pricing is sometimes used. The main drawback of
this method is that, whenever new stock is purchased, the average price has to be
recalculated. This method also has a weakness when inflationary pressures may cause the
price to lag behind current costs but not as badly as under FIFO. Standards costs are pre-
calculated estimates of material costs. Thus the project is charged at standard costs. This
method requires careful control be kept between standard cost and actual costs and be
reconciled at the end of the project. Early stage estimating will use standard costs while the
construction phase will look to reconcile actual costs against estimated material costs.

The development of just in time1 (JIT) in construction obviates the need for complex material
calculations. A JIT system requires a good purchasing system and reliable pricing from
suppliers. The allocation of material to a project is often more a matter of policy than actual
procedure. The allocation of cost has to be carefully judged.

Estimating Materials

When estimating quantities of materials there is a need to understand how the material
functions and performs. In some cases it might relate to volume (concrete) or coverage (brick
walls) or just be composite items (sanitary fittings).

Example – one brick wall

One brick wall in common bricks in 1:3

cement mortar m2 100

Material Quantity/m2 Net cost Waste Quantity Cost

Bricks 120 Number £ 450/1000 10% 132 £59.48
Mortar 0.045/m3 £ 120/m3 10% .05m3 £6.00
Total £65.48

Notes: There are normally 60 bricks/skin in a square metre. A one brick wall is two skins
thick. There is an allowance for wastage. Mortar is normally estimated by volume. A 1:3 mix
is one part cement and three parts sand. On large scale work the cement will come in a
similar form as ready mix concrete. Our material cost unit rate is £65.48/m2. The cost of
materials for our wall is £65.48 x 100m2= £6548.00.

The costs of most materials can be attained from suppliers to provide who will help with
estimates before construction. If you are using a traditional or design/construct contract you
will look at contractor claim profiles as most rates will be a unit rate2. If you are using a cost-
plus contract then you will need to monitor the actual invoices produced to check if they line
up with your estimates. A contractor’s project manager will have to check up on invoices as
well.

Measuring the Costs of Equipment

Equipment used in operations can either be owned or hired. In developing the method
statement for an activity or planning site operations an indication of the equipment required
may be determined. Some of the equipment will be assigned to the site for a significant time.
For example a tower crane may be assigned to a project for a significant duration and
contribute to a number of activities. In this situation the crane may be charged to the project

1
a manufacturing system in which materials or components are delivered immediately before they are
required in order to minimize storage costs.
2
A unit rate is all in rate.

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Principles of Management Cost Modeling and Estimating

as fixed cost with a charge directly to the activity or deemed as an indirect cost to be
retrieved from the entire project. In some cases the crane may be hired and the pricing will
be a lump sum and might also include the operator. If the equipment is owned then the
operator costs and any maintenance, fuel and related costs have to be included. The
effective locating/positioning of equipment like a tower crane will improve overall efficiency by
supporting many activities.

Equipment example
Total m3 of concrete to be place 2000m3
Duration of operations 30 weeks
Equipment 1 mobile crane, 2 concrete skips, 4 dumper
trucks, 4 vibrators

Each of these items is priced for 30 weeks. Additionally the number of labourers and
operatives required in placing this concrete has to be calculated separately. In some cases
there is a contingency for the project running beyond the stipulated time. Many organisations
will now look at the difference between hiring equipment as opposed to owning the
equipment. The cost of buying equipment means that capital is tied into the equipment and
the opportunity cost3 of capital has to be considered and included in the price. If there is a
plentiful supply of equipment many companies choose to hire.

Measuring the Costs of Labour

There are two elements within most labour costs:

Time related (hours worked x hourly rate)

Output related (piece work, incentives)

Hourly rates will vary with the number of hours worked in a day and in a week. Overtime is
prescribed if work is carried out outside the defined maximum. Working outside the 38 hour
standard week, or at weekends may entitle individuals to overtime. In certain situations
payment may be made for special conditions, such as working in dangerous environments.
The pay structure can become complex if there are bonus or incentive schemes which may
complicate the payment structure. The direct wages described above are only one part of the
calculation.

In addition there can be provision for holiday pay, sick pay, national insurance, private
medical, pension schemes, redundancy provisions, training levies, travel benefits and
accommodation.

When a person is assigned a specific task, the direct cost arises. The calculation of this
direct cost is the combination of the direct wage plus the cost to the company for additional
benefits. The direct labour allocated is dependent on the number of hours worked on the
project. The next step is to identify how long a task will take; hence the productivity of the
worker has to be determined. It is important to remember that productivity measurements are
based on historical trend. What may have happened in the past may not necessarily happen
in the future. Care has to be taken in assessing productivity.

What has to be done is to allocate labour costs against production is to agree a notional
labour cost £ per hour and to monitor regularly how close current trends are to historical

3
 A benefit, profit, or value of something that must be given up to acquire or achieve something else. 

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trends. Labour rates and the associated productivity measurements have to be regularly
monitored and updated.

Labour Example – one brick wall

One brick wall in common bricks in 1:3

Cement mortar m2 100

Labour Cost/hour Output/usage Total cost

Bricklayer £25/hour 1.8h/m2 £45
Labourer (unloading,etc) £10/hour 5 min/m2 £2.50
£47.50

Notes: The productivity level of the bricklayer is based on fairly straight simple runs. A good
bricklayer can normally lay about 600 bricks a day. Productivity will be lower if the work is
more complex. A bricklayer is normally supported by a labourer who unloads the bricks,
checks that mortar is available and supports the bricklayer. It is much more difficult to work
out productivity levels of labourers. In wider productivity terms it is possible to create bigger
production teams. If you added another bricklayer to this team the labour cost will go up but
the work will be finished earlier. The planner has to decide what is more important the
cost/m2 or the saved time.

For our one brick wall the direct cost/m2 is £47.50 + £65.48 = £112.98/m2

Overheads

Overhead is the term used for indirect costs, such as offices, administrative staff, office
furniture, etc. They are the costs the firm has to undertake whether it performs a task or not.
The problem with overhead is less in the measurement and more in the allocation. If a
company undertakes a single activity then it must recover the overhead of the firm. This is
fairly simple

Price = Direct Costs (Labour, Material, Equipment) + Overheads + Profits

Overhead is the term used for indirect costs, such as offices, administrative staff, office
furniture, etc. They are the costs the firm has to undertake whether it performs a task or not.
The problem with overhead is less in the measurement and more in the allocation. If a
company undertakes a single activity then it must recover the overhead of the firm. This is
fairly simple. If a firm produces more than one product how is the cost then built into the price
of the product?

Take the case where the installation of a (A) radiator requires four workers and another
radiator (B) requires two workers. One method of cost recovery might be to recover the cost
in the ratio 2:1. If radiator B had a higher capital cost associated with it, then it may be
inappropriate to use the headcount as a way of overhead recovery. This method is used as it
is relatively simple.

The two more common methods of the recovery of overhead are direct costing(the
contribution approach) and absorption costing( the functional or full costing approach)
These methods differ in one principal area: the fixed part of the manufacturing overhead is
excluded from the cost of the product or service under direct costing but included in the costs
of the product under absorption costing.

Direct Costing (Marginal Costing)

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Direct costing is more accurately called variable or marginal costing, because it applies only
to the variable production costs to the product. In the direct costing system the variable costs
are charged to the product, while the fixed costs are charged against the aggregate
contribution.

In theory, marginal costing is very easy to adopt, although in practice it is more difficult.
These arise largely out of the assumptions built into the system. These assumptions are as
follows:

1. It is possible to analyse total costs into fixed costs and variable costs.
2. Fixed costs remain constant in the short term irrespective of the level of activity.
3. Fixed costs do not bear any relationship to the units produced
4. Variable costs vary in direct proportion to the activity.
5. Some costs are semi variable in that they have both a fixed and fluctuating element.

While these assumptions are somewhat simplistic, they are useful to arrive at decisions
where it is safe to ignore fixed costs.

Under direct costing the cost of the product and provision of service is directly related to the
following items

Direct Labour
Direct Material
Variable overhead

The cost of the good is then calculated on this basis. The elements directly associated with
the product are recovered. The selling price however has to have an element in the price
built in to recover any fixed overhead. This system does expose the level of burden that is
created by overheads not directly related to the product.

The breakdown of the Price under a direct costing approach is as follows

Price or Revenue aaa (S)

less Variable Costs (bbb) (V)
Contribution or Gross margin xx (C)
less Fixed costs (yy) ( F)
Profit/Income zz (P)

The marginal cost equation

S-V= F+P

Criticisms of marginal costing

1. Costs cannot be divided easily into fixed and variable categories.

2. Fixed costs can change as activity varies.
3. It is difficult to determine over what period of time costs remain fixed.
4. The same fixed and variable principles may not be the same from product to product.
5. Variable costs do not vary in direct proportion to activity at all levels.

Despite these criticisms, direct costing provides a useful decision making tool in pricing and
control.

Absorption Costing

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Under absorption costing all indirect costs are collected in the production cost centre and
charged to specific units. This system is widely used in inter-departmental transfer systems.

Absorption costing is widely used in management control systems.

Stage 1: Allocate costs to cost centre or departments. Costs can be directly attributed to a
particular cost centre if control is to be achieved. It is not easy to identify and allocate all
types of cost but this should be done where possible. Those costs that are not directly
attributable can be allocated later.

Stage 2: Share out service centre costs. The next stage is to share out among the cost
centres and production departments, the costs associated with service provision. This is
done by apportioning the total cost of each service cost centre. A few of the common
methods of apportioning costs are:

A. The number of employees. Allocation is on the basis of the number of employees

allocated to the particular cost centre.
B. Floor area. The amount of space a particular department occupies.
C. Activity. Based on the amount of service activity provided e.g. the number of drawings
produced.

A particular problem occurs where service departments charge each other. It is conceivable
that the process becomes circular. A clear policy decision has to be arrived at where
charging is considered.

Example

The following relates to TWR Design and Build Contractors for the year ending March 199x

Cost Centre £
Production 1: indirect expenses (to units) Structures 24000
Production 2: indirect expenses (to units) Fit Out 15000
Service Cost Centre A: allocated expenses Architectural 20000
Service Cost Centre B: allocated expenses Administration 8000
Service Cost Centre C: allocated expenses Estimating & Buying 3000

Additional information
The estimated benefit provided by the three service cost centres to other cost centres is as
follows

Service Centre A: Production 1 50%; Production 2 30%; Service Centre B 10%; Service
Centre C 10%

Service Centre B: Production 1 70%; Production 2 20%; Service Centre C 10%

Service Centre C: Production 1 50%; Production 2 50%

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Overhead Distribution Scheme TWR

Cost centre Pro 1 Pro 2 SerA SerB SerC

Allocated 24000 15000 20000 8000 3000

In direct
Costs

Apportion
Service cost
centres
A (5:3:1:1) 10000 6000 (20000) 2000 2000
B (7:2:0:1) 7000 2000 - (10000) 1000
C (5:5) 3000 3000 - - (6000)

Total
Absorbed
Overhead 44000 26000 - - -

Lessons

The overhead passing through production centre 1 is £ 44000. Overheads passing through
production centre 2 is £ 26000. Although both units may be tied to the same production
output their overhead allocation may change.

The amount of overhead shared amongst the cost centre is £ 70000. This value does not
change despite the reallocation.

This example indicates how interdepartmental reapportionment of cost occurs. It is important

to note that the reapportionment of cost occurs through given policy breakdowns. Policy may
be needed to ensure proper breakdown.

The objective of this system of apportioning service costs is to charge them to specific
projects that relate to production.

The next stage in the process of absorption costing is to absorb the overhead.

Absorption of Production Overhead

Once all the indirect costs have been collected in the production cost centre, the next step is
to charge them to the specific units. This procedure is known as absorption.

The method of absorption is normally fairly simple. It is normally recommended that the
mechanism for absorption be kept as close to the method for overhead collection. There is
no obvious factor to choose. All methods do however relate to the following equation:

Total cost centre overhead

Cost centre absorption rate 
Total cost centre activity

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A different absorption rate will be calculated for each unit of production, so as the unit passes
through various cost centres it will have been charged an overhead rate.

The main methods for absorption are as follows:

Specific Units:

Total cost centre overhead

Absorption rate 
Number of units produced at cost centre

The same rate of overhead recovery is used for each unit of output produced. This method is
only suitable if the units of production are all identical.

Direct material Costs

Total cost centre overhead

Absorption rate  x 100
Cost centre total direct material cost

The direct material cost of each unit is multiplied by the absorption rate. It is unlikely that
there will be a strong relationship between the direct material used and the level of overhead.
There are few cases where the material has a fairly high value thus making a link to
overheads more tangible.

Direct labour Costs

Total cost centre overhead

Absorption rate  x 100
Cost centre total direct labour cost

The direct labour cost of each unit is multiplied by the absorption rate. Overheads tend to
relate more closely to the time spent on production. This method is particularly suitable
because labour costs relate directly to the number of hours worked and specific rates. This
method is not suitable if the number of labour hour is particularly low at a high labour rate as
the costs will not then relate to time spent in production.

Direct Labour Hours

Total cost centre overhead

Absorption rate 
Cost centre direct labour hours

The direct labour hour of each unit of output is multiplied by the overhead rate. This method
is highly acceptable in cost centres where there is a high labour intensity, because time
spent in production is related to the cost of overhead incurred.

Machine Hours

Total cost centre overhead

Absorption rate 
Cost centre total machine hours

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The total machine hours of each unit is then multiplied by the absorption rate. This method is
only appropriate where there is equipment intensive production. In such cases there will be a
strong correlation between the amount of machine time that a unit takes to produce and
overhead.

These are key methods but what happens in the case of administrative and non-production
overhead. The following methods are used.

Administrative overhead

Total administrative overhead

Absorption rate  x 100
Total Production costs

Total research and development overhead

Absorption rate  x 100
Total Production costs

Total sales and marketing overhead

Absorption rate  x 100
Total Production costs

In each case the overhead is recovered through the units of production. This is difficult in the
construction context.

The most appropriate method of absorption rate will depend upon individual circumstances.
A careful study should be made between direct labour hours, direct machine hours, direct
material, other direct expenses and the total overhead expenditure. It is generally accepted
that a large proportion of overheads move with time, so the longer time production takes the
larger the overheads are likely to be. It should be stressed that the recovery of overheads
does not mean that costs are controlled. All this approach suggests is that costs are
recovered properly. Careful choices have to be made.

The price breakdown under absorption costing is as follows

Revenue aaa
less All manufacturing costs (bbb)
Gross Margin xx
less All non-manufacturing costs (yy)
Profit/Income zz

The format for absorption costing differs from direct costing in the separation of costs into
manufacturing and non-manufacturing. In contrast the direct costing approach separates
costs into fixed and variable costs. In absorption costing, revenue less manufacturing costs is
the gross profit or gross margin. In direct costing, revenue less variable costs represents the
gross margin. The primary differences between the two systems are in the way in which the
systems treat direct overhead.

Absorption costing aims to help management plan and control a company’s operations more
effectively and efficiently. It depends initially on being able to determine those costs that can
be economically identified as specific (direct) and those that cannot (indirect). This distinction
cannot always be easily made. There is also the issue of service costs between the
departments.

Absorption costing is a technique which must be used with caution.

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Standard Costs

Managers are required to make decisions on the current and future operations on the basis
of experience and knowledge of costs. For management to make the correct decisions it
must have up-to-date data on costs. Costing is not perfect and information is still needed on
costs. With this in view companies keep records of standard costs which are updated at
regular intervals. These standards costs are predetermined estimates of costs of carrying out
standard operations under standard conditions. Standard costs can be kept for specific tasks
which employ labour, equipment and materials. Standard costs do not include overhead, this
is normally added by management, depending upon the purpose of estimating the costs of
the work to be done.

Since standard costs are not actual costs, the differences need to be noted. These
differences are referred to as variances and reason for their existence need to be
determined. Variance may arise for the following reasons:

 work is not being carried out under standard conditions

 productivity differs from that assumed by standard costing
 standard costs have not been updated

The objectives of the variance analysis are twofold; to ensure that standard costs held on
record are suitable for current and future use and to monitor the performance of the work in
hand.

Standard costs are only suitable for elements of work conducted in a quantitative manner.

Construction and Services Pricing

The principles we have discussed earlier are applicable to the construction industry. There
are a number of characteristics that make construction slightly different.

Overheads- the traditional approaches to overhead recovery are made difficult by the nature
of the product. In general manufacturing the product produced is identical and the costs can
be easily established. It is possible to use a standard overhead recovery. This is not the case
with construction related work. Each project is different and this creates difficulty in
establishing the correct overhead to establish a reasonable profit.

This difficulty is compounded by the fact that the nature of pricing in the building engineering
sector is tackled slightly differently. Unit pricing for individual work packages are the starting
point and then added together in a notional schedule of quantities. This accumulated figure
then provides the basis of the actual final price of the work. The dilemma is where you
recover overheads at each item of work or at a project level.

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A major misconception is often created when adding a profit figure to the cost of work. The
final figure fails to adequately reflect the pricing of all the items. The following should always
be present in any price

Direct Labour
Direct Plant
Direct Material

Site Overhead/Project Infrastructure

Company Overhead
Company Profit

Any price that is put forward for a global project or a final price must include all these items. If
this is not done then the firm is likely to cause losses. Poor pricing practice is a major reason
why UK contractors often find themselves making poor profits. In particular where there is a
failure of understanding of the real level of profit when the overheads have been removed.

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