The notion of a standard cost is a familiar one in manufacturing and distribution companies. In manufacturing companies, for example, standard costs are used to build up the full cost of a manufactured item, combining the costs of fixed quantities of purchased or consumed material, fixed quantities of labor and overheads. The standard costs of materials at one level contribute to the material costs at the next level and so on.
During the manufacturing process, variances against standards are monitored, since these affect overall profitability when all costs are set against sales prices. Variances can be of a number of different kinds: purchase price variances when supplier costs rise or fall, labor cost variances when labor is more or less expensive than planned, quantity variances when the materials or labor consumed are in different quantities from those suggested by the standard bill of materials, and overhead variances when the cost of running machinery, or providing energy to the process differs.
Standard costs are essential in the planning process, since decisions about the profitability of products depend on the costs of making them, and initially these are theoretical.
Standard costs are also useful in PSOs, in monitoring profitability and the variances that threaten it, in estimating the profitability of specific projects and in the overall budgeting process for the organization.
How can we determine the standard cost of a professional employee? In other words, how much does an hour of professional work cost?
There are two deeper underlying questions that hide behind these two initial ones:
- What are employee costs?
- How do we allocate employee costs to time?
Let’s start with the first one, which is by far the more simple question. Basically, an employee’s costs are those variable costs that come with employment of any member of staff:
- Salary (including bonuses)
- Taxes on Salary
- Social Insurance/Security Payments
- Medical Insurance
- Pension Contributions
- Mobile Phone
- PC, software and other equipment depreciation, where the equipment is unequivocally the equipment of the individual
- Car and Fuel
- Any other direct expenses
These costs may be aggregated to determine a total annual direct cost for each employee. Let’s suppose these costs come to 176,000.
The second, more complex, question is how many days should these costs be spread over to determine a daily (and thus hourly) cost? Do we want to determine a cost:
- Per working hour, regardless of how it is spent (perhaps on holiday, perhaps on administration, perhaps on client work)?
- Per available hour, regardless of how it is spent (perhaps on administration, perhaps on client work)?
- Per project hour (of client or internal work that adds value)?
In fact, we need to have an understanding of all three.
But let’s take the last of these three first, since we will definitely want a cost that can be set against revenue, so that we can ask questions such as ‘Are we making a good gross margin on this project?’. The ‘final purpose’ of employing professional staff is to earn service revenue from their work, so we need to be able to set these costs against the days on which he or she might work. The ‘real’ cost of productive project work must include the costs of time lost on unproductive activities.
In order to calculate the cost of a ‘professional hour’ we need to start with some basic questions. How many working days are there in the year?
Days per year: 365
Weekend Days: -104
Public Holidays: -8
Working Days: 253
And then, for how many of these days is each employee available for chargeable work?
Working Days: 253
Holiday Allowance: -25 (we are in Europe!)
Company Conference: -3
Available Days: 220
And lastly, on how many of these available days do we expect him or her to work on chargeable or value-adding work? In other words, what utilization do we expect?
(Note that in cases where an employee is only partially available for chargeable work (as, for example, the Managing Director, who expects to spend 10% of his or her time on chargeable work) then a portion (say, 10%) of cost may be allocated across a portion (say, 10%) of available days. In some of these cases you might, by the way, assume 100% utilization, since the expectation is that exactly that portion of time will be spent on chargeable projects.)
Available Days: 220
Un-utilized Days: -44
Utilized Days: 176
We can therefore calculate standard project cost per day as:
(Total cost / Utilized days):
176,000 / 176 = 1,000
Assuming an 8-hour day standard project cost per hour is 125.
This means that if we can invoice 1,000 for each day this employee works, and if he or she works four out of every five available days, on average, then we will cover his or her costs. To make a profit, and a contribution to company overheads, we must obviously charge more than 1,000.
Standard project cost can therefore be defined in this way:
Standard project cost is the cost of professional work, whether client-directed or internal, determined by taking an employee’s direct costs and dividing them by available time and then adjusting for expected utilization. It is usually expressed as a daily or hourly cost.
Margins are not always generous in professional services (despite what our clients sometimes think), mainly because they can be easily undermined by adverse circumstances, including poor utilization, fee discounts, poor realization, and many others. They are also undermined if an employee’s costs are greater than anticipated (and are improved if they are lower). If this happens, then all the projects on which an employee works are less profitable than expected, and less profitable than suggested by gross margin calculations based on project standard cost. Project standard cost, after all, is only an estimate.
In fact, there are several factors that may result in project standard cost being an overestimate or underestimate. These are:
- The possibility that more or fewer days are available than assumed in the calculation. If an employee spends less time on training courses than planned and if conferences are cancelled, then there are more days across which costs might be spread, and if utilization holds steady, then we can expect our standard project cost to be an overestimate.In these circumstances, we can expect a variance to emerge due to the change in availability.
- The possibility that utilization is greater or lower than planned
In these circumstances, we can expect a variance to emerge due to the change in utilization.
- The possibility that employee actual costs are different from planned costs. In these circumstances, we can expect a variance to emerge due to the change in actual costs.
In all these cases, a variance can emerge between planned and actual costs, and it can be important to understand the factors that create these variances. If we put all three instances together then we see an overall variance in project cost but we do not necessarily understand the causes.
In order to track variances and their cause it may be useful to have three definitions of standard costs:
- Standard Project Cost Standard project cost is the cost of professional work, whether client-directed or internal, determined by taking an employee’s direct costs and dividing them by available time and then adjusting for expected utilization. It is usually expressed as a daily or hourly cost.
- Standard Availability Cost Standard availability cost is the cost of available time, however spent, determined by taking an employee’s direct costs and dividing them by available time. It is usually expressed as a daily or hourly cost.
- Standard Working Cost Standard working cost is the cost of standard working time, however spent, determined by taking an employee’s direct costs and dividing them by standard time. It is usually expressed as a daily or hourly cost.
In determining variances, over a year, we would calculate as follows:
Utilization Variance = (Utilized Days * Standard Project Cost) – (Available Days * Standard Availability Cost)
Availability Variance = (Available Days * Standard Availability Cost) – (Working Days * Standard Working Cost)
Cost Variance = Actual Costs – (Working Days * Standard Working Cost)
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