Indirect costs and their implications for budgeting
Our recent white paper — Cutting unnecessary costs with strong financial controls — explores how businesses can save money by making a few simple adjustments to their day to day financial processes.
In particular it focuses on unnecessary costs that arise from a lack of spend visibility, poor data, and a lack of interdepartmental communication. Most businesses aren’t aware of these issues, but they’re actually surprisingly common.
One of the biggest sources of unnecessary spending, which we also touch on in the white paper, is indirect costs. They are especially tricky to pin down and can pose a serious headache for finance teams when it comes to proper attribution and budget management.
However, with proper spend management and attribution capabilities, and a clear process for classifying different indirect costs, it’s possible to reduce this headache significantly. In this article we’ll explain how and why in more detail.
Indirect costs and their effect on reporting
Because indirect costs cannot be directly attributed to a specific product or cost object, they raise a few challenges for budgeting and cost allocation.
Methodologies to account for indirect costs in financial reporting vary. However, it’s effectively impossible to allocate indirect costs to specific projects or products with 100 percent accuracy.
This is a normal and accepted part of financial reporting. But it can have a negative impact on teams’ ability to accurately forecast production costs. This is especially true if indirect costs are reported or allocated to certain projects over a longer period of time.
Additionally, the list of indirect costs that businesses face and the relationship between indirect costs and end products has become more and more complex. Businesses have undergone widespread digitalisation, supply chains have become longer, and regulatory demands have become more stringent.
Digitalisation involves the addition of many different software platforms and tools to a company’s tech stack. Software adds a lot of complexity to indirect cost structures because it is hard to directly attribute its cost to specific projects, especially if it used cross functionally. It also comes with a number of other additional overheads, like data storage, training, infrastructure costs, consultancy fees etc.
This does not go to say that conventional indirect costing methods are inadequate for financial reporting. However, businesses do need to be better equipped to properly account for indirect or overhead costs when budgeting.
Classifying and attributing indirect costs with greater accuracy
Businesses can improve the way they estimate and allocate indirect costs with different costs allocation methodologies. Conventional costing assigns overhead costs using volume based metrics or cost drivers, including labour hours or units produced. This costing method is simple but it can be inaccurate, especially when dealing with more complex cost structures.
Activity based costing, on the other hand, applies indirect costs to ‘activities’, and then charges production for the various activities it uses. When activity based costing arrived on the scene in the late 1980s, it was seen as a viable solution to the issue of accurately attributing indirect costs to the overall cost of production.
While it did enjoy a wave of adoption, its growth has dwindled due to some limitations, namely being expensive, time consuming, and not suitable for external reporting. However, it is still a popular costing method among companies with complex production or service structures.
Ultimately, the underlying cause for many ABC’s limitations was a lack of suitable data and sufficient data modelling tools when it was first introduced. In the early 1990s, ERP (Enterprise Resource Planning) systems were in their infancy and primarily designed to facilitate absorption costing. What’s more, widespread automated data collection and pooling wasn’t really possible back then.
The importance of data
Nowadays things are very different. Companies can equip themselves with tools that can provide real time granular data about practically every aspect of their business. This data is fed to the ERP, which has evolved to become an indispensable tool that sits at the heart of businesses of all shapes and sizes.
ERPs track all sorts of key operational metrics for project management, compliance, procurement, and much more. But they need to be fed high quality data to provide accurate resource and planning insights.
When it comes to spend data, businesses need to be able to track, collect and review all of the relevant metrics and parameters that they need for budgeting and forecasting. This includes real time and historical data, as well as the ability to classify and segment this data in fine detail by department, project, cost type, etc.
This is where spend management solutions come in. They give businesses the ability to dictate exactly how their money is spent on expenses and other business costs, and provide granular data about all of this spend.
Businesses that use conventional spend systems, like ACH (Automated Clearing House) payment or standard business credit cards, do not get granular data. These payment types do not provide a breakdown of individual purchase items, and can take significantly longer to process than modern smart corporate credit card payments.
This negatively affects finance teams' ability to build indirect costs or overheads into production cost forecasts with full accuracy.
Being able to allocate indirect costs with high accuracy has major positive implications for businesses’ decision making capabilities.
In our next article we’ll take a closer look at the type of data that businesses need to carry out cost control effectively.