Cost Efficiency Analysis and Direct Cost Calculation

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Cost Efficiency Analysis and Direct Cost Calculation

Project Management · Chapter 4: Financial Planning and Cost ManagementSection 4.3 · lesson 27 of 7312 min · free with a free account

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In this lesson

Classifying project costs and using them to compare options fairly.

  • Classify costs as direct or indirect and as fixed, variable, mixed, or step, stating the driver and range
  • Allocate overhead with a stated base and explain how the base changes each project's share
  • Calculate a work package's planned direct cost, unit cost, benefit-cost ratio, and break-even quantity
  • Compare options using only the costs that differ between them

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Transcript

Everything said in the video, section by section (1,549 words). Read along, or search it.

Opening Question

Van or Courier, Three Different Answers

A laundry cooperative compares two ways to collect and return laundry for care homes: its own van and driver, or a contract courier. Count only the variable costs, and the van wins easily. Add the fixed costs, and the courier is cheaper. Add the office overhead, and the gap grows even wider. Same two options, three different answers. Which one is right? It depends on classifying costs correctly, and knowing which ones actually differ.

Why Classify

Pricing, Budgeting, Control, and Choosing

Cost classification sorts costs by how they're traced to a project, and how they respond to the amount of work done. Four decisions depend on it. Pricing needs to know which costs a charge must recover. Budgeting needs to know which costs rise if scope grows. Control needs to know who can influence each cost. And choosing between options needs to know which costs actually differ.

Direct and Indirect

Tracing Costs to the School Annex

A direct cost can be traced to one particular project or work package, because it's incurred specifically for it. For a builder adding a two-room school annex: the bricks, the bricklayers' wages on the annex, and the crane hired for the structural lift. An indirect cost supports several projects, or the whole organization, so it can't be traced to one without a sharing rule: head-office rent, the accounts clerk, the safety officer who visits every site. The same cost can be either. A site manager is direct for a project that employs one full time, but indirect when visiting five sites a week, charged to none.

Fixed and Variable

A Grid of Two Independent Questions

A fixed cost's total doesn't change as the amount of work changes, within a relevant range. A variable cost's total changes in proportion to the work. The two questions are independent, so they make a grid. Direct and fixed: the crane, hired as a two-week block, whatever the number of bricks. Direct and variable: bricks and mortar, which rise with the wall area. Indirect and fixed: head-office rent and the safety officer's salary. Indirect and variable: fuel for the shared supervisor vans, which rises with the number of active sites, but needs a rule to be charged to the annex. Adding scope is a decision about variable costs. Keeping a resource is a decision about fixed ones.

Mixed Costs

Standing Charge Plus a Unit Rate

A mixed cost has both parts, like an electricity bill with a standing charge plus a charge per unit. A workshop pays $40 a month, plus 12 cents per unit used. At 500 units: 40 plus 60 is $100, an average of 20 cents a unit. At 800 units: 40 plus 96 is $136, an average of 17 cents. The rate never changed. The average fell because the fixed part was shared by more units, which is why analysts split a mixed cost into its parts.

Relevant Range

Step Costs and the Chosen Driver

Two refinements keep these labels honest. A fixed cost is fixed only within a relevant range of activity. A step cost stays flat, then jumps. With one supervisor per ten workers, at $3,000 a month, ten workers cost 3,000. Eleven need two supervisors: 6,000. And the labels describe behavior against one chosen driver. Fuel is fixed with respect to bricks laid, but variable with respect to the number of sites. So when you call a cost fixed or variable, state the driver and the range. Over a long horizon, even a van lease can be ended or resized, so it behaves more like a variable cost.

Quick Check

Classifying Hourly Painters on the Annex

Quick check. Painters are paid by the hour, and they work only on the annex. How would you classify their wage cost? Pause, and decide. Direct and variable. They work only on the annex, so the cost traces to it, and paid by the hour, the total rises with the work. If they also painted other sites, the cost would need a sharing rule. And a flat monthly fee would make it fixed.

Overhead Allocation

Same Overhead, Two Different Bases

Overhead is the pool of indirect costs an organization incurs to keep running. Allocation spreads it over projects, using a stated base, like labor hours or direct cost. The rate is the pool divided by the total base. A project's share is the rate times its own amount of the base. A builder has $60,000 of overhead and two projects. Alpha: 1,500 labor hours and $90,000 of direct cost. Beta: 500 hours and $110,000. By labor hours, 60,000 over 2,000 hours is $30 an hour. Alpha gets 45,000, for 135,000 in all. Beta gets 15,000: 125,000. By direct cost: 60,000 over 200,000 is 30 percent. Alpha gets 27,000: 117,000. Beta gets 33,000: 143,000. Under the first base, Alpha looks dearer. Under the second, Beta does. Nothing about the work changed, only the sharing rule. So pick a base that reflects what drives the overhead: floor area for rent, headcount for payroll administration. Where nothing clearly drives it, say the choice is partly arbitrary.

Worked Example

Direct Cost of Playground Surfacing

Now a work package's planned direct cost: labor, plus materials, plus equipment, plus subcontracts. A community center installs 200 square meters of playground surfacing. The crew lead works 40 hours at $30. Three workers together work 120 hours at $22. Wages: 1,200 plus 2,640, or 3,840. The rates exclude on-costs, the employer's payroll taxes and benefits, which add 20 percent: 768. Labor is 4,608. Materials: surfacing at $38 a square meter is 7,600, plus 1,150 of adhesive and edging: 8,750. Equipment: a compactor for five days at $90, and a mixer for two days at $60: 570. A drainage test subcontract: 1,300. Planned direct cost: 15,228. Leave out on-costs, and labor is understated by 768.

Efficiency Measures

Unit Cost and Cost per Deliverable

Efficiency measures turn totals into comparable ratios. Unit cost is total cost over units of output: 15,228 over 200 square meters is $76.14 a square meter. Cost per deliverable is the cost of one finished, accepted output. Three training modules cost 4,200, 5,100 and 3,900: 13,200, or 4,400 per module. The modules differ in length, so cost per page would mislead. The deliverable is what the sponsor actually accepts. The benefit-cost ratio is benefits over costs. Above one, benefits exceed costs.

Ratio Versus Difference

Benefit-Cost Ratio and Net Benefit

A ratio and a difference answer different questions. Option X has benefits of 45,000 for costs of 30,000: a ratio of 1.50. Option Y has benefits of 120,000 for costs of 90,000: a ratio of 1.33. X returns more per dollar. But net benefit, benefits minus costs, is 15,000 for X and 30,000 for Y. Y creates more total value. With limited funds and many projects, the ratio shows where each dollar goes furthest. If either can be funded alone, net benefit shows which leaves you better off. Name the question first.

Break-Even

When a Repair Clinic Covers Its Costs

Break-even is the quantity where income exactly equals total cost. It's the fixed cost divided by price minus variable cost per unit. Price minus variable cost is what each unit contributes toward the fixed cost. A pop-up repair clinic has fixed costs of $1,800 a month, charges $25 a repair, and spends $10 on parts per repair. Each repair contributes 15. Break-even is 1,800 over 15: 120 repairs. Check: 120 repairs bring in 3,000, and cost 1,800 plus 1,200, also 3,000. Below that, a loss; above it, a surplus. At 90 repairs, each one costs $30 to deliver, more than its price.

Quick Check

Break-Even for a Tool Library

Quick check. A tool library's fixed costs are $900 a month. It charges $12 a loan, and each loan costs $3 in cleaning and repairs. How many loans a month to break even? Pause, and decide. One hundred. Each loan contributes twelve minus three: nine dollars. Nine hundred over nine is one hundred loans. Seventy-five divides by the fee alone, ignoring the variable cost. Three hundred divides by the variable cost.

Comparing Options

Only Costs That Differ Count

Back to the laundry. A fair comparison uses the same basis, the same period, and every cost that differs between the options. In-house: the van lease and insurance, 24,000 a year, and the driver, 30,000, both fixed. Fuel and upkeep, $2 a delivery for 4,000 deliveries: 8,000. Total: 62,000. Courier: $14 a delivery, 56,000, plus 3,000 of contract administration: 59,000. And the 12,000 of office overhead charged to the in-house service? It's paid whichever option is chosen, so it doesn't differ, and it's irrelevant to this decision. So the courier is cheaper by 3,000: $14.75 a delivery against $15.50. The options tie at 4,250 deliveries. At 5,000, in-house wins by 9,000. So the analyst recommends the courier for now, reports the break-even, and flags the trade-off: less control over pickup times.

Debate

How Much Overhead to Include

How much overhead to include is disputed. Full-cost thinking says an organization survives only if every project recovers a fair share of overhead. The other view says a decision should rest only on costs that change with the choice, because overhead that continues regardless misstates what the decision costs. How far overhead really moves with activity is empirical. Whether each project ought to carry a share is a question of values. So learn both calculations. And remember the limits. Allocated figures depend on the base. Unit cost depends on volume. A benefit-cost ratio ignores timing and anything not measured in money. These are screening aids, not verdicts.

Key Takeaways

Classify, Allocate, Calculate, and Compare

To recap. Classify each cost twice: direct or indirect, and fixed or variable, stating the driver and range. Allocated overhead depends on the base, so choose one that drives the cost. Planned direct cost is labor with on-costs, plus materials, equipment and subcontracts. And compare options using only the costs that differ, with break-even showing where the answer flips.

About Project Management at UPI Study

Project Management (Business 230) is a self-paced online course of 73 video lessons in 12 chapters, from starting and defining a project to planning, budgets, scheduling tools, proposals, contracts, execution, monitoring, closure, teams and certification. It carries a NCCRS credit recommendation for 3 semester credits.

Every lesson transcript is free on pages like this one, and the videos are free with a free UPI Study account. Enrolling adds a practice quiz after each lesson, the graded work and final exam that earn the credit, lifetime access, and an official transcript on completion. UPI Study has helped over 130,000 students with college credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

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Why take it here

Why students take Project Management with UPI Study

How projects are planned, run and closedProject Management teaches how to deliver work on time and on budget: scope, schedules, the critical path, budgets and earned value, risk, contracts, monitoring and closing a project, and leading the team. It is a common course in business, management and engineering degrees.
Credit at a fraction of the priceThe same 3 credits can cost $750 or more at a US college. Here it is one payment, self-paced, with lifetime access.
Finish your degree soonerTransfer credits reduce the courses you still owe, so you can graduate earlier or lighten a heavy semester.
Strengthen an applicationA completed college-level course on an official transcript shows admissions and scholarship committees you can do the work.
Study on your own scheduleNo start dates, no deadlines. Watch the lessons, practice, and take the final when you are ready.
130,000+students helped with college creditsACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Where the credit goes

Universities that work with NCCRS

Project Management carries a NCCRS credit recommendation. These universities work with NCCRS; some are UPI Study's signed partners. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Thomas Edison State UniversityThomas Edison State UniversitySigned partnerUniversity of the PeopleUniversity of the PeopleSigned partnerCharter Oak State CollegeCharter Oak State CollegeSigned partnerStrayer UniversityStrayer UniversitySigned partnerColumbia Southern UniversityColumbia Southern UniversitySigned partnerIndiana TechIndiana TechSigned partnerPenn StatePenn StateWorks with NCCRSSouthern New Hampshire UniversitySouthern New Hampshire UniversityWorks with NCCRSSUNYSUNYWorks with NCCRS +many more cooperating universitiesFind my college →

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FAQ

Questions students ask us

About Cost Efficiency Analysis and Direct Cost Calculation

What is the difference between direct and indirect project costs?
A direct cost can be traced to one particular project or work package, while an indirect cost supports several projects or the whole organization and needs a sharing rule. Bricks and a crane hired for a school annex are direct, while head-office rent is indirect. The same cost can be either: a site manager is direct when employed full time on one project.
How does the choice of allocation base change a project's overhead share?
The allocation base decides how the overhead pool is split, so a different base can make a different project look more expensive. Splitting $60,000 of overhead by labor hours at $30 an hour gives a 1,500-hour project $45,000. Splitting by direct cost at 30 percent gives the same project, with $90,000 of direct cost, only $27,000. The base should reflect what actually drives the overhead.
How do you calculate the break-even quantity for a service?
Divide fixed costs by the price minus the variable cost per unit, which is each unit's contribution. A repair clinic with $1,800 of monthly fixed costs, a $25 price, and $10 of parts per repair contributes $15 per repair, so it breaks even at 120 repairs. A common mistake is dividing fixed costs by the price alone, which ignores the variable cost.
What is the difference between a benefit-cost ratio and net benefit?
A benefit-cost ratio divides benefits by costs, while net benefit subtracts costs from benefits. Option X with $45,000 of benefits for $30,000 of costs has a ratio of 1.50 and a net benefit of $15,000. Option Y with $120,000 for $90,000 has a ratio of 1.33 but a net benefit of $30,000. The ratio shows value per dollar, and net benefit shows total value created.

About the Project Management course

How many college credits is Project Management?
Project Management (Business 230) carries a NCCRS credit recommendation for 3 semester credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
How much does Project Management cost and what is included?
$250, paid once, with lifetime access: all 73 video lessons, a practice quiz after each, the graded work and final exam, and an official transcript when you finish. Students who want several courses choose UPI Study PRO instead.
Which universities accept UPI Study credits?
UPI Study has signed partner agreements with universities such as Thomas Edison State University, University of the People and Charter Oak State College, and works with universities such as Penn State, SNHU and SUNY. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities. Use "Find my college" on this page to check yours.
How long does Project Management take?
It is self-paced with no deadlines. The 73 lessons total about 15 hours of video; most students add reading and practice time and finish in a few weeks to a few months, on their own schedule.
How are the exams done?
Quizzes and assignments are online in the course. The final exam is taken online with proctoring; a person on the UPI Study team checks assignments, usually within two days.
How do my credits reach my college?
When the course shows 100% complete, request the official transcript from your dashboard. It is sent to the college you name, and you can send it to more than one. Check your college first with "Find my college" on this page, or ask Athena.

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73 video lessons, a quiz after each one, and the graded work that earns the credit. Recommended for credit by NCCRS.

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