Analysis of Direct Costs
What Is Most Likely to Go Wrong in the Analysis of Direct Material and Other Direct Costs
“Direct material costs include the costs of items such as raw materials, parts, subassemblies, and manufacturing supplies, which may be purchased or manufactured by the offeror” (Crosson & Needles, 2010). Direct costs are totally allocable to the contract. These may sometimes include transportation and in-transit insurance. Other direct costs include special tooling, travel, computer and consultant services, preservation, packaging and packing, spoilage and rework and federal excise taxes.
During the analysis of direct material and other direct costs, one of the aspects likely to go wrong is failure to adjust direct costs to reflect credits such as trade discounts, refunds, allowances, sale of scrap or other actions that reduce their net cost. The second issue likely to go wrong is when adjustments for the exclusion of nonrecurring and abnormal write-off and transfers-back of obsolete material to productive inventory are not made (Murphy, 2009). Although some quantities may contain allowances for scrap and spoilage, they may be overstated. From a quality standpoint, the items may be adequate but excessively high in quality. The quality may not be regulated to reflect the cost.
When estimating a direct material cost, the contractor may fail to take into account all possible prices, inflation, changes in available quantities and new sources of supply (Crosson & Needles, 2010). This may affect the organizations costing process. According to Murphy (2009), the analysis of direct material and other direct costs can be influenced negatively by factors such as quality, quantity discounts, and distance of the source from the plant, and so on.
To counter the issues, commercial companies must ensure that material variance and similar costs are not excluded from cost estimates because the costs may be recorded directly against cost of sales without being charged to production costs. Offerors must project a unit material cost and be very careful in assessing these projected unit material costs. Murphy (2009) indicated that when materials are purchased specifically for a contract, the actual purchase price of the materials should be charged to the contract to prevent the mistakes. Crosson & Needles (2010) noted that to avoid the occurrence of wrongs in the analysis of direct costs and other costs, reasonable adjustments should be made in the cost of materials charged to a contract when a difference in inventories occurs.
During the analysis of the direct materials and other direct costs, it is important to ensure that the cost of the materials is based on an established price for a commercial item sold in substantial quantities to the public. When products are being purchased, comparison of estimated quantities with the bill of materials is the most common, and reasonable, approach. Murphy (2009) says that in service contracting, the bill of materials does not commonly exist. In this case, it is a matter of comparing the proposed quantity against government experience in similar work, if available, or assessing based on the best judgments of technical personnel.
The accuracy of the estimate for type and quantity of material is one major component of the total cost. It is important to ensure the accuracy of the materials because it is more significant towards overall cost estimate reliability estimate (Weygandt, Kimmel & Kieso, 2008). It is, therefore, the responsibility of the technical personnel to judge whether the material types and quantities are reasonable.
It is reasonable and realistic for offerors to plan on the need for some extra materials over the basic amount expressed in a bill of materials. It is important to determine the amount of extra materials required over the basic amount expressed in a bill of materials (Murphy, 2009). During the analysis there should be a small scrap allowance and possibly none, for very large and heavy metal objects that are the main frame of the product being ordered. Weygandt, Kimmel & Kieso (2008) indicated that the contractor should allocate a large scrap allowance for parts made of glass or with rather delicate components. Murphy (2009) indicated that excessive scrap allowances will unnecessarily inflate the estimated cost and lead to excessive pricing. This factor is particularly significant when negotiating a fixed price contract.
In conclusion, when materials are bought specifically for a contract, their cost should be charged to that contract. It is important to ensure if material is issued from stores, the generally accepted methods for pricing are acceptable if they consistently applied. The method of analysis should follow the principle of breaking the overall proposed costs into their components and critically examine each one.