1. In our business idea, we are opening a construction company that is focusing on the construction of flats only. All our projects will be made to order and we hope to get ample work over the course of the next 5 years. We have based our working on the data provided to us by a construction company known as Contech Pvt Ltd. The data provided included all the firm's assets, method of financing, and all costs associated with a project the company had undertaken in Chakri(Rawalpindi) that involved the construction of flats. The manufacturing process involves the construction of these flats which involves labor, material and overheads.
2. Due to the complex nature of this assignment, we have many material costs. Firstly, there are the building costs. These include all the materials needed for the structure of the building. These include bricks, cement, floor tiles, wood and sanitation equipment. Some materials are also included in miscellaneous category which includes cost of paint, cost of steel, cost of sand, crush, girders etc. In addition of these we have other material costs which include the equipment used for water and sanitation, sui gas and electricity installations. These range from wires and qu-plugs to gas nozzles and pipes.
Construction process also requires the services of a wide variety of specialized direct labor. Direct Labor essentially includes masons, carpenters, plumbers and electricians.
The construction process also requires continuous use of various raw materials such as wood, crush, and sand etc. Therefore, the company stores these materials in order to ensure continuous and uninterrupted construction of flats.
As is the norm with the construction industry, the transportation in costs is normally included in the costs of the materials. Therefore, Contech does not display transportation costs as a separate cost.
3. The non-manufacturing costs are broadly divided into indirect materials, indirect labor, plant depreciation, fuel and electricity. Indirect materials include those that cannot be conveniently traced to the flats. These include materials such as saw dust, screws, glue, tar, turpentine oil etc. The indirect labor costs include wages of security guards, salary of architects and engineers, drivers. Other costs in the non-manufacturing category include fuel costs of the generator and utility costs including electricity, gas and water charges.
4. Cost Classification
We currently own
1: All office buildings
2: Plant and equipment
4: All machinery
40% of these fixed assets were purchased on cash while the rest of the 60% were acquired on account. All these assets are recorded on the balance sheet at their book value and all of these are going to be depreciated using Accelerated depreciation method. During the next five years we will pay all the payables concerning these assets. As the cost of land and the construction material has increased manifold during the past years, that's why a much portion of the stating cash balance was dedicated in buying these assets. Almost 47% of the starting cash balance expired on acquiring these assets. Moreover we have the plans to expand the business in the coming years. This is the major reason why we decided to purchase the buildings, land and other equipment so that in the future we do not face any problems regarding fixed assets. It is also true that a larger portion of the net income is going to be spend on paying out the accounts payable of these assets.
Labor costs (idle time, overtime, fringe benefits):
The cost of typical construction labor which we use in the construction processes comes under "Direct Labor". The reason is quite simple. We usually contact the contractors who then provide the company with the specified amount of skilled workers. A deal is signed between company and contractor and hence we pay the contractor a specified amount for all the workers' wages. Thus we indirectly pay the labor through a contractor. For an undertaken project a budgeted amount of labor hours are calculated. Usually the workers work for almost 9 hours a day. We pay contracted wages for these 9 hours per day. In case, there is work which exceeds these nine hours we treat it as a manufacturing overhead and pay the workers directly. In case there is idle time, we still have to pay for 9 hours each day which we treat as Direct Labour. From all these information we calculate the number of workers to be employed to complete a job in a specified time period.
Some direct workers like carpenters are also given fringe benefits like motorcycles which are treated as a direct labour cost.
Apart from the construction workers, the company workers such as guards, drivers etc are also included in the indirect labour costs.
During the recent past government and other agencies have taken great measures on the quality of material and other sources used to construct the buildings. This is one reason why a lot of emphasis is paid on the material by Contech. The other reason being we want the customers to be fully satisfied in every aspect of the construction. A detail of all the costs are given in the following table.
Usually the G&A costs constitute a little portion of the overall costs. The reason is evident as a lot of work is done on the site of construction. Moreover the administration department of our company comprises of only a small portion of workforce. Hence major portion of the costs are allocated to the ONSITE COSTS.G&A costs are therefore very little. These include the CEO Jawad Bashir's salary, the costs of electricity of the head office, depreciation of head office building and other vehicles(unrelated to manufacturing), salaries for bookkeeper and other running expenses.
The cost which is the lowest in our company is the marketing cost. The reason being only a few construction companies are currently working in the same Rawalpindi-Islamabad area. Furthermore increase in the demand of housing in the nearby suburbs has proven to be very profitable for all construction companies and there is no dire need to advertise for a company when the demand for it is above breakeven. Although this is the case, we have still advertised in local newspapers which have increased sales. Still, marketing costs as percentage of sales is only 3%.
5. Contech has used absorption costing for applying our overheads to the products. Theyhave not used activity based costing due to certain limitation like unskilled labour. We have discussed this in great detail later on. Secondly, they could not use process costing because the flats/apartments we build are not homogenous. They are built as per the requirement of customers hence we cannot allocate costs equally to all the products. The activity base used is direct labour hours. The rationale behind using direct labour hours as the activity base is that the overheads they used mostly depend on the direct labour hours. For example, the fuel and electricity charges move in the same direction as the DLHs. But this is incorrect logic that they have used. Expenses like escalation, head office expenses and depreciation are in no way related to DLHs and using DLH as an allocation base misallocates expenses to products.
Moreover, absorption costing makes no classification between fixed and variable costs hence management cannot base its plans on absorption costing.
6 Activity based costing
Construction of flats generally requires the interaction of a lot of activities. For example, construction requires the use of various types of workers including mason, carpenters, electricians, plumbers. In addition, the direct materials also involve different materials including bricks, cement, wood, tiles etc. The inter-relation of all these various activities means that most of the costs pools required to allocate overheads for an Activity Based Costing are difficult to identify.
This means that a single activity such as indirect factory wages can have multiple cost pools and it is difficult to determine the percentage of wages that are consumed by various cost pools. This is primarily because ABC requires constant interaction with the workers in order to obtain the various cost allocations. However, most of the indirect labor used in construction is either semi-skilled or unskilled (such as the security guards and mazdoors) and it will be difficult to obtain from them the information regarding what percent of their wages is consumed by the various cost pools.
In addition, the construction industry is quite informal because there are no set regulations regarding the organization and collection of data. Even Contech Pvt. Ltd did not maintain proper accounts and did not properly document the various cost flows with in their company. Therefore, the lack of properly organized data also makes it very difficult to estimate the cost pools and the cost drivers.
The construction of a standard block of flats usually takes up to one year. As we mentioned in the introduction, Contech is a contract based business in that it only begins any project once the order has been received. Therefore, the number of active customers and orders is very limited. This means that as we only have a few orders, it is difficult to differentiate between unit level, product level and batch level activities.
In addition, the construction industry nowadays is very competitive and cost sensitive. ABC system is very expensive and time consuming. Therefore, it is very unlikely, given, the informal nature of the construction industry that any medium-sized company such as Contech would invest in employing an expensive system such as ABC.
However, besides these limitations if the company can organize its data effectively and develops a strong communication with workers it might be able to differentiate between different cost pools. Possible costs pool could include number of customer orders, numbers of design of the flats, size of the flats, etc.
The company should switch to marginal costing because It would enable the company to make better decisions based on relevant costs and also employ the contribution margin approach while calculating its profit.
Nevertheless, given the overlapping nature of activities within the company and that the company operates within an informal industry and that ABC is an expensive system to use, it is unlikely that Contech would employ such a system.