Including operation costs in projects: For or against?

IBM 403 Accounting MachineThere are two schools of thought when it comes to project costing:

  • Charge only direct costs to the projects. In a second step use the project’s contribution margin to cover operation costs, also called overhear costs. This method makes the global profit margin more visible.
  • Charge all costs, including the operation costs, to the projects, and get net profit directly from each project.

How does it work?

Computing net profit globally

When charging only direct costs to the projects, the profit is called a contribution margin. It’s normal, since operation costs are not paid for yet.

At the end of the project, I compute my contribution margin:

  • I invoiced $50,000.
  • Direct costs for the project, including employee work, supplier invoices and contractor costs, are $23,000.
  • My contribution margin is $27,000.

By adding this contribution margin to that of my other projects, I create a reserve to pay for operation costs. At the end of the quarter, for example, I can total my operation costs and subtract them from my contribution margin, to get my net profit for the period.

  • I have $103,000 in contribution margin from my projects this quarter.
  • I have incurred $60,000 in operation costs.
  • My net profit for the quarter is $43,000.

Charging operation costs to projects

Project direct costs are easy to charge: supplier invoices, expense reports, time sheets and contractor costs are already associated with a project when logging them in Abak. When we want to add operations costs, it gets tricky. How can we decide how much of the operation costs to charge to each project? We’re talking about rent, administrative staff, computers, etc.

The simpler method is to add an extra amount to the hourly cost of resources.

Here’s an example:

  • My operation costs are $100,000 per year. This includes all costs not charged directly to my projects.
  • I have 10 employees who work on projects, on average 2,000 hours per year.
  • My total worked hours for the year is 20,000 hours.
  • I can divide my operation costs by my worked hours: $100,000 / 20,000 hours = $5.
  • This $5 is the amount I will add to my hourly costs for all employees that charge to projects. If my employee has an hourly cost of $32, including salary and benefits, then I’ll us a cost rate of $37 per hours to include operation costs. I can do this directly in the employee’s cost rate in Abak, or I can configure a $5 cost mark-up in the employee functions.

With the adjusted hourly costs, I can include my operation costs in my projects. This operation cost mark-up can be computed on a yearly basis by accounting and finance teams.

At the end of the project, I can see my net profit easily:

  • I invoiced $50,000 for my project.
  • My costs, including the operation costs mark-up on hours worked, total $37,000.
  • My net profit is then $13,000.

Good sides, bad sides

Charge only direct costs to projects, compute net profit globally.

Charge operation costs to projects

Benefits Costs a more accurate and allow analysing the contribution margin for each project. This method ensures all costs are covered by projects revenues.
Drawbacks Contribution margins can provide a false sense of profitability, and influence decision-makers to accepts projects that a less profitable. This method can influence decision makers to turn down projects that have strategic value but may not cover operation costs.

What do you think?

In or out, operation costs? Tell us in the comments.