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COST IN THE PROJECT MANAGEMENT

doc. Ing. Jaroslava Kádárová, PhD. 1. It is used for planning for future activities or
budgets.
Technical Universityof Košice,
2. It is used for decision making throughout an
Faculty of Mechanical Engineering,
organization.
Department of Industrial Engineering and
3. It is used to compare actual results with
Management
budgets and determine why there are variances.
Němcovej 32, 042 00 Košice, Slovakia
4. It is used to calculate income from the
e-mail: [email protected]
company’s operations and projects.
Abstract
The nature and form of cost can vary
Many, if not most, project managers come across organizations. In the Slovakia, there are
from areas of expertise outside of business, and three basic types of organizations: manufacturing,
most do not have the formal education in business, retail, and service. Manufacturing once is the
accounting, or finance required to take their skills greatest portion of the Slovak. Economy.
to the higher level. Project management accounting
is much more than considering how project income 2 COST CLASSIFICATIONS
and expense impact the general ledger. This article
Costs are classified according to the
contain fundamental information on different areas
purpose of the cost information that is sought (see
of accounting and financial expertise, such as cost
Tab. 1).
accounting and budgeting.
Key words: project management, accounting, cost, Tab. 1 Cost clasification in project management,
cost clasification source: [4]
Purpose of the Types of the cost
INTRODUCTION clasification
• Product Cost
Over the last few decades project Financial Statements
management has moved from its roots in industries • Period Cost
such as construction and defense into the • Variable
mainstream of Slovak business. Many different Cost Behavior • Fixed
industries, in particular the service sector, rely • Semi-variable
heavily on project management as an integral part • Direct
Assigning Costs
of a successful strategy. In support of the widening • Indirect
importance of project management, a number of • Differential Costs
important professional organizations, such as the Cost Decisions • Sunk Costs
Project Management Institute, have been created • Opportunity Costs
and are thriving in the twenty-first century. • Prevention
Project management accounting is much Cost of Quality • Correction
more than considering how project income and • Warranty
expense impact the general ledger. The topic
encompasses traditional accounting, cost Product and period costs provide
accounting, budgeting, financing, cash flow, and information needed to create external financial
earned value along with the more quantitative statements, such as the income statement and
subjects. Project management accounting also balance sheet. Cost behavior helps a company look
includes such areas as strategy and executive into the future by seeing how costs may change
decision making, portfolio management, and the based on other changing variables, such as demand
more traditional phases of project management. or production rate, or how a fixed cost affects
different situations. Costs must also be assigned to
1 DEFINITION OF THE COST IN PROJECT a source, giving rise to the concept of direct and
Cost is the measurement of resources that indirect costs. At other times, cost information
must be expended in order to obtain an object or supports business decisions, such as understanding
complete an activity. Cost is usually expressed in the differential between costs of two possibilities or
monetary terms, as in employee time; the materials the cost of pursuing one opportunity over another.
to manufacture an object may be represented by Finally, cost of quality compares the cost of
their monetary value. [4] Cost normally falls into preventing defects as opposed to correcting defects
the domain of managerial accounting and has four and the cost of providing a warranty on products or
essential purposes. services.

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2.2 Cost Behavior

2.1 Product and Period Cost Cost behavior is valuable in predicting
Period and product costs provide future cost when creating budgets or planning for
information to create financial statements for future activities such as production or projects.
external use. In order to better explain these costs, Certain activities affect cost in different ways. In
we need to return briefly to some basic concepts of the manufacturing example discussed earlier, we
cost accounting. As you will recall from Chapter 2, discovered that the fixed setup cost and variable
the matching principle of accrual accounting holds machine time cost of making prototypes could yield
that cost is recognized at the time when the benefit costs that were quite different from what was
that the cost provides occurs. For example, if a originally expected.
company pays for liability insurance for two years
in advance, the cost of insuring the company for There are three major types of cost
this year only will be reflected or accrued to this behavior: (1) variable, (2) fixed, and (3) semi-
year’s income and expense statement. In other variable. However, often there are more subtle
words, the company derives only part of the benefit nuances to how each cost behavior will react in a
of the insurance premium this year, so it can claim given situation.
only that part of the premium as an expense this
year. VARIABLE COSTS are those that change
in direct relationship to changes in the activity that
However, the cost to acquire or make a triggers the cost. For example, the cost of the
product to sell or provide a service is recognized material needed to manufacture a bolt increases in
when the sale of the product or service triggers direc proportion to the number of bolts that are
revenue. manufactured. A grocery retailer will incur
PRODUCT COST is the sum of all costs increased cost as more containers of milk are sold.
that are directly linked to the production or A consulting company will incur increased cost for
acquisition of a product or service to be sold later. each hour of service provided by hourly
Product costs might include direct materials and consultants. In essence, a variable cost is a fixed
direct labor for a product, programming time for a amount of cost per unit produced or activity used.
piece of software, or professional time for creating As the units produced or activities increase, the cost
a new service—such as training—to be sold. The increases by the same proportion. If more bolts are
cost of marketing and selling that product or service produced, the cost will increase by the same
is not included in the product cost because they can amount for each bolt. If more milk is sold, the cost
be very difficult to link directly to theproduct or will increase by the same amount for each
service. container; and if more consulting hours are
delivered, the cost increases by the same amount
PERIOD COSTS are all costs that are not for each hour of service. There are other costs that,
related directly to creating the product or service although variable, can be obtained only in large
and may fall into several categories. For example, quantities.
the cost of administration of a company or for
marketing and sales cannot be directly linked to the FIXED COSTS In contrast to variable
production of an individual product. In addition, the costs, fixed costs remain the same despite increases
cost of administration, such as human resources or decreases in business activity. For example, a
services, salaries, or insurance and rent cannot be manufacturing plant must heat the plant during the
linked directly to a product or service. These are winter whether production increases or decreases.
period costs that are recognized as expenses when The grocery retailer that rents its building must pay
the benefit occurs. For some, the benefit is the rent no matter how many containers of milk are
immediate; for others (such as the insurance sold, and the service company must pay the rent for
example) the benefit is recognized later. its offices, whether billable hours increase or
decrease.
It is important for project managers to
recognize the difference between when the cost is In addition, fixed costs may or may not be
recognized for accounting purposes and when it controllable. It is up to management to decide
actually occurs. Although the cost of programming whether to use those resources and incur the cost. If
time may be recognized only when the software is incurred, the cost would be fixed. Committed fixed
sold, the actual expense occurs during project costs cannot be controlled. The example of heat in
execution. This means that cash flow out of the the plant manufacturing bolts is non-discretionary.
company occurs before the expense that causes the A service company may subcontract consultants for
cash outflow is recognized and that outflow has a a fixed fee per month, but a cancellation clause in
real effect on the company bank account. the contract would be an example of non-
committed or discretionary fixed cost.

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future decisions. Sunk costs should never have a

SEMI-VARIABLE COSTS contain both place in deciding future activities or operations.
fixed and variable elements. The real key is in
being able to identify each element of semi-variable OPPORTUNITY COSTS results when a
costs. In the new product development project decision is made to pursue one benefit over another.
example, the project budget predicts that the overall Although opportunity cost is important in making
cost of producing a prototype is 3,000 €. However, decisions, it is not a cost that enters into accounting
we discovered that the cost could be broken down statements, such as income expense reports or
into three major components: materials, direct balance sheets. Some examples of opportunity cost
labor, and machine costs. could be:

2.3 Assigning Costs • The selection of one project over another.

DIRECT COSTS - Based on our initial Since both projects represent potential
definition of cost, a direct cost is the measure of revenue to the company, the revenue of the
resources that must be given in order to obtain an project not chosen is an opportunity cost.
object or complete an activity that can be directly • Not pursuing a particular new product in
related to that object or activity. In a manufacturing order to invest in other areas. The potential
setting, direct materials and labor would be direct revenue of this product is an opportunity
costs. In a retail industry, the cost of acquiring cost.
goods for sale would be a direct cost. In a service
industry, the cost of paying the employee to do As we can see in each of the decision costs
consulting is a direct cost. descriptions, often the information used to make a
decision comes from the same source and is in a
INDIRECT COSTS - Indirect costs are similar format as other costs, but is used for a
those costs that are not related directly to the object different purpose. For example, in the differential
or activity that produce a project or service. cost example the production cost of the software
Referring to previous examples, the cost of heating could include variable, semi-variable, and fixed
a factory is an indirect cost, as are the salaries of cost, but in order to make a decision about whether
administrators not directly working on the to subcontract, the type of cost was less important
production of goods or services. than the difference in cost between the two options.

2.4 Cost Decisions 2.5 Cost of Quality

Project managers are often called on to An old adage about quality goes, ‘‘You
make decisions between different opportunities or can’t inspect in quality.’’ In other words, no matter
different ways of accomplishing the goals and how much you inspect a product or a service, if you
objectives of a company. The three types of cost are not putting quality into the work being done,
that are used to make decisions are differential cost, you can’t inspect it in after the fact. You will wind
sunk cost, and opportunity cost. up spending a lot of Money either correcting the
problem immediately or correcting it later. The
DIFFERENTIAL COST is simply the longer you wait to correct, the more expensive the
difference in cost between choosing one of two or correction. We define quality as fitness for use
more options to pursue. The other side of according to the original design of the product or
differential cost is differential revenue. When service.
considering the different options to pursue, the
differential cost and revenue of each option is The first criterion of quality is whether the
reviewed, and the option that presents the higher product or service is what it is supposed to be.
income usually is chosen. During quality planning, you must take up the
answer to this question and decide how you would
SUNK COST is any cost that is already know if the end deliverable is what it is supposed to
incurred or sunk into a project. At times, when be. On a technical project, this might involve a
making decisions, managers may not wish to throw comparison with the detailed specification of a
away money that has already been spent and will product or software. On a non-technical project—
decide to continue so as to recoup the money for example, a project to reengineer a business
already spent. This happens frequently in projects process, this would be a comparison with the
that are not going well. proposed workflow of the new process.

Therefore, spending more money when the The three costs associated with quality are
success of the project is not clear (or when failure is prevention costs, correction costs, and warranty
all too clear) is not justified. In reality, since the costs. As indicated, quality costs are a balance
money is already spent, it cannot be used to make

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between preventing mistakes and discovering and process; for example, the maintenance cost
correcting them. of a machine that is used in the process can
be attributed to the products that are
PREVENTION - The best place to ensure manufactured with it.
quality in a product or service is at the time that the • Finished Goods Cost. The total cost of
product or service is created. The cost of prevention producing units of the product.
includes all of the activities that take place to
ensure that the product or service can meet the The key to understanding cost and the
standard established by the two questions, what is it manufacturing process is in the state of the material
and what does it do. In the case of a new product, that is being transformed. During the manufacturing
this may be engineering tests; for a service, it may process, materials are transformed by labor to
be a pilot test. When planning for the execution of a become finished goods. Often a product goes
project, be sure that the cost of preventing mistakes through more than one stage during the process.
and ensuring quality does not become more Work in process is any intermediary state between
expensive than the price the product or service can direct material and finished good.
bear in a competitive marketplace or more than can
be charged for the product or service. All of the costs associated with the
manufacturing process are product costs, which
CORRECTION - The cost of correction must be tracked in order to calculate the final cost
includes all of the activities that take place to find of the product. Inventory keeps track of product
and correct problems. Correcting problems can be a costs before the product is sold. A good part of
costly enterprise. managerial accounting is given over to tracking
costs through the intermediary stages of
WARRANTY - The cost of warranty manufacturing, each of which has an inventory,
includes all of those activities that correct problems until the finished goods are sold and the revenues
that occur after the product or service has been sold. and expenses are accounted for.
Normally, this is the most expensive quality cost. It
can involve return, repair, or replacement of If we return to the income and expense
merchandise and rework of services. Although statement for Warren Manufacturing, we see that
warranty expenses may seem obvious in the the company has a finished goods inventory but has
manufacturing and retail industries, poor no figure in purchasing. Warren’s inventory is
programming and the resulting debugging often can made up of goods that have been manufactured by
take a great deal of time and be very expensive. the company. [4]

3 COST AND INDUSTRY CONCLUSION

Now let’s take a look at how cost affects As we have seen, cost is a complex subject
the finances of companies in the different industry that reaches far beyond the individual budget of any
categories: service, merchandising, and given project. Different areas of the company use
manufacturing. cost information in different ways, and the
information must be formulated to suit the company
The manufacturing industry presents a area that it serves.
more complex picture of cost. Most of that
complexity is due to the introduction of the other When project managers are planning a
subset of cost of goods: cost of manufacturing. Cost project, and in particular are creating a project
of manufacturing has a number of components that budget, knowledge of the different kinds of costs
contribute to the final cost of an individual product: that the project will incur is essential to successful
budgeting. In addition, an understanding of overall
• Direct Material Cost. The cost of cost at a particular company in a specific industry
purchasing the materials that are will help project managers create budgets that take
transformed into the final product. cost into proper consideration and deliver winning
• Direct Labor Cost. The cost of the people results.
that perform the manufacturing process.
• Work in Progress (WIP). The cost of References
partially completed products at the end of an [1] Kádárová Jaroslava – Durkáčová Michaela:
accounting period. Warren Manufacturing Most widely used management tools and
had a certain amount of unfinished goods in techniques. In: MACHINES,
the pipeline at the end of 2010. TECHNOLOGIES, MATERIALS, International
• Indirect Cost of Manufacturing. The virtual journal, year VI, Issue 4/2012, Sofia,
overhead cost of manufacturing that can be Bulgaria 2010, s. 25-28. ISSN 1313–0226
directly attributed to the manufacturing

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[2] Kevin Callahan, Gary Stetz, Lynne Brooks: [5] Teplická Katarína - Kádárová Jaroslava:
Project management accounting: budgeting, Comparison of calculation methods in the
tracking, and reporting costs and profitability. formation of product pricing. In: Acta Technica
2nd ed., New York: McGraw-Hill, 2011. ISBN Corviniensis, Bulletin of Engineering, Vol. VI,
978–0–470–95234–4. no. 2, 2013, p. 59-62. ISSN 2067-3809.
[3] Potkány Marek – Hajduková Alexandra - [6] Teplická Katarína: Moderné trendy v
Katarína Teplická: Target costing calculation in manažérskom účtovníctve. 1. Vyd.,Košice : ES
the woodworking industry to support demand at F BERG TU - 2012. - 93 s. - ISBN 978-80-553-
a time of global recession. In: Drewno. Vol. 55, 0916-3.
no. 187, 2012, p. 89-104. - ISSN 1644-3985.
[4] Ray Garrison - Eric Noreen: Managerial This contribution is the result of the
Accounting, 14th edition, New York: McGraw- projects implementation: Project VEGA
Hill/Irwin, 2011. ISBN-10: 0078111005. 1/0669/13 Proactive crisis management of
industrial enterprises based on the concept of
controlling.

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