Costs Can Come in Many Flavors, Part 2: Direct vs. indirect costs

March 1, 2003

Costs come in many flavors: Part 2, direct vs. indirect costs

By Brandon Battles

Brandon Battles

Maintenance managers have expressed frustration to me when they hear or discuss various terms involving different types of costs such as variable, fixed, direct, indirect, discretionary, period, and many others. Often the frustration occurs because costs, and all that they imply, fall outside of the manager’s area of maintenance expertise. And, as with many of us when placed in an unfamiliar situation, discomfort and frustration can quickly set in. The following offers a brief explanation about costs. The intent is not make you an expert but to make you feel more comfortable when exposed to these terms, whether in text or conversation.

Direct vs. indirect costs
However, as discussed last issue, fixed and variable are just two terms frequently associated with costs. Two other terms that maintenance managers have asked about are direct and indirect. Whereas fixed and variable deal with a cost’s behavior, direct and indirect deal with the attachability or traceability of a cost.

Direct costs are directly attributable to an activity or product. Let’s use a maintenance example to illustrate. If a technician works on an aircraft (product or activity) to replace a part, the labor cost is directly attributable to the aircraft. For that matter so is the part’s cost.

An indirect cost is not directly attributable to an activity or product. Therefore, it is more difficult to handle and must have some basis of allocation. For example, if an organization wants to assign hangar costs to each aircraft in the fleet, then some type of allocation method is required. Remember, if we want to determine as accurately as possible the cost of each aircraft, then the allocation method needs to be reasonable. The allocation method can be quite simple or complex depending upon the cost.

Let’s assume that an organization with four aircraft has a $10,000 monthly hangar rental fee. Depending upon the significance of the fee, the organization might use the following methods to assign the fee to each aircraft.

  • The easiest method would be to assign an equal amount of $2,500 to each aircraft.
  • If each aircraft is different in type, the organization could use size as the basis, such as wingspan, aircraft height, cabin volume, or empty weight. Determine the hangar fee unit cost based upon the basis selected, and then allocate to each aircraft.
  • If the hangar fee is somewhat significant, then perhaps a more elaborate allocation basis could be used based upon number of days (hours) each aircraft is in the hangar. Determine each aircraft’s percentage of the total and apply that to the monthly fee.

An organization could certainly get carried away assigning indirect costs to an activity or product. The objective is to get as accurate a cost picture as possible, within reason, for the activity or product of interest.

As a manager in maintenance it is important to understand the basis used to allocate costs. You may not have input to the method chosen, but you will have a better understanding about how the total cost per hour is calculated. And you will have more information to answer questions on an aircraft’s cost per hour and to differentiate between the costs that you control vs. those that you don’t.

Direct and indirect costs up to this point probably seem easy enough. However, there is one more point that is worth mentioning. A direct cost in one instance may not be a direct cost in another. The same is true for indirect costs. Remember, what makes a cost direct or indirect is its traceability or assignability to an activity or product. Costs can also be assigned to the department in which the aircraft operated. In this case the hangar fees change from indirect to direct. At the department level, the hangar fees no longer have to be assigned or allocated. If the activity or product changes, the classification of costs may also change.

Period vs. capital expenditures
Just as certain products have their warning labels, I must issue mine again before explaining the next terms. Remember, my intent is not to make you an expert but to help eliminate frustration.

Every organization has a system in place (some more formal than others) that captures relevant information about transactions that affect the organization daily. This system is commonly referred to as an accounting system. A compilation of the various and frequent transactions are commonly referred to as financial statements. Financial statements can be compiled based upon internal or external requirements (rules and procedures). These rules and procedures will dictate or offer guidance as to how an organization will handle or classify certain transactions. The significance of a transaction will determine how it is recorded.

In our case, we are discussing one type of transaction commonly referred to as an expense. Based upon how the organization benefits from the expense, it will be handled primarily in one of two ways. The organization will either recognize the expense immediately or spread it out over several periods (years).

A commonly used term that refers to the immediate recognition of an expense is period expense. The expense is recognized in the period in which it was encountered. For example, the purchase of consumables fits this scenario. If the expense is significant, it may still be recognized in the current period if there is no future benefit. The hangar fee from the earlier discussion would be an example.

If the expense is significant, increases the value of the aircraft, and benefits future periods, then it should be handled differently. Rather than having a period expense, the organization now has a capital expense.

For example, let’s assume an organization has just completed a $400,000 airframe refurbishment of its aircraft. The organization determines that the expense is significant, has extended the life of the aircraft, and is beneficial to future periods. The organization will capitalize the expense and then determine a method for allocating it to future periods. The allocation should reflect as closely as possible the “using up of the asset” in the future periods. In other words, how fast and over what period of time will the asset depreciate? Let’s assume the asset will be used up evenly over an eight-year period. Therefore, the annual recognition of expense will be $50,000.

Why is this important to you? How your organization handles significant expenditures can greatly affect your cost per hour. Can you imagine if you flew only 100 hours in the year that the major refurbishment occurred and your organization decided to handle it as a period expense? Your cost per hour for the year when considering only the refurbishment, would be $4,000. Add in all of your other fixed expenses and your cost per hour would be extraordinary. This situation could be compounded if someone simply saw the cost per hour on a report and you did not have an opportunity to explain the cause.

If the organization capitalizes the expense and allocates to future periods, then the effect of the cost is mitigated in the year in which the refurbishment occurred. The cost per hour would be $500 assuming the same 100 flight hours. The cost per hour is probably still higher than in previous years but much easier to explain if given the opportunity.

The many flavors of costs
What’s the important piece of information to learn from these articles? Recognize that costs are not just costs. Costs can behave differently, an organization can classify costs based upon their traceability or assignability, or an organization can make decisions that affect the timing of the recognition of expenses.

In most situations, as the manager in the maintenance organization, you won’t have a great deal of influence over the types of decisions that affect these costs, but you will certainly be the recipient of the effects of those decisions. By gaining a better understanding about costs, you will feel more comfortable the next time you encounter them.

Brandon Battles is a partner with Conklin & de Decker. He has spent more than 15 years in aviation working with maintenance organizations in the areas of cost collection and analysis, systems review, inventory analysis, and management training.