Question 8.2: A landscaping firm has two types of clients: those that requ...
A landscaping firm has two types of clients: those that request a cost-plus 20 percent contract, and those that request a fixed fee of £20,000 for landscape design and installation services. During the year, the firm completes 50 projects of each type. The average direct costs of each design are £10,000. Indirect costs for the design firm are £500,000. The first method of allocating indirect costs assigns £200,000 to the cost-plus designs and £300,000 to the fixed-fee designs. The second method allocates £400,000 to cost-plus designs and £100,000 to fixed-fee designs. Which method provides a higher profit for the landscaping firm?
The reported cost for the cost-plus designs under the first method is as follows:
| Direct costs (50 × £10,000) | £500,000 |
| Indirect costs | 200,000 |
| Total | £700,000 |
The total profit of both the cost-plus and fixed fee contracts using the first method of allocating indirect costs is calculated as follows:
| Revenues | |
| Cost-plus (£700,000 × 120%) | £ 840,000 |
| Fixed fee (50 × £20,000) | 1,000,000 |
| Total | £1,840,000 |
| Costs | |
| Direct (100 × £10,000) | £1,000,000 |
| Indirect | 500,000 |
| Net profit | £ 340,000 |
The reported cost for the cost-plus designs under the second method follows:
| Direct costs (50 × £10,000) | £500,000 |
| Indirect costs | 400,000 |
| Total | £900,000 |
The total income of both the cost-plus and fixed fee contracts using the second method of allocating indirect costs is determined as follows:
| Revenues | |
| Cost-plus (£900,000 × 120%) | £1,080,000 |
| Fixed fee (50 × £20,000) | 1,000,000 |
| Total | £2,080,000 |
| Costs | |
| Direct (100 × £10,000) | £1,000,000 |
| Indirect | 500,000 |
| Net profit | £ 580,000 |
The second method provides a higher profit, as more reimbursable indirect costs are allocated to the cost-plus designs.