Cost Estimation & Control

Indirect Cost

Demystifying Indirect Costs in the Oil & Gas Industry

In the complex world of oil and gas operations, understanding the nuances of cost allocation is crucial. While direct costs are easily traceable to specific products or projects, indirect costs are often less obvious and require careful analysis. These costs, sometimes referred to as overhead or burden, are essential for maintaining a successful oil and gas enterprise but are not directly linked to a single, identifiable product or service.

What exactly are indirect costs?

Indirect costs are expenses incurred by a company that are not directly tied to a single, final cost objective like drilling a well or producing a barrel of oil. Instead, they are associated with two or more final cost objectives or an intermediate cost objective, such as a support department.

Examples of Indirect Costs in Oil & Gas:

  • Administrative costs: Salaries of office staff, rent, utilities, legal fees, insurance, and accounting services.
  • Engineering costs: Salaries of engineers and technicians, design and planning fees, and software licenses.
  • Maintenance and repair: Costs associated with maintaining equipment and facilities, including labor, parts, and supplies.
  • Environmental costs: Costs associated with environmental monitoring, remediation, and compliance.
  • Safety costs: Costs associated with safety training, equipment, and programs.
  • Transportation costs: Costs associated with transporting personnel and equipment to and from the work site.
  • Depreciation and amortization: Costs associated with the decline in value of assets over time.

Why are indirect costs important?

Understanding and accurately allocating indirect costs is essential for several reasons:

  • Accurate cost accounting: Knowing the true cost of a project or product is crucial for making informed decisions about pricing, profitability, and resource allocation.
  • Compliance with regulations: Many regulations require companies to track and allocate indirect costs, particularly in the areas of environmental and safety compliance.
  • Financial reporting: Accurate allocation of indirect costs is necessary for accurate financial reporting and auditing.

How are indirect costs allocated?

Allocating indirect costs can be a complex process. Common methods include:

  • Direct allocation: Assigning costs directly to a specific cost objective based on a clearly identifiable relationship.
  • Activity-based costing (ABC): Allocating costs based on the specific activities that drive them.
  • Percentage of sales: Allocating costs based on a percentage of total sales revenue.
  • Equal allocation: Distributing costs equally across all cost objectives.

The Importance of Careful Allocation:

Choosing the right method for allocating indirect costs is critical. An inaccurate allocation can lead to:

  • Over- or under-pricing products or services.
  • Misleading financial statements.
  • Inaccurate profitability assessments.
  • Poor decision-making.

Conclusion:

Indirect costs are a crucial aspect of managing an oil and gas enterprise. By carefully understanding and allocating these costs, companies can ensure accurate cost accounting, compliance with regulations, and informed decision-making for a more sustainable and profitable future.


Test Your Knowledge

Quiz: Demystifying Indirect Costs in the Oil & Gas Industry

Instructions: Choose the best answer for each question.

1. Which of the following is NOT an example of an indirect cost in the oil & gas industry?

a) Salaries of office staff b) Cost of drilling a new well c) Maintenance costs for drilling equipment d) Environmental monitoring fees

Answer

b) Cost of drilling a new well

2. What is the primary reason for accurately allocating indirect costs?

a) To determine the exact cost of producing a barrel of oil. b) To comply with environmental regulations. c) To ensure accurate financial reporting and decision-making. d) To reduce overall operating costs.

Answer

c) To ensure accurate financial reporting and decision-making.

3. Which cost allocation method assigns costs based on the activities that drive them?

a) Direct allocation b) Activity-based costing (ABC) c) Percentage of sales d) Equal allocation

Answer

b) Activity-based costing (ABC)

4. What can happen if indirect costs are not allocated accurately?

a) Increased profitability b) Reduced environmental impact c) Misleading financial statements d) Improved decision-making

Answer

c) Misleading financial statements

5. Which of the following is a benefit of understanding and allocating indirect costs?

a) Reduced reliance on external financing b) Increased market share c) Improved resource allocation d) Enhanced public image

Answer

c) Improved resource allocation

Exercise: Allocating Indirect Costs

Scenario:

An oil & gas company has the following indirect costs for the month:

  • Administrative costs: $100,000
  • Engineering costs: $50,000
  • Maintenance costs: $25,000

The company has two main projects:

  • Project A: Drilling a new well (estimated to require 20% of company resources)
  • Project B: Maintaining existing production facilities (estimated to require 80% of company resources)

Task:

Allocate the indirect costs to Projects A and B using the percentage of resources method.

Show your calculations and the final allocated costs for each project.

Exercice Correction

**Project A (20% of resources):** * Administrative costs: $100,000 * 0.20 = $20,000 * Engineering costs: $50,000 * 0.20 = $10,000 * Maintenance costs: $25,000 * 0.20 = $5,000 * **Total Indirect Costs for Project A: $35,000** **Project B (80% of resources):** * Administrative costs: $100,000 * 0.80 = $80,000 * Engineering costs: $50,000 * 0.80 = $40,000 * Maintenance costs: $25,000 * 0.80 = $20,000 * **Total Indirect Costs for Project B: $140,000**


Books

  • Cost Accounting: A Managerial Emphasis by Horngren, Datar, and Rajan: This classic textbook covers cost accounting principles, including indirect costs, with specific examples relevant to various industries, including oil & gas.
  • Oil and Gas Accounting: A Comprehensive Guide by Douglas R. Allison: This book focuses specifically on accounting practices within the oil & gas sector, providing insights into indirect cost allocation methods and their implications.
  • The Oil and Gas Industry: A Guide to the Fundamentals by Robert E. Eberts: This comprehensive guide provides an overview of the oil & gas industry, including a section on cost management and indirect costs.

Articles

  • "Indirect Cost Allocation in the Oil and Gas Industry" by Deloitte: This article explores the challenges and best practices for allocating indirect costs in the oil & gas sector, including regulatory compliance and financial reporting considerations.
  • "Activity-Based Costing for the Oil and Gas Industry" by KPMG: This article discusses how activity-based costing (ABC) can be applied to oil & gas operations to improve the accuracy of indirect cost allocation and decision-making.
  • "Understanding and Managing Overhead Costs in the Oil and Gas Industry" by PwC: This article provides a practical overview of managing overhead costs, including strategies for reducing and optimizing indirect cost allocation.

Online Resources

  • Society of Petroleum Engineers (SPE): SPE offers a vast repository of technical papers and resources on various oil & gas topics, including cost accounting and indirect cost allocation.
  • American Petroleum Institute (API): API provides industry standards and guidelines for various aspects of the oil & gas industry, including cost accounting and financial reporting.
  • AccountingTools: This online platform offers comprehensive information on various accounting concepts, including indirect costs, with specific examples and explanations.

Search Tips

  • Use specific keywords like "indirect cost allocation oil and gas" or "overhead cost management oil and gas" to narrow your search results.
  • Combine keywords with specific industry terms like "upstream," "downstream," or "production," to find more relevant articles and resources.
  • Include specific companies or organizations like "ExxonMobil" or "Shell" to see how these companies address indirect cost management in their operations.
  • Use quotation marks around specific phrases, like "activity-based costing" or "direct allocation," to find resources that discuss those concepts in detail.

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Oil & Gas ProcessingCost Estimation & ControlBudgeting & Financial ControlProject Planning & SchedulingContract & Scope ManagementProcurement & Supply Chain Management
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