Cost allocations are necessary when costs cannot be directly related to a specific product or service.
The cost object is what you want to allocate costs to (e.g., different departments working on couches, tables, and desks).
In the oil and gas industry, cost objects are the wells being drilled for production.
Cost Pool and Cost Drivers
A cost pool consists of different costs that will be allocated to various departments.
Costs are allocated based on cost drivers (e.g., headcount, working hours).
Managers must consider appropriate cost drivers for their departments.
Direct Cost vs. Indirect Cost
Direct costs can be specifically attributed to a service or product.
Example: In public accounting, the time spent preparing complicated tax returns (e.g., 20 hours) is a direct cost of preparing tax returns for customers.
Example: Auditors billing time to specific clients is a direct cost.
Indirect costs cannot be directly related to a service or product.
Example: Administrative work like filling out timesheets is an indirect cost.
Example: Continuing education and professional development are indirect costs.
Allocation Based on Usage
Equipment costs can be allocated based on usage.
Allocation can be based on the number of hours used by different departments.
Allocation can be based on the lifespan of the equipment and how long each department used it.
Example: If a piece of equipment lasts less than a year and one department uses it for eight months while another uses it for two months, the cost can be allocated accordingly.
Manufacturing Cost Flows
In service companies, costs are often related to the hours spent working on a particular service.
In manufacturing, the cost flow involves:
Beginning work-in-process inventory.
Materials purchased.
Direct labor.
Manufacturing overhead.
Inventory Stages
Beginning Materials: Initial raw materials available.
Purchases: Additional materials bought during the period.
Physical counts of WIP inventory are done periodically (quarterly, semiannually, or monthly).
Finished Goods
Goods move from WIP to finished goods inventory once production is complete.
These are the goods produced during the year.
Cost of Goods Sold (COGS)
COGS is calculated by subtracting ending finished goods inventory from the goods produced during the year.
Income Statement
The final COGS number goes to the income statement.
The management accountants monitor the entire process from raw materials to finished goods.
Income Statement:
Revenues
Cost of Goods Sold (COGS)
Gross Margin
Marketing and Admin Expenses
Operating Profit
Exhibits 2.7 and 2.8 on page 34 of the book provide a detailed breakdown of this process.
Cost Behavior
Cost behavior is categorized as variable, fixed, semivariable, and step cost.
Variable Costs
Variable costs change in proportion to the level of production or service.
If the cost per unit is constant (1 per unit), the total variable cost increases linearly with the number of units.
Fixed Costs
Fixed costs remain constant regardless of the level of production or service.
Example: Rent of 10,000 per month remains the same, regardless of production levels.
Semivariable Costs
Semivariable costs have both fixed and variable components.
Example: Utilities might have a fixed monthly charge plus a variable charge based on usage.
Step Costs
Step costs remain constant within a range of activity but increase in steps as activity levels rise.
These costs increase at certain levels.
Example: In the oil and gas industry, one manager can supervise 10 wells. If more wells are drilled, additional managers are needed, causing a step increase in supervisory costs.
Conclusion
Understanding different types of costs and their behavior is essential in cost accounting.