Building-Block Concepts of Costing Systems

Learning Objective 1 Describe the building-block concepts of costing systems

• the building blocks are cost object, direct costs, indirect costs, cost pools, and cost-allocation bases

Before we begin our discussion of costing systems, let’s review the cost-related terms from Chapter 2 and introduce some new terms.

1. A cost object is anything for which a measurement of costs is desired—for example, a product, such as an iMac computer, or a service, such as the cost of providing a knee replacement surgery.
2. The direct costs of a cost object are costs that are directly related to a particular cost object and that can easily and unambiguously be traced to it —for example, the implants needed for a knee replacement surgery.
3. The indirect costs of a cost object are costs that are related to a particular cost object but that cannot easily and unambiguously be traced to it —for example, the salaries of supervisors who oversee multiple products, only one of which is the iMac, or the depreciation of a hospital facility where many different types of healthcare services are performed. Indirect costs are allocated to the cost object using a cost-allocation method. Recall that cost assignment is a general term for assigning costs, whether direct or indirect, to a cost object. Cost tracing is the process of assigning direct costs. Cost allocation is the process of assigning indirect costs. The relationship among these three concepts can be graphically represented as

1. We also need to introduce and explain two more terms to understand costing systems:

4. Cost pool. A cost pool is a grouping of individual indirect cost items. Cost pools can range from broad, such as all manufacturing-plant costs, to narrow, such as the costs of operating metal-cutting machines. The cost items in a cost pool have the same cost-allocation base and they are grouped together and allocated to cost objects. Cost pools thus simplify the allocation of indirect costs because the separate cost items do not have to be allocated individually.
5. Cost-allocation base. How should a company allocate the costs of operating metal-cutting machines among the different products that are manufactured on them? One way is to determine the number of machine-hours that are used to manufacture the different products. The cost-allocation base (number of machine-hours) is a systematic way to link an indirect cost or group of indirect costs (operating costs of all metal-cutting machines) to cost objects (different products). For example, if the indirect costs of operating metal-cutting machines is $500,000 based on running these machines for 10,000 hours, the cost-allocation rate is  per machine-hour, where machine-hours is the cost-allocation base. If a product uses 800 machine-hours, it will be allocated $50 per $\text{machine}‐\text{hour}\times 800 \text{machine}‐\text{hours}=\mathrm{\$}\text{40,000}.$ The ideal cost-allocation base is the cost driver of the indirect costs because there is a cause-and-effect relationship between the cost driver and the indirect costs. A cost-allocation base can be either financial (such as direct labor costs) or nonfinancial (such as the number of machine-hours). 

1. Sometimes a cost may need to be allocated in a situation where the cause-and-effect relationship is not clear-cut. Consider a corporate-wide advertising program that promotes the general image of a company and its various divisions and products, rather than the image of an individual product. Many companies, such as PepsiCo, allocate costs like these to their individual divisions and products on the basis of revenues: The higher a division’s revenue, the higher the allocated costs of the advertising program. Allocating costs this way is based on the criterion of benefits received rather than cause-and-effect. Divisions with higher revenues benefit from the advertising program more than divisions with lower revenues and, therefore, are allocated more of the advertising costs.

1. Another criterion for allocating some costs is the cost object’s ability to bear the costs allocated to it. The city government of Houston, Texas, for example, distributes the costs of the city manager’s office to other city departments—including the police department, fire department, library system, and others—based on the size of their budgets. The city’s rationale is that larger departments should absorb a larger share of the overhead costs. Organizations generally use the cause-and-effect criterion to allocate costs, followed by benefits received, and finally, and more rarely, by ability to bear.

The concepts represented by these five terms constitute the building blocks we will use to design the costing systems described in this chapter.