Full Costs and Their Uses
Cost & Cost Object


Cost = a measurement, in monetary
terms, of the amount of resources used
for some purpose.
Cost object = the product, project,
organizational unit, or other activity or
purpose for which costs are measured.

Can be defined broadly or narrowly, e.g.,
one pair of jeans or a batch of a single
style of jeans.
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Cost Concepts

Full cost = all the resources used for a
cost object = direct costs + fair share
of indirect costs.

Technically should include both production
and non-production costs


Marketing
Administrative
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Direct Costs

Direct costs of a cost object = items of
costs that are specifically traced to, or
caused by, that cost object.
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Indirect Costs

Costs that are associated with or
caused by, 2 or more cost objects
jointly but are not directly traced to
each of them individually.


Not possible or feasible to trace directly to
a cost object.
Terms direct and indirect are only
meaningful in the context of a specific
cost object.
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Conversion Costs




Direct labor costs of a cost object = labor
quantities * unit price of direct labor.
Usually only DM & DL are direct costs.
Overhead costs = all indirect production
costs.
Conversion costs = direct labor cost +
overhead cost = all production costs needed
to convert direct material into finished goods.
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Uses of full costs




Financial reporting: inventory/COGS.
Analysis of profitability: by product.
product line, plant, division, sales
territory.
Cost plus contracts.
Pricing
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Product Pricing


Setting regulated prices: utilities, cable.
Product pricing.

Differentiated product: Normal price = direct costs
+ applicable indirect costs + profit.


Target pricing = price set and then product designed to
cover full cost + profit, e.g., apparel industry.
Undifferentiated product = commodities.

Company does not set price, market does.
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Product Costing Systems

2 basic types of costing systems:


Job order
Process
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Job Order Cost System


Collects costs for each job as it moves
through the production process.
Each job: separate identification number and
entered on a separate job cost record.



DM entered from material requisitions releasing
materials from stockroom.
DL entered from employee time records.
Overhead charged using departmental rates.
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Process Cost System


Collects costs by process (i.e.,
department).
Determine unit costs by dividing total
costs by total number of units worked
on in the period.

Difficult part is determining how many
units were worked on.

What do you do with partially completed units?
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Direct & Indirect vs.
Variable & Fixed



Some variable costs are direct costs.
Some fixed costs are indirect costs.
Direct vs indirect:



Refers to traceability.
Accounting concept.
Variable vs. fixed:


Refers to cost behavior.
Economic concept.
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Allocation of Indirect Costs



Desirable to classify a cost as direct.
Assignment of indirect costs to product
is more roundabout and less accurate.
Reasons for not tracing directly:


Impossible to do so; Not feasible because
it is too costly; Mgmt chooses not to do so.
How to determine fair share of indirect
costs?

Based on causal relationship.
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Allocation of Indirect Costs

Process of assigning indirect costs to
individual cost objects.


Overhead rate = means of allocating
indirect costs to products.
All costs are assigned to cost objects.

Costs are assigned directly or

Or indirectly, that is, allocated.
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Cost and Responsibility Centers

Cost center = cost object for which costs of
one or more related functions or activities are
accumulated.




In a product costing system, items of indirect
(overhead) cost are first accumulated in cost
centers and then assigned to products.
Cost center = intermediate cost object.
Product is a final cost object.
Responsibility center = an organization unit
headed by a manager.

Could be one or more cost centers.
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Types of Cost Centers

Production cost center:



Produces a product or a component or
Performs a distinct step or task of production.
Service cost center = all other cost centers.

Provides services to production cost centers, to other
cost service centers, or for benefit of the
organization as a whole.


e.g., maintenance department, general factory office,
occupancy cost center.
Also called indirect cost pools or overhead pools.
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Calculating Overhead Rates



Series of steps
Direct materials and direct labor costs
are assigned directly to product costs.
Allocation of overhead costs to product
cost objects involves 3 steps:



All overhead costs are assigned to
production (PC) or service centers (SC).
SC costs are reassigned to PCs.
Costs allocated to products from PCs.
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First Allocation Step

All overhead costs for an accounting
period are assigned to the service and
production cost centers.


Some costs are directly charged to center.
Overhead costs that benefit several centers
are jointly allocated to those centers.
Examples of allocation bases:

Square footage, headcount.
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Second Allocation Step

Cost accumulated in each service cost
center is reassigned to production cost
centers.

Step down order:

Allocating service costs in a prescribed order
(following assumes 2 service cost centers).


First allocate either the costs of the service center
that provides the most services to other cost centers
or the costs of the service center that receives the
fewest services from other service centers.
Then allocate costs of remaining service cost center
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Final Allocation Step

Allocate from production cost centers to
products that pass through.


In a process cost system: Overhead per unit = total
overhead divided by the number of equivalent units.
In a job cost system: overhead is assigned to product by
using some activity measure (e.g., direct labor hours,
machine hours).
 Rate is determined by dividing total overhead costs by
the activity measure.
 For each job, overhead costs are allocated to it or
applied to it or absorbed by it by multiplying the activity
measure by the rate.
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Cost Drivers (allocation bases)

Causal relationship between cost & object.




Payroll related (social security taxes, fringe
benefits).
Headcount related (Human resource related).
Material related (purchasing receiving).
Space related (facility related).
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Establishing Predetermined Rates

Prepare overhead budgets for various levels
of activity.




Identify costs as variable, fixed, semi-variable.
Estimate average level of activity expected in
each cost center for the coming year.
Calculate each production center’s overhead
rate by dividing budgeted overhead cost at
standard volume by standard volume.
Some companies use a plant wide overhead
rate instead of by production cost center.
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Why Use Predetermined
Overhead Rates?



Actual monthly rates are unduly
affected by conditions peculiar to the
month.
Permits more prompt calculation of
product costs.
Calculating once a year is less effort
than going through the calculation
every month.
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Under-absorbed and Overabsorbed Overhead


Actual overhead costs are charged to cost
center overhead clearing account.
Overhead clearing account is reduced for the
amounts determined from predetermined
overhead rate.



Amount absorbed by product > actual costs,
overhead is over-absorbed (under-absorbed).
If overhead is over-absorbed (under-absorbed),
there is a credit (debit) balance in the overhead
clearing account.
This balance is transferred to Overhead variance
account. Adjusts COGS or Inv.
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Accuracy of Costing


GAAP requires aggregate inventory and
COGS (not by product), to be materially
accurate.
For better decision making:

Some companies use activity based costing
primarily to estimate costs for
profitability analysis.
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Cross Subsidies

If actual cost structure is complex and a
simple overhead allocation approach is
used, some products costs will be
understated and some overstated.
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Steps of Activity Based Costing



Many more service center cost pools
(called activities or activity centers) are
created.
Activity’s costs can be assigned directly
to product rather than through a
production cost center.
Each activity is allocated based on the
cost driver determined to be most
appropriate for that pool of costs.
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Steps in an ABC Costing
Approach




Cost drivers are identified for each activity.
All costs for the period are assigned either
directly to the product (e.g., direct material)
or to a cost pool associated with each activity
and cost driver.
Costs are assigned to the product based on
the cost driver.
Cost per unit are determined by dividing the
total costs assigned to the product by the
number of units of product.
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