Measuring Cost of
Product/Service
Direct VS Indirect Cost
• Direct Cost needs no specific treatment as it
can be traced to the product/service (cost
object) directly
• Indirect cost however needs to be divided
among the cost objects
General Framework for Cost Allocation
• Direct costs can be physically traced to each
department.
• Indirect costs must be allocated.
Process of Cost Allocation
• Cost allocation is achieved by a three step
process
1. Determine the cost object (objective)
2. Form cost pools
3. Select a cost driver (allocation base) to relate
cost pools to the cost objective
4. Compute the Allocation Rate
5. Allocate Costs
Example
Standard
No. of units
Sales
Direct Costs
Indirect Costs:
- Depreciation
- Other Manf. overheads
- Rent
- Administration
Total Indirect Costs
Profit
Area Occupied (Sq.ft)
Machine Hours
1.
20,000
2,00,00,000
1,40,00,000
Customized
5,000
1,50,00,000
75,00,000
Total
25,000
3,50,00,000
2,15,00,000
35,00,000
25,00,000
14,00,000
16,00,000
90,00,000
45,00,000
8,000
2 per unit
4,000
10 per unit
Depreciation and Manufacturing overheads pertains mostly to usage of
machineries and equipment.
2. Rent and Administration cost be related to the area occupies by two
product lines.
Allocate the indirect cost on two products. Compute the Total Cost and Cost
per unit of both the products
Process of Cost Allocation
• Step 1 – determine the cost object
– Determine the product, service, or department
that is to receive the allocation
– For example, if computer costs are allocated to
contracts worked on, the contracts are the cost
objectives
Process of Cost Allocation
• Step 2 – form cost pools
– A cost pool is a grouping of individual costs whose
total is allocated using one allocation base/ cost
driver
– Cost pools can be organized along departmental
lines or major activities, e.g. equipment setups,
inspections etc.
• Costs in the pool must be homogeneous (similar)
Process of Cost Allocation
• Step 3 – Select a cost driver (or allocation base) that
relates the cost pool to the cost objectives
– The base must be some characteristic that is common to
all of the cost objectives
– Deciding which base to use is not easy
• The allocation should be based on a cause-and-effect
relationship
Process of Cost Allocation
• Step 4 – Compute the Allocation Rate
– Allocation rate is indirect costs or overhead per
unit of the cost driver (resources).
– For example, if the cost driver is Labour Hours,
cost allocation rate is computed by dividing the
indirect costs by total labour consumed by all the
cost obejcts
– Allocation rate is referred to as Overhead Rate, or
Burden Rate
Process of Cost Allocation
• Step 5 –Allocate the costs
– It is process of finally allocating by multiplying the
allocation rate with the consumption of the cost
driver (resource) by respective cost object.
Select an Allocation Base
• Two products : Standard and Customized
– Indirect manufacturing costs of $2,00,000 need to be
allocated
– Should labor hours or machine hours be used as the
allocation base?
Labour Hours Allocation Machine Hours
Allocation
Standard
20,000
80,000
11,000
110,000
Customized
30,000
120,000
9,000
90,000
Total
50,000
200,000
20,000
200,000
Allocation Rate
4
10
Example
Dragon Fire Hot Sauce makes two types of hot sauces—meek and mild.
Budgeted information for the two flavors appears below:
NO. of units
Sales
Direct materials
Direct labor cost
Labor rate per hour
Meek
9,000
$600,000
$100,000
$108,000
$12.00
Mild
7,500
$400,000
$120,000
$180,000
$12.00
The company estimates it will incur $345,600 in overhead costs for the
period. Dragon Fire allocates overhead cost to products based on the labor
hours worked on each product. How much is the total overhead allocated
to Meek and Mild? What is the total cost for both the products? What is
the total per unit cost for both products?
ALLOCATIONS:
INCENTIVE EFFECTS
Behavior Modification
• Allocations modify behavior
– Can induce desired actions
– Make undesired actions costly
• Allocation is like a “tax”
– Increases the cost of the driver unit
• If “price” increases, demand decreases
– Allocate on labor hours / labor cost
• Reduce demand for labor
– Allocate based on materials cost
• Incentives to in-source
Allocations and Behavior
• We can use this property to
– Sensitize users to the long-term cost of a resource
• Cost of support departments such as IT are allocated even if
“fixed” in the short term
– Discourage undesired behavior
• Use some measure correlated with use as the basis
• Use will go down as the “price” for the measure has increased
– Encourage desired behavior
• Suppose we want to tradeoff labor for materials cost
• Using labor as an allocation basis provides the incentives to
employees