1
Chapter 3
Cost Assignment
Introduction 2
• In this chapter we are going to
concentrate on:
• Allocating costs between cost of goods sold
and inventories for internal and external profit
reporting and
• Providing relevant decision-making
information for distinguishing between
profitable and unprofitable activities.
• In order to perform the above functions a
cost accumulation system is required
that assigns costs to cost objects.
Introduction 3
• Cost object is anything for which a separate
measurement of cost is desired. Typical cost
objects include products, services, customers and
locations.
• We shall concentrate on how costs are assigned
to products in manufacturing firms that produce
unique products in batches and where the
products incur different costs resulting in the
need to keep track of the cost of each product or
batch.
• This cost assignment system is referred to as a
job-order costing system.
ASSIGNMENT OF DIRECT
AND INDIRECT COSTS 4
• Costs that are assigned to cost objects can be
divided into two categories:
• Direct costs and indirect costs.
• Sometimes the term overheads is used instead of
indirect costs. Direct costs can be accurately traced to
cost objects because they can be specifically and
exclusively traced to a particular cost object whereas
indirect costs cannot.
• Where a cost can be directly assigned to a cost
object the term direct cost tracing is used.
ASSIGNMENT OF DIRECT
AND INDIRECT COSTS 5
• A cost allocation is the process of assigning
costs when the quantity of resources
consumed by a particular cost object cannot
be directly measured.
• Cost allocations involve the use of surrogate
rather than direct measures.
• The basis that is used to allocate costs to
cost objects is called an allocation base or
cost driver.
ASSIGNMENT OF DIRECT
AND INDIRECT COSTS 6
• Where allocation bases are significant
determinants the terms cause-and
effect allocations or driver tracing are
used.
• Where a cost allocation base is used that
is not a significant determinant of its cost,
the term arbitrary allocation is used.
ASSIGNMENT OF DIRECT
AND INDIRECT COSTS 7
ASSIGNMENT OF DIRECT
AND INDIRECT COSTS 8
• A direct costing system (also known as
a marginal or variable costing system)
assigns only direct costs to cost objects.
• an absorption costing system assigns
both direct and indirect costs to cost
objectives.
• Absorption costing systems can be sub-divided
into traditional costing systems and
activity-based-costing (ABC) systems.
DIFFERENT COSTS FOR
DIFFERENT PURPOSES 9
• Manufacturing organizations assign costs to
products for two purposes:
• First, for internal profit measurement and external
financial accounting requirements in order to
allocate the manufacturing costs incurred during a
period between cost of goods sold and inventories;
• Second, to provide useful information for
managerial decision-making requirements.
• For decision-making purposes, however, more
accurate product costs are required so that
we can distinguish between profitable and
unprofitable products.
DIFFERENT COSTS FOR
DIFFERENT PURPOSES 10
• For meeting external financial accounting
requirements, financial accounting regulations
and legal requirements in most countries
require that inventories should be valued at
manufacturing cost. Therefore, only
manufacturing costs are assigned to products
for meeting external financial accounting
requirements.
• For decision-making, non-manufacturing costs
must be taken into account and assigned to
products. Not all costs, however, may be
relevant for decision-making.
COST-BENEFIT ISSUES AND
COST SYSTEMS DESIGN 11
ASSIGNING DIRECT COSTS
TO COST OBJECTS 12
• Both simplistic and sophisticated systems
accurately assign direct costs to cost objects.
• Consider direct labour. The time spent on
providing a service to a specific customer, or
manufacturing a specific product, is recorded on
source documents, such as time sheets or job
cards. Details of the customer’s account
number, job number or the product’s code are
also entered on these documents. The
employee’s hourly rate of pay is then entered so
that the direct labour cost for the employee can
be assigned to the appropriate cost object.
ASSIGNING DIRECT COSTS
TO COST OBJECTS 13
• For direct materials the source document is a materials
requisition. Details of the materials issued for
manufacturing a product, or providing a specific
service, are recorded on the materials requisition.
• The customer’s account number, job number or
product code is also entered and the items listed on
the requisition are priced at their cost of acquisition.
• The details on the material requisition thus represent
the source information for assigning the cost of the
materials to the appropriate cost object.
• Assignment of direct costs to cost objects is a
straightforward process, whereas the assignment of
indirect costs is a more complex process.
PLANT-WIDE (BLANKET)
OVERHEAD RATES 14
• The most simplistic traditional costing system
assigns indirect costs (overheads) to cost
objects using a single overhead rate for the
organization as a whole, known as blanket
overhead rate or plant-wide rate.
• Let us assume that the total manufacturing
overheads for the manufacturing plant of
Arcadia are £9 million and that the company
has selected direct labour hours as the
allocation base for assigning overheads to
products.
PLANT-WIDE (BLANKET)
OVERHEAD RATES 15
• Assuming that the total number of direct
labour hours are 600 000 for the period,
the plant-wide overhead rate for Arcadia
is £15 per direct labour hour.
• The overhead costs are assigned to
products by multiplying the plant-wide
rate by the units of the selected
allocation base (direct labour hours) used
by each product.
PLANT-WIDE (BLANKET)
OVERHEAD RATES 16
• Assume now that Arcadia is considering
establishing separate overheads for each of
its three production departments.
• Further investigations reveal that the
products made by the company require
different operations and some products do
not pass through all three departments.
• These investigations also indicate that the £9
million total manufacturing overheads and
600 000 direct labour hours can be analyzed
as follows:
PLANT-WIDE (BLANKET)
OVERHEAD RATES 17
PLANT-WIDE (BLANKET)
OVERHEAD RATES 18
• Now consider a situation where product Z
requires 20 direct labour hours in department C
but does not pass through departments A and B.
• If a plant-wide overhead rate is used then
overheads of £300 (20 hours at £15 per hour)
will be allocated to product Z. On the other
hand, if a departmental overhead rate is used,
only £100 (20 hours at £5 per hour) would be
allocated to product Z.
• Which method should be used?
THE TWO-STAGE
ALLOCATION PROCESS 19
• To establish departmental overhead rates, an
approach known as the two-stage
allocation process, is used. This process
applies to assigning costs to other cost
objects, besides products, and is applicable
to all organizations that assign indirect costs
to cost objects.
• The approach applies to both traditional and
ABC systems.
• The two-stage allocation process is
illustrated in Figure 3.3.
THE TWO-STAGE
ALLOCATION PROCESS 20
THE TWO-STAGE
ALLOCATION PROCESS 21
THE TWO-STAGE
ALLOCATION PROCESS 22
• The first stage overheads are assigned to
cost centres (also called cost pools). The
terms cost centres or cost pools are used
to describe a location to which overhead
costs are initially assigned.
• In the second stage the costs
accumulated in the cost centres are
allocated to cost objects using selected
allocation bases.
THE TWO-STAGE
ALLOCATION PROCESS 23
• Within the two-stage allocation process
ABC systems differ from traditional
systems by having a greater number of
cost centres in the first stage and a
greater number, and variety, of cost
drivers or allocation bases in the second
stage.
AN ILLUSTRATION OF THE TWO-
STAGE PROCESS 24
• Example 3.1 (practically solved on the
whiteboard) to provide a more detailed
illustration of the two-stage allocation
process for a traditional costing system.
• To keep the illustration manageable it is
assumed that the company has only five
cost centres – machine departments X
and Y, an assembly department and
materials handling and general factory
support cost centres.
Step 1 – Assigning all manufacturing
overheads to production and service 25
cost centres
• The term first stage allocation bases is
used to describe allocations at this point.
The following list summarizes commonly
used first stage allocation bases:
Step 2 – Reallocating the costs assigned
to service cost centres to production cost 26
centres
• The next step is to reallocate the costs that have been
assigned to service cost centres to production cost centres.
• We shall assume that the value of materials issued (shown in
Example 3.1) provides a suitable approximation of the benefit
that each of the production centres receives from materials
procurement.
• It is also assumed that direct labour hours provides an
approximation of the benefits received by the production
centres from general factory support resulting in the total costs
for this centre being reallocated to the production centres
proportionate to direct labour hours.
Step 3 – Computing separate
overhead rates for each production 27
cost centre
• The allocation bases most frequently used by traditional
costing systems for computing production cost centre rates,
are based on the amount of time products spend in each
production centre – for example direct labour hours,
machine hours and direct wages.
• In respect of non-machine centres, direct labour hours is the
most frequently used allocation base. This implies that the
overheads incurred by a production centre are closely
related to direct labour hours worked.
• We shall assume that the Enterprise Company uses a
machine hour rate for the machine production centres and
a direct labour hour rate for the assembly centre.
AN ILLUSTRATION OF THE TWO-STAGE PROCESS 28
AN ILLUSTRATION OF THE TWO-STAGE PROCESS 29
Step 3 – Computing separate
overhead rates for each production 30
cost centre
Step 4 – Assigning cost centre
overheads to products or other 31
chosen cost objects
• The final step is to allocate the overheads to products passing
through the production centres.
• We shall compute the manufacturing costs of two products.
• Product A is a low sales volume product with direct costs of
£100. It is manufactured in batches of 100 units and each unit
requires 5 hours in machine centre A, 10 hours in machine
centre B and 10 hours in the assembly centre.
• Product B is a high sales volume product thus enabling it to be
manufactured in larger batches. It is manufactured in batches
of 200 units and each unit requires 10 hours in machine centre
A, 20 hours in machine centre B and 20 hours in the assembly
centre. Direct costs of £200 have been assigned to product B.
Step 4 – Assigning cost centre
overheads to products or other
chosen cost objects
32
EXTRACTING RELEVANT COSTS
FOR DECISION-MAKING 33
• Relevance of Costs
• Some costs (e.g., property taxes, depreciation) are irrelevant for
decisions like product discontinuation.
• Non-Manufacturing Costs
• Include non-manufacturing costs in pricing and profitability decisions .
• Overhead Allocation
• Overhead costs must be coded flexibly for different decision
contexts.
• Tailored Cost Information
• Adjust cost data for specific decisions (e.g., pricing vs.
discontinuation). For example, when determining the selling price for
a product, overhead costs must be factored in.
BUDGETED OVERHEAD
RATES 34
Challenges of Using Actual Overhead
Rates
• - Delayed product cost calculations (end of
period)
• - Monthly rates fluctuate due to fixed costs &
variable activity
• - Seasonal expenses (e.g., heating) create
unfair cost allocations
Why Use Budgeted
Overhead Rates?
• - Provides a stable, representative cost allocation
• - Based on annual estimated overhead & activity
• - Supports timely decision-making (pricing,
inventory valuation)
• - Aligns with industry best practices
Key Approach
• Instead of using actual production levels, which
fluctuate monthly, businesses should use a
consistent, predetermined activity level
• This helps achieve more reliable and comparable
cost allocations across different periods.
• By using an annual budgeted overhead rate,
companies avoid large fluctuations in costs due to
seasonal variations or unexpected changes in
production.
• This results in smoother pricing, better cost
control, and fairer inventory valuation.
Under- and Over-Recovery of
Overheads
• - Differences between actual and budgeted
activity cause under- or over-recovery.
• - Example: If actual activity is lower than
estimated, overheads are under-recovered.
• - If actual overheads are lower but activity
remains the same, overheads are over-
recovered.
• - This difference is known as **volume
variance**.
Accounting Treatment of
Over/Under-Recovery
• - Accounting standards (SSAP 9, IAS 2) require
overheads to be based on normal activity.
• - Any under- or over-recovery should be written
off in the current year.
• - Under-recovery is recorded as an **expense**.
• - Over-recovery is recorded as a **reduction in
expenses**.
UNDER- AND OVER-
RECOVERY OF OVERHEADS 39
• EXAMPLE: Consider a situation where the estimated
annual fixed overheads are £2 000 000 and the
estimated annual activity is 1 000 000 direct labour
hours. The estimated fixed overhead rate will be £2
per hour. Assume that actual overheads are £2 000
000 and are therefore identical with the estimate, but
that actual activity is 900 000 direct labour hours
instead of the estimated 1 000 000 hours. In this
situation only £1 800 000 will be charged to
production. This calculation is based on 900 000 direct
labour hours at £2 per hour, giving an under-recovery
of overheads of £200 000.
UNDER- AND OVER-
RECOVERY OF OVERHEADS 40
• EXAMPLE: Consider an alternative situation where the actual
overheads are £1 950 000 instead of the estimated £2 000 000,
and actual activity is 1 000 000 direct labour hours, which is
identical to the original estimate.
• In this situation 1 000 000 direct labour hours at £2 per hour will be
charged to production giving an over recovery of £50 000.
• This example illustrates that there will be an under- or over-
recovery of overheads whenever actual activity or overhead
expenditure is different from the budgeted overheads and
activity used to estimate the budgeted overhead rate.
• This under- or over-recovery of fixed overheads is also called a
volume variance.
