1.WHAT IS COST?

Cost is the amount of money, time, or effort required to obtain something. Cost is the sum of
explicit and implicit as well as other types of cost used to produce or acquire something. For
example, the cost of a car or a haircut, the cost of buying raw material to produce different
kind of output, salaries .wages, etc.

In accounting, cost is the expenditure required to create and sell products and services, or to
acquire assets. When a cost is designated as an expense, it can be assigned to a wide range of
possible expenses, such as: Cost of goods sold, Selling expenses, General and administrative
expenses, and Financing costs. In addition to this cost is the monetary value of expenditures
for supplies, services, labor, products, equipment and other items purchased for use by a
business or other accounting entity it is the amount denoted on invoices as the price and
recorded in book keeping records as an expense or assets cost basis.

Cost is the expenditure required to create and sell products and services, or to acquire assets.
When sold or consumed, a cost is charged to expense. In the case of an asset, the charge to
expense could be significantly deferred. The cost concept underlies the transition of assets
from the balance sheet to expenses in the income statement. When a cost is designated as an
expense, it can be assigned to a wide range of possible expenses, such as:

Cost accounting is a tool used by managers and decision makers to identify inefficiencies and
apply improvements to control costs. Cost accounting uses the same information as financial
accounting, but interprets it differently to help guide internal decisions.
 Cost of goods sold
 Selling expenses
 General and administrative expenses
 Financing costs

Thus, the nature of a cost drives the type of expense to which it is eventually assigned

2.Classification of Costs

Classification of Costs on The Basis of Their Common Characteristics are:

 By Nature or Elements
 By Functions
 By Identifiably
 By Variability
 By Controllability

1
 By Normality
 Other Costs

BY NATURE OR ELEMENT

MATERIAL:COST Cost of materials used for the manufacture of a product, a particular

work order, or provision of a service. Example: Cloth for making a dress, stores used for
maintaining machines and buildings such as lubricants, cotton waste, bricks etc.

LABOUR COST: Labour cost is defined as the total Expenditure borne by employers in
order to employ workers. Labour costs include the direct costs linked to remuneration for
work carried out such as direct remuneration, bonuses and ex gratia payments not paid at
each pay period, payments for days not worked, severance pay, benefits in kind. They also
include indirect costs linked to employees, independently of the remuneration paid by the
employer, such as direct social benefits, vocational training

EXPENSES: Expense is defined as money expended or cost incurred in a firm's efforts to

generate revenue, representing cost of doing business. They may be in the form of actual cash
payments (such as wages and salaries), a computed 'expired' portion (depreciation) of an
asset, or an amount taken out of the firm's earnings (such as bad debts). Whereas all expenses
are costs, not all costs (such as those incurred in acquisition of income generating assets) are
expenses.

By Functions

PRODUCTION COST: The cost of the sequence of operations which begins with supplying
materials, labour and services and ends with primary packing of the product. Thus it includes
the cost of direct materials, direct labour, direct expenses and factory overheads.

SELLING COST: The cost seeking to create and stimulate demand (sometimes termed
„marketing‟) and of securing orders.

DISTRIBUTION COST: The cost of the sequence of operations which begins with making
the packed product available for dispatch and ends with making the reconditioned returned
empty package, if any available for re-use. It also includes expenditure incurred in
transporting articles to central or local storage as well as in moving articles to and from
prospective customers as in case of goods on sale or return basis. In gas, electricity and water
industry distribution means pipes, mains and services which may be regarded as the
equivalent of packing and transportation.

2
ADMINISTRATIVE COST: The Cost of formulating the policy, directing the organization
and controlling the operations of an undertaking which is not related directly to a production,
selling and distribution, research or development activity or function.

RESEARCH COST: The cost of researching for new or improved products, new applications
of materials, or improved methods

DEVELOPMENT COST: The cost of the process which begins with the implementation of a
decision to produce a new or improved product or to employ a new or improved method and
ends with commencement of formal production of that product or by that method.

PRE-PRODUCTIONCOST: The part of development cost incurred in making a trial

production run preliminary to formal product.  This term is sometimes used to cover all
activities prior to production including Research & Development, but in such cases the usage
should be made clear in the context

CONVERSION COST: The sum of direct wages, direct expenses and overhead cost of
converting raw materials to the finished stage or converting a material from one stage of
production to the next.

In some cases this also includes any excess material cost or loss of material incurred at the
particular stage of production.

PRODUCT COST: These are inventorial cost. These are the costs which are assigned to the
product. Under marginal costing variable manufacturing cost and under absorption costing,
total manufacturing cost constitutes product cost.

BY IDENTIFIABLITY

DIRECT COST: The expenses on material and labour economically and easily traceable to a
product, service or job are considered as direct costs. In the process of manufacture or
production of articles, materials are purchased, labourers are employed and the wages are
paid to them, certain other expenses are also incurred directly. Since all these take an active
and direct part in the manufacture of a particular commodity, hence are called direct costs.

Example: Cost of meat in a burger

INDIRECT COST: The expenses incurred on those items which are not directly chargeable
to production are known as indirect costs. Example: In production, salaries of timekeepers,
storekeepers, foremen are paid, certain expenses for running the administration are incurred.
All of these cannot be conveniently allocated to production and hence are called indirect costs

FIXED COST: The cost which does not vary but remains constant within a given period of
time and range of activity in spite of the fluctuations in production, is known as fixed cost.

3
Example: rent, insurance of factory buildings etc. remain the same for different levels of
production.

VARIABLE COST: These costs tend to vary with the volume of output. Any increase in the
volume of production results in an increase in the variable cost and vice versa.

Example: cost of material, cost of labour etc.

Semi-variable Cost: The cost which does not vary proportionately but simultaneously cannot
remain stationery at all times is known as semi variable cost. It can also be called as semi-
fixed cost.

Example: Depreciation, repairs etc.

STEP COSTS: Fixed cost can be further classified into committed fixed costs and
discretionary fixed costs

Committed fixed costs are unavoidable in the short term if the organization has to function.
Examples are depreciation, rent, pay etc.

Discretionary fixed costs are those which are set at a fixed amount for specific time periods
by management. Examples are research and development costs, advertisement and market
research expenses

Certain costs remain fixed over a range of activity and then jump to a new level as activity
changes. Such costs are treated as “Step Costs”.

Example: A foreman is in a position to supervise a given number of employees. Beyond this

number it will be necessary to hire a second then a third and so on.

BY CONTROLABILITY

CONTROLLABLE COSTS: These are the costs which can be influenced by the action of a
specified member of an undertaking. A business organization is usually divided into a
number of responsibility centres and each centre is headed by an executive. The executive
can thus control the costs incurred in that particular responsibility centre.

UNCONTROLLABLE COSTS: Costs which cannot be influenced by the action of a

specified member of an undertaking. Example: Expenditure incurred by the tool room is
controllable by the foreman in charge of that section but the share of the tool room
expenditure which is apportioned to a machine shop is not to be controlled by the machine
shop foreman.

By Normality

4
 NORMAL COSTS: It is the cost which is normally incurred at a given level of output under
the conditions in which that level of output is normally attained.

ABNORMAL COST: It is the cost which is not normally incurred at a given level of output
in the conditions in which that level of output is normally attained. This is charged to Costing
P&LA/c

Other Cost

 Product Costs and Period Costs

 Decision making Costs and Accounting Costs
 Relevant and Irrelevant Costs
 Shutdown and Sunk Costs
 Avoidable / Escapable and Unavoidable / Inescapable
 Imputed or Hypothetical Costs
 Differential, Incremental or Decrement cost
 Out of Pocket Costs
 Traceable, Untraceable Costs

PRODUCT COSTS: Costs which become part of the cost of the product rather than an
expense of the period in which they are incurred are called as “Product Costs”. In financial
statements such costs are treated as assets until the goods they are assigned to are sold. They
become an expense at that time. These costs may be fixed as well as variable.

Example: Cost of raw materials and direct wages, depreciation on plant & equipment etc.

PERIOD COSTS: Costs which are not associated with production are called “Period Costs”.
They are treated as an expense of the period in which they are incurred. They may also be
fixed as well as variable. Such costs include General Administration costs, Salesman salaries
and commission, depreciation on office facilities etc. They are charged against the revenue of
the relevant period.

DECISIONMAKING COSTS: These are special purpose costs that are applicable only in the
situation in which they are compiled. They have no universal application. They need not tie
into routine financial accounts. They do not and should not conform to the accounting rules.

ACCOUNTING COSTS: These costs are compiled primarily from financial statements. They
have to be altered before they can be used for decision making. Moreover they are historical
costs and show what has happened under an existing set of circumstances, while decision
making costs are future costs

Example: Accounting costs may show the cost of the product when the operations are
manual, while decision making costs might be calculated to show the costs when the
operations are mechanised.

5
RELEVANT & IRRELEVANT COST: Relevant costs are those costs which would be
changed by the managerial decision, while irrelevant costs are those which would not be
affected by the decision.

Example: If a manufacturer is considering closing down of an unprofitable retail sales shop,

wages payable to the workers of the shop are relevant in this connection since they will
disappear on closing down of the shop. But prepaid rent for the shop or unrecovered costs of
any equipment which will have to be scrapped, will be irrelevant costs which must be
ignored.

SHUTDOWN COSTS: A manufacturer or an organization rendering service may have to

suspend its operations for a period on account of some temporary difficulties such as shortage
of raw materials, non availability of labour etc. During this period though no work is done yet
certain fixed costs such as rent and insurance of buildings, depreciation etc. for the entire
plant will have to be incurred. Such costs of the idle plant are known as shut down costs.

SUNK COSTS: These are costs which have been created by a decision that was made in the
past that cannot be changed by any decision that will be made in the future. Investment in
plant & machinery are prime examples of such costs. Since sunk costs cannot be altered by
later decisions, they are irrelevant for decision making.

IMPUTED OR HYPOTHETICAL COSTS: These are costs which do not involve any cash
outlay. They are not included in cost accounts but are important for taking into consideration
while making management decisions.

Examples: Interest on internally generated funds, salaries of the proprietor or partner of a

partnership firm, rented value of company’s own property etc. When two projects require
unequal outlays of cash, the management must take into consideration interest on capital for
judging the relative profitability of the projects though the company may use internally
generated funds for the purpose.

DIFFERENTIALCOSTS: The difference in total costs between two alternatives is termed as

„differential costs‟. In case the choice of an alternative results in increase in total costs, such
increase in costs is known as „incremental costs.‟ In case the choice results in decrease in
total costs, such decrease in total costs is termed as decrement costs. While assessing the
profitability of a proposed change the incremental costs are matched with incremental
revenue and vice versa. The proposed change is taken only when it is profitable.

OUT-OF-POCKET COST: This means the present or future cash expenditure regarding a
certain decision which varies depending upon the nature of decision made.

Example: A company has its own trucks for transporting raw materials and finished products
from one place to another. It seeks to replace these trucks by employment of public carrier of
goods. In making this decision of course , the depreciation of the trucks is not to be

6
considered, but the management must take into account the present expenditure on fuel,
salary to drivers and maintenance. Such costs are termed as out- of-pocket expenses.

OPPORTUNITY COST: This cost refers to the advantage, in measurable terms, which has
been foregone on account of not using the facilities in the manner originally planned.

Example: If an owned building is proposed to be utilized for housing a new project plant, the
likely revenue which the building could fetch if rented out is the opportunity cost which
should be taken into account while evaluating the profitability of the that project.

TRACEABLE OR UNTRACEABLE COSTS: Costs which can be easily identified with a

department, process or product are termed as traceable costs. Example: the cost of direct
material, direct labour etc. Costs which cannot be so identified are termed as untraceable or
common costs.

In other words common costs are costs incurred collectively for a number of cost centres and
are to be suitably apportioned for determining the cost of individual cost centres. Example:
overheads incurred for a factory as a whole etc.

JOINT COSTS: These are a sort of common costs. When two or more products are produced
out of one and the same material or process, the costs of such material or process are called
joint costs.

Example: When cotton seeds and cotton fibre are produced from the same raw materials, the
cost incurred till split off or separation point will be joint costs.

COMMON COSTS: Common costs are those which are incurred for more than one product,
job, territory or any other specific costing unit. They are not capable of being identified with
individual product, and are therefore apportioned on a suitable basis. Example: Rent, lighting
and supervision costs are common costs to all departments located in the factory.

3.WHAT IS COST OBJECT AND COST DRIVER

A. COST OBJECT

It is the method of measuring the cost of the product, segment, customer, etc., separately so
as to determine the exact cost along with the determination of the selling price. Sometimes,
there is a requirement of law to maintain the cost records of the product based on the type of
product or the turnover of the product

A cost object refers to anything for which costs are measured and accumulated, typically for
the purpose of determining the total cost incurred in producing goods or delivering services.
Cost objects can vary widely depending on the context and requirements of the organization,
and they serve as focal points for cost analysis and allocation. Cost objects can be tangible
items such as products, services, projects, or departments, as well as intangible entities like

7
customers, distribution channels, or geographic regions. Essentially, any entity that consumes
resources or drives costs within an organization can be designated as a cost object.

The identification of cost objects is critical for accurately assigning costs to specific
activities, products, or services, enabling organizations to track and analyze the cost behavior
of various operations. By associating costs with specific cost objects, management gains
insights into the cost drivers and profitability of different aspects of the business, helping
them make decisions related to pricing, resource allocation, product mix, and performance
evaluation.

For example, in a manufacturing company, the cost object approval may be related to a
specific product line, allowing management to determine the total cost of producing each
product and evaluate its profitability. In a service-oriented business, the cost object could be a
particular client or project, helping management assess the profitability of individual
contracts or customer relationships.

Overall, cost objects play a fundamental role in cost accounting and management by
providing a framework for analysing and understanding the costs associated with various
aspects of the business. By effectively identifying and defining cost objects, organizations
can improve cost transparency, optimize resource allocation, and make more strategic
decisions to enhance profitability and efficiency. In addition to the above explanation cost
Object is the method of measuring the cost of the product, segment, customer, etc., separately
so as to determine the exact cost along with the determination of the selling price.
Sometimes, there is a requirement of law to maintain the cost records of the product based on
the type of product or the turnover of the product. A cost object refers to anything for which
costs are measured and accumulated, typically for the purpose of determining the total cost
incurred in producing goods or delivering services. Cost objects can vary widely depending
on the context and requirements of the organization, and they serve as focal points for cost
analysis and allocation. Cost objects can be tangible items such as products, services,
projects, or departments, as well as intangible entities like customers, distribution channels,
or geographic regions. Essentially, any entity that consumes resources or drives costs within
an organization can be designated as a cost object. The identification of cost objects is critical
for accurately assigning costs to specific activities, products, or services, enabling
organizations to track and analyse the cost behaviour of various operations. By associating
costs with specific cost objects, management gains insights into the cost drivers and
profitability of different aspects of the business, helping them make decisions related to
pricing, resource allocation, product mix, and performance evaluation. For example, in a
manufacturing company, the cost object approval may be related to a specific product line,
allowing management to determine the total cost of producing each product and evaluate its
profitability. In a service-oriented business, the cost object could be a particular client or
project, helping management assess the profitability of individual contracts or customer
relationships. Overall, cost objects play a fundamental role in cost accounting and
management by providing a framework for analysing and understanding the costs associated
with various aspects of the business. By effectively identifying and defining cost objects,

8
 organizations can improve cost transparency, optimize resource allocation, and make more
strategic decisions to enhance profitability and efficiency.

In budgeting, the cost object is very useful, as the price of products is fluctuating as per the
market situations. Hence large organizations prepare the budgets so as to draw the line
between profits and cost. Budgeting enables effective cost management. There is also a
margin for price fluctuations in the budgeting. For example, Organization engaged in event
management prepares the budget for each type of event so that optimum utilization of
resources can be achieved and profit can be maximized

B. COST DRIVERS

A cost drivers are the direct cause of a business expense. A cost driver is activity that triggers
a cost of something else.

A cost driver is the direct cause of a cost and its effect is on the total cost incurred. For
example, if you are to determine the amount of electricity consumed in a particular period,
the number of units consumed determines the total bill for electricity. In such a scenario, the
number of units of electricity consumed is a cost driver.
Types of Drivers in Cost Accounting

In a traditional system of accounting, the indirect costs or manufacturing overheads are

allocated to the production cost based on a predetermined rate. In some accounting systems,
cost drivers are almost irrelevant in determining the contribution

 Number of machine hours

 Number of processed orders
 Number of orders completed
 Number of labor hours
 Number of orders packed and delivered
Significance of Cost Drivers in Cost Accounting

Whatever determines the total cost of a particular activity should be analyzed in-depth to
ensure that a proper allocation base is used. Cost drivers follow a cause-effect relationship,
and if the relationship cannot be established, then a more relevant driver should be looked
for.

COST DRIVER EXAMPLES

NUMBER OF LABOR HOURS

9
The number of hours that a company's employees work is one of the most common types of
cost drivers. This determines the wages that the company pays its employees. It also directly
correlates with the amount of production that takes place during those assigned work hours.
Typically, more working hours results in a higher product yield

NUMBER OF CUSTOMER

A company's clientele helps determine its profits. The more customers a business has, the
more products it can sell, therefore increasing its revenue. This cost driver is one of the most
vital for planning a company's business model. The number of customers determines the rate
of production, and an increase in demand requires an increase in supply

MACHINERY OPERATION HOURS

For industries that require the use of machinery to create their products, the number of hours
that companies spend running those machines is a major cost driver. It's a good idea to
consider the amount of time the machines run, as this directly correlates with the amount of
electricity and other resources that the machines use. Tracking time and resources may result

10
NUMBER OF RETURNED PRODUCTS.

Returns are a cost driver because if a company issues a refund to a consumer, the company
loses money. A return also reflects production, manufacturing and delivery costs that are not
offset by a final sale. Ensuring product quality can help minimize customer returns, which
allows your company to maximize its revenue

COST OBJECT VS COST DRIVERS

Some of the differences are as follows:

Cost object approvals deal with the overall cost of the product or services, whereas cost
driver deals with the quantity of resources consumed by the enterprise

 A cost object is more of accounting and budgeting, whereas cost driver is more of the
management
 Cost object increases the transparency in cost allocation whereas cost driver increases
the efficiency of employees
 The cost object tries to reduce cost by budgeting methods, whereas cost driver reduces
the cost by incentives and motivation to employee’s method
 Cost objects are used to track and analyse the cost behaviour of various operations
within an organization

4. THE FLOW OF COST THROUGH PRODUCTION PROCESS

11
THIS FIGURES SHOWS HOW COST FLOWS THROUGH PRODUCTION PROCESS?

Cost flows through the production process in a systematic manner, starting from the
procurement of raw materials to the final product. The cost incurred at each stage of the
production process is known as production cost. The production cost includes direct
materials, direct labour, and manufacturing overheads.
Direct materials are the raw materials used in the production process, and their cost is directly
attributable to the product. Direct labour is the cost of the workforce involved in the
production process, and it is also directly attributable to the product. Manufacturing
overheads include all other costs incurred in the production process, such as utilities,
depreciation, and maintenance.

Once the production process is complete, the cost of the finished product is determined by
adding the cost of direct materials, direct labour, and manufacturing overheads. This cost is
known as the cost of goods manufactured (COGM) and is used to determine the cost of goods
sold (COGS) when the product is sold.

In summary, cost flows through the production process in a systematic manner, starting from
the procurement of raw materials to the final product. The cost incurred at each stage of the
production process is known as production cost, and it is used to determine the cost of goods
manufactured and cost of goods sold. I addition to this the production process involves
several stages, and cost flows through each stage in a systematic manner. The cost incurred at

12
each stage is known as production cost, which includes direct materials, direct labour, and
manufacturing overheads.

Direct materials are the raw materials used in the production process, and their cost is directly
attributable to the product. For example, if a company manufactures furniture, the cost of
wood, nails, and other materials used in the production process is considered direct materials
cost.
Direct labour is the cost of the workforce involved in the production process, and it is also
directly attributable to the product. For example, the wages paid to the workers who assemble
the furniture is considered direct labour cost.

Manufacturing overheads include all other costs incurred in the production process, such as
utilities, depreciation, and maintenance. These costs are not directly attributable to the
product but are necessary for the production process to take place.

Once the production process is complete, the cost of the finished product is determined by
adding the cost of direct materials, direct labour, and manufacturing overheads. This cost is
known as the cost of goods manufactured (COGM) and is used to determine the cost of goods
sold (COGS) when the product is sold.

In summary, cost flows through the production process in a systematic manner, starting from
the procurement of raw materials to the final product. The cost incurred at each stage of the
production process is known as production cost, and it is used to determine the cost of goods
manufactured and cost of goods sold.

13
5. COST ACCUMULATION ASSIGNMENT AND TRAILING/ALLOCATION

A.COST ACCUMULATION
Meaning
Cost Accumulation is the process of collecting all costs information about the business with
the help of the cost accounting system
It is a process of collection of all relevant data regarding the various costs incurred by the
company at various stages of production. This calculation is the result or outcome of the cost
accounting system prevalent or practices in the company.
Cost Accumulation calculates all manufacturing costs in a sequential pattern. It considers all
costs in the production process, starting from inventory to the finished goods. The focus and
the objective are to come up with the cost of a particular product or service by identifying
various cost objects and their respective cost drivers
Here there exists a cause-effect relationship between cost object and their cost drivers. Thus
Cost Accumulation becomes a very connected and integral part of the Cost Accounting
System.
Whether Cost Accumulation a part of Managerial accounting too?
The management of the company, after collecting and analysing the cost data, makes
calculative decisions regarding the day-to-day working of the company. The costing data
helps the management at all stages of operations, including planning, monitoring, controlling,
and decision making the management also decides when and how the assignment of cost to a
particular job or process will happen. And thus, Cost Accumulation becomes a part of both
Cost Accounting and Managerial Accounting.
TYPES OF COST ACCUMULATION

There are majorly three types of Cost Accumulation methods, as follows:-

JOB COSTING SYSTEM

Job Costing System is most useful when the total production quantity is small or there exist
small batches of production. It is also relevant and important when each job is unique. It is a
process of accumulating cost information about a particular project or a specific production
or product. Under this system, linking and recording the accumulation of direct labor, direct
materials, and manufacturing overhead costs happens with respect to the particular job or
batch.
This system is widely useful in the delivery of a special or customized product. It also helps
while asking for cost- reimbursements or stage-wise advances from the customer. Once the
job completion happens, all the costs of the respective job are accumulated. And after that,
that particular job sheet and costing exercise on that job also close. It is necessary to consider
both direct and indirect costs under this system. At times calculation of indirect costs for a
particular job may become difficult.

14
Thus under the Job Costing System, accumulation takes place according to the respective job
order.
PROCESS COSTING SYSTEM
Accumulation of cost through the Process Costing System occurs when the production of a
huge amount of identical goods occurs. In this system, the accumulation of costs for a large
batch of products takes place. And afterward, further allocation of all such accumulated costs
takes place for an individual unit. Process Costing System accumulates costs on the basis of
departments or divisions. In this system, identification and booking of costs to respective cost
centers take place. Cost centers are the places of origination of the costs. Accumulation of
costs takes place according to the cost center they belong to.
This method is best suitable when the production is very large in quantity. The production
process is also generally continuous in nature without any customization.
Hybrid Costing System
Manufacturing units where some production is large while some are small, this is best
suitable. Under Hybrid Costing System, process costing is used where the production
quantities are large. While if the product is in small batches, the Job System is used. Thus this
hybrid system is widely used and now well accepted in such circumstances.

COST ASSIGNMENT

Cost assignment is the process of allocating costs to specific cost objects, such as products,
services, or activities, based on how resources are used or consumed. It's a key concept in
managerial accounting and is important for understanding and managing costs in
organizations.

Cost assignment involves:

Tracing direct costs: Assigning direct costs to a cost object
Allocating indirect costs: Assigning indirect costs to a cost object
To properly assign costs, you need to define the cost drivers and assignment paths:
Assignment paths: Identify the source account (the account whose cost is being assigned) and
the destination accounts (the accounts to which the costs are being allocated)
Cost drivers: Identify the measure or rationale for the assignment
For example, the cost of issuing purchase orders could be assigned to the various objects
procured. The cost driver could be based on the number of purchase orders issued for each
cost object, or on a defined percentage value.
As we have already discussed cost assignment is a sub-topic of cost accumulation for
inventory valuation and profit measurement. In this topic we are going to see how to trace
direct costs to cost objective and allocate indirect costs/overheads to cost objective.
Assigning Direct Costs to Cost Objective
This is referred to as tracing the costs to cost objective. For direct materials the source
document is a materials requisition form. Details of the materials issued for
manufacturing a product, or providing a specific service, are recorded on the materials

15
requisition form. The details of 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 materials requisition form thus represent the source
information for assigning the cost of the materials to the appropriate cost objective.
Details for recording labour cost incurred for manufacturing a product, or providing a
specific service, are recorded on labour requisition (or job ticket labour time record). The
details of customer’s account number, job number or product code is entered on these
documents. The employees hourly or daily rate is then entered so that the direct labour
cost for the employee can be assigned to the appropriate cost objective.
Assigning Indirect Costs to Cost Objective
Indirect costs (or overheads) are assigned to cost objective through the process of cost
allocation. Allocation of indirect costs is done by using overhead allocation rate. If a
single overhead rate is used for the whole organization then it is referred to as blanket
overhead rate or plant-wide overhead rate. If each cost centre uses its own overhead rate
then these overhead rates are referred to as cost centre overhead rates.
The term cost centres or cost pools are used to describe a location to which overhead
costs are initially assigned or accumulated.
Steps of assigning Overheads to Cost Objectives
There are four steps in assigning overheads to cost objectives. These steps are assigning
all manufacturing overheads to production and service cost centres; re-allocating the
costs assigned to service cost centres to production cost centres; computing separate
overhead rates for each production cost centre and assigning cost centre overheads to
products or other chosen cost
COST ALLOCATION
What is Cost Allocation?
Cost allocation is the process of identifying, accumulating, and assigning costs to costs
objects such as departments, products, programs, or a branch of a company. It involves
identifying the cost objects in a company, identifying the costs incurred by the cost objects,
and then assigning the costs to the cost objects based on specific criteria.
When costs are allocated in the right way, the business is able to trace the specific cost
objects that are making profits or losses for the company. If costs are allocated to the wrong
cost objects, the company may be assigning resources to cost objects that do not yield as
much profits as expected. Cost Allocation Mechanism
The following are the main steps involved when allocating costs to cost objects:
1. Identify cost objects
The first step when allocating costs is to identify the cost objects for which the organization
needs to separately estimate the associated cost. Identifying specific cost objects is important
because they are the drivers of the business, and decisions are made with them in mind.

The cost object can be a brand, project, product line, division/department, or a branch of the
company. The company should also determine the cost allocation base, which is the basis that
it uses to allocate the costs to cost objects.

2. Accumulate costs into a cost pool

16
After identifying the cost objects, the next step is to accumulate the costs into a cost pool,
pending allocation to the cost objects. When accumulating costs, you can create several
categories where the costs will be pooled based on the cost allocation base used. Some
examples of cost pools include electricity usage, water usage, square footage, insurance, rent
expenses, fuel consumption, and motor vehicle maintenance. Benefits of Cost Allocation
The following are some of the reasons why cost allocation is important to an organization:

1. Assists in the decision-making process

Cost allocation provides the management with important data about cost utilization that they
can use in making decisions. It shows the cost objects that take up most of the costs and helps
determine if the departments or products are profitable enough to justify the costs allocated.
For unprofitable cost objects, the company’s management can cut the costs allocated and
divert the money to other more profitable cost objects.

2. Helps evaluate and motivate staff

Cost allocation helps determine if specific departments are profitable or not. If the cost object
is not profitable, the company can evaluate the performance of the staff members to
determine if a decline in productivity is the cause of the non-profitability of the cost objects.

On the other hand, if the company recognizes and rewards a specific department for
achieving the highest profitability in the company, the employees assigned to that department
will be motivated to work hard and continue with their good performance.

Additional Resources
Thank you for reading CFI’s guide to Cost Allocation. In order to help you become a world-
class financial analyst and advance your career to your fullest potential, these additional
resources will be very helpful:

17