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Lesson 1a: Cost Concepts
Cost Assignment
Cost assignment is a general term indicating the process of putting costs incurred into cost objects. Now, how do we assign costs? In general, there are two ways we do it: we either (1) trace the cost, or (2) allocate the cost.
Cost Tracing
Cost tracing is the placement of a cost that belongs to only one cost object into that cost object. To the extent that you can trace costs, determining cost is easy. The costs that can be traced are called direct costs, and they are covered in another presentation.
Cost Allocation
Cost allocation is the placement of a cost that belongs to two or more cost objects into those cost objects, which we will do extensively in future lessons. The costs that cannot be traced and, therefore, must be allocated are called indirect costs, and they are covered in another presentation.
Cost allocation involves a numerator and a denominator. The numerator is always money, while the denominator is always some measure of activity. The result of the division is always the amount of the numerator for every one of the denominators.
For example, your manufacturing overhead is $1,000,000 and you produce 100,000 units of a product. For the product cost object, the allocation would be $1,000,000/100,000 = $10 of manufacturing overhead per unit produced.
Product cost object allocation =
Product cost object allocation = of manufacturing overhead per unit produced
Here is an extremely important point about cost allocations that people do not always realize. Numbers look very precise, so if someone says that the product cost for making a particular part is $17.33, people tend to think of that as gospel; but a lot of cost allocations went into that $17.33. If you change how cost allocations are done, it might be $16.05 or $18.10, and these other amounts might be just as correct, that is just as defensible. So, what is the point?
The point is that there is more than one logically defensible way to allocate the same costs to the cost objects. And if there is more than one logically defensible way to allocate the cost, then there is more than one right answer. From the standpoint of an independent observer, the choice between multiple right answers is arbitrary. So, accountants say that all cost allocations are arbitrary.
A simple example is depreciation methods. One company might allocate depreciation of its machinery based on a ten-year life with no salvage value. Another might allocate depreciation on the same equipment based on 1,000,000 units of output. A third organization might allocate it based on a nine-year life with a 10% salvage value. Each time you change how you calculate depreciation or change any of the depreciation assumptions, you will get a different amount of depreciation allocated to each unit of product produced. Which cost per unit is correct? Well, they're all correct as long as your assumptions are reasonable. Notice that your assumptions need to be reasonable. You cannot simply say, "Ah, well, if all cost allocations are all right, I'm just going to use a 10,000-year life for my equipment." Of course, that's not reasonable.
Saying all cost allocations are arbitrary does not mean they are unnecessary. People need a reasonable estimate of cost in order to make decisions. But you want to remember that no matter how precise your costs look when you hand them to people, the number is not the right answer. In fact, if someone says, "The true cost is...", they are misspeaking, because there is no one true cost. At best, all you can reasonably say it that some cost calculations are more accurate than others for the particular decision to be made.