Week 2 – Cost Assignment

• This means dividing costs up between cost objects

• Remember that direct costs are those that are completely
attributable to the cost object.
• Indirect costs (or overheads) have to be divided up in a
reasonable manner. There are two basic ways
– Factory wide or “blanket” rates
– Specific cost centre rates
• You need to know
– What your costs are
– What assumptions you are going to make about cost driver.
 Why do we need to do this
• Inventory valuation
• Product costs
• Setting selling prices and bidding for work
• Measuring profitability
• Long term decision making (but not short
term!)
 Designing the system
• Blanket rates
– Cheap to run
– Low accuracy, arbitrary, errors?
• Cost centre rates
– Expensive to run (cost of accountants)
– More accurate, less errors.
• What is the cost of costing – cost-benefit
analysis.
 Blanket rate example
• Total Overheads £900000
• Total worked hours 60000
• Overhead rate £15 per hour
• Suppose product X takes 5 hours to make
– Then the overhead cost is 5 * £15 =£75
– This is in addition to the direct cost.
 Cost centre rate example
• Suppose the company has 3 departments
– Dept A Dept B Dept C Total
• The Overheads have been divided up
– £200000 £600000 £100000 £900000
• The worked hours in each department are
– 20000 20000 20000 60000
• So the cost centre rates are
– £10 £30 £5
 The results
• Suppose the 5 hours to make Product X are 1
hour in dept A, 0 in dept B and 4 in dept C
– The overhead cost is now 1*£10 + 4 * £5 = £30
• Compares with £75 with the blanket rate.
– Your budgeting would be inaccurate
– Your price setting would be inaccurate
– You would send the wrong signals to your customers
– Your long term profitability would be damaged.
 The process for the cost centre
system
• Assign all manufacturing overhead to production
and service cost centres
– Some direct
– Some shared or apportioned
• Reallocate costs to production costs
• Calculate overhead rates for production cost centre
– Labour hours or machine hours
• Assign overheads to the chosen cost objects
Operating Expense
Allocations
 Actual rates or predetermined
rates?
• Actual rates are rarely used
– Delay in producing product costs (and prices/invoices)
– Monthly fluctuations due to seasonal change
• Budgeted rates mostly used
– Estimate the annual cost
– Estimate the annual hours
– Gives “long run” cost (not affected by monthly change)
 Effect of using predetermined
rates
• We talk about absorption of overhead
• PDRs usually result in over- or under- absorption
• Over
– if cost is less or activity is more
• Under
– If cost is more or activity is less
• May damage short term pricing
• Gives long term stability