Question

Among other things, faulty cost information can have an impact on inventory valuation (if it is a manufacturing or retail business) and/or pricing of goods and services. When you calculate your product's cost incorrectly, you end up pricing it incorrectly, and in the long run it can affect your market.

Last week we discussed cost containment, cost management, cost reduction, etc. In order to contain, manage or reduce costs, it is important to first gather and record costs as accurately as possible.

This week we learned that a cost is direct or indirect depending on whether it can be traced to a cost object in economically feasible way. Whereas a direct cost can be traced to a cost object, an indirect cost has to be allocated to a cost object. If the cost object is a unit of your product (e.g., a piece of furniture), the above becomes important because it can affect the way you determine the cost of each sofa, and hence can affect all those decisions that are based on the cost, including the pricing of each sofa.

Going forward, you will be exposed to several terms including the following. Let’s make sure that we understand these terms clearly. Can you explain briefly one or more of these terms, in your own words, using an example from the business world?

Cost tracing?

Cost allocation? How is it different from cost tracing?

Cost allocation base?

Overhead allocation rate?

Answer 1

Cost Tracing :

Cost tracing is the process of directly matching a cost with a product being produced. Cost tracing is mostlu used in places where it is possible to directly trace a cost to a costing unit. Eg: In Card printing industry, it is possible to trace a speificic cost a specific job.

Cost Alocation :

Cost allocation (also called cost assignment) is the process of finding cost of different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

It is different from cost tracing as in this Cost is accumulated and then allocated to the costing units on a reasonable basis, whereas in cost tracing, whole cost is traced to a costing unit.

Cost Allocation base :

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

Overhead Allocation rate :

You can allocate overhead costs by any reasonable measure, as long as it is consistently applied across reporting periods. Common bases of allocation are direct labor hours charged against a product, or the amount of machine hours used during the production of a product. The amount of allocation charged per unit is known as the overhead Allocation rate.