Day 203 Cost measurement and allocation

Cost measurement and allocation

Cost control has always been an important subject for management. The direct impact over the profit margin attracts managers’ attention on this specific topic, hence it is crucial for us to understand the categorization of costs and the allocation method in management accounting.

In order to control costs, we must be able to measure them in the first place. There are many different diversifications of costs, for instance: manufacture cost/non-manufacture cost, direct/indirect cost, and product/period costs. In fact, the various aspects of these costs enable management accountants to categorize them correspondingly. In both manufacture and service companies, the manufacture cost as the fundamental drivers of contribution margin, which can be divided into three sections: the direct material, direct labor and manufacturing over head. It is also classified as product cost, where direct material is the raw materials used directly in the production. Similarly, the direct labor is the salary expense for the employee who directly involved in the manufacturing process. In the contrast, other indirect labor and material that also contributed to the production are classified as manufacturing overhead. For example, the depreciation of the machine, salary of the manager who is responsible for supervising the production, and the electricity consumed in the factor are typical indirect cost. Managers cannot continently or economically trace them back to specific product or service, therefore accountants use a special allocation method to assign them to individual jobs. The corporation would calculate a predetermined manufacture overhead rate (POHR) at the start of reporting period, which is equal to the estimated total overhead divided by the estimated total units of allocation base. Generally, this allocation base is the cost driver for the manufacture overhead, such as labor hour, machine hour or working units. Then the management accountants will use this POHR times the actual units of allocation base used in individual job to determined the unique overhead cost for that job. As a consequence, we are able to find out the total product cost, which is all direct costs plus manufacture overhead. On the other hand, other costs that support the sell of the product/service are referred as the period cost, thus shipping and administration of the sell provide some good example for this type of cost.

In conclusion, define and accurately record different categories of costs are only the first step of cost control. However, it is the fundamental knowledge therefore it should be fully understood by any management participant.