Cost tracing vs cost allocation (Deborah Agostino) - YouTube

In this class we will focus on the problem of cost assignment which means that

given a certain cost object which can be a product, a service, a project or an organizational unit,

the objective is to assign the value of the resources which are absorbed by this cost object.

Let’s see the graphical representation of this problem.

We have our cost object and in order to define the value of the resources

which are absorbed by this cost object, it is important to go back to the distinction

between direct and indirect costs.

So, we have the direct cost and this cost can be traced

directly to the cost object. So, we are talking about tracing.

Why? The reason why is because of the definition of the direct cost.

Because we have that direct material or direct labour

can be univocally assigned in an objective way to one unit of our cost object.

If we think, for example, of a wooden table, we can know exactly the amount of wood

that is absorbed in order to realize one table and the same happens with the direct work.

So, we can, in an objective way, assign the value of both direct materials and direct labour,

to our final cost object.

This is not the case, instead in the moment in which we have indirect costs.

That you know, we call them also overhead.

In this case, if we have the overhead, by definition, they are absorbed jointly by more than one cost object.

This means that we cannot assign their value in a univocal way to he cost object,

but we need to allocate the value of the overhead to the final output.

So, we are talking about allocation.

Allocation means that we are using a proxy in order to assign this value to the final cost object.

So, we are introducing subjectivity in order to translate,

to share the value of this overhead on the final cost object.

Let’s see how this allocation works with a simple example.

Assume that we have this situation.

So, we have a machine, in this case the circular saw, which is used both

to realize chairs and to realize tables. Specifically, in the period that we are analyzing,

we have the overhead that we want to assign which is the machine depreciation whose value is 90€.

And the machine is used to produce 12 chairs and we need 10 minutes in order to realize one unit;

and at the same time we are realizing 2 tables and we need 30 minutes in order to realize one unit.

This is the alue of our overhead and we want to share

this value between the two different products. We need to allocate this resource. How?

By applying a simple formula. We need to calculate what is defined as allocation coefficient.

And the allocation coefficient is also known as k. Usually, we use the abbreviation k to

talk about the allocation coefficient. And this allocation coefficient is that quantity

that explains the relationship between the resource and the final product.

The formula to calculate k equals the total value of the overhead that we want to assign,

(that in this case is 90€, it is the value of our machine depreciation),

divided by the allocation basis, the total one.

Where this allocation basis is exactly the proxy that explains the relationship

between the usage of the machine and the output that is realized.

In the specific example which is the quantity that explains the relationship between

the usage of the machine and the final output? We can see from the data that we have

that we can use the production time in order to explain

the percentage of absorption of our machine by the two different products.

We need the total allocation basis which means that we need to calculate

the allocation basis of the chairs plus the allocation basis of the tables.

So, we will have first of all, the allocation basis of the chairs.

We are producing 12 chairs and we need 10 minutes in order to realize one unit.

This is 120 minutes which is the allocation basis of the chairs;

plus the allocation basis of the tables,

we are realizing 2 tables and we need 30 minutes to realize one table.

This means that overall we need 60 minutes in order

to realize the 2 tables which is the allocation basis of our tables.

If we divide 90 by 180 minutes we can find 0,5 €/ minute

that represents exactly the allocation coefficient.

So, we are saying, basically, that every minute in which the machine is used, it absorbs 0,5€ of resources.

So this allocation coefficient that can be written down here, is 0,5€/minute.

Once we are here, we need to, finally, assign the value of the machine depreciation

to the two different products. So, the formula goes on and

says that if we want to assign the value of the overheads to the chairs,

we need to multiply this k by the allocation basis of the chairs.

So, if we apply the formula we will have 0,5 €/minute, which is the same for all of

the products, that should be multiplied by the allocation basis of our chairs, so 120 minutes.

So we will have that the overhead of the chairs is equal to 60€.

If we do the same with the tables, we will have that the overhead of the tables equals,

again, our k that is the same either for the chairs and then for the tables, multiplied

by the allocation basis of the tables. So, we will have, again, 0,5€/minutes, that

should be multiplied by the allocation basis of the tables which is 60 minutes.

So we will have 30€.

So, if we look at the final result we have that given the value of overhead of

the machine depreciation, by using an allocation coefficient, which is that ratio that explains

the relationship in a proportional way between the usage of the resource and the final output,

we can assign the value of our overhead tothe two different products which are the chairs and the tables.

So, let’s go back to the general rule.

This is the allocation, so if we have the overhead, by using k, we can assign the value of overhead

to the different cost object. But we can be even more precise because

if we need to assign the overhead, there are two different approaches that we can use

in order to assign the value of the overheads.

We can use what is defined as traditional costing system,

or we can use another approach which is defined as activity based costing system,

which is often abbreviated as ABC.

What’s the difference between the two approaches?

In both of the cases we are allocating the overheads to the cost object by using k,

but if we have traditional costing system and we are just performing one time the allocation;

while in the second case, if we have the activity based costing we performing the allocation,

so we are calculating the allocation coefficient twice with the final objective to improve

the precision in the allocation of the overheads.

So, that’s the reason why if we have an activity based costing

we are trying to improve precision in allocating these overheads and

we are talking about a cause and effect relationship.

Because we want to overcome the problem of assigning in a proportional way the value of the resources.

And in the next two classes we will see how a traditional costing system works and how an ABC approach works.