IES469

CN-225-E
June 2014

Cost Systems

What Is a Cost System?

Consider a construction company bidding for a project. To design its bidding strategy, the
company will first take into account the costs that are directly attributable to the project. For
example, the company will estimate the cost related to materials, subcontractors and workers
that will be assigned to the project. But what about the cost related to engineers that work on
several simultaneous projects? How should the company account for the construction
equipment and machinery owned by the company that will be used in the project? What
about other overhead costs such as those related to the company’s headquarters? Should the
company take all these costs into account in its bidding strategy? If so, which criterion
should we use to allocate these costs to each project?

Let’s consider another case. A CEO of an international distribution business wants to analyze
the profitability of the company’s markets because she perceives that the company is losing
its competitive edge in one of them. Helped by the controller, she thinks about how to
separate the costs of each market. She hopes that this information will help her learn about
the problematic market. Some costs are easy to assign. For example, assigning the cost of the
products and the employees working exclusively in one market does not pose any challenge.
However, the allocation of other costs could be more controversial. How should they allocate
overhead costs such as those related to the corporate office? What about the salaries of the
management team?

Finally, consider a divisional manager who receives an annual bonus that depends on divisional
profits. Some of the costs attributed to her division are fairly uncontroversial. For example, she
has no issues with including the salaries of her division’s employees in the computation of the
divisional profits. However, she also observes that the headquarters have included a charge for
corporate overhead costs when computing the divisional profits. She complains about this
number because she thinks it is unfair. General overhead costs are allocated equally across
divisions but, in her view, her division generates significantly less work for the headquarters than
other divisions. Should the headquarters change the allocation criterion?

This technical note was prepared by of Professor Gaizka Ormazabal and Eduardo Soler, Lecturer. June 2014.

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 CN-225-E Cost Systems

Note that the common theme in the previous situations is the allocation of indirect costs. In
contrast to direct costs, indirect costs are resources shared by products, clients, departments,
divisions or other organizational units.1 The model used by a company to allocate and trace
costs is called a cost system. Thus, cost-accounting systems trace, assign and allocate the
costs of resources to cost objects.

Elements of a Cost System

Let’s use an example to illustrate the elements of a cost system. Liqueurs de Montagne
(Limon) is a French producer of creamy liquors. Limon operates two distilleries located in the
heart of the Alps: Chartreuse and Vercors. Each plant produces two different varieties of
liquors. Chartreuse produces Crème de cassis and Crème de menthe. Vercors produces Crème
de violette and Crème d’or. The Limon headquarters are located in Grenoble.

Anne Davant (Limon’s CEO) wants to learn about the profitability of the two distilleries and
the company’s four products. With this objective in mind, she collects the following
information:
Table 1
Cost and revenue information by distillery and product

Chartreuse Crème de cassis Crème de menthe Total

Number of bottles 200,000 250,000 450,000
Sales (€000) 3,000 2,500 5,500
Materials (€000) 560 440 1,000
Labor hours 27,000 18,000 45,000
Labor (€000) 540 360 900
Use of equipment (hours) 14,000 16,000 30,000

Vercors Crème de violette Crème d’or Total

Number of bottles 100,000 25,000 125,000
Sales (€000) 2 650 2,650
Materials (€000) 500 185 685
Labor hours 20,000 10,000 30,000
Labor (€000) 400 200 600
Use of equipment (hours) 15,000 5,000 20,000

“Materials” relates to the costs of bottles and other materials used in the production of each type
of liquor. “Labor” includes the salaries of the workers involved in the production of the liquors.
Moreover, the distilling and bottling processes require machinery and equipment, which is
depreciated at €1,500,000 a year (Chartreuse) and €500,000 (Vercors). The production overhead
costs of Chartreuse and Vercors (including maintenance and packing and shipping) are €675,000
and €250,000, respectively. Finally, LIMON’s headquarters in Grenoble incur annual selling,
general and administrative expenses (SG&A) of €850,000 and R&D expenses of €650,000.

1 Some indirect costs need to be allocated because it is not practical to measure the relative consumption of that resource. For
example, measuring the time that employees devote to each job is often impractical. In some other cases, this measurement is
unfeasible (e.g., plant and property costs, administrative costs, etc.).

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 Cost Systems CN-225-E

Anne organized all this information in Table 2. However, she noticed that the information in
Table 2 was not enough to estimate the profitability of LIMON’s distilleries and products.
Anne realized that she had to allocate the costs that are not directly attributable to the
distilleries and the products (i.e., the indirect costs).
Table 2
Profitability analysis before allocating indirect costs (in €000)

Chartreuse Vercors
Cassis Menthe Total Violette Or Total Total
Sales 3,000 2,500 5,500 2,000 650 2,650 8,150
Materials 560 440 1,000 500 185 685 1,685
Labor 540 360 900 400 200 600 1,500
Equipment 1,500 500 2,000
Distillery OH 675 250 925
Corporate SG&A 850
Corporate R&D 650
Profit 540

Thus, the first step in establishing a cost system is to distinguish between direct and indirect
costs (recall that we only need allocation criteria for indirect costs). In this case, there are
indirect costs with respect to two cost objects: the distilleries and the products.2

a) With respect to the distilleries, the indirect costs are corporate SG&A and R&D
expenses.

b) With respect to the products (the types of liquor), the indirect costs are labor costs,
equipment depreciation and the production overhead (OH) costs of the distillery that
manufactures the product.

Note that labor costs, equipment and distillery overhead costs are indirect with respect to
products but direct with respect to the distilleries.

2 The distinction between direct and indirect costs is relative to the cost object. For example, assume that the company is
analyzing the profitability of the firm’s divisions (i.e., the cost objects are the company’s divisions). In that case, the salary of
the head of the division would be a direct cost with respect to the division itself. However, if the focus of the analysis were the
profitability of a specific product (i.e., the cost objects are the company’s products), the salary of the head of the division would
be an indirect cost with respect to the products of that division.

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 CN-225-E Cost Systems

Cost Pools
Next, Anne organizes the indirect costs into groups called cost pools. In the case of LIMON,
Anne considers the following cost pools:

a) With respect to the distilleries, Anne considers only one cost pool that includes SG&A
and R&D expenses. She calls this pool “corporate overhead” (OH).

b) With respect to the products, Anne considers two cost pools: equipment depreciation
and the distillery overhead costs. Although distillery employees work on all the
products within each distillery, Anne has a good estimation of how much time
the employees devote to each liquor (Table 1). Thus, she considers that there is no
need to use an allocation criterion for these costs.

The Allocation Base

After defining the cost pools, Anne needs to come up with a criterion to allocate each of
these cost pools, i.e., an allocation base. Anne defines the following allocation bases for the
cost pools:

At the corporate level:

a) The corporate OH expenses (SG&A and R&D) will be allocated to distilleries based on
labor hours.

At the distillery level:

b) The equipment depreciation costs will be allocated to products based on machine

hours.

c) The distillery overhead costs will be allocated to products based on the number of
bottles of liquor produced during the year.

d) After being allocated to each distillery, the corporate overhead (SG&A and R&D
expenses) will be allocated to products based on labor hours.

Anne decides to allocate all indirect costs in two stages. In the first stage, she allocates one
pool of indirect costs with respect to the distilleries. In the second stage, she allocates three
pools of indirect costs with respect to the products. Graphically:

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 Cost Systems CN-225-E

Figure 1
LIMON’s cost system

Step 1: Allocation to distilleries:

Chartreuse Vercors
Cost pool: Allocation base:

Corporate OH
(SG&A and R&D) # Labor hours

Cost of Cost of
chartreuse vercors

Step 2: Allocation to products (Chartreuse):

Crème de cassis Crème de menthe

Cost pool: Allocation base:

Depreciation of
distillery equipment Machine hours by product

Distillery OH # of bottles by product

Corporate OH
allocated to winery Labor hours

Cost of Crème de Cost of Crème de

cassis menthe

The Allocation Rate

After defining cost pools and allocation criteria, Anne allocates indirect costs through an
allocation rate, which she obtains for each cost pool by dividing the total amount of indirect cost
by the total amount of the metric used as the allocation base. For example, in the case of the
Chartreuse distillery, the €1,500,000 of equipment depreciation costs are allocated based on a
total of 30,000 machine hours, so the allocation rate is €1,500,000 / 30,000 hours = €50 /h. Anne
allocates the rest of the costs proceeding similarly.

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 CN-225-E Cost Systems

At the corporate level:

Cost allocated to distilleries
Cost pool (€000) Allocation base (000) Allocation rate Chartreuse Vercors
Corporate OH (1,500) Labor hours (75) 1,500/75 = €20 /h 20*45 = 900 20*30 = 600

At Chartreuse (distillery level):

Cost allocated to products
Cost pool (€000) Allocation base (000) Allocation rate Cassis Menthe
Equipment (1,500) Machine hours (30) 1,500/30 = €50 /h 50*14 = 700 50*16 = 800
Distillery OH (675) # of bottles (450) 675/450 = €1.5 /bottle 1.5*200 = 300 1.5*250 = 375
Corporate OH (900) Labor hours (45) 900/45 = €20 /h 20*27 = 540 20*18 = 360

At Vercors (distillery level):

Cost allocated to products
Cost pool (€000) Allocation base (000) Allocation rate Violette Or
Equipment (500) Machine hours (20) 500/20 = €25 /h 25*15 = 375 25*5 = 125
Distillery OH (250) # of bottles (125) 250/125 = €2 /bottle 2*100 = 200 2*25 = 50
Corporate OH (600) Labor hours (30) 600/30 = €20 /h 20*20 = 400 20*10 = 200

Note that the allocation rates are not variable costs per unit, but accounting numbers
generated by the internal accounting system to distribute indirect costs across products. For
example, the allocation rate of €2 /bottle for the overhead costs of the Vercors distillery does
not mean that these costs will increase by €2 (the allocation rate) if Limon produces one
additional bottle of liquor. Distillery OH is a fixed cost in this case.

Using the previous allocation rates Anne obtains the following profitability estimates for
Limon’s distilleries and products:

Table 3
Profitability analysis by distillery and product (in €000)

Chartreuse Vercors
Cassis Menthe Total Violette Or Total Total
Sales 3,000 2,500 5,500 2,000 650 2,650 8,150
Materials 560 440 1,000 500 185 685 1,685
Labor 540 360 900 400 200 600 1,500
Equipment 700 800 1,500 375 125 500 2,000
Distillery OH 300 375 675 200 50 250 925
Corporate OH 540 360 900 400 200 600 1,500
Profit 360 165 525 125 -110 15 540

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 Cost Systems CN-225-E

In summary, a cost system involves the following steps:

Step 1: Identify indirect costs and group them into cost pools
Step 2: Define a cost allocation base for each cost pool
Step 3: Compute the allocation rate for each allocation base
Step 4: Compute the cost allocated into cost objects (products, departments, etc.)

The Limon example used so far has helped us describe a cost system in a manufacturing
situation. These systems are sometimes called “traditional” costs systems. However, the
principles and processes described are equally applicable to cost-system design and use in
non-manufacturing functions (i.e., sales or human resource management) as well as
in service companies or nonprofit organizations. The next section describes a more refined
cost system that takes into account the variety and complexity of products and services in
today’s businesses, not just the physical volumes produced.

Activity-Based Costing (ABC)

During that summer, Limon hired Brigitte, an IESE first-year MBA student, to do a summer
internship at the company. Brigitte carefully analyzed Limon’s cost system and made a
suggestion for improving it. Brigitte realized that, although the production volume of Crème
de cassis and Crème de menthe was significantly larger than that of Crème de violette and
Crème d’or, the latter products required more work in terms of shipping and packing. For that
reason, Brigitte suspected that allocating distillery overhead costs based on production
volume could underestimate the cost of Crème de violette and Crème d’or.

To address this issue, Brigitte proposed that Anne break down the distillery overhead costs
into the two main activities associated with those costs: packing and shipping, and
maintenance. The table below shows this breakdown:
Table 4
Activity costs (in €000)

Activity Chartreuse Vercors

Packing and shipping costs 525 150
Maintenance costs 150 100
Total 675 250

Brigitte also proposed allocating the cost of these activities based on what she thought was
driving those amounts. Specifically, Brigitte thought that packing and shipping costs were
probably driven by the number of orders of liquor products that the distillery received rather
than the total number of bottles (there was a wide variation in the orders that Limon received
from its clients: some clients asked for a large number of bottles, while other orders were
very small). Also, Brigitte observed that the manufacturing process for some products
required more maintenance work than for others. After some research, Brigitte found out that
maintenance costs were mainly driven by the number of hours that maintenance workers
devoted to the bottling machines.

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Brigitte collected the following data on these cost drivers:

Table 5
Activity cost drivers by product (amounts expressed in thousands)

Chartreuse Cassis Menthe Total

Number of orders 5 7.5 12.5
Maintenance hours 1.5 6.0 7.5

Vercors Violette Or Total

Number of orders 1.0 4.0 5.0
Maintenance hours 1.5 1.0 2.5

Brigitte conceptualized her modification of the cost system in the following way:

Figure 2
Limon’s cost system based on activities (allocation to products at Chartreuse)

Crème de Crème de
Activites: cassis menthe

Depreciation of
Machine hours
distillery
by product
equipment

Packing and
# of orders
shipping
Distillery
OH
Maintenance
Maintenance hours

Corporate OH
Labor hours
allocated to distillery

Cost of Crème de Cost of Crème de

cassis menthe

Next, Brigitte computed the allocation rates and the allocated costs for the two activities at
the two distilleries:

At Chartreuse:
Cost allocated to products
Cost driver or
Activity (€000) Allocation rate Cassis Menthe
allocation base (000)
Packing and shipping (525) Transactions (12.5) 525/12.5 = €42 /Tr. 42*5 = 210 42*7.5 = 315
Maintenance (150) Maintenance hrs (7.5) 150/7.5 = €20 /h 20*1.5 = 30 20*6 = 120

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 Cost Systems CN-225-E

At Vercors:
Cost allocated to products
Cost driver or
Activity (€000) Allocation rate Violette Or
allocation base (000)
Packing & shipping (150) Transactions (5) 150/5 = €30 /Tr. 30*1 = 30 30*4 = 120
Maintenance (100) Maintenance hrs (2.5) 100/2.5 = €40 /h 40*1.5 = 60 40*1 = 40

Finally, Brigitte presented a new version of the profitability analysis for Limon’s distilleries
and products:

Table 6
Profitability analysis for LIMON using the ABC system designed by Brigitte (rounded, in €000)

Chartreuse Vercors
Cassis Menthe Total Violette Or Total Total
Sales 3,000 2,500 5,500 2,000 650 2,650 8,150
Materials 560 440 1,000 500 185 685 1,685
Labor 540 360 900 400 200 600 1,540
Equipment 700 800 1,500 375 125 500 2,000
Packing & shipping 210 315 525 30 120 150 675
Maintenance 30 120 150 60 40 100 250
Corporate OH 540 360 900 400 200 600 1,500
Profit 420 105 525 235 -220 15 540

As shown in Table 6, the profitability of Crème d’or is even lower using this alternative
system. Anne thought that these numbers made sense because this premium liquor was a
high quality product and thus required more packing and shipping costs per order than the
other products (the typical order of Crème d’or contained just a few bottles). Table 6 also
suggested that Crème de menthe required substantial maintenance costs and thus might be
less profitable than previously thought. This analysis also revealed that, in contrast with the
results in Table 3, Crème de violette appeared to be more profitable than Crème de menthe.

The idea of designing cost systems based on activities (like the one proposed by Brigitte) is
known as “activity-based costing” or just “ABC.” Rather than allocating costs based on
production volume, ABC systems use the driver (i.e., the “cause”) of each activity cost as the
allocation base. This is why ABC allocation bases are often called cost drivers.

Capacity Utilization and Cost Allocation

Let’s take a closer look at how Anne and Brigitte computed the allocation rates. Recall that
the allocation rate for the cost of equipment at the Chartreuse distillery was €1,500,000
/30,000 hours = €50 /h. Anne and Brigitte computed this allocation rate using the number of
machine hours actually used in the production process. But, what if the machine was
underutilized? In fact, that year the demand for liquor products was low and, although the

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Chartreuse machines had worked for 30,000 hours, Anne estimated that those machines
could have worked as many as 50,000 hours at full production capacity. What if Anne used
the maximum capacity of the machines (i.e., 50,000 hours) to compute the allocation rate
instead of the actual capacity utilization of the machines (i.e., 30,000 hours)? Note that if
Anne used the maximum capacity utilization as the denominator for the allocation rate she
would obtain a rate of €1,500,000 /50,000 h = €30 /h, which is lower than the previous €50
/h. Would this lower allocation rate make any difference in terms of the information
generated by the cost system?

An allocation rate of €30 /h would not fully allocate indirect costs to products. To see this,
note that the machinery cost allocated to the liquors cassis and menthe would be 30*14,000
+ 30*16,000 = 900,000. Thus, the difference between the total machinery costs and the
allocated amount (i.e., 1,500,000 - 900,000 = 600,000) would not be allocated to products.
The remaining 600,000 reflects that the company has idle capacity (the equipment has not
been fully utilized). Thus, based on an allocation rate of €30 /h, the cost system would not
allocate the cost of the idle capacity of the Chartreuse equipment to products.

Moreover, using €30 /h instead of €50 /h as the allocation rate would result in a difference in
the cost of each bottle of Crème de cassis of (50–30)*14,000/200,000 = €1.4 /bottle (recall
that the company produces 200,000 bottles of Crème de cassis). For the Crème de menthe, the
difference would be (50–30)*16,000/250,000 = €1.28 /bottle (the production of Crème de
menthe is 250,000 bottles). If prices were set based on unit costs (for example, by adding a
markup to the full cost of each bottle), the difference in allocation rates would have pricing
consequences.

The previous example suggests that, if our company is operating under capacity, we need to
think carefully about how we allocate the cost of the idle capacity. If we include the cost of
the idle capacity in the cost computations we use to set prices (by allocating it to products),
our clients will pay for it. If we include the cost of the idle capacity in divisional profits (by
allocating it to divisions), the allocation will reduce divisional performance (and thus bonus
payments).

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