Direct cost

- Direct costs can be accurately traced to cost objects because they can be specifically and
exclusively traced to a particular cost object.
- Method: Direct cost tracing.

Tracing system
a. Time sheet / job card for time tracing x hourly pay rate to employee
b. Material requisition

Indirect cost (also called overheads)

- Indirect costs cannot be traced specifically.

- Method: cost allocation – use of surrogate rather than director measure.

For example, consider an activity such as receiving incoming materials.

Influence of cost: Number of receipts (allocation base / cost driver)
Allocation to products based on: Number of material receipt each product require
If 20 % of the total number of receipts for a period were required for a particular product then
20 % of the total costs of receiving incoming materials would be allocated to that product.
Assuming that the product was discontinued, and not replaced, we would expect action to be
taken to reduce the resources required for receiving materials by 20 per cent. (Cause and effect
allocation)

Two absorption systems

Traditional

- Tend to use arbitrary allocations

- First stage: Overheads are assigned to cost pools / cost centers (normally departments but in
some cases they consist of smaller segments such as separate work centers within a
department)
- Second stage: Cost accumulated in first stage are allocated to products using allocation bases /
cost drivers.

Four steps to achieve above allocation

1. assigning all manufacturing overheads to production and service cost centres;

o Require preparation of overhead analysis sheet

2. reallocating the costs assigned to service cost centres to production cost centres;
o logical basis: value of material issued – suitable approximation that each production
center receive of benefit from Material Procurement service center
3. computing separate overhead rates for each production cost centre;
o Cost center overhead / Cost center direct labour / machine hour (capacity
determinant)
4. assigning cost centre overheads to products or other chosen cost objects.
ABC

- Mainly use Cause-and-effect allocations