Basic Cost Management Concepts

Multi-product firms have to account for costs that can be tied to a product, direct costs. They also have to account for indirect costs not directly measurable (e.g., electricity). A 'cost object' can be a product, service, process or any items which management requires cost information. The way that costs are assigned depends on their nature. A direct costs is easily traceable with a high degree of accuracy and indirect, or overhead, cost cannot be easily identifiable with a particular object.

Product costs are costs allocated to a product; this is not just physical products. All other costs are period costs. Such costs are expenses to the income statement in the period they are incurred. Product costs are recognised as an expense in the income statement only when the product is sold. Prior to sale the cost of products is shown as an asset (work in progress or finished good) due to the accrual principle.

The stages in the allocation of overheads to products are as follows;

1) Identify overhead costs collected from production and service cost centres and apportion as appropriate and possible.
2) Once identified allocate to production departments.
3) Allocate overheads to a single product by dividing the number of products into the total overhead. The resulting sum can then be applied as cost to the product.

Total Overheads of a Production Costs Centre ($s)/Level of Activity (units)

Predetermined overhead absorption rates are estimates of future expenditures. Estimates are used becuase some overhead costs are not known for some time until afterthey have incurred (e.g., electricity). Normal costing is where the cost object is determined using the actual costs for the direct the direct costs and a predetermined rate for the allocation of indirect costs.

Functional-based cost accounting classifies all costs as either fixed or variable in relation to changes in the volume of units produced.

Activity-based costing tries to capture changes in technology by apportioning oveheads to product costs taking into account activity and transactions that drive the cost. An activity cost pool is where the costs of an activity under the ABC system are accumulated. Drives are factors that cause changes in the use of resources. The focus in ABC is managing activities instead of costs.

Absorption costing is where the cost of inventories is determined in order to include an appropriate share of variable and fixed costs. Fixed costs are allocated on the basis of normal operating capacity. In variable costing, only the production costs are used.

Using absorption costsing, production overhead costs are included as a product cost whereas in variable costing they are treated as a period cost. This leads to different values of inventory and therefore different net profit figures.

The difference in profits derived from the application of the two methods can be reconciled by the following:

Fixed Overhead Absorption Rate * Movement of Inventories in a period = Difference in Profits