In the past, manufacturing operations were mainly labor paced, and direct costs comprised the majority of product costs. Since the early 20th century, automation has been evolving which then gradually replaced labor cost. Those allow almost every staffs/workers to multi-tasking. The emerging trends increases the use of indirect costs in manufacturing which then increased the need for costing systems to deal adequately with indirect costs.
The first thing to do in classifying cost is to test if a cost is direct—a cost that is uniquely and unequivocally attributable to a single “cost object”. If the cost fails the test of being direct it is classified as indirect.
If a single cost object consumes a consumable resource, the cost of the consumable resource is a direct cost for that cost object. The cost of wood used to make a table in a furniture factory is a direct cost that would be assigned to the table. Any cost that fails the test of being a direct cost is an indirect cost. This may sound simple, but disputes in costing about whether a cost should be treated as direct or indirect, outnumber all other costing disputes. So, how to deal with indirect cost in a manufacturing environment? Before going to the topic, you would need to be familiar with some terms used in costing which I will introduce now. Following on, let’s also have a look how cost flows in manufacturing organization and how to differentiate direct and indirect cost. Read on…
Important Costing Terms
A few important costing terms you need to know before going forward:
1. Cost Object – A cost object is anything for which a cost is computed. Examples of cost objects are activities, products, product lines, departments, or even entire organizations.
2. Consumable Resources – The defining characteristic of a consumable resource, also called a flexible resource, is that its cost depends on the amount of resource that is used. Examples of consumable resources are wood in a furniture factory and iron ore in a steel mill. The cost of a consumable resource is often called a “variable cost” because the total cost depends on how much of the resource is consumed.
3. Capacity-Related Resources – The defining characteristic of a “capacity-related resource” is that its cost depends on the amount of resource capacity that is acquired and not on how much of the capacity is used. As the size of a proposed factory or warehouse increases, the associated capacity-related cost will increase. Examples of capacity-related costs are depreciation on production equipment (the capacity-related resource) and salaries paid to employees (the capacity-related resource) in a consultancy. The cost of a capacity-related resource is often called as “fixed cost” because the cost of the resource is independent of how much of the resource is used in the short run.
Cost Flow In a Manufacturing Organizations
The next graph summarizes the manufacturing sequence in a simple organization. Although the production and costing process in most organizations is usually much more complex, the next graph provides the basic idea behind all manufacturing:
As a start, manufacturing costs are usually classified into three groups: (1) direct materials; (2) direct labor; and (3) manufacturing overhead.
Materials are withdrawn from raw materials inventory as production begins. The cost of the raw materials entered into production is moved from the raw materials account to the work-in-process (WIP) inventory account.
The manufacturing operation consumes labor and overhead items (such as machine time and factory supplies), the cost of which are assigned to production by adding them to the work-in-process inventory account.
Overhead costs are assigned (or allocated or apportioned) as determined by the cost system. When manufacturing is completed, work is transferred to finished goods inventory, and costs are moved from the work-in-process inventory account to the finished goods inventory account. Finally, when goods are sold their costs are moved from the finished goods inventory account to cost of goods sold.
Differentiating Indirect Cost with Direct Cost
It is rare but possible for the cost of a “consumable resource” to be properly classified as indirect. For example, suppose that a number of different products are shipped to a customer in one truck. The fuel used by the truck is a consumable resource. However, the fuel is jointly used by all of the products being carried in the truck. Therefore, if the cost object is an individual product on board the truck, the cost of the fuel is an indirect cost to that product since all of the products on board the truck jointly consume the fuel.
Most capacity-related costs are indirect. It is unusual for a capacity-related cost to be a direct cost but it is not rare. For example, the cost of production equipment or a factory supervisor that was acquired for and used exclusively by one product is a direct cost for the product. A good test of whether the cost of a capacity resource is indirect is whether the organization would have no use for the resource if the cost object was abandoned.
- Management Accounting calls the “cost of consumable resources” as “VARIABLE COST” and almost all variable costs are “DIRECT COSTS”.
- Management Accounting calls the “cost of capacity resources” as “FIXED COST” and almost all fixed costs are “INDIRECT COSTS”.
How To Deal with Indirect Costs
To sum up, costing systems first classify costs as direct or indirect. Direct costs are assigned to the appropriate cost object.
Indirect costs are allocated to cost objects in a reasonable way, which means that the allocation ideally should reflect the cause-and-effect relationship between the long-run use of a capacity resource by a cost object and the associated cost of that long-run use. Indirect cost is assigned to an indirect cost pool (there can be one or many). An appropriate portion of the indirect cost is then allocated from the cost pool (or pools) to the cost object (or objects). We now consider some of the details surrounding the design and use of indirect cost pools.
The simplest structure in a manufacturing system is to have a single indirect cost pool for the entire manufacturing operation. This is the setting depicted in the previous “Cost Flow in Manufacturing” graph. Examples of indirect costs in a factory setting, which are usually called “fixed manufacturing overhead,” include: heating, lighting, depreciation on factory equipment, factory taxes, and supervisory salaries. In the simple costing system shown in the previous graph, these indirect costs are accumulated in a single indirect cost pool.
Some organizations create another category called “variable overhead”, which includes costs for such items as machine electricity usage, minor materials grouped as indirect materials (thread, glue, etc.), and machine supplies. Variable overhead costs are actually direct costs that are too costly and too immaterial (in relation to total product cost) to trace to individual cost objects. An example is the cost of the glue used to make each piece of furniture. These variable costs are accumulated in a variable cost account. Variable overhead costs may be assigned as direct costs.
Alternatively, for simplicity, variable overhead costs may be grouped together with fixed overhead in developing methods for allocating overhead to cost objects. In this chapter, we maintain the “indirect cost” terminology for overhead to emphasize the challenges in allocating fixed manufacturing overhead to cost objects.
Organizations use a separate account (such as “Indirect Cost Applied” in the next graph) to record applied indirect costs (that is, indirect costs allocated as production occurs during the year). The resulting situation is shown in the next graph, which shows one indirect cost account that accumulates the actual indirect costs that have been incurred, and a second indirect cost account that accumulates the indirect costs that have been applied to production.
Because the total indirect costs for the year are not known until after the year end, when all the costs have been accumulated, organizations allocate indirect costs to production during the year using a “predetermined indirect cost rate”. The first step in developing this rate is to determine the basis, often called the “cost driver,” which will be used to allocate the indirect cost to production.
Cost analysts try to choose a cost driver that best explains the long-run behavior of the indirect cost. In a labor-intensive environment the cost driver of indirect costs in the factory might be labor hours as factory workers use factory space, utilities, and other overhead resources to make products. In a machine-intensive environment the cost driver of indirect costs in the factory might be machine hours because machines consume electricity, lubricants, and other supplies to make products.
Once the cost driver is chosen, cost analysts divide expected indirect factory costs by the number of cost driver units to compute what is called the predetermined indirect cost rate. Other common names for this rate include predetermined overhead rate and cost driver rate.
The choice of the number of cost driver units to use to determine the predetermined indirect cost rate is a source of debate. We will sidestep that debate for a moment and assume that the cost driver unit chosen in calculating the predetermined indirect cost rate is the factory’s practical capacity. We can now compute the predetermined indirect cost rate as follows:
Predetermined indirect cost rate = [Estimated total factory indirect cost] / [Practical capacity in cost driver units]
Assume that estimated total factory indirect cost at Lie Dharma Company is $14,000,000. The cost analyst has decided to use labor hours as the cost driver, and the factory practical capacity expressed in labor hours is 250,000. The predetermined indirect cost rate is $56 (=14,000,000/250,000) per direct labor hour. Therefore for every labor hour used in the factory to produce the product, $56 of indirect cost will be applied to the product. This example uses what is called a “predetermined plant-wide indirect cost rate” since a single indirect cost rate is used for the entire factory. Sowing it in a cost summary of a product, will be as follows:
Direct materials = $27.89
Direct labor (2 hours @ $25.00 per hour) = $50.00
Indirect manufacturing cost (2 hours @ $56.00) = $112.00
Total manufacturing cost = $189.89
Assigning Indirect Cost with Multiple Indirect Cost Pools
Most organizations use multiple indirect cost pools in order to improve costing. Improvement in costing is defined as the ability of the costing system to more accurately reflect the cause-and-effect relationship between the cost object and the cost of the resources used by the cost object.
Indirect cost pool design is considered to be one of the most important choices in costing system design and requires a considerable amount of skill and understanding of the manufacturing process in the organization. The two most widely used alternatives for designing multiple indirect cost pools are to base them on organizational units, such as departments, or activities (sometimes processes), such as setup and manufacturing.
We will continue the example at Lie Dharma Company to illustrate multiple cost pools designed around organizational units. Production involves two major activities, which are organized into departments: (1) manufacturing; and (2) assembly. Workers in the Manufacturing Department enter large pieces of sheet metal into a computer controlled machine that cuts the sheets of metal into the pieces needed to make the two products.
Workers in the Assembly Department assemble the pieces of metal and undertake finishing operations such as grinding and coating. Machines do most of the work (called a machine-paced operation) in the Manufacturing Department, and workers do most of the work in the Assembly Department (called a labor-paced operation).
Putra, the production supervisor at Lie Dharma, believes that the current system has the potential to distort product costs because the company’s two most important products place very different demands on the manufacturing system, as shown below:
The major difference between the two products is that Product X is assembled using fewer but much larger pieces than Product Y. Therefore, relative to Y it takes longer to cut the pieces for X in the Machining Department, but less time to assemble them in the Assembly Department.
It is important to remember that costing system distortions relate to the handling of indirect costs. Direct costs are not subject to distortions caused by inappropriate costing system design relating to the handling of indirect costs. Therefore, in the following discussion we will focus only on the treatment of the products’ indirect costs.
Suppose that the plant accountant advises that $9,000,000 of the plant’s indirect costs are appropriately assigned to the Machining Department and $5,000,000 of the plant’s indirect costs are appropriately assigned to the Assembly Department.
The practical capacity of the Machining Department expressed in machine hours (the assumed cost driver in that department) is 30,000 and the practical capacity of the Assembly Department expressed in labor hours (the assumed cost driver in that department) is 200,000. Therefore we can compute the predetermined indirect cost rate for the two departments as follows:
Predetermined indirect cost rate:
Assembly Department = 5,000,000 / 200,000 = $25
Machining Department = 9,000,000 / 30,000 = $300
The next table summarizes the indirect cost allocations resulting from the two department system.
Indirect Cost Allocation Product Y:
From machining (0.15 x $300) = $45.00
From assembly (1.75 x $25) = $43.75
Indirect Cost Allocation Product X:
From machining (0.25 x $300) = $75.00
From assembly (0.75 x $25) = $18.75
Total = $93.7
Note that the indirect cost allocation to Product X under the plant-wide rate system is $58.80 [=(0.30 + 0.75) x $56]. Recalling the earlier calculation of the factory indirect cost allocation to Product Y in the plant-wide rate system, we have the comparative results shown below:
The two-rate system tracks the two products’ use of the capacity resources (machine time and labor time) more closely and, therefore, provides a more accurate and meaningful allocation of the costs of the capacity resources the two products use. Note that for Product X the allocated indirect cost increases (relative to the plant-wide rate approach) because of its heavier consumption of machine time (the more costly resource). For Product Y the allocated indirect cost drops because it consumed relatively less of the more costly resource.
Costing Distortions Due To Different Cost Drivers
Costing distortions can arise when indirect cost pools include costs that have different cost drivers. The following example illustrates this idea:
Lauw Dharma Chemist manufactures two products used for disinfecting sensitive surfaces such as operating theaters in hospitals. The major difference in the two products is that one has an active ingredient that causes the product to have a shelf life of only about 60 days. The other product has virtually unlimited shelf life.
Indirect factory overhead at Lauw Dharma Chemist amounts to $35,000,000 per accounting period. The factory accountant believes that the practical capacity of the plant is best represented by production volume, which is 2,000,000 liters of product.
This results in a predetermined factory overhead rate of $17.50 (=$35,000,000/2,000,000) per liter of product. The next table summarizes the resulting cost per liter estimate for each product, which was doubled to determine the selling price of each product.
Product ABC Product XYZ
Direct materials $35.00 $44.50
Direct labor $12.00 $14.25
Variable overhead $4.25 $6.75
Fixed overhead $17.50 $17.50
Total cost $68.75 $83.00
Price $137.50 $166.00
Based on complaints that Product ABC seemed overpriced relative to its competitors and XYZ underpriced, a cost study was undertaken. This study revealed that approximately $8,000,000 of the indirect overhead costs relate to providing the capacity for setting up production runs. Setup costs are high because the packaging machines have to be carefully cleaned and disinfected to ensure product integrity.
Product ABC is usually produced in batches averaging 10,000 liters, whereas XYZ is usually produced in batches averaging 1,000 liters.
With this information in mind, the factory accountant organized the fixed manufacturing overhead into two pools. The first pool of $27,000,000 in costs was allocated based on production volume and the second pool of $8,000,000 was deemed to supply setup capacity amounting to 1,000 batches per period. The predetermined rates for volume-driven and setup-driven overhead were then computed as $13.50 (=$27,000,000/2,000,000) and $8,000 (=$8,000,000/1,000), respectively. This resulted in the product cost estimates reported below:
Product ABC Product XYZ
Direct materials $35.00 $44.50
Direct labor 12.00 14.25
Variable overhead 4.25 6.75
-Volume driven overhead
(1 liter @ $13.50) 13.50 13.50
-Setup driven overhead
-Setup driven overhead
Total cost $65.55 $87.00
Price (Total cost x 2) $131.10 $174.00
This example illustrates the costing distortions that can arise when an indirect cost pool includes costs with different cost drivers and where different products use the capacities underlying the indirect costs differentially. In this case Product XYZ, a heavy user of setup activities, was being under-costed in the volume-based system because significant costs were being driven by setups and not production volume.