Companies must accurately determine the costs of their products and services to make sound management decisions. For instance, if a particular item costs $540 to produce, but the market price is only $515, the company will lose money and might be better off discontinuing that product.

Let’s take an example from a general situation: a Sales Manager (SM), a Production Manager (PM), and a Cost Accountant (CA) walk into a nice bar. You are the cost accountant. The three of you have dinner discussing Yore Company’s current product lines and how to make them profitable. You order a Caesar salad. The sales manager orders steak, and the production manager has the pasta special. You also split a plate of escargot, but the SM and the PM don’t really like them, so you eat four of the six snails. They each have only one. The SM has two glasses of wine during dinner, and the PM has one. You stick to water. After dinner, the three of you split a tiramisu three ways. The service was excellent so you all agree to leave a 20% tip. When the bill comes, the sales manager suggests you split it three ways evenly:

$270 split three ways is $90 each.

However, the production manager notices that the steak dinner was quite a bit more than the pasta, and so suggests that the meals be separated and the rest of the bill split evenly, and pencils it out on a napkin:

As a cost accountant, you suggest the items be allocated as directly as possible and that anything shared, like dessert and the appetizer, be allocated according to a rational basis. You grab a pen and a napkin and sketch out the following proposal, splitting the escargot appetizer by pieces (1:1:4) and the dessert in equal thirds.

Notice that each iteration gave a clearer and more accurate picture of the actual cost of each meal, with specifically identified costs allocated directly to each person and shared costs (these would be like manufacturing overhead) allocated on a rational basis.

A manufacturer’s product costs consist of direct materials, direct labor, and indirect costs such as factory overhead. In addition, some costs are variable (such as direct materials and direct labor) and some are fixed (most of the factory overhead costs). The materials and labor are direct costs that can be identified and traced to the product. Factory overhead, however, is indirect and must be allocated to the product to determine the actual cost of the item.

Let’s take a hypothetical situation. Yore Company makes two kinds of purses, basic and deluxe, and for October, it reported the following results from operations:

Sales are broken down as follows:

The new sales manager is paid a bonus on the gross profit above $80,000, so did not receive a bonus in October, and is arguing that since the company sold 3,760 purses at a total manufacturing cost of $1,001,600, the cost of each purse must be approximately $266.38, and since the deluxe purse sells for $515.00, the company should focus on that product and discontinue the basic purse completely since it has a negative gross profit.

The production manager, however, notes that the deluxe model takes more than twice as long to manufacture and is much more labor-intensive and is arguing that if the deluxe model was discontinued, the company could focus on the basic model and would ultimately make more money.

Both the production manager and the sales manager would like the managerial accountants to come up with an exact cost for each purse which includes both fixed and variable costs so they can better analyze their approach to production and sales.

In this module, you’ll learn how to allocate indirect costs using various methods, from simple to complex, and how managers use that cost data to make production and sales decisions.

Here are the three different methods of allocating factory overhead that you will study:

1. Single factory-wide rate – the same rate based on the same activity base for all departments.
2. Departmental rates – different rates for different departments, but a single rate within a department.
3. Activity-based costing – different rates for different processes and activities, regardless of department.