Apportioning costs to profit and cost centres
When considering contribution costing, we identified the arbitrary nature of trying to allocate fixed and indirect costs to products in a multi-product firm and examined the salary of an employee in marketing department. Contribution analysis is based on the principle that unless a cost is directly attributable to a product, it should not be apportioned.
However, many firms do attempt to allocate fixed and overhead costs. This may be as a way of making managers of departments and products aware of their responsibility for covering more than the direct costs of what they do. After all, the firm must pay for company-wide costs, such as administration costs, IT and rent, to establish whether it is profitable overall. The choice of method to allocate overhead costs will have a significant impact on the performance of each of a firm's cost and profit centres. The choice of method is at best quasi-scientific, and at worst subjective, because using one method may show a product is profit making, and using another method may indicate it is making a loss. Strategically, this could impact on whether a firm continues to sell a product or maintain a regional office.
Assume a factory produces 3 products A, B and C
|SALES (% of total)||30||30||40|
The following costs apply to the business:
|Raw materials||100 000|
|Total VC/DC||300 000|
|Rent of factory||40 000|
|IT costs||20 000|
|Catering costs||6 000|
|Total FC/IO||100 000|
DIRECT COSTS: these are the costs that can be directly related to a department or product e.g. wages and raw materials. It is easy to identify the cost of the raw materials used to produce A and those cost of the materials used to produce B and C. These costs can be allocated to each product. The same applies to wages. Assuming each worker earns the same, the cost to A is 100 workers multiplied by the individual wage. For B this is 50 workers and will be half of the cost for A.
INDIRECT COSTS: these are costs that are not directly related to the cost of producing an individual product. For instance, how is the factory rent of $40 000 divided between the three products? The firm could decide to divide this cost up in proportion to floor area - product A assumes 40% of the rent as it has 40% of the area, but B only 20%. However, the firm could also decide to divide it up according the ratio of sales, or by some other method.
Similarly how does the firm divide up the cost of the HRM department? This could be in the ratio of the number of workers of A B and C - 100:50:50 (2:1:1) or could be on area or sales.
Some choices for allocation may appear more sensible, but still may lead to inaccuracies.
Why? - Any allocation of costs to A, B and C is likely to be inaccurate. For example, the HRM department may spend most of its time dealing with the staff making product B and not product A, despite the fact that there are fewer staff in number.
However, it is necessary for someone to pay indirect costs as it is impossible to work out PROFIT until indirect costs are paid.
The most common methods of allocating costs are:
- Full costing
- Absorption costing
- Marginal costing
We consider each of these methods on the next few pages.