Accounting Business Reporting for Decision Making

472 Accounting: Business Reporting for Decision Making

Total indirect costs

Indirect cost

e.g. rent

Indirect cost

e.g. insurance

Indirect cost

e.g. salaries

Department/Activity Department/Activity

Direct costs

Department/Activity

Final cost object of interest

Total cost = Direct cost + Allocated indirect cost

FIGURE 11.5 Refinement of simple costing system

ILLUSTRATIVE EXAMPLE 11.2

Determination of full cost — cost objects (business units)

Partridge Insurance Company has three service departments — finance, personnel, and computer ser-

vices — each providing services to the entity’s three operating departments: home insurance, car insur-

ance, and life insurance. Partridge’s management wants to determine the full cost of each operating

department to assist in the pricing of insurance premiums for the various policies issued by the entity.

An investigation by the accounting department identified the direct costs for each department (both

service and operating) and appropriate cost drivers to allocate the service department costs to the oper-

ating departments. (Remember the costs of the service departments are indirect costs of the operating

departments.) There were also a number of other cost categories (rent, electricity, and general adminis-

tration) that were deemed indirect as the resources were used for the benefit of all departments.

The first stage allocation involves the allocation of costs sourced from the accounting system to the

cost objects, which in this stage are the departments. (Note: In this example it is assumed that the ser-

vice departments do not share resources. Further study of service departments sharing resources can

be found in more advanced texts.)

An overview of the relationships between the costs and cost objects in this first stage allocation is

shown in figure 11.6. You will notice that the direct costs are traced directly to each department.