Accounting Business Reporting for Decision Making

CHAPTER 11 Costing and pricing in an entity 465

resource. For example, material requisitions record the product, service, business unit or activity that

has requested the material items, and payroll records record employee costs against specific business

units or tasks. The more costs that can be directly traced increases the accuracy of the costs for the cost

object. However, the cost of a tracking system can be prohibitive and entities will only commit resources

to trace costs if such costs are deemed important to the entity or the cost of tracking is minimal. A cost/

benefit test will be used by an entity to assess the costs against the benefits of a more detailed system

of tracking cost information. If the cost does not exceed the benefit, then the cost will be directly traced

to the cost object. If the cost is greater than the benefit, the cost will be assigned to an indirect cost

category, which is discussed below.

Direct cost Cost object

F I G U R E 11. 2 Relationship of direct cost to a single cost object

Indirect costs

Indirect costs (also referred to as overheads) are those costs that are used for the benefit of multiple

cost objects. An indirect cost has a relationship to many cost objects. Figure 11.3 shows the relation-

ship between an indirect cost and the many cost objects that consume the resource. These costs may be

directly traceable to an individual cost object, but such an exercise may not always pass the cost/benefit

test. For example, what would be involved in collecting information about the number of nails used in

the construction of a particular house if the builder is constructing 20 houses at the same time, or the

amount of glue used to laminate individual office desks? Clearly, the benefits of calculating these costs

would be outweighed by the cost of doing so. The question then arises as to how these indirect costs can

be allocated to the many cost objects that have made use of the resources? We will address this issue in

the following section.

The classification of a cost as either direct or indirect will depend on the specific cost object that has

been identified as the focus for the cost analysis, as well as on a cost/benefit assessment of tracing the

cost. The total cost of a cost object is:

Total cost of a cost object = direct costs + indirect costs

Cost object A

Cost object B

Cost object C

Indirect cost

FIGURE 11.3 Relationship of indirect cost to multiple cost objects

Illustrative example 11.1 explores the classification of costs as direct or indirect in relation to a cost

object.