Accounting Business Reporting for Decision Making

466 Accounting: Business Reporting for Decision Making

ILLUSTRATIVE EXAMPLE 11.1

Classifying costs as direct or indirect

Oh Belgium! is a local rock group that performs regularly at venues around the Asia–Pacific region.

Costs incurred by the group during October are listed below. Note the classification of each cost as

either direct or indirect in relation to a show held at the Toff of the Town venue in Melbourne.

1. Rehearsal room hire to practise for the shows in October (indirect cost).


2. Petrol costs incurred to go to rehearsals and the shows in October (no record of kilometres travelled;
   indirect cost).


3. Wages of a sound engineer for each show (direct cost).


4. Advertising brochures for the shows during October (indirect cost).


5. Interest payment on loan for musical instruments (indirect cost).


6. Payments to band members for each show (direct cost).


7. Guitar strings — new set needed for each show (direct cost).
   The cost object in the Oh Belgium! example is the show held at the Toff of the Town venue in October.
   Only those costs that were incurred directly for this particular show would be classified as direct
   costs — items 3, 6 and 7. All other costs (items 1, 2, 4 and 5) would be classified as indirect because
   the expenditure is for the benefit of all shows held in October.

VALUE TO BUSINESS

•   Cost information assists entities in price setting, profitability analysis, performance evaluation and

cost management.

•   As the costs in the financial reports are aggregated, information is not provided in sufficient detail to

assist in the day-to-day management of entity activities or in strategic decision making.

•   To better understand why costs are incurred, the entity will allocate costs to the specific objects that

caused costs to be incurred.

•   To determine the full cost of a cost object, it is necessary to assign the direct costs and to allocate

the indirect costs.

•   With a tracking system, direct costs can be traced to specific cost objects.

•   Indirect costs are incurred for the benefit of multiple cost objects and need to be allocated to

individual cost objects because it is not economically feasible to trace them directly to individual

cost objects.

11.3 Cost allocation

LEARNING OBJECTIVE 11.3 Discuss the allocation process for indirect costs.

As indirect costs are incurred for the benefit of multiple cost objects, determining the full cost of a

particular cost object will require assigning such costs to the many cost objects that have received the

benefit of the resources. Cost allocation refers to the process of allocating indirect costs to the cost

objects that make use of the resource.

Unless required by an external party, the allocation of costs by an entity is discretionary. For example,

to comply with external requirements/regulations, entities must calculate inventoriable product costs in

line with International Financial Reporting Standards (IFRS). This requires the recognition of direct pro-

duction costs and indirect production costs.

Some examples of the reasons why entities choose to allocate indirect costs include:

• to determine the full cost of a specific cost object in order to undertake profitability analysis, which

will provide a basis for pricing decisions and assist in resource allocation decision

• to allocate the cost of shared services such as accounts payable, payroll and information technology

(cost assignment will remind business unit managers of the full economic impact of their decisions)