How do you classify costs based on traceability?


After separating costs incurred to manufacture products from costs incurred for other purposes, costs can further be divided in two other categories based on whether they can be unambiguously assigned to cost objects.

A direct cost is a resource consumed for a unique and well identified cost object, i.e. uniquely and unequivocally attributable to this cost object, and which can thus be traced to this cost object in an economically feasible way.

An indirect cost is a resource consumed by several cost objects that cannot be uniquely and unequivocally attributed to a specific cost object because it is too costly or impossible to trace.

It is important to stress here that costs are direct of indirect relative to a cost object which must be clearly identified. For instance, wages of maintenance personnel are direct to the maintenance department, but indirect to the products which are manufactured with the maintained equipment. And if a company ships several distinct products to the same customer, shipping costs are direct to the customer but indirect to the products.

Solution.

  1. Direct to the product (employees maintain only machines used by only one product, so you know for which product they work) and direct to the (maintenance) department (employees are explicitly attached to the department).
  2. Indirect to the products (the cost is incurred for two distinct products, and you do not know a priori how much goes to each product) and direct to the (molding) department
  3. Indirect to the products (they sell all products), direct to the customer (each sales person is dedicated to one customer) and probably direct to the (sales) department.
  4. Direct to the product (each sales person is dedicated to one product), indirect to the customers (each one work with several customers) and probably direct to the (sales) department.
  5. Direct to the product (each documentation is dedicated to one product), indirect to the customers (each one is destined to several markets and customers).
  6. Indirect to the product (the campaign benefits all the products of the brand) and direct to the (marketing) department.


Another important distinction which is implicit in the definition of indirect costs is the difference between indirect costs which are too expensive to trace (although it would be technically possible) and indirect costs which cannot be traced at all (it is not technically possible). The former are called common costs and the latter joint costs.


A common cost is a resource consumed for several cost objects and which could technically be traced to each cost object, but not in economically feasible way (i.e. the cost of tracing would exceed its benefit).

Common costs result from the decision of not tracing, and whether a cost is too expensive to trace is to some extent a judgment call. This judgment is influenced by three factors: (1) the materiality of the cost (the bigger the cost, the greater the risks associated with mis-attribution and thus the more justifiable the tracing); (2) the availability of an information gathering technology (like bar-codes, GPS trackers, or dedicated meters); and (3) the design of operations (whether some equipment is dedicated to specific purposes or used for many different ones). The existence of common costs is a typical example of the trade-off between the (certain) costs of greater accuracy in assignment and the (uncertain) expected benefits of such greater accuracy. Tracing is the most accurate rate in theory, but it is also the most expensive and the benefits which can be extracted from these greater accuracy are not necessarily sufficient to justify it.


Joint costs are the cost of a single process which yields multiple distinct products simultaenously. They are the resources consumed for two or more products before these products become separately identifiable, and which thus cannot technically be traced to these products.

Joint costs are indirect not because it would be too expensive to trace them, but because it is impossible to trace them. Examples include the costs of producing raw milk and then separating it into semi-skimmed milk and cream or butter. Or the cost of producing cocoa liquor and pressing it to separate the cocoa powder from the cocoa butter. Or the cost of raising ducks and separating legs and breast to sell them separately. The point where these different joint products and by-products are separated from each other is called the split-off point.

Joint products are the outputs of a joint process which have relatively high sales value and cannot be distinguished, or are not separately identifiable as individual products, before the split-off point.

The split-off point is a juncture of the manufacturing process where joint products become separately identifiable.

Joint products differ from by-product in the sense that they have a significant market value (this will matter for their allocation).

A by-product is the product of a joint process that has a low market value compared to the other joint product(s). To the extreme, the byproduct without market value at all is scrap.

Joint costs are all the costs incurred before the split-off point. All the costs incurred after the split-off point to prepare the joint products for the market are called separable costs.

Separable costs are any costs incurred beyond the split of point.

As we will see later, the distinction between common costs and joint costs is important, first because they cannot be allocated following the same principles, and second because they affect decision making in different ways.

Solution.

  1. joint products
  2. split-off point
  3. joint cost
  4. separable costs



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