eAnnexure 3: Cost Accounting

Coauthored by Deborah Agostino

Politecnico di Milano, Department of Management, Economics & Industrial Engineering

A3.1 COSTS AND COST ACCOUNTING

Cost is the monetary measure of the resources sacrificed or forgone to achieve a spe-
cific objective (where this objective is called the cost object), such as acquiring a good
or a service. If you think of a T-shirt or a dinner at a restaurant, all the resources
required for realizing the product or rendering the service can be defined as costs. For
example, yarn and buttons are some costs that can be associated with the production
of the T-shirt. Food, wine, or waiters are examples of resources for rendering the din-
ner service at a restaurant. In accounting, the term “cost” must be defined more pre-
cisely. It is usually accompanied by an adjective (e.g., fixed or direct).
Cost accounting can be defined as the set of rules and systems devoted to compute
and distribute enterprise costs, which serves different purposes:
• Calculating the costs of products, services, and projects for profitability analysis or
for inventory valuation
• Assigning costs to organizational units and
• Supporting short-term decision making, such as to make or buy.
Cost accounting therefore provides information to managers inside the organization.
It can be said that cost accounting supports internal accountability, contrary to finan-
cial accounting, which is for external accountability (i.e., providing information to
external decision makers). Given its aim to support internal decision makers, cost
accounting is nonregulated. This does not imply the absence of rules, but the absence
of international accounting standards to be adopted by enterprises. General rules and
techniques can be identified, even though each enterprise can then customize the
approach on the basis of its specific needs. This chapter aims to provide knowledge on
the main cost accounting rules and techniques that can be adopted. The first section
discusses cost classifications, whereas the second section details the approaches to
assign costs to products or services (generally to cost objects).

A3.1.1 Cost Classification

In accounting, the term “cost” is never used as a stand-alone entity but is always
accompanied by an adjective that further specifies the type of cost to which it refers.
Three different cost classifications can be identified:
• Direct and indirect costs
• Product and period costs and
• Fixed and variable costs.
e16 eAnnexure 3: Cost Accounting

Each of these classifications serves different purposes. The first two classifications are
usually adopted to compute the cost of the product or service (hence addressing the first
purpose of cost accounting) or to assign resources to organizational units (the second pur-
pose of cost accounting). The distinction between fixed and variable costs and between
avoidable and nonavoidable costs is particularly useful when the purpose of cost account-
ing is to support short-term decision making (the third purpose of cost accounting).

A3.1.1.1 Direct and Indirect Costs

An initial important classification of costs distinguishes between direct and indirect costs.
Direct costs are those costs that can be specifically and exclusively identified with a
particular cost object. For example, the plastic used in producing bottles of water is an
example of a direct cost, given that its consumption can be directly traced to each unit
of the product. For large projects, the amount of direct costs is very high, given that
several resources can be directly associated with one unit; think, for example, of the
construction of cruise ships: metal, labor, and furniture are all direct costs. Usually,
direct material and direct labor are classified as direct costs. Direct material refers to
all the physical components that are used for realizing a single unit of the final product
or service. If we think of the manufacture of laptops, all the components used for pro-
ducing one unit are direct costs: every realized unit will absorb the same amount of
direct resources. Direct labor refers to employees who are physically involved in the
realization of one unit of the product. In a manufacturing department, employees
working in the production or assembly lines can be defined as direct workers because
it is possible to identify the time spent for realizing one unit of a product and therefore
the cost absorbed by the single unit.
Indirect costs are those costs that cannot be identified specifically and exclusively with
a given cost object; in other words, they are caused by two or more cost objects jointly.
With reference to the production of bottles of water, plant depreciation is an indirect
cost because it cannot be associated exclusively and specifically with one unit of a water
bottle. In large projects, such as building a cruise ship, the depreciation of fabrication
and assembly shops is shared by more than one project. Indirect costs are also defined
as overhead (OVH). With reference to a manufacturing process, OVH can be further
distinguished between manufacturing and nonmanufacturing. Manufacturing OVH
refers to indirect costs related to the production process: machine depreciation, energy
consumption, and machine maintenance are examples of manufacturing indirect costs.
They cannot be assigned univocally to one unit of the final product, but they represent
resources involved in the production process. All the remaining resources that do not
enter the production process are defined as nonmanufacturing OVH. They include, for
instance, marketing expenses or administrative and commercial expenses (Box eA3.1).

A3.1.1.2 Period and Product Costs

A second relevant distinction is between product and period costs.
Product costs are the value of resources used for producing a product or delivering
services. They include the following categories of resources:
• Direct materials, encompassing raw materials and components that can be traced
to a single product or service.
• Direct labor, which are costs incurred directly in bringing the product into its cur-
rent condition (transformation) and location.
• Manufacturing overheads, which are costs associated with manufacturing activities
overall but not specifically to a single product or service.
 eAnnexure 3: Cost Accounting e17

Box eA3.1 Example: Distinction Between Direct and Indirect Costs

The following resources are employed within a production department in charge
of making T-shirts:
• One production machine
• Four direct workers
• One supervisor of the entire production process.
We want to distinguish between direct and indirect costs. This distinction can-
not be defined a priori for all the resources, but it depends on the cost object.
If the cost object is represented by the final product (the T-shirt), direct work-
ers are considered direct costs, while the remaining resources can be classified as
indirect. Direct workers represent the only resource that can be unambiguously
assigned to the realization of one unit of the final product.
On the contrary, if the cost object is the production department, all the listed
resources (production machine, direct workers, and supervisor) have to be classi-
fied as direct costs, given that they are specifically absorbed by the production
department itself.

Period costs refer to the value of resources used in activities that cannot be directly
associated with the manufacturing activity or service delivery. Typical examples of
these costs are selling and marketing expenses, research and development expenses,
and administrative and general expenses.
Direct costs (i.e., direct material and direct labor) are always classified as product
costs. On the contrary, indirect costs can be either product or period costs. It depends
on their direct contribution to the realization of the product or rendering the service.
Manufacturing overheads are product costs, whereas nonmanufacturing overheads
correspond to period costs.

A3.1.1.3 Fixed and Variable Costs

Another cost classification distinguishes between fixed and variable costs. The division
between fixed and variable costs relates to how the cost varies in relation to changes in
volumes or, more generally, the level of activity of the enterprise/unit. In particular:
• Variable costs are resources that vary, in total, directly and proportionately with
the variation of the volume (or activity level).
• Fixed (or nonvariable) costs are resources that, in total, do not vary with the vol-
ume (or activity level).
• Semivariable costs include a combination of variable- and fixed-cost items.
Figure eA3.1 shows the graphical representation of the three types of costs on a
Cartesian graph, where the vertical axis reports total costs and the horizontal axis
reports the activity level (most commonly, the volume of output).
Suppose that you are organizing a party in a villa you are going to rent, with an
external catering service and a boy band playing some music. You want to estimate
the cost of this party to determine the amount of money you need. Some costs will be
dependent on the number of people who will attend (the activity level). For example,
food, drink, or entry tickets will increase proportionally with the number of guests
e18 eAnnexure 3: Cost Accounting

Variable costs

Total cost (€)

Semi variable costs

Fixed costs

Activity level (units of outputs)

Figure eA3.1 Variable, fixed, and semivariable costs.

attending, and these can be classified as variable costs: the more people who come, the
higher the value.
Some other costs would not be dependent on the activity level. The cost to rent the
villa or the boy band would be the same amount regardless of the number of guests.
This means that they can be classified as fixed costs. Furthermore, assume that you
hire a promoter. He or she will receive a fixed amount for this activity, plus a commis-
sion depending on the number of people he or she will be able to convince to come to
the party. This is a typical example of a semivariable cost given the existence of both a
fixed and a variable component.
In the case of a manufacturing process, utilities are typical examples of semivariable
costs: a monthly charge, which is the fixed component, plus the variable part that
depends on the level of the activity.
The distinction between variable and fixed costs is very useful in simulating cost
trends in the face of activity level changes. In the example of the party, you can calcu-
late the amount of the total costs per a different number of guests. This type of analy-
sis would be useful to understand the feasibility of the party itself. Moreover,
assuming that you will set an entry price for the party itself, the estimation of the cost
per each activity level would support you in the selection of the price rate that allows
you to cover your expenses. As you can see from the example, this cost classification is
particularly useful in decision making.

A3.1.2 Assigning Costs to Cost Objects

One of the purposes of cost accounting is to determine the value of products or ser-
vices by assigning the value of resources to the final cost object. This section will dis-
cuss the rules and managerial techniques that can be adopted in order to calculate the
cost of products or services. The process of assigning costs to cost objects includes two
main decisions:
• The selection of the cost configuration
• The definition of the allocation methodology.
 eAnnexure 3: Cost Accounting e19

A3.1.2.1 Cost Configuration

The first two cost classifications (direct versus indirect and product versus period) are
particularly useful within cost accounting, given that they support the identification of
cost configuration. Assume that we want to define the cost for producing a T-shirt.
The first problem is represented by the identification of the resources we want to
assign to our T-shirt: Which resources do we want to include to determine the value of
the T-shirt itself? The selected resources represent the cost configuration. Three differ-
ent cost configurations can be identified (Figure eA3.2):
• Prime cost, which is associated with a product’s direct costs only (material and
labor).
• Full manufacturing cost, which assigns all product costs to the final product (i.e.,
direct material, direct labor, and manufacturing overheads).
• Full cost, which associates all costs (both product and period) to products.
The selection of the cost configuration is a managerial choice. A prime cost configu-
ration is particularly precise in tracing costs to cost objects, but it is not complete,
given that all the indirect resources are not considered in defining the value of the final
product. On the contrary, a full cost configuration is complete by considering all the
involved resources. At the same time, it is also less precise because of the introduction
of some approximations for assigning the value of shared resources to the final
product.
If we return to the example of the T-shirt, a prime cost configuration would assign
the T-shirt the value of raw materials and direct labor only. The adoption of a full
cost configuration, however, would also include the value of machine depreciation,

Direct Direct
material labour

Prime cost

Direct Direct Manufacturing

material labor OVH

Full manufacturing cost

Non
Direct Direct Manufacturing
manufacturing
material labor OVH
OVH

Full cost
Non
Direct Direct Manufacturing
manufacturing
material labor OVH
OVH

Figure eA3.2 Cost configurations.

e20 eAnnexure 3: Cost Accounting

energy, electricity, supervisors, and commercial and administrative expenses. The value
of the T-shirt—by adopting either the prime or the direct cost configuration—will be
very different, and this trade-off between completeness and precision should be consid-
ered before deciding which configuration to adopt.

A3.1.2.2 Definition of Allocation Methodology

Once companies have decided which cost configuration to adopt, a method for allocat-
ing costs has to be chosen. The distinction between direct and indirect costs impacts
the definition of the allocation methodology. In the presence of direct costs, the value
of the cost object is defined by tracing costs to the cost object. If a good information
system is in place, there is no subjectivity in apportioning resources to the final prod-
uct or service. On the contrary, indirect costs should be allocated to costs, which means
making a hypothesis about the consumption of joint resources.
Assume that we want to calculate the cost for producing our T-shirt. The unit value
of the raw material and of the direct labor will be univocally assigned to our unit of
the T-shirt with no subjectivity. If the cost of raw material would be 3 h per T-shirt,
whereas the labor cost would be 2 h per T-shirt, then the total direct cost for realizing
one unit of our T-shirt would be 5 h.
The problem arises when we want to assign indirect costs, such as machine deprecia-
tion, warehouse rent, or a department supervisor, to one unit of our T-shirt, given that
these resources are involved in the joint realization of more than one unit. The assign-
ment of indirect costs to the final cost object is defined as allocation.
The allocation process includes the following steps:
• Calculating the amount of indirect costs to be allocated (OVH).
• Choosing an allocation basis, which is a metric used as a proxy for the resource
consumption. For example, if the indirect resource is production machinery, a com-
mon allocation basis is the number of units produced or the time of production.
• Calculating the value assumed in a specific period of the allocation basis.
• Calculating the allocation coefficient by dividing OVH by the total value of the
allocation basis.
• Calculating the proportion of indirect costs to be assigned to each project/project/
service by multiplying the allocation coefficient by the value assumed by the alloca-
tion basis for a specific product.
The following example can clarify the allocation process.
Suppose that a company, Textile, has two products (scarves and ties) that share the
same production machine during the year, for which these costs arise:
• Machine depreciation: 90,000 h
• Cost of machinery supervisor: 50,000 h
During the year, the production was as follows:
• Ties produced: 10,000 ties (unit time of production 5 30 min)
• Scarves produced: 20,000 scarves (unit time of production 5 20 min)
Following the cost allocation process for indirect costs, the steps are:
• Calculating total-OVH: 90,000 h 1 50,000 h 5 140,000 h
• Choosing the allocation basis-Textile determines machine time as the allocation
basis
 eAnnexure 3: Cost Accounting e21

Table eA3.1 Example of Allocation Basis Calculation

Ties Scarves Total

Production unit time 30 min/unit 20 min/unit —

Units produced 10,000 units 20,000 units 30,000 units
Total production time 300,000 min 400,000 min 700,000 min

Table eA3.2 Example of Cost Allocation Using a Proportional Approach

Ties Scarves

Allocation coefficient 0.2 h/min

Production unit time 30 min/unit 20 min/unit
Portion of OVH assigned to products 6 h/unit 4 h/unit

• Calculating the value of the allocation basis (Table eA3.1)

• Calculating the allocation coefficient by dividing OVH by the total value of the
allocation basis
140; 000 h
Allocation coefficient 5 5 0:2 h=min
700; 000 min
• Calculating the proportion of indirect costs to be assigned to each project/project/
service by multiplying the allocation coefficient by the value assumed by the alloca-
tion basis for a specific product (Table eA3.2).
This type of allocation is called proportional allocation, given that indirect costs are
apportioned according to proportional criteria. Actually, different allocation methods
can be adopted depending on the level of precision in the assignment of resources to
the final product. The following paragraph will discuss the available allocation
methods.

A3.1.3 Cost Allocation Methods

This paragraph illustrates four methods that allocate both direct and indirect costs so
that they can be employed for full cost and full manufacturing cost configurations.
These methods include the following: process costing, job order costing, operation
costing, and activity-based costing (ABC), which vary in terms of precision.
Table eA3.3 shows how these methods vary in terms of precision. Process costing is
the less precise method, adopting proportional criteria for all types of costs (direct
material, direct labor, and overhead). Operation costing improves precision by tracing
direct material to products with cause
effect criteria. Job order costing traces direct
resources (both direct material and direct labor) to products with cause
effect criteria
and allocates overhead with a proportional allocation. Finally, ABC is the most pre-
cise method, which also aims at a more precise allocation for overhead.

A3.1.3.1 Process Costing

Process costing is the simpler and less expensive method in terms of data collection
and analysis. Following this method, all the costs (direct material, labor, and
e22 eAnnexure 3: Cost Accounting

Table eA3.3 Cost Allocation Methods

Direct Material Direct Labor Overhead

Process costing Proportional Proportional Proportional

Operation costing Cause
effect Proportional Proportional
Job order costing Cause
effect Cause
effect Proportional
Activity-based costing Cause
effect Cause
effect Cause
effect

overhead) are allocated with proportional criteria. Then, the unit cost is determined as
a ratio between total costs and the units of output produced.
total costs
Unit cost 5
units produced
In real cases, the allocation is not so simple because costs are calculated with refer-
ence to a specific time interval (a month or a week); hence, there can be both units of
final products and work in progress (WIP). In this case, WIPs have to be qualified in
terms of degree of completion, which is the percentage of total costs a product in pro-
cess has already absorbed with respect to the total amount of resources absorbed by a
finished product.
The degree of completion allows the calculation of the number of equivalent units,
which is the number of finished products a company could have realized using
resources employed for WIP and finished goods for producing only finished products.
Analytically, we have:
Neq 5 QC 1 QWIP 3 dcWIP
where
Neq 5 number of equivalent units
QC 5 completed quantity
QWIP 5 work in progress quantity
dcWIP 5 degree of completion (in percentage).
Having calculated Neq, it is now possible to calculate:
total costs
Unit costðeqÞ 5
N eq
To illustrate this calculation, suppose that, over a period of time, Company A pro-
duced 600 completed units and 400 units of work in progress at 50% of completion.
During the same period, the value of materials and conversion costs that entered into
the process is 16,000 h (Figure eA3.3).
Neq 5 600 1 400 3 0:5 5 800 units
 
16; 000 h
Unit cost 5 5 200
800 equivalent unit
Following these calculations, the cost of each completed unit is 200 h/unit; the cost
of WIP at 50% of completion is
   
h
100 h=u 5 200 3 0:5
equivalent unit
 eAnnexure 3: Cost Accounting e23

Total cost = 16,000€ Completed units

600 units
(100% completion)

Ending work in progress

400 units (50% completion)

Figure eA3.3 Variable, fixed, and semivariable costs.

A similar calculation is carried out when there are two or more products processed.
In this case, one product is taken as a reference, and equivalent units are calculated in
proportion to the resources absorbed in relation to this product.
A final element to be taken into account is the possible presence of initial invento-
ries. In this case, the application of process costing varies if products and WIP are val-
ued with the first in first out (FIFO) method or the weighted-average cost method. In
the case of average cost logic, the unit cost is determined including the cost of initial
WIP (CWIPinitial) as resources that are added to material and conversion costs used in
the period t (Ct) divided by the number of equivalent units summing both ending WIP
and completed units:
Neq 5 QC 1 QWIPending 3 dcWIPending
Ct 1 CWIPinitial
Unit costðeqÞ 5
N eq

Using the FIFO approach, allocation is done only for resources sustained during
the period—hence, subtracting the initial WIP from the number of equivalent units is:
Neq 5 Qc 1 WIPending 3 dcWIPending
WIPinitial 3 dcWIPinitial
Unit costs are calculated as follows:
Ct 1 CWIPinitial
Unit costðeqÞ 5
N eq
Process costing is the least precise and onerous cost allocation method among the
four aforementioned methods. Its use is appropriate with homogenous productions,
where a few similar products or services are processed on a large scale. When varia-
tions in products and processes increase, the equivalence coefficient is difficult to cal-
culate. For these reasons, process costing is often used in enterprises with continuous
production processes such as chemical and oil or in companies characterized by large
batch production, where the unit value of the product is usually low.

A3.1.3.2 Job Order Costing

Job order costing refers to jobs as the main element for cost allocation and tracing. A
job is a single unit of a product (e.g., a machine) or batches of many units (e.g., a
batch of pencil coils).
e24 eAnnexure 3: Cost Accounting

Job number: Customer: Code:

Direct material Direct labor Overhead

Date Code Quantity Unitary Date Code Quantity Unitary Date Code Quantity Unitary Total
price price price
(€/u) (€/u) (€/u)

Figure eA3.4 Job order sheet.

Across the whole production process, each job is associated to a sheet

(Figure eA3.4) on which the incurred costs are registered. More specifically:
• Direct material costs are traced to the job according to the consumption.
• Direct labor costs are traced to the job on the basis of completed operations.
• Overhead is instead allocated with proportional criteria using an allocation basis.
Typical examples of an allocation basis adopted are labor costs/time and machine
time.
Job order costing is a precise method that traces direct material and labor in a con-
tinuous and ordered way. Hence, this method is suggested when these components
(direct material and direct labor) are significant in terms of incidence on the final prod-
uct costs. Although it is precise, job order costing is time-consuming; however, infor-
mation technologies have significantly reduced the cost of data collection and analysis.
This method is not appropriate in enterprises that operate with continuous cycles due
to the impossibility of identifying the job (single units or a batch of units). In the case
of discrete processes, companies should weigh the trade-off between the benefit of
more precise information against the cost of data collection and analysis. An element
that can be used to valuate is the production scale: enterprises that operate with large
orders or with small batches have potential benefits in applying job order costing. For
companies operating on a larger scale, other, less precise methods are suggested, par-
ticularly when the value of single units is low. In these cases, the cost of data collection
might be higher than the product value.

A3.1.3.3 Operation Costing

Operation costing is a system between job order costing and process costing. In opera-
tion costing, direct material costs are traced to products/services, similar to what hap-
pens for job order costing. Conversion costs (direct labor plus overhead) are allocated
proportionally, similar to process costing (Figure eA3.5).
The unit of analysis per cost allocation is the “operation,” which is a homogenous
phase within the transformation process. For each operation, the total conversion cost
is calculated, summing direct labor costs and overhead incurred in the period. The
overall “operation cost” is then apportioned among products/services with propor-
tional criteria. The most frequently used allocation bases in operation costing are the
quantity produced and the operation duration.
Operation costing emphasizes tracing precisely direct material costs; hence, this
method is appropriate in manufacturing processes where the cost of direct material is
the most significant element and the process is characterized by a limited number of
operations.
 eAnnexure 3: Cost Accounting e25

Cost of all product

Costs for each
worked during an
identifiable job
accounting period
Unit production Assembly lines
Batch production Process production
operations

Job order system Process costing

Direct raw Labor and

materials overhead (CC)
Operation costing
Operation as unit
of analysis

Figure eA3.5 Operation costing (between job order costing and process costing).

A3.1.3.4 Activity-Based Costing

ABC first appeared during the 1980s (Kaplan, 1983; Johnson and Kaplan, 1987;
Bhimani and Brimson, 1989) as a solution to the problems in traditional methods and
in particular to the allocation of indirect costs through a proportional method using a
unique allocation basis.
ABC puts the activities at an intermediate level in the cost allocation and includes
the following steps:
1. Identifying indirect costs (overhead) to allocate (cost pool)
2. Identifying activities that determine the consumption of overhead
3. Dividing overhead among the identified activities
4. Defining activity drivers, which are indicators explaining the consumption of each
activity
5. Calculating the allocation coefficients for each activity (activity costs divided by
drivers)
6. Apportioning activity costs to each cost object using coefficients (Step 5).
Consider the example of the Textile Company, which produces scarves and ties. The
company wants to assign the machine depreciation of the year (90,000 h) using an
ABC approach. The following data are available:
• Ties produced: 10,000 units (unit time of production 5 30 min)
• Scarves produced: 20,000 units (unit time of production 5 20 min).
The machine is used for both production and setup. During the last year, the total
setup time was 50,000 min; one setup was performed before launching the production
of ties, and another setup was performed before launching the production of scarves.
Following the ABC steps, the calculations are as follows:
• Step 1: Identification of indirect costs. In this case, we already have the value of the
indirect cost we want to assign, which is the machine depreciation (90,000 h).
e26 eAnnexure 3: Cost Accounting

Table eA3.4 Example of Cost Allocation on Activities

Production Setup

Total time (10,000 unit 3 30 min/unit) 1 (20,000 unit 3 20 min/unit) 5 50,000 min
700,000 min
Allocation 90,000 h/750,000 min 5 0.12 h/m
coefficient
Portion of OVH 0.12 h/min 3 700,000 5 84,000 h 0.12 h/min 3 50,000 5 6000
assigned to each
activity

Table eA3.5 Example of Allocation Coefficient Calculation

Production Setup

Total cost 84,000 h 6000 h

Allocation coefficient 84,000 h/700,000 min 5 0.12 h/min 6000 h/two setups 5 3000 h/setup

Table eA3.6 Example of Total Cost Calculation by Using ABC

Ties Scarves

Production cost assigned to product 0.12 h/min 3 300,000 min 5 0.12 h/min 3 400,000 min 5
36,000 h 48,000 h
Setup cost assigned to product 3000 3 1 setup 5 3000 h 3000 3 1 5 3000 h
Total cost of product 39,000 h 51,000 h
Unit cost of product 3.9 h/unit 2.55 h/unit

• Step 2: Identification of activities. The machine is employed for two main activities:
the production and setup of scarves and ties.
• Step 3: Dividing overheads among the different activities. We can use the time for
performing both the activities as the allocation basis. The cost allocation will be as
follows (Table eA3.4).
• Step 4: Defining activity drivers. The choice of activity drivers is arbitrary and usu-
ally depends on the available data. In this case, we can use the production time as
the activity driver for the production activity (700,000 min) and the number of set-
ups as the driver for the setup activity (two setups in total).
• Step 5: Calculating the allocation coefficient per each activity. The approach
remains the same as for the previous step (Step 3) but instead uses the cost of the
activity as the total cost to be assigned between the two products. Calculations will
give the following results (Table eA3.5).
• Step 6: Apportioning activity costs to each product by using the previously identi-
fied allocation coefficient (Table eA3.6).
In so doing, ABC divides indirect costs—previously allocated as a unique cost pool
using different activities—by adopting an activity driver for each of them, hence
 eAnnexure 3: Cost Accounting e27

Activity based costing Traditional method

Cost Cost
pool pool
Allocation
Cost Division across basis
activities Allocation
coefficient

Activity 1 Activity 2 Activity 3

Activity driver 1 Activity driver 2 Activity driver 3

Activity coefficient 1 Activity coefficient 2 Activity coefficient 3

Cost Cost Cost Cost Cost Cost Cost Cost

object object object object object object object object
A B C D A B C D

Figure eA3.6 ABC and traditional methods in allocating overhead.

defining more precisely how products/services consume indirect costs. ABC is more
precise, and its use is suggested when the incidence of overhead is high and these indi-
rect resources are absorbed for heterogeneous activities. In this case, using a unique
allocation basis will not provide realistic information on the overhead consumption.
Figure eA3.6 compares traditional methods in apportioning indirect costs and ABC.