Below image provides an overview of the cost assignment process for an absorption costing system, The term cost tracing is used in this photo to denote the fact that direct costs can be specifically and exclusively identified with a particular cost object.
Cost assignment merely involves the implementation of suitable data processing procedures that identify
and record those resources that can be specifically and exclusively identified with a particular cost object. above image also shows that indirect costs are assigned to cost objects using cost allocations. To illustrate a cost allocation, consider an activity such as receiving incoming materials. Assuming that the cost of receiving materials is strongly
influenced by the number of receipts, then costs can be allocated to products (i.e. the cost object) based on the number of material receipts each product requires if 20 per cent of the total number of receipts for a period were required for a particular product then 20 per cent of the total costs of receiving incoming materials would be allocated to that product.
Assuming that the product was discontinued, and not replaced we would expect action to be taken to reduce the resources required for receiving materials by 20 per cent.
in the above illustration the allocation base is assumed to be a significant determinant of the cost of receiving incoming materials. Where allocation bases are significant determinants of the costs we shall describe them as cause-and-effect allocations Where a cost allocation base is used that is not a significant determinant of its cost the term arbitrary allocation will be used.
Arbitrary Allocation Example
An example of an arbitrary allocation would be if direct labor hours were used as the allocation base to allocate the costs of materials receiving.
if a labor-intensive product required a large proportion of direct labor hours (say 30 per cent) but few material receipts it would be allocated with a large proportion of the costs of material receiving. The allocation would be an inaccurate assignment of the resources consumed by the product. Furthermore if the product were discontinued, and not replaced, the cost of the material receiving activity would not decline by 30 per cent because the allocation base is not a significant determinant of the costs of the materials receiving activity Arbitrary allocations are therefore likely to result in inaccurate allocations of indirect costs to cost objects, For the accurate assignment of indirect costs,
cause-and-effect allocations should be used.
Above image identifies two types of absorption costing systems that can be used to assign indirect costs to cost objects.
- Traditional costing systems
- Traditional costing systems were developed in the early 1900s and are still widely used today They rely extensively on arbitrary cost allocations
- Activity-based costing (ABC) systems
- ABC systems only emerged in the late 1980s. One of the major aims of ABC systems is to use only cause-and-effect cost allocations. Both cost systems adopt identical approaches to assigning direct costs to cost objects.