Describe and provide specific examples of direct and indirect costs. Describe the importance of using appropriate drivers for allocating indirect costs. What is the risk of using an inappropriate driver when allocating costs? What is the potential impact of various cost allocation methods on employee motivation?
There are two kinds of costs in the manufacturing which are classified on the base whether they attribute to the production or not. Direct costs refer to those costs which are directly linked to the object in production which is known as the cost object. cost object can be any project, product or even a department. The benefit of the direct cost is to a single cost object; the direct cost for any particular cost object can be the indirect cost of another. At times, the direct costs are also variable; the example of direct cost is the cost of sand, gravel and cement when the concrete is produced. Indirect cost is that cost which does not related directly to any cost object in particular and they tend to benefit multiple cost objects. According to Manea and Barbu (2012), indirect cost are those “which at the time when they are performed they cannot be identified on the subject of business activity, but only on the places of production or activity that generated it.” The very common examples of indirect cost are the salaries of the supervisors, cost of power and insurance for the concrete plant.
It is highly critical to choose the best cost driver while allocating the costs; best cost driver is that which has more accuracy in reflecting the resource amount used by the cost object. The best cost driver is that which has the strongest relationship of cause-and-effect. The cost driver should not influence the behavior of staff negatively; should be easily identified, and must be the cause of the resource variation in consumption. Cost allocations have significant affect on humans and they impact the compensation and evaluation of performance of the managers. The management may dictate and control the resources given to the departments and through this way; they would feel authoritative and influential on the operations of the organization (Edmunds and Tsay et al., 2011). If the cost driver used is inappropriate, the cost allocation would be distorted and the result would be that the managers would make decisions that would be unfavorable for the profitability of the organization.
Barbu, M. and Manea, D. (2012). BENEFITS OF INDIRECT COSTS ALLOCATION WITH COST DRIVERS. Review of General Management, (1), pp. 214--222.
Edmunds, T., Tsay, B. and Olds, P. (2011). Fundamental Managerial Accounting Concepts. 6th ed. New York: McGraw Hill-Irwin.