Accuracy of Assignments
Assigning costs accurately to cost objects is crucial. Accuracy is not evaluated based
on knowledge of some underlying “true” cost. Rather, it is a relative concept and has
to do with the reasonableness and logic of the cost assignment methods used. The
objective is to measure and assign, as well as possible, the cost of the resources con-
sumed by a cost object. The intuitive and somewhat tongue-in-cheek guideline is
expressed as follows: “It is better to be approximately correct than precisely inaccu-
rate.” Some cost assignment methods are clearly more accurate than others. For
example, suppose you want to determine the cost of lunch for Ryan Chesser, a stu-
dent who frequents Hide
away, an
off-campus pizza parlor. One cost assignment
approach is to count the number of customers Hide
away
has between 12:00 p.m.
and 1:00 p.m. and then divide the total receipts earned during this period by this
number of customers. Suppose that this comes out to $5.175 per lunchtime cus-
tomer (note the three-decimal precision). Thus, based on this approach, we would
conclude that Ryan spends $5.175 per day for lunch. Another approach is to go with
Ryan and observe how much he spends. Suppose that he has a small pizza, salad,
and a medium drink each day, costing $6.50. It is not difficult to see which cost
assignment is more accurate. The $5.175 cost assignment is distorted (in spite of
its three-decimal precision) by the consumption patterns of other customers (cost
objects). As it turns out, most lunchtime clients order the luncheon special for $4.99
(a minipizza, salad, and medium drink).
Distorted cost assignments can produce erroneous decisions and bad evalua-
tions. For example, if a plant manager is trying to decide whether to continue pro-
ducing power internally or to buy it from a local utility company, then an accurate
assessment of how much it is costing to produce the power is fundamental to the
analysis. An overstatement of the cost of power production could suggest to the
manager that the internal power department should be shut down in favor of exter-
nal purchase, whereas a more accurate cost assignment might reveal the opposite. It
36
Part 1 / Basic Management Accounting Concepts
Managers Decide
When Jim Kilts took over
as chairman and CEO of
Gillette in early 2001, the
company was in deep trou-
ble. Its market share for
most product lines was
falling, sales were stagnant
or declining, and the share
value had dropped by 30
percent over the past three
years. Kilts knew that the
first step in turning the com-
pany around was to instill
financial discipline through
more detailed management
accounting. Sales and
income by product line were
calculated and tracked. This
allowed Kilts to see that
Gillette’s razor blades were
very profitable, but Duracell
batteries were not. Previ-
ously, the company tallied
up its sales results at the end
of the quarter—too late to
take quick action on prob-
lems. Now, Kilts and his sen-
ior management team
receive a morning report
detailing the number of
razors, batteries, and tooth-
brushes the company sold
the day before.
We can see that Jim Kilts
needed detailed financial
information by product line.
The product line, and indi-
vidual products within the
product line, became impor-
tant cost objects.
■
Source: Katrina Brooker, “Jim Kilts Is an
Old-School Curmudgeon,”
Fortune
(December 30, 2002): 94–102.
Real-Time Accounting Information
Helps Companies Thrive
is easy to see that bad cost assignments can prove to be costly. As the pizza example
suggests, establishing a cause-and-effect relationship between the cost to be assigned
and the cost object is the key to creating a reasonably accurate cost assignment.
Traceability
The relationship of costs to cost objects should be exploited to increase
the accuracy of cost assignments. Costs are directly or indirectly associated with cost
objects.
Indirect costs
are costs that cannot be easily and accurately traced to a cost
object.
Direct costs
are those costs that can be easily and accurately traced to a cost
object.
3
“Easily traced” means that the costs can be assigned in an economically fea-
sible way, while “accurately traced” means that the costs are assigned using a cause-
and-effect relationship. Thus,
traceability
is simply the ability to assign a cost to a
cost object in an economically feasible way by means of a cause-and-effect relation-
ship. The more costs that can be traced to the object, the greater the accuracy of the
cost assignments. Establishing traceability is fundamental in building accurate cost
assignments.
It is possible for a particular cost item to be classified as both a direct cost and
an indirect cost. Management accounting systems typically deal with many cost
objects. It all depends on which cost object is the point of reference. For example,
if a hospital is the cost object, then the cost of heating and cooling the hospital is
a direct cost. However, if the cost object is a surgical procedure performed in the
hospital, then this utility cost is an indirect cost.
Methods of Tracing
Traceability means that costs can be assigned easily and
accurately, whereas
tracing
is the actual assignment of costs to a cost object using
an observable measure of the resources consumed by the cost object. Tracing costs
to cost objects can occur in one of two
ways: (1) direct tracing or (2) driver tracing.
Direct tracing
is the process of identifying and assigning costs that are exclusively
and physically associated with a cost object. This is most often accomplished by
physical observation.
Consider the pizza example. The cost object is Ryan Chesser’s
lunch. By observing that he has a small pizza, salad, and medium drink, we can
assign the cost of $6.50. The cost is directly traceable to him. As a second example,
let the cost object be a product: bicycles. The product uses both materials and labor.
It is easy to observe how many wheels, other parts, and hours of labor are required
to produce each bicycle. Both material and labor usages are physically observable,
and therefore, their costs can be directly charged to a bicycle. In both examples, the
cost objects are the
exclusive
consumers of the resources in ques
tion. Ideally, all costs
should be charged to cost objects using direct
tracing. Unfortu
nately, it is often the
case that cost objects are not the exclusive consumers of resources. In this case, we
appeal to driver tracing to assign costs.
Driver tracing
is the use of drivers to assign costs to cost objects. In a cost
assignment context,
drivers
are observable causal factors that
measure
a cost object’s
resource consumption. They are factors that cause changes in resource usage and
thus have a cause-and-effect relationship with the costs associated with a cost object.
For example, assume that Ryan Chesser and Shana Parker go to lunch together.
Shana and Ryan agree to share the cost of the lunch. They order a medium pizza
(divided into 10 slices) for $9, a pitcher of root beer for $2 (five glasses of content),
and Shana orders a small salad for $1. How much cost should be assigned to each
person? Note that the two share the pizza and root beer, whereas the salad is a
“resource” exclusive to Shana. The cost of the salad, then, is assigned by direct trac-
ing ($1 to Shana and $0 to Ryan). To assign the costs of the pizza and root beer,