Skip to main content

Cost Accounting

Cost Accounting


Cost accounting, often referred to as managerial or management accounting, is the branch of accounting that provides economic and financial information to decision makers within a company. The idea of providing information for use within the company (to aid management to plan, direct, and control operations) differentiates cost accounting from other segments of the accountancy profession. For example, financial accounting serves the public by providing financial reporting via financial statements or financial press releases. This public information is prepared and presented based on generally accepted accounting principles (GAAP), the broad rules that assure the user of the underlying framework supporting the information.

On the other hand, cost accounting is limited predominantly to use within the company to aid management in the process of making choices that will benefit the stockholders by maximizing company profits that translate into maximizing stockholder wealth. Since the information is used internally, the information may be presented on any logical basis just so long as it will aid the manager to reach an appropriate, informed decision.

A few concepts in cost accounting, however, form the bridge between financial and managerial accounting topics. One such concept is that of product costing for a manufacturing company. Not only is this information used internally in decision making (e.g., does a company make or buy a component?), product costing is also used to determine the historical basis to account for the cost of products sold during a period and the cost of the unsold inventory that remains as an asset on the statement of financial position at the end of the period.


Numerous cost accounting concepts can benefit management in decision making, both for manufacturing and service companies. While many of the concepts discussed below are applicable to both types of companies, the basis for ease of discussion will be that of a manufacturing company. Therefore, some of the concepts to be discussed include understanding the distinction between manufacturing and non-manufacturing costs (and how these are disclosed in the financial statements), computing the cost of manufacturing a product (or providing a service), identifying cost behavior in order to utilize cost-volume-profit relationships, setting prices, budgeting and budgetary controls, and capital budgeting. These topics will be briefly discussed below.


Manufacturing costs are those costs incurred by a producer of goods that are needed to transform raw materials into finished products, ready to sell. These costs consist of the cost of basic materials and components, plus the costs of labor and factory overhead needed to convert the materials into finished products.

Materials and labor can be classified as either direct or indirect in relation to the final product. Direct materials are those major components that can be easily traced to the finished good and are accounted for carefully due to their significance to the product. In the case of manufacturing a lawn mower, for example, these types of materials would include the engine, housing, wheels, and handle. Indirect materials would include those minor items that are essential but which cannot be easily traced to the finished product. Examples of these would be screws, nuts, bolts, washers, and lubricants. One might say that the cost of keeping an account of each of these indirect items exceeds the benefit derived from having the information. Consequently, the costs of these items are accumulated as part of factory overhead and prorated to products on some appropriate basis.

Direct labor refers to the efforts of factory workers that can be directly associated with transforming the materials into the finished product, such as laborers who assemble the product. Indirect laborers are those whose efforts cannot be traced directly or practically to the finished product. The indirect laborers would include maintenance personnel and supervisors.

Factory overhead includes all factory costs that can only be indirectly associated with the finished inventory, that is, all factory costs incurred in making a product other than the costs of direct materials and direct labor. In terms of cost behavior, some of these costs do not change in total even if the number of products manufactured increases or decreases from period to period; the behavior of these costs is said to be a fixed cost. For example, the amount of the monthly factory rent would not fluctuate based on the number of units produced during a particular month.

Other factory overhead costs that change in total in direct proportion to changes in the number of products manufactured are known as variable costs. For example, the number of nuts and bolts needed to assemble lawn mowers would increase and decrease exactly in proportion to the number of mowers produced and are therefore considered to be a variable cost. In summarizing this brief discussion of factory overhead costs, these costs include such things as depreciation of factory buildings and machinery, factory utilities, factory insurance, indirect materials, and indirect labor; some of these costs are variable while others are fixed in total for a specific time period.

All material, labor, and factory overhead costs are summarized into totals that represent the cost of the goods manufactured during a period of time. The cost of products that have been completed and sold during a time period are deducted from the related sales revenue total to determine the gross profit for the period. Thus it is logical that these manufacturing costs are referred to as product costs. The cost of unsold completed units at period's end is shown as finished goods on the balance sheet. Any costs of goods that are only partially completed at period's end are shown as work in process inventory, and any materials that have not yet entered into the manufacturing process are disclosed as raw materials inventory.

All the costs incurred by a manufacturing company other than the cost of factory operations are collectively known as non-manufacturing costs. These include all selling, administrative, and financing costs; all these costs are deducted as expenses from sales revenues as they are incurred each period. Costs other than manufacturing costs are called period costs for this reason. None of the period costs are deferred to a future period because none of them represent an asset as defined by the accounting profession.

The discussion above has focused on the costs incurred by a manufacturer of goods. The discussion is also pertinent to a business that provides a service to its customers. Providers of services still incur material costs (such as cleaning supplies), labor costs, and general overhead related to providing the services. The major distinction is that, since no tangible product is created, no product costs can be deferred to a later period in which they will be sold.


Manufacturing companies use a variety of production processes in creating goods. These processes include job shops, batch flows, machine-paced line flows, worker-paced line flow, continuous flows, and hybrids that consist of more than one of the previous separate flow process. The type of production process to a certain extent determines the type of product costing system that a company utilizes.

Job shops, such as machine shops, receive orders for products that are manufactured to the unique blueprint specifications of the requesting customer. As such, it would be rare for these products to meet the needs of any other customer. Thus each job must be accounted for separately as the goods are produced and no goods would be produced on a speculative basis. An appropriate method to determine the cost of each unique item produced is activity-based costing (ABC). The essence of ABC costing is that the exact costs of materials and labor, and a highly accurate estimate of factory overhead costs based on the specific activities (cost drivers) incurred to produce the goods, are determined for each unique product.

Batch flow processes (such as clothing manufacturers use) and worker-paced line flows (such as found in fast-food operations) can both use traditional product costing. This product costing system captures the exact costs of materials and labor while using some predetermined overhead rate to associate an appropriate amount of overhead with each product made. A very common basis for determining the overhead rate is the amount of labor time required to produce each unit of product. To determine the overhead rate, management must first estimate the total overhead costs for the upcoming year. Then an estimate of direct labor hours expected for the same period must be made. Finally the estimated overhead is divided by the estimated total direct labor hours and the resulting overhead rate per hour can be established. As each batch of products is completed and the total direct

labor hours used is made known from time cards, the overhead rate is multiplied by the actual hours and the overhead is said to be applied to the products.

The traditional product costing method was especially popular in the United States until the mid-1980s when labor costs were still a significant portion of the total cost of products. However, with technological changes (such as computer-integrated manufacturing) and more capital intensive approaches to production (such as robotics), the use of a dwindling labor component of product cost as a basis to apply overhead cost was no longer adequate. This was the impetus for the development of ABC costing mentioned above.

Machine-paced line flow processes (such as used by automobile manufacturers) lend themselves to process cost accounting. In this system of product costing, products' costs are accumulated during each of the numerous processes through which the products flow. In the case of an automobile manufacturer, some of the processes might include subassembly stations that reside offline from the main conveyor system where engine assembly, dashboard assembly and the like occur. These major components and their related material, labor, and overhead costs are then carried forward to the next process and new material, labor, and overhead costs are added in each successive process until completion. Thus the individual costs incurred in each process and the total costs incurred are available for financial statements and decision-making purposes.

Companies that use a continuous flow process of production, such as a paper manufacturing company that operates 24/7, would likely use a standard costs system. This product costing system not only accumulates the actual costs incurred in manufacturing the product, but it also determines the standard costs that should have been incurred (based on predetermined standards for material, labor, and factory overhead). By allowing comparisons between actual and standard totals, any discrepancy or variance can be noted and investigated. In particular, any unfavorable costs being incurred can be corrected in a timely manner.


One of the critical steps in decision making is the estimation of costs to be incurred for the particular decision to be made. To be able to do this, management must have a good idea as to how costs behave at different levels of operations; i.e., will the cost increase if production increases or will the cost remain the same? A common use of cost behavior information is the attempt by management to predict the total production costs for units to be manufactured in the upcoming month. There are several methods used to estimate total product costs: the high-low method, a scatter-graph, and least-squares regression. Each of these methods attempts to separate costs into components that remain constant (fixed) in total, regardless of the number of units produced and those that vary in total in proportion to changes in the number of units produced. Once the behavior of costs is known, predictive ability is greatly enhanced.

Use of the high-low method requires the use of only two past data observations: the highest level of activity (such as the number of units produced during a time period) and the associated total production cost incurred at that level, and the lowest level of activity and its associated cost. All other data points are ignored and even the two observations used must represent operations that have taken place under normal conditions. The loss of input from the unused data is a theoretical limitation of this method.

The scatter-graph method requires that all recent, normal data observations be plotted on a cost (Y-axis) versus activity (X-axis) graph. A line that most closely represents a straight line composed of all the data points should be drawn. By extending the line to where it intersects the cost axis, a company has a fairly accurate estimate of the fixed costs for the period. The angle (slope) of the line can be calculated to give a fairly accurate estimate of the variable cost per unit. The inclusion of the effect of all data points is a strength of this method, but the unsophisticated eyeballing of the appropriate line is a weakness.

The most robust method is the least-squares regression method. This method requires the use of thirty or more past data observations, both the activity level in units produced and the total production cost for each. This technique is known for its statistical strengths but its sophistication requiring the use of software packages can be a hindrance.

Assuming that a company has used one of the techniques above and has separated costs of manufacturing its products into fixed and variable components, it can use the following general model and substitute derived fixed and variable amounts to create a specific model:

General Model: Total cost = Fixed Costs for a Month + Variable Cost per Unit

Specific Model: Total Cost Expected = $10,000 per Month + $5.00 per Unit

Given this specific model, a prediction can easily be made of the total costs expected when any number of units are budgeted, as long as the number of units is far within the normal range of operations for the company.

For example, if 5,000 units are budgeted for the next month's production, the total expected cost would be:

$10,000 + $5.00 (5,000) = Total Cost = $35,000

If the cost separation technique is fairly accurate, we are in a position to review whether actual costs are in line with our projected cost. Any significant variation between anticipated cost and actual costs should be investigated. The identification of any variances does not answer any questions; the variances merely note that investigation to ascertain the answers is needed.

One other idea is worth mentioning. Considering total production costs in the example above, the same techniques used to separate total costs into fixed and variable components can be utilized to separate any individual cost that isn't readily identifiable as being fixed or variable. A company could, for instance, take the past monthly factory electrical utility bills or the sales wages and use any of the three techniques to separate this individual cost into its fixed and variable components.


Setting the price for goods and services involves an interesting interaction of several factors. The price must be sufficient to exceed the product and period costs and earn a desirable profit. For normal sales to external customers, most companies are unable to unilaterally set prices. Prices are typically set in these competitive markets by the laws of supply and demand. However, if a company manufactures a product unique to customer specifications, or if the company has a patent to its product, then the company can set its own price. One approach to accomplish this is cost-plus pricing. As discussed above, the company must have knowledge of the costs that it will incur. Then the company can apply the proper markup, given the competitive market conditions and other factors, to set its target-selling price.

Some companies add their markup to their variable costs, rather than using the full cost needed for cost-plus pricing. Variable cost pricing is especially useful in special instances such as in pricing special orders or when the company has excess capacity. In both of these cases, production and sales at normal prices to regular customers will be sufficient to cover the total fixed and variable costs for typical sales levels and the concern is only for the incremental units above normal sales levels.

Nissan Motors and other automobile manufacturers take what might be considered a backward approach to setting the prices of their vehicles relative to their expected costs. This approach is known as target costing. Once these companies determine what type of vehicle and market niche they wish to pursue, they test the market to see what target price the market will bear for their vehicle. From this number they deduct their desired profit in order to determine the target cost for their product. Then they gather the experts needed to ascertain if they will be able to produce the vehicle for this targeted cost.

If a company has two or more divisions and the output of one division can be used as input to a subsequent division, a price can be set for sale from one division to the next in order to measure profitability for each division. This internal transfer price should be set so as to encourage division managers to purchase and sell internally, thus maximizing overall company profits. Transfer prices can be determined based on negotiations between the affiliated divisions, based on the existence of excess capacity by the producing division, based on marking up the variable cost of the goods sold internally, or based on market prices for similar goods, and other approaches.


Managers use budgets to aid in planning and controlling their companies. A budget is a formal written expression of the plans for a specific future period stated in financial terms. Jerry Weygandt, Donald Kieso, and Paul Kimmel's book, Managerial Accounting: Tools for Business Decision Making lists the following benefits of budgeting:

  1. It requires all levels of management to plan ahead and formalize goals on a repetitive basis.
  2. It provides definite objectives for evaluating performance at each level of responsibility.
  3. It creates an early warning system for potential problems so that management can make changes before things get out of hand.
  4. It facilitates the coordination of activities within the company by correlating segment/division goals with overall company goals.
  5. It results in greater management awareness of the company's overall operations including the impact of external factors such as economic trends.
  6. It motivates personnel throughout the company to meet planned objectives.

The master budget is the set of interrelated budgets for a selected time period. The specific parts to the master budget are the operating budgets and the financial budgets. The operating budgets begin with a sales budget derived from the sales forecasts provided by the marketing department, followed by the related unit production budget with detail budgets for direct materials, direct labor, and factory overhead. Finally a budget for selling

and administrative expenses provides the final information needed for a budgeted income statement. The financial budgets, based on data from the budgeted income statement, are composed of a cash budget, a budgeted balance sheet, and a budget for capital expenditures.

Budgetary control is the process of comparing actual operating results to planned operating results and thereby identifying problem areas in order to take corrective actions. A starting point in this effort is the conversion of the master budget (determined at the start of the period and based on the most probable level of operations) into a flexible budget for the actual level of operations attained. Developing a flexible budget requires identifying the variable costs and the fixed costs for the period as discussed above. Once these cost behavior determinations have been made, total variable costs for the actual level of operations and the total fixed costs for the period can be combined into a flexible budget that discloses the costs that should have been incurred for the actual level of operations achieved.

In taking corrective actions, one must be aware of whether or not a manager is responsible for a particular cost that has been incurred. While all costs are controllable at some level of responsibility within a company, only the costs that a manager incurs directly are controllable by them. Any costs that are allocated to the manager's responsibility level are not controllable at the manager's level.

The information above focused on budgetary controls for total costs, including product costs for units being produced and sold, general and administrative expenses, selling expenses, and any financial expenses incurred during the period. When comparing actual to standard costs for material, labor, and factory overhead costs, the use of a standard product costing system is needed to provide the detail to analyze each separate product cost component.


Companies with excess funds must make decisions as to how to invest these funds to maximize their potential. The choices that involve long-term projects require the use the technique of capital budgeting, that is, choosing among many capital projects to find those that will maximize the return on the invested capital. Several methods of capital budgeting are available to management; among these are the payback period method, the net present value method, and the internal rate of return method. All of these methods require the use of estimated cash flow amounts.

The payback period method is especially simple if future inflows from the project being considered happen to be equal in amount each year. In this case, the formula for computing the payback period is:

Cost of Capital Project ÷ Net Annual Cash Inflow = Payback Period

If the project has uneven cash flows, creating a table with a cumulative net cash-flow column will identify the year and an estimate of the portion of a year in which the project recoups its cost. A weakness of this method is that it does not consider the time value of money over the life of the project. However, the shorter the payback period is, the sooner the project's cost is recovered and the more attractive the project is.

A strength of the net present value method is that it uses the same cash flow information as described above and it requires that each cash flow be discounted by an appropriate discount rate to allow for the time value of money. The appropriate discount rate could be the company's weighted average cost of capital or its required rate of return. After each cash inflow has been discounted to the point in time at which the investment is made, the total of the discounted cash inflows is compared to the cost of the capital project. If the present value of the net cash inflows equals the cost of the investment in the project, then the project is earning exactly the interest rate chosen for discounting. The exact discount rate at which the two values are equal is known as the internal rate of return. If the present value of the net cash inflows exceeds the cost of the capital project, the project is earning more than the discount rate. If the cost of the capital project exceeds the present value of the net cash inflows, that is, the net present value is negative; then the project is not earning at least the discount rate. While the project is profitable if the cash inflows exceed the cash outflows, it would be rejected since it is not earning the return that is needed.

Modern management theory stresses that setting and reaching goals requires that test readings and adjustments along the way are essential. The recent period of increased international competition has led to the need for cost cutting; some companies have been successful by down-sizing, expanding globally, and capturing long-term contracts to minimize the increase in costs. Cost accounting can greatly benefit management by providing product or service cost information for use in planning, directing, and controlling the operations of the business.

While many firms vigorously support cost accounting, it does have its detractors as well. For instance, cost accounting has been criticized for being too focused on cutting costs rather than maximizing efficiency. In 1984 Eliyahu M. Goldratt (1948-) wrote The Goal, which described an alternative management-accounting theory called throughput accounting (TA) based on the

performance measures used in the theory of constraints (TOC). According to TA, the method of applying overhead rates in cost accounting distorts figures by assuming that all parts of a system are equally valuable. TA seeks to maximize profit by increasing throughput, defined as the rate at which a system generates money. The TOC contends there is a limiting factor in all production processes, which can be identified and managed to increase throughput.

SEE ALSO Activity-Based Costing; Financial Ratios


Bragg, Steven M. Throughput Accounting: A Guide to Constraint Management. Hoboken, NJ: John Wiley & Sons, 2007.

Eldenburg, Leslie G., and Susan K. Wolcott. Cost Management: Measuring, Monitoring, and Motivating Performance. Hoboken, NJ: John Wiley & Sons, 2004.

Goldratt, Eliyahu M. and Jeff Cox. The Goal (A Process of Ongoing Improvement). North River Press, 1984.

Hitt, Michael, Stewart Black, and Lyman Porter. Management. Prentice Hall, 2005.

Horngren, Charles T., Gary L. Sundem, and William O. Stratton. Introduction to Management Accounting. Prentice Hall, 2005.

Rasmussen, Nils H., and Christopher J. Eichom. Budgeting: Technology, Trends, Software Selections, and Implementation. Hoboken, NJ: John Wiley & Sons, 2004.

Robbins, Stephen P., and David A. DeCenzo. Fundamentals of Management. Prentice Hall, 2005.

Weygandt, Jerry J., Donald E. Kieso, and Paul D. Kimmel. Managerial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons, 2005.

Whitten, David A., and Kim Cameron. Developing Management Skills. Prentice Hall, 2005.

Cite this article
Pick a style below, and copy the text for your bibliography.

  • MLA
  • Chicago
  • APA

"Cost Accounting." Encyclopedia of Management. . 29 Apr. 2017 <>.

"Cost Accounting." Encyclopedia of Management. . (April 29, 2017).

"Cost Accounting." Encyclopedia of Management. . Retrieved April 29, 2017 from

Cost Allocation


A cost is generally understood to be that sacrifice incurred in an economic activity to achieve a specific objective, such as to consume, exchange, or produce. All types of organizationsbusinesses, not-for-profits, governmentalincur costs. To achieve missions and objectives, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions.

When incurred, costs are initially reviewed and accumulated by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then reassigned, differently for specified purposes, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or service, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs. Costs assigned to a cost object are either direct or indirect. A direct cost can be traced and assigned to the cost object in an unbiased, cost-effective manner. The incurrence of an indirect cost cannot be so easily traced. Without such a direct relationship to the cost object, an indirect cost requires an in between activity to help establish a formula relationship. When the indirect cost is assigned through the use of this formula, the cost is considered allocated. The activity used to establish the in-between linkage is called the basis of allocation.


Cost allocations can be made both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common cost to the users and must be divided or allocated to them. Bases of allocation typically are based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common service activity across product lines or programs based on relative amounts of revenue is an ability to bear basis, whereas the same allocation based on the relative number of service units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria. Cost allocation then is the assignment of an indirect cost to one or more cost objects according to some formula. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or the method (formula) selected, some consider cost allocation to be of an arbitrary nature, to some extent.

Costs of long-lived assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the reclassification of tangible assets is called depreciation (for anything other than natural resources) or depletion (for natural resources) expense. The bases for these allocations are normally either time or volume of activity. Different methods of depreciation and depletion are available. The costs of long-lived intangible assets, such as patents, are allocated across time periods and reclassified as amortization expense. The basis for these allocations is normally time.

Cost allocations within a time period are typically across either organizational segments known as responsibility centers or across units of product or service or programs for which a full cost is needed. Allocations may differ depending on whether a product or program is being costed for financial reporting, government contract reimbursement, reporting to governmental agencies, target pricing or costing, or life-cycle profitability analysis. Allocations to responsibility centers are made to motivate the centers' managers to be more goal-congruent in their decisions and to assign to each center an amount of cost reflective of all the sacrifices made by the overall organization on behalf of the center. These allocations can be part of a price or transfers of cost pools from one department to another.


Allocations can involve ethical issues. Often the federal government issues contracts to the private sector on a cost-plus basis; that is, all the actual costs incurred to complete a contract plus a percentage of profit is reimbursed to the contractor performing the contract. A contractor completing both governmental and private-sector contracts may select a formula that tends to allocate more indirect costs to governmental contracts than to nongovernmental ones. A contractor may also try to include in reimbursement requests costs that are not allowable by the governmental agency. A contractor may even try to double-count a cost item by including it as a direct cost of the contract and as a part of an indirect cost pool allocated to the contract. Lastly, a contractor may attempt to have a reimbursement cover some of the costs of unused capacity. Audits are made of costs of government contracts to identify inappropriate costs.


Service and not-for-profit organizations also allocate costs. The cost object can be a unit of service, an individual client, or a cluster (category) of clients. The costs of a service firm are typically professional labor and indirect costs in support of the labor. The basis for allocating these indirect costs is often professional labor hours (either billable or total) or the cost of such, reflective of either cause- and effect or benefits-received criteria. For not-for-profit organizations, the proportions to be allocated are best figured in terms of units of the resource on hand, such as the number of full-time equivalents, amount of square footage, or number of telephone lines. An important point to remember is that the principles of allocation are the same for for-profit and not-for-profit organizations. The only difference is that the cost objects will be dissimilar.

Merchandisers, unlike most service and not-for-profit organizations, have inventory that must be costed for external and internal reporting purposes. In these cases, the cost object is a unit of inventory. Incidental costs associated with the acquisition and carrying of the inventory are mostly direct costs easily traceable clearly assignable to the entire inventory, if not to individual units.


Manufacturers need to cost the resources required to complete their products. In costing a unit of product for inventory valuation, costs of production are assigned. With the unit of product as the cost object, production costs are either direct costs (traceable usage of materials and labor) or indirect costs (all of the other production costs, referred to as overhead). The indirect production costs are allocated. Traditionally, manufacturers using labor-intensive technologies used a single basis of allocation based on labor, either in hours or in cost, associated with a single indirect cost pool. A manufacturer using a more capital intensive technology might use a nonlabor basis such as machine hours. Today many firms produce a varied set of products, using varied technologies with many levels of complexity. Such firms need a more refined cost assignment system that uses multiple bases of allocation with multiple indirect cost pools, such as activity based costing.

While a unit of output remains the final cost object for product costing, the technology a producer uses can require a cost assignment to an intermediate cost pool (object) prior to an assignment to a unit of output. For instance, a batch technology has a cost assignment first to an individual job order (batch), and the total cost assigned to the job order is then unitized over the units in the batch to determine cost of one unit of output. Alternatively, for a given period in a process technology, costs are accumulated by (assigned to) each production process; the total cost assigned is then unitized across the total number of (equivalent) units produced by that process to cost-out a unit of output.

Manufacturers also incur service department costs (such as computer center costs) in support of production departments. These service department costs are indirect to a unit of production and for full costing must be allocated, first to respective production areas and then to the units of output. Such allocations are called service department allocations, and the basis of allocation is normally an activity reflective of the nature of demands made on the service department by other departments, both service and production.


Allocations are also required in a joint production process. When two or more separately identifiable final products initially share a common joint production process, the products are called joint products. The point at which they become separately identifiable is referred to as the split-off point. Manufacturing costs incurred prior to this split-off point are referred to as joint costs and need to be allocated across the different joint products for product costing purposes. The bases for allocating the joint costs typically include (1) relative sales value at split-off, (2) net realizable value at split-off (as an approximation of the sales value at split-off), (3) final sales value at the completion of the production process, and (4) the number of physical units of the joint products at split-off.

Many would consider this list of bases to be in an order of descending preference of use. Normally there are additional production costs beyond the split-off point. These additional costs are incurred in order to complete each joint product. For a given joint product, the net realizable value at split-off is calculated by subtracting the additional costs to complete from the final sales value of the finished joint product.


There are three basic methods to allocate service department costs to production departments or programs in a not-for-profit: (1) the direct method; (2) the step method; and (3) the reciprocal method. The basis for allocation of service area costs should ideally be causally related to the demands made on that area by other areas. Both cause-and-effect and benefits-received criteria are taken into account. If the service areas provide service to each other (referred to as reciprocal services), the reciprocal method is the most accurate, the step method next, and the direct method the least accurate. With different service and production departments as cost objects, costs are initially accumulated on a department-by-department basis. Departments working directly on programs or units of product or service are production departments. The other departments are service departments. The allocation problem then is to reassign service department costs to production departments or programs for both performance evaluation and product or program costing. Within a production department, these allocated service costs are then reallocated to units of service or product according to the bases of allocation that each respective production department uses for its indirect costs.

The direct method ignores reciprocal services. A service department's costs are allocated to the production departments according to the extent to which each production department uses (or, for budgeting purposes, intends to use) the services of the service department. This extent is determined on a percentage basis by either the amount of services actually provided by the service department to all the production departments or by the amount of services the service department is capable of providing at normal or full capacity. Variable and fixed costs may be allocated separately, resulting in a dual allocation process (for example, variable costs based on actual usage and fixed costs based on budgeted usage).

The step method partially takes reciprocal services into account by allocating service department costs to production departments on a sequential basis. The service department that provides the greatest amount of service to the other service departments is allocated first; the one providing the second greatest amount of service to the other service departments is allocated second; and so forth. The absolute dollar amounts of costs incurred within service departments can be used to break a tie in usage, the larger amount allocated first. Once a service department has been allocated, it is ignored for all subsequent allocations.

The reciprocal method takes into account all the reciprocal services by setting up a set of simultaneous equations, one equation per service department. For any given service department, its equation is: Total allocable cost = direct costs of the service department + costs allocated from each of the other service departments based on this department's use of the other service departments. Once these equations are solved, the resultant allocable cost (sometimes referred to as the reciprocal or artificial cost) is reallocated across all the other departments, service and production, according to the original percentage usages.

Two additional issues, fairness and acquiring the service from the inside or from the outside, concern the allocation of a common cost. The amount of common service cost allocated to a using department may be greater that what it would cost that department to obtain the same service from the outside. A variation of the reciprocal method provides an analysis to help the manager of a using department decide whether to obtain the service from another department within the organization or to contract outside for the service from another organization. The amount of a particular service department's cost allocated to a using department may be dependent on the extent to which other departments also use this service department.

see also Costs


Blocher, Edward J., Chen, Kung H., and Lin, Thomas W. (2005). Cost Management: A Strategic Emphasis.Boston: McGraw-Hill/Irwin.

Horngren, Charles T., Foster, George, and Datar, Srikant M. (2005). Cost Accounting: A Managerial Emphasis (12th ed.). Upper Saddle River, NJ: PrenticeHall.

Ijiri, Yuji (1975). Theory of Accounting Measurement. Sarasota, FL: American Accounting Association.

Kaplan, Robert S., and Atkinson, Anthony A. (1998). Advanced Management Accounting (3rd ed.). Upper Saddle River, NJ: PrenticeHall.

Willson, James D., Colford, James P., Roehl-Anderson, Janice M., and Bragg, Steven M. (1999). Controllership: The Work of the Managerial Accountant. New York: J. Wiley.

Lawrence A. Klein

Clifford Brown

Cite this article
Pick a style below, and copy the text for your bibliography.

  • MLA
  • Chicago
  • APA

"Cost Allocation." Encyclopedia of Business and Finance, 2nd ed.. . 29 Apr. 2017 <>.

"Cost Allocation." Encyclopedia of Business and Finance, 2nd ed.. . (April 29, 2017).

"Cost Allocation." Encyclopedia of Business and Finance, 2nd ed.. . Retrieved April 29, 2017 from

Standard Costing


Standard costing is an objective method of optimizing the use of resources in the provision of goods or services. This is a traditional method for monitoring the use of resources that was initially applied to basic inputs for only basic factory costs of production of goods. In the last two decades of the twentieth century, the technological capabilities of computers initiated innovative ways to identify and monitor costs, but the basic concepts of standard costing have continued to have relevance in many businesses.

Costing is the identification of the value of resources used for specified goods or services. One purpose of costing is to determine what resources, and in what quantities, are required to provide the goods or services. A second purpose is to provide a guide to resource usage monitoring. It is the second purpose that is considered in the following discussion.


Budget figures may be based on actual, budgeted, or standard costs. These categories are not mutually exclusive. For example, while a standard cost is a budgeted cost, a budgeted cost is not always a standard cost. An actual cost for a prior year may be a budgeted cost for the forthcoming year and recorded in the budget.

Budgeted costs are generally described as the best estimate about what should be allowed for forthcoming activity. Some budgeted costs are based on actual costs of the previous year, information from supervisors about where resources might be more efficiently used, and subjective judgments about how much should be allowed for resources. Another basis for recording budgeted costs is to use standard costs.


Standard costs are determined costs that reflect the effective and efficient use of resources. Standard costs are costs established through identifying an objective relationship between specified inputs and expected outputs. Engineers in laboratories are often involved in establishing standards for manufacturing processes, for example. Standard costs are generally related to carefully analyzed phenomena both in the laboratory and in the workplace. For example, in a factory that produces personal computers, standard costs are often used for direct materials, direct labor, and variable overhead, at the unit level. Resource usage that can be traced exactly to what is to be produced is referred to as direct.

To establish the standard usage of a direct material for the production of the keyboard of the personal computer, the possibilities are analyzed in a laboratory, where conditions are maintained as optimum as possible. Prior attention has been given, generally, to the quality of the metal to be used. There are times, though, that alternative materials that meet company standards for quality have been selected and each is tested to find out if there are differences in quantities needed, since scrap and problems in cutting may not be the same for all the alternatives. At this point, the focus is not on how many minutes are needed by an experienced cutter to meticulously cut the metal so as to minimize usage, but rather on how much of the metal is to be allowed for each keyboard.

What is determined to be the optimum usage of materialthe standard usage of material for the production of a single personal computer of a specified typein the laboratory undergoes another assessment. This then answers the question: "What usage is to be allowed for an adequately qualified worker in the factory?" Often, a technically determined standard in laboratory testing is modified to take into account the conditions of the workplace, which might not be as ideal as those maintained in the laboratory.

The goal of the personnel responsible for setting standard costs is to provide realistic standards. Only standards perceived to be reasonable are likely to motivate workers to adhere to what is prescribed. Workers are motivated to achieve output by meeting specified standards. If standards are unreasonable, either too tight or too loose, the level of discipline expected is seriously undermined. If standards cannot be achieved with reasonable effort, workers may become discouraged and become so indifferent that their work quality deteriorates significantly. If standards are too easy to achieve, there may be an unnecessary waste of resources.

Standard costing has applications to any type of business activity. The process described briefly above can be applied, for example, for processing documents in an insurance company or in a financial services business, as well as in manufacturing firms.


Standard costs are monitored as a basis for determining the extent to which expectations are realized. Before the widespread use of computer-based systems, typical reporting was done weekly or monthly. In contemporary companies, it is not uncommon for a company with factories or stores to monitor on a daily basis their resource usage, thereby allowing modifications, if judged necessary, to be introduced promptly. Computer-integrated production methods, for example, allow for maintaining both the actual cost/usage and the standard cost/usage figures in the records maintained.

A commonly used method is to determine the difference between what was allowed by standard costs, which are the budget allowances, and what was actually spent for the output achieved. This difference is called a variance. For example, assume that the factory producing personal computers completed 10,000 computers where the standard usage of one type of metal, as a direct material, was 2 pounds per computer, or 20,000 pounds. The actual usage of the output achieved, 10,000 units, was 20,430 pounds. Since actual usage of the direct material was greater than the standard allowed, the excess usage is called an unfavorable variance, or 430 pounds unfavorable. The monetary cost of this variance is then determined: The variance in units is multiplied by standard cost per unit for the metal. Therefore, if the standard cost for the metal was $2.95 per pound, the variance would be reported as $1,268.50 unfavorable (430 pounds × $2.95, the standard price).

What has been described for a direct material is the process that is used for each component of production. Resources monitored include, in addition to direct material and direct labor, variable factory overhead and fixed factory overhead. Both standard usage of resources and standard costs for each are established and monitored. The process for variable overhead is somewhat more complex because the components of variable overhead are multiple indirect resources that are related to volume of production processed. For example, while a chain of fast food restaurants may consider ground beef as a direct material, they will consider the wrapping used for the cooked hamburger an indirect material. Such a chain's controller's office has determined the material costs that cannot be directly tied to each unit and/or those material costs which individually are not significant for direct tracing. This collection of material costs is then analyzed to determine the most appropriate basis for allocating to the goods produced.

Standards are developed for fixed overhead costs, too. Fixed costs are costs incurred in production that are not a function of volume produced. Though in the long run all costs can vary, fixed costs are costs that do not change as activity levels change.


Companies have policies about the level of variance that is to be investigated. Some variation from expectations is allowed, and if standards are realistic, much of the variation is eliminated over the period of a year; insignificant favorable variances cancel out insignificant unfavorable variances. Companies monitor the extent to which standards appear to be reasonable by assessing the end-of-year balances in variance accounts.

Variances that are determined to be significant are investigated. Careful observation and discussion with those workers involved in producing the output that led to a significant variance will aid in determining an explanation. The explanation is the basis for considering what changes need to be made.

In an objective review of observations and discussions, questions may arise as to the appropriateness of a standard, if the actual result is unreasonably different from the standard. There may need to be a reconsideration of the earlier analyses that were the basis for the standards used in the budget followed by operational personnel.

For an organization to gain optimum value from standard costing, all employees involved must understand the motivation for such costing and also understand the assessment that will be made. Imposing standard costs without communicating in an honest, candid manner will undermine much of the perceived value of such costing.


An Ernst & Young survey in 2003 found that 76 percent of U.S. manufacturing companies reported that they used standard costs. Developments in the global business world, however, are influencing many companies to make changes. For example, in the twelfth edition of a popular German textbook, Flexible Plankostenrechnung und Deck-ungsbeitragsrechnung (Flexible plan cost accounting and contribution margin accounting), a cost system that is widely used in Germany and other European countries is outlined. It can be described as a direct or variable costing system, commonly referred as Grenzplankostenrechnung, or in the United States as GPK. A subsidiary of a Germany company in the United States began reporting on a GPK basis by December 31, 2004.

Developments beginning in the twenty-first century reflect the continuing need for more effective methods in cost accounting. Lean accounting, modified activity-based costing, along with GPK, were all getting considerable attention at seminars and conferences attended by practitioners in mid-2005. Considerably more careful studies are needed to determine most effective strategies for costing. There is evidence, though, to support the fundamental concept of standard costing as relevant for effective monitoring of resource usage. Yet, the scope of the fundamental concept requires reconsideration as newer strategies are proposed.

see also Budgets and Budgeting ; Cost Allocation ; Costs


Ernst & Young (2003). 2003 survey of management accounting. New York: Author.

Fleischman, R., and Tyson, T. (1998, March). The evolution of standard costing in the U.K. and U.S.: From decision making to control. Abacus, 92119.

Merwe, A. V. (2004). Chapter zero in perspective. Management Accounting Quarterly, 5 (2), 1.

National Association of Accountants (now Institute of Management Accountants) (1974). Standard Costs and Variance Analysis. Montvale, NJ: Author.

Offenbacker, S. (2004). Zero: Introduction: Marginal costing as a management tool. Management Accounting Quarterly, 5 (2), 7.

Smith, C. (2005, April). Going for GPK: Stihl moves toward this costing system in the United States. Strategic Finance, 3639.

Bernard H. Newman

Mary Ellen Oliverio

Cite this article
Pick a style below, and copy the text for your bibliography.

  • MLA
  • Chicago
  • APA

"Standard Costing." Encyclopedia of Business and Finance, 2nd ed.. . 29 Apr. 2017 <>.

"Standard Costing." Encyclopedia of Business and Finance, 2nd ed.. . (April 29, 2017).

"Standard Costing." Encyclopedia of Business and Finance, 2nd ed.. . Retrieved April 29, 2017 from

cost accounting

cost accounting: see accounting.

Cite this article
Pick a style below, and copy the text for your bibliography.

  • MLA
  • Chicago
  • APA

"cost accounting." The Columbia Encyclopedia, 6th ed.. . 29 Apr. 2017 <>.

"cost accounting." The Columbia Encyclopedia, 6th ed.. . (April 29, 2017).

"cost accounting." The Columbia Encyclopedia, 6th ed.. . Retrieved April 29, 2017 from