What Are the Issues Associated With Cost Tracing & Cost Allocation?
Cost tracing is the process of directly matching a cost with a product being produced, where cost allocation uses estimates to apply costs to products. While many costs can be directly allocated to products, some costs change on a per-unit basis and should be allocated. Knowing some of the concerns associated with cost allocation and tracing can help you decide which approach to take with the costs of running your small business.
Perhaps the biggest impediment to cost tracing is that some costs are inherently difficult to trace. For example, tracing the cost of lumber to a house being built isn't very difficult. The cost of all of the boards used in construction can be added together and the cost applied to the house. However, assigning the cost of a factory security worker's wages to an individual computer being manufactured is much more difficult. In this case, managerial accounting staff would likely allocate a portion of the security worker's salary to each computer. However, even that can become difficult if multiple products or types of products are being produced simultaneously.
When looking at cost tracing and allocation, company owners need to determine how closely to allocate individual costs. With modern computer systems, it is often possible to track every cost down to the gram of glue or individual screw. However, the cost involved with this level of tracking often outweighs the benefit. This question of what extent to account for things is known as materiality to accountants. The idea is that pursuit of information is not costless. Therefore, accountants must decide what amount of information is optimal as it pertains to company profitability.
Cost tracing and analysis can be conducted using a multitude of methods and assumptions. Some of these techniques, such as job-order costing or process costing, can be used for internal decision making but are designed for external financial reporting. Others, such as variable costing, are not permissible for external reporting but are designed to help managers make resource allocation and other business decisions. In larger small businesses, management may implement multiple costing systems. In this case, one system is usually run to support the financial reporting function and is managed by the financial accounting group. At the same time, an additional managerial accounting system is maintained for internal planning and reporting.
While every accounting system needs to be accurate to some degree, the trade-off between accuracy and timeliness is considered when making decisions related to cost tracing and allocation. For most costs, it is more accurate to attempt to trace these costs directly to products because there is little estimation that needs to take place. However, tracing a cost usually requires that the person determines the cost of the item being traced before it can be traced. When costs are not known accurately until they are billed, this can delay cost estimates significantly. Cost allocation can be done at any time after an estimate has been completed; at the end of the accounting period, the difference between actual costs and estimates is reconciled. This can cause costs within the year to be inaccurately reported.