2.2 Cost Allocation

Now I want to talk a bit about cost allocation. And there’s really three main ways to do this. And the last two ways you, you might hear these interchanged sometimes. It, I’m gonna teach you the way that I tend to teach this and the way that I call them. And I’ll tell you why I do it that way. It makes it clear for me. The first way is direct costing. At least everybody agrees on direct costing. Direct costing means that I’m going to apply the only the actual direct costs used in making that product. Go back to pizza. So in direct costing of the pizza, I’m gonna put in the, the price of the, of the flour, the price of the water, the yeast, the the tomato sauce, the cheese, any toppings I put on. Those are direct costs to making the pizza. Now there’s someone making the pizza, right? And I gotta pay that guy. But see, he’s on staff, he’s paid, he’s salaried, or hourly. I got to pay him anyway so, it’s not a direct, a direct cost. Cuz if we were sitting there at my pizza restaurant and nobody walked in, I’d still have to pay that guy, right? So, the direct cost is the cost actually used in just making that pizza, that’s only incurred when that pizza is made. Okay. A lot of times we, we can, call direct costs variable costs. The costs that will go up and down based on the, the quantity of pizzas that I produce. The next kinda cost allocation is called absorption costing. And the next two are absorption costing because the one after that is full costing, and full costing is absorption costing. And many people call full costing absorption costing. I use them differently and this is why. Because absorption costing says that I’m going to absorb some or all of my non-direct costs. So I’m gonna take some or all of those costs and apply them to the pizza. So in this case, I’m gonna take what I pay my staff and I’m gonna find a way to apply that to my pizzas. So I’ll look at how many pizzas were produced during a shift and then how much I pay them for their shift. And I will take their salaries and apply them that, their salaries will be absorbed into the cost of the pizza. So, that’s absorption costing. Now, I can choose to absorb all my costs. You see, I’m still not absorbing rent, the rent for my location. I’m not absorbing electricity for, or gas for my pizza ovens. If I take all of my costs, every single one, direct and indirect, and I divide those all up amongst my pizzas. And I, and I put the cost of all of those into my pizzas, that is full costing. So full costing is absorption costing, but you’re absorbing everything. And because sometimes we absorb some indirect cost and sometimes we absorb all of our indirect costs. I like to give them different names so I know which one we’re talking about. So direct costing, absorption costing, and full costing. The three primary ways of allocating the cost to what it is we’re producing.