A Basic Definition of Managerial Costing

Managerial costing can be thought as of a transformation of raw accounting data to a focused, managerially useful view.

Think of raw accounting data as building blocks. It represents a summation of many transactions of a similar nature. Salary and wages cost, for example, would capture all transactions from the payroll system.

But just knowing the total cost for salary and wages is of limited value operationally. Managers might want to know the salary and wages for each of the many operations on their organization chart. Alternatively, they might want to know the total costs for each of the products or services they provide and salary and wages cost is one component of that total.

The raw data doesn’t answer these questions but rather is the starting point for a translation process that provides the managerial useful information. In practice there are three ways this translation can occur: guessing, direct costing, and allocation. Don’t laugh: guessing happens everywhere there is no managerial costing effort that uses direct costing or allocation. It is cheap, flexible, and good enough for many simple needs.

Direct Costing in Managerial Costing

Direct costing builds a detailed capture mechanism that works with the accounting system to capture cost in some detail. For salary and wages, for example, this might involve a time and attendance system where employees log into a management information system. They would then report their hours worked in a variety of areas or one a mix of products depending on the application.

As you can imagine, there is significant cost in direct costing. There is the cost of a management information system to develop and maintain. There is also the time it takes all employees to track and enter the data. There must also be capability to correct erroneous inputs and this often requires that some level of supervisor reviews the input and vouches for accuracy.

Another disadvantage of direct costing is that it is relatively inflexible. Adding an operation or product might require significant rework of the time and attendance reporting system.

Allocation in Managerial Costing

Allocation is something of a compromise between estimation and direct costing. It makes an assumption, really a judgment, of how cost should be distributed. The distribution itself is simply a mechanical process that I’ll cover in a separate blog.

The assumption of how cost should be distributed is very important. It can have significant impact on the usefulness, credibility, and affordability of the managerial costing effort. It can also have profound impact on the behavior of those held accountable for the costs distributed. I will cover some of these pitfalls in subsequent blogs.

Some Other Key Terminology

The starting point of cost to be distributed is often called a cost pool. As such it is usually an aggregation of many related cost details. Perhaps it is a pool comprised of all the overhead in a factory. Or it might be the cost of the Personnel Department in a retail company. It is simply a summation of cost that we need to distribute in order to meet the informational views sought by managers and decision makers.

The transformational mechanics distributes or spreads the cost pool in order to meet those informational needs. This relies on the assumption mentioned above that defines the basis of distribution. That basis could be anything, but some common ones would be square footage occupied, labor dollars, labor hours, sales, headcount, and number of something. Whatever the basis, the allocation process uses a rate or proportion for the distribution. See the Dinner Check blog.

The sought after views are called cost objects. They are views that we wish to cost out. Cost objects could simply be a cost center. Or they might be the products and services of the organization. Managerial costing allows a myriad of possibilities. In fact there are far too many to cost all of them. This is why we start with the information goals of the managers and decision makers and work backwards to determine how best to inform those needs.