When you do cost center-accounting, you always have to take into account three important allocation steps. Without these allocation steps, you won't be able to understand what is going on within each individual cost-center. In order to understand that, it is good to look at the following graph that includes cost-type accounting, cost-center accounting, and product and service costing. These three important subsystems of any cost accounting that you need to better understand what is going on here. In cost-type accounting, you distinguish between direct costs and indirect costs, here we have them as overhead costs, a bit loosely defined. When it comes to the question, what type of cost do we have, we have this cost-type accounting, but at the same time we need the very first allocation procedure, to allocate the cost to each individual cost center, and that is called the primary cost allocation procedure. We allocate indirect cost to the cost centers, indirect cost centers or direct cost centers. Primary cost allocation. The second allocation step then is finally to allocate those costs that are relatively far away from each individual product, those from the indirect cost centers, such as energy and maintenance, to the direct cost centers such as manufacturing, that is called the inter-department cost allocation. This is necessary in order to have all the costs allocated relatively close to the product. The most important step finally is to allocate the costs from the direct cost centers, to the cost objects. The allocation of all these indirect costs to the individual cost object, otherwise you won't know what it would cost you to produce one single unit of output. These three steps of cost center accounting are necessary, three allocation procedures that basically help you to better understand how the cost flows from collecting the cost to distributing it to the individual cost object, typically the product of the firm. Direct costs, as the last step, they are very easy to understand, because direct cost, as the name says, can be directly traced to each individual cost object. If you buy steel for a car, then you can directly trace the steel for the car, to each individual cost object. You do not have to go over the cost-center accounting, so here, the relationship is much clearer. Now, how does this cost allocation work? Typically, you can look at that in the form of a sheet, a table, where you have all the cost centers, and where you have all the cost types. If you look at the different cost types, you would allocate each cost type then to the different cost centers, and that is something that you would already do in the bookkeeping department. In the bookkeeping department, you would assign to each invoice that you are paying the cost center that is responsible for that, or even split up between different cost centers there. Here you see that this allocation of direct and overhead cost to the cost centers, would work exactly in the way I described. You would then have as the second step, the inter-department cost allocation. The second step, basically means that you need to do the allocation procedure from the indirect cost centers to the direct cost centers. Finally, all of the direct cost centers costs have to be allocated using certain overhead rates, and having then the cost of the final product. These three steps will be analyzed further in the clips that follow.
