Now we proceed our study of total cost, and in this episode we will emphasize again the two major procedures here. Namely the measurement of direct costs, and the procedures aimed at the assignment and delegation of indirect costs. Now, in what follows, we will go specifically over this second part that is by far, the most challenging. Because with respect to direct costs, we will sort of say, well, it does not produce such a challenge. We have to just keep this in mind. All right, so let's say a few words about measuring direct costs. Well, first of all, the idea here is that normally these direct costs, they come in the form of direct materials and direct labor. So these are the, again we remember that these costs may be direct with respect to one object, and indirect with respect to the other. So each and every time we have to be really careful in making sure that we are talking about this cost as direct cost. But normally this is the major breakdown. Major direct costs, these are direct. Labor, And then direct materials. So how do we measure them? Well, direct labor, so we have to, first of all, choose some units, so unit of measurement. And here, let's say maybe it's man-hours. And then the next thing clearly is the price per unit. So again it's absolutely trivial. If in this department, they used 1,000 of man hours of direct labor. And then people in this department are paid whatever, $15 per hour, then you just multiply one by the other and you get the dollar amount of direct labor. You have the material is the same. So you have to know the volume. Let’s say, how many pounds of this alloy you use in order to make this piece? And then you know at what is the cost of this. So this is at what price you bought it. So then there is also a price per unit, and by multiplying in this volume we know how many units, and you get the overall thing. So although that sometimes is cumbersome, and sort of the process that requires a lot of accuracy and a lot of attention. But we can say, maybe in sort of a little bit of an arrogant way, that this is the easy part. Now, when we talked about the easy part, let's move on to the, Harder part. And now we introduce, like I said, the absolutely core topic of managerial accounting. This is indirect, Cost allocation. Well, we touch that here. And we will proceed, so I will say some major things about that. We'll analyze approaches, then we will go over a very specific example that is three episodes long. And then, at the very end of this week, we will wrap up that with the, let's say, cost allocation road map. We will say this is step one, step two, step three, and so on. And I specifically do that later because on this example you will see how this goes, or otherwise we will have to go back to these steps or stages. And here, we start with the idea, what is the nature, Of this cost allocation? So we know that total cost, that includes, remember, That includes the again, direct cost I will put here, because we just talked about that. And now comes the proportional share of indirect costs. And we know that this is, I put it in red, this is the big question. Now, And let's, Just put one after the other. The purposes of this allocation, because you can say well, remember we talked about the need to do that in a economically efficient way, maybe we can forget about this allocation altogether. Maybe it's way too difficult, maybe we do not gain anything, we do not have any benefit from that. Well we do, and that is why we sort off torture ourselves with these procedures that are logically clear, but not so very trivial to complete them in the right way. So we know that purposes are as follows, this is the information for decision making. This is motivation. This is cost justification. That's income reporting. So look at that. Can we ignore these things? Well, maybe not. Well, we cannot ignore income reporting because that's required. But, what if we de-motivate people? Again I gave you an example, so there are two divisions, so these are indirect costs. You charge them arbitrarily, without any procedure, and then it came out that one division is a loss making one, the other is a profit making. So they are working, they provide some value added, but as a result of your arbitrary charging of a direct cost, one became a losing unit. So does it motivate people who work there? Or probably doesn't. So these people, they are working hard, they are doing the best to do that, and then you tell them, you're losers. Not only you are losers in general, but you are also, you lose money for the company. This is not a great motivator is it? So we can see that we wish we could do it in an easier way, not such a cumbersome way, not such a logical and loaded way, but we cannot. By the way, here it's time to recall, and this is not a very arrogant statement. But the problem is that at many companies, systems of visual accounting and these cost systems, they do not work very efficiently. People spend a lot of time, effort, and money to come up with these systems that will be mostly adequate to the business of this and that company. But they sometimes do not contribute to the extent that people have thought them to be. And that just, that's a problem or the challenger, it only supports this idea. So it is not so easy to reach this goal, but unfortunately we cannot ignore this goal. And now I would like to point out some other important things, these are criteria for cost allocation. Well,and there are some of them that are very important and core, one this is cause and effect. So basically we analyze this, remember this idea of cost driver, what results in the creation of cost? So we have to see why this procedure, or this product, this action, this whatever, how that affects the result. Then, the next thing is the benefit received. Then the next thing is, fairness, that's what I was talking about before. You can arbitrarily charge them, but if it's unfair, then that's too bad. And well, there's another thing, this is ability to bear. Let's say your company has two divisions. One is small, the other is large. And then there is headquarters. In this headquarters there is CEO and the top management. So all these people, they cost this much. And let's say you are arbitrarily divide this cost by two. You say that half of that goes in this department and half of this one that. For a large department, It's easy to bear this. For the small one, you cannot bear, because then you immediately become money losing. So such a trivial example shows to you that maybe there is a better way. Let's say you charge the bigger part to the bigger department and the smaller part to the smaller department. And then the next question is, how exact do you calculate this share? And what you use as a basis? And about that, we will talk later on. Now, the next thing is, again like I said, the important thing, this is the cost benefit, Story. So here, we can, if it's really, if you have developed the advanced system, but then it results in some strange or inefficient outcomes, then probably you would not be interested in that. Let me give you a classic example how this idea of indirect costs normally may result in something very much unexpected. Well this is quoted in many books, as let's say that you get the bill from the hospital when you, God forbid, you just broke your leg while skiing. And then you spent some time there and you got the bill. And if you analyze this bill you could see that the overall cost of a bottle of water is let's say $15, and you say, wait a minute, how can that be? And then when you study, you see that, let's say the cost of the bottle is $3. At that price you can buy it at the supermarket or anywhere else. But the remainder, these are the components of indirect costs, including, malpractice insurance. Treatment of uninsured customers. Then handling of that, and then some other expenses. So basically, you can see that if you added all those proportionally to all inputs, because water is sort of a direct material for you, then you might see that it's prohibitively expensive. Now you can obviously exclude part of this charging, and then say well, that goes not for water but for something else, but that's another story. And that just gives you the idea that when you cope with this criteria. And when you talk about cost benefit here, you have to operate not in a standard, or let's say trivial, or let's say, a robotic way. Instead, you have to think. And often times the general idea is by this thinking. You have to create a proper motivation, and the proper understanding of what's going on in your company. Because if you did that in a mechanic way, that sometimes results in the fact that the picture, and your bottom line may be very much skewed. Well, in the next episode we'll proceed with the idea of cost allocation
