You will surely recollect the following transactions structure:

This is the basic rule:

Allocate direct Cost Elements directly to the Production Cost accounts in Class 5. Allocate indirect Costs to the different Departments in Class 3 (Responsibility Centers).

Note that in today's cost accounting books--used by universities worldwide--all indirect costs are charged to only one overhead account. And in those exhibits, many professors just do not know where in their graphic they should show the expense accounts. So they simply do not show these expense accounts in their exhibits about cost accounting. Therefore, our present financial accounting is not prepared to work for cost accounting.

Because internal accounting is structured separately from financial accounting, our expenditure accounts should be recorded as part of general accounting, while our cost element accounts belong restrictively to internal accounting. We are then ready to realize all necessary transactions specifically related to our internal accounting. Let us start with this important part of our Internal Accounting study.

Indirect Costs
We begin by allocating all of our indirect costs to the different departments (or cost centers). All costs that are not classified as direct, and that have cause in our departments, will be indirect.

To give our direct laborer an opportunity to produce a product, we must establish a department with all the necessary costs it will require to operate this department. So we must have in this department an employee who is paid a salary and who will be responsible for the activity within this area. We will also need an indirect laborer who will oversee the operating procedure of this department. Naturally, we also need a space (rent), electricity, insurance, phone and many other indirect costs in order to obtain the smooth operation of this department.

All of these indirect costs must be allocated to some specific department or cost center that we have established in our company. This means that we are not only interested in controlling the operating costs of our production departments, but also the operating costs of all other departments that we have in our company.

Under the Responsibility Accounting system, we have to control our:

Following is the basic departments code structure of our Internal Chart of Accounts:

Re-Allocation

Every company has departments that do not work directly with production. These departments may provide some service to both the direct production department or to other departments in the company. These indirect and service department operating costs must be re-allocated to those departments to which they gave their service.

Why should we re-allocate these department's costs to other departments? Two reasons:

1. Because we should not apply these departmental costs directly to the production cost accounts. We would not find any way to apply these costs to the different products.
2. We have to determine how these costs could be applied to our production (or be absorbed by our production), because we accept the basic philosophy of Activity Based Costing.

This means that in addition to applying out direct costs, and the indirect costs of the production department, to our productions cost accounts, we must also apply the costs that refer to different basic departments in our company. We will not apply to the production costs some administrative and sales costs, but we will apply all other costs allocated to those departments that support in a direct or indirect way the operation of our direct production departments.

Re-allocation is necessary to transfer the departmental operating cost of these indirect production and service departments to those departments to which they have given their services.

We must establish the annual operating cost budgets and outline the re-allocation procedures and their rate. Through this procedure we will credit the service departments and debit these amounts monthly to the corresponding departments. This will create important new information recorded on the accounts of these receiving departments, and new reports will be prepared based on how much of these service department operating costs correspond to the different direct production departments.

This creates awareness by the manager of the costs that his/her department has to accept. These re-allocated costs will be included in preparing the direct production department's rates. These rates will be multiplied by the corresponding production activity levels (expressed with actual or standard data) and will be absorbed by the different elaborated products. (I will study those in my next article.)