Cost Allocation

CHAPTER 6CHAPTER 6

Cost Allocation

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Activity-Based Costing

Cost Allocation

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Activity-Based Costing

Slide 6-1

Purposes of Cost AllocationPurposes of Cost Allocation

To provide information for decision making

To reduce frivolous use of common resources

To encourage evaluation of services

To provide “full cost” information

Slide 6-2 Learning objective 1: Explain why indirect costs are allocated




Provide information for decision making

Allocated cost should measure the opportunity cost of using a company resource

In practice, difficult to operationalize since cost may quickly change

Provides a useful benchmark



Reduce frivolous use of common resources

Frivolous use may have hidden cost such as slower service

Allocation of centrally provided services provides incentive for departments to reduce frivolous use of resource



Encourage evaluation of services

If costs are not allocated, there is no incentive to evaluate the services and look for lower cost alternatives

With cost allocation, there is a strong incentive to critically evaluate the efficiency and necessity of services



Provide “full cost” information

GAAP requires full costing for external reporting purposes

Full cost information is needed when the company has an agreement whereby revenue received depends upon cost incurred, i.e.“cost-plus” contracts


Cost-Plus ContractsCost-Plus Contracts


Process of Cost AllocationProcess of Cost Allocation

Determine the cost objective Form cost pools Select an allocation base to

relate cost pools to the cost objective

Slide 6-9 Learning objective 2: Describe the cost allocation process

Process of Cost AllocationProcess of Cost Allocation


Determine the Cost ObjectiveDetermine the Cost Objective


Determine the product, service, or department that is to receive the allocation. Object of the allocation is called the cost objective

For example, if computer costs are allocated to contracts, the contracts are the cost objective

Cost ObjectivesCost Objectives


In the cost allocation process, the cost objective is the:

a. The allocation base used to allocate the costs

b. A grouping of individual costs whose total is allocated using one allocation base

c. The product, service or department that is to receive the allocation

d. None of the above

Answer: cThe product, service or department that is to receive the allocation


Form Cost PoolsForm Cost Pools

A grouping of individual costs whose total is allocated using one allocation base

Costs in the pool must be homogeneous (similar)

Cost pools can be organized along -departmental lines, e.g.

Maintenance, Personnel depts.-major activities, e.g. equipment

setups, inspections.Slide 6-14 Learning objective 2: Describe the

cost allocation process

Select an Allocation BaseSelect an Allocation Base

Select an allocation base that relates cost pool to the cost objectives-base must be some characteristic that is

common to all of the cost objectives-should be based on cause-and-effect

relationship If indirect costs are fixed, cause-and-

effect relationships are difficult to establish and other approaches are used


Select an Allocation BaseSelect an Allocation Base

Two production departments: Assembly and Finishing- both receive allocations of indirect costs

from the maintenance department- should labor hours or machine hours be

used as the allocation base?


Selecting an Allocation Base

Selecting an Allocation Base


In the cost allocation process, an allocation base:

a. Must be some characteristic that is common to all of the cost objectives

b. Ideally should result in cost being allocated based on a cause-and-effect relationship

c. Both a and bd. None of the above

Answer: c Both a and b


Fixed Indirect Costs – Other Approaches

Fixed Indirect Costs – Other Approaches

Relative benefits approach to allocation- More costs allocated to those objectives

that benefit most from incurring the cost Ability to bear costs

- More costs allocated to those that are more profitable

Equity approach to allocation- Base results in allocations that are

perceived to be fair or equitable


Allocating Service Department Costs

Allocating Service Department Costs

Organizational units of manufacturing firms classified as either:- production departments, or - service departments

Cost pools- formed by service departments- Allocated to production departments

Slide 6-20 Learning objective 3: Discuss allocation of service department costs

Direct Method of Allocating Service Department Costs

Direct Method of Allocating Service Department Costs

Service department costs allocated to production departments but not to other service departments


Direct Method – Mason Furniture


Slide 6-22

Allocate janitorial cost of $100,000 Allocation base: square feet

Assembly Dept: 20,000 square feetFinishing Dept: 30,000 square feet

Calculate Allocation Rate:$100,000 / (20,000 + 30,000) = $2/sq ft

Allocation to Production Departments:

Assembly Dept.:20,000 sq ft x $2 = $40,000Finishing Dept.: 30,000 sq ft x $2 = $60,000 Learning objective 3: Discuss allocation of

service department costs



Slide 6-23

Allocate personnel cost of $200,000 Allocation base: number of employees

Assembly Dept: 60 employees

Finishing Dept: 40 employees Calculate Allocation Rate:

$200,000 / (60 + 40) = $2,000/employee Allocation to Production Departments

Assembly Dept: 60 x $2,000 = $120,000Finishing Dept: 40 x $2,000 = $80,000

Learning objective 3: Discuss allocation of service department costs

The direct method of allocating costs:

a. Allocates service department costs to other service departments

b. Allocates only direct costsc. Allocates service department costs to

production departments onlyd. Both b and c

Answer: cAllocates service department costs to production departments only





Three production departments:- Showers- Bathtubs- Vanities

Two service departments:- Mailroom- Janitorial

Suggest allocation base for mailroom costs:

Number of employees, labor hours, or labor cost


Three production departments:- Showers- Bathtubs- Vanities

Two service departments:- Mailroom- Janitorial

Suggest allocation base for janitorial costs:

Square footage, number of work stations


Three production departments:- Showers: 80 employees- Bathtubs: 40 employees- Vanities: 30 employees

Allocate mailroom costs of $600,000 based on employees

Calculate Allocation Rate: $600,000 / (80+40+30) = $4,000/employee

Allocation to Production Departments:Showers: 80 x $4,000 = $320,000Bathtubs: 40 x $4,000 = $160,000Vanities: 30 x $4,000 = $120,000


Three production departments:- Showers: 1,500 sq ft- Bathtubs: 1,000 sq ft- Vanities: 500 sq ft

Allocate janitorial costs of $90,000 based on sq ft

Calculate Allocation Rate: $90,000 / (1,500+1,000+500) = $30 per sq ft

Allocate to production departments: Showers : 1,500 x $30 = $45,000Bathtubs: 1,000 x $30 = $30,000Vanities : 500 x $30 = $15,000


Allocating Budgeted and Actual Service Department

Costs

Allocating Budgeted and Actual Service Department

Costs

Management should allocate based on budgeted costs rather than actual costs

Allocation of actual amounts allows service department to pass on cost of inefficiencies and waste to production departments


Problems with Cost Allocation

Problems with Cost Allocation

Potential problems brought about by:1. Allocations of costs that are not

controllable2. Arbitrary allocations3. Allocation of fixed costs that make the

fixed costs appear to be variable costs4. Allocations of mfg. overhead to

products using too few overhead cost pools

5. Use of only volume related allocation bases

Slide 6-31 Learning objective 4: Identify potential problems with cost allocation

Responsibility Accounting and Controllable Costs

Responsibility Accounting and Controllable Costs

Responsibility accountingIdentifies those responsible for generating revenue and controlling costs

Some cost allocations are not consistent with responsibility accounting- Controllable costs are those under the

manager’s control- Some argue that managers should only be

allocated controllable costs


Arbitrary AllocationsArbitrary Allocations

Cost allocations are inherently arbitrary

Typically there are numerous allocation bases that are equally justifiable- Managers support the allocation which

makes them look best- Managers reject allocations which cast

an unfavorable light on their performance


Unitized Fixed Costs and Lump Sum Allocations

Unitized Fixed Costs and Lump Sum Allocations

Unitized fixed costs - Fixed costs are stated on a per unit basis

and allocated as a variable cost- Perception of costs as variable could alter

decision making Lump-sum allocations

- Allocate predetermined amount of fixed costs that is not affected by level of activity

- Allocation must appear to be fixed to managers of departments receiving charge


When fixed costs are stated on a per unit basis:

a. Fixed costs are said to be “unitized”b. Fixed costs may appear to be variable

to managers receiving allocationsc. Decision making is greatly improvedd. Both a and b

Answer: dBoth a and b


Too Few Cost PoolsToo Few Cost Pools

Although simple, may lead to distortion of cost allocation, i.e. some products will be overcosted or undercosted

Product costs will be more accurate when more overhead cost pools are used

Must analyze cost-benefit relationship of more cost pools


Problem of Using Measures of Production Volume to Allocate

Overhead

Problem of Using Measures of Production Volume to Allocate

Overhead Typical allocation bases include direct

labor hours and machine hours

Assumes all overhead costs are proportional to production volume

When OH costs not proportional to production volume: - High-volume products are overcosted - Low-volume products are undercosted

Slide 6-37 Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Using Only Volume-Related Allocation Bases

Using Only Volume-Related Allocation Bases

Some firms allocate manufacturing overhead based on volume, e.g. direct labor or machine hours

Not all overhead costs vary with volume

Activity-based costing (ABC) solves this problem


Activity-Based CostingActivity-Based Costing

Identifies major activities that cause overhead costs to be incurred

Cost of resources consumed performing these activities grouped into cost pools

Costs are assigned to products using a measure of activity, i.e. cost driver


The ABC ApproachThe ABC Approach


Common Activities and Associated Cost DriversCommon Activities and Associated Cost Drivers


Activity Based Costing- McMaster Screen Technologies

Activity Based Costing- McMaster Screen Technologies


Two cost pools used: Equipment setups

- Total setups = 10,000- Total cost = $1,500,000

Inspections - Total inspections = $15,000 - Total cost = $3,000,000

Cost per equipment setup:$1,500,000 / 10,000 = $150 per setup


Two cost pools used: Equipment setups

- Total setups = 10,000- Total cost = $1,500,000

Inspections- Total inspections = 15,000- Total cost = $3,000,000

Cost per inspection:$3,000,000 / 15,000 = $200 per inspection


Allocation Rates:Equipment setups = $150 per setupInspections = $200 per inspection

Product cost and activity:


Product Units Materials Labor Setups InspectionsEP150 1,000 5,500 2,700 10 3 EP175 600 2,800 1,400 40 8

Materials 5,500 Labor 2,700 Setups 10 X $150 = 1,500 Inspections 3 X $200 = 600

Total 10,300 / 1,000 units = $10.30

Cost/Unit for Product EP150:

Allocation Rates:Equipment setups = $150 per setupInspections = $200 per inspection

Product costs and activity:


Product Units Materials Labor Setups InspectionsEP150 1,000 5,500 2,700 10 3 EP175 600 2,800 1,400 40 8

Cost/unit for product EP175:Materials 2,800 Labor 1,400 Setups 40 X $150 = 6,000 Inspections 8 X $200 = 1,600

Total 11,800 / 600 units = $19.67

Benefits of ABCBenefits of ABC

Provide more accurate costing- Less likely to undercost/overcost due to

cost driver usage

May lead to improvements in cost control- Costs broken out into a number of

activities rather than into one or two overhead cost pools


Limitations of ABCLimitations of ABC

More costly to develop and maintain than a traditional costing system

Used to develops full cost of products- Includes fixed costs- Lacks incremental information

necessary for decision making


Fixed and Variable CostsFixed and Variable Costs


Activity-Based ManagementActivity-Based Management

Activity analysis aimed at improving efficiency and effectiveness of business processes

ABC focus is on measuring cost of products and services

ABM focus is on goal of managing the activities themselves

Slide 6-50 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)




Determine major activities Identify resources used by each

activity Evaluate the performance of the

activities Identify ways to improve the

efficiency and/or effectiveness of the activities


Cost Allocation and Decision Making

Cost Allocation and Decision Making


Cost Allocation

Documents

allocated cost

cost objectiveslide

hidden cost

opportunity cost

cost informationslide

cost allocation process12in

cost information gaap

learning objective