12 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e,...

Chapter 12

Cost Allocation

12 - 2

Cost Allocation

Costs are linked with cost objectives by selectingappropriate cost drivers.

A cost driver is often called a cost-allocation base.

A cost pool is a grouping of individual cost itemsthat are allocated to cost objectives.

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Learning Objective 1

Explain the major reasons

for allocating costs.

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Purposes of Allocation

There are four major purposes for allocating costs:

1 To predict the economic effects of planning and control decisions

2 To obtain desired motivation3 To compute income and asset valuation4 To justify costs or obtain reimbursement

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Three Types of Cost Allocations

1 – Allocation to the appropriateorganizational unit

2 – Allocation from one organizationalunit to another

3 – Allocation to products or services

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Allocate the variable and fixed

costs of service departments

to other organizational units.

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Allocation of Service Department Costs

Guidelines for allocatingservice department costs:

Establish the details regardingcost allocation in advance.

Allocate variable- and fixed-costpools separately.

Evaluate performance using budgets.

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Service Department Example

Computer Department

School of Business School of Engineering

5-year lease

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Analyze the costs of the computerdepartment in detail.

The primary activity performedis computer processing.

Resources consumed includeprocessing time, operator time,consulting time, energy, materials,and building space.

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Suppose there are two major purposes for the allocation:

1 Predicting economic effects of the use of the computer

2 Motivating departments and individuals to use its capabilities more fully

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Assume that cost behavior analysis has been performed.

The budget formula for the forthcoming year is $100,000 monthly fixed cost plus $200 variable cost per hour of computer time used.

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Variable-Cost Pool

The cost driver for the variable-cost pool is hours of computer time used.

Therefore, variable costs should be allocated as follows:

Budgeted unit rate × Actual hours ofcomputer time used

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Variable-Cost Pool

Consider the allocation of variablecosts to a department that uses600 hours of computer time.

Assume that inefficiencies in thecomputer department caused thevariable costs to be $140,000instead of $120,000.

600 hours × $200 = $120,000

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Variable-Cost Pool

A good cost-allocation scheme would allocateonly the $120,000 to the consuming departmentand would let the $20,000 remain as anunallocated unfavorable budget variance of thecomputer department.

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Fixed-Cost Pool

The cost driver for the fixed-cost pool is the amount of capacity required when the computer facilities were acquired.

Therefore, fixed costs should be allocated as follows:

Budgeted % of capacity available for use× Total budgeted fixed costs

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Fixed-Cost Pool

Suppose the deans, in our university computer department example, had originally predicted the long-run average monthly usage as follows:

School of Business 210 hours

School of Engineering 490 hours

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Fixed-Cost Pool

How is the fixed-cost pool allocated?

Business:210 ÷ 700 × $100,000 = $30,000Engineering:490 ÷ 700 × $100,000 = $70,000

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Fixed-Cost Pool

This predetermined lump-sum approach is basedon the long-run capacity available to the user,regardless of actual usage from month to month.

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Allocate the central costs

of an organization.

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Allocation of Central Costs

UsageUsage

RevenueRevenue

Cost of goods soldCost of goods sold

Total assetsTotal assets

Total cost of each divisionTotal cost of each division

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Use the direct and step-down

methods to allocate service

department costs to user

departments.

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Reciprocal Services

Service departments often support other service departments in addition to producing departments.

There are two popular methods for allocating service department costs:

1 The direct method2 The step-down method

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Direct and Step-Down Methods

The direct method ignores other service departmentswhen any given service department’s costs areallocated to the revenue-producing (operating)departments.

The step-down method recognizes that some servicedepartments support the activities in other servicedepartments as well as those in productiondepartments.

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Direct and Step-Down Methods

Service Departments Production Departments

Facilities$126,000

$100,000Molding

Personnel$24,000

$160,000Finishing

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Direct Method

Facilities$126,000

$100,000Molding

Personnel$24,000

$160,000Finishing

$105,000

$19,200

$21,000

$4,800

320 ÷ 400 × $24,000

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Step-Down Method

Facilities$126,000

$100,000Molding

Personnel$24,000 + $42,000

$160,000Finishing

$70,000

$52,800

$14,000

$13,2009

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Step-Down Method

Finishing DepartmentMolding Department

Direct costs $100,000From Fac. Mgt. 70,000From Personnel 13,200Total $183,200

Direct costs $160,000From Fac. Mgt. 14,000From Personnel 52,800Total $226,800

12 - 28

Facility Management Example

Assume management wants to analyze facility management’s costs.

What are the possibilities?1 Divide costs into two or more different cost

pools and use a different cost driver to allocate the costs in each pool.

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2 Allocate variable costs using the direct or step-down method, but do not allocate the fixed costs.

3 Allocate all costs using square footage as the cost driver.

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Allocate usingCost Driver 2

Facilities Management Cost

Cost Pool Cost Pool Cost Pool

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Describe the traditional

approach to allocating

costs to products or services.

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Traditional Approach

Operating orproductiondepartments

Step 1:Allocate production-related costs todepartments.

Step 2:Select one or morecost drivers.

Directlaborhours

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Step 3:Allocate coststo products orservices.

ProductA

ProductB

ProductC

Direct labor hours

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Fixedcosts

Variablecosts

One cost driver

If only one cost driver is used,two cost pools should be maintained

12 - 35

Use activity-based costing to

allocate costs in a modern

manufacturing environment

to products or services.

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Activity-Based Costing

ABC systems focus on accumulating costs into key activities.

If many costs are caused by non-volume-based cost drivers, activity-based costing (ABC) should be considered.

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Determine cost objective, key activitycenters, resources, and related cost drivers.

Step 1:

Step 2:

Develop a process-based map representingthe flow of activities, resources, and theirinterrelationships.

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Step 3:

Collect relevant data concerning costs andthe physical flow of the cost-driver unitsamong resources and activities.

Step 4:

Calculate and interpret the new activity-based information.

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Use the physical-units and

relative-sales-value methods to

allocate joint costs to products.

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Meaning of Terms

Joint products Joint costs

Separable costs Split-off point

Main product By-product

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Joint Costs

Physical unitsRelative sales

values

Two conventional ways of allocatingjoint costs to products are widely used:

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The physical-unitsmethod requires acommon physicalunit for measuringthe output of eachproduct.

The joint costs areallocated based oneach product’spercentage of thetotal physicalunits produced.

Physical-Units Method

12 - 43

Relative-Sales-Value Method

The joint costs are allocated based on each product’s sales value as a percentage of the total sales value at split-off.

Sales value at split-off method

Estimated net realizable value (NRV) method

Constant gross-margin percentage NRV method

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Why Allocate Joint Costs?

To determine inventory cost and cost of goods sold

To determine cost reimbursement under contracts

For conducting customer profitability analysis

For insurance settlement computations

For rate regulation

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No Allocation of Joint Costs

Some companies refuse to allocatejoint costs and instead carry theirinventories at estimated net realizablevalue minus a normal profit margin.

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By-Product Costs

If an item is accounted for as a by-product, only separable costs are allocated to it.

All joint costs are allocated to the main products.

Any revenues from by-products, less their separable costs, are deducted from the cost of the main products.

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Joint Costs Allocation Example

100 pounds Z-1Separable cost $300

400 pounds Z-2Separable cost $150

Joint costis $900.

Product A$800

Z-1 and Z-2are worthlessat split-off point.

Product B$800

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Physical Units Example

Joint Cost Allocated

To A:100 ÷ 500 × $900 = $180

To B:400 ÷ 500 × $900 = $720

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Physical Units Example

A B Total

Sales Value $800 $800 $1,600Separable Costs 300 150 450Allocation of Joint Cost 180 720 900Operating Profit (Loss) $320 $(70) $ 250

12 - 50

Relative-Sales-Value Method Example

A B TotalSales Value $800 $800 $1,600Separable Costs 300 150 450Sales Value Imputedat Splitoff Point $500 $650 $1,150Allocation of Joint Cost500/1,150; 650/1,150 391 509 900Operating Profit (Loss) $109 $141 $ 250

12 - 51

Understand how cost allocation

is used in cost planning

and control.

12 - 52

Cost Allocation in Planning and Control

Across the entire chain, managers need accurate cost information in order to effectively plan and control operations.

End of Chapter 12

12 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e,...

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