Chap 15 - Cost Allocation

Purposes of cost allocation

1. Provide information for economic/profit decisions

2. Motivate managers and other employees (establishes accountability, encourages cost efficiency, etc)

3. Justify costs or compute reimbursement amounts (insurance)

4. Measure income and assets for reporting to tax authorities

Criteria for cost allocation decisions

• Cause and effect

  • Indirect and shared costs should be assigned to a cost object based on a logical driver (entity/activity that actually causes the cost to be incurred should bear the responsibility for paying it)

    • Integral part of ABC

• Benefits received

  • Beneficiaries of the outputs of the cost object are charged in proportion to the benefits received

• Fairness (equity)

  • The established price is satisfactory to gov, customers, and suppliers

• Ability to bear

  • Costs are allocated in proportion to the cost object’s ability to bear them (e.g. larger/more profitable objects receive more of the allocated costs)

What is ABC (activity based costing)?

Assigns indirect and overhead costs to products and services based on the specific activities required to produce them

What is a cost object

Any item, product, service, project, customer, or department for which a business measures and tracks costs separately. Examples include:

• Chair, tables, hospital patient treatment

• An internal team, HR department, marketing division

• Custom client order

• An individual client account, a specific customer, geographic sales territory

How are indirect costs (overhead) assigned?

Shared expenses that can’t be directly traced (e.g. factory rent, general supervisor salaries) are allocated to a cost object using specific cost drivers (e.g. machine hours, labour hours)

What are cost drivers?

Any factor, activity, or event that directly causes a change in the cost of a business activity, product, or service (the root cause why an expense goes up or down).

Example: # of hrs a factory machine runs is a cost driver for electricity and maintenance expenses

Methods to allocate support department (service department) costs

• Single rate method

• Dual rate method

What is the single rate method

Pools all costs into one cost pool and allocates them to cost objects using the same rate per unit of the single allocation base. No distinction is made b/w fixed and variable costs w/ this method.

What is the dual rate method

Classifies costs within each cost pool into two typical segments (a variable cost pool and a fixed cost pool). Then, each pool uses a different cost allocation base.

Methods for allocating support costs to production departments

1. Direct

2. Step down

3. Reciprocal

What is direct method

• Allocates support costs to only the operating departments

  • Support departments only allocate cost to producing/operating departments

• No interaction b/w support departments

What is step down method

• Allocate support costs to other support departments AND operating departments in a pre-determined (ranked) order

• One way interaction b/w support departments

  • The first ranked support department will allocate its costs down to the other support department and operating departments

    • However, once a support department’s costs have been allocated, no subsequent support department costs are allocated back to it

What is reciprocal method

• Allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments

  • Full two way interaction b/w support departments

  • Uses “equations” to obtain reciprocal costs

How do you determine rank of support departments for step down method?

• Highest usage OR

• Highest dollar allocated

Choosing between methods

• Reciprocal is the most precise

• Direct and step down are simplest to apply and understand

• Direct method is widely used and the simplest

There is often not a significant difference (non material) between methods to implement a costlier analysis

Advantages to direct method

• Simple to calculate

• Easy to understand

• Inexpensive to implement

• Does not require support departments to be ranked

Advantages to step down method

• simpler than the reciprocal method

• Recognizes some of the activity b/w support divisions

• May be viewed as “fairer” than the direct method

• If one division provides a majority of the interdivisional support, there is minimal distortion of cost (compared to the direct method)

Advantages of reciprocal method

• Conceptually the best method

• Reflects the economic reality of support division activities

• Does not require support divisions to be ranked

Disadvantages of reciprocal method

• Difficult for non accountants to understand, therefore it may be difficult to justify the numbers

• Complex to calculate, so it can be subjected to error

• Most expensive (due to its complexity and training requirements)

Disadvantages to step down method

• Not as economically plausible as the reciprocal method

• More complex than the direct method

• Requires support divisions to be ranked by some method

Disadvantages to direct method

• May not accurately reflect the economic reality of value being added by support division activities

• Fails to recognize level of activity between support divisions

• May result in large cost/value distortions

What are common costs

A cost object that is shared by two or more users

Methods of allocating common costs

• Stand alone cost allocation method

• Incremental cost allocation method

What is stand alone cost allocation method

• Uses info pertaining to each user as a separate entity to determine the cost allocation weights

  • Individual costs are added together and allocated on the basis of each user’s percentage of the total of individual stand alone costs

What is incremental cost allocation method

• Ranks the individual users of a cost object in the order of users most responsible for a common cost and then uses this ranking to allocate the cost among the users

  • The first ranked user is the Primary User and gets the highest allocation of the common costs

  • The second ranked user is the First Incremental User and is alloced the additional cost that arises from two users rather than one

  • Subsequent users are handled in the same manner as the second ranked user