cost allocation method

Overhead Allocation

Overall Allocation Method

• Having service departments further complicates the allocation process, requiring a structured approach to ensure accurate cost distribution.

• It becomes a two-stage process:

  • Stage 1: Service department overhead costs are allocated to operating departments. This involves identifying the services provided by support departments (e.g., IT, HR, maintenance) and allocating their costs to the departments that directly contribute to the production or service delivery.

  • Stage 2: Overhead costs are applied to the cost object (i.e., product). Once the operating departments have received their share of service department costs, they allocate these costs, along with their own overhead, to the products or services they produce.

• The allocation from service to operating departments is called apportionment. This process involves selecting an appropriate allocation base (e.g., direct labor hours, square footage, machine hours) that reflects the usage of the service department's resources by each operating department.

Two-Stage Overhead Cost Allocation

• First Stage: Service department costs are allocated to operating departments. Common methods for allocation include the direct method, step-down method, and reciprocal method. The choice of method depends on the complexity of the inter-relationships between service departments.

• Second Stage: Operating department overhead costs, plus allocated service department costs, are applied to products and services using departmental overhead rates. This stage often involves calculating a predetermined overhead rate for each operating department, which is then used to apply overhead costs to products based on a cost driver such as direct labor hours or machine hours.

Activity-Based Costing (ABC)

• A costing approach that assigns resource costs to cost objects based on activities performed. It recognizes that activities consume resources and that products or services consume activities.

• Assumption: A firm's products or services result from activities, and activities require resources, which have costs. ABC aims to provide a more accurate and detailed understanding of the costs associated with producing goods or services.

• ABC refines the costing system by focusing on individual activities fundamental to the cost object. By identifying and analyzing the activities that drive costs, ABC provides a more precise allocation of overhead costs compared to traditional methods.

• Activities are events, tasks, or units of work with a specified purpose (e.g., ordering materials, storing materials, designing a product, setting up a machine, checking quality). Each activity is analyzed to determine the resources it consumes and the associated costs.

Steps in ABC System

1. Identify Activities: Determine what happens in a process (e.g., production, selling, customer service). This involves a thorough analysis of the organization's processes to identify all significant activities. Examples: setting up a machine, delivering a product, calling a customer.

2. Group Indirect Costs into Activity Cost Pools: Create pools for similar activities. An activity cost pool is a collection of costs associated with a specific activity. For example, a cost pool for machine setup might include the wages of setup personnel, depreciation of setup equipment, and the cost of setup materials.

3. Select Appropriate Cost Driver: Find the driver that drives the cost for each activity pool. A cost driver is a factor that causes or influences the cost of an activity. There should be a causal relationship between the cost and cost driver.

4. Compute the Cost Driver Rate (CDR): This is similar to Overhead Allocation Rate calculation. The cost driver rate is calculated by dividing the total cost in the activity cost pool by the total quantity of the cost driver. $CDR = {∑Activity Pool Cost \over ∑Cost Driver}$

5. Assign Cost of the Activities to Products: Allocate the costs from the activity cost pools to the products or services based on their consumption of the activities. This involves multiplying the cost driver rate by the quantity of the cost driver consumed by each product.

6. Compute the Total Cost of the Products: Sum up all costs assigned to each product, including direct materials, direct labor, and allocated overhead costs. This provides a more accurate picture of the total cost of producing each product.

Cost Driver Rate (CDR) Formula

• $OAR = {∑Manufacturing Overhead \over ∑Allocation Base}$

• $CDR = {∑Activity Pool Cost \over ∑Cost Driver}$

Traditional vs. ABC Methods

• Traditional Method:

  • May overcost some products and undercost others. Traditional costing systems often use a single overhead rate based on direct labor hours or machine hours, which can lead to distortions in product costs when products consume overhead resources differently.

• ABC Method:

  • Aims to provide a more accurate cost structure for products. By assigning costs based on activities, ABC provides a more precise allocation of overhead costs compared to traditional methods.

  • Helps to eliminate non-value-added activities. ABC can help identify activities that do not add value to the product or service, allowing management to eliminate or reduce these activities and lower costs.

  • Supports decisions on product mix and customer mix. With more accurate cost information, management can make better decisions about which products to offer and which customers to target.

Pluses and Minuses of ABC Method

• Benefits:

  • Provides a more accurate cost structure for products. ABC provides a more detailed and accurate picture of the costs associated with producing goods or services.

  • Can help eliminate non-value-added activities. By identifying and analyzing activities, ABC can help management identify and eliminate activities that do not add value to the product or service.

  • Helps with decisions on product and customer mix. More accurate cost information allows management to make better decisions about which products to offer and which customers to target.

• Limitations:

  • Companies with homogeneous production and labor-intensive operations may gain little from ABC. In situations where products are similar and overhead costs are driven primarily by direct labor, the benefits of ABC may be limited.

  • Inaccurate costs if the wrong cost driver is selected. The accuracy of ABC depends on the selection of appropriate cost drivers that accurately reflect the consumption of resources by activities.

  • Relies on data availability. Implementing ABC requires detailed data on activities, costs, and cost drivers, which may not be readily available in all organizations.

  • Doesn't indicate customer satisfaction or process control. ABC focuses primarily on cost allocation and does not provide information on other important performance measures such as customer satisfaction or process control.

Changes Over Time in Dealing with Overhead Costs

• Traditional cost allocation methods haven't changed much in the last 60 years. This is despite significant changes in the business environment and the nature of overhead costs.

• Traditional Methods ignore the fact that the economic environment of company had significantly changed. The shift towards more automated production processes, increased product complexity, and greater emphasis on customer service has rendered traditional methods less relevant.

• Overheads are no longer mainly linked to direct labor hours. As production processes become more automated, direct labor costs represent a smaller proportion of total costs, and overhead costs are driven by other factors such as technology, product design, and marketing.

• Direct labor represents only a small fraction of total costs. In many industries, direct labor costs account for less than 10% of total costs, making direct labor hours an inadequate basis for allocating overhead costs.

• In the long term many costs are influenced by support activities relating to the complexity of production rather than the volume of production. Activities such as product design, engineering, and quality control can have a significant impact on costs, and these activities are often driven by the complexity of the production process rather than the volume of production.

• Managers must ensure that their costing system does not over-cost one product while under-cost another. Accurate cost information is essential for making informed decisions about pricing, product mix, and investment.

Key Definitions

• Direct Costs: Costs related to a particular cost object