Cost Allocation in Departments

Cost Allocation in Departments

Understanding departmental costs informs user departments about service costs, aiding in planning and control.

Allocation Methods

Cost allocation methods from one internal customer to another include:

  • Direct Method
  • Step-Down Method
  • Reciprocal Services Method

Support vs. Production Departments

Support departments (e.g., equipment maintenance, quality control, material handling) support production departments (e.g., bending, welding).

Challenge: How to allocate costs from support to production, then to products or jobs.

Cost Allocation Process

  1. Identify costs to allocate to internal customers.
  2. Choose an appropriate allocation basis and rates.
  3. Select and use a cost allocation method.
  4. Check for an accurate allocation.

Multiple Cost Pools

Using multiple cost pools (e.g., finance, HR, IT, planning & development) allows for more accurate cost allocations by managing different support services.

Seek cause-and-effect relationships when developing cost allocation bases.

Cost Allocation Bases Examples

  • Finance: size of budget
  • Human Resources: number of full-time employees
  • IT: number of computers
  • Planning & Development: number of project applications

Steps for Cost Allocation

  1. Measure support service spending.
  2. Identify activities demanded by internal customers.
  3. Divide spending by cost rate to derive a cost driver rate.
  4. Use percentages to allocate costs among support centers.

Direct Method

Allocations go directly to production or direct service departments, ignoring services between support divisions. Simplest but most subjective.

Step Method

Recognizes that some support departments provide services to other support services. Better than the direct method but still subjective.

Choosing the right method

Begin with the service department servicing the largest number of other service departments or the one with the largest overhead budget.

Reciprocal Method

Reciprocal problems can also be solved in Excel using matrix algebra.

Method Comparison

  • Direct: Easiest, ignores interactions.
  • Step: Considers some interactions.
  • Reciprocal: Thorough, considers all interactions but is more complex.

Significant differences in outcomes can affect performance evaluations, product decisions, and contracts.

Cost Benefit Analysis

Complex systems are costly to design and maintain, requiring continual revision. Choose based on cost vs. benefits.

Additional Considerations

  • Use cost drivers as an allocation basis.
  • Increase overhead rates to potentially increase product cost accuracy.
  • Allocate indirect costs to encourage resource management.
  • Activity based costing may provide more reliable outcomes.