PART 1 LESSON 8

COST ALLOCATION TECHNIQUES

LESSON 8 COST ALLOCATIONTECHNIQUES

CONTENT
1. Absorption Costing
2. Full Costing
3. Joint & By Product Costing
4. Overhead Cost & Normal Cost
5. Allocation of Service Department Costs

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ABSORBTION COSTING & FULL COSTING:

There are 2 methods of manufacturing overheads costing.

1. Absorption Costing/ Full Costing

2. Variable Costing / Direct Costing

ABSORPTION COSTING:

Under this method, the fixed portion of the manufacturing overhead is absorbed
into the cost of each product. Therefore to arrive at the gross margin, the absorption-basis
cost of goods sold is subtracted from the sales.

VARIABLE COSTING:

Under this method, the product cost includes only variable manufacturing costs.
Therefore in order to arrive at the gross margin, the variable-basis cost of goods sold and
the variable portion of the selling & administration expenses are subtracted from the sales

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COST ALLOCATION TECHNIQUES:

Absorption costing Variable costing

Actual Costing Actual absorption Costing Actual Variable costing

Normal costing Normal absorption costing Normal variable costing

Standard costing Standard absorption Standard variable

Costing costing

Absorption vs. Variable Costing:

 The difference between Absorption and Variable costing arises due to the
difference in the manner in which fixed overhead costs are treated.

a. In absorption costing system, both variable and fixed overhead are

treated as product costs, and both are assigned to products or services.
b. In a variable costing system, only variable overheads are treated as
product costs.

 Fixed overhead is treated as period cost under variable costing.

1. Absorption costing is also called full costing.

a. The traditional approach to product costing is absorption costing.
b. Absorption costing treats all manufacturing overheads whether fixed or
variable as product costs. Therefore the inventoried costs include both
variable costs and fixed costs

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c. Fixed costs are applied to work in process account on a predetermined
bases
d. Non manufacturing costs are treated as period costs.
e. With regard to presentation absorption costing presents expenses on an
income statement according to functional classification
f. Functional classification is a group of costs that were all incurred for the
same principal purpose. Functional classification include categories such
as cost of goods sold, selling expense, and general and administrative
expense
g. Absorption cost is required for reporting under GAAP. Authoritative
bodies like FASB and SEC believe that absorption costing provides
external parties with more informative picture of earnings than does
variable costing

2. Variable costing also called direct costing

a. Variable costing is also known as direct costing
b. Variable costing treats only variable overheads to the inventoried cost

c. Only variable costs are considered as costs of production since fixed costs
are incurred whether production takes place or not
d. Fixed costs are not applied to work in process
e. Fixed expenses are treated as period cost and expensed during the time
period.
f. Variable costing allows costs to be separated by cost behavior on the
income statement or internal management reports.
g. Variable costing method determines CONTRIBUTION margin which is
arrived by deducting variable costs from net sales revenue. Contribution
margin represents the amount available to cover fixed expenses

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A. Allocation of Indirect Costs to Products (Product Costing) :

1. Actual costing

In an actual costing system the actual costs of direct material, direct labor, and
overhead are assigned to products or services. This costing procedure can be
used only after the production costs have been incurred and are known.

Actual costing is accurate method of assigning costs:

i. In this method in which actual cost of direct material, direct labor and
overheads are assigned to cost objects
ii. This is accurate method of costing because it assigns the actual historic
cost
iii. The costing procedures can be used only after the production is
completed and all costs are known.

2. Normal Costing:

In a normal costing system the actual costs of direct material and direct labor
are assigned to products or services, but an estimated overhead is assigned on
the basis of predetermined overhead rate.

i. Actual cost of direct material and direct labor are assigned while
overheads are allocated on the basis of budgeted estimates
ii. Predetermined overheads are determined according to budgeted
estimates and are allocated to the cost objects
iii. Costs are estimated before the completion of production process

Predetermined Overhead rate: (Budgeted overhead rates)

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a. One of the most widely used methods of allocating manufacturing overhead is
through use of predetermined overhead rate (also called peanut butter costing).
b. The overheads are estimated using Budgeted overhead rather than actual
overheads.

Separate Variable and Fixed Overhead Application Rates:

• Either combined or separate overhead rates are effective for purpose of assigning
overhead costs to products.
• Combined overhead rates are traditional in business for three reasons.
• Combined rates are easy to calculate, less expensive to calculate and eliminate the
need to separate overhead costs by cost behavior.
• The disadvantages are:

a. First, the specific information needed by managers to perform their

functions is not available.
b. Second, cause and effect relationships between costs and activity are
blurred when combined rates are used

B. Allocation of Indirect Costs to Periods (Period Costing):

1. In addition to incurring taxes, salaries, utilities etc as part of operation of

factory, manufacturing firms also incur same kinds of costs in relation to other
parts of their operations.

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a. For example salaries, utilities etc arising from activities of front office.
b. The cost of these non manufacturing expenses should not go into
manufacturing overheads.
c. Rather these expenses should be treated as PERIOD COSTS and charged
directly to income account.
2. Allocating Costs of One Department to Another (Period Costing)
A. Costs of one department will include costs allocated from another department
B. Service department costs are collected according to the period and allocated to
all the units of products/services produced during the period
C. The cost allocation method should decide on
a. Single rate or dual rate methods
b. Budgeted versus Actual rates
c. Budgeted versus Actual usage allocation bases
D. Allocating costs of support departments:
a. Organizations distinguish between operating departments and support
departments. An operating department is also called production
department and support department is also called service department
b. Different methods of cost allocation are used to allocate support
department costs to operating departments viz:
i. Direct allocation method
ii. Step down allocation method
iii. Reciprocal allocation method

E. Allocating Common Costs:

a. Costs shared by two or more departments. Common costs cannot be
directly traced but must be allocated using some systematic and
rational basis. For example depreciation on headquarter building.
Methods used in allocating common costs include:
i. Stand Alone Cost allocation method
ii. Incremental Cost Allocation method

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C. Under or over applied overheads:

1) Since predetermined rates are used to apply overheads to work in process

there will be difference between amount of overheads applied and actual
overheads incurred during a period.
2) The under or over applied manufacturing overheads may be:

 Closed to cost of goods account or

 Allocated between work in process, finished goods and cost of goods
sold in proportion to ending balance.
 Most firms follow first approach

Under costing and Over costing:

• Product under costing- product consumes higher costs (inputs) than actually
reported.
• The under reporting arises due to using budgeted rates instead of actual rates
• Product over costing- product consumes lesser costs (inputs) than actually
reported.
• The over reporting arises due to using budgeted rates instead of actual rates

Product Cost Cross subsidization:

Product cost subsidization means one miscosted product results in miscosting other
products

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JOINT PRODUCTS/BY PRODUCTS COSTING

JOINT COSTS: Example Coconut

Processed Dept 1
Joint Process
Shell
(By Product)

Marketed
Ropes

Coir
Marketed
(Joint Product)

Carpets
Marketed

Coconut Marketed

Marketed
Copra

Kernel
Marketed
(Joint Product)

Coconut Marketed
Milk

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Marketed
(By Product) Marketed
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JOINT COSTS: Example: Corn

Discarded
Corn Husk
(Waste)

Marketed
Corn on the cob directly
(Joint product)

Marketed
Canned
(Processed)
Whole kernels
(Joint product)

Fresh Corn Marketed

Ground to make
corn meal Marketed
(Processed)
Partial kernels
(By product)

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Marketed
(Scrap) (Animal
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Joint products:
Two or more products so related that one cannot be produced without producing the
others. All the products have relatively substantial value and are produced simultaneously
by the same process up to a split-off point. For example beef and hides are joint products
For instance in the above figure Coconut shell, Coconut water, Coconut coir, Coconut
kernel are all joint products because one cannot be produced without other.

Definition

Two or more outputs generated simultaneously, by a single manufacturing process using

common input, and being substantially equal in value. Joint products (such as butter,
cheese, and cream from milk, and fuel oil, gasoline, and kerosene from crude oil) are
separately unidentifiable, and incur undifferentiated joint costs, until they reach the split-
off point.
Joint Costs:
The cost of simultaneously producing or otherwise acquiring two or more
products (joint products) that must, by the nature of the process, be produced or
acquired together. The cost of beef and hides of cattle are joint costs (IMA)
Split-off point:
The point of production beyond which the cost of separate products can be
measured. Up to this point, the products were either joint products or byproducts.

Methods for allocating joint costs:

Physical unit method:
This is an easy, objective way to prorate joint cost at split off point. Physical
measurement allocation uses a common physical charact4eristic of the joint products
as the pro ration base. Examples are:
Tons of ore
Cubic feet
Barrels of oil
Kilograms of meat. Bones and hides
Kilobytes of memory in computer chips

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Monetary Measure Allocation
1. Sale value at split off point method: The joint costs are allocated to the
joint products in the ratio of the respective realizable value at the split off
point. All the joint products must be marketable at split off point
Net Realizable Value at Split off: Net realizable value is the sales revenue at
the split off point less costs necessary to prepare and dispose of the product.
This method requires all the joint products to be marketable at split off point
2. Approximated Net Realizable Value: Where any of the joint products do
not have sale value at split off point but could be marketed with further
processing, Approximated net Realizable value is calculated by deducting
incremental separate costs necessary to make the joint product salable from
the expected selling price after processing.
3. Constant gross margin percentage NRV method: The constant gross
margin percentage BNRV method allocates joint costs in such a way that the
overall gross margin percentage is identical for all the individual products.
This method entails three steps:
i. Compute overall gross margin percentage
ii. Use the overall gross margin percentage and deduct the gross
margin from the final sales values to obtain the total costs that
each product should bear
iii. Deduct the expected separable costs from the total costs to obtain
the joint cost allocation.

Non allocation of joint costs:

Some companies do not make joint cost allocation. Instead they carry all
inventories at estimated net realizable value.
Income on each product is recognized when production is completed.
Accountants criticize this approach because income is recognized before sales.
In response to this criticism, some companies using no allocation approach
carry their inventories at estimated NRV minus a normal profit margin

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Irrelevance of Joint Costs for Decision Making:
Joint costs are sunk costs and so they are irrelevant to decision making. Managerial
decisions regarding whether a product should be sold at split off point or processed
further should not be based on Joint Costs.
Sell or process further: The decision to incur additional costs beyond split-off should
be based on incremental costs and revenue beyond split off Companies often face the
decision of whether to further process or sell at split off point. The accounting reports
for such decisions must be based on incremental costs

Byproducts:
A product necessarily obtained during the course of manufacturing, having relatively
small importance as compared with that of the main product or products. The cost of
a byproduct is commonly regarded as indeterminable; the revenue, if any, from its
sale is usually credited to the main product(s) or to a miscellaneous revenue account.
In the example relating to corn the Corn on the cob and Whole kernels are joint
products because both of them have substantial value. Partial kernels are By products
because they do not have substantial value.
ALLOCATION OF SERVICE DEPARTMENT COSTS
Service (support) department costs are considered part of overhead (indirect costs).
Thus, they cannot feasibly be traced to cost objects and therefore must be allocated to the
operating departments that use the services. .
When service departments also render services to each other, their costs may be allocated
to each other before allocation to operating departments.

Four criteria are used to allocate costs.

• Cause and effect should be used if possible because of its objectivity and
acceptance by operating management.
• Benefits received are the most frequently used alternative when a cause-and-effect
relationship cannot be determined. However, it requires an assumption about the
benefits of costs, for example, that advertising which promotes the company but
not specific products was responsible for increased sales by the various divisions.

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• Fairness is sometimes mentioned in government contracts but appears to be more
of a goal than an objective allocation base.
• Ability to bear (based on profits) is usually unacceptable because of its
dysfunctional effect on managerial motivation.

Methods of service department allocation

DIRECT METHOD
The direct method is the simplest.
1) The direct method allocates service department costs directly to the producing
departments without regard for services rendered by service departments to each other.
2) Service department costs are allocated to production departments based on an
allocation base appropriate to each service department's function.

STEP DOWN METHOD

The step or step-down method allocates some of the costs of services rendered by service
departments to each other.
1) The step method derives its name from the procedure involved: The service
departments are allocated in order, from the one that provides the most service to other
service departments down to the one that provides the least.
EXAMPLE:
The services that each service department provides the other must be ascertained:

CPU Cycles Floor Space

Service Department Used % in Sq. Ft. %
Information Technology 196,000,000 98.0% 20,000 80.0%
Custodial Services 4,000,000 2.0% 5,000 20.0%

Totals 200,000,000 100.0% 25,000 100.0%

-

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b) Looking just at reciprocal service department activity, custodial services provides 20%
of its services to information technology but IT only provides 2% of its services to
custodial. Thus, custodial will be allocated first.
c) The next step is to determine the relative Proportions of the three departments that will
receive the first allocation

Floor Space
Allocate Custodial Services: in Sq. Ft. %
To Department A 56,000 56.0%
To Department 8 24,000 24.0%
To Information Technology 20,000 20.0%
Totals 100,000 100.0%

THE STEP DOWN METHOD IS PERFORMED AS FOLOWS

Service depts. Prdn. dept.
Custodial Info.
Services Tech. Milling Finishing Total
Totals before Allocation $40,000 $1,20,000 $3,00,000 $2,00,000 $6,60,000
Allocate Custodial (40,000) 8,000 22,400 9,600 0
Totals after first allocation $0 $1,28,000 $3,22,000 2,09,000 $6,60,000

RECIPROCAL METHOD
The reciprocal method is the most complex and the most theoretically sound of the three.
It is also known as the simultaneous solution method, cross allocation method, matrix
allocation method, or double distribution method. The reciprocal method recognizes
services rendered by all service departments to each other.
EXAMPLE:
The reciprocal method requires calculating the allocation base amounts for information
technology, i.e., the service department that was not allocated to the other service
department under the step method.

CPU Cycles

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Allocate Information Technology: Used %
To Department A 60,000,000 60.0%
To Department B 36,000,000 36.0%
To Custodial Services 4,000,000 4.0%
Totals 100,000,000 100.0%
Use linear algebra to calculate fully reciprocated information technology costs (FRITC)
and fully reciprocated custodial services costs (FRCSC):
FRITC = Preallocation IT costs + (FRCSC x Portion of custodial effort used by IT) =
$120,000 + (FRCSC x 20%)
FACSC = Preallocation custodial costs + (FAITC x Portion of IT effort used by
custodial) = $40,000 + (FAITC x 4%)

These algebraic equations can be solved simultaneously.

FRITC = $120,000 + (FRCSC x 20%)
= $120,000+ {[$40,000 + (FRITC x 4%)] x 20%} = $120,000 + [($40,000 + .04FRITC)
x .2]
= $120,000 + $8,000 + .008FRITC .992FRITC = $128,000
FRITC = $129,032
FRCSC= $40,000 + (FRITC x 4%)
= $40,000 + ($129,032 x .04%) = $40,000 + $5,161
=$45,161
The reciprocal allocation is performed as follows:

Service depts. Prdn. dept.

Custodial Info.
Services Tech. Milling Finishing Total

Totals before allocation $40000 $1,20,000 $3,00,000 $2,00,000 $6,60,000

Allocate Custodial Services
(20.0%, 56.0%, 24.0%) (45,161) 9,032 25,290 10,839 0
Allocate Info. Technology
(4.0%, 60.0%, 36.0%) 5,161 (1,29,032) 77,419 46,452 0
Totals after allocation $0 $1,28,000 $3,22,000 2,09,000 $6,60,000

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