Cost Assignment

Introduction to Management Accounting
Chapter
12
Cost Allocation
12 - 1
2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Sch
Learning
Objective 1
General Framework for Cost

Allocation
Cost allocation methods comprise an important

part of a companys cost management system.
Four types of cost objectives:
Service departments
Producing departments
Products/services, and
Customers.
12 - 2
General Framework for Cost Allocation

Producing departments are where employees
Work on the organizations products or services.
Service departments exist only to

support other departments or customers.
12 - 3
rect costs can be physically traced to each departme

departm
Indirect costs must be allocated.
Many companies develop
allocation methods to assign
service department costs to the
producing departments.
12 - 4
All organizations accumulate costs for their

products or services for financial reporting purposes
Increasingly, companies measure and manage
the costs and profitability of their customers.
Customer related costs include:
Order processing
Customer service sales
commissions
Dedicated customer support
12 - 5
accounting system will assign to a departments out

ts direct costs plus all the indirect costs allocated to
its
ost driver that has a logical, cause-effect relationship

to the cost will be used as a cost-allocation base
12 - 6
Learning
Objective 2
Allocation of Service Department

Costs
Establish the details regarding

cost allocation in advance.
Allocate variable- and fixedcost pools separately.
Evaluate performance using budgets for

each production and service department.
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Service Department Example

5-year lease
Computer Department
School of Business
School of Engineering
12 - 8

Suppose there are two major
purposes for the allocation:
Predicting economic effects
of the use of the computer
Motivating departments and
individuals to use its
capabilities more fully
12 - 9

The primary activity performed
is computer processing.
Resources consumed include

1. Processing time
The budget formula for the
2. Operator time
forthcoming year is $100,000
3. Consulting time
monthly fixed cost plus $200
4. Energy
variable cost per hour of
5. Materials
computer time used.
6. Building space
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Variable-Cost Pool
The cost driver for the variable-cost pool is
Actual hours of computer time used.
Therefore, variable costs should

be allocated as follows:
Budgeted unit rate X Actual
hours of computer time used
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Variable-Cost Pool
Consider the allocation of variable
costs to a department that uses
600 hours of computer time.
600 hours $200 = $120,000
Suppose inefficiencies in the
computer department caused the
variable costs to be $140,000
instead of $120,000.
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Variable-Cost Pool
A good cost-allocation scheme would allocate
only the $120,000 to the consuming department
and would let the $20,000 remain as an
unallocated unfavorable budget variance
of the computer department.
This scheme holds computer department
managers responsible for the $20,000
and reduces the resentment of user
managers.
12 - 13
Fixed-Cost Pool
The cost driver for the fixed-cost pool is
the amount of capacity required when
the computer facilities were acquired.
Fixed costs should be allocated as follows:
Budgeted percent of capacity available for use
Total budgeted fixed costs
12 - 14
Fixed-Cost Pool
Suppose the deans had originally predicted the
long-run average monthly usage as follows:
School of Business: 210 hours

School of Engineering: 490 hours
How is the fixed-cost pool allocated?

Business:
210 700 = 30%
$100,000 X .3 = $30,000
Engineering:
490 700 = 70%
$100,000 X .7 = $70,000
12 - 15
Fixed-Cost Pool
This predetermined lump-sum approach
is based on the long-run capacity
available to the user, regardless of
actual usage from month to month.
A major strength of using capacity available rather

than capacity used when allocating budgeted fixed
osts is that actual usage by user departments does no
ect the short-run allocations to other user departmen
ffect
12 - 16
Reciprocal Services
Service departments often support
other service departments in addition
to production departments.
There are two popular methods for
allocating service department costs:
The direct method
The step-down method
12 - 17
Learning
Objective 3
Direct and Step-Down Methods
The direct method ignores other service

departments when any given service
departments costs are allocated
to the revenue-producing
(operating) departments.
The step-down method recognizes that some
service departments support the activities
in other service departments as well as
those in production departments.
12 - 18
Direct and Step-Down Methods

Facilities management cost = $1,260,000
Human resources cost = $240,000
Total square footage in production departments:
15,000 processing + 3,000 assembly = 18,000
Total employees in production departments
16 processing + 64 assembly = 80
Square footage in human resources = 9,000
12 - 19
Direct Method
Facilities management cost

allocated to processing =
(15,000 18,000) $1,260,000 = $1,050,000
Facilities management cost
allocated to assembly =
(3,000 18,000) $1,260,000 = $210,000
12 - 20
Direct Method
Human resources cost
allocated to processing =
(16 80) $240,000 = $48,000
Human resources cost
allocated to assembly =
(64 80) $240,000 = $192,000
12 - 21
Step-Down Method
To human resources:
(9 27) $1,260,000 = $420,000
To processing:
(15 27) $1,260,000 = $700,000
To assembly:
(3 27) $1,260,000 = $140,000
12 - 22
Step-Down Method
$240,000 + $420,000 = $660,000

To processing:
(16 80) $660,000 = $132,000
To assembly:
(64 80) $660,000 = $528,000
12 - 23
Step-Down Method
Processing department
Direct
Step-Down
Direct department costs
$1,000,000 $1,000,000
From facilities management
1,050,00
700,000
From Personnel
48,000
132,000
Total costs
$2,098,000
$1,832,000
12 - 24
Step-Down Method
Assembly department
Direct
Step-Down
Direct department costs
$1,600,000 $1,600,000
From facilities management
210,000
140,000
From personnel
192,000
528,000
Total costs
$2,002,000 $2,268,000
12 - 25
Costs Not Related to Cost Drivers
Identify additional cost drivers.

Allocate all costs by the direct
or step-down method using
square footage as the costallocation base.
12 - 26
Learning
Objective 4
Traditional Approach
1. Divide the costs in each

producing departments.
Direct costs
Indirect costs
2. Assign direct costs to the appropriate

products, services, or customers.
12 - 27
3. Select one or more cost pools and related
cost drivers in each production department.
Indirect departmental costs
Cost
pool
Cost
pool
Cost
pool
12 - 28
4. Allocate costs
Costs
Product
A
Product
B
Product
C
12 - 29
Activity-Based Costing
Step 1:
Determine the key
components of the system.
Step 2:
Develop the relationships among
resources, activities, and cost objectives.
12 - 30
Activity-Based Costing
Step 3:
Collect relevant data concerning costs
and the physical flow of the cost-driver
units among resources and activities.
Step 4:
Calculate and interpret the new
activity-based cost information.
12 - 31
Learning
Objective 5
Allocation of Customer Costs
Allocate costs associated with

customer actions to customers.
Customer profitability depends on more than gross

margin, it depends on the costs incurred to fulfill
stomer orders and to provide other customer servic
12 - 32

Customer Type 1
Low Cost to
Serve
Large order quantity
Few order changes
Little pre- and
post-sales support
Regular scheduling
Standard delivery
Few returns
Customer Type
2 High Cost to
Serve
Small order quantity

Many order changes
Large amounts of preand post-sales support
Expedited scheduling
Special delivery requireme
Frequent returns
12 - 33

Customer Type 1
Low Cost to
Serve
Buys a mix of
products that
have high gross
margins
Has a low cost-toserve %
Has a high level of
profitability
Customer Type
2 High Cost to
Serve
Buys a mix of
products that
have lower gross
margins
Has a high costto-serve %
Has a low level of
profitability
12 - 34

Assume Cedar City Distributors
(CCD),
distributes many
products to retail outlets.
The products are classified into just
two product groups apparel and
sports gear.
CCD has two types of
customers:
1. Small store
2. Large store
12 - 35

CCD uses a simple cost accounting
system to calculate both product
and customer profitability.
The only direct costs

are costs of the
purchase of apparel
and sports gear
products.
Costs
Indirect costs are

allocated to the
product groups
using a single
indirect cost pool
for all indirect costs
with pounds of
product as the
allocation base.
12 - 36
To determine customer profitability:

1. Calculate the profit margin per case for each product
2. Use the product mix ordered by each customer to calculate
Small Stores
Large Stores
Cases
Profit Margin
Total
Cases Profit Margin
Total
per case
Profit Margin
per case
Profit M
Apparel
600 $265.00
$159,000
800 $265.00
Sports Gear 200
315.00
63,000
800
315.00
222,000
464,000
Profit Margin Percentage
43.7%
41.4
12 - 37
Allocation of Costs-to-Serve
Might number of customer orders

be a
more plausible costallocation base?
The cost of resources used for order
processing and customer service
activities should be included in a
separate cost pool and allocated on
the basis of number of orders.
This system gives managers at
CCD more insight into
operations, and a tool to
measure and manage customer 12 - 38
Learning
Objective 6
Allocation of Central Costs
Many managers believe it is desirable

to fully allocate all costs to the revenueproducing parts of the organization.
Whenever possible, the preferred
driver for central services is usage.
If a company does allocate the costs of
central services based on sales, although
costs do not vary in proportion to sales, it
should use budgeted, not actual, sales.
12 - 39
Allocation of Central Costs

Usage
Not always economically viable
Revenue
Total assets
Cost of goods sold
Total cost of each division
12 - 40
Learning
Objective 7
Allocation of Joint Costs
Two conventional ways of allocating

joint costs to products are widely used:
Physical
units
Relative
sales values
Joint costs include all inputs of material, labor, and

erhead costs that are incurred before the split-off po
12 - 41
Allocation of Joint Costs

The physical-units
method requires a
common physical
unit for measuring
the output of each
product.
The joint costs are

allocated based on
each products
percentage of the
total physical
units produced.
Allocation of joint costs should

not affect decisions about the
individual products.
12 - 42
Physical-Units Method
Dow Chemical produces two chemicals, X
and Y. The joint cost is $100,000. X sells
for $.09 per liter and Y for $.06.
Liters
X 1,000,000
Y
500,000
1,500,000
Allocation
Sales Value at
Weighting
of Joint Costs
Split-off Po
(10/15)X$100,000 $ 66,667
$ 90,000
(5/15)X$100,000
33,333
30,000
100,000
120,000
12 - 43
Relative-Sales-Value Method
The joint costs are allocated based on each
products sales value as a percentage
of the total sales value at split-off.
12 - 44
Relative-Sales-Value Method
When weighting is based on the sales
value of the individual products, the
allocation of a cost to one product
depends upon the sales value of both
products.
X
Y
Relative Sales
Value at
Spit-off Point
$ 90,000
30,000
$120,000
Allocation
Weighting
of Joint Costs
(90/120)X$100,000
$ 75,00
(30/120X$100,000
25,000
$100,000
12 - 45
By-Product Costs
A by-product is not individually

identifiable until manufacturing
reaches a split-off point.
They have relatively insignificant
sales value.
12 - 46
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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The End
End of Chapter 12
12 - 48

Cost Assignment

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Introduction to Management Accounting

General Framework for Cost

Cost allocation methods comprise an important

General Framework for Cost Allocation

Service departments exist only to

General Framework for Cost Allocation

rect costs can be physically traced to each departme

General Framework for Cost Allocation

All organizations accumulate costs for their

General Framework for Cost Allocation

accounting system will assign to a departments out

ost driver that has a logical, cause-effect relationship

Allocation of Service Department

Establish the details regarding

Evaluate performance using budgets for

Service Department Example

Service Department Example

Service Department Example

Resources consumed include

Therefore, variable costs should

School of Business: 210 hours

How is the fixed-cost pool allocated?

A major strength of using capacity available rather

Direct and Step-Down Methods

The direct method ignores other service

Direct and Step-Down Methods

Facilities management cost

$240,000 + $420,000 = $660,000

Costs Not Related to Cost Drivers

Identify additional cost drivers.

1. Divide the costs in each

2. Assign direct costs to the appropriate

Allocation of Customer Costs

Allocate costs associated with

Customer profitability depends on more than gross

Allocation of Customer Costs

Small order quantity

Allocation of Customer Costs

Allocation of Customer Costs

Allocation of Customer Costs

The only direct costs

Indirect costs are

Allocation of Customer Costs

To determine customer profitability:

Might number of customer orders

Allocation of Central Costs

Many managers believe it is desirable

Allocation of Central Costs

Not always economically viable

Allocation of Joint Costs

Two conventional ways of allocating

Joint costs include all inputs of material, labor, and

Allocation of Joint Costs

The joint costs are

Allocation of joint costs should

A by-product is not individually

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