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Chapter 5

Cost Allocation
Introduction
Cost allocation is an inescapable problem
in nearly every organisation and in
nearly every facet of accounting.
This chapter emphasises the allocation of
costs to divisions, plants, departments,
and contracts.
The chapter also addresses the allocation
of costs to products and customers.
Learning Objectives
1. Outline four purposes for allocating costs to cost objects
2. Describe how a costing system can have multiple cost
objects
3. Discuss key decisions faced when collecting costs in
indirect cost pools
4. Describe how the single-rate cost-allocation method
differs from the dual-rate method
5. Explain how the choice of budgeted versus actual
allocation rates changes the risks that managers face
6. Distinguish among direct allocation, step-down and
reciprocal methods of allocating support department
costs
7. Distinguish between the incremental and stand-alone
cost-allocation methods
8. Criterias used to guide cost-allocation decisions
Learning Objective 1

Outline four purposes for


allocating costs to cost
objects
Learning Objective 1(continued)
Purposes of Cost Allocation
Indirect costs are costs that are related to a particular cost
object but cannot be traced to it in an economically
feasible (cost effective) way.
Why do managers allocate indirect costs to these
cost objects?
There are four essential purposes of cost allocation:
To provide information for economic decisions
To motivate managers and other employees
To justify costs or compute reimbursement
To measure income and assets for reporting to external
parties
Learning Objective 1 (continued)
Provide Information
What economic decisions may require cost allocation
information?
To decide whether to add a new product
To decide whether to manufacture a component part or to
purchase it from another manufacturer
To decide on the selling price for a product
Motivation
Managers and employees need to be encouraged to
design products that are simpler to manufacture or less
costly to service.
Sales representatives need to be motivated to push
high-margin products or services.
Learning Objective 1 (continued)
Justify Costs
It is important to cost products at a fair price, especially in
government defence contracts.
A consulting firm that is paid a percentage of the cost savings
resulting from the implementation of its recommendations needs
to justify costs in order to compute reimbursement.
Reporting
Inventory costs must be determined for financial reporting and for
reporting to tax authorities.
Under generally accepted accounting principles, stock costs
include manufacturing costs but exclude research and
development, marketing, distribution, and customer service costs.
Learning
Learning objective
objective 22

Describe
Describe how
how aa costing
costing system
system
can
can have
have multiple
multiple cost
cost objects
objects
Learning Objective 3

Discuss key decisions


faced when collecting
costs in indirect cost
pools
Learning Objective 3 (continued)
Cost Allocation and Costing Systems
Costs incurred in different parts of an
organisation can be assigned, and then
reassigned, when costing products, services,
customers, or contracts.
Sandy Corporation manufactures clothes
washers and dryers in two international
divisions:
Clothes Washer Division in Paris (CWD)
Clothes Dryer Division in Prague (CDD)
Learning Objective 3 (continued)
Sandy Corporation collects costs at the following levels in
its organisation:
Corporate costs:
Treasury costs: 600,000 interest on debt used to
finance the construction of new assembly equipment
which cost 4,000,000 in the Paris Division and
2,000,000 in the Prague Division.
Human resources costs: 1,200,000 in
recruitment and ongoing employee training and
development.
Corporate administration costs: 4,800,000
in executives salaries, rent, and general administration.
Learning Objective 3 (continued)
Division costs:

Paris Prague Direct


costs 2,200,000 4,000,000 Indirect
costs 1,980,000 2,500,000
Total 4,180,000 6,500,000
Learning Objective 3 (continued)
Allocating Corporate Costs
Some companies allocate all corporate costs to divisions
because ...
it sparks interest on the part of division managers regarding
how corporate costs are planned and controlled, and ...
to calculate the full costs of products.
Other companies do not allocate corporate costs to
divisions.
They maintain that division managers generally have no
say or role in incurring these costs.
Other companies allocate only those costs for which
there is widespread agreement, such as human
resources.
Learning Objective 3 (continued)
If Sandy Corporation allocates corporate costs
to divisions, how many cost pools should it use
to allocate corporate costs?
One single cost pool?
Numerous individual corporate cost pools?
A key factor is the concept of homogeneity.
In a homogeneous cost pool, all costs have the same or
a similar cause-and-effect or benefits- received
relationship with the cost-allocation base.
If each cost category has a different cost driver,
companies may prefer to maintain separate cost-pools
for these costs.
Learning Objective 3 (continued)
If Sandy Corporation allocates corporate costs to
divisions, which allocation basis should it use?
The one that has the best cause-and-effect relationship
with costs.
Which allocation basis should Sandy Corporation
use to allocate treasury costs?
Cost of new Assembly Department equipment
Treasury costs: 600,000
Paris Division: 600,000
(4,000,000 6,000,000) = 400,000
Prague Division:
600,000 (2,000,000 6,000,000) = 200,000
Learning Objective 3 (continued)
Sandy Corporation analysis indicates that the demand for
corporate human resource management costs for recruitment and
training varies with direct labour costs.
These costs are allocated to divisions on the basis of the total
direct labour costs incurred in each division.
Suppose direct labour costs in the Paris Division are 1,200,000
and 1,800,000 in the Prague Division.
How does Sandy Corporation allocate its 1,200,000 of
human resources costs?
Paris Division:
1,200,000 (1,200,000 3,000,000) = 480,000
Prague Division:
1,200,000 (1,800,000 3,000,000) = 720,000
Sandy Corporation does not allocate corporate
administration costs to the divisions.
Learning Objective 3 (continued)

Paris Prague
Treasury costs:
600,000
(2/3) and (1/3) 400,000 200,000
Human resources
costs: 1,200,000
(40%) and (60%) 480,000
720,000
Total allocated to
divisions 880,000 920,000
Learning Objective 3 (continued)
Corporate treasury and human resources costs are
reallocated by the divisions to Assembly.
Corporate human resource management costs are
reallocated by the divisions to the Department of Human
Resources.
Division costs are reallocated to the departments within
the division.
The Paris division of Sandy Corporation has two operating
departments Assembly and Finishing, plus two support
departments Maintenance and Human Resources.
The Paris Division management decided to reallocate the
400,000 treasury costs to the Assembly Department, and
the 480,000 human resources costs to its Human
Resources Department.
Learning Objective 3 (continued)

Paris
Paris Division
Division

Assembly
Assembly
direct
direct costs:
costs: 1,300,000
1,300,000 Finishing
Finishing
Corporate
Corporate direct
direct costs:
costs:
costs:
costs: 400,000
400,000 900,000
900,000
Total
Total costs
costs 1,700,000
1,700,000
Learning Objective 3 (continued)

Paris
Paris Division
Division

Human
Human Resources
Resources
Maintenance
Maintenance direct
direct costs:
costs: 1,680,000
1,680,000
direct
direct costs:
costs: Corporate
Corporate
300,000
300,000 costs:
costs: 480,000
480,000
Total
Total costs
costs 2,160,000
2,160,000
Learning Objective 3 (continued)
Assembly
AssemblyDepartment
Department
1,700,000
1,700,000
Finishing
FinishingDepartment
Department
900,000
900,000
Maintenance
MaintenanceDepartment
Department Paris
ParisDivision
Division
300,000
300,000 5,060,000
5,060,000

Human
HumanResources
ResourcesDepartment
Department
2,160,000
2,160,000
Learning Objective 4

Describe how the single-


rate cost-allocation
method differs from the
dual-rate method
Learning Objective 4 (continued)
Single-Rate and Dual-Rate Methods
The single-rate cost allocation method pools together all
costs in a cost pool and allocates these costs to cost
objects using the same rate per unit of the single
allocation base.
There is no distinction between costs in the cost pool in
terms of cost behaviour.
The dual-rate cost allocation method classifies costs in
each cost pool into two cost pools a variable cost
cost-pool and a fixed-cost cost-pool.
Each of these pools uses a different cost-allocation base.
Learning Objective 5

Explain how the choice of


budgeted versus actual
allocation rates changes
the risks that managers
face
Learning Objective 5 (continued)
Budgeted versus Actual Rates
The decision of whether to use budgeted cost rates or
actual cost rates affects the level of uncertainty user
divisions face.
Budgeted rates let the user department know in advance
the cost rates they will be charged.
Users are better equipped to determine the amount of
the service to request.
Budgeted rates also help motivate the manager of the
supplier department to improve efficiency.
During the budget period, the supplier department, not
the user departments, bears the risk of any unfavourable
cost variances. Why?
because the user departments do not pay for any costs that
exceed the budgeted rates
Learning Objective 5 (continued)
When cost allocations are made using budgeted rates,
managers of divisions to which costs are allocated face no
uncertainty about the rates to be used in that budget period.
When actual rates are used for cost allocation, managers do not
know the rates to be used until the end of the budget period.
When budgeted usage is the allocation base, user divisions will
know in advance their allocated costs.
This information helps the user divisions with both short-run and
long-run planning.
The main justification given for the use of budgeted usage to
allocate fixed costs relates to long-run planning.
Organisations commit to infrastructure costs on the basis of a
long-run planning horizon.
The use of budgeted usage to allocate these fixed costs is
consistent with the long-run horizon.
Learning Objective 6

Distinguish among direct


allocation, step-down
and reciprocal methods
of allocating support
department costs
Learning Objective 6 (continued)
Allocating Support Department Costs
Organisations distinguish between operating
departments and support departments.
An operating department (a production department in
manufacturing companies) adds value to a product or
service.
A support department (service department) provides the
services that assist other operating and support
departments in the organisation.
Three methods are widely used to allocate the
costs of support departments to operating
departments:
Direct allocation method
Step-down method
Reciprocal method
Learning Objective 6 (continued)
Direct method: Allocates support department
costs to operating departments only.
Step-down (sequential allocation) method:
Allocates support department costs to other
support departments and to operating
departments.
Reciprocal allocation method: Allocates costs by
including the mutual services provided among all
support departments.
The direct method and the step-down method are less
accurate than the reciprocal method when support
departments provide services to one another
reciprocally.
Learning Objective 6 (continued)
The following information pertains to the Paris
Division of Sandy Corporation:
Recall that the Paris Division has two operating
departments Assembly and Finishing, and two support
departments Maintenance and Human Resources.
Total square feet = 255,000
Total number of employees = 95
Maintenance is allocated using square feet.
Human Resources are allocated using number of
employees.
Learning Objective 6 (continued)
Human
Maintenance Resources
Budgeted costs
before allocations: 300,000 2,160,000
Square feet: 5,000 30,000
Number of employees: 8 15

Assembly Finishing
Budgeted costs
before allocations: 1,700,000 900,000
Square feet: 110,000 110,000
Number of employees: 48 24
Learning Objective 6 (continued)
Direct Method
allocates support department costs to operating
departments only.
The allocation ratio for allocating Maintenance to
Assembly is 110,000/220,000 300,000 =
150,000.
The allocation ratio for allocating Maintenance to
Finishing is 110,000/220,000 300,000 =
150,000.
The allocation ratio for allocating Human Resources
to Assembly is 48/72 2,160,000 = 1,440,000.
The allocation ratio for allocating Human Resources
to Finishing is 24/72 2,160,000 = 720,000.
Learning Objective 6 (continued)

Assembly Finishing
Original costs: 1,700,000 900,000
Maintenance
Allocated: 150,000 150,000 Human
Resources Allocated:
1,440,000 720,000
Total 3,290,000 1,770,000
Learning Objective 6 (continued)
Step-down Method
allocates support department costs to other
support departments and to operating
departments.
Which support department should be
allocated first?
The support department providing the greatest
percentage of support to other support
departments is allocated first.
Learning Objective 6 (continued)
Maintenance provides 12% of its services to
Human Resources.
Human Resources provides 10% of its services to
Maintenance.
The ratio to allocate Maintenance to Human Resources is
30,000/250,000 (or 12%) 300,000 = 36,000.
The ratio to allocate Maintenance to Assembly is
110,000/250,000 (or 44%) 300,000 = 132,000.
The ratio to allocate Maintenance to Finishing is
110,000/250,000 (or 44%) 300,000 = 132,000.
Learning Objective 6 (continued)

Costs before Allocated


allocation
costs Maintenance 300,000
(300,000) Human Resources 2,160,000
36,000 Assembly
1,700,000 132,000
Finishing 900,000 132,000
Learning Objective 6 (continued)
Human Resources costs to be allocated
become 2,160,000 + 36,000 = 2,196,000.
The ratio to allocate the 2,196,000 Human
Resources costs to:
Assembly is 48/72 2,196,000 = 1,464,000.
Finishing is 24/72 2,196,000 = 732,000.
Learning Objective 6 (continued)

Costs before Allocated Allocated


allocation costs costs
Human
Resources:2,160,000 36,000 (2,196,000)
Assembly: 1,700,000 132,000 1,464,000
Finishing: 900,000 132,000 732,000
Learning Objective 6 (continued)
Total cost after allocation:
Assembly Department = 1,700,000 +
132,000 + 1,464,000 = 3,296,000
Finishing Department = 900,000 + 132,000
+ 732,000 = 1,764,000
Learning Objective 6 (continued)
Reciprocal
M HR A F
Maintenance - 12% 44% 44%
Human
Resources 10% - 60% 30%
Maintenance cost = 300,000 + 0.10HR
Human Resource cost = 2,160,000 + 0.12M
Learning Objective 6 (continued)
Maintenance cost (M)
= 300,000 + 0.10(2,160,000 + 0.12M)
M = 300,000 + 216,000 + 0.012M
0.988M = 516,000
M = 522,267
HR = 2,160,000 + 0.12(522,267)
HR = 2,160,000 + 62,672
HR = 2,222,672
Learning Objective 6 (continued)

M HR A F
Before allocation:
300,000 2,160,000 1,700,000 900,000 Allocation: (522,267)
62,672 229,797 229,797 Allocation: 222,267
(2,222,672) 1,333,603 666,802 Total
3,263,400 1,796,599

Total cost Assembly Department: 3,263,400 Total cost


Finishing Department: 1,796,599
Learning Objective 6 (continued)
Overview of Methods
Overhead rate for the Assembly Department is
determined using direct labour cost as a
denominator.
Overhead rate for the Finishing Department is
determined using machine-hours as the
denominator.
Learning Objective 6 (continued)
Comparison of Methods
Assembly Finishing
Direct Labour cost: 698,880
349,440 Machine-hours: 24,000
23,500

What are the various overhead rates using the


three methods?
Learning Objective 6 (continued)
Overhead Rates Direct Method
Assembly: 3,290,000 698,880 direct labour costs = 471% of
direct labour costs
Finishing: 1,770,000 23,500 = 75.32 per machine-hour
Overhead Rates Step-Down Method
Assembly: 3,296,000 698,880 direct labour costs = 472% of
direct labour cost
Finishing: 1,764,000 23,500 = 75.06 per machine-hour
Overhead Rates Reciprocal
Assembly: 3,263,400 698,880 direct labour costs = 467% of
direct labour cost
Finishing: 1,796,599 23,500 = 76.45 per machine hour
Learning Objective 6 (continued)
Comparison of Rates
Assembly Finishing
Direct method: 471% 75.32 Step-down
method: 472% 75.06 Reciprocal method:467%
76.45
Learning Objective 7

Distinguish between the


incremental and stand-
alone cost-allocation
methods
Learning Objective 7 (continued)
Allocating Common Costs
A common cost is a cost of operating a facility, activity,
or like cost object that is shared by two or more users.
Two methods for allocating common costs are:
Stand-alone cost allocation method
Incremental cost allocation method
The stand-alone cost allocation method uses
information pertaining to each user of a cost
object as a separate entity to determine the
cost-allocation weights.
A consultant in London is planning to go to Nice and
meet with an international client.
The round-trip London/Nice/London airfare costs 540.
Learning Objective 7 (continued)
The consultant is also planning to attend a business
meeting with a UK client in Barcelona.
The round-trip London/Barcelona/London airfare costs
360.
The consultant decides to combine the two trips into a
London/Barcelona/Nice/London itinerary that will cost
760.
How much should the consultant charge to the
UK client?
360 (360 + 540) = 0.40
0.40 760 = 304
Therefore, the consultant should charge the
International client 760 304 = 456.
Learning Objective 7 (continued)
The incremental cost allocation method ranks the
individual users of a cost object and then uses this ranking
to allocate costs among those users.
The first-ranked user of the cost object is termed the primary party
and is allocated costs up to the cost of it as a stand-alone user.
The second-ranked user is termed the incremental party and is
allocated the additional cost that arises from there being two
users instead of only the primary user.
Assume that the business meeting in Nice is viewed as the
primary party.
What would be the cost allocation?
International client (primary)
540 Barcelona client
(incremental) 760 540 = 220
Learning Objective 8

Criterias used to guide cost-allocation


decisions
Learning Objective
Criterias used to guide cost-allocation decisions
Cause-and-effect: Using this criterion, managers
identify the variable or variables that cause resources to be
consumed.
For example, managers may use hours of testing as the variable
when allocating the costs of quality-testing areas to products.
Allocation based on this criterion is likely to be the most credible to
operating personnel.
Benefits-received: Using this criterion, managers
identify the beneficiaries of the outputs of the cost object.
The costs of the cost object are allocated among the beneficiaries
in proportion to the benefits each receives.
For example, the cost of a corporate-wide advertising programme
may be allocated on the basis of division revenues.
Learning Objective)
Fairness or equity: This criterion is often cited
on government contracts when cost allocations are
the basis for establishing a price satisfactory to the
government and its suppliers.
Cost allocation is viewed as a reasonable or fair
means of establishing a selling price in the minds of
the contracting parties.
Ability to bear: This criterion advocates allocating
costs in proportion to the cost objects ability to bear
them.
An example is the allocation of corporate executive
salaries on the basis of division operating income.
Learning Objective
Role of Dominant Criteria
The criteria used to guide cost-allocation decisions
affect both the number of indirect cost pools and the
cost-allocation base for each indirect cost pool.
Managers must first choose the purpose for a particular
cost allocation and then select the appropriate criterion
to implement the allocation.
The cause-and-effect and the benefits-received criteria
guide most decisions related to cost allocations.
Fairness and ability to bear are less frequently used
criteria than cause-and-effect or benefits- received.
Learning Objective
Why are fairness and ability to bear less frequently used?
Fairness is an especially difficult criterion to obtain agreement
on.
What one party views as fair, another party may view as unfair.
The ability to bear criterion raises issues related to cross-
subsidisation across users of resources in an organisation.
Cost-Benefit Approach
Companies place great importance on the cost-benefit
approach when designing and implementing their cost-
allocation system.
The costs of designing and implementing a system are highly
visible.
The benefits from using a well-designed system are difficult to
measure and are frequently less visible.