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Presenting…

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Cost Allocation

Cost Allocation means the allotment of proportions of cost to cost centers or cost units.

Cost centre has been defined as “a location, person or item of equipment for which costs
may be ascertained and used for the purpose of cost control”.
Whereas a cost unit is a “unit of quantity of product service or time in relation to which
costs may be ascertained and or expressed”.

Cost allocation includes choosing the object of costing, accumulating the costs that relate
to the object of costing and choosing the method to identify those costs. Usually, the
allocation of costs would be done based on machine-hours, direct-labor hours etc

Cost Apportionment: Cost allocation is also referred to as Cost apportionment. Cost


apportionment means the allotment of proportions of items of cost of cost centers or cost
units.

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Example 1

A manufacturing company has to allocate the total manufacturing overheads of $30,000 to


its’ Products A, B and C and uses the traditional method of allocating based on the direct-
labor hours. The direct labor hours for Products A, B and C are 2000, 1000 and 3000
respectively.

Solution:
Total labor hours = 6000
Cost Allocation:

Overheads allocated for Product A = 30,000 x 2,000 / 6,000 = Rs. 10,000


Overheads allocated for Product B= 30,000 x 1,000 / 6,000 = Rs. 5,000
Overheads allocated for Product C= 30,000 x 3,000 / 6,000 = Rs. 15,000

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Cost Absorption

Cost absorption means allotment of overhead expenses to cost units.

Overhead absorption is usually achieved by the use of one or a combination of overhead


recovery rates.

An example of cost absorption would be the application of factory overhead costs to


processing departments using a pre-determined overhead rate.

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Example 2

A company follows a practice of allocating the factory overheads based on a pre-


determined overhead rate of Rs. 12 per unit produced. The number of units produced
during the period is 5000.

Solution:

Cost absorbed would be = 5000 units x Rs. 12 per unit = Rs. 60,000.

This amount would be finally compared with the actual overheads incurred during the end
of the period and under-applied or over-applied overheads will be calculated and adjusted
accordingly.

Pre-determined overhead rate is a rate based on the budgeted overhead and yearly /
period budgeted activity either in direct labor hours, machine hours or number of units etc.

Pre-determined Over head rate = Budgeted Yearly Factory Overhead costs


Budgeted yearly activity

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Cost Ascertainment

This technique of costing involves:

(i) Collection & classification of expenditure according to cost elements and

(ii) Allocation and apportionment of the expenditure to the cost centres or cost units, or
both.
Element of cost

Materials Labour Expenses

Direct Indirect Direct Indirect Direct Indirect

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Cost Unit

The quantity upon which cost can be conveniently allocated is known as a unit of cost or
cost unit.

The Chartered Institute of Management Accountant (CIMA), London defines a unit of cost
as “a unit of quantity of product, service or time in relation to which costs may be
ascertained or expressed.

Example: (i) Brick kilns per 1000 bricks made


(ii) Textile Milss per yard or per lb. of cloth manufactured
(iii) Electricity Companies per unit of electricity generated

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Cost Centre

Cost Centre refers to one of those convenient units into which the whole factory
organization has been appropriately divided for costing purposes.

Each such unit consists of a department or a sub department or item of equipment or


machinery or a person or a group of persons.

Example: In a laundry, activities such as collecting, sorting marking and washing of clothes
are performed. Each activity may be considered as a separate cost centre and all costs
relating to a particular cost centre may be found out separately.

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Profit Centre

The profit centre is that segment of the activity of a business with which both the
revenues and expenses are identified and profit or loss made by that particular
segment of activity is ascertained.

There are two main differences between a profit centre and a cost centre:

(i) A cost centre is created for accounting convenience for ascertaining and controlling
costs. Whereas the profit centre is created because of decentralization of business
operations.

(ii) A cost centre does not have target cost. However, a profit centre has a profit target and
it enjoys authority to adopt such policies which are necessary for achieving its target.

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Absorption Costing

Apportionme
nt

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Absorption Costing

Absorption Costing is a principle whereby fixed as well as variable costs are allotted to cost
units and total overheads are absorbed according to activity level.

Conceptually, absorption costing is a simple and fundamental method of ascertaining the


cost of a product or service. It is the oldest and widely used system of cost accounting in
operation.

Absorption Costing is also termed as ‘cost plus’ costing where a fixed percentage is added
to total cost, to cover profit.

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Absorption of overheads

Criteria for absorption of overheads:

To decide a rate for the absorption of overheads the most common criteria are:

• Percentage of direct material cost


• Percentage of direct labour cost
• Percentage of prime cost
• Rate per unit produced
• Rate per labour hour
• Rate per machine hour

The circumstances of a particular situation must be considered befora a choice is made.

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Over and Under recovery

Over and Under recovery of overheads:

The overheads incurred in running a business are known with certainty, but the amount of
overhead absorbed is based on prior estimates of the levels of production and therefore
over or under recovery of overheads is likely to be incurred during the period.

The explanations behind the major causes of over and under recovery of overheads are
price functions, a change in level of general economic activity, poor marketing and so on.

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Advantages

• Absorption costing conforms with the accrual concept by matching costs with
revenue for a particular accounting period.

• Stock valuation complies with the accounting standards, and fixed production
costs are absorbed into stocks.

• It avoids separation of costs into fixed and variable elements, which is not easily
and accurately achieved.

• The analysis of under / over absorbed overheads reveals any inefficient utilization
of production resources.

• The apportionment and allocation of fixed production overheads to cost centres


(e.g., departments) makes managers more aware of the costs and services
provided.

• Cost plus pricing under absorption costing ensures that all costs are covered.

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Limitations

• This method employs highly arbitrary way of apportionment of overheads which


reduces the practical utility of cost data for control purposes.

• In this method all fixed costs are not charged against the revenue of the year in
which they are incurred. It is an unsound practice.

• Assigning product cost with a reasonable share of fixed overhead obscures cost-
volume-profit relationship

• Behavioural pattern of costs is not given importance

• In reporting enterprise results, the profit of a particular period will be affected by


the amount of overheads absorbed into closing inventories or work-in-progress or
finished stock or charged against the period when opening inventories are sold.

• In most cases accuracy in determining selling prices cannot be achieved due to


the nature of overheads included in the calculations.

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Example 3

A company is manufacturing 3 products A, B and C. Their manufacturing cost is:


A B C
Direct Material per unit Rs. 3 Rs. 4 Rs. 5
Direct Labour 2 3 4
Selling Price 10 15 20
Output 1,000 units 1,000 units 1,000 units

The total overheads are Rs. 6,000 out of which Rs. 3,000 are fixed and rest are variable.
It is decided to apportion these costs over different products in the ratio of output.
Prepare a statement showing cost of each product and profit according to Absorption
Costing.

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Solution 3
STATEMENT SHOWING COST AND PROFIT
A B C
Per unit Total Rs. Per Unit Total Rs. Per Unit Total Rs.
Rs. Rs. Rs.
Direct Materials 3 3,000 4 4,000 5 5,000
Direct Labour 2 2,000 3 3,000 4 4,000
Overheads:
Fixed 1 1,000 1 1,000 1 1,000
Variable 1 1,000 1 1,000 1 1,000
Total Cost 7 7,000 9 9,000 11 11,000
Profit 3 3,000 6 6,000 9 9,000
Selling Price 10 10,000 15 15,000 20 20,000
Total Profit Rs. 3,000 + Rs. 6,000 + Rs. 9,000 = Rs. 18,000

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QUESTIONS ?

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