Cost Allocation

1
Introduction to Management Accounting
Chapter 12
Cost Allocation
2
General Framework for Cost Allocation
Learning Objective 1
Cost allocation methods comprise an important
part of a companys cost management system.
Four types of cost objectives Service
departments Producing departments Products/service
s, and Customers.
3
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.
4
General Framework for Cost Allocation
Direct costs can be physically traced to each
department.
Indirect costs must be allocated.
Many companies develop allocation methods to
assign service department costs to the producing
departments.
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General Framework for Cost Allocation
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
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General Framework for Cost Allocation
An accounting system will assign to a
departments output all its direct costs plus all
the indirect costs allocated to it.
A cost driver that has a logical, cause-effect
relationship to the cost will be used as a
cost-allocation base
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Allocation of Service Department Costs
Learning Objective 2
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Service Department Example
5-year lease
Computer Department
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Service Department Example
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
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Service Department Example
The primary activity performed is computer
processing.
Resources consumed include 1. Processing time 2.
Operator time 3. Consulting time 4. Energy 5.
Materials 6. Building space
The budget formula for the forthcoming year is
100,000 monthly fixed cost plus 200 variable
cost per hour of computer time used.
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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.
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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
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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
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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 costs is that actual usage by user
departments does not affect the short-run
allocations to other user departments.
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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
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Direct and Step-Down Methods
Learning Objective 3
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.
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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
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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
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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
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Step-Down Method
Facilities management allocation
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
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Step-Down Method
Human resources allocation
240,000 420,000 660,000
To processing (16 80) 660,000 132,000
To assembly (64 80) 660,000 528,000
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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
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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
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Costs Not Related to Cost Drivers
Guidelines
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Traditional Approach
Learning Objective 4
1. Divide the costs in each producing departments.
2. Assign direct costs to the appropriate products
, services, or customers.
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Traditional Approach
3. Select one or more cost pools and related cost
drivers in each production department.
Indirect departmental costs
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Traditional Approach
4. Allocate costs
Costs
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Activity-Based Costing
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Activity-Based Costing
Step 3
Collect relevant data concerning costs and the
physical flow of the cost-driver units among
resources and activities.
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Allocation of Customer Costs
Learning Objective 5
Allocate costs associated with customer actions
to customers.
Customer profitability depends on more than gross
margin, it depends on the costs incurred to
fulfill customer orders and to provide other
customer services.
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Allocation of Customer Costs
Customer Type 1
Customer Type 2 High Cost to Serve
Low Cost to Serve

• Large order quantity
• Few order changes
• Little pre- and
• post-sales support
• Regular scheduling
• Standard delivery
• Few returns

• Small order quantity
• Many order changes
• Large amounts of pre-
• and post-sales support
• Expedited scheduling
• Special delivery requirements
• Frequent returns

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Allocation of Customer Costs
Customer Type 1
Customer Type 2 High Cost to Serve
Low Cost to Serve

• Buys a mix of products that
• have high gross margins
• Has a low cost-to-serve
• Has a high level of profitability

• Buys a mix of products that
• have lower gross margins
• Has a high cost-to-serve
• Has a low level of profitability

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Allocation of Customer Costs
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
• Small store
• Large store

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Allocation of Customer Costs
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.
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.
Costs
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Allocation of Customer Costs

• To determine customer profitability
• 1. Calculate the profit margin per case for each
  product
• Use the product mix ordered by each customer to
  calculate profitability

Small Stores Large Stores Cases Profit
Margin Total Cases Profit Margin
Total per case Profit Margin per case
Profit Margin Apparel 600 265.00
159,000 800 265.00
212,000 Sports Gear 200 315.00
63,000 800 315.00 252,000
222,000 464,000
Profit Margin Percentage 43.7 41.4
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Allocation of Costs-to-Serve
Might number of customer orders be a
more plausible cost-allocation 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 profitability.
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Allocation of Central Costs
Learning Objective 6
Many managers believe it is desirable to fully
allocate all costs to the revenue- producing
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.
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Allocation of Central Costs
Usage
Revenue
Total assets
Cost of goods sold
Total cost of each division
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Allocation of Joint Costs
Learning Objective 7
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 overhead costs that are incurred
before the split-off point.
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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.
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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.
Allocation Sales Value at
Liters Weighting of Joint Costs
Split-off Point X 1,000,000
(10/15)X100,000 66,667
90,000 Y 500,000 (5/15)X100,000
33,333 30,000
1,500,000 100,000 120,000

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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.
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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.
Relative Sales Value at
Allocation Spit-off Point
Weighting of Joint Costs X 90,000
(90/120)X100,000 75,000 Y
30,000 (30/120X100,000
25,000 120,000
100,000
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By-Product Costs
A by-product is not individually identifiable
until manufacturing reaches a split-off point.
They have relatively insignificant sales value.
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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