Cost Allocation: Theory

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Cost Allocation Theory
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• Accountancy 503
• Fall 2006
• Prof. Clifton Brown

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Cost allocation defined
Cost allocation is the assignment of
A cost or group of costs (cost pools)
To one or more cost objects.
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Cost object
Economic phenomena for which we desire
measurement in financial terms
To help management plan and control such
phenomena.
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Cost allocation objectives, I
Information for decision-making and control
Economic decisions such as determining the
profit-maximizing levels of output
Motivation for decentralized managers to make
decisions in the best interests of the
company-as-a-whole.
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Externalities
Costs or benefits imposed on others without their
participation in the decision making.
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Relations between AC and MC
MC
Total Cost
AC
Quantity of output
SlopeACgt SlopeMC
SlopeAClt SlopeMC
SlopeAC SlopeMC
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Relations between AC and MC
Why then, do firms generally charge units an
allocation of the fixed capacity cost of a common
service?
Particularly if there is a chance that ACgtMC?
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Cost allocation objectives, II
Cost reimbursement/sharing
Establish a surrogate market price when a
competitive market does not exist
Reimburse operating parties in a joint-venture
agreement.
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Cost allocation objectives, III
External reporting taxation
GAAP and IRS require use of absorption costing
when valuing (i.e., measuring) and reporting
manufactured inventories.
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Relationship of costs to cost objects
Costs can be
Directly related to the cost object (which are
traced)
Indirectly related (which are allocated).
Consider the wages and benefits paid to a
building maintenance worker in a manufacturing
plant. Why might the classification of these
costs be direct at some times and indirect at
other times?
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Cost allocation process
Identify cost object and reason for that objects
existence
Identify and accumulate (pool) the costs that
relate to the cost object
Identify an allocation base (or bases)
Allocate cost pool to outputs or activities of
cost object using allocation base(s).
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Allocation base criteria
.
Cause and effect relationship
Benefits received
Fairness or equity
Ability to bear
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Caribe Royale A
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Budgeted unit operating statement
Facilities management 16,913,068Security
2,500,000 Marketing
2,846,911 Administration
1,277,600
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Common costs Facilities management
Facilities management costs 16,913,068
Allocation basis
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Common costs Security
Security costs 2,500,000
Allocation basis
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Common costs Marketing
Marketing costs 2,846,911
Allocation basis
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Common costs Administration
Administration costs 1,277,600
Allocation basis
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Budgeted unit operating statement
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Cost allocation justification

• Common cost allocation vs. non-allocation?
• Given cost allocation, should hotel allocate them
  in a single lump sum or a variety of separate
  cost pools?
• Allocation method insulating vs.
  non-insulating?
• Extent of interdependence between the profit
  centers?

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Recommendations
Evaluation/Reward of Unit Managers

• Contribution margin of the unit
• Contribution margin of hotel overall
• Unit operating income (i.e., after common cost
  allocation)
• Non-financial factors (re balanced scorecard).

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Turn-in a case write-up
The following individuals should e-mail a
write-up of the Caribe Royale A case to the
instructor no later than 24-hours from now
Ates, NuriChen, JeffreyChoi, Hong JooHa,
Seung-HyupJinsirivanich, NapapornLaw, Pi-Cheng
Lee, Jun-heeLee, Szu-HsienMuttayasuwan,
PongsathornParli, BenjaminWei, BaisongZhang,
Yinan