Cost Allocation

1
Cost Allocation

• Chapter 14

2
Introduction

• Cost allocation is an inescapable problem
  in nearly every organization and in nearly every
  facet of accounting.
• This chapter emphasizes the allocation of costs
  to divisions, plants, departments, and contracts.
• This chapter also addresses the allocation
  of costs to products and customers.

3
Learning Objectives

• Outline four purposes for allocating costs to
  cost objects
• Guide cost-allocation decisions using appropriate
  criteria
• Discuss key decisions faced when collecting costs
  in indirect cost pools

4
Learning Objectives

• Differentiate the single-rate cost-allocation
  method from the dual-rate cost-allocation method
• Understand how the risks managers face are
  affected by the choice between budgeted versus
  actual cost-allocation rates
• Distinguish among direct, step-down, and
  reciprocal methods of allocating support
  department costs

5
Learning Objectives

• Make decisions that draw on the allocation of
  common costs using either the stand-alone or
  incremental methods
• Explain the importance of explicit agreement
  between parties when reimbursement is based on
  costs incurred

6
Learning Objective 1

• Outline four purposes for allocating costs to
• cost objects

7
Purposes of Cost Allocation

• Indirect costs are costs that are related to the
  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?

8
Purposes of Cost Allocation

• 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

9
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

10
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.

11
Justify Costs

• It is important to cost products at a fair
  price, especially in government defense
  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.

12
Reporting

• Inventory costs must be determined for financial
  reporting and for reporting to tax authorities.
• Under generally accepted accounting principles,
  inventoriable costs include manufacturing costs
  but exclude research and development,
  marketing, distribution, and customer service
  costs.

13
Cost Allocation

• The allocation of a particular cost need not
  satisfy all four purposes simultaneously.

N
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14
Learning Objective 2

• Guide cost-allocation decisions using appropriate
  criteria

15
Criteria 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 are likely
  to be the most credible to operating personnel.

16
Criteria to Guide
Cost-Allocation Decisions

• 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 program may be allocated on the basis
  of division revenues.

17
Criteria to Guide
Cost-Allocation Decisions

• 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.

18
Criteria to Guide
Cost-Allocation Decisions

• 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.

19
Role of Dominant Criteria

• The criterion 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.

20
Role of Dominant Criteria

• 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.
• Why are fairness and ability to bear less
  frequently used?

21
Role of Dominant Criteria

• 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-subsidization across users
  of resources in an organization.

22
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.

23
Learning Objective 3

• Discuss key decisions faced when collecting costs
  in indirect cost pools

24
Cost Allocation and Costing Systems

• Costs incurred in different parts of an
  organization can be assigned, and then
  reassigned, when costing products, services,
  customers, or contracts.
• Sandy Company manufactures clothes washers and
  dryers in two divisions
• Clothes Washer Division in Toledo (CWD)
• Clothes Dryer Division in Dayton (CDD)

25
Cost Allocation and Costing Systems

• Sandy Corporation collects costs at the following
  levels in its organization
• 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 Toledo
  Division and 2,000,000 in the Dayton Division.

26
Cost Allocation and Costing Systems

• 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.

27
Cost Allocation and Costing Systems

• Division costs
  
  Toledo Dayton
  Direct costs 2,200,000 4,000,000 Indirect
  costs 1,980,000 2,500,000
  Total 4,180,000 6,500,000

28
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.

29
Allocating Corporate Costs

• 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.

30
Allocating Corporate Costs

• 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.

31
Allocating Corporate Costs

• 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.

32
Allocating Corporate Costs

• 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

33
Allocating Corporate Costs

• Treasury costs 600,000
• Toledo Division
  600,000 (4,000,000 6,000,000)
  400,000
• Dayton Division
  600,000 (2,000,000 6,000,000)
  200,000

34
Allocating Corporate Costs

• Sandy Corporation analysis indicates that the
  demand for corporate human resource management
  costs for recruitment and training varies with
  direct labor costs.
• These costs are allocated to divisions on the
  basis of the total direct labor costs incurred
  in each division.

35
Allocating Corporate Costs

• Suppose direct labor costs in the Toledo Division
  are 1,200,000 and 1,800,000 in the
  Dayton Division.
• How does Sandy Corporation allocate its
  1,200,000 of human resources costs?

36
Allocating Corporate Costs

• Toledo Division
  1,200,000 (1,200,000 3,000,000)
  480,000
• Dayton Division
  1,200,000 (1,800,000 3,000,000)
  720,000
• Sandy Corporation does not allocate corporate
  administration costs to the divisions.

37
Allocating Corporate Costs

• 
  Toledo Dayton 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

38
Allocating Corporate Costs

• Corporate treasury and human resources costs
  are reallocated by the
  Toledo and Dayton Divisions
  to Assembly.
• Corporate human resource management
  costs are reallocated by
  the divisions to the
  Department of Human Resources.

39
Allocating Corporate Costs

• Division costs are reallocated to the departments
  within the division.
• The Toledo division of Sandy Corporation has
  two operating departments Assembly and
  Finishing, plus two support departments
  Maintenance and Human Resources.

40
Allocating Corporate Costs

• The Toledo 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.

41
Allocating Corporate Costs
Toledo Division
Assembly direct costs 1,300,000 Corporate
costs 400,000 Total costs 1,700,000
Finishing direct costs 900,000
42
Allocating Corporate Costs
Toledo Division
Human Resources direct costs 1,680,000 Corporate
costs 480,000 Total
costs 2,160,000
Maintenance direct costs 300,000
43
Allocating Corporate Costs
Assembly Department 1,700,000
Finishing Department 900,000
Toledo Division 5,060,000
Maintenance Department 300,000
Human Resources Department 2,160,000
44
Learning Objective 4

• Differentiate the single-rate cost-allocation
  method from the dual-rate cost-allocation method

45
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 behavior.

46
Single-Rate and Dual-Rate
Methods

• 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.

47
Learning Objective 5

• Understand how the risks managers face are
  affected by the choice between budgeted
  versus actual cost-allocation rates

48
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.

49
Budgeted versus Actual Rates

• 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 unfavorable cost variances.
• Why?

50
Budgeted versus Actual Rates

• because the user departments do not pay for any
  costs that exceed the budgeted rates

51
Budgeted versus Actual Rates

• 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.

52
Budgeted versus Actual Usage Allocation Bases

• 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.

53
Budgeted versus Actual Usage Allocation Bases

• Organizations 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.

54
Learning Objective 6

• Distinguish among direct, step-down, and
  reciprocal methods of allocating support
  department costs

55
Allocating Support Departments Costs

• Organizations 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 organization.

56
Allocating Support Departments Costs

• Three methods are widely used to allocate the
  costs of support departments to operating
  departments
• Direct allocation method
• Step-down method
• Reciprocal method

57
Allocating Support Departments Costs

• 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.

58
Allocating Support Departments Costs

• 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.

59
Allocating Support Departments Costs

• The following information pertains to the Toledo
  Division of Sandy Corporation
• Recall that the Toledo Division has two operating
  departments Assembly and Finishing, and two
  support departments Maintenance and
  Human Resources.

60
Allocating Support Departments Costs

• Total square feet 255,000
• Total number of employees 95
• Maintenance is allocated using square feet.
• Human Resources is allocated using number of
  employees.

61
Allocating Support Departments Costs

• Human
• Maintenance Resources
• Budgeted costs
• before allocations 300,000
  2,160,000
• Square feet 5,000
  30,000
• Number of employees 8
  15

62
Allocating Support Departments Costs

• Assembly
  Finishing
• Budgeted costs
• before allocations 1,700,000
  900,000
• Square feet 110,000
  110,000
• Number of employees 48
  24

63
Direct Method...

• allocates support department costs to operating
  departments only.
• The allocation ratio for allocating Maintenance
  to Assembly is 110,000/220,000 x 300,000
  150,000.
• The allocation ratio for allocating Maintenance
  to Finishing is 110,000/220,000 x 300,000
  150,000.

64
Direct Method

• 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.

65
Direct Method

• 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

66
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.

67
Step-Down Method

• 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.

68
Step-Down Method

• 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.

69
Step-Down Method

• 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

70
Step-Down Method

• 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.

71
Step-Down Method

• 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

72
Step-Down Method

• 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

73
Reciprocal

• M HR A
  F Maintenance - 12 44
  44 Human
  Resources
  10 - 60 30
• Maintenance cost 300,000 .10P
• Human Resource cost 2,160,000 .12M

74
Reciprocal

• Maintenance cost (M)
  300,000 .10(2,160,000 .12M)
• M 300,000 216,000 .012M
• .988M 516,000
• M 522,267

75
Reciprocal

• HR 2,160,000 .12(522,267)
• HR 2,160,000 62,672
• HR 2,222,672

76
Reciprocal

• 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

77
Overview of Methods

• Overhead rate for the Assembly Department is
  determined using direct labor cost as a
  denominator.
• Overhead rate for the Finishing Department is
  determined using machine hours as the denominator.

78
Comparison of Methods

• Assembly
  Finishing Direct labor cost 698,880 349
  ,440 Machine hours 24,000 23,500
• What are the various overhead rates using the
  three methods?

79
Overhead Rates Direct Method

• Assembly 3,290,000 698,880 direct labor
  costs 471 of direct labor costs
• Finishing 1,770,000 23,500 75.32 per
  machine hour

80
Overhead Rates Step-Down
Method

• Assembly 3,296,000 698,880 direct labor
  costs 472 of direct labor cost
• Finishing 1,764,000 23,500 75.06 per
  machine hour

81
Overhead Rates Reciprocal

• Assembly 3,263,400 698,880 direct labor
  costs 467 of direct labor cost
• Finishing 1,796,599 23,500 76.45 per
  machine hour

82
Comparison of Rates

• Assembly
  Finishing Direct method 471 75.32
  Step-down method 472 75.06 Reciprocal
  method 467 76.45

83
Learning Objective 7

• Make decisions that draw on the allocation of
  common costs using either the stand-alone or
  incremental methods

84
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 cost are
• Stand-alone cost allocation method
• Incremental cost allocation method

85
Allocating Common Costs

• 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 Tampa is planning to go to
  Chicago and meet with an international client.
• The round-trip Tampa/Chicago/Tampa airfare costs
  540.

86
Allocating Common Costs

• The consultant is also planning to attend a
  business meeting with a North Carolina client
  in Durham.
• The round-trip Tampa/Durham/Tampa airfare costs
  360.
• The consultant decides to combine the two trips
  into a Tampa/Durham/Chicago/Tampa itinerary that
  will cost 760.

87
Allocating Common Costs

• How much should the consultant charge to the
  North Carolina client?
• 360 (360 540) .40
• .40 760 304
• Therefore, the consultant should charge the
  international client 760 304 456.

88
Allocating Common Costs

• 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.

89
Allocating Common Costs

• 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.

90
Allocating Common Costs

• Assume that the business meeting in Chicago is
  viewed as the primary party.
• What would be the cost allocation?
• International client
  (primary) 540
  Durham client
  (incremental) 760 540 220

91
Learning Objective 8

• Explain the importance of explicit agreement
  between parties when reimbursement is based on
  costs incurred

92
Cost Allocation and Contracts

• Many commercial contracts include clauses that
  require the use of cost accounting information.
• Contract disputes arise with some regularity,
  often with respect to cost allocation.

93
Cost Allocation and Contracts

• Contract disputes over amounts to be paid often
  can be reduced by making the cost assignment
  rules as explicit as possible (and in
  writing).
• These rules should include details such as the
  allowable cost item, the acceptable
  cost-allocation bases and how differences between
  budgeted and actual costs are to be handled.

94
End of Chapter 14