Cost Allocations

COST ALLOCATIONS

What is Allocation?

To distribute a common cost or benefit among different items

Dinner bill among friends

Rent among roommates

Overhead costs among products

Salesperson salary among customers

Sales revenue among bundled products

Split `2000 among two families (2 and 3 people)

` 2000/5 = ` 400

` 400*2 = ` 800

` 400*3 = ` 1200

Purposes of Cost Allocation


Provide information for decision making

Allocated cost should measure the opportunity cost of using

a company resource

In practice, difficult to operationalize since cost may quickly

change

Provides a useful benchmark


Reduce frivolous use of common resources

Frivolous use may have hidden cost such as slower service

Allocation of centrally provided services provides incentive

for departments to reduce frivolous use of resource

Example: Support services like maintenance


Encourage evaluation of services

If costs are not allocated, there is no incentive to evaluate

the services and look for lower cost alternatives

With cost allocation, there is a strong incentive to critically

evaluate the efficiency and necessity of services


Provide “full cost” information

GAAP requires full costing for external reporting purposes

Full cost information is needed when the company has an

agreement whereby revenue received depends upon cost

incurred, i.e.“cost-plus” contracts

Process of Cost Allocation

Determine the cost objective

Form cost pools

Select an allocation base to relate cost pools to the cost objective

Example: Process of Cost Allocation Cost Pool

Allocation basis

Cost objective

Divide cost in pool by denominator volume to get allocation rate

` 2000 / 5 persons = ` 400 per person

Multiply rate by the number of driver units in cost objective to determine allocated cost

3 persons * ` 400/person = ` 1200

2 persons * ` 400/person = ` 800

Dinner bill

# of persons

Each family

Determine the Cost Objective

Determine the product, service, or department that

is to receive the allocation. Object of the allocation

is called the cost objective

Family is the cost objective

If computer costs are allocated to contracts, the

contracts are the cost objective

Cost Objectives

In the cost allocation process, the cost objective is the:

a. The allocation base used to allocate the costs

b. A grouping of individual costs whose total is allocated using one allocation base

c. The product, service or department that is to receive the allocation

d. None of the above

Answer: c

The product, service or department that is to receive the allocation

Form Cost Pools

A grouping of individual costs whose total is allocated

using one allocation base

Costs in the pool must be homogeneous (similar)

Cost pools can be organized along

-departmental lines, e.g. Maintenance, Personnel depts.

-major activities, e.g. equipment setups, inspections.

Select an Allocation Base

Select an allocation base that relates cost pool to the

cost objectives

-base must be some characteristic that is common to all of the

cost objectives

Mfg products - Machine hours, Direct Labor hours/cost

Divisions – Sales, Assets, Profits

-should be based on cause-and-effect relationship

Select an Allocation Base

Two production departments: Assembly and Finishing

- both receive allocations of indirect costs from the

maintenance department

- should labor hours or machine hours be used as the

allocation base?

In the cost allocation process, an allocation base:

a. Must be some characteristic that is common to all of the

cost objectives

b. Ideally should result in cost being allocated based on a

cause-and-effect relationship

c. Both a and b

d. None of the above

Answer: c Both a and b

Selecting an Allocation Base

Fixed Indirect Costs

If indirect costs are fixed, cause-and-effect

relationships are difficult to establish and other

approaches are used

Fixed Indirect Costs – Other Approaches

Relative benefits approach to allocation

- More costs allocated to those objectives that benefit most

from incurring the cost

Ability to bear costs

- More costs allocated to those that are more profitable

Equity approach to allocation

- Base results in allocations that are perceived to be fair or

equitable

Allocating Service Department Costs

Organizational units of manufacturing firms classified as

either:

- production departments, or

- service departments

Cost pools

- formed by service departments

- Allocated to production departments

Direct Method of Allocating Service

Department Costs

Service department costs allocated to production departments

but not to other service departments

Direct Method – Mason Furniture

Allocate janitorial cost of $100,000

Allocation base: square feet

Assembly Dept: 20,000 square feet

Finishing Dept: 30,000 square feet

Calculate Allocation Rate:

$100,000 / (20,000 + 30,000) = $2/sq ft

Allocation to Production Departments:

Assembly Dept.:20,000 sq ft x $2 = $40,000

Finishing Dept.: 30,000 sq ft x $2 = $60,000


Allocate personnel cost of $200,000

Allocation base: number of employees

Assembly Dept: 60 employees

Finishing Dept: 40 employees


$200,000 / (60 + 40) = $2,000/employee

Allocation to Production Departments

Assembly Dept: 60 x $2,000 = $120,000

Finishing Dept: 40 x $2,000 = $80,000

The direct method of allocating costs:

a. Allocates service department costs to other service departments

b. Allocates only direct costs

c. Allocates service department costs to production departments only

d. Both b and c

Answer: c

Allocates service department costs to production departments only


Three production departments:- Showers

- Bathtubs

-Vanities

Two service departments:- Mailroom

- Janitorial

Suggest allocation base for mailroom costs:

Number of employees, labor hours, or labor cost

Three production departments:- Showers

- Bathtubs

-Vanities

Two service departments:- Mailroom

- Janitorial

Suggest allocation base for janitorial costs:

Square footage, number of work stations

Three production departments:

- Showers: 80 employees

- Bathtubs: 40 employees

-Vanities: 30 employees

Allocate mailroom costs of $600,000 based on employees


$600,000 / (80+40+30) = $4,000/employee

Allocation to Production Departments:

Showers: 80 x $4,000 = $320,000

Bathtubs: 40 x $4,000 = $160,000

Vanities: 30 x $4,000 = $120,000

Three production departments:- Showers: 1,500 sq ft- Bathtubs: 1,000 sq ft-Vanities: 500 sq ft

Allocate janitorial costs of $90,000 based on sq ft

Calculate Allocation Rate:$90,000 / (1,500+1,000+500) = $30 per sq ft

Allocate to production departments:Showers : 1,500 x $30 = $45,000Bathtubs: 1,000 x $30 = $30,000Vanities : 500 x $30 = $15,000

The Step-Down Method

The step-down method is also called the sequential method.

This method allocates the costs of some service departments

to other service departments, but once a service department’s

costs have been allocated, no subsequent costs are allocated

back to it.

The choice of which department to start with is important

The most defensible sequence is to start with the service

department that provides the highest percentage of its total

services to other service departments, or the service

department that provides services to the most number of

service departments, or the service department with the

highest costs, or some similar criterion.


Example: Human Resources (H.R.), Data Processing

(D.P.), and Risk Management (R.M.) provide services to

the Machining and Assembly production departments, and

in some cases, the service departments also provide

services to each other:


Total Cost Service

Dept

% of services provided by the service department listed at

left to:

H.R. D.P. R.M. Machining Assembly

$ 80,000 H.R. -- 20% 10% 40% 30%

120,000 D.P. 8% -- 7% 30% 55%

40,000 R.M. -- -- -- 50% 50%

$240,000


H.R. D.P. R.M. Machining Assembly

Costs prior to allocation $ 80,000 $120,000 $40,000 -- --

Allocation of H.R. ($ 80,000) 16,000 8,000 $32,000 $24,000

Allocation of D.P. (136,000) 10,348 44,348 81,304

Allocation of R.M. (58,348) 29,174 29,174

0 0 0 $105,522 $134,478

After the first service department has been allocated, in

order to derive the percentages to apply to the

production departments and any remaining service

departments, it is necessary to “normalize” these

percentages so that they sum to 100%.

Risk Management: 7% ÷ 92% = 7.61%Machining: 30% ÷ 92% = 32.61%Assembly: 55% ÷ 92% = 59.78%

Total: 100.00%

The Reciprocal Method

The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations.

Using the data from the step-down method example, the simultaneous equations are:

H.R. = $ 80,000 + (0.08 x D.P.)

D.P. = $120,000 + (0.20 x H.R.)

R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.)

The Reciprocal Method

H.R. = $ 91,057D.P. = $138,211R.M. = $ 58,781

H.R. D.P. R.M. Machini

ng

Assembly

Costs prior to allocation $80,000 $120,000 $40,000 -- --

Allocation of H.R. ($91,057) 18,211 9,106 $36,423 $ 27,317

Allocation of D.P. 11,057 (138,211) 9,675 41,463 76,016

Allocation of R.M. (58,781) 29,390 29,390

$ 0 $ 0 $ 0 $107,276 $132,723

Allocating Budgeted and Actual Service

Department Costs

Management should allocate based on budgeted costs

rather than actual costs

Allocation of actual amounts allows service

department to pass on cost of inefficiencies and

waste to production departments

Problems with Cost Allocation

Potential problems brought about by:

1. Allocations of costs that are not controllable

2. Arbitrary allocations

3. Allocation of fixed costs that make the fixed costs

appear to be variable costs

4. Allocations of mfg. overhead to products using too few

overhead cost pools

5. Use of only volume related allocation bases

Responsibility Accounting and

Controllable Costs

Responsibility accounting

Identifies those responsible for generating revenue and

controlling costs

Some cost allocations are not consistent with

responsibility accounting

- Controllable costs are those under the manager’s control

- Some argue that managers should only be allocated

controllable costs

Arbitrary Allocations

Cost allocations are inherently arbitrary

Typically there are numerous allocation bases that are

equally justifiable

- Managers support the allocation which makes them

look best

- Managers reject allocations which cast an unfavorable

light on their performance

Unitized Fixed Costs and Lump Sum

Allocations

Unitized fixed costs

- Fixed costs are stated on a per unit basis and allocated as a

variable cost

- Perception of costs as variable could alter decision making

Lump-sum allocations

- Allocate predetermined amount of fixed costs that is not

affected by level of activity

- Allocation must appear to be fixed to managers of

departments receiving charge

When fixed costs are stated on a per unit basis:

a. Fixed costs are said to be “unitized”

b. Fixed costs may appear to be variable to managers

receiving allocations

c. Decision making is greatly improved

d. Both a and b

Answer: d

Both a and b

Too Few Cost Pools

Although simple, may lead to distortion of cost

allocation, i.e. some products will be overcosted or

undercosted

Product costs will be more accurate when more

overhead cost pools are used

Must analyze cost-benefit relationship of more cost

pools

Problem of Using Measures of Production

Volume to Allocate Overhead

Typical allocation bases include direct labor hours and

machine hours

Assumes all overhead costs are proportional to

production volume

When OH costs not proportional to production

volume:

- High-volume products are overcosted

- Low-volume products are undercosted

Using Only Volume-Related Allocation

Bases

Some firms allocate manufacturing overhead based on

volume, e.g. direct labor or machine hours

Not all overhead costs vary with volume

Activity-based costing (ABC) solves this problem

ALLOCATIONS:

INCENTIVE EFFECTS

Reimbursements

Costs common among reimbursable and non-reimbursable reasons

Defense contracting

Hospital settings

Negotiate rates with insurance companies

Choice of basis will affect amount reimbursed

Incentives to be strategic!

Example

Ryan Supply Systems (Ready to eat meals)

Contract allows use of either M/c hours or no. of. Meals (Units)

Which is the preferred (profit maximizing) mechanism?

Public Military

Sales 2,000,000 2,000,000

Variable cost $5.00 $4.000 per unit

M/c hours 60% 40% of total

Price $8.00 Cost plus 20%

Common fixed cost $8,000,000

Unit Data

(Public/Military)

Sales volume (in units) 2,000,000 2,000,000 Panel A: Using Units as the

Allocation Basis

Revenue $8.00 / $7.20 $16,000,000 $14,400,000 $30,400,000

Variable costs $5.00 / $4.00 10,000,000 8,000,000 18,000,000

Allocated fixed costs $2.00 / $2.00 4,000,000 4,000,000 8,000,000

Gross Margin $2,000,000 $2,400,000 $4,400,000

Panel B: Using Machine Hours

as the Allocation Basis

Revenue $8.00 /$6.72 $16,000,000 $13,440,000 $29,440,000

Variable costs $5.00 /$4.00 10,000,000 8,000,000 18,000,000

Allocated fixed costs 60% / 40% 4,800,000 3,200,000 8,000,000

Gross Margin $1,200,000 $2,240,000 $3,440,000

Ryan Supply Systems: Condensed Income StatementsPublic Military Total

Government agencies understand firms’ incentives to engage in this cost shifting behavior.

Government contract generally specify the method of allocation and conduct audit to

ensure the compliance.

Behavior Modification

Allocations modify behavior

Can induce desired actions

Make undesired actions costly

Allocation is like a “tax”

Increases the cost of the driver unit

Example: Computer support

If “price” increases, demand decreases

Allocate on labor hours / labor cost

Reduce demand for labor

Allocate based on materials cost

Incentives to in-source

Allocations are a “Tax”

Strategic Allocations

By choosing pools and drivers strategically, we can

use allocations to increase the amount cost allocated

to some products

Of course, costs for other products will decrease

Such allocations might be useful if one set of items

has cost based pricing or reimbursements

Example: Defense contracting

Allocations and Behavior

We can use this property to

Sensitize users to the long-term cost of a resource

Cost of support departments such as IT are allocated even if “fixed”

in the short term

Discourage undesired behavior

Use some measure correlated with use as the basis

Use will go down as the “price” for the measure has increased

Encourage desired behavior

Suppose we want to tradeoff labor for materials cost

Using labor as an allocation basis provides the incentives to

employees

Documents

Cost Allocations