cost allocations
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cost allocationsTRANSCRIPT
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
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
Purposes of Cost Allocation
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
Purposes of Cost Allocation
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
Purposes of Cost Allocation
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
Direct Method – Mason Furniture
Allocate personnel cost of $200,000
Allocation base: number of employees
Assembly Dept: 60 employees
Finishing Dept: 40 employees
Calculate Allocation Rate:
$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
Direct Method – Mason Furniture
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
Calculate Allocation Rate:
$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.
The Step-Down Method
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:
The Step-Down Method
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
The Step-Down Method
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