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

Dinner bill
# of persons
Each family

Divide cost in pool by denominator volume to get allocation

rate

Cost Pool
Allocation basis
Cost objective

` 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

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.
b.
c.

d.

The allocation base used to allocate the costs

A grouping of individual costs whose total is allocated using
one allocation base
The product, service or department that is to receive the
allocation
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.
b.

c.
d.

Must be some characteristic that is common to all of the

cost objectives
Ideally should result in cost being allocated based on a
cause-and-effect relationship
Both a and b
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.
b.
c.
d.

Allocates service department costs to other service

departments
Allocates only direct costs
Allocates service department costs to production
departments only
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 = $45,000
Bathtubs: 1,000 x $30 = $30,000
Vanities : 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 departments
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.

Costs prior to allocation

Allocation of H.R.

D.P.

R.M.

Machining

Assembly

$ 80,000

$120,000

$40,000

--

--

($ 80,000)

16,000

8,000

$32,000

$24,000

(136,000)

10,348

44,348

81,304

(58,348)

29,174

29,174

$105,522

$134,478

Allocation of D.P.

Allocation of R.M.
0

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:
Machining:
Assembly:
Total:

7% 92%
30% 92%
55% 92%

= 7.61%
= 32.61%
= 59.78%
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. =
D.P. =
R.M. =

$ 91,057
$138,211
$ 58,781
H.R.

Costs prior to allocation

D.P.

$80,000

Allocation of H.R.

($91,057)

Allocation of D.P.

11,057

$120,000 $40,000

Machini Assembly
ng
--

--

18,211

9,106

$36,423

$ 27,317

(138,211)

9,675

41,463

76,016

(58,781)

29,390

29,390

$107,276

$132,723

Allocation of R.M.
$

R.M.

0 $

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.
2.
3.
4.
5.

Allocations of costs that are not controllable

Arbitrary allocations
Allocation of fixed costs that make the fixed costs
appear to be variable costs
Allocations of mfg. overhead to products using too few
overhead cost pools
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 managers 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.
b.
c.
d.

Fixed costs are said to be unitized

Fixed costs may appear to be variable to managers
receiving allocations
Decision making is greatly improved
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 nonreimbursable 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)

Sales
Variable cost
M/c hours
Price

Public
2,000,000
$5.00
60%
$8.00

Military
2,000,000
$4.000 per unit
40% of total
Cost plus 20%

Common fixed cost $8,000,000

Contract allows use of either M/c hours or no. of. Meals (Units)
Which is the preferred (profit maximizing) mechanism?

Ryan Supply Systems: Condensed Income Statements

Unit Data
(Public/Military)

Sales volume (in units)

Panel A: Using Units as the
Allocation Basis
Revenue
Variable costs
Allocated fixed costs
Gross Margin
Panel B: Using Machine Hours
as the Allocation Basis
Revenue
Variable costs
Allocated fixed costs
Gross Margin

Public

Military

2,000,000

2,000,000

Total

$8.00 / $7.20
$5.00 / $4.00
$2.00 / $2.00

$16,000,000
10,000,000
4,000,000
$2,000,000

$14,400,000 $30,400,000
8,000,000 18,000,000
4,000,000
8,000,000
$2,400,000 $4,400,000

$8.00 /$6.72
$5.00 /$4.00
60% / 40%

$16,000,000
10,000,000
4,800,000
$1,200,000

$13,440,000 $29,440,000
8,000,000 18,000,000
3,200,000
8,000,000
$2,240,000 $3,440,000

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

Discourage undesired behavior

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

in the short term

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