Chapter Six:

Cost Allocation
6.1 Meaning of cost allocation and other related terms
Cost Allocation: the process of assigning or applying collected indirect costs to cost
objects using an allocation base is known as cost allocation. The following terms are to
be known and they have strong tie with the allocation of costs to products or services.
These are:
-Cost object
-Cost pool and
- Cost driver
Cost object: - is the destination of all assigned or allocated costs. For example, a cost
may be assigned to a particular product, service or department. For purposes of
product costing, cost allocation is the assignment of manufacturing overhead costs to
the product (cost object) during the accounting period.
Cost pool: is a collection of overhead costs related to a cost object (a product related
activity).
Cost driver: is an activity that causes the cost pool to increase in amount as the cost
driver increases in volume,
Cost allocation requires.
(a) the pooling of manufacturing overhead costs that are affected by a common
activity and
(b) the selection of a cost driver whose activity level causes a change in the cost
pool
6.2.Purposes of cost allocation
 To provide information for economic decisions:
For making economic decisions like add a new product to existing product, make or
buy a product, and pricing of a product true cost is required. The true cost can be
arrived only if the manufacturing overhead cost is properly and correctly assigned to a
product.
 To motivate managers and other employees:
To encourage the design of products that is simpler to manufacture or less costly to
service and to encourage sales representatives to increase high margin product or
services.

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  To justify cost or compute reimbursement:
To fix the fair price for a product especially government defense contracts, the true costs
are to be arrived. Besides, to get reimbursement for a consulting firm the correct and
true costs are to be arrived.
 To measure income and assets for reporting to external parties:
The true cost of product enables the management to report inventories correctly in
financial reporting to stockholders, bondholders etc. And also to cost inventories for
reporting to tax authorities.

Criteria to guide cost allocation decisions

While allocating cost to different units or products or some other cost objects, there
should be some criteria to be followed. Accordingly, there are certain commonly used
criteria as guide lines while allocating cost to units and/or products and services.
a. Cause and Effect: - The managers should identify the variable or variables that
cause resources to be consumed. Example, Managers may use hours of testing as
the variable when allocating the costs of quality testing area to products. Cost
allocation based on the cause and affect criterion are likely to be the most
credible to operating personnel.
b. Benefits Received: - The mangers should 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 receives. For example, corporate wide
advertising program that promotes the general image of the corporation rather
than any individual product. The costs of this program may be allocated on the
basis of division revenues. The higher the revenues, the higher the division’s
allocated cost of the advertising program. The rationale behind this allocation is
the belief that divisions with higher revenues apparently benefit from the
advertising more than divisions with lower revenues and therefore ought to be
allocated more of the advertising costs.
c. Fairness or Equity: This criterion is often cited in government contracts when
cost allocations are the basis for establishing a price satisfactory to the
government and its suppliers. Cost allocation here is viewed as a “reasonable” or
“fair” means of establishing a selling price in the minds of the contracting
parties.
d. 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. The presumption is
that the more profitable divisions have a greater ability to absorb corporate
headquarters’ costs.

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The cause and effect and the benefits received criteria is superior to the other criteria
when the purpose of cost allocation is economic decisions or motivation. The cause and
effect criterion is the primary one in activity based costing applications. Fairness and
ability to bear are less frequently used criteria than cause and effect and benefits
received.
Steps in manufacturing overhead allocation process
1. Planning step
2. Application step
3. Recording step and
4. Reconciling step
1. Planning step: In planning step, a predetermined overhead rate is calculated in
traditional settings and activity pool rate is calculated in activity based costing
settings. If a rate is calculated before an accounting period begins, managers can
better estimate the product costs by applying manufacturing overhead costs in the
same way to all units of production during the year. For example, using a single,
plant wide overhead rate requires the grouping of all estimated manufacturing
overhead costs into one cost pool with direct labor hours or machine hours as the
cost driver. No journal entry is required during this stage.
2. Application step: In the application step, the estimated manufacturing overhead
costs are assigned to the products costs as units are manufactured. The actual cost
driver level (for example, the actual number of direct labor hours used to complete
the product) is multiplied by the predetermined manufacturing overhead rate or
activity pool rate for that cost driver. The following entry is required in this step.
Work in process inventory debit
Manufacturing overhead Credit
Example, assume Afro company has incurred 78,000 birr direct labor cost for the month
of April and from past experience of the company, the manufacturing overhead cost
rate is 80% of direct labor costs. This implies the overhead costs applied are birr 62,400.
Thus, the journal entry to apply the manufacturing costs is:
Work in process inventory 62,400
Manufacturing overhead 62,400
3. Recording step: In the recording step, the actual manufacturing overhead costs
incurred during the accounting period are recorded. These costs will be part of the
actual product cost and include the costs of indirect materials, indirect labor,
depreciation, property taxes and other production cost. Journal entry:
Manufacturing overhead cost debit
Cash or A/p Credit

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Dear students, considering the example under the application step, the actual overhead
cost incurred by Afro company in the month of April indicates that birr 12,000 for
indirect materials purchased on account, indirect labor cost of birr 28,000 and other
manufacturing costs other than indirect materials and indirect labor are birr 28,000. The
journal entry to record the actually incurred overhead costs is:
Manufacturing overhead cost 68,000
Various accounts 68,000
(The various accounts stand for accounts payable, wages payable and other accounts
like depreciation costs, tax paid, etc)
4. Reconciliation step: The difference between the applied manufacturing overhead
costs and the actual overhead costs is calculated at the end of accounting period
under reconciliation step. If applied manufacturing overhead is more than the
actual manufacturing overhead it is known as over- applied overhead. On the
other hand, if applied overhead is less than the actual manufacturing overhead, it
is known as under-applied overhead. The following journal entry is to be made for
over or under applied manufacturing overhead. Dear student, attention here, both
adjustments are made to cost of goods sold if the difference between the applied
and actual manufacturing overhead costs is immaterial (i.e. less in amount)
(i) For over applied
Manufacturing overhead debit
Cost of goods sold credit
(ii) For under applied
Cost of goods sold debit
Manufacturing overhead cost credit.
However, if the over or under-applied overhead is material (i.e. more) the adjustments
are made not only to cost of goods sold but also to work in process inventory and
finished goods inventory since the materiality of the over applied or under applied has
a material effect on not only cost of goods sold but also on working in process and
finished goods. Example, refer the examples that we have made under the application
step and the recording step for the reconciliation purpose. Herein, the applied overhead
cost is birr 62,400 and the actual overhead cost incurred is birr 68,000, therefore, there is
under-application of overhead costs by birr 5,600 and assume the under-applied
overhead cost is immaterial (i.e., the amount is not significant). The journal entry to
record the under-applied overhead is:
Cost of goods sold 5,600
Manufacturing overhead cost 5,600

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However, if the under-applied overhead is material, the adjustment should be to cost of
goods sold, work in process and finished goods based on their ending balances.
Assume at the end of April, the Afro Company has birr 50,000 work in process, birr
30,000 finished goods reported in its balance sheet and birr 120,000 cost of goods sold
reported in its income statement. Accordingly, the under-applied is allocated to the
three accounts as follows:
50,000
Work in process = x 5,600 = 1,400
200,000
30,000
Finished Goods = x 5,600 = 840
200,000
120,000
Cost of goods sold = x 5,600 = 3,360
200,000
Cost of goods sold 3,360
Work in process 1,400
Finished goods 840
Manufacturing overhead cost 5,600
Allocation of costs from service departments to production departments
Most large organizations have both production departments and service departments.
Producing departments are directly responsible for creating the products or services
sold to customers. In a large public accounting firm, examples of producing
departments are auditing, tax, and management advisory services (computer systems
services). In a manufacturing setting such as Volkswagen (VW), producing departments
are those that work directly on the products being manufactured (e.g., assembly and
painting). Support departments provide essential services for producing departments.
These departments are indirectly connected with an organization’s services or products.
At VW, those departments might include engineering, maintenance, personnel, and
building and grounds.

Once the producing and support departments have been identified, the overhead costs
incurred by each department can be determined. Note that this involves tracing costs to
the departments, not allocating costs, because the costs are directly associated with the
individual department. Then, once the company has been departmentalized and all
overhead costs have been traced to the individual departments, support department
costs are assigned to producing departments, and overhead rates are developed to cost
products. Although support departments do not work directly on the products or
services that are sold, the costs of providing these support services are part of the total
product cost and must be assigned to the products. This assignment of costs consists of

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a two-stage allocation: (1) allocation of support department costs to producing
departments and (2) assignment of these allocated costs to individual products. The
second-stage of allocation is achieved through the use of departmental overhead rates,
is necessary because there are multiple products being worked on in each producing
department.
Therefore, producing department’s overhead consists of two parts: overhead directly
associated with a producing department and overhead allocated to the producing
department from the support departments. A support department cannot have an
overhead rate that assigns overhead costs to units produced, because it does not make a
salable product. That is, products do not pass through support departments. The nature
of support departments is to service producing departments, not the products that pass
through the producing departments.

Types of allocation base

In choosing a basis for allocating support department costs, every effort should be made
to identify appropriate causal factors (activity drivers). Causal factors are variables or
activities within a producing department that provoke the incurrence of support costs.
In effect, producing departments cause support activities; therefore, the costs of support
departments are also caused by the activities of the producing departments. Using
causal factors as allocation base results in more accurate costs of product. Furthermore,
if the causal factors are known, managers are more able to control the consumption of
services. While the use of a causal factor to allocate common cost is the best solution,
sometimes an easily measured causal factor cannot be found. In that case, the
accountant looks for a good proxy. For example, the common cost of plant depreciation
may be allocated to producing departments on the basis of square footage. Though
square footage does not cause depreciation, it can be argued that the number of square
feet a department occupies is a good proxy for the services provided to it by the factory
building.

Single-Rate Vs. Dual-Rate Methods

Frequently, the costs of a support department are allocated to another department
through the use of a charging rate:
 The single-rate allocation method pools all costs in one cost pool and allocates
theses costs to cost objects using the same rate per unit of the single allocation
base. There is no distinction between costs in a cost pool in terms of cost
behavior, such as fixed costs versus variable costs.

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  The dual-rate cost allocation method classifies costs in each cost pool into to sub
cost pools, a variable cost pool and a fixed cost pool. Each of these pools uses a
different cost allocation base.
Example: Sand Hill Co. has a Central Computer Department; the department has two
users, Microcomputer Division and Peripheral Equipment Division. The following data
apply to the coming budget year.
Fixed costs of operating the computer facility in the
6000-18000hr relevant range Br3, 000,000/year
Total capacity available 18,000hrs
Budgeted long-run usage
Microcomputer Division 8,000hrs
Peripheral Equipment Division 4,000hrs
Total 12,000hrs
Budgeted variable cost per hour $200/hour used
Assume during the year the Microcomputer uses 9,000 hrs and Peripheral Equipment uses
3,000 actual hours.
1. Single Rate Allocation Method
Total cost pool =3,000,000+200*12,000 5,400,000
Budgeted usage 12,000hrs

Budgeted totals rate per hour= 5,400,000 = Br.450/hr

12,000hrs
Allocation rate for Microcomputer Division Br. 450/hr
Allocation rate for Peripheral Division Br. 450/hr
Microcomputer=9000*450= Br. 4,050,000.
Peripheral Equipment= 3000*450= Br.1, 350,000.
2. Dual-rate Allocation Method
Allocation of Fixed Costs to:
Microcomputer Division = 8000/1200hrs * 3,000,000 = Br. 2,000,000/year.
Peripheral Equipment Division = 4000/12000hrs * 3,000,000 = Br. 1,000,000/year.
Allocation of variable costs to:
Microcomputer: 2,000,000 + (200*9000) = Br. 3,800,000.
Peripheral Equipment: 1,000,000 + (200*3000) = Br. 1,600,000.

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 I. Support Department’s cost allocation methods
Support Department creates a special cost allocation problem when they provide
reciprocal support to each other as well as support to operating departments. The
following are the methods that we use to allocate service department’s cost to
production departments and other service departments:
1. Direct Allocation Method
2. Step-Down Allocation Method
3. Reciprocal Allocation Method
Example: ABC Engineering has two Support Departments and Two operating
Departments. Costs are accumulated in each department for planning and control
purposes.
Support Departments Operating Departments
Plant Maintenance Machining
Information Systems Assembly
The two support departments provide reciprocal support to each other as well as to the
two operating departments. The costs incurred and services provided to operating and
other service departments are given as follow:
Support Departments Operating Departments
Plant Main Info. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Support work finished
By plant maintenance
Budgeted labor hrs- 1,600 2,400 4,000 8,000
Percentage - 20% 30% 50% 100%
By Infor. System.
Budgeted com. Hrs 200 - 1600 200 200
Percentage 10% - 80% 10% 100%
Required: Allocate costs using the three methods.

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1. Direct Allocation Method
This method is the most widely used method of allocating support department costs.
This method allocates each support department costs directly to the operating
departments with no intermediate allocation to other service departments. That is, no
consideration is given to service provided by one service department for another.
Graphically, this can be depicted as:
Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments

Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (600,000) 225,000 375,000
(2400/6400; 4000/6400)
Allocation by Inf. Syste. 0 (116,000) 103,111 12,889
(1600/1800; 200/1800)
Total Budgeted MOH of 0 $728,111 $578,889 $1,316,000
Operating department
Advantages of direct method
 Simplicity
 No need to predict the usage of support department service by other
support departments.
Disadvantage
 Failure to recognize reciprocal services provided among support
departments.
2. Step-Down Allocation Method (Sequential Allocation Method)
This method allows for the partial recognition of the service rendered by one support
department to other support departments. It requires the support departments to be
ranked (sequenced) in order that the step-down allocation is to proceed. Different
sequences will result in different allocation of support department costs to operating
departments. Popular step-down begins with the support department that renders the
highest percentage of its total services to other support departments and so on, ending

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with the support department that renders the lowest percentage of its total services to
other support departments. Graphically, this can be depicted as:

Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments

Plant Main. Infor.Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (600,000) 120,000 180,000 300,000
(1600/8000, 2400/8000, 4000/8000)
Allocation by Inf. Syste. 0 (236,000) 209,778 26,222
(1600/1800, 200/1800)
Total Budgeted MOH of 0 0 $789,778 $526,222 $1,316,000
Operating departments
Note: The step-down method does not recognize the total services that support
department provide to each other.
3. Reciprocal Allocation Method
Allocates cost by explicitly including the mutual services provided among all support
departments. Conceptually the direct method and the step-down allocation method are
less accurate than the reciprocal method when the support departments provide service
to another reciprocally. The reciprocal method enables us to incorporate
interdepartmental relationships fully. Implementing the reciprocal allocation method
requires three steps:
1. Express Support Department Costs and support department reciprocal
relationships in the form of Linear Equation.
Let PM be the completed reciprocated costs1 of Plant Maintenance and IS be the
complete reciprocated costs to Information Systems.

PM = $600,000 + 0.1 IS
IS = $116,000 + 0.2 PM
2. Solve the cost of linear equation to obtain the complete reciprocated costs
of each support departments.

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Complete reciprocated cost mean the support departments own cost plus any interdepartmental cost allocations.

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 PM = 600,000 + 0.1 (116,000 + 0.2PM)
PM = 600,000 + 11,600 + 0.02PM
0.98PM = 616,000
PM = $624,082
IS = 116,000 + 0.2(624,082)
IS = $ 240,816
3. Allocate the complete reciprocated costs of each department to all other
departments (both support department and operating departments).

Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments

Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (624,082) 124,816 187,225 312,041
(1600/8000, 2400/8000, 4000/8000)
Allocation by Inf. Syste. 24,082 (240,816) 192,652 24,082
(200/2000, 1600/2000, 200/2000)
Total Budgeted MOH of 0 0 $779,877 $536,123 $1,316,000
Operating departments
II. 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.
Consider Ayele, a senior student in Addis Ababa University who has been invited to an
interview with an employer in Mekele. The round trip Addis-Mekele airfare costs Br.
1200. A week prior to leaving, Ayele is also invited to an interview with an employer in
Dessie. The Addis-Dessiee round trip airfare costs Br. 800. Ayele decided to combine the
two recurring trips into an Addis-Dessie-Mekele trip that will cost $1,500 in airfare.
Thus, the Br. 1,500 is a common cost that benefits both prospective employers. Two
methods of allocating this common cost are:
1. Stand-Alone Cost-Allocation Method
This method uses information pertaining to each user of a cost object as a separate
entity to determine the cost-allocation weights. For the common cost $1,500,

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information about the separate (stand alone) round-trip airfares ($1200, and $800) is
used to determine the allocation weights.
Mekele employer: $1,200 * 1,500 = 0.60*1,500= $900
$1,200 + $ 800

Dessie employer: $800 * 1,500 = 0.4 * 1,500 = $600

$800 + $1,200
Advantage: Fairness occurs because each employer bears a proportionate share of total
costs in relation to their individual stand-alone costs.
2. Incremental Cost Allocation Method
This 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 user. The second ranked user is termed the incremental party and is allocated
with the additional cost that arises from there being two users instead of only the
primary user.
Assume in the example the Mekele fight is viewed as the primary party. Ayele’s
rational is that he had already committed to go to Mekele before accepting the
invitations to interview in Dessie. The cost allocation would be:

Party Cost Allocated Costs remaining to be

Allocated to other parties

Mekele (primary) $1,200 $300 ($1,500 - $1,200)

Dessie (incremental) 300 0
Had the Dessie employer been chosen as the primary party, the cost allocations would
have been Dessie $800 and Mekele $700(1500-800).
Under the incremental method, the primary party typically receives the highest
allocation of the common costs. Most users in common cost situations propose
themselves as the incremental party.

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Exercise 1:
Computer Horizon budgets the following amounts for it’s to central corporate support
departments (legal and personnel) in supporting each other and the two manufacturing
divisions- the Laptop Division (LTD) and the Work Station Division (WSD):
Budgeted Capacity
To be supplied by Legal Personnel LTD WSD Total
Legal (hours) - 250 1,500 750 2,500
Percentages - 10% 60% 30% 100%
Personnel (hours) 2,500 - 22,500 25,000 50,000
Percentages 5% - 45% 50% 100%

Details on actual usage are as follows:

Actual usage by
To be supplied by Legal Personnel LTD WSD Total
Legal (hours) - 400 400 1,200 2,000
Percentages - 20% 20% 60% 100%
Personnel (hours) 2,000 - 26,600 11,400 40,000
Percentages 5% - 66.5% 28.5% 100%

Total costs were:

Legal Personnel
Fixed $360,000 $475,000
Variable $200,000 $600,000
Fixed costs are allocated on the basis of budgeted capacity. Variable costs are allocated
on the basis of actual usage.

Required: What amount of support department costs for legal and personnel will be allocated
LTD and WSD using:
a. The Direct Method
b. The Step-Down Method (allocating the Legal Department First).
c. The Reciprocal Method
Exercise 2:
Phoenix consulting provides outsourcing services and advice to both government and
corporate clients. For costing purposes Phoenix classifies its departments into two
support departments (Administrative/Human Resources and Information Systems)

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and two operating departments (Government Consulting and Corporate Consulting).
For the first quarter of 2000, Phoenix incurs the following costs in its four departments:
Administrative/Human Resource (A/H) $600,000
Information Systems (IS) $2,400,000
Government Clients (GOVT) $8,756,000
Corporate Clients (CORP) $12,452,000

The actual level of support relations among the four departments for the first quarter of
2000 was:
Used by
Supplied by A/H IS GOVT CORP
A/HR - 25% 40% 35%
IS 10% - 30% 60%
The Administrative/Human Resources support percentages are based on headcount.
The Information Systems support percentages are based on actual computer times used.
Required:
Allocate the two support department’s costs to the two operating departments using the
following methods:
1. Direct Method
2. Step-down method (allocate A/H first)
3. Step-down method (allocate IS first)
4. Reciprocal Method.

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