Chapter 4

Cost Allocation

Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A
cost object is any activity or item for which you want to separately measure costs. Cost
allocation is used for financial reporting purposes, to spread costs among departments or
inventory items. Cost allocation is also used in the calculation of profitability at the department
or subsidiary level, which in turn may be used as the basis for bonuses or the funding of
additional activities. Cost allocations can also be used in the derivation of transfer prices between
subsidiaries.

4.1. Types of Overheads cost

There are three main types of overhead that businesses incur. The overhead expenses vary
depending on the nature of the business and the industry it operates in.

1. Fixed overhead costs

Fixed overheads are costs that remain constant every month and do not change with changes in
business activity levels. Examples of fixed overheads include salaries, rent, property taxes,
depreciation of assets, and government licenses.

2. Variable Overhead Costs

Variable overheads are expenses that vary with business activity levels, and they can
increase or decrease with different levels of business activity. During high levels of
business activity, the expenses will increase, but with reduced business activities, the
overheads will substantially decline or even be eliminated.

3. Semi-variable overhead costs.

Semi-variable overheads possess some of the characteristics of both fixed and variable
costs. A business may incur such costs at any time, even though the exact cost will
fluctuate depending on the business activity level. A semi-variable overhead may come
with a base rate that the company must pay at any activity level, plus a variable cost that
is determined by the level of usage.

4.1.1 Overhead Cost in general

Overhead Cost refers to the cost of indirect material, indirect labor, and other operating
expenses, which are associated with the typical day-to-day running of the business but cannot be
conveniently charged directly to any specific product or service, or cost center. They are Indirect
and need to be shared among the cost units as precisely as possible. In other words, it is the cost
incurred on labor, material, or services that cannot be economically identified with a specific
saleable cost of goods or services per unit of the business.

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4.1.2. Indirect overhead cost is any cost not directly identified with a single, final cost
objective, but identified with two or more final cost objectives or an intermediate cost objective.
It is not subject to treatment as a direct cost. After direct costs have been determined and charged
directly to the contract or other work, indirect costs are those remaining to be allocated to the
several cost objectives. An indirect cost shall not be allocated to a final cost objective if other
costs incurred for the same purpose in like circumstances have been included as a direct cost of
that or any other final cost objective.

4.1.3. Direct overhead cost

Is totally traceable to the production of a specific item, such as a product or service. For example,
the cost of the materials used to create a product is a direct cost. There are very few direct costs.
The cost of any consumable supplies directly used to manufacture a product can be considered a
direct cost. However, production labor is frequently not a direct cost, because employees usually
are not sent home if there is one less incremental item being produced; instead, they are paid for
the duration of their work shifts, irrespective of the volume of production.

Examples of Direct Costs

The preceding discussion should clarify that the typical business has very few direct costs. The
most common ones are direct materials, freight in and freight out, commissions, and consumable
supplies.

Direct materials
Are those materials and supplies that are consumed during the manufacture of a product, and
which are directly identified with that product. Items designated as direct materials are usually
listed in the bill of materials file for a product. The bill of materials itemizes the unit quantities
and standard costs of all materials used in a product, and may also include an overhead
allocation.
Freight in
Freight in is the transportation cost associated with the delivery of goods from a supplier to the
receiving entity. For accounting purposes, the recipient adds this cost to the cost of the received
goods.
Freight out
Freight out is the transportation cost associated with the delivery of goods from a supplier to its
customers. This cost should be charged to expense as incurred and recorded within the cost of
goods sold classification on the income statement. Freight out is not an operating expense, since
the supplier only incurs this cost when it sells goods to a customer.

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Commission
A commission is a fee paid to a salesperson in exchange for services in facilitating or completing
a sale transaction. The commission may be structured as a flat fee, or as a percentage of the
revenue, gross margin, or profit generated by the sale.
4.1.4. Traceable cost
A traceable cost is a cost for which there is a direct, cause-and-effect relationship with a process,
product, customer, geographical area, or other cost object. If the cost object goes away, then the
traceable cost associated with it should also disappear. A traceable cost is important, because it is
an expense that you can reliably assign to a cost object when constructing an income statement
showing the financial results of that cost object. It is also useful to understand when cutting back
on expenses, so that you can focus on eliminating certain cost objects, for which the related
expenses will also be eliminated. Thus, a traceable cost is an expense management tool.
Examples of traceable costs are:

Traceable Cost Cost Object

Advertising Product, Product Line, or Company
Liability Insurance Company or Subsidiary
Marketing Manager Product Line
Rent Product Line
Warehouse Costs Geographical Area
A traceable cost may only be associated with an intermediate level of cost object, and not drill
down all the way to the most detailed level. For example, a company may incur the cost of
building insurance for its production facility. This cost is only traceable to the building, in that
the cost would disappear if the building were to be sold. The cost cannot be traced to the cost
objects within the building, such as a production line, since the line could be shuttered but the
insurance expense would still be incurred as long as the building was owned by the company.
4.1.5. Allocated costs
Are those costs which have been specifically identified and allocated to a particular cost center
or project. They may be direct costs, such as labor or materials, or indirect costs, such as
overheads. Allocated costs may be fixed or variable, depending on the nature of the cost. They
are used to track and monitor the performance of a particular cost center or project.

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4.2. How to create cost pools

To create cost pools for your costing strategy, you will first need to find out how much overhead
the business had during the time frame you are measuring.

Then, you will identify the activities that were associated with the amount of overhead, and
group them into cost pools. These cost pools will identify how the money was spent. You will
identify the cost pools (activities) and how you will measure them.

For instance, one cost pool could be order processing which is measured by the number of orders
during the time period. Another could be manufacturing which is measured by the number of
units produced.

Cost pools in activity-based costing

Cost pools are used in the activity based costing method to allocate costs.

Once you have determined your cost pools and how they are measured, you allocate the
overhead to the cost pools. You do this by interviewing employees about how much time is spent
on each activity and estimate the amount of overhead that cost pool used.

Once you allocate the amount of overhead used for each cost pool, you can calculate the ‘activity
rate’, which is calculated by dividing the cost associated with the cost pool by the measurement.

4.2.1 Cost center

A cost center is a business unit that is only responsible for the costs that it incurs. The costs incurred by a
cost center may be aggregated into a cost pool and allocated to other business units, if the cost center
performs services for the other business units. A cost center can be defined at a smaller level than a
department. It could involve a particular job position, machine, or assembly line. However, this more
detailed view of cost centers requires more detailed information tracking, and so is not commonly used.
4.2.2. Cost pool
A cost pool is a grouping of individual costs, typically by department or service center. Cost pools are
commonly used for the allocation of factory overhead to units of production, as required by several
accounting frameworks. They are also used in activity-based costing to allocate costs to activities. A
business that wants to allocate costs at a highly-refined level may choose to do so using a number of cost
pools.

4.2.3 Purpose of a Cost Center

The main function of a cost center is to track expenses. A cost center manager is only responsible for
keeping costs in line with the budget and does not bear any responsibility regarding revenue or
investment decisions. Cost centers provide metrics more relevant to internal reporting. Internal
management utilizes cost center data to improve operational efficiency and maximize profit.

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4.2.5. Operational Cost Center

Operational cost centers group people, equipment, and activities that engage in a singular commonly-
themed activity. Most often, operational cost centers may be seen as common company departments that
group employees based on their function within the company.

4.4. Support Department cost allocation methods

In the preceding discussions allocation of a single service department was illustrated. In many cases,
however, multiple service departments exist. Under such circumstances allocation of support department
costs are made using one of three methods: direct method, sequential (step) method or reciprocal method.
Usually service departments provide service not only to producing departments but also to other support
departments. For instance maintenance department (support department) provides maintenance service
to producing and support departments such as purchasing. All the three methods allocate service
department costs to producing departments but they differ on whether they recognize the service one
support department gets from other support departments and whether the method recognizes the
interaction between the departments fully or partially.
The three methods are described as follows.

1. Direct method
The direct method allocates service department costs only to producing departments. It is the simplest
and most straightforward way to allocate support department costs. However no support department cost
is allocated to other support departments. That is it doesn’t recognize the interaction among support
departments.
2. Step down method
The step-down method—also called the sequential allocation method—allocates support-
department costs to other support departments and operating departments in a sequential
manner that partially recognizes the mutual services provided among support departments. This method
requires managers to rank (sequence) the support departments in the
order that the step-down allocation is to proceed.
3. Reciprocal method
The reciprocal method recognizes all interactions of support departments. Under the reciprocal method,
the usage of one support department by another is used to determine the total cost of each support
department, where the total cost reflects interactions among the support departments. Thus, the new total
of support department costs is allocated to the producing departments. This method fully accounts for
support department interaction.

Example: Malor Company has two support departments, Power and Maintenance, and two producing
departments, Grinding and Assembly. The allocation bases of Power department costs and Maintenance
department costs are number of employees and maintenance hours respectively. The budgeted direct
costs and budgeted activity levels are given below. For producing departments, direct costs refer only to
overhead costs that are directly traceable to the department. For simplicity a single charging rate is used.

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 Support departments Producing departments
Particulars Power Maintenance Grinding Assembly
Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Activity levels – Kilowatt-hours - 200,000 600,000 200,000
Maintenance hours 1,000 - 4,500 4,5000

Direct Method
Support departments Producing departments
Particulars Power Maintenance Grinding Assembly
Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Power department cost allocation in
Kilowatt-hours basis
(600,000/800,000) (200,000/800,000)
Weights: (0.75 : 0.25)
Power department costs allocated (250,000) 187,500 62,500

Maintenance department cost allocation in

maintenance hours basis
(4,500/9,000)(4,500/9,000)
Weights: (0.5:0.5)
Maintenance department cost allocated (160,000) 80,000 80,000
0 0 367,500 202,500
Even if power department and maintenance department provide service to producing departments and to
each other as well, their costs are allocated only to the producing departments (Grinding & assembly).

Sequential method
Support departments Producing departments
Particulars Power Maintenanc Grinding Assembly
e
Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Power department cost allocation in
Kilowatt-hours basis
(200,000/1,000,000)(600,000/1,000,000)
(200,000/1,000,000)
Weights: (0.2: 0.6 : 0.2)
Power department costs allocated (250,000) 50,000 150,000 50,000

Maintenance department cost allocation in

maintenance hours basis
(4,500/9,000)(4,500/9,000)
Weights: (0.5:0.5)
Maintenance department cost allocated (210,000) 105,000 105,000
Total costs 0 0 355,000 215,000

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The fact that power department serves all the other three departments is recognized by the sequential
method because power department costs are allocated to all of the three departments. Nevertheless
power department doesn’t share maintenance department costs, i.e. this method failed to account for the
service power department gets from maintenance department. Hence the interaction between power and
maintenance departments is recognized partially.
Reciprocal Method
Let P be the total costs of power department (the costs incurred in power department plus cost of
maintenance department allocated to power department) and Let M be the total costs of maintenance
department (the costs incurred in maintenance department plus cost of power department allocated to
maintenance department).

Support departments Producing

Particulars departments Total
Power Maintenance Grinding Assembly
Kilowatt-hours - 200,000 600,000 200,000 1,000,000
Weights 0.2 0.6 0.2 1.00
Maintenance hours 1,000 - 4,500 4,500 10.000
Weights 0.1 0.45 0.45 1.00

Support departments Producing departments

Particulars Power Maintenance Grinding Assembly
Direct costs Br.250,000 Br. 160,000 Br. 100,000 Br. 60,000
Power department cost allocation in Kilowatt-
hours basis
(200,000/1,000,000)(600,000/1,000,000)
(200,000/1,000,000)
Weights: (0.2: 0.6 : 0.2)
Power department costs allocated (271,429) 54,286 162,857 54,286

Maintenance department cost allocation in

maintenance hours basis
(1,000/10,000)(4,500/10,000)(4,500/10,000)
Weights: (0.1: 0.45:0.45)
Maintenance department cost allocated 21,429 (214,286) 96,429 96,429
Total costs 0 0 359,286 210,714

 The reciprocal method fully recognizes the services support departments provide to each other. But
as the number of support departments increases the computations will become more complex.
 It is important to keep a cost-benefit perspective in choosing an allocation method. We must weigh
the advantages of better allocation against the increased cost using a more theoretically preferred
method.
 For example the reciprocal method may be superior to the other methods. But the increased cost
resulting from using it may outweigh the additional benefit it produces.

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Departmental Overhead rates and Product Costing
 When the costs of goods and services produced in producing departments are determined, direct costs
are traced to the products and overhead costs are allocated using overhead rtes.
 A single overhead rate may be used for all the producing departments or separate rates may be
developed for each of them.
 The overhead rate is computed by adding the allocated service cots to the overhead costs that are
directly traceable to the producing department and dividing this total by the overhead allocation base
selected for the department.
Example: Assume that Malor Company uses the sequential method of service department costs
allocation. Therefore total budgeted overhead costs of Grinding and Assembly departments are Br.
355,000 and Br 215,000 respectively. The allocation bases and expected levels of the allocation bases are
given below.
Grinding department Assembly department
Overhead allocation bases machine hours direct labour hours
Budgeted machine hours 71,000 --
Budgeted direct labour hours -- 107,500
Data pertaining to one unit of a product follow.
Grinding department Assembly department
Direct materials costs Br.7 Br.8
Direct labour costs 2 4
Machine hours 2 -
Direct labour hours - 1

Compute the unit cost

Grinding department Assembly department

Overhead rate = Br. 355,000 Br. 215,000

71,000 M/H 107,500 DLH

Br.5 per MH Br. 2 per DLH

Direct material costs (7 + 8) 15
Direct labour cost (2 + 4) 6
Overhead costs
Grinding (2 machine hour x Br. 5) 10
Assembly (1 direct labour hour x Br. 2) 2 12
Unit cost
33

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4.5. Joint and by – products
4.5.1. The Joint Process & its Outputs
 Joint products are typically produced in companies using mass production processes and, thus, a
process costing accounting method. For simplicity, chapter 4 and 5 on process costing included
examples of only single-product processes.
 Joint costs – are the costs of a production process up to the point of separation that yields multiple
products simultaneously. These costs include DMs, DL, and FOH and disposal of waste. These are
costs not specifically identifiable with any of the products being simultaneously produced.
 The split-off point – is the juncture (point) in a joint production process at which two or more
products become separately identifiable. A joint process may have one or more split-off point,
depending on the number and types of output produced.
 Separable cost – are all costs – manufacturing, marketing, distribution, and so on incurred beyond
the split-off point that are identifiable with individual products.
Joint costs
Joint process Cream Further processing Butter cream
Raw Milk
Split-off point L. Skim Further Processing Condensed milk

Separable costs
 At or beyond the split-off point, decisions relating to sale or further processing of each
identifiable product can be made independently of decisions about the other products.(this
special decision will be discussed in the management accounting course)
 The outputs of a joint production process can be classified into two general categories: outputs
with a positive sales value and outputs with a zero sales value.
 Product – describes any output that has a positive sales value (or an output that enables an
organization to avoid incurring costs). The sales value can be high or low.
 Main products – the product with the highest sales value relative to other products beyond split-off
point.
 Joint products - two or more products with a relative high sales value that are not identifiable as
individual products until the split-off point. These products are also called primary products, main
products, or co-products. Main product /Joint products are the primary reason management
undertakes the production process yielding them.

Characteristics of joint product

Dear student, from our above discussions we can summarize the following characteristics.
 Joint products are produced from the same raw material
 They are produced simultaneously a common process
 They are comparatively of equal importance
 They may require further processing after their point of separation
 By-product and Scrap - both are incidental outputs of a joint process identified at split-off point.
Both are saleable, but have low sales value that would not be sufficient for management to justify
undertaking the joint process. By-products are viewed as having a higher sales value than scrap.

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 Waste – refers to outputs of the joint production process with zero sales value. Any cost of
disposing waste materials (e.g. cost of handling non-saleable toxic substances) should be added to the
joint production costs that are allocated to joint products or main products.
 Note that the basis of the classification is selling price. Thus the classification of a product as
main, joint, by-product may change over time and may vary from one company to the other.
 In accounting for joint products, the basic question is how much of the production cost incurred
before separation (joint costs) should be allocated to each product.
Approaches to Allocating Joint Costs
Two approaches are used to allocate joint costs.
 Approach 1.Allocate joint costs using market-based data such as revenues.
1. Sales value at split off method
2. Net realizable value (NRV) method
3. Constant gross-margin percentage NRV method
 Approach 2.Allocate joint costs using physical measures, such as the weight, quantity (physical
units), or volume of the joint products.
In preceding chapters, we used the cause-and-effect and benefits-received criteria for guiding cost-
allocation decisions. Joint costs do not have a cause-and-effect relationship with individual products
because the production process simultaneously yields multiple products. Using the benefits-received
criterion leads to a preference for methods under approach 1 because revenues are, in general, a better
indicator of benefits received than physical measures.
4.5.2. Accounting for Byproducts
Joint production processes can yield not only joint products and main products but also byproducts.
Although their total sales values are relatively low, the byproducts in a joint production process can affect
the allocation of joint costs. Moreover, byproducts can be quite profitable for a firm. Wendy’s, the fast-
food chain, uses surplus hamburger patties in its “rich and meaty” chili and, because it cooks meat
specifically for the chili only 10% of the time, makes great margins even at a price of $0.99 for an eight-
ounce serving of chili.
4.6. Common costs Allocation
We next consider two methods used to allocate common costs. A common cost is a cost of operating a
facility, operation, activity or other cost object that is shared by two or more users. Consider Paul O’Shea,
a third-year undergraduate student in Galway who has been invited to an interview with an employer in
Moscow. The round-trip Galway–Moscow airfare costs €1200. A week prior to leaving, O’Shea is also
invited to an interview with an employer in Prague. The round-trip Galway–Prague airfare costs €800.
O’Shea decides to combine the two recruiting steps into a Galway–Moscow–Prague trip that will cost
€1500 in airfare. The €1500 is a common cost that benefits both employers. Two methods for allocating
this common cost between the two potential employers are now discussed: the stand-alone method and
the incremental method.
A. Stand-alone cost-allocation method
The stand-alone cost-allocation method uses information pertaining to each cost object as a separate
operating entity to determine the cost-allocation weights. For the airfare common cost of €1500,
information about the separate (stand-alone) return airfares (€1200 and €800) is used to determine the
allocation weights:
Moscow employer: €1200 × €1500 = 0.60 × €1500 = €900
€1200 + €800
Prague employer: €800 × €1500 = 0.40 × €1500 = €600
€800 + €1200

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Advocates of this method often emphasis an equity or fairness rationale. That is, fairness occurs because
each employer bears a proportionate share of total costs in relation to their individual stand-alone costs.
B. Incremental cost-allocation method
The incremental cost-allocation method ranks the individual cost objects and then uses this ranking to
allocate costs among those cost objects. The first-ranked cost object is termed the primary party and is
allocated costs up to its cost as a stand-alone entity. The second-ranked cost object is termed the
incremental party and is allocated the additional cost that arises from there being two users instead of
only the primary user. If there are more than two parties, the non-primary parties will need to be ranked.
Consider Paul O’Shea and his €1500 airfare cost. Assume that the Moscow employer is viewed as the
primary party. O’Shea’s rationale was that he had already committed to go to Moscow. The cost
allocations would then be:
Party Costs allocated Costs remaining to be allocated to other
parties
Moscow (primary) €1200 €300 (€1500 – €1200)
Prague (incremental) 300 0
The Moscow employer is allocated the full Galway–Moscow airfare. The non-allocated part of the total
airfare is allocated to the Prague employer. Had the Prague employer been chosen as the primary party,
the cost allocations would have been Prague, €800 (the stand-alone Galway–Prague return airfare) and
Moscow, €700 (€1500 – €800). Where there are more than two parties, this method requires them to be
ranked and the common costs allocated to those parties in the ranked sequence.
Under the incremental method, the primary party typically receives the highest allocation of the common
costs. Not surprisingly, most users in common cost situations propose themselves as the incremental
party. In some cases, the incremental party is a newly formed ‘organization’ such as a new product line or
a new sales territory. Chances for its short-term survival may be enhanced if it bears a relatively low
allocation of common costs.
A caution is appropriate here as regards O’Shea’s cost-allocation options. His chosen method must be
acceptable to each prospective employer. Indeed, some prospective employers may have guidelines that
recruiting candidates must follow. For example, the Moscow employer may have a policy that the
maximum reimbursable airfare is a seven-day advance booking price in economy class. If this amount is
less than the amount that O’Shea would receive under (say) the stand-alone method, then the employer’s
upper limit guideline would govern how much could be allocated to that interviewer. Before he purchases
his ticket as to which cost-allocation method(s) each potential employer views as acceptable.

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