CHAPTER FIVE

COST
ALLOCATIO
N
• Costs that are related to a particular cost
object but cannot be traced to it in an
economically feasible way are called
manufacturing overhead cost or indirect cost.

• The term cost allocation describes assigning

indirect cost to the chosen cost object.

• Cost allocation can also be assigning cost

from one or more service giving departments
to operating departments.
 5.1. PURPOSE OF COST ALLOCATION

To provide information for economic decision

To justify cost or compute reimbursement
To measure income and asset for reporting
To encourage managers of operating departments to make
wise use of services provided by service departments.
To provide more complete cost data for making decisions in
operating departments
To help measure profitability in the operating departments
To put pressure on the service departments to operate
efficiently
 To develop overhead rates in the operating departments.
 5.2.COST ALLOCATION
CRITERIA
Cause and Effect Criteria: Using this criterion, a manager
identifies the variables that cause a resource to be consumed.
Benefit Received Criteria: using these criteria managers identifies
the beneficiary of the output of the cost object. The cost of the cost
object is allocated among the beneficiaries in proportion to the
benefit each received
Fairness or Equity: - is often cited in government contracts when
cost allocations are the basis of establishing a price satisfactory to
the government and its suppliers.
Ability to Bear: This criteria advocates allocating costs in
proportion to the cost objects ability to bear cost allocated to
income. The presumption is that the more profitable division have
a greater ability to absorb corporate headquarters cost.
5.3.ALLOCATING COSTS OF MULTIPLE
SUPPORT DEPARTMENTS
 Companies distinguish operating departments from support
giving departments.
 An operating department, which is also called a production
department in manufacturing companies, directly adds value to a
product or service. These are departments which participate in
production of goods and service.
 A support giving department, which is also called a service
department, provides services that assist other internal
departments (operating departments and other support
departments) in the company.
 In this section, we examine the special cost – allocation
problems that arise when two or more of the support departments
whose costs are being allocated provide reciprocal support to
each other as well as to operating departments.
  Illustration: Consider Mesfin engineering, which operates at
maximum capacity to assemble Vehicles in its factory. Mesfin
Engineering has two support departments and two operating
departments in its manufacturing facility.
Support Departments Operating Department
Plant Maintenance (PM) Machining (M)
Information Systems (IS) Assembly (A)

 The two support departments provide reciprocal support to each

other as well as support to the two operating departments.
 Costs are accumulated in each department for planning and
control purposes. For inventory costing, however, the support
department cost must be allocated to the operating departments.
The data for our example is given below.
 Support department Operating department
PM IS M A
Budgeted MOH cost
before allocation Br.600,000 Br.116,000 Br.400,000 Br.200,000
Service provides by:
Plant maintenance - 1600hrs 2400hrs 4000hrs
Information system 200hrs - 1600hrs 200hrs
We now examine the three methods of allocating the
costs of reciprocal support departments:
 Direct method,
step – down method and
reciprocal methods.
DIRECT METHOD

Allocates each support department’s costs to operating departments

only.
The direct method does not allocate support department costs to
other support departments.
The base used to allocate plant maintenance costs to the operating
departments is the budgeted total maintenance labor – hours worked
in the operating department:
2,400 + 4,000 = 6,400 hours.
This amount excludes the 1,600 hours of budgeted support time
provided by plant maintenance to information systems.
Similarly, the base used for allocation of information systems costs
to the operating departments is 1,600 + 200 = 1,800 budgeted hours
of computer time,
which excludes the 200 hours of budgeted support time provided by
information systems to plant maintenance.
 The cost in each service departments will be allocated to
the operating departments as follows:
 Allocating cost of Plant maintenance to :
Machining = (2400/6400) ×Br. 600,000 = Br.
225,000
Assembly = (4000/6400) ×Br. 600,000 = Br. 375,000
 Allocating cost of Information systems to :
Machining = (1600/1800) ×Br. 116,000 = Br.
103,111
Assembly = (200/1800) × Br. 116,000 = Br. 12,889
 The above allocated costs can be summarized for the two
operating departments using the following cost summary as
follows
  Machining Assembly Total
Cost before Allocation Br.400,000 Br.200,000 Br.600,000
Cost allocated from PM 225,000 375,000 600,000
Cost allocated from IS 103,111 12,889 116,000

Total cost Br 728,111 Br.587,889 Br.1,316,000

y acc ep te d be ca u se of it s ease of
 The direct method is widel si m p li city.
the d ir e c t m e tho d is
use. The benefit of of su p po rt d e pa rt m ent
the usa g e
 There is no need to predict
ts.
services by other departmen o d is th at it ignores
d ir ec t m eth
 A disadvantage of the pp ort d ep art m ents by
d am on g su
reciprocal services provide
other support departments.
STEP – DOWN METHOD

Allocates support – department costs to other support

departments and to operating departments in a sequential
manner that partially recognizes the mutual services
provided among all support departments.
Step down method requires the support departments to be
ranked (sequenced) in the order that the step – down
allocation is to proceed.
A popular step – down sequence begins with the support
department that renders the highest percentage of its total
services to other support departments.
 The sequence continues with the department that renders
the next –highest percentage, and so on, ending with the
support department that renders the lowest percentage.
 PM 2,400 Hrs M
Br. 600,000
4,000 Hrs
1,600 Hrs 1,600 hrs
IS A
Br 116,000 200 Hrs

The cost in each service departments will be allocated to the operating

departments as follows using step down method:
 Allocating cost of Plant maintenance to :
Machining = (2400/8000) ×Br. 600,000 = Br. 180,000
Assembly = (4000/8000) ×Br. 600,000 = Br. 300,000
Information system = (1600/8000) ×Br. 600,000 = Br. 120,000
 Allocating cost of Information systems( 116,000 + 120,000 = Br.236,000)
to :
Machining = (1600/1800) ×Br. 236,000 = Br. 209,778
Assembly = (200/1800) × Br. 236,000 = Br. 26,222
3. RECIPROCAL METHOD
Allocates support – department costs to operating
departments by fully recognizing the mutual services
provided among all support departments.
For example, the plant maintenance department maintains
all the computer equipment in the information systems
department.
 Similarly, information systems provide database support for
plant maintenance
This method fully incorporates interdepartmental
relationships into the support – department cost allocations
The following diagram shows the relationship among the departments under the reciprocal method
PM 2,400 Hrs M
Br. 600,000
4,000 Hrs
200 hrs 1,600 Hrs 1,600 hrs
IS A
Br 116,000
The reciprocal method requires formulation and solving
of linear equations. This requires three steps.
Step 1: Express support – Department costs and support
– Department Reciprocal relationships in the form of
linear equations.
Let PM be the complete reciprocated costs of plant
maintenance and IS be the complete reciprocated costs of
information systems.
We then express the relationship between support giving departments as:
PM = Br. 600, 000 + 0.1IS (1)
IS = Br. 116, 000 + 0.2PM (2)
Step 2: Solve the set of linear equations to obtain the complete reciprocated
costs of each support department. Substituting equation (2) in to (1):
PM = Br. 600, 000 + [0.1(Br.116, 000 + 0.2PM]
PM = Br. 600, 000 + Br.11, 600 + 0.02PM
 0.98PM = Br. 611, 600
PM = Br. 624, 082
Substituting into equation (2):
IS = Br.116, 600+0.2(Br. 624, 082)
IS = Br.116, 000 + Br.124, 816 = Br. 240, 816
Step 3: Allocate the Complete Reciprocated costs of each
support department to all other departments (Both support
departments and operating departments) on the basis of the
usage percentages (based on total units of service provided
to all departments).
The cost in each service departments will be allocated to the operating
departments and the service departments using reciprocal method as follows
 Allocating cost of Plant maintenance (Br. 624, 082) to:
Machining = (2400/8000) × Br. 624, 082= Br. 187,225
Assembly = (4000/8000) × Br. 624, 082= Br. 312,041
Information system = (1600/8000) × Br. 624, 082= Br.124,816
 Allocating cost of Information systems (116,000 + 120,000 = Br. 236,000)
to:
Machining = (1600/2000) × Br. 240, 816= Br.192,653
Assembly = (200/2000) × Br. 240, 816= Br. 24,082
Plant Maintenance = 200/2000) × Br. 240, 816 = Br. 24,082
The cost summary for reciprocal cost allocation
method will be given as follows
Assembly
  Machining Total
Br.200,000
Cost before Allocation Br.400,000 Br.600,000
Br. 312,041
Cost allocated from PM Br. 187,225 Br.499,269
Br. 24,082
Cost allocated from IS Br.192,653 Br.216,735
Br.536,123

Total cost Br. 779,878 Br.1,316,000

e nt s wi l l not
t he se r vic e departm
a l l oc a te d t o
a t t he c o s t .
No t e t h t s u m m ar y
e d i n t h e cos
be inclu d