Cost allocation of

departments/common
cost

Chapter 15(P.626-633),
Chapter 16(P.658-678)
Learning objectives
1.Explain the general purposes of cost
allocation
2.Understand criteria to guide cost allocation
3.Understand how cost allocated from
corporate to divisions
4.Allocating cost of support departments to
operating departments (direct, stepdown,
reciprical methods)
5.Allocating Common cost
2
 1. General Purposes of Cost
Allocation

1 To provide information for economic

decisions
2 To motivate managers and other
employees review resources consumption
3 To justify costs or compute
reimbursement
4 To measure income and assets for
reporting to external parties
3
2. Criteria to Guide Cost Allocations

-Cause and Effect: Using this criterion, managers

identify the variables that cause resources to be
consumed.

-Benefits Received: Using this criterion, managers

identify the beneficiaries of the outputs of the cost
object.

-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.
Criteria to Guide Cost Allocations

-Ability to Bear: This criterion advocates

allocating costs in proportion to the cost object’s
ability to bear cost allocated to it.

The criterion chosen affect both the number of

indirect cost pools and the cost-allocation base for
each indirect cost pool.
Managers must select the appropriate criterion
to implement the allocation
Criteria to Guide Cost Allocations

 The cause-and-effect and the benefits-

received criteria guide most decisions
related to cost allocations.
 Fairness and ability to bear are less
frequently used criteria
- Difficult to obtain agreement on “Fair”
- “Ability to bear” raises issues related to
cross-subsidization across users of
resources in an organization

6
Cost-Benefit Approach
 Companies place great importance on
the cost-benefit approach
 Balance the benefit of using a multiple
cost-pool system against the cost of
implementing it.
 Advances in IT technology make it more
likely that a multiple cost-pool system
will pass the cost–benefit test

7
3.Cost allocation from corporate to
divisons
 Costs incurred in different parts of an
organization can be assigned, and then
reassigned, when costing products,
services, customers, or contracts.
 Sandy Company manufactures clothes
washers and dryers in two divisions:
– Clothes Washer Division in Toledo (CWD)
– Clothes Dryer Division in Dayton (CDD)

8
Cost Allocation and Costing Systems
 Sandy Corporation collects costs at the
following levels in its organization:
 Corporate costs:
– Treasury costs: $600,000 interest on debt
used to finance the construction of new
assembly equipment which cost $4,000,000
in the Toledo Division and $2,000,000 in
the Dayton Division.
(supplementary notes p.1)

9
Cost Allocation and Costing Systems
– Human resources costs: $1,200,000
in recruitment and ongoing employee
training and development.
– Corporate administration costs:
$4,800,000 in executives salaries,
rent, and general administration.

10
Allocating Corporate Costs
 Some companies allocate all
corporate costs to divisions because...
– it sparks interest on the part of
division managers regarding how
corporate costs are planned and
controlled, and...
– to calculate the full costs of products.

11
Allocating Corporate Costs
 Other companies do not allocate
corporate costs to divisions.
- division managers generally have no
say or role in incurring these costs.
- Other companies allocate only those
costs for which there is widespread
agreement, such as human
resources.

12
Cost Allocation and Costing
system
 Division cost
Toledo Dayton
 Direct cost 2,200,000
4,000,000
 Indirect cost 1,980,000 2,500,000
4,180,000 6,500,000

13
Allocating Corporate Costs
 If Sandy Corporation allocates corporate
costs to divisions, how many cost pools
should it use to allocate corporate costs?
– One single cost pool?
– Numerous individual corporate cost pools?
 A key factor is the concept of homogeneity.

14
Allocating Corporate Costs
 In a homogeneous cost pool, all costs
have the same or a similar cause-
and-effect or benefits- received
relationship with the cost-allocation
base.
 If each cost category has a different
cost driver, companies may prefer to
maintain separate cost-pools for
these costs.

15
Allocating Corporate Costs
 Which allocation basis should Sandy
Corporation use to allocate treasury
costs?
– Cost of new Assembly Department
equipment

16
Allocating Corporate Costs
 Treasury costs: $600,000
 Toledo Division:
$600,000 X
($4,000,000/$6,000,000)
= 400,000
 Dayton Division:
$600,000 X ($2,000,000 /
6,000,000) = $200,000

17
Allocating Corporate Costs
 Analysis shows HR management costs
varies with direct labor costs.
 Cost allocated on the basis of the
total direct labor costs incurred in
each division.

18
Allocating Corporate Costs
 Suppose direct labor costs in the
Toledo Division are $1,200,000 and
$1,800,000 in the Dayton Division.
 How does Sandy Corporation allocate
its $1,200,000 of human resources
costs?

19
Allocating Corporate Costs
 Toledo Division:
$1,200,000 X ($1,200,000 /$3,000,000)
= $480,000
 Dayton Division:
$1,200,000 X($1,800,000 /$3,000,000)
= $720,000
 Sandy Corporation does not allocate
corporate administration costs to the
divisions.

20
Allocating Corporate Costs

Toledo Dayton
Treasury costs:$600,000 (2/3) and (1/3)
$400,000 $200,000

Human resources costs:

$1,200,000
(40%) and (60%) 480,000 720,000

Total allocated to divisions $880,000 $920,000

21
 Allocating Corporate Costs
 Corporate treasury costs are reallocated by
the Toledo and Dayton Divisions to their
Assembly department respectively.
 Corporate human resource management
costs are also reallocated by the Toledo and
Dayton divisions to their respectively
department of Human Resources

22
Allocating Corporate Costs
 Division costs are reallocated to the
departments within the division.
 The Toledo division of Sandy Corporation
has two operating departments : Assembly
and Finishing, plus two support
departments, Maintenance and Human
Resources.

23
Allocating Corporate Costs
 The Toledo Division management
decided to reallocate the $400,000
treasury costs to the Assembly
Department, and the $480,000
human resources costs to its Human
Resources Department.

24
Allocating Corporate Costs

Toledo Division

Assembly
direct costs: $1,300,000 Finishing
Corporate direct costs:
costs: 400,000 $900,000
Total costs $1,700,000 25
 Allocating Corporate Costs

Toledo Division

Human Resources
direct costs: $1,680,000
Maintenance Corporate
direct costs: costs: 480,000
$300,000 Total costs $2,160,000
26
 Allocating Corporate Costs
Total cost of
Assembly Department the division
$1,700,000 after allocation

Finishing Department
$900,000 Toledo Division
Maintenance Department $5,060,000
$300,000
Human Resources Department
$2,160,000 27
 4.Allocating Support Departments
Costs to operating departments

 An operating department (a production

department in manufacturing companies)
adds value to a product or service.
 A support department (service
department) provides the services that
assist other operating and support
departments in the organization.

28
 Allocating Support Departments
Costs
1 Direct allocation method
- allocate support department costs to
operating departments only.
2. Step down method
- Allocates support department costs to other
support departments and to operating
departments.
3. Reciprocal method (most accurate)
- Allocates costs by including the mutual
services provided among all support
departments 29
Allocating Support
Departments Costs
 The following information pertains to
the Toledo Division of Sandy
Corporation:
 Recall that the Toledo Division has
two operating departments: Assembly
and Finishing, and two support
departments: Maintenance and
Human Resources.

30
Allocating Support
Departments Costs
 Total square feet = 255,000
 Total number of employees = 95
 Maintenance is allocated using square
feet.
 Human Resources is allocated using
number of employees.

31
 Allocating Support
Departments Costs
Human
Maintenance
Resources
Budgeted costs
before allocations: $300,000 $2,160,000
Square feet: 5,000 30,000
Number of employees: 8 15
Assembly
Finishing
Budgeted costs
before allocations: $1,700,000 $900,000
Square feet: 110,000 110,000
Number of employees: 48 24
32
Direct Method...
– allocates support department costs to
operating departments only.
 The allocation ratio for allocating
Maintenance to Assembly is
110,000/220,000 x $300,000 = $150,000.
 The allocation ratio for allocating
Maintenance to Finishing is
110,000/220,000 x $300,000 = $150,000.

33
Direct Method
 The allocation ratio for allocating Human
Resources to Assembly is 48/72
X$2,160,000 = $1,440,000.
 The allocation ratio for allocating Human
Resources to Finishing is 24/72
X$2,160,000 = $720,000.

34
 Direct Method
M HR A F
 300,000 2,160,000 1,700,000 900,000
 (300,000) 150,000 150,000
 (2,160,000) 1,440,000 720,000
 3290,000 1,770,000

35
Step-Down Method...
– allocates support department costs to
other support departments and to
operating departments.
 The support department providing the
greatest percentage of support to
other support departments is
allocated first.

36
Step-Down Method
 Maintenance provides 12% of its services to
Human Resources.
 Human Resources provides 10% of its
services to Maintenance.

 Therefore, allocate cost from Maintainance

to HR first

37
Step-Down Method
 Step 1 :
 The ratio to allocate Maintenance to Human
Resources is 30,000/250,000 (or 12%)
X$300,000 = $36,000.
 The ratio to allocate Maintenance to Assembly
is 110,000/250,000 (or 44%) X $300,000 =
$132,000.
 The ratio to allocate Maintenance to Finishing is
110,000/250,000 (or 44%) X $300,000 =
$132,000.

38
Step-Down Method
 Step 2:

 The ratio to allocate HR to Assembly is

 2,196,000 X 48/72 =1,464,000
 The ratio to allocate HR to Finishing is
 2,196,000 X 24/72 =732,000

39
 Step-Down Method

 M HR A F
 300,000 2,160,000 1,700,000 900,000
 (300,000) 36 000 132 000 132 000
 (2196 000) 1,464 000 732,000
 0 0 3,296,000 1,764,000

40
Reciprocal
 M HR A F
Maintenance - 12% 44%
44% Human
Resources
10% - 60% 30%
 Step 1: Set up the equations, solve
unknowns

 M = $300,000 + .10HR
 HR = $2,160,000 + .12M
41
Reciprocal
 Maintenance cost (M)
= $300,000
+ .10($2,160,000 + .12M)
 M = $300,000 + $216,000 + .012M
 M = $522,267
 Human Resources cost = $2,160,000
+ .12($522,267)
 HR = $2,160,000 + $62,672
 HR = $2,222,672 42
Reciprocal

Step 2: allocate cost to the support and

operating dep

M HR A F
300,000 2,160,000 1,700,000 900,000
(522,267) 62,672 229,797 229,797
222,267 (2,222,672) 1,333,603 666,802
0 0 3,263,400 1,796,599

43
 Comparisons of methods

 Direct method and step down method-

simple and easier to understand
 Reciprocal method- most precise, considers
mutual services among support
departments, highlights the complete
reciprocated costs of support departments.
Company can determine whether to
outsource the services
44
5.Allocating Common Costs
 A cost of operating a facility, activity, or
like cost object that is shared by two or
more users.
 Two methods for allocating common cost
are:
1 Stand-alone cost allocation method
2 Incremental cost allocation method

45
Allocating Common Costs
 The stand-alone cost allocation method:
uses information pertaining to each user of
a cost object as a separate entity to
determine the cost-allocation weights.
 A consultant in Hong Kong is planning to go
to Tokyo and meet with an international
client.
 The round-trip Hong Kong/Tokyo/Hong
Kong airfare costs $540.

46
Allocating Common Costs
 The consultant is also planning to attend a business
meeting with a Taiwanese client in Taipei.
 The round-trip HK/Taipei/HK airfare costs $360.
 The consultant decides to combine the two trips into a
HK/Taipei/Tokyo/HK itinerary that will cost $760.

47
Allocating Common Costs
 How much should the consultant
charge to the Taiwanese client?
 $360 /($360 + $540) = .40
 .40 X$760 = $304
 Therefore, the consultant should
charge the international client $760 -
$304 = $456.

48
 Allocating Common Costs

 The incremental cost allocation 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 party and is allocated costs up to the
cost of it as a stand-alone user.
 The second-ranked user is termed the
incremental party and is allocated the additional
cost that arises from there being two users
instead of only the primary user.

49
Allocating Common Costs
 Assume that the business meeting in
Tokyo is viewed as the primary party.
 What would be the cost allocation?
 International client
(primary)
$540 Taipei client

(incremental) $760 -$540 = $220

50