Chapter -5

Cost Allocation
 Cost Allocation

 Cost allocations stands for the assignment of costs which are

indirectly attributable and uneconomical to trace to cost object. Cost
allocation is the process of identifying, accumulating, and assigning
costs to costs objects such as departments, products, programs, or a
branch of a company.

 It involves identifying the cost objects in a company, identifying the

costs incurred by the cost objects, and then assigning the costs to the
cost objects based on specific criteria.
 Purposes of Cost Allocation

 Indirect costs are costs that are related to a particular cost

object but cannot be traced to it in an economically feasible
(cost effective) way.
 Why do managers allocate indirect costs to these cost objects?
– There are four essential purposes of cost allocation:
1 .To provide information for economic decisions
2 .To motivate managers and other employees
3 .To justify costs or compute reimbursement
4 .To measure income and assets for reporting to external
parties
 continued
 Provide Information
– What economic decisions may require cost allocation
information?
– To decide whether to add a new product
– To decide whether to manufacture a component part or to
purchase it from another manufacturer
– To decide on the selling price for a product
 Motivation
– Managers and employees need to be encouraged to design
products that are simpler to manufacture or less costly to
service.
– Sales representatives need to be motivated to push high-margin
products or services.
 continued
 Justify Costs
– It is important to cost products at a “fair” price, especially in
government defence contracts.
– A consulting firm that is paid a percentage of the cost savings
resulting from the implementation of its recommendations
needs to justify costs in order to compute reimbursement.
 Reporting
– Inventory costs must be determined for financial reporting and
for reporting to tax authorities.
– Under generally accepted accounting principles, stock costs
include manufacturing costs but exclude research and
development, marketing, distribution, and customer service
costs.
 Criteria for Guiding Cost
Allocation Decisions
a. Cause and effect
 Allocate based on the variable or variables that cause cost to
be incurred
b. Benefits received
 Allocate costs among the beneficiaries in proportion to the
benefits each receives
c. Fairness or equity
 Allocate costs in such a manner as to be “fair” or
“reasonable” for both parties
d. Ability to bear
 Allocate costs based on who can best absorb them
 Single-Rate and Dual-Rate Methods

– The single-rate cost allocation method pools together all costs in a cost
pool and allocates these costs to cost objects using the same rate per unit
of the single allocation base.
 There is no distinction between costs in the cost pool in terms of cost
behaviour.

– The dual-rate cost allocation method classifies costs in each cost pool
into two cost pools – a variable cost -pool and a fixed-cost cost-pool.
 Each of these pools uses a different cost-allocation base.
 Budgeted versus Actual Rates

– The decision of whether to use budgeted cost rates or actual cost rates
affects the level of uncertainty user divisions face.

– Budgeted rates - the user department know in advance the cost rates
they will be charged. Users are better equipped to determine the
amount of the service to request. Budgeted rates also help motivate
the manager of the supplier department to improve efficiency.

– During the budget period, the supplier department, not the user
departments, bears the risk of any unfavourable cost variances.
because the user departments do not pay for any costs that exceed the
budgeted rates
 continued
– When cost allocations are made using budgeted rates, managers of
divisions to which costs are allocated face no uncertainty about the rates
to be used in that budget period.
– When actual rates are used for cost allocation, managers do not know the
rates to be used until the end of the budget period.
– When budgeted usage is the allocation base, user divisions will know in
advance their allocated costs. This information helps the user divisions
with both short-run and long-run planning.
– The main justification given for the use of budgeted usage to allocate
fixed costs relates to long-run planning.
– Organisations commit to infrastructure costs on the basis of a long-run
planning horizon.
– The use of budgeted usage to allocate these fixed costs is consistent with
the long-run horizon.
 Allocating Support Department Costs

– Organisations distinguish between operating departments and

support 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 organisation.
 Con,t

 Three methods are widely used to allocate the costs

of support departments to operating departments:

1 . Direct allocation method

2 . Step-down method
3 . Reciprocal method
 Con,t
– Direct method: Allocates support department costs to operating
departments only.
– Step-down (sequential allocation) method: Allocates support
department costs to other support departments and to operating
departments.

– Reciprocal allocation method: Allocates costs by including the

mutual services provided among all support departments.

– The direct method and the step-down method are less accurate
than the reciprocal method when support departments provide
services to one another reciprocally.
 Con,t
Direct approach
 Allocate support costs directly to operating departments
Step-down approach
 Recognize some of the work support departments do for each other
and allocate support costs to other support departments and
operating departments in a pre-determined order
Reciprocal approach
 Recognize all of the work support departments do for each other and
allocate support costs among all departments using their services
 Example
 The following information pertains to the Tana Division of ABC Corporation:
– Recall that the Tana Division has two operating departments – Assembly
and Finishing, and two support departments – Maintenance and Human
Resources.

– Total square feet = 255,000

– Total number of employees = 95
– Maintenance is allocated using square feet.
– Human Resources are allocated using number of employees.
 Con,t
Human
Maintenance Resources
Budgeted costs
before allocations: Br.300,000 Br.2,160,000
Square feet: 5,000 30,000
Number of employees: 8 15

Assembly Finishing
Budgeted costs
before allocations: Br.1,700,000 Br.900,000
Square feet: 110,000 110,000
Number of employees: 48 24
 Direct Method

– Allocates support department costs to operating departments only.

 The allocation ratio for allocating Maintenance to Assembly is
110,000/220,000 × Br.300,000 = Br.150,000.
 The allocation ratio for allocating Maintenance to Finishing is
110,000/220,000 × Br.300,000 = Br.150,000.
 The allocation ratio for allocating Human Resources to Assembly is
48/72 × Br.2,160,000 = Br.1,440,000.
 The allocation ratio for allocating Human Resources to Finishing is
24/72 × Br.2,160,000 = Br.720,000.
 Con,t
Assembly Finishing
Original costs: Br.1,700,000 Br.900,000
Maintenance
Allocated: 150,000 150,000 Human
Resources
Allocated: 1,440,000 720,000
Total Br.3,290,000 Br.1,770,000
 Step-down Method

 Allocates support department costs to other support

departments and to operating departments.

 Which support department should be allocated first?

– The support department providing the greatest
percentage of support to other support departments is
allocated first.
 Continued
 Maintenance provides 12% of its services to Human Resources.
 Human Resources provides 10% of its services to Maintenance.
– The ratio to allocate Maintenance to Human Resources is
30,000/250,000 (or 12%) × Br.300,000 = Br.36,000.

– The ratio to allocate Maintenance to Assembly is 110,000/250,000

(or 44%) × Br.300,000 = Br.132,000.

– The ratio to allocate Maintenance to Finishing is 110,000/250,000

(or 44%) × Br.300,000 = Br.132,000.
 Con,t

Costs before Allocated

allocation costs
Maintenance Br. 300,000 (Br.300,000)
Human Resources Br.2,160,000 Br.36,000
Assembly Br.1,700,000
Br.132,000 Finishing
Br.900,000 Br.132,000
 Con,t
– Human Resources costs to be allocated become
Br.2,160,000 + Br.36,000 = Br.2,196,000.

– The ratio to allocate the Br.2,196,000 Human

Resources costs to:
– Assembly is 48/72 × Br.2,196,000 = Br.1,464,000.

– Finishing is 24/72 × Br.2,196,000 = Br.732,000.

 Con,t

Costs before Allocated Allocated

allocation costs costs
Human Resources: Br.2,160,000 36,000
(2,196,000) Assembly: 1,700,000 132,000
1,464,000

Finishing: 900,000 132,000 732,000

 Con,t
 Total cost after allocation:
– Assembly Department = Br.1,700,000 +
Br.132,000 + Br.1,464,000 = Br.3,296,000

– Finishing Department = Br.900,000 +

Br.132,000 + Br.732,000 = Br.1,764,000
 Reciprocal Method

M HR A F
Maintenance - 12% 44% 44%
Human
Resources 10% - 60% 30%

– Maintenance cost = Br.300,000 + 0.10HR

– Human Resource cost = Br.2,160,000 + 0.12M
 Con,t
– Maintenance cost (M)
= Br.300,000 + 0.10(Br.2,160,000 + 0.12M)

M = Br.300,000 + Br.216,000 + 0.012M

0.988M = Br.516,000

M = Br.522,267

– HR = Br.2,160,000 + 0.12(Br.522,267)
HR = Br.2,160,000 + Br.62,672

HR = Br.2,222,672
 Con,t
M HR A F

Before allocation: Br.300,000 2,160,000 1,700,000 900,000

Allocation: (522,267) 62,672 229,797 229,797
Allocation: 222,267 (2,222,672) 1,333,603 666,802
Total Br.3,263,400 Br.1,796,599

Total cost Assembly Department: Br.3,263,400

Total cost Finishing Department: Br.1,796,599

 Allocating Joint Costs
 Joint products are two or more products that are generated within a single
production process. Joint products are multiple products generated by a
single production process at the same time.

 An example could be the processing of milk, which yields skim milk and
cream.

 Joint Costs – costs of a single production process that yields multiple

products simultaneously.

 Split-off Point – the place in a joint production process where two or more
products become separately identifiable.
 Allocating Joint Costs
 Separable Costs – all costs incurred beyond the split-off
point that are assignable to each of the now-identifiable
specific products.

 Byproducts – outputs of a joint production process that

have low sales values compare to the sales values of the
other outputs.
Joint Cost and Product
Overview
 Reasons for Allocating Joint Costs

• To compute inventory cost and cost of goods sold

• To determine cost reimbursement under contracts
• For insurance settlement computations
• For rate regulation/Required by regulators
• For litigation purposes
• Required for GAAP/IFRS and taxation purposes
 Joint Cost Allocation Methods
 Market-Based approach – allocate using market-derived data
(dollars):

1. Sales value at split-off method

2. Net Realizable Value (NRV) method
3. Constant Gross-Margin percentage NRV method
 Physical Measures approach– allocate using tangible attributes
of the products, such as pounds, gallons, barrels, etc.
 Allocating Joint Costs
 Sales Value at Split-off Method-Uses the sales value of
the entire production of the accounting period to calculate
allocation percentage.

 Net Realizable Value Method-Allocates joint costs to joint

products on the basis of relative NRV of total production
of the joint products.

 NRV = Final Sales Value – Separable Costs.

 Allocating Joint Costs
 Constant Gross Margin NRV Method -Allocates joint costs to
joint products in a way that the overall gross-margin percentage
is identical for the individual products.

 Joint Costs are calculated as a residual amount

 Physical-Measure Method-Allocates joint costs to joint
products on the basis of the relative weight, volume, or other
physical measure at the split-off point of total production of the
products.
Joint Cost allocation-
Illustration Data
Joint Cost Illustration
Overview
Sales Value at Splitoff
Illustration
Net Realizable Value Method
Overview
Net Realizable Value Method
Illustrated
Net Realizable Value Method
Illustrated
Constant Gross Margin NRV
Illustrated
Physical Measures Illustration
 Accounting for by products
 Two methods for accounting for byproducts
 Production Method – recognizes byproduct inventory as it is created,
and sales and costs at the time of sale. The production method
recognizes byproducts at the time their production is completed.
 Sales Method – recognizes no byproduct inventory, and recognizes
only sales at the time of sales: byproduct costs are not tracked
separately. The sale method delays recognition of byproducts until the
time of their sale.
 Accounting for Byproducts
Example
Main Products Byproducts
(Units) (Units)
Production 1,000 400
Sales 800 300
Ending inventory 200 100
Sales price Br.13/unit
Br.1.00/unit
No beginning finished goods inventory
 Accounting for Byproducts
Example
Joint production costs for joint (main) products and
byproducts:
Material Br.2,000
Manufacturing labor 3,000
Manufacturing overhead 4,000
Total production cost Br.9,000
 The production method
 What is the value of ending inventory of joint (main)
products?

Br.9,000 total production cost – Br.400 net realizable

value of the byproduct

= Br.8,600 net production cost for the joint products

 200 ÷ 1,000 × Br.8,600 = Br.1,720 is the value assigned to the
200 units in ending inventory.
 The production method

 What is the cost of goods sold?

Joint production costs Br.9,000

Less byproduct revenue 400

Less main product inventory 1,720

Cost of goods sold Br.6,880

 What are the inventoriable costs?

- Main product: 200 ÷ 1,000 × Br.8,600 = Br.1,720

- Byproduct: 100 × Br.1.00 = Br.100

 The sale method

- What is the value of ending inventory of joint (main)

products?

- 200 ÷ 1,000 × Br.9,000 = Br.1,800

- No value is assigned to the 400 units of byproducts

at the time of production.
- The Br.300 resulting from the sale of byproducts is
reported as revenues.
 The sale method

Revenues: Main product (800 × Br.13) Br.10,400

Byproducts sold 300

Total revenues Br.10,700

Cost of goods sold:

Joint production costs 9,000

Less main product inventory 1,800 Br. 7,200

Gross margin Br. 3,200

 Allocating Common Costs
 Common Cost – the cost of operating a facility, activity, or
like cost object that is shared by two or more users at a
lower cost than the individual cost of the activity to each
user.
 Methods of Allocating
Common Costs

 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

 Individual costs are added together and allocation

percentages are calculated from the whole, and applied
to the common cost
 Methods of Allocating
Common Costs
 Incremental Cost-Allocation Method ranks the individual users of a cost
object in the order of users most responsible for a common cost and then
uses this ranking to allocate the cost among the users

– The first ranked user is the Primary User and is allocated costs up to the
costs of the primary user as a stand-alone user (typically gets the highest
allocation of the common costs)

– The second ranked user is the First Incremental User and is allocated the
additional cost that arises from two users rather than one and
Subsequent users handled in the same manner as the second ranked user

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