Cost allocation


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Cost allocation

  1. 1. Cost Allocation
  4. 4. LearningObjective 1 General Framework for Cost Allocation Cost allocation methods comprise an important part of a company’s cost management system. Four types of cost objectives: Service departments Producing departments Products/services, and Customers.
  5. 5. General Framework for Cost AllocationProducing departments are where employeesWork on the organization’s products or services. Service departments exist only to support other departments or customers.
  6. 6. General Framework for Cost AllocationDirect costs can be physically traced to each department. Indirect costs must be allocated. Many companies develop allocation methods to assign service department costs to the producing departments.
  7. 7. General Framework for Cost AllocationAll organizations accumulate costs for theirproducts or services for financial reporting purposes. Increasingly, companies measure and manage the costs and profitability of their customers. Customer related costs include: Order processing Customer service sales commissions Dedicated customer support
  8. 8. General Framework for Cost Allocation An accounting system will assign to a department’s output all its direct costs plus all the indirect costs allocated to it.A cost driver that has a logical, cause-effect relationshipto the cost will be used as a cost-allocation base
  9. 9. LearningObjective 2 Allocation of Service Department Costs Establish the details regarding cost allocation in advance. Allocate variable- and fixed- cost pools separately. Evaluate performance using budgets for each production and service department.
  10. 10. Service Department Example 5-year lease Computer DepartmentSchool of Business School of Engineering
  11. 11. Service Department Example Suppose there are two major purposes for the allocation:Predicting economic effectsof the use of the computer Motivating departments and individuals to use its capabilities more fully
  12. 12. Service Department Example The primary activity performed is computer processing.Resources consumed include1. Processing time The budget formula for the2. Operator time forthcoming year is £100,0003. Consulting time monthly fixed cost plus £2004. Energy variable cost per hour of5. Materials computer time used.6. Building space
  13. 13. Variable-Cost PoolThe cost driver for the variable-cost pool isActual hours of computer time used. Therefore, variable costs should be allocated as follows: Budgeted unit rate X Actual hours of computer time used
  14. 14. Variable-Cost PoolConsider the allocation of variablecosts to a department that uses600 hours of computer time.600 hours × £200 = £120,000Suppose inefficiencies in thecomputer department caused thevariable costs to be £140,000instead of £120,000.
  15. 15. Variable-Cost PoolA good cost-allocation scheme would allocateonly the £120,000 to the consuming departmentand would let the £20,000 remain as anunallocated unfavorable budget varianceof the computer department.This scheme holds computer department managers responsible for the £20,000and reduces the resentment of user managers.
  16. 16. Fixed-Cost PoolThe cost driver for the fixed-cost pool isthe amount of capacity required whenthe computer facilities were acquired.Fixed costs should be allocated as follows:Budgeted percent of capacity available for use× Total budgeted fixed costs
  17. 17. Fixed-Cost Pool Suppose the deans had originally predicted the long-run average monthly usage as follows:School of Business: 210 hours School of Engineering: 490 hours How is the fixed-cost pool allocated?Business: Engineering:210 ÷ 700 = 30% 490 ÷ 700 = 70%£100,000 X .3 = £30,000 £100,000 X .7 = £70,000
  18. 18. Fixed-Cost PoolThis predetermined lump-sum approachis based on the long-run capacityavailable to the user, regardless ofactual usage from month to month.A major strength of using capacity available ratherthan capacity used when allocating budgeted fixedcosts is that actual usage by user departments does notaffect the short-run allocations to other user departments.
  19. 19. Reciprocal Services Service departments often support other service departments in addition to production departments.There are two popular methods forallocating service department costs:The direct methodThe step-down method
  20. 20. LearningObjective 3 Direct and Step-Down Methods The direct method ignores other service departments when any given service department’s costs are allocated to the revenue-producing (operating) departments. The step-down method recognizes that some service departments support the activities in other service departments as well as those in production departments.
  21. 21. Direct and Step-Down MethodsFacilities management cost = £1,260,000Human resources cost = £240,000Total square footage in production departments:15,000 processing + 3,000 assembly = 18,000Total employees in production departments16 processing + 64 assembly = 80Square footage in human resources = 9,000
  22. 22. Direct MethodFacilities management costallocated to processing =(15,000 ÷ 18,000) × £1,260,000 = £1,050,000Facilities management costallocated to assembly =(3,000 ÷ 18,000) × £1,260,000 = £210,000
  23. 23. Direct MethodHuman resources costallocated to processing =(16 ÷ 80) × £240,000 = £48,000Human resources costallocated to assembly =(64 ÷ 80) × £240,000 = £192,000
  24. 24. Step-Down MethodTo human resources:(9 ÷ 27) × £1,260,000 = £420,000To processing:(15 ÷ 27) × £1,260,000 = £700,000To assembly:(3 ÷ 27) × £1,260,000 = £140,000
  25. 25. Step-Down Method£240,000 + £420,000 = £660,000To processing:(16 ÷ 80) × £660,000 = £132,000To assembly:(64 ÷ 80) × £660,000 = £528,000
  26. 26. Step-Down Method Processing department Direct Step-DownDirect department costs £1,000,000 £1,000,000From facilities management 1,050,00 700,000From Personnel 48,000 132,000Total costs £2,098,000 £1,832,000
  27. 27. Step-Down Method Assembly department Direct Step-DownDirect department costs £1,600,000 £1,600,000From facilities management 210,000 140,000From personnel 192,000 528,000Total costs £2,002,000 £2,268,000
  28. 28. Costs Not Related to Cost Drivers Identify additional cost drivers. Allocate all costs by the direct or step-down method using square footage as the cost- allocation base.
  29. 29. LearningObjective 4 Traditional Approach 1. Divide the costs in each producing departments. Direct costs Indirect costs 2. Assign direct costs to the appropriate products, services, or customers.
  30. 30. Traditional Approach3. Select one or more cost pools and relatedcost drivers in each production department.Indirect departmental costs Cost Cost Cost pool pool pool
  31. 31. Traditional Approach 4. Allocate costs CostsProduct Product ProductA B C
  32. 32. Activity-Based CostingStep 1:Determine the keycomponents of the system.Step 2:Develop the relationships amongresources, activities, and cost objectives.
  33. 33. Activity-Based Costing Step 3: Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities.Step 4: Calculate and interpret the new activity-based cost information.
  34. 34. LearningObjective 5 Allocation of Customer Costs Allocate costs associated with customer actions to customers. Customer profitability depends on more than gross margin, it depends on the costs incurred to fulfill customer orders and to provide other customer services.
  35. 35. Allocation of Customer Costs Customer Type 1 Customer Type 2 High Cost Low Cost to Serve to Serve  Small order quantity Large order quantity  Many order changes Few order changes  Large amounts of pre- Little pre- and and post-sales support post-sales support  Expedited scheduling Regular scheduling  Special delivery requirements Standard delivery  Frequent returns Few returns
  36. 36. Allocation of Customer Costs Customer Type 1 Customer Type 2 High Cost to Serve Low Cost to Serve Buys a mix of products that  Buys a mix of products have high gross margins that Has a low cost-to-serve % have lower gross margins Has a high level of  Has a high cost-to-serve %profitability  Has a low level of profitability
  37. 37. Allocation of Customer CostsAssume Cedar City Distributors (CCD), distributes many productsto retail outlets.The products are classified into just two product groups – apparel andsports gear. CCD has two types of customers: 1. Small store 2. Large store
  38. 38. Allocation of Customer Costs CCD uses a simple cost accounting system to calculate both product and customer profitability.The only direct costs are costs Indirect costs areof the purchase of apparel allocated to the productand sports gear products. groups using a single indirect cost pool for all indirect costs with “pounds of product” as Costs the allocation base.
  39. 39. Allocation of Customer CostsTo determine customer profitability:1. Calculate the profit margin per case for each product2. Use the product mix ordered by each customer to calculate profitability Small Stores Large Stores Cases Profit Margin Total Cases Profit Margin Total per case Profit Margin per case Profit MarginApparel 600 £265.00 £159,000 800 £265.00 £212,000Sports Gear 200 315.00 63,000 800 315.00 252,000 222,000 464,000Profit Margin Percentage 43.7% 41.4%
  40. 40. Allocation of Costs-to-ServeMight number of customer orders be a more plausible cost-allocation base?The cost of resources used for order processing and customer serviceactivities should be included in a separate cost pool and allocated on thebasis of number of orders. This system gives managers at CCD more insight into operations, and a tool to measure and manage customer profitability.
  41. 41. LearningObjective 6 Allocation of Central Costs Many managers believe it is desirable to fully allocate all costs to the revenue- producing parts of the organization. Whenever possible, the preferred driver for central services is usage. If a company does allocate the costs of central services based on sales, although costs do not vary in proportion to sales, it should use budgeted, not actual, sales.
  42. 42. Allocation of Central Costs Usage Not always economically viable Revenue Total assets Cost of goods sold Total cost of each division
  43. 43. LearningObjective 7 Allocation of Joint Costs Two conventional ways of allocating joint costs to products are widely used: Physical Relative units sales values Joint costs include all inputs of material, labor, and overhead costs that are incurred before the split-off point.
  44. 44. Allocation of Joint CostsThe physical-units The joint costs aremethod requires a allocated based oncommon physical each product’sunit for measuring percentage of thethe output of each total physicalproduct. units produced. Allocation of joint costs should not affect decisions about the individual products.
  45. 45. Physical-Units MethodDow Chemical produces two chemicals, X and Y. The jointcost is £100,000. X sells for £.09 per liter and Y for £.06. Allocation Sales Value at Liters Weighting of Joint Costs Split-off PointX 1,000,000 (10/15)X£100,000 £ 66,667 £ 90,000Y 500,000 (5/15)X£100,000 33,333 30,000 1,500,000 100,000 120,000
  46. 46. Relative-Sales-Value Method The joint costs are allocated based on each product’s sales value as a percentage of the total sales value at split-off.
  47. 47. Relative-Sales-Value MethodWhen weighting is based on the sales value of theindividual products, the allocation of a cost to one productdepends upon the sales value of both products. Relative Sales Value at Allocation Spit-off Point Weighting of Joint Costs X £ 90,000 (90/120)X£100,000 £ 75,000 Y 30,000 (30/120X£100,000 25,000 £120,000 £100,000
  48. 48. By-Product CostsA by-product is not individuallyidentifiable until manufacturingreaches a split-off point.They have relatively insignificantsales value.
  49. 49. By-Product CostsIf an item is accounted for as aby-product, only separablecosts are allocated to it.All joint costs are allocatedto the main products.Any revenues from by-products, lesstheir separable costs, are deductedfrom the cost of the main products.