This document discusses cost allocation, which refers to assigning indirect costs to cost objects with the aim of ensuring all organizational costs are reflected in product pricing and financial reporting. Key concepts include direct and indirect costs, cost objects, cost pools, and the benefits of cost allocation for decision-making, fairness, and financial accuracy. It also outlines manufacturing overhead allocation processes and introduces traditional and activity-based costing methods for more accurate product cost assessment.

1. CHAPTER-3
COST ALLOCATION
1

2. Cost allocation
 Cost allocation refers to the assignment of all indirect costs to a
cost object using an allocation base.
 The ultimate goal of cost allocation is to make certain that all
costs incurred by the organization finally are assigned to its
products or services.
 This is important for several purposes including;
 cost based pricing, bidding, cost reimbursement
(return) from outside parties like insurance
companies, valuation of inventory, determination of
income and all other economic decisions.
 The allocation of all costs to departments serves to make
departmental managers aware of the cost incurred.
2

3. Product cost Elements
 Also called inventoriable costs.
 Classified in to three:
 Direct material cost
 Direct labor cost
 Manufacturing overhead costs (indirect costs)
 Direct costs are costs that are conveniently and economically
traced to a specific cost object.
 Direct materials and Direct labor costs are
referred as direct cost.
 Indirect costs are costs that cannot be conveniently or
economically traced to a specific cost object.
 Any production cost not classified as a direct cost
is an indirect cost. 3

4. Direct
Materials
Direct
Labor
Assigned
Overhead
Traceable
Unit Cost
for Finished
Goods
Allocation
Mfg. Process
(Work in
Process)
Estimated Overhead
POR = --------------------------
Estimated Units in Activity Base
Solution?
4

5. Cost allocation and related terms
 Cost Allocation: the process of assigning or applying collected
(all) indirect costs to cost objects using an allocation base.
 Cost object: is the destination of all assigned or allocated
costs.
 E.g. a cost may be assigned to a particular product, service or
department.
 Cost pool: is a collection of overhead costs related to a cost
object (a product related activity).
 Cost driver: is an activity that causes the cost pool to change
(increase/decrease) in amount as the cost driver changes
(increase/decrease) in volume.
5

6. Purposes of cost allocation
 To provide information for economic decisions:
 For making economic decisions like add a new product to
existing product, make or buy a product, and pricing of a
product true cost is required.
 The true cost can be arrived only if the MoH costs are
properly and correctly assigned to a product.
 To motivate mangers and other employees:
 To encourage the design of products that is simpler to
manufacture or less costly to service.
 To encourage sales representatives to increase high profit
margin product or services.
6

7.  To justify costs for fair pricing and reimbursement:
 To fix the fair price for a product, the true costs are to be
arrived.
 To get reimbursement for a consulting firm, the correct and
true costs are to be arrived.
 To measure income and assets for reporting to external
parties:
 The true cost of product enables the management;
 to measure the costs of inventory and cost of goods sold.
 to report inventories correctly in financial reporting.
 to cost inventories for reporting to tax authorities.
7

8. Criteria to guide cost allocation decisions
 While allocating cost to different units or products or some other
cost objects, there should be some criteria to be followed.
Cause and Effect
 The managers should identify the variable or variables that
cause resources to be consumed.
Example, Managers may use hours of testing as the variable
when allocating the costs of quality testing area to products.
 Cost allocation based on the cause and effect criterion are
likely to be the most credible to operating personnel.
8

9. Benefits Received
 The mangers should identify the beneficiaries of the outputs
of the cost object.
 The costs of the cost object are allocated among the
beneficiaries in proportion to the benefits receives.
Example, corporate wide advertising program that promotes the
general image of the corporation rather than any individual
product.
 The costs of this program may be allocated on the basis of
division revenues.
 The higher the revenues, the higher the division’s allocated
cost of the advertising program.
9

10. Fairness or Equity
 Is often cited in government contracts when cost allocations are
the basis for establishing a price satisfactory to the government
and its suppliers.
 Cost allocation here is viewed as a “reasonable” or “fair”
means of establishing a selling price in the minds of the
contracting parties.
Ability to bear
 This criterion advocates allocating costs in proportion to the
cost objects ability to bear them.
Example; the allocation of corporate executive salaries on
the basis of division operating income.
 The assumption is that the more profitable divisions have a
greater ability to absorb corporate headquarters’ costs.
10

11. Manufacturing overhead allocation process stages
 There are four stages involved in the process of allocating MoH
cost to products or services.
1. Planning stage: In this stage, manufacturing overhead costs are
estimated and an application rate is calculated.
 A predetermined overhead rate is calculated in traditional
settings and activity pool rate is calculated in activity based
costing settings.
 If a rate is calculated before an accounting period begins,
managers can better estimate the product costs by applying
MoH costs to all units during the year.
 No journal entry is required during this stage.
11

12. 2. Application step: In this step, the estimated manufacturing
overhead costs are assigned to the products costs as units are
manufactured.
 The actual cost driver level (for example, the actual number of
direct labor hours used to complete the product) is multiplied by
the predetermined manufacturing overhead rate or activity
pool rate for that cost driver.
 The following entry is required in this step.
Work in process inventory ………….. xxx
Manufacturing overhead ………….. Xxx
Applied manufacturing Actual cost Predetermined
manufacturing
overhead cost = driver level X overhead rate
12

13.  Example, assume Afro company has incurred 78,000 birr direct
labor cost for the month of April and from past experience of the
company, the manufacturing overhead cost rate is 80% of direct
labor costs.
 Thus, the journal entry to apply the manufacturing costs is:
Work in process inventory…………..62,400
Manufacturing overhead ……………..
62,400
 This implies the overhead costs applied are birr 62,400.
13

14. 3. Recording step: In this step, the actual manufacturing overhead
costs incurred during the accounting period are recorded.
 These costs will be part of the actual product cost and include the
costs of indirect materials, indirect labor, depreciation, property taxes
and other production cost.
Journal entry:
Manufacturing overhead cost……………xxx
Cash or A/p
……………………………………….xxx
 Example, the actual overhead cost incurred by Afro company in the
month of April indicates that birr 12,000 for indirect materials purchased
on account, indirect labor cost of birr 28,000 and other manufacturing
costs other than indirect materials and indirect labor are birr 28,000.
 The journal entry to record the actually incurred overhead costs is:
Manufacturing overhead cost …………. 68,000
Various accounts
………………………………68,000
(The various accounts stand for accounts payable, wages payable and other accounts like
depreciation costs, tax paid, etc.)
14

15. 4. Reconciliation step: at this step, the difference between the
applied manufacturing overhead costs and the actual overhead
costs is calculated at the end of accounting period.
 If applied manufacturing overhead is more than the actual
manufacturing overhead it is known as over-applied
overhead.
 If applied overhead is less than the actual manufacturing
overhead, it is known as under-applied overhead.
 If the difference between the applied and actual MOH is
immaterial (i.e. less in amount), both adjustments are made
to cost of goods sold.
 The following journal entry is to be made for over or under
applied manufacturing overhead.
For over-applied
Manufacturing overhead …………….. xxx
Cost of goods sold ……………………………xxx
15

16. For under-applied
Cost of goods sold ………………..xxx
Manufacturing overhead cost…………………xxx
 However, if the over or under-applied overhead is material (i.e.
more) the adjustments are made not only to cost of goods sold
but also to work in process inventory and finished goods
inventory.
 Because, the materiality of the over applied or under applied has
a material effect on not only cost of goods sold but also on
working in process and finished goods.
Example, based on step 2 & 3 before, the applied
overhead cost is birr 62,400 and the actual overhead
cost incurred is birr 68,000, therefore, there is under-
application of overhead costs by birr 5,600 and
assume the under-applied overhead cost is immaterial
(i.e., the amount is not significant).
 The journal entry to record the under-applied overhead is: 16

17.  However, if the under-applied overhead is material, the
adjustment should be to cost of goods sold, work in process and
finished goods based on their ending balances.
 Assume at the end of April, the Afro Company has birr 50,000 work
in process, birr 30,000 finished goods reported in its balance sheet
and birr 120,000 cost of goods sold reported in its income
statement.
 Accordingly, the under-applied is allocated to the three accounts
as follows: Cost of goods sold ………3,360
Work in process ………..1,400
Finished goods ……………840
MoH cost
……………………..…5,600
17

18. Manufacturing overhead allocation
Using the Traditional approach and Activity based
1. Traditional Approach
 A single predetermined overhead rate is used by many
organizations for the application of manufacturing overhead.
 This method is useful if companies manufacture only one
product or two very similar products that require the same
production related activities such as set up, inspection and
material handling.
 The total MoH cost represent one cost pool and a traditional
activity base, such as direct labor hours, direct labor costs,
machine hours or unit of production, become the cost driver.
 The calculation of the predetermined overhead costs rate under
the traditional approach is based on the budgeted cost as a
numerator and the budgeted allocation base as denominator.
18

19.  However, the application of manufacturing overhead costs to the
products is based on the actual usage, i.e., the budgeted rate
multiplied by the actual usage of the allocation base or cost driver
by each product or batch of product.
 Example: Assume Philips TV set manufacturer
producing 14” and 21” color TV sets.
 They are using the application of one cost pool of
manufacturing overhead costs to two product
lines.
 Suppose the Philips set manufactures choose
machine hours as the cost driver.
 For the next year, the overhead cost will amount to
$300,000 and that total machine hours worked will
be 30,000 hours.
 The corporation supplied the following data for the two
product lines:
14 inch 21 inch
Actual direct materials cost/unit $ 70 $ 80
Actual direct labor cost/unit 30 40
Prime cost per unit 100 120
19

20. Required: Using Traditional Approach
a) Compute the predetermined overhead rate
b) Apply manufacturing overhead to the products
Step1. Compute the predetermined overhead rate
20

21. Step 2: Apply manufacturing overhead to the products.
 Assume, during the year 10,000 machine hours were used to
produce 5000, 14-inch TV sets and 20,000 machine hours were
used to produce 4000, 21-inch TV sets.
 Philips Corporation used the predetermined overhead rate,
 the portion of MoH cost applied to the 14-inch TV sets = $100,000
($10 x 10,000 MHrs) or $20 per unit ($100,000/ 5,000units) and
 the portion of MoH cost applied to 21-inch TV sets totaled =
$200,000 ($10 x 20,000 MHrs) or $50 per unit ($200,000/
4000units)
14 inch 21 inch
Cost drive
level
Cost applied Cost drive level Cost applied
Overhead cost applied:
Manufacturing overhead rate:
$10/MHrs
x 10,000MHrs $100,000 X 20,000MHrs $200,000
Number of units 5,000 units 4,000units
Manufacturing overhead cost
per unit
$ 20 $ 50
21

22.  Philips Corporation also wanted to calculate the normal
product unit cost during the accounting period.
 The 21-inch product unit cost of $170 is higher than the 14-inch
product unit cost of $120 because the 21-inch TV set required
more materials that are expensive and more machines time.
Product unit Cost for each product line is
14inch 21inch
Direct Materials $70 $80
Direct labor 30 40
Manufacturing overhead 20 50
Product unit cost 120 170
22

23. 2. Activity Based costing (ABC)
 Activity–Based Costing (ABC) is a method of assigning costs
that calculates a more accurate product cost by categorizing
all indirect costs by activity, tracing the indirect costs to
those activities and assigning activity costs to product using
cost driver that are related to the cause of the product.
 ABC identifies production-related activities, events and
circumstances that cause, or drive those activities, such as
number of inspections, number of moves or maintenance hours.
 As a result, many smaller activity pools are created based on
their similarity to obtain more accurate product costs.
 ABC will improve the accuracy of product costs for
organizations that sell many different types of products
(product diversity).
23

24.  It would provide managers with better information for making
decisions related to fixing selling prices, determination of accurate
income, ask compensation, tax refunds, inventory valuation and make
or buy decisions.
 Avoids understatement or overstatement of income and
inventory valuation through accurate costs of products or
services
 The manager will calculate a predetermined overhead rate or
activity cost rate, for each activity pool and then use that rate
and a cost driver amount to determine the portion of
manufacturing overhead costs to assign to a product.
 Example: refer the above example and observe how activities
and costs are pooled in to different activity pools and activity
cost pools and how costs are allocated under the Activity Based
Costing Approach in the following illustration
24

25. Philips Corporation analyzed the production related activities and
decided that the estimated $300,000 in manufacturing overhead
cost should be grouped into four activity pools.
 The first activity, setup, includes estimated total costs of
$100,000 for indirect labor and indirect materials used in
preparing machines for each batch of production.
 The second activity, inspection, includes $90,000 for salaries
and costs of indirect materials, indirect labor and depreciation
on testing equipment.
 Packaging, the third activity, includes estimated total costs of $
65,000 for indirect materials, indirect labor and equipment
depreciation.
 The last activity, building, includes, estimated total cost
$45,000 for wages, property taxes, insurance, security and all
other costs not related to the first three activities.
25

26.  After identifying the four activity pools, Philips Corporation
selected a cost driver and estimated the cost driver level for
each activity pool.
 The following schedule shows those amounts by product line and in
total.
Estimated Cost Driver
Level per activity
Cost driver Total 14inch 21inch
26
Expected Cost Driver
Level per product

27. Step 1: Calculate activity cost rate using ABC Approach
Activity
Pool
Estimated
Activity
pool
amount
Cost
Driver
Budgeted Cost
driver level Activity cost
rate
Set up $100,000 No. of set
ups
1,000 setups $100 per setup
Inspection 90,000 No. of
inspections
600
inspections
$150 per inspection
Packaging 65,000 Packaging
hours
2,500 packing
hours
$26 per packing
hour
Building 45,000 Machine
hours
30,000Machin
e hours
$1.5 per machine
hour
27

28. Step 2: Application of manufacturing overhead costs to
production:
 In applying the MoH to the products, the activity pool rate is
multiplied by the actual cost driver used by the products.
14 inch 21 inch
Activity
pool
Activity cost
rate
Cost
Driver
level
Cost
applied
Cost
Driver
level
Cost
applied
Set up $100 per set
up
*500 set
ups
$ 50,000 *500 set
ups
$50,000
Inspect
ion
$150 per
inspection
*250
inspection
$ 37,500 *350
inspection
s
$52,500
Packin
g
$26 per
packing hour
*1,200
packing
hour
$31,200 *1,300
packing
hour
$33,800
Buildin $1.5 per *14,000 $21,000 *16,000 $24,000
Cost applied = Activity cost pool rate x actual cost driver
level
28

29. Product Unit Cost
14inch 21inch
Product cost per unit:
Direct materials $ 70 $ 80
Direct labor 30 40
Manufacturing overhead 28 40
Product unit cost 128 160
14-inch
21-inch
Product unit cost:
One MoH Cost pool (traditional approach). $ 120 $ 170
Product unit cost: (ABC with four activity pools) $ 128
$ 160
Differences: Decrease (increase) $ (8)
$ 10
 Management accountant presented the following information
to Philips Corporation using two approaches
29

30. Allocating corporate costs to divisions and products
 Corporate costs are costs that are incurred at the corporate level
(administration level of the organization).
 There are several choices in accumulating and allocating
corporate costs to divisions and products.
 The essence of accumulating and allocating overhead costs is
different in different organization.
Some of these are presented as below:
1) Some companies allocate all corporate costs to
divisions
 They maintain that corporate costs are incurred to support the
activities of the divisions.
 In this case, companies that want to calculate the full cost of
products must allocate corporate costs to activity-cost pools
of divisions 30

31. 2. Other companies do not allocate corporate costs to
divisions.
 They maintain that division managers generally have no say
or role in incurring corporate costs.
3. Still other companies allocate only those corporate costs,
such as corporate human resources costs, for which there is
widespread agreement that they are either
causally/fundamentally/ relate to division activities or they
provide explicit benefits to divisions.
 These companies exclude corporate costs such as corporate
donations to the charitable foundations because
 division manager often have no say in making these
decisions.
 these benefits to the divisions are less evident or too remote.
31

32. Why do we allocate corporate costs and other support
costs to divisions and departments?
a) To remind profit center managers that indirect costs exists and that
profit center earnings must be adequate to cover some share of
corporate cost as well as their costs.
b) To encourage use of central services that would otherwise be
underutilized; and
c) To stimulate profit - center managers’ to put pressure on central
manager to control service costs.
 Other different studies cited the following objectives, ranked in order of
importance, for allocating costs to divisions and departments: -
a. to determine costs
b. to evaluate profit centers
c. to fix accountability
d. to allocate costs per unit of usage
e. to promote more effective resources usage and
f. to foster cost awareness
32

33.  In most manufacturing and non-manufacturing organizations,
corporate costs are grouped in to three major categories of
costs.
 These are:
1) Treasury costs:- interest on debt used to finance the
construction of new assembly equipment divisions.
2) Human resource management costs:- recruitment
and ongoing employee training and development .
3) Corporate administration costs:- executive salaries,
rent and general administration costs.
 Thus, corporate overhead costs can be allocated to products by
establishing its own activity pool cost.
33

34. Allocating costs from one department to another
Why costs of one department are allocated to another department?
 Cost of a central department which emerges to give service for
other departments centrally are incurred only because it provides
service to these departments or divisions.
 Accordingly, the costs of this department should be allocated to
the departments or divisions that are directly involved in the
production process or accomplishments of activities to ascertain
the actual costs of the activities or products.
 The issues of allocating costs from a corporate department to
divisions are to be:
 Whether different methods of allocation be used for fixed costs and
variable costs
 Whether budgeted rates or actual rates be used
 Whether budgeted quantities or actual quantities is used.
34

35. Single Rate and Dual Rate Methods
 Single-rate cost allocation method
 Pools all costs in one 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 behaviors (such as fixed cost vs. variable
costs).
 Merits of single rate method:
 This method is low cost of implementation.
 It avoids the often-expensive analysis to classify the
individual cost items of a department into fixed and
variable categories.
 Demerit:
 Leads division managers to make out sourcing
decisions which are not in the best interest of the
organization as a whole. 35

36.  The dual- rate cost allocation method
 Classify costs in each cost pool into two sub-cost pools (a
variable cost sub-pool and a fixed cost sub-pool).
 When the dual rate method is used, allocation bases must be
chosen for each cost pool.
 Assume that the budgeted rates are used, the allocation
quantities chosen are budgeted usage for fixed costs and
actual usage for variable costs.
 Merit: This method indicates to division managers;
 how variable costs and fixed costs behave differently.
 to make decisions that benefit the organization as a whole
as well as each division.
36

37. Budgeted Vs Actual Rates
Budgeted Rates:
 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.
 Budgeted rates let the user departments know in advance the
cost rates they will be charged.
 Users are then better equipped to determine the amount of the
service to request and if the option exists whether to use the
internal department source or an external vendor.
 Budgeted rates also help to motivate the manager of the
supplier department to improve efficiency.
 As inefficiencies at the department providing the service do not
affect the costs allocated to the user department.
37

38. Actual Rates:
 In contrast, when actual rates are used, the user departments
will not know the rates charged until the end of the period.
 Since actual costs and actual allocation bases are known only
when they are actually incurred and actually used, actual
rates are determined after these items are known.
 Therefore, managers will not have an insight in advance about
these until the actual costs are incurred, whereas, budgeted
rates are known in advance since they are determined using
budgeted costs and budgeted usages.
38

39. Example:
 Dell Computer Corporation has a central computer
department.
 This department has only two users–Dell- Microcomputer
division and Dell peripheral equipment division.
The following data apply to the coming budget year:
Fixed costs of operating the computer facility in the 4000
to 12000 hours= $4,000,000 per annum relevant range
Total capacity available…………………………..…….=
12,000 hours
Budgeted long run usage………………………………=
10,000 hours
Microcomputer Division…………………………=
7,500 hours
Peripheral Equipment Division……………………=
2,500 hours
Budgeted variable cost per hour (4000 to 12000 hours
39

40. You are required to calculate:
a) Under single rate method (assuming budgeted usage is
the allocation base and budgeted rates are used)
i. Total cost pool
ii. Budgeted total rate per hour.
iii. Total cost allocated to Microcomputer division
iv. Total cost allocated to peripheral Division
b) Under Dual Rate Method (Budgeted usage for fixed costs
and actual usage for variable costs)
i. Total fixed cost for microcomputer division
ii. Total fixed cost for peripheral equipment division
iii. Total cost allocated to microcomputer division
iv. Total cost allocated to peripheral division.
Note: Assuming that during the coming year the microcomputer
division actually uses 8000 hours and peripheral equipment division
2000 hours.
40

41. Solution:
a) Under Single Rate Method:
(i) Calculation of total cost pool:
Fixed cost (Budgeted) for the year……….=$ 4,000,000
Variable cost @ $300 per hour for
10,000 budgeted hours ……………….= 3,000,000
=$ 7,000,000 per annum
ii) Calculation of Budgeted rate per hour:
Budgeted total cost pool………………= 7,000,000 per
annum
Budgeted total hours…………………..= 10,000 hours
Budgeted rate per hour = 7,000,000/10,000
= $700 per hour used.
41

42. i) Calculation of Total cost allocated to Microcomputer Division:
Budgeted rate per hour …………………..= $ 700
Actual usage…………………………………….= 8,000 hours.
Total cost allocated…………………………..= 8000 hrs @700
per hour
=$ 5,600,000
ii) Calculation of total cost allocated to Peripheral equipment
division:
Budgeted rate per hour …………………..= $ 700
Actual usage……………………………………= 2000 hours
Total cost allocated………………………….= 2000 hrs@ 700
per hour
= $ 1,400,000
42

43. B) Under Dual Rate Method:
(i) Calculation of fixed cost for Microcomputer Division:-
Total fixed cost (for 10,000hrs)……………….= $ 4,000,000
P.a.
Total fixed cost for budgeted hours
of 7,500 hours………………………………....=
4,000,000 x
= $3,000,000
(ii) Calculation of fixed cost for Peripheral equipment Division:-
Total fixed cost (for 10,000hrs)……………….= $ 4,000,000
P.a.
Total fixed cost for budgeted hours
of 2,500 hours…………………………….…..= 4,000,000
x
= $1,000,000
000
,
10
7500
000
,
10
2500
43

44. (iii). Calculation of total cost allocated to microcomputer
division
Fixed cost allocated……………………………… = $
3,000,000.
Variable cost @300 per hour
for 8000 actual hours…………………………=
2,400,000
Total cost allocation………………………………= $
5,400,000
(iv). Calculation of total cost allocated to peripheral division:
Fixed cost allocated…………………………………..= $
1,000,000
Variable cost @300 per hour
for 2000 actual hours…………………………….=
600,000
Total cost………………………………………………..=
1,600,000
44

45. Allocating costs of support (service) departments
 How costs of support departments are allocated (assigned)
to operating departments?
 Departments in an organization can be divided into two
broad classes: Operating and Support (service)
departments.
 In almost many manufacturing and non-manufacturing
organizations, service departments are important in
providing support services to many of the productive
(operating) departments.
Operating Department and Support Departments:
 Operating department: is also called production department
in manufacturing companies.
 is a department that is directly involved in the production of
goods and services and adds value to a product or service
that is observable by a customer. 45

46.  Example include the surgery department in a hospital; the
undergraduate and graduate programs in a university;
various flight groups in an airline;
 Production department such as milling, assembly, and
painting in a manufacturing company, etc.
 Support department: It is also called service department.
 A support department provides the services to other internal
departments (operating and other support departments) in
the organization.
 Support department does provide a service that enables the
organization’s production process to takes place.
 In order to determine the cost of those goods or services, all
service department costs must be allocated to the production
departments in which the goods or services are produced.
46

47.  Support departments create special cost allocation problems
when they provide reciprocal support to each other.
 The reciprocal services rendered by one service department
to other service department are to be recognized.
 More accurate support department cost allocations results in
more accurate product, service and customer costs.
 Examples: Human resource departments, plant and equipment
departments, information systems, maintenance department, etc.
 Assume the maintenance department in an automobile plant,
it does not make automobiles, but if it does not exist, the
production process would stop when the manufacturing
machines broke down.
47

48. Effect of service department costs on products and services
 Service department cost are allocated to operating department
 Operating department overhead costs, plus allocated service
department costs, are applied to products and services by means
of departmental overhead rates
Service
department-I
Service
department-II
Service
department-III
Operating
department-A
Operating
department-B
Product or
service costs
48

49. Methods of Cost Allocation
 To recognize and allocate service department costs, there are
three different methods to be followed.
 These are direct method, step-down method and reciprocal
method
1. Direct Method:
 Is the most widely used method allocates each support
department’s costs directly to the operating departments.
 It ignores any reciprocal services among support
departments (it ignores the services provided by service
departments to another service departments).
49

50.  Its advantage is its simplicity.
 There is no need to predict the usage of support department
services by other support department.
 Its disadvantage is its failure to recognize reciprocal
services provided among support departments.
Manufacturing
Information Systems
Accounting
Packaging
Support Departments Production Departments
50

51.  Example
 Assume we are given the following information by Agora
manufacturing company: this example will help us to allocate
all support (Service) department costs under all methods (Direct
method, step-down method and reciprocal method)
51

52. 30/80
10/90
0% 0%
Support
Departments
Operating
Departments
$4,000,000
Machining
$2,000,000
Assembly
Maintenance
$6,300,000
Information System
$1,452,150
3/31/2022 Mekonnen K. 52

53. Solution: Direct allocation method
$6, 300,000 ×
30
30+50
= $2,362,500
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54. 3/31/2022 Mekonnen K. 54

55. 2. Step-Down Method
 Also called the sequential allocation method
 Allocates support-department costs to other support departments
and to operating departments in a sequential manner
 (begins with the support department that renders the
highest percentage of its total services to other
support department, followed by the next highest
percentage of total service and ending with the
lowest percentage of total services to other support
departments).
 Partially recognizes the services rendered by support
departments to other support departments.
 Once a support department’s costs have been allocated, no
subsequent support department’s costs are allocated back to it
rather goes down ward to other support and operating
departments.
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56. Manufacturing
Information Systems
Accounting
Packaging
Support Departments Production Departments
3/31/2022 Mekonnen K. 56

57. Support
Departments
Operating
Departments
$4,000,000
Machining
$2,000,000
Assembly
30%
10/90
20% 0%
Maintenance
$6,300,000
Information System
$1,452,150
3/31/2022 Mekonnen K. 57

58. $2,712,150 ×
10
10+80 = $301,350
$ 2,712,150 ×
80
10+80 = $2,410,800
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59. 3/31/2022 Mekonnen K. 59

60. 3. Reciprocal Method
 The reciprocal allocation method allocates costs including
the mutual services provided among all support
departments.
 Reciprocal method fully incorporates interdepartmental
relationships into the support-department cost allocation.
 The direct method and the step down method are less
accurate than the reciprocal method when support
departments provide services to one another reciprocally.
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61. Manufacturing
Information Systems
Accounting
Packaging
Support Departments Production Departments
Implementing the reciprocal allocation method requires the following
three steps:
Step 1: Express support department costs and support
department reciprocal relationships in the form of linear
equations.
Step 2: Solve the set of linear equations to obtain the complete
reciprocal costs of each department
Step 3: Allocate the complete reciprocal costs each support
department to all other departments (both support
departments and operating departments) based on the
usage percentages (Based on the total units of service
3/31/2022 Mekonnen K. 61

62. 30%
10%
20% 10%
Support
Departments
Operating
Departments
$4,000,000
Machining
$2,000,000
Assembly
Maintenance
$6,300,000
Information System
$1,452,150
3/31/2022 Mekonnen K. 62

63. C. $2,767,500 ×
10
10+80+10
= $276,750
B. $6, 576,750 ×
20
20+30+50
= $1,315,350
0.1[$1,452,150+0.2X ] = $6,576,750
A. X=$6, 300,000 +
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64. Items Total
Operating Depts. Support Depts.
Machinin
g
Assembl
y
Maintena
nce
Informatio
n system
Budgeted
MOH
(amounts are
given in birr)
13,752,150 4,000,000 2,000,000 6,300,000 1,452,150
Allocation of
Maintenance ,
3:5:2
1,973,025 3,288,375
(-) 276,
750
1,315,350
Information
system, 8:1:1 2,214,000 276,750 276, 750 (-) 1, 315,350
Total 3,752,150 8,187,025 5,565,125 0 0
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65. Allocation of Manufacturing Overhead to Products
 Once the service departments MoH costs are distributed to the
operating departments, then they are to be allocated to products
produced by the concerned departments (operating
departments).
 For this purpose, two steps are to be followed
i. Computing overhead rate (either machine hour, or
direct labor hour or any other suitable base it to be
calculated) and
ii. Apply the overhead rate to the products by
multiplying the overhead rate calculated in step no.1
by machine hours taken or direct labor hours taken by
the production department.
MoH applied = Overhead rate X machine hr or DL hrs taken
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66. Example: The manufacturing overhead after reallocating service
department overhead costs to production departments are (all
amounts are given in birr):
Dept Direct method Step down method Reciprocal
method
Machining 7,653,300 8,300,800 8,187,025
Assembly 6,089,850 5,451,350 5,565,125
 The budgeted machine hours for machining department
are 10000 hours and direct labor hours for assembly
department are 7000 hours.
 Compute the manufacturing overhead rate for
machining department and Assembly department and
also calculate manufacturing overhead charged to a
product consuming 1000 machine hours for plant
machining department and 500 direct labor hours for
assembly departments under three methods.
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67. Solution:
a) Computation of overhead rate
Support depts.
Allocation
Method
Total Budgeted
MOH after reallocation of
support departments
Budgeted overhead rate per
hour for product costing
purposes
Machining Assembly Machining
(10000 hours)
Assembly
(7000 hours)
Direct 7,653,300 6,089,850 765.00
(7,653,300/10000)
870.00
(6,089,850/7000)
Step down 8,300,800 5,451,350 830.00 778.00
Reciprocal 8,187,025 5,565,125 818.00 795.00
b) Allocation of manufacturing overhead to products.
Allocation Methods
Direct method Step method Reciprocal method
Machining 1000hrs x 765 =
765,000
1000hrs x 830 =
830,000
1000hrs x 818 =
818,000
Assembly: 500hrs x 870 =
435,000
500hrs x 778 =
389,000
500hrs x 795 =
397,500
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68. Methods of Allocating Common Costs
 A common cost is a cost of operating a facility, activity or like
cost object that is shared by two or more users.
 There are two methods to be followed to allocate among or
between prospective users.
a) Stand alone cost- Allocation Method:
 This uses information pertaining to each user of a cost object
as a separate entity to determine the cost allocation weights.
 Fairness occurs because each employer bears a proportionate
share of total costs in relation to their individual stand–alone
costs.
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69. b) Incremental Cost –Allocation Method:
 The incremental cost-allocation method ranks (may be based on
order of dates etc) the individual users of a cost object and then
uses this ranking to allocate costs among those users.
 The first ranked user is termed the primary party and is
allocated costs up to the costs of the primary party as a
stand-alone user.
 The second ranked user is termed the incremental party and
is allocated the additional cost that arises from two users
instead of only the primary user.
 Subsequent users are handled in the same manner as the
second ranked user.
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70. Example: A, B, and C are members of the first service
group. They share an apartment that has a lounge room with
the latest 50” T.V. (owns the apartment, its furniture and the
TV.)
He can subscribe to a cable television company that has the
following packages available:
A is a TV news in big way, has average interest in movies and
zero interest in sports (they are overpaid jocks)
B is a movie buff, likes sports and avoids the news (it is all
depressing anyway).
C is into sports in a big way, has average interest in news and
zero interest in movies (he always falls asleep before the
end).
They all agree that the purchase of the $110 total package is a
“win-win-win” situation.
Each of the roommates works on a different eight-hour shift at
3/31/2022 Mekonnen K. 70

71. Required
i. What criteria might be used to guide the choice about how to
allocate the $110 monthly cable fee among A, B & C?
ii. Outline two methods of allocating the $110 among A, B &
C.
Solution:
1) There are four criteria can be used to allocate common cost.
 They are: 1, caused and Effect, 2, Benefits received, 3, Fairness
or Equity and 4, Ability to pay.
 Cause and effect, and the benefits received criteria, especially
when the purpose of cost allocated is economic decisions or
motivation.
 Fairness and ability to bear are less frequently used criteria than
cause and effect or benefits received.
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72.  Fairness is an especially difficult criterion on which to obtain
agreement.
 The cause and effect criterion is the primary one in activity
based costing applications.
 Fairness or Equity is advocated for this problem because the
costs allocated to A, B &C should be fair.
2) The common cost allocation is made based on the two
methods as follows:
a) Stand alone – cost allocation method: -
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73. b) Incremental Method of allocation:
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74. End of Chapter 3
3/31/2022
Mekonnen K. 74