This document discusses cost allocation theory. It defines key terms like cost objects, common costs, and allocation bases. It explains that common costs are assigned to cost objects using an allocation base, like hours or sales dollars. The goals of cost allocation include providing information for decision making, external reporting, and controlling manager behavior. The best allocation bases closely match the related costs. Insulating and noninsulating allocation schemes both aim to motivate cost reduction.

1. Cost Allocation:
Theory

2. COST ALLOCATION THEORY
 Pervasiveness of Cost Allocations
 Reasons To Allocate Costs
 Incentive/Organizational Reasons for Cost
Allocations

3. COST ALLOCATION THEORY
 A Cost object is a department, product, or process.
 A Common cost is a cost shared by two or more
cost objects.
◦ Examples: Accounting, building
maintenance, supervisors.
 Cost allocation is the assignment of
common, indirect or joint costs to cost objects.
 The Allocation base is the measure of activity used
to allocate costs.
◦ Examples: hours, floor space, sales dollars.

4. COST ALLOCATION THEORY
 1. Define the cost objects. Decide what
departments, products, or processes need to
be costed.
 2. Accumulate the common costs to be
allocated to the cost objects.
 3. Allocate the common costs to cost
objects using an allocation base.

5. COST ALLOCATION THEORY
 What corporate-level common costs are
allocated to profit centers?
◦ Most often: selling and distribution
expenses
◦ Least often: income taxes
 What allocation bases are used?
◦ Actual use (e.g. hours).
◦ Estimated use.
◦ Proration: relative proportions of
sales, profits, or assets.

6. COST ALLOCATION THEORY
 Some firms without a profit motive purchase goods
and services using cost-based contracts.
 Suppliers are paid for their costs plus a fixed
profit percentage.
 Examples: Military aircraft, university research
grants.
 Incentives: Contractors maximize the costs allocated
to cost-based contracts.
 Solution:
 Tighter regulation of cost allocation practices.
 Abandon cost-based contracts in favor of fixed-price
contracts.

7. COST ALLOCATION THEORY
 External financial reports:
◦ Allocate production costs between expenses
(expired costs, such as cost of goods sold) and
assets (unexpired costs, such as ending
inventory.)
 Income taxes:
◦ Tax laws specify when product costs can be
deducted.
 Bookkeeping costs are reduced if the same costs
are used for external and internal reporting.

8. COST ALLOCATION THEORY
 Decision Making:
◦ Managers try to reduce their use of
common resources that have high cost
allocation rates.
 Decision Control:
◦ Central executives can control the behavior
of operating managers with cost allocation
policies.
◦ Allocating more costs to a center
constrains that center from using other
resources.

9. COST ALLOCATION THEORY
 Cost allocations are economically equivalent
to taxes.
 Increasing cost allocation rates decreases
the profits of the center.
 Increasing the cost allocation rate motivates
profit-maximizing managers to use less of
the resource with higher cost allocation
rates.
 Imposing an overhead rate on sales units
decreases the optimum output of the sales
units.

10. COST ALLOCATION THEORY
 When costs are allocated, the overhead rate
is a proxy for externalities.
 Negative externalities are costs imposed on
other persons.
 Positive externalities are benefits imposed
on other persons.

11. COST ALLOCATION THEORY
 The activity measure in the allocation base should be closely
related to the cost.
 Good base: Electricity costs associated with electric meters for
each department.
 Worse base: Allocating utility costs based on floor space.
 Examples of allocation bases:
Overhead Cost Allocation Bases
 Executive salaries Time
 Central office rent Square footage
 Advertising and marketing Number of customers
 Data processing Number of transactions

12. COST ALLOCATION THEORY
 Insulating allocation scheme: The allocation base is
chosen so that the costs allocated to one division do
not depend on the operating performance of another
division.
 Example: Floor area or a fixed pre-determined rate.
 Noninsulating allocation scheme: The allocation
base is chosen so that the costs allocated to one
division does depend on the operating performance
of another division.
 Example: Share of sales or costs of each division.
 Both schemes motivate mangers to reduce waste of
common resources.

13. COST ALLOCATION THEORY
 Insulating cost allocation:
 Performance of a division does not influence rewards for
another division.
 Each division bears its own risk of events outside its control.
 Noninsulating allocation:
 Creates incentives for mutual monitoring and cooperation
because rewards depend on each other.
 Reduce risk to managers of events outside their control. If
random events are uncorrelated across divisions, then when
one division is doing poorly, the others are doing well and
bear more of the costs.