Prepared by Debby Bloom-Hill CMA, CFM

Activity-Based Costing CHAPTER 6 Cost Allocation & Activity-Based Costing

Purposes of Cost Allocation

Process of Cost Allocation Cost allocation is achieved by a three step process: Determine the cost objective. Form cost pools. Select an allocation base to relate cost pools to the cost objective.

Allocating Service Department Costs Organizational units of manufacturing firms classified as either: Production departments: Engage in direct manufacturing activity. Service departments: Provide indirect support. Cost pools: Formed by service departments. Allocated to production departments.

Direct Method of Allocating Service Department Costs Service department costs allocated to production departments but not to other service departments:

Direct Method – Mason Furniture Allocate janitorial cost of $100,000. Allocation base: square feet Assembly department: 20,000 square feet Finishing department: 30,000 square feet Calculate the allocation rate: $100,000 / (20,000 + 30,000) = $2/sq ft Allocation to production departments: Assembly dept.:20,000 sq ft x $2 = $40,000 Finishing dept.: 30,000 sq ft x $2 = $60,000

Direct Method – Mason Furniture Allocate personnel cost of $200,000. Allocation base: number of employees. Assembly department: 60 employees Finishing department: 40 employees Calculate the allocation rate: $200,000 / (60 + 40) = $2,000/employee Allocation to Production Departments. Assembly dept: 60 x $2,000 = $120,000 Finishing dept: 40 x $2,000 = $80,000

Direct Method – Mason Furniture

Allocating Budgeted and Actual Service Department Costs Management should allocate based on budgeted rather than actual costs. Allocation of actual amounts allows service department to pass on cost of inefficiencies and waste to production departments.

Problems with Cost Allocation Potential problems are brought about by: Allocations of costs that are not controllable. Arbitrary allocations. Allocation of fixed costs that make the fixed costs appear to be variable costs. Allocations of manufacturing overhead to products using too few overhead cost pools. Use of only volume-related allocation bases.

Activity-Based Costing (ABC) Using the ABC approach, companies identify major activities that cause overhead costs to be incurred. Some activities are related to production volume, some are not. The cost of resources consumed performing these activities are grouped into cost pools. Costs are assigned to products using a measure of activity referred to as a cost driver.

The ABC Approach

Common Activities and Associated Cost Drivers

Pros and Cons of ABC Pros: Less likely to undercost complex low volume products and overcost simple high volume products. Drivers used in ABC are not always volume related. ABC may lead to improvements in cost control. Costs are not buried in one or two pools.

Pros and Cons of ABC Cons: More costly to develop and maintain than a traditional costing system. Allocations are made from each cost pool to each product. Used to develop full cost of products. Includes fixed costs. Lacks incremental information necessary for decision making.

Activity-Based Management

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