2. Cost Allocation and Activity-Based Costing
CHAPTER 6
Cost Allocation and Activity-Based Costing

3. Purposes of Cost Allocation

4. Purposes of Cost Allocation
To Provide Information for Decision Making
Allocated cost should measure the opportunity cost of using a company resource.
Difficult to operationalize
Provides a useful benchmark

5. Purposes of Cost Allocation
To Reduce Frivolous Use of Common Resources
Without allocation of costs, resources may be used for nonessential purposes
Allocation of cost provides incentive for departments to reduce frivolous use of resource

6. Purposes of Cost Allocation
To Encourage Evaluation of Services
If costs are not allocated, there is no incentive to evaluate the services
With cost allocation, there is a strong incentive to critically evaluate the efficiency and necessity of services

7. Purposes of Cost Allocation
To Provide “Full Cost” Information
GAAP requires full costing for external reporting purposes
Additionally, full cost information needed in areas such as “cost-plus” contracts

8. Process of Cost Allocation
Identify the Cost Objectives
Form Cost Pools
Select an Allocation Base to Relate the Cost Pools to the Cost Objectives

9. Cost-Plus Contracts

10. Process of Cost Allocation

11. Determining the Cost Objective

12. Forming Cost Pools A grouping of individual costs
Total is allocated using one allocation base
Cost Pool Examples
Departments (Maintenance, Personnel)
Major Activities (Equipment Setups)

13. Selecting an Allocation Base
Should select an allocation base that relates the cost pool to the cost objectives
Should be based on cause-and-effect relationship
If indirect costs are fixed, cause-and-effect relationships are difficult to establish and other approaches are used

14. Study Break #1
In the cost allocation process, the cost objective is the:
The allocation base used to allocate the costs
A grouping of individual costs whose total is allocated using one allocation base
The product, service or department that is to receive the allocation
None of the above
Answer:
c. The product, service or department that is to receive the allocation

15. Study Break #2 In the cost allocation process, an allocation base:
Must be some characteristic that is common to all of the cost objectives
Ideally should result in cost being allocated based on a cause-and-effect relationship
Both a and b
None of the above
Answer:
c. Both a and b

16. Fixed Indirect Costs – Other Approaches
Relative Benefits Approach to Allocation
More costs allocated to those objectives that benefit most from incurring the cost
Ability to Bear Costs
More costs allocated to those that are more profitable
Equity Approach to Allocation
Base results in allocations that are perceived to be fair or equitable

17. Allocating Service Department Costs
Organizational Units of Manufacturing Firms
Production Departments
Service Departments
Cost Pools
Formed by Service Departments
Allocated to Production Departments

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

19. Direct Method – Mason Furniture

20. Example Exercise #1
The building maintenance department for Taylor Bath Manufacturing Company budgets annual costs of $3,000,000 based on the expected operating level for the coming year. The costs are allocated to two production departments. Taylor Bath is considering two allocation bases for assignment of costs to departments: (1) square footage and (2) direct labor hours. The following data relate to the potential allocation bases:
Production Dept Production Dept. 2
Square Footage , ,000
Direct Labor Hours , ,000
Calculate the costs allocated to the production departments using each allocation base. Comment on which allocation base is preferable.

21. Example Exercise #1 Solution
Square Footage as an Allocation Base
Production Department 1
= (20,000/50,000) x $3,000,000
= $1,200,000
Production Department 2
= (30,000/50,000) x $3,000,000
= $1,800,000

22. Example Exercise #1 Solution
Direct Labor Hours as an Allocation Base
Production Department 1
= (30,000/50,000) x $3,000,000
= $1,800,000
Production Department 2
= (20,000/50,000) x $3,000,000
= $1,200,000

23. Example Exercise #1 Solution
Which allocation base is preferable?
As indicated, the choice of the allocation base greatly affects the allocations of cost. Use of square footage as the allocation base assigns 60% of the cost to department 2 and 40% to department 1. However, use of direct labor hours allocates 60% of the cost to department 1 and only 40% to department 2. Department 1 would prefer to be allocated cost based on square footage and department 2 would prefer direct labor hours as the base.
An allocation base that results in a cause and effect allocation is preferred. If maintenance costs are mostly related to building maintenance, then square footage is more likely to result in a cause and effect allocation. However, if maintenance costs are mostly made up of machine maintenance, then machine hours might be a better allocation base.

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

25. Problems with Cost Allocation
Responsibility Accounting
Identifies units and individuals responsible for generating revenue and controlling costs
Controllable Costs
Allocation based solely on costs management can control

26. Problems with Cost Allocation
Arbitrary Allocations
Cost allocations are inherently arbitrary
Typically there are numerous allocation bases that are equally justifiable

27. Problems with Cost Allocation
Unitized Fixed Costs
Fixed costs are divided into a per unit basis and allocated as a variable cost
Perception of costs as variable could alter decision making
Lump-Sum Allocations
Allocate predetermined amount of fixed costs that is not affected by level of activity
Allocation must appear to be fixed to management

28. Problems with Cost Allocation
Too Few Cost Pools
Although simple, may lead to distortion of cost allocation
Product costs will be more accurate when more overhead cost pools are used
Must analyze cost-benefit relationship of more cost pools

29. Problems with Cost Allocation
Using Only Volume-Related Allocation Bases
Some firms allocate manufacturing overhead based on volume such as direct labor or machine hours
Not all overhead costs vary with volume

30. Study Break #3 The direct method of allocating costs: Answer:
Allocates service department costs to other service departments
Allocates only direct costs
Allocates service department costs to producing departments only
Both b and c
Answer:
c. Allocates service department costs to producing departments only

31. Study Break #4 When fixed costs are stated on a per unit basis:
Fixed costs are said to be “unitized”
Fixed costs may appear to be variable to managers receiving allocations
Decision making is greatly improved
Both a and b
Answer:
d. Both a and b

32. Activity-Based Costing
Relatively recent development in managerial accounting
Is considered to have helped to improve managerial accounting information

33. Typical allocation bases include:
The Problem of Using Only Measures of Production Volume to Allocate Overhead
Typical allocation bases include:
Direct labor hours
Machine hours
Assumes all overhead costs are proportional by production volume
When they are not proportional by production volume:
High-volume products are overcosted
Low-volume products are undercosted

34. ABC Portal

35. The ABC Approach

36. Common Activities and Associated Cost Drivers

37. Example Exercise #2
Power Electronics manufactures portable power supply units. Power has recently decided to use an activity-based approach to cost its products. Production line setups is a major activity at Power. Next year Power expects to perform 1,000 setups at a total cost of $1,500,000. Power plans to produce 750 units of product EP150, which will require two setups. How much setup cost will be allocated to each unit of EP150 produced?

38. Example Exercise #2 Solution
Cost Per Setup
= $1,500,000 / 1,000
= $1,500
Cost of Setups Related to EP150
= 2 setups x $1,500
= $3,000
Setup Cost Per Unit of EP150
= $3,000 / 750 units produced
= $4 per unit

39. Benefits of ABC Provide more accurate costing
Less likely to undercost/overcost due to cost drive usage
May lead to improvements in cost control
Costs divided into a number of activities as compared to two overhead cost pools

40. Limitations of ABC
More costly to develop and maintain than a traditional costing system
Develops full cost of products
Includes fixed costs
Lacks incremental information necessary for decision making

41. Fixes and Variable Costs

42. Activity-Based Management
Improve efficiency and effectiveness by analyzing and costing activities

43. Cost Allocation and Decision Making

44. Activity-Based Management
Determine Major Activities
Identify Resources Used by Each Activity
Evaluate the Performance of the Activities
Identify Ways to Improve the Efficiency and/or Effectiveness of the Activities

45. Copyright
© 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.