 Cost allocation is an inescapable problem in nearly every organisation and in nearly every facet of accounting.
 This chapter emphasises the allocation of costs to divisions, plants, departments, and contracts.
 The chapter also addresses the allocation of costs to products and customers.

Learning Objectives
1.
Outline four purposes for allocating costs to cost objects
2.
Describe how a costing system can have multiple cost objects
3.
Discuss key decisions faced when collecting costs in indirect cost pools
4.
Describe how the single-rate cost-allocation method differs from the dual-rate method
5.
Explain how the choice of budgeted versus actual allocation rates changes the risks that managers face
6.
Distinguish among direct allocation, step-down and reciprocal methods of allocating support department costs
7.
Distinguish between the incremental and stand-alone cost-allocation methods
8.
Criterias used to guide cost-allocation decisions

Learning Objective 1

Learning Objective 1(continued)
 Purposes of Cost Allocation
 Indirect costs are costs that are related to a particular cost object but cannot be traced to it in an economically feasible (cost effective) way.
 Why do managers allocate indirect costs to these cost objects?
 There are four essential purposes of cost allocation:
1 To provide information for economic decisions
2 To motivate managers and other employees
3 To justify costs or compute reimbursement
4 To measure income and assets for reporting to external parties

Learning Objective 1 (continued)
 Provide Information
 What economic decisions may require cost allocation information?
– To decide whether to add a new product
– To decide whether to manufacture a component part or to purchase it from another manufacturer
– To decide on the selling price for a product
 Motivation
 Managers and employees need to be encouraged to design products that are simpler to manufacture or less costly to service.
 Sales representatives need to be motivated to push high-margin products or services.

Learning Objective 1 (continued)
 Justify Costs
 It is important to cost products at a “fair” price, especially in government defence contracts.
 A consulting firm that is paid a percentage of the cost savings resulting from the implementation of its recommendations needs to justify costs in order to compute reimbursement.
 Reporting
 Inventory costs must be determined for financial reporting and for reporting to tax authorities.
 Under generally accepted accounting principles, stock costs include manufacturing costs but exclude research and development, marketing, distribution, and customer service costs.

Learning Objective 3

Learning Objective 3 (continued)
 Cost Allocation and Costing Systems
 Costs incurred in different parts of an organisation can be assigned, and then reassigned, when costing products, services, customers, or contracts.
 Sandy Corporation manufactures clothes washers and dryers in two international divisions:
– Clothes Washer Division in Paris (CWD)
– Clothes Dryer Division in Prague (CDD)

Learning Objective 3 (continued)
 Sandy Corporation collects costs at the following levels in its organisation:
 Corporate costs:
–
: £600,000 interest on debt used to finance the construction of new assembly equipment which cost £4,000,000 in the Paris Division and
£2,000,000 in the Prague Division.
–
: £1,200,000 in recruitment and ongoing employee training and development.
–
costs: £4,800,000 in executives’ salaries, rent, and general administration.

Learning Objective 3 (continued)
Division costs:
Paris
Direct costs £2,200,000
£4,000,000 Indirect costs
Prague
1,980,000 2,500,000 Total
£4,180,000 £6,500,000

Learning Objective 3 (continued)
 Allocating
 Some companies allocate all corporate costs to divisions because ...
– it sparks interest on the part of division managers regarding how corporate costs are planned and controlled, and ...
– to calculate the full costs of products.
 Other companies do not allocate corporate costs to divisions.
 They maintain that division managers generally have no say or role in incurring these costs.
 Other companies allocate only those costs for which there is widespread agreement, such as human resources.

Learning Objective 3 (continued)
 If Sandy Corporation allocates corporate costs to divisions, how many cost pools should it use to allocate corporate costs?
– One single cost pool?
– Numerous individual corporate cost pools?
 A key factor is the concept of homogeneity.
 In a homogeneous cost pool , all costs have the same or a similar cause-and-effect or benefits- received relationship with the cost-allocation base.
 If each cost category has a different cost driver, companies may prefer to maintain separate cost-pools for these costs.

Learning Objective 3 (continued)
 If Sandy Corporation allocates corporate costs to divisions, which allocation basis should it use?
 The one that has the best cause-and-effect relationship with costs.
 Which allocation basis should Sandy Corporation use to allocate
?
– Cost of new Assembly Department equipment
 Treasury costs: £600,000
 Paris Division:
£600,000 × (£4,000,000 ÷ £6,000,000) = £400,000
 Prague Division:
£600,000 × (£2,000,000 ÷ £6,000,000) = £200,000

Learning Objective 3 (continued)
 Sandy Corporation analysis indicates that the demand for corporate human resource management costs for recruitment and training varies with direct labour costs.
 These costs are allocated to divisions on the basis of the total direct labour costs incurred in each division.
 Suppose direct labour costs in the Paris Division are £1,200,000 and £1,800,000 in the Prague Division.
 How does Sandy Corporation allocate its £1,200,000 of
?
 Paris Division:
£1,200,000 × (£1,200,000 ÷ £3,000,000) = £480,000
 Prague Division:
£1,200,000 × (£1,800,000 ÷ £3,000,000) = £720,000
 Sandy Corporation does not allocate
to the divisions.

Learning Objective 3 (continued)
Paris Prague
:
£600,000
(2/3) and (1/3) £400,000 £200,000
: £1,200,000
(40%) and (60%) 480,000 720,000
Total allocated to divisions
£880,000 £920,000

Learning Objective 3 (continued)
 Corporate treasury and human resources costs are reallocated by the divisions to Assembly.
 Corporate human resource management costs are reallocated by the divisions to the Department of Human
Resources.
 Division costs are reallocated to the departments within the division.
 The Paris division of Sandy Corporation has two operating departments – Assembly and Finishing, plus two support departments – Maintenance and Human Resources.
 The Paris Division management decided to reallocate the
£400,000 treasury costs to the Assembly Department, and the £480,000 human resources costs to its Human
Resources Department.

Learning Objective 3 (continued)

Learning Objective 3 (continued)

Learning Objective 3 (continued)
Assembly Department
£1,700,000
Finishing Department
£900,000
Maintenance Department
£300,000
Human Resources Department
£2,160,000
Paris Division
£5,060,000

Learning Objective 4

Learning Objective 4 (continued)
 Single-Rate and Dual-Rate Methods
 The single-rate cost allocation method pools together all costs in a 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 behaviour.
 The dual-rate cost allocation method classifies costs in each cost pool into two cost pools – a variable cost cost-pool and a fixed-cost cost-pool.
 Each of these pools uses a different cost-allocation base.

Learning Objective 5

Learning Objective 5 (continued)
 Budgeted versus Actual Rates
 The decision of whether to use budgeted cost rates or actual cost rates affects the level of uncertainty user divisions face.
 Budgeted rates let the user department know in advance the cost rates they will be charged.
 Users are better equipped to determine the amount of the service to request.
 Budgeted rates also help motivate the manager of the supplier department to improve efficiency.
 During the budget period, the supplier department, not the user departments, bears the risk of any unfavourable cost variances. Why?
– because the user departments do not pay for any costs that exceed the budgeted rates

Learning Objective 5 (continued)
 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.
 When actual rates are used for cost allocation, managers do not know the rates to be used until the end of the budget period.
 When budgeted usage is the allocation base, user divisions will know in advance their allocated costs.
 This information helps the user divisions with both short-run and long-run planning.
 The main justification given for the use of budgeted usage to allocate fixed costs relates to long-run planning.
 Organisations commit to infrastructure costs on the basis of a long-run planning horizon.
 The use of budgeted usage to allocate these fixed costs is consistent with the long-run horizon.

Learning Objective 6

Learning Objective 6 (continued)
 Allocating Support Department Costs
 Organisations distinguish between operating departments and support departments.
 An operating department (a production department in manufacturing companies) adds value to a product or service.
 A support department (service department) provides the services that assist other operating and support departments in the organisation.
 Three methods are widely used to allocate the costs of support departments to operating departments:
1 Direct allocation method
2 Step-down method
3 Reciprocal method

Learning Objective 6 (continued)
 Direct method : Allocates support department costs to operating departments only.
 Step-down (sequential allocation) method :
Allocates support department costs to other support departments and to operating departments.
 Reciprocal allocation method : Allocates costs by including the mutual services provided among all support departments.
 The direct method and the step-down method are less accurate than the reciprocal method when support departments provide services to one another reciprocally.

Learning Objective 6 (continued)
 The following information pertains to the Paris
Division of Sandy Corporation:
 Recall that the Paris Division has two operating departments – Assembly and Finishing, and two support departments – Maintenance and Human Resources.
 Total square feet = 255,000
 Total number of employees = 95
 Maintenance is allocated using square feet.
 Human Resources are allocated using number of employees.

Learning Objective 6 (continued)
Maintenance
Human
Resources
Budgeted costs before allocations: £300,000 £2,160,000
Square feet: 5,000 30,000
Number of employees: 8 15
Assembly Finishing
Budgeted costs before allocations: £1,700,000 £900,000
Square feet: 110,000 110,000
Number of employees: 48 24

Learning Objective 6 (continued)
 Direct Method
– allocates support department costs to operating departments only.
 The allocation ratio for allocating Maintenance to
Assembly is 110,000/220,000 × £300,000 =
£150,000.
 The allocation ratio for allocating Maintenance to
Finishing is 110,000/220,000 × £300,000 = £150,000.
 The allocation ratio for allocating Human Resources to Assembly is 48/72 × £2,160,000 = £1,440,000.
 The allocation ratio for allocating Human Resources to Finishing is 24/72 × £2,160,000 = £720,000.

Learning Objective 6 (continued)
Original costs:
Maintenance
Allocated:
Assembly
£1,700,000
Finishing
£900,000
150,000 150,000
Human Resources
Allocated : 1,440,000 720,000
Total £3,290,000 £1,770,000

Learning Objective 6 (continued)
 Step-down Method
– allocates support department costs to other support departments and to operating departments.
 Which support department should be allocated first?
 The support department providing the greatest percentage of support to other support departments is allocated first.

Learning Objective 6 (continued)
 Maintenance provides 12% of its services to
Human Resources.
 Human Resources provides 10% of its services to
Maintenance.
 The ratio to allocate Maintenance to Human Resources is
30,000/250,000 (or 12%) × £300,000 = £36,000.
 The ratio to allocate Maintenance to Assembly is
110,000/250,000 (or 44%) × £300,000 = £132,000.
 The ratio to allocate Maintenance to Finishing is
110,000/250,000 (or 44%) × £300,000 = £132,000.

Learning Objective 6 (continued)
Costs before Allocated allocation costs
Maintenance £ 300,000 (£300,000)
Human Resources £2,160,000 £36,000
Assembly
Finishing
£1,700,000
£900,000
£132,000
£132,000

Learning Objective 6 (continued)
 Human Resources costs to be allocated become £2,160,000 + £36,000 = £2,196,000.
 The ratio to allocate the £2,196,000 Human
Resources costs to:
– Assembly is 48/72 × £2,196,000 = £1,464,000.
– Finishing is 24/72 × £2,196,000 = £732,000.

Learning Objective 6 (continued)
Costs before Allocated Allocated allocation costs costs
Human
Resources: £2,160,000 36,000 (2,196,000)
Assembly:
Finishing:
£1,700,000 132,000 1,464,000
£ 900,000 132,000 732,000

Learning Objective 6 (continued)
 Total cost after allocation:
 Assembly Department = £1,700,000 +
£132,000 + £1,464,000 = £3,296,000
 Finishing Department = £900,000 + £132,000
+ £732,000 = £1,764,000

Learning Objective 6 (continued)
 Reciprocal
M HR A F
Maintenance 12% 44% 44%
Human
Resources 10% 60% 30%
 Maintenance cost = £300,000 + 0.10HR
 Human Resource cost = £2,160,000 + 0.12M

Learning Objective 6 (continued)
 Maintenance cost (M)
= £300,000 + 0.10(£2,160,000 + 0.12M)
 M = £300,000 + £216,000 + 0.012M
 0.988M = £516,000
 M = £522,267
 HR = £2,160,000 + 0.12(£522,267)
 HR = £2,160,000 + £62,672
 HR = £2,222,672

Learning Objective 6 (continued)
Before allocation: £300,000 £2,160,000 £1,700,000
Allocation:
Total
M
(522,267)
HR
62,672
Allocation: 222,267 (£2,222,672)
A
229,797
1,333,603
£3,263,400
F
£ 900,000
229,797
666,802
£1,796,599
Total cost Assembly Department: £3,263,400 Total cost
Finishing Department: £1,796,599

Learning Objective 6 (continued)
 Overview of Methods
 Overhead rate for the Assembly Department is determined using direct labour cost as a denominator.
 Overhead rate for the Finishing Department is determined using machine-hours as the denominator.

Learning Objective 6 (continued)
 Comparison of Methods
Assembly
Direct Labour cost: £698,880
Machine-hours: 24,000
Finishing
£349,440
23,500
 What are the various overhead rates using the three methods?

Learning Objective 6 (continued)
 Overhead Rates Direct Method
 Assembly: £3,290,000 ÷ £698,880 direct labour costs = 471% of direct labour costs
 Finishing: £1,770,000 ÷ 23,500 = £75.32 per machine-hour
 Overhead Rates Step-Down Method
 Assembly: £3,296,000 ÷ £698,880 direct labour costs = 472% of direct labour cost
 Finishing: £1,764,000 ÷ 23,500 = £75.06 per machine-hour
 Overhead Rates Reciprocal
 Assembly: £3,263,400 ÷ £698,880 direct labour costs = 467% of direct labour cost
 Finishing: £1,796,599 ÷ 23,500 = £76.45 per machine hour

Learning Objective 6 (continued)
 Comparison of Rates
Direct method:
Step-down method:
Reciprocal method:
Assembly Finishing
471% £75.32
472%
467%
£75.06
£76.45

Learning Objective 7

Learning Objective 7 (continued)
 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.
 Two methods for allocating common costs are:
1 Stand-alone cost allocation method
2 Incremental cost allocation method
 The stand-alone cost allocation method uses information pertaining to each user of a cost object as a separate entity to determine the costallocation weights.
 A consultant in London is planning to go to Nice and meet with an international client.
 The roundtrip London/Nice/London airfare costs £540.

Learning Objective 7 (continued)
 The consultant is also planning to attend a business meeting with a UK client in Barcelona.
 The round-trip London/Barcelona/London airfare costs
£360.
 The consultant decides to combine the two trips into a
London/Barcelona/Nice/London itinerary that will cost
£760.
 How much should the consultant charge to the
UK client?
 £360 ÷ (£360 + £540) = 0.40
 0.40 × £760 = £304
 Therefore, the consultant should charge the
International client £760 – £304 = £456.

Learning Objective 7 (continued)
 The incremental cost allocation method ranks the individual users of a cost object and then uses this ranking to allocate costs among those users.
 The first-ranked user of the cost object is termed the primary party and is allocated costs up to the cost of it as a stand-alone user.
 The second-ranked user is termed the incremental party and is allocated the additional cost that arises from there being two users instead of only the primary user.
 Assume that the business meeting in Nice is viewed as the primary party.
 What would be the cost allocation?
 International client
(primary) £540
Barcelona client
(incremental) £760 – £540 = £220

Learning Objective 8

Learning Objective


: Using this criterion, managers identify the variable or variables that cause resources to be consumed.
 For example, managers may use hours of testing as the variable when allocating the costs of quality-testing areas to products.
 Allocation based on this criterion is likely to be the most credible to operating personnel.

Using this criterion, managers 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 each receives.
 For example, the cost of a corporate-wide advertising programme may be allocated on the basis of division revenues.

Learning Objective)

This criterion is often cited on government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers.
 Cost allocation is viewed as a “reasonable” or “fair” means of establishing a selling price in the minds of the contracting parties.

: This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.
 An example is the allocation of corporate executive salaries on the basis of division operating income.

Learning Objective
 Role of Dominant Criteria
 The criteria used to guide cost-allocation decisions affect both the number of indirect cost pools and the cost-allocation base for each indirect cost pool.
 Managers must first choose the purpose for a particular cost allocation and then select the appropriate criterion to implement the allocation.
 The cause-and-effect and the benefits-received criteria guide most decisions related to cost allocations.
 Fairness and ability to bear are less frequently used criteria than cause-and-effect or benefits- received.

Learning Objective
 Why are fairness and ability to bear less frequently used?
 Fairness is an especially difficult criterion to obtain agreement on.
 What one party views as fair, another party may view as unfair.
 The ability to bear criterion raises issues related to crosssubsidisation across users of resources in an organisation.
 Cost-Benefit Approach
 Companies place great importance on the cost-benefit approach when designing and implementing their costallocation system.
 The costs of designing and implementing a system are highly visible.
 The benefits from using a well-designed system are difficult to measure and are frequently less visible.