# Chapter 6: Cost Allocation and Activity-Based Costing

```Managerial Accounting
by James Jiambalvo
Chapter 6:
Cost Allocation and
Activity-Based Costing
Slides Prepared by:
Scott Peterson
Northern State
University
Objectives
1. Explain why indirect costs are allocated.
2. Describe the cost allocation process.
3. Discuss allocation of service department
costs.
4. Identify potential problems with cost
allocation.
5. Discuss activity-based costing (ABC) and
cost drivers.
6. Discuss activity-based management
(ABM).
Purposes of Cost Allocation
1. To provide information needed for
decision making.
2. To reduce the frivolous use of common
resources.
3. To encourage managers to evaluate
the efficiency of internally provided
services.
4. To calculate the full cost of products
for financial reporting purposes and for
determining cost-based prices.
Purposes of Cost Allocation
Rationale #1: To Provide
Information for Decision
Making
From a decision making standpoint, the
allocated cost should measure the
opportunity cost of using a company
resource.
Rationale #2: To Reduce
Frivolous Use of Common
Resources
By not allocating costs, these resources
appear “free” to the users. But resources
never come with zero costs.
Rationale #3: To Encourage
Evaluation of Services
The flip-side of the previous point (to
reduce frivolous usage); to compel the
current users to evaluate the costs and
benefits of the services for which they are
being charged (allocated).
Rationale #4: To Provide “Full”
Cost Information
1. GAAP requires full-costing for external
reporting purposes.
2. In the long-run, all costs must be
covered.
Process of Cost Allocation
Steps include:
 Identify the cost objectives
 Form cost pools
 Select an allocation base to relate
the cost pools to the cost
objectives.
Process of Cost Allocation
Determining the Cost Objective
Cost Objective: Determine the product,
service or department that is to receive
the allocation.
Determining the Cost Objective
Forming Cost Pools
Cost pool: A grouping of individual costs,
the sum of which is allocated using a
single allocation base.
Cost pools could include:
1. Departments (maintenance or
personnel departments)
2. Major Activities (equipment setups)
Selecting an Allocation Base
1. Allocation Base: Very important to
choose a base that relates the cost
pool to the cost objectives.
2. Allocation should be based on a
cause-and-effect relationship between
costs and objectives.
3. If cause-and-effect cannot be
established, other approaches are
used.
Other Approaches to Cost
Allocation (Fixed-Indirect)
1. Relative benefits approach.
2. Ability to bear costs.
3. Equity approach.
These are all merely accounting
convention; allocation for the sake of
allocation.
Allocating Service Department
Costs
1. Manufacturing firms are often
organized either
a. By production department
b. By service department
2. Production department implies a
“direct” activity.
3. Service department implies an
“indirect” activity.
Direct Method of Allocating
Service Department Costs
The Direct Method.
Direct Method of Allocating
Service Department Costs
Allocating Budgeted and
Actual Service Department
Costs
1. Managers should allocate budgeted
rather than actual costs.
2. In this way inefficiencies cannot be
passed on to production.
Problems With Cost Allocation
1. Allocation of uncontrollable costs.
2. Arbitrary allocations.
3. Allocations of fixed costs that make the
fixed costs appear to be variable.
to products using too few overhead
and cost pools.
5. Use of only volume-related allocation
bases.
Responsibility Accounting and
Controllable Costs (1)
1. Responsibility accounting holds
someone in some unit accountable for
generating revenue and controlling
costs.
2. The trick is to find out whom to hold
accountable and at what level.
3. Managers should be held accountable
only for controllable costs.
Arbitratry Allocations (2)
1. Cost allocations are inherently
arbitrary.
2. Managers frequently make educated
guesses.
Unitized Fixed Costs and
Lump-Sum Allocations (3)
1. Unitized fixed costs pose a significant
problem.
2. Costs that are fixed (in the short run),
are often divided by some base and
allocated as variable (per-unit).
3. Importantly, this is a question of
perspective.
4. The higher up in the hierarchy the
manager is, the greater the number of
all costs that appear variable.
Lump-Sum Allocations (3)
1. The remedy is to allocate these costs, like
allocations.
2. Lump-sum allocations should remain the
same, year-by-year, regardless of total
production.
3. Lump-sum allocations ignore changes in
activity-levels.
The Problem With Too Few
Cost Pools (4)
1. Too few cost pools cause serious product
costing distortions.
2. Generally, the more cost pools, the more
accuracy is enhanced.
3. Does the benefit of more accurate
allocation methods (i.e.more cost pools)
outweigh the cost of obtaining this
information?
Using Only Volume-Related
Allocation Bases (5)
1. Some manufacturers allocate
only volume measures (such as):
a. labor hours
b. machine hours
2. Not all overhead costs vary in relation to
volume!
Activity-Based Costing
Activity-Based Costing (ABC) is a
relatively recent development in
management accounting.
The Problem of Using Only
Measures of Production
1. Traditionally firms use labor hours or
machine hours as allocation bases for
2. This assumes that all costs are
proportional to production volume.
3. Setup costs are not proportional.
4. For example, a setup might work for a
400,000 unit production run just as well as
a 200,000 production run.
5. Low-volume items are undercosted and
high-volume items are overcosted.
The ABC Approach
1. Identify the major activities that cause
2. Group costs of activities into cost
pools.
3. Identify measures of activities (the cost
drivers)
4. Relate costs to products using the cost
drivers.
The ABC Approach
Examples of Activities
1.
2.
3.
4.
5.
Processing purchase orders.
Handling materials and parts.
Inspecting incoming material and parts.
Setting up equipment.
Producing goods using manufacturing
equipment.
6. Supervising assembly workers.
7. Inspecting finished goods.
8. Packing customer orders.
Examples of Associated Costs
1. Various labor costs.
2. Depreciation.
Examples of Cost Drivers
1.
2.
3.
4.
5.
6.
7.
8.
Number of purchase orders processed.
Number of material requisitions.
Number of receipts.
Number of setups.
Number of machine hours.
Number of assembly labor hours.
Number of inspections.
Number of boxes shipped.
Pros and Cons of ABC
Benefits:
1. ABC is less likely than traditional costing to
undercost or overcost products.
2. ABC may lead to improvements in cost
control.
Limitations:
1. Expensive relative to traditional system!
“You Get What You Measure”
Quick Review Question #1
1. The direct method of allocating costs:
a. Allocates service department costs
to other service departments.
b. Allocates only direct costs.
c. Allocates service department costs
to production departments only.
d. Both (b) &amp; (c).
1. The direct method of allocating costs:
a. Allocates service department costs
to other service departments.
b. Allocates only direct costs.
c. Allocates service department costs
to production departments only.
d. Both (b) &amp; (c).
Quick Review Question #2
1. In the cost allocation process, the cost
objective is:
a. The allocation base used to
allocate the costs.
b. A grouping of individual costs
whose total is allocated using one
allocation base.
c. The product, service or department
that is to receive the allocation
d. None of these.
1. In the cost allocation process, the cost
objective is:
a. The allocation base used to
allocate the costs.
b. A grouping of individual costs
whose total is allocated using one
allocation base.
c. The product, service or department
that is to receive the allocation.
d. None of these.
2. Units produced = 2,000, units sold =
1,800, contribution margin ratio is
37%, fixed S &amp; A expenses are
\$90,000. Fixed mfg. Expenses are
\$80,200 By how much is net income
greater under full costing than variable
costing?
a. \$8,020
b. \$80,200
c. \$9,000
d. \$17,020
Quick Review Question #3
3. The errant process of treating fixed
costs a variable, or a per-unit basis, is
called?
a. A cost driver.
b. A cost object.
c. Unitizing fixed costs.
d. An arbitrary allocation.
3. The errant process of treating fixed
costs a variable, or a per-unit basis, is
called?
a. A cost driver.
b. A cost object.
c. Unitizing fixed costs.
d. An arbitrary allocation.
Quick Review Question #4
4. What does it mean to “Get
What You Measure?”
Appendix: Activity-Based
Management (Four-Steps)
1.
2.
3.
4.
Determine major activities.
Identify resources used by each activity.
Evaluate the performance of the activities.
Identify ways to improve the effficiency
and/or effectiveness of the activities.
Step 1: Determine major
activities through interviews
and observations
a. Determine customer locations, determine
availability of stock, and prepare delivery
schedules.
b. Pick orders from warehouse.
d. Deliver merchandise.
Step 1: Determine major
activities through interviews
and observations
(continued)
e. Return merchandise to stock if not
acceptable to customer or customer not
home.
f. Wash delivery trucks (each night).
g. Schedule truck for routine service and
nonroutine repairs.
Step 2: Identify Resources
Used By Each Activity (ex.)
1. Return merchandise to stock (e)
a. Different item received than ordered
b. Customer not home at time of delivery
2. Wash delivery trucks (f)
a. How many trucks washed per night?
b. Salary/wage costs associated with
employees
c. Cleaning supplies, materials,
equipment depreciation
Step 3: Evaluate The
Performance Of The Activities
1. Benchmarking.
2. Compare with other firms.
3. How do costs compare with others?
Step 4: Identify Ways To
Improve The Efficiency And/Or
Effectiveness Of The Actvities
1. Suggest improvements based on
analysis.
2. Best practices at other firms.
3. Examples:
 Have sales staff seek customer input.
 Have clerk call customers the day prior
to delivery to assure someone is home
(note: dentists office now do this
regularly).
 Consider converting part-time positions
to full-time or outsourcing washing.
Conclusion
1. ABM focuses on process improvements.
2. ABC focuses on costing.
3. ABM often identifies “low hanging fruit,” or
costs which are out of line with
benchmarks.
4. ABM can produce substantial returns.