Managerial Accounting
by James Jiambalvo
Chapter 5:
Cost Allocation and ActivityBased Costing
Slides Prepared by:
Scott Peterson
Northern State University
Chapter 5: Cost Allocation and
Activity-Based Costing
Chapter Themes:

Think about how much
products really cost to
produce. How do you
measure that?

Focus on indirect costs
(not direct labor or direct
materials).

Remember—You Get
What You Measure!
Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Purposes of Cost Allocation
Companies allocate costs for
four major reasons:
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.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Purpose #1: To Provide
Information for Decision Making
Generally, as resources are
consumed during production,
cost allocations are made to
the products, departments
etc… much like a fee or
charge. From a decision
making standpoint, the
allocated cost should
measure the opportunity cost
of using a company resource.
Unfortunately this is difficult
to implement in practice as
opportunity costs can change
quickly.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Purpose #2: To Reduce Frivolous
Use of Common Resources
It may be argued that fixed
costs should not be allocated
at all. But without charging a
fee (or allocating these
costs), resources are often
used frivolously or for
nonessential purposes.
Consider fixed costs
associated with computer
resources. Examples include
recreational web surfing,
playing games, sending
personal e-mail etc… One
way to eliminate frivolous use
is to charge for it.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Purpose #3: To Encourage
Evaluation of Services
Cost allocation is also useful
because is causes management
to evaluate the services for
which they are being charged
(e.g. costs allocated to their
departments or products). For
example, centrally administered
services such as janitorial or
computer services should be
allocated to various
departments. If these services
were free and no allocation were
made, users would not consider
them. But if a charge is levied,
management has a strong
incentive to evaluate these
services and charges and
consider alternatives.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Purpose #4: To Provide “Full”
Cost Information
First of all, GAAP requires
“Full Costing” for external
reporting purposes. As a
result indirect production
costs must be allocated to
goods produced.
Furthermore, full cost
information is required when
a contract calls for “Cost
Plus” pricing. In this case not
only is manufacturing
overhead allocated, but so
are other general and
administrative costs.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Process of Cost Allocation
Cost allocation has three
steps:
1.
identify the cost
objectives,
2.
form cost pools,
3.
select an allocation base
to relate the cost pools to
the cost objectives.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Determining the Cost
Objective
The first step in the cost
allocation process is to
determine the product,
service or department that is
to receive the allocation. The
object of this cost allocation
is called the cost objective.
See the next slide for
examples.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Determining the Cost
Objective (Graphic)
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Forming Cost Pools
The second step in the cost
allocation process is to form
cost pools. A cost pool is a
grouping of individual costs
whose total is allocated using
one allocation base. For
example, maintenance
department costs might
constitute a cost pool. Cost
pools are often formed along
department lines.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Selecting an Allocation Base
The third step in the
allocation process is to select
an allocation base that relates
the cost pool to the cost
objectives. If the cost
objectives are manufactured
products, then direct labor
hours, direct labor dollars or
machine hours are examples
of characteristics that could
be used as allocation bases.
Ideally, the allocation base
should relate costs to cost
objectives.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
More
Selecting an Allocation Base
When indirect costs are fixed,
establishing a cause-and-effect
relationship is infeasible. So,
accountants use other criteria:
1.
Relative benefits (the allocation
base should result in more
costs being allocated to the cost
objectives that benefit most
from incurring the cost).
2.
Ability to bear costs (the
allocation base should result in
more costs being allocated to
products which are more
profitable).
3.
Equity (the allocation base
should result in allocations
which are fair and equitable.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Allocating Service Department
Costs
Organizational units in most
manufacturing firms are often
classified by department;
either production or service.
Since service departments,
like maintenance, are
support departments, their
costs are pooled and
allocated to production
departments.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Direct Method of Allocating
Service Department Costs
The text book uses a method of
allocating service department costs
called the direct method. Here,
service departments are allocated to
production departments, but not
other service departments.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Allocating Budgeted and Actual
Service Department Costs
Budgeted rather than actual
service costs should be
allocated to production
departments. Because if
budgeted costs are allocated,
service department
inefficiencies cannot be
passed on to production
departments.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Problems With Cost Allocation
A number of problems may arise
when costs are allocated.
They may be brought about
by
1.
allocations of costs that are
not controllable,
2.
arbitrary allocation,
3.
allocations of fixed costs
that make the fixed costs
appear to be variable costs,
4.
allocation of manufacturing
overhead to products using
too few overhead cost pools,
and
5.
use of only volume-related
allocation bases.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Responsibility Accounting and
Controllable Costs
Responsibility accounting
requires tracing revenues and
costs to organizational units
and individual managers with
related responsibility for
generating revenue and
controlling costs.
Furthermore cost allocations
are consistent with
responsibility accounting.
But, only costs for which the
individual manager has
control.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Arbitrary Allocations
As might be expected, cost
allocation fairness is the
topic of heated management
discussions. Unfortunately,
allocations of costs are
inherently arbitrary. It is
impossible to determine the
“true” or “correct” allocation.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Unitized Fixed Costs and
Lump-Sum Allocations
Another potential problem is that
cost allocation may make fixed
costs appear variable. This
happens when fixed costs are
unitized or stated on a per unit
basis. Examples include fixed
general and administrative costs
like administrative salaries.
These costs should be allocated
in a lump-sum regardless of total
production. The reason is that as
production rises, more and more
fixed costs are added, despite
the fact that, by definition, fixed
costs are static and do not
change with respect to changes
in activity levels.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
The Problem of Too Few Cost
Pools
Assigning costs using just
one or two cost pools can
cause serious product
costing distortions. While
easy to implement and use,
this approach is not as
accurate. Ultimately, a costbenefit decision has to be
made. The question is “does
the benefit of more accurate
allocation methods (e.g. more
accurate product costs)
outweigh the cost of
obtaining this information?”
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Using Only Volume-Related
Allocation Bases.
Some manufacturers allocate
manufacturing overhead to
products using only
measures of production
volume (labor hours, machine
hours). The problem is that
not all overhead costs vary in
relation to volume.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Activity-Based Costing
Activity-Based Costing (ABC)
is a relatively recent
development in management
accounting.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
The Problem of Using Only Measures of
Production Volume to Allocate Overhead
As discussed a few slides ago,
companies commonly use labor
hours or machine hours as
allocation bases for assigning
overhead to products. This
“Traditional Approach” assumes
that all costs are proportional to
production volume. In reality this
is not true. For example, setup
costs are not proportional. A
setup might work for a 400,000
unit production run just as well
as a 200,000 production run. As a
result, low-volume items are
undercosted and high-volume
items are overcosted.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
The ABC Approach
In the ABC Approach, companies
identify the major activities
that cause overhead costs
to be incurred. Some of
these are related to
production volume, but
others are not. The steps
are as follows:
1.
Identify activities.
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.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Major Activities
Following are examples of major
activities under ABC:
1.
Processing purchase orders.
2.
Handling materials and
parts.
3.
Inspecting incoming
material and parts.
4.
Setting up equipment.
5.
Producing goods using
manufacturing equipment.
6.
Supervising assembly
workers.
7.
Inspecting finished goods.
8.
Packing customer orders.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Associated Costs
Costs associated with the
preceding major activities
have to do with salaries and
wages, depreciation on
equipment and the like.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Cost Drivers
Following are examples of cost
drivers under ABC:
1.
Number of purchase orders
processed.
2.
Number of material
requisitions.
3.
Number of receipts.
4.
Number of setups.
5.
Number of machine hours.
6.
Number of assembly labor
hours.
7.
Number of inspections.
8.
Number of boxes shipped.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Pros and Cons of ABC
Benefits: First, ABC is less
likely than traditional costing
to undercost or overcost
products. Second, ABC may
lead to improvements in cost
control.
Related Learning Objectives:
1.
2.
3.
4.
Limitations: It’s expensive
relative to a traditional
system!
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Activity-Based Management
Activity-Based Management (ABM) is
a management tool with the goal of
improving efficiency and
effectiveness. It is similar to ABC,
except that where ABC focuses on
cost measurement, ABM focuses on
the the activities themselves.
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
Remember—You Get What
You Measure!
How does this statement
relate to cost allocation?
Allocations affect the profit
that managers have reported
on their performance reports!
Related Learning Objectives:
1.
2.
3.
4.
5.
6.
Explain why indirect costs are
allocated.
Describe the cost allocation
process.
Discuss allocation of service
department costs.
Identify potential problems with
cost allocation.
Discuss activity-based costing
(ABC) and cost drivers.
Discuss activity-based
management (ABM).
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