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Chapter 5

Chapter 5. Cost Allocation. Introduction. 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.

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Chapter 5

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  1. Chapter 5 Cost Allocation

  2. Introduction • 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.

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

  4. Learning Objective 1 Outline four purposes for allocating costs to cost objects

  5. 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: • To provide information for economic decisions • To motivate managers and other employees • To justify costs or compute reimbursement • To measure income and assets for reporting to external parties

  6. 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.

  7. 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.

  8. Learning objective 2 Describe how a costing system can have multiple cost objects

  9. Learning Objective 3 Discuss key decisions faced when collecting costs in indirect cost pools

  10. 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)

  11. Learning Objective 3 (continued) • Sandy Corporation collects costs at the following levels in its organisation: • Corporate costs: • Treasury 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. • Human resources costs: £1,200,000 in recruitment and ongoing employee training and development. • Corporate administration costs: £4,800,000 in executives’ salaries, rent, and general administration.

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

  13. Learning Objective 3 (continued) • Allocating Corporate Costs • 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.

  14. 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.

  15. 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 treasury costs? • 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

  16. 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 human resources costs? • 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 corporate administration costs to the divisions.

  17. Learning Objective 3 (continued) ParisPragueTreasury costs: £600,000 (2/3) and (1/3) £400,000 £200,000 Human resources costs: £1,200,000 (40%) and (60%) 480,000 720,000 Total allocated to divisions £880,000 £920,000

  18. 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.

  19. Learning Objective 3 (continued) Paris Division Assembly direct costs: £1,300,000 Corporate costs: 400,000 Total costs £1,700,000 Finishing direct costs: £900,000

  20. Learning Objective 3 (continued) Paris Division Human Resources direct costs: £1,680,000 Corporate costs: 480,000 Total costs £2,160,000 Maintenance direct costs: £300,000

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

  22. Learning Objective 4 Describe how the single-rate cost-allocation method differs from the dual-rate method

  23. 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.

  24. Learning Objective 5 Explain how the choice of budgeted versus actual allocation rates changes the risks that managers face

  25. 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

  26. 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.

  27. Learning Objective 6 Distinguish among direct allocation, step-down and reciprocal methods of allocating support department costs

  28. 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: • Direct allocation method • Step-down method • Reciprocal method

  29. 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.

  30. 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.

  31. Learning Objective 6 (continued) Human MaintenanceResources 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

  32. 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.

  33. Learning Objective 6 (continued) AssemblyFinishing Original costs: £1,700,000 £900,000MaintenanceAllocated: 150,000 150,000 Human Resources Allocated: 1,440,000 720,000 Total £3,290,000 £1,770,000

  34. 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.

  35. 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.

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

  37. 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.

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

  39. 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

  40. Learning Objective 6 (continued) • Reciprocal MHRAF Maintenance - 12% 44% 44% Human Resources 10% - 60% 30% • Maintenance cost = £300,000 + 0.10HR • Human Resource cost = £2,160,000 + 0.12M

  41. 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

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

  43. 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.

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

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