Managerial accounting 6e jams jambalvo chapter 06

Prepared by
Debby Bloom-Hill
CMA, CFM


CHAPTER 6
Cost Allocation &
Activity-Based Costing


Purposes of Cost Allocation
 To provide information for decision
making
 To reduce frivolous use of common
resources
 To encourage evaluation of services
 To provide “full cost” information

Slide 6-3

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Purposes of Cost Allocation

Slide 6-4

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and

discuss allocation of service department costs.


Purposes of Cost Allocation
 To provide information for decision making
 When managers use a company resource
they are receiving a charge for use
 Allocated cost should measure the
opportunity cost of using a company
resource

 Provides a useful benchmark
 The closer to the opportunity cost of use, the
better the allocation

Slide 6-5

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Purposes of Cost Allocation
 To reduce frivolous use of common
resources
 When managers are not charged for a
service, they may tend to use it for
frivolous or nonessential purposes
 Frivolous use may have hidden costs
such as slower service

 Allocation provides incentive for
departments to reduce frivolous use
Slide 6-6

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Purposes of Cost Allocation
 To encourage evaluation of services
 If costs are not allocated, there is no
incentive to evaluate the services and
look for lower cost alternatives
 With cost allocation, there is a strong
incentive to critically evaluate the
efficiency and necessity of services
 Users will certainly bring lower cost
alternatives to the company’s attention
Slide 6-7

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Purposes of Cost Allocation
 To provide “full cost” information
 GAAP requires full costing for external
reporting purposes

 Full cost information is needed when
the company has an agreement
whereby revenue received depends
upon cost incurred
 Also called “cost-plus” contracts

Slide 6-8

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Test Your Knowledge 1
All of the following are reasons indirect
costs are allocated to products, services
and departments, except:
a. To improve decision making
b. To reduce frivolous use of resources
c. To provide information on variable and
fixed costs
d. To encourage evaluation of services
Answer: c
The allocation of indirect costs does not provide
information on variable and fixed costsLearning objective 1: Explain why indirect costs are

Slide 6-9

allocated, describe the cost allocation process, and
discuss allocation of service department costs.

Cost-Plus Contracts

Slide 6-10

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Process of Cost Allocation
 Cost allocation is achieved by a three step
process
1. Determining the cost objective
2. Forming cost pools
3. Selection of an allocation base to
relate cost pools to the cost objective

Slide 6-11

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Process of Cost Allocation
 Step 1 – determine the cost objective
 Determine the product, service, or
department that is to receive the

allocation
 The object of the allocation is referred
to as the cost objective
 For example, if computer costs are
allocated to contracts worked on, the
contracts are the cost objectives
Slide 6-12

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Process of Cost Allocation

Slide 6-13

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Test Your Knowledge 2
In the cost allocation process, the cost objective
is the:
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 the above
Answer: c
The product, service or department that is to receive the
allocation
Slide 6-14

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Process of Cost Allocation
 Step 2 – form cost pools
 A cost pool is a grouping of individual
costs whose total is allocated using one
allocation base
 Cost pools can be organized along
departmental lines or major activities, e.g.
equipment setups, inspections.
 Costs in the pool must be homogeneous
(similar) to other costs in the pool
Slide 6-15

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Process of Cost Allocation

Slide 6-16

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Process of Cost Allocation
 Step 3 – select an allocation base that relates the
cost pool to the cost objectives
 The base must be some characteristic that is
common to all of the cost objectives
 Deciding which base to use is not easy
 The allocation should be based on a cause-andeffect relationship
 Establishing cause-and-effect relationships is not
feasible when indirect costs are fixed
 Accountants use other methods which are
shown on the next slide
Slide 6-17

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


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 products, services or
departments that are more profitable

 Equity approach to allocation
 Base results in allocations that are perceived
to be fair or equitable
Slide 6-18

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Select an Allocation Base
 Two production departments: Assembly and
Finishing
 Both receive allocations of indirect costs from
the maintenance department
 Should labor hours or machine hours be used
as the allocation base?

Slide 6-19

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.

Selecting an Allocation Base

Slide 6-20

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Test Your Knowledge 3
In the cost allocation process, an allocation base:
a. Must be some characteristic that is common
to all of the cost objectives
b. Ideally should result in cost being allocated
based on a cause-and-effect relationship
c. Both a and b
d. None of the above
Answer: c
Both a and b
Slide 6-21

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Allocating Service Department Costs
 Organizational units of manufacturing firms
classified as either:
 Production departments

 Engage in direct manufacturing activity
 Service departments
 Provide indirect support

 Cost pools
 Formed by service departments
 Allocated to production departments

Slide 6-22

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Direct Method – Mason Furniture
 Allocate janitorial cost of $100,000
 Allocation base: square feet
Assembly department: 20,000 square feet
Finishing department: 30,000 square feet

 Calculate the allocation rate:
$100,000 / (20,000 + 30,000) = $2/sq ft

 Allocation to production departments:
Assembly dept.:20,000 sq ft x $2 = $40,000
Finishing dept.: 30,000 sq ft x $2 = $60,000
Slide 6-23

Learning objective 1: Explain why indirect costs are

allocated, describe the cost allocation process, and
discuss allocation of service department costs.


Direct Method – Mason Furniture
 Allocate personnel cost of $200,000
 Allocation base: number of employees
Assembly department: 60 employees
Finishing department: 40 employees

 Calculate the allocation rate:
$200,000 / (60 + 40) = $2,000/employee

 Allocation to Production Departments
Assembly dept: 60 x $2,000 = $120,000
Finishing dept: 40 x $2,000 = $80,000
Slide 6-24

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.


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

Slide 6-25

Learning objective 1: Explain why indirect costs are
allocated, describe the cost allocation process, and
discuss allocation of service department costs.