Managerial accounting 5th jiambalvo ch06

Prepared by Debby Bloom-Hill
CMA, CFM


CHAPTER
CHAPTER 66

Cost Allocation
&
Activity-Based Costing

Slide 6-2


Purposes
Purposes of
of Cost
Cost Allocation
Allocation






Slide 6-3

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

Learning objective 1: Explain why indirect costs are allocated


Purposes
Purposes of
of Cost
Cost Allocation
Allocation

Slide 6-4

Learning objective 1: Explain why indirect costs are allocated


Purposes
Purposes of
of Cost
Cost Allocation
Allocation



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


Purposes
Purposes of
of Cost
Cost Allocation
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 cost 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


Purposes
Purposes of
of Cost
Cost Allocation
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

Purposes
Purposes of
of Cost
Cost Allocation
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


Test Your Knowledge 1

All of the following are reasons indirect costs are allocated to
products, services and departments, except:

a.
b.
c.

d.

To improve decision making
To reduce frivolous use of resources
To provide information on variable and fixed costs
To encourage evaluation of services

Answer: c
Indirect costs are allocated to provide full cost information

Slide 6-9

Learning objective 1: Explain why indirect costs are allocated


Cost-Plus
Cost-Plus Contracts
Contracts

Slide 6-10

Learning objective 1: Explain why indirect costs are allocated


Process
Process of
of Cost
Cost Allocation
Allocation



Cost allocation is achieved by a three step process

1.
2.
3.

Determine the cost objective
Form cost pools
Select an allocation base to relate cost pools to the cost
objective

Slide 6-11

Learning objective 2: Describe the cost allocation process


Process
Process of
of Cost
Cost Allocation
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 2: Describe the cost allocation process


Process
Process of
of Cost
Cost Allocation
Allocation

Slide 6-13

Learning objective 2: Describe the cost allocation process


Process
Process of
of Cost
Cost Allocation
Allocation

Slide 6-14

Learning objective 2: Describe the cost allocation process

Test Your Knowledge 2
In the cost allocation process, the cost objective is the:

a.
b.

The allocation base used to allocate the costs
A grouping of individual costs whose total is allocated using one allocation
base

c.
d.

The product, service or department that is to receive the allocation
None of the above

Answer: c
The product, service or department that is to receive the allocation

Slide 6-15

Learning objective 2: Describe the cost allocation process


Process
Process of
of Cost
Cost Allocation

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.



Slide 6-16

Costs in the pool must be homogeneous (similar)

Learning objective 2: Describe the cost allocation process


Process
Process of
of Cost
Cost Allocation
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-and-effect relationship
Establishing cause-and-effect relationships is not feasible when indirect costs are
fixed



Slide 6-17

Accountants use other methods which are shown on the next slide

Learning objective 2: Describe the cost allocation process


Fixed
Fixed Indirect

Indirect Costs
Costs –
– Other
Other Approaches
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



Slide 6-18

Base results in allocations that are perceived to be fair or equitable

Learning objective 2: Describe the cost allocation process


Select
Select an
an Allocation
Allocation Base
Base



Two production departments: Assembly and Finishing



Both receive allocations of indirect costs from the maintenance
department



Slide 6-19

Should labor hours or machine hours be used as the allocation base?

Learning objective 2: Describe the cost allocation process

Selecting
Selecting an
an Allocation
Allocation Base
Base

Slide 6-20

Learning objective 2: Describe the cost allocation process


Test Your Knowledge 3
In the cost allocation process, an allocation base:

a.
b.

Must be some characteristic that is common to all of the cost objectives
Ideally should result in cost being allocated based on a cause-and-effect
relationship

c.
d.

Both a and b
None of the above

Answer: c
Both a and b

Slide 6-21

Learning objective 2: Describe the cost allocation process


Allocating
Allocating Service
Service Department
Department Costs
Costs



Organizational units of manufacturing firms classified as either:



Production departments

 Engage in direct manufacturing activity


Service departments

 Provide indirect support



Cost pools




Slide 6-22

Formed by service departments
Allocated to production departments

Learning objective 3: Discuss allocation of service department costs


Direct
Direct Method
Method –
– Mason
Mason Furniture
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 3: Discuss allocation of service department costs


Direct
Direct Method
Method –
– Mason
Mason Furniture
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 3: Discuss allocation of service department costs


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

Slide 6-25

Learning objective 3: Discuss allocation of service department costs