COST ALLOCATION AND ACTIVITYThe process BASED

of assigning
indirect costs
COSTING

is

referred to as cost allocation.

The problem arises because most product
costing systems allocate overhead using
measures related to production volume.
Activity-based costing (ABC) is an approach to
allocating overhead costs.

PURPOSES OF COST ALLOCATION

To provide information needed to make

appropriate decisions.
To reduce the frivolous use of common
resources
To encourage managers to evaluate the
efficiency of internally provided services
To calculate the full cost of products for

 From a decision making standpoint, the

allocated cost should measure the opportunity
cost of using a company resource.
How close is this allocation to the opportunity
cost of use? The closer it is, the better the
allocation.
One way to eliminate frivolous use is to charge
for the use of centrally provided services. And
one of the most common ways to charge for use
is to allocate the cost of the service.
Cost allocation is also useful because it
encourages managers to evaluate the services
for which they are being charged.
GAAP requires full
reporting purposes.

costing

for

external

Indirect production costs must be allocated to

PROCESS OF COST ALLOCATION

Identify the cost objectives,
Form cost pools, and
Select an allocation base to relate the cost
pools to the cost objectives.
The object of the allocation is referred to as the
cost objective.
The overriding concern in forming a cost pool is
to ensure that the costs in the pool are
homogeneous, or similar.
Use of a single cost pool for overhead seems
too broad, exactly how many cost pools are
appropriate is not clear.
The allocation can be on a cause-and-effect
relationship.
When indirect costs are fixed, establishing

ALLOCATING SERVICE DEPARTMENT

COSTSservice department
The method of allocating
costs that we cover is called the direct method.
In the direct method of allocating cost, service
department costs are allocated to production
departments
but
not
to
other
service
departments.
Allocate budgeted rather than actual service
department costs.
PROBLEMS
If budgeted WITH
costs COST
are allocated,
service
ALLOCATION
departments cannot pass on the cost of
Allocations
of and
costs
that are not controllable.
inefficiencies
waste.
Evaluate the performance of managers and the
operations under their control.

 Performance evaluation is facilitated by a

system of accounting that traces revenues and
costs to organizational units and individuals
with related responsibility for generating
revenue and controlling costs. Such a system is
referred to as a responsibility accounting
system.
Cost allocation is generally required in a
responsibility accounting system because one
ARBITRARY ALLOCATIONS
organizational unit is often responsible for the
Allocations
of by
costs
are organizational
to a great extent
costs incurred
an other
unit.
inherently arbitrary.

UNITIZED FIXED COSTS AND LUMP-SUM

Most significantALLOCATIONS
problems associated with cost

allocation is due to the fact that allocation

process may make fixed costs appear to be
variable costs.
This happens when fixed costs are unitized

 Allocations of fixed costs must be made in such

a way that they appear fixed to the managers
whose departments receive the allocations.
This is achieved by lump-sum allocations of
fixed costs.
If lump-sum allocations of fixed costs are to
appear fixed, the amount of the allocation must
not depend on changes in activity.
Once the amount of the lump-sum is
determined, it does not vary in response to
THE
PROBLEM
OF TOO FEW COST POOLS
changes
in activity.
Product costs may be seriously distorted when
only a small number of cost pools are used.
In general, product costs will be more accurate
when more overhead cost pools are used.

USING ONLY VOLUME-RELATED

Many overhead
costs are affected
ALLOCATION
BASES by product
complexity rather than volume.
The result is that simple high-volume products
are often overcosted, whereas complex lowvolume products are undercosted.

THE ABC APROACH

Step 1

Identify major activities

Step 2

Group costs of activities into cost

pools

Step 3

Identify measures of activitiesthe

cost drivers

Step 4

Relate costs to products using the

cost drivers

Major Activities

Associated Costs

Cost Driver

Processing
purchase Labor cost for workers determining Number of purchase
orders for materials
order quantities, contacting vendors,
orders processed
and parts
and preparing purchase orders
Handling material and Labor cost for workers handling Number of material
parts
material and parts, depreciation of
requisitions
equipment used to move material
and parts (e.g. depreciation of fork
lift trucks), etc.
Inspecting
incoming Labor cost for workers performing Number of receipts
material and parts
inspections,
depreciation
of
equipment used to test strength of
materials, tolerances, etc.
Setting up equipment

Labor cost for workers involved in Number of setups

setups, depreciation of equipment
used to adjust equipment

Producing goods using Depreciation

manufacturing
equipment
equipment

on

manufacturing Number of machine

hours

Supervising assembly Salary of assembly supervisors

workers
Inspecting
goods

Number of assembly
labor hours

finished Labor
cost
for
finished
goods Number
inspectors,
depreciation
of
inspections
equipment used to test whether
finished goods meet customer
specifications, etc.

of

Model
250
Spade
Number of units

Model
900
Mower

85,000

800

$765,000

$240,000

91,800

12,000

Direct material

153,000

48,000

Overhead

459,000

60,000

Total cost

703,800

120,000

$ 61,200

$120,000

$8.28

$150.00

$.72

$150.00

8.00%

50.00%

Sales revenue
Direct labor

Gross profit
Cost per unit
Gross profit per unit
Gross profit as a % of sales

Overhead
Cost Items

Annual
Cost

Cost driver

Estimated
Annual
Value

Setup costs

$4,000,0
00

Number
setups

Material
handling
costs

$2,000,0
00

Number
of 2,000
material
requisitions

$1,000 per
requisition

Depreciation
of
equipment

$10,000,
000

Number
machine
hours

$500
per
machine
hour

Other

$24,000,
000

Number
of 3,000
$8,000 per
workstations workstatio workstation
used
in ns
s
Model
250 used Model
900
production of across all
Mower
a product Spade
products

Number of setups
Number
of
requisitions

material

Number of machine hours

Number of work stations

of 1,000

Cost per
Driver Unit

of 20,000

$4,000
setup

50

40

100

15

per

Model
250
Spade
Number of units

Model
900
Mower

85,000 Number of units

Direct labor

$91,800 Direct labor

Direct material

153,000 Direct material

Overhead:

800
$12,000
48,000

Overhead:

Setup cost ($4,000

X 2)

8,000

Setup cost ($4,000

X 5)

20,000

Material
handling
cost ($1,000 X 3)

3,000

Material
handling
cost ($1,000 X 50)

50,000

Depreciation
of
equipment ($500
X 40)

20,000

Depreciation
of
equipment ($500
X 100)

50,000

8,000

Other ($8,000 X 15)

120,000

Other ($8,000 X 1)
Total overhead
Total cost

Cost per unit

39,000 Total overhead

$283,0
00

Total cost

$3.34 Cost per unit

240,000
$300,0
00
$375.00

PROS AND CONS OF ABC

Benefits
Accurate costing.
ABC may lead to improvements in cost control.
Limitations
A major disadvantage of ABC is its expense.
Major limitation of ABC is that, in practice, it is
used to develop the full cost of products.
The cost per unit generated by the ABC system
does not measure the incremental costs
needed to produce an item.
Activity-based
management
(ABM)
is
a
management tool that involves analyzing and
costing activities with the goal of improving
efficiency and effectiveness.
ABM focuses on activities with the goal of

REMEMBER YOU GET WHAT YOU

Managers pay attention
to controlling the
MEASURE!

allocation base.
Choice of an allocation base affects other
decisions in
ways that
may
not
be
management
Discuss activity-based
costing
(ABC)
and
cost
obvious.
drivers. Activity-based costing (ABC) is a
costing method that recognizes that costs are
caused by activities. Measures of the key
activities that cause costs to be incurred are
referred to as cost drivers. The cost drivers
are used as the allocation bases to relate
indirect
costs to products.
Unlike traditional
STEP
1: DETERMINE
MAJOR ACTIVITIES
systems, ABC does not focus solely on volumeSTEP
2:
IDENTIFY
RESOURCES
USED
BY
related cost drivers.

EACH ACTIVITY
STEP 3: EVALUATE THE PERFORMANCE OF
THE ACTIVITIES