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Cost Allocation
Cost Allocation means the allotment of proportions of cost to cost centers or cost units.
Cost centre has been defined as “a location, person or item of equipment for which costs
may be ascertained and used for the purpose of cost control”.
Whereas a cost unit is a “unit of quantity of product service or time in relation to which
costs may be ascertained and or expressed”.
Cost allocation includes choosing the object of costing, accumulating the costs that relate
to the object of costing and choosing the method to identify those costs. Usually, the
allocation of costs would be done based on machine-hours, direct-labor hours etc
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Example 1
Solution:
Total labor hours = 6000
Cost Allocation:
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Cost Absorption
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Example 2
Solution:
Cost absorbed would be = 5000 units x Rs. 12 per unit = Rs. 60,000.
This amount would be finally compared with the actual overheads incurred during the end
of the period and under-applied or over-applied overheads will be calculated and adjusted
accordingly.
Pre-determined overhead rate is a rate based on the budgeted overhead and yearly /
period budgeted activity either in direct labor hours, machine hours or number of units etc.
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Cost Ascertainment
(ii) Allocation and apportionment of the expenditure to the cost centres or cost units, or
both.
Element of cost
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Cost Unit
The quantity upon which cost can be conveniently allocated is known as a unit of cost or
cost unit.
The Chartered Institute of Management Accountant (CIMA), London defines a unit of cost
as “a unit of quantity of product, service or time in relation to which costs may be
ascertained or expressed.
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Cost Centre
Cost Centre refers to one of those convenient units into which the whole factory
organization has been appropriately divided for costing purposes.
Example: In a laundry, activities such as collecting, sorting marking and washing of clothes
are performed. Each activity may be considered as a separate cost centre and all costs
relating to a particular cost centre may be found out separately.
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Profit Centre
The profit centre is that segment of the activity of a business with which both the
revenues and expenses are identified and profit or loss made by that particular
segment of activity is ascertained.
There are two main differences between a profit centre and a cost centre:
(i) A cost centre is created for accounting convenience for ascertaining and controlling
costs. Whereas the profit centre is created because of decentralization of business
operations.
(ii) A cost centre does not have target cost. However, a profit centre has a profit target and
it enjoys authority to adopt such policies which are necessary for achieving its target.
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Absorption Costing
Apportionme
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Absorption Costing
Absorption Costing is a principle whereby fixed as well as variable costs are allotted to cost
units and total overheads are absorbed according to activity level.
Absorption Costing is also termed as ‘cost plus’ costing where a fixed percentage is added
to total cost, to cover profit.
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Absorption of overheads
To decide a rate for the absorption of overheads the most common criteria are:
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Over and Under recovery
The overheads incurred in running a business are known with certainty, but the amount of
overhead absorbed is based on prior estimates of the levels of production and therefore
over or under recovery of overheads is likely to be incurred during the period.
The explanations behind the major causes of over and under recovery of overheads are
price functions, a change in level of general economic activity, poor marketing and so on.
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Advantages
• Absorption costing conforms with the accrual concept by matching costs with
revenue for a particular accounting period.
• Stock valuation complies with the accounting standards, and fixed production
costs are absorbed into stocks.
• It avoids separation of costs into fixed and variable elements, which is not easily
and accurately achieved.
• The analysis of under / over absorbed overheads reveals any inefficient utilization
of production resources.
• Cost plus pricing under absorption costing ensures that all costs are covered.
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Limitations
• In this method all fixed costs are not charged against the revenue of the year in
which they are incurred. It is an unsound practice.
• Assigning product cost with a reasonable share of fixed overhead obscures cost-
volume-profit relationship
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Example 3
The total overheads are Rs. 6,000 out of which Rs. 3,000 are fixed and rest are variable.
It is decided to apportion these costs over different products in the ratio of output.
Prepare a statement showing cost of each product and profit according to Absorption
Costing.
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Solution 3
STATEMENT SHOWING COST AND PROFIT
A B C
Per unit Total Rs. Per Unit Total Rs. Per Unit Total Rs.
Rs. Rs. Rs.
Direct Materials 3 3,000 4 4,000 5 5,000
Direct Labour 2 2,000 3 3,000 4 4,000
Overheads:
Fixed 1 1,000 1 1,000 1 1,000
Variable 1 1,000 1 1,000 1 1,000
Total Cost 7 7,000 9 9,000 11 11,000
Profit 3 3,000 6 6,000 9 9,000
Selling Price 10 10,000 15 15,000 20 20,000
Total Profit Rs. 3,000 + Rs. 6,000 + Rs. 9,000 = Rs. 18,000
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QUESTIONS ?
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