Cost Allocation Decisions ACG 4361 Cost Allocation Decisions Prepared by Diane Tanner University of North Florida 2-1

Cost Allocation The process of identifying, aggregating, and assigning common costs to multiple cost objects Is somewhat arbitrary Goal is to allocate the costs fairly Based on the root causes of the common costs instead of simply spreading the costs Process of allocation Identify the allocation purpose This defines which costs will be allocated Determine cost pools Identify an allocation base for each cost pool—an activity

Why Do We Allocate Costs? 3 Why Do We Allocate Costs? To make decisions of pricing, expansion, product dropping, cost-plus contracts, etc. Encourage managers to conserve resources GAAP requires inventory to be reported at its full cost Create incentives for evaluating efficiency of ‘fee’ based company services Cost allocations influence behavior because they are often components of manager’s compensation.

Justifying Cost Allocation Cost allocation requires judgment. Problem  Judgments differ amongst managers. Common criteria used to justify cost allocation methods Cause-and-effect Identifies the activity that causes costs Most used of all criterion in activity based costing Benefits received Allocates the cost to the cost object that received the benefit of the cost Equity/fairness Problematic because fairness is difficult to achieve Ability to bear costs Cost objects that can afford costs (are most profitable) are allocated costs

Two Stages of Cost Allocation Trace direct and allocate indirect costs. Support Department #1 Production Department #1 Cost Object A Direct and Indirect Costs Support Department #2 Production Department #2 Cost Object B Support Department #3 Stage 1. Allocate Support Costs to Cost Pools Stage 2. Allocate Production Cost Pools to Cost Objects

Methods of Allocating Overhead Costs to Cost Objects Allocation method depends on how managers ‘group’ overhead costs Groups of overhead costs are cost pools Simple cost allocation A single “plant-wide” overhead rate used for entire factory Often called traditional allocation Dual rate cost allocation A separate rate for fixed and for variable costs Prevents managers from being influenced by usage Activity based costing Multiple overhead rates—one for each activity Expensive to implement More accurate product costing

Methods of Allocating Service Costs Direct method All service department costs are allocated directly to production departments. Ignores services rendered by one service department to another Step down method Service department costs are allocated based on the department that provides the most service to other service departments Partial recognition of services provided to other service departments is recognized Reciprocal method Recognizes that all service departments provide services to production departments and to all other service departments

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