Cost Allocation Concepts Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 35

Trend Towards Indirect Costs  Automated manufacturing environments experience overhead costs that exceed 60% of total product costs  Recent trends  Reduction of direct costs  Creates greater indirect costs  More services provided  Very little direct costs  High levels of indirect costs 2

Why Do We Allocate Costs? 1.GAAP requires full cost information 2.To make decisions of pricing, expansion, product dropping, cost-plus contracts, etc. 3.Make managers conserve resources 4.Create incentives for evaluating efficiency of ‘fee’ based company services 3

Criteria Used When Selecting Allocation Bases Problem : Identifying a relationship with indirect fixed costs is not feasible  To allocate more costs to the cost objectives that benefit most from incurring the cost  To allocate more costs to most profitable products  To allocate fairly and equitably Relative Benefits Relative Benefits Equity Ability to Bear Costs Ability to Bear Costs 4

Approaches to Assigning Overhead Costs  Traditional allocation  A single “plant-wide” overhead rate used for entire factory  Normal costing  Simple to use  Traditional allocation bases  Direct labor cost  Direct labor hours  Machine hours  Units produced  Activity-based costing  Multiple overhead rates—one for each activity  Expensive to implement  More accurate product costing 5

 Can distort unit product costs  Direct labor and other volume-based rates are not highly correlated with overhead costs  I.e., not all overhead costs increase for the same reason  Single allocation basis does not reflect the activity for all overhead costs Concerns of Using One Overhead Rate 6 6

What is a Cost Object?  A product, job, service provided, batch, or department that will receive a portion of a cost allocation  Something for which we want to know its cost 7

What is a Cost Pool?  A grouping of individual costs whose total is allocated using one allocation base  Often based on departments or the output of a particular process in a company  Usually consists of both variable and fixed costs  Sometimes called a cost bucket 8

What is a Cost Driver?  An activity that causes the cost pool to increase  Often called an activity base because more of the activity ‘drives’ a cost up Products Cost Objects # of DL Hours # of DL Hours # of packages # of packages Amt. of DL$ Amt. of DL$ Activity Bases # of Employees # of Employees # Sq. Feet # Sq. Feet # of Inspections # of Inspections # of Crates # of Crates # of Customers # of Customers 9

Cost Hierarchies Cost hierarchies are levels in which costs occur. 10 Factory costs that impact all the products produced in a factory, such as depreciation on the factory building, factory insurance, factory janitors, factory supplies Facility-level activities Costs specific to particular products such as training employees how to produce it, quality control on a product, etc. Product-level activities Costs specific to particular batches of products such as machine setup for a particular product, machine maintenance between each batch, etc. Batch-level activities Costs performed every time a product is produced. They are usually variable and correlate to the number of products produced, such as packaging, sanding a product edge, printing labels, etc. Unit-level activities

11 The End