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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. The End