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Cost Allocationand Activity-Based

Costing Systems

5

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Cost Allocation• Cost allocation attempts to identify some cost or group of

costs with one or more cost objectives • Cost objectives may be products, departments or divisions • Ideally, the cost-allocation base or cost driver should link

the cost to the cost objective that caused it• Cost pool is a group of individual costs that are allocated to

cost objectives using a single cost driver

Why allocate costs?• Allocate to obtain desired motivation• Allocate to compute income and asset valuations• Allocate to justify costs and obtain reimbursement • Difficult to achieve all three purposes at once• Cost allocations often cause discontent and confusion for

managers

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Three Types of Cost Allocation• Allocation of joint costs to the appropriate responsibility center• Reallocation of costs from one centre to another• Allocation of costs of a unit to its outputs or products or services

Allocation Type 3 Cost Object 3Costs allocated to products, Products, jobs or projects

jobs or projects

Allocation Type 1 Cost Object 1Costs allocated to Responsibility centres

responsibility centres

Cost accounting system accumulates costs

Allocation Type 2 Cost Object 2Costs allocated from one Responsibility centres

responsibility centre to another receiving products or services

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Allocation of Service Department Costs

General Guidelines• Allocate costs based on the activity (cost driver) which caused

the cost to be incurred• Always evaluate performance using budgets• Charge variable and fixed cost pools separately• Establish details of cost allocation procedures in advance

Variable Cost Pool• Allocate variable costs of service department based on usage at

budgeted rates

variable = budgeted x actual volumecost allocation unit rate of usage

Fixed Cost Pool• Allocate fixed costs based on the budgeted amount of capacity

in the service department required by each user department

fixed = budgeted fraction of x total budgetedcost allocation capacity available fixed costs

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Allocating Service Costs – Direct Method

• Allocate service department costs directly to production departments only

Direct costs $126,000 $24,000 $100,000 $160,000 $410,000Step 1:Facilities (126,000) 105,000 21,000

Step 2:Personnel (24,000) 4,800 19,200

Totals $0 $0 $209,800 $200,200 $410,000

Service ProductionDepartments Departments

Facilities PersonnelRestaurants Accom. Total

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Allocating Service Costs - Step Method

• Recognize that some service departments work for other service departments so allocate to all departments sequentially

Direct costs $126,000 $24,000 $100,000 $160,000 $410,000Step 1:Facilities (126,000) 42,000 70,000 14,000

66,000

Step 2:Personnel (66,000) 13,200 52,800

Totals $0 $0 $183,200 $226,800 $410,000

Service ProductionDepartments Departments

Facilities Personnel Restaurants Accom. Total

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Allocating Service Costs - Reciprocal Method

• Recognize that all service departments work for other service departments so allocate to all departments

Direct costs $126,000 $24,000 $100,000 $160,000 $410,000Step 1:Facilities (129,220) 43,073 71,789 14,358

Step 2:Personnel 3,192 (67,030) 12,768 51,070

Totals $0 $0 $184,557 $225,428 $410,000

Service ProductionDepartments Departments

Facilities Personnel RestaurantsAccom. Total

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Allocating Cost to Outputs

• Allocate production-related costs to the production or revenue-producing departments

• Select one or more cost drivers in each production department

• Allocate (or assign) total costs to products or services produced by the department

Restaurants Accommodation

Total costs after allocatingservice department costs(step-down approach) $183,200 $226,800

Divided by cost driver• customer receipts 30,000• direct labour hours 10,000

Cost allocation $6.11 $22.68 base per customer receipt per direct labour hour

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Allocating Joint and By-Product Costs

• Joint costs: Inputs of material, labour and overhead incurred before the split-off point

• Separable Costs: Identifiable with specific end products

• By-product: A product with relatively insignificant sales value identifiable after the split-off point

Chemical X1,000,000 litres$0.09 per litre

= $90,000

Chemical Y 500,000 litres $0.06 per litre

= $30,000

Joint Costs$100,000

ChemicalYA

SeparableProcessing

Costs$20,000

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Allocation of Joint CostsPhysical Units Basis

• Allocate joint costs based on the relative physical measurement of the products after the split-off point

• Often difficult to determine a reasonable unit of measure which is common to all products

Relative Allocation ofProduct Litres Weighting Joint Cost

X 1,000,000 10/15 $66,667

Y 500,000 5/15 33,333

Total 1,500,000 $100,000

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Allocation of Joint CostsSales Value at Split-Off Basis

• Allocate joint costs based on the relative sales value of the products after the split-off point

• Allocations are interdependent

Sales Value Relative Allocation of

Product @ Split-off Weighting Joint Cost

X $90,000 90/120 $75,000

Y 30,000 30/120 25,000

Total $120,000 $100,000

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Activity-Based Costing (ABC)

• Allocation of indirect costs to products/services in relation to the activities which caused them to be incurred

• For example, apply more "quality control" costs to those products which require more quality control testing

• Results in more accurate measurements of product costs

• Causes attention to be directed on activities rather than products

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Traditional Cost System

DirectMaterialCosts

DirectLabourCosts

OverheadCosts

DirectTrace

DirectTrace

DLHAllocation

Products

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ABC Cost System

DirectMaterialCosts

DirectLabourCosts

Overhead Costs

DirectTrace

DirectTrace

Products

Machiningactivitycosts

Assemblyactivitycosts

Inspectionactivitycosts

# of partsProcessing

Hours# of

inspections

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Steps in ABC Costing

Step 1 Determine cost objectives, key activity centres, resources, and related cost drivers

Step 2 Develop a process-based map representing the flow of activities, resources, and their relationships

Step 3 Collect relevant data concerning costs and the physical flow of cost-driver units among resources and activities

Step 4 Calculate and interpret the new ABC information

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Activity-Based Accounting Example

AccountInquiry

$205,332

Corresp-ondence

$35,384

AccountBilling

$235,777

AccountVerification

$88,847

Residential Customers$273,893

CommercialCustomers$291,447

$62.22per labour

hour

$12.64per

letter

$0.097perline

$4.44per

account

Cost Pools Cost ObjectsCost Drivers

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Cost Management SystemsCost Management System• identifies how management’s decisions affect costs

Activity-Based Management (ABM)• distinguish between value-added and non-value-added

costs• eliminate non-value-added cost without affecting the value

of the product to the customer

Just-In-Time (JIT Systems)• focus on eliminating waste and improving quality• purchase material and produce products when needed

• focus on quality• shorter production cycle times• smooth the flow of production• adopt more flexibility with facilities and employees