7. Learning
Objective 1
General Framework for Cost Allocation
Cost allocation methods comprise an important
part of a company’s cost management system.
Four types of cost objectives:
Service departments
Producing departments
Products/services, and
Customers.
8. General Framework for Cost Allocation
Producing departments are where employees
Work on the organization’s products or services.
Service departments exist only to
support other departments or customers.
9. General Framework for Cost Allocation
Direct costs can be physically traced to each department.
Indirect costs must be allocated.
Many companies develop allocation methods to assign service
department costs to the producing departments.
10. General Framework for Cost Allocation
All organizations accumulate costs for their
products or services for financial reporting purposes.
Increasingly, companies measure and manage
the costs and profitability of their customers.
Customer related costs include:
Order processing
Customer service sales commissions
Dedicated customer support
11. General Framework for Cost Allocation
An accounting system will assign to a department’s output
all its direct costs plus all the indirect costs allocated to it.
A cost driver that has a logical, cause-effect relationship
to the cost will be used as a cost-allocation base
12. Learning
Objective 2
Allocation of Service Department Costs
Establish the details regarding
cost allocation in advance.
Allocate variable- and fixed-
cost pools separately.
Evaluate performance using budgets for
each production and service department.
14. Service Department Example
Suppose there are two major
purposes for the allocation:
Predicting economic effects
of the use of the computer
Motivating departments and
individuals to use its
capabilities more fully
15. Service Department Example
The primary activity performed
is computer processing.
Resources consumed include
1. Processing time The budget formula for the
2. Operator time forthcoming year is £100,000
3. Consulting time monthly fixed cost plus £200
4. Energy variable cost per hour of
5. Materials computer time used.
6. Building space
16. Variable-Cost Pool
The cost driver for the variable-cost pool is
Actual hours of computer time used.
Therefore, variable costs should
be allocated as follows:
Budgeted unit rate X Actual
hours of computer time used
17. Variable-Cost Pool
Consider the allocation of variable
costs to a department that uses
600 hours of computer time.
600 hours × £200 = £120,000
Suppose inefficiencies in the
computer department caused the
variable costs to be £140,000
instead of £120,000.
18. Variable-Cost Pool
A good cost-allocation scheme would allocate
only the £120,000 to the consuming department
and would let the £20,000 remain as an
unallocated unfavorable budget variance
of the computer department.
This scheme holds computer department managers responsible for the £20,000
and reduces the resentment of user managers.
19. Fixed-Cost Pool
The cost driver for the fixed-cost pool is
the amount of capacity required when
the computer facilities were acquired.
Fixed costs should be allocated as follows:
Budgeted percent of capacity available for use
× Total budgeted fixed costs
20. Fixed-Cost Pool
Suppose the deans had originally predicted the
long-run average monthly usage as follows:
School of Business: 210 hours School of Engineering: 490 hours
How is the fixed-cost pool allocated?
Business: Engineering:
210 ÷ 700 = 30% 490 ÷ 700 = 70%
£100,000 X .3 = £30,000 £100,000 X .7 = £70,000
21. Fixed-Cost Pool
This predetermined lump-sum approach
is based on the long-run capacity
available to the user, regardless of
actual usage from month to month.
A major strength of using capacity available rather
than capacity used when allocating budgeted fixed
costs is that actual usage by user departments does not
affect the short-run allocations to other user departments.
22. Reciprocal Services
Service departments often support
other service departments in addition
to production departments.
There are two popular methods for
allocating service department costs:
The direct method
The step-down method
23. Learning
Objective 3
Direct and Step-Down Methods
The direct method ignores other service
departments when any given service
department’s costs are allocated
to the revenue-producing
(operating) departments.
The step-down method recognizes that some
service departments support the activities
in other service departments as well as
those in production departments.
24. Direct and Step-Down Methods
Facilities management cost = £1,260,000
Human resources cost = £240,000
Total square footage in production departments:
15,000 processing + 3,000 assembly = 18,000
Total employees in production departments
16 processing + 64 assembly = 80
Square footage in human resources = 9,000
29. Step-Down Method
Processing department
Direct Step-Down
Direct department costs £1,000,000 £1,000,000
From facilities management 1,050,00 700,000
From Personnel 48,000 132,000
Total costs £2,098,000 £1,832,000
30. Step-Down Method
Assembly department
Direct Step-Down
Direct department costs £1,600,000 £1,600,000
From facilities management 210,000 140,000
From personnel 192,000 528,000
Total costs £2,002,000 £2,268,000
31. Costs Not Related to Cost Drivers
Identify additional cost drivers.
Allocate all costs by the direct
or step-down method using
square footage as the cost-
allocation base.
32. Learning
Objective 4 Traditional Approach
1. Divide the costs in each
producing departments.
Direct costs Indirect costs
2. Assign direct costs to the appropriate
products, services, or customers.
33. Traditional Approach
3. Select one or more cost pools and related
cost drivers in each production department.
Indirect departmental costs
Cost Cost Cost
pool pool pool
36. Activity-Based Costing
Step 3:
Collect relevant data concerning costs
and the physical flow of the cost-driver
units among resources and activities.
Step 4:
Calculate and interpret the new
activity-based cost information.
37. Learning
Objective 5 Allocation of Customer Costs
Allocate costs associated with
customer actions to customers.
Customer profitability depends on more than gross
margin, it depends on the costs incurred to fulfill
customer orders and to provide other customer services.
38. Allocation of Customer Costs
Customer Type 1 Customer Type 2 High Cost
Low Cost to Serve to Serve
Small order quantity
Large order quantity
Many order changes
Few order changes
Large amounts of pre-
Little pre- and
and post-sales support
post-sales support
Expedited scheduling
Regular scheduling
Special delivery requirements
Standard delivery
Frequent returns
Few returns
39. Allocation of Customer Costs
Customer Type 1 Customer Type 2 High Cost
to Serve
Low Cost to Serve
Buys a mix of products that Buys a mix of products
have high gross margins that
Has a low cost-to-serve % have lower gross margins
Has a high level of Has a high cost-to-serve %
profitability Has a low level of
profitability
40. Allocation of Customer Costs
Assume Cedar City Distributors (CCD), distributes many products
to retail outlets.
The products are classified into just two product groups – apparel and
sports gear.
CCD has two types of customers:
1. Small store
2. Large store
41. Allocation of Customer Costs
CCD uses a simple cost accounting system to calculate both product and
customer profitability.
The only direct costs are costs Indirect costs are
of the purchase of apparel allocated to the product
and sports gear products. groups using a single
indirect cost pool for all
indirect costs with
“pounds of product” as
Costs
the allocation base.
42. Allocation of Customer Costs
To determine customer profitability:
1. Calculate the profit margin per case for each product
2. Use the product mix ordered by each customer to calculate profitability
Small Stores Large Stores
Cases Profit Margin Total Cases Profit Margin Total
per case Profit Margin per case Profit Margin
Apparel 600 £265.00 £159,000 800 £265.00 £212,000
Sports Gear 200 315.00 63,000 800 315.00 252,000
222,000 464,000
Profit Margin Percentage 43.7% 41.4%
43. Allocation of Costs-to-Serve
Might number of customer orders be a more plausible cost-
allocation base?
The cost of resources used for order processing and customer service
activities should be included in a separate cost pool and allocated on the
basis of number of orders.
This system gives managers at CCD more insight into operations, and
a tool to measure and manage customer profitability.
44. Learning
Objective 6 Allocation of Central Costs
Many managers believe it is desirable
to fully allocate all costs to the revenue-
producing parts of the organization.
Whenever possible, the preferred
driver for central services is usage.
If a company does allocate the costs of
central services based on sales, although
costs do not vary in proportion to sales, it
should use budgeted, not actual, sales.
45. Allocation of Central Costs
Usage Not always economically viable
Revenue
Total assets
Cost of goods sold
Total cost of each division
46. Learning
Objective 7 Allocation of Joint Costs
Two conventional ways of allocating
joint costs to products are widely used:
Physical Relative
units sales values
Joint costs include all inputs of material, labor, and
overhead costs that are incurred before the split-off point.
47. Allocation of Joint Costs
The physical-units The joint costs are
method requires a allocated based on
common physical each product’s
unit for measuring percentage of the
the output of each total physical
product. units produced.
Allocation of joint costs should not affect
decisions about the individual products.
48. Physical-Units Method
Dow Chemical produces two chemicals, X and Y. The joint
cost is £100,000. X sells for £.09 per liter and Y for £.06.
Allocation Sales Value at
Liters Weighting of Joint Costs Split-off Point
X 1,000,000 (10/15)X£100,000 £ 66,667 £ 90,000
Y 500,000 (5/15)X£100,000 33,333 30,000
1,500,000 100,000 120,000
49. Relative-Sales-Value Method
The joint costs are allocated based on each
product’s sales value as a percentage
of the total sales value at split-off.
50. Relative-Sales-Value Method
When weighting is based on the sales value of the
individual products, the allocation of a cost to one product
depends upon the sales value of both products.
Relative Sales
Value at Allocation
Spit-off Point Weighting of Joint Costs
X £ 90,000 (90/120)X£100,000 £ 75,000
Y 30,000 (30/120X£100,000 25,000
£120,000 £100,000
51. By-Product Costs
A by-product is not individually
identifiable until manufacturing
reaches a split-off point.
They have relatively insignificant
sales value.
52. By-Product Costs
If an item is accounted for as a
by-product, only separable
costs are allocated to it.
All joint costs are allocated
to the main products.
Any revenues from by-products, less
their separable costs, are deducted
from the cost of the main products.
