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CHAPTER 6
Cost Allocation and ActivityBased Costing
Purposes of Cost Allocation
Purposes of Cost Allocation
To Provide Information for Decision
Making
 Allocated cost should measure the
opportunity cost of using a company
resource.
 Difficult to operationalize
 Provides a useful benchmark
Purposes of Cost Allocation
To Reduce Frivolous Use of
Common Resources
 Without allocation of costs, resources
may be used for nonessential purposes
 Allocation of cost provides incentive for
departments to reduce frivolous use of
resource
Purposes of Cost Allocation
To Encourage Evaluation of Services
 If costs are not allocated, there is no
incentive to evaluate the services
 With cost allocation, there is a strong
incentive to critically evaluate the
efficiency and necessity of services
Purposes of Cost Allocation
To Provide “Full Cost” Information
 GAAP requires full costing for external
reporting purposes
 Additionally, full cost information
needed in areas such as “cost-plus”
contracts
Process of Cost Allocation
 Identify the Cost Objectives
 Form Cost Pools
 Select an Allocation Base to Relate
the Cost Pools to the Cost Objectives
Cost-Plus Contracts
Process of Cost Allocation
Determining the Cost Objective
Forming Cost Pools
 A grouping of individual costs
 Total is allocated using one
allocation base
 Cost Pool Examples
 Departments (Maintenance, Personnel)
 Major Activities (Equipment Setups)
Selecting an Allocation Base
 Should select an allocation base that
relates the cost pool to the cost objectives
 Should be based on cause-and-effect
relationship
 If indirect costs are fixed, cause-andeffect relationships are difficult to
establish and other approaches are used
Study Break #1
In the cost allocation process, the cost
objective is the:
a. The allocation base used to allocate the
costs
b. A grouping of individual costs whose total
is allocated using one allocation base
c. The product, service or department that is
to receive the allocation
d. None of the above
Answer:
c. The product, service or department
that is to receive the allocation
Study Break #2
In the cost allocation process, an
allocation base:
a. Must be some characteristic that is
common to all of the cost objectives
b. Ideally should result in cost being allocated
based on a cause-and-effect relationship
c. Both a and b
d. None of the above
Answer:
c. Both a and b
Fixed Indirect Costs – Other
Approaches
 Relative Benefits Approach to Allocation
 More costs allocated to those objectives that
benefit most from incurring the cost
 Ability to Bear Costs
 More costs allocated to those that are more
profitable
 Equity Approach to Allocation
 Base results in allocations that are perceived
to be fair or equitable
Allocating Service Department
Costs
 Organizational Units of Manufacturing
Firms
 Production Departments
 Service Departments
 Cost Pools
 Formed by Service Departments
 Allocated to Production Departments
Direct Method of Allocating
Service Department Costs
Service department costs allocated to production
departments but not other service departments
Direct Method – Mason Furniture
Example Exercise #1
 The building maintenance department for Taylor Bath
Manufacturing Company budgets annual costs of $3,000,000
based on the expected operating level for the coming year.
The costs are allocated to two production departments.
Taylor Bath is considering two allocation bases for assignment
of costs to departments: (1) square footage and (2) direct labor
hours. The following data relate to the potential allocation
bases:
Square Footage
Direct Labor Hours
Production Dept. 1
20,000
30,000
Production Dept. 2
30,000
20,000
 Calculate the costs allocated to the production departments
using each allocation base. Comment on which allocation
base is preferable.
Example Exercise #1 Solution
 Square Footage as an Allocation Base
 Production Department 1
= (20,000/50,000) x $3,000,000
= $1,200,000
 Production Department 2
= (30,000/50,000) x $3,000,000
= $1,800,000
Example Exercise #1 Solution
Direct Labor Hours as an Allocation
Base
 Production Department 1
= (30,000/50,000) x $3,000,000
= $1,800,000
 Production Department 2
= (20,000/50,000) x $3,000,000
= $1,200,000
Example Exercise #1 Solution
Which allocation base is preferable?
 As indicated, the choice of the allocation base greatly
affects the allocations of cost. Use of square footage as
the allocation base assigns 60% of the cost to
department 2 and 40% to department 1. However, use
of direct labor hours allocates 60% of the cost to
department 1 and only 40% to department 2.
Department 1 would prefer to be allocated cost based
on square footage and department 2 would prefer
direct labor hours as the base.
 An allocation base that results in a cause and effect
allocation is preferred. If maintenance costs are mostly
related to building maintenance, then square footage is
more likely to result in a cause and effect allocation.
However, if maintenance costs are mostly made up of
machine maintenance, then machine hours might be a
better allocation base.
Allocating Budgeted and Actual
Service Department Costs
 Management should allocate based
on budgeted costs rather than actual
costs.
 Allocation of actual amounts allows
for cost of inefficiencies and waste
to be passed on to production
departments.
Problems with Cost Allocation
 Responsibility Accounting
 Identifies units and individuals responsible
for generating revenue and controlling
costs
 Controllable Costs
 Allocation based solely on costs
management can control
Problems with Cost Allocation
Arbitrary Allocations
 Cost allocations are inherently
arbitrary
 Typically there are numerous allocation
bases that are equally justifiable
Problems with Cost Allocation
 Unitized Fixed Costs
 Fixed costs are divided into a per unit basis
and allocated as a variable cost
 Perception of costs as variable could alter
decision making
 Lump-Sum Allocations
 Allocate predetermined amount of fixed costs
that is not affected by level of activity
 Allocation must appear to be fixed to
management
Problems with Cost Allocation
Too Few Cost Pools
 Although simple, may lead to distortion
of cost allocation
 Product costs will be more accurate
when more overhead cost pools are
used
 Must analyze cost-benefit relationship
of more cost pools
Problems with Cost Allocation
Using Only Volume-Related
Allocation Bases
 Some firms allocate manufacturing
overhead based on volume such as
direct labor or machine hours
 Not all overhead costs vary with volume
Study Break #3
The direct method of allocating costs:
a. Allocates service department costs to other
service departments
b. Allocates only direct costs
c. Allocates service department costs to
producing departments only
d. Both b and c
Answer:
c. Allocates service department costs to
producing departments only
Study Break #4
When fixed costs are stated on a per unit
basis:
a. Fixed costs are said to be “unitized”
b. Fixed costs may appear to be variable to
managers receiving allocations
c. Decision making is greatly improved
d. Both a and b
Answer:
d. Both a and b
Activity-Based Costing
 Relatively recent development in
managerial accounting
 Is considered to have helped to
improve managerial accounting
information
The Problem of Using Only Measures of
Production Volume to Allocate Overhead
 Typical allocation bases include:
 Direct labor hours
 Machine hours
 Assumes all overhead costs are
proportional by production volume
 When they are not proportional by
production volume:
 High-volume products are overcosted
 Low-volume products are undercosted
ABC Portal
The ABC Approach
Common Activities and
Associated Cost Drivers
Example Exercise #2
Power Electronics manufactures
portable power supply units. Power has
recently decided to use an activity-based
approach to cost its products.
Production line setups is a major
activity at Power. Next year Power
expects to perform 1,000 setups at a
total cost of $1,500,000. Power plans to
produce 750 units of product EP150,
which will require two setups. How
much setup cost will be allocated to each
unit of EP150 produced?
Example Exercise #2 Solution
 Cost Per Setup
= $1,500,000 / 1,000
= $1,500
 Cost of Setups Related to EP150
= 2 setups x $1,500
= $3,000
 Setup Cost Per Unit of EP150
= $3,000 / 750 units produced
= $4 per unit
Benefits of ABC
 Provide more accurate costing
 Less likely to undercost/overcost due to
cost drive usage
 May lead to improvements in cost
control
 Costs divided into a number of
activities as compared to two overhead
cost pools
Limitations of ABC
 More costly to develop and maintain
than a traditional costing system
 Develops full cost of products
 Includes fixed costs
 Lacks incremental information
necessary for decision making
Fixes and Variable Costs
Activity-Based Management
Improve efficiency and effectiveness
by analyzing and costing activities
Cost Allocation and Decision
Making
Activity-Based Management
 Determine Major Activities
 Identify Resources Used by Each Activity
 Evaluate the Performance of the Activities
 Identify Ways to Improve the Efficiency
and/or Effectiveness of the Activities
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