Chapter 3

Cost Allocation
1
 Cost Allocation
Cost allocation Is the process of assignment or applying collected indirect
costs to a cost object using an allocation base.

The ultimate goal of cost allocation is to make certain that all costs
incurred by the organization are eventually assigned to products or services.

The purpose of cost allocation includes cost based pricing, bidding/request,

cost reimbursement/repayment/compensation from outside parties like

insurance companies, valuation of inventory, determination of income and

all other economic decisions. 2

 Product cost Elements

Are broadly classified in to three: they are

Direct material cost

Direct labor cost

Manufacturing overhead costs (indirect costs)

Also called inventoriable costs.

3
 Cont.
Direct costs are conveniently and economically traced to a specific cost

object
Direct materials and Direct labor costs are referred as direct cost.

Indirect costs cannot be conveniently or economically traced to a specific

cost objective.
Any production cost not classified as a direct cost is an indirect

4
 Cost allocation and related terms

Cost Allocation: the process of assigning or applying collected

indirect costs to cost objects using an allocation base.

Cost object: is the destination of all assigned or allocated costs.

• E.g. A cost may be assigned to a particular product, service or

department.

5
 Cont.

Cost pool: is a collection of overhead costs related to a cost object (a

product related activity).

Cost driver: is an activity that causes the cost pool to change

(increase/decrease) in amount as the cost driver changes

(increase/decrease) in volume.

6
Purposes of cost allocation
 To provide information for economic decisions:

For making decisions like add a new product to existing,

make or buy a product, and pricing of a product.

The true cost can be arrived only if the manufacturing

overhead cost is properly and correctly assigned.

7
Cont.
To motivate mangers and other employees:

To encourage the design of products that is simpler to manufacture or less costly to

service
To encourage sales representatives to increase high margin product or services.

 To justify cost or compute reimbursement:

To fix the fair price for a product.

To get reimbursement for a consulting firm the correct and true costs are to be arrived.

8
 Cont.
 To measure income and assets for reporting to external parties:

To report inventories correctly in financial reporting to stockholders,

bondholders etc.
To cost inventories for reporting to tax authorities.

9
Criteria to guide cost allocation decisions
Cause and Effect

Identify the variable or variables that cause resources to be consumed.

E.g. Managers may use hours of testing as the variable when allocating the costs of quality testing

area to products.
Benefits Received

Identify the beneficiaries of the outputs of the cost object.

The costs are allocated among the beneficiaries in proportion to the benefits receives.

E.g. corporate wide advertising program that promotes the general image of the corporation rather

than any individual product.

Divisions with higher revenues apparently benefit from the advertising more than divisions with
10
Cont.
Fairness or Equity
Is often cited in government contracts when cost allocations are the basis for
establishing a price satisfactory.
A “reasonable” or “fair” means of establishing a selling price
Ability to bear
Allocating costs in proportion to the cost objects ability to bear them.
E.g. Allocation of corporate executive salaries on the basis of division operating
income.
The presumption is that the more profitable divisions have a greater ability to absorb
corporate headquarters’ costs. 11
Steps in the process of applying manufacturing overhead

1. Planning step

Predetermined overhead rate is calculated in traditional settings

Activity pool rate is calculated in activity based costing settings

No journal entry is required during this stage.

12
Cont.
Application step

The estimated manufacturing overhead costs are assigned to the products costs as

units are manufactured.

The actual cost driver level is multiplied by the predetermined manufacturing

overhead rate or activity pool rate for that cost driver

Applied manufacturing Actual cost * Predetermined
manufacturing
overhead cost = driver level overhead rate
13
 Cont…
The journal entry to record the application of manufacturing overhead would
be:

Work in process inventory debit

Manufacturing overhead Credit

Example 1: Assume Afro company has incurred 78,000 birr direct labor cost
for the month of April and from past experience of the company, the
manufacturing overhead cost rate is 80% of direct labor costs.

This implies the overhead costs applied is Birr 62,400.

14
cont

Work in process inventory 62,400

Manufacturing overhead 62,400

15
 Cont.
3. Recording step
Record the actual manufacturing overhead costs incurred during the period

These costs will be part of the actual product costs

Include the costs of indirect materials, indirect labor, depreciation, property taxes and other
production cost.

Journal entry:
Manufacturing overhead cost debit
Cash or A/p Credit
The credited account will also be various accounts that stands for accounts
payable, wages payable and other accounts like depreciation costs, tax paid,16 etc.)
In the previous example under the application step, the actual overhead
cost incurred by Afro company in the month of April indicates that Birr
12,000 for indirect materials purchased on account, indirect labor cost of
Birr 28,000 and other manufacturing costs other than indirect materials and
indirect labor are Birr 28,000.

Manufacturing overhead cost 68,000

various accounts 68,000

17
Cont….

4. Reconciliation step

The difference between the applied manufacturing overhead costs and the actual
overhead costs is calculated at the end of accounting period.

If applied manufacturing overhead is more than the actual manufacturing overhead
called over- applied overhead

If applied overhead is less than the actual manufacturing overhead called under-
applied overhead

Here both adjustment for difference is made based on the materiality of the amount.
18
 Cont.
If the amount is Immaterial (less in amount)
1. for over applied
Manufacturing overhead debit
Cost of goods sold credit
2. For under applied

Cost of goods sold debit

Manufacturing overhead cost credit

19
 Cont.

Note that if the difference is material (more) then the adjustments are made to
finished goods, cost of goods sold and work in process

Example: Refer the previous example and make the adjustments by assuming:

a. The amount is immaterial

b. The amount is material and assume at the end of April the company has Birr
50,000 work in process, Birr 30,000 finished goods reported in its balance
sheet and Birr 120,000 cost of goods sold reported in its income statement.

20
 Cont
A. Cost of goods sold 5,600

Manufacturing overhead cost 5,600

B. Cost of goods sold 3,360

Work in process 1,400
Finished goods 840
Manufacturing overhead cost 5,600

21
 Cont….
Example 2

Assume for Delt corporation the applied manufacturing overhead is Br.320,000 and the Actual
manufacturing overhead cost is Br.300,000 for the month of July.

Required:

Pass the necessary journal entries to apply the estimated overhead cost, to record the actually incurred
overhead cost

Determine either over applied or under applied.

Make adjustments by assuming the difference is immaterial.

Make adjustments by assuming the difference is material. (work in process Br.28,000, finished goods
Br.42,000 and cost of goods sold Br.130,000.) 22
Manufacturing overhead allocation using the traditional
approach
• A single predetermined overhead rate is used by many organizations for the
application of manufacturing overhead.

• This method is useful if companies manufacture only one product or two very
similar products that require the same production related activities such as set
up, inspection and material handling.

• In the tradition approach of cost allocation, manufacturing overhead costs are

allocated using a single cost pool and single cost allocation base.
23
 Cont.
• The total manufacturing overhead cost represent one cost pool and a traditional
activity base, such as direct labor hours, direct labor costs, machine hours or unit
of production, become the cost driver.

• The calculation of the predetermined overhead costs under the traditional

approach is based on the budgeted cost as a numerator and the budgeted
allocation base as denominator.

• However, the application of manufacturing overhead costs to the products is

based on the actual usage, i.e., the budgeted rate multiplied by the actual usage
of the allocation base or cost driver by each product or batch of product. 24
 Example:
• Assume Philips TV set manufacture manufacturing 14” and 21” color TV sets.

• They are using the application of one cost pool of manufacturing overhead costs to
two product lines.

• Suppose the Philips set manufactures choose machine hours as the cost driver.

• For the next year, the overhead cost will amount to $300,000 and that total
machine hours worked will be 30,000 hours.

• During the year 10,000 machine hours were used to produce 5000, 14-inch TV sets
and 20,000 machine hours were used to produce 4000, 21inch TV sets.
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 Solution
• Step1. First compute the predetermined overhead rate by using the
traditional approach.

• Predetermined overhead = Budgeted cost

• Budgeted allocation base

300,000
• = $ 30,000

• =$ 10 per machine hour

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Step 2
• The second step is to apply manufacturing overhead to the products.

• Apply manufacturing overhead= predetermined rate x actual cost allocation base

• Philips Corporation the portion of manufacturing overhead cost applied to the 14inch
TV sets

• = ($10 x 10,000 MH) = $100,000

• or ($100,000  5,000units) = $20 per unit

• The portion applied to 21-inch TV sets totaled ($10 x 20,000 MH) = $200,000

• or ($200,000  4000units)= $50 per unit 27

• Philips Corporation also wanted to calculate the normal product unit cost

during the accounting period. The corporation supplied the following data for

the two product lines:

• 14 inch 21 inch

• Actual direct materials cost per unit $ 70 $ 80

• Actual direct labor cost per unit 30

40

• Prime cost per unit 100 120

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• Philips Corporation also wanted to calculate the normal product unit cost

during the accounting period. The corporation supplied the following data for

the two product lines:

• 14 inch 21 inch

• Actual direct materials cost per unit $ 70 $ 80

• Actual direct labor cost per unit 30

40

• Prime cost per unit 100 120

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Manufacturing Overhead allocation using Activity based costing (ABC)

• Activity –Based Costing (ABC) is a method of assigning costs that calculates

a more accurate product cost by categorizing all indirect costs by activity,

tracing the indirect costs to those activities and assigning activity costs to

product using cost driver that are related to the cause of the product.

• Activity Based costing focuses on activities performed to produce a product

and categorizes (pools) the activities and activity costs based on their

similarity.
30
Cont.
• The manager will calculate a predetermined overhead rate or activity cost rate,
for each activity pool and then use that rate and a cost driver amount to
determine the portion of manufacturing overhead costs to assign to a product.

• Managers must select an appropriate number of activity pools for

manufacturing overhead.

• A system must be designed to capture the actual cost driver amounts.

• ABC will improve the accuracy of product costs for organizations that sell
many different types of products (product diversity) or use varying, significant
amounts of different production related activities to complete the products. 31
 Cont.
• Thus, ABC, by assigning overhead costs based on the relative use of
overhead resources, would provide managers with better information for
making decisions related to fixing selling prices, determination of accurate
income, ask compensation, tax refunds, inventory valuation and make or
buy decisions.

• Determination of accurate costs of products or services avoids

understatement or overstatement of income and inventory valuation.

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 Example
• Philips Corporation analyzed the production related activities and decided
that the estimated $300,000 in manufacturing overhead cost should be
grouped into four activity pools.

• The 1st activity, setup, includes estimated total costs of $100,000 for indirect
labor and indirect materials used in preparing machines for each batch of
production.

• The 2nd activity, inspection, includes $90,000 for salaries and costs of
indirect materials, indirect labor and depreciation on testing equipment. 33
Cont.
• Packaging, the 3rd activity, includes estimated total costs of $ 65,000 for
indirect materials, indirect labor and equipment depreciation.

• The last activity, building, includes wages, property taxes, insurance,

security and all other costs not related to the first three activities.

• After identifying the four activity pools, Philips Corporation selected a cost
driver and estimated the cost driver level for each activity pool.

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The following schedule shows those amounts by product line
and in total
• Estimated Cost Driver Level
• Cost driver 14inch 21inch
Total
• Number of setups 500 500 1,000
• Number of inspections 250 350 600
• Packaging hours 1,200 1,300 2,500
• Machine hours 14,000 16,000
30,000

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• Step 1 Calculation of overhead activity cost rates

• Activity cost pool rate = Estimated activity pool cost

• Budgeted cost driver level

• Activity Estimated Cost driver activity

• Pool Activity pool level cost rate
• Amount Cost Driver
• Set up $100,000 No. of set ups 1,000 setups $100per setup
• Inspection 90,000 No. of inspections 600 inspections $150per
inspection
• Packaging 65,000 Packaging hours 2,500 packing hours $26per packing
hour
• Building 45,000 Machine hours 30,000Machine hours 1.5per machine
hour 36
 Step 2: Application of manufacturing overhead costs to
production:
• Cost applied = Activity cost pool rate x actual cost driver level
14 inch 21 inch

Activity pool Activity cost rate Cost Driver level Cost applied Cost Driver level Cost applied

Set up $100 per set up *500 set ups $ 50,000 *500 set ups $50,000

Inspection $150 per inspection *250 inspection $ 37,500 *350 inspections $52,500

Packing $26 per packing hour *1,200 packing hour $31,200 *1,300 packing hour $33,800

Building $1.5 per Machine hour *14,000 Machine hour $21,000 *16,000 Machine hour $24,000

Total $ 139,700 $ 160,300

Number of units 5,000 4,000

Manufacturing overhead cost per unit $ 28 $ 40

37
Product Unit Cost
14inch 21inch
Direct materials $ 70 $ 80
Direct labor 30 40
Manufacturing overhead 28 40
Product unit cost 128 160

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Step 2
• In step 2, Philips Corporation applied manufacturing overhead to the two product lines
using the cost driver level for each product multiplied by the activity cost rate shown.

• For example, Philips Corporation applied cost to 14-inch model

• =($100 x 500 set-ups)

• =$50,000 in set up costs

• To the 21-inch model.

• =($100 x 500 set ups)

• =$50,000 to the 21-inch model.

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 Allocating Costs from One Department to Another.

• Single-Rate and Dual-Rate Methods

• The single-rate allocation method pools all costs in one cost pool and allocates
theses costs to cost objects using the same rate per unit of the single allocation base.

• There is no distinction between costs in a cost pool in terms of cost behavior, such
as fixed costs versus variable costs.

• The dual-rate cost allocation method classifies costs in each cost pool into to sub
cost pools, a variable cost pool and a fixed cost pool.

• Each of these pools uses a different cost allocation base.

40
 Example:
• Sand Hill Co. has a Central Computer Department; the department has two users, Microcomputer
Division and Peripheral Equipment Division. The following data apply to the coming budget year.
• Fixed costs of operating the computer facility in the
• 6,000-18,000 hr relevant range Br3, 000,000/year
• Total capacity available 18,000hrs
• Budgeted long-run usage
• Microcomputer Division 8,000hrs
• Peripheral Equipment Division 4,000hrs
• Total 12,000hrs
• Budgeted variable cost per hour $200/hour used
• Assume during the year the Microcomputer uses 9,000 hrs and Peripheral Equipment uses 3,000
actual hours. 41
 1. Single Rate Allocation Method

• Total cost pool =3,000,000+200*12,000 5,400,000

• Budgeted usage 12,000hrs
•
• Budgeted totals rate per hour= 5,400,000 = Br.450/hr
• 12,000hrs
• Allocation rate for Microcomputer Division Br. 450/hr
• Allocation rate for Peripheral Division Br. 450/hr
• Microcomputer=9000*450= Br. 4,050,000.
• Peripheral Equipment= 3000*450= Br.1, 350,000.

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 2. Dual-rate Allocation Method

• Allocation of Fixed Costs to:

• Microcomputer Division = 8000/1200hrs * 3,000,000 = Br. 2,000,000/year.

• Peripheral Equipment Division = 4000/12000hrs * 3,000,000 = Br.

1,000,000/year.

• Allocation of variable costs to:

• Microcomputer: 2,000,000 + (200*9000) = Br. 3,800,000.

• Peripheral Equipment: 1,000,000 + (200*3000) = Br. 1,600,000.

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 Allocating Support Departments cost
• Operating and Support Departments

• Operating Department (Production Department) adds value to a product or service that is observable

by a customer.

• Support Departments (Service Department) provide the service that assists other internal departments.

• Support Department creates a special cost allocation problem when they provide reciprocal support to

each other as well as support to operating departments.

• Methods:

A. Direct Allocation Method

B. Step-Down Allocation Method

C. Reciprocal Allocation Method 44

Example
• ABC Engineering has two Support Departments and Two operating Departments.
Costs are accumulated in each department for planning and control purposes.

• Support Departments Operating Departments

• Plant Maintenance Machining

• Information Systems Assembly

• The two support departments provide reciprocal support to each other as well as to
the two operating departments. Costs are accumulated in each department for
planning and control purpose. 45
Departments
Plant Main.Info. Systems. Machining Assembly
Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000
1,316,000
Support work finished
By plant maintenance
Budgeted labor hrs - 1,600 2,400 4,000
8,000
Percentage - 20% 30% 50% 100%
By Infor. System.
Budgeted com. Hrs 200 - 1600 200
200 46
Required: Allocate costs using the three methods.
1.Direct Allocation Method
This method is the most widely used method of allocating
support department costs.
This method allocates each support department costs
directly to the operating departments.

Information Systems Assembly

Plant Maintenance
Machining
47
 Support Departments Operating Departments
Plant Main. Infor. Systems. Machining Assembly
Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 400,000 $200,000
1,316,000
Allocation by Plant Mai. (600,000) 225,000
375,000
(2400/6400, 4000/6400)
Allocation by Inf. Syste. 0 (116,000) 103,111
12,889
(1600/1800, 200/1800)
Total Budgeted MOH of 0 $728,111 $578,889
$1,316,000 48
• Advantage of this method:
• Simplicity

• No need to predict the usage of support department service by other support

departments.

• Disadvantage
• Failure to recognize reciprocal services provided among support
departments.
49
1.Step-Down Allocation Method (Sequential Allocation Method)
1.Allows the partial recognition of the service rendered by support departments to other
support departments.
2.This method requires the support departments to be ranked (sequenced) in order that the
step-down allocation is to proceed. Different sequences will result in different allocation of
support department costs to operating departments.
3.Popular step-down begins with the support department that renders the highest
percentage of its total services to other support departments and so on, ending with the
support department that renders the lowest percentage of its total services to other support
departments.

Plant Maintenance Machining

Information Systems Assembly

50
Solution
• Support Departments Operating Departments
• Plant Main.Infor. Systems. Machining Assembly Total
• Budgeted MOH cost
• Before any inter-dept
• Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
• Allocation by Plant Mai. (600,000) 120,000 180,000 300,000
• (1600/8000, 2400/8000, 4000/8000) 236,000
• Allocation by Inf. Syste. 0 (236,000) 209,778 26,222
• (1600/1800, 200/1800)
• Total Budgeted MOH of 0 $789,778 $526,222
$1,316,000
• Operating departments
• Note: The step-down method does not recognize the total services that support
department provide to each other. 51
 Reciprocal Allocation Method
• Allocates cost by explicitly including the mutual services provided among all
support departments.

• Conceptually the direct method and the step-down allocation method are less
accurate than the reciprocal method when the support departments provide
service to another reciprocally.

• The reciprocal method enables us to incorporate interdepartmental relationships

fully not the support department cost allocations.

• Implementing the reciprocal allocation method requires three steps: 52

 Cont.
1. Express Support Department Costs and support department
reciprocal relationships in the form of Linear Equation.

• Let PM be the completed reciprocated costs of Plant Maintenance and

IS be the complete reciprocated costs to Information Systems.

• PM = $600,000 + 0.1 IS

• IS = $116,000 + 0.2 PM

53
Cont.
• 2. Solve the cost of linear equation to obtain the complete reciprocated costs
of each support departments.

• PM = 600,000 + 0.1 (116,000 + 0.2PM)

• PM = 600,000 + 11,600 + 0.02PM

• 0.98PM = 611,600

• PM = $624,082

• IS = 116,000 + 0.2(624,082)

• IS = $ 240,816 54
3. Allocate the complete reciprocated costs of each department
to all other departments (both support department and
operating departments).
Support Departments Operating Departments
Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000
1,316,000
Allocation by Plant Mai. (624,082) 124,816 187,225 312,041
(1600/8000, 2400/8000, 4000/8000)
Allocation by Inf. Syste. 24,082 (240,816) 192,652 24,082
(200/2000 1600/2000, 200/2000)
Total Budgeted MOH of 0 0 $779,877 $536,123 $1,316,000
Operating departments

Plant Maintenance Machining

Information Systems
Assembly 55
Allocating Common Costs
• A common cost is a cost of operating a facility, activity, or like cost object that is shared by
two or more users.

• Consider Ayele, a senior student in Addis Ababa University who has been invited to an
interview with an employer in Mekele. The round trip Addis-Mekele airfare costs Br.1200.

• A week prior to leaving Ayele is also invited to an interview with an employer in Bahir Dar.

• The Addis- Bahir Dar round trip airfare costs Br. 800.

• Ayele decided to combine the two recurring trips into an Addis-Mekele- Bahir Dar trip that
will cost $1,500 in airfare.

• The Br 1, 500 is a common cost that benefits both prospective employers

56
Two methods of allocating this common cost are:

• Stand-Alone Cost-Allocation Method

• This method uses information pertaining to each user of a cost object as a

separate entity to determine the cost-allocation weights.

• For the common cost $1,500, information about the separate (stand alone)
round-trip airfares ($1200, and $800) is used to determine the allocation
weights.

57
Mkele employer: $1,200 * 1,500 = 0.60*1,500= $900
$1,200 + $ 800

Bahir Dar employer: $800 * 1,500 = 0.4 * 1,500 = $600

$800 + $1,200
Advantage: Fairness occurs because each employer bears a proportionate share
of total costs in relation to their individual stand-alone costs.

58
 B. Incremental Cost Allocation Method

• This method ranks the individual users of a cost object and then uses this ranking to
allocate costs among those users.

• The first ranked user of the cost object is termed the primary user.

• The second ranked user is termed the incremental party and is allocated the
additional cost that arises from there being two users instead of only the primary
user.

• Assume in the example the Mekele flight is viewed as the primary party.

• Ayele’s rational is that he had already committed to go to Mekele before accepting

the invitations to interview in Bahir Dar. 59
The cost allocation would be:
Party Cost Allocated Costs remaining to be
Allocated to other parties
Mekele (primary) $1,200 $300 ($1,500 - $1,200)
Bahir Dar (incremental) 300 0
Had the Bahir Dar employer been chosen as the primary party, the cost
allocations would have been Bahir Dar $800 and Mekele $700(1500-800).
Under the incremental method, the primary party typically receives the
highest allocation of the common costs.
Most users in common cost situations propose themselves as the 60
E
n
d
61
 CHAPTER-4
PRODUCT COSTING
SYSTEMS

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 We are what we do repeatedly.
Therefore, excellence is a habit, not an
incidence

63
To do some thing and fail is experience,
real failure is not doing any thing at all

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