Cost Allocations

EMBA 5412
Fall 2007

What are Cost Allocations

Assignment of

Indirect
Common
Joint costs

To cost objects

Processes
Products
Programs etc.
2

Process of cost allocation

Define cost objects

Accumulate costs for different cost
centers that serve the cost object
Choose the method and apply to
allocate the accumulated costs to
objects

definitions

Cost object is a product, process, department, or program that

managers wish to cost.

Common cost is a cost shared by two or more cost objects.

Examples: Accounting, building maintenance, supervisors.

Cost allocation is the assignment of indirect, common, or joint

costs to cost objects.

Allocation base is the measure of activity used to allocate

costs. Examples: hours, floor space, sales amount.

Surveys of Cost Allocation

Practices by Large Corporations

What corporate-level costs are allocated to profit centers?

Most often: selling and distribution expenses
Least often: income taxes
What allocation bases are used?
Meter: measure actual use
Negotiate: estimate usage
Prorate: based on relative proportions of sales, profits, or
assets

why
Control and behavioral uses 42%
Signaling resource allocation 32%
Cost determination 19%
Overhead allocation 5%
Fairness 2 %
(source: Zimmerman, 2003,p338)

What costs are allocated

Income taxes 44%
Interest expenses and capital charges
62%
Research and development 72%
Finance and accounting 73%
Selling costs 91%
Distribution costs 100%
(source: Zimmerman, 2003, p.338

Types of cost allocations

Service department cost allocations

Allocations to products

Basis of Allocations

Budgeted vs actual vs capacity

Based on budgeted costs;

Managers know with certainty what will

be allocated both user and service dept
managers
Better for planning of user departments
Responsibility of variances from the
budget lies with the service department
manager

lead to more efficient budgeting?

9

Allocation methods used by banks

in the USA
Types of overhead costs allocated to responsibility centers
Level of
importance
1: most 7: least

Executive
salaries

Central office
rent/depreciation

Advertising and
other marketing
expenses

Data processing
and accounting
expenses

Time spent with

executives

Square footage

Time spent by
marketing pers

Time spent by
accountants,etc

Personnel costs

Personnel costs

No of customers
served

Transaction
volume

Transaction
volume

Transaction
volume

Other (includes
no allocation)

Personnel costs

Other (includes
no allocation

No of customers
served

Transaction
volume

No of customers
served

No of customers
served

Interest Costs

Personnel costs

No of customers
served

Interest Costs

Other (includes
no allocation)

Interest Costs

Interest Costs

Square footage

Not reported

Square footage

Square footage

Source: Zimmerman, 2003,p.351

10

Service Department Cost Allocation

Supporting (Service) Department

provides the services that assist other
internal departments in the company
Operating (Production) Department
directly adds value to a product or
service

11

Service Department Cost Allocation

Helps in usage of common resourcesuser departments consumption of

common costs are affected by the
internal price charged
Provides information about the
demand on the service department
Comparison of internal costs (internal
transfer price) and external purchase
price)
12

Methods to Allocate
Support Department Costs

Single-Rate Method allocates costs in

each cost pool (service department) to cost
objects (production departments) using the
same rate per unit of a single allocation
base

No distinction is made between fixed and

variable costs in this method

Dual-Rate Method segregates costs within

each cost pool into two segments: a
variable-cost pool and a fixed-cost pool.
Each pool uses a different cost-allocation
base
13

Discussion of single vs double

Single-rate method is simple to implement,

but treats fixed costs in a manner similar to
variable costs in the user department
Dual-rate method treats fixed and variable
costs more realistically, but is more
complex to implement

Hard to classify costs as fixed and variable

More data should be gathered

14

Allocation Bases

Under either method, allocation of support costs can

be based on one of the three following scenarios:

Budgeted overhead rate by the service department

and budgeted hours of usage by the user department

Budgeted overhead rate by the service department

and actual hours usage by the user department

Actual overhead rate of the service department and

actual hours usage by the user department

Choosing between actual and budgeted rates:

budgeted is known at the beginning of the period,
while actual will not be known with certainty until the
end of the period
15

Illustration
Computer center of BN corporation has two user departments: assembly and
polishing.
The following data are taken from 2008 budget:
Total costs of CC TL 6.750.000
Fixed costs of CC
3.000.000
Practical Capacity
20.000 hours
Budgeted Usage-hours
Assembly
10.000
Polishing
5.000
total
15.000
Budgeted Variable cost per hour TL 150
Actual Usage in 2008
Assembly
9.000 hours
Polishing
6.000
Total
15.000
Actual Total Costs of CC TL 6.900.000
Actual Variable Costs of CC TL 160/hour
Actual Capacity of CC 20.000 hours

16

Illustration
From the supply side:
CC average rate= 6.750.000 20.000= 337.50 TL
(at practical capacity of 20.000 hours)
From the demand side:
Budgeted usage 15.000 hours
Per hour of usage = 6.750.000 15.000= 450 TL/hr

utilization of common resources is below capacity

creates excess capacity

Producing this internally might become very

expensive for the user department and they might
want to buy it from outside creating more excess
capacity

Leads to death spiral

17

Death spiral

Death spiral occurs when large fixed costs of a

common resource are allocated to users who could
decline to use that resource. As the allocated costs
increase, some users choose to decrease use. Then
the fixed costs are allocated to the remaining users,
more of whom use less. This process repeats until no
users are willing to pay the fixed costs.

Possible solutions to death spiral:

When excess capacity exists, charge users only for
variable costs.

Reduce the total amount of fixed costs allocated .

18

Illustration single rate- budgeted

vs actual
6750000/15000

6750000/20000

6.900.000/20000

6.900.000/20000

19

Dual Rates- illustration

Divide Fixed
Costs equally.

20

Discussion Single vs Double

Single rate lower cost- no classification of

costs as to fixed and variable
Single rate makes fixed costs of the service
department appear as variable costs in the
user departments
May lead death spiral
Dual rate better for decision making- eg.
Outsourcing decisions

21

Allocating Service Department

Costs

SD1

OD 4

SD3

SD2

OD 3

OD2

OD 1
22

Cost allocation methods

For companies with at least 2 service departments and 2

operating departments

Alternative methods of allocation:

Direct allocation or Direct Method

Step-down allocation
Reciprocal allocation

23

Example 1

EMBA 2 company buys and sells luxury items to select

customers over the internet and through target based
selling.
The company has two service departments and two
operating departments:

Service Depts- Accounting

- Data Processing
Operating Depts Procurement
- Selling

24

Example 1
The service of each service department to itself, to each other
and to the operating divisions are as follows:

These are own (incurred) costs of each service

department before any allocations.
25

Example 1

26

Direct Method Discussion

Ignores each departments use of other

service departments and its own use
Allocation is based on operating
departments utilization of the service
department resources
Simple
May lead to inaccurate pricing
Each service department uses other service
departments resources at no cost
27

Step-down method

Also called graph or sequential method

Sequence is arbitrary might lead to large
differences in cost per unit of service
Allocates service departments costs to
other service departments and operating
departments
Choose a service department to start with;
allocate its cost to other service
departments and operating departments;
then go the next service department and
allocate its cost to remaining service depts
and operating depts
28

Step-down allocations

29

Example 1

30

Example 1

Pricing effects
Assume the following basis is used to allocate the
overhead

Accounting department base: number of processed items

3,000 items
Data processing base: number of hits per year 12.000.000
hits

31

Example 1 price effects

32

Example 1 price effects-step down

33

Example 1 price effects-step down

34

Reciprocal Allocations

Fully recognizes mutual services among service

departments
More precise than the other methods
Better to use with variable costs mainly
Fixed costs may be allocated on other basis
Construct a system of linear equations-one for each
service dept showing % of services used by itself and
by other service departments
If there are 30 service departments; then construct 30
equations
Solve for the unknowns- cost share for each operating
department and cost per unit of output in each service
department
35

Reciprocal Allocation-Calculation
Step 1: interactions among service
departments -develop a total charge
for each department
Step 2: Allocate total charge of each
service department to operating
departments

36

Example 1-Reciprocal Allocation

A(accounting)=Initial Costs +0.1 A + 0.25 D
D(data processing)= Initial Costs +0.2 A + 0.15 D
A(accounting)=2.750.000 +0.1 A + 0.25 D
D(data processing)= 6.770.000 +0.2 A + 0.15 D

37

Simultaneous equations
A(accounting)=2.750.000 +0.1 A + 0.25 D
D(data processing)= 6.770.000 +0.2 A + 0.15 D
0.9A=2.75+0.25D
A=2.75/0.9 +0.25/0.9 = 3.056+0.278 D
D=6.77+0.29(3.056+0.278 D)+0.15 D
D=7.381+0.2056 D
0.7944 D=7.381 D=9.291 million TL
(charge per hit 9.291.000/12.000.000=0,77)
0.9 A= 2.75 +0.25D=2.75+.25*9.291=5.073
A=5.073/0.9=5.636 million TL
(charge per processed item 5636000/3000=1.878,67
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Comparison

39

Allocation of Service Department

Costs by Country Practices
Support Department
Cost-Allocation
Method

Australia
%

Japan
%

United
Kingdom
%

Poland
%

Direct Method

43

58

64

19

Step-down

27

39

Reciprocal

10

14

33

Other

15

Not allocated

34

Horngren,et al, 2008, p.544

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Allocating common costs

Common costs- cost of operating a
facility or activity shared by two or
more users
Methods:
Stand alone- all users equitably share
the cost
Incremental- rank the users; first user
incurs its stand alone cost- next user
incurs the additional cost
41

Revenue Allocation

Bundle costs- when two or more

products are sold for a single price
Allocating revenues to each revenue
object
Each product in the bundle can be
sold separately at their own standalone prices
Price of the bundle < sum of
individual prices of products
42

Example 2

CHES company sells three haircare products: shampoo, conditioner, fixer

The company sells these products individually as well as bundled products

43

Example 2 Revenue Allocation

Stand-alone
Based on selling prices

Based on unit costs

Based on physical units

44

Example 2 Revenue Allocation

Incremental

22.00-12.50

45