Cost Allocation And

Activity-Based Costing
DR. VUONG THI HUONG GIANG
Learning Objectives

• Explain why indirect costs are allocated, describe the cost allocation
process, and discuss allocation of service department costs.
• Discuss activity- based costing (ABC) and cost drivers, and distinguish
activity- based costing (ABC) from activity-based management (ABM).
Purposes of Cost allocation
Purposes of Cost allocation
To Provide information for Decision Making:
When managers use a company resource and receive an allocation of its cost, they are, in essence, receiving
a charge for use.
For example, when Malinda Smith, a product manager at Mayfield Software, asks the art department to
design a prototype box for a product under development, she will likely receive an allocation, on her
product-line profit and loss statement, of costs incurred in the art department. The more artwork she orders,
the more cost she will receive, reducing the profit for which she is responsible. But what is the appropriate
allocation?

To reduce frivolous use of Common resources:

Consider a company that runs a computer network used by all three of its divisions. Almost all of the costs
associated with running the network are fixed, and they amount to $100,000 per year. Some accountants
would argue that because these costs are fixed, the divisions should not be charged for using the network
since use creates no incremental cost. However, if the three divisions do not incur any charge for using the
network, they may tend to use it for frivolous or nonessential purposes (e.g., playing computer games,
sending unnecessary e-mail, or accessing streaming video or otherwise creating unnecessary loads on
network traffic).
Purposes of Cost allocation
To encourage evaluation of services
Cost allocation is also useful because it encourages managers to evaluate the services for which
they are being charged. If the users are charged for the services, then the users have a strong
incentive to look critically at the services and consider the possibility of lower-cost alternatives.

Let’s reconsider the example of Malinda Smith, a product manager at Mayfield Software, who
is being charged for using the company’s art department to design packaging for a product she
manages. Suppose she receives a charge of $5,000 and believes that if she purchased the service
outside the company, the cost would be only $2,000. In this case, she is likely to bring this
matter to the attention of higher-level company officials who will encourage the manager of the
art department to lower that operation’s costs, perhaps by reducing head count or replacing staff
who are inefficient. If the cost of the art department cannot be lowered, the company may
consider shutting down the service and using an independent design firm.
Purposes of Cost allocation
To Provide “full Cost” information
As we have mentioned, GAAP requires full costing for external
reporting purposes. Indirect production costs must be allocated to goods
produced to meet this requirement. In addition, full cost information is
required when a company has an agreement whereby the amount of
revenue received depends on the amount of cost incurred (matching
principle).
Process of Cost allocation

Determine of cost Selecting allocation

Forming cost pools
objective base
Determining the Cost objective
• The object of the allocation is referred to as the cost objective.
For example, if a company allocates depreciation of a drilling press to products such
as flanges and brackets, the products are the cost objectives. If computer-processing
costs are allocated to the contracts worked on by a computer-aided design group, the
contracts are the cost objectives. If a bank allocates general and administrative costs
to product lines (e.g., loan services and estate-planning services), the product lines
are the cost objectives (see Illustration 6-3).
Determining the Cost objective
Forming Cost pools
• A cost pool is a grouping of individual costs whose total is allocated using one
allocation base.
• For example, all of the costs in the maintenance department could be treated as a
cost pool. In this case, the cost pool would include the wages of workers in the
maintenance department, supplies, small tools, and a variety of additional cost
items. Cost pools are often formed along departmental lines (e.g., maintenance
department costs in one cost pool and personnel department costs in another cost
pool). They may also be formed according to major activities. For example, costs
related to equipment setups, a major activity in most manufacturing firms, are in
one cost pool, and costs related to inspecting products for defects, another major
activity, are in another cost pool.
Selecting an Allocation base
• The third step in the allocation process is to select an allocation base that
relates the cost pool to the cost objectives. The allocation base must be
some characteristic that is common to all of the cost objectives. If the cost
objectives are manufactured products, then direct labor hours, direct labor
cost, and machine hours are examples of characteristics that could be used
as allocation bases. If the cost objectives are the divisions of a
multidivisional firm, then sales dollars, total assets, and divisional profit are
examples of characteristics that could be used as allocation bases.
 For example:
• Let’s consider an example. The Watts Equipment Company has two producing departments,
assembly and finishing, that receive allocations of indirect costs from the maintenance department.
In the coming year, the maintenance department expects to incur variable costs of $200,000. These
costs are related to both the labor hours and the machine hours incurred in the producing
departments. The quantities of labor and machine hours are indicated here. With labor hours as the
allocation base, the allocation rate is $4 per labor hour, and the assembly department receives an
$80,000 allocation of cost from the maintenance department. However, with machine hours as the
allocation base, the allocation rate is $10 per machine hour, and the assembly department receives a
$110,000 allocation of cost from the maintenance department. The $30,000 difference in the
allocations occurs even though both labor hours and machine hours are reasonable allocation bases
to use.
Allocating service Department Costs
The organizational units in most manufacturing firms can be classified as either production
departments or service departments. Production departments engage in direct manufacturing activity,
whereas service departments provide indirect support.
Direct Method of Allocating service Department Costs

In the direct method of allocating cost, service department costs are allocated to production
departments but not to other service departments.
Allocating service Department Costs
Allocating Budgeted and Actual Service Department Costs

It is generally a good idea to allocate budgeted rather than actual service department
costs. If budgeted costs are allocated, service departments cannot pass on the cost of
inefficiencies and waste. For example, suppose at the start of the year, budgeted
costs in the janitorial department are $100,000, and the accounting department
informs assembly and finishing that they will receive allocations of $2 per square
foot ($100,000 ÷ 50,000 square feet).
Activity-Based Costing (ABC)
• In the ABC approach, companies identify the major activities that cause overhead costs to be incurred.
Some of these activities are related to production volume, but others are not. The costs of the resources
consumed performing these activities are grouped into cost pools. Finally, the costs are assigned to products
using a measure of activity referred to as a cost driver (an allocation base in an ABC system). The steps
involved in the ABC approach, then, are:

Direct labor hours

Direct labor costs

Machine hours
Some common activities and associated cost drivers are listed in Illustration 6-8.

Hierarchy of Activities. Sometimes managers classify activities into a hierarchy of unit level
activities, batch-level activities, product-level activities, and facility-level activities.
Relating cost pools to products using cost drivers
• Kim Electronics produces a variety of electronic products ranging from simple handheld
calculators to hard disk drives. Inspection to ensure that products are of high quality is a major
activity at Kim. In the coming year, the company expects to incur inspection costs of $2,500,000.
Forty workers are employed in the inspection process, and they are expected to perform 1,000,000
product inspections in the coming year. Using inspection cost as a cost pool and the number of
inspections as a cost driver, the company arrives at a rate of $2.50 per inspection for purposes of
allocating inspection costs to products.
The ABC Approach at McMaster screen technologies:
A comprehensive example
• Our comprehensive example of the ABC approach uses the situation
faced by McMaster Screen Technologies presented at the start of the
chapter. As you read through the example, make sure you can explain
why using the ABC approach reduces the cost of the high-volume
product (the Model ND32 touch screen used in automobile navigation
devices) and increases the cost of the low-volume product (the MK420
touch screen used in a military targeting device).
McMaster’s Costs under the traditional Approach
• For product costing purposes, McMaster traces labor and material costs directly to
products produced. Manufacturing overhead is allocated to products based on
labor cost. At the start of 2016, estimated manufacturing overhead was
$100,000,000 and estimated labor cost was $25,000,000. Thus, the overhead
allocation rate was $4 per dollar of labor. For 2016, the following costs and
revenues are expected from sale of the Model ND32 and the Model MX420:
McMaster’s Costs under the traditional Approach

Note that the overhead allocated to the Model ND32 Display, $8,100,000, is equal to
the overhead rate of $4 per dollar of labor times the $2,025,000 of direct labor
incurred in production of the display used in an automobile navigation system.
Also recall that Michael Soma, the CFO at McMaster Screen Technologies, suspects
that the relatively low gross profit (less than 10 percent of sales) may be due to
problems with the costing system in use. Furthermore, he is somewhat surprised that
the company is able to earn such a high gross profit on the display used in a military
targeting device (more than 70 percent of sales). While this product has a relatively
high selling price, the low-volume product required new production techniques to
meet stringent quality standards and he suspected that production inefficiencies
would keep gross profit low for more than a year.
 McMaster’s Costs under the ABC Approach
• The company’s approach to allocating overhead assumes that all overhead is proportional to a single
measure of production volume—labor cost. However, overhead is likely caused by several key activities.
Suppose the CFO authorizes a study of how the costs of the Model ND32 touch screen and the Model
MX420 touch screen will change if an ABC approach is taken. The study determines that the $100,000,000
of overhead cost is related to the seven cost drivers identified in Illustration 6-9.
McMaster’s Costs under the ABC Approach

• Note that in constructing the table in Illustration 6-9, we are following

the steps in the ABC process that we previously discussed. We start
by identifying major activities (Step 1). We then group associated
costs into cost pools (Step 2), and we identify measures of the
activities—the cost drivers (Step 3). Now we’ll turn to relating the
costs to specific products using the cost drivers (Step 4). This last step
is shown in Illustration 6-11.
McMaster’s Costs under the ABC Approach
• Manufacturing the Model ND32 touch screen used in an automotive navigation system
requires 20 setups, 250 purchase orders, 180 material requisitions, 500 machine hours,
450 inspections, 60 design hours, and 20 workstations. Manufacturing the Model MX420
touch screen used in a military targeting device requires 2 setups, 30 purchase orders, 5
material requisitions, 8 machine hours, 50 inspections, 325 design hours, and 30
workstations. This information is summarized in Illustration 6-10.
McMaster’s Costs under the ABC Approach
Pros and Cons of ABC approach
• A major disadvantage of ABC is its expense; an ABC system is more costly to develop
and maintain than a traditional costing system. Consider an ABC system with 20 cost
pools applied to 100 different products. Assigning costs to each of the 20 pools will be
costly, and then 2,000 allocations will have to be made (20 pools × 100 products) to
assign costs to products.
• Perhaps the major limitation of ABC is that, in practice, it is used to develop the full cost
of products. Because full costs include allocations of costs that are fixed (e.g.,
depreciation of plant and equipment and supervisory salaries), the cost per unit generated
by the ABC system does not measure the incremental costs needed to produce an item.
And incremental information is what is needed to make decisions.
Pros and Cons of ABC approach
• ABC is less likely than traditional costing systems to undercost complex, low
volume products and overcost simple, high-volume products. This follows because
ABC uses more cost drivers to assign costs and the drivers are not necessarily
volume related.
• A second benefit is that ABC may lead to improvements in cost control. With
ABC, managers see costs broken out by a number of activities rather than buried
in one or two overhead cost pools. Unless managers know the costs of setups,
inspections, order taking, stocking, moving inventory, and other key activities,
they are not likely to see a need to improve efficiency and reduce these costs.
Activity-based management
• Activity-based management (ABM) is a management tool that involves
analyzing and costing activities with the goal of improving efficiency
and effectiveness. As you would expect, ABM is closely related to ABC,
but the two schemes differ in their primary goals. Whereas ABC focuses
on activities with the goal of measuring the costs of products and
services produced by them, ABM focuses on activities with the goal of
managing the activities themselves. This difference is shown graphically
in Illustration 6-12.