Chapter 6: Cost Allocation

6.1 Cost Allocation –in General

Cost allocation is a method to determine the cost of services provided to users of that service. It does not
determine the price of the service, but rather determines what the service costs to provide. It is important to
determine the cost allocation of the services that the department provides, in order to determine a justifiable
fee/charge/tax for those services.
Cost allocation, which is a problem in nearly every organization and nearly every facet of accounting,
provides information needed for both strategic and operating decisions. There is rarely one "best" way to
allocate costs. Cost allocation requires judgment, and reasonable people may differ in their judgments. Cost
allocation is fundamentally a problem of linking some cost or group of costs with one or more cost
objectives such as, products, departments and divisions. Ideally costs should be assigned to the cost object
that caused it. In short cost allocation tries to identify some cost or group of costs with one or more cost
objectives via some function representing causation. Linking costs with cost objectives is accomplished by
selecting cost drivers. When used for allocating costs a cost driver is often called a cost allocation base.
Major costs such as news print for newspaper and direct professional labour for a law firm, may each be
allocated to departments, jobs, and projects on an item by item basis using obvious cost drivers.
6.2 General Purpose of Cost Allocation
Indirect costs often comprise a sizeable percentage of the costs assigned to cost objects such as products,
distribution channels and customers. There are four purposes for allocating indirect costs to such cost
objects:
1. To provide information for economic decisions
 To decide whether to add a new airline flight
 To decide whether to make a component part of a television set or to purchase it from another
manufacturer
 To decide on the selling price for a customized product or service
2. To motivate managers and employees
 To encourage the design of products that are simpler to manufacture or less costly to service
 To encourage sales representatives to push high-margin products or services
3. To justify costs or calculate reimbursement
 To cost products at a ‘fair’ price, often done with government defense contracts
 To compute reimbursement for a consulting firm that is paid a percentage of the cost savings resulting
from the implementation of its recommendations
4. To measure income and assets for reporting to external parties.
 To cost shares for financial reporting to shareholders, bondholders and so on. (Under generally
accepted accounting principles, inventoriable costs include manufacturing costs but exclude R&D,
marketing, distribution and customer-service costs.)
Criteria to Guide Cost-Allocation Decisions
1. Cause and Effect. Using this criterion, managers identify the variables that cause resources to be
consumed. For example, managers may use hours of testing as variable when allocating the costs of a
quality-testing area to products. Cost allocations based on the cause-and-effect criterion are likely to be the
most credible to operating personnel.
2. Benefits Received. Using this criterion, managers identify the beneficiaries of the outputs of the cost
object. The costs of the cost object are allocated among the beneficiaries in proportion to the benefits each
receives. Consider a corporate wide advertising program that promotes the general image of the corporation
rather than any individual product. The costs of this program may be allocated on the basis of division
revenues; the higher the revenues, the higher the division’s allocated cost of the advertising program. The
rationale behind this allocation is that divisions with higher revenues apparently benefited from the

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advertising more than divisions with lower revenues and, therefore, ought to be allocated more of the
advertising costs.
3. Fairness or Equity. This criterion is often cited in government contracts when cost allocations are the
basis for establishing a price satisfactory to the government and its suppliers. Cost allocation here is viewed
as a “reasonable” or “fair” means of establishing a selling price in the minds of the contracting parties. For
most allocation decisions, fairness is a matter of judgment rather than an operational criterion.
4. Ability to Bear. This criterion advocates allocating costs in proportion to the cost object’s ability to bear
costs allocated to it. An example is the 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.
6.1 Allocation for economic decisions and motivations
Different costs are appropriate for different purposes Consider costs of a product in terms of the business
functions in the value chain (research and development, marketing, distribution, and customer service
costs).
For some decision related to the economic-decision purpose (for example, long-run product pricing), the
costs in all functions should be included.
For the motivation purpose, costs from more than one business function are often included to emphasize to
managers how costs in different functions are related to each other.
• For example, product designers in some Japanese companies incorporate costs of other functions in the
value chain - such as production, distribution, and customer service into their product-cost estimates. The
aim is to focus attention on how different product design options affect total costs. Cost allocations can be
used to motivate managers to consume less or more of the company's resources
• To discourage use, the cost of a department's services could be allocated according to the amount of
services used.
• To encourage use of a department's services (for example, internal audit). Top management might not
allocate any of the cost of that department's services or allocate a fixed amount of the cost of that
department to other departments regardless of how much of those services are used by those other
departments (the other departments may feel obligated to use the services to get their "money's worth")
SERVICE DEPARTMENT COSTS ALLOCATION
 The first step in cost allocation is to determine just what the cost objects are. A department is one
common cost object. There are two categories of departments: Producing (operating) departments and
support (service) departments.
 Producing departments are directly responsible for creating the products or services sold to customers. In
a large public accounting firm, examples of producing departments are Auditing, Tax, and Management
Advisory Services (Computer System Services).
 In a manufacturing setting, producing departments are those that work directly on the products being
manufactured such as Assembly & Finishing.
 Support departments provide essential services for producing departments. These departments are
indirectly connected with an organization’s services or products. Examples of support departments
included purchasing, personnel, maintenance and cafeteria.
 Once the producing and support departments have been identified, the overhead costs incurred by each
department can be determined.
 Note that this involves tracing costs to the departments, not allocating costs, because the costs are directly
associated directly with the individual department.
 A factory cafeteria, for example, would have food costs, wages of cooks and servers, depreciation on
dishwashers and stoves, and supplies (e.g. napkins and plastic forks).

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 Overhead directly associated with a producing department such as assembly in a furniture-making plant
would include utilities (if measured in that department), supervisory salaries, and depreciation on
equipment used in that department.
 Overhead that cannot be easily assigned to a producing or support department is assigned to a catchall
department such as General Factory. General Factory might include depreciation on the factory building,
the plant manger’s salary, telephone service costs and the costs of restriping the parking lot.
 Once the company has been departmentalized and all overhead costs have been traced to the individual
departments, support departments costs are assigned to producing departments, and overhead rates are
developed to cost products. Although support departments do not work directly on the products and
services that are sold, the costs of providing these support services are part of the total product cost and
must be assigned to the products. This assignment of costs consists of a two-stage allocation:
1. Allocation of support department costs to producing departments and
2. Assignment of these allocated costs to individual products.
 The second-stage allocation achieved through the use of departmental overhead rates is necessary because
there are multiple products being worked on in each producing department.
 If there were only one product with in a producing department, all the support costs allocated to that
department would belong to that product.
 A predetermined overhead rate is computed by taking total estimated overhead for a department and
dividing it by an estimate of an appropriate base.
 Now we see that a producing department’s overhead consists of two parts: overhead directly associated
with a producing department and overhead allocated to the producing department from the support
departments.
 A support department cannot have an overhead rate that assigns overhead costs to units produced, because
it doesn’t make a saleable product. That is, products do not pass through support departments.
 The nature of support departments is to service producing departments, not the products that pass through
support departments.
 For example, maintenance personnel repair and maintain the equipment in the assembly department, not
the furniture that is assembled in that department.
Allocation Bases
 Producing departments cause support activities; therefore, the costs of support departments are also
caused by the activities of the producing departments.
 Causal factors are variables or activities within the producing departments that provoke the incurrence of
support costs.
 In choosing a basis for allocating support department costs, effort should be made to identify appropriate
causal factors (activity drivers). Using causal factors results in product costs being more accurate.
 Furthermore, if the causal factors are known, managers are more able to control the consumption of
service.

Below is a list of possible allocation bases for support departments.

Accounting Number of transactions
Cafeteria Number of employees
Data processing Number of lines entered, Number of house of services
Engineering Number of change orders, Number of machine hours
Maintenance Machine hours, maintenance hours
Materials store room number of material moves, Pounds of material moved,

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 Number of different parts
Payroll Number of employees
Personnel Number of employees, Number fog firings or layoffs,
Number of new hires, Direct labor cost
Purchasing Number of orders
Shipping Number of orders
Cost allocation for a single support department
 Frequently the costs of a support department are allocated to another department through the use of a
charging rate. In this case, we focus on the allocation of one department’s costs to other departments.
For example a company’s data processing department may serve various other departments.
 The costs of operating the data processing department are then allocated to the user departments.
While this seems simple and straightforward, a number of considerations go into determining an
appropriate charging rate. The two major factors are:
1. The choice of a single or dual charging rate and
2. The use of budgeted versus actual support department costs.
A Single charging rate
Some companies prefer to use a single charging rate. That is both variable and fixed costs of the supporting
department are allocated using a single rate.
Example: Hana and Associates, a large public accounting firm, develops an in-house photocopying
department to serve its three producing departments (Audit, Tax, and Management Advisory Systems, or
MAS). The budgeted costs of Photocopying department include fixed costs of Br. 26,190 per year (salaries
and machine rental) and variable costs of Br. 0.023 per page copied (paper and toner). Estimated and actual
pages are given below.
Estimated usage Actual usage
Audit department 94,500 92,000
Tax department 67,500 65,000
MAS department 108,000 115,000
Total Br.270,000 Br. 272,000

Variable costs (o.023 x 270,000) Br. 6,210

Fixed costs 26,190
Total cost estimated for the photocopying department Br. 32,400
Budgeted cost per page = 32,400/270,00 = Br. 0.12
Photocopying department costs allocated
Audit department 0.12 x 92,000 = 11,040
Tax department 0.12 x 65,000 = 7,800
MAS department 0.12 x 15,000 = 13,800
272,000 Br.32,640
Note that the use of a single rate treats the fixed costs as if it were variable. The photocopying department
didn’t actually need Br. 32,640 to copy 272,000 pages. It needed only Br. 32,446 (Br. 26,190 + 272,000 x
0.023). The extra amount charged is due to the treatment of a fixed cost in a variable manner.
Dual charging rates
 While the use of single rate is simple, it ignores the differential impact of changes in usage on costs.
The variable costs of a support department increase as the level of service increases.
 For example, the costs of paper and toner for the photocopying department increase as the number o
pages copied increases. Fixed costs, on the other hand, do not vary with the level of service.
 For example, the rental payment for photocopying machines doesn’t change as the number of pages
increases or decreases. We can avoid the treatment of fixed costs as variable by developing two rtes:
one for fixed costs and one for variable costs.
Variable rate

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  The variable rate depends on the costs that change as the activity driver changes. In photocopying
department, for example, the activity driver is the number of pages copied.
 As the number of pages increases; more paper and toner are required. Since these materials average Br.
0.023 per page, the variable rate is br. 0.023.
Fixed costs allocation ratio
 Fixed service costs can be considered capacity costs; they are incurred to provide the capacity necessary
to deliver the service units required by the producing departments.
 When the support department was established, its delivery capability was designed to serve the long
term needs of the producing departments.
 Since the original support needs caused the creation of the support service capacity, it seems reasonable
to allocate fixed costs based on those needs.
 Either the normal or peak activity of the producing departments provides a reasonable measure of
original support needs. Normal capacity is the average capacity achieved over more than one fiscal
period.
 If service is required uniformly over the time period, normal capacity is a good measure of the activity.
Peak capacity. Peak capacity allows for variation in the need for the support department, and the size of
the department is structured to allow for maximum need.
 The choice of normal or peak capacity in allocating budgeted fixed service costs depends on the needs
of the needs of the individual firm.
The allocation of the costs photocopying department in Hana and Associates using dual rates follows.
Variable rate = Br. 0.023 per page
Assume the photocopying departments fixed costs are allocated using normal photocopying needs of
producing departments and the budgeted usage given represents normal support needs.
Original support needs
Audit department 94,500 (35%)
Tax department 67,500 (25%)
MAS department 108,000 (40%)
Total 270,000
Variable costs (A) fixed costs (B) Total costs (C= A+B)
Audit 0.023 x 92,000 = 2,116 0.35 x 26,190 = 9,167 11,283
Tax 0.023 x 65,000 = 1,495 0.25 x 26,190 = 6,548 8,043
MAS 0.023 x 115,000 =2,645 0.40 x 26,190 = 10,476 13,121
26,191 32,447
Budgeted versus Actual Costs
 Managers of both producing and support departments are held accountable for the costs of their
departments. The costs of support departments allocated to other departments must be budged rather than
actual costs.
 Otherwise the efficiencies or inefficiencies of the support departments will be transferred to other
departments. And we shouldn’t use in the performance evaluation of a manager costs over which he or she
has no control.
 The level of usage used in allocating service department costs may be actual or budgeted depending on
the purpose of the allocation. For product cost determination a budgeted overhead rate must be known for
each producing department at the beginning of every year,
 Computing the overhead rate requires the total overhead costs of the producing departments. A
producing department’s overhead consists of two parts: overhead directly associated with a producing
department and overhead allocated to the producing department from the support departments.
 Therefore support department costs should first be allocated at the beginning of the year on the basis of
the budgeted usage.

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 During the year each department would also be responsible for support department costs allocated to it.
This is done using costs allocated using actual usage.
Support Department cost allocation methods
 In the preceding discussions allocation of a single service department was illustrated. In many cases,
however, multiple service departments exist.
 Under such circumstances allocation of support department costs are made using one of three methods:
direct method, sequential (step) method or reciprocal method.
 Usually service departments provide service not only to producing departments but also to other support
departments.
 For instance maintenance department (support department) provides maintenance service to producing
and support departments such as purchasing.
 All the three methods allocate service department costs to producing departments but they differ on
whether they recognize the service one support department gets from other support departments and
whether the method recognizes the interaction between the departments fully or partially.
 The three methods are described as follows.
1. Direct method
 The direct method allocates service department costs only to producing departments. It is the
simplest and most straightforward way to allocate support department costs.
 However no support department cost is allocated to other support departments. That is it doesn’t
recognize the interaction among support departments.
2. Sequential (step) method
 This method recognizes partially the services one support departments provides to another. First the
support departments are ranked according to the amount of service they provide from the highest to the
least. The amount of service is usually measured by the direct costs of the support departments.
 The costs of the support department rendering the greatest support service are allocated first. They are
distributed to all support departments below it in the sequence and to all producing departments.
 Then, the costs of the support department next in sequence are similarly allocated, and so on. In the
sequential method, once a support department’s costs are allocated, it never receives s subsequent
allocation from another support department above it in the sequence.
 Also note that the costs allocated from a support department are its direct costs plus any costs it receives
in allocations from other support departments.
3. Reciprocal method
 The reciprocal method recognizes all interactions of support departments. Under the reciprocal
method, the usage of one support department by another is used to determine the total cost of each
support department, where the total cost reflects interactions among the support departments.
 Thus, the new total of support department costs is allocated to the producing departments. This
method fully accounts for support department interaction.
Example: Malor Company has two support departments, Power and Maintenance, and two producing
departments, Grinding and Assembly. The allocation bases of Power department costs and Maintenance
department costs are number of employees and maintenance hours respectively. The budgeted direct costs
and budgeted activity levels are given below. For producing departments, direct costs refer only to overhead
costs that are directly traceable to the department. For simplicity a single charging rate is used.

Support departments Producing departments

Particulars Power Maintenance Grinding Assembly
Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Activity levels – Kilowatt-hours - 200,000 600,000 200,000

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Maintenance hours 1,000 - 4,500 4,5000

Direct Method
Support departments Producing departments
Particulars Power Maintenance Grinding Assembly
Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Power department cost allocation in Kilowatt-
hours basis
(600,000/800,000) (200,000/800,000)
Weights: (0.75 : 0.25)
Power department costs allocated (250,000) 187,500 62,500

Maintenance department cost allocation in

maintenance hours basis
(4,500/9,000)(4,500/9,000)
Weights: (0.5:0.5)
Maintenance department cost allocated (160,000) 80,000 80,000
0 0 267,500 202,500
Even if power department and maintenance department provide service to producing departments and to each
other as well, their costs are allocated only to the producing departments (Grinding & assembly).
Sequential method
Support departments Producing departments
Particulars Power Maintenance Grinding Assembly
Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Power department cost allocation in Kilowatt-
hours basis
(200,000/1,000,000)(600,000/1,000,000)
(200,000/1,000,000)
Weights: (0.2: 0.6 : 0.2)
Power department costs allocated (250,000) 50,000 150,000 50,000

Maintenance department cost allocation in

maintenance hours basis
(4,500/9,000)(4,500/9,000)
Weights: (0.5:0.5)
Maintenance department cost allocated (210,000) 105,000 105,000
Total costs 0 0 355,000 215,000
The fact that power department serves all the other three departments is recognized by the sequential method
because power department costs are allocated to all of the three departments. Nevertheless power department
doesn’t share maintenance department costs, i.e. this method failed to account for the service power
department gets from maintenance department. Hence the interaction between power and maintenance
departments is recognized partially.
Reciprocal Method
Let P be the total costs of power department (the costs incurred in power department plus cost of maintenance
department allocated to power department) and Let M be the total costs of maintenance department (the costs
incurred in maintenance department plus cost of power department allocated to maintenance department).
Support departments Producing

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 Particulars departments Total
Power Maintenance Grinding Assembly
Kilowatt-hours - 200,000 600,000 200,000 1,000,000
Weights 0.2 0.6 0.2 1
Maintenance hours 1,000 - 4,500 4,500 10.000
Weights 0.1 0.45 0.45 1

P = 250,000 + 0.1M
M = 160,000 + 0.2P
M = 160,000 + 0.2(250,000 + 0.1M)
M = 160,000 + 50,000 + 0.02M)
M = 214,286
P = 250,000 + 0.1(214,286) = 271,429
Support departments Producing departments
Particulars Power Maintenance Grinding Assembly
Direct costs Br.250,000 Br. 160,000 Br. 100,000 Br. 60,000
Power department cost allocation in Kilowatt-
hours basis
(200,000/1,000,000)(600,000/1,000,000)
(200,000/1,000,000)
Weights: (0.2: 0.6 : 0.2)
Power department costs allocated (271,429) 54,286 162,857 54,286

Maintenance department cost allocation in

maintenance hours basis
(1,000/10,000)(4,500/10,000)(4,500/10,000)
Weights: (0.1: 0.45:0.45)
Maintenance department cost allocated 21,429 (214,286) 96,429 96,429
Total costs 0 0 359,286 210,714

 The reciprocal method fully recognizes the services support departments provide to each other. But as the
number of support departments increases the computations will become more complex.
 It is important to keep a cost-benefit perspective in choosing an allocation method. We must weigh the
advantages of better allocation against the increased cost using a more theoretically preferred method.
 For example the reciprocal method may be superior to the other methods. But the increased cost
resulting from using it may outweigh the additional benefit it produces.
Departmental Overhead rates and Product Costing
 When the costs of goods and services produced in producing departments are determined, direct costs are
traced to the products and overhead costs are allocated using overhead rtes.
 A single overhead rate may be used for all the producing departments or separate rates may be developed
for each of them.
 The overhead rate is computed by adding the allocated service cots to the overhead costs that are directly
traceable to the producing department and dividing this total by the overhead allocation base selected for
the department.
Example: Assume that Malor Company uses the sequential method of service department costs allocation.
Therefore total budgeted overhead costs of Grinding and Assembly departments are Br. 355,000 and Br
215,000 respectively. The allocation bases and expected levels of the allocation bases are given below.
Grinding department Assembly department

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 Overhead allocation bases machine hours direct labor hours
Budgeted machine hours 71,000 --
Budgeted direct labor hours -- 107,500
Data pertaining to one unit of a product follow.
Grinding department Assembly department
Direct materials costs Br.7 Br.8
Direct labor costs 2 4
Machine hours 2 -
Direct labor hours - 1

Compute the unit cost

Grinding department Assembly department
Overhead rate = Br. 355,000 Br. 215,000
71,000 M/H 107,500 DLH
Br.5 per MH Br. 2 per DLH
Direct material costs (7 + 8) 15
Direct labor cost (2 + 4) 6
Overhead costs
Grinding ( 2 machine hour x Br. 5) 10
Assembly (1 direct labor hour x Br. 2) 2 12
Unit cost 33
Allocating common costs
We next consider two methods used to allocate common costs. A common cost is a cost of operating a
facility, operation, activity or other cost object that is shared by two or more users. Consider Paul O’Shea, a
third-year undergraduate student in Galway who has been invited to an interview with an employer in
Moscow. The round-trip Galway–Moscow airfare costs €1200. A week prior to leaving, O’Shea is also invited
to an interview with an employer in Prague. The round-trip Galway–Prague airfare costs €800. O’Shea
decides to combine the two recruiting steps into a Galway–Moscow–Prague trip that will cost €1500 in
airfare. The €1500 is a common cost that benefits both employers. Two methods for allocating this common
cost between the two potential employers are now discussed: the stand-alone method and the incremental
method.
A. Stand-alone cost-allocation method
The stand-alone cost-allocation method uses information pertaining to each cost object as a separate
operating entity to determine the cost-allocation weights. For the airfare common cost of €1500, information
about the separate (stand-alone) return airfares (€1200 and €800) is used to determine the allocation weights:
Moscow employer: €1200 × €1500 = 0.60 × €1500 = €900
€1200 + €800
Prague employer: €800 × €1500 = 0.40 × €1500 = €600
€800 + €1200
Advocates of this method often emphasise an equity or fairness rationale. That is, fairness occurs because
each employer bears a proportionate share of total costs in relation to their individual stand-alone costs.
B. Incremental cost-allocation method
The incremental cost-allocation method ranks the individual cost objects and then uses this ranking to
allocate costs among those cost objects. The first-ranked cost object is termed the primary party and is
allocated costs up to its cost as a stand-alone entity. The second-ranked cost object is termed the incremental
party and is allocated the additional cost that arises from there being two users instead of only the primary
user. If there are more than two parties, the non-primary parties will need to be ranked.
Consider Paul O’Shea and his €1500 airfare cost. Assume that the Moscow employer is viewed as the primary
party. O’Shea’s rationale was that he had already committed to go to Moscow. The cost allocations would
then be:
Party Costs allocated Costs remaining to be allocated to other
parties

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Moscow (primary) €1200 €300 (€1500 – €1200)
Prague (incremental) 300 0
The Moscow employer is allocated the full Galway–Moscow airfare. The non-allocated part of the total
airfare is allocated to the Prague employer. Had the Prague employer been chosen as the primary party, the
cost allocations would have been Prague, €800 (the stand-alone Galway–Prague return airfare) and Moscow,
€700 (€1500 – €800). Where there are more than two parties, this method requires them to be ranked and the
common costs allocated to those parties in the ranked sequence.
Under the incremental method, the primary party typically receives the highest allocation of the common
costs. Not surprisingly, most users in common cost situations propose themselves as the incremental party. In
some cases, the incremental party is a newly formed ‘organisation’ such as a new product line or a new sales
territory. Chances for its short-term survival may be enhanced if it bears a relatively low allocation of
common costs.
A caution is appropriate here as regards O’Shea’s cost-allocation options. His chosen method must be
acceptable to each prospective employer. Indeed, some prospective employers may have guidelines that
recruiting candidates must follow. For example, the Moscow employer may have a policy that the maximum
reimbursable airfare is a seven-day advance booking price in economy class. If this amount is less than the
amount that O’Shea would receive under (say) the stand-alone method, then the employer’s upper limit
guideline would govern how much could be allocated to that interviewer. O’Shea should obtain approval
before he purchases his ticket as to which cost-allocation method(s) each potential employer views as
acceptable.

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