CHAPTER 6

COST ALLOCATION
Aims and objectives
After completing this chapter, you will be able to:
 Describe how a costing system can have multiple cost objects
 Outline four purposes for allocating costs to cost objects
 Discuss key decisions faced when collecting costs in indirect cost pools
 Describe how the single-rate cost-allocation method differs from the dual-rate method
 Explain how the choice of budgeted versus actual allocation rates changes the risks that
managers face
 Distinguish between direct allocation, step-down and reciprocal methods of allocating
support department costs

Introduction
A cost accounting system collects and classifies costs and assigns them to cost objects. The goal
of cost accounting is to measure the cost of designing, developing, producing (purchasing),
selling, distributing and servicing particular product/services. Cost allocation is the heart of cost
accounting system.
Cost allocation is fundamentally a problem of linking some costs or a group of costs with one or
more cost objectives such as products, departments, customer classes, activities and divisions.
Hence, cost allocation should assign each cost to the cost object that caused it.
Key terms:
Cost object: anything for which a separate measurement of cost is desired
Direct cost of a cost object: costs related to a particular cost object and can be traced into it in an
economically feasible way.
Indirect cost of a cost object: costs related to a particular cost object but can’t be traced into it in
an economically feasible way.
Purposes of Cost Allocation
Indirect costs often comprises of a sizable percentage of the costs assigned to cost objects. Cost
allocation is useful:
 To provide information for economic decision
eg. To make or buy a product, to add new part to the existing asset
 To motivate managers and employees
eg. To encourage the design of less costly product
 To justify costs or calculate reimbursements
eg. To cost products at fair price
 To measure income and assets for reporting to external parties

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Eg. 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.)

Operating Departments and Supporting Departments

Operating departments (also called a production department in manufacturing companies) are
departments which involved in changing the shape or size of an item and add value to a product
or service that is observable by the customer.
Supporting departments (also called a service department) are departments that provide
services that maintain other internal departments (operating and other supporting departments) in
the organization.

Types of Cost Allocation

They are of three types:
1. Allocation of cost to the appropriate organizational unit: direct costs are physically traced
to the unit, but costs used jointly by more than one unit are allocated based on cost driver
activity in the unit. Eg. Allocating rent to departments based on floor space occupied,
allocating depreciation on jointly used machinery based on machine hour etc

2. Reallocation of costs from one organization unit to another: when one unit provides
products or services to another, the costs are transferred along with the products or services.
Some units exist only to support others, are called service departments and their costs are
totally reallocated.

3. Allocating of costs of a particular organizational unit or activity to products/service

Allocating Costs from One Department to the Other (Supporting Department to Operating
Department or Division)

Usually the cost of a department will include costs allocated from other departments. Three key
issues that arise when allocating costs from one department to another are:

1. Whether to use a single rate method or a dual rate method

2. Whether to use budgeted rate or actual rate and
3. Whether to use budgeted quantities or actual quantities

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Single rate and Dual rate method
Single rate method: pools all costs in one cost pool and allocates them to cost objects using the
same rate per unit of the single allocation base. There is no distinction between costs in the pool
in terms of cost variability (such as fixed or variable cost).

Dual rate method: classifies costs in one cost pool into two sub pools (fixed cost sub pool and
variable cost sub pool). Each cost pool has a different allocation rate or a different allocation
base.

Example: Assume that XYZ Company has a computer department which serves testing and
terminal departments only. The following data apply to the next budget year
Fixed cost of operating the facility ………………………………………..$ 300,000 per year
Total capacity available …………………………………………………. 1,500 hours
Budgeted hours
Testing department ……………………………………………………….. 800
Terminal department …………………………………………...………… 400
Total ………………..…………………………………… 1,200
Budgeted variable cost per hour in the 1,000 – 1,500 hours relevant range..... $200/hour used

Assume further that in the next year Testing department actually uses 900 hours and Terminal
300 only.
Required: use the budgeted rate and budgeted usage as a base and allocate the XYZ Company’s
computer department cost under
1. Single rate method
2. Dual rate method
Under Single rate
Total cost pool [$300,000 + (1,200hrs * $200)] ………..…… $540,000 per year
Budgeted usage ………………………………...…………………. 1,200 hours
Budgeted total rate per hour ($540,000/1,200 hrs)…………... $450/hr used
Cost allocated to:
Testing department …………………………..……………… $450*900 = $405,000
Terminal department ……………………..…………….…… $450*300 = $135,000

Under Dual rate

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Cost allocated to testing department:
Fixed cost function ($300,000* 800/1,200)……………..………… $200,000
Variable cost function ………………………...……………….…….. $200/hour used
Allocated cost $200,000 + (900*200)……….………………….…. $380,000
Cost allocated to terminal department:
Fixed cost function ($300,000* 400/1,200)………………………… $100,000
Variable cost function …………………….………………..………… $200/hour used
Allocated cost $100,000 + (300*200)…………. ………….………. $160,000

Allocation of Multiple Service/Support Department Costs

There are three methods of allocating the costs of supporting departments:
1. Direct method
2. Step down method
3. Reciprocal method
Example
Assume that the following data is given for BLK co.(with two support departments: maintenance
and Information System; and two operating departments: Machining and Assembly) for the year
ended 2008 and it will be used to show how each support department cost allocation methods are
different to each other

Support Departments Operating Departments

Maintenance Info system Machining Assembly
Budgeted FOH cost
Before allocation … $600,000 $116,000 $400,000 $200,000
Support work rendered:
By Maintenance
Budgeted labor hour ……… - 1,600 2,400 4,000
Percentage …………………. - 20% 30% 50%
By Information System
Budgeted service hour 200 - 1,600 200
Percentage 10% - 80% 10%

Direct method
 Is most widely used

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  Allocates each support department costs directly to the operating departments
Support Departments Operating Departments
Maintenance Info system Machining Assembly
Budgeted FOH cost
Before allocation ………. $600,000 $116,000 $400,000 $200,000
Allocation of maintenance ($600,000 225,000* 375,000
Allocation of info system - ($116,000) 103,111** 12,889
Total allocated cost $728,111 $587,889
*[2,400/ (2,400+4000)]*$600,000
** [1,600/ (1,600+200)]*$116,000
Step down method
 Also called sequential allocation method
 Allows partial recognition of the service rendered by support departments to other
support department
 This method requires the support departments to be ranked in the order which the step
down allocation is to proceed
 The costs in the first ranked support department are allocated to other support
departments and to other operating departments
 The costs in the second ranked department are allocated to those support departments
whose cost is not yet allocated and to the operating departments. This procedure is
followed until the costs in the last ranked support department have been allocated to the
operating departments.
How to rank?
There are two approaches
Approach A: rank support departments based on the percentage of the support department’s
total support provided to other support departments. The support department with the highest
percentage is allocated first.
For our Example: %ge of total service provided to other support departments

Maintenance …………………………………………………….……… 20%

Inf. System ……………………………………………………….…….. 10%
Approach B: rank support departments on the total birr of service provided to the other support
departments.
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For our Example
Birr amount of total service provided to other support departments
Maintenance …………………………………………….……… $120,000
Inf. System ……………………..………………………….……..$116,000
Support Departments Operating Departments
Maintenance Info system Machining Assembly
Budgeted FOH cost
Before allocation … $600,000 $116,000 $400,000 $200,000
Allocation of maintenance ($600,000) 120,000* 180,000 300,000
Allocation of info system - ($236,000) 209,778** 26,222
Total allocated cost $789,778 $526,222
*[1,600/(1,600+2,400+4000)]*$600,000
**[1,600/(1,600+200)]*$236,000

Reciprocal method
 Allocates costs by explicitly including the mutual services provided among all support
departments
 It considers interdepartmental relationship fully into the support department cost allocation
 Has three steps
Step 1: Express support department costs and reciprocal relationship in linear equation form
Eg. Let M = the completed reciprocated cost of maintenance department
IS = the completed reciprocated cost of inf. system department
Then M= $600,000 + 0.1 IS
IS= $116,000 + 0.2 M
Step 2: Solve the equation to obtain the completed reciprocated costs of each support department
M= $600,000 + [0.1($116,000+0.2M)]
M= $600,000 + $11,600 + 0.02M
0.98M = $611,600
M = $624,082
For IS cost
IS = $116,000 + 0.2M
IS = $116,000 + 0.2(624,082)
IS = $240,816

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Step 3: Allocate the computed reciprocated costs of each support department to all other
departments (both support and operating) on the basis of the usage proportion (based on total
units of services provided to all departments)

Support Departments Operating Departments

Maintenance Info system Machining Assembly
Budgeted FOH cost
Before allocation … $600,000 $116,000 $400,000 $200,000
Allocation of maintenance ($624,082) 124,816* 187,225 312,041
Allocation of info system 24,082** ($240,816) 192,652 24,084
Total allocated cost $779,877 $536,123

*[1,600/(1,600+2,400+4000)]*$624,082

**[200/(1,600+200+200)]*$240,816

Class Work

SUPPORT DEPARTMENTS OPERATING DEPARTMENTS

Plant Information Machining Assembly
Maintenance Systems
Budgeted overhead costs
before any inter-department cost $6,300,000 $1,452,150 $4,000,000 $2,000,000
allocations
Support work furnished:
By plant maintenance
Budgeted labor-hours 4,000 6,000 10,000
Percentage 20% 30% 50%
By information systems
Budgeted computer hours 500 4,000 500
Percentage 10% 80% 10%