Cost and Managerial Accounting L Chap 5

Chapter 5
Cost allocation
1
© 2012 Pearson Prentice Hall. All rights reserved.
Meaning of cost allocation
Cost Allocation: the process of assigning or applying
collected indirect costs to cost objects using an allocation

base is known as cost allocation.
The following terms are to be known and they have strong
tie with the allocation of costs to products or services.

These are:
 Cost object
 Cost pool and
2
 Cost driver
Cont…
Cost object: - is anything for which a measurement of costs is
desired.
Cost pool: is a collection of overhead costs related to a cost
object.
Cost driver: is an activity that causes the cost pool to increase
in amount as the cost driver increases in volume.

 Cost allocation requires:
 the pooling of manufacturing overhead costs that are affected by
a common activity and

 the selection of a cost driver whose activity level causes a change
3 © 2012 Pearson Prentice Hall. All rights reserved.
Purposes of cost allocation
To provide information for economic
decisions
To motivate managers and other employees
To justify costs or compute reimbursement
To measure income and assets for reporting
to external parties
Steps in Manufacturing overhead
allocation process
Planning step
Application step
Recording step and
Reconciling step

Planning step
In planning step, a predetermined overhead rate is
calculated in traditional settings and activity pool

rate is calculated in activity based costing settings.
No journal entry is required during this stage.
Predetermined overhead rate = Budgeted MOH

costs__________________
Budgeted MOH cost allocation
bases (cost drivers)
Application step
In the application step, the estimated manufacturing
overhead costs are assigned to the products costs as units

are manufactured.
Applied MOH Cost
= Predetermined MOH rate*Actual MOH cost allocation bases (cost
drivers)
The following entry is required in this step.

Work in process inventory Debit
Manufacturing overhead allocated Credit
Recording step
In the recording step, the actual manufacturing overhead
costs incurred during the accounting period are

recorded.
These costs will be part of the actual product cost and
include the costs of indirect materials, indirect labor,

depreciation, property taxes and other production cost.
Journal entry:
Manufacturing overhead control Debit
Various Accounts Credit
8 © 2012 Pearson Prentice Hall. All rights reserved.

Reconciliation step
The difference between the applied manufacturing overhead costs
and the actual overhead costs is calculated at the end of

accounting period under reconciliation step.
If applied manufacturing overhead is more than the actual
manufacturing overhead it is known as over- applied overhead.

On the other hand, if applied overhead is less than the actual
manufacturing overhead, it is known as under-applied overhead.

 This difference will be eliminated in the end-of-period adjusting entry
process, using one of three possible methods (See chapter 2).
 © 2012 Pearson Prentice Hall. All rights reserved. 9

Allocating Costs of a Supporting
Department to Operating Departments
Supporting (service) department—provides the

services that assist other internal departments in the
company. Examples of support departments are
information systems and plant maintenance.
Operating (production) department—directly adds
value to a product or service.

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.
© 2012 Pearson Prentice Hall. All rights reserved. 11

Allocation Method Trade-Offs
Single-rate method is simple to implement, but treats fixed
costs in a manner similar to variable costs.
Dual-rate method treats fixed and variable costs more
realistically, but is more complex to implement.

Allocation Bases
When using either the single-rate method or the dual-rate
method, managers can allocate support-department costs to

operating divisions based on either a budgeted rate or the
eventual actual cost rate.
The latter approach is neither conceptually preferred nor
widely used in practice.

Accordingly, we illustrate the single rate and dual-rate
methods next based on the use of budgeted rates.

Example
Consider the central computer department of SHC. This support
department has two users, both operating divisions: the

microcomputer division and the peripheral equipment division.
The following data relate to the 2012 budget:

Allocation Based on the Usage of Computer Services
Single-Rate Method
In this method, a combined budgeted rate is used for fixed and
variable costs. The rate is calculated as follows:
Under the single-rate method, divisions are charged the

budgeted rate for each hour of actual use of the central
facility. The support costs allocated to the two divisions under
this method are as follows:

Dual-Rate Method
As in the single-rate method, variable costs are assigned
based on the budgeted variable cost per hour of $200 for
actual hours used by each division.
However, fixed costs are assigned based on budgeted fixed
costs per hour and the budgeted number of hours for
each division.
Given the budgeted usage of 8,000 hours for the microcomputer
division and 4,000 hours for the peripheral equipment division,

the budgeted fixed-cost rate is $250 per hour ($3,000,000 ÷
Cont…
The costs allocated to the microcomputer division in 2012
under the dual-rate method would be as follows:
The costs allocated to the peripheral equipment division in 2012
would be as follows:

Methods of Allocating Costs of Multiple
Support Departments
1. Direct
2. Step-down
3. Reciprocal

Direct Method
Allocates support costs only to operating
departments.
Direct method does not allocate support-
department costs to other support departments.

Direct Method
Support Departments Production Departments
Information Systems
Manufacturing
Packaging

Accounting
Data Used in Cost Allocation Illustrations

Cont…
The base used to allocate plant maintenance costs
to the operating departments is the budgeted total

maintenance labour-hours worked in the operating
departments: 6,000 + 10,000 = 16,000 hours.
Similarly, the base used for allocation of
information systems costs to the operating
departments is 4,000 + 500 = 4,500 budgeted
hours of computer time.
Direct Allocation Method Illustrated

23
Direct Allocation Method Illustrated

Step-Down Method
Also called the sequential allocation method
Allocates support-department costs to other support

departments and to operating departments in a sequential
manner
Partially recognizes the mutual services provided among all
support departments
The latter slides shows the step-down method. Assume that
the plant maintenance costs of $6,300,000 are allocated

Step-Down Method
Information Systems
Manufacturing
Packaging
Accounting
Step-Down Allocation Method
Illustrated

Step-Down Allocation Method
Illustrated

Reciprocal Method
Allocates support-department costs to operating
departments by fully recognizing the mutual

services provided among all support
departments.
Reciprocal method fully incorporates
interdepartmental relationships into the support-
department cost allocation.
Reciprocal Method
Information Systems
Manufacturing
Packaging
Accounting
Reciprocal Allocation Method Illustrated

Choosing Between Methods
Reciprocal is the most precise.
Direct and step-down are simple to compute and understand.
Direct method is widely used.

Allocating Common Costs
Common cost—the cost of operating a facility,
activity, or like cost object that is shared by two or
more users at a lower cost than the individual cost
of the activity to each user.

Methods of Allocating
Common Costs
Stand-alone cost-allocation method—uses
information pertaining to each user of a cost object
as a separate entity to determine the cost-allocation
weights.
Individual costs are added together and allocation
percentages are calculated from the whole, and

applied to the common cost.
Methods of Allocating Common Costs
Incremental cost-allocation method ranks the individual users
of a cost object in the order of users most responsible for a

common cost and then uses this ranking to allocate the cost
among the users.
The first ranked user is the primary user and is allocated costs up
the cost as a stand-alone user (typically gets the highest allocation

of the common costs).
The second ranked user is the first incremental user and is allocated
the additional cost that arises from two users rather than one.
35
Subsequent users are handled in the same manner as the second
Example
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.1,200. A
week prior to leaving Ayele is also invited to an interview with
an employer in Dessie. The Addis-Dessie round trip airfare
costs Br. 800. Ayele decided to combine the two recurring trips
into an Addis-Mekele-Dessie trip that will cost Br. 1,500 in
airfare. The Br. 1, 500 is a common cost that benefits both
prospective employers.
Stand-alone cost-allocation method
Mekele employer: Br1,200 * 1,500 = 0.60*1,500= Br 900
Br1,200 + Br 800
Dessie employer: Br 800 * 1,500 = 0.4 * 1,500 = Br

600
Br 800 + Br 1,200

Incremental cost-allocation method
Assume in the example the Mekele employer 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 Dessie. The cost allocation would be:
Party Cost Allocated Cumulative Costs Allocated
Mekele (primary) Br 1,200 Br 1,200
Dessie (incremental) 300 (1,500 – 1,200) Br 1,500
• Had the Dessie employer been chosen as the primary party, the
cost allocations would have been Dessie $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 incremental party.
Cost Allocation:
Joint Products and Byproducts

Joint Cost Terminology
Joint costs—costs of a single production process that yields
multiple products simultaneously.

Splitoff point—the place in a joint production process where
two or more products become separately identifiable.

Separable costs—all costs incurred beyond the splitoff point
that are assignable to each of the now-identifiable specific

products.
40
Joint Cost Terminology
Joint products—outputs of a joint production process that
yields two or more products with a high sales value

compared to the sales values of any other outputs.
Byproducts—outputs of a joint production process that
have low sales values compare to the sales values of the

other outputs.
41
Joint Process Overview
Steam:
An Output with Zero Sales Value
Joint Product #1
Single Production
Process
Joint Product #2
Byproduct
42
Joint Cost Allocation Methods
 Market-based—allocate using market-derived data
(dollars):
1. Sales value at splitoff
2. Net realizable value (NRV)
3. Constant gross-margin percentage NRV
 Physical measures—allocate using tangible attributes of
the products, such as pounds, gallons, barrels, and so on
43
Sales Value at Splitoff Method
Uses the sales value of the entire production of the
accounting period to calculate allocation

percentage
Ignores inventories
44
Joint Cost Illustration Overview
45
Cont…
The selling price per gallon
For cream is $8
For liquid skim is $4
46
Sales Value at Splitoff Illustration
Allocation of Joint Costs Using Liquid
Sales Value at Splitoff Method Cream Skim Total
Sales value of total production at splitoff
point: (25,000*$8; 75,000*$4) $200,000 $300,000 $500,000
Weighting ($200,000/$500,000;
$300,000/$500,000) 0.40 0.60
Joint costs allocated:
(0.40*$400,000; 0.60*$400,000) $160,000 $240,000 $400,000
47
Net Realizable Value Method
Allocates joint costs to joint products on the basis
of relative NRV of total production of the joint

products.
NRV = Final Sales Value – Separable Costs
48
Net Realizable Value Method
Overview

50
Cont…
Solution:
51
Constant Gross Margin NRV Method
Allocates joint costs to joint products in a way that
the overall gross-margin percentage is identical for
the individual products.
Joint costs are calculated as a residual amount.
52
Cont…
 Step 1: Compute overall gross margin percentage
This is based on the final sales value of total production during the
accounting period.
 Step 2: Compute total production costs for each product.
The difference between the final sales value of total production and the
gross margin then yields the total production costs that the product must
bear.
 Step 3: Compute allocated joint costs.
As the final step, the separable costs for each product are deducted from
the total production costs that the product must bear to obtain the joint-
cost allocation for that product.
53
Cont…
Solution:
54
Physical-Measure Method
Allocates joint costs to joint products on the basis of
the relative weight, volume, or other physical measure

at the splitoff point of total production of the products.
55
Physical Measures Illustration
Allocation of Joint Costs Using Liquid
Physical Measure Method Cream Skim Total
Physical Measure of total production
(gallons) 25,000 75,000 100,0000
Weighting (25,000/100,000;
75,000/100,000) 0.25 0.75
Joint costs allocated (0.25*$400,000;
0.75*$400,000) $100,000 $300,000 $400,000
56
Byproducts
Two methods for accounting for byproducts
Production method—recognizes byproduct inventory as it is
created, and sales and costs at the time of sale.

Sales method—recognizes no byproduct inventory, and
recognizes only sales at the time of sales: byproduct costs are not
tracked separately.
57
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Chapter 5

collected indirect costs to cost objects using an allocation

tie with the allocation of costs to products or services.

 Cost pool and

in amount as the cost driver increases in volume.

 the pooling of manufacturing overhead costs that are affected by

a common activity and

To justify costs or compute reimbursement

To measure income and assets for reporting

Recording step and

5 © 2012 Pearson Prentice Hall. All rights reserved.

calculated in traditional settings and activity pool

Predetermined overhead rate = Budgeted MOH

overhead costs are assigned to the products costs as units

The following entry is required in this step.

costs incurred during the accounting period are

include the costs of indirect materials, indirect labor,

8 © 2012 Pearson Prentice Hall. All rights reserved.

and the actual overhead costs is calculated at the end of

manufacturing overhead it is known as over- applied overhead.

manufacturing overhead, it is known as under-applied overhead.

process, using one of three possible methods (See chapter 2).

 © 2012 Pearson Prentice Hall. All rights reserved. 9

Supporting (service) department—provides the

value to a product or service.

10 © 2012 Pearson Prentice Hall. All rights reserved.

department) to cost objects (production departments) using the

Dual-rate method—segregates costs within each cost pool into

two segments: a variable-cost pool and a fixed-cost pool.

© 2012 Pearson Prentice Hall. All rights reserved. 11

Single-rate method is simple to implement, but treats fixed

costs in a manner similar to variable costs.

Dual-rate method treats fixed and variable costs more

realistically, but is more complex to implement.

12 © 2012 Pearson Prentice Hall. All rights reserved.

method, managers can allocate support-department costs to

widely used in practice.

methods next based on the use of budgeted rates.

department has two users, both operating divisions: the

14 © 2012 Pearson Prentice Hall. All rights reserved.

Under the single-rate method, divisions are charged the

© 2012 Pearson Prentice Hall. All rights reserved. 15

division and 4,000 hours for the peripheral equipment division,

under the dual-rate method would be as follows:

The costs allocated to the peripheral equipment division in 2012

17 © 2012 Pearson Prentice Hall. All rights reserved.

18 © 2012 Pearson Prentice Hall. All rights reserved.

Allocates support costs only to operating

Direct method does not allocate support-

department costs to other support departments.

19 © 2012 Pearson Prentice Hall. All rights reserved.

20 © 2012 Pearson Prentice Hall. All rights reserved.

21 © 2012 Pearson Prentice Hall. All rights reserved.

to the operating departments is the budgeted total

© 2012 Pearson Prentice Hall. All rights reserved.

24 © 2012 Pearson Prentice Hall. All rights reserved.

Allocates support-department costs to other support

the plant maintenance costs of $6,300,000 are allocated

© 2012 Pearson Prentice Hall. All rights reserved. 27

28 © 2012 Pearson Prentice Hall. All rights reserved.

departments by fully recognizing the mutual

© 2012 Pearson Prentice Hall. All rights reserved. 31

Reciprocal is the most precise.