Cost and management

1. Chapter 3
Cost Allocation
1

2. Cost allocation
• Cost allocation is the assignment of all
indirect costs to a cost object using an
allocation base.
• The ultimate goal of cost allocation is to
make certain that all costs incurred by
the organization eventually are assigned
to its products or services.
2

3. Product cost Elements
•Product cost elements are broadly
classified into three:
–Direct material cost
–Direct labor cost and
–All indirect manufacturing cost (i.e.
manufacturing overhead).
3

4. Meaning of cost allocation and other related terms
• Cost Allocation: the process of assigning or applying collected
indirect costs to cost objects using an allocation base.
• To know the cost allocation the following terms should be
known
1. Cost object: - is the destination of all assigned or allocated costs. For
example, a cost may be assigned to a particular product, service or
department.
2. Cost pool: is a collection of overhead costs related to a cost object (a
product related activity).
3. Cost driver: is an activity that causes the cost pool to change
(increase/decrease) in amount as the cost driver changes
(increase/decrease) in volume.
4

5. Purposes of Cost Allocation
–To provide information for economic decisions
–To motivate mangers and other employees
–To justify cost or compute reimbursement
–To measure income and assets for reporting to
external parties
5

6. Steps in the process of applying manufacturing overhead
• Steps to be followed for the purpose of allocating
manufacturing overhead (factory overhead) costs.
1. 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.
6

7. 2. Application step
• In the application step, the estimated manufacturing
overhead costs are assigned to the products costs as
units are manufactured.
• The following entry is required in this step.
Work in process inventory debit
Manufacturing overhead Credit
7

8. • Example, assume Afro company has incurred 78,000
birr direct labor cost for the month of April and from
past experience of the company, the manufacturing
overhead cost rate is 80% of direct labor costs.
• This implies the overhead costs applied are birr 62,400
(78,000*0.80)
• Thus, the journal entry to apply the manufacturing
costs is:
Work in process inventory 62,400
Manufacturing overhead 62,400
8

9. 3. Recording step: In the recording step, the actual
manufacturing overhead costs incurred during the
accounting period are recorded.
Journal entry:
Manufacturing overhead cost debit
Cash or A/p Credit
9

10. • Considering the example under the application step,
the actual overhead cost incurred by Afro company in
the month of April indicates that
– Birr 12,000 for indirect materials purchased on account
– Indirect labor cost of birr 28,000 and
– Other manufacturing costs other than indirect materials and indirect
labor are birr 28,000.
• The journal entry to record the actually incurred overhead
costs is:
Manufacturing overhead cost 68,000
Various accounts 68,000
10

11. 4. 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.
11

12. • The following journal entry is to be made for over
or under applied manufacturing overhead.
–For over applied
Manufacturing overhead debit
Cost of goods sold credit
–For under applied
Cost of goods sold debit
Manufacturing overhead cost credit
12

13. Example: Refer the examples that we have made under the
application step and the recording step for the
reconciliation purpose.
Herein, the applied overhead cost is birr 62,400 and the
actual overhead cost incurred is birr 68,000, therefore,
there is under-application of overhead costs by birr 5,600
and assume the under-applied overhead cost is immaterial
(i.e., the amount is not significant).
The journal entry to record the under-applied overhead is
Cost of goods sold 5,600
Manufacturing overhead cost 5,600
13

14. However, if the under-applied overhead is material, the
adjustment should be to cost of goods sold, work in process
and finished goods based on their ending balances.
Assume at the end of April, the Afro Company has birr 50,000
work in process, birr 30,000 finished goods reported in its
balance sheet and birr 120,000 cost of goods sold reported in
its income statement.
Accordingly, the under-applied is allocated to the three
accounts as follows:
Cost of goods sold 3,360
Work in process 1,400
Finished goods 840
Manufacturing overhead cost 5,600 14

15. Manufacturing overhead allocation using the traditional
approach:
• A single predetermined overhead rate is used by many
organizations for the application of manufacturing
overhead.
• This method is useful if companies manufacture only one
product or two very similar products that require the
same production related activities such as set up,
inspection and material handling.
• The total manufacturing overhead cost represent one
cost pool and a traditional activity base, such as direct
labor hours, direct labor costs, machine hours or unit of
production, become the cost driver. 15

16. • Example: Assume Philips TV set manufacture
manufacturing 14” and 21” color TV sets. They are using
the application of one cost pool of manufacturing
overhead costs to two product lines.
• Suppose the Philips set manufacturers choose machine
hours as the cost driver. For the next year, the overhead
cost will amount to $ 300,000 and that total machine hours
worked will be 30,000 hours.
• The corporation supplied the following data for the
two product lines:
14 inch 21 inch
Actual direct materials cost/unit $ 70 $ 80
Actual direct labor cost/unit 30 40
Prime cost per unit 100 120 16

17. 17

18. Step 2: Application of manufacturing overhead costs to production
• Application: Budgeted rate x Actual usage
18
14 inch 21 inch
Cost drive level Cost applied Cost drive level Cost applied
Overhead cost applied:
Manufacturing
overhead rate: $10/MH
x 10,000MH $100,000 X 20,000 MH $200,000
Number of units 5,000 units 4,000units
Manufacturing
overhead cost per unit
$ 20 $ 50

19. Product unit Cost
Product cost per unit 14inch 21inch
Direct Materials $70 $80
Direct labor 30 40
Manufacturing overhead 20 50
Product unit cost 120 170
19

20. Manufacturing Overhead allocation using Activity
Based costing (ABC)
• Activity Based Costing (ABC) is a method of assigning
costs that calculates a more accurate product cost by
categorizing all indirect costs by activity, tracing the
indirect costs to those activities and assigning activity
costs to product using cost driver that are related to the
cause of the product.
20

21. • Example: Refer the above example: Philips
Corporation analyzed the production related activities
and decided that the estimated $300,000 in
manufacturing overhead cost should be grouped into
four activity pools.
– The first activity, setup, includes estimated total costs of $100,000 for
indirect labor and indirect materials used in preparing machines for
each batch of production.
– The second activity, inspection, includes $90,000 for salaries and
costs of indirect materials, indirect labor and depreciation on testing
equipment.
21

22. – Packaging, the third activity, includes estimated total costs of $ 65,000
for indirect materials, indirect labor and equipment depreciation.
– The last activity, building, includes 45,000 for wages, property taxes,
insurance, security and all other costs not related to the first three
activities
Estimated Cost Driver Level
Cost driver 14inch 21inch Total
Number of setups 500 500 1,000
Number of inspections 250 350 600
Packaging hours 1,200 1,300 2,500
Machine hours 14,000 16,000 30,000
Required:
• Calculate overhead activity cost rates
• Apply manufacturing overhead costs to production 22

23. 23
Activity
Pool
Estimated Activity
pool Amount/cost
Cost Driver Level Activity Cost rate
Set up $100,000 1,000 setups $100 per setup
Inspection 90,000 600 inspections $150 per inspection
Packaging 65,000 2,500 packaging hours $26 per packing hour
Building 45,000 30,000 machine hours $1.5 per machine hour

24. Step 2: Application of manufacturing overhead costs to production
• In applying the manufacturing overhead to the
products under the ABC approach, the activity pool
rate is multiplied by the actual cost driver used by the
products
Cost applied = Activity cost pool rate x actual cost driver level
24

25. 14 inch 21 inch
Activity pool
Activity cost
rate (from step 1)
Cost Driver
level
Cost
applied
Cost Driver
level
Cost applied
Set up $100 per set up *500 set ups $ 50,000 *500 set ups $50,000
Inspection
$150 per
inspection
*250
inspection
$ 37,500
*350
inspections
$52,500
Packing
$26 per
packing hour
*1,200 packing
hour
$31,200
*1,300 packing
hour
$33,800
Building
$1.5 per
Machine hour
*14,000
Machine hour
$21,000
*16,000
Machine hour
$24,000
Total $ 139,700 $ 160,300
Number of units 5,000 4,000
Manufacturing overhead cost per unit $ 27.94 ≈ 28 $ 40.075≈ 40
25

26. • Product Unit Cost 14inch 21inch
Direct materials $ 70 $ 80
Direct labour 30 40
Manufacturing overhead 28 40
Product unit cost 128 160
Management accountant presented the following information to Philips Corporation:
26
Product unit cost: 14-inch 21-inch
One manufacturing overhead Cost pool $ 120 170
Product unit cost: ABC with four activity pools $ 128 $ 160
Differences: Decrease (increase) $ (8) $ 10

27. Allocating costs from one department to another
• Cost of a central department which emerges to give service for
other departments centrally are incurred only since it provides
service to these departments or divisions.
• Issues arising when allocating costs from one cost pool in
a division to another cost pool within the division, or
when allocating costs from activity cost pools in a
division to products are:
– Whether different methods of allocation be used for fixed costs and for
variable costs
– Whether budgeted rates or actual rates be used
– Whether quantities actual or quantities budgeted is used.
27

28. 1. Single Rate Methods
–This method pools all costs in one cost pool and allocates
these costs to cost objects using the same rate per unit of
the single allocation base.
–There is no distinction between costs in the cost pool in
terms of cost behaviors (such as fixed cost vs. variable
costs).
2. The dual- rate method:
–The dual rates cost allocation method classify costs in each
cost pool into two sub cost pools (a variable cost sub pool
and a fixed cost sub pool).
28

29. Budgeted Vs. Actual Rates
Budgeted Rates:
• When cost allocations are made using budgeted rates,
managers of divisions to which costs are allocated face
no uncertainty about the rates to be used in that budget
period.
• Budgeted rates let the user departments know in
advance the cost rates they will be charged.
Actual Rates:
• In contrast, when actual rates are used, the user
departments will not know the rates changed until the
end of the period.
29

30. Example:
DELL Computer Corporation has a central computer department. This
department has only two users – DELL- Microcomputer division and
DELL Peripheral equipment division.
The following data apply to the coming budget year:
– Fixed costs of operating the computer facility in the 4000-to 12000
hours= $4,000,000 per annum relevant range
– Total capacity available 12,000
– Budgeted long run usage
• Microcomputer Division = 7,500 hours
• Peripheral Equipment Division = 2,500 hours
• Total 10,000 hours
• Budgeted variable cost per hour (4000 to 12000 hours rate = $ 300 per hour used
30

31. Calculate:
A. Under single rate method (assuming budgeted usage is the
allocation base and budgeted rates are used)
I. Total cost pool
II. Budgeted total rate per hour.
III. Total cost allocated to Microcomputer division
IV. Total cost allocated to peripheral Division
B. Under Dual Rate Method (Budgeted usage for fixed costs and
actual usage for variable costs)
i. Total fixed cost for microcomputer division
ii. Total fixed cost for peripheral equipment division
iii. Total cost allocated to microcomputer division
iv. Total cost allocated to peripheral division. 31

32. 32

33. I. Calculation of Total cost allocated to Microcomputer division
Budgeted rate per hour: $ 700
Actual usage 8,000 hours
Total cost allocated 8,000 hours @ 700 per hr = $ 5,600,000
II. Calculation of Total cost allocated to Peripheral Division
Budgeted rate per hour: $ 700
Actual usage 2,000 hours
Total cost allocated 2,000 hours @ 700 per hr = $ 1,400,000
33

34. 34

35. I. Calculation of Total cost allocated to Microcomputer division
Fixed cost allocated: $ 3,000,000
Variable cost @300 per hr
for 8000 actual hrs 2,400,000
Total cost allocated = $ 5,400,000
II. Calculation of Total cost allocated to peripheral Division
Fixed cost allocated: $ 1,000,000
Variable cost @300 per hr
for 2000 actua; hrs 600,000
Total cost allocated = $ 1,600,000
35

36. Exercise:
Sand Hill Co. has a Central Computer Department; the department has
two users, Microcomputer Division and Peripheral Equipment Division.
The following data apply to the coming budget year.
Fixed costs of operating the computer facility in the 6000-18000hr relevant
range Br 3,000,000/year
Total capacity available 18,000hrs
Budgeted long-run usage
Microcomputer Division 8,000hrs
Peripheral Equipment Division 4,000hrs
Total 12,000hrs
Budgeted variable cost per hour $200/hour used
36

37. 37

38. 2. Dual-rate Allocation Method
Allocation of Fixed Costs to:
Microcomputer Division = 8000/12000hrs * 3,000,000 = Br. 2,000,000/year.
Peripheral Equipment Division = 4000/12000hrs * 3,000,000 = Br. 1,000,000/year.
Allocation of variable costs to:
Microcomputer: (200*9000) = Br. 1,800,000
Peripheral Equipment: (200*3000) = Br. 600,000
Total cost allocated to:
Microcomputer: 2,000,000 + 1,800,000 = Br. 3,800,000
Peripheral Equipment: 1,000,000 + 600,000 = Br. 1,600,000
38

39. Allocating costs of support departments (Service
Departments) to operating departments
• Departments in an organization can be divided into
two broad classes:
–Operating departments & Support (service) departments.
• In almost many manufacturing and non-
manufacturing, service departments are important in
providing support services to many of the productive
(operating) departments.
39

40. Operating department:
• Is a department that is directly involved in the
production of goods and services and adds value to a
product or service that is observable by a customer.
• Also called production department in manufacturing
companies.
40

41. • Support department: It is also called service department.
• A support department provides the services to other internal
departments (operating departments and other support
departments) in the organization.
• It is a unit in an organization that is not involved directly in
producing the organization’s goods or services. However,
support (service) department does provide a service that
enables the organization’s production process to takes place.
• For example, assume the maintenance department in an
automobile plant, it does not make automobiles, but if it does
not exist, the production process would stop when the
manufacturing machines broke down.
41

42. Examples: Human resource departments, plant and equipment
departments, information systems, maintenance department, etc.
42
.
Service
department-I
Service
department-II
Service
department-III
Operating
department-A
Operating
department-B
Product or service
costs

43. Support department
• Therefore, the cost of running support (service) departments is
part of the costs incurred by the organization in producing
goods or services.
• In order to determine the cost of those goods or services, all
service department costs must be allocated to the production
departments in which the goods or services are produced.
43

44. Methods of allocation
• Before costs are allocated to products or services, they are
accumulated in each department for planning and control
purposes.
• To recognize and allocate service department costs, there are three
different methods to be followed.
• These are direct method, step down method and reciprocal
method and are presented in detail with supporting examples.
1. Direct Method:
• Direct allocation method is the most widely used method of
allocating support department costs. This method allocates each
support department’s costs directly to the operating departments.
• The advantage of the direct method is its simplicity. 44

45. Example: Assume we are given the following information by Agora
manufacturing company: this example will help us to allocate all support
(Service) department costs under all methods (Direct method, step-down
method and reciprocal method
45
Operating Departments Support Departments
Machining Assembly Plant
Maintenance
Information
System
Total
Budgeted manufacturing
Overheads (amounts in Br)
80,000 40,000 120,000 23,200 263,200
Support work furnished
By plant Maintenance %
4,800
30%
8,000
50%
--
--
3,200
20%
16,000
100%
By info System
Budgeted computer Hr %
3,200
80%
400
10%
400
10%
--
--
4,000
100%

46. Solution: Direct allocation method:
46
Items Total
Operating depts. Supporting departments
Machining Assembly Maintenance Information
system
Budgeted MOH
(amounts in birr)
263,200 80,000 40,000 120,000 23,200
Allocation of Plant
maintenance 3:5
120,000*3/8
45,000
120,000*5/8
75,000 (--) 120,000 --
Allocation of
Information system 8:1
23,200*8/9
20,622
23,200*1/9
2,578 -- (--) 23,200
Total 263,200 145,622 117,578 -- --

47. 2. Step down allocation method:
• This method of allocation is also known as sequential
allocation method.
• Step down allocation method allows for partial
recognition of the services rendered by support
departments to other support departments.
• This method requires the support departments to be
ranked in the order that the step down allocation is to
proceed.
• Different sequences will result in different allocations
of support department costs to operating departments.
47

48. • Example: Refer the earlier example under the direct method
for allocating the service department costs to operating
departments under the step-down allocation method.
48
Departments Budgeted MOH
(amounts in Br)
2: 3: 5
Plant Maintenance $ 120,000 (-) 120,000 8: 1
Information systems
23, 200
120,000*2/10
24,000 (--) 47,200
Machining 80, 000 120,000*3/10
36,000
47,200*8/9
41,956
157,956
Assembly 40,000 120,000*5/10
60,000
47,200*1/9
5,244
105,244
263,200 263,200

49. 3. Reciprocal allocation method
• The reciprocal allocation method allocates costs
including the mutual services provided among all
support departments.
• The direct method and the step down method are less
accurate than the reciprocal method when support
departments provide services to one another
reciprocally.
• The reciprocal method is the most defensible
(justifiable) method of allocation because of its accuracy
in cost allocation, but the direct methods and step down
methods are more widely used.
49

50. • Example: Still we are referring the example that we have under direct
method: in allocating of support department costs to operating
departments, we have to follow the three steps which help us to create a
reciprocal relationship among the departments.
Solution:
• Step 1: Forming of linear equations of supporting department costs and
support department reciprocal relationship. First, we have to formulate a
linear equation that creates a reciprocal relationship as seen below.
• Let X be the complete reciprocal cost of plant maintenance and
Y be the complete reciprocated costs of Information systems.
• Then, the equation is
X = 120,000 + 10% of Y Equation 1
Y = 23 200 + 20% of X Equation 2
50

51. 51

52. • Step 3: Allocate the complete reciprocated costs of each support
department to all other departments (both support departments and
operating departments) based on the usage percentage (Based on total
units of service provided to all departments).
52
Items Total
Operating Depts. Support Depts.
Machining Assembly Maintenance Information
system
Budgeted MOH ( amounts
are given in birr)
263,200
80,000 40,000 120,000 23,200
Allocation of Maintenance
3:5:2
124,816*3/10
37,445
124,816*5/10
62,408 (-) 124,816
124,816*2/10
24,963
Information system,
8:1:1
48,163*8/10
38,530
48,163*1/10
4,817
48,163*1/10
4,816 (-) 48,163
Total 263,200 155,975 107,225 - -

53. Allocation of Manufacturing Overhead to Products
• We allocated all service (support) department costs to
operating departments, once the service departments
manufacturing overhead costs are distributed to the operating
departments, then they are to be allocated to products
produced by the concerned departments (operating
departments).
• For this purpose, two steps are to be followed
– Computing overhead rate (either machine hour, or direct labor hour
or any other suitable base) it to be calculated and
– Apply the overhead rate to the products by multiplying the
overhead rate so calculated in step no.1 by machine hours taken or
direct labor hours taken by the production department. 53

54. Example: The manufacturing overhead after reallocating
service department overhead costs to production
departments are (all amounts are given in birr):
Dept Direct method Step down method Reciprocal method
Machining 145,622 157,956 155,975
Assembly 117,578 105,244 107,225
54

55. • The budgeted machine hours for machining
department are 1000 hours and direct labor hours for
assembly department are 700 hours.
• Compute the manufacturing overhead rate for
Maintenance department and Assembly department
and also calculate manufacturing overhead charged to
a product consuming 100 machine hours for plant
Maintenance department and 50 direct labor hours for
Assembly departments under three methods.
55

56. Solution:
Computation of overhead rate
56
Support depts.
Allocation Method
Total Budgeted MOH after
reallocation of support depts
Budgeted overhead rate/hour
for product costing purposes
Maintenance Assembly Maintenance
(1000 hours)
Assembly
(700 hours)
Direct 145,622 117,578 145.62 167.97
Step down 157,956 105,244 157.95 150.35
Reciprocal 155,975 107,225 155.97 153.18

57. Allocation of manufacturing overhead to products.
57
Allocation Methods
Direct method Step method Reciprocal method
Maintenance 100hrs x 145.62 = 14,562 100hrs x 157.95 = 15,795 100hrs x 155.97 = 15,597
Assembly 50hrs x 167.97 = 8,398.50 50hrs x 150.35 =7,517.50 50hrs x 153.18 = 7,659
∑ = 22,960.50 ∑ = 23,312.50 ∑ = 23,256.00

58. END OF
CHAPTER
3 58