Cost Allocation Definition¶
All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client's needs and circumstances.
But what about cost allocation's other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)?
Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or
…show more content…
Implementing Activity Based Costing¶
The steps involved in activity based costing are:
1) Clarify the purpose of the allocation, defining why the need to allocate these costs exists and defining the benefit of doing so.
2) Identify support and operating department cost pools;
3) Select an allocation base or cost driver for each support department cost pool based on a cause-and-effect relationship between the support departments and the operating/production departments.
4) Choose and apply a method for allocating support department costs to operating/production departments. The three most widely used methods are the direct method, the step-down method, and the reciprocal method, all of which will be discussed shortly.
5) Once the allocation of support costs to the operating departments is complete, cost drivers are selected for the newly formed cost pools (production/operating department overhead costs) and costs are then allocated to the units of goods or services.
Direct Method of Allocation¶
Before we continue, it would be good to discuss the three methods discussed in step 4. The direct method allocates costs directly from the support departments to the operating departments that use its services. Example: the personnel department might allocate its overhead (i.e., ALL of its
The current cost system allocates overhead costs once a year, as a function of direct labor dollars. This allocation strategy results in:
choose the most appropriate and effective overhead rate, particularly, because it guides management in its tasks of product pricing, job costing, and budgeting. Businesses can use the single company-wide method or can opt for the departmental method. Auerbach
Cost drivers can be identified for each activity or cost category based on observation, discussions with management, simulations and statistical studies. The key is to determine the behavior of indirect costs with respect to activity or resource usage in each activity center (Leslie, 2009). These efforts have identified the eight cost drivers shown in Table 3.
Under a traditional system, overhead cost is allocated to an activity based on hours or rates for direct labor or machine usage. However, this approach does not clearly indicate how much overhead cost will be needed in order to complete a job through a particular function. ABC methodology is to be used as an alternative to traditional accounting where a business 's overhead costs (indirect costs such as electrical energy consumption for heating or cooling, or indirect cost associated with marketing) are allocated as a proportion of direct costs, to an activity. This approach is unsatisfactory because there can be cases where two activities could absorb the same direct costs
Both systems have their advantages and disadvantages, the labor-based allocation method provides a fast straightforward method for businesses with labor intensive processes that in many businesses make up the majority of these costs. For this microbrewery however, especially within overheads the percentage of costs labor attributes towards is relatively minimal. Therefore reducing the effectiveness of such a method. ABC however represents a more in depth look at cost allocation and within such a business where there are a huge variety of factors involved looking at a more segmented form of activity based cost allocation is extremely important.
Standardizing the cost management system companywide is an important step in improving the link between cost management and
• This cost method does not provide the best system for JDCW’s cost allocation. By using only three overhead rates the present system grossly undermines the true production costs since other activities of the production process are not acknowledged.
Allocating overhead costs is one of the important tasks and is necessary to be done by management accountant. One key reason is that in term of pricing strategies, many firms decide their products’ selling price based on their cost. And the selling price has to cover all the costs and profit.
7.Anticipate business problems that may result from allocating manufacturing overhead based on the cost of the prints.
The current method of apportioning production overheads based on direct labour hours can be described as a traditional approach to product costing. In a manufacturing company’s financial statements, each item produced must be allocated some of the production overheads to make the statements compliant. Sometimes the individual costs of these items can be calculated incorrectly based on overall production overhead and the system of allocating in place, however the overall financial statement can still be accurate. This traditional method of allocating the production
2. handle amassing expenses area unit gathered for each vocation severally. Fetches area unit gathered for
The purpose of this paper is to answer a few important questions: Why do companies allocate costs? How do companies allocate costs? And how this cost allocation can affect the decision making of the company. It is important for the companies to find the proper method to allocate the costs. Cost allocation is an important issue in many companies because many of the costs associated with designing, producing and distributing products and services are not easily identified with the products and services that are created. It would have been easier for companies to allocate cost if costs were directly traceable with the products and the cost allocation would have been minor issue for the company. The decision-making
There are different costs that respond to the different activities like variable costs are directly associated with the products sold. The cost behavior patterns of selling, general, administrative, and other operating expenses are determined, and these expenses are budgeted accordingly. For example, sales commissions will be a function of the forecast of either sales dollars or units. The historical pattern of some expenses will be affected by changes in strategy that management may plan for the budget period. In a participative budgeting system, the manager of each department or cost responsibility center will submit the anticipated cost of the department 's planned activities, along with descriptions of the activities and explanations of significant differences from past experience. After review by higher levels of management, and perhaps negotiation, a final budget will be established. Because of the necessity to recognize cost behavior patterns for planning and control purposes, overhead costs will be classified as variable or fixed.
Oak City is an interdisciplinary case that involves cost allocation and determination issues in a
During the 1980s the limitations of traditional product costing systems began to be widely publicised. These systems were designed decades ago when most companies manufactured a narrow range of products, and direct labour and materials were the dominant factory costs. Overhead costs were relatively small, and the distortions arising from inappropriate overhead allocations were not significant. Information processing costs were high, and it was therefore difficult to justify more sophisticated overhead allocation methods.