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Chapter 5

COMM-2016EL Chapter Notes - Chapter 5: Dow Chemical Company, Particle Board, Board Foot

Commerce and Administration
Course Code
Kayla Levesque

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Chapter 5 Cost Allocatio & Activity-Based Costig Systes
Cost Accounting System the techniques used to determine the cost of a product or service by collecting and
classifying costs and assigning them to cost objectives
The goal of a cost account system is to measure the cost of designing, developing, producing, selling,
distributing, and servicing particular products or services
Cost Allocation in General
Ideally, costs should be assigned to the cost objective that caused them. Cost allocation is fundamentally a
problem of linking: (1) some cost or group of costs; with (2) one or more cost objectives, such as products,
departments, and divisions
Linking costs with cost objectives is accomplished by selecting cost drivers…
Cost-Allocation Base a cost driver that is used for allocating costs
It is impossible to objectively determine which cost-allocation base perfectly describes the link between
the cost and the cost objective
Major costs (ex. direct labour for a law firm) may each be allocated to departments, jobs, & projects on
an item-by-item basis, using obvious cost drivers such as direct-labour-hours used
Other costs, taken one at a time, are not important enough to justify being allocated individually. These costs
are pooled and then allocated together…
Cost Pool a group of individual costs that is allocated to cost objectives using a single cost driver
Building rent, utilities cost, and janitorial services may be in the same cost pool because all are allocated
on the basis of m2 of space occupied
All costs in a given cost pool should be caused by the same factor. The factor is the cost driver.
Managers within an organizational unit should be aware of all the consequences of their decisions, even outside
of their unit (ex. addition of a new course in a university that causes additional work in the registrar’s office)
Managers assign direct costs without using allocated costs. The allocation of costs is necessary when the
linkage between the costs and the cost objective is indirect
Due to the subjectivity in the selection of a cost-allocation base, it has always been difficult for managers to
determine “When should costs be allocated?” and “On what basis should costs be allocated?”. The answers to
these questions depend on the principle purposes/purpose of the cost allocation.
Costs are allocated for 3 main purposes:
1. To obtain desired motivation cost allocations are sometimes made to influence management
behaviour and thus promote goal congruence and managerial effort
2. To compute income and asset valuations costs are allocated to products and projects to measure
inventory costs and COGS. These allocations frequently serve financial accounting purposes. However,
the resulting costs are often used by managers in planning, performance evaluation, and motivation
3. To justify costs or obtain reimbursement sometimes prices are based directly on costs, or they may
be necessary to justify an accepted bid
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Different allocations of costs to products may be made for various purposes. Thus, full costs may guide pricing
decisions, manufacturing costs may be appropriate for asset valuations, and some “in-between” costs may be
negotiated for a government contract
Ideally, all 3 purposes would be served simultaneously by a single cost allocation, but this is often not
the case. Often, inventory-costing purposes dominate by default because they are externally imposed
There are 3 basic types of cost allocation:
1. Allocation of joint costs to the appropriate responsibility centres
Costs that are used jointly by more than one unit are allocated based on cost-driver activity in the units
EX. allocating rent to departments based on floor space occupied, allocating depreciation on jointly used
machinery based on machine hours, and allocating general admin expense based on total direct cost
2. Reallocation of costs from one responsibility centre to another
When 1 unit provides products or services to another, the costs are transferred along with the products/services
A service department is a cost center that provides services to the rest of a company. The manager of a service
department is responsible for keeping costs down, or meeting the costs stated in a budgetThese units exist
ONLY to serve other departments, and their costs are totally reallocated
EX. personnel departments, laundry departments in hospitals, and legal departments in industrial firms
3. Allocation of costs of a particular organizational unit to its outputs of products or services
The costs allocated to products/services include those allocated to the organizational unit in allocation types one
and two
EX. The pediatrics department of a med clinic allocates its costs to patient visits, the assembly department of a
manufacturing firm to units assembled, and the tax department of a CA firm to clients served
Allocation of Service Department Costs
To perform activities, resources are required. These resources have costs
Some costs vary in direct proportion to the consumption of resources (ex. materials, labour, & supplies)
Other costs do not directly vary (in the short-run) with resource usage (ex. supervisor salaries, rent, &
Therefore, the manager and the accountant should search for some cost driver that establishes a convincing
relationship between the cause (activity being performed) and the effect (consumption of resources and related
costs) and that permits reliable predictions of how costs will be affected by decisions regarding these activities
The preferred guidelines for allocating service department costs are:
1. Evaluate performance using budgets for each service (staff) department, just as is done for each
production or operating (line) department
The performance of a service department is evaluated by comparing actual costs with a budget,
regardless of how the costs are later allocated
From this budget, variable-cost pools and fixed-cost pools can be identified
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2. Charge variable- and fixed-cost pools separately (AKA. dual method of allocation)
Note that one service department, such as the computer department, can contain multiple cost
pools if more than one cost driver causes the department’s cost
At minimum, there should be a variable-cost pool & a fixed-cost pool
3. Establish part or all of the details regarding cost allocation in advance of rendering the service,
rather than after the fact. This approach establishes the “rules of the game” so that all departments can
plan appropriately
Consider a computer department in a university that serves 2 major users: The School of Business and
School of Engineering
Suppose there are 2 major purposes for the info: (1) predicting the economic effects of the use of the
computer, and (2) motivating departments & individuals to use its capabilities more fully
The primary activity performed is computer processing. Resources consumed include processing time,
operator time, consulting time, energy, materials, and building space
Suppose cost behaviour analysis has been performed and the budget formula for the forthcoming fiscal
year is $1,000 monthly fixed costs plus $200 variable cost per hour of computer time used
The cost-driver for the variable-cost pool in this case is hours of computer time used. Variable costs should be
assigned as follows:
Budgeted Unit Rate x Cost-Driver for Variable-Cost Pool
The use of budgeted cost rates rather than actual cost rates for allocating variable costs of service departments
protects the using departments from intervening price fluctuations & also often protects from inefficiencies in
the service departments
When an organization allocates actual total service department cost, it holds user-department managers
responsible for costs beyond their control and provides less incentive for service depts. to be efficient
Suppose inefficiencies in the computer department caused the variable costs to be $140,000 instead of (600 x
$200) or $120,000 budgeted. A good cost accounting scheme would charge ONLY $120,000 to the consuming
departments and would let the $20,000 remain as an unfavourable budget variance of the computer department
The cost-driver for the fixed-cost pool in this case is the amount of capacity required when the computer
facilities were acquired. Therefore, fixed costs should be allocated as follows:
Total Budgeted Fixed Costs x Cost-Driver for Fixed-Cost Pool
Consider again our example of the computer department. Suppose the dean had originally predicted the
following long-run average monthly usage: Business 210 and Engineering 490 for a total of 700 hours. The
fixed-cost pool would be allocated as follows:
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