Notes 13 1 of 5
1 Describe how a costing system can have multiple cost objects;
2 Outline four purposes for allocating costs to cost objects;
3 Describe alternative criteria used to guide decisions related to cost allocations;
4 Discuss key decisions faced when collecting costs in indirect cost pools;
5 Describe how the single-rate cost-allocation method differs from the dual-rate method;
6 Explain how the choice of budgeted versus actual allocation rates changes the risks
7 Distinguish among the direct allocation, step-down, and reciprocal methods of
allocating support department costs;
8 Distinguish between the incremental and stand-alone common cost allocation methods.
The Terminology of Cost Allocation
Describe how a costing system can have multiple cost objects.
F Cost object - anything for which a separate measurement of costs is desired.
F Direct costs of a cost object - costs that are related to the particular cost object and
can be traced to it in an economically feasible way.
F Cost tracing - assigning direct costs to the chosen cost object.
F Indirect costs of a cost object - costs that are related to a cost object but cannot be
traced to it in an economically feasible way.
F Cost allocation - assigning indirect costs to the chosen cost object.
Purposes of Cost Allocation
(Refer to Exhibit 13-1), page 473.)
1 To make economic decisions for resource allocation (lease or buy, replacement, pricing).
2 To motivate managers and employees (improved profitability via better product/process
design; control of factors of production such as direct labor).
3 To justify costs or compute reimbursement (establishing a price under defense contracting).
4 To measure income and assets for reporting to external parties (investors and creditors -
annual reporting, IRS - tax reporting).
Criteria to Guide Cost Allocation Decisions
(Refer to Exhibit 13-2, page 475.)
1 Cause and effect - managers identify the variables (hours of testing) that cause cost objects
(quality testing area) to incur costs.
Use the cause and effect criteria when the purpose for allocation is an
accurate resource allocation or motivation for improved profitability.
2 Benefits Received
3 Fairness or equity
4 Ability to bear.
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The Cost-Benefit Consideraton
F Costs of a cost allocation system include those to gather the data and to educate
managers on the use of the information generated by the system.
F Benefits, which are usually difficult to measure and frequently less visible than
costs, include the ability to make better make-or-buy, pricing, and cost-control
F Rapid cost reductions for gathering data and information processing have spurred
many companies to adopt more complex systems than they had used previously.
Cost Allocation and Costing Systems
(Refer to Exhibit 13-3.)
This section uses the Computer Horizons example to illustrate how a given cost can be
both a direct cost for one cost object and an indirect cost for another. It also illustrates the
application of a costing system which is allocating indirect costs to a product.
Indirect Cost Pools and Cost Allocation
F A cost pool is a grouping of individual cost items.
F Examples of Indirect Cost Pools
(Refer to Exhibit 13-4.)
F Questions in Collecting Costs
1 Which costs to include in indirect pools?
2 How many cost pools should be used?
3 Which allocation base should be used for each pool used?
Homogeneity of cost pools
A cost pool is homogeneous if all the individual activities whose costs are included in the pool
have the same or a similar cause-and-effect relationship or benefits-received relationship
between the cost allocator and the costs of the activity
Recognizing More Cost Pools
Due to changes in processes, product mix, and the ability to provide the information,
more cost pools are being used in many organizations.
Allowability of Costs in Cost Pools
Costs for alcohol cannot be included in cost pools which are charged to the government.
Allocating Costs from One Department to Another
Single-rate versus dual-rate methods:
F Sngle-rate assumes that all costs are variable; dual-rate allows for fixed costs.
F Using a single-rate method may cause some managers to take actions that are good for their
divisions, but harmful to the company as a whole.
Budgeted versus Actual Rates
Budgeted cost rates enhance planning since rates are known in advance;
also, the support department manager is motivated to control costs.
Budgeted versus Actual Usage Allocation Bases
F Budgeted usage as the allocation base for allocating fixed costs allows the user divisions to
know their allocated costs in advance; this facilitates planning.
F Actual usage as an allocation base for allocating fixed costs makes a division's allocation
subject to variability in usage by other divisions.
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Allocating Costs of Support Departments
A support department (service department) is one whose efforts are directed
toward providing services to other departments (both support and operating).
F A operating department (production department) is one whose efforts are
directed toward adding value to the product or service.
F Direct allocation method (refer to Exhibit 13-7, page 485): most widely used;
ignores services provided to other support departments; simple to use; least
accurate, especially when significant interdepartmental relationships exist among
F Step-down allocation method (refer to Exhibit 13-8, page 487): partial
recognition of services provided by one support department to other support
F Reciprocal allocation method (refer to Exhibit 13-9, page 488): enables full
incorporation of interdepartmental relationships; utilizes simultaneous equations;
theoretically the most accurate; but, most difficult for managers to understand ?
potentially diminished motivation to control costs
Allocating Common Costs
F A common cost is a cost of operating a facility, operation, activity area, or like
cost object that is shared by two or more users.
F Stand-Alone Cost-Allocation Method
Allocates the common costs in proportion to the costs that would be
incurred if each cost object required its own resources or was done
F Incremental Cost-Allocation Method
Allocates the common costs treating one cost object as the primary party
and the other as the incremental party.
Chapter 13 Quiz/Demonstration Exercises
1 As used in the text, the term defined as "anything for which a separate measurement of cost is
a. a direct cost. c. a cost allocation base.
b. an indirect cost. d. a cost object.
2 A machining company that utilizes bar codes on individual cutting tools would most likely
classify these tools as
a. cost objects. c. indirect costs.
b. direct costs. d. fixed costs.
3 The salary of an assistant manager in the personnel department would be classified as a
direct cost when the cost object is
The Personnel Department Yes No
An Operating Department Yes No
4 Consider the six business functions in the firm's value chain. For the purpose of income and asset
measurement for reporting to external parties which functions should be included in product costs?
a. Production and in some cases design.
b. Design, production, distribution.
c. Research and development, design, and production.
d. All six functions.
5 In building costs, the purpose or objective must be considered. Should the following costs be included or
Notes 13 4 of 5
excluded from cost buildups if the purpose of allocation is "to measure income and assets for reporting to
Research and Development Manufacturing
The following data apply to items 6-7.
Big Ag Components Inc. budgets the following amounts for its Maintenance and Utilities
Departments in servicing each other and the two manufacturing divisions - Implements
Division (ID), and Engines Division (ED):
To Be Supplied By: Maintenance Utilities Implements Engines
Maintenance 10.00% 30.00% 60.00%
Utilities 20.00% 40.00% 40.00%
Details on actual usage: Actual Usage By
Supplied By: Maintenance Utilities Implements Engines
Maintenance 20.00% 20.00% 60.00%
Utilities 20.00% 30.00% 50.00%
Actual costs were: Fixed Variable
Maintenance $100,000 $160,000
Utilities $ 50,000 $ 80,000
Fixed costs are allocated on the basis of budgeted capacity.
Variable costs are allocated on the basis of actual usage.
The direct method is used to allocate service department costs to operating departments.
6 Total fixed costs allocated from the Maintenance Division to the Implement Division were
a. 25,000 b. 30,000 c. 33,333 d. 66,667
7 The total amount of variable costs allocated from the Utilities Division to the Engines Division was
a. 20,000 b. 30,000 c. 40,000 d. 50,000
10 The cost of operating a facility, operation, activity area, or like cost object that is shared by two or more
users is a
a. homogeneous cost. c. common cost.
b. artificial cost. d. complete reciprocated cost.
Solutions to Chapter 13 Quiz/Demonstration Exercises____
Direct/Dual Rate Method
Support Departments Manufacturing Divisions
Maintenance Utilities Implements Engines
Fixed Costs: 100,000 50,000
Maintenance (3/9;6/9) (100,000) 33,333 66,667
Utilities (4/8;4/8) (50,000) 25,000 25,000
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Variable Costs: 160,000 80,000
Maintenance (2/8;6/8) (160,000) 40,000 120,000
Utilities (3/8;5/8) (80,000) 30,000 50,000