Cost Allocation

COST ALLOCATION ISSUES

CA.Naveen.NChartered AccountantVisiting Faculty : XLRI, TAPMI, IIM(K), GLIM, SIBM(B)

WHAT IS COST ALLOCATION

Indirect costs associated with shared resources cannot be directly traced to products or services.

There is a need of assigning them. This process of assigning indirect costs is referred to as cost allocation.

Yes… we

know it !

PURPOSE OF COST ALLOCATION

PROCESS OF COST ALLOCATION

Single-rate and Dual-rate

cost-allocation method.

Single-Rate and Dual-Rate Methods

The single-rate cost allocation method makes no distinction between Fixed and variable costs.It allocates support departmentcosts to the operating departmentusing the same rate per unit.

The dual-rate cost allocation method classifies costs in each cost pool into two cost pools – a variable-cost cost pool and a fixed-cost cost pool and allocates each using a differentcost base.

Managers can allocate support department cost to operating divisions based on either a budgeted rate or actual rate

Budgeted versus Actual rates

In both single rate and dual rate methods, variable costs are assigned on the basis of budgeted rates and actual usage.

Cannot be based on budget – noincentive to control consumption of support services

In dual rate method fixed costs are allocated based on Budgeted rates and budgeted usageOrBudgeted fixed cost based on actual usage

Managers may be tempted to underestimate their planned usage

Budgeted versus Actual rates

Should we allocate budgeted cost or actual cost? Answer is Budgeted cost forfollowing reasons:

Budgeted support department costs are allocated to producing departments in forming overhead rate. This rate is calculated at the beginning of the period whenactual costs are not known.

Actual costs of the support department should not be allocated to the production departments because they include efficiencies or inefficiencies achieved by the support departments. Managers of the production department have no control overthe degree of efficiency achieved by the support department.

It also depends on the purpose of allocation. For product costing, the allocationis done at the beginning of the year on the basis of budgeted usage. If for performance evaluation , it is done at the end of the year and is based on actual usage.

SINGLE RATE / DUAL RATE METHOD

Data relating to a company having 2 support departments and 2 operating departments are as follows:

Practical capacity – 18,750 hoursFixed costs – Rs 3,00,00,000Budgeted long run usage in hoursOperating department 1 – 8,000 hoursOperating department 2 – 4,000 hoursBudgeted variable cost per hour – Rs 2,000 per hour usedActual usage in hoursOperating department 1 – 9,000 hoursOperating department 2 – 3,000 hours


Single rate method:

Budgeted usage (1) 12,000 hours

Budgeted total cost (2) 5,40,00,000

Budgeted total rate per hour (1/2) 4,500 per hour

Allocation for Operating department 1 (9,000 hours * 4,500)

4,05,00,000

Allocation for Operating department 2 (3,000 hours * 4,500)

1,35,00,000


Dual rate method:Operating division 1Variable cost – 2,000 per hour * 9,000 actual hours =1.80 croreFixed cost – 2,500 per hour * 8,000 budgeted hours = 2 croreTotal cost – 3.80 crore

Operating division 2Variable cost – 2,000 per hour * 3,000 actual hours =0.6 croreFixed cost – 2,500 per hour * 4,000 budgeted hours = 1 croreTotal cost – 1.60 crore

ALLOCATING SERVICE DEPARTMENT COSTS

SERVICE DEPARTMENTS PRODUCTION DEPARTMENT

PRODUCTS

PERSONNEL COSTS

JANITOR COSTS

FINISHING

ASSEMBLY

PRODUCT B

PRODUCT A

ALLOCATING SERVICE DEPARTMENT COSTS

SERVICE DEPARTMENTS PRODUCTION DEPARTMENT

PRODUCTS

PERSONNEL COSTS Rs 2,00,000

JANITOR COSTS Rs 1,00,000

FINISHING – 30,000 sq ft, 40 staff

ASSEMBLY – 20,000 sq ft, 60 staff

PRODUCT B

PRODUCT A

DISTRIBUTION

PrimaryAll overhead costs should be allocated to the production and service department on some equitable basis.

Secondary distributionThe process of distribution of service department cost to the production department is called as secondary distribution.

Methods:1.Direct method.2.Step down method.3.Repeated distribution method.

Allocating Support Departments Costs

Direct methodAllocates support department costs to operating

departments only.

Step-down (sequential allocation) methodAllocates support department costs to other support

departments and to operating departments.

Reciprocal allocation methodAllocates costs by services provided among all

support departments.

Illustration

Particulars

Support departments Operating departments

Plant maintenance

Information systems Machining Assembly

Overheads before allocating service departments cost 6,30,00,000 1,45,21,500 4,00,00,000 2,00,00,000

Support work furnished

Plant maintenance

Budgeted labour hours 4,000 6,000 10,000

% 20 30 50

Information systems

Budgeted computer hours 500 4,000 500

% 10 80 10

Solution – Direct method

Particulars


Plant maintenance




Plant maintenance (6,000 :10,000) (6,30,00,000) 2,36,25,000 3,93,75,000

Information systems (4,000 : 500) (1,45,21,500) 1,29,08,000 16,13,500

Total overheads 7,65,33,000 6,09,88,500

Illustration

Particulars


Plant maintenance




Plant maintenance

Budgeted labour hours 4,000 6,000 10,000

% 20 30 50

Information systems

Budgeted computer hours 500 4,000 500

% 10 80 10

Solution – Step down method

Particulars


Plant maintenance



Support work furnishedPlant maintenance (20:30:50) (6,30,00,000) 1,26,00,000 1,89,00,000 3,15,00,000

Information systems (4,000 : 500) (2,71,21,500) 2,41,08,000 30,13,500

Total overheads 8,30,08,000 5,45,13,500

Solution – Reciprocal method

Particulars


Plant maintenance




1. Plant maintenance (2 : 3 : 5) (6,30,00,000) 1,26,00,000 1,89,00,000 3,15,00,000

1. Information systems (5 : 40 : 5) 27,12,150 (2,71,21,500) 2,16,97,200 27,12,150

2. Plant maintenance (2 : 3 : 5) (27,12,150) 5,42,430 8,13,640 13,56,080

2. Information systems (5 : 40 : 5) 54,240 (5,42,430) 4,33,950 54,243

3. Plant maintenance (2 : 3 : 5) (54,240) 10,850 16,270 27,120

3. Information systems (5 : 40 : 5) 1,090 (10,850) 8,670 1,090

4. Plant maintenance (2 : 3 : 5) (1,090) 220 330 540

4. Information systems (5 : 40 : 5) 20 (220) 180 20

5. Plant maintenance (2 : 3 : 5) (20) 0 10 10

Total overheads 8,18,70,250 5,56,51,250

Allocation of common costs using either the

stand-alone or incremental method.

COMMON COST – is a cost of operating

a facility, activity or like cost object that

is shared by two or more users

Allocation of common costs using either

1)Stand-alone or

2)Incremental method.

Allocating Common Costs

Stand-alone cost allocation method

-Weights for cost allocation by considering each user of the cost as a separate entity

Incremental cost allocation method

-Ranks users of the cost object in theorder of users most responsible for the common cost

Example

Mr. Sumeet, MBA from IIMK from Mumbai has been invited for a interview at New Delhi

The round-trip Mumbai – New Delhi costs Rs 12,000

Sumeet is also invited to an interview with an employer in BangaloreMumbai – Bangalore round trip costs Rs 8,000

Recruiting trips into a Mumbai – New-Delhi – Bangalore – Mumbai Round trip will cost Rs 15,000

Stand-Alone Example

How much should the Mr. Sameer chargeto the New Delhi employer?

Rs 12,000 ÷ (Rs 12,000 + Rs 8,000) = 0.60

0.60 × Rs 15,000 = Rs 9,000

How much to the Bangalore employer?

Rs 15,000 – Rs 9,000 = Rs 6,000

Incremental Cost Example

Assume that the Employer in New Delhiis viewed as the primary party.

What would be the cost allocation?

New-Delhi Employer (Primary) – Rs 12,000Bangalore Employer (incremental) – Rs 3,000

Would also be interested in calling himself incremental party? Solution!!!“ SHAPELY VALUE ”

Consider each party as once as Primary party and then incremental partyNew –Delhi employer – (12,000 + 7,000)/2 = 9,500

Bangalore employer – (8,000 + 3,000)/2 = 5,500

Case study Solution


Particulars


Administration Info-systems Corporate Consumer

Overheads before allocating service departments cost 72,700 2,34,400 9,98,270 4,89,860


Administration (42:28) (72,700) 43,620 29,080

Info syst (1920:1600) (2,34,400) 1,27,855 1,06,545

Total overheads 0 0 11,69,745 6,25,485

Solution – Step down allocation

Particulars


Administration Info-systems Corporate Consumer

Overheads before allocating service departments cost 72,700 2,34,400 9,98,270 4,89,860


Administration (21:42:28) (72,700) 16,777 33,554 22,369

Info syst (1920:1600) (2,51,177) 1,37,006 1,14,171

Total overheads 0 0 11,68,830 6,26,400

Case study 2 Solution


Particulars


A B X Y

Overheads before allocating service departments cost 1,00,000 40,000 0 0


Department A (1,00,000) 62,500 37,500

Department B (40,000) 8,000 32,000

Total overheads 0 0 70,500 69,500

Solution – Reciprocal method

ParticularsSupport departments Operating departments

A B X YOverheads before allocating 1,00,000 40,000 - -

1. Dept A (2 : 5 : 3) (1,00,000) 20,000 50,000 30,000

1. Dept B (5 : 1 : 4) 30,000 (60,000) 6,000 24,000

2. Dept A (2 : 5 : 3) (30,000) 6,000 15,000 9,000

2. Dept B (5 : 1 : 4) 3,000 (6,000) 600 2,400

3. Dept A (2 : 5 : 3) (3,000) 600 1,500 900

3. Dept B (5 : 1 : 4) 300 (600) 60 240

4. Dept A (2 : 5 : 3) (300) 60 150 90

4. Dept B (5 : 1 : 4) 30 (60) 6 24

5. Dept A (2 : 5 : 3) (30) 6 15 9

5. Dept B (5 : 1 : 4) 3 (6) 1 2

6. Dept A (2 : 5 : 3) (3) 0 2 1

Total overheads 0 0 73,334 66,666

Evaluation of external offer

Outside power units neededX – 100Y – 400A (500* 80%) - 400Total costs – 900Total costs – 900 units@ Rs 40, total costs – Rs 36,000

SavingsVariable – Rs 10,000Supervision – Rs 10,000Material handling – Rs 70,000*20% – Rs 14,000Probable savings Rs 34,000 + ----

Documents

Cost Allocation