COST ALLOCATION

 AHAM  NZENWATA  

1.     INTRODUCTION – WHAT IS COST ALLOCATION?

Keeping track of costs is an essential part of running a business. Cost allocation methods are generally used as a management accounting tool to help get an accurate idea of the costs associated with various departments within an organization. Proper cost allocation is an essential element in ensuring that organizations are run efficiently and cost effectively. Allocating the costs associated with various service departments within an organization allows management to create a clear idea of the actual cost of their services or products (Caplan, ????).

In a nutshell, cost allocation (also called cost assignment) is the process of finding cost of different cost objects such as a project, a department, a branch, a customer, etc and allocating them to the cost centre involved in generating such a cost object or item.

It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some objective/reasonable basis. In this way, management can identify what sections of the organization that generate the most cost and the costs: within the departments in the firm, departments in other firms, or more generally, with industry standards.

According to (Wikipedia, 2014), today’s organizations face growing pressure to control costs and enable responsible financial management of resources. In this environment, an organization is expected to provide services cost-effectively and deliver business value while operating under tight budgetary constraints. One way to contain costs is to implement a cost allocation methodology, where the business units become directly accountable for the services they consume.

2.     TYPES AND CLASSIFICATIONS OF COSTS

Fixed Costs and Variable Costs

Fixed costs are costs which remain constant within a certain level of output or sales. This certain limit where fixed costs remain constant regardless of the level of activity is called relevant range. For example, depreciation on fixed assets, etc.

On the other hand, Variable costs are costs which change with a change in the level of activity. Examples include direct materials, direct labour, etc.

Sunk Costs and Opportunity Costs

The costs discussed so far are historical costs which means they have been incurred in past and cannot be avoided by our current decisions. Relevant in this regard is another cost classification, called sunk costs. Sunk costs are those costs that have been irreversibly incurred or committed; they may also be termed unrecoverable costs.

In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone. For example the opportunity cost of going on a picnic is the money that you would have earned in that time.

Prime Costs and Conversion Costs

Prime costs are the sum of all direct costs such as direct materials, direct labour and any other direct costs.

Conversion costs are all costs incurred to convert the raw materials to finished products and they equal the sum of direct labor, other direct costs (other than materials) and manufacturing overheads.

Product Costs and Period Costs

Product costs are costs assigned to the manufacture of products and recognized for financial reporting when sold. They include direct materials, direct labor, factory wages, factory depreciation, etc.

Period costs are on the other hand are all costs other than product costs. They include marketing costs and administrative costs, etc.

The product costs that can be specifically identified with each unit of a product are called direct product costs. Whereas those which cannot be traced to a specific unit are indirect product costs.

Thus direct material cost and direct labor cost are direct product costs whereas manufacturing overhead cost is indirect product cost.

3.     METHODS OF ALLOCATING COSTS

Schwulst (2014) assert that historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they account for the fact that service departments provide services to other service departments as well as to production departments:

Ø The Direct Method:

The direct method is the most widely-used method. This method allocates each service department’s total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments.

The characteristic feature of the direct method is that no information is necessary about whether any service departments utilized services of the other departments. Under the direct method, service department to service department services are ignored, and no costs are allocated from one service department to another.

Ø The Step-Down Method:

The step-down method is also called the sequential method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it.

The choice of which department to start with is important. The sequence in which the service departments are allocated usually affects the ultimate allocation of costs to the production departments, in that some production department’s gain and some lose when the sequence is changed.

Hence, the most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

Ø The Reciprocal Method:

The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations. Thus, many firms - especially smaller ones avoid the use of this method.

4.      REASONS FOR COST ALLOCATION

Provides Accurate Cost Profile

By allocating cost to the respective departments that used a particular resource, you’re able to show that the item associated with the cost had an input in the cost generation. Specifically, you can easily identify the amount spent on specific areas of the company. For example, if your human resources, accounting and customer service departments use the same computer system, you would spread the cost out for the computer system over all three departments. Accurate product cost information also enhances the quality of financial reporting and improves decision-making within the company.

Enhances Resource Usage

By assigning costs to specific departments, you may use those costs only to the point that their benefits supersede their cost. Specifically, when deciding whether to use a specific department’s resource, you would first consider the department’s fixed and variable costs. Depending on your business, fixed costs such as rent, insurance and salary of full-time employees generally stay constant. Variable costs rise directly in accordance to the level of sales in dollars or units sold, such as shipping charges, sales commissions and cost of goods sold. By allocating costs, you’re able to determine the extent that you can use company resources without negatively impacting cost.

Controls Limited Resources

By knowing how to use company resources and making it known that there are costs associated with those resources, you generally limit the demand for them. Specifically, if the resources were free, the demand for them likely would be greater than if you assigned a cost to them. For example, the production department controls a fixed asset, such as machinery or motor vehicles; however, demand outweighs supply. In this case, you may charge all the departments that use that fixed asset a cost, which enables you to balance demand with supply. This allocation has more to do with managing the demand than the actual cost for obtaining the asset.

Considerations

One of the best ways to understand cost allocation is to view it as a process that requires you to identify, aggregate and assign costs to cost objects. A cost object is an item or activity, such as a department or product that requires you to separately weigh costs. The direct method is the most widely used alternative for allocating costs. For example, your accounting and payroll departments are the only divisions that hired employees during a particular month. After determining the total cost to human resources for hiring the respective employees for that month, you would allocate the specific percentages and flat dollar amounts of the total cost to the accounting and payroll departments.

REFERENCES

Caplan, Dennis (????) MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES, Oregon State University, Retrieved: 18/04/2016 from: http://www.bus.oregonstate.edu/   

Schwulst, Brigitta (2014): Cost Allocation Methods For Accurate Costing to Maximize Profits, Retrieved: 18/04/2016 from: https://blog.udemy.com/Cost_Allocation_Methods_For_Accurate_Costing_to_Maximize_Profits

Wikipedia (2014): Cost allocation, Retrieved: 18/04/2016 from https://en.wikipedia.org/wiki/ cost_allocation

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