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CHAPTER FIVE
COST ALLOCATION
Introduction
Cost allocation is the general term used to describe the assignment of indirect costs to cost objects.
Indirect costs of a particular cost object are costs that are related to that cost object but cannot be
traced to it in an economically feasible (cost-effective) way. These costs often comprise a large
percentage of the overall costs assigned to such cost objects as products, customers, and distribution
channels. Total cost of a cost object is the sum of direct and indirect costs. There are different ways of
cost allocation because cost allocation requires judgments and managers may differ in their judgments.
To determine which product, customer, program, or department is profitable; organizations must
decide how to allocate costs. Hence, this chapter is intended to describe the purposes of cost
allocation, the criterion guiding cost allocation, different methods of allocating a support department
costs to cost operating departments, allocating multiple support department cost to operating
departments and other support departments and allocation of common costs.

Purposes of Cost Allocation

Why do managers allocate indirect costs to these cost objects?

1. To provide information for economic decisions: - To decide whether to add a new products, to
decide whether to manufacture a component part of a product set or to purchase it from another
manufacturer, to decide on the selling price for a customized product or service, to evaluate the
cost of available capacity used to support different products so on.

2. To motivate managers and other employees:- To encourage the design of products that are
simpler to manufacture or less costly to service, to encourage sales representatives to
emphasize high-margin products or services
3. To justify costs or compute reimbursement amounts:- To cost products at a “fair” price, often
required by law and government defense contracts, To compute reimbursement for a consulting
firm based on a percentage of the cost savings resulting from the implementation of its
recommendations
4. To measure income and assets:- To cost inventories for reporting to external parties and to
cost inventories for reporting to tax authorities
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For the motivation purpose, costs from more than one but not all business functions are often included
to emphasize to decision makers how costs in different functions are related to one another. For the
cost-reimbursement purpose, a particular contract will often stipulate what costs will be reimbursed.
For the purpose of income and asset measurement for reporting to external parties under GAAP, only
manufacturing costs, and in some cases product-design costs, are inventoriable and allocated to
products
Guide to Cost-Allocation Decisions

After identifying the purposes of cost allocation, managers and management accountants must decide
how to allocate costs. Four criteria used to guide cost-allocation decisions. These decisions affect both
the number of indirect-cost pools and the cost-allocation base for each indirect-cost pool. We
emphasize the superiority of the cause-and-effect and the benefits received criteria, especially when
the purpose of cost allocation is to provide information for economic decisions or to motivate
managers and employees.

a. Cause and Effect. Using this criterion, managers identify the variables that cause resources to
be consumed. For example, managers may use hours of testing as the variable when allocating
the costs of a quality-testing area to products. Cost allocations based on the cause-and-effect
criterion are likely to be the most credible to operating personnel.
b. Benefits Received. Using this criterion, managers identify the beneficiaries of the outputs of
the cost object. The costs of the cost object are allocated among the beneficiaries in proportion
to the benefits each receives. Consider a corporate wide advertising program that promotes the
general image of the corporation rather than any individual product. The costs of this program
may be allocated on the basis of division revenues; the higher the revenues, the higher the
division’s allocated cost of the advertising program. The rationale behind this allocation is that
divisions with higher revenues apparently benefited from the advertising more than divisions
with lower revenues and, therefore, ought to be allocated more of the advertising costs.
c. Fairness or Equity. This criterion is often cited in government contracts when cost allocations
are the basis for establishing a price satisfactory to the government and its suppliers. Cost
allocation here is viewed as a “reasonable” or “fair” means of establishing a selling price in the
minds of the contracting parties. For most allocation decisions, fairness is a matter of judgment
rather than an operational criterion.
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d. Ability to Bear. This criterion advocates allocating costs in proportion to the cost object’s
ability to bear costs allocated to it. An example is the allocation of corporate executive salaries
on the basis of division operating income. The presumption is that the more-profitable
divisions have a greater ability to absorb corporate headquarters’ costs.
Cause and effect is the primary criterion used in activity-based costing (ABC) applications. ABC
systems use the concept of a cost hierarchy to identify the cost drivers that best demonstrate the cause
and-effect relationship between each activity and the costs in the related cost pool. The cost drivers are
then chosen as cost-allocation bases. Fairness and ability-to-bear are less-frequently-used and more
problematic criteria than cause-and-effect or benefits-received. Fairness is a difficult criterion on
which to obtain agreement.

 Allocating Support Department Costs

Companies distinguish operating departments (operating divisions) from support departments. An

operating department, also called a production department, directly adds value to a product or service.
A support department, also called a service department, provides the services that assist other internal
departments (operating departments and other support departments) in the company. Examples of
support departments are information systems and plant maintenance. There are two approaches to
allocating support-department costs:

i) the single-rate cost-allocation method

ii) and the dual-rate cost-allocation method.

Using the Single-Rate and Dual-Rate Methods

The single-rate method makes no distinction between fixed and variable costs. It allocates costs in
each cost pool (support department in this section) to cost objects (operating divisions in this section)
using the same rate per unit of a single allocation base. By contrast, the dual-rate method partitions the
cost of each support department into two pools, a variable cost pool and a fixed-cost pool, and
allocates each pool using a different cost-allocation base. When using either the single-rate method or
the dual-rate method, managers can allocate support-department costs to operating divisions based on
either a budgeted rate or the eventual actual cost rate. The latter approach is neither conceptually
preferred nor widely used in practice. Accordingly, we illustrate the single rate and dual-rate methods
next based on the use of budgeted rates.

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Consider the central computer department of Sand Hill Company (SHC). This support
department has two users, both operating divisions: the microcomputer division and the
peripheral equipment division. The following data relate to the 2012 budget:

Practical capacity (hours)………………………………………………………………… 18,750 hours

Fixed costs of operating the computer facility within 6000 hour to 18750 hour…………..$3,000,000
Budgeted long-run usage (quantity) in hours:
Microcomputer division……………………………………8,000 hours
Peripheral equipment division …………………………….4,000 hours
Total ………………………………………………………12,000 hours
Budgeted variable cost per hour in the 6,000 hour to 18,750 hour relevant range ……$200 per hour used
Actual usage in 2012 in hours:
Microcomputer division……………………………………………………………. 9,000 hours
Peripheral equipment division…………….……………………………..………… 3,000 hours
Total………………………………………………………………….. 12,000 hours
The budgeted rates for central computer department costs can be computed based on either the
demand for computer services or the supply of computer services. We consider the allocation of
central computer department costs based first on the demand for (or usage of) computer services and
then on the supply of computer services.

1. Allocation Based on the Demand for (or Usage of) Computer Services
A) Using Single-Rate Method: In this method, a combined budgeted rate is used for fixed and
variable costs. The rate is calculated as follows.

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Note that the budgeted rate of $450 per hour is substantially higher than the $200 budgeted variable
cost per hour. That’s because the $450 rate includes an allocated amount of $250 per hour (budgeted
fixed costs, $3,000,000, ÷ budgeted usage, 12,000 hours) for the fixed costs of operating the facility.

Under the single-rate method, divisions are charged the budgeted rate for each hour of actual use of
the central facility. Applying this to our example, SHC allocates central computer department costs
based on the $450 per hour budgeted rate and actual hours used by the operating divisions. The
support costs allocated to the two divisions under this method are as follows:

Microcomputer division: 9,000 hours x $450 per hour ----------- $4,050,000

Peripheral equipment division: 3,000 hours x $450 per hour------ $1,350,000
B) Using Dual-Rate Method: When the dual-rate method is used, allocation bases must be chosen for
both the variable and fixed cost pools of the central computer department. As in the single-rate
method, variable costs are assigned based on the budgeted variable cost per hour of $200 for actual
hours used by each division. However, fixed costs are assigned based on budgeted fixed costs per hour
and the budgeted number of hours for each division.

Given the budgeted usage of 8,000 hours for the microcomputer division and 4,000 hours for the
peripheral equipment division, the budgeted fixed-cost rate is $250 per hour ($3,000,000 ÷ 12,000
hours), as before. Since this rate is charged on the basis of the budgeted usage, however, the fixed
costs are effectively allocated in advance as a lump-sum based on the relative proportions of the
central computing facilities expected to be used by the operating divisions. The costs allocated to the
microcomputer division in 2012 under the dual-rate method would be as follows:

Fixed costs: $250 per hour 8,000 (budgeted) hours $2,000,000

Variable costs: $200 per hour 9,000 (actual) hours 1,800,000
Total costs 3,800,000
The costs allocated to the peripheral equipment division in 2012 would be as follows:
Fixed costs: $250 per hour 4,000 (budgeted) hours $1,000,000
Variable costs: $200 per hour 3,000 (actual) hours 600,000
Total costs $1,600,000
Note that each operating division is charged the same amount for variable costs under the single-rate
and dual-rate methods ($200 per hour multiplied by the actual hours of use). However, the overall
assignment of costs differs under the two methods because the single-rate method allocates fixed costs
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of the support department based on actual usage of computer resources by the operating divisions,
whereas the dual-rate method allocates fixed costs based on budgeted usage.

2. Allocation Based on the Supply Capacity

This approach is an alternative approach of allocating central computer department costs based on the
capacity of computer services supplied.

Let’s illustrate this approach using the 18,750 hours of practical capacity of the central computer
department. The budgeted rate is then determined as follows:

Budgeted fixed-cost rate per hour, $3,000,000 ÷ 18,750 hours = $160 per hour
Budgeted variable-cost rate per hour = $200 per hour
Budgeted total-cost rate per hour =$360per hour
Using the same procedures for the single-rate and dual-rate methods as in the previous section, the
support cost allocations to the operating divisions are as follows:

A. Single-Rate Method
Microcomputer division: $360 per hour 9,000 (actual) hours-------------------------------- $3,240,000
Peripheral equipment division: $360 per hour 3,000 (actual) hours ----------------------- 1,080,000
Fixed costs of unused computer capacity:
$160per hour 6750 hours -----------------------------------------------1,080, 000
((Where 6,750 hours = Practical capacity of 18,750 – (9,000 hours used by microcomputer
division +3,000 hours used by peripheral equipment division)).
B. Dual-Rate Method
Microcomputer division
Fixed costs: $160 per hour 8,000 (budgeted) hours $1,280,000
Variable costs: $200 per hour 9,000 (actual) hours 1,800,000
Total costs $3,080,000
Peripheral equipment division
Fixed costs: $160 per hour 4,000 (budgeted) hours $ 640,000
Variable costs: $200 per hour 3,000 (actual) hours 600,000
Total costs $1,240,000
Fixed costs of unused computer capacity:
$160 per hour 6,750 hours $1,080,000
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(Where 6,750 hours = Practical capacity of 18,750 hours – (8,000 hours budgeted to be used by
microcomputer division + 4,000 hours budgeted to be used by peripheral equipment division).

 ALLOCATING COSTS OF MULTIPLE SUPPORT DEPARTMENTS

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure
that all service department costs are allocated. Budgeted rates provide service department managers
incentives to control costs, and also provide user departments more accurate information about service
department billing rates for planning purposes. In either case, service department costs should be
allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible.
Here are some examples:
**Allocate building maintenance costs based on square footage; Allocate costs of the company
airplane based on miles flown; Allocate costs of the data processing department based on CPU time**.
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:
1. 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.

Example: Machining and Assembly are the only production departments that used the services of the
Human Resources Department in March. Costs from Human Resources are allocated based on the
number of new hires. Machining hired seven employees in March and Assembly hired three
employees. Human Resources incurred total costs of $93,000 in March.

            Allocation of H.R. Department costs to Machining:        70% of $93,000 = $65,100

            Allocation of H.R. Department costs to Assembly:         30% of $93,000 = $27,900 
 The characteristic feature of the direct method is that no information is necessary about whether any
service departments utilized services of the Human Resources Department. It does not matter whether
no other service department hired anybody, or whether three other service departments each hired five
employees (implying that more than 50% of the hiring occurred in the service departments). Under the
direct method, service department to service department services are ignored, and no costs are
allocated from one service department to another. 

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2. 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 effects the ultimate allocation of costs to the production
departments, in that some production departments gain and some lose when the sequence is changed.
Hence, production department managers usually have preferences over the sequence. 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.

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide
services to the Machining and Assembly production departments, and in some cases, the service
departments also provide services to each other: 

Total Service % of services provided by the service department

Cost Dept
H.R. D.P. R.M. Machining Assembly

$  80,000 H.R. -- 20% 10% 40% 30%

120,000 D.P. 8% -- 7% 30% 55%

40,000 R.M. -- -- -- 50% 50%

$240,000

 The amounts in the far left column are the costs incurred by each service department. Any services
that a department provides to itself are ignored, so the intersection of the row and column for each
service department shows zero. The rows sum to 100%, so that all services provided by each service
department are charged out. 

The company decides to allocate the costs of Human Resources first, because it provides services to
two other service departments, and provides a greater percentage of its services to other service
departments. However, a case could be made to allocate Data Processing first, because it has greater
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total costs than either of the other two service departments. In any case, the company decides to
allocate Data Processing second.

In the table below, the row for each service department allocates the total costs in that department (the
original costs incurred by the department plus any costs allocated to it from the previous allocation of
other service departments) to the production departments as well as to any service departments that
have not yet been allocated.

H.R. D.P. R.M. Machining Assembly

Costs prior to allocation $  80,000 $120,000 $40,000 -- --

Allocation of H.R. ($  80,000) 16,000 8,000 $32,000 $24,000

Allocation of D.P. (136,000) 10,348 44,348 81,304

Allocation of R.M. (58,348) 29,174 29,174

0 0 0 $105,522 $134,478

 After the first service department has been allocated, in order to derive the percentages to apply to the
production departments and any remaining service departments, it is necessary to “normalize” these
percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P.
can be allocated back to H.R. The percentages for the remaining service and production departments
sum to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages are normalized as follows:

            Risk Management:          7% ÷ 92%     =     7.61%

            Machining:                    30% ÷ 92%     =   32.61%
            Assembly:                     55% ÷ 92%     =   59.78%
                        Total:                                           100.00%
 For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to Assembly, not 55%. 

The characteristic feature of the step-down method is that once the costs of a service department have
been allocated, no costs are allocated back to that service department. As can be seen by adding
$105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to
the two production departments. The intermediate allocations from service department to service
department improve the accuracy of those final allocations. 

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3. 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. 

Using the data from the step-down method example, the simultaneous equations are:

 H.R. = $ 80,000 + (0.08 x D.P.)

D.P. = $120,000 + (0.20 x H.R.)
R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.)
Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of these service
departments. For example, Human Resources receives services from Data Processing, but not from
Risk Management. 8% of the services that Data Processing provides, it provides to Human Resources.
Therefore, the total costs allocated from Human Resources should include not only the $80,000
incurred in that department, but also 8% of the costs incurred by Data Processing. Solving for the three
unknowns:

H.R.     =  $ 91,057 D.P.  =   $138,211 R.M. =  $ 58,781

 Hence, costs are allocated as follows: 

H.R. D.P. R.M. Machining Assembly

Costs prior to allocation $80,000 $120,000 $40,000 -- --

Allocation of H.R. ($91,057)   18,211     9,106 $36,423 $  27,317

Allocation of D.P.       11,057  (138,211)     9,675   41,463     76,016

Allocation of R.M. (58,781)   29,390     29,390

$            0 $         0 $        0 $107,276 $132,723

……..Thank you for your committed effort…..

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