Cost Allocation & ABC

Chapter 6
Cost Allocation and Activity-

Based Costing
Presentation Outline
I. Purposes of Cost Allocation
II. The Process of Cost Allocation
III. Activity Based Costing
I. Purposes of Cost Allocation
A. To Provide Information for Decision
Making
B. To Reduce Frivolous Use of Common
Resources
C. To Encourage Evaluation of Services
D. To Provide “Full” Cost Information
A. To Provide Information for
Decision Making
From a decision making
standpoint, the
allocated cost should
measure the
opportunity cost of
using a company
resource.
B. To Reduce Frivolous Use of
Common Costs
By not allocating costs,

resources may appear
“free” to users.
However, resources
never come with zero
costs.
C. To Encourage Evaluation of
Services
Users of services should
consider the
possibility of lower
cost alternative. This
is unlikely to be
considered if costs are
not allocated to the
user.
D. To Provide “Full” Cost
Information
 GAAP requires full-

costing for external
reporting purposes.
 In the long run, all
costs must be covered.
II. The Process of Cost
Allocation
A. The Steps of Cost Allocation

B. Arbitrary Approaches to Cost Allocation
C. Allocating Service Department Costs
D. Problems with Cost Allocation
A. The Steps of Cost Allocation
1. Determine the Cost Objective (Cost

Object).
2. Form Cost Pools
3. Select an Allocation Base to Relate the
Cost Pools to Cost Objects
1. Identifying the Cost Objective
(Cost Object)
Determine the product,

service, department,
etc., that is to receive
the allocation.
2. Form Cost Pools
A cost pool is a grouping of individual costs, the
sum of which is allocated using a single allocation
base.
Cost pools include:

 Departments (i.e., maintenance or personnel
departments)
 Major Activities (i.e., equipment setups)
3. Select an Allocation Base to Relate the
Cost Pools to Cost Objects
 It is very important that the allocation base relates

the cost pool to the cost object.
 Allocation should be based on a cause and effect
relationship between costs and cost objects.
 If cause and effect cannot be established, other
approaches are used.
B. Arbitrary Approaches to Cost
Allocation
 Relative benefits approach – cost should be
allocated in accordance with the cost objects that
benefit the most from the cost.
 Ability to bear costs – cost should be allocated to
cost objects in proportion to profitability.
 Equity approach – allocate costs in a method that
is perceived to be fair and equitable.
C. Allocating Service
Department Costs
 Manufacturing areas are often organized by (1)
production departments directly involved in the
manufacturing process, and (2) service
departments that provide assistance to production
departments.
 In order to avoid passing on inefficient cost
control of service departments to production
departments, budgeted rather than actual service
department costs should be allocated to production
departments.
See illustration on pages 195-196

D. Problems with Cost
Allocation
 Managers may be evaluated on the basis of costs
beyond their control.
 Allocations of fixed costs make them appear as
variable.
 Use of only volume related allocation bases are
inappropriate for costs that are not affected by
volume. This can result in low volume items
being undercosted, while high volume items are
overcosted.
III. Activity Based Costing
(ABC)
A. The ABC Approach

B. Pros and Cons of ABC
C. Activity Based Management (ABM)
D. An Illustration of ABC
A. The ABC Approach
Identify the major activities that cause
overhead costs to be incurred.
Group costs of activities into cost pools.
Identify measures (allocation bases) of
activities (the cost driver).
Relate costs to products using the cost
drivers.
B. Pros and Cons of ABC
ABC is less likely than traditional costing
to undercost or overcost products.
ABC may lead to improvements in cost
control (thru ABM)
ABC can be expensive since data regarding
numerous allocation bases must be
collected.
C. Activity Based Management
(ABM)
Determine major activities
Identify resources used by each activity
Evaluate the performance of the activity
(benchmark against similar activities at
other places)
Identify ways to improve the efficiency
and/or effectiveness of the activities
(compare to best practices at other places)
D. An Illustration of ABC
Combining Activity Cost Pools
• Unit-level activities – Performed each time a
unit is produced. Example: Machine power.
• Batch-level activities – Performed each time a
batch is produced. Example: Setup costs.
• Product-level activities – Relates to a certain
product regardless of runs or batches.
Example: Product design
• Organization-sustaining activities – Activities
independent of customers or products.
Example: Providing a computer network.
A Traditional Overhead Calculation
Gardenrite Co. manufactures 85,000 units of a
Spade and 800 units of a Mower. The company
currently uses direct-labor cost to assign
overhead costs to products. The company
estimates that it will incur $40,000,000 in
manufacturing overhead and estimates that
labor cost will be $8,000,000. Compute the
predetermined overhead rate.
$40,000,000 $5 per labor dollar

=
$8,000,000
A Spade uses $1.08 direct-labor cost per unit while a
Mower uses $15.00 direct-labor cost per unit. Use the
following information to compute each product’s total
unit cost:
Spade Mower
Direct materials $1.80 Direct materials $60.00
Direct labor 1.08 Direct labor 15.00
Mfg. Overhead Mfg. Overhead
1.08 DL$ x $5 = 5.40 15 DL$ x $5 = 75.00
$8.28 $150.00
Expand the number of indirect-cost pools until each of
these pools is homogeneous.
Identify the preferred cost-allocation base (cost driver)
for each indirect cost pool.
Number Number of Number of Number of

of Material Machine Workstations
Setups Requisitions Hours Used
The First Stage Allocation
Overall Overhead
Cost Pool
$40,000,000
Setup Material Equipment

Costs Handling Deprec. Other
$4,000,000 $2,000,000 $10,000,000 $24,000,000
Manufacturing Activities
Annual Per 85,000 Per 800
Activity Center Total Spades Mowers
Number of setups 1,000 2 5
Number of requisitions 2,000 3 50
Number of machine hrs. 20,000 40 100
Number of workstations 3,000 1 15
The Second Stage Allocation - Spades
Machine Material Machine Work-
Setups Req. Hours stations
$4,000,000/ $2,000,000/ $10,000,000/ $24,000,000/
1,000 = 2,000 = 20,000 = 3,000 =
$4,000 $1,000 $500 $8,000
$4,000 $1,000 $500 $8,000

x2 x3 x 40 x1
$8,000 $3,000 $20,000 $8,000
$39,000 / 85,000 units = 0.46 per unit

The Second Stage Allocation - Mowers
Machine Material Machine Work-
Setups Req. Hours stations
$4,000,000/ $2,000,000/ $10,000,000/ $24,000,000/
1,000 = 2,000 = 20,000 = 3,000 =
$4,000 $1,000 $500 $8,000
$4,000 $1,000 $500 $8,000

x5 x 50 x 100 x 15
$20,000 $50,000 $50,000 $120,000
$240,000 / 800 units = $300 per unit

Product Unit Cost Comparison
Traditional Costing Activity-Based Costing
Spade (85,000 units) Spade (85,000 units)
Direct materials $1.80 Direct materials $1.80
Mfg overhead 5.40 Mfg overhead .46
Unit cost $8.28 Unit cost $3.34
Mower (800 units) Mower (800 units)

Direct materials $ 60.00 Direct materials $ 60.00
Mfg overhead 75.00 Mfg overhead 300.00
Unit cost $150.00 Unit cost $375.00

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Chapter 6

Cost Allocation and Activity-

By not allocating costs,

 GAAP requires full-

A. The Steps of Cost Allocation

1. Determine the Cost Objective (Cost

Determine the product,

Cost pools include:

 It is very important that the allocation base relates

See illustration on pages 195-196

A. The ABC Approach

$40,000,000 $5 per labor dollar

Number Number of Number of Number of

Setup Material Equipment

$4,000 $1,000 $500 $8,000

$39,000 / 85,000 units = 0.46 per unit

$4,000 $1,000 $500 $8,000

$240,000 / 800 units = $300 per unit

Mower (800 units) Mower (800 units)

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