CH 12

Chapter 12
Cost Allocation
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 12 - 1
Cost Allocation
Costs are linked with cost objectives by selecting

appropriate cost drivers.
A cost driver is often called a cost-allocation base.
A cost pool is a grouping of individual cost items

that are allocated to cost objectives.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 1
Explain the major reasons

for allocating costs.
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Purposes of Allocation
 There are four major purposes for allocating
costs:
1 To predict the economic effects of planning
and control decisions
2 To obtain desired motivation
3 To compute income and asset valuation
4 To justify costs or obtain reimbursement
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Three Types of Cost Allocations
1 – Allocation to the appropriate

organizational unit
2 – Allocation from one organizational

unit to another
3 – Allocation to products or services
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Allocate the variable and fixed

costs of service departments
to other organizational units.
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Allocation of
Service Department Costs
Guidelines for allocating
service department costs:
Establish the details regarding
cost allocation in advance.
Allocate variable- and fixed-cost
pools separately.
Evaluate performance using budgets.
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Service Department Example
5-year lease
Computer Department
School of Business School of Engineering

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Analyze the costs of the computer
department in detail.
The primary activity performed
is computer processing.
Resources consumed include
processing time, operator time,
consulting time, energy, materials,
and building space.
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 Suppose there are two major purposes for
the allocation:
1 Predicting economic effects of the use of
the computer
2 Motivating departments and individuals to
use its capabilities more fully
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 Assume that cost behavior analysis has
been performed.
 The budget formula for the forthcoming
year is $100,000 monthly fixed cost plus
$200 variable cost per hour of computer
time used.
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Variable-Cost Pool
 The cost driver for the variable-cost pool is
hours of computer time used.
 Therefore, variable costs should be
allocated as follows:
Budgeted unit rate × Actual hours of

computer time used
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Variable-Cost Pool
Consider the allocation of variable
costs to a department that uses
600 hours of computer time.
Assume that inefficiencies in the
computer department caused the
variable costs to be $140,000
instead of $120,000.
600 hours × $200 = $120,000
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Variable-Cost Pool
A good cost-allocation scheme would allocate

only the $120,000 to the consuming department
and would let the $20,000 remain as an
unallocated unfavorable budget variance of the
computer department.
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Fixed-Cost Pool
 The cost driver for the fixed-cost pool is the
amount of capacity required when the
computer facilities were acquired.
 Therefore, fixed costs should be allocated as
follows:
Budgeted % of capacity available for use

× Total budgeted fixed costs
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Fixed-Cost Pool
 Suppose the deans, in our university
computer department example, had
originally predicted the long-run average
monthly usage as follows:
School of Business 210 hours

School of Engineering 490 hours
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Fixed-Cost Pool
How is the fixed-cost pool allocated?

Business:
210 ÷ 700 × $100,000 = $30,000
Engineering:
490 ÷ 700 × $100,000 = $70,000
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Fixed-Cost Pool
This predetermined lump-sum approach is based

on the long-run capacity available to the user,
regardless of actual usage from month to month.
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Allocate the central costs

of an organization.
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Allocation of Central Costs
Usage
Usage
Revenue
Revenue
Total
Total assets
assets
Cost
Cost of
of goods
goods sold
sold
Total
Total cost
cost of
of each
each division
division
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Use the direct and step-down

methods to allocate service
department costs to user
departments.
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Reciprocal Services
 Service departments often support other
service departments in addition to
producing departments.
 There are two popular methods for
allocating service department costs:
1 The direct method
2 The step-down method
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Direct and Step-Down Methods
The direct method ignores other service departments

when any given service department’s costs are
allocated to the revenue-producing (operating)
departments.
The step-down method recognizes that some service
departments support the activities in other service
departments as well as those in production
departments.
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Direct and Step-Down Methods
Service Departments Production Departments
15
Facilities 27 $100,000
$126,000 3 Molding
27
9 20
27 420
80
420
Personnel $160,000
$24,000 320 Finishing
420
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Direct Method
Facilities $105,000 $100,000
$126,000 $2 Molding
1 ,00
0
0% 0%
00
,8
$4
Personnel $19,200 $160,000
$24,000 Finishing
320 ÷ 400 × $24,000

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Step-Down Method
Facilities $70,000 $100,000
$126,000 $1 Molding
4 ,00
9 0
27 0 0
3,2
$1
Personnel $52,800 $160,000
$24,000 + $42,000 Finishing
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Step-Down Method
Molding Department Finishing Department

Direct costs $100,000 Direct costs $160,000
From Fac. Mgt. 70,000 From Fac. Mgt. 14,000
From Personnel 13,200 From Personnel 52,800
Total $183,200 Total $226,800
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Facility Management Example
 Assume management wants to analyze
facility management’s costs.
 What are the possibilities?
1 Divide costs into two or more different cost

pools and use a different cost driver to
allocate the costs in each pool.
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2 Allocate variable costs using the direct or
step-down method, but do not allocate the
fixed costs.
3 Allocate all costs using square footage as
the cost driver.
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Facilities Management Cost
Cost Pool Cost Pool Cost Pool
Allocate using Allocate using Allocate using

Cost Driver 1 Cost Driver 2 Cost Driver 3
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Describe the traditional

approach to allocating
costs to products or services.
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Traditional Approach
Step 1: Operating or
Allocate production- production
related costs to departments
departments.
Step 2: Direct
Select one or more labor
cost drivers. hours
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Step 3: Direct labor hours

Allocate costs
to products or
services.
Product Product Product

A B C
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One cost driver
Variable Fixed
costs costs
If only one cost driver is used,

two cost pools should be maintained
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Use activity-based costing to

allocate costs in a modern
manufacturing environment
to products or services.
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Activity-Based Costing
 ABC systems focus on accumulating costs
into key activities.
 If many costs are caused by non-volume-
based cost drivers, activity-based costing
(ABC) should be considered.
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Step 1:
Determine cost objective, key activity
centers, resources, and related cost drivers.
Step 2:
Develop a process-based map representing
the flow of activities, resources, and their
interrelationships.
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Step 3:
Collect relevant data concerning costs and
the physical flow of the cost-driver units
among resources and activities.
Step 4:
Calculate and interpret the new activity-
based information.
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Use the physical-units and

relative-sales-value methods to
allocate joint costs to products.
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Meaning of Terms
Joint products Joint costs
Separable costs Split-off point
Main product By-product
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Joint Costs
Two conventional ways of allocating

joint costs to products are widely used:
Relative sales
Physical units values
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Physical-Units Method
The physical-units The joint costs are

method requires a allocated based on
common physical each product’s
unit for measuring percentage of the
the output of each total physical
product. units produced.
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Relative-Sales-Value Method
 The joint costs are allocated based on each
product’s sales value as a percentage of the
total sales value at split-off.
Sales value at split-off method
Estimated net realizable value (NRV) method
Constant gross-margin percentage NRV method
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Why Allocate Joint Costs?
To determine inventory cost and cost of goods sold

To determine cost reimbursement under contracts
For conducting customer profitability analysis
For insurance settlement computations
For rate regulation
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No Allocation of Joint Costs
Some companies refuse to allocate

joint costs and instead carry their
inventories at estimated net realizable
value minus a normal profit margin.
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By-Product Costs
 If an item is accounted for as a by-product,
only separable costs are allocated to it.
 All joint costs are allocated to the main
products.
 Any revenues from by-products, less their
separable costs, are deducted from the cost
of the main products.
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Joint Costs Allocation Example
Product A
100 pounds Z-1 $800
Joint cost Separable cost $300
is $900. 400 pounds Z-2
Separable cost $150 Product B
$800
Z-1 and Z-2
are worthless
at split-off point.
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Physical Units Example
Joint Cost Allocated

To A:
100 ÷ 500 × $900 = $180
To B:
400 ÷ 500 × $900 = $720
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Physical Units Example
A B Total
Sales Value $800 $800 $1,600
Separable Costs 300 150 450
Allocation of Joint Cost 180 720 900
Operating Profit (Loss) $320 $(70) $ 250
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Relative-Sales-Value Method
Example
A B Total
Sales Value $800 $800 $1,600
Separable Costs 300 150 450
Sales Value Imputed
at Splitoff Point $500 $650 $1,150
Allocation of Joint Cost
500/1,150; 650/1,150 391 509 900
Operating Profit (Loss) $109 $141 $ 250
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Understand how cost allocation

is used in cost planning
and control.
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Cost Allocation in
Planning and Control
 Across the entire
chain, managers
need accurate cost
information in
order to effectively
plan and control
operations.
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End of Chapter 12
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 12 - 53

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CH 12

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Chapter 12

Costs are linked with cost objectives by selecting

A cost pool is a grouping of individual cost items

Explain the major reasons

1 – Allocation to the appropriate

2 – Allocation from one organizational

3 – Allocation to products or services

Allocate the variable and fixed

School of Business School of Engineering

Budgeted unit rate × Actual hours of

A good cost-allocation scheme would allocate

Budgeted % of capacity available for use

School of Business 210 hours

How is the fixed-cost pool allocated?

This predetermined lump-sum approach is based

Allocate the central costs

Use the direct and step-down

The direct method ignores other service departments

320 ÷ 400 × $24,000

Molding Department Finishing Department

1 Divide costs into two or more different cost

Facilities Management Cost

Cost Pool Cost Pool Cost Pool

Allocate using Allocate using Allocate using

Describe the traditional

Step 3: Direct labor hours

Product Product Product

One cost driver

If only one cost driver is used,

Use activity-based costing to

Use the physical-units and

Joint products Joint costs

Separable costs Split-off point

Main product By-product

Two conventional ways of allocating

The physical-units The joint costs are

To determine inventory cost and cost of goods sold

Some companies refuse to allocate

Joint Cost Allocated

Understand how cost allocation

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