See Also:
Activity Based Costing vs Traditional Costing
Segmenting Customers for Proft
Activity Based Management
Standard Costing
Process CostingUses of Cost Allocation
All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by
GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client's needs and circumstances.
But what about cost allocation's other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)?
Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for
assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability. By knowing what the true "cause-and-effect" relationship is, managers are able to more accurately assess the true cost of a product or service and determine if carrying certain products and/or services contributes to overall profitability given the demand for and price these products/services sell for. This is especially important as it pertains to both operational decisions (such as calculating the maximum price a firm can charge, especially for a "commodity" product, determining the maximum cost a firm is willing to pay to provide this product or service, and in making special order and transfer pricing decisions) and capital/long-term decisions (such as make-or-buy component decisions, continue or discontinue a product line decisions, process further decisions, etc,).
Cost allocation can also be used to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E) by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. It can also used to manage product and process design. As allocations are broken down/determined, the use of resources becomes transparent from a process standpoint, allowing managers to improve operations as needed.
Traditional Cost Allocation
Prior to the advent of computers, the traditional method of allocating
overhead costs was based on a single volume-based allocation base or
cost-driver. Unfortunately, volume-based costing allocated overhead using one allocation base that may or may not have had a "cause and effect" relationship to the costs being allocated to the product or service. Example: suppose a manufacturing firm had two production departments, one that used a large labor force with few pieces of equipment and one that was predominantly machine driven. Allocating Personnel or janitorial costs on the basis of machine hours would be very inefficient. By the same token, allocating maintenance costs and building costs to products or services based on
direct labor costs would be equally inaccurate.
Fortunately for both our clients and our firms, a better method of cost allocation was developed:
Activity Based Costing (ABC) thus allowing overhead costs to be more accurately allocated to products. The purpose of allocation at that time was merely to put a price on inventory for reporting purposes.
Activity Based Costing
Activity Based Costing allocates costs based on multiple cost pools (activities or department budgets) each with its own appropriate ("cause and effect") cost drivers. This leads to more accurate costing and improved control over overhead costs. Activity based costing is especially effective when a firm has a highly diverse or heterogeneous product or service mix, when overhead costs account for much of the total costs, and in situations where the manufacturing process is capital/PP&E-intensive.
Clients need help identifying cost pools and their appropriate cost drivers (allocation bases) and then calculating the overhead costs to be assigned to production departments and, ultimately, to the final service or product. Since this is time consuming and requires a certain amount of skill, it can be expensive to implement, if not done properly, which is where you can help your client.
Steps Involved in Implementing Activity Based Costing
The steps involved in activity based costing are:
1) Clarify the purpose of the allocation, defining why the need to allocate these costs exists and defining the benefit of doing so.
2) Identify support and operating department cost pools;
3) Select an allocation base or cost driver for each support department cost pool based on a cause-and-effect relationship between the support departments and the operating/production departments.
5) Choose and apply a method for allocating support department costs to operating/production departments. The three most widely used methods are the direct method, the step-down method, and the reciprocal method, all of which will be discussed shortly.
6) Once the allocation of support costs to the operating departments is complete, cost drivers are selected for the newly formed cost pools (production/operating department overhead costs) and costs are then allocated to the units of goods or services.
Direct Method of Allocating Department Costs
Before we continue, it would be good to discuss the three methods discussed in step 5. The direct method allocates costs directly from the support departments to the operating departments that use its services. Example: the personnel department might allocate its overhead (i.e., ALL of its departmental costs) based on the number of employees in each of the operating or production departments. It is a simple method that only considers the total cost drivers in the operating departments. Continuing with this example, personnel department costs would be allocated 100% based on 100% of the employees in the operating departments with no regard to those employed in personnel, maintenance, engineering, service or any other support department.
Step Down Method of Allocating Costs
The step-down method takes the allocation process one step further by taking into account that support departments use other support department's services (e.g., the personnel department provides services to employees in the janitorial department). Under this method, costs are allocated in a series of steps. First, costs are allocated from the most used support department to all remaining departments. Then another support department is chosen and its costs are 100% allocated to the remaining support departments and all the operating departments. And this process is continued until all of the support departments' overhead have been allocated to the operating departments. While this method is typically a little more complicated than the direct method it is also, as a rule, more effective in allocating costs.
Reciprocal Method of Allocating Costs
The third method, the reciprocal method, takes the concept that support departments make use of each other’s resources one step further. In this two-step method that uses allocation ratios, the total cost of each support department is calculated based on the formula that total cost for one support department is equal to its costs (overhead since no support department's costs are direct costs) plus that of the allocated costs from other support departments it accepts services from.
Activity Based Costing Example
Lets consider a simple example that involves a company with two support departments; Janitorial (with a budget of $160,000) and Personnel (with a budget of $250,000) and two production departments ; Assembly (with overhead costs of its own of $110,000) and Finishing (with overhead costs of its own of $60,000). Lets further assume that 10 employees work in Janitorial, that Personnel uses 1,000 square feet of building space, that Assembly employs 60 workers in a 4,500 square feet area, and that Finishing has 20 employees who also work in a 4,500 square foot space.
Step one would involve solving simultaneous equations for the two support departments (e.g., P = J = $160,000 + .20P and $250,000 + .10J) to determine the total cost of each support department ($271,429 and $214,286, respectively). Support department costs would then be allocated to operating departments based on how much of the support department's services each operating department used.
In this example, 45% (4,500 sf/10,000 sf) of Janitorial's total cost would be assigned to each production department; 60% (60 employees/100 employees) of Personnel's total costs would be assigned to Assembly; and, 20% (20 employees/100 employees) of Personnel's costs would be assigned to Finishing. Thus, the Assembly Department would have total overhead of $269,286 ($160,000 + $160,857 from Personnel + $96,429 from Janitorial) and the Finishing Department's overhead would total $210,714 ($60,000 + $54,285 from Personnel + $96,429 from Janitorial). These overhead costs would then be allocated to products based on the appropriate cost drivers for each operating department (perhaps machine hours for Assembly and direct labor hours for Finishing).
Allocating Costs to Maximize Profits
One point that needs to be emphasized here is that all the allocation methods discussed to this point are based on the "cause and effect" concept. This is important because CEOs and other managers need to know what the real cost of a product or service is. Once that is known, two other considerations need to be addressed; maximizing profit and keeping the Board of Directors happy.
The first question that needs to be asked is whether or not on any of the products or services have a negative income (after allocated fixed manufacturing costs). If so, the next question if whether or not eliminating/discontinuing those products or services will result in loss of profit. In other words, is any of your client's other income a result of carrying that product or service, or is there some other product or service that can replace that income source and increase profitability. If so, the product or service needs to be eliminated so that overall profitability can be increased.
If the answer is "no" then a different approach needs to be taken. This approach involves assigning/allocating costs based on the ability to bear costs or some other equitable method. The goal for these methods is to both keep the Board happy (so the firm does not show any products or services that are losing money) and to find another way to maximize profit by
incentivizing the sales staff to sell certain products (by allocating overhead in such a way that each sales person's bonus or commission is tied to the products or services that maximize profit for the firm).
Common Approach to Allocate Overhead
The most common approach used to allocate overhead (and joint costs) equitably is the relative sales value approach which allocates overhead to products based on overall sales value. This approach works best in situations such as a full service hardware store that offers lumber, equipment and garden supplies. Chances are in a situation of that nature that the garden supply area would either break even or lose money if only based on its "cause and effect" share of overhead. Chances are that that department also contributes to the profitability of the other departments. As a result, allocating the building overhead based on total revenues of each department would enhance the perceived profitability of the garden supplies department and thus keep the Board happy/the CEO from constantly having to explain that overhead is a
fixed cost that is allocated and that all that matters is overall profitability. Over, and over, and over again.
In conclusion, allocating costs can do more than save taxes under full costing. It can be used as an additional service you can offer your clients to help them maximize their profits.