Cost Allocation | Cost Accounting | CPA Exam BEC | CMA Exam

These lectures cover cost allocation to service departments using techniques such as direct method, reciprocal method and step method.

Introduction to cost allocation

Cost Allocation Direct method Example

Cost Allocation Step Method Example

Cost Allocation Reciprocal Method Example

 

Cost allocation  (CA) is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs.

There are two main cost allocation applications—departmental cost allocation and joint product costing. Most important, the objectives and methods for cost allocation are determined based on the firm’s strategy. CA is concerned with strategy in four key ways: (1) to determine accurate departmental and product costs as a basis for evaluating each department’s cost efficiency and the profitability of different products, (2) to motivate managers to work hard, (3) to provide the proper incentive for managers to achieve the firm’s goals, and (4) to provide a fair basis for rewarding managers for their effort. Ethical issues often arise in CA when managers must choose between alternative allocation methods. The manager must choose between methods that might decrease the cost of one product, customer, or business unit at the expense of increased costs for another product, customer, or unit. Departmental cost allocation is performed in three phases: (1) trace all direct costs and allocate overhead to service and production departments, (2) allocate service department costs to production departments, and (3) allocate production department costs to products. The second phase is the most complex. Service department costs can be allocated to production departments using three methods—the direct method, the step method, and the reciprocal method. The three methods differ in the way they include service flows among service departments. The direct method ignores these flows, the step method includes some of them, and the reciprocal method includes all. For this reason, the reciprocal method is preferred. A number of implementation issues arise when applying cost allocation methods, including the strategic and ethical issues of the cost allocation. It is also important to allocate variable and fixed costs separately (in a process called dual allocation), to use budgeted rather than actual amounts in the allocation, and to consider alternative allocation methods when the result of an allocation to a department is a cost that is greater than what the department would pay to purchase the service from an outside entity.