AHAM
NZENWATA
1. INTRODUCTION
Keeping track of costs is an essential
part of running a business. Cost allocation methods are generally used as a
management accounting tool to help to get an accurate idea of the costs
associated with various departments within an organization. Proper cost
allocation is an essential element in ensuring that organizations are run
efficiently and cost effectively. Allocating the costs associated with various
service departments within an organization allows management to create a clear
idea of the actual cost their services or products. Actual costs are essential
for creating accurate accounts to enable the proper billing of clients
(Korok and Goldmanis 2005).
Businesses often calculate product
costs as the costs that go into making a product but service costs and
administration costs are often ignored as part of the product cost. This
creates a skewed idea of how much a product actually costs. Cost allocation
methods are designed to allocate costs not necessarily associated with a
product, to the appropriate products to get a realistic estimate of costs so
that a proper price can be determined for a particular product. In the rest of
this paper, we will shed more light on the different methods, the reasons and
purposes of cost allocation.
2 REASONS
FOR COST ALLOCATION
Provides Accurate Cost
By
allocating cost to the respective departments that used a particular resource,
you’re able to show that the item associated with the cost had an input in the
cost generation. Specifically, you can easily identify the amount spent on
specific areas of the company. For example, if your human resources, accounting
and customer service departments use the same computer system, you would spread
the cost out for the computer system over all three departments. Accurate
product cost information also enhances the quality of financial reporting and
improves decision-making within the company.
Enhances Resource Usage
By
assigning costs to specific departments, you may use those costs only to the
point that their benefits supersede their cost. Specifically, when deciding
whether to use a specific department’s resource, you would first consider the
department’s fixed and variable costs. Depending on your business, fixed costs such
as rent, insurance and salary of full-time employees generally stay constant.
Variable costs rise directly in accordance to the level of sales in dollars or
units sold, such as shipping charges, sales commissions and cost of goods sold.
By allocating costs, you’re able to determine the extent that you can use
company resources without negatively impacting cost.
Controls Limited Resources
By knowing how to use company resources
and making it known that there are costs associated with those resources, you
generally limit the demand for them. Specifically, if the resources were free,
the demand for them likely would be greater than if you assigned a cost to
them. For example, the production department controls a fixed asset, such as
machinery or motor vehicles; however, demand outweighs supply. In this case,
you may charge all the departments that use that fixed asset a cost, which
enables you to balance demand with supply. This allocation has more to do with
managing the demand than the actual cost for obtaining the asset (Zimmerman,
2006).
3. TYPES
OF COST ALLOCATIONS
· Allocation of joint costs to the appropriate responsibility
centres: Costs
that are used jointly by more than one unit are allocated based on cost-driver
activity in the units. Examples are allocating rent to departments based on
floor space occupied, allocating amortization on jointly used machinery based
on machine-hours, and allocating general administrative expense based on total
direct cost (Ferguson 2013).
· Reallocation of costs from one responsibility centre to
another: When
one unit provides products or services to another, the costs are transferred
along with the products or services. Some units, called service departments,
exist only to support other departments, and their costs are totally
reallocated. Examples include personnel departments, laundry departments in
hospitals, and legal departments in industrial firms (Ferguson
2013).
·
Allocation of costs of a particular
organizational unit to its outputs of products or services: The paediatrics department of a medical
clinic allocates its costs to patient visits, the assembly department of a
manufacturing firm to units assembled, and the tax department of a CA firm to
clients served. The costs allocated to products or services include those
allocated to the organizational unit in joint cost allocation and reallocation.
4. PURPOSE
OF COST ALLOCATION
Costs
are allocated for three main purposes:
a)
To obtain desired motivation
Cost allocations are sometimes made to influence management
behaviour and thus promote goal congruence and managerial effort. Consequently,
in some organizations there is no cost allocation for legal or internal
auditing services or internal management consulting services because top
management wants to encourage their use. In other organizations there is a cost
allocation for such items to spur managers to make sure the benefits of the
specified services exceed the costs.
b)
To compute income and asset valuations
Costs are allocated to products and projects to measure
inventory costs and cost of goods sold. These allocations frequently service
financial accounting purposes. However, the resulting costs are also often used
by managers in planning, performance evaluation, and to motivate managers, as
described above.
c)
To justify costs or obtain
reimbursement
Sometimes prices are based directly on costs, or it may be
necessary to justify an accepted bid. For example, government contracts often
specify a price that includes reimbursement for costs plus some profit margin.
In these instances, cost allocations become substitutes for the usual working
of the marketplace in setting prices.
The first purpose specifies planning
and control uses for allocation. The second and third show how cost allocations
may differ for inventory costing (and cost of goods sold) and for setting
prices. Moreover, different allocations of costs to products may be made for
various purposes. Thus, full costs may guide pricing decisions, manufacturing
costs may be appropriate for asset valuations, and some “in-between” costs may
be negotiated for a government contract.
Ideally, all three purposes would be
served simultaneously by a single cost allocation. But managers and accountants
are of the opinion that for most costs, this ideal is rarely achieved. Instead,
cost allocations are often a source of discontent and confusion for the
affected parties. Allocating fixed costs usually causes the greatest problems.
When all three purposes cannot be attained simultaneously, the manager and the
accountant should start attacking a cost allocation problem by trying to
identify which of the purposes should dominate in the particular situation at
hand.
Often
inventory-costing purposes dominate by default because they are externally
imposed. When allocated costs are used in decision making and performance
evaluation, managers should consider adjusting the allocations used to satisfy
inventory-costing purposes. Often the added benefit of using separate allocations
for planning and control and inventory-costing purposes is much greater than
the added cost.
5. METHODS
OF ALLOCATING COSTS
Direct Method
As
its name implies, the direct method ignores other service departments when any
given service department’s costs are allocated to the revenue-producing
(operating) departments. In other words, the fact that facilities management
provides services for personnel is ignored, as is the support that personnel provide
to facilities management. Facilities management costs are allocated based on
the relative square metres occupied by the production departments only.
Likewise, personnel department costs are allocated only to the production
departments on the basis of the relative number of employees in the production
departments (Ferguson 2013).
Step-Down Method
The
step-down method recognizes that some service departments support the
activities in other service departments as well as those in production
departments. A sequence of allocations is chosen, usually by starting with the
service department that renders the greatest service (as measured by costs) to
the greatest number of other service departments. The last service department
in the sequence is the one that renders the least service to the least number
of other service departments. Once a department’s costs are allocated to other
departments, no subsequent service department costs are allocated back to it.
Reciprocal Allocation Method
The
reciprocal allocation method allocates costs by recognizing that the service
departments provide services to each other as well as to the production
departments. This method is generally viewed as being the most theoretically
correct as it enables us to cost the interdepartmental relationships fully into
the service department cost allocations. For example, the facilities management
cost is allocated to the personnel department and the personnel cost is
allocated to the facilities management department before the costs of the
service departments are allocated to the production departments (Ferguson
2013).
6. CONCLUSION
No single method exists for allocating costs and it’s not an
exact science. A company’s overall goals might help to determine the method
used. While some allocation methods might have the objective of being as fair
as possible to each cost object, others might have the objective of influencing
the behavior of managers and employees. For example, basing allocation on the
number of employees in a department might cause department managers to avoid
hiring needed employees, or even to lay off workers to reduce department size.
In a nutshell, the only way a realistic estimate of a product's cost and hence
it's price can be ascertained is through the mechanism of cost allocation.
REFERENCES
Ferguson Grace (2013) Reasons to
Allocate Costs, http://www.smallbusiness.chron.com/reasons_to_allocate_costs
Garrison, R. H., Noreen, E., Brewer,
P. C., (2004) Managerial Accounting, 11th Edition. McGraw-Hill/Irwin, New York,
NY.
Korok, Ray and Goldmanis, Maris
(2005) Efficient cost allocation, Georgetown University, Washington, DC 20057.
Zimmerman, J. L., (2006)
Accounting for Decision Making and Control, 5th Edition. McGraw-Hill/Irwin, New
York, NY.
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