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Cost Allocation Activity Based Costing

This document discusses cost allocation and activity-based costing (ABC). It explains that indirect costs are allocated to provide information for decision making, reduce frivolous resource use, and encourage service evaluation. The cost allocation process involves determining a cost objective, forming cost pools, and selecting an allocation base. ABC identifies activities that cause overhead and assigns costs using cost drivers rather than assuming proportional volume-based allocation. ABC provides more accurate costing but is more complex than traditional methods.

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Saurabh Singh
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19 views

Cost Allocation Activity Based Costing

This document discusses cost allocation and activity-based costing (ABC). It explains that indirect costs are allocated to provide information for decision making, reduce frivolous resource use, and encourage service evaluation. The cost allocation process involves determining a cost objective, forming cost pools, and selecting an allocation base. ABC identifies activities that cause overhead and assigns costs using cost drivers rather than assuming proportional volume-based allocation. ABC provides more accurate costing but is more complex than traditional methods.

Uploaded by

Saurabh Singh
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Cost Allocation & Activity Based Costing

LO1-Explain why indirect costs are allocated

LO2- Describe the cost allocation process

LO3- Identify potential problems with cost allocation

LO4- Discuss activity-based costing (ABC) and cost drivers

LO5- Distinguish activity-based costing (ABC) from activity-based


management (ABM)
Purposes of Cost
Allocation
Purposes of Cost
Allocation
Provide information for decision making
– Allocated cost should measure the opportunity cost of
using a company resource

– In practice, difficult to operationalize since cost may


quickly change

– Provides a useful benchmark


Purposes of Cost
Allocation
Reduce frivolous use of common resources
– Frivolous use may have hidden cost such as slower service

– Allocation of centrally provided services provides incentive


for departments to reduce frivolous use of resource
Purposes of Cost
Allocation
Encourage evaluation of services
– If costs are not allocated, there is no incentive to evaluate
the services and look for lower cost alternatives

– With cost allocation, there is a strong incentive to critically


evaluate the efficiency and necessity of services
Purposes of Cost
Allocation
Provide “full cost” information
– GAAP requires full costing for external reporting purposes

– Full cost information is needed when the company has an


agreement whereby revenue received depends upon cost
incurred, i.e.“cost-plus” contracts
Process of Cost Allocation

• Determine the cost objective


• Form cost pools
• Select an allocation base to relate cost pools
to the cost objective
Process of Cost Allocation
Determine the Cost Objective

• Determine the product, service, or department that


is to receive the allocation. Object of the allocation
is called the cost objective

• For example, if computer costs are allocated to


contracts, the contracts are the cost objective
Cost Objectives
Allocating Budgeted and Actual
Service Department Costs
• Management should allocate based on budgeted
costs rather than actual costs

• Allocation of actual amounts allows service


department to pass on cost of inefficiencies and
waste to production departments
Problem of Using Measures of Production
Volume to Allocate Overhead
• Typical allocation bases include direct labor hours
and machine hours
• Assumes all overhead costs are proportional to
production volume
• When OH costs not proportional to production
volume:
- High-volume products are overcosted
- Low-volume products are undercosted
Activity-Based Costing
• Identifies major activities that cause overhead costs
to be incurred
• Cost of resources consumed performing these
activities grouped into cost pools
• Costs are assigned to products using a measure of
activity, i.e. cost driver
The ABC Approach
Common Activities and
Associated Cost Drivers
Activity Based Costing-
McMaster Screen Technologies
Benefits of ABC
• Provide more accurate costing
- Less likely to undercost/overcost due to cost driver usage

• May lead to improvements in cost control


- Costs broken out into a number of activities rather than
into one or two overhead cost pools
Limitations of ABC
• More costly to develop and maintain than a
traditional costing system

• Used to develops full cost of products


- Includes fixed costs
- Lacks incremental information necessary for
decision making
Activity-Based
Management
Appendix
• The steps in activity-based management are:
1. Determine major activities
2. Identify resources used by each activity
3. Evaluate the performance of the activities
4. Identify ways to improve the efficiency and/or
effectiveness of the activities

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