Cost Allocations

7/28/2015

1

Cost allocations

B&S 1

Recall that..

• Cost allocation refers to the allocation of fixed costs using

some basis (e.g., units, labor hours, machine hours, labor

dollars) to products.

• Examples: Precision Worldwide, Jupiter

• In the short run, fixed costs are not relevant because they

are not controllable

• So, we have been STRIPPING out fixed costs to focus only on

the relevant variable costs and contribution margins

• But allocations are pervasive in practice. WHY?

• We will focus on this question now.

B&S 2

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2

How can we get the

most from available

resources?

(C4, C5, C6)  Class 2,3

Are we using

resources

efficiently?

(C8)  Class 7‐8

Are we using

resources

effectively?

(C12, C13) Class 9,10

How do we match the

supply and demand for

resources?

(C9, C10)  Class 4,5,6

Planning Control

Long

term

Short

Term

C11

C7

3

Short

term

Long

term

Three sources of demands for allocations

B&S 4

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3

Costing individual jobs/products

Focus on inventory valuation

B&S 5

Valuing individual products: general idea

• GAAP requires that we allocate indirect costs (overhead) to

products to value inventories of individual products

• Cost = Traceable (materials + labor) + allocated (overhead)

• Allocation to products will be based on some “cost driver”

• Identifiable and measurable at the product level

• Units, labor hours, machine hours, # of setups, # of moves,…

• What to include?

• Only manufacturing overhead (i.e., only product costs) for valuing

inventory

• Nature of allocation will depend on the production system in

place

• Detail in system also varies considerably

B&S 6

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4

How is an allocation typically done?

• Overhead rates are predetermined at the beginning of each

accounting period

• Use estimated overhead costs and denominator volume (e.g.,

estimated direct labor hours, machine hours and so on)

• Use this rate to apply overhead to individual jobs

• At the end of the period, actual overhead may not turn out

to be the same as applied overhead (which is based on

estimates). So some adjustments have to be made for:

Under / over‐applied overhead

=  applied overhead – actual overhead

B&S 7

Difference between inflows and outflows

• Under‐applied • Over‐applied

8

Applied

Actual

Under‐

applied

Overhead Control

Applied

Actual

Over‐

applied

 Ramji Balakrishnan

Overhead Control

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5

Disposition of under‐ or over‐applied overhead

• When overhead is under‐applied (over‐applied), COGS and

inventory accounts are under‐stated (under‐applied). S,

some end‐of‐period adjustments become necessary

• Three methods permitted

• Write off entire amount to COGS

• Prorate (i.e., allocate) among WIP, FG and COGS accounts

• Re‐compute the rates

• Which method to use?

• Write off to COGS is the easiest method. OK if amount is not large

• Proration (i.e., allocating among) among WIP inventory , FG

inventory,