If a department derives more value from a resource or service, then it should bear a higher proportion of the cost. Consequently, such a sideways view of cost allocation can incentivize departments to be more efficient in how they use shared resources or services. By correctly allocating costs, companies can more accurately calculate potential returns, leading to more informed investment decisions. Misplacing or underestimating costs might mistakenly make an unprofitable investment appear profitable, resulting in detrimental financial outcomes.
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If different products consume indirectresources in different proportions in the various departments, then using departmental overhead rates will provide more accurate product costs than usinga plant wide rate. When a department produces (or partially produces) many different products and some of the products consume different indirect resources in different proportions, a moreinvolved method is needed to provide accurate product costs. For example, if Product X consumes 30 percent of the power, 15 percent of the engineering workand 20 percent of the maintenance activity in Department A, then a single departmental overhead rate would distort product costs. This is because a singleactivity measure, or allocation basis can only represent one of these percentages. If the company uses machine hours as a basis, then power costsmight be accurately traced to Product X, but the product would be overcharged with engineering and maintenance costs. From the management decision perspective, joint cost allocations are useless because they are not relevant in decisions concerning the separate products.
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Both are methods of solving a simultaneous equation and should give the same result. In the exam, the examiner will indicate that he wants you to use one or either of these methods by asking for a method that ‘fully reflects the reciprocal services involved’. Practically in the FMA/MA exam, where this topic would be examined by two-mark questions, the focus will be on the algebraic approach as repeated distribution would be too time consuming. Which of the stage I methods is more useful from the service cost perspective, i.e., for “make or buy” decisions? The accounting techniques that relate to joint and by products are placed in this chapter because these products create special cost allocation problems for systemdesigners. However, this section is placed in an appendix because it represents a sideline topic in the sense that it can be omitted without interfering withthe flow of the learning process.
- Departmental rates based on machine hours would provide accurate product costs.b.
- In essence, cost drivers provide the linkage between the collected costs (cost pools) and the segments to which those costs are assigned.
- D’s overheads would be similarly reapportioned on the basis of 75/95 and 20/95.
- Describe the direct, step-down and reciprocal methods of allocating service department costs to producing departments.6.
- In the end, the calculation “goes flat,” because all costs are allocated.
a) Subjectivity in allocation basis:
This method is particularly suitable for organizations with a clear hierarchical structure, where some cost centers provide services to others. We would allocate administration to the operatingdepartments only by taking each department number of employees xthe administration rate per employee (round final answer to nearestdollar). Cost allocation within a business entity should uphold certain principles for the process to be fair, efficient, and effective. The guiding principles of cost allocation are causality, benefits received, fairness, and ability to bear. In conclusion, while cost allocation is not without its challenges and criticisms, these can be managed and mitigated through thoughtful and informed management practices.
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In the step-down method, no costs are allocated (orreallocated) back to a service department once the service department’s costs have been allocated. The step-down method is a technique used in cost accounting to allocate service department costs to production departments in a systematic 2021 tax return preparation and deduction checklist in 2022 manner. This method aims to ensure a more accurate distribution of costs, leading to better decision-making and budgeting. Departmental rates based on machine hours would provide accurate product costs.b. A plant wide rate based on machine hours would provide accurate product costs.c.
A second method, frequently referred to as the traditional two stage allocation approach, recognizes that there are service areas and producing areas in the plant. Usually, only one overhead rate is developed for each producing department, although the basis for these rates may differ betweendepartments. The various producing departments might use direct labor hours, equivalent units, material costs or machine hours, as an allocation basis. Inthe traditional approach, the activity measures, or allocation bases, are almost always related to production volume (like the four mentioned in the previoussentence).
The idea is to allocate the cost to whatever causes, or drives the cost. If the driver for a cost cannot beidentified, or identified easily, then an allocation scheme perceived to be “fair and equitable” might be used. A search for a “fair andequitable” allocation method often leads the system designer to the “ability to bear” the cost logic.
This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence.
