Cost Alocation

1. Introduction 2

2. Purpose of cost allocation 2

To predict the economic effects of 2

Strategic and operational control decisions 2

To obtain the desired motivation and to provide 2

Feedback for performance evaluation 2

To compute income and asset valuations 2

To justify costs or obtain reimbursements 2

3. Types of costs 3

4. Allocation of Service Department costs 3

5. Allocating costs to final product 4

The Traditional Approach 4

ABC Costing 4

6. ABC vs. Traditional costing 4

6. Conclusion 4

Bibliography 5

1. Introduction

The purpose of this paper is two answer two important questions: Why do companies allocate costs? How do companies allocate costs? It is important for the companies to find the proper method to allocate the costs. Cost allocation is an important issue in many companies because many of the costs associated with designing, producing and distributing products and services are not easily identified with the products and services that are created. It would have been easier for companies to allocate cost if costs were directly traceable with the products and the cost allocation would have been minor issue for the company.

2. Purpose of cost allocation

In the past and some even today believed that costs are allocated only for accounting purposes. On the other hand many believe that cost allocation is an important segment in the accounting system of the company since it can help companies to value inventory for external reporting purposes, for planning and monitoring the cost of activities and processes, and for various short term and long term strategic decisions. According to the authors of the text book there are four majr reasons why company should allocate costs (Horngem et all, 522-523)

To predict the economic effects of

Strategic and operational control decisions

By having proper cost allocation a company will be able to set the optimal product and costumer mix, establish the proper pricing policy and help the company to decide upon lunching a new product.

To obtain the desired motivation and to provide

Feedback for performance evaluation

As we know most of the times managers are pressed from their owners to increase the profitability and decrease costs. In order to achieve this managers sometimes try to eliminate some costs in order to show good results to the owners. By proper cost allocation managers can find out which costs can be decreased and the company can be profitable.

To compute income and asset valuations

In order to be able to create the balance sheet and income statements accounts such as inventory and cost of goods sold are need. In order to compute this accounts cost allocation is needed.

To justify costs or obtain reimbursements

Sometimes it’s possible to get a contract as additional profit to the costs. The price in this case is directly based on the costs.

3. Types of costs

There are different classifications of costs same as when we decide to produce something we divide costs as fixed and variable. There are two categories of the costs:

a. Traceable- Costs that be directly connected to the production of certain good or service which usually include the following subcategories:

1. Direct Labour Costs-costs of labour directly included in the production

2. Direct Material Costs-material used for production of a unit

пÑ"ј Untraceable-Cost that connected to more than one product or department and whose allocation can be a result of different cost allocation methods.

1. Indirect Labour Costs-Additional staff that is not directly connected to the production process.

2. Manufacturing overhead вЂ"the cost of additional materials which can not be traced to a single product and all additional costs connected to their transportation and maintenance.

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4. Allocation of Service Department costs

Mostly in all companies among the producing department they have and the service department that support the work of producing department. Most of the costs of this department are untraceable and this costs need to be addressed to the product. Depending to the company there are three different methods that this costs can be assigned:

пÑ"ј Direct method- This method does not recognize self servicing and servicing