CHAPTER ONE: INTRODUCTION

1. Cost Accounting

Cost accounting provides information for management accounting and financial accounting. It
measures, analyzes, and reports financial and non financial information relating to the cost of
acquiring or using resources in an organization. For example, calculating the cost of a product is
a cost accounting function that answers financial accounting’s inventory valuation needs and
management accounting’s decision making needs (such as choosing products to offer). Modern
cost accounting takes the perspective that collecting cost information is a function of the
management decisions being made. Thus, the distinction between management accounting and
cost accounting is not so clear-cut, and we often use these terms interchangeably.

2. Cost accounting can be viewed as the intersection between financial

and management accounting. Cost accounting addresses the
informational demands of both financial and management accounting
by providing product cost information to
• External parties (stockholders, creditors, and various
regulatory bodies) for investment and credit decisions and for
reporting purposes, and
• Internal managers for planning, controlling, decision making,
and evaluating performance.
3. Management Accounting and Financial Accounting
Management Accounting
It measures, analyzes, and reports financial and non financial information that helps managers
make decision to fulfil the goal of an organization. Managers use management accounting
information to choose, communicate, and implement strategy. They also use it to coordinate
product design, production, and marketing decisions. Management accounting focuses on
internal report.

Financial Accounting

Focuses on reporting to external parties such as investors, government agencies,, banks, and
suppliers. It measures and records business transactions and provides financial statements that
are based on GAAP. Managers’ compensation is often directly affected by the members in these

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financial statements. Consequently, managers are interested in both management accounting and
financial accounting

As shown in the below table, financial and managerial accounting differ not only in their user
orientation but also in their emphasis on the past and the future, in the type of data provided to
users, and in several other ways. These differences are discussed in the following paragraphs.

Financial Accounting Managerial Accounting

 Reports to those outside the organization:  Reports to those inside the organization for:
Owners, Lenders, Tax authorities & Planning, Directing and motivating,
Regulators Controlling, & Performance evaluation

 Emphasizes financial consequences of past  Emphasizes decisions affecting the future.

activities.
 Emphasizes relevance
 Emphasizes objectivity and verifiability.
 Emphasizes timeliness
 Emphasizes precision.
 Emphasizes detailed segment reports about
 Emphasizes summary data concerning the departments, products, customers, and
entire organization. employees.

 Must follow GAAP.  Need not follow GAAP.

• Mandatory for external reports  Not mandatory

Emphasis on the Future

Since planning is such an important part of the manager’s job, managerial accounting has a
strong future orientation. In contrast, financial accounting primarily summarizes past financial
transactions. These summaries may be useful in planning, but only to a point. The future is not
simply a reflection of what has happened in the past. Changes are constantly taking place in
economic conditions, customer needs and desires, competitive conditions, and so on. All of these

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changes demand that the manager’s planning be based in large part on estimates of what will
happen rather than on summaries of what has already happened.

Relevance of Data
Financial accounting data should be objective and verifiable. However, for internal uses
managers want information that is relevant even if it is not completely objective or verifiable. By
relevant, we mean appropriate for the problem at hand. For example, it is difficult to verify
estimated sales volumes for a proposed new store at Good Vibrations, but this is exactly the type
of information that is most useful to managers. Managerial accounting should be flexible enough
to provide whatever data are relevant for a particular decision.
Less Emphasis on Precision
Making sure that dollar amounts are accurate down to the last dollar or penny takes time and
effort. While that kind of accuracy is required for external reports, most managers would rather
have a good estimate immediately than wait for a more precise answer later. For this reason,
managerial accountants often place less emphasis on precision than financial accountants do. For
example, in a decision involving hundreds of millions of dollars, estimates that are rounded off
to the nearest million dollars are probably good enough. In addition to placing less emphasis on
precision than financial accounting, managerial accounting places much more weight on
nonmonetary data. For example, data about customer satisfaction may be routinely used in
managerial accounting reports.
Segments of an Organization
Financial accounting is primarily concerned with reporting for the company as a whole. By
contrast, managerial accounting focuses much more on the parts, or segments, of a company.
These segments may be product lines, sales territories, divisions, departments, or any other
categorization that management finds useful. Financial accounting does require some break-
downs of revenues and costs by major segments in external reports, but this is a secondary
emphasis. In managerial accounting, segment reporting is the primary emphasis.
Generally Accepted Accounting Principles (GAAP)
Financial accounting statements prepared for external users must comply with generally
accepted accounting principles (GAAP). External users must have some assurance that the
reports have been prepared in accordance with a common set of ground rules. These common
ground rules enhance comparability and help reduce fraud and misrepresentation, but they do not

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 necessarily lead to the type of reports that would be most useful in internal decision making. For
example, if management at Good Vibrations is considering selling land to finance a new store,
they need to know the current market value of the land. However,

GAAP requires that the land be stated at its original, historical cost on financial reports. The
more relevant data for the decision—the current market value—is ignored under GAAP.

Managerial accounting is not bound by GAAP. Managers set their own rules concerning the
content and form of internal reports. The only constraint is that the expected benefits from using
the information should outweigh the costs of collecting, analyzing, and summarizing the data.
Nevertheless, as we shall see in subsequent chapters, it is undeniably true that financial reporting
requirements have heavily influenced management accounting practice.

Managerial Accounting—Not Mandatory

Financial accounting is mandatory; that is, it must be done. Various outside parties such as the
Securities and Exchange Commission (SEC) and the tax authorities require periodic financial
statements. Managerial accounting, on the other hand, is not mandatory. A company is
completely free to do as much or as little as it wishes. No regulatory bodies or other outside
agencies specify what is to be done, or, for that matter, whether anything is to be done at all.
Since managerial accounting is completely optional.

4. The Value Chain of Business Function

Value chain refers to the sequence of business functions in which customer usefulness is added
to products and services. The exhibit below shows six business functions: R& D, Design,
Production, and Marketing, Distribution, and Customer service.

Resear Design of Custom

ch and products, er
services Produc Mark Distrib
or tion eting ution

1. Research and development: generating and experimenting with ideas related to new
products, services, or processes. Instance, at Sony, this function includes research on

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 alternative television signal transmission and on the clarity of different shapes and
thicknesses of television screens.

2. Design of products, services, or processes: detailed planning and engineering of products,

services, or processes. Design at Sony includes determining the number of component parts
in a television set and the effect of alternative product designs on quality and manufacturing
costs

3. Production: acquiring, coordinating, and assembling resources to produce a product or

deliver a service. Production of a Sony television sets includes the acquisitions and assembly
of the electronic parts, the cabinet, and the packaging used for shipping.

4. Marketing: promoting and selling products or services to customers or prospective

customers. SONY markets its televisions through trade shows, advertisements in news papers
and magazines, and on the internet.

5. Distribution: delivering products or services to customers. Distributions for SONNY

includes shipping retail outlets, catalogue vendors, direct sale via the internet

6. Customer services: providing after sale support to customers. SONY provides customer
service on its televisions in the form of customer help telephone lines, support on the internet
and warranty repair work.

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CHAPTER TWO: COST TERMINOLOGY AND CLASSIFICATION

2.1. Costs and Costs Terminology:

Cost: accountants define cost as a resource sacrificed or forgone to achieve a specific objective.
A cost is usually measured as the monetary amount that must be paid to acquire goods or
services.

An actual cost the cost incurred (a historical or past cost), as distinguished from a budgeted
cost, which is a predicted or forecasted cost (future cost).

To guide their decisions, manager wants to know how mach a particular thing (such as a product,
machine, service, or process) costs. We call this thing a cost object, which is anything for which
a measurement of costs is desired. A cost object is anything for which cost data are desired—
including products, customers, jobs, and organizational subunits

A costing system typically accounts for costs in two basic stages: accumulation followed by
assignment

Cost accumulation: it is the collection of cost data in some organized way by means of an
accounting system. For example a publishing company that purchases a rolls of paper for
printing magazine collects(accumulates) the cost of individual rolls used in any one month to
obtain the total monthly cost of paper.

Cost assignment: beyond accumulating costs, managers with the help of management
accountants assign costs to designated cost objects (such as the different magazines the company
publishes) to help them make strategic decisions (such as the pricing of different magazines and
which magazine to emphasize). Managers also assign costs to cost objects to implement strategy.
For example, cost assigned to a department aid in decision making about department efficiency.
Costs assigned to customers help managers understand the profit earned from different customers
and help them make decisions about how to allocate resources to support different customers.

Cost assignment is a general term that encompasses both (1) tracing accumulated costs that have
a direct relationship to a cost object and (2) allocating accumulated costs that have an indirect
relationship to the cost object

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2.2. Direct costs and indirect costs: Cost Classifications for Assigning Costs to Cost Objects
Costs are assigned to cost objects for a variety of purposes including pricing, preparing
profitability studies, and controlling spending. For purposes of assigning costs to cost objects,
costs are classified as either direct or indirect.
Direct Cost of a cost object
A direct cost is a cost that can be easily and conveniently traced to a specified cost object. The
concept of direct cost extends beyond just direct materials and direct labor. For example, if
Reebok is assigning costs to its various regional and national sales offices, then the salary of the
sales manager in its Tokyo office would be a direct cost of that office.
Indirect Cost of a cost object
An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost object.
To be traced to a cost object such as a particular product, the cost must be caused by the cost
object.
. A common cost is a cost that is incurred to support a number of cost objects but cannot be
traced to them individually. A common cost is a type of indirect cost.
A particular cost may be direct or indirect, depending on the cost object.

TYPES OF COST COST ASSIGNMENT COST OBJECT

Direct Costs Cost tracing

Example: material cost

Indirect cost
Cost allocation
2.3. Cost Classifications for Predicting Cost Behaviour

Quite frequently, it is necessary to predict how a certain cost will behave in response to a change
in activity. Cost behaviour refers to how a cost reacts to changes in the level of activity. As the
activity level rises and falls, a particular cost may rise and fall as well—or it may remain
constant.

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For planning purposes, a manager must be able to anticipate which of these will happen; and if a
cost can be expected to change, the manager must be able to estimate how much it will change.
To help make such distinctions, costs are often categorized as variable or fixed.
Variable Cost
A variable cost is a cost that varies, in total, in direct proportion to changes in the level of
activity. The activity can be expressed in many ways, such as units produced, units sold, miles
driven, beds occupied, lines of print, hours worked, and so forth. A good example of a variable
cost is direct materials. The cost of direct materials used during a period will vary, in total, in
direct proportion to the number of units that are produced.
There are many examples of costs that are variable with respect to the products and services
provided by a company. In a manufacturing company, variable costs include items such as
direct materials, shipping costs, and sales commissions and some elements of manufacturing
overhead such as lubricants. We will also usually assume that direct labor is a variable cost,
although direct labor may act more like a fixed cost in some situations
In a merchandising company, the variable costs of carrying and selling products include items
such as cost of goods sold, sales commissions, and billing costs.
In service rendering company instance in a hospital, the variable costs of providing health care
services to patients would include the costs of the supplies, drugs, meals, and perhaps nursing
services.
Fixed Cost
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity.
Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the
activity level rises and falls, total fixed costs remain constant unless influenced by some outside
force, such as a price change. Rent is a good example of a fixed cost. Suppose the Mayo Clinic
rents a machine for $8,000 per month that tests blood samples for the presence of leukemia cells.
The $8,000 monthly rental cost will be incurred regardless of the number of tests that may be
performed during the month.
Very few costs are completely fixed. Most will change if activity changes enough.
For example, suppose that the capacity of the leukemia diagnostic machine at the Mayo

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Clinic is 2,000 tests per month. If the clinic wishes to perform more than 2,000 tests in a month,
it would be necessary to rent an additional machine, which would cause a jump in the fixed
costs. When we say a cost is fixed, we mean it is fixed within some relevant range.
A particular cost item could be variable with respect one level of activity and fixed with
respect to another. Consider annual registration and license costs for a fleet of planes owned by
an airline company. This cost could be a variable cost with respect to the number of planes
Relevant range
It is the band of normal activity level or volume in which there is a specific relationship between
the level of activity or volume and the cost in question. For example, a fixed cost is fixed only in
relation to a given wide range of a total activity or volume (at which the company is expected to
operate) and only for a given time span (usually a particular budget period).
The relevant range is the range of activity within which the assumptions about variable and
fixed costs are valid. For example, the assumption that the rent for diagnostic machines is $8,000
per month is valid within the relevant range of 0 to 2,000 tests per month.
2.4. Manufacturing organization cost terms
Most manufacturing companies separate manufacturing costs into three broad categories: direct
materials, direct labour, and manufacturing overhead as discussed below.
A. Direct Materials
The materials that go into the final product are called raw materials. This term is somewhat
misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore.
Actually, raw materials refer to any materials that are used in the final product; and the finished
product of one company can become the raw materials of another company.
Direct materials are those materials that become an integral part of the finished product
and whose costs can be conveniently traced to the finished product. This would include, for
example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft
and the tiny electric motor Panasonic uses in its DVD players.
Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materials
to end products. Such minor items would include the solder used to make electrical connections
in a Sony TV or the glue used to assemble an Ethan Allen chair. Materials such as solder and
glue are called indirect materials and are included as part of manufacturing overhead, which is
discussed later in this section.

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B. Direct Labor
Direct labor consists of labor costs that can be easily (i.e., physically and conveniently) traced to
individual units of product. Direct labor is sometimes called touch labor, since direct labor
workers typically touch the product while it is being made. Examples of direct labor include
assembly-line workers at Toyota, carpenters at the home builder Kaufman and Broad, and
electricians who install equipment on aircraft at Bombardier Learjet.
Labor costs that cannot be physically traced to the creation of products, or that can be
traced only at great cost and inconvenience, are termed indirect labor. Just like indirect
materials, indirect labor is treated as part of manufacturing overhead. Indirect labor includes the
labor costs of janitors, supervisors, materials handlers, and night security guards. Although the
efforts of these workers are essential to production, it would be either impractical or impossible
to accurately trace their costs to specific units of product. Hence, such labor costs are treated as
indirect labor.
C. Manufacturing Overhead
Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct materials and direct labor. Manufacturing overhead includes items
such as indirect materials; indirect labor; maintenance and repairs on production equipment; and
heat and light, property taxes, depreciation, and insurance on manufacturing facilities. A
company also incurs costs for heat and light, property taxes, insurance, depreciation, and so
forth, associated with its selling and administrative functions, but these costs are not included as
part of manufacturing overhead. Only those costs associated with operating the factory are
included in manufacturing overhead.
Various names are used for manufacturing overhead, such as indirect manufacturing cost,
factory overhead, and factory burden. All of these terms are synonyms for manufacturing
overhead.
2.5. Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2)
administrative costs. Selling costs include all costs that are incurred to secure customer orders
and get the finished product to the customer. These costs are sometimes called order-getting and
order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales
commissions, sales salaries, and costs of finished goods warehouses.

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 Administrative costs include all executive, organizational, and clerical costs associated
with the general management of an organization rather than with manufacturing or selling.
Examples of administrative costs include executive compensation, general accounting,
secretarial, public relations, and similar costs involved in the overall, general administration of
the organization as a whole. Nonmanufacturing costs are also often called selling, general, and
administrative (SG&A) costs.
2.6. Product Costs versus Period Costs
Product Costs
For financial accounting purposes, product costs include all costs involved in acquiring or
making a product. In the case of manufactured goods, these costs consist of direct materials,
direct labor, and manufacturing overhead. Product costs “attach” to units of product as the goods
are purchased or manufactured and they remain attached as the goods go into inventory awaiting
sale. Product costs are initially assigned to an inventory account on the balance sheet. When the
goods are sold, the costs are released from inventory as expenses (typically called cost of goods
sold) and matched against sales revenue. Since product costs are initially assigned to inventories,
they are also known as inventoriable costs. Product costs are often called inventoriable costs.
The reason is that these costs go directly into inventory accounts as they are incurred (fi rst into
Work in Process and then into Finished Goods), rather than going into expense accounts. Thus,
they are termed inventoriable costs. This is a key concept because such costs can end up on the
balance sheet as assets if goods are only partially completed or are unsold at the end of a
period.
We want to emphasize that product costs are not necessarily treated as expenses in the
period in which they are incurred. Rather, as explained above, they are treated as expenses in the
period in which the related products are sold. This means that a product cost such as direct
materials or direct labor might be incurred during one period but not recorded as an expense until
a following period when the completed product is sold.
Period Costs
Period costs are all the costs that are not product costs. For example, sales commissions and the
rental costs of administrative offices are period costs. Period costs are not included as part of the
cost of either purchased or manufactured goods; instead, period costs are expensed on the
income statement in the period in which they are incurred using the usual rules of accrual

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accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period
in which cash changes hands. For example, as discussed earlier, the costs of liability insurance
are spread across the periods that benefit from the insurance— regardless of the period in which
the insurance premium is paid.
As suggested above, all selling and administrative expenses are considered to be period
costs. Advertising, executive salaries, sales commissions, public relations, and other
nonmanufacturing costs discussed earlier are all examples of period costs.
They will appear on the income statement as expenses in the period in which they are incurred.
2.7. Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs—prime cost and
conversion cost. These terms are quite easy to define. Prime cost is the sum of direct materials
cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing
overhead cost. The term conversion cost is used to describe direct labor and manufacturing
overhead because these costs are incurred to convert materials into the finished product.
2.8. Cost Classifications for Decision Making
Costs are an important feature of many business decisions. In making decisions, it is essential to
have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business decisions, each alternative will
have costs and benefits that must be compared to the costs and benefits of the other available
alternatives. A difference in costs between any two alternatives is known as a differential cost.
A difference in revenues between any two alternatives is known as differential revenue.
A differential cost is also known as an incremental cost , although technically an
incremental cost should refer only to an increase in cost from one alternative to another;
decreases in cost should be referred to as decremental costs. Differential cost is a broader term,
encompassing both cost increases (incremental costs) and cost decreases (decremental costs)
between alternatives.
Differential costs can be either fixed or variable. To illustrate, assume that Nature Way
Cosmet-ics, Inc., is thinking about changing its marketing method from distribution through
retailers to distribution by a network of neighborhood sales representatives. Present costs and
revenues are compared to projected costs and revenues in the following table

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 Retailer Sales Differential
Distribution Representatives Costs and
(present) (proposed) Revenues
Revenues (Variable) . . . . . . . . . . . . . . . . $700,000 $800,000 $100,000
Cost of goods sold (Variable) . . . . . . . . . 350,000 400,000 50,000
Advertising (Fixed) . . . . . . . . . . . . . . . . . 80,000 45,000 (35,000)
Commissions (Variable) . . . . . . . . . . . . . 0 40,000 40,000
Warehouse depreciation (Fixed) . . . . . . 50,000 80,000 30,000
Other expenses (Fixed) . . . . . . . . . . . . . 60,000 60,000 0
Total expenses . . . . . . . . . . . . . . . . . . . . 540,000 625,000 85,000
Net operating income . . . . . . . . . . . . . . . $160,000 $175,000 $ 15,000

According to the above analysis, the differential revenue is $100,000 and the differential costs
total $85,000, leaving a positive differential net operating income of $15,000 under the proposed
marketing plan.
The decision of whether Nature Way Cosmetics should stay with the present retail distribution or
switch to sales representatives could be made on the basis of the net operating incomes of the
two alternatives. As we see in the above analysis, the net operating income under the present
distribution method is $160,000, whereas the net operating income with sales representatives is
estimated to be $175,000. Therefore, using sales representatives is preferred, since it would
result in $15,000 higher net operating income. Note that we would have arrived at exactly the
same conclusion by simply focusing on the differential revenues, differential costs, and
differential net operating income, which also show a $15,000 advantage for sales representatives.
In general, only the differences between alternatives are relevant in decisions. Those items that
are the same under all alternatives and that are not affected by the decision can be ignored. For
example, in the Nature Way Cosmetics example above, the “Other expenses” category, which is
$60,000 under both alternatives, can be ignored, since it has no effect on the decision. If it were
removed from the calculations, the sales representatives would still be preferred by $15,000.

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Opportunity Cost
Opportunity cost is the potential benefit that is given up when one alternative is selected over
another. To illustrate this important concept, consider the following examples:
Example 1 Vicki has a part-time job that pays $200 per week while attending college. She
would like to spend a week at the beach during spring break, and her employer has agreed to
give her the time off, but without pay. The $200 in lost wages would be an opportunity cost of
taking the week off to be at the beach.
Example 2 Steve is employed by a company that pays him a salary of $38,000 per year. He is
thinking about leaving the company and returning to school. Since returning to school would
require that he give up his $38,000 salary, the forgone salary would be an opportunity cost of
seeking further education.
Opportunity costs are not usually found in the accounting records of an organization, but they are
costs that must be explicitly considered in every decision a manager makes.
Virtually every alternative involves an opportunity cost. In Example 2 above, for instance, the
higher income that could be realized in future years as a result of returning to school is an
opportunity cost of staying in his present job.
Sunk Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision
made now or in the future. Because sunk costs cannot be changed by any decision, they are not
differential costs. And because only differential costs are relevant in a decision, sunk costs can
and should be ignored.
To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a
special-purpose machine. The machine was used to make a product that is now obsolete and is
no longer being sold. Even though in hindsight purchasing the machine may have been unwise,
the $50,000 cost has already been incurred and cannot be undone. And it would be folly to
continue making the obsolete product in a misguided attempt to “recover” the original cost of the
machine. In short, the $50,000 originally paid for the machine is a sunk cost that should be
ignored in current decisions.

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 CHAPTER THREE: Cost Allocation
I. Purpose of cost allocation
Purpose Illustration
To provide information To decide whether to add a new airline flight
for economic decisions To decide whether to manufacture a component part of a television
set or to purchase it from another manufacturer
To decide on the selling price for customized product or service
To motivate managers To encourage the design of products that are simpler to
and other employees manufacturer or less costly to service
To encourage sales representatives to emphasise high margin
products or services
To justify costs or To cost products at a “fair” price, often required by government
compute defence contracts
reimbursement amount To compute reimbursement for a consulting firm based on a
percentage of the cost savings resulting from the implementation of
its recommendations
To measure income and To cost inventories for financial reporting to external parties
assets To cost inventories for reporting to tax authorities

For some decisions related to the economic decision purpose (for example, long run
product pricing ),the costs in all function(D&D –design- production- marketing- distribution-
customer service ) of are relevant. For other decisions particularly short run economic decisions
(for example make or buy decision), costs from only one or two functions (for example design
and manufacturing) might be relevant
For the motivation purpose, costs from more than one business functions are often
included to emphasis to decision makers how costs in different functions are related to one
another.
For the cost reimbursement purpose, the particular contact will often stipulate whether all
six of the business functions or only a subset of them are to be reimbursed For the purpose of
income and asset measurement for reporting to external parties, inventory costs under GAAP
include only manufacturing costs (and product design costs in some cases).

II. Criteria to guide cost allocation decision

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How to allocate costs? How should Wollo University allocate costs among undergraduate
programs, graduate programs, and research?
Here below we are going to discuss the four different criteria’s companies use to allocate costs.
These for criteria are used to guide cost allocation decisions. This decision affect both the
number of indirect cost pools and the cost allocation base for each indirect cost pool.
1. Cause and effect
Under this criterion Managers identify the variables that cause resourced to be consumed. For
example managers any use hours of testing as the variable when allocating the cost of a quality
testing area to products.
We emphasize the superiority of the cause-and-effect and the benefits-received criteria,
especially when the purpose of cost allocation is to provide information for economic decisions
or to motivate managers and employees.
2. Benefit received
Using this criterion, managers identify the beneficiaries of the output of the cost object. The
costs of the cost object are allocated among the beneficiaries in proportion to the benefit each
receives. Consider a corporate wide advertising program that promotes the general image of the
corporation rather than any individual product. The cost of this program may be allocated on the
basis of division revenues; the higher the revenues, the higher the divisions allocated cost of the
advertising program. The rationale behind this allocation is that divisions with higher revenues
apparently benefited from the advertising more than divisions with lower revenues and therefore,
ought to be allocated more of the advertising costs.
3. Fairness or equity
This criterion often cited in government contracts when cost allocation are the basis for
establishing a price satisfactory to the government and its suppliers. Cost allocation here is
viewed as a “reasonable” or “fair” means of establishing a selling price in the minds of the
contracting parties. For most allocation decisions fairness is a difficult-to-achieve objective
rather than an operational criterion.
4. Ability to bear
This criterion advocates allocating costs in proportion to the cost objects ability to bear costs
allocated to it. An example is the allocation of corporate executive salaries on the basis of

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division operating income. The presumption is that the more profitable divisions have a greater
ability to absorb corporate head quarters’ costs
Fairness and ability to bear are less frequently used criterion than cause and effect or benefit
received. Fairness is a difficult criterion on which to obtain agreement. What one party views as
fair, another party may view as unfair. For example, a university may view allocating a share of
general administrative costs to government contracts as fair because general administrative costs
are incurred to support all activities of the university. The government may view the allocation of
such costs as unfair because the general administration costs would have been incurred by the
university regardless of whether the government contract existed.
To get the sense of the issues that arises when using the ability to be criterion, consider a product
that consumes a large amount of indirect costs but whose selling price is currently its below
direct costs. This product has no ability to bear any of the indirect costs it uses. If the indirect
costs it consumes are allocated to other products, these other products are subsidising the product
that is losing money.
Allocating costs of multiple support departments

We just examined general issues that arise when allocating costs from one support department to
operating divisions. In this section, we examine the special cost-allocation problems that arise
when two or more of the support departments whose costs are being allocated provide reciprocal
support to each other as well as to operating departments. An example of reciprocal support is a
firm’s human resource department providing recruiting, training, and performance management
services to all employees of a firm, including those who work in the legal department, while also
utilizing the services of the legal department for compliance activities, drafting of contracts,
checking stock option plan documents, etc. More accurate support-department cost allocations
result in more accurate product, service, and customer costs.

Consider Castleford Engineering, which operates at practical capacity to manufacture engines

used in electric-power generating plants. Castleford has two support departments and two
operating departments in its manufacturing facility:

Support Departments Operating Departments

Plant (and equipment) maintenance Machining
Information systems Assembly
The two support departments at Castleford provide reciprocal support to each other as well as
support to the two operating departments. Costs are accumulated in each department for planning
and control purposes. Exhibit 15-2 displays the data for this example. To understand the

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 percentages in this exhibit, consider the plant maintenance department. This support department
provides a total of 20,000 hours of support work: 20% (4,000 ÷ 20,000 = 0.20) for the
information systems department, 30% (6,000 ÷ 20,000 = 0.30) for the machining department,
and 50% (10,000 ÷ 20,000 = 0.50) for the assembly department. We now examine three methods
of allocating the costs of reciprocal support departments: direct, step-down, and reciprocal. To
simplify the explanation and to focus on concepts, we use the single-rate method to allocate the
costs of each support department using budgeted rates and budgeted hours used by the other
departments. (The Problem for SelfStudy illustrates the dual-rate method for allocating
reciprocal support-department costs.)

Exhibit 15-2 Data for Allocating Support-Department Costs at Castleford Engineering for
2012

1 Support departments Operating

departments
2 Plant Information Machining Assembly Total
Maintenance Systems

3 Budgeted overhead costs

4 Before any interdepartmental 6,300,000 1,452,150 4,000,000 2,000,000 13,752,150
cost allocations
5 Support work furnished:
6 By plant maintenance
7 Budgeted labour ------ 4,000 6,000 10,000 20,000

-hours
8 Percentage 20% 30% 50% 100%
9 By information system
10 Budgeted computer hour 500 …… 4,000 500 5,000
11 Percentage 10% 80% 10% 100%

Direct Method
The direct method allocates each support department’s costs to operating departments only. The
direct method does not allocate support-department costs to other support departments. Exhibit
15-3 illustrates this method using the data in Exhibit 15-2.

The Base used to allocate plant maintenance costs to the operating departments is the budgeted
total maintenance labor-hours worked in the operating departments: 6,000 + 10,000 = 16,000
hours. This amount excludes the 4,000 hours of budgeted support time provided by plant
maintenance to information systems. Similarly, the base used for allocation of information
systems costs to the operating departments is 4,000 + 500 = 4,500 budgeted hours of computer
time, which excludes the 500 hours of budgeted support time provided by information systems to
plant maintenance. An equivalent approach to implementing the direct method involves

18
 calculating a budgeted rate for each support department’s costs. For example, the rate for plant
maintenance department costs is 6,300,000 ÷ 16,000 hours, or 393.75 per hour. The machining
department is then allocated 2,362,500 (393.75 per hour x 6,000 hours) while the assembly
department is assigned 3,937,500 (393.75 per hour 10,000 hours). For ease of explanation
throughout this section, we will use the fraction of the support-department services used by other
departments, rather than calculate budgeted rates, to allocate support-department costs. The
direct method is widely practiced because of its ease of use. The benefit of the direct method is
simplicity. There is no need to predict the usage of support-department services by other support
departments. A disadvantage of the direct method is that it ignores information about reciprocal
services provided among support departments and can therefore lead to inaccurate estimates of
the cost of operating departments. We now examine a second approach, which partially
recognizes the services provided among support departments.

Direct Method of Allocating Support Department Costs at Castleford Engineering for 2012

1 Support departments Operating departments

2 Plant Information Machining Assembly Total
Maintenance Systems

3 Budgeted overhead costs

4 Before any interdepartmental 6,300,000 1,452,150 4,000,000 2,000,000 13,752,150
cost allocations
5 Allocation of plant maintenance (6,300,000) 2,362,500 3,937,500
(3/8, 5/8):
6 Allocation of information (1,452,150) 1,290,800 161,350
systems (8/9, 1/9)
7
8 Total budgeted overhead of 0 0 7,653,300 6,098,850 13,752,150
operating departments
9

Base is (6,000 + 10,000), or 16,000 hours; 6,000 ÷ 16,000 = 3/8; 10,000 ÷ 16,000 = 5/8.
Base is (4,000 + 500), or 4,500 hours; 4,000 ÷ 4,500 = 8/9; 500 ÷ 4,500 = 1/9

Step down method

Some organizations use the step-down method, also called the sequential allocation method,
which allocates support-department costs to other support departments and to operating
departments in a sequential manner that partially recognizes the mutual services provided among
all support departments. Exhibit 15-4 shows the step-down method.

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The plant maintenance costs of 6,300,000 are allocated first. Exhibit 15-2 shows that plant
maintenance provides 20% of its services to information systems, 30% to machining, and 50% to
assembly. Therefore, 1,260,000 is allocated to information systems (20% of 6,300,000),
1,890,000 to machining (30% of 6,300,000), and 3,150,000 to assembly (50% of 6,300,000). The
information systems costs now total 2,712,150: budgeted costs of the information systems
department before any interdepartmental cost allocations, 1,452,150, plus 1,260,000 from the
allocation of plant maintenance costs to the information systems department. The 2,712,150 is
then only allocated between the two operating departments based on the proportion of the
information systems department services provided to machining and assembly. From Exhibit 15-
2, the information systems department provides 80% of its services to machining and 10% to
assembly, so 2,410,800 (8/9 $2,712,150) is allocated to machining and $301,350 (1/9
$2,712,150) is allocated to assembly. Note that this method requires the support departments to
be ranked (sequenced) in the order that the step-down allocation is to proceed. In our example,
the costs of the plant maintenance department were allocated first to all other departments,
including the information systems department. The costs of the information systems support
department were allocated second, but only to the two operating departments. If the information
systems department costs had been allocated first and the plant maintenance department costs
second, the resulting allocations of support-department costs to operating departments would
have been different. A popular step-down sequence begins with the support department that
renders the highest percentage of its total services to other support departments. The sequence
continues with the department that renders the next-highest percentage, and so on, ending with
the support department that renders the lowest percentage. In our example, costs of the plant
maintenance department were allocated first because it provides 20% of its services to the
information systems department, whereas the information systems department provides only
10% of its services to the plant maintenance department (see Exhibit 15-2). Under the step-down
method, once a support department’s costs have been allocated, no subsequent support-
department costs are allocated back to it. Once the plant maintenance department costs are
allocated, it receives no further allocation from other (lower ranked) support departments. The
result is that the step-down method does not recognize the total services that support departments
provide to one another.

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 Step-Down Method of Allocating Support Department Costs at Castleford Engineering for 2012

1 Support departments Operating departments

2 Plant Information Machining Assembly Total
Maintenance Systems

3 Budgeted overhead costs

4 interdepartmental cost 6,300,000 1,452,150 4,000,000 2,000,000 13,752,150
allocations
5 Allocation of plant maintenance (6,300,000) 1,260,000 1,890,000 3,150,000
(2/10, 3/10, 5/10
6 2,712,150
7 Allocation of information (2,712,150) 2,410,800 301,350
systems(8/9,1/9)b
8
9 Total budgeted overhead of 0 0 8,300,800 5,451,350 13,752,150
operating departments

Base is (4,000 + 6,000 + 10,000), or 20,000 hours; 4,000 ÷ 20,000 = 2/10; 6,000 ÷ 20,000 = 3/10; 10,000 ÷
10 20,000 = 5/10.
Base is (4,000 + 500), or 4,500 hours; 4,000 ÷ 4,500 = 8/9; 500 ÷ 4,500 = 1/9.

Reciprocal Method
The reciprocal method allocates support-department costs to operating departments by fully
recognizing the mutual services provided among all support departments. For example, the plant
maintenance department maintains all the computer equipment in the information systems
department. Similarly, information systems provide database support for plant maintenance. The
reciprocal method fully incorporates interdepartmental relationships into the support-department
cost allocations. One way to understand the reciprocal method is as an extension of the step-
down method. This approach is illustrated in Exhibit 15-5. As in the step-down procedure, plant
maintenance costs are first allocated to all other departments, including the information systems
support department: information systems, 20%; machining, 30%; assembly, 50%. The costs in
the information systems department then total 2,712,150 (1,452,150 + 1,260,000 from the first-
round allocation), as in Exhibit 15-4. Under the step-down method, these costs are allocated
directly to the operating departments alone. But the reciprocal method recognizes that a portion
of the information systems department costs arises because of the support it provides to plant
maintenance. Accordingly, the 2,712,150 is allocated to all departments supported by the
information systems department, including the plant maintenance department: plant
maintenance, 10%; machining, 80%; and assembly, 10% (see Exhibit 15-2). The plant
maintenance costs that had been brought down to $0 now have 271,215 from the information
systems department allocation. In the next step, these costs are again reallocated to all other
departments, including information systems, in the same ratio that the plant maintenance costs
were previously assigned. Now the information systems department costs that had been brought
down to 0 have 54,243 from the plant maintenance department allocations. These costs are again

21
 allocated in the same ratio that the information systems department costs were previously
assigned. Successive rounds result in smaller and smaller amounts being allocated to and
reallocated from the support departments until eventually all support-department costs are
allocated to the operating departments.
Reciprocal Method of Allocating Support-Department Costs Using Repeated Iterations at
Castleford Engineering for 2012
1 Support departments Operating departments

2 Plant Information Machining Assembly Total

Maintenance Systems

3 Budgeted overhead costs

4 interdepartmental cost 6,300,000 1,452,150 4,000,000 2,000,000 13,752,150

allocations
5 First allocation of plant (6,300,000) 1,260,000 1,890,000 3,150,000
maintenance (2/10, 3/10, 5/10)
6 2,712,150
7 First allocation of information 271,215 (2,712,150) 2,169,720 271,215
systems (1/10, 8/10, 1/10)
8 Second allocation of plant (271,215) 54,243 81,364 135,608
maintenance(2/10, 3/10, 5/10)a
9 Second allocation of 5,424 (54,243) 43,395 5,424
information systems (1/10,
8/10, 1/10
10 Third allocation of plant (5,424) 1,085 1,627 2,712
maintenance (2/10, 3/10, 5/10)a
11 Third allocation of information 109 (1,085) 867 109
systems (1/10, 8/10, 1/10)
12 Fourth allocation of plant (109) 22 33 54
maintenance (2/10, 3/10, 5/10)
13 Fourth allocation of 2 (22) 18 2
information systems (1/10,
8/10, 1/10
14 Fourth allocation of plant (2) 0 1 1
maintenance (2/10, 3/10, 5/10)a
15 Total budgeted overhead of 0 0 8,187,025 5,565,125 13,752,150
operating departments
Total support department amounts allocated and reallocated (the numbers in parentheses in the first two
16 columns):
Plant Maintenance: 6,300,000 + 271,215 + 5,424 + 109 + 2 = 6,576,750
Information Systems: 2,712,150 + 54,243 + 1,085 + 22 = 2,767,500
Base is (4,000 + 6,000 + 10,000), or 20,000 hours; 4,000 ÷ 20,000 = 2/10; 6,000 ÷ 20,000 = 3/10; 10,000 ÷
20,000 = 5/10.
Base is (500 + 4,000 + 500), or 5,000 hours; 500 ÷ 5,000 = 1/10; 4,000 ÷ 5,000 = 8/10; 500 ÷ 5,000 = 1/10.

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Allocating common costs
A common cost is a cost operating a facility, activity, or like cost object that is shared by two or
more users. The goal is to allocate common costs to each user in an equitable way on the basis of
the individual costs of the cost object. Consider janson stevens, a graduating senior in seattle
who has been invited to a job interview with an employer in Albany. The round tripseattle
Albany airfare costs birr1, 200. A week later, stevens is also invited to an interview with an
employer in Chicago. The seattle Chicago round trip airfare costs birr 800.stevens decided to
combine the two recruiting trip into a seattle-Albany-chicago-seattle trip that will cost 1500 in
airfare. This is a common cost that benefits both prospective employers. We do have stand-
alone method and the incremental method of allocating such a common costs

1. Stand alone cost allocation method

It uses information pertaining to each user of a cost object as separate entity to determine the cost
allocation weight. For the common cost airfare of 1500, information about the separate (stand
alone) round trip airfares (1,200 and 800) is used to determine the allocation weights.

Albany employer 1200 x 1500 = 0.6x1500= 900

1,200 + 800
Chicago employer 800 x 1500 = 0.4x1500= 600
1,200 + 800
2. Incremental cost allocation method

It ranks the individual users of a cost object in the order of users most responsible for common
cost and the uses this ranking to allocate cost among those users. The first ranked user of the cost
object is the primary users (also called the primary party) and is allocated costs up to the cost of
the primary user as a stand-alone user. The second ranked user is the first incremental user (first
incremental party) and is allocated the additional cost that arises from two users instead of only
the primary user. The third ranked user is the second incremental user (second incremental party)
and is allocated the additional cost that arises from three users instead of two users, and so on.
Considering the above example, the cost allocation would be
Party costs allocated cumulative costs allocated

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Albany (primary) 1,200 1,200

Chicago (incremental) 300 (1500-1200) 1,500

Total 1500

24