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One of the key concepts in activity-based costing (ABC) is cost allocation, which is the process of assigning indirect costs to cost objects based on their consumption of resources and activities. cost allocation is important because it helps managers to measure the profitability and performance of different products, services, customers, or business units. However, cost allocation is not a simple or straightforward task. It involves several steps and decisions that affect the accuracy and usefulness of the cost information. In this section, we will discuss some of the main aspects and challenges of cost allocation in ABC, such as:
- The selection of cost drivers and allocation bases
- The calculation of cost pools and allocation rates
- The allocation of costs to cost objects
- The evaluation and improvement of the cost allocation system
We will also provide some examples and insights from different perspectives to illustrate the benefits and limitations of cost allocation in ABC.
### The selection of cost drivers and allocation bases
The first step in cost allocation is to identify the cost drivers and allocation bases for each indirect cost category. A cost driver is a factor that causes or influences the amount of indirect costs incurred by an activity. For example, the number of machine hours, the number of orders, or the number of inspections are possible cost drivers for different activities. A cost driver should be measurable, relevant, and controllable by the management.
An allocation base is a measure of the consumption of an activity by a cost object. A cost object is anything for which a separate cost measurement is desired, such as a product, a service, a customer, or a business unit. An allocation base should be correlated with the cost driver, meaning that the more a cost object consumes an activity, the more it should be allocated of the related indirect costs. For example, the number of machine hours, the number of orders, or the number of inspections can also be used as allocation bases for different cost objects.
The selection of cost drivers and allocation bases is a critical decision in cost allocation, because it affects the accuracy and fairness of the cost information. Ideally, the cost drivers and allocation bases should reflect the causal relationship between the activities and the cost objects, meaning that the cost objects should be allocated only the costs that they actually cause or influence. However, in reality, this is not always possible or practical, because some indirect costs are not directly traceable or attributable to specific cost objects, such as common costs, joint costs, or overhead costs. In these cases, the cost drivers and allocation bases have to be chosen based on some assumptions, estimates, or approximations, which may introduce some errors or distortions in the cost information.
Therefore, the selection of cost drivers and allocation bases should be done carefully and judiciously, taking into account the following factors:
- The purpose and scope of the cost information. Different cost drivers and allocation bases may be appropriate for different purposes and levels of analysis. For example, for strategic decisions, such as product mix, pricing, or outsourcing, more accurate and refined cost drivers and allocation bases may be needed, such as activity-based cost drivers or transaction-based cost drivers. For operational decisions, such as budgeting, variance analysis, or performance evaluation, more simple and aggregated cost drivers and allocation bases may be sufficient, such as volume-based cost drivers or output-based cost drivers.
- The cost-benefit trade-off. The selection of cost drivers and allocation bases involves a trade-off between the benefits of more accurate and relevant cost information and the costs of collecting and processing the data. More cost drivers and allocation bases may increase the accuracy and usefulness of the cost information, but they also increase the complexity and difficulty of the cost allocation system. Therefore, the cost drivers and allocation bases should be chosen based on the marginal benefit and marginal cost of each additional cost driver or allocation base. The optimal number and type of cost drivers and allocation bases may vary depending on the size, diversity, and complexity of the organization and its activities and cost objects.
- The availability and reliability of the data. The selection of cost drivers and allocation bases depends on the availability and reliability of the data that can be used to measure them. The data should be accessible, timely, consistent, and verifiable. If the data is not available or reliable, the cost drivers and allocation bases may not be valid or meaningful, and the cost information may be misleading or inaccurate. Therefore, the cost drivers and allocation bases should be chosen based on the quality and quantity of the data that can be obtained and used.
### The calculation of cost pools and allocation rates
The second step in cost allocation is to calculate the cost pools and allocation rates for each indirect cost category. A cost pool is a group of indirect costs that share the same cost driver and allocation base. For example, all the indirect costs related to the machine maintenance activity can be grouped into one cost pool, and the cost driver and allocation base for this cost pool can be the number of machine hours. A cost pool should be homogeneous, meaning that the indirect costs in the cost pool should have the same or similar cost behavior and cost allocation criteria.
An allocation rate is the ratio of the total indirect costs in a cost pool to the total amount of the allocation base for that cost pool. For example, if the total indirect costs in the machine maintenance cost pool are $100,000 and the total number of machine hours for all the cost objects are 10,000, then the allocation rate for this cost pool is $10 per machine hour. An allocation rate is used to allocate the indirect costs in a cost pool to the cost objects based on their consumption of the allocation base.
The calculation of cost pools and allocation rates is a technical and mathematical process that involves the following steps:
- Identify and classify the indirect costs into different cost categories, such as materials, labor, utilities, depreciation, etc.
- identify and measure the cost driver and allocation base for each cost category, such as the number of machine hours, the number of orders, the number of inspections, etc.
- Group the indirect costs in each cost category into one or more cost pools based on the cost driver and allocation base, such as the machine maintenance cost pool, the order processing cost pool, the quality control cost pool, etc.
- Calculate the total indirect costs in each cost pool by adding up the individual indirect costs in the cost pool, such as the total machine maintenance costs, the total order processing costs, the total quality control costs, etc.
- Calculate the total amount of the allocation base for each cost pool by adding up the individual amounts of the allocation base for all the cost objects, such as the total number of machine hours, the total number of orders, the total number of inspections, etc.
- Calculate the allocation rate for each cost pool by dividing the total indirect costs in the cost pool by the total amount of the allocation base for the cost pool, such as $10 per machine hour, $5 per order, $2 per inspection, etc.
The calculation of cost pools and allocation rates is an important step in cost allocation, because it determines the amount and proportion of indirect costs that are allocated to each cost object. The calculation of cost pools and allocation rates should be done accurately and consistently, taking into account the following factors:
- The time period and frequency of the calculation. The cost pools and allocation rates should be calculated for a specific time period and updated regularly. The time period and frequency of the calculation may depend on the nature and variability of the indirect costs and the allocation bases. For example, for fixed or stable indirect costs and allocation bases, such as depreciation or rent, the cost pools and allocation rates can be calculated annually or quarterly. For variable or fluctuating indirect costs and allocation bases, such as materials or labor, the cost pools and allocation rates can be calculated monthly or weekly.
- The choice of the cost accounting method. The cost pools and allocation rates can be calculated using different cost accounting methods, such as actual costing, normal costing, or standard costing. Actual costing is based on the actual amount of indirect costs and allocation bases incurred in a given period. Normal costing is based on the budgeted or estimated amount of indirect costs and allocation bases for a given period. Standard costing is based on the predetermined or expected amount of indirect costs and allocation bases for a given period. The choice of the cost accounting method may affect the accuracy and timeliness of the cost information. For example, actual costing may provide more accurate but less timely cost information, while standard costing may provide more timely but less accurate cost information.
- The treatment of under- or over-allocated costs. Under- or over-allocated costs are the difference between the actual amount and the allocated amount of indirect costs for a given period. Under-allocated costs occur when the actual amount of indirect costs is more than the allocated amount of indirect costs, meaning that the cost objects are undercharged for the indirect costs. Over-allocated costs occur when the actual amount of indirect costs is less than the allocated amount of indirect costs, meaning that the cost objects are overcharged for the indirect costs. Under- or over-allocated costs may arise due to errors, estimates, or approximations in the calculation of cost pools and allocation rates. Under- or over-allocated costs should be adjusted or disposed of at the end of the period, either by prorating them among the cost objects based on the allocated amount of indirect costs, or by writing them off to the income statement as a period cost.
### The allocation of costs to cost objects
The third step in cost allocation is to allocate the costs to the cost objects based on their consumption of the allocation bases. The allocation of costs to cost objects is the final and most visible step in cost allocation, because it provides the cost information that is used for decision making and performance evaluation. The allocation of costs to cost objects is done by multiplying the allocation rate for each cost pool by the amount of the allocation base for each cost object.