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How and why cost allocation is used

Cost allocation is an extensively used practice in virtually every organization and in nearly every facet of accounting (Harris K., Curry W.,1997 Cost Accounting Prentice Hall 9th edition). Cost allocation is defined as a method of assigning and reassigning of a cost to one or more cost objectives (Horngren and Foster, 1987). The major reason for adopting this practice is concerned with “best” decision making for managers. These decisions may not necessarily be seen as profit-maximizing (Woulters, 1996 Woulters M.J.F. “Why managers Use Cost Allocations: A research note”) Indirect cost allocation is kept simple but effective, and gives management an accurate, reliable cost picture of all departments, avoiding petty details.

Answers to cost-allocation questions are debatable and rarely can be right or wrong. At the cornerstone of this concept, four purposes of cost allocation can be distinguished (Harris K., Curry W.,1997 Cost Accounting Prentice Hall 9th edition):

To provide information for proper decision making

To motivate both managers and employees

To justify costs or calculate reimbursement

To measure income and assets for reporting to external parties

In the world of business, cost allocation techniques have been regarded as one of the “seven most common accounting weaknesses in manufacturing organizations” (Davis, J.J.,”These seven Accounting Weaknesses Can Harm Your Company”, Management Accounting (August 1983), p.55)). Nevertheless, in a survey conducted by Fremgen and Liao (1981) it is demonstrated that at least part of indirect costs of 84 percent firms were allocated to profit centers, and 80 percent adopted this technique to calculate the performance or profit centre managers. Similarly, Govindarajan and Anthony (1983) reported that 83 percent of companies that were researched allocated their indirect costs to make decisions connected with pricing on a full cost basis. Atkinson’s census (1987) stated that the principal aims for indirect cost allocation were employee motivation factors as well as the provision of signals for allocation of resources.

This study is aimed at examining of how indirect costs need to be allocated for pricing decisions as well as takes a step further in considering how differently managers will behave if cost are allocated. In addition, the study sets an objective to examine how decisions on cost allocation are guided by the cause-and-effect criteria and the purpose for which cost information is desired.

Literature review

Allocation of indirect cost

There is a host of ways to calculate and allocate indirect costs. It is also known that no two companies or even industries are expected to adopt the same structure for indirect cost. Yet compliance with certain key principles is required to the process (Norfleet, D.,A., 2007)

Proper allocation is the key principle in the process since indirect costs must be pertinent and allocated to numerous cost objectives; the allocation method is of extreme importance. The adopted method prescribed is some form of indirect rate determination. An indirect rate can be counted up basing on the casual and beneficial relationship between the indirect cost, or group of costs, being allocated and the base to which the rate will be applied.

Another fundamental principle is consistency. The adopted method for cost allocation must be employed consistently throughout the whole process.

The type of contract used plays not less important role in the entire process of indirect cost allocation. Cost reimbursement contracts are intended to allow final indirect rate determinations based on factual costs at the closing of the contract.

Behavior of indirect cost

Indirect cost behavior associates with the correlation between volume and indirect cost. As a rule, indirect costs go up as the volume goes up, and decline as the volume do so. However, the degree to which indirect costs increase or decrease rests on the nature of the cost. Being able to estimate how an indirect cost will respond to volume that has been changed is paramount for pricing processes involving equitable adjustments and for projection of indirect costs.

Composition of Indirect Rates

Indirect Rate =

The equation above reveals that indirect rate can be derived from dividing “Indirect Cost Pool” over the appropriate “Allocation Base”. It is vital to know how cost pool and allocation base interrelate to understand indirect rates.

Indirect Cost Pool

To allocate indirect costs to appropriate cost objectives, the former needs to be accumulated into homogenous groups. All costs which have similar beneficial or casual relationship to cost objectives are found in a homogeneous indirect cost pool. Provided that costs are allocated individually, all of them in a homogeneous indirect cost pool would be allocated to the same cost objective. To achieve homogeneity a company is required to have enough indirect cost pools inside each pool. The pools may be classified into primary and secondary ones.

Primary pools are used to develop the indirect rate and either relate to specific operations of the firm or relate to the overall operation and management of the firm. They consist of logical cost groupings with due consideration of the reasons for which the costs were incurred. When determining which cost belongs in which pool, the key question is, "Who benefits from the expense?"

A secondary pool exists to guarantee that costs are dispersed appropriately to cost objectives which may not be final cost objectives. Secondary pool costs are frequently allocated to other secondary pools or sometimes to primary pools. For instance, manufacturing and engineering divisions utilize 50 percent of the same premise each. The costs of the premise are considered as indirect as they are not directly charged to a single final cost objective. Since the costs are shared by two divisions they are collected in a secondary pool, which have their own primary pools. The secondary pool between the two primary cost pools for both divisions. In view of the fact that both cost centers obtain equal benefits from the premise; the cost should be evenly shared. The relationships between the example of primary and secondary pools is illustrated in the figure 2.1

Allocation Bases

Types of costs involved in the pool determine the way how an indirect cost pool will be assigned to a particular allocation base. Referring to figure 2.1; direct labor hours may not be a relevant allocation base for the building expenses, since the relationship between them is not clearly established. However, building’s square footage that each division occupies can be seen as a far more appropriate base as the cost of building expenses relies on the size of the building.

On the whole, there are multiple of factors to take into consideration while choosing an appropriate allocation base and no any rule can be applied in every situation. Selecting a proper and rational allocation base lies with the organizations’ accounting system and is subject to some judgment. Most necessarily, allocation base should lead to an equitable allocation of indirect costs to cost objectives. Secondly, it is expected to be consistently applied as the time passes and among cost objectives. Finally, it is needed to meet the terms of generally accepted accounting principles (GAAP). Examples of several allocation bases might be sales, machine hours, direct labor etc. Furthermore, all costs must be included in the allocation base, even though if some of them are not allowable under Government contracts. Being not allowable under Government contracts doesn’t necessarily mean that it obtains no gain from indirect cost.

If any of the following conditions present, the method for cost allocation needs to be closely examined:

The cost patterns of work under the contract are substantially different from the contractor’s other work.

Considerable changes happen in the nature of a contractor’s business, fixed-asset improvement programs, inventories, or other relevant circumstances.

Indirect cost groupings developed for a contractor’s primary location are applied to off-site locations. Distinct cost groupings for costs allocable to off-site locations may be necessary to allow equitable allotment of costs based on the benefits accruing to the several cost objectives.

Allocating overhead costs

Overhead costs allocation is carried out in four major steps that correlates to the steps of management process: (Belverd, E. et all, 2008)

Planning. In this step, managers compute overhead cost and calculate the rate at which the cots will be assigned to those products and services.

Performing. Secondly, managers apply this rate to products while overhead costs are incurred and registered during production.

Evaluating. As the overhead costs are incurred they are kept recorded. Thus it becomes possible for managers to compare actual and estimated costs.

Communicating. Finally, managers will report on the difference.

Planning the overhead rate

Prior to accounting period, managers come up with cost pools as well as cost drivers and compute a predetermined overhead rate. Applying this rate to all production units over the perid will enable managers to better evaluate product cost. No recordings are required at this stage as no business activity has taken place.

Recording actual overhead costs.

The recording of actual overhead costs occurs at the time they are incurred during the accounting period. The costs including indirect materials, indirect labor, taxes on property, costs for production etc will account for the actual product cost. A debit will be recorded in the overhead account and the credit in the asset.

Motivational consideration

Motivational considerations were basically correlated with budgets in the accounting area (Becker, S. and Green, D., “Budgeting and Employee Behavior”, The Journal of Business, 1962). However, in the cost allocation process they were introduced by Bodnar and Lusk (1977). They contended a model which sensitizes joint cost allocation to non-financial objectives of an organization. They claimed that their model will structure the environment of the organization and encourage desired subunit behavior. As the authors stated cost allocation had to be carefully done as the motivational dimension in any kind of allocation could impact financial performance of a company.

Research Methodology

Purpose of study: The nature of the current study is exploratory one, as it relies on secondary research that includes reviewing literature that is available and helps better comprehend the nature of the problem. Furthermore, it can be useful for decision making procedures.

Type of investigation: Since the study is carried out to analyze the behavioral considerations of managers in indirect cost allocation, the investigation type is co relational one.

Source of data: Type of data that is being collected in the current study is secondary qualitative data. Therefore, mainly data from written reports, websites and books is involved in this report.

Allocating indirect costs

Indirect costs need to be distinguished and subsequently separated from general and administrative costs. As soon as indirect costs pool has been singled out, the method used to indirect cost allocation must be evaluated on degree of relevancy to the circumstances. It is extremely important to look for casual relationships. Per SOP 81-1:

Methods of indirect costs allocations need to be rational and systematic. They could include allocations based on direct labor costs, direct labor hours or a combination of direct labor and material costs. To evaluate the relevancy of indirect allocations as well as the methods of their allocation depends on the circumstances and involves judgment. Taking overhead in consideration, it should not be neglected that direct costs impact the two cost pools in different ways. This means that the increase in direct labor will cause the increase in other items such as payroll taxes, health insurance and gas, whereas rent, office supplies and other utilities will remain stable over the period.

One of the following methods in allocation of indirect costs can be used by many contractors:

Percentage of total direct costs

Percentage of direct labor costs

Percentage of direct labor hours

Percentage of direct labor costs and charges for equipment

Sample Grading Contractor

Figure 2.2 demonstrates income statement of a small grading contractor functioning in the US. As additional information, the company has elected to be taxed as a Subchapter S type corporation. Therefore there is no provision for corporate income taxes.

Sample Grading Contractor has considerable indirect equipment and other costs. Successful performance or a failure of a company directly depends on how accurately indirect costs are estimated. Many contractors set up an equipment rate for single piece of equipment based on hours of usage. Each job is then charged costs based on the rates and hours of use for each piece of equipment. The total amounts charged to all the jobs are then compared to the actual costs. The difference between the two is referred to as a variance. Table 2.3 provides example direct and indirect costs of Sample Grading Contractor for the income statement.

Allocations of indirect costs

Presumably Sample Grading Contractor is considering three methods of overhead allocation costs to construction projects for the year. The three methods will be based on:

Total direct costs

Direct labor costs

Direct labor costs and equipment hours

Adopting suitable theoretical methods can produce different results. Table 2.4 reveals schedules for three methods. The first method relates to total direst costs only. The second method is one of direct labor only. Final method is based direct labor and equipment hours. As can be seen, managers can achieve different results for individual projects based on the method of overhead cost allocations. It is noticeable that project B ranges in cost from a low of $178.632 to a high of $222.649, relying on overhead allocation methodology. This illustrates the fact that indirect cost allocations can influence the decision of which project to pursue.

le piece of equipment particularly identified. The expenses are subsequently made based directly on used hours on the job with a separate rate for not used time. This can lead to over estimation of the equipment utilization or other way round, with an attendant under or over charge to a range of projects, a variance. As to this equipment variance, the cause of a large variance might indicate outdated equipment rates, a considerable change in volume, or a considerable increase in one of the cot components such as insurance or gas. It is paramount, in any case, to the success of jobs that the rates accurately depict actual costs.

Methods may be different, in as much as they allow the contractor to calculate the equipment costs within a range that is of no real importance to financial statements. By means of this process, it can be mode possible for contractors to develop their own accurate internal equipment rates to be applied when calculating a project. The main principle to analyzing profitability for a construction contractor is to examine every contract as a profit cost center. Then only can one begin to understand the performance of a company. Allocating cost to the original estimate as well as to the actual costs as they are incurred, gives the contractor a more accurate picture of the individual jobs performance. What’s more, the adherence to revenue for costs in excess of billings and billings in excess of costs for the contracts in progress will give a more accurate picture. Provided that this adherence is wrong, the contractor’s revenue will be inaccurate, thus disfiguring the gross profit for the individual jobs and the company as a whole.

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