Page 188 - Encyclopedia of Business and Finance

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Cost Allocation

bility centers or across units of product or service or pro- Merchandisers, unlike most service and not-for-profit
grams for which a full cost is needed. Allocations may dif- organizations, have inventory that must be costed for
fer depending on whether a product or program is being external and internal reporting purposes. In these cases,
costed for financial reporting, government contract reim- the cost object is a unit of inventory. Incidental costs asso-
bursement, reporting to governmental agencies, target ciated with the acquisition and carrying of the inventory
pricing or costing, or life-cycle profitability analysis. Allo- are mostly direct costs easily traceable clearly assignable to
cations to responsibility centers are made to motivate the the entire inventory, if not to individual units.
centers’ managers to be more goal-congruent in their deci-
sions and to assign to each center an amount of cost reflec-
MANUFACTURERS
tive of all the sacrifices made by the overall organization
on behalf of the center. These allocations can be part of a Manufacturers need to cost the resources required to com-
price or transfers of cost pools from one department to plete their products. In costing a unit of product for
another. inventory valuation, costs of production are assigned.
With the unit of product as the cost object, production
costs are either direct costs (traceable usage of materials
ETHICAL CONSIDERATIONS
and labor) or indirect costs (all of the other production
Allocations can involve ethical issues. Often the federal
costs, referred to as overhead). The indirect production
government issues contracts to the private sector on a
cost-plus basis; that is, all the actual costs incurred to com- costs are allocated. Traditionally, manufacturers using
plete a contract plus a percentage of profit is reimbursed labor-intensive technologies used a single basis of alloca-
to the contractor performing the contract. A contractor tion based on labor, either in hours or in cost, associated
completing both governmental and private-sector con- with a single indirect cost pool. A manufacturer using a
tracts may select a formula that tends to allocate more more capital intensive technology might use a nonlabor
indirect costs to governmental contracts than to non- basis such as machine hours. Today many firms produce a
governmental ones. A contractor may also try to include varied set of products, using varied technologies with
in reimbursement requests costs that are not allowable by many levels of complexity. Such firms need a more refined
the governmental agency. A contractor may even try to cost assignment system that uses multiple bases of alloca-
double-count a cost item by including it as a direct cost of tion with multiple indirect cost pools, such as activity
the contract and as a part of an indirect cost pool allocated based costing.
to the contract. Lastly, a contractor may attempt to have a
While a unit of output remains the final cost object
reimbursement cover some of the costs of unused capac- for product costing, the technology a producer uses can
ity. Audits are made of costs of government contracts to require a cost assignment to an intermediate cost pool
identify inappropriate costs.
(object) prior to an assignment to a unit of output. For
instance, a batch technology has a cost assignment first to
SERVICE FIRMS, NOT-FOR-PROFIT an individual job order (batch), and the total cost assigned
ORGANIZATIONS, AND
to the job order is then unitized over the units in the batch
MERCHANDISERS to determine cost of one unit of output. Alternatively, for
Service and not-for-profit organizations also allocate costs. a given period in a process technology, costs are accumu-
The cost object can be a unit of service, an individual lated by (assigned to) each production process; the total
client, or a cluster (category) of clients. The costs of a serv- cost assigned is then unitized across the total number of
ice firm are typically professional labor and indirect costs
(equivalent) units produced by that process to cost-out a
in support of the labor. The basis for allocating these indi-
unit of output.
rect costs is often professional labor hours (either billable
or total) or the cost of such, reflective of either cause-and- Manufacturers also incur service department costs
effect or benefits-received criteria. For not-for-profit (such as computer center costs) in support of production
departments. These service department costs are indirect
organizations, the proportions to be allocated are best fig-
ured in terms of units of the resource on hand, such as the to a unit of production and for full costing must be allo-
number of full-time equivalents, amount of square cated, first to respective production areas and then to the
footage, or number of telephone lines. An important units of output. Such allocations are called service depart-
point to remember is that the principles of allocation are ment allocations, and the basis of allocation is normally an
the same for for-profit and not-for-profit organizations. activity reflective of the nature of demands made on the
The only difference is that the cost objects will be dissim- service department by other departments, both service
ilar. and production.

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 165