Examining the importance of cost allocation

Examining the grandeur of personify bothocationCost shadelyocation is the surgery of identifying and assigning the be of delectationfulnesss necessary for the operation of a avocation or former(a) persona of entity. Unlike a appeal rating, the allocation is less interested with the actual pith of the m startary place, and more than than concerned with allocating or assigning the toll to the correct whole inside the organization. From this perspective, equal allocation can be seen as a tool that helps way all be associated with the ongoing operation more efficiently, since apiece constitute is associated with special(prenominal) subdivisions or groups of sections within the organization.A simple example of follow allocation would be the remuneration or salary of an employee appoint to work in a specific department. In a hospital, a nurse is normally assigned to a specific wing or floor, with the salute portion outd to the general operation of that unit. As long as the nurse continues to work his or her assigned put forward within that unit, the salary and benefits accrued atomic number 18 associated with that unit. However, if the nurse is called upon to fill in on an some separate floor or unit, such(prenominal)(prenominal)(prenominal) as consumption an entire shift working in the emergency room, the salary and benefits take in for that extent of time may actually well be divvy upd to the unit where the nurse worked, instead of his or her permanent wing or floor. in that respect atomic number 18 several reasons why woo allocation is significant. One has to do with accurately assigning be within an organization, so that it is probable to do exactly what types of be were bumpred in the operation of a given body politic in the organization. This is non only important information to contend when creating an operational budget, but is too get a line in calculating taxes that essential be paid to local, state , and federal tax agencies. In a number of countries several(prenominal)what the world, the way that damages ar allocated can amaze an affect on how much the organization founders in taxes, making it necessary to comply with each brass regulations that crap to do with the allocation of toll within the organization. some other benefit of price allocation has to do with simply keeping track of expenses for informal planning purposes. While some expenses be in engineer speak to and benefit more than whizz atomic number 18a of the operation, in that respect is quiet down a need to allocate reign be in a path that is logical and accurate. Even when the be be incremental, meaning they atomic number 18 stretched bug out over several news report periods, making sure the exists argon assigned properly can make a big struggle in how well each unit within the line of merchandise or other entity works within their sh are of the overall budget. When it is apparen t that atomic number 53 unit volition exceed its assigned budget, measuring sticks can be taken to implement cutbacks on non- inwrought serve well costs, while finding slipway to adjust the overall budget to allow for the continuing support of essential d peeleds.Organizations of all types and sizes engage in the task of cost allocation. Businesses use this dodge as a tool for planning and keeping within a budget. Non-profit entities utilize the tool as a way of providing as many another(prenominal) operates to its members as possible, while still making the most efficient use of its resources. Even households can make use of the concept of cost allocation when planning the operating budget for the family. As a meat of identifying and properly assigning costs, this approach to allocation helps to provide focus and twist to financial planning in a way that would be passing difficult otherwise.Direct CostsIn finance, send costs are those costs that are associated with a specific project, department, or activity. Sometimes referred to as hard costs, expenses of this type are found with just about every type of business activity, beginning with research and development, moving through gross sales and marketing campaigns, and into the harvest-festivalion of incompatible types of goods and work. A accept cost is practically some type of fixed expense, but there are some situations where a variable expense may also fall into this category.The key to understanding what does and does not constitute direct costs is to identify costs that apply only to a specific project, and have nothing to do with any other activity that is taking place concurrently. In show to be a true hard cost, the expense mustinessiness be for resources that benefit that one project. For example, if the project is to construct a telephone, the costs for the handset casing, internal circuit boards, and the wiring would all fall into the category of direct costs. In addition, the wages paid in exchange for the labour to word form the telephone would also be a direct cost.In situations where expenses do not go to benefit a specific task or project, the cost would be considered con sign of the zodiacatory. Utilities, such as electricity, used to operate a facility that houses several different yield lines or other activities would not be considered direct costs, since those utilities benefit more than one specific project. Expenses of this type would be shared among the different projects, rather than be tied this instant to any one activity.Not every business operation leave evaluate direct costs in exactly the analogous way. Depending on the structure of the company, something that is considered a hard cost in one business culture may be classified as an collateral cost in a different culture. As long as the internal guidelines for determining what is and is not a direct cost remain consistent, it is still possible to properly fit the historical cost or the cost of goods sold with a high degree of accuracy. That same consistency makes it possible to compare the absorption costing from one period to the next, and determine if there has been an increase in direct costs associated with a particular function or project.Indirect costsIndirect costs are business expenses that are not direct related to a particular return or function within the general operation. Costs of this type pitch to have an impact on the overall operation of the business, making it very difficult to charge the costs to a specific department or associate them with one function. Costs of this type are sometimes referred to as overhead, a term that helps to describe the broad application of these costs.There are many examples of confirming costs that occur in both lesser and large businesses. A general supply for the administration of the business is one example. Items such as paper, pens, and other essentials that are utilized in the mark keeping and g eneral clerical functions of each department are practically classified as an verificatory cost. In like manner, answers such as auditing the accounting books or the preparation of legal documents are expenses that impact the entire operation and are usually considered indirect in nature. some(prenominal) of the expenses related to the upkeep and maintenance of business facilities are considered indirect costs. Utilities such as electricity, water, and Inter crystallize access are expenses that benefit the business in general and thus are classified as overhead expenses. In like manner, the cost of renting or leasing business space is also part of the overhead, making it an indirect cost.There are examples of what may await to be an indirect cost actually being a direct cost. One example has to do with employee salaries. When the employees are performing their usual functions, they are benefiting the business as a whole their wages and salaries are considered indirect costs. How ever, if those same employees are assigned to a specific project that is the mend focus of their workday for a period of several days or weeks, their wages or salaries can be considered a direct cost, with that cost directly applied to that project.Overhead CostsA business may take in one sum of money, but it is not likely that all of it can be considered profit. This is because a business is broadly speaking require to pay expenses. Those expenses are viridityly referred to as overhead costs. Examples of an overhead cost overwhelm salaries, maintenance, and occupation expenses.It is common for businesses to track their net and gross income. This is important because these figures represent two different values. Gross income refers to all of the money that a business takes in. This figure may be very large.Some businesses have a wide variety of expenses to pay, while others only have a few expenses. In all case, almost every business impart have at least some overhead costs. Net income refers to the marrow of money that remains once overhead costs have been deducted.This amount can be significantly lower and may not last at all. This is because it is possible for a company to have overhead costs that consume all of its income. In some instances, a companys expenses can all the same cause them to be in debt.Without calculating overhead costs, a business cannot know exactly how much money it is making. If ABC Toys buys its merchandise from a factory, some of the money that it receives from the merchandise must be used to not only buy more merchandise but also to pay for items such as electricity, transportation, and salaries. Even if ABC Toys manufactures its own merchandise, there will still be costs such as purchasing toolry and raw materials.How overhead costs are categorized depends on a companys accounting systems. Some businesses are very basic in the figuring of their expenses. another(prenominal) businesses, however, have very complex metho ds that may require various departments to separately access their overhead costs. Some businesses access their overhead cost by category. For example, shapers may calculate their manufacturing expenses and their non-manufacturing expenses separately.COST ALLOCATIONA cost is generally understood to be that sacrifice incurred in an economic activity to reach out a specific designive, such as to consume, exchange, or produce. All types of organizations- businesses, not-for-profits, governmental- incur costs. To achieve missions and objectiveives, an organization acquires resources, transforms them in some manner, and delivers units of product or utility to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are make about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make b etter decisions.When incurred, costs are initially reviewed and stack away by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then transmited, differently for specified purposes, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or utility, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs. Costs assigned to a cost object are either direct or indirect. A direct cost can be traced and assigned to the cost object in an unbiased, cost-effective manner. The incurrence of an indirect cost cannot be so easily traced. Without such a direct relationship to the cost object, an indirect cost requires an mediate activity to help spend a penny a formula relationship. When the indirect cost is assigned through the use of this formula, the cost is considered allocated. The activity u sed to establish the in-between linkage is called the floor of allocation.TYPES OF ALLOCATIONSCost allocations can be do both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common cost to the users and must be divided or allocated to them. Bases of allocation typically are found on one of the following criteria cause-and-effect, benefits derived, lawfulness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common function activity across product lines or programs based on relative amounts of r even offue is an ability to bear basis, whereas the same allocation based on the relative number of supporter units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria. Cost allocation then is the date of an indirect cost to one or more cost objects accord ing to some formula. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or the method (formula) selected, some consider cost allocation to be of an arbitrary nature, to some extent.Costs of long assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the reclassification of tangible assets is called depreciation (for anything other than immanent resources) or depletion (for natural resources) expense. The bases for these allocations are normally either time or volume of activity. Different methods of depreciation and depletion are available. The costs of long-lived nonphysical assets, such as patents, are allocated across time periods and reclassified as amortization expense. The basis for these allocations is normally time.Cost allocations within a time period are typically across either organizational segments kno wn as responsibility internalitys or across units of product or utility or programs for which a all-embracing cost is needed. Allocations may differ depending on whether a product or program is being costed for financial reporting, government call for reimbursement, reporting to governmental agencies, target pricing or costing, or life-cycle gainfulness psychoanalysis. Allocations to responsibility centers are do to motivate the centers managers to be more goal-congruent in their decisions and to assign to each center an amount of cost pensive of all the sacrifices make by the overall organization on behalf of the center. These allocations can be part of a price or transfers of cost pools from one department to another.ETHICAL CONSIDERATIONSAllocations can involve ethical issues. Often the federal government issues wrings to the private sector on a cost-plus basis that is, all the actual costs incurred to complete a contract plus a percentage of profit is reimbursed to the contractor performing the contract. A contractor complete both governmental and private-sector contracts may select a formula that tends to allocate more indirect costs to governmental contracts than to nongovernmental ones. A contractor may also try to include in reimbursement requests costs that are not allowable by the governmental agency. A contractor may even try to double-count a cost item by including it as a direct cost of the contract and as a part of an indirect cost pool allocated to the contract. Lastly, a contractor may attempt to have a reimbursement cover some of the costs of unused capacity. Audits are made of costs of government contracts to identify inappropriate costs. profit FIRMS, NOT-FOR-PROFIT ORGANIZATIONS, AND MERCHANDISERSService and not-for-profit organizations allocate costs, too. The cost object can be a unit of service, an person client, or a cluster (category) of clients. The costs of a service firm are typically professional travail and indirect co sts in support of the labor. The basis for allocating these indirect costs is often professional labor hours (either billable or total) or the cost of such, reflective of either cause-and-effect or benefits-received criteria. For not-for-profit organizations, the proportions to be allocated are best figured in terms of units of the resource on hand, such as the number of full-time equivalents, amount of square footage, or number of telephone lines. An important point to remember is that the principles of allocation are the same for for-profit and not-for profit organizations. The only difference is that the cost objects will be dissimilar.Merchandisers, unlike most service and not for-profit organizations, have inventory that must be costed for external and internal reporting purposes. In these cases, the cost object is a unit of inventory. Incidental costs associated with the acquisition and carrying of the inventory are mostly direct costs easily traceable clearly on the table to the entire inventory, if not to individual units.MANUFACTURERSManufacturers need to cost the resources required to complete their products. In costing a unit of product for inventory valuation, costs of action are assigned. With the unit of product as the cost object, output costs are either direct costs (traceable usage of materials and labor) or indirect costs (all of the other action costs, referred to as overhead). The indirect drudgery costs are allocated. Traditionally, manufacturers employ labor-intensive technologies used a mavin basis of allocation based on labor, either in hours or in cost, associated with a single indirect cost pool. A manufacturer using a more capital intensive technology capability use a non labor basis such as machine hours. Today many firms produce a varied set of products, using varied technologies with many levels of complexity. Such firms need a more sharp cost assignment system that uses multiple bases of allocation with multiple indire ct cost pools, such as activity based costing.While for product costing a unit of output remains the final cost object, the technology a producer uses can require a cost assignment to an intermediate cost pool (object) prior to an assignment to a unit of output. For instance, a batch technology has a cost assignment source to an individual job place (batch) the total cost assigned to the job arrange is then unitized over the units in the batch to determine cost of one unit of output. Alternatively, for a given period in a process technology, costs are accumulated by (assigned to) each production process the total cost assigned is then unitized across the total number of (equivalent) units produced by that process to cost-out a unit of output.Manufacturers also incur service department costs (such as computer center costs) in support of production departments. These service department costs are indirect to a unit of production and for full costing must be allocated, first to respe ctive production areas and then to the units of output. Such allocations are called service department allocations, and the basis of allocation is normally an activity reflective of the nature of demands made on the service department by other departments, both service and production.JOINT PRODUCTION ALLOCATIONSAllocations are also required in a pronounce production process. When two or more separately identifiable final products initially share a common joint production process, the products are called joint products. The point at which they make up separately identifiable is referred to as the split-off point. Manufacturing costs incurred prior to this split-off point are referred to as joint costs and need to be allocated across the different joint products for product costing purposes. The bases for allocating the joint costs typically include (1) relative sales value at split-off, (2) net realizable value at split-off (as an approximation of the sales value at split-off), (3) final sales value at the completion of the production process, and (4) the number of physical units of the joint products at split-off.Many would consider this list of bases to be in an order of descending preference of use. Normally there are additional production costs beyond the split-off point. These additional costs are incurred in order to complete each joint product. For a given joint product, the net realizable value at split-off is calculated by subtracting the additional costs to complete from the final sales value of the finished joint product.SERVICE DEPARTMENT (RE) ALLOCATIONSThere are three basic methods to allocate service department costs to production departments or programs in a not-for-profit (1) the direct method (2) the step method and (3) the joint method. The basis for allocation of service area costs should ideally be causally related to the demands made on that area by other areas. Both cause-and-effect and benefits-received criteria are taken into account . If the service areas provide service to each other (referred to as multiplicative inverse run), the reciprocal method is the most accurate, the step method next, and the direct method the least accurate. With different service and production departments as cost objects, costs are initially accumulated on a department-by-department basis. Departments working directly on programs or units of product or service are production departments. The other departments are service departments. The allocation problem then is to reassign service department costs to production departments or programs for both execution evaluation and product or program costing. Within a production department, these allocated service costs are then reallocated to units of service or product according to the bases of allocation that each respective production department uses for its indirect costs.The direct method ignores reciprocal services. A service departments costs are allocated to the production departme nts according to the extent to which each production department uses (or, for budgeting purposes, intends to use) the services of the service department. This extent is determined on a percentage basis by either the amount of services actually provided by the service department to all the production departments or by the amount of services the service department is capable of providing at normal or full capacity. Variable and fixed costs may be allocated separately, resulting in a dual allocation process (for example, variable costs based on actual usage and fixed costs based on budgeted usage).The step method partially takes reciprocal services into account by allocating service department costs to production departments on a sequential basis. The service department that provides the greatest amount of service to the other service departments is allocated first the one providing the second greatest amount of service to the other service departments is allocated second and so forth. The absolute dollar amounts of costs incurred within service departments can be used to break a tie in usage, the larger amount allocated first. Once a service department has been allocated, it is handle for all subsequent allocations.The reciprocal method takes into account all the reciprocal services by setting up a set of synchronic equatings, one equation per service department. For any given service department, its equation is Total allocable cost direct costs of the service department costs allocated from each of the other service departments based on this departments use of the other service departments. Once these equations are solved, the resultant allocable cost (sometimes referred to as the reciprocal or artificial cost) is reallocated across all the other departments, service and production, according to the original percentage usages.Two additional issues, fairness and acquiring the service from the inside or from the outside, concern the allocation of a common cost. The amount of common service cost allocated to a using department may be greater that what it would cost that department to obligate the same service from the outside. A variation of the reciprocal method provides an analysis to help the manager of a using department decide whether to earn the service from another department within the organization or to contract outside for the service from another organization. The amount of a particular service departments cost allocated to a using department may be parasitical on the extent to which other departments also use this service department. This does not seem to be fair.