Cost Allocation: Methods of Cost Allocation

Cost allocation is an accounting operation that falls under management accounting. Management accounting is thus a branch of accounting that is of great importance to any business enterprise (Weiner 11). It provides the managers as well as the internal personnel with a summary of all the company’s activities that are of importance to them. Unlike financial accounting which provides the company’s financial data to the external environment such as the company’s debtors and creditors, shareholders and many others, management accounting is only answerable to the internal organizational environment.

As a matter of fact, management accounting is majorly concerned with cost analysis of products or services hence responsible for issuance of budgets, costs of products produced and cash flow statements (Leslie 78). As all the latter functions are being performed, cost allocation, therefore, comes in. Cost allocation is thus the process of apportioning or distributing costs among various, products, departments or processes in an organization. It is through cost allocation that manufacturers are able to come up with the final cost of a product.

Methods of cost allocation

There are various methods used to allocate costs among the various departments of an organization. The method of cost allocation is usually attributed to a variety of factors that the organization puts into consideration. Some of these factors may include the productivity of the department, the type of department, whether it is a service or an operating department and many other factors. However, despite the method of cost allocation used, the aim is always to achieve the desired objective.

One method of cost allocation is the direct method whereby the allocation is only based on the department’s own operations (Atrill and McLaney 15). This means that the interdepartmental transfers of duties are ignored and no allocation is made on them. It has been termed as the simplest way of allocating costs among the three methods of cost allocation. This is because of the same reason of ignoring the interdepartmental services. However, it is not an efficient method as it may lead to a deficiency of funds in one department while the other has a surplus.

Variable costing is also another method of allocating costs in the organization. Variable costing entails the allocation of costs while varying the cost of production as per the output generated. Variable costing, therefore, puts into consideration the cost of materials, labor charges, and production overheads. The aforementioned costs are usually treated as product costs; however, the fixed costs of production are not categorized as part of the product costs under this method of cost allocation. They are instead termed as period costs of production.

Absorption costing on the other hand is a method of allocating costs whereby all the costs used in production fall under the category of product costs without looking at their variability (Leslie 81). This therefore the final cost of the product will have been allocated both the variable and fixed costs.

Last but not least methods of cost allocation belong to their own category based on the allocation of overheads that arise during production. These are the original costing method and the activity-based costing method. Both original costing methods and activity-based methods have different implications for price determination. This is due to different approaches in the allocation of resources they use. In the original costing method, allocation of cost is done using direct labor.

Therefore the use of direct labor makes labor-intensive products have a higher cost compared to other products. The original costing method fails to give a more accurate cost because it relies on one parameter in the determination of the cost of the products. Besides, allocations of costs to the activities are done randomly based on labor and machine hours. In the original costing method labor is the main factor of production. In this case, overheads are charged against the cost of materials and direct labor.

Activity-based costing methods allocate cost using all the activities that are involved in the production like machine setups, salaries, orders among others. Through the use of the activity-based costing approach, allocation of costs is more accurate especially in the circumstances where there are no similar rates of direct labor hours.

The activity-based accounting approach is more recommendable because it captures all the costs at the activity centers thus it gives a fair cost to each product. Besides, activity-based costing approach enables decision-makers figure out on how they can improve their productivity and also on how to maximize shareholder value. As evidenced in the above discussion, the fact that cost reduction opportunities are available in activity based costing makes it preferable than original costing (Weiner 17).

A comparison between variable and absorption costing methods

One of the main differences between the variable and absorption costing is that both end up with different figures of the net operating income. The difference comes about due to the different treatments given to costs and especially the overhead costs. For example when it comes to the generation of the cost volume profit, the absorption costing method is usually not applied as it does not distinguish between variable and fixed costs. This therefore makes variable costing best suited for the generation of cost volume profit.

Since variable costing usually emphasizes on fixed costs of production their impingement on the total profits can be clearly seen unlike in absorption costing method where they are allocated together. This therefore indicates that variable method of costing is more efficient as compared to the absorption method of cost allocation.

Works Cited

Atrill, P. & McLaney, E. Management accounting for decision makers. U.K. McMillan Publishing, 2006. Print.

Leslie, Chadwick. Management Accounting. Britain. Bell & Bain, 1999. Print.

Weiner, Jerry. Activity based costing for financial institutions. Journal of Bank Cost & Management Accounting, 1995.