Cost allocation, cost apportionment accounting defined, explained gasbuddy

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The difference between direct and indirect (overhead) costs has to do with the firm’s ability to assign cost figures to individual product units, service deliveries, sale closings, or organizations. Allocating Internal Cross Charge Costs for Support Services

Organizations that support other organizations throughout the business may have to cross-charge their internal clients for services. This is a typical situation for IT departments, for instance, that support other cost centers in the company.

• The IT department can measure some costs for individual cost centers directly. Measureable direct costs might include the number of personal computers provided to each department, data storage volume, data transmission volume, and transaction volume.

• Other IT department resources, however, are shared, more or less continuously, among all cost centers. Total costs are known, of course, for such things as IT staff salaries, IT maintenance, and server system operation. The amount due to each cost center, however, is not easy to measure directly. As a result, these are indirect costs.

For indirect costs, the IT department may instead create an allocation rule so that it can cross-charge each department its fair share of the total. Rules for this sometimes reflect other factors they can measure directly. Cross charges might simply reflect, for instance, the size of each cost center’s user base. Allocating Indirect Manufacturing Costs

Income statement and budget figures for direct labor and direct materials expenses are direct because the labor time and materials for each product unit are known. However, the Income statement cost figures for other cost items cannot be measured directly for individual product units. For example:

Instead, under traditional costing, firms typically assign indirect costs like these by allocation or apportionment. The intent is to assign figures for indirect cost items to individual product units. One method they may use for this purpose is production volume based (PVB) allocation. In PVB, indirect costs are allocated as proportions of known direct cost items. The next section shows how this is done.

The simple cost allocation method appearing here uses only the indirect cost total from the Exhibit 3 bottom line. Here, the total indirect cost line is the cost pool for allocation later to individual product units. A more complex example could, of course, use single items (e.g. Purchasing materials) as cost pools and then allocate each pool’s costs by its own rules.

For this example, however, putting all indirect costs into a single cost pool is appropriate because allocation percentages will derive from a single direct cost item. That direct cost item is known as a cost base. Selecting a Cost Base for Allocation

In traditional cost accounting, firms normally allocate the indirect cost total ( cost pool), based on proportional usage of a designated resource they can measure directly (the cost base). This approach is production volume based (PVB) cost allocation.

Note that the indirect cost total from Exhibit 3 above is $1,422,500. And, the direct labor total (line 6 from Exhibit 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product’s own direct labor cost:

• Firstly, the estimated Indirect cost per unit is the same for both products, $0.47 (Exhibit 4, line 14). This must be the case because indirect costs for both products apply the same allocation rate ( 94.8%) to the same direct labor costs ($0.50 / unit).

Note that this same example appears in the article " Activity Based Costing." That article compares costing results under Activitiy based costing to traditional costing results like those above. As a result, ABC finds different indirect costs and therefore different margins and profits for products Alpha and Beta.