Introduction: ‘Allocation based costing’ or ‘Activity based costing’ is an accounting method that identifies the business entity’s activities, and then assigns indirect cost to products. It recognizes the relationship between costs, activities and products. By adopting this method the allocation is less arbitrary than the traditional methods. Management costs and office salaries are sometimes difficult to assign. In view of this, allocation based costing has become an important tool in the manufacturing sector. The object of adopting allocation based costing of products is primarily for cost control, pricing of products, understanding the products that are competing for scarce resources and being sensitive to how resources are used for producing multiple products in an organization. This is not necessarily restricted to product oriented industries but can be effectively utilized in service industries having multiple services. Also, industries having a combination of both can also adopt this technique effectively in taking major decisions for the organization. There are industries that adopt this tool to take decisions on whether to manufacture in-house or to outsource a job, to economize its total operations. At the outset, it is important to understand that allocation based costing and activity based costing are used synonymously but there is still a subtle difference between the two. No attempt is being made to distinguish them in a detailed manner in this article.
Identification of the core activity or the product:
It is necessary to identify what are the core units to which the expenditure and resources are to be allocated. When we say core units, it can either be a product or a service expected to bring in positive cash flows. Any indication that a product or service is not likely to bring in positive cash flows, are not considered within the organizational effort plan. In other words it is the allocation of all items of income and expenditure across different products and services with an effort to bring in positive cash flows for each one of them.
Setting up the allocation base:
Having chosen the allocation units, the next step is to set up a criteria or a base to decide how costs and income are going to be allocated to different products and services. It defines the manner of determining what expense or value of a resource is going to be allocated to a product, among several of them being produced simultaneously. This is the heart of most cost accounting systems and is also an area beset with problems for the top management. We must understand that costs are to be linked with cost objectives, and cost objectives literally emerge from what are called as cost drivers. This is often termed as the cost allocation base. The base may include factors such as:
Direct allocation when a particular expenditure relates to a specific product or activity;
Staff time being allocated based on the number of hours spent by staff on the product;
Based on the number of transactions allocable to each product or service;
Utilization of a resource in the form of building or machinery being allocated based on their use in producing individual products;
Actual consumption of area by the department, division or the activity;
Equal distribution of common costs;
Costs being absorbed into a department or division and allocating further on an appropriate basis;
Core product to absorb most of the costs and a smaller portion being taken up by other products – marginal costing uses this method.
Quantifying the allocation between different products and activities: Once the allocation base is determined, which often depends on the type of industry, the extent and the manner in which expenses or income is going to be allocated is determined. It is expressed as a percentage. The allocation base has then to be quantified and applied to different products and services. Certain costs are directly attributable and allocable to a particular product. In this situation there is no need for any further exercise. It gets fully allocated to the product. However, when two or more product compete for resources or that the expenses incurred have to be shared between the two, allocation of the expense, or attributable values for the use of resources, are quantified and added to the product cost, based on the allocation base.
While it is easy to have an allocation base and quantify the allocable costs to different products when they are direct, the task becomes subjective when costs are remote. General expenses like the vehicle maintenance, office staff expenses, guest entertainment, etc., have to be allocated based on some logical criteria. Allocation of general expenses has to be consistent over the years unless there is a substantiating evidence to alter the same.
Transfer Price adjustment:
It could be possible that an entity has several departments are divisions and costs incurred by one department for the benefit of another department needs to be adjusted. May be the accounting structure is not too sophisticated to provide this data. A transfer price adjustment comes into play to give effect to this inter-department costs. Similarly, resources that have been purchased and used by two are more departments, shall have to share the depreciation cost based on some allocation base. Although costs are not actually incurred in the concerned year, the deferred costs have to be picked up to arrive at the true value of the cost of production. Entities should make transfer price adjustments based on full opportunity cost of the resource.
Review of the allocation exercise: When once the allocation base is established, quantified and allocated the allocation exercise needs to be reviewed. Some products may show up losses and others may show profits some of them reasonable and others showing super profits. The review exercise will help one to diagnose any defects in the allocation base or the quantification. Further, this exercise will tone the entire organization in defining what products to retain and what needs to be dispensed with.
Marginal cost approach: Marginal cost approach takes into its ambit the concept of allocating costs to the core group products or the core business activities and only incremental costs are allocated to the secondary activities. These incremental costs would not normally be incurred if the secondary products were not in existence.
Steps involved in setting up allocation based costing:
The following steps can be adopted to put activity or allocation based costing in any organization-
The costing exercise has to be meticulously planned;
All products and services that need to be covered under the costing exercise have to be identified;
Core activities are identified and key drivers for these activities have to be noted. The key drivers could be the use of machines, use of manpower, availability of space, etc;
Activity log, use of power or space, man-hours spent, key personnel involved, etc., are some factors that have to be documented to determine the allocation;
Depending on some key driver, costs are allocated to the activity;
The cost driver (method of allocating activity cost to individual products) based on the usage of the expense;
Activities that are required in sustaining the entity are also allocated to products so that the contribution from these products is able to absorb such indirect costs.
Allocation and activity based costing:
As was explained in the earlier paragraph, allocation based costing and activity based costing have subtle differences between them. Allocation based costing is much simpler when compared to activity based costing. Activity based costing requires allocation skills depending on the type of activity, understanding the processes and understanding the core activities from the non-core. Commitment from the top is essential for activity based costing and it is always better to start with allocation based costing to graduate to activity based costing. The information for activity based costing has to be more robust when compared to allocation based costing.
Need for cost allocation between products:
One may wonder the need and purpose of cost allocation. Yes, allocation is important from several angles. Specifically,
It provides information for many cost decisions and pricing decisions;
To avoid frivolous use of resources;
To evaluate the efficient use of internally generated or internally provided services;
To arrive at full cost of various products manufactured in the organization;
They also help in substantiating pricing for statutory purposes such as Central Excise and Transfer Pricing issues between Associated Enterprises.
Concept of cost pools:
When a resource or an expense can be directly allocated, an allocation base is established and the quantified amount will get allocated by satisfying the allocation logic. However, it’s often difficult to allocate general and remote costs to products directly. In order to overcome this impediment, companies often create a cost pool. Cost pool refers to small individual indirect costs that are accumulated into a common pool and then all of them are allocated to different activities or products using a single allocation base. Cost pools may include service department expenses or the equipment setup costs. Allocations from the pool will be on the basis of the allocation base by determining the cause and effect between costs and objectives. One should remember that any allocation i.e., the direct allocation or the indirect allocation from the pool should be realistic and there is no room for allocation inefficient costs into the product. It is therefore preferable that allocation is done either on the basis of standard allocation costs or the budgeted costs. Generally, variable cost pool and fixed cost pool are identified from the budgets drawn for the entity as a whole.
Arbitrary approaches to cost allocation:
There are three arbitrary approaches to cost allocation. The relative benefits approach takes into consideration as to which activity has derived the maximum benefit from the cost. Based on the benefits derived, costs are allocated in the proportion of what benefits each product or the activity has derived. In the ability to bear costs approach, it is considered useful to allocate more costs that have the maximum profit among the profit contenders. But this approach has the drawback of not identifying efficiencies among the contenders. In the equity approach it is believed that costs are to be allocated based on what is fair and equitable.
Impediments in cost allocation: There are certain problems beset with cost allocation. Efficient managers often face certain problems in cost allocation as they have to face the wrath of uncontrollable costs that are allocated to the products or activities that they control. Further when we allocate fixed costs, it will only mean that fixed costs are converting themselves into variable cost. If volume increases or decreases then it obviously means that the fixed costs also vary, which is not true. Irrespective of the volume we all know that fixed costs never vary. Also, the allocation base itself may be subjective and arbitrary and therefore requires fine tuning from time to time depending upon the changing situations and changes in the external environment.
In order to overcome the arbitrariness or the subjectivity and to be more realistic, the allocation based approach should consider the following aspects-
Proper determination of major activities that define the organization;
Proper identification of resources that are used by the contending opportunities within the organization;
The activity or the product is benchmarked for comparable products and services in the market;
Adopt best practices of allocation and adopt a rationale approach to cost allocation.
When the above approach is adopted, the subjectivity or the bias in cost allocation will reduce and will prove to be more useful than the traditional methods. Also, it will provide a basis for competing with similar products in the market by adopting cost reduction techniques.
Types of cost allocation: Basically there are 3 types of cost allocation.
Joint costs have to be appropriately allocated to the concerned product or service centre;
The supporting or the service departments have to further allocate to the ultimate product or service centre depending on the nature and type of service rendered.
Direct costs allocated to jobs, products or projects directly as they have a very close relationship with the product or the activity.
Having said this, it is important to understand that the cost allocation exercise has to be rational and realistic.
Allocation of central costs: Central costs have no real bearing on the variability of output. It would be proper to ignore allocating central costs. But many do believe that all costs have to be allocated. It is then that the question arises as to how this allocation has to be done. The cost deriver obviously has to be knowledgeable of the extent of usage of the central services by an activity or the product or the department. When we consider issues like legal and taxation services it is not the usage that is important but the bottom-line that has been contributed by the product. Hence, usage cannot be the only criteria for sharing the cost of central services. It is the cause and effect relationship that becomes important and not the usage. The allocation exercise has to be sensitive to this aspect and define proper polices for central cost allocations to products.
Allocation of service department costs to products: The existing literature on service cost allocation speaks of three methods. It includes the Direct Method, the Step-Down Method and the Reciprocal Allocation Method. The Direct Method allocates cost to the product divisions ignoring services rendered by other service department to it. It takes within its ambit all expenses incurred by the concerned service department and no part of allocated costs from other service departments are considered. In the Step-Down Approach it is believed that some service departments render service to other service departments and the production departments as well. The service department that provides service to maximum number of departments is chosen and in a sequential manner the costs are allocated. When once the service department costs are allocated, no other service department’s costs are allocated back to it. In the Reciprocal Allocation Method, it is to be understood that service departments provide services to each other apart from providing services to the production departments. Costs are allocated based on the extent of services provided by one to the other. Theoretically, this approach is the best alternative to all other methods. What method is used determines the extent of costs borne by products or a department and the costs can substantially vary depending on the method used.
Conclusion:
The traditional method of allocating costs was by looking at labor-hour costs or the machine-hour costs. But they no longer are good measures under the modern production methods. Most production methods are automated and labor intensity in production is gradually coming down, and has drastically come down in the western countries. We also know that cost allocation cannot also be based merely on volume of production. Cause and effect relationship provide accurate results in the cost allocation process in the present times. When labor-hours method or the machine-hour rates become inapplicable, then allocation based costing method or the activity based costing approach may be adopted by establishing the cause and effect relationship.