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How to Allocate Costs Using Cost Hierarchy in Cost Accounting

In cost accounting, cost hierarchy is a methodology that allows you to allocate costs more specifically, and that’s good. Think of it this way: you have a “bucket” of costs. When you start taking costs out of the bucket, where do they end up? Maybe they end up attached to a unit.

Or it might be broader. You could attach the costs to a batch (a group of units), and that’s often a more accurate way to allocate. You could expand the allocation even more broadly to an entire company division.

The benefit of performing any cost analysis should be greater than the cost to obtain it. Cost allocations may become complex. Complexity costs more, and you need to educate managers on how the cost allocations were derived. The managers will be concerned about how the cost allocation impacts their performance. You need to be prepared to justify your cost allocations. (That’s why the company chief financial officer makes big money.)

Say you manage a company that makes refrigerators. You have a residential division and a commercial division. Your commercial customers are grocery stores that need refrigeration. Each division sells three different models. You have determined the cost hierarchies and cost allocation bases for your three largest indirect costs. (Recall that a cost allocation base is the type of activity you use to allocate costs.)

Cost Hierarchies and Cost Allocation Bases
Activity Cost Cost Hierarchy Allocation Base
Manufacturing Plant utility cost Unit level Machine hours
Machine setup Labor cost Batch level Setup hours
Administration Head-office salary Facility sustaining Company-wide revenue

You could allocate your plant’s utility cost (heating, lighting, and so forth) to each unit you produce. When you change from making one refrigerator model to another, you incur setup cost to change your machinery settings, so you’d likely allocate setup labor cost to batches.

Say you need the ongoing administrative services (such as legal and accounting) provided by the head office, and that suggests allocating the cost company-wide. However, you can likely allocate head-office administrative cost to divisions, based on each division’s percentage of total revenue.

Ideally, all costs are eventually allocated down to a unit of product. After all, you don’t sell batches; you sell units of product. So you attach all costs to a unit of product. When you sell a unit, you recover all of your product costs — as well as earn a profit.

Allocating all costs to a unit is not always possible. Keep in mind that all costs are totaled and posted to your financial statements. Whereas an individual unit may not absorb the cost, your overall company profit or loss is affected by the cost.

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