How to Justify Cost Allocation Decisions in Cost Accounting
In cost accounting, justifying cost allocation decisions is important. Your justification verifies that you’re selecting the method that allocates costs most accurately. If you can defend your choice of an allocation method, it’s likely that you’ve selected the best one.
Consider these four criteria that support your cost allocation decisions. Most organizations use one of these four criteria to support their cost allocation decisions:
Document the activity that caused the costs to be incurred.
Identify the benefits received as a result of incurring the cost.
Justify that the cost is reasonable or fair with the other party in a contract.
Show that the cost object has the ability to bear the cost.
The cause-and-effect criterion relates to activity-based costing concept. Say you make several kinds of ovens. You pay labor costs to change machinery setups to switch from making one model of oven to making a different model. The activity (setups) is driving the cost (labor hours). You then allocate more cost to the model oven that requires the most machinery setups.
Consider who might benefit from your spending. Say your product engineers make design changes to the ovens you produce. As a result, you notice that oven repairs under warranty decrease, and that reduces your warranty expense (repair costs). The lower cost of the change should be assigned to the new products, because they benefited from the change.
Businesses might sign contracts with customers. Think about that factory-building contract earlier in this chapter. Every industry has cost levels that are considered reasonable or fair. You may assign costs to the customer based on these levels that typically occur in the industry.
Think about a fixed overhead cost for insurance. You pay insurance premiums to cover a job site against theft or damage. Every builder incurs that cost. So everyone in the industry has an idea about a fair and reasonable cost of insurance. That’s how you can justify your cost to the customer.
The more revenue and profits your division generates, the more costs you can bear (incur). Say you’re deciding how to allocate the cost of your corporate headquarters (building, insurance, and salaries of head-office staff) to each company division. You might decide to allocate costs based on the percentage of total profit each division produces. If, for example, the Midwest division generates 30 percent of the profit, it would get 30 percent of the head-office cost.
The biggest arguments often seen in companies have been over indirect cost allocations. Compensation, bonuses, and promotions are calculated on costs and profits, so there’s a lot riding on the cost allocations to a division or department. If a cost allocation is increased, the manager might miss a profit goal and take a hit on his own personal compensation.
You can imagine the conversations. Why should we get that large cost allocation? We’re the ones who are carrying the company. You’re punishing our division for being successful! What’s the motivation for increasing revenue and profit — you’re just going to allocate more costs.
As an owner, you need to consider how you evaluate managers. In particular, how do you fairly judge the manager who gets a big allocation of head-office costs? Evaluate the manager’s profit before counting the corporate-office cost allocation. In that way, the division manager isn’t punished for a large cost allocation based on his or her division’s profit total.