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Lesson 1a: Cost Concepts
Cost Allocation Bases
This is an extremely important concept, meaning you will use it repeatedly during the rest of the course! Learn it well!
Cost allocation bases are an extremely important subject that any student of managerial or cost accounting must master early in the course. Because there is no single "correct" way to allocate a particular cost, there is no single "right" answer when doing allocation. Still, estimates of cost are needed, making cost allocations necessary.
You should know from your high school math that the top of a fraction is called the "numerator" and the bottom is called the "denominator." The cost allocation base is the bottom or the denominator of the cost allocation fraction. For example, $200,000 manufacturing overhead divided by 10,000 machine hours equals $20 of manufacturing overhead per machine hour. In this case, machine hours are the allocation base.
Cost allocation = of manufacturing overhead per machine hour
Notice that whenever you do a fraction, you're always suppressing the denominator to one and saying how much numerator you have for every one of the denominator. Let's just say that in your hometown there are 1,000 dogs and 100 cats. Well, 1,000 dogs divided by 100 cats is 10 dogs per cat. If you flip it, and put the 100 cats over the 1,000 dogs, it is 0.1 cats per dog. You're always ending up with one of the denominator and saying how much of the numerator there is for that one of the denominator. If you keep that in mind, any fraction you learn is a pretty simple thing.
If you get into financing, you learn the debt-to-equity ratio, which is debt divided by equity. What does it tell you? It tells you the amount of debt for every one dollar of equity. Now you have to know how debt is defined. Is it just long-term liabilities or all liabilities? What do we mean by equity? Is it just stockholder's equity or is it creditor and stockholder's equity? But the point is that the fraction, debt-to-equity, is simply the amount of debt for every one dollar of equity.
We have unit level allocation bases. What do we mean by unit level? The allocation base changes proportionally with changes in production—if production goes up 10%, the base goes up 10%, and if production goes down 4%, the base goes down 4%. It is called unit level because it changes along with the units.
Let's look at three unit-level allocation bases:
- Direct labor hours: if you're going to increase production by 10%, then you should need 10% more direct labor hours.
- Direct labor dollars: if you're using 10% more direct labor hours, you're going to pay 10% more in direct labor dollars.
- Machine hours: if you increase production 10%, you're going to need to run the machines 10% longer.
So, these are all called unit level because they vary with the number of units produced. You can also have unit-level allocation bases that vary with the number of units sold. Sales commissions vary with the number of dollars sold, so commissions are unit level with respect to sales revenue.
Some costs are unit level. For example, factory machinery electricity is unit level. If you make 10% more units, you run the machines 10% longer and your electric bill is going to go up about 10%. Allocating it based on a unit-level allocation base such as machine hours is logical.
However, a unit level allocation base is often used to allocate costs that do not vary with the number of units produced. Factory building depreciation is not unit level. Allocating it with a unit-level allocation base can lead to misleading cost calculations. For example, your building depreciation is $1,000,000 a year and you make 200,000 units, so you say it is $5 a unit. Well, it is $5 a unit if you make 200,000 units. If you make 100,000 units, it would be $10 per unit. If you make 500,000 units, it would be $2 a unit. When you start using a unit-level allocation base to allocate something that is not unit level, people can start thinking it is unit level and make some very bad business decisions. That's something you need to watch out for in this situation.
Using Cost Drivers for the Allocation Base
For any cost allocation, it's preferable to use a cost driver as the denominator; that is, use a factor that actually causes the particular cost in the numerator to change.
When using a cost driver, focus on the one cost driver considered best suited for allocation. You might allocate "setup machines" cost using the number of setups or the number of setup hours. You might allocate shipping costs using the number of shipments or the weight of shipments, if weight is the most important factor.
Something to remember is that the best cost driver for allocating the cost may not be the most important cost driver for managing the cost. You shouldn't forget that other cost drivers exist. For example, you might allocate "setup machines" cost based on the number of setups; however, you might decide that decreasing the time needed to do a setup—setup hours—is the most important cost driver for managing the cost.
Sometimes you cannot use a cost driver to allocate a cost, because there is no cost driver. An example is straight-line depreciation of a factory building, which is based on the passage of time. You cannot logically allocate it using direct labor hours or number of setups or any other denominator that drives the cost, because it is strictly a function of time. We might allocate it based on square footage used by different products, which is logical, but changing the square footage used by any product does not change the depreciation. Where a cost driver is not available, there are other criteria for selecting an allocation base that will be covered in another presentation.