Accounting Business Reporting for Decision Making

CHAPTER 11 Costing and pricing in an entity 477

Department (cost pool) Allocation formula Indirect cost rate

Finance $150 000/5 000 invoices $30 per invoice

Personnel $120 000/100 employees $1 200 per employee

Computer services $300 000/60 computers $5 000 per computer

Step 3: Allocating indirect costs to the cost objects
Now that the indirect cost rate has been determined, allocation of the indirect costs can be under-
taken by applying the indirect cost rate to the cost object’s use of the cost driver. For Partridge Insur-
ance Company, indirect costs are allocated according to the cost object’s actual use of the cost driver.
For example, the indirect cost rate for the finance department is $30 per invoice. The home insurance
department raises 1500 invoices per year and so will be allocated $45 000 (1500 invoices × $30) to
cover its share of the costs incurred by the finance department.
Indirect costs are assigned to individual cost objects by multiplying the indirect cost rate by the cost
object’s use of the cost driver.

Home insurance Car insurance Life insurance

Finance $45 000

(1500 invoices × $30)

$60 000

(2000 invoices × $30)

$45 000

(1500 invoices × $30)

Personnel $60 000

(50 employees × $1200)

$36 000

(30 employees × $1200)

$24 000

(20 employees × $1200)

Computer services $125 000

(25 computers × $5000)

$125 000

(25 computers × $5000)

$50 000

(10 computers × $5000)

Indirect costs $230 000 $221 000 $119 000

Step 4: Determining the full cost of each cost object
The full cost for each of the cost objects can now be determined. You will notice that the total cost of
$1 770 000 (refer to original information) has now been assigned to the three cost objects — the oper-
ating departments.

Home insurance Car insurance Life insurance Total costs

Indirect costs

(allocated from service

departments)

$230 000 $221 000 $119 000 $ 570 000

Direct costs 500 000 400 000 300 000 1 200 000

Full cost $730 000 $621 000 $419 000 $1 770 000

This example highlights the different lenses that have been used to view the costs — the total cost
for the entity, the costs of the individual departments, and the full cost of each operating department.
Partridge Insurance Company can now use the data from the allocation process in many ways, for
example:
• to determine the full cost of each operating unit
• to review current premiums on insurance policies
• in strategic management — making decisions about which insurance policies to offer in the future
based upon the profitability analysis of each type of policy
• in cost management — if individual operating department managers believe that the charges are too
high, they will pressure the service departments to lower costs.
The above process for determining the full cost of the operating departments can be used to deter-
mine the full cost of any cost object. Obviously there may be different cost pools and different cost
drivers; however, the process will be the same. In the following section we illustrate how the costing
system is structured to meet the requirements of the accounting standards for determining inventory
valuation for manufacturing entities.