Accounting Business Reporting for Decision Making

470 Accounting: Business Reporting for Decision Making

11.4 Allocation process

LEARNING OBJECTIVE 11.4 Calculate the full cost of a cost object.

To determine the full cost for any cost object, direct costs are traced and indirect costs are allocated

based on the cost object’s usage of the chosen cost driver(s) (allocation base). The indirect cost allo-

cation formula is used to calculate the rate at which indirect costs will be assigned:

Indirect costs to be allocated

=Indirect cost rate per unit of cost driver

Total cost driver usage

The allocation process involves three phases.

1. Structure the indirect cost allocation formula. This requires identifying the indirect costs to be allo-

cated, and selecting the cost driver that will link the indirect cost to the cost object.

2. Calculate the indirect cost rate. This is done by dividing the indirect costs by the total cost driver usage.


3. Allocate the indirect cost to the cost object. This is calculated by multiplying the indirect cost rate by

the cost object’s use of the cost driver.

To develop the indirect cost allocation formula, the entity must first decide on the number

of indirect cost pools in its costing system; that is, whether there is to be one or many. An indi-

rect cost allocation formula will then be developed for each indirect cost pool. A cost pool is a

grouping of ‘similar’ costs that can be classified on a departmental basis, an activity basis, or on

some other criterion for grouping. Breaking down the entity’s costs into different cost pools indi-

cates that different cost drivers are needed to explain the cost object’s resource consumption. The

complexity or sophistication of the cost allocation system (i.e. the number of cost pools to be used

to allocate indirect costs) will be determined by comparing the cost of collecting detailed data

against the cost of error in decision making that arises from having a less accurate measure of

full cost.

An entity may choose to measure the indirect costs using actual costs or budgeted costs, or

even further classify them according to cost behaviour (fixed or variable). The determination of

an actual indirect cost rate (which is the rate used to assign actual indirect costs based on a cost

object’s actual use of the chosen cost driver) will not be possible until the end of the financial period,

when actual results are known. Also, if the actual indirect cost rate is calculated on a monthly basis, it

can vary from month to month due to fluctuations in the cash flow pattern. To overcome this delay in

obtaining information and to smooth out fluctuations in cash flows, entities will often use budgeted costs

to calculate a predetermined indirect cost rate. This is the estimated level of indirect cost divided by

the estimated level of the cost driver. The use of budgeted costs will also provide a benchmark against

which actual costs can be measured to assess both cost variances and performance, and to assist in

budget preparation and pricing.

As the number of cost pools increases, the accuracy of the cost information is also increased, as a dif-

ferent cost driver will be used for allocation purposes that best explains resource consumption. However,

as the number of cost pools increases, the need to collect information about individual cost drivers also

increases. This will lead to an overall increase in the cost of the system due to the level of resources

needed to undertake the cost assignment and data collection.

Therefore, once the cost driver has been identified for each cost pool, the total use of the cost driver

for the financial period under investigation will need to be determined. Cost driver usage will be based

on either the budgeted or actual usage to match the type of indirect costs to be allocated. By dividing the

total indirect costs by the total use of the cost driver, a measure of the cost per unit of the cost driver will

be calculated. The determination of this indirect unit cost rate allows the indirect costs to be allocated to

the many cost objects that have made use of the resource. Allocation will be based on each cost object’s

use of the cost driver.