Question

What are the four purposes of cost allocation?

Why should budgeted cost rates, rather than actual cost rates, be used for allocating the variable costs of service departments?

Answer 1

Solution:

1. The four purposes of cost allocation are indirect costs to cost objects such as products, distribution channels and customers.

Purpose	Illustration
To provide information for economic decisions	To decide whether to add a new airline flight
To motivate managers and employees	To encourage the design of products that are simpler to manufacture or less costly to service
To justify costs or calculate reimbursement	To cost product at a fair price often done with government defense contracts
To measure income and assets for meeting external regulatory and legal reporting obligations	To cost shares for financial reporting to shareholders, bondholders and so on

Consider product costs of the following business functions in the value chain: Research and development---design---production----marketing----distribution------customer service.

2. Budgeted cost and budgeted cost activity are planned in advance or the next period. From this data a predetermined overhead rate is computed.

• This predetermined overhead rate is used to allocate the overhead costs of service department to producing departments.
• Actual costs are available at the end of the period. If actual costs are used for computing the rate of allocation, the preparation of costing records will be delayed. Actual cost activity data will be computed after the end of the period, which may take some time.
• Thereafter, the process of allocation of costs of service department will be completed.
• To overcome this delay in preparation of costing records, predetermined overhead rate, based on budgeted cost data is used, instead of actual.