Question

1 (a). Define the followings:

Cost pool

Cost driver

Direct cost allocation

Step-down cost allocation

Direct Cost

Indirect Cost

Fixed cost

Variable cost

(b) Effective cost drivers, and hence the resulting cost allocation system, must have what two important attributes?

(c) What is the better cost driver for the costs of a hospital’s financial services department: patient services department revenues or number of bills generated? Explain your rationale.

Answer 1

A) Cost Pool - Cost Pool refers to all those costs of goods as well as services which are attributable to a particular business line or manufacturing unit within an organization.

Cost Driver - Any activity that leads to the change in the cost of the underlying activity is referred to as Cost Driver.

Cost Allocation - Cost Allocation is a process by which the cost pertaining to the entire organization is distributed or apportioned among the various units within the organization. the apportionment is done on various basis such as floor/space used (in sq feet) etc.

Step-Down Cost Allocation - It is a process wherein the cost incurred in the service departments are allocated to other service departments as well as operating departments. For e.g., the cost incurred in Service department 1 is allocated to Service department 2, Operating department 1 and 2 on the basis of employee hours used. Similarly, cost incurred in the Service department 2 along with the cost that was attributed to it by the service department 1 shall be allocated to the Operating departments 1 and 2 on the basis of space/floor occupied in the respective departments.

Direct Costs - Costs which are directly attributable to the production, selling of goods or services are known as Direct Costs. - For e.g., direct material cost, direct labour cost, piece rate wages, sales commission etc.

Indirect Costs - All those costs which are not directly related to the production or manufacturing of the goods or provision of services are referred to as Indirect Costs. For e.g., For a manufacturing unit, rent of space where the manufacturing plant has been installed is an indirect cost as it directly does not support in the manufacturing process but allows the plant to be installed in that space which is used in the production of the goods.

Fixed Costs - These costs are not related to the level of goods being produced or sold or to the amount of services being provided. These costs are usually time related costs like interest, rent etc.

Variable Costs - These are those costs which are directly related to the level of production of goods or provision of services. these costs are said to quantity/volume related costs. For e.g., raw materials used in the manufacture of a goods is directly related to the quantity of the output being produced.

B) The two most important attributes of the allocation system using effective cost drivers are as follows:

1. Cost controls - Prevents over utilization of overheard costs.

2. Fairness - Assures fair allocation of the cost to the departments.

C) The effective cost driver in case of a hospital's financial services department shall be the Number of Bills Generated. The reason being that the revenue is usually directly related to the input and therefore the services used can be attributed to the the number of bills generated.