Question

What cost allocation method is appropriate for different type of assets? How do managers know what method to use?

Answer 1

In order to distribute costs within the organisation, various methods have been developed to Allocate the Cost.

Generally three methods of Cost Allocation are followed:

a. DIRECT METHOD: This is the simplest method of all. Under this method, Service Department Costs are directly allocated to other Operating Departments as per their use. Use by other Service Departments is ignored.

This method is generally used by Managers when Service Departments offer services only to Operating(Manufacturing) Departments and not too other Service Departments.

b. STEP DOWN METHOD: Under this method, Service Department Costs are alocated to other Service Deaprtments Operating(Manufacturing) Departments in a sequential manner. The Service Department whose costs are highest are allocated first of all to other Departments and then the process continues with other Service Departments.

THis method is little complicated from Direct Method but gives better cost allocation results. The step method shows a relationship between service departments and once the service department cost has been allocated, we do not refer back and allocate costs to that department.

c. RECIPROCAL METHOD: This method is most complicated but gives most accurate results. This method allocates services department costs to operating(manufacturing) departments and other service departments. Under it, the relationship between service departments is recognized and cost is allocated to and from each service department.

These methods are selected based on the complexity involved in the operations, availability of cost data, manager's judgement and decision and accuracy of results.