Question

Answer the following question in your own words. Your answer must have a 150 minimum word count:

• Describe the three (3) primary methods of cost allocation and describe how they differ.

Answer 1

THE INSTITUTE OF COST AND MANAGEMENT ACCOUNTANTS, LONDON DEFINES THE COST ALLOCATION AS "THE ALLOTMENT OF THE WHOLE ITEMS OF COST CENTRES OR COST UNITS". COST ALLOCATION IS A DIRECT PROCESS OF ASSIGNING THE ITEM OF THE OVERHEAD COST OF DEPARTMENT WITH WHICH IT CAN BE IDENTIFIED . ALLOCATION OF COST OR OVERHEADS IS POSSIBLE WHEN THE NATURE OF EXPENSE IS SUCH THAT IT CAN BE EASILY IDENTIFIED WITH THE PARTICULAR COST CENTRE.

METHODS OF COST ALLOCATION

1. DIRECT REDISTRIBUTION METHOD UNDER THIS METHOD OVERHEADS OF SERVICE DEPARTMENTS ARE DIRECTLY APPORTIONED TO PRODUCTION DEPARTMENTS TOTALLY IGNORING THE SERVICES RENDERED BY ONE SERVICE DEPARTMENT TO ANOTHER SERVICE DEPARTMENT. THE METHOD IS SIMPLE INVOLVING LESS CALCULATION. IT FAILS TO GIVE TOTAL OVERHEAD COST OF OPERATING DIFFERENT SERVICE DEPARTMENTS. THE METHOD FAILS TO OFFER SOUND BASIS FOR BUDGETING CONTROLLING OVERHEADS & DETERMINING ACCURATE OVERHEAD ABSORPTION RATES. HOWEVER, THE METHOD CAN BE USED BY SMALL ORGANIZATIONS WHERE SERVICE DEPARTMENT COSTS ARE ALSO RELATIVELY SMALL.

2. STEP DISTRIBUTION METHOD OR GRADED DISTRIBUTION METHOD OR STEP LADDER METHOD: THIS METHOD INVOLVES APPORTIONMENT OF OVERHEADS OF SERVICE DEPARTMENTS TO OTHER SERVICE DEPARTMENTS ON NON-RECIPROCAL BASIS UNDER THIS METHOD, THE SERVICE DEPARTMENT WHICH PROVIDES SERVICES TO THE OTHER SERVICE DEPARTMENT BUT DOES NOT AVAIL SERVICES FROM THE OTHER SERVICE DEPARTMENT RANK FIRST FOR DISTRIBUTION. HOWEVER, IF THE SERVICE DEPARTMENTS PROVIDE RECIPROCAL SERVICES & THIS METHOD OF SECONDARY DISTRIBUTION IS TO BE USED, THEN THE SERVICE DEPARTMENT WHICH PROVIDES MORE SERVICE TO THE OTHER SERVICE DEPARTMENT & AVAILS LESS SERVICE FROM THE OTHER SERVICE DEPARTMENT SHALL RANK FIRST FOR DISTRIBUTION ANOTHER METHOD OF RANKING IS THE AMOUNT OF COST OF SERVICES RENDERED. HENCE, THE SERVICE DEPARTMENT WHOSE COST OF SERVICES RENDERED IS MORE THAN THE COST OF SERVICES AVAILED RANKS FIRST FOR DISTRIBUTION. THE SEQUENCE HERE BEGINS WITH THE DEPARTMENT THAT RENDERS SERVICE TO THE MAXIMUM NUMBER OF OTHER SERVICE DEPARTMENTS.

3. RECIPROCAL SERVICE METHOD: THESE METHODS ARE USED WHEN DIFFERENT SERVICE DEPARTMENTS RENDER SERVICES TO EACH OTHER, IN ADDITION TO RENDERING SERVICES TO PRODUCTION DEPARTMENTS. THUS, VARIOUS SERVICE DEPARTMENTS ARE MUTUALLY DEPENDENT. IN THIS CASE TOTAL OVERHEADS OF SERVICE DEPARTMENT ARE ITS OWN SHARE OF OVERHEADS UNDER PRIMARY DISTRIBUTION PLUS A SHARE OF OVERHEADS OF TOTAL OVERHEADS OF OTHER SERVICE DEPARTMENT. IN THE SAME WAY TOTAL OVERHEADS OF SI DEPARTMENT ARE ITS OWN SHARE UNDER PRIMARY DISTRIBUTION PLUS ON APPROPRIATE SHARE OF TOTAL OVERHEADS OF FORMER SERVICE DEPARTMENT. SUCH REDISTRIBUTION ON RECIPROCAL BASIS MAY BE DONE WITH THE HELP OF SIMULTANEOUS EQUATIONS OR THROUGH REPEATED DISTRIBUTION OR ACCORDING TO TRIAL & ERROR METHOD

• SIMULTANEOUS EQUATION METHOD: TOTAL OVERHEADS OF EACH SERVICE DEPARTMENT ARE ASCERTAINED WITH THE HELP OF TWO SIMULTANEOUS EQUATIONS & THEN THE OVERHEADS SO ASCERTAINED ARE REDISTRIBUTED TO PRODUCTION DEPARTMENTS BASED ON GIVEN PERCENTAGE SHARE PREDETERMINED BY TECHNICAL ESTIMATES
• REPEATED DISTRIBUTION METHOD: UNDER THIS METHOD OVERHEADS ASCERTAINED AS PER PRIMARY DISTRIBUTION ARE ARRANGED IN ON NOW & THEN OVERHEADS OF SERVICE DEPARTMENTS ARE DISTRIBUTED & REDISTRIBUTED TO ALL DEPARTMENTS TILL THE OVERHEADS IN SERVICE DEPARTMENT BECOME NEGLIGIBLE. AT THIS STAGE OVERHEAD OF SERVICE DEPARTMENT IS DISTRIBUTED TO PRODUCTION DEPARTMENTS ONLY
• TRIAL & ERROR METHOD: UNDER THIS METHOD THE COST OF FIRST SERVICE DEPARTMENT IS APPORTIONED TO OTHER SERVICE DEPARTMENT ONLY AT A GIVEN PERCENTAGE. THE COST OF THE SECOND SERVICE DEPARTMENT IS THEN APPORTIONED TO THE FIRST SERVICE DEPARTMENT. THE PROCESS IS REPEATED TO THE COST OF A SERVICE DEPARTMENT REQUIRING APPORTIONMENT BECOMES NEGLIGIBLE. TOTAL OF OVERHEADS OF EACH SERVICE DEPARTMENT AS PER PRIMARY DISTRIBUTION PLUS OVERHEADS APPORTIONED IN DIFFERENT STAGES GIVES TOTAL OVERHEADS OF EACH SERVICE DEPARTMENT

ALL THE THREE RECIPROCAL SERVICE METHODS WILL GIVE APPROXIMATELY THE SAME APPORTIONMENT