Question

On page 180 of the text there is a very simple personal example of three roommates who set up cost allocation. The allocation was for rent, TV, internet and groceries. The the cost allocation system was using the three roommates as equals so the cost allocation was the total cost divided by three. That method worked our for a short period of time then each roommate found specific reasons why that cost allocation system did not work "fairly". One example was: "well since I now am really focused on school work I don't watch TV, so I should not have to pay for the cable TV".

Although this is a simple personal example, it does highlight how with any cost allocation system there can be and usually are issues. For your post, provide either a personal or professional example of a cost allocation. Then, with that cost allocation, identify any issues that you were aware of with that methodology.

180 CHAPTER 4 Why and How do Companies Refine Their Cost Allocation Systems? Organizations from Dell to Carolina Power and Light to the U.S. Marine Corps use refned cost allocation systems. Why? Because simple cost allocation systems don't always dos good job of matching the cost of overhead resources with the products that consume thow resources. The following example illustrates why Simple Cost Allocation Systems Can Lead to Cost Distortion David, Matt, and Marc are three college friends who share an apartment. They agree to split the following monthly costs equally Rent and utilities. S57 Cable TV... 50 High-speed intemet access. 40 Groceries.. 240 Total monthly costs.... 5900 Each roommate's share is $300 (S900/3) Things go smoothly for the first few months. But then David calls a meeting "Sing I started having dinner at Amy's cach night, I shouldn't have to chip in for the groceries Matt then pipes in: "I'm so busy studying and using the internet that I never have time to watch TV. I doa't want to pay for the cable TV anymore. And Marc, since your friend Jennifer eats here most evenings, you should pay a double share of the grocery bill" Marc replies, "If that's the way you feel, Matt, then you should pay for the internet access since you're the only one around here who uses it!" What happened? The friends originally agreed to share the costs equally. But they are not participating equally in watching cable TV, using the internet, and eating the groceries. Splitting these costs equally is not equitable. The roommates could use a cost allocation approach that better matches costs with the people who participate in the activities that cause those costs. This means splitting the cable TV costs between David and Marc, assigning the internet access cost to Matt, and allocating the grocery bill one-third to Matt and rwo-thirds to Marc. Exhibit 4-1 compares the results of this refined cost allocation system with the original cost allocation system. No wonder David called a meeting! The original cost allocation system charged him $300 a month, but the refined system shows that a more equitable share would be only $215. The new system allocates Mare $375 a month instead of $300. David was paying for resources he did not use finternet and groceries), while Marc was not paying for al of the resources (groceries) he and his guest consumed. The simple cost allocation sysen the roommates initially devised had ended up distorting the cost that should be charged to each roommate: David was overcharged by $85 while Matt and Marc were wndercharges by an equal, but offsetting amount ($10+ $75 $85). Notice that the total "pool monthly costs ($900) is the same under both allocation systems. The only difference is how the pool of costs is allocated among the three roommates.

Answer 1

In my Office, the below mentioned expenses were incurred and allocated to various department on equal basis.

The expenses allocated were as below:-

• Rental expense of the Office $ 10,000
• Insurance expense of the Employees $ 5,000
• Depreciation of the computers $ 7,000
• Training Expenses $ 8,000

All these expenses were allocated to the below department equally:-

• Finance Department
• HR Department
• IT Department
• Operations Department

Now, as can be seen from the current methodology, every department have been allocated a cost of $ 7,500, but if we analyze the cost drivers for the above expenses, then we can conclude that the following issues are there in the current methodology of cost allocation:-

1. Rental expense of the office should be allocated on the basis of area occupied by each department instead of allocating it equally. The area occupied by each department was as follows:-

Finance - 200 Sqft ; HR - 150 Sqft ; IT Department - 250 Sqft; Operations - 400 Sqft

2. Insurance is taken for the employees, hence it should be allocated on the basis of number of Employees per department, instead of allocating it equally. The department wise Employee count is as follows:-

Finance - 10 Employees ; HR - 4 Employees; IT - 10 Employees; Operations - 26 Employees

3. Depreciation on computers should be allocated on the basis of no of Computers used by each department, instead of allocating it equally. The department wise computer count is as follows:-

Finance - 10 Computers; HR - 3 Computers ; IT - 12 Computers; Operations - 10 Computers

4. Training is generally done for every department equally, hence it should also be allocated on the basis of no of employees per department, instead of allocating it equally.

Now if we change the allocation policies as per the above recomendations, then the revised cost allocation per department will be as follows:-

Basis for Nature of cost lallocation Rental expense of office Area occupied Insurance expenses of Employees No of Employees Depreciation of Computers No of Computers Training Expenses No of Employees Total Total Cost incurred 10,000 5,000 7,000 8,000 30,000 Allocation to Finance 2,000 1,000 2,000 1,600 6,600 Allocation to HR 1,500 400 600 640 3,140 Allocation Allocation to to IT Operations 2,500 4,000 1,000 2,600 2,400 2,000 1,600 4,160 7,500 12,760

As it can be seen from the above calculations, if we adopt this method, then the cost allocated to Operations department will increase significantly, being the largest department of the organization, whereas the cost allocated to HR department will decrease significantly, being the smallest department of the organization.

Hope this example fits in aptly !!