How do you allocate indirect manufacturing costs to cost objects?

Under absorption costing, all direct and indirect manufacturing costs must be assigned to products for inventory valuation. Ideally, costing should assign to products the cost of the resources they consumed, all the resources they consumed, and only the resources they consumed. That way, there is no risk of cross-subsidization:

Cross-subsidization happens when resources consumed for some cost objects are mistakenly assigned to other cost objects. All costs are then distorted because some cost objects bear the cost of other cost objects. In other words, some products are over-costed while other products are under-costed.

Direct manufacturing costs are easy to assign to cost objects because the cost object using the resource is clearly identified at the cost accumulation stage (the cost is traced or “directly assigned”). Unfortunately, which cost objects consumed the resource is by definition unclear for indirect manufacturing costs. They cannot be traced efficiently, so they are first gathered in cost pools waiting to be allocated (i.e. “assigned indirectly”) in proportion of each cost object’s usage of an allocation base.

A cost pool is a grouping of individual indirect cost items.

An allocation base is a measure of activity (input, throughput or output) used to determine the amount of indirect cost to be allocated from a cost pool to each cost object causing this activity.

Cost allocation techniques are designed to assign as efficiently as possible indirect manufacturing costs to cost objects in proportion of each cost object’s actual use of these resources. They are simplifications of costing, compared to their expensive alternative which consists in tracing every resource from their origin to their destination. Now, there are several other simplifications of allocation itself which can be considered in specific circumstances.

In this section, I will present the different ways to allocate indirect manufacturing costs (first for common costs, then for joint costs), from the simplest to the most accurate, systematically explaining when a more expensive approach might be justified. Indeed, you should always start simple and inexpensive and, only if this is not good enough, increase progressively the complexity (and thus the costs) until such increases are not worth it anymore.

Technically, allocation consists in accumulating indirect costs in various cost pools and then emptying these cost pools into cost objects by multiplying the quantity of each cost pool’s allocation base used by each cost object by the cost pool’s allocation rate. In this section, you will learn about how to define cost pools, select allocation bases, and compute allocation rates.

At the end of this section, you should be able to:

  • define cost pools for common costs;
  • select an allocation base for each cost pool of common costs;
  • allocate indirect manufacturing costs using the direct allocation method;
  • allocate indirect manufacturing costs using the sequential allocation method;
  • allocate indirect manufacturing costs using the reciprocal allocation method;
  • select an allocation base and compute allocation rates for joint costs;
  • evaluate the situated appropriateness of a cost allocation system.

In Excel, you should also be able to:

  • use matrix computations.

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