Briefly describe the following cost allocation terms in advanced management accounting study

Briefly describe the following cost allocation terms in advanced management accounting study

(Terms used in Chapter 5)

 

1.    Cost pool determination

2.    Allocation bases

3.    Cost drivers

4.    Cost hierarchies

5.    Cost assignment

 

These terms describe how an organisation groups indirect costs and links them to products, services, customers, or departments (the cost objects) in a way that is as causally meaningful as practicable.

1. Cost pool determination

The process of grouping related indirect costs into a cost pool because they share a common cause or activity. Each pool should be sufficiently homogeneous—its costs should respond to the same principal driver.

Example: machine depreciation, machine maintenance, and machine electricity may form a machine-processing cost pool if they are mainly driven by machine-hours.

2. Allocation bases

A measurable factor used to distribute the cost in a pool among cost objects. It is the operational measure used in the calculation:

Allocated cost = (Total cost pool/ Total allocation-base quantity) × Cost-object’s base quantity

Typical allocation bases include direct labour-hours, machine-hours, floor area, purchase orders, number of production runs, or number of inspections. Ideally, the base has an observable cause-and-effect relationship with the relevant cost pool.

3. Cost drivers

A cost driver is the underlying activity or factor that causes a cost to arise or change. When that driver is used specifically to allocate costs, it becomes a cost-allocation base.

For example, the number of setups drives setup-related costs; the number of purchase orders drives purchasing costs. Advanced systems such as activity-based costing (ABC) use several activity-specific drivers rather than relying only on volume measures such as labour-hours.

4. Cost hierarchies

A cost hierarchy classifies costs according to the level of activity that causes them. It prevents the mistake of assigning all overhead using one unit-level measure.

·      Unit-level costs: Incurred for each unit produced, such as machine power per machine-hour.

·     Batch-level costs: Incurred whenever a batch is processed, such as setup or inspection costs.

·  Product- or service-sustaining costs: Support a particular product line regardless of volume or batches, such as product design or engineering changes.

·  Facility-sustaining costs: Support the organisation overall, such as plant security, rent, or senior management.

5. Cost assignment

Cost assignment is the overall process of attaching costs to cost objects. It includes:

Direct tracing: Identifying a cost directly with a cost object—for example, materials used in a specific product.

Driver tracing: Linking costs through a cause-and-effect driver—for example, assigning setup costs using number of setups.

Allocation: Apportioning indirect costs using a selected allocation base when direct or driver tracing is not feasible.

Thus, allocation is one method within the broader process of cost assignment. The objective is to provide a decision-useful measure of the resources consumed by products, services, customers, departments, or activities.

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