Activity Based Costing

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Cost Allocation Definition¶ All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client's needs and circumstances. But what about cost allocation's other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)? Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or…show more content…
Implementing Activity Based Costing¶ The steps involved in activity based costing are: 1) Clarify the purpose of the allocation, defining why the need to allocate these costs exists and defining the benefit of doing so. 2) Identify support and operating department cost pools; 3) Select an allocation base or cost driver for each support department cost pool based on a cause-and-effect relationship between the support departments and the operating/production departments. 4) Choose and apply a method for allocating support department costs to operating/production departments. The three most widely used methods are the direct method, the step-down method, and the reciprocal method, all of which will be discussed shortly. 5) Once the allocation of support costs to the operating departments is complete, cost drivers are selected for the newly formed cost pools (production/operating department overhead costs) and costs are then allocated to the units of goods or services. Direct Method of Allocation¶ Before we continue, it would be good to discuss the three methods discussed in step 4. The direct method allocates costs directly from the support departments to the operating departments that use its services. Example: the personnel department might allocate its overhead (i.e., ALL of its

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