In cost accounting, if you use actual usage to allocate costs, one division’s change in usage has an impact on another division’s cost. If one division has higher or lower actual usage than budgeted, the cost allocations can change.
As a division manager, when you’re dealing with actual costs, you’re dealing with two unknowns. You won’t know your actual cost until the end of the period. And your cost allocation may be higher or lower, depending on the actual usage of other divisions.
Now be a CEO or CFO, not a division manager. Say you manage a business with a residential and commercial division. You allocate all $1,000,000 of your actual shipping department fixed costs. The allocation is based on the percentage of total hours used by each division. The first table lists the shipping department fixed cost allocation for the previous year.
| Budgeted Usage (Hours) | Percent Usage Hours | Cost Allocation |
|---|---|---|
| Residential division | ||
| 1,500 hours | 45.45 | $454,545 |
| Commercial division | ||
| 1,800 hours | 54.55 | $545,555 |
| Fixed costs allocated | $1,000,000 |
Take a look at the residential division. That division’s percentage of the total usage hours is 45.45 percent (1,500 hours ÷ 3,300 hours). The table then computes 45.45 percent of $1,000,000 in fixed costs, which is $454,545.
You decide to allocate fixed cost using actual costs this year. The residential-division manager needs some sort of cost allocation total to plan for the year. After all, the division manager can’t price the product without knowing all the costs.
One of those costs is the division’s cost allocation for the shipping department. After staring out the window for a minute, the division manager decides to budget using last year’s allocation.
Now consider what would happen if the commercial division uses fewer shipping department hours than last year. At year-end, you determine that the commercial division used 1,200 hours. The residential division used 1,500 hours, the same as last year. The results are shown in the second table.
| Budgeted Usage (Hours) | Percent Usage Hours | Cost Allocation |
|---|---|---|
| Residential division | ||
| 1,500 hours | 55.56 | $555,556 |
| Commercial division | ||
| 1,200 hours | 44.44 | $444,444 |
| Fixed costs allocated | $1,000,000 |
Over at the residential division, the manager pulls up the shipping cost allocation report — and nearly chokes on a breakfast bagel. The residential division’s allocation is over $100,000 higher than last year! “Wait a minute. My division had the same 1,500 hours of usage as last year,” the manager says (to no one in particular). Then he realizes what happened.
The entire $1,000,000 fixed cost is allocated between two divisions. The cost allocation is based on total actual usage for both divisions. If one division uses less (in usage hours), the other division is allocated more costs. At that point, the residential manager’s blood pressure starts to go back down. He isn’t any happier, but at least nobody’s going to have a stroke.