Cost allocation methods and applications

¶ … Allocation

Keeping track of the costs is a crucial part of running a business. Cost allocation is assigning common costs to several cost objects. Cost allocation methods are used as a management accounting tool that helps in getting an accurate idea of costs that are associated with various departments in an organization. Proper cost allocation is an important element in making sure that any organization is run efficiently and cost effectively. There are different cost allocation methods that can be used in an organization. The common cost allocation methods are direct allocation method and the step-down method (Monico, & Fiertz, 2002).

Direct allocation method

This is the most popular method that is used for cost allocation. It involves the allocation of all service departments cost to the production department and does not factor in the fact that the service department offers services to other departments. The costs of manufacturing service department are therefore directly allocated to the production department of the company and to the product itself. It is the simplest method of allocating cost and used in cost allocations in all companies worldwide. Under this method of cost allocation, the service department costs of a department are not allocated to any other service department regardless of the circumstance. Though it does not seem fair for the costs of manufacturing services such as factory administration and maintenance to be allocated to the production department there is a justification as to why companies allocate cost of service production (Audit IT, 2014).

Step-down method

This method takes into account that certain costs are incurred by the maintenance and HR departments. It ranks the service departments according to the importance and then uses various steps for allocating the costs to the various products that are involved. The managerial accountant choses a sequence whereby the service department costs will be allocated. A common way used to sect the first department in the sequence is by choosing one which serves the largest number of the other service departments. The service departments are then ordered in a way that the last service department is the one which serves the smallest number of other service departments. The managerial accountant then allocates costs to each of the service departments. This method is more complicated compared to the direct method of allocating costs but its results are more accurate when it comes to allocation of costs (Monico, & Fiertz, 2002).

Cost allocation method for patient-level costs

The common cost allocation method for patient-level costs is the direct allocation method. This involves the direct allocation of an individual patient's episodes using the service volumes. Under the direct allocation method the service volumes such as the actual tests that are conducted on the patient, the minutes they spend in theatre and the prices of the drugs the patient has been prescribed are allocated. Each of the costs of the service volumes are noted down and put together and the total is the cost allocation for that individual patient. This direct cost allocation method is the most appropriate for patient level costs because it minimizes assumptions that can be used to allocate funds. This means that there will be a more accurate cost allocation at the level of an individual patient.