Cost Allocation is the foundation of all knowledge in Cost Accounting. Here we will illustrate what is Cost Allocation.
Suppose that A and B are having lunch together by ordering a pizza; a large Meat Lovers with Stuffed Crust. We shall assume that a large pizza consists of eight slices, as is common in all pizza parlors. The cost for the pizza is 800. Now, we need to allocate that cost (800) to A and B, to find out how much does A really incurs and how much does B really incurs in cost.
First of all, we can take the simplest approach, and equally divide the cost for A and B. This way A gets allocated 400, and B gets allocated 400. In the absence of any other information, then we can say that this method of allocation is reasonably accurate.
However, suppose that we get an additional information that A is consuming 5 slices of pizza, while B is consuming 3 slices of pizza, then our previous method becomes inaccurate. Our method of dividing the cost equally between A and B does not reflect the actual cost incurred by each person.
To improve our method of cost allocation, we can use the newly available information, the actual slices of pizza consumed by each person. We reason that allocating based on slices of pizza actually consumed is more reasonable and more accurate than simply dividing the cost equally. Therefore, A will be allocated 5/8 x 800 = 500, and B will be allocated 3/8 x 800 = 300.
We can go even further by finding out if the slices in a pan of pizza are of equal size. Sometimes it happened that the pizza chef did not slice the pizza exactly in the middle, so the resulting slices will be of different sizes. If the information about the size of each slices of pizza can be obtained in an economically feasible way, including the future pizza lunches they will be having together again, then we are justified in using that information to further increase the accuracy of our cost allocation method. But as we can see, it will not be easy to find out the size slices that A and B actually eat, and it will be quite difficult and inconvenient for them to measure every slice of pizza that they are going to eat, so the use of this information will not be justified.
-- to be continued --
Suppose that A and B are having lunch together by ordering a pizza; a large Meat Lovers with Stuffed Crust. We shall assume that a large pizza consists of eight slices, as is common in all pizza parlors. The cost for the pizza is 800. Now, we need to allocate that cost (800) to A and B, to find out how much does A really incurs and how much does B really incurs in cost.
First of all, we can take the simplest approach, and equally divide the cost for A and B. This way A gets allocated 400, and B gets allocated 400. In the absence of any other information, then we can say that this method of allocation is reasonably accurate.
However, suppose that we get an additional information that A is consuming 5 slices of pizza, while B is consuming 3 slices of pizza, then our previous method becomes inaccurate. Our method of dividing the cost equally between A and B does not reflect the actual cost incurred by each person.
To improve our method of cost allocation, we can use the newly available information, the actual slices of pizza consumed by each person. We reason that allocating based on slices of pizza actually consumed is more reasonable and more accurate than simply dividing the cost equally. Therefore, A will be allocated 5/8 x 800 = 500, and B will be allocated 3/8 x 800 = 300.
We can go even further by finding out if the slices in a pan of pizza are of equal size. Sometimes it happened that the pizza chef did not slice the pizza exactly in the middle, so the resulting slices will be of different sizes. If the information about the size of each slices of pizza can be obtained in an economically feasible way, including the future pizza lunches they will be having together again, then we are justified in using that information to further increase the accuracy of our cost allocation method. But as we can see, it will not be easy to find out the size slices that A and B actually eat, and it will be quite difficult and inconvenient for them to measure every slice of pizza that they are going to eat, so the use of this information will not be justified.
-- to be continued --
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