April 23, 2012
The purpose of cost allocation is to identify and correctly allocate costs associated with a job, product, or service. The main uses of cost allocation are to facilitate decision-making regarding costs, justify prices charged for products and services, cost control, and for optimal utilization of resources. There are several methods used for cost allocation, depending on the type of product or service offer by the company.
Variable cost allocation includes only variable manufacturing costs, such as direct materials, direct labor, and variable manufacturing overhead. Absorption cost allocation includes manufacturing costs, including both variable and fixed overhead as
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Absorption costing because of its all-inclusive nature, is used for such things as income tax reporting and for generating reports to be used by external financial investors. In contrast, variable costing is used for CVP analysis (Break Even analysis) and therefore lends its uses more to managerial decision making. Absorption costing because it does not distinguish between fixed and variable cost cannot be used for CVP analysis. In the automobile industry we may see both systems at work. If Ford sells a car under the absorption costing method and it cost $20,000 ($15000 for variable cost and $5000 for fixed cost). The $20,000 will be deducted from the income statement as cost of goods sold. At the same time, any unsold cars would be expressed as inventory on the balance sheet at the full cost of $20,000. In the variable costing system, all variable costs of production are included as production costs. If Ford sells a car under this method, then only $15,000 will be deducted as cost of goods sold. All unsold cars will be carried on the balance sheet as inventory at $15,000.
In today’s economical environment