 Hello and welcome to this session. This is Professor Farhad. In this session I will discuss introduction to cost allocation and this topic is covered in a typical cost accounting or sometime managerial accounting course and it's definitely covered on the CPA as well as the CMA exam and for more lectures you can always go to my website farhadlectures.com and you can look up the any documents that I post under cost accounting course. So I'm going to go ahead and start to discuss this topic cost allocation. What is cost allocation and what's the issue with cost allocation? So let's go back and talk about something we called factory overhead. If you remember the factory overhead is one of the three cost component which is direct labor, direct material and factory overhead. So factory overhead the issue with factory overhead it's not easily traceable to the product it's not directly traceable. So when we started to talk about factory overhead but we said he said okay let's assume we have one product and what we do is we're going to assign the overhead by establishing a rate some some sort of a rate so we establish a rate then we allocate the overhead the money here to the product directly. Okay and this is what we call this formula it's a single plant-wide overhead. So for all our overhead cost we use that single rate and we allocate it directly to the product. What we discussed earlier here is a simple explanation of allocating factory overhead. In the real world what we have we do have factory overhead but what's going to happen we're going to have more than one department more than one product so on and so forth. So rather than establishing one rate a plant-wide overhead rate for all for for all the company what we do is we're going to allocate the overhead and we learn about this earlier to certain departments so we're going to allocate some overhead to this department to this production department let's call it production one and we're going to allocate other overhead to production department two then from this department what we're going to do we're going to establish a rate for a production department one so we're going to do so we allocated some money here we're going to divide this money by some activity and we're going to divide this money by some activity that's related to that production department, maybe production department A uses machine hours, more machinery, it's machine intensive, and production in department two is more labor intensive. So what we did is for department one, it's more machine driven, department two labor driven. And what's going to happen by doing so, by having two rates rather than just simply one rate, we enhance the allocation of the overhead. What does that mean? It means now we have a better pricing, we have better pricing model, now we are pricing our product better. Also our inventory, remember, our inventory is a better reflective for financial accounting purposes, we have a better number. Also our cost of goods sold is truly reflective of our effort. So when you enhance your overhead allocation, you're helping your pricing strategy, you know, you know how much you should price your inventory is accurate and your cost of goods sold is accurate. So you had three advantages. But to make things more complicated is this. What's going to happen is some of the overhead, it's going to be allocated to service department, we're going to have service department one, and maybe service department two. So some of the overhead pool and the money that's in this pool, some of it will be allocated not directly to the production department, but to other service department. And this is going to make this a little bit messier. Why? Because the service department don't touch the product. So in the production department, we're going to touch the product. So the money from here will be allocated to the product that we are selling. It will be allocated to the product that we are selling. But the service department, they don't touch the product. So what's going to happen is this. To make, to make matter worse, what's going to happen is the service department, it's going to allocate some of the costs to production one, some of the costs to production two. And sometime the service department one might allocate the product to service department two. And to kind of make little this little bit more realistic is for example, service department one could be the IT support. So the IT support would support production one and production two and will support service department two. Or this could be maybe HR or maintenance. It doesn't matter. Some, some sort of a service department that service the company. And this S2 might service S1, will service P1 and service P2. So the question becomes, how should we allocate those service costs that don't touch the product directly? Well, what we do is we have three methods, we can learn about three methods. I'm going to list them in this session, but we're going to work examples to illustrate how those three methods work. The first method is the direct method. And this is the simplest method. And how does it work? It allocate the overhead directly to the production department. So it goes from the S to the P directly. So we skip there's so the service department don't allocate money to another service department goes right from the service department to the P department. Okay. That's the first one, only to the production. So this is one, one of three, two is the is the step method. And obviously the step method is a little bit more complicated, a little bit more complicated than the direct method. Again, it's one way. Okay. But what's going to happen is the S, the service department could allocate money to the other service department, and then the money could be allocated to the production department. Okay. So what's going to happen is it's a one way. So it's it goes only one way. It doesn't go no interaction in between service department. Okay. And the third method is called the reciprocal method. And this is basically what it assumes the service department will allocate money to the production department, but also the service department allocate money among themselves, then they allocate it to the production department. So this is more complicated from an accounting perspective, but you would say this is going to be the most accurate. I'll say this is the least accurate or least reflective of reality and the step method is someplace in between. So those are the three methods that we're going to be working with. And obviously the best way to illustrate this is to actually work with actual numbers. So in the next session, I will go ahead and work an example, show you how those three methods work. If you have any questions, any comments by all, by all means email me or see me in class or if you're studying for your CPA exam, all means study hard.