Understanding the Rational Allocation Model for Cost Management

Understanding the Rational Allocation Model

The rational allocation model is a complementary model to homogeneous sections, which takes into account the level of activity of the company. Its basic premise is that variations in the level of activity cause changes in the cost figures from the perspective of the Full Cost. It is intended to prevent fluctuations in activity levels from affecting the cost of products, and therefore the outcome of the exercise.

Variable Costs

Variable costs are totally related to the level of activity. Therefore, these costs will increase or decrease as the level of activity does. These variable costs (VC) are usually fixed per unit of product. Therefore, they will not present distortions in the cost figures.

Fixed Costs

Fixed costs are constant and thus independent of the level of activity. They do not vary with the level of activity (within limits). These fixed costs (FC) are variable per unit of output (more units produced involve lower unit fixed cost, and vice versa). This method arises to avoid this variability in the FC unit to influence the product cost, causing the existence of sub-activity costs.

If an exercise activity is very low, the costs would be borne by the few products or services obtained, increasing the cost per unit (Cu). The rational allocation model can charge as cost of product only the normal or necessary part of the costs of sub-activity. Therefore, we correct the cost of units of work in sections to be independent of the level of activity.

This model allows us to charge a normal amount of fixed costs, constant whatever their level of activity. This relates the fixed costs needed to a normal activity level. Therefore, we correct the fixed costs for the Rational Allocation Index.

To avoid previous failures in the full cost, the Method of Rational allocation operates on fixed costs - variable costs fluctuate with the level of activity cost center while fixed costs remain entrenched for any level of activity (within the limits for which the study is valid).

Cost per Unit section "x" = Cost Section "X" / Activity Section "X"

The first term - if they were proportional variable costs - remain constant, but not the second term.

Depending on the normal capacity, and once known the actual activity of the period, we calculate the coefficient of rational allocation cost center or section by dividing the second between the first:

K = REAL ACTIVITY / NORMAL CAPACITY

Real Activity is the activity that was actually developed in the cost center (section) and is expressed in number of units of work that the section has worked in that period.

NORMAL CAPACITY is the annual measure of the average production level to be attained to meet the expected demand of customers within a medium term horizon (sales forecasts are revised to 3 or 5 years to observe any changes cyclical fluctuations eliminate and more accurately estimating normal capacity).