Chapter 12

1. Chapter 12 Cost Allocation

2. Cost Allocation Costs are linked with cost objectives by selecting appropriate cost drivers. A cost driver is often called a cost-allocation base. A cost pool is a grouping of individual cost items that are allocated to cost objectives.

3. Explain the major reasons for allocating costs. Learning Objective 1

4. Purposes of Allocation • There are four major purposes for allocating costs: • To predict the economic effects of planning and control decisions • To obtain desired motivation • To compute income and asset valuation • To justify costs or obtain reimbursement

5. Three Types of Cost Allocations 1 – Allocation to the appropriate organizational unit 2 – Allocation from one organizational unit to another 3 – Allocation to products or services

6. Allocate the variable and fixed costs of service departments to other organizational units. Learning Objective 2

7. Allocation of Service Department Costs Guidelines for allocating service department costs: Establish the details regarding cost allocation in advance. Allocate variable- and fixed-cost pools separately. Evaluate performance using budgets.

8. Service Department Example 5-year lease Computer Department School of Business School of Engineering

9. Service Department Example Analyze the costs of the computer department in detail. The primary activity performed is computer processing. Resources consumed include processing time, operator time, consulting time, energy, materials, and building space.

10. Service Department Example • Suppose there are two major purposes for the allocation: • Predicting economic effects of the use of the computer • Motivating departments and individuals to use its capabilities more fully

11. Service Department Example • Assume that cost behavior analysis has been performed. • The budget formula for the forthcoming year is $100,000 monthly fixed cost plus $200 variable cost per hour of computer time used.

12. Variable-Cost Pool • The cost driver for the variable-cost pool is hours of computer time used. • Therefore, variable costs should be allocated as follows: Budgeted unit rate × Actual hours of computer time used

13. Variable-Cost Pool Consider the allocation of variable costs to a department that uses 600 hours of computer time. Assume that inefficiencies in the computer department caused the variable costs to be $140,000 instead of $120,000. 600 hours × $200 = $120,000

14. Variable-Cost Pool A good cost-allocation scheme would allocate only the $120,000 to the consuming department and would let the $20,000 remain as an unallocated unfavorable budget variance of the computer department.

15. Fixed-Cost Pool • The cost driver for the fixed-cost pool is the amount of capacity required when the computer facilities were acquired. • Therefore, fixed costs should be allocated as follows: Budgeted % of capacityavailable for use × Total budgeted fixed costs

16. Fixed-Cost Pool • Suppose the deans, in our university computer department example, had originally predicted the long-run average monthly usage as follows: School of Business 210 hours School of Engineering 490 hours

17. Fixed-Cost Pool How is the fixed-cost pool allocated? Business: 210 ÷ 700 × $100,000 = $30,000 Engineering: 490 ÷ 700 × $100,000 = $70,000

18. Fixed-Cost Pool This predetermined lump-sum approach is based on the long-run capacity available to the user, regardless of actual usage from month to month.

19. Allocate the central costs of an organization. Learning Objective 3

20. Allocation of Central Costs Usage Revenue Total assets Cost of goods sold Total cost of each division

21. Use the direct and step-down methods to allocate service department costs to user departments. Learning Objective 4

22. Reciprocal Services • Service departments often support other service departments in addition to producing departments. • There are two popular methods for allocating service department costs: • The direct method • The step-down method

23. Direct and Step-Down Methods The direct method ignores other service departments when any given service department’s costs are allocated to the revenue-producing (operating) departments. The step-down method recognizes that some service departments support the activities in other service departments as well as those in production departments.

24. Direct and Step-Down Methods Service Departments Production Departments Facilities $126,000 $100,000 Molding Personnel $24,000 $160,000 Finishing

25. Direct Method Service Departments Production Departments Facilities $126,000 $100,000 Molding $105,000 $21,000 0% 0% $4,800 Personnel $24,000 $160,000 Finishing $19,200 320 ÷ 400 × $24,000

26. Step-Down Method Service Departments Production Departments Facilities $126,000 $100,000 Molding $70,000 $14,000 $13,200 Personnel $24,000 + $42,000 $160,000 Finishing $52,800

27. Step-Down Method Molding Department Finishing Department Direct costs $100,000 From Fac. Mgt. 70,000 From Personnel 13,200 Total $183,200 Direct costs $160,000 From Fac. Mgt. 14,000 From Personnel 52,800 Total $226,800

28. Facility Management Example • Assume management wants to analyze facility management’s costs. • What are the possibilities? • Divide costs into two or more different cost pools and use a different cost driver to allocate the costs in each pool.

29. Facility Management Example • Allocate variable costs using the direct or step-down method, but do not allocate the fixed costs. • Allocate all costs using square footage as the cost driver.

30. Facility Management Example Facilities Management Cost Cost Pool Cost Pool Cost Pool Allocate using Cost Driver 1 Allocate using Cost Driver 2 Allocate using Cost Driver 3

31. Describe the traditional approach to allocating costs to products or services. Learning Objective 5

32. Traditional Approach Step 1: Allocate production- related costs to departments. Operating or production departments Step 2: Select one or more cost drivers. Direct labor hours

33. Traditional Approach Step 3: Allocate costs to products or services. Direct labor hours Product A Product B Product C

34. Traditional Approach One cost driver Variable costs Fixed costs If only one cost driver is used, two cost pools should be maintained

35. Use activity-based costing to allocate costs in a modern manufacturing environment to products or services. Learning Objective 6

36. Activity-Based Costing • ABC systems focus on accumulating costs into key activities. • If many costs are caused by non-volume-based cost drivers, activity-based costing (ABC) should be considered.

37. Activity-Based Costing Step 1: Determine cost objective, key activity centers, resources, and related cost drivers. Step 2: Develop a process-based map representing the flow of activities, resources, and their interrelationships.

38. Activity-Based Costing Step 3: Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities. Step 4: Calculate and interpret the new activity- based information.

39. Use the physical-units and relative-sales-value methods to allocate joint costs to products. Learning Objective 7

40. Meaning of Terms Joint products Joint costs Split-off point Separable costs Main product By-product

41. Joint Costs Two conventional ways of allocating joint costs to products are widely used: Physical units Relative sales values

42. Physical-Units Method The physical-units method requires a common physical unit for measuring the output of each product. The joint costs are allocated based on each product’s percentage of the total physical units produced.

43. Relative-Sales-Value Method • The joint costs are allocated based on each product’s sales value as a percentage of the total sales value at split-off. Sales value at split-off method Estimated net realizable value (NRV) method Constant gross-margin percentage NRV method

44. Why Allocate Joint Costs? To determine inventory cost and cost of goods sold To determine cost reimbursement under contracts For conducting customer profitability analysis For insurance settlement computations For rate regulation

45. No Allocation of Joint Costs Some companies refuse to allocate joint costs and instead carry their inventories at estimated net realizable value minus a normal profit margin.

46. By-Product Costs • If an item is accounted for as a by-product, only separable costs are allocated to it. • All joint costs are allocated to the main products. • Any revenues from by-products, less their separable costs, are deducted from the cost of the main products.

47. Joint Costs Allocation Example Product A $800 100 pounds Z-1 Separable cost $300 Joint cost is $900. 400 pounds Z-2 Separable cost $150 Product B $800 Z-1 and Z-2 are worthless at split-off point.

48. Physical Units Example Joint Cost Allocated To A: 100 ÷ 500 × $900 = $180 To B: 400 ÷ 500 × $900 = $720

49. Physical Units Example A B Total Sales Value $800 $800 $1,600 Separable Costs 300 150 450 Allocation of Joint Cost 180 720 900 Operating Profit (Loss) $320 $(70) $ 250

50. Relative-Sales-Value Method Example A B Total Sales Value $800 $800 $1,600 Separable Costs 300 150 450 Sales Value Imputed at Splitoff Point $500 $650 $1,150 Allocation of Joint Cost 500/1,150; 650/1,150 391 509 900 Operating Profit (Loss) $109 $141 $ 250