Cost Allocation Methods in Accounting: Service Department & Joint Costs

1. Accounting 4310 Chapter 11 Service Department and Joint Cost Allocation

2. Terms • Service department • Provides services to other departments in the organization • User department • Uses services • Intermediate cost centers • Costs are charged to other departments in the organization • Final cost centers • Costs are not charged to other cost centers

3. Purposes • Provide information • Motivation • Justify costs or compute reimbursement • Measure income and assets • Determine outsourcing decisions

4. Methods of Allocation • Direct Method • Only assign costs to final cost centers • Step Method • Assign costs to other support departments in a step fashion • Support department most used or has highest cost assigned first • Once the costs of that support department are assigned, do not assign costs from other support departments to it

5. Methods of Allocation • Reciprocal Method • Based on algebraic equations • Assign costs of support departments to each other and the final cost centers • More accurate • More difficult to calculate

6. Which Cost Driver • One must determine which cost driver to use: • Cause and effect • Reasonableness • Equally

7. Allocation of Joint Costs • Joint costs – costs of production process that yield multiple products simultaneously • Split-off point – juncture in joint production process when two or more products become separately identifiable • Separable costs – all costs incurred beyond the split-off point that are assignable to each of the specific products identified at split-off point

8. Split-off Point

9. Reasons for Allocating Joint Costs • Inventory calculations for GAAP and IRS • Computations for divisional profitability • Cost reimbursements • Insurance-settlement computations for damage claims • Rate regulation • Costing products

10. Approaches to Allocating Joint Costs • Market-based methods • Net realizable value (NRV) method • Better method • Physical measures • Physical quantities method • Used when market price is volatile

11. Net Realizable Value at Split-off Point • Total sales value of joint products if sold at the split-off point, regardless of if actually sold at split-off point • Based on sales value of entire production of accounting period, not just those products sold • Best method to use • Follows benefits-received • Straightforward and intuitive • Sometimes data at split-off point not available

12. Estimated Net Realizable Value (NRV) • Based on total final sales price of each product less separable costs • Follows benefits-received • Use if net realizable value at split-off point is not available

13. Physical Quantity Method • Based on physical weight or units of the products at the split-off point • Has no relationship to the revenue-producing power of the individual product (no benefits-received criterion) • Generally not the best method to use • Sometimes used in rate regulation

14. Irrelevance of Joint Costs for Decision Making • Joint-cost allocations are somewhat arbitrary • When deciding whether to process a joint product further, ONLY look at incremental revenues beyond the split-off point and compare to incremental costs beyond the split-off point; joint costs should not be considered because they are sunk costs (irrelevant).

15. Accounting for Byproducts • Byproducts – outputs from a joint process that are relatively minor • Estimated NRV of byproduct produced offset against joint costs of main or joint products OR • Proceeds from sale are treated as other revenue. • Byproduct recognized in inventory at NRV when produced • Byproduct amounts are often immaterial so both methods satisfy GAAP