Service Department and Joint Cost Allocation Chapter 11 Service Department and Joint Cost Allocation We have seen how cost allocation is used to develop the costs of products, services, and customers. However, part of the indirect cost incurred is from departments that do not directly produce the product or service but rather provide service to the departments that do produce the product or provide the service. In this chapter we will allocate the costs of these “service” departments. We will also consider product costing when multiple products are produced from the same inputs in fixed proportions. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11 - 1

Service Department Cost Allocation L.O. 1 Explain why service costs are allocated. Service Department: Department that provides services to other subunits in the organization. User Department: Department that uses the functions of service departments. A service department does not directly produce the product or service but rather provide service to the departments that do produce the product or provide the service. For example, an information systems department is a service department that provides information system support to other departments and a payroll department provides payroll services to other departments. The departments using these services are the user departments. User departments could be other service departments or production or marketing departments that produce or market the products. 11 - 2

Cost Allocation: Direct Method L.O. 2 Allocate service department costs using the direct method. Direct method: Charges costs of service departments to user departments without making allocations among service departments. Service Department: Information Systems (S1) User Department: Hilltop Mine (P1) Administration (S2) Pacific Mine (P2) The direct method of service department cost allocation charges costs of service departments to user departments without making allocations between or among service departments. In other words, costs are charged only to the final cost centers, in the case of CCC P1 and P2. 11 - 3

Cost Allocation: Step Method L.O. 3 Allocate service department costs using the step method. The step method allocates some service department costs to other service departments. Once an allocation is made from a service department no further allocations are made back to that service department. The step method allocates some service department costs to other service departments. However, once an allocation is made from a service department, no further allocations are made back to that service department. Given that once a department’s costs have been allocated, no other services received by that department are recognized. The question one asks is, “What department gets allocated first, second, etc.?” Generally, costs are allocated in order of the proportion of services provided to other service departments. In other words, the department that does the highest proportion of its services for other service departments gets allocated first, and so on. Generally, allocate in order of proportion of services provided to other service departments. 11 - 4

Cost Allocation: Reciprocal Method L.O. 4 Allocate service department costs using the reciprocal method. The reciprocal method recognizes all services provided by any service department, including services provided to other service departments. It accounts for cost flows among service departments providing services to each other. The reciprocal method recognizes all services provided by any service department, including services provided to other service departments. In other words, it recognizes all services provided by service departments to other service departments. Allocating costs using the reciprocal method requires a simultaneous equation solution. It requires a simultaneous equation solution. 11 - 5

The Reciprocal Method and Decision Making L.O. 5 Use the reciprocal method for decisions. Suppose that the variable cost in Information Services (S1) is $200,000 (out of the total of $800,000) and the variable cost in Administration (S2) is $3,500,000 (out of $5,000,000). Let's repeat the reciprocal cost analysis substituting the variable costs from the total costs. The reciprocal method can be used for decision making. Let’s look at variable costs. 11 - 6

The Reciprocal Method and Decision Making LO5 The Reciprocal Method and Decision Making The total variable cost of Information Services, when you consider the use of Administration by Information Services is $1,000,000. The total cost savings that would come from eliminating Information Services are the $1,000,000 variable costs plus any avoidable fixed costs. The total cost savings from eliminating Information Services are the $1,000,000 variable costs. 11 - 7

Allocation of Joint Costs L.O. 6 Explain why joint costs are allocated. Joint cost is the cost of a manufacturing process with two or more outputs. A joint cost is the cost of a manufacturing process with two or more outputs. 11 - 8

Allocation of Joint Costs Joint Products Outputs from a common input and common production process Split-Off point Stage of processing that separates two or more products By now you realize that any time you have indirect costs these costs must be allocated. When a manufacturing process has two or more outputs from a common input and a common production process, those common costs, called joint costs, must be allocated to the final outputs called joint products. The split-off point is the stage of processing that separates the joint products. 11 - 9

Allocation of Joint Costs Why allocate joint costs? Evaluating executive performance Determining the inventory value How should joints costs be allocated? Net realizable value method The joint costs must be allocated in order to value the Hi-grade and Lo-grade coal and to evaluate performance. How should the costs be allocated? Joint costs can be allocated using either the net realizable value method or the physical quantities method. Physical quantities method 11 - 10

Allocation of Joint Costs L.O. 7 Allocate joint costs using the net realizable value method. Net realizable value method: Joint cost allocation based on the proportional values of the products at the split-off point. Net realizable value (NRV): Sales value of each product at the split-off point. The net realizable value method allocates joint costs based on their net realizable value. What is the net realizable value? Net realizable value or NRV is the sales value of each product at the split-off point. If additional processing costs are necessary to prepare the product for sale, the estimated NRV is used. The estimated NRV is the sales price minus the estimated additional processing costs. Estimated net realizable value: Sales price of a final product minus additional processing costs necessary to prepare a product for sale. 11 - 11

Physical Quantities Method L.O. 8 Allocate joint costs using the physical quantities method. Joint cost allocation is based on measurement of the volume, weight, or other physical measure of the joint products at the split-off point. When significant processing occurs between the split-off point and the first point of marketing the product, or when output prices, i.e. sales values, are volatile and not set by the market, the physical quantity method of allocating joint product costs is appropriate. 11 - 12

Sell or Process Further L.O. 9 Explain how cost data are used in the sell-or-process-further decision. Suppose CCC can sell Lo-grade coal for $450,000 at the split-off point or process it further to make mid-grade coal. Mid-grade coal would sell for $550,000 and additional processing costs would be $50,000. Let’s return to the Mid-grade versus the Lo-grade coal. Suppose CCC can sell Lo-grade coal for $450,000 at the split-off point or process it further to make Mid-grade coal. Mid-grade coal would sell for $550,000. However, it requires an additional processing costs of $50,000. Should CCC sell Lo- or Mid-grade coal? CCC profits increase $50,000 if the Lo-grade coal output is processed further and Mid-grade coal is sold. Additional revenue: $100,000 Additional cost: $ 50,000 ? 11 - 13

Sell or Process Further Differential Analysis Carlyle Coal Company Revenues Less: Separate processing costs Margin $450,000 -0- $550,000 50,000 $500,000 $100,000 $ 50,000 Sell Lo-Grade Coal Process Further (Mid-Grade) Differential Revenue/ Costs Showing the decision in statement format verifies the $50,000 net gain from processing further. Net gain from processing further 11 - 14

Deciding What to Do with By-products L.O. 10 Account for by-products. By-products are outputs of joint production processes that are relatively minor in quantity or value. Accounting for by-products: Method 1: The net realizable value from sale of the by-products is deducted from the joint costs before allocation to the main products. By-products are outputs of joint production processes that are relatively minor in quantity or value. Two methods of accounting for by-products are acceptable. The net realizable value from the sale of the by-products can be deducted from the joint costs to be allocated to the main products or the total joint costs can be allocated to the main products and the proceeds from the sale of the by-products are treated as other revenue. Method 2: The proceeds from sale of the by-product are treated as other revenue. 11 - 15

Calculation of the Reciprocal Method Using Spreadsheets L.O. 11 (Appendix) Use spreadsheets to solve reciprocal cost allocation problems. For any department, we can state the equation: Total costs = Direct costs + Allocated costs Equations can be expressed in matrix form and solved using the matrix functions of a spreadsheet program such as Microsoft Excel®. Spreadsheets can be used to calculate the reciprocal method. 11 - 16

End of Chapter 11 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.