Cost Allocation: Service Departments and Joint Product Costs 1 1
The Strategic Role of Cost Allocation Determine accurate departmental and product costs for evaluating the cost efficiency of departments and the profitability of products. Motivate managers to exert a high level of effort to achieve the goals of top management. Provide the right incentive for managers to make decisions that are consistent with the goals of top management. Fairly determine the rewards earned by the managers for their effort and skill, and for the effectiveness of their decision making.
The Ethical Role of Cost Allocation Companies having both commercial and government business may attempt to shift overhead to the cost-plus government business. Each dollar of additional cost results in additional revenue on the government work. To avoid disputes, both parties should agree in the contract precisely how common costs will be allocated.
Types of Overhead Cost Allocation Overhead allocated directly to products Overhead allocated to departments, and then from departments to products Overhead Overhead Production Department Products Products
Service and Production Department Cost Allocation Production Departments Service Departments Carry out the central purposes of an organization. Provide support that facilitates the activities of user departments.
Choosing Cost Drivers for Allocation Bases Machine related costs Labor related costs Occupancy related costs Service related costs A cost driver is the factor that causes or “drives” an activity’s costs. Miles driven
Choosing Cost Drivers for Allocation Bases Selection Criteria Causal Relation A cost driver is the factor that causes or “drives” an activity’s costs. Benefits Received Reasonableness
Choosing Cost Drivers for Allocation Bases
Choosing Cost Drivers for Allocation Bases
Choosing Allocation Bases Based on Cost Drivers We identify the cost driver in the service department. Then we measure the consumption of the cost driver activity in the production departments. How are service department costs charged to production departments?
Choosing Allocation Bases Based on Cost Drivers Then we allocate the service department cost based on the relative amount of the cost driver activity used in each production department. How are service department costs charged to production departments?
Choosing Allocation Bases Based on Cost Drivers What happens to service department costs after they are allocated to production departments? Allocated service department costs become a part of the manufacturing overhead in each production department.
Choosing Allocation Bases Based on Cost Drivers I get it. They become a part of the overhead that is applied to products with a predetermined overhead rate. That’s right. Take a look at this flow chart. I think it will summarize our discussion of the allocation process.
Service and Production Department Cost Allocation First Phase: Trace direct costs and allocate indirect costs Service Department (Cafeteria) Direct and Indirect Costs Production Department (Machining) Service Department (Accounting) The Product Production Department (Assembly) Service Department (Personnel)
Service and Production Department Cost Allocation Second Phase: Allocate service department costs to production departments. Service Department (Cafeteria) Direct and Indirect Costs Production Department (Machining) Service Department (Accounting) The Product Production Department (Assembly) Service Department (Personnel)
Service and Production Department Cost Allocation Service Department (Cafeteria) Direct and Indirect Costs Production Department (Machining) Service Department (Accounting) The Product Production Department (Assembly) Service Department (Personnel) Third Phase: Allocate production department overhead costs, plus allocated service department costs to products.
Methods of Allocating Service Department Costs Problem Allocating costs when service departments provide services to each other Solutions Direct method Step method Reciprocal method
Direct Method Service Department (Cafeteria) Production Department (Machining) Cost of services between service departments are ignored and all costs are allocated directly to user departments. Service Department (Custodial) Production Department (Assembly)
Direct Method Example
Direct Method Example
Direct Method Example $360,000 × 20 20 + 30 = $144,000 $360,000 × 20 20 + 30 = $144,000 Allocation base: Number of employees
Direct Method Example $360,000 × 30 20 + 30 = $216,000 $360,000 × 30 20 + 30 = $216,000 Allocation base: Number of employees
Direct Method Example $90,000 × 25,000 25,000 + 50,000 = $30,000 $90,000 × 25,000 25,000 + 50,000 = $30,000 Allocation base: Square feet occupied
Direct Method Example 50,000 25,000 + 50,000 = $60,000 $90,000 × = $60,000 $90,000 × Allocation base: Square feet occupied
Step Method Service Department (Cafeteria) Production Department (Machining) Service department costs are allocated to other service departments and to production departments, usually starting with the service department that provides the greatest amount of service to other departments. Service Department (Custodial) Production Department (Assembly)
Step Method Service Department (Cafeteria) Production Department (Machining) Once a service department’s costs are allocated, other service department costs are not allocated back to it. Service Department (Custodial) Production Department (Assembly)
Step Method Service Department (Cafeteria) Production Department (Machining) Custodial will have a new total to allocate to production departments: its own costs plus those costs allocated from the cafeteria. Service Department (Custodial) Production Department (Assembly)
Step Method Example We will use the same data used in the direct method example.
Step Method Example
Step Method Example $360,000 × 10 10 + 20 + 30 = $60,000 $360,000 × 10 10 + 20 + 30 = $60,000 Allocation base: Number of employees
Step Method Example $360,000 × 20 10 + 20 + 30 = $120,000 $360,000 × 20 10 + 20 + 30 = $120,000 Allocation base: Number of employees
Step Method Example $360,000 × 30 10 + 20 + 30 = $180,000 $360,000 × 30 10 + 20 + 30 = $180,000 Allocation base: Number of employees
Step Method Example New total = $90,000 original custodial cost plus $60,000 allocated from the cafeteria.
Step Method Example 25,000 25,000 + 50,000 $150,000 × = $50,000 $150,000 × = $50,000 Allocation base: Square feet occupied
Step Method Example 50,000 25,000 + 50,000 $150,000 × = $100,000 $150,000 × = $100,000 Allocation base: Square feet occupied
Reciprocal Method Service Department (Cafeteria) Production Department (Machining) Interdepartmental services are given full recognition rather than partial recognition as with the step method. Service Department (Custodial) Production Department (Assembly)
Reciprocal Method Example We will use the same data used in the previous examples.
Reciprocal Method Example The Custodial Department receives: 10 10 + 20 + 30 = of Cafeteria costs. 1 6 The Cafeteria Department receives: 5,000 5,000 + 25,000 + 50,000 1 16 = of Custodial costs. The total cost of each service department is equal to: Direct costs of that department + Costs allocated to that department
Reciprocal Method Example In equation form: Cu = $90,000 + Ca and Ca = $360,000 + Cu 1 6 1 16 Cu = Total costs of Custodial Department Ca = Total costs of Cafeteria Department
Reciprocal Method Example In equation form: 1 6 Cu = $90,000 + Ca and Ca = $360,000 + Cu 1 16 Two equations and two unknowns are solved by substitution: Ca = $360,000 + ($90,000 + Ca) Ca = $369,474 (rounded) and Cu = $90,000 + ($369,474) = $151,579 1 16 1 6
Reciprocal Method Example
Reciprocal Method Example 10 10 + 20 + 30 $369,474 × = $61,579 Allocation base: Number of employees
Reciprocal Method Example 20 10 + 20 + 30 $369,474 × = $123,158 Allocation base: Number of employees
Reciprocal Method Example 30 10 + 20 + 30 $369,474 × = $184,737 Allocation base: Number of employees
Reciprocal Method Example 5,000 5,000 + 25,000 + 50,000 = $9,474 (rounded) $151,579 × Allocation base: Square feet occupied
Reciprocal Method Example 25,000 5,000 + 25,000 + 50,000 = $47,368 (rounded) $151,579 × Allocation base: Square feet occupied
Reciprocal Method Example 50,000 5,000 + 25,000 + 50,000 = $94,737 (rounded) $151,579 × Allocation base: Square feet occupied
Comparison of Methods
Comparison of Methods The reciprocal method is superior because: It considers all services provided to other service departments. The total cost of operating a service department is computed. The reciprocal method requires the use of matrix algebra with three or more service departments.
Separate Fixed and Variable Costs: Dual Allocation Fixed Costs Allocate budgeted amounts to user departments in proportion to the capacity demanded by the user department. Charge to user departments at a budgeted rate times the actual usage of the allocation base.
Separate Fixed and Variable Costs: Dual Allocation Fixed Costs Allocate budgeted amounts to user departments in proportion to the capacity demanded by the user department. Charge to user departments at a budgeted rate times the actual usage of the allocation base. Budgeted costs should be allocated to avoid passing on inefficiencies from the service departments.
Separate Fixed and Variable Costs: Dual Allocation Ace Co. has a maintenance department and two operating departments: cutting and assembly. Variable maintenance costs are budgeted at $0.60 per machine hour. Fixed maintenance costs are budgeted at $200,000 per year. Data relating to the current year are: Allocate maintenance costs to the two operating departments.
Separate Fixed and Variable Costs: Dual Allocation Variable costs are allocated based on hours used.
Separate Fixed and Variable Costs: Dual Allocation Variable costs are allocated based on hours used. Fixed costs are allocated based on capacity demanded..
Separate Fixed and Variable Costs: Dual Allocation Variable costs are allocated based on hours used. Fixed costs are allocated based on capacity demanded..
Joint Product Costing Product Joint Costs Product Product
Joint Product Costing Concept: In some industries, a number of products are produced from a single raw material input. Key terms: Joint products – products resulting from a process with a common input. Split-off point – the stage of processing where joint products are separated. Joint cost – costs of processing joint products prior to the split-off point.
Joint Product Costing Consider the following example of an oil refinery. We will assume only two products, gasoline and oil.
Joint Product Costing Joint Costs Separate Processing Costs Split-Off Additional Processing Final Sale Oil Common Production Process Separate Processing Costs Joint Input Additional Processing Final Sale Gasoline Split-Off Point Separate Processing Costs
Joint Cost Allocation Methods Physical measure Sales value at split-off Net Realizable Value Joint costs are allocated based on a relative measure (weight, volume, etc.) of products at the split-off point. Joint costs are allocated based on relative values of products at the split-off point. Joint costs are allocated based on relative values of products after additional processing.
Joint Cost Allocation Methods Let’s look at an example illustrating the joint cost allocation methods.
Physical Measure Method Joint Costs Oil 240,000 gallons Common Production Process Joint Input Gasoline 360,000 gallons Split-Off Point
Physical Measure Method Joint conversion cost = $225,000 Oil 240,000 gallons Common Production Process Joint material cost = $275,000 Gasoline 360,000 gallons Split-Off Point
Physical Measure Method
Physical Measure Method
Physical Measure Method
Sales Value at Split-Off Method Joint Costs Oil Common Production Process Joint Input Gasoline Split-Off Point
Sales Value at Split-Off Method Joint conversion cost = $225,000 $200,000 sales value at split-off point Oil Common Production Process Joint material cost = $275,000 $600,000 sales value at split-off point Gasoline Split-Off Point
Sales Value at Split-Off Method
Sales Value at Split-Off Method
Sales Value at Split-Off Method $275,000 joint conversion cost plus $225,000 joint material cost
Net Realizable Value Method If products require further processing beyond the split-off point before they are marketable, it may be necessary to estimate the net realizable value at the split-off point. Estimated NRV Final Sales Value Added Processing Costs – =
Net Realizable Value Method Joint Costs Additional Processing Final Sale Oil Common Production Process Additional Processing Costs Joint Input Additional Processing Final Sale Gasoline Split-Off Point Additional Processing Costs
Net Realizable Value Method Joint conversion cost = $225,000 Sales Value $500,000 Additional Processing Oil Common Production Process Additional Processing Costs $200,000 Joint material cost = $275,000 Sales Value $1,200,000 Additional Processing Gasoline Split-Off Point, Sales Value Unknown Additional Processing Costs $500,000
Net Realizable Value Method
Net Realizable Value Method
Net Realizable Value Method
Net Realizable Value Method
End of Chapter 14 What a Chapter!