1. Cost Allocation: Service Departments and Joint Product Costs1 1

2. 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.

3. 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.

4. 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

5. 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.

6. 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

7. 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

8. Choosing Cost Drivers for Allocation Bases

9. Choosing Cost Drivers for Allocation Bases

10. 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?

11. 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?

12. 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.

13. 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.

14. 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)

15. 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)

16. 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.

17. Methods of Allocating Service Department Costs
Problem
Allocating costs when service departments provide services to each other
Solutions
Direct method
Step method
Reciprocal method

18. 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)

19. Direct Method Example

20. Direct Method Example

21. Direct Method Example $360,000 × 20 20 + 30 = $144,000
$360,000 × 20
= $144,000
Allocation base: Number of employees

22. Direct Method Example $360,000 × 30 20 + 30 = $216,000
$360,000 × 30
= $216,000
Allocation base: Number of employees

23. Direct Method Example $90,000 × 25,000 25,000 + 50,000 = $30,000
$90,000 ×
25,000
25, ,000
= $30,000
Allocation base: Square feet occupied

24. Direct Method Example 50,000 25,000 + 50,000 = $60,000 $90,000 ×
= $60,000
$90,000 ×
Allocation base: Square feet occupied

25. 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)

26. 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)

27. 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)

28. Step Method Example
We will use the same data used in the direct method example.

29. Step Method Example

30. Step Method Example $360,000 × 10 10 + 20 + 30 = $60,000
$360,000 × 10
= $60,000
Allocation base: Number of employees

31. Step Method Example $360,000 × 20 10 + 20 + 30 = $120,000
$360,000 × 20
= $120,000
Allocation base: Number of employees

32. Step Method Example $360,000 × 30 10 + 20 + 30 = $180,000
$360,000 × 30
= $180,000
Allocation base: Number of employees

33. Step Method Example
New total = $90,000 original custodial cost plus $60,000 allocated from the cafeteria.

34. Step Method Example 25,000 25,000 + 50,000 $150,000 × = $50,000
$150,000 ×
= $50,000
Allocation base: Square feet occupied

35. Step Method Example 50,000 25,000 + 50,000 $150,000 × = $100,000
$150,000 ×
= $100,000
Allocation base: Square feet occupied

36. 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)

37. Reciprocal Method Example
We will use the same data used in the previous examples.

38. Reciprocal Method Example
The Custodial Department receives: 10
= of Cafeteria costs.
1 6
The Cafeteria Department receives:
5,000
5, , ,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

39. Reciprocal Method Example
In equation form:
Cu = $90, Ca
and
Ca = $360, Cu
1 6
1 16
Cu = Total costs of Custodial Department
Ca = Total costs of Cafeteria Department

40. Reciprocal Method Example
In equation form:
1 6
Cu = $90, Ca
and
Ca = $360, Cu
1 16
Two equations and two unknowns are solved by substitution:
Ca = $360, ($90, Ca)
Ca = $369,474 (rounded)
and
Cu = $90, ($369,474) = $151,579
1 16
1 6

41. Reciprocal Method Example

42. Reciprocal Method Example10
$369,474 ×
= $61,579
Allocation base: Number of employees

43. Reciprocal Method Example20
$369,474 ×
= $123,158
Allocation base: Number of employees

44. Reciprocal Method Example30
$369,474 ×
= $184,737
Allocation base: Number of employees

45. Reciprocal Method Example
5,000
5, , ,000
= $9,474 (rounded)
$151,579 ×
Allocation base: Square feet occupied

46. Reciprocal Method Example
25,000
5, , ,000
= $47,368 (rounded)
$151,579 ×
Allocation base: Square feet occupied

47. Reciprocal Method Example
50,000
5, , ,000
= $94,737 (rounded)
$151,579 ×
Allocation base: Square feet occupied

48. Comparison of Methods

49. 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.

50. 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.

51. 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.

52. 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.

53. Separate Fixed and Variable Costs: Dual Allocation
Variable costs are allocated based on hours used.

54. Separate Fixed and Variable Costs: Dual Allocation
Variable costs are allocated based on hours used.
Fixed costs are allocated based on capacity demanded..

55. Separate Fixed and Variable Costs: Dual Allocation
Variable costs are allocated based on hours used.
Fixed costs are allocated based on capacity demanded..

56. Joint Product Costing
Product
Joint Costs
Product
Product

57. 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.

58. Joint Product Costing
Consider the following example of an oil refinery.
We will assume only two products, gasoline and oil.

59. 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

60. 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.

61. Joint Cost Allocation Methods
Let’s look at an example illustrating the joint cost allocation methods.

62. Physical Measure Method
Joint
Costs
Oil
240,000 gallons
Common
Production
Process
Joint
Input
Gasoline
360,000 gallons
Split-Off
Point

63. 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

64. Physical Measure Method

65. Physical Measure Method

66. Physical Measure Method

67. Sales Value at Split-Off Method
Joint
Costs
Oil
Common
Production
Process
Joint
Input
Gasoline
Split-Off
Point

68. 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

69. Sales Value at Split-Off Method

70. Sales Value at Split-Off Method

71. Sales Value at Split-Off Method
$275,000 joint conversion cost plus $225,000 joint material cost

72. 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 – =

73. 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

74. 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

75. Net Realizable Value Method

76. Net Realizable Value Method

77. Net Realizable Value Method

78. Net Realizable Value Method

79. End of Chapter 14
What a Chapter!