1. Cost Allocation: Service Department Costs and Joint Product Costs
Chapter Twelve
Cost Allocation: Service Department Costs and Joint Product Costs

2. Learning Objectives Identify the strategic role of cost allocation
Explain the ethical issues of cost allocation
Use three methods for allocating service department costs to production departments
Explain problems in implementing each of the three departmental cost allocation methods

3. Learning Objectives (continued)
Explain the use of cost allocation in service firms
Use the three methods for allocating joint product costs
Understand alternative methods to account for by-products associated with a joint production process

4. The Strategic Role of Cost Allocation
Determine accurate departmental and product costs as a basis for evaluating the cost efficiency of departments and the profitability of different 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

5. The Strategic Role of Cost Allocation (continued)
Fairly determine the rewards earned by managers for their effort and skill and for the effectiveness of their decision-making
The most objective basis for cost allocation exists when a cause-and-effect relationship can be determined, such as the relationship between machine breakdowns and maintenance costs
Other alternatives exist in the absence of cause-and-effect relationships, such as ability-to-bear and benefit received

6. Ethical Issues in Cost Allocation
An ethical issue arises when costs are allocated to products or services that are produced for both a competitive market and a public or governmental entity
The latter often purchases on a cost-plus basis creating an incentive to shift costs from the competitive products to “cost-plus” products
An equity or fair-share issue arises when a governmental unit reimburses the costs of a private institution or when it provides a service to the public for a fee–no single measure of equity exists

7. Ethical Issues in Cost Allocation (continued)
A third ethical issue is the effect if the chosen allocation method on the costs of the products sold to or from foreign subsidiaries
By increasing the costs of products purchased in high-tax countries or in countries where the firm does not have favorable tax treatment, the firm can reduce its overall tax liability
International tax authorities watch the cost-allocation methods of multinational firms very closely for this reason

8. Overhead Allocations: Three General Approaches
Three general approaches for allocating overhead costs to products:
The direct approach allocates overhead from a single cost pool
The departmental approach allocates overhead to production departments, and then from production departments to products
The activity-based approach allocates overhead to production activities, and then from production activities to products

9. The Departmental Approach
The departmental approach classifies manufacturing departments into production and service departments
This approach involves three phases:
Trace all direct overhead costs and allocate common overhead costs to both the various production and service departments
Allocate the service department costs to the production departments
Allocate production department costs to products

10. Departmental Approach Example
Beary Company manufactures two products and has two production departments (P-1 and P-2) and two service departments (S-1 and S-2). Beary uses both labor-hours and machine-hours for allocating indirect manufacturing costs.
Not Traceable

11. Departmental Approach: Phase 1

12. Departmental Approach: Phase 2
Phase 2, allocation of service department costs: whether, and to what extent, reciprocal cost flows are recognized?
Three methods are used to allocate service department costs:
The direct method
The step method
The reciprocal (i.e., simultaneous equations) method

13. Phase 2: Direct Method

14. Phase 3: Direct Method

15. Phase 2: Step Method

16. Phase 3: Step Method

17. Phase 2: Reciprocal Method

18. Phase 2: Reciprocal Method (continued)

19. Phase 3: Reciprocal Method

20. Key Implementation Issues
Choosing the most accurate method is key
Wide variations can occur in the product allocation amounts
Determining an appropriate allocation base and a percentage amount for service provided by the service departments is often difficult
Often firms have difficulty distinguishing fixed and variable costs
Ideally, firms would use dual allocation, which separates variable and fixed costs and traces the variable costs directly to the departments that caused the cost

21. Key Implementation Issues (continued)
Using budgeted vs. actual amounts?
Budgeted or predetermined amounts can be more difficult to determine but are more motivating for the allocation of fixed costs
Using predetermined amounts makes fixed costs more predictable and less dependent upon the usage of other departments
Allocated costs can exceed external purchase cost
Occasionally the cost a department is allocated exceeds the cost of purchasing that service from an outside supplier

22. Joint Product Costing
Some manufacturing plants yield more than one product from a common resource input; this is called a “joint production process”
Joint products are products from a joint production process that have relatively substantial sales values
Products whose total sales values are minor in comparison to the sales value of the joint products are classified as by-products

23. Joint Product Costing (continued)
Joint products and by-products start their manufacturing life as part of the same raw material, so up until a certain point, no distinction can be made between the products
The point in a joint production process at which individual products can be identified for the first time is called the split-off point
Joint costs include all manufacturing costs incurred prior to the split-off point

24. Joint Product Costing (continued)
Costs incurred after the split-off point are called additional processing costs or separable costs
Three methods are commonly used to allocate joint product costs
Relative physical units (measures) produced
Relative sales values of the products
Relative net realizable values (NRV) of the products

25. Cost Allocation Based on Relative Physical Units
The physical units method uses a physical measure such as pounds, gallons, or yards or units or volume to allocate the joint costs to joint products
The greater the output (however measured), the greater the share of joint costs allocated to the product
This method is also called the average cost method when units of output are used in the costing procedure

26. The Physical Units Method: Example
Assume Johnson Seafood produces tuna filets and canned tuna for distribution to restaurants and supermarkets:

27. The Physical Units Method (continued)

28. The Physical Units Method: Summary
Advantages
Disadvantages
Easy to use
Ignores the revenue-producing capability of individual products
The criterion for the allocation of the joint costs is objective
Each product can have its own unique physical measure

29. Relative Sales Values at Split-off Method
The sales value at split-off method allocates joint costs to joint products on the basis of their relative sales values at the split-off point
This method can only be used joint products can be sold at the split-off point

30. Sales Value at Split-off Point: Example
Using the same example, the sales value at split-off point method produces the following results:

31. Sales Values at Split-off Point Method: Summary
Advantages
Disadvantages
Easy to calculate
Market prices for some industries change constantly
Costs are allocated according to the individual product’s revenue
Sales price at split-off might not be available because additional processing is necessary for sale

32. The Net Realizable Value (NRV) Method
The NRV method can be used when joint products cannot be sold at split-off
The net realizable value (NRV) of a product is the product’s estimated sales value at the split-off point
NRV is determined by subtracting additional processing and selling costs beyond the split-off point from the estimated ultimate sales value of the product

33. The Net Realizable Value Method: Example
Assume Johnson Seafood also produces cat food from the raw, unprocessed tuna

34. The NRV Method: Example (continued)

35. The NRV Method: Summary
Advantages
Disadvantages
It produces an allocation that yields a predictable, comparable level of profitability among products
More difficult to calculate than the other two methods
Selling price at split-off does not have to be available
Based on an estimated value

36. By-Product Costing Asset Recognition Methods: Revenue Methods:
Net Realizable Value (NRV) Method
Other Income at Production Point Method
Revenue Methods:
Other Income at Selling Point Method
Manufacturing Cost Reduction at Selling Point Method
The main difference between these methods is the former grouping records by-product produced as inventory at NRV, while the latter grouping recognizes by-product revenue in the period sold

37. Chapter Summary
Cost allocation is strategically important in determining accurate departmental and product costs, for evaluating the cost efficiency of departments, and for assessing the profitability of different products
Ethical issues arise when costs are allocated to products or services
What method is being used to allocate the costs?
Is the market competitive or on a cost-plus basis?
Is the allocation method equitable?

38. Chapter Summary (continued)
There are three methods of overhead allocation:
The direct approach allocates overhead costs from a single cost pool, directly to products and services
The departmental approach allocates overhead to production departments, and then from production departments to products
The activity-based approach allocates overhead to production activities, and then from production activities to products

39. Chapter Summary (continued)
This chapter focused on the departmental approach, which has three phases:
Assign total overhead costs to production and service departments by tracing direct overhead costs to production and service departments and by allocating common (joint) overhead costs to service and production departments
Allocate service department costs to production departments (using either the direct, step, or reciprocal method)
Allocate overhead costs from production department costs to products, customers, jobs, etc.

40. Chapter Summary (continued)
Joint production processes - two different types of output:
Joint products
By-products
Two types of costs associated with a joint production process:
Joint costs
Separable processing costs
Three methods commonly used to allocate joint costs:
Relative physical units
Relative sales values at the split-off point
Relative NRVs (estimated sales values at the split-off)

41. Chapter Summary (continued)
There are four by-product costing alternatives:
Asset Recognition Methods (i.e., by-product benefits
recognized in period of production):
Net Realizable Value (NRV) Method
Disclosure of By-Product Benefits as “Other Income”
Revenue Methods (i.e., by-product benefits recognized in period of sale):
Disclosure of By-Product Benefits as a Reduction in
Manufacturing Costs Associated with Joint Products