Chapter 7: Cost Allocation

The Strategic role of cost allocation has four objectives

1. Determine accurate departmental and product costs as a basis for the evaluation of the cost efficiency of departments and the profitability of different products, financial reporting, and tax compliance

2. Motivate managers to exert a high level of effort to achieve the goals of top management

3. Provide the right incentive for managers to make decisions that are consistant with the goals of top manaement

4. Fairly determine the rewards earned by the managers for their effort and skill and for the effectiveness of their decision making

Objective one

requires the cost allocation method to be sufficiently accurate to support effective management decision making about the products and departments

-must comply with FASB and the IRS

-the desired cost allocation method might differ for the three functions: cost management, financial reporting, and tax compliance

Objective two

-to be effective the cost allocation (when it is later used as part or performance evaluation and compensation) must reward department managers for reducing costs as desired

-motivation issue is whether the manager controls the allocated cost

Objective Three

-providing the incentive for decision making is achieved when cost allocation effectively provides the incentives for the individual manager to act autonomously in a manner that is consistent with top management's goals

-the cost allocation provides an incentive for individual and joint efforts to manage these costs and encourages managers to use these costs and encourages managers to use these resources to improve the performance of their units

Objective four

-the cost allocation is clear and consistently applied in determining the manager's performance evaluation and compensation

-the most clear and unbiased basis for cost allocation exists when a cause and effect relationship can be determined

alternative concepts of fairness when cause-and-effect bases are not available

-ability-to-bear= commonly employed with bases related to size, such as total sales, total assets, or the profitability of the user departments

-benefit received= based on equity perceived in the circumstance which is often measured in a nonquantitative way

The ethical issues of cost allocation

-ethical issues arise when costs are allocated to products or services that are produced for both a competitive market and a public agency or government department. Although government agencies very often purchases on a cost-plus basis, products sold competitvely are subject to price competition. The incentive in these situations is for the manufacturer, using cost allocation methods, to shift costs from the competitive products to the cost-plus products

-another issue is the equity or fair share issue that arises when a governmental unit reimburses the costs of a private institution or when it provides a service for a fee to the public. In both cases, cost allocation methods are used to determine the proper price or reimbursement amount. There is no single measure of equity in these cases

-the effect of the chosen allocation method on the costs of p/s sold to or from foreign subsidiaries. The cost allocation method usually affects the costs of products traded internationally and therefore the amount of taxes paid on the domestic and the foreign countries. Firms can reduce their worldwide tax liability by increasing the costs of products or services purchased in high-tax countries or in countries where the firm does not have favorable tac treatment. International tac authorities closely watch the cost allocations used by multinational firms

Departmental Cost Allocation Method

1. Trace, rather than allocate, all direct manufacturing costs and allocate manufacturing overhead costs to both the service departments and the production departments

2. Allocate the service department costs to the production departments

3. Allocate the production department costs to the products

-direct manufacturing costs are wages and materials that can be directly linked or traced to a department.

-indirect costs, such as indirect materials, indirect labor, and other costs that cannot be easily and economically traced to a department are allocated by means of a predetermined cost driver to the departments that use those resources

First Phase: Trace Direct Costs and Allocate Indirect Costs to all Departments

-traces the direct costs and allocates the indirect manufacturing costs in the plant to each service and production dept

Allocation in Second and Third phases

-the second phase allocates service department costs to the production departments

--> most complex of the allocation phases because services can flow back and forth between the service departments called reciprocal flows (the flow of services back and forth between service departments)

-the percentage of service relationships is commonly determined by reference to labor hours, units processed, or some other allocation base that best reflects the service provided in the departments

-management accountants can choose among three common methods to allocate costs for the second phase

1. Direct method

2. Step Method

3. Reciprocal method

The Direct Method

the simplest of the three methods

-it ignores the reciprocal flows

-using the service flows only to production departments and determining each production department's share of that service

-these percentage shares are used to allocate the costs from service departments to production departments

-the allocation from production departments to products typically is based on the number of labor hours or machine-hours used in the production departments that produce the products

The Step Method

-uses a sequence of steps in allocating service department costs to production departments

Step one: one service department is selected to be allocated fully, that is, to allocate its costs to the other service departments as well as to each production department. The department to be allocated first usually is chosen because it provides the highest percentage of service to other service departments

-the step method may provide more accurate allocation because one of the reciprocal flows between the two service departments is considered in the allocation (unlike the direct method which ignores all reciprocal flows)

Step two: service department one which is in the first step is allocated to service department two and the two production departments

Step Three: add for the total cost allocated

-Costs are allocated one department at a time, creating a "step-down" effect.

The Reciprocal Method

the preferred of the three methods because, unlike the others, it considers all reciprocal flows among the service departments

-the reciprocal flows are simultaneously determined in a system of equations

an equation for each service department represents the cost to be allocated, consisting of the first-phase allocation costs plus the cost allocated from the other deparment

-The values for S1 and S2 are allocated to the producing departments using the percentage service amounts for each department

--> Because the recriprocal method has considered all reciprocal service department activities, the allocation in the second phase is based on the actual service percentages for each production department

-you can use Solver to solve for S1 and S2

-find the total cost by adding

Implementation issues

the choice of the most accurate allocation method

-the total costs for the methods are the same, the amounts allocated to each product varies

-when significant differences exist, use the reciprocal method

-The additional issues to consider when implementing the departmental allocation approach are (1) disincentive effects when allocation base is unrelated to usage, (2) disincentive effects when the allocation base is actual usage, (3) disincentive effects when allocated costs exceed external purchase cost

Cost Allocation in Service Industries

all these concepts can be applied to any organization that incurs joint costs

joint Product costing

many manufacturing plants yield more than one product from a joint manufacturing process

joint production process

one that yield multiple outputs from a common resource input

Joint products

product form a joint production process that have relatively substantial sales values

by-products

products whos total sales values are minor in comparison to the sales value of the joint products

Split off point

joint products and by-products both start their manufacuting life as part of the same direct materials. Until a certain point in the production process, no distinction can be made between the products.

-The point in a joint production process at which individual products can be separatley identified for the first time is the split-off point

-after the split off point, separate production processes can be applied ot the individual products. At the split off point, joint products or by-products might be salable or require further processing to be salable

joint costs

include all manufactirng costs incurred prior to the split-off point

-thes costs are allocated among the joint products

separable processing costs

additional costs incurred after the split off point that can be identified directly with individual products

Other outputs of joint production

scrap, waste, spoilage, and rework

-scrap: residue from a production process that has little or no recovery value

-waste: a residual material that has no recovery value and must be disposed of by the firm as required

-some products do not meet quality standards and can be rewored for resale

Methods for allocating joint costs to joint products

-joint costs are most frequently allocated to joint products using

1. the physical measure

2. The sales value at slit-off

3. the net realizable value

4. the constant gross margin percentage methods

The physical measure method

A method that uses a physical measure such as pounds, gallons, yards, or units of volume produced at the split-off point to allocate the joint costs to joint products.

1. select the proper physical measure as the basis for allocation (can be units of inputs or outputs; when outputs are used this is the average cost method)

2. 2. when the joint products reach the split off point, we ca compute the relationship of each of the joint products to the sum of the total units.

3. the physical measure is used to determine the relative weights for allocating the joint cost should be the measure of the products at the split-off point, not the measure when the production of products is complete

Advantages and limitations of the physical measure method

adv: easy to use and the criterion for the allocation of the joint costs is objective

dis: ignores the revenue producing capability of individual products that can vary widely among the joint products and have no relationship at all to any physical measure. Each product can also have a unique physical measure and the physical method might not be applicable

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

-used only when joint products can be sold at the split off point

1. Compute the total sales value of the joint products at the split off point

2. determine the proportion of the sales value of each joint product to the total sales value

3. the final operation allocated the total joint costs among the joint products based on those proportions

Advantages and limitations of the sales value at split-off method

adv: easy to calculate and allocated according to each product's revenues

-superior to phy measure method because it allocates the joint costs in proportion to the products ability to absorb these costs

dis: market prices for some industries change constantly. also the sale price at split off might not be available because separable processing is necessary before the product can be sold

The net realizable value method (NRV)

good for products who need more prpcessing after the pslit off point

-the ultimate net sales value that is estimated at the split off point

-est sales value minus separable processing and sellling costs

Advantages and limitations of NRVM

superior to the phy meas meathod because is produces an allocation that yeilds a predictable comparable level of profitabilty among the products

The decision to sell before or after an additional processing

will the seperable costs increase or decrease profits?

-joint costs are not relevent in this decision

The constant gross margin percentage method

-sometimes it is desirable that the compant has joint products with constant or equal gross margin percentages. IF seperable costs for the joint prodcuts are zero or negligable, the NRV will produce a joijnt cost allocation that results in equal or nearly equal gross margin percentages for all joint products. WHen seperable costs are significant and an important goal of the allocation is to achieve an allocation that results in the same gross margin percentage for all joijnt products, then a variation of the NRV method is used.

-The CGMPM determines an allocation of joint cpsts so that after allocation all joint products hav eht esame GM percentage

-assemble nevesary information, determine company wide GMP, determine the amt of joint cost allocation as the residual (rev-seperable costs-desired gross margin amt for each product), complete the method byt shoing the calc of the gross margin and gross margnin percentage