Chapter 11 Cost Allocation Outline

Chapter 11 Cost Allocation Outline LO 11-1 Explain why service costs are allocated. SERVICE DEPARTMENT COST ALLOCATION • The cost allocation process has other roles, two of which are explored in this chapter. o In our discussion of two-stage cost allocation, we took the first-stage allocation process as given and concentrated on allocating the cost pools in the second stage. •  In the first stage of the two-stage cost allocation, part of the overhead costs is incurred for departments that do not produce the service or product directly.  We will consider service department cost allocation, which is the process used to allocate the costs of these “service” departments. Service departments provide services to other departments in the organization. o Examples of service departments and what they do: •  Personnel, accounting, and purchasing departments provide services to production departments.  An information systems department provides support for information technology support to other departments.  A human resources department provides hiring and training services to other departments. User departments use the functions of service departments. For example, the production department uses the services provided by the information systems and human resources departments. o User departments could be other service departments or production or marketing departments that produce or market the organization’s products. • Our focus in this chapter is on allocating the costs of service departments to production departments. o We also discuss how the allocation process can help managers make decisions about keeping or eliminating the service departments. (See Business Application box “Outsourcing Information Services—Managed Service Providers.”) • As shown in Exhibit 11.1, most user departments make use of all service departments. Depending on the situation, the service departments also provide service to each other. o An intermediate cost center is any cost center whose costs are charged to other departments in the organization. o A final cost center is a cost center, such as a production or marketing department, whose costs are not allocated to another cost center. o All organizations (service, merchandising, and manufacturing) have production or marketing departments and service departments. METHODS OF ALLOCATING SERVICE DEPARTMENT COSTS • Three methods to allocate service department overhead costs are: o Direct method o Step method o Reciprocal method • Service department costs are allocated for two purposes: o To determine the cost to produce and market products or services. o To encourage operating department managers to monitor service department costs (crossdepartment monitoring).  • Each service department is an intermediate cost center whose costs are recorded as incurred and then distributed to other cost centers. Allocation Bases  An important decision in cost allocation is to choose which allocation base to use. The usual criteria (cause and effect, reasonableness, and fairness) are still important here. LO 11-2 • Allocate service department costs using the direct method. Direct Method o The direct method is a cost allocation method that charges costs of service departments to user departments without making allocations between or among service departments.  The direct method allocates costs directly to the final users of a service, ignoring intermediate users. o Allocate Information Systems Department Costs  Exhibit 11.4 is the cost flow diagram that illustrates the direct method.  Using the direct method, there are no allocations between service departments. It ignores the costs that the service departments themselves incur when they use services from other departments. Cross-department monitoring is lost in that regard.  The application of the direct method of cost allocation is shown in Exhibit 11.3. o Allocate Administration Department Costs  Exhibit 11.5 shows the flow of costs in T-accounts and the allocations to be recognized for the departments when the direct method is used. • The direct costs of service departments are first recorded in those service departments and shown on the debit side of the service department accounts. • Then, the service department costs are allocated to the user departments. • The user departments also have direct costs (indicated as the direct overhead costs) that do not have to be allocated to the user departments because they are debited to the department accounts when incurred. See Demonstration Problem 1 o Limitations of the Direct Method • Some people have criticized the direct method because it ignores services provided by one service department to another. • If one purpose of cost allocation is to encourage cross-departmental monitoring, the direct method falls short because it ignores the costs that service departments themselves incur when they use other service departments.  This criticism has led some companies to use other methods of service department cost allocation, which is described next. LO 11-3 • Allocate service department costs using the step method. Step Method o The step method is the method of service department cost allocation that allocates some service department costs to other service departments.   The step method recognizes that some services are provided by one service department to others. • The sequence of allocation is determined so that the allocation begins with the service department that has provided the largest proportion of its total services to other service departments, or the service department with the largest cost. • The percentage of service costs ignored in the step allocation process is minimized by choosing either of the allocation orders suggested. • Once an allocation is made from a service department, no further allocations are made back to that department. Allocate Service Department Costs •  A service department that provides services to, and receives services from, another service department has only one of these two relationships recognized.  Exhibit 11.6 shows the computation of the step method.  Exhibit 11.7 is the cost flow diagram for the step method example.  The flow of costs through the accounts is shown in Exhibit 11.8. The step method may result in more reasonable allocations than the direct method because it recognizes that some service departments use other service departments for support. (See Business Application box “Step Method at Stanford University.”) See Demonstration Problem 2 o Limitations of the Step Method  The step method does not recognize reciprocal services.  The step method is not necessarily better than the direct method when both the costs and benefits of using cost allocation are considered. A company already uses the direct method can find it uneconomical to switch methods. LO 11-4 • Allocate service department costs using the reciprocal method. Reciprocal Method o The reciprocal method is the method to allocate service department costs that recognizes all services provided by any service department, including services provided to other service departments.  The reciprocal method is identical to the actual process by which services are exchanged among departments within organizations.  Allocating Service Department Costs • With the reciprocal method, the costs of each service department are written in equation form: Total service department costs • = Direct costs of the service department + Cost allocated to the service department  There is a single equation for each of the service departments and there is a single unknown (the total cost of the service department) for each service department in the organization.  The system of equations is solved simultaneously using matrix algebra. (For this reason, the reciprocal method is also called the simultaneous solution method.) In the case with two service departments, define the unknowns S1 and S2 to be the total service department costs for the two service departments. Then the simultaneous equations can be set up as:  S1= Direct costs of the first service department + α × S2, and S2 = Direct costs of the second service department + β × S1, where: α = Proportion of services provided by the second service department to the first. β = Proportion of services provided by the first service department to the second.  Exhibit 11.9 shows the computation of the reciprocal method  Exhibit 11.10 is the cost flow diagram for the reciprocal method.  The flow of costs through the accounts is shown in Exhibit 11.11.  The reciprocal method accounts for cost flows in both directions among service departments that provide services to each other.  Both the step method and the direct method could understate the cost of running service departments because these methods omit costs of certain services consumed by one service department that were provided by other service departments. See Demonstration Problem 3 • Comparison of Direct, Step, and Reciprocal Methods o The three service department allocation methods can be compared in two ways.  The first is to examine how each allocates costs to departments receiving services. As shown in Exhibit 11.12, only the reciprocal method allocates costs to all departments receiving services from other departments.  The second way is to examine the costs each ultimately allocates to manufacturing and marketing departments, as shown in Exhibit 11.13.  Each method allocates the same total cost. o The direct method results sometimes are closer to the reciprocal method results than the results using the step method. o All three allocation methods are arbitrary. If one production department stops using the service of a service department, the costs saved by the firm are unlikely to be equal to the costs allocated by any of the methods. LO 11-5 • Use the reciprocal method for outsourcing decisions. The Reciprocal Method and Decision Making o The primary purpose of allocating service department costs to the production departments is to obtain the manufacturing costs for each of the production departments for product costing and inventory valuation.  The cost information is also developed to assist managers in making decisions, such as whether to outsource some or all of the activities of the service departments.   The cost savings will depend on how much an outside vendor will charge and how much cost in the service departments can be eliminated if outsourced. • If there are no reciprocal services among the service departments, the cost savings are the cost of the eliminated service department that is avoidable (= variable costs + any avoidable fixed costs). • If there are reciprocal services, the manager has to consider the effect of eliminating one of the service departments on the service requirements of the remaining service departments. Because the reciprocal method explicitly recognizes the use of one service department by another, it provides an estimate of what one department costs when reciprocal service costs are included. See Demonstration Problem 4 LO 11-6 Explain why joint costs are allocated. ALLOCATION OF JOINT COSTS • Joint cost is a cost of a manufacturing process with two or more different outputs. Joint products are such outputs from a common input and common production process. o The problem is whether and how to allocate the joint cost of the input to the joint products. • Joint Costing Defined o Exhibit 11.14 shows a diagram of joint cost flows.  Example 1: The following shows a joint production process and its joint costs. After the split-off point, two discernable joint products, A and B, emerge from the process. The costs before the split-off point are joint; any costs spent afterwards are separable. Raw materials Joint production process (with additional materials, labor, and overhead) Joint cost Joint product A Joint product B • Reasons for Allocating Joint Costs o Cost allocations are often used to determine departmental or division costs for measuring executive performance.  When a single raw material is converted into products sold by two or more departments, the cost of the raw material must be allocated to the products involved. • Manufacturing companies must allocate joint costs to measure the inventory value of the products that result from the joint process.  When companies are subject to rate regulation, the allocation of joint costs can be a significant factor in determining the regulated rates.  Any cost allocation method contains an element of arbitrariness and must be clearly stated before being implemented. LO 11-7 Allocate joint costs using the net realizable value method. JOINT COST ALLOCATION METHODS • The two major methods of allocating joint costs are the: o Net realizable value method. o Physical quantities method. • Net Realizable Value Method o The net realizable value method allocates joint costs based on the proportional net realizable value of the joint products at the split-off point.  The net realizable value is the estimated sales value of each product at the split-off point. • If the joint products can be sold at the split-off point, the market value or sales price should be used for this allocation. • If the products require further processing before they are marketable, it could be necessary to estimate the net realizable value at the split-off point. This approach is called the estimated net realizable value, sometimes referred to as the netback or work-back method.  The estimated net realizable value is the sales price of a final product minus additional processing costs necessary to prepare a product for sale. Estimated net realizable value = Sales price of a final product after further processing - Additional processing costs necessary to prepare a product for sale • Normally, when a market value is available at the split-off point, it is preferable to use that value rather than the estimated net realizable value method. • If the market value is not available, the net realizable value at the split-off point is estimated by taking the sales value after further processing and deducting the additional processing costs. Joint costs are then allocated to the products in proportion to their net realizable values at the split-off point. • The terms “net realizable value” and “estimated net realizable value” are used to emphasize that we are attempting to determine the value of the products at the split-off point.  • The difference is that in the former case (net realizable value), we can sell the product at the split-off point, so we do not have to estimate a value. See Exhibit 11.15 for a condensed statement of gross margins at the split-off point. Note that the gross margin as a percentage of sales is the same for both products.  This demonstrates an important concept of the net realizable value method, namely, that revenue dollars from any joint product are assumed to make the same percentage contribution at the split-off point as the revenue dollars from any other joint product.  The net realizable value approach implies a matching of input costs with revenues generated by each output. See Demonstration Problem 5 o Estimation of Net Realizable Value  See Exhibit 11.16 for a diagram of the process used by Carlyle Coal Company.  See Exhibit 11.17 for the allocation of the joint cost to the two products using the estimated net realizable value method. See Demonstration Problem 6 LO 11-8 • Allocate joint costs using the physical quantities method. Physical Quantities Method o The physical quantities method allocates joint costs based on measurement of the volume, weight, or other physical measure of the joint products at the split-off point.   The physical quantities method is used when: • Output product prices are highly volatile. • Significant processing occurs between the split-off point and the first point of marketability. • Product prices are not set by the market. Using the physical quantities method, joint costs are assigned to products based on a physical measure. •  This could be volume, weight, or any other common measure of physical characteristics. See Exhibit 11.18 for the allocation of joint costs using the physical quantities method. See Demonstration Problem 7 • Evaluation of Joint Cost Methods o The “jointness” of the joint production process makes it impossible to separate the portion of joint costs attributable to one product from another on a cause-and-effect basis. o Accountants and managers realize that no one allocation method is appropriate for all situations. o If allocated joint costs are used for decision-making purposes, they should be used only with full recognition of their limitations. LO 11-9 Explain how cost data are used in the sell-or-process-further. DECIDING WHETHER TO SELL GOODS NOW OR PROCESS THEM FURTHER • Managers must decide whether it is more profitable to sell the output at an intermediate stage or to process it further. o The relevant data to be considered are the:  Additional revenue after further processing.  Additional costs of processing further. o The decision rules about whether to process further are as follows.  Sell at split-off point if: Sales value at split-off > (Sales value after process – Additional processing cost)  Process further if: Sales value at split-off < (Sales value after process – Additional processing cost) • This decision is illustrated in Exhibit 11.19. o It is important to note that the allocation of the joint costs is irrelevant for the current decision. The only costs and revenues relevant to the decision are those that result from it.  See Business Application box “Different Demands for Different Parts” See Demonstration Problem 8 LO 11-10 Account for by-products. DECIDING WHAT TO DO WITH BY-PRODUCTS • By-products are outputs from a joint production process that are relatively minor in quantity and/or value when compared to the main products. o By-product accounting attempts to reflect the economic relationship between the by-products and the main products with a minimum of recordkeeping for inventory valuation purposes. o Two common methods of accounting for by-products are:  Method 1: The net realizable value from sale of the by-products is deducted from the joint cost of the main product(s). The remaining joint costs are allocated to the main products. •  See Panel A of Exhibit 11.20 for the computation of the gross margin for the two joint products when the net realizable value of the by-product is used to reduce the joint cost (method 1). Method 2: The proceeds from sale of the by-products are treated as other revenue. All joint costs are allocated to the main products. o A complication can arise under both methods if the cost of processing by-products occurs in one period but they are not sold until the next period. Companies may find it necessary to keep an inventory of the by-product processing cost in the Additional by-product cost account until the byproducts are sold. o Some companies expense the by-products’ costs in the period they are incurred and then record the total revenue from by-products when they are sold, a simple approach that technically violates the matching principle. See Demonstration Problem 9