Service Department and Joint Cost Allocation: Solutions to Review Questions

11 Service Department and Joint Cost Allocation Solutions to Review Questions 11-1. Why do companies allocate costs? What are some of the advantages and disadvantages to doing so? Companies allocate costs to estimate or assess the costs of their activities (products, processes, etc.). It is an estimate and subject to the problem that cost allocation contains an arbitrary element. Not allocating costs, however, is also an estimate—an estimate of zero. This may be appropriate for some decisions, but not for others. Some of the disadvantages (costs) include: (1) Additional bookkeeping; (2) Additional management costs in selecting allocation methods and allocation bases; (3) Costs of making the wrong decision if the allocations provide misleading information. Some of the advantages (benefits) of cost allocation include: (1) Instilling responsibility for all costs of the company in the division managers; (2) Relating indirect costs to contracts, jobs, and products; (3) Constructing performance measures (“net profit”) for a division that may be more meaningful to management than contribution margins. 11-2. What are the three methods of allocating service department costs? The three methods of allocating service department costs are the (1) direct method, (2) step method, and (3) reciprocal method. 11-3. What are the similarities and differences among the direct method, the step method, and the reciprocal method of allocating costs? The essential difference is the allocation of costs among service departments. The direct method makes no inter-service-department allocation, the step method makes a partial inter-service-department allocation, while the reciprocal solution method fully recognizes inter-service-department activities. All three methods allocate costs to the production departments based on the production department’s relative use. 11-4. What criterion should be used to determine the order of allocation from service departments when the step method is used? Explain why. Allocations usually begin from the service department that has provided the greatest proportion of its services to other service departments, or that services the greatest number of other service departments. This criterion is used to minimize the unrecognized portion of reciprocal service department costs. (Recall that the amount of service received by the first department to allocate in the step allocation sequence is ignored.) Another criterion employed is the amount of cost incurred by the service department. As with other allocation problems, it is a combination of the diversity (the proportion of resources used by other service departments) and the costs involved that are important in making this choice. 11-5. What is a limitation of the direct method of allocating service department costs? The direct method ignores any use of one service department by another. 11-6. What is a limitation of the step method of allocating service department costs? The step method ignores any reciprocal (simultaneous) use of two or more service departments. 11-7. What is the objective of joint cost allocation? Joint cost allocations are usually made to assign a cost to a product after the split-off point. This is usually done for external reporting, tax, or rate-making purposes or to satisfy contract requirements. Because the joint costs are common to the outputs, it is not possible to find a direct way of relating the costs. Rather, the costs are related to economic benefits on the basis of some measure of relative outputs. 11-8. Why would a number of accountants express a preference for the net realizable value method of joint cost allocation over the physical quantities method? Because net realizable values of the output provide a measure of the economic benefit received from each output from the production process, this method is usually preferred when it can be implemented. Further, the physical quantities may be difficult to compare (e.g., weights versus volumes). 11-9. When would a physical quantities method for allocation be preferred? It could be preferable to use a physical quantities measure if it reflects the economic benefit ultimately obtainable from the production process, particularly if there is no objective selling price for joint products. Some examples include public utility rate setting, energy price regulation, new market setting, and new product price setting. In all of these cases, it is not possible to use the relative sales value method. Of course, the physical quantity measure used must make sense. Thus, ounces of lead should not be added to ounces of silver for joint cost allocation purposes. 11-10. What is the basic difference between the allocation of joint costs to (a) joint products and (b) by-products? For joint products, costs of the inputs up to the split-off point are allocated to each of the products. Costs prior to split-off are not allocated to by-products in the same way as to the main (joint) products. Either joint costs (costs incurred prior to split-off) equal to the sales value of the by-product are allocated to the byproduct, reducing the costs allocated to the main products (Method 1 in the text) or no joint costs are allocated to the by-product and it is credited with its sales value (Method 2). 11-11. What costs are irrelevant for the decision of whether to sell a joint product or process it further? The joint costs of the product are irrelevant to this decision. Using the principle of differential costs, the joint costs are not differential in this decision. They are sunk costs, because they must be incurred under either decision.