Cost Allocation in General

7/27/2019 Cost Allocation in General

http://slidepdf.com/reader/full/cost-allocation-in-general 1/51

Cost Allocations



We Allocate Costs for Many Reasons



General Framework for Cost Allocation

Cost allocation methods comprise an important

part of a company’s cost management system.




Service departments exist only to

support other departments or customers.

Producing departments are where employees

Work on the organization’s products or services.




Indirect costs must be allocated.

Direct costs can be physically traced to each department.

Many companies develop allocation methods

to assign service department costs to the

producing departments.




Increasingly, companies measure and managethe costs and profitability of their customers.

All organizations accumulate costs for their

products or services for financial reporting purposes.

Customer related costs include:

Order processingCustomer service

Dedicated customer support




A cost driver that has a logical, cause-effect relationship

to the cost will be used as a cost-allocation base

An accounting system will assign to a department’s output

all its direct costs plus all the indirect costs allocated to it.



Allocation of Service Department Costs

Establish the details regarding

cost allocation in advance.

Allocate variable- and fixed-

cost pools separately.

Evaluate performance using budgets for

each production and service department.



Service Department Example

Computer Department

5-year lease

School of Business School of Engineering




Suppose there are two major

purposes for the allocation:

Predicting economic effects

of the use of the computer

Motivating departments and

individuals to use its

capabilities more fully




The primary activity performed

is computer processing.

Resources consumed include1. Processing time

2. Operator time

3. Consulting time

4. Energy

5. Materials

6. Building space

The budget formula for the

forthcoming year is $100,000

monthly fixed cost plus $200

variable cost per hour of

computer time used.



Variable-Cost Pool

The cost driver for the variable-cost pool is

Actual hours of computer time used.

Therefore, variable costs should

be allocated as follows:

Budgeted unit rate X Actualhours of computer time used



Variable-Cost Pool

Consider the allocation of variable

costs to a department that uses

600 hours of computer time.

Suppose inefficiencies in the

computer department caused the

variable costs to be $140,000

instead of $120,000.

600 hours × $200 = $120,000



Variable-Cost Pool

A good cost-allocation scheme would allocate

only the $120,000 to the consuming department

and would let the $20,000 remain as an

unallocated unfavorable budget varianceof the computer department.

This scheme holds computer department managersresponsible for the $20,000 and reduces the resentment of

user managers.



Fixed-Cost Pool

The cost driver for the fixed-cost pool is

the amount of capacity required when

the computer facilities were acquired.

Fixed costs should be allocated as follows:

Budgeted percent of capacity available for use

× Total budgeted fixed costs



Fixed-Cost Pool

Suppose the deans had originally predicted the

long-run average monthly usage as follows:

School of Business: 210 hours School of Engineering: 490 hours

How is the fixed-cost pool allocated?

Business: 210 ÷ 700 = 30%

$100,000 X .3 = $30,000

Engineering: 490 ÷ 700 = 70%

$100,000 X .7 = $70,000



Fixed-Cost Pool

This predetermined lump-sum approach

is based on the long-run capacity

available to the user, regardless of

actual usage from month to month.

A major strength of using capacity available rather

than capacity used when allocating budgeted fixedcosts is that actual usage by user departments does not

affect the short-run allocations to other user departments.



The city of Clare leases a photocopy machine, which it uses in its Copy Services Department

for $2,500 per month plus 4¢ per copy made. In addition to the lease costs, operating costs

for toner, paper, operator salaries, and so on are variable at 7¢/copy. All departments of the

city combined estimated that they would 70,000 copies per month. The Parks and Recreation

Department estimated that they would make 10,000 copies per month on average. In June,the Parks and Recreation Department made 12,000 copies and the total number of copies

made by Copy Services for the month was 58,000.

Following the guidelines of allocating variable- and fixed-costs of service departments

separately, the variable costs of the Copy Services Department that should be allocated to the

Parks and Recreation Department in June are _____.

a. $480 b. $840 c. $1,130 d. $1,320 e. some other amount

Following the guidelines of allocating variable- and fixed-costs of service departments

separately, the fixed costs of the Copy Services Department that should be allocated to theParks and Recreation Department in June are _____.

a. $0 b. $200 c. $357 d. $2,500 e. some other amount



Open Q. 9.47 on pg. 390



Reciprocal Services

Service departments often support

other service departments in addition

to production departments.

There are three popular methods for

allocating service department costs:

The direct method

The step-down method

The Reciprocal method



Available Options• There are three methods that we could use

– Direct method – Step down method

– Reciprocal method

• Methods increase in accuracy from direct to step

down to reciprocal – The number of computations needed also increases

• Spreadsheets make step-down method easy toimplement

• Standard accounting software allows us toimplement the reciprocal method



Direct and Step-Down Methods

The direct method ignores other service

departments when any given service

department’s costs are allocated

to the revenue-producing(operating) departments.

The step-down method recognizes that someservice departments support the activities

in other service departments as well as

those in production departments.



Direct and Step-Down Methods

Facilities management cost = $1,260,000

Human resources cost = $240,000

Total square footage in production departments:

15,000 processing + 3,000 assembly = 18,000

Total employees in production departments16 processing + 64 assembly = 80

Square footage in human resources = 9,000



Direct Method

Facilities management cost

allocated to processing =

(15,000 ÷ 18,000) × $1,260,000 = $1,050,000

Facilities management cost

allocated to assembly =(3,000 ÷ 18,000) × $1,260,000 = $210,000



Direct Method

Human resources cost

allocated to processing =

(16 ÷ 80) × $240,000 = $48,000

Human resources cost

allocated to assembly =(64 ÷ 80) × $240,000 = $192,000



The Step-down method

• Concept

– Takes some account of interactions

– Rank order support departments per some criterion

(usually size) – Allocate from S1 to all others (including S2, S3…)

– S2 cost now includes own cost plus cost allocated from S1

– Allocate from S2 to remaining departments (S3,…)

– In this way, we close out one support pool at each step



Step-Down Method

To assembly:

(3 ÷ 27) × $1,260,000 = $140,000

To human resources:

(9 ÷ 27) × $1,260,000 = $420,000

To processing:

(15 ÷ 27) × $1,260,000 = $700,000



Step-Down Method

To assembly:

(64 ÷ 80) × $660,000 = $528,000

$240,000 + $420,000 = $660,000

To processing:

(16 ÷ 80) × $660,000 = $132,000



Step-Down Method

Processing department

Direct Step-Down

Direct department costs $1,000,000 $1,000,000

From facilities management 1,050,00 700,000

From Personnel 48,000 132,000

Total costs $2,098,000 $1,832,000



Step-Down Method

Assembly department

Direct Step-Down

Direct department costs $1,600,000 $1,600,000

From facilities management 210,000 140,000

From personnel 192,000 528,000

Total costs $2,002,000 $2,268,000



The Reciprocal Method

• Conceptually most accurate

– Takes all linkages into account

• Views the allocation problem as a system of

equations

– Uses matrix algebra to solve

• Easily implemented with modern computer packages

– Makes interpretation of rates quite hard, however

– The rate from S1 includes cost from S2, S3 etc, each of which has costs from S1!

• This circularity has the potential to confuse the casual user



Mechanics

• Set up system of equation

– A = $650,000 + 0.10 P

– P = $250,000 + 0.30 A.

• We solve this system of equations by substituting the

second equation into the first equation.

– A = $719,895, P = $465,969

• Can use Excel for more complex systems



Direct Method: Computations



Step-down Method: Computations



Reciprocal Method: Computations



Open Q. 16.32 on pg. 656



Open Q. 16.35 on pg. 657



ALLOCATIONS FOR VALUING

INVENTORY

Wh d W N d Thi All i ?



Why do We Need This Allocation?

• Required by GAAP/AS

– Determine inventory values

• Matching principle

– Manufacturing costs inventoriable

• Pertains to units made

• Product cost / Inventoriable cost

– SGA cost is expensed

• Pertains to units sold

• Period cost

Fl f C t i V i bl C ti



In Income Statement In Balance Sheet

Produce unitsStandard: 18,000 unitsDeluxe: 12,000 units

Panel A: Physical flow of units

Spend $5,040,000

on fixedmanufacturing

overhead

Panel B: Variable Costing

Expense theentire amount

$5,040,000

Sell unitsStandard: 17,000 unitsDeluxe: 11,600 units

Put units intoinventory

Standard: 1,000 units

Deluxe: 400 units

Alwayszero dollars

intoinventory

Flow of Costs in Variable Costing



Income Statement Standard Deluxe Total

Production volume (in units) 18,000 12,000 30,000

Sales volume (in units) 17,000 11,600 28,600

Revenue $11,050,000 $10,150,000 $21,200,000

Variab le Costs

Manufacturing $6,290,000 $5,800,000 $12,090,000

Marketing & sales 408,000 835,200 $1,243,200

Contribution Margin $4,352,000 $3,514,800 $7,866,800

Fixed Costs

Manufacturing overhead $5,040,000

2,520,000

Profit before Taxes $306,800

Unit-Level Data Standard Deluxe

Direct materials 295 350

Direct labor 75 150

Inventoriable cost per unit $370 $500

× # of units in inventory 1,000 400

Value of inventory (total) $370,000 $200,000 $570,000

SGA costs

Flow of Costs in Absorption Costing



Flow of Costs in Absorption Costing

In Income Statement In Balance Sheet

Panel C: Absorption Costing

Produce unitsStandard: 18,000 unitsDeluxe: 12,000 units

Panel A: Physical flow of units

Spend

$5,040,000 onfixed

manufacturingoverhead

Allocate to

products

Standard: $120/unit Deluxe: $240/unit

1,000 Standard* $120/unit+ 400 Deluxe

*240/unit= $216,000

7,000 Standard* $120/unit+ 11,600 Deluxe

* $240/unit= $4,824,000

Sell unitsStandard: 17,000 unitsDeluxe: 11,600 units

Put units into inventoryStandard: 1,000 units

Deluxe: 400 units





Production volume (in units) 18,000 12,000 30,000

Sales volume (in units) 17,000 11,600 28,600

Revenue $11,050,000 $10,150,000 $21,200,000

Produc t Costs Variable costs $6,290,000 $5,800,000 $12,090,000

Manufacturing overhead 2,040,000 2,784,000 $4,824,000

Gross Margin $2,720,000 $1,566,000 $4,286,000

Period Costs

Variable marketing & sales 408,000 835,200 $1,243,2002,520,000

Profit before Taxes $522,800

Unit-Level Data Standard Deluxe

Direct materials 295 350

Direct labor 75 150 Allocated overhead $120 $240

Inventoriable cost per unit 490 740

× # of units in inventory 1,000 units 400 units

Value of inventory (total) 490,000 296,000 786,000

Fixed SG&A



ALLOCATIONS:INCENTIVE EFFECTS

B h i M difi ti



Behavior Modification

• Allocations modify behavior – Can induce desired actions

– Make undesired actions costly

•

Allocation is like a “tax” – Increases the cost of the driver unit

• If “price” increases, demand decreases

– Allocate on labor hours / labor cost

• Reduce demand for labor

– Allocate based on materials cost

• Incentives to in-source

Allocations and Behavior



Allocations and Behavior

• We can use this property to

–

Sensitize users to the long-term cost of a resource• Cost of support departments such as IT are allocated even if

“fixed” in the short term

– Discourage undesired behavior

• Use some measure correlated with use as the basis

• Use will go down as the “price” for the measure has increased

– Encourage desired behavior

•Suppose we want to tradeoff labor for materials cost

• Using labor as an allocation basis provides the incentives to

employees



Strategic Allocations

• By choosing pools and drivers strategically, we can

use allocations to increase the amount cost allocated

to some products

– Of course, costs for other products will decrease

• Such allocations might be useful if one set of items

has cost based pricing or reimbursements

– Example: Government contracting



Unit Data

(Public/Military)

Sales volume (in units) 2,000,000 2,000,000 Panel A: Using Un its as the

Allocation Basis

Revenue $8.00 / $7.20 $16,000,000 $14,400,000 $30,400,000Variable costs $5.00 / $4.00 10,000,000 8,000,000 18,000,000 Allocated fixed costs $2.00 / $2.00 4,000,000 4,000,000 8,000,000

Gross Margin $2,000,000 $2,400,000 $4,400,000

Panel B: Using Mach in e Hours

as the Allocation Basis

Revenue $8.00 /$6.72 $16,000,000 $13,440,000 $29,440,000Variable costs $5.00 /$4.00 10,000,000 8,000,000 18,000,000 Allocated fixed costs 60% / 40% 4,800,000 3,200,000 8,000,000

Gross Margin $1,200,000 $2,240,000 $3,440,000

Ryan Supply Systems: Condensed Income StatementsPublic Military Total

Choices Depend on Why We Allocate



Choices Depend on Why We Allocate

Conclusion



Conclusion

• Allocations pervasive in organizations

•

Multiple reasons for why organizations allocatecommon costs

– Only decision making related to controllability

– Incentives drive the other demands for allocations

• Same allocation used for multiple purposes

– When using allocations to make decisions

• Be aware of how allocations might help

• How the validity of the choices affect estimated capacity cost

• Consider incentive effects of the allocation mechanism in place



Group Assignements

• Case Analysis

• Group #1 – Case 9.63

• Group#2 – Case 9.65

Cost Allocation in General

Documents

Transcript of Cost Allocation in General