Cost Allocations

We Allocate Costs for Many Reasons

General Framework for Cost Allocation

Cost allocation methods comprise an important part of a companys cost management system.

General Framework for Cost Allocation

Producing departments are where employees Work on the organizations products or services.

Service departments exist only to support other departments or customers.

General Framework for Cost Allocation

Direct costs can be physically traced to each department.

Indirect costs must be allocated.

Many companies develop allocation methods to assign service department costs to the producing departments.

General Framework for Cost Allocation

All organizations accumulate costs for their products or services for financial reporting purposes. Increasingly, companies measure and manage the costs and profitability of their customers. Customer related costs include: Order processing Customer service Dedicated customer support

General Framework for Cost Allocation

An accounting system will assign to a departments output all its direct costs plus all the indirect costs allocated to it.

A cost driver that has a logical, cause-effect relationship to the cost will be used as a cost-allocation base

Allocation of Service Department Costs

Establish the details regarding cost allocation in advance. Allocate variable- and fixedcost pools separately. Evaluate performance using budgets for each production and service department.

Service Department Example

5-year lease

Computer Department

School of Business

School of Engineering

Service Department Example

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

Service Department Example

The primary activity performed is computer processing. Resources consumed include 1. 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 Actual hours of computer time used

Variable-Cost Pool
Consider the allocation of variable costs to a department that uses 600 hours of computer time. 600 hours $200 = $120,000 Suppose inefficiencies in the computer department caused the variable costs to be $140,000 instead of $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 variance of the computer department.

This scheme holds computer department managers responsible 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 fixed costs 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 the Parks 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

 There are three methods that we could use

Direct method Step down method Reciprocal method

Available Options

Methods increase in accuracy from direct to step down to reciprocal

The number of computations needed also increases

Spreadsheets make step-down method easy to implement Standard accounting software allows us to implement the reciprocal method

Direct and Step-Down Methods

The direct method ignores other service departments when any given service departments costs are allocated to the revenue-producing (operating) departments.

The step-down method recognizes that some service 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 departments 16 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 human resources: (9 27) $1,260,000 = $420,000 To processing: (15 27) $1,260,000 = $700,000 To assembly: (3 27) $1,260,000 = $140,000

Step-Down Method

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

To processing: (16 80) $660,000 = $132,000 To assembly: (64 80) $660,000 = $528,000

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 Direct department costs $1,600,000 From facilities management 210,000 From personnel 192,000 Total costs $2,002,000

Step-Down $1,600,000 140,000 528,000 $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

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

Flow of Costs in Variable Costing

Panel A: Physical flow of units
In Income Statement In Balance Sheet

Produce units Standard: 18,000 units Deluxe: 12,000 units

Sell units Standard: 17,000 units Deluxe: 11,600 units

Put units into inventory Standard: 1,000 units Deluxe: 400 units

Panel B: Variable Costing

Spend $5,040,000 on fixed manufacturing overhead

Expense the entire amount $5,040,000

Always zero dollars into inventory

Income Statement Production volume (in units) Sales volume (in units) Revenue Variable Costs Manufacturing Marketing & sales Contribution Margin Fixed Costs Manufacturing overhead SGA costs Profit before Taxes Unit-Level Data Direct materials Direct labor Inventoriable cost per unit # of units in inventory Value of inventory (total)

Standard 18,000 17,000 $11,050,000 $6,290,000 408,000 $4,352,000

Deluxe 12,000 11,600 $10,150,000 $5,800,000 835,200 $3,514,800

Total 30,000 28,600 $21,200,000 $12,090,000 $1,243,200 $7,866,800 $5,040,000 2,520,000 $306,800

Standard 295 75 $370 1,000 $370,000

Deluxe 350 150 $500 400 $200,000

$570,000

Flow of Costs in Absorption Costing

Panel A: Physical flow of units
In Income Statement In Balance Sheet

Produce units Standard: 18,000 units Deluxe: 12,000 units

Sell units Standard: 17,000 units Deluxe: 11,600 units

Put units into inventory Standard: 1,000 units Deluxe: 400 units

Panel C: Absorption Costing

Spend $5,040,000 on fixed manufacturing overhead

Allocate to products Standard: $120/unit Deluxe: $240/unit

7,000 Standard * $120/unit + 11,600 Deluxe * $240/unit = $4,824,000

1,000 Standard * $120/unit + 400 Deluxe *240/unit = $216,000

Income Statement Production volume (in units) Sales volume (in units)

Standard 18,000 17,000

Deluxe 12,000 11,600

Total 30,000 28,600 $21,200,000 $12,090,000 $4,824,000 $4,286,000 $1,243,200 2,520,000 $522,800

Revenue $11,050,000 $10,150,000 Product Costs Variable costs $6,290,000 $5,800,000 Manufacturing overhead 2,040,000 2,784,000 Gross Margin $2,720,000 $1,566,000 Period Costs Variable marketing & sales 408,000 835,200 Fixed SG&A Profit before Taxes 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

ALLOCATIONS: INCENTIVE EFFECTS

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

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

Ryan Supply Systems: Condensed Income Statements

Unit Data (Public/Military) Public Military Total

Sales volume (in units) Panel A: Using Units as the Allocation Basis Revenue Variable costs Allocated fixed costs Gross Margin Panel B: Using Machine Hours as the Allocation Basis Revenue Variable costs Allocated fixed costs Gross Margin

2,000,000

2,000,000

$8.00 / $7.20 $5.00 / $4.00 $2.00 / $2.00

$16,000,000 10,000,000 4,000,000 $2,000,000

$14,400,000 $30,400,000 8,000,000 18,000,000 4,000,000 8,000,000 $2,400,000 $4,400,000

$8.00 /$6.72 $5.00 /$4.00 60% / 40%

$16,000,000 10,000,000 4,800,000 $1,200,000

$13,440,000 $29,440,000 8,000,000 18,000,000 3,200,000 8,000,000 $2,240,000 $3,440,000

Choices Depend on Why We Allocate

Conclusion
Allocations pervasive in organizations Multiple reasons for why organizations allocate common 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