1. Cost Allocation Introduction to Management Accounting Chapter 12

2. General Framework for Cost Allocation Four types of cost objectives: Service departments Producing departments Products/services, andCustomers. Learning Objective 1 Cost allocation methods comprise an importantpart of a companys cost management system. 3. General Framework for Cost Allocation Service departments exist only tosupport other departments or customers. Producing departments are where employees Work on the organizations products or services. 4. General Framework for Cost Allocation 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. 5. General Framework for Cost Allocation Increasingly, companies measure and managethe costs and profitability of their customers. All organizations accumulate costs for theirproducts or services for financial reporting purposes. Customer related costs include: Order processing Customer service sales commissions Dedicated customer support 6. General Framework for Cost Allocation A cost driver that has a logical, cause-effect relationshipto the cost will be used as a cost-allocation base An accounting system will assign to a departments output all its direct costs plus all the indirect costs allocated to it. 7. Allocation of Service Department Costs Learning Objective 2 Establish the details regarding cost allocation in advance. 1 Allocate variable- and fixed- cost pools separately. 2 Evaluate performance using budgets for each production and service department. 3 8. Service Department Example Computer Department 5-year lease School of Business School of Engineering 9. 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 10. Service Department Example The primary activity performed is computer processing. Resources consumed include 1. Processing time2. Operator time 3. Consulting time4. 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. 11. Variable-Cost Pool The cost driver for the variable-cost pool isActual hours of computer time used. Therefore, variable costs should be allocated as follows: Budgeted unit rate X Actualhours of computer time used 12. 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 13. 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. 14. 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 15. Fixed-Cost Pool Suppose the deans had originally predicted thelong-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 16. 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 notaffect the short-run allocations to other user departments. 17. Reciprocal Services Service departments often support other service departments in addition to production departments. There are two popular methods for allocating service department costs: The direct method The step-down method 18. 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. Learning Objective 3 19. 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 20. DirectMethod 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 21. DirectMethod Human resources cost allocated to processing = (16 80) $240,000 = $48,000 Human resources cost allocated to assembly = (64 80) $240,000 = $192,000 22. Step-Down Method Facilities management allocation: 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 23. Step-Down Method Human resources allocation: To assembly: (64 80) $660,000 = $528,000 $240,000 + $420,000 = $660,000 To processing: (16 80) $660,000 = $132,000 24. Step-Down Method Processing department DirectStep-Down Direct department costs $1,000,000 $1,000,000From facilities management 1,050,00 700,000 From Personnel 48,000 132,000Total costs $2,098,000 $1,832,000 25. Step-Down Method Assembly department Direct Step-Down Direct department costs $1,600,000 $1,600,000From facilities management 210,000 140,000From personnel 192,000 528,000Total costs $2,002,000 $2,268,000 26. Costs Not Related to Cost Drivers Guidelines: Identify additional cost drivers. 1 Allocate all costs by the direct or step-down method using square footage as the cost- allocation base. 2 27. Traditional Approach 1. Divide the costs in each producing departments. 2. Assign direct costs to the appropriate products, services, or customers. Learning Objective 4 Direct costs Indirect costs 28. Traditional Approach 3. Select one or more cost pools and related cost drivers in each production department. Indirect departmental costs Cost pool Cost pool Cost pool 29. Traditional Approach 4. Allocate costs Costs Product B Product A Product C 30. Activity-Based Costing Determine the key components of the system. Step 1: Step 2: Develop the relationships among resources, activities, and cost objectives. 31. Activity-Based Costing Step 3: Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities. Step 4: Calculate and interpret the new activity-based cost information. 32. Allocation of Customer Costs Customer profitability depends on more than grossmargin, it depends on the costs incurred to fulfillcustomer orders and to provide other customer services. Allocate costs associated withcustomer actions to customers. Learning Objective 5 33. Allocation of Customer Costs

Small order quantity

Many order changes

Large amounts of pre-

and post-sales support

Expedited scheduling

Special delivery requirements

Frequent returns

Large order quantity

Few order changes

Little pre- and

post-sales support

Regular scheduling

Standard delivery

Few returns

Customer Type 1 Customer Type 2 High Cost to Serve Low Cost to Serve 34. Allocation of Customer Costs Customer Type 1 Low Cost to Serve

Buys a mix of products that

have high gross margins

Has a low cost-to-serve %

Has a high level of profitability

Buys a mix of products that

have lower gross margins

Has a high cost-to-serve %

Has a low level of profitability

Customer Type 2 High Cost to Serve 35. Allocation of Customer Costs Assume Cedar City Distributors (CCD),distributes many products to retail outlets. The products are classified into just two product groups apparel and sports gear.

CCD has two types of customers:

Small store

Large store

36. Allocation of Customer Costs CCD uses a simple cost accounting system to calculate both product and customer profitability. The only direct costs are costs of the purchase of apparel and sports gear products. Indirect costs are allocated to the product groups using a single indirect cost pool for all indirect costs with pounds of product as the allocation base. Costs 37. Allocation of Customer Costs Small Stores Large Stores Cases Profit MarginTotalCases Profit MarginTotal per caseProfit Marginper caseProfit Margin Apparel 600$265.00$159,000800 $265.00$212,000Sports Gear200 315.0063,000 800315.00252,000 222,000 464,000Profit Margin Percentage 43.7%41.4%

To determine customer profitability:

1.Calculate the profit margin per case for each product

Use the product mix ordered by each customer to calculate profitability

38. Allocation of Costs-to-Serve Might number of customer orders be amore plausible cost-allocation base? The cost of resources used for order processing and customer service activities should be included in a separate cost pool and allocatedon the basis of number of orders. This system gives managers at CCD more insight into operations, and a tool to measure and manage customer profitability. 39. Allocation of Central Costs Many managers believe it is desirable to fully allocate all costs to the revenue- producing parts of the organization. Whenever possible, the preferred driver for central services is usage. Learning Objective 6 If a company does allocate the costs ofcentral services based on sales, althoughcosts do not vary in proportion to sales, itshould use budgeted, not actual, sales. 40. Allocation of Central Costs Usage Revenue Cost of goods sold Total assets Total cost of each division Not always economically viable 41. Allocation of Joint CostsLearning Objective 7 Two conventional ways of allocating joint costs to products are widely used: Physical units Relative sales values Joint costs include all inputs of material, labor, andoverhead costs that are incurred before the split-off point. 42. Allocation of Joint Costs The physical-units method requires a common physical unit for measuring the output of each product. The joint costs are allocated based on each products percentage of the total physical units produced. Allocation of joint costs should not affect decisions about the individual products. 43. Physical-Units Method Dow Chemical produces two chemicals, X and Y.The joint cost is $100,000.X sells for $.09 per liter and Y for $.06.AllocationSales Value at Liters Weightingof Joint CostsSplit-off PointX1,000,000(10/15)X$100,000$66,667$90,000Y500,000 (5/15)X$100,00033,333 30,000 1,500,000100,000120,000 44. Relative-Sales-Value Method The joint costs are allocated based on each products sales value as a percentage of the total sales value at split-off. 45. Relative-Sales-Value Method Relative SalesValue atAllocationSpit-off Point Weightingof Joint Costs X$90,000(90/120)X$100,000$75,000Y3 0,000 (30/120X$100,00025,000 $120,000$100,000When weighting is based on the sales value of the individual products, the allocation of a cost to one product depends upon the sales value of both products. 46. By-Product Costs A by-product is not individually identifiable until manufacturing reaches a split-off point. They have relatively insignificant sales value. 47. By-Product Costs If an item is accounted for as a by-product, only separable costs are allocated to it. All joint costs are allocated to the main products. Any revenues from by-products, less their separable costs, are deducted from the cost of the main products. 48. The End End of Chapter 12