Learning Objectives
Identify the strategic role of cost allocation
Explain the ethical issues of cost allocation
Use three methods for allocating service department costs to production departments
Explain the implementation issues of the three departmental cost allocation methods
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Cost Allocation: Departments, Joint Products, and By-ProductsChapter Seven7-2Identify the strategic role of cost allocationExplain the ethical issues of cost allocationUse three methods for allocating service department costs to production departmentsExplain the implementation issues of the three departmental cost allocation methodsLearning Objectives7-3Learning Objectives (continued)Explain the use of cost allocation in service firmsUse the three methods for allocating joint product costsUse the four by-product costing methods7-4The Strategic Role of Cost Allocation Determine accurate departmental and product costs as a basis for evaluating the cost efficiency of departments and the profitability of different products Motivate managers to exert a high level of effort to achieve the goals of top management Provide the right incentive for managers to make decisions that are consistent with the goals of top management Fairly determine the rewards earned by managers for their effort and skill and for the effectiveness of their decision-making7-5Cost Allocation Bases The most objective basis for cost allocation exists when a cause-and-effect relationship can be determined, such as the relationship between machine breakdowns and maintenance costsOther alternatives exist in the absence of cause-and-effect relationships, such as ability-to-bear and benefit received7-6Ethical Issues in Cost AllocationAn ethical issue arises when costs are allocated to products or services that are produced for both a competitive market and a public or governmental entityThe latter often purchases on a cost-plus basis creating an incentive to shift costs from the competitive products to cost-plus-based products and contractsAn equity or fair-share issue arises when a governmental unit reimburses the costs of a private institution or when it provides a service to the public for a fee–no single measure of equity exists7-7Ethical Issues in Cost Allocation (continued)A third ethical issue is the effect 0f the chosen allocation method on the costs of the products sold to or from foreign subsidiariesBy increasing the costs of products purchased in high-tax countries or in countries where the firm does not have favorable tax treatment, the firm can reduce its overall tax liabilityInternational tax authorities watch the cost-allocation methods of multinational firms very closely for this reason 7-8Overhead Allocations: Three General Approaches Three general approaches for allocating overhead costs to products:The volume-based approach allocates overhead from a single cost poolThe departmental approach allocates overhead to production departments, and then from production departments to productsThe activity-based approach allocates overhead to production activities, and then from production activities to products 7-9The Departmental ApproachThe departmental approach classifies manufacturing departments into production and service departmentsThis approach involves three phases:Trace all direct overhead costs and allocate common overhead costs to both the various production and service departmentsAllocate the service department costs to the production departmentsAllocate production department costs to products7-10The Three Phases of Departmental Cost Allocation7-11Departmental Approach ExampleBeary Company manufactures two products and has two production departments (P-1 and P-2) and two service departments (S-1 and S-2). Beary uses labor-hours (DLH) to allocate indirect labor costs and machine-hours (MH) to allocate indirect materials costs.Not TraceableDepartmental Approach: Phase 17-127-13Departmental Approach: Phase 2 Phase 2, allocation of service department costs: whether, and to what extent, reciprocal cost flows are recognized? Three methods are used to allocate service department costs: The direct method The step method The reciprocal methodPhase 2: Direct Method7-14Phase 3: Direct Method7-15Phase 2: Step Method7-16Phase 3: Step Method7-17Phase 2: Reciprocal Method7-18Phase 2: Reciprocal Method (continued)7-19Phase 3: Reciprocal Method7-207-21Choosing the most accurate method is keyWide variations can occur in the product allocation amountsDetermining an appropriate allocation base and a percentage amount for service provided by the service departments is often difficultVariable costs can be traced easily, but fixed costs are difficult to allocate to departmentsIdeally, firms would use dual allocation, which separates variable and fixed costs and traces the variable costs directly to the departments that caused the costKey Implementation Issues7-22Using budgeted vs. actual amounts?Budgeted (predetermined) amounts can be more difficult to determine but are more motivating for the allocation of fixed costsUsing budgeted amounts makes the allocation of fixed costs more predictable and less dependent upon the usage of other departmentsAllocated costs can exceed external purchase costOccasionally the cost a department is allocated exceeds the cost of purchasing that service from an outside supplier Key Implementation Issues (continued)7-23Joint Product CostingSome manufacturing plants yield more than one product from a common resource input; this is called a joint production process Joint products are products from a joint production process that have relatively substantial sales valuesProducts whose total sales values are minor in comparison to the sales value of the joint products are classified as by-products7-24Joint Product Costing (continued)Joint products and by-products start their manufacturing life as part of the same raw material, so up until a certain point, no distinction can be made between the productsBy-products differ from joint products in that the sales value of the by-product is somewhat lower than that of the joint productsThe point in a joint production process at which individual products can be identified for the first time is called the split-off pointJoint costs include all manufacturing costs incurred prior to the split-off point7-25Joint Product Costing (continued)Costs incurred after the split-off point are called separable processing costsThree methods are commonly used to allocate joint product costsRelative physical units (measures) producedRelative sales values of the products Relative net realizable values (NRV) of the products7-26Cost Allocation Based on Relative Physical UnitsThe physical units method uses a physical measure such as pounds, gallons, or units or volume to allocate the joint costs to joint productsThe greater the output (however measured), the greater the share of joint costs allocated to the productThis method is also called the average cost method when units of output are used in the costing procedureThe Physical Units Method: Example Assume Johnson Seafood produces tuna filets and canned tuna for distribution to restaurants and supermarkets:7-27The Physical Units Method (continued) 7-28The Physical Units Method: SummaryAdvantagesDisadvantages Easy to useIgnores the revenue-producing capability of individual productsThe criterion for the allocation of the joint costs is objectiveEach product can have its own unique physical measure7-297-30Relative Sales Values at Split-off MethodThe sales value at split-off method allocates joint costs to joint products on the basis of their relative sales values at the split-off pointThis method can only be used when joint products can be sold at the split-off pointSales Value at Split-off Point Method: Example Using the same example, the sales value at split-off point method produces the following results:7-31Sales Values at Split-off Point Method: SummaryAdvantagesDisadvantages Easy to calculate Market prices for some industries change constantly Costs are allocated according to the individual product’s revenue Sales price at split-off might not be available because additional processing is necessary for sale7-327-33The Net Realizable Value (NRV) MethodThe NRV method can be used when joint products cannot be sold at split-offThe net realizable value (NRV) of a product is the product’s estimated sales value at the split-off pointNRV is determined by subtracting additional processing and selling costs beyond the split-off point from the estimated ultimate sales value of the productThe Net Realizable Value (NRV) Method: ExampleAssume Johnson Seafood also produces cat food from the raw, unprocessed tuna 7-34The NRV Method: Example (continued) 7-357-36By-Product CostingFour Methods: Two based on assets, two based on revenues:Asset Recognition Methods:Net Realizable Value (NRV) MethodOther Income at Production Point MethodRevenue Methods:Other Income at Selling Point MethodManufacturing Cost Reduction at Selling Point MethodThe main difference between these methods is the former grouping records by-product produced as inventory at NRV, while the latter grouping recognizes by-product revenue in the period sold7-37Cost allocation is strategically important in determining accurate departmental and product costs, for evaluating the cost efficiency of departments, and for assessing the profitability of different productsEthical issues arise when costs are allocated to products or servicesWhat method is being used to allocate the costs?Is the market competitive or on a cost-plus basis?Is the allocation method equitable? Chapter SummaryChapter Summary (continued)There are three methods of overhead allocation:The volume-based approach allocates overhead costs from a single cost pool, directly to products and servicesThe departmental approach allocates overhead to production departments, and then from production departments to productsThe activity-based approach allocates overhead to production activities, and then from production activities to products7-387-39Chapter Summary (continued) This chapter focused on the departmental approach, which has three phases:Assign total overhead costs to production and service departments by tracing direct overhead costs to production and service departments and by allocating common (joint) overhead costs to service and production departmentsAllocate service department costs to production departments (using either the direct, step, or reciprocal method)Allocate overhead costs from production department costs to products, customers, jobs, etc. 7-40Methods Used for Departmental Cost AllocationDirect Method (ignores reciprocal service between service departmentsStep Method (assigns reciprocal service costs in steps)Reciprocal Method (accounts for all reciprocal service between service departments)Chapter Summary (continued)7-41Chapter Summary (continued) Joint production processes - two different types of output: Joint products By-products Two types of costs associated with a joint production process: Joint costs Separable processing costs Three methods commonly used to allocate joint costs: Relative physical units Relative sales values at the split-off point Relative NRVs (estimated sales values at the split-off)7-42Chapter Summary (continued)There are four by-product costing alternatives:Asset Recognition Methods (i.e., by-product benefits recognized in period of production):Net Realizable Value (NRV) MethodDisclosure of By-Product Benefits as “Other Income”Revenue Methods (i.e., by-product benefits recognized in period of sale):Disclosure of By-Product Benefits as “Other Income”Disclosure of By-Product Benefits as a Reduction in Manufacturing Costs Associated with Joint Products7-43End of Cost Allocation time’s up