Cost Allocation Chapter 6

1. Describe how a costing system can have multiple cost objects 2. Outline four purposes for allocating costs to cost objects 3. Describe alternative criteria used to guide decisions related to cost allocations 4. Discuss key decisions faced when collecting costs in indirect cost pools Learning Objectives

5. Describe how the single-rate cost-allocation method differs from the dual-rate method 6. Explain how the choice of budgeted versus actual allocation rates changes the risks managers face 7. Distinguish among direct allocation, step-down, and reciprocal methods of allocating support department costs 8. Distinguish between the incremental and stand- alone cost allocation methods Learning Objectives

Purposes of Cost Allocation 1. To provide information for economic decisions 2. To motivate managers and employees u To decide whether to add a new airline flight u To decide whether to make a component part of a television set or to purchase if from another manufacturer television set or to purchase if from another manufacturer u To decide on the selling price for a customized product or service service u To encourage the design of products that are simpler to manufacture or less costly to service manufacture or less costly to service u To encourage sales representatives to push high-margin products and services products and services

Purposes of Cost Allocation 3. To justify costs or compute reimbursement 4. To measure income and assets for meeting external regulatory and legal reporting obligations external regulatory and legal reporting obligations u To cost products at a “fair” prices, often done with government defense contracts government defense contracts u To compute reimbursement for a consulting firm u To cost inventories for financial reporting u To cost inventories for reporting to tax authorities

Different Costs are appropriate for Different Purposes Purpose 4 Purpose 3 Purpose 1 and 2 R&DR&DDesignDesign Produc-toinProduc-toin Maket- ing Distri- butoin ServiceService

S U R V E Y S OF C O M P A N Y P R A C T I C E Why Allocate Corporate and Other Support Costs to Divisions and Departments ? 1. To remind profit-center managers that indirect costs exist and that profit-center earnings must be adequate to cover some share of those costs 2. To encourage the use of central services that would otherwise be underutilized 3. To stimulate profit-center managers to put pressure on central managers to control service costs

S U R V E Y S OF C O M P A N Y P R A C T I C E Why Allocate Corporate and Other Support Costs to Divisions and Departments ? 1. To determine costs 2. To evaluate profit centers 3. To fix accountability 4. To allocate costs per usage 5. To promote more effective resource usage 6. To foster cost awareness

S U R V E Y S OF C O M P A N Y P R A C T I C E Why Allocate Corporate and Other Support Costs to Divisions and Departments ? 1. To acknowledge that divisions incur such costs if they were independent units or if the services were not provided centrally 2. To make division managers aware that central costs exist 3. To stimulate divisional managers to put pressure on central support managers to control costs 4. To stimulate divisional managers to economize in usage of central services

Criteria for Guiding Cost-Allocation Decisions Cause and Effect Benefits Received Fairness or Equity Ability to Bear

Cost Tracing and Cost Allocation at the Louis Assembly Plant of Computer Horizons

Indirect Cost Pools of Computer Horizons Corporate executive salaries Central Computer Facility D. Controller’s Department Treasury Department Legal Department Marketing Department Payroll Department Personnel Department Research and Development Government Relations D. Investor Relations Department Public Relations Department Level 1: Corporate Headquarter Indirect labor Indirect materials Machinery and equipment costs Plant-leasing costs Energy costs Product development Process development Indirect labor Indirect materials Machinery and equipment costs Plant-leasing costs Energy costs Product development Process development Level 2 Indirect Costs of Products Assembled in each Micro Computer Manufacturing Plant Indirect Costs of Products Assembled in each Peripheral Equipment Peripheral Equipment Manufacturing Plant

Indirect Cost Pools and Cost Allocation n Which cost categories from Corporate Headquarters and the other divisions should be included in the indirect costs of the MicroComputer Division ? n How many cost pools should be used when allocating corporate costs to the MicroComputer Division ? n Which allocation base should be used for each of the corporate cost pools when allocating costs to the MicroComputer Division ? n Which allocation base should be used when allocating the indirect-cost pools at each manufacturing plant to the products assembled in those plants ? Choices Related to Indirect Costs

Indirect Cost Pools and Cost Allocation n The greater the degree of homogeneity, the fewer cost pools required to explain accurately the differences in how products use resources of the organization n Factors that may prompt managers to consider recognizing multiple cost pools when a single cost pool is currently used * The views of managers and personnel * The views of managers and personnel * Changes in plant layout, general operations, and so on * Changes in plant layout, general operations, and so on * Changes in products and the way those products use * Changes in products and the way those products use resources in the cost pools resources in the cost pools * Changes in information-gathering technology * Changes in information-gathering technology n A given cost item or amount may be included or excluded from a cost pool depending on the purpose at hand

Allocating Costs from one Department to Another Whether to use a single-rate method or a dual-rate method ? Whether to use budgeted rates or actual rates ? Whether to use budgeted quantities or actual quantities ?

Single Rate Method and Dual Rate Method Single Rate Method Dual Rate Method Base objectBobjectBobjectAobjectB Base Base objectA

One obvious benefit of using single -rate method is the low cost of implementation. A single-rate method mat lead divisions to take actions that appear to be in their own best interest but not in the best interest of the organization as a whole An important benefit of the dual-rate method is that it signals to division managers how variable costs and fixed costs behave differently. This important information could steer division managers into making decisions that benefit the corporation as well as each division.

Budgeted rates let the user departments know the cost rates they will charged in advance. Budgeted rates also help motivate manager of the support department to improve efficiency. The choice between actual usage and budgeted usage for allocating department fixed costs also can affect a manager’s behavior. When budgeted usage is the allocation base, user divisions will know their allocated costs in advance. If fixed costs are allocated on the basis of estimated long-run use, some managers may be tempted to underestimate their planned usage.

Allocating Costs of Support Departments S1S1 P3P3 P2P2 P1P1

Operating and Support Departments Operating (production) departments add value to a product or service that is observable by a customer. Support (service) departments provide the services that maintain other internal departments in the organization.

Methods to Allocate Support Department’s Costs  Direct allocation method  Step-down allocation method  Reciprocal allocation method

Data for Allocating Support Department Costs at Castleford Engineering for 20_7

Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated

Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated 30% 50% 20%

Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated 30% 50% 20%10% 80% 10%

Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated $0 $103,111 $12,889 $0 $225,000 $375,000 $116,000  10%/[80%+10%

Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly$587,889 Machining$728,111 Not Allocated $0 $103,111 $12,889 $0 $225,000 $375,000 $116,000  10%/[80%+10%

Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000+Allocated Assembly Machining Not Allocated 30% 50% 10% 80% 10% 20%20%

Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000+$120,000 Assembly Machining Not Allocated $180,000 $300,000 $120,00010% 80% 10%

Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $236,000 Assembly$300,000 +$236,000  1/9 Machining$180,000 +$236,000  8/9 Not Allocated $180,000 $300,000 $120,00010% 80% 10%

Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $236,000 Assembly$526,222 Machining$789,778 Not Allocated $180,000 $300,000 $120,00010% 80% 10%

Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining 30% 50% 20%10% 80% 10%

Reciprocal Method SUPPORT DEPARTMENTS Plant Maintenance $600,000+Allocated Information Systems $116,000+Allocated 20%10% Let PM = total reciprocal cost of the Plant Maintenance Department Let IS = total reciprocal cost of the Information Systems Department PM = $600, IS IS = $116, PM Solving for PM and IS, PM = $624,082 IS = $240,816

Reciprocal Method SUPPORT DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Let PM = total reciprocal cost of the Plant Maintenance Department Let IS = total reciprocal cost of the Information Systems Department PM = $600, IS IS = $116, PM Solving for PM and IS, PM = $624,082 IS = $240,816

Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Assembly Machining 30% 50% 80% 10%

Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Assembly$312,041+$24,082 Machining$187,225+$192,652 30% 50% 80% 10% $624,082*(3/10)+$240,816*(8/10)

Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Assembly$536,123 Machining$779,877 30% 50% 80% 10%

Comparison of Methods ALLOCATED SERVICE DEPARTMENT COST METHODMachiningAssemblyTotal DIRECT$728,111$587,889$1,316,000 STEP$789,778$526,222 RECIPROCAL$779,877$536,123 Differences among the 3 methods’ allocations increase  as the magnitude of the reciprocal services increases, and  as the differences across operating departments’ usage of each support service increase. $1,316,000 $1,316,000

The reciprocal method, while conceptually preferable, is not widely used. Because (1) many managers find it difficult to understand, and to understand, and (2) the numbers obtained by using the reciprocal method differ little, in some reciprocal method differ little, in some cases, from those obtained by using the cases, from those obtained by using the direct or step-down method. direct or step-down method.

Allocation of Support Department Costs Method 1. Direct method 2. Step-down method 3. Reciprocal method 4. Other method 5. Not allocated Source: Blayney & Yokohama (1991) 43% % % S U R V E Y S OF C O M P A N Y P R A C T I C E

Allocating Common Costs Stand-Alone Cost- Allocation Method Incremental Cost- Allocation Method Methods for Allocating Common Costs A common cost is a cost of operating a facility, operation, activity, or like cost object that is shared by two or more users. A common cost is a cost of operating a facility, operation, activity, or like cost object that is shared by two or more users.

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