Cost Allocation: Practices Chapter Eight Cost Allocation: Practices McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Death Spiral Death spiral occurs when large fixed costs of a common resource are allocated to users who could decline to use that resource. As the allocated costs increase to the remaining users, some users choose to decrease use. Then the fixed costs are allocated to the remaining users, more of whom use less. This process repeats until no users are willing to pay the fixed costs. Possible solutions to death spiral: When excess capacity exists, charge users only for variable costs. Reduce the total amount of fixed costs allocated.

Death Spiral Example: Internal Services Internal Telecommunications Department: Telecommunications service department allocates fixed costs to users. If some users are allowed to switch to outside phone company, the fixed costs allocated to remaining users increase. Eventually, the number of users of the telecommunications department is so small that the department is closed.

Death Spiral Example: Cost-based Contracts Military Aircraft (not in text): Defense contractors working on advanced technology incur large fixed cost over-runs that are allocated to each aircraft manufactured. Government reduces number of aircraft purchased and that causes average cost to increase on remaining orders. Government responds by ordering even fewer aircraft. Eventually, the entire project is abandoned before all fixed costs are recovered.

Death Spiral in Reverse! Clay Sprays: Increasing the allocation base for fixed costs can lead to misleading product line profit figures. Decisions should be consistent with an overall economic strategy and a meaningful understanding of the impacts of accounting practices. “I left this to the accountants” would not cut it in today’s business environment.

Allocating Capacity Costs: Depreciation Accounting depreciation represents the annual historical cost of acquired capacity. Allocating depreciation involves a tradeoff - with excess capacity, allocation causes underutilization. However, allocation controls overinvestment. Most firms allocate depreciation to users. If confronted with a choice between control and decision making - accounting systems usually choose control.

Methods of Service Department Allocation Methods for complex firms with at least 2 service departments and at least 2 operating departments (see Figure 8-1). Alternative methods: Direct allocation Step-down allocation Reciprocal allocation

Service Allocation: Direct Method Procedure: Ignore each service department’s use of other service departments. Allocate service department costs only to operating departments. Advantages: Simple to administer and explain. Disadvantages: Allocations are not accurate estimates of opportunity costs when service departments use other service departments. Incentives exist for service departments to make excessive use of other service departments.

Service Allocation: Step-down Method Procedure: Start with one service department and allocate all of its costs to the remaining service and operating departments. Continue one-by-one through each service department allocating all direct costs of that department and costs allocated to it. A good way of choosing the order of allocation is by (1) most reliable “cause and effect” cost driver, (2) number of other departments serviced, and (3) finally, as the default, total budget of department. Advantages: Considers some of the interdependence of service departments Disadvantages: Resulting allocations are inaccurate estimates of opportunity costs. Allocation less than opportunity cost for first department Allocation more than opportunity cost for last department

Service Allocation: Reciprocal Method (Appendix) Procedure: Write equations defining variable cost relationships among divisions. Solve system of simultaneous equations with linear algebra. Allocate fixed costs based on each operating division’s planned use of the service department’s capacity. Advantages: Most accurate method (best approximates opportunity costs) Disadvantages: Slightly harder to set up and compute solution Difficult to explain results to unsophisticated managers Prevents managers from “managing” cost allocations for financial reporting and/or taxes.

Service Allocation Example Allocation Method Total Allocated to Car Division (Millions) Transfer price ($/phone) Direct $4.643 $1,143 Step-down – Telecommunications first 4.648 889 Step-down – IT first 4.621 2,151 Reciprocal 4.623 1,492 Each method allocates all service costs Total allocation does not vary significantly in this case Transfer prices do differ depending on allocation method

Service Allocation Example As a thought question: Under what conditions would you expect that the service department allocations under each of these methods would be materially different from each other?

Reasons to Allocate Service Department Costs Encourages reduction of use of costly services With no cost allocation (zero transfer prices), management must use non-price priority schemes to control use. Reveals economic demand for services Rational users will pay a transfer price only when the benefits are greater than or equal to that price. Compare internal service departments to external vendors Gross inefficiency is revealed when internal transfer prices greatly exceed external prices

Joint Costs Defined Joint cost is incurred to produce two or more outputs from the same input. Joint costs occur only in disassembly processes, such as refining and food processing. Common costs occur in either disassembly or assembly processes, such as building cars.

Joint Costs: Process Further? Split-off point: The point in the disassembly processing at which all joint costs have been incurred (See Figure 8-5). Decision: Should each joint product be processed further or sold as is at the split-off point? Solution concept: The joint costs are sunk costs at the split-off point. Do the incremental benefits of further processing exceed the incremental costs?

Joint Costs: Net Realizable Value Net realizable value (NRV) is the difference between selling price and costs that would be incurred after the split-off point. Compute NRV of each product after the split-off point. Decide to produce products with positive NRV, but not with negative NRV. For control and divisional reporting, allocate joint costs to products in the ratio of the NRV of each product. Example: Fillets have 64% of the sum of the NRV’s of the three joint products. Therefore, allocate 64% of the joint costs (64% x $2.00 = $1.28) to fillets.

Segment Reporting: Controllability The following segment report format is based on the controllability principle (managers should be held responsible only for costs under their control). Proponents argue that performance rewards for divisional managers should be based on the division’s controllable segment margin. Division A Division B Division revenues X,XXX - Division controllable expenses - XXX = Controllable segment margin XXX Allocated common costs - XXX Net income

Segment Reporting: Joint Benefits The segment margin approach does not consider joint benefits (positive externalities) of one division on another. Separating controllable and noncontrollable costs on segment margin reports will not show how segments are interdependent. Example: Products of two different segments are sold to the same customers Dropping one segment will adversely affect customer demand for the products of the surviving segment See Self Study Problem.

Appendix: Reciprocal Method Procedure: Write equations estimating variable cost functions among service departments only. Write equations estimating variable cost functions between service and operating departments. Solve system of simultaneous equations with linear algebra to allocate variable costs. Allocate fixed costs based on each operating division’s planned use of the service department’s capacity. Use: Difficult to estimate cost functions in actual practice