EMBA Presentation November 17,2012

Cost Allocations Involve:  Common Costs  Joint Costs

Purposes of Cost Allocation  To provide information for economic decision making  To motivate managers  To justify costs for reimbursement  To measure income and use of assets

Criteria for Allocation of Costs  Cause and effect  Benefits received  Fairness or equity  Ability to bear

Steps in Cost Allocation  Define the cost objects  Accumulate common costs  Choose a method for assigning costs

Allocation of Joint Costs  Sales value at split-off  Physical measure  Estimated net realizable value

Method Select White Knotty Total Physical units Split off NRV Comparison of the Three Methods

So, which is the best method?

None... they are all arbitrary

Pros and Cons  Physical units – is easy to calculate  Split-off – may not be appropriate if there is no market at the split-off point  NRV – assumes that the greater the end sales dollars, the better it can bear the joint cost

Allocation of Common Costs  Direct Method  Step-down Method  Reciprocal Method

Direct Method Allocations

Direct Method A/HR IS GOVT CORP Costs$ 600,000$ 2,400,000$ 0$ 0 All A/HR: (.53333, )(600,000)0320,000280,000 All IS: (.33333,.66667) 0(2,400,000) 800,0001,600,000 Totals$ 0$ 0$1,120,000$1,880,000

Step Down Allocations

Step Down Method – A/HR First A/HR IS GOVT CORP Cost$ 600,000$ 2,400,000$ 0$ 0 A/HR (.25,.40,.35)(600,000)150,000240,000210,000 IS ( ) 0(2,550,000)850,0001,700,000 Totals $ 0$ 0$1,090,000$1,910,000

Reciprocal Allocations

Reciprocal Method A/HR IS GOVT CORP Costs$ 600,000 $2,400,000 A/HR (.25,.40,.35)(861,538)215,385344,615301,538 IS (.10,.30,.60) 261,538 (2,615,385) 784,615 1,569,231 Totals$ 0 $ 0 $1,129,230 $1,870,769 A = 600, IS IS = 2,400, A IS = 2,400, , IS.9750 IS = 2,550,000 IS = 2,615,385 A = 600, (2,615,385) A = 861,538

Comparison of Results MethodGovernmentCorporate Direct$1,120,000$1,880,000 Stepdown Adm first$1,098,000$1,910,000 Stepdown IT first$1,128,000$1,892,000 Reciprocal$1,129,230$1,870,769

Pros and Cons of Methods  Direct method – easy but ignores how support departments use each other  Step down – widely accepted but requires designation of a “first” department  Reciprocal – most accurate but not well understood or widely used

Summary  Reason for cost allocations  Allocating joint costs  Allocating common costs

Copyright by Frank Ilett, 2012