©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 12 Cost Allocation

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost Allocation Costs are linked with cost objectives by selecting appropriate cost drivers. A cost driver is often called a cost-allocation base. A cost pool is a grouping of individual cost items that are allocated to cost objectives.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 1 Explain the major reasons for allocating costs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Purposes of Allocation l There are four major purposes for allocating costs: 1 To predict the economic effects of planning and control decisions 2 To obtain desired motivation 3 To compute income and asset valuation 4 To justify costs or obtain reimbursement

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Three Types of Cost Allocations 1 – Allocation to the appropriate organizational unit 2 – Allocation from one organizational unit to another 3 – Allocation to products or services

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 2 Allocate the variable and fixed costs of service departments to other organizational units.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Allocation of Service Department Costs Guidelines for allocating service department costs: Establish the details regarding cost allocation in advance. Allocate variable- and fixed-cost pools separately. Evaluate performance using budgets.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Service Department Example Computer Department School of BusinessSchool of Engineering 5-year lease

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Service Department Example Analyze the costs of the computer department in detail. The primary activity performed is computer processing. Resources consumed include processing time, operator time, consulting time, energy, materials, and building space.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Service Department Example l Suppose there are two major purposes for the allocation: 1 Predicting economic effects of the use of the computer 2 Motivating departments and individuals to use its capabilities more fully

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Service Department Example l Assume that cost behavior analysis has been performed. l The budget formula for the forthcoming year is $100,000 monthly fixed cost plus $200 variable cost per hour of computer time used.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Variable-Cost Pool l The cost driver for the variable-cost pool is hours of computer time used. l Therefore, variable costs should be allocated as follows: Budgeted unit rate × Actual hours of computer time used

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Variable-Cost Pool Consider the allocation of variable costs to a department that uses 600 hours of computer time. Assume that inefficiencies in the computer department caused the variable costs to be $140,000 instead of $120, hours × $200 = $120,000

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Fixed-Cost Pool l The cost driver for the fixed-cost pool is the amount of capacity required when the computer facilities were acquired. l Therefore, fixed costs should be allocated as follows: Budgeted % of capacity available for use × Total budgeted fixed costs

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Fixed-Cost Pool l Suppose the deans, in our university computer department example, had originally predicted the long-run average monthly usage as follows: School of Business 210 hours School of Engineering 490 hours

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Fixed-Cost Pool How is the fixed-cost pool allocated? Business: 210 ÷ 700 × $100,000 = $30,000 Engineering: 490 ÷ 700 × $100,000 = $70,000

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 3 Allocate the central costs of an organization.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Allocation of Central Costs Usage Revenue Cost of goods sold Total assets Total cost of each division

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 4 Use the direct and step-down methods to allocate service department costs to user departments.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Reciprocal Services l Service departments often support other service departments in addition to producing departments. l There are two popular methods for allocating service department costs: 1 The direct method 2 The step-down method

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Direct and Step-Down Methods The direct method ignores other service departments when any given service department’s 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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Direct and Step-Down Methods Service DepartmentsProduction Departments Facilities $126,000 $100,000 Molding Personnel $24,000 $160,000 Finishing

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Direct Method Service DepartmentsProduction Departments Facilities $126,000 $100,000 Molding Personnel $24,000 $160,000 Finishing 0% $105,000 $19,200 $21,000 $4, ÷ 400 × $24,000

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step-Down Method Service DepartmentsProduction Departments Facilities $126,000 $100,000 Molding Personnel $24,000 + $42,000 $160,000 Finishing $70,000 $52,800 $14,000 $13,200

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step-Down Method Finishing DepartmentMolding Department Direct costs$100,000 From Fac. Mgt. 70,000 From Personnel 13,200 Total$183,200 Direct costs$160,000 From Fac. Mgt. 14,000 From Personnel 52,800 Total$226,800

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Facility Management Example l Assume management wants to analyze facility management’s costs. l What are the possibilities? 1 Divide costs into two or more different cost pools and use a different cost driver to allocate the costs in each pool.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Facility Management Example 2 Allocate variable costs using the direct or step-down method, but do not allocate the fixed costs. 3 Allocate all costs using square footage as the cost driver.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Allocate using Cost Driver 2 Allocate using Cost Driver 3 Facility Management Example Facilities Management Cost Cost Pool Allocate using Cost Driver 1

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 5 Describe the traditional approach to allocating costs to products or services.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Traditional Approach Operating or production departments Step 1: Allocate production- related costs to departments. Step 2: Select one or more cost drivers. Direct labor hours

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Traditional Approach Step 3: Allocate costs to products or services. Product A Product B Product C Direct labor hours

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Fixed costs Variable costs Traditional Approach One cost driver If only one cost driver is used, two cost pools should be maintained

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 6 Use activity-based costing to allocate costs in a modern manufacturing environment to products or services.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Activity-Based Costing l ABC systems focus on accumulating costs into key activities. l If many costs are caused by non-volume- based cost drivers, activity-based costing (ABC) should be considered.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Activity-Based Costing Determine cost objective, key activity centers, resources, and related cost drivers. Step 1: Step 2: Develop a process-based map representing the flow of activities, resources, and their interrelationships.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 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 information.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 7 Use the physical-units and relative-sales-value methods to allocate joint costs to products.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Meaning of Terms Joint productsJoint costs Separable costs Split-off point Main productBy-product

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Joint Costs Physical units Relative sales values Two conventional ways of allocating joint costs to products are widely used:

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton The physical-units method requires a common physical unit for measuring the output of each product. The joint costs are allocated based on each product’s percentage of the total physical units produced. Physical-Units Method

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Relative-Sales-Value Method l The joint costs are allocated based on each product’s sales value as a percentage of the total sales value at split-off. Sales value at split-off method Estimated net realizable value (NRV) method Constant gross-margin percentage NRV method

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Why Allocate Joint Costs? To determine inventory cost and cost of goods sold To determine cost reimbursement under contracts For conducting customer profitability analysis For insurance settlement computations For rate regulation

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton No Allocation of Joint Costs Some companies refuse to allocate joint costs and instead carry their inventories at estimated net realizable value minus a normal profit margin.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton By-Product Costs l If an item is accounted for as a by-product, only separable costs are allocated to it. l All joint costs are allocated to the main products. l Any revenues from by-products, less their separable costs, are deducted from the cost of the main products.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Joint Costs Allocation Example 100 pounds Z-1 Separable cost $ pounds Z-2 Separable cost $150 Joint cost is $900. Product A $800 Z-1 and Z-2 are worthless at split-off point. Product B $800

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Physical Units Example Joint Cost Allocated To A: 100 ÷ 500 × $900 = $180 To B: 400 ÷ 500 × $900 = $720

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Physical Units Example A B Total Sales Value$800$800$1,600 Separable Costs Allocation of Joint Cost Operating Profit (Loss)$320$(70)$ 250

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Relative-Sales-Value Method Example A B Total Sales Value$800$800$1,600 Separable Costs Sales Value Imputed at Splitoff Point$500$650$1,150 Allocation of Joint Cost 500/1,150; 650/1, Operating Profit (Loss)$109$141$ 250

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 8 Understand how cost allocation is used in cost planning and control.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost Allocation in Planning and Control l Across the entire chain, managers need accurate cost information in order to effectively plan and control operations.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton End of Chapter 12