2. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 1 Cost Allocation Chapter 12

3. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 2 Learning Objective 1 Explain the major reasons for allocating costs.

4. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 3 Purposes of Allocation External reporting Cost allocation supports a company’s cost management system. Strategic decision making Operational control

5. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 4 Purposes of Allocation There are four major purposes for allocating costs: 1. To predict the economic effects of planning and control decisions of planning and control decisions 2. To obtain desired motivation 3. To compute income and asset valuation 4. To justify costs or obtain reimbursement

6. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 5 Three Types of Cost Objectives 1 – Service departments 2 – Producing departments 3 – Final cost objective ProductService

7. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 6 Learning Objective 2 Allocate the variable and fixed costs of service departments to other organizational units.

8. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 7 General 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.

9. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 8 Service Department Example Computer Department 5-year lease School of Business School of Engineering

10. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 9 Service Department Example Suppose there are two major purposes for the allocation: Predicting economic effects of the use of the computer Motivating departments and individuals to use its capabilities more fully

11. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 10 Service Department Example The primary activity performed is computer processing. Resources consumed include processing time, operator time, consulting time, energy, materials, and building space.

12. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 11 Service Department Example Suppose the university performed cost behavior analysis. The budget formula for the forthcoming year is $100,000 monthly fixed cost plus $200 variable cost per hour of computer time used.

13. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 12 Variable-Cost Pool The cost driver for the variable-cost pool is actual hours of computer time used. Therefore, variable costs should be allocated as follows: Budgeted unit rate × Actual hours of computer time used

14. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 13 Variable-Cost Pool Consider the allocation of variable costs to a department that uses 600 hours of computer time. Suppose inefficiencies in the computer department caused the variable costs to be $140,000 instead of $120,000. 600 hours × $200 = $120,000

15. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 14 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.

16. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 15 Fixed-Cost Pool The cost driver for the fixed-cost pool is the amount of capacity required when the computer facilities were acquired. Fixed costs should be allocated as follows: Budgeted percent of capacity available for use × Total budgeted fixed costs

17. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 16 Fixed-Cost Pool Suppose the deans had originally predicted the long-run average monthly usage as follows: School of Business: 210 hours School of Engineering: 490 hours

18. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 17 Fixed-Cost Pool How is the fixed-cost pool allocated? Business: 210 ÷ 700 × $100,000 = $30,000 Engineering: 490 ÷ 700 × $100,000 = $70,000

19. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 18 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.

20. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 19 Learning Objective 3 Use the direct and step-down methods to allocate service department costs to user departments.

21. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 20 Reciprocal Services Service departments often support other service departments in addition to production departments. There are two popular methods for allocating service department costs: The direct method The step-down method

22. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 21 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.

23. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 22 Direct and Step-Down Methods Facilities management cost = $1,260,000 Human resources cost = $240,000 Total square footage in production departments: 15,000 processing + 3,000 assembly = 18,000 Total employees in production departments 16 processing + 64 assembly = 80 Square footage in human resources = 9,000

24. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 23 Direct Method Facilities management cost allocated to processing = (15,000 ÷ 18,000) × $1,260,000 = $1,050,000 Facilities management cost allocated to assembly = (3,000 ÷ 18,000) × $1,260,000 = $210,000

25. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 24 Direct Method Human resources cost allocated to processing = (16 ÷ 80) × $240,000 = $48,000 Human resources cost allocated to assembly = (64 ÷ 80) × $240,000 = $192,000

26. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 25 Step-Down Method To assembly: (3 ÷ 27) × $1,260,000 = $140,000 To human resources: (9 ÷ 27) × $1,260,000 = $420,000 To processing: (15 ÷ 27) × $1,260,000 = $700,000

27. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 26 Step-Down Method To assembly: (64 ÷ 80) × $660,000 = $528,000 $240,000 + $420,000 = $660,000 To processing: (16 ÷ 80) × $660,000 = $132,000

28. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 27 Step-Down Method Processing department Direct costs$1,000,000 From facilities management 700,000 From human resources 132,000 Total$1,832,000

29. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 28 Step-Down Method Assembly department Direct costs$1,600,000 From facilities management 140,000 From human resources 528,000 Total$2,268,000

30. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 29 Costs Not Related to Cost Drivers Identify additional cost drivers. Allocate all costs by the direct or step-down method.

31. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 30 Learning Objective 4 Integrate service-department allocation systems with traditional and ABC systems to allocate total systems costs to final cost objectives.

32. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 31 Traditional Approach 1. Divide the costs in each producing departments. 2. Assign direct costs to the appropriate products, services, or customers. Direct costs Indirect costs

33. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 32 Traditional Approach 3. Select one or more cost pools and related cost drivers in each production department. Indirect departmental costs CostpoolCostpoolCostpool

34. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 33 Traditional Approach 4. Allocate costs Costs ProductB ProductAProductC

35. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 34 Activity-Based Costing Determine the key components of the system. Step 1: Step 2: Develop the relationships among resources, activities, and cost objectives.

36. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 35 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 cost information.

37. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 36 Learning Objective 5 Allocate the central corporate costs of an organization.

38. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 37 Allocation of Central Costs Many managers believe it is desirable to fully allocate all costs to the revenue- producing parts of the organization. Whenever possible, the preferred driver for central services is usage.

39. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 38 Allocation of Central Costs Usage Revenue Cost of goods sold Total assets Total cost of each division Not always economically viable

40. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 39 Learning Objective 6 Allocate joint costs to products using the physical-units and relative-sales-value methods.

41. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 40 Allocation of Joint Costs Joint costs Split-off point

42. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 41 Joint Costs Physicalunits Relative sales values Two conventional ways of allocating joint costs to products are widely used:

43. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 42 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

44. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 43 Physical-Units Example 1,000,000 liters of X 10 ÷ 15 × $100,000 500,000 litters of Y 5 ÷ 15 × $100,000 Product X $66,667 Product Y $33,333 Joint cost: $100,000 X and Y sales value at split-off point: $90,000 X and $30,000 Y

45. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 44 Physical-Units Example X Y Total X Y Total Sales value$90,000$30,000$120,000 Allocation of joint cost 66,667 33,333 100,000 Operating profit (loss)$23,333$ (3,333)$ 20,000

46. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 45 Relative-Sales-Value Method The joint costs are allocated based on each product’s sales value as a percentage of the total sales value at split-off.

47. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 46 Relative-Sales-Value Method 1,000,000 liters of X 90 ÷ 120 × $100,000 500,000 litters of Y 30 ÷ 120 × $100,000 Joint cost: $100,000 Product X $75,000 Product Y $25,000 X and Y sales value at split-off point: $90,000 X and $30,000 Y

48. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 47 Relative-Sales-Value Method This method can be used when one or more of the joint product cannot be sold at the split-off point. Sales value at split-off = Final sales value – Separable costs

49. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 48 By-Product Costs A by-product is not individually identifiable until manufacturing reaches a split-off point. They have relatively insignificant sales value.

50. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 49 By-Product Costs If an item is accounted for as a by-product, only separable costs are allocated to it. All joint costs are allocated to the main products. Any revenues from by-products, less their separable costs, are deducted from the cost of the main products.

51. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 12 - 50 End of Chapter 12