1. Allocating Costs To Responsibility Centers Managerial Accounting 11E
CHAPTER 13
Allocating Costs To Responsibility Centers
PowerPoint Presentation by
LuAnn Bean Professor of Accounting Florida Institute of Technology
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Chapter 13: Allocating Costs to Responsibility Centers
Managerial Accounting 11E
Maher/Stickney/Weil

2. ☼ ☼
CHAPTER GOAL
Chapter 13 discusses concepts and methods of assigning indirect costs such as overhead, to departments. Additionally, service department cost allocation and joint-process cost allocation are explained.
Chapter 13 discusses concepts and methods of assigning indirect costs, such as overhead, to departments. We call such cost assignment cost allocation. Additionally, service department cost allocation and joint-process cost allocation are explained.

3. DIRECT COST: Definition
LO 1
DIRECT COST: Definition
Is one that firms can identify specifically with, or trace directly to a particular product, department, or process.
A direct cost is one that firms can identify specifically with a particular product, department, or process.

4. INDIRECT COST: Definition
LO 1
INDIRECT COST: Definition
Results from joint use of a facility or service by several products, departments, or processes.
An indirect cost, in contrast, results from the joint use of a facility or a service by several products, departments, or processes.

5. MANAGERS WANT TO KNOW!
LO 1
What are common costs?
Common costs are indirect costs that cannot be identified by a cost object.
Common costs are indirect costs that no specific cost object causes. For example, the cost of the engine pulling a train is common to all the cars it pulls. Firms allocate these common costs to develop division, department, or product cost information.

6. Why allocate indirect costs to products?
MANAGERS WANT TO KNOW!
LO 1
Why allocate indirect costs to products?
Full product costs should be known, including allocated indirect costs, for pricing and planning decisions.
Why do we allocate indirect costs to products? It is because the full product costs should be known, including allocated indirect costs, for pricing and planning decisions.

7. LO 2
SERVICE DEPARTMENT
Service department costs, a source of indirect costs, should be charged to users because:
These costs should be covered by the contribution margin of revenue-generating departments
User departments must be aware of what costs their department must cover
User departments should not treat service departments as if they are free
Virtually every organization has departments whose main job is to service other departments. These departments include the laundry in a hospital, the media services center in a university, maintenance in a factory, security in a retail store, and so forth. Because the firm does not sell the output of these departments to customers outside the organization, it must cover their costs by the contribution margins of revenue-generating departments. Thus, organizations often allocate the costs of departments that do not generate revenue (which we call service departments) to revenue-generating departments as an attention-getting device. The allocation makes managers of user departments aware that just covering their own department’s costs is not enough for the organization as a whole to break even or make a profit. The firm must cover indirect costs as well. User departments should not treat service departments as if they are free.

8. COST ALLOCATION The cost allocation process has three steps:
Assign direct costs to departments
Allocate indirect costs to departments
Allocate service department costs to production departments
There are three steps in allocating costs:
Assign direct costs to departments;
Allocate indirect costs to departments; and
Allocate service department costs to production departments.

9. FB
LO 3
EXAMPLE: First Bank
First Bank (FB) has 4 departments. Production departments are the Commercial Department and the Personal Department. Service departments are Computer Services and Processing.
Indirect costs are allocated to each department.
Service department costs are allocated to production departments in order to properly price their products.
Let’s look at a cost allocation example of First Bank. A division of First Bank has four departments. The Commercial Department and Personal Department are production departments that handle banking services for businesses (commercial) and people (personal). Computer Services and Processing are service departments. That is, they exist to provide support to the production departments. First Bank keeps records of the direct material and direct labor costs incurred in both production departments. First Bank considers all other costs associated with (but not easily traceable to) each production department to be overhead. Examples of overhead for First Bank include ATM machine maintenance and online banking technical support.
Continued

10. FB
LO 3
What department would be responsible for cost allocation and preparing accounting reports for managerial use?
Exhibit 13.1 shows an organizational chart that depicts the relationship among departments at the bank. What department would be responsible for cost allocation and for preparing accounting reports for managerial use? The answer is Central Corporate Staff.
EXHIBIT 13.1

11. Step 1: Distribute direct overhead costs.FB
LO 3
Step 1: Distribute direct overhead costs.
Exhibit 13.2 shows the three steps in allocating costs. The ultimate goal is to assign or allocate all overhead costs to the production departments (Commercial and Personal departments in this example).
Step 1: Assigning Direct Costs to Departments First Bank will identify which costs are direct with respect to each department—that is, which costs are easily traceable to each of the four departments. Examples include salaries of managers in each department, hourly wages of department workers, and supplies used within each department. Other costs are harder to trace.
EXHIBIT 13.2

12. Step 2: Allocate indirect overhead costs.FB
LO 3
Step 2: Allocate indirect overhead costs.
Step 2: Allocating Indirect Costs to Departments Next, First Bank allocates overhead costs that it cannot attribute directly to one of the departments. These costs include payments to an outside security agency, property taxes, rent and utilities, and miscellaneous costs.
EXHIBIT 13.2

13. FB
LO 3
ALLOCATION
First Bank has four indirect costs: security, property taxes, rent and utilities and miscellaneous. When allocating indirect costs, First Bank must select a cost driver for each indirect cost, although miscellaneous costs may not have a cost driver.
Next we will look at how the total indirect cost amounts can be allocated to one or more of the four departments. First Bank has four indirect costs: security, property taxes, rent and utilities and miscellaneous. When allocating indirect costs, First Bank must select a cost driver for each indirect cost, although miscellaneous costs may not have a cost driver.

14. FB
LO 3
Cost drivers for First Bank’s indirect costs. Miscellaneous costs will be allocated evenly.
The goal is to select an activity or measure of an activity that drives each cost. First Bank decided that the number of security guard visits to each department drives the security costs; the book value of assets in each department drives the property tax costs; and the square footage of floor space drives rent and utility costs. Given the insignificant amount of miscellaneous costs ($600) and the difficulty in identifying an appropriate cost driver, First Bank chose to allocate the $600 evenly among the four departments. A summary of the selected cost drivers is provided in Exhibit 13.4.
EXHIBIT 13.4

15. FB
LO 3
Example: proportionate allocation of indirect costs based on department use of indirect costs.
Once the accountants select the cost drivers, they accumulate the data necessary to begin the allocation process. Exhibit 13.5 shows the cost driver data necessary to allocate indirect costs. For example, proportionate allocation of indirect costs based on department use of indirect costs is a likely way to do this.
EXHIBIT 13.5

16. LO 3
Allocation of security costs to four departments. Cost driver: # of security visits.
Exhibit 13.6 shows the allocation of indirect costs in Section 1 for security to departments. For example, the allocation of security costs to four departments is based on the cost driver of number of security visits. Miscellaneous costs are allocated equally to the four departments.
EXHIBIT 13.6

17. LO 3
Allocation of property tax costs to four departments. Cost driver: book value of assets.
Exhibit 13.6 shows the allocation of indirect costs in Section 2 for property taxes to departments. For example, the allocation of property tax costs to four departments is based on the cost driver of book value of assets.
EXHIBIT 13.6

18. LO 3
Allocation of rent and utilities to four departments. Cost driver: floor space.
Exhibit 13.6 shows the allocation of indirect costs in Section 3 for rent and utilities to departments. For example, the allocation of rent and utilities to four departments is based on the cost driver of floor space.
EXHIBIT 13.6

19. Step 3: Allocate service department costs to production departments.
Step 3 for the allocation process is to allocate Service Department Costs to Production Departments. Once all company overhead costs are distributed to all departments (see Steps 1 and 2), we can begin the final step of the process. The final step is to allocate the service department costs to the production departments. Accountants use one of three methods to allocate service department costs to production departments: the direct method, the reciprocal method, or the step method.
EXHIBIT 13.2

20. How should service department costs be allocated?
MANAGERS WANT TO KNOW!
LO 3
How should service department costs be allocated?
Service department costs should be allocated by one of three methods: direct, step, or reciprocal.
Accountants use one of three methods to allocate service department costs to production departments: the direct method, the reciprocal method, or the step method.

21. SERVICE DEPARTMENT ALLOCATIONS
Under the direct method, service department costs are only allocated to production departments.
Under the step method, service department costs are sequentially allocated to other service departments pro rata and finally to production departments.
The reciprocal method employs matrix algebra to simultaneously allocate all department costs to each other.
Using the direct method, which is the easiest of the three methods, accountants ignore work done by service departments for other service departments. Service department costs are only allocated to production departments.
The step method allocates costs in steps as follows: Begin with the service department that receives the smallest dollar amount of service from the other service departments. Allocate its cost to the other service and production departments. Next, distribute the total costs of the service department receiving the next smallest amount of service from other service departments, and so on, until all service department costs are allocated to the production departments. Once a given service department’s cost has been allocated to other departments, do not allocate any costs back to that service department.
The reciprocal method, which is the most complicated of the three methods, uses matrix algebra to simultaneously allocate all department costs to each other. The reciprocal method recognizes all of the work done by each service department for each other and for the work service departments do for production departments.

22. MARKETING and ADMINISTRATIVE COSTS
LO 5
MARKETING and ADMINISTRATIVE COSTS
Allocating marketing and administrative costs and finding a basis for allocation are difficult. They are separate from overhead costs that are allocated to production departments. But allocation is important for pricing and planning decisions.
In allocating company costs to departments, management will often include marketing and administrative costs. Macy’s department store, for example, may wish to have its customer service and billing department costs allocated to men’s clothing, furnishings, teen wear, and other departments for purposes of performance evaluation. A wholesaler of Honda motorcycles may wish to allocate the costs of advertising to different territories or types of customers (such as college students). These costs are separate from the production overhead costs.

23. JOINT PROCESS: Definition
LO 6
JOINT PROCESS: Definition
Simultaneously converts common input into several outputs.
Example: timber logs are processed into lumber of various grades and sizes.
Many companies, particularly those in forest products, oil and gas, and chemicals and mining, produce multiple products from a joint process. A joint process simultaneously converts a common input into several outputs. For example, timber (logs) can be processed into lumber of various grades and sizes. The resulting sawdust and wood chips can be converted into paper pulp.

24. SPLITOFF POINT: Definition
LO 6
SPLITOFF POINT: Definition
Is the stage of processing when two products are separated.
The stage of processing when the two products are separated is called the split off point.

25. The NRV method implies a matching of
LO 6
The NRV method implies a matching of
input costs with revenues generated by
each output.
The physical quantities method is used when
output product prices are highly volatile
or when significant processing occurs
between split off and the 1st point
of marketability.
The two major methods of allocating joint-process costs are (1) the net realizable value (NRV) method and (2) the physical quantities method.
The net realizable value approach implies a matching of input costs with revenues generated by each output.
The physical quantities method is appropriate when output product prices are volatile or when significant processing occurs between the split off point and the first point of marketability. This approach may also be appropriate when product prices are not set by the market—for example, with regulated companies.

26. ALLOCATING JOINT-PROCESS COSTS
Organizations allocate joint costs for many reasons:
Measuring performance
Determining and responding to regulatory rate changes
Estimating casualty losses
Resolving contractual interests and obligations
Financial and tax reporting
Why should managerial accountants and managers allocate joint-process costs when joint-cost allocations tend to be somewhat arbitrary?
Organizations allocate joint costs for many reasons, including measuring performance, determining and responding to regulatory rate changes, estimating casualty losses, and resolving contractual interests and obligations.
Financial and tax accounting rules require manufacturing companies to use joint-process cost allocations to value inventories and cost of goods sold. For example, Humbolt Company must allocate joint-process costs to its products to value inventory and measure income for reporting purposes.

27. End of CHAPTER 13
End of Chapter 13.