2. 12 - 1 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall

3. 12 - 2 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 12 Cost Allocation

4. 12 - 3 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 12 Learning Objectives 1. Describe the general framework for cost allocation. 2. Allocate the variable and fixed costs of service departments to other organizational units. 3. Use the direct and step-down methods to allocate service department costs to user departments.

5. 12 - 4 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 12 Learning Objectives 4. Allocate costs from producing departments to products or services using the traditional and ABC approaches. 5. Allocate costs associated with customer actions to customers. 6. Allocate the central corporate costs of an organization. 7. Allocate joint costs to products using the physical-units and relative-sales-value methods.

6. 12 - 5 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall General Framework for Cost Allocation Less than half of most companies’ operating costs can be traced directly to products and services. Learning Objective 1 Cost allocation methods comprise an important part of a company’s cost accounting system to determine the cost of a product, service, customer, or other cost object. The rest of a company’s costs must be allocated using a cost-allocation base or left unallocated.

7. 12 - 6 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall General Framework for Cost Allocation After developing a general framework for cost allocation, companies assign costs to cost objectives. There are four types of cost objectives: 1.service departments, 2.producing departments, 3.products/services, and 4.customers.

8. 12 - 7 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall General Framework for Cost Allocation The cost accounting system first accumulates costs and assigns them to organizational units, which are also called departments. There are two types of departments: (1) producing departments, where employees work on the organization’s products or services, and (2) service departments, which exist only to support other departments or customers.

9. 12 - 8 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall General Framework for Cost Allocation Indirect costs must be allocated. Direct costs can be physically traced to each department. Many companies develop allocation methods to assign service department costs to the producing departments.

10. 12 - 9 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Service Department Costs Allocate variable- and fixed-cost pools separately. Establish the cost allocation procedures in advance. Evaluate performance using budgets for each production and service department. Learning Objective 2

11. 12 - 10 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Service Department Example University computer department serves two major users: Allocate the cost of a 5-year lease on computer mainframe School of BusinessSchool of Engineering

12. 12 - 11 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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

13. 12 - 12 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Service Department Example The primary activity performed is computer processing. Resources consumed: 1. Processing time 2. Operator time 3. Consulting time 4. Energy 5. Materials 6. Building space The budget formula for the forthcoming year is $100,000 monthly fixed cost plus $200 variable cost per hour of computer time used.

14. 12 - 13 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall General Framework for Cost Allocation

15. 12 - 14 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Variable-Cost Pool The cost driver for the variable-cost pool is actual hours of computer time used. Variable costs should be allocated as follows: Cost-allocation rate per hour × Actual hours of computer time used

16. 12 - 15 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Variable-Cost Pool Consider the allocation of variable costs to a department that uses 500 hours of computer time. Suppose inefficiencies in the computer department caused the variable costs to be $120,000 instead of $100,000. 500 hours × $200 = $100,000

17. 12 - 16 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Variable-Cost Pool A good cost-allocation scheme would allocate only the $100,000 to the consuming department and would let the $20,000 remain as an unallocated unfavorable budget variance of the computer department. This scheme holds computer department managers responsible for the $20,000 and reduces the resentment of user managers.

18. 12 - 17 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Fixed-Cost Pool Allocation of fixed costs will be based on the long-run capacity available to the user, regardless of actual Usage from month to month. Long-range planning regarding the expected required overall level of service, not short-run fluctuations in actual usage, affects the level of fixed costs

19. 12 - 18 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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 How is the fixed-cost pool allocated?

20. 12 - 19 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Fixed-Cost Pool Such a budgeted lump-sum approach is more likely to have the desired motivational effects with respect to the ordering of services in both the short run and the long run. A major strength of using capacity available rather than capacity used to allocate budgeted fixed costs is that actual usage by user departments does not affect the short-run allocations to other departments.

21. 12 - 20 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Direct and Step-Down Methods 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 Learning Objective 3

22. 12 - 21 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Processing Facility: Service Department Allocation

23. 12 - 22 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Direct Methods The direct method ignores other service departments when any given service department’s costs are allocated to the producing departments. Facilities management cost = $1,260,000 The direct method allocates these costs to the processing and assembly departments based on the relative square footage occupied by each of the two departments.

24. 12 - 23 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Direct Methods The direct method allocates these costs to the processing and assembly departments based on the relative square footage occupied by each of the two departments.

25. 12 - 24 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Direct Methods The direct method allocates human resources department costs to the producing departments on the basis of the relative number of employees in the producing departments. Human Resources costs = $48,000

26. 12 - 25 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Step-Down Methods The step-down method recognizes that some service departments support the activities in other service departments as well as those in production departments. To apply the step-down method, choose the sequence in which to allocate service department costs.

27. 12 - 26 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Step-Down Method Allocate facilities management department costs then allocate human resources cost.

28. 12 - 27 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Service Department Costs Costs not related to cost drivers? Identify multiple cost pools, each with its own cost-allocation base. Divide facilities management costs into two or more cost pools. Use a different cost- allocation base to allocate costs in each pool via the direct or step-down method.

29. 12 - 28 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Service Department Costs Allocate all costs by the direct or step-down method using square footage as the cost allocation base. Direct Versus Step-Down Method

30. 12 - 29 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Traditional Approach 1. Divide the costs in each producing department. 2. Assign direct costs to the appropriate products, services, or customers. Direct costsIndirect costs Learning Objective 4

31. 12 - 30 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Traditional Approach 3. Select one or more cost pools and related cost drivers in each production department. Indirect departmental costs Cost pool Cost pool Cost pool

32. 12 - 31 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Traditional Approach 4. Allocate costs Costs Product B Product A Product C

33. 12 - 32 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Traditional Approach and Step-Down Method

34. 12 - 33 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Activity-Based Costing (ABC) 1. Determine the key components of the system and the relationships among them. 2. Collect relevant data concerning costs and the 1. physical flow of the cost-allocation base units 2. among resources and activities. 3. Calculate and interpret the new ABC 1. information.

35. 12 - 34 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Activity-Based Costing

36. 12 - 35 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Customer Costs Customer Type 1 Low Cost to Serve 1.Buys a mix of products with high gross margins 2. Low cost-to-serve % 3. High profitability 1. Buys a mix of products with lower gross margins 2. High cost-to-serve % 3. Low profitability Customer Type 2 High Cost to Serve Customer profitability depends on the costs incurred to fulfill customer orders and to provide other customer services such as order changes, returns, and expedited scheduling or delivery.

37. 12 - 36 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 1. Small order quantity 2. Many order changes 3. Large amounts of pre- and post-sales support 4. Expedited scheduling 5. Special delivery 6. Frequent returns 1. Large order quantity 2. Few order changes 3. Little pre- and post-sales support 4. Regular scheduling 5. Standard delivery 6. Few returns Allocation of Customer Costs Customer Type 2 High Cost to Serve Customer Type 1 Low Cost to Serve

38. 12 - 37 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Customer profitability depends on more than gross margin, it is a function of customer gross margin and cost to serve. Learning Objective 5 Allocation of Customer Costs

39. 12 - 38 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Customer Costs Assume Cedar City Distributors (CCD) distributes products to retail outlets. The products are classified into just two product groups – apparel and sports gear. CCD has two types of customers: 1.Small store 2.Large store

40. 12 - 39 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Customer Costs CCD uses a simple cost accounting system to calculate both product and customer profitability. The only direct costs are costs of the purchase of apparel and sports gear products. Indirect costs are allocated to the product groups using a single indirect cost pool for all indirect costs with “pounds of product” as the allocation base. Costs

41. 12 - 40 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall To determine customer profitability: 1.Calculate profit margin per case for each product 2.Use the product mix ordered by each customer to calculate profitability Allocation of Customer Costs Small stores’ product mix is 75% apparel. Large stores’ product mix is 50% apparel. Small store customers are expected to have the larger profit margin percentage. But, the refined cost-allocation system shows large stores are the most profitable customers.

42. 12 - 41 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Customer Costs Profit Margin Per Case of Apparel and Sports Gear

43. 12 - 42 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Customer Costs Customer Profitability at Cedar City Distributors

44. 12 - 43 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Costs-to-Serve Might number of customer orders be a more plausible cost-allocation base? Include cost of order processing and customer service activities in a separate cost pool and allocate on a number of order basis. Gives managers more insight into operations, and a tool to measure and manage customer profitability.

45. 12 - 44 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Costs-to-Serve Product and Customer Profitability Measures Based on CCD’s Refined Cost-Allocation System

46. 12 - 45 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Central Costs Many managers believe it is desirable to fully allocate all costs to the revenue- producing parts of the organization. If a company allocates central support costs, it is important to allocate them in a way that managers accept as “fair.” Learning Objective 6 Some companies find measures that managers believe are fair, such as usage, either actual or estimated.

47. 12 - 46 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Central Costs Revenue Cost of goods sold Total assets Total cost of each division Often used cost-allocation bases

48. 12 - 47 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Use of Budgeted Sales for Allocation If management allocates the costs of central services based on sales, it should use budgeted sales rather than actual sales. The method has the advantage that the fortunes of other departments will not affect the costs allocated to a given department. It has the disadvantage of providing an incentive for the department to under-predict their own sales.

49. 12 - 48 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Allocation of Joint Costs Learning Objective 7 Two conventional ways of allocating joint costs to products are widely used: Physical Units and Relative Sales Values Joint costs include all inputs of material, labor, and overhead costs that are incurred before the split-off point. Companies allocate joint product costs to products for inventory valuation purposes and income determination.

50. 12 - 49 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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. Allocation of Joint Costs Allocation of joint costs should not affect decisions about the individual products.

51. 12 - 50 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Physical-Units Method Dow Chemical produces two chemicals, X and Y. Joint cost is $100,000. X sells for $.09 per liter and Y for $.06. Two-thirds of the liters produced are chemical X; allocate two-thirds of the joint cost to X. One-third of the liters are chemical Y; allocate one-third of the cost to Y.

52. 12 - 51 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Relative-Sales-Value Method Weighting is based on the sales values of the individual products at the split-off point. If a common physical unit is lacking, many companies use the relative-sales-value method for allocating joint costs.

53. 12 - 52 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall By-Product Costs By-product costs are not individually identifiable until manufacturing reaches a split-off point. By-product costs have a relatively insignificant sales value in comparison with other products emerging at split-off.

54. 12 - 53 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall By-Product Costs Allocate only separable costs to by-products. Allocate all joint costs to the main products. Deduct revenues from by-products, less their separable costs, from the main products cost.

55. 12 - 54 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.