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General Framework for Cost General Framework for Cost AllocationAllocation
Four types of cost objectives:Four types of cost objectives:Service departmentsService departments
Producing departmentsProducing departmentsProducts/services, and Products/services, and
Customers.Customers.
LearningLearningObjective 1Objective 1
Cost allocation methods comprise an important Cost allocation methods comprise an important part of a company’s cost management system.part of a company’s cost management system.
General Framework for Cost AllocationGeneral Framework for Cost Allocation
Service departments exist only to Service departments exist only to support other departments or customers.support other departments or customers.
Producing departments are where employeesProducing departments are where employeesWork on the organization’s products or services.Work on the organization’s products or services.
General Framework for Cost AllocationGeneral Framework for Cost Allocation
Increasingly, companies measure and manage Increasingly, companies measure and manage the costs and profitability of their customers.the costs and profitability of their customers.
All organizations accumulate costs for their All organizations accumulate costs for their products or services for financial reporting purposes.products or services for financial reporting purposes.
Customer related costs include:Customer related costs include:Order processingOrder processing
Customer service sales Customer service sales commissionscommissions
Dedicated customer supportDedicated customer support
General Framework for Cost AllocationGeneral Framework for Cost Allocation
A cost driver that has a logical, cause-effect relationship A cost driver that has a logical, cause-effect relationship to the cost will be used as a cost-allocation baseto the cost will be used as a cost-allocation base
An accounting system will assign to a department’s outputAn accounting system will assign to a department’s outputall its direct costs plus all the indirect costs allocated to it.all its direct costs plus all the indirect costs allocated to it.
Allocation of Service Department Allocation of Service Department CostsCosts
Establish the details regardingEstablish the details regardingcost allocation in advance.cost allocation in advance.
Allocate variable- and fixed-Allocate variable- and fixed-cost pools separately.cost pools separately.
Evaluate performance using budgets forEvaluate performance using budgets foreach production and service department.each production and service department.
Resources consumed includeResources consumed include1. Processing time 1. Processing time 2. Operator time2. Operator time3. Consulting time 3. Consulting time 4. Energy4. Energy5. Materials5. Materials6. Building space6. Building space
The budget formula for theThe budget formula for theforthcoming year is $100,000forthcoming year is $100,000monthly fixed cost plus $200monthly fixed cost plus $200
variable cost per hour ofvariable cost per hour ofcomputer time used.computer time used.
The cost driver for the variable-cost pool is The cost driver for the variable-cost pool is Actual hours of computer time used.Actual hours of computer time used.
Therefore, variable costs shouldTherefore, variable costs shouldbe allocated as follows:be allocated as follows:
Budgeted unit rate XBudgeted unit rate X Actual Actual hours of computer time usedhours of computer time used
A good cost-allocation scheme would allocateA good cost-allocation scheme would allocateonly the $120,000 to the consuming departmentonly the $120,000 to the consuming department
and would let the $20,000 remain as anand would let the $20,000 remain as anunallocated unfavorable budget varianceunallocated unfavorable budget variance
of the computer department.of the computer department.
This scheme holds computer department This scheme holds computer department managers responsible for the $20,000 managers responsible for the $20,000 and reduces the resentment of user and reduces the resentment of user
The cost driver for the fixed-cost pool isThe cost driver for the fixed-cost pool isthe amount of capacity required whenthe amount of capacity required whenthe computer facilities were acquired.the computer facilities were acquired.
Fixed costs should be allocated as follows:Fixed costs should be allocated as follows:
Budgeted percent of capacityBudgeted percent of capacity available for useavailable for use× Total budgeted fixed costs× Total budgeted fixed costs
Suppose the deans had originally predicted the Suppose the deans had originally predicted the long-run average monthly usage as follows:long-run average monthly usage as follows:
School of Business: 210 hoursSchool of Business: 210 hoursSchool of Engineering: 490 hoursSchool of Engineering: 490 hours
How is the fixed-cost pool allocated?How is the fixed-cost pool allocated?Business:Business:
210 ÷ 700 = 30% 210 ÷ 700 = 30% $100,000 X .3 = $30,000$100,000 X .3 = $30,000
This predetermined lump-sum approachThis predetermined lump-sum approachis based on the long-run capacityis based on the long-run capacity
available to the user, regardless ofavailable to the user, regardless ofactual usage from month to month.actual usage from month to month.
A major strength of using capacity available ratherA major strength of using capacity available ratherthan capacity used when allocating budgeted fixedthan capacity used when allocating budgeted fixed
costs is that actual usage by user departments does not costs is that actual usage by user departments does not affect the short-run allocations to other user departments.affect the short-run allocations to other user departments.
Direct and Step-Down MethodsDirect and Step-Down Methods
The direct method ignores other serviceThe direct method ignores other servicedepartments when any given servicedepartments when any given service
department’s costs are allocateddepartment’s costs are allocatedto the revenue-producingto the revenue-producing(operating) departments.(operating) departments.
The step-down method recognizes that someThe step-down method recognizes that someservice departments support the activitiesservice departments support the activities
in other service departments as well asin other service departments as well asthose in production departments.those in production departments.
Human resources cost = $240,000Human resources cost = $240,000
Total square footage in production departments:Total square footage in production departments:15,000 processing + 3,000 assembly = 18,00015,000 processing + 3,000 assembly = 18,000
Total employees in production departmentsTotal employees in production departments16 processing + 64 assembly = 8016 processing + 64 assembly = 80
Square footage in human resources = 9,000Square footage in human resources = 9,000
Allocate all costs by the directAllocate all costs by the director step-down method usingor step-down method usingsquare footage as the cost-square footage as the cost-
3. Select one or more cost pools and related3. Select one or more cost pools and relatedcost drivers in each production department.cost drivers in each production department.
Step 3:Step 3:Collect relevant data concerning costsCollect relevant data concerning costsand the physical flow of the cost-driverand the physical flow of the cost-driverunits among resources and activities.units among resources and activities.
Step 4:Step 4:Calculate and interpret the newCalculate and interpret the newactivity-based cost information.activity-based cost information.
Customer profitability depends on more than gross Customer profitability depends on more than gross margin, it depends on the costs incurred to fulfill margin, it depends on the costs incurred to fulfill
customer orders and to provide other customer services.customer orders and to provide other customer services.
Allocate costs associated with Allocate costs associated with customer actions to customers.customer actions to customers.
LearningLearningObjective 5Objective 5 Allocation of Customer CostsAllocation of Customer Costs
Small order quantitySmall order quantity Many order changesMany order changes Large amounts of pre-Large amounts of pre- and post-sales supportand post-sales support Expedited schedulingExpedited scheduling Special delivery requirementsSpecial delivery requirements Frequent returnsFrequent returns
Large order quantityLarge order quantity Few order changesFew order changes Little pre- and Little pre- and post-sales supportpost-sales support Regular schedulingRegular scheduling Standard deliveryStandard delivery Few returnsFew returns
Allocation of Customer CostsAllocation of Customer Costs
Customer Type 1Customer Type 1 Customer Customer Type 2 High Type 2 High
Allocation of Customer CostsAllocation of Customer Costs
Customer Type 1Customer Type 1Low Cost to Low Cost to
ServeServe Buys a mix of Buys a mix of products that products that have high gross have high gross marginsmargins Has a low cost-to-Has a low cost-to-serve %serve % Has a high level of Has a high level of profitabilityprofitability
Buys a mix of Buys a mix of products that products that have lower gross have lower gross marginsmargins Has a high cost-Has a high cost-to-serve %to-serve % Has a low level of Has a low level of profitabilityprofitability
Allocation of Customer CostsAllocation of Customer Costs
Assume Cedar City Distributors Assume Cedar City Distributors (CCD), distributes many (CCD), distributes many
products to retail outlets.products to retail outlets.The products are classified into just The products are classified into just two product groups – apparel and two product groups – apparel and
sports gear.sports gear.CCD has two types of CCD has two types of
customers:customers:1.1. Small storeSmall store2.2. Large storeLarge store
To determine customer profitability: To determine customer profitability: 1. Calculate the profit margin per case for each product 1. Calculate the profit margin per case for each product 2.2. Use the product mix ordered by each customer to calculate profitabilityUse the product mix ordered by each customer to calculate profitability
Allocation of Customer CostsAllocation of Customer Costs
Allocation of Costs-to-ServeAllocation of Costs-to-Serve
Might number of customer orders Might number of customer orders be a more plausible cost-be a more plausible cost-
allocation base?allocation base?The cost of resources used for order The cost of resources used for order
processing and customer service processing and customer service activities should be included in a activities should be included in a
separate cost pool and allocated on separate cost pool and allocated on the basis of number of orders.the basis of number of orders.This system gives managers at This system gives managers at
CCD more insight into CCD more insight into operations, and a tool to operations, and a tool to
measure and manage customer measure and manage customer profitability.profitability.
Allocation of Central CostsAllocation of Central Costs
Many managers believe it is desirableMany managers believe it is desirableto fully allocate all costs to the revenue-to fully allocate all costs to the revenue-
producing parts of the organization.producing parts of the organization.
Whenever possible, the preferredWhenever possible, the preferreddriver for central services is usage.driver for central services is usage.
LearningLearningObjective 6Objective 6
If a company does allocate the costs of If a company does allocate the costs of central services based on sales, although central services based on sales, although costs do not vary in proportion to sales, it costs do not vary in proportion to sales, it
should use budgeted, not actual, sales.should use budgeted, not actual, sales.
Allocation of Joint Costs Allocation of Joint Costs LearningLearningObjective 7Objective 7
Two conventional ways of allocatingTwo conventional ways of allocatingjoint costs to products are widely used:joint costs to products are widely used:
PhysicalPhysicalunitsunits
RelativeRelativesales valuessales values
Joint costs include all inputs of material, labor, and Joint costs include all inputs of material, labor, and overhead costs that are incurred before the split-off point.overhead costs that are incurred before the split-off point.
The physical-unitsThe physical-unitsmethod requires amethod requires acommon physicalcommon physicalunit for measuringunit for measuringthe output of eachthe output of each
product.product.
The joint costs areThe joint costs areallocated based onallocated based on
each product’seach product’spercentage of thepercentage of the
total physicaltotal physicalunits produced.units produced.
Allocation of Joint CostsAllocation of Joint Costs
Allocation of joint costs should Allocation of joint costs should not affect decisions about the not affect decisions about the
Dow Chemical produces two chemicals, X Dow Chemical produces two chemicals, X and Y. The joint cost is $100,000. X sells and Y. The joint cost is $100,000. X sells
for $.09 per liter and Y for $.06. for $.09 per liter and Y for $.06.
Allocation Sales Value atAllocation Sales Value at LitersLiters Weighting Weighting of Joint Costs Split-off Point of Joint Costs Split-off Point X 1,000,000 (10/15)X$100,000 $ 66,667 $ 90,000 X 1,000,000 (10/15)X$100,000 $ 66,667 $ 90,000 Y Y 500,000500,000 (5/15)X$100,000 (5/15)X$100,000 33,33333,333 30,00030,000 1,500,000 1,500,000 100,000 120,000 100,000 120,000
The joint costs are allocated based on eachThe joint costs are allocated based on eachproduct’s sales value as a percentageproduct’s sales value as a percentage
of the total sales value at split-off.of the total sales value at split-off.
Relative Sales Relative Sales Value at Value at Allocation Allocation Spit-off PointSpit-off Point Weighting Weighting of Joint Costsof Joint CostsX $ 90,000 (90/120)X$100,000 X $ 90,000 (90/120)X$100,000 $ 75,000 $ 75,000 Y 3Y 30,0000,000 (30/120X$100,000 (30/120X$100,000 25,00025,000 $120,000 $120,000 $100,000 $100,000
When weighting is based on the sales When weighting is based on the sales value of the individual products, the value of the individual products, the allocation of a cost to one product allocation of a cost to one product
depends upon the sales value of both depends upon the sales value of both products.products.
If an item is accounted for as aIf an item is accounted for as aby-product, only separableby-product, only separable
costs are allocated to it.costs are allocated to it.
All joint costs are allocatedAll joint costs are allocatedto the main products.to the main products.
Any revenues from by-products, lessAny revenues from by-products, lesstheir separable costs, are deductedtheir separable costs, are deductedfrom the cost of the main products.from the cost of the main products.