Ch14 Cost Allocations Additional

Cost Allocation
Chapter 14
Copyright 2007 Pearson Education Canada Inc.
14-1
Purposes of Cost Allocation

Provide information for economic decisions Motivate managers and other employees Justify costs or compute reimbursement amounts Measure income and assets for reporting to tax authorities
14-2
Six-Function Value Chain
Traditional Life Cycle approach may not yield the costs necessary to meet the four-purpose criteria for cost allocation Costs necessary for decision making may pull costs from some or all of these six functions
14-3
Criteria for Cost-Allocation Decisions

Cause and Effect

Variables are identified that cause resources to be consumed

Most credible to operating managers Integral part of ABC
Benefits Received

The beneficiaries of the outputs of the cost object are charged with costs in proportion to the benefits received
14-4
Criteria for Cost-Allocation Decisions

Fairness (Equity)

The basis cited for establishing a price satisfactory to the government, customers and suppliers

Cost allocation here is viewed as a reasonable or fair means of establishing a selling price
Ability to Bear

Costs are allocated in proportion to the cost objects ability to bear them

Generally, larger or more profitable objects receive proportionally more of the allocated costs
14-5
Supporting Departments and Operating Departments

Supporting (Service) Department

Provides the services that assist other internal departments in the organization Directly adds value to a product or service
Operating (Production) Department

14-6
Methods to Allocate Support Department Costs

Single-Rate Method Dual-Rate Method
14-7
Single-Rate Method

Pools all costs into one cost pool and allocates them to cost objects using the same rate per unit of the single allocation base

No distinction is made between fixed and variable costs in this method

Total Costs (all pools added together) Total Allocation base
14-8
Dual-Rate Method

Classifies costs within each cost pool into two typical segments:

a variable cost pool a fixed cost pool.
Each pool uses a different cost-allocation base

Total Variable Costs Total Allocation base Total Fixed Costs__ Total Allocation base
14-9
Allocation Method Tradeoffs

Single-rate method

Simple to implement, but treats fixed costs in a manner similar to variable costs Treats fixed and variable costs more realistically, but is more complex to implement
Dual-rate method

14-10
Allocation Bases

Under either method, allocation of support costs can be based on one of the three following scenarios:
1. 2. 3.
Budgeted overhead rate and budgeted hours Budgeted overhead rate and actual hours Actual overhead rate and actual hours

Choosing between actual and budgeted rates:

Budgeted is known at the beginning of the period Actual will not be known with certainty until the end of the period
14-11
Stages of Cost Allocation

Service Department (Computer) Service Department (Accounting) Service Department (Maintenance)
First Service department costs are allocated to user departments Second User department costs, plus allocated service department costs, are applied to products
User Department (Assembly) User Department (Machining)
Product
14-12
Methods of Allocating Support Costs to Production Departments

1. 2. 3.
Direct Step-Down Reciprocal
14-13
Direct Method

Allocates support costs to only the Operating Departments No interaction between Support Departments prior to allocation
14-14
Direct Method
14-15
Direct Method Example

Maintenance Info System s Departm ental costs before allocation Budgeted labour hours Percentage Budgeted com puter hours Percentage 200 $ 600,000 $ 116,000 1,600 $ 400,000 2,400 3/8 1,600 8/9 $ 200,000 4,000 5/8 200 1/9 Machining Assem bly
Service Department Maintenance Information system
Allocation Base Budgeted labour hours Budgeted computer hours

14-16
Direct Approach to Cost Allocation

Plant Maintenance $600,000
$225,000
Machinery Department $400,000 Plus allocated $328,111
$728,111 will be allocated in total to products
$375.000
$103,111
Information Systems $116,000
Assembly Department $200,000 Plus allocated $387,889
Products
$12,889

14-17
Direct Method
Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 ? ? ? $ 116,000 ? ? ? $ 400,000 ? ? ? $ 200,000 ? ? ? Production Departm ents Machining Assem bly
14-18
Direct Method
Service Departm ents Maintenance Info systems Departm ental costs before allocation Maintenence allocation Info systems allocation Total after allocation $ 600,000 (600,000) ? ? ? ? $ 116,000 $ 400,000 225,000 ? ? $ 200,000 ? ? ? Production Departments Machining Assem bly
$600,000
2,400 2,400 + 4,000
= $225,000
Allocation base: budgeted labour hours

14-19
Direct Method
Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 (600,000) ? ? ? ? $ 116,000 $ 400,000 225,000 ? ? $ 200,000 375,000 ? ? Production Departm ents Machining Assem bly
$600,000
4,000 = $375,000 2,400 + 4,000
Allocation base: Budgeted labour hours

14-20
Direct Method
Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 (600,000) (116,000) $ $ 116,000 $ 400,000 225,000 103,111 728,111 $ 200,000 375,000 ? ? Production Departm ents Machining Assem bly
$116,000
1,600 1,600 + 200
= $103,111
Allocation base: Budgeted computer hours

14-21
Direct Method
Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenance allocation 3/8,5/8 Info system s allocation 8/9,1/9 Total after allocation $0 $ 600,000 (600,000) $ 116,000 (116,000) $0 $ $ 400,000 225,000 103,111 728,111 $ $ 200,000 375,000 12,889 587,889 Production Departm ents Machining Assem bly
$116,000
200 1,600 + 200
= $12,889

14-22
Step-Down Method

Allocate support costs to other support departments and operating departments in a pre-determined (ranked) order which partially recognizes the mutual services provided among all support departments One-way interaction between Support Departments prior to allocation
14-23
Step-Down Method
14-24
Step-Down Method Example

Same data used in the direct allocation method example
Maintenance Info System s Departm ental costs before allocation Budgeted labour hours Percentage Budgeted com puter hours Percentage 200 $ 600,000 $ 116,000 1,600 2/10 $ 400,000 2,400 3/10 1,600 8/9 $ 200,000 4,000 5/10 200 1/9 Machining Assem bly
14-25
Step-Down Approach to Cost Allocation

Plant Maintenance $600,000
$180,000
$300.000 $120,000 $209,778
Information Systems $116,000 Plus $120,000
Products
$26,222

14-26
Step-Down Allocation Method Example

14-27

Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 (600,000) ? ? $ 116,000 120,000 ? ? ? ? $ 400,000 $ 200,000 ? ? ? Production Departments Machining Assem bly
$600,000
1,600 1,600 +2,400 + 4,000
= $120,000

14-28

Service Departm ents Cafeteria Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 (600,000) ? ? $ 116,000 120,000 ? ? $ 400,000 180,000 ? ? $ 200,000 ? ? ? Custodial Production Departments Machining Assem bly
$600,000
2,400 1,600 +2,400 + 4,000
= $180,000

14-29

Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 (600,000) ? ? $ 116,000 120,000 ? ? $ 400,000 180,000 ? ? $ 200,000 300,000 ? ? Production Departm ents Machining Assem bly
$600,000
4,000 1,600+2,400 + 4,000
= $300,000
Allocation base: Budgeted labour hours

14-30

Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenence allocation Info system s allocation Total after allocation $ 600,000 (600,000) $ 116,000 120,000 (236,000) $ $ 400,000 180,000 209,778 789,778 $ 200,000 300,000 ? ? Production Departm ents Machining Assem bly
$236,000
1,600 1,600 + 200
= $209,778

14-31

Service Departments Maintenance Info system s Departm ental costs before allocation Maintenance allocation 2/10,3/10,5/10 Info system s allocation 8/9,1/9 Total after allocation $0 $ 600,000 (600,000) $ 116,000 120,000 (236,000) $0 $ $ 400,000 180,000 209,778 789,778 $ $ 200,000 300,000 26,222 526,222 Production Departments Machining Assembly
$236,000
200 1,600 + 200
= $26,222

14-32
Reciprocal Method

Allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments Full two-way interaction between Support Departments prior to allocation Utilization of simultaneous equations to obtain reciprocal costs
14-33
Reciprocal Method
14-34
Reciprocal Method Example

Same data used in the direct allocation method example
Maintenance Info System s Departm ental costs before allocation Budgeted labour hours Percentage Budgeted com puter hours Percentage 200 10% $ 600,000 $ 116,000 1,600 20% $ 400,000 2,400 30% 1,600 80% $ 200,000 4,000 50% 200 10% Machining Assem bly

14-35
Reciprocal Approach to Cost Allocation

Plant Maintenance $600,000 Plus $24,082
$187,225
$312,041 $124,816 $24,082 $192,652
Information Systems $116,000 Plus $124,816
Products
$24,082

14-36
Reciprocal Method
The Maintenance Department receives:
200 200 + 1,600 + 200
1 10
of Information systems costs
The Information systems Department receives: 1,600 2 = of maintenance costs 10 1,600 + 2,400 + 4,000
The total cost of each service department is equal to: Direct costs of that department + Costs allocated to that department
14-37
Reciprocal Method
Express in linear equation form the relationships
PM = $ 600,000 + 0.1 IS IS = $ 116,000 + 0.2 PM

PM = Total costs of Maintenance Department IS = Total costs of Information systems Cafeteria Department
14-38
Reciprocal Method
PM = $ 600,000 + 0.1 IS IS = $ 116,000 + 0.2 PM Solve simultaneous equations by substitution
PM = $ 600,000 + 0.1 IS PM = $ 600,000 + [0.1($ 116,000 + 0.2 PM)] 0.98PM = $ 611,600 PM = $ 624,082 IS = $ 116,000 + 0.2 ( $ 624,082) IS = $ 240,816
14-39
Reciprocal Method
14-40
Reciprocal Method
Service Departm ents Maintenance Info system s Departm ental costs before allocation Maintenance allocation 20%,30%,50% Info system s allocation 10%,80%,10% Total after allocation $ 600,000 (624,082) 24,082 $0 $ 116,000 124,816 (240,816) $0 $ $ 400,000 187,225 192,652 779,877 $ $ 200,000 312,041 24,082 536,123 Production Departm ents Machining Assem bly
Allocations based on % usage of service department resources as calculated in the data slide 14-35 and as noted above in the table
14-41
Comparison of Methods
Totals after allocation Machining Method Direct Step dow n Reciprocal Departm ent $ 728,111 789,778 779,877 Assem bly Departm ent $ 587,889 526,222 536,123
14-42
Choosing Between Methods

Reciprocal is the most precise Direct and Step-Down are simple to apply and understand Direct Method is widely used and the simplest Often not a significant difference between methods to justify additional cost to implement costlier analysis
14-43
Common Costs

The cost of operating a facility, activity, or like cost object that is shared by two or more users
14-44
Methods of Allocating Common Costs

Stand-Alone Cost Allocation Method Incremental Cost Allocation Method
14-45
Stand-Alone Cost Allocation Method

Uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights

Individual costs are added together and Allocated on the basis of each users percentage of the total of the individual stand-alone costs
14-46
Incremental Cost-Allocation Method

Ranks the individual users of a cost object in the order of users most responsible for a common cost and then uses this ranking to allocate the cost among the users

The first ranked user is the Primary User and is allocated costs up to the costs of the primary user as a stand-alone user (typically gets the highest allocation of the common costs) The second ranked user is the First Incremental User and is allocated the additional cost that arises from two users rather than one Subsequent users handled in the same manner as the second ranked user
14-47
Cost Allocations and Contracting

The government reimburses most contractors in either of two main ways:

1.
2.
The contractor is paid a set price without analysis of actual contract cost data The contractor is paid after an analysis of actual contract cost data. In some cases, the contract will state that the reimbursement amount is based on actual allowable costs plus a fixed fee (costplus contract)
14-48
Common Cost Example Data

Winnipeg-Halifax round trip airfare $1,200 Winnipeg-Montreal round trip airfare $800 Winnipeg-Montreal-Halifax airfare $1,500 Common cost $1,500 to be allocated between two potential employers

Halifax Montreal
14-49
Stand-Alone Cost Allocation

Halifax Employer $1,200 $1,200 + $800 X $1,500 = 0.60 x $1,500 = $900
Montreal Employer
$800 $1,200 + $800
X $1,500 = 0.40 x $1,500 = $600
Information about the stand alone return airfares are used to determine the allocation weights
14-50
Incremental-Cost Allocation

One user viewed as primary and others as secondary

Costs Allocated $1,200 300 Costs remaining to be Allocated to Other Parties
Party
Halifax (primary) Montreal (incremental)
$300($1,500 - $1,200) 0
14-51

Ch14 Cost Allocations Additional

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Ch14 Cost Allocations Additional

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Cost Allocation

Copyright 2007 Pearson Education Canada Inc.

Purposes of Cost Allocation

Six-Function Value Chain

Criteria for Cost-Allocation Decisions

Cause and Effect

Variables are identified that cause resources to be consumed

Most credible to operating managers Integral part of ABC

Criteria for Cost-Allocation Decisions

Supporting Departments and Operating Departments

Supporting (Service) Department

Operating (Production) Department

Copyright 2007 Pearson Education Canada Inc.

Methods to Allocate Support Department Costs

Single-Rate Method Dual-Rate Method

Copyright 2007 Pearson Education Canada Inc.

No distinction is made between fixed and variable costs in this method

Copyright 2007 Pearson Education Canada Inc.

a variable cost pool a fixed cost pool.

Each pool uses a different cost-allocation base

Allocation Method Tradeoffs

Copyright 2007 Pearson Education Canada Inc.

Choosing between actual and budgeted rates:

Stages of Cost Allocation

User Department (Assembly) User Department (Machining)

Copyright 2007 Pearson Education Canada Inc.

Methods of Allocating Support Costs to Production Departments

Direct Step-Down Reciprocal

Copyright 2007 Pearson Education Canada Inc.

Copyright 2007 Pearson Education Canada Inc.

Copyright 2007 Pearson Education Canada Inc.

Direct Method Example

Service Department Maintenance Information system

Allocation Base Budgeted labour hours Budgeted computer hours

Copyright 2007 Pearson Education Canada Inc.

Direct Approach to Cost Allocation

Machinery Department $400,000 Plus allocated $328,111

$728,111 will be allocated in total to products

Information Systems $116,000

Assembly Department $200,000 Plus allocated $387,889

$587,889 will be allocated in total to products

Copyright 2007 Pearson Education Canada Inc.

2,400 2,400 + 4,000

Allocation base: budgeted labour hours

4,000 = $375,000 2,400 + 4,000

Allocation base: Budgeted labour hours

1,600 1,600 + 200

Allocation base: Budgeted computer hours

200 1,600 + 200

Allocation base: Budgeted computer hours

Copyright 2007 Pearson Education Canada Inc.

Step-Down Method Example

Service Department Maintenance Information system

Allocation Base Budgeted labour hours Budgeted computer hours

Copyright 2007 Pearson Education Canada Inc.

Step-Down Approach to Cost Allocation

Machinery Department $400,000 Plus allocated $389,778

$789,778 will be allocated in total to products

$300.000 $120,000 $209,778

Information Systems $116,000 Plus $120,000

Assembly Department $200,000 Plus allocated $326,222

$526,222 will be allocated in total to products

Step-Down Allocation Method Example