horngren_ima16_stppt12.ppt

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

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Chapter 12
Cost Allocation

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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.

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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.

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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.

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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.

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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.

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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.

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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

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Service Department Example
University
computer department
serves two major users:
Allocate the cost of a 5-year
lease on computer mainframe
School of Business School of Engineering

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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

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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.

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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

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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

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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.

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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

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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?

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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.

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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

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Processing Facility:
Service Department Allocation

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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.

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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.

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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

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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.

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Step-Down Method
Allocate facilities management department
costs then allocate human resources cost.

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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.

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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

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Traditional Approach
1. Divide the costs in each
producing department.
2. Assign direct costs to the appropriate
products, services, or customers.
Direct costs Indirect costs
Learning
Objective 4

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3. Select one or more cost pools and related
cost drivers in each production department.
Indirect departmental costs
Cost
pool
Cost
pool
Cost
pool

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4. Allocate costs
Costs
Product
B
Product
A
Product
C

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Traditional Approach and Step-Down Method

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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.

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Activity-Based Costing

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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.

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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
Customer Type 2
High Cost to Serve
Customer Type 1
Low Cost to Serve

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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

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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

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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

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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
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.

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Profit Margin Per Case of Apparel and Sports Gear

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Customer Profitability at Cedar City Distributors

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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.

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Allocation of Costs-to-Serve
Product and Customer Profitability Measures
Based on CCD’s Refined Cost-Allocation System

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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.

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Allocation of Central Costs
Revenue
Cost of goods sold
Total assets
Total cost of each division
Often used cost-allocation bases

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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