Managerial Accounting - Ottawa Week 5

1. Instructor: Mary Haines, MBA, CPA

2. Cost Allocation:
Theory
Chapter Seven
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

3.  Chapter 2 (costing for decision making): Cost allocations
might be used as proxies for opportunity costs.
 Chapter 4 (organizational architecture): Cost allocations
are a form of transfer pricing and are useful for control.
 Chapter 5 (responsibility centers): Cost allocations
influence decision rights and performance measurement.
 Chapter 6 (budgeting): Cost allocations influence how
resources are allocated within the firm.
 Chapter 8 discusses practical problems of cost allocation.
 Chapters 9 through 13 (product costing): Indirect
manufacturing costs are allocated to products.
7-3

6.  These non-product related costs are
allocated internally to products to provide
management useful information for decision
making.
 Non-manufacturing costs are not GAAP;
therefore, not for purpose of financial
reporting.

7.  Cost object is a product, process, department,
or program that managers wish to cost.
 Common cost is a cost shared by two or more
cost objects.
 Cost allocation is the assignment of indirect,
common, or joint costs to cost objects.
 Allocation base is the measure of activity used
to allocate costs. Examples: hours, floor space,
sales dollars.
7-7

8. 1. Define the cost objects. Decide what
departments, products, or processes to cost.
2. Accumulate the common costs to be assigned
to the cost objects. (Also known as indirect
cost pools.)
3. Allocate the accumulated costs to cost objects
using an allocation base. (Also known as cost
assignment, apportionment, or distribution.)
Usually the allocation base approximates how
the cost objects consume common resources.
7-8

9.  The measurable activity in the allocation base
often is closely related to the hard-to-measure
opportunity cost.
 Allocation Bases:
◦ Time spent or personnel costs
◦ Square footage or personnel costs
◦ Time spent or number of customers
◦ Time spent or number of accounting transactions
7-9

10. To provide email services for its employees, a firm
incurs the following expenses each year: Computer
lease ($275,000), labor ($250,000), software
($100,000) and other costs ($30,000). Below is a
chart with the amount of terabytes used by
department.
7-10
Users
Terabytes of
Memory Used
Manufacturing 50 Computer Lease 275,000
Sales 100 Labor 250,000
Research & Development 20 Software 100,000
Administration 80 Other 30,000
Total 250 Total 655,000
Total Email Services Costs

11. Users
Cost per
Terabyte
Terabytes
of Memory Allocated Cost
Manufacturing 2,620$ 50 131,000$
Sales 2,620 100 262,000$
Research & Development 2,620 20 52,400$
Administration 2,620 80 209,600$
Total 250 655,000$

12. Fixed Fee
Contract
Cost Plus
Contract TOTAL
GIVEN:
# of contracts 15 20 35
Revenues $ 3,000,000
Direct cost as % of Rev 75%
Direct Cost 2,250,000$ 550,000$ 2,800,000$
Indirect OH Cost 400,000$
Network Systems offers telecommunications design and consulting services to
organizations. The firm offers two types of contracts to clients: a cost+25%
contract and a fixed-fee contract. For cost+ contracts the total cost includes both
direct costs and indirect overhead. NS completes 20 cost+ contracts with a
direct cost total of $550,000 and 15 fixed-fee contracts. Revenues collected from
the fixed-fee contracts totaled $3,000,000. Total direct cost of the fixed-fee
contracts represents 75% of total revenues. Total indirect overhead is $400,000.
7-12

13. Fixed Fee
Contract
Cost Plus
Contract TOTAL
Direct Cost 2,250,000$ 550,000$ 2,800,000$
% of direct cost 80.36% 19.64% 100.00%
Indirect OH Cost 321,429$ 78,571$ 400,000$
b. Now Allocate indirect OH using # of contracts
# of contracts 15 10 25
% of contracts 60% 40% 100%
Indirect OH Cost 240,000$ 160,000$ 400,000$
a. Allocate indirect OH of $400,000 to the fixed-fee and cost-plus 25%
contracts using direct costs as the overhead allocation base

14.  Decision Making
◦ Managers will try to reduce their use of common
resources that have relatively high cost allocation
rates
 Decision Control
◦ Central executives can control behavior of operating
managers with cost allocation policy
◦ Allocating more costs to a center constrains that
center from using other resources
7-14

15. Freddie Victoria Kevin Catherine TOTAL
Cost of
Lunch
$50 $25 $20 $10 $105
Allocate
Evenly
25% 25% 25% 25% 100%
Split Cost 26.25 26.25 26.25 26.25 $105

16.  Insulating allocation scheme: The allocation base is
chosen so that the costs allocated to one division
do not depend on the operating performance of
some other division.
Example: Floor area or a fixed pre-determined
rate.
 Noninsulating allocation scheme: The allocation
base is chosen so that the costs allocated to one
division does depend on the operating
performance of some other division.
Example: Fixed percentage to each division.
 Both schemes motivate mangers to reduce waste of
common resources, but they differ in other
incentives.
7-16

17.  Insulating cost allocation:
◦ Performance of a division does not influence rewards
for others.
◦ Each division bears its own risk of events outside its
control.
 Noninsulating allocation:
◦ Creates incentives for mutual monitoring and
cooperation because rewards depend on each other
◦ Reduce risk to managers of events outside their
control. If random events are uncorrelated across
divisions, then when one division is doing poorly, the
others are probably doing well and bear more of the
costs.
7-17

18. GIVEN DATA in $000's
Watch
Division
Camera
Division Total Co.
Watch
Division
Camera
Division Total Co.
Division Profits (given) 6,000$ 6,000$ 12,000$ 6,000$ 2,000$ 8,000$
Factory Sq. Footage used 60% 40% 60% 40%
Common Costs 1,000$ 1,000$
Cost allocations can promote or discourage cooperation between managers. Consider this
example: Two divisions of an electronics manufacturer share the same factory building and both
are profit centers. Assume the common costs of the shared factory space are $1 million per
month. Below are the divison profits and factor square footage used in Jan and Feb.
January February

19. Watch
Division
Camera
Division Total Co.
Watch
Division
Camera
Division Total Co.
Allocate common costs of $1 million using actual profits:
(Non-Insulating Method)
% of profits 50% 50% 100% 75% 25% 100%
Division Profits before
allocation (given) 6,000$ 6,000$ 12,000$ 6,000$ 2,000$ 8,000$
Less: Allocated common
costs 500 500 1,000 750 250 1,000
Net Income 5,500 5,500 11,000 5,250 1,750 7,000
FebruaryJanuary

20. Watch
Division
Camera
Division Total Co.
Watch
Division
Camera
Division Total Co.
Allocate common costs using square footage of factory space:
(Insulating Method)
% of factory space 60% 40% 100% 60% 40% 100%
Division Profits before
allocation 6,000 6,000 12,000 6,000 2,000 8,000
Less: Allocated common
costs 600 400 1,000 600 400 1,000
Net Income 5,400 5,600 11,000 5,400 1,600 7,000
How do the two methods relate to the operating performance of the other divisions?
What are the pros and cons of the two methods?
January February

21. Cost Allocation:
Practices
Chapter Eight
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

22.  Death spiral occurs when large fixed
costs of a common resource are
allocated to users who could decline
to use that resource. As the allocated
costs increase to the remaining users,
some users choose to decrease use.
Then the fixed costs are allocated to
the remaining users, more of whom
use less. This process repeats until
no users are willing to pay the fixed
costs.
 Possible solutions to death spiral:
◦ When excess capacity exists,
charge users only for variable
costs.
◦ Reduce the total amount of fixed
costs allocated.

24. 8-24
A company that makes aerosol
spray scents for hospitals is
considering acquiring a similar
company that makes aerosol
sprays for home consumers. All
of the volume from acquiring
Consumer can be handled by
their current production facility
without adding fixed overhead
or affecting current variable
costs. They carry no beginning
and ending inventory. They
would share the factory space.

25. Industrial
Scents
Consumer
Scents
Sales Price/unit 8.00 4.00
Variable Cost/unit 4.00 4.00
Less: Fixed Cost 2,800,000 -
Quantity prod/sold 1,000,000 1,000,000

26. Allocate based on
units sold:
Industrial Scents
Alone
Consumer Scents
Alone TOTAL
% of units 50% 50%
Revenue 8,000,000$ 4,000,000$ 12,000,000$
Variable Cost 4,000,000 4,000,000 8,000,000
Fixed Cost 1,400,000 1,400,000 2,800,000
Net income 2,600,000$ (1,400,000)$ 1,200,000$
Quanity sold 1,000,000 1,000,000 2,000,000

27.  Accounting depreciation represents the annual
historical cost of acquired capacity.
 Allocating depreciation involves a tradeoff -
with excess capacity, allocation causes
underutilization. However, allocation controls
overinvestment.
 Most firms allocate depreciation to users.
 If confronted with a choice between control and
decision making - accounting systems usually
choose control.
8-27

28.  Methods for complex firms with at least 2
service departments and at least 2 operating
departments.
 Alternative methods:
◦ Direct allocation
◦ Step-down allocation
◦ Reciprocal allocation (complex-not widely used)
8-28

31.  Procedure:
◦ Ignore each service department’s use of other service
departments.
◦ Allocate service department costs only to operating
departments.
 Advantages:
◦ Simple to administer and explain.
 Disadvantages:
◦ Allocations are not accurate estimates of opportunity
costs when service departments use other service
departments.
◦ Incentives exist for service departments to make
excessive use of other service departments.
8-31

33.  Procedure:
◦ Start with one service department and allocate all of its
costs to the remaining service and operating departments.
◦ Continue one-by-one through each service department
allocating all direct costs of that department and costs
allocated to it.
 A good way of choosing the order of allocation is by (1) most
reliable “cause and effect” cost driver, (2) number of other
departments serviced, and (3) finally, as the default, total
budget of department.
 Disadvantages:
◦ Resulting allocations are inaccurate estimates of
opportunity costs.
◦ Allocation less than opportunity cost for first department
◦ Allocation more than opportunity cost for last department
8-33

35.  Joint cost is incurred to produce two or more
outputs from the same input (shared costs)
 Joint costs occur only in disassembly
processes, such as refining and food
processing.
 Common costs occur in either disassembly or
assembly processes, such as building cars.
8-35

36.  Net realizable value (NRV) is the difference between
selling price and costs that would be incurred after
the split-off point.
1. Compute NRV of each product after the split-off
point. Decide to produce products with positive
NRV, but not with negative NRV.
2. For control and divisional reporting, allocate joint
costs to products in the ratio of the NRV of each
product.
8-36

37. 8-37
A chicken processor buys live chickens and dissembles them
into fillets, wings, and drumsticks. Live chickens cost $1.60
each. Variable cost to process a live chicken into parts is $0.40
each. Costs beyond split off: Fillets $.80, Drumsticks $.04,
Wings $.16. Sales per unit after processing: Fillets $2.40,
Drumsticks $0.80, Wings $.30. Weight of the chicken parts in
ounces is: Fillets 16 oz, Drumsticks 12 oz, Wings 4 oz.
A. Calculate the joint costs 1.60$
0.40$ 2.00$
Chicken
Cut into parts

38. B. Calculate Product Line Profitability, Including Joint Costs
Fillets Drumsticks Wings Total
Sales 2.40$ 0.80$ 0.30$ 3.50$
Less: Costs beyond split-off (0.80) (0.04) (0.16) (1.00)
Less: Joint costs (1.00)$ (0.75)$ (0.25)$ (2.00)$
Profit (loss) per chicken 0.60$ 0.01$ (0.11)$ 0.50$
Allocated costs makes the Wings division appear unprofitable.

39. C. Cost Allocation based on weight without the wings:
Fillets Drumsticks Wings Total
Weight (ounces) 16 12 28
% of weight 57.1% 42.9% 100.0%
Allocated Joint Costs 1.14$ 0.86$ 2.00$
D. Product Line Profitablity without the unprofitable wings:
Fillets Drumsticks Wings Total
Sales 2.40$ 0.80$ 3.20$
Less: Costs beyond split-off (0.80) (0.04) (0.84)
Less: Joint costs (1.14)$ (0.86)$ -$ (2.00)$
Profit (loss) per chicken 0.46$ (0.10)$ 0.36$

40. E. Now allocate the joint costs using Net Realizable Value
Thighs Drumsticks Wings Total
Sales 2.40$ 0.80$ 0.30$ 3.50$
Less:Costs beyond split-off (0.80) (0.04) (0.16) (1.00)
= Net Realizable Value 1.60 0.76 0.14 2.50
Less:Joint costs (alloc by NRV) (1.28)$ (0.61)$ (0.11)$ (2.00)$
Profit (loss) per chicken 0.32$ 0.15$ 0.03$ 0.50$
% of NRV above 64.0% 30.4% 5.6% 100.0%
Using net realizable value as the allocation base does NOT cause one product to bear a
disproportionately larger percentage of joint costs than it generates in NRV.