Chapter SevenCost Allocation Theory© 2017 by McGraw-H.docx

Chapter Seven
Cost Allocation: Theory
© 2017 by McGraw-Hill Education. All rights reserved. No
reproduction or distribution without the prior written consent of
McGraw-Hill Education
Connection of Cost Allocation to Other Chapters in this
BookChapter 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.

Definitions and GlossaryCost 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.
Examples: Accounting, building maintenance, supervisors.
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.
Steps of Cost Allocation1. Defining the cost objects. Decide
what departments, products, or processes to cost.
2. Accumulating the common costs to be assigned to the cost
objects. (Also known as indirect cost pools.)
3. Allocating 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.
See Self-Study Problem.

Surveys of Cost Allocation Practices by Large
CorporationsWhat corporate-level costs are allocated to profit
centers?Most often: selling and distribution expensesLeast
often: income taxes
What allocation bases are used?Meter: measure actual
useNegotiate: estimate usageProrate: based on relative
proportions of sales, profits, or assets
External Cost-based ContractsUsage: Some organizations
purchased goods and services with cost-based contracts.
Suppliers were paid for their reported costs plus a stated profit
percentage.
Examples: Military aircraft, hospital services, university
research grants.
Incentives: Contractors maximize the indirect costs allocated to
cost-based contracts.
Responses:
Tighter regulation of cost allocation practices.
Abandon cost-based contracts in favor of fixed-price contracts.

External Reasons for Cost AllocationExternal financial
reports:Allocate production costs between expenses (expired
costs, such as cost of goods sold) and assets (unexpired costs,
such as ending inventory.Income taxes:Uniform capitalization
(“Unicap”) rules of the tax law prescribe when product costs
can be deducted.Cost-based reimbursement:Some government
contracts and regulated industries use cost-plus
contracts.Bookkeeping costs are reduced if the same costs are
used for external and internal reporting.
Internal Reasons for Cost AllocationDecision MakingManagers
will try to reduce their use of common resources that have
relatively high cost allocation rates
Decision ControlCentral executives can control behavior of
operating managers with cost allocation policyAllocating more
costs to a center constrains that center from using other
resources
Cost Allocations are a Tax SystemCost allocations are

economically equivalent to taxes on resource factors.Increasing
cost allocation rates (or taxes) decrease profits reported by the
center bearing the allocated costs.Increasing the cost allocation
rate (or taxes) motivates profit-maximizing managers to use less
of the cost allocation base.Example shows imposing an
overhead rate R on salespersons decreases the number of
salespersons. This is economically equivalent to a payroll tax
on salesperson compensation.
Even in the Federal Reserve System …The Fed reportedly
shifted the allocation of costs from competitive services and
markets to less competitive services.
This allowed the Fed to “justify” charging lower prices in its
competitive services and higher prices for its less competitive
services.
Who was best served by this process?
Microeconomic Analysis of Cost Allocation (Figures 7-1 – 7-
2)Manager’s decision problem:Minimize cost to produce sales
level Q by choosing levels for two inputs: advertising (A) and

salespersons (S) .With no cost allocation: Costs = PaA +
PsSWith cost allocation, overhead rate R is added to
salesperson costs: Costs = PaA + (Ps+R)S Since R makes sales
persons more expensive, the optimum level of salespersons
decreases from SY to SZ.Some advertising is substituted for
salespersons, and the optimum level of advertising increases
from AY to AZ.
Allocation Proxies for ExternalitiesPositive externalities are
benefits imposed on other individuals without their participation
in the decision and without compensation for the benefits
imposed on them.
Negative externalities are costs imposed on other individuals
without their participation in the decision and without
compensation for the costs imposed on them.
When costs are allocated, the overhead rate is a proxy for
externalities that are hard to measure.
Average Overhead Rate as a Proxy

for Marginal Opportunity CostsExternality: Adding more
salespersons degrades human resource department services for
all users.
Marginal cost (MC): Slope of smooth opportunity cost. MC is
constantly increasing along the curve. MC is hard to measure.
Overhead rate (R): The average cost approximated by dividing
total accounting cost by the number of salespersons. R is the
slope of the dashed line in Figures 7-2, 7-3, and 7-4.
Allocation is better for decision making when R>MC. (Case 1
and 2).
Allocation might or might not be better when R>MC. (Case 3).
Multiproduct Firm CaveatIn multiproduct firms, the average
cost curve for each product might not be well-behaved.
Thus, applying the preceding analysis may be problematic.
However, if most externalities arise due to additional employees
then the text’s analysis continues to hold as long as the total
cost (including externalities) as a function of the number of
employees is well-behaved.

Choice of Allocation BaseThe measurable activity in the
allocation base often is closely related to the hard-to-measure
opportunity cost.
Allocation Bases:Time spent or personnel costsSquare footage
or personnel costsTime spent or number of customersTime spent
or number of accounting transactions
Insulating vs. Noninsulating: DefinedInsulating 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.
Insulating vs. Noninsulating: IncentivesInsulating 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
otherReduce 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.
Appendix: Cost Allocation as TaxesThe standard economic
solution
See Figure 7-5
Cost allocations
See Figure 7-6
Substitute away from the more expensive input, salespeople,
and toward the relatively cheaper input, advertising.

Chapter Eight
Cost Allocation: Practices
Death SpiralDeath 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.
Death Spiral Example: Internal ServicesInternal
Telecommunications Department:Telecommunications service
department allocates fixed costs to users. If some users are
allowed to switch to outside phone company, the fixed costs
allocated to remaining users increase.Eventually, the number of
users of the telecommunications department is so small that the

department is closed.
Death Spiral Example: Cost-based ContractsMilitary Aircraft
(not in text):Defense contractors working on advanced
technology incur large fixed cost over-runs that are allocated to
each aircraft manufactured. Government reduces number of
aircraft purchased and that causes average cost to increase on
remaining orders.Government responds by ordering even fewer
aircraft.Eventually, the entire project is abandoned before all
fixed costs are recovered.
Death Spiral in Reverse!Clay Sprays:
Increasing the allocation base for fixed costs can lead to
misleading product line profit figures.
Decisions should be consistent with an overall economic
strategy and a meaningful understanding of the impacts of
accounting practices.
“I left this to the accountants” would not cut it in today’s
business environment.

Allocating Capacity Costs: DepreciationAccounting
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.
Methods of Service Department AllocationMethods for complex
firms with at least 2 service departments and at least 2 operating
departments (see Figure 8-1).
Alternative methods:Direct allocationStep-down allocation
Reciprocal allocation

Service Allocation: Direct Method 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.
Service Allocation: Step-down Method 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.
Advantages:Considers some of the interdependence of service
departmentsDisadvantages:Resulting allocations are inaccurate
estimates of opportunity costs. Allocation less than opportunity
cost for first departmentAllocation more than opportunity cost
for last department

Service Allocation: Reciprocal Method
(Appendix)Procedure:Write equations defining variable cost
relationships among divisions.Solve system of simultaneous
equations with linear algebra.Allocate fixed costs based on each
operating division’s planned use of the service department’s
capacity.
Advantages:Most accurate method (best approximates
opportunity costs)
Disadvantages:Slightly harder to set up and compute
solutionDifficult to explain results to unsophisticated
managersPrevents managers from “managing” cost allocations
for financial reporting and/or taxes.
Service Allocation ExampleEach method allocates all service
costsTotal allocation does not vary significantly in this
caseTransfer prices do differ depending on allocation method
McGraw-Hill EducationAllocation MethodTotal Allocated to
Car Division (Millions)Transfer price

($/phone)Direct$4.643$1,143Step-down – Telecommunications
first4.648889Step-down – IT
first4.6212,151Reciprocal4.6231,492
Service Allocation ExampleAs a thought question:
Under what conditions would you expect that the service
department allocations under each of these methods would be
materially different from each other?
Reasons to Allocate Service Department CostsEncourages
reduction of use of costly services With no cost allocation (zero
transfer prices), management must use non-price priority
schemes to control use.
Reveals economic demand for servicesRational users will pay a
transfer price only when the benefits are greater than or equal to
that price.
Compare internal service departments to external vendorsGross
inefficiency is revealed when internal transfer prices greatly
exceed external prices

Joint Costs DefinedJoint cost is incurred to produce two or
more outputs from the same input.
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.
Joint Costs: Process Further? Split-off point: the point in the
disassembly processing at which all joint costs have been
incurred (See Figure 8-5).
Decision: Should each joint product be processed further or sold
as is at the split-off point?
Solution
concept: The joint costs are sunk costs at the split-off point.
Do the incremental benefits of further processing exceed the
incremental costs?

Joint Costs: Net Realizable ValueNet realizable value (NRV) is
the difference between selling price and costs that would be
incurred after the split-off point.
Compute NRV of each product after the split-off point. Decide
to produce products with positive NRV, but not with negative
NRV.
For control and divisional reporting, allocate joint costs to
products in the ratio of the NRV of each product.
Example: Fillets have 64% of the sum of the NRV’s of the three
joint products. Therefore, allocate 64% of the joint costs (64% x
$2.00 = $1.28) to fillets.

Segment Reporting: Controllability
The following segment report format is based on the
controllability principle (managers should be held responsible
only for costs under their control).
Proponents argue that performance rewards for divisional
managers should be based on the division’s controllable
segment margin.
McGraw-Hill EducationDivision ADivision BDivision
revenuesX,XXXX,XXX-Division controllable expenses- XXX-
XXX=Controllable segment margin XXX XXX-Allocated
common costs- XXX- XXX= Net income XXXXXX

Segment Reporting: Joint BenefitsThe segment margin approach
does not consider joint benefits (positive externalities) of one
division on another.Separating controllable and noncontrollable
costs on segment margin reports will not show how segments
are interdependent.
Example:Products of two different segments are sold to the
same customers Dropping one segment will adversely affect
customer demand for the products of the surviving segment
See Self Study Problem.
Appendix: Reciprocal MethodProcedure:Write equations
estimating variable cost functions among service departments

only.Write equations estimating variable cost functions between
service and operating departments.Solve system of simultaneous
equations with linear algebra to allocate variable costs.Allocate
fixed costs based on each operating division’s planned use of
the service department’s capacity.
Use:Difficult to estimate cost functions in actual practice
Case Study: Phonetex
Phonetex is a medium-size manufacturer of telephone sets and
switching equipment. Its primary business is government
contracts, especially defense contracts, which are very
profitable. The company has two plants: Southern and
Westbury. The larger plant, Southern, is running at capacity
producing a phone system for a new missile installation.
Existing government contracts will require Southern to operate
at capacity for the next nine months. The missile contract is a
firm, fixed-price contract. Part of the contract specifies that
3,000 phones will be produced to meet government

specifications. The price paid per phone is $300.
The second Phonetex plant, Westbury, is a small, old facility
acquired two years ago to produce residential phone systems.
Phonetex feared that defense work was cyclical, so to stabilize
earnings, a line of residential systems was developed at the
small plant. In the event that defense work deteriorated, the
excess capacity at Southern could be used to produce residential
systems. However, just the opposite has happened. The current
recession has temporarily depressed the residential business.
Although Westbury is losing money ($10,000 per month), top
management considers this an investment. Westbury has
developed a line of systems that are reasonably well received.
Part of its workforce has already been laid off. It has a very
good workforce remaining, with many specialized and
competent supervisors, engineers, and skilled craftspeople.
Another 20 percent of Westbury’s workforce could be cut
without affecting output. Current operations are meeting the
reduced demand. If demand does not increase in the next three
months, this 20 percent will have to be cut.
The plant manager at Westbury has tried to convince top
management to shift the missile contract phones over to his
plant. Even though his total cost to manufacture the phones is
higher than at Southern, he argues that this will free up some
excess capacity at Southern to add more government work. The
unit cost data for the 3,000 phones are as follows:

Westbury cannot do other government work, because it does not
have the required security clearances. But Westbury can do the
work involving the 3,000 phones. And it can complete this
project in three months. “Besides,” Westbury’s manager argues,
“my labor costs are not going to be $95 per phone. We are
committed to maintaining employment at Westbury at least for
the next three months. I can utilize most of my existing people
who have slack. I will have to hire back about 20 production
workers I laid off. For the three months, we are talking about
$120,000 of additional direct labor.”
Phonetex is considering another defense contract with an
expected price of $1.1 million and an expected profit of
$85,000. The work would have to be completed over the next
three months, but Southern does not have the capacity to do the
work and Westbury does not have the security clearances or
capital equipment required by the contract.
Southern’s manager says it isn’t fair to make him carry
Westbury. He points out that Westbury’s variable cost, ignoring
labor, is 33 percent greater than Southern’s variable costs.
Southern’s manager also argues, “Adding another government
contract will not replace the profit that we will be forgoing if
Westbury does the telephone manufacturing. See my schedule.”
Required:

Top management has reviewed the Southern manager’s data and
believes his cost estimates on the new contract to be accurate.
Should Phonetex shift the 3,000 phones to Westbury and take
the new contract or not? Prepare an analysis supporting your
conclusions.
APA format. Use Chapter 7 Power Point. At least 2 references.
Case Study: Vista View Wines
Vista View Wines (VVW) is a large vineyard that produces a
host of varietal wines (premium reds and whites) and fortified
wines. Fortified wines such as brandy, vermouth, sherry,
madeira, and port consist of wine with additional distilled
products. Besides sourcing grapes for its wines from its own
vineyard, VVW purchases grapes from surrounding vineyards.
VVW is organized around two profit centers: Wines (all of the
premium wines) and Ports (all of the fortified wines). A case of
wine or fortified wine is sold as soon as it is produced. Each
profit center faces its own demand curve as depicted below, and
each profit center has different and distinct marketing and
distribution channels. Wines sells its products by private
labeling them to hotels, whereas Ports sells its fortified wines to
liquor stores.
VVW purchased 5,000 tons of grapes that were then crushed and
the juice from the first and second pressings was used by Wines

and the juice from the third and fourth pressings was used by
Ports. Each subsequent pressing applies more pressure, and the
resulting juice contains more impurities. The cost of the grapes
(including pressing) amounted to $5 million and these costs are
recovered from Wines and Ports using predetermined rates
based on the budgeted number of juice gallons used in the cases
produced (and sold). Based on their budgeted gallons used and
cases produced, Wines is charged $19 per case and Ports $13
per case to recover the grape and pressing costs of $5 million.
(Grape and pressing cost is charged to each of the two profit
centers.)
In addition to the grape and pressing cost, Wines and Ports
incur variable costs to ferment, age, bottle, package, and
distribute their products. Wines incurs variable costs of $25 per
case and Ports incurs $20 of variable costs per case. Wines and
Ports have separate fermenting, packaging, marketing, and
distribution channels and incur their own fixed costs ($6.3
million by Wines and $2.8 million by Ports). The managers of
Wines and Ports are compensated based on the profits of their
individual operation, which is calculated based on their own
revenues, variable and fixed costs, and the grape and pressing
costs.
Case Study: Vista View Wines

Required:
a. How many cases of wines do you expect Wines to produce,
and how many cases of fortified wines do you expect Ports to
produce?
b. Based on your calculations in part (a), how much profit will
Wines and Ports report?
c. If central management has the same knowledge of the demand
conditions as Wines and Ports and makes the Wines and Ports
price-quantity decisions to maximize firm profits instead of
allowing each division to make its own price-quantity decision,
would the same price-quantity decisions be made? Justify your
answer with supporting calculations and analyses.
d. Explain why your answers in part (a) and (c) are the same or
different.
e. Assuming that VVW continues to maintain its decentralized
organizational structure and continues to compensate its Wines
and Ports managers based on their own profits as described in
the problem, what, if any, changes would you recommend VVW
make in the way profits of each profit center is calculated?

Use Chapter 8 PowerPoint. APA format.

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