EMBA 5412 Fall 2010

 We will
 emphasize the allocation of costs to divisions, plants, departments, and contracts;
 also address
 the common cost allocation
 the joint cost allocations;
 and
 the revenue allocations
2

 We allocate indirect costs that can not be easily traced to products, services, etc.
 Why do managers allocate indirect costs to these cost objects?
3

1 To provide information for economic decisions
2 To motivate managers and other employees
3 To justify costs or compute reimbursement
4 To measure income and assets for reporting to external parties
4

 Cause-and-effect: identify the variable or variables that cause resources to be consumed
 Allocation based on this relation would be the most acceptable by the departments/managers
5

 Benefits-received: managers identify the beneficiaries of the outputs of the cost object
 The costs of the cost object are allocated among the beneficiaries in proportion to the benefits each receives
 Have to convince the managers of departments
6

 Fairness or equity: This criterion is often cited on government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers.
 Cost allocation is viewed as a
“reasonable” or “fair” means of establishing a selling price in the minds of the contracting parties.
7

 Ability to bear: This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.
 An example is the allocation of corporate executive salaries on the basis of division operating income.
8

 Companies place great importance on the cost-benefit approach when designing and implementing their cost-allocation system.
 The costs of designing and implementing a system are highly visible.
 The benefits from using a well-designed system are difficult to measure and are frequently less visible.
9

Allocating Costs of a Supporting
Department to Operating Departments
 Supporting (Service) Department – provides the services that assist other internal departments in the company
 Operating (Production) Department – directly adds value to a product or service
10

 Single-Rate Method – allocates costs in each cost pool (service department) to cost objects
(production departments) using the same rate per unit of a single allocation base
 No distinction is made between fixed and variable costs in this method
11

 Dual-Rate Method – segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool.
 Each pool uses a different costallocation base
12

 Single-rate method is simple to implement, but treats fixed costs in a manner similar to variable costs
 Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement
13

 Under either method, allocation of support costs can be based on one of the three following scenarios:
1.
Budgeted overhead rate and budgeted hours
2.
Budgeted overhead rate and actual hours
3.
Actual overhead rate and actual hours
 Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period
14

1.
Direct
2.
Step-Down
3.
Reciprocal
15

 Allocates support costs only to
Operating Departments
 No interaction between Support
Departments prior to allocation
16

Support Departments
Information Systems
Production Departments
Manufacturing
Packaging
Accounting
17

 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.
18

 Allocates support costs to other support departments and to operating departments that partially recognizes the mutual services provided among all support departments
 One-way interaction between Support
Departments prior to allocation
19

Support Departments Production Departments
Information Systems
Manufacturing
Packaging
Accounting
20

 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 departments
 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
21

 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
22

Support Departments Production Departments
Information Systems
Manufacturing
Packaging
Accounting
23

 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 solution
 Difficult to explain results to unsophisticated managers
 Prevents managers from “managing” cost allocations for financial reporting and/or taxes.
24

 Reciprocal is the most precise
 Direct and Step-Down are simple to compute and understand
 Direct Method is widely used
25

DATA
Budgeted Manufacturing
Overhead Cost before allocations (TL)
Support work provided:
By Plant Maintenance
Budgeted Labor hours
Percentage
By Information Systems
Budgeted Computer hours
Percentage
Support Depts Operating Depts
Plant
Maintenance
Information
Systems Machining Assembly Total
600.000
200
10%
116.000
1600
20%
400.000
2400
30%
1600
80%
200.000 1.316.000
4000
50%
200
10%
8.000
100%
2.000
100%
26

Budgeted
Cost
Support Departments
Budgeted Manufacturing
Overhead Cost before allocations
Plant Maintenance
600.000
Budgeted
Cost Operating Depts
Machining Assembly
116.000
400.000
Total
200.000 1.316.000
Labor Hours
Percentage
Allocated Plant Main Cost (600.000)
2400 /
(2400+4000)
0,375
225.000
4000/
(2400+4000)
0,625
375.000
600.000
Information System
Computer Hours
Percentage
Allocated Info System Cost
Total Budgeted Overhead
(116.000)
1600/
(1600+200)
0,889
103.111
200/
(1600+200)
0,111
12.889
116.000
728.111
587.889 1.316.000
27

 Two service depts;
 We can start with either one but would yield different results
 Usually start with the service dept that provides a higher percentage of service to other service departments first
 Rank the service departments in the order that they provide service to other service departments
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Budgeted
Cost
Budgeted
Cost Operating Depts
Machining Assembly Total Support Departments
Budgeted Manufacturing
Overhead Cost before allocations
Plant Maintenance
Labor Hours
Percentage
Allocated Plant Main Cost
600.000
116.000
1600
20%
(600.000) 120.000
400.000
2400
30%
180.000
200.000 1.316.000
4000 8.000
50% 100%
300.000
600.000
Information System
Computer Hours
Percentage
Allocated Info Sys Cost
Total Budgeted Overhead
(236.000)
1600/
(1600+200)
0,889
209.778
200/
(1600+200)
0,111
26.222
236.000
789.778
526.222 1.316.000
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Budgeted
Cost
INFO SYS
Budgeted
Cost
PLANT
Operating Depts
Machining Assembly Total Support Departments
Budgeted Manufacturing
Overhead Cost before allocations
Information System
Computer Hours
Percentage
Allocated Info Sys Cost
Plant Maintenance
116.000
600.000
(116.000)
200
10%
11.600
400.000
1600
80%
92.800
200.000 1.316.000
200 2.000
10% 100%
11.600
116.000
Labor Hours
Percentage
Allocated Plant Main Cost 611.600
2400 /
(2400+4000)
38%
229.350
4000/
(2400+4000)
63% 100%
382.250
611.600
Total Budgeted Overhead 722.150
593.850 1.316.000
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Machining
Assembly
Total
Step down
Plant Main
Step down
Info Sys
Direct first
728.111
789.778
587.889
526.222
first
722.150
593.850
1.316.000
1.316.000
1.316.000
31

[A]=
Plant
Info
[I] =
[I- A]=
0
0,2
0,1
0
1
0
0
1 cost [C] = Plant
Info
1,00 -0,10
-0,20 1,00 multiply [I- A] inverse x [C] = det [I-A] = 0,98
1/ det[I-A] = [I-A] inverse 1,02 0,102
0,204 1,0204
600.000
116.000
624.082
240.816
32

Budgeted
Cost
Plant Support Departments
Budgeted Manufacturing
Overhead Cost before allocations
Allocation of Plant Maintenance
600.000
Budgeted
Cost
Info Sys
116.000
Percentage
Amount (624.082)
Allocation of Information System
20%
124.816
Percentage
Amount
10%
24.082
(240.816)
Total budgeted overhead for operating departments
Operating Depts
Machining Assembly
400.000
30%
187.224
80%
192.653
779.878
200.000
50%
312.041
10%
24.082
Total
1.316.000
100%
100%
536.122
1.316.000
33

Machining
Assembly
Total
Step down Step down
Plant Main Info Sys
Direct
728.111
587.889
first
789.778
526.222
first
722.150
593.850
Reciprocal
779.878
536.122
1.316.000
1.316.000
1.316.000
1.316.000
34

35

Service Department Cost Allocation assuming separate fixed and variable costs
Example
 Dual rates are used
 Distributed in class
36

 Common Cost – the cost of operating a facility, activity, or like cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user
37

 Stand-Alone Cost-Allocation Method – uses information pertaining to each user of a cost object as a separate entity to determine the costallocation weights
 Individual costs are added together and allocation percentages are calculated from the whole, and applied to the common cost
38

 The manager of your plants in Russia wanted to consult you and wanted you to visit their sites.Below are the possible fares for these trips individually or combined. You will charge the cost of your plane ticket to these two sites.
 Dubna and St.Petersburg
 Ankara-Dubna-Ankara costs TL 800
 Ankara-St.Peterburg-Ankara costs TL 1300
 Ankara-Dubna-St.Peterburg-Ankara costs TL 1900
 How would you allocate the cost between these two sites?
39

Determine weights:
Dubna =
800
800

1300

38 .
1 %
St.Peterburg =
1300
800

1300

61 .
9 %
Then costs are
Dubna 38.1% *1900= 723.90
St.Peterburg 69.1% *1900 =1176.10
40

 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
41

 Assuming Dubna plant is the first user
 Dubna gets 800 TL; St.Peterburg gets
1900 – 800 = 1100 TL
 Assuming St.Peterburg is the first
 St.Peterburg gets 1300 TL; Dubna gets
1900 – 1300 = 600 TL
Probably have to agree with the management.
42

 two main ways:
1.
The contractor is paid a set price without analysis of actual contract cost data
2.
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
(cost-plus contract)
43

 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, 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.
44

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.
45

 Joint 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
46

 Split-off point: the point in the disassembly processing at which all joint costs have been incurred
 Decision: Should each joint product be processed further or sold as is at the splitoff 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?
47

 Net 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.
48

Yogurt
Raw
MILK
Pasteurize
MILK
Split off point
Process further
Sell as MILK
White Cheese
49

 In June 2008, Bizim Sut processes 220,000 lt of raw milk.
During processing until the split off point 10,000 lt are lost due to evaporation, spillage,etc.
 After the split off point, the may be processed further to yogurt or cheese that share a second common processing which costs 200.000 TL .
 Price of milk: 1.50 TL per lt
 Price of Yogurt 3.50 TL per kg; further processing cost 0.60
TL per kg
 Price of cheese 7 TL per kg further processing cost 2 TL per kg
 Joint cost of processing raw milk 100.000 TL
 The company decides to sell half of pasteurized milk as is; and process the rest yielding 75,000 kg yogurt and 25,000 cheese losing 5,000 lt more during the process.
50

JOINT COST 1
Sales value at split off
amount (lt,kg)
sales price (lt, kg)
Total Sales value
Weights of sales value
JOINT COST 1 Allocation joint cost 1 per lt or kg
Milk
105.000
1,50
157.500
50,0%
(100.000) 50.000
Yogurt and Cheese
105.000
4,00
420.000
50,0%
50.000
210.000
0,48 0,48
Based on physical units
51

JOINT COST 2
Sales value at split off
amount (lt,kg)
sales price (lt, kg)
Total Sales value
Weights of sales value
JOINT COST 2 Allocation joint cost 1 per lt or kg
Yogurt
75.000
3,50
262.500
60,00%
(200.000) 120.000
1,60
Cheese
25.000
7,00
175.000
437.500
40,00%
80.000
3,20
52

Using NRV
JOINT COST 2
Sales value at split off
amount (lt,kg)
sales price (lt, kg)
Total Sales value
Separable Costs per kg
Less Separable Costs
Net Realizable Value at Split-off
Weights of sales value
JOINT COST 2 Allocation joint cost 1 per kg
Yogurt
75.000
3,50
262.500
0,60
45.000
217.500
Cheese
25.000
7,00
175.000
437.500
2,00
50.000
125.000
342.500
63,50%
(200.000) 127.007
1,69
36,50%
72.993
2,92
53

TOTAL COST per kg sales value
NRV
Yogurt
2,68
2,77
Cheese
5,68
5,40
54

 Revenue Allocation occurs when revenues are related to a particular revenue object but cannot be traced to it in an economically feasible manner
 Revenue Object – anything for which a separate measurement of revenue is desired
 Bundled Product – a package of two or more products or services that are sold for single price, but individual components of the bundle also may be sold as separate items at their own “stand-alone” prices
55

 Stand-Alone (separate) Revenue
Allocation Method uses productspecific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. Three types of weights may be used:
1.
Selling Prices
2.
Unit Costs
3.
Physical Units
56

 Cybersoft produces and sells three software programs: Writeperfect; Computeperfect; and
Graphperfect.
 Cybersoft sells these products individually as well as bundled products.
Individually
Writeperfect
Computeperfect
Graphperfect
Bundled:
Write and Compute
Write and Graph
Compute and Graph
Write, Compute and Graph
Selling Price
TL
125
150
225
Manufacturing Cost per Unit
TL
18
20
25
220
280
305
380
57

Individual Revenue Allocation
Use Selling Prices write and compute prices of individual products write and graph prices of individual products compute and graph write, compute and graph weights and prices total individual prices
275 bundle price write
220 0,45
100,00 compute graph
0,55
120,00
350 280 0,36
100,00
375
500
305
380 0,25
95,00
0,40
122,00
0,30
114,00
0,64
180,00
0,60
183,00
0,45
171,00
58

 Incremental Revenue-Allocation Method ranks individual products in a bundle according to criteria determined by management and then uses this ranking to allocate bundled revenues to individual products
 The first-ranked product is the primary product
 The second-ranked product is the first incremental product
 The third-ranked product is the second incremental product, etc.
 If the bundled price is more than the individual price of the primary product, the primary product is allocated its regular price; and then the secondary product gets its regular price; and so forth
 If the bundled price is less than or equal to the individual price of the primary product, the primary product is allocated 100% of revenue; and the others in the same bundle receive no allocation
59

Incremental Revenue Allocation Method let's assume the following rank: Write
Product
Writeperfect
Computeperfect
Graphperfect
Graph Compute
Bundle
Write and Compute
Write
Compute
Bundle
Price
220
Revenue
Allocated
125
95
Cumulative
Revenue
Allocated
125
220
280 Write and Graph
Write
Graph
Compute and Graph
Compute
Graph write,compute and graph
Write
Compute
Graph
305
380
125
155
150
155
125
150
105
125
280
150
305
125
275
380
60

Primary
Write
Write
Compute
Compute
Graph
Graph
Order
First incremental
Compute
Second
Incremental
Graph
Graph
Write
Compute
Graph
Graph
Write
Compute
Write
Compute
Write
Revenues Allocated to each product
Write
125
125
(220-150)
70
75
(380-305)
55
(280-225)
(380-305)
75
Compute
95
(220-125)
100
(380-280)
150
150
100
(380-280)
80
(305-225)
Graph
160
(380-220)
155
(280-125)
160
(380-220)
155
(305-150)
225
225
61

Primary
Write
Write
Compute
Compute
Graph
Graph
Order
First incremental
Compute
Graph
Write
Graph
Write
Compute
Second
Incremental
Graph
Compute
Graph
Write
Compute
Write average price=Shapley value
Revenues Allocated to each product
Write
125
125
70
75
55
75
Compute
95
100
150
150
100
80
Graph
160
155
160
155
225
225
87,5 112,5 180
Assume equal weights on all products.
62