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Cost Allocations
EMBA 5412Fall 2007
2
What are Cost Allocations
Assignment of Indirect Common Joint costs
To cost objects Processes Products Programs etc.
3
Process of cost allocation
Define cost objects Accumulate costs for different cost
centers that serve the cost object Choose the method and apply to
allocate the accumulated costs to objects
4
definitions 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. 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 amount.
5
Surveys of Cost Allocation Practices by Large Corporations What corporate-level costs are allocated to profit centers? Most often: selling and distribution expenses Least often: income taxes
What allocation bases are used? Meter: measure actual use Negotiate: estimate usage Prorate: based on relative proportions of sales, profits, or
assets
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why
Control and behavioral uses 42% Signaling resource allocation 32% Cost determination 19% Overhead allocation 5% Fairness 2 %(source: Zimmerman, 2003,p338)
7
What costs are allocated Income taxes 44% Interest expenses and capital charges
62% Research and development 72% Finance and accounting 73% Selling costs 91% Distribution costs 100%(source: Zimmerman, 2003, p.338
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Types of cost allocations
Service department cost allocations Allocations to products
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Basis of Allocations Budgeted vs actual vs capacity Based on budgeted costs;
Managers know with certainty what will be allocated – both user and service dept managers
Better for planning of user departments Responsibility of variances from the
budget lies with the service department manager- lead to more efficient budgeting?
10
Allocation methods used by banks in the USA
Types of overhead costs allocated to responsibility centers
Level of importance1: most 7: least
Executive salaries
Central office rent/depreciation
Advertising and other marketing expenses
Data processing and accounting expenses
1 Time spent with executives
Square footage Time spent by marketing pers
Time spent by accountants,etc
2 Personnel costs Personnel costs No of customers served
Transaction volume
3 Transaction volume
Transaction volume
Other (includes no allocation)
Personnel costs
4 Other (includes no allocation
No of customers served
Transaction volume
No of customers served
5 No of customers served
Interest Costs Personnel costs No of customers served
6 Interest Costs Other (includes no allocation)
Interest Costs Interest Costs
7 Square footage Not reported Square footage Square footage
Source: Zimmerman, 2003,p.351
11
Service Department Cost Allocation
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
12
Service Department Cost Allocation
Helps in usage of common resources- user departments’ consumption of common costs are affected by the internal price charged
Provides information about the demand on the service department
Comparison of internal costs (internal transfer price) and external purchase price)
13
Methods to Allocate Support Department Costs 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 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 cost-allocation base
14
Discussion of single vs double Single-rate method is simple to implement,
but treats fixed costs in a manner similar to variable costs in the user department
Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement Hard to classify costs as fixed and variable More data should be gathered
15
Allocation Bases Under either method, allocation of support costs can
be based on one of the three following scenarios: Budgeted overhead rate by the service department
and budgeted hours of usage by the user department Budgeted overhead rate by the service department
and actual hours usage by the user department Actual overhead rate of the service department and
actual hours usage by the user department
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
16
IllustrationComputer center of BN corporation has two user departments: assembly and
polishing.The following data are taken from 2008 budget:Total costs of CC TL 6.750.000Fixed costs of CC 3.000.000Practical Capacity 20.000 hoursBudgeted Usage-hours –
Assembly 10.000Polishing 5.000total 15.000
Budgeted Variable cost per hour TL 150Actual Usage in 2008
Assembly 9.000 hours Polishing 6.000 Total 15.000Actual Total Costs of CC TL 6.900.000Actual Variable Costs of CC TL 160/hourActual Capacity of CC 20.000 hours
17
IllustrationFrom the supply side:CC average rate= 6.750.000 ÷20.000= 337.50 TL (at practical capacity of 20.000 hours)From the demand side:Budgeted usage 15.000 hoursPer hour of usage = 6.750.000 ÷15.000= 450 TL/hr utilization of common resources is below capacity
creates excess capacity Producing this internally might become very
expensive for the user department and they might want to buy it from outside creating more excess capacity
Leads to death spiral
18
Death spiral 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.
19
Illustration – single rate- budgeted vs actual
Assembly demand side 10000 450,00 4.500.000 9000 450,00 4.050.000 9000 460,00 4.140.000supply side 10000 337,50 3.375.000 9000 337,50 3.037.500 9000 345,00 3.105.000
Polishing demand side 5000 450,00 2.250.000 6000 450,00 2.700.000 6000 460,00 2.760.000supply side 5000 337,50 1.687.500 6000 337,50 2.025.000 6000 345,00 2.070.000
Budgeted Rate x Budgeted Usage Hours
Budgeted Rate x Actual usage hours
Actual Rate x Actual Usage Hours
6750000/150006750000/20000
6.900.000/20000
6.900.000/20000
20
Dual Rates- illustrationTotal Costs= 6.900.000Variable Costs-Actual = 3.200.000 (160*20000)Fixed Costs- Actual = 3.700.000
Divide Fixed Costs equally.
DepartmentsAssembly variable costs 10000 150,00 1.500.000 9000 150,00 1.350.000 9000 160,00 1.440.000 fixed costs 1.850.000 1.850.000 1.850.000total costs 3.350.000 3.200.000 3.290.000
Polishing variable costs 5000 150,00 750.000 9000 150,00 1.350.000 9000 160,00 1.440.000 fixed costs 1.850.000 1.850.000 1.850.000total costs 2.600.000 3.200.000 3.290.000
Budgeted Rate x Budgeted Usage Hours
Budgeted Rate x Actual usage hours
Actual Rate x Actual Usage Hours
21
Discussion – Single vs Double Single rate – lower cost- no classification of
costs as to fixed and variable Single rate makes fixed costs of the service
department appear as variable costs in the user departments
May lead ‘death spiral’ Dual rate better for decision making- eg.
Outsourcing decisions
22
Allocating Service Department Costs
OD 4OD 3 OD2 OD 1
SD1 SD2SD3
23
Cost allocation methods For companies with at least 2 service departments and 2
operating departments
Alternative methods of allocation: Direct allocation or Direct Method Step-down allocation Reciprocal allocation
24
Example 1 EMBA 2 company buys and sells luxury items to select
customers over the internet and through target based selling.
The company has two service departments and two operating departments: Service Depts- Accounting
- Data Processing Operating Depts – Procurement
- Selling
25
Example 1
Costs of departments to be allocated:
Accounting 2.750.000Data Processing 6.770.000Total TL 9.520.000
The service of each service department to itself, to each other and to the operating divisions are as follows:
Service providedby/to Accounting Data Processing Procurement Selling TotalAccounting 10% 20% 40% 30% 100%Data Processing 25% 15% 35% 25% 100%
These are “own” (incurred) costs of each service department before any allocations.
26
Example 1Direct Allocations1st Step:by/to Procurement Selling Total AllocatedTotal Cost IncurredTotal UnallocatedAccounting 40% 30% 70%
1.100.000 825.000 1.925.000 2.750.000 825.000Data Processing 35% 25% 60%
2.369.500 1.692.500 4.062.000 6.770.000 2.708.0009.520.000
2nd Step
by/to Procurement Selling Total Allocated Total Cost Incurred Total UnallocatedAccounting 4/7 3/7
0,57 0,43 100%1.571.429 1.178.571 2.750.000 2.750.000 0
Data Processing 7/12 5/120,58 0,42 100%
3.949.167 2.820.833 6.770.000 6.770.000 09.520.000
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Direct Method Discussion Ignores each department’s use of other
service departments and its own use Allocation is based on operating
departments utilization of the service department resources
Simple May lead to inaccurate pricing Each service department uses other service
departments’ resources at no cost
28
Step-down method Also called graph or sequential method Sequence is arbitrary – might lead to large
differences in cost per unit of service Allocates service departments costs to
other service departments and operating departments
Choose a service department to start with; allocate its cost to other service departments and operating departments; then go the next service department and allocate its cost to remaining service depts and operating depts……
29
Step-down allocations
Accounting FirstDetermine share of usageby/to Data Processing Procurement SellingAccounting 20% 40% 30%
20/(20+40+30)=2/9 40/(20+40+30)=4/930/(20+40+30)=1/30,22 0,44 0,33 100%
Data Processing 0 7/12 5/120,58 0,42 100%
Allocate Costs
Data Processing Procurement Selling Total AllocatedOwn Costs 6.770.000Accounting 611.111,11 1.222.222,22 916.666,67 2.138.888,89 Cost after allocation 7.381.111,11
Data Processing 0,00 4.305.648,15 3.075.462,96 7.381.111,11to be allocated to products 5.527.870,37 3.992.129,63 9.520.000,00
30
Example 1
Data Processing FirstDetermine share of usageby/to Accounting Procurement SellingData Processing 20% 40% 30%
25/(25+35+25)=5/17 35/(25+35+25)=7/1725/(25+35+25)=5/170,29 0,41 0,29 100%
Accounting 0 4/7 3/70,57 0,43 100%
Allocate Costs
Accounting Procurement Selling Total AllocatedOwn Costs 2.750.000Data Processing 1.991.176,47 2.787.647,06 1.991.176,47 4.778.823,53 Cost after allocation 4.741.176,47
Accounting 0,00 2.709.243,70 2.031.932,77 4.741.176,47to be allocated to products 5.496.890,76 4.023.109,24 9.520.000,00
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Example 1 Pricing effects Assume the following basis is used to allocate the
overhead
Application Basis AccountingData Processing Procurement Selling
Total Applied
Total Available
Accounting 0 600 1.200 900 2.700 3.000Data Processing 3.000.000 1.800.000 4.200.000 3.000.000 10.200.000 12.000.000
Accounting department base: number of processed items 3,000 items
Data processing base: number of hits per year 12.000.000 hits
32
Example 1 price effects
Direct Method Total Costnumber of
items number of hits per item per hitAccounting 2.750.000 2.100 1309,52Data Processing 6.770.000 7.200.000 0,94Total TL 9.520.000
TOTAL DEPTCharged to Procurement 1.571.428,57 3.949.166,67 5.520.595,24Charged to Selling 1.178.571,43 2.820.833,33 3.999.404,76
2.750.000,00 6.770.000,009.520.000,00
33
Example 1 price effects-step down
Accounting FirstCosts of departments to be allocated:
Total Costnumber of
items number of hits per item per hitAccounting 2.750.000 2.700 1018,52Data Processing 7.381.111 7.200.000 1,03Total TL 10.131.111
TOTAL DEPTCharged to Procurement 1.222.222,22 4.305.648,15 5.527.870,37Charged to Selling 916.666,67 3.075.462,96 3.992.129,63
2.138.888,89 7.381.111,119.520.000,00
34
Example 1 price effects-step down
Data Processing FirstCosts of departments to be allocated:
Total Costnumber of
items number of hits per item per hitAccounting 4.741.176 2.100 2257,70Data Processing 6.770.000 10.200.000 0,66Total TL 11.511.176
TOTAL DEPTCharged to Procurement 2.709.243,70 2.787.647,06 5.496.890,76Charged to Selling 2.031.932,77 1.991.176,47 4.023.109,24
4.741.176,47 4.778.823,539.520.000,00
35
Reciprocal Allocations Fully recognizes mutual services among service
departments More precise than the other methods Better to use with variable costs mainly Fixed costs may be allocated on other basis Construct a system of linear equations-one for each
service dept showing % of services used by itself and by other service departments
If there are 30 service departments; then construct 30 equations
Solve for the unknowns- cost share for each operating department and cost per unit of output in each service department
36
Reciprocal Allocation-Calculation
Step 1: interactions among service departments -develop a total charge for each department
Step 2: Allocate total charge of each service department to operating departments
37
Example 1-Reciprocal Allocation
A(accounting)=Initial Costs +0.1 A + 0.25 D
D(data processing)= Initial Costs +0.2 A + 0.15 D
A(accounting)=2.750.000 +0.1 A + 0.25 D
D(data processing)= 6.770.000 +0.2 A + 0.15 D
38
Simultaneous equationsA(accounting)=2.750.000 +0.1 A + 0.25 DD(data processing)= 6.770.000 +0.2 A + 0.15 D0.9A=2.75+0.25DA=2.75/0.9 +0.25/0.9 = 3.056+0.278 D
D=6.77+0.29(3.056+0.278 D)+0.15 DD=7.381+0.2056 D0.7944 D=7.381 D=9.291 million TL(charge per hit 9.291.000/12.000.000=0,77)
0.9 A= 2.75 +0.25D=2.75+.25*9.291=5.073A=5.073/0.9=5.636 million TL(charge per processed item 5636000/3000=1.878,67
39
Comparison
Charge per processed
itemCharge per
hitDirect Method 1.309,52 0,94Step-Down Accounting First 1.018,52 1,03 Data Processing First 2.257,70 0,66Reciprocal Method 1.878,67 0,77
40
Allocation of Service Department Costs by Country Practices
Support Department Cost-Allocation Method
Australia%
Japan%
United Kingdom%
Poland%
Direct Method 43 58 64 19
Step-down 3 27 6 39
Reciprocal 5 10 14 33
Other 15 1 8 6
Not allocated 34 4 8 3
Horngren,et al, 2008, p.544
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Allocating common costs
Common costs- cost of operating a facility or activity shared by two or more users
Methods:Stand alone- all users equitably share
the costIncremental- rank the users; first user
incurs its stand alone cost- next user incurs the additional cost
42
Revenue Allocation Bundle costs- when two or more
products are sold for a single price Allocating revenues to each revenue
object Each product in the bundle can be
sold separately at their own stand-alone prices
Price of the bundle < sum of individual prices of products
43
Example 2 CHES company sells three haircare products: shampoo, conditioner, fixer The company sells these products individually as well as bundled products
Selling PriceManufacturing cost per unit
Stand alone Shampoo 12,50 1,80 Conditioner 15,00 2,00 Fixer 22,50 2,50
Bundle Shampoo and Conditioner 22,00 Shampoo and Fixer 28,00 Conditioner and Fixer 30,50Shampoo and Conditioner and Fixer 38,00
44
Example 2 Revenue Allocation Stand-alone
shampoo conditioner bundle shampoo and conditioner 12,50 15,00 22,00weight 12,50/(12,50+15,00) 10/(12,50+15,00)
0,454545455 0,545454545times the bundle price 10 12
shampoo conditioner bundle shampoo and conditioner 1,80 2,00 22,00weight 1,8/3,8 2/3,8
0,473684211 0,526315789times the bundle price 10,42 11,58
Based on selling prices
Based on unit costs
Based on physical unitsshampoo conditioner bundle
shampoo and conditioner 1,00 1,00 22,00weight 1/2 1/2
0,5 0,5times the bundle price 11 11
45
Example 2 Revenue Allocation Incremental
Product Revenue Allocated
Cumulative Revenue Allocated
Shampoo 12,50 12,50 Conditioner 9,50 22,00
22,00
22.00-12.50