Transcript Cost Allocations - Middle East Technical University

Cost Allocations
EMBA 5412
Fall 2007
What are Cost Allocations
 Assignment of
 Indirect
 Common
 Joint costs
 To cost objects
 Processes
 Products
 Programs etc.
2
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
3
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.
4
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
5
why
 Control and behavioral uses 42%
 Signaling resource allocation 32%
 Cost determination 19%
 Overhead allocation 5%
 Fairness 2 %
(source: Zimmerman, 2003,p338)
6
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
7
Types of cost allocations
 Service department cost allocations
 Allocations to products
8
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?
9
Allocation methods used by banks
in the USA
Types of overhead costs allocated to responsibility centers
Level of
importance
1: 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
10
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
11
Service Department Cost Allocation
 Helps in usage of common resourcesuser 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)
12
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
13
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
14
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
15
Illustration
Computer center of BN corporation has two user departments: assembly and
polishing.
The following data are taken from 2008 budget:
Total costs of CC TL 6.750.000
Fixed costs of CC
3.000.000
Practical Capacity
20.000 hours
Budgeted Usage-hours –
Assembly
10.000
Polishing
5.000
total
15.000
Budgeted Variable cost per hour TL 150
Actual Usage in 2008
Assembly
9.000 hours
Polishing
6.000
Total
15.000
Actual Total Costs of CC TL 6.900.000
Actual Variable Costs of CC TL 160/hour
Actual Capacity of CC 20.000 hours
16
Illustration
From 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 hours
Per 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
17
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.
18
Illustration – single rate- budgeted
vs actual
6750000/15000
6750000/20000
Budgeted Rate x Budgeted
Usage Hours
6.900.000/20000
Budgeted Rate x Actual
usage hours
Actual Rate x Actual Usage
Hours
Assembly demand side 10000 450,00 4.500.000
supply side 10000 337,50 3.375.000
9000 450,00 4.050.000
9000 337,50 3.037.500
9000
9000
460,00 4.140.000
345,00 3.105.000
Polishing demand side
supply side
6000 450,00 2.700.000
6000 337,50 2.025.000
6000
6000
460,00 2.760.000
345,00 2.070.000
5000 450,00 2.250.000
5000 337,50 1.687.500
6.900.000/20000
19
Dual Rates- illustration
Total Costs=
Variable Costs-Actual =
Fixed Costs- Actual =
6.900.000
3.200.000 (160*20000)
3.700.000
Budgeted Rate x Budgeted
Usage Hours
Departments
Assembly
variable costs 10000 150,00 1.500.000
fixed costs
1.850.000
total costs
3.350.000
Polishing
variable costs
fixed costs
total costs
5000 150,00
750.000
1.850.000
2.600.000
Budgeted Rate x Actual
usage hours
Divide Fixed
Costs equally.
Actual Rate x Actual Usage
Hours
9000 150,00 1.350.000
1.850.000
3.200.000
9000
160,00 1.440.000
1.850.000
3.290.000
9000 150,00 1.350.000
1.850.000
3.200.000
9000
160,00 1.440.000
1.850.000
3.290.000
20
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
21
Allocating Service Department
Costs
SD1
OD 4
SD3
SD2
OD 3
OD2
OD 1
22
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
23
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
24
Example 1
The service of each service department to itself, to each other
and to the operating divisions are as follows:
Service provided
by/to
Accounting
Data Processing
Accounting
10%
25%
Data Processing Procurement
20%
40%
15%
35%
Selling
30%
25%
Total
100%
100%
Costs of departments to be allocated:
Accounting
Data Processing
Total TL
2.750.000
6.770.000
9.520.000
These are “own” (incurred) costs of each service
department before any allocations.
25
Example 1
Direct Allocations
1st Step:
by/to
Accounting
Data Processing
Procurement
40%
1.100.000
35%
2.369.500
Selling
30%
825.000
25%
1.692.500
Total AllocatedTotal Cost Incurred
Total Unallocated
70%
1.925.000
2.750.000
825.000
60%
4.062.000
6.770.000
2.708.000
9.520.000
2nd Step
by/to
Accounting
Data Processing
Procurement
4/7
0,57
1.571.429
7/12
0,58
3.949.167
Selling
3/7
0,43
1.178.571
5/12
0,42
2.820.833
Total Allocated
100%
2.750.000
100%
6.770.000
Total Cost Incurred
Total Unallocated
2.750.000
0
6.770.000
9.520.000
0
26
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
27
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……
28
Step-down allocations
Accounting First
Determine share of usage
by/to
Accounting
Data Processing
Data Processing
Procurement
Selling
20%
40%
30%
20/(20+40+30)=2/9 40/(20+40+30)=4/9
30/(20+40+30)=1/3
0,22
0,44
0,33
0
7/12
5/12
0,58
0,42
100%
100%
Allocate Costs
Own Costs
Accounting
Cost after allocation
Data Processing
to be allocated to products
Data Processing
Procurement
6.770.000
611.111,11
1.222.222,22
7.381.111,11
0,00
4.305.648,15
5.527.870,37
Selling
Total Allocated
916.666,67
2.138.888,89
3.075.462,96
3.992.129,63
7.381.111,11
9.520.000,00
29
Example 1
Data Processing First
Determine share of usage
by/to
Data Processing
Accounting
Accounting
Procurement
Selling
20%
40%
30%
25/(25+35+25)=5/17 35/(25+35+25)=7/17
25/(25+35+25)=5/17
0,29
0,41
0,29
0
4/7
3/7
0,57
0,43
100%
100%
Allocate Costs
Own Costs
Data Processing
Cost after allocation
Accounting
to be allocated to products
Accounting
2.750.000
1.991.176,47
4.741.176,47
0,00
Procurement
Selling
Total Allocated
2.787.647,06
1.991.176,47
4.778.823,53
2.709.243,70
5.496.890,76
2.031.932,77
4.023.109,24
4.741.176,47
9.520.000,00
30
Example 1
 Pricing effects
 Assume the following basis is used to allocate the
overhead
Application Basis
Accounting
Data Processing
Data
Total
Total
Accounting
Processing
Procurement Selling
Applied
Available
0
600
1.200
900
2.700
3.000
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
31
Example 1 price effects
Direct Method
Accounting
Data Processing
Total TL
Charged to Procurement
Charged to Selling
Total Cost
2.750.000
6.770.000
9.520.000
number of
items
number of hits
2.100
7.200.000
1.571.428,57
1.178.571,43
2.750.000,00
per item
1309,52
per hit
0,94
TOTAL DEPT
3.949.166,67 5.520.595,24
2.820.833,33 3.999.404,76
6.770.000,00
9.520.000,00
32
Example 1 price effects-step down
Accounting First
Costs of departments to be allocated:
Accounting
Data Processing
Total TL
Charged to Procurement
Charged to Selling
Total Cost
2.750.000
7.381.111
10.131.111
number of
items
number of hits
2.700
7.200.000
1.222.222,22
916.666,67
2.138.888,89
per item
1018,52
per hit
1,03
TOTAL DEPT
4.305.648,15 5.527.870,37
3.075.462,96 3.992.129,63
7.381.111,11
9.520.000,00
33
Example 1 price effects-step down
Data Processing First
Costs of departments to be allocated:
Accounting
Data Processing
Total TL
Charged to Procurement
Charged to Selling
Total Cost
4.741.176
6.770.000
11.511.176
number of
items
number of hits
2.100
10.200.000
2.709.243,70
2.031.932,77
4.741.176,47
per item
2257,70
per hit
0,66
TOTAL DEPT
2.787.647,06 5.496.890,76
1.991.176,47 4.023.109,24
4.778.823,53
9.520.000,00
34
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
35
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
36
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
37
Simultaneous equations
A(accounting)=2.750.000 +0.1 A + 0.25 D
D(data processing)= 6.770.000 +0.2 A + 0.15 D
0.9A=2.75+0.25D
A=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 D
D=7.381+0.2056 D
0.7944 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=5.073
A=5.073/0.9=5.636 million TL
(charge per processed item 5636000/3000=1.878,67
38
Comparison
Direct Method
Step-Down
Accounting First
Data Processing First
Reciprocal Method
Charge per
processed Charge per
item
hit
1.309,52
0,94
1.018,52
2.257,70
1.878,67
1,03
0,66
0,77
39
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
40
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 cost
Incremental- rank the users; first user
incurs its stand alone cost- next user
incurs the additional cost
41
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 standalone prices
 Price of the bundle < sum of
individual prices of products
42
Example 2


CHES company sells three haircare products: shampoo, conditioner, fixer
The company sells these products individually as well as bundled products
Selling Price
Stand alone
Shampoo
Conditioner
Fixer
12,50
15,00
22,50
Bundle
Shampoo and Conditioner
Shampoo and Fixer
Conditioner and Fixer
Shampoo and Conditioner and Fixer
22,00
28,00
30,50
38,00
Manufacturing
cost per unit
1,80
2,00
2,50
43
Example 2 Revenue Allocation
Stand-alone
Based on selling prices
shampoo
shampoo and conditioner
weight
conditioner
1,80
1,8/3,8
times the bundle price
2,00
bundle
22,00
2/3,8
0,473684211
0,526315789
10,42
11,58
Based on unit costs
shampoo
shampoo and conditioner
weight
times the bundle price
conditioner
bundle
12,50
15,00
22,00
12,50/(12,50+15,00) 10/(12,50+15,00)
0,454545455
0,545454545
10
12
Based on physical units
shampoo
shampoo and conditioner
weight
times the bundle price
conditioner
1,00
1/2
0,5
11
bundle
1,00
22,00
1/2
0,5
11
44
Example 2 Revenue Allocation
Incremental
Product
Shampoo
Conditioner
Cumulative
Revenue
Revenue Allocated Allocated
12,50
12,50
9,50
22,00
22,00
22.00-12.50
45