5 Cost Allocation and Activity Based Cos

Systems Systems

LEARNING OBJECTIVES

After studying this chapter, you will be able to

1. Explain the major purposes for allocating costs.

2. Explain the relationship between activities, resources, costs, and cost drivers.

3. Use recommended guidelines to charge the variable and fixed costs of service departments to other organizational units.

4. Identify methods for allocating the central costs of an organization.

5. Use the direct, step-down, and reciprocal allocation methods to allocate service department costs to user departments.

6. Describe the general approach to allocating costs to products or services.

7. Use the physical units and relative-sales-value methods to allocate joint costs to products.

8. Use activity-based costing to allocate costs to products or services.

9. Identify the steps involved in the design and implementation of activity-based costing systems.

10. Calculate activity-based costs for cost objects.

11. Explain why activity-based costing systems are being adopted.

12. Explain how just-in-time systems can reduce non-value-added activities

A u n iversity’s com pu ter is u sed for teach in g an d for govern m en t-fu n ded research . How m u ch of its cost sh ou ld be assign ed to each task? A city creates a special police u n it to in vestigate a series of related assau lts. Wh at is th e total cost of th e effort? A com pan y u ses a m ach in e to m ake two differen t produ cts. How m u ch of th e cost of th e m ach in e belon gs to each produ ct? Th ese are all problem s of cost allocation , th e su bject of th is ch apter. Un iversity presiden ts, city m an - agers, corporate execu tives, an d oth ers all face problem s of cost allocation .

Cost Accounting System.

Th is is th e first of th ree ch apters on co st acco u n tin g syste m s—th e tech -

The techniques used to

n iqu es u sed to determ in e th e cost of a produ ct or service. A cost accou n tin g sys-

determine the cost of a

tem collects an d classifies costs an d assign s th em to cost objects. Th e goal of a cost

product or service by col- lecting and classifying

accou n tin g system is to m easu re th e cost of design in g, developin g, produ cin g (or

costs and assigning them

pu rch asin g), sellin g, distribu tin g, an d servicin g particu lar produ cts or services.

to cost objects.

Cost allocation is at th e h eart of m ost cost accou n tin g system s. The first part of this chapter describes general approaches to cost allocation. Although we present some factors to consider in selecting cost-allocation methods, there are no easy answers. Recent attempts to improve cost-allocation methods have focused on activity-based costing, the subject of the last part of this chapter.

CO ST ALLO CATI O N I N GEN ERAL

As Ch apter 4 poin ted ou t, cost allocation is fu n dam en tally a problem of lin kin g (1) som e cost or grou ps of costs with (2) on e or m ore cost objectives , su ch as prod- u cts, departm en ts, an d division s. Ideally, costs sh ou ld be assign ed to th e cost objective th at caused it. In sh ort, cost allocation tries to iden tify (1) with (2) via som e fu n ction represen tin g cau sation .

Lin kin g costs with cost objectives is accom plish ed by selectin g cost drivers. Cost-Allocation Base. A Wh en u sed for allocatin g costs, a cost driver is often called a co st-allo catio n

cost driver when it is

base . Major costs, su ch as n ewsprin t for a n ewspaper an d direct profession al

used for allocating costs.

labou r for a law firm , m ay each be allocated to departm en ts, jobs, an d projects on an item -by-item basis, u sin g obviou s cost drivers su ch as ton n es of n ewsprin t con - su m ed or direct-labou r-h ou rs u sed. Oth er costs, taken on e at a tim e, are n ot im portan t en ou gh to ju stify bein g allocated in dividu ally. Th ese costs are pooled an d

Cost Pool.

A group of indi-

th en allocated togeth er. A co st p o o l is a grou p of in dividu al costs th at is allocated

vidual costs that is allo-

to cost objectives u sin g a sin gle cost driver. For exam ple, bu ildin g ren t, u tilities cost,

cated to cost objectives

an d jan itorial services m ay be in th e sam e cost pool becau se all are allocated on

using a single cost driver.

th e basis of squ are m etres of space occu pied. Or a u n iversity cou ld pool all th e operatin g costs of its registrar’s office an d allocate th em to its colleges on th e basis of th e n u m ber of stu den ts in each facu lty. In su m m ary, all costs in a given cost pool sh ou ld be cau sed by th e sam e factor. Th at factor is th e cost driver.

Man y differen t term s are u sed by com pan ies to describe cost allocation in practice. You m ay en cou n ter term s su ch as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion , an d reapportion , wh ich can be u sed in terch an geably to describe th e allocation of costs to cost objectives.

Three Purposes of Allocation

Managers within an organizational unit should be aware of all the consequences of their decisions, even consequences outside of their unit. Examples are the addition of a new course in a university that causes additional work in the registrar’s office,

Chapter 5 Cost Allocation and Activity-Based Costing Systems

O BJECTI V E 1

th e addition of a n ew fligh t or an addition al passen ger on an airlin e th at requ ires reservation an d bookin g services, an d th e addition of a n ew specialty in a m ed-

Explain the major

ical clin ic th at produ ces m ore work for th e m edical records departm en t.

purposes for

In each of th ese situ ation s, it is im portan t to assign to th e organ ization al u n it

allocating costs.

th e direct in crem en tal costs of th e decision . Usin g th e distin ction n oted in Ch apter

4, m an agers assign direct costs with ou t u sin g allocated costs. Th e allocation of costs is n ecessary wh en th e lin kage between th e costs an d th e cost objective is in direct. In th is case, a basis for th e allocation , su ch as direct-labou r-h ou rs or ton n es of raw m aterial, is u sed even th ou gh its selection is arbitrary.

A cost allocation base has been described as incorrigible , since it is impossible to objectively determine which base perfectly describes the link between the cost and the cost objective. Given this subjectivity in the selection of a cost-allocation base, it has always been difficult for managers to determine “When should costs be allo- cated?” and “On what basis should costs be allocated?” The answers to these ques- tions depend on the principal purpose or purposes of the cost allocation.

Costs are allocated for th ree m ain pu rposes:

1. To obtain desired motivation. Cost allocation s are som etim es m ade to in flu en ce m an agem en t beh aviou r an d th u s prom ote goal con gru en ce an d m an agerial effort. Con sequ en tly, in som e organ ization s th ere is n o cost allocation for legal or in tern al au ditin g services or in tern al m an - agem en t con su ltin g services becau se top m an agem en t w an ts to en cou rage th eir u se. In oth er organ ization s th ere is a cost allocation for su ch item s to spu r m an agers to m ake su re th e ben efits of th e specified services exceed th e costs.

2. To compute income and asset valuations. Costs are allocated to produ cts an d projects to m easu re in ven tory costs an d cost of goods sold. Th ese allo- cation s frequ en tly service fin an cial accou n tin g pu rposes. However, th e resu ltin g costs are also often u sed by m an agers in plan n in g, perfor- m an ce evalu ation , an d to m otivate m an agers, as described above.

3. To justify costs or obtain reimbursement. Som etim es prices are based directly on costs, or it m ay be n ecessary to ju stify an accepted bid. For exam ple, govern m en t con tracts often specify a price th at in clu des reim bu rsem en t for costs plu s som e profit m argin . In th ese in stan ces, cost allocation s becom e su bstitu tes for th e u su al w orkin g of th e m ar- ketplace in settin g prices.

Th e first pu rpose specifies plan n in g an d con trol u ses for allocation . Th e sec- on d an d th ird sh ow h ow cost allocation s m ay differ for in ven tory costin g (an d cost of goods sold) an d for settin g prices. Moreover, differen t allocation s of costs to produ cts m ay be m ade for variou s pu rposes. Th u s, fu ll costs m ay gu ide pric- in g decision s, m an u factu rin g costs m ay be appropriate for asset valu ation s, an d som e “in -between ” costs m ay be n egotiated for a govern m en t con tract.

Ideally, all three purposes would be served simultaneously by a single cost allo- cation. But thousands of managers and accountants will testify that for most costs, this ideal is rarely achieved. Instead, cost allocations are often a source of discontent and confusion for the affected parties. Allocating fixed costs usually causes the great- est problems. When all three purposes cannot be attained simultaneously, the man- ager and the accountant should start attacking a cost allocation problem by trying to identify which of the purposes should dominate in the particular situation at hand.

Often inventory-costing purposes dominate by default because they are exter- nally imposed. When allocated costs are used in decision making and perform an ce

180 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS 180 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

Three Types of Allocations

As Exh ibit 5-1 sh ows, th ere are th ree basic types of cost allocation s:

1. Allocation of joint costs to the appropriate responsibility centres. Costs th at are u sed join tly by m ore th an on e u n it are allocated based on cost-driver activity in th e u n its. Exam ples are allocatin g ren t to departm en ts based on floor space occu pied, allocatin g am ortization on join tly u sed m ach in ery based on m ach in e-h ou rs, an d allocatin g gen eral adm in is- trative expen se based on total direct cost.

2. Reallocation of costs from one responsibility centre to another. Wh en on e u n it provides produ cts or services to an oth er, th e costs are tran sferred alon g

Service D epartments. Units

with th e produ cts or services. Som e u n its, called se rvice d e p art-

that exist only to serve

ments , exist on ly to su pport oth er departm en ts, an d th eir costs are

other departments.

totally reallocated. Exam ples in clu de person n el departm en ts, lau n dry departm en ts in h ospitals, an d legal departm en ts in in du strial firm s.

3. Allocation of costs of a particular organizational unit to its outputs of products or services. Th e paediatrics departm en t of a m edical clin ic allocates its costs to patien t visits, th e assem bly departm en t of a m an u factu rin g firm to u n its assem bled, an d th e tax departm en t of a CA firm to clien ts served. Th e costs allocated to produ cts or services in clu de th ose allo- cated to th e organ ization al u n it in allocation types 1 an d 2.

All th ree types of allocation s are fu n dam en tally sim ilar. Let u s look first at

h ow service departm en t costs are allocated to produ ction departm en ts.

EX H I B I T 5 - 1

Cost accounting system accumulates costs

Three Types of Cost Allocations

Allocation Type 1

Cost Objective 1

Costs allocated to

Responsibility centres

responsibility centres

Allocation Type 2

Cost Objective 2

Costs allocated from

Responsibility centres

one responsibility centre

receiving products

to another

or services

Allocation Type 3

Cost Objective 3

Costs allocated to products,

Products, jobs,

jobs, or projects

or projects

Chapter 5 Cost Allocation and Activity-Based Costing Systems

ALLO CATI O N O F SERVI CE D EPARTM EN T CO STS

What causes costs? Organizations incur costs to produce goods and services and to

O BJECTI V E 2

provide the support services required for that production. Essentially, costs are

Explain the

caused by the very same activities that are usually chosen as cost objectives.

relationship between

Examples are products produced, patients seen, personnel records processed, and

activities, resources,

legal advice given. The ultimate effects of these activities are various costs. It is impor-

costs, and cost drivers.

tant to understand how cost behaviour relates to activities and the consumption of resources. To perform activities, resources are required. These resources have costs. Some costs vary in direct proportion to the consumption of resources. Examples could be materials, labour, energy, and supplies. Other costs do not directly vary (in the short run) with resource usage. Examples of their indirect costs could be amor- tization, supervisory salaries, and rent. So we say that activities consume resources and the costs of these resources follow various behavioural patterns. Therefore, the manager and the accountant should search for some cost driver that establishes a convincing relationship between the cause (activity being performed) and the effect (consumption of resources and related costs) and that permits reliable predictions of how costs will be affected by decisions regarding the activities.

To illu strate th is im portan t prin ciple, we will con sider allocation of service departm en t costs. Service departm en ts typically provide a service to a broad ran ge of fu n ction s an d produ cts with in an organ ization , an d th u s th e allocation of costs becom es m ore difficu lt. Th e preferred gu idelin es for allocatin g service departm en t costs are:

1. Evaluate performance using budgets for each service (staff) department, just as is done for each production or operating (line) department. The per- formance of a service department is evaluated by comparing actual costs with a budget, regardless of how the costs are later allocated. From the budget, variable-cost pools and fixed-cost pools can be identified.

2. Charge variable-and fixed-cost pools separately (som etim es called th e du al m eth od of allocation ). Note th at on e service departm en t (su ch as a com pu ter departm en t) can con tain m u ltiple cost pools if m ore th an on e cost driver cau ses th e departm en t’s costs. At a m in im u m , th ere sh ou ld be a variable-cost pool an d a fixed-cost pool.

3. Establish part of all of the details regarding cost allocation in advance of ren - derin g th e service, rath er th an after th e fact. Th is approach establish es th e “ru les of th e gam e” so th at all departm en ts can plan appropriately.

Con sider a sim plified exam ple of a com pu ter departm en t of a u n iversity th at serves two m ajor u sers: th e Sch ool of Bu sin ess an d th e Sch ool of En gin eerin g. Th e com pu ter m ain fram e was acqu ired on a five-year lease th at is n ot can cellable u n less proh ibitive cost pen alties are paid.

How sh ou ld costs be ch arged to th e u ser departm en ts? Su ppose th ere are two m ajor pu rposes for th e in form ation : (1) predictin g econ om ic effects of th e u se of th e com pu ter an d (2) m otivatin g departm en ts an d in dividu als to u se its capabilities m ore fu lly.

To apply th e first of th e above gu idelin es, we n eed to an alyze th e costs of th e com pu ter departm en t in detail. Th e prim ary activity perform ed is com pu ter processin g. Resou rces con su m ed in clu de processin g tim e, operator tim e, con su lt- in g tim e, en ergy, m aterials, an d bu ildin g space. Su ppose cost beh aviou r an alysis

h as been perform ed an d th e bu dget form u la for th e forth com in g fiscal year is $100,000 m on th ly fixed costs plu s $200 variable cost per h ou r of com pu ter tim e u sed. We will apply gu idelin es two an d th ree in th e n ext two section s.

182 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

COMPANY

STRATEGIES

CO ST ALLO CATIO N S AT BO REAL LABO RATO RIES LTD.

B oreal is Canada’s largest supplier of science supplies and apparatus to Canadian schools.

The product line is diverse and thus product costing is complex.

Boreal Laboratories

A recent project included revisiting our inventory costing. In order to determine the

www.boreal.com

inventory cost, many allocations have had to be made. A combination of all the costing techniques listed in Chapter 13 have been used since there are several dif- ferent production departments and the production activities vary for each commodity. In making allocations, three guidelines should be kept in mind.

1. The allocation must be fair. 2. The allocation must be rational and verifiable. 3. The impact on the people who use or work with this information must be known.

These guidelines provide a useful reference since there may be ramifications beyond just the immediate task or project, for which the initially intended allocation calculation was made. Recently, the Inventory Costing System was revised to reflect current input costs and to reflect the change in operating costs and procedures as a result of moving to a new facility. When this inventory information was updated, the above three guidelines were considered when it came time to make allocations of costs.

This proved to be very beneficial since there have been many other applications of these calculations than those originally made for inventory purposes. Some of the additional uses of this information have been:

• Used to re-calculate selling prices in our catalogue to reflect the fact that our costs have changed. • Used to calculate a selling price on several special orders that involve different quantities and mixture of

products. • Assisted in determining if Boreal would continue to produce a product in-house or to buy elsewhere. • Useful for accounting taxation purposes. • A useful calculation in determining a profit-share amount since each department manager’s work is based

upon performance. Based upon the number and varying uses of an allocation, we can see how important allocations are in busi-

ness. Furthermore, we should be aware that allocations may be used for more than one intended use. Source: Written by John Richardson, Controller, Boreal Laboratories Ltd.

Variable-Cost Pool O BJECTI V E 3

Th e cost driver for th e variable-cost pool is hours of computer time used . Th erefore, variable costs sh ou ld be assign ed as follows:

Use recommended guidelines to charge

bu dgeted u n it rate × actu al h ou rs of com pu ter tim e u sed the variable and fixed

costs of service

Th e cau se-an d-effect relation sh ip is direct an d clear: th e h eavier th e u sage,

departments to other

th e h igh er th e total costs. In th is exam ple, th e rate u sed wou ld be th e bu dgeted

organizational units.

rate of $200 per h ou r.

The use of budgeted cost rates rather than actual cost rates for allocating variable costs of service departments protects the using departments from intervening price fluctuations and also often protects them from inefficiencies in the service depart- ments. When an organization allocates actual total service department cost, it holds user-department managers responsible for costs beyond their control and provides less in cen tive for service departm en ts to be efficien t. Both effects are u n desirable.

Chapter 5 Cost Allocation and Activity-Based Costing Systems

Con sider th e ch argin g of variable costs to a departm en t th at u ses 600 h ou rs of com pu ter tim e. Su ppose in efficien cies in th e com pu ter departm en t cau sed th e variable costs to be $140,000 in stead of th e 600 h ou rs tim es $200, or $120,000 bu dgeted. A good cost-accou n tin g sch em e wou ld ch arge on ly th e $120,000 to th e con su m in g departm en ts an d wou ld let th e $20,000 rem ain as an u n favou rable bu dget varian ce of th e com pu ter departm en t. Th is sch em e h olds com pu ter departm en t m an agers respon sible for th e $20,000 varian ce an d redu ces th e resen tm en t of u ser m an agers. User-departm en t m an agers som etim es com plain m ore vigorou sly abou t u n certain ty over allocation s an d th e poor m an agem en t of

a service departm en t th an abou t th e ch oice of a cost driver (su ch as direct-labou r dollars or n u m ber of em ployees). Su ch com plain ts are less likely if th e service departm en t m an agers h ave bu dget respon sibility an d th e u ser departm en ts are protected from sh ort-ru n price flu ctu ation s an d in efficien cies.

Most con su m ers prefer to kn ow th e total price in advan ce. Th ey becom e n ervou s wh en an au tom obile m ech an ic or con tractor u n dertakes a job with ou t specifyin g prices. As a m in im u m , th ey like to kn ow th e h ou rly rates th at th ey m u st bear. Th erefore, predeterm in ed u n it prices (at least) sh ou ld be u sed. Wh ere feasible, predeterm in ed total prices sh ou ld be u sed for variou s kin ds of work based on bu dgets an d stan dards.

To illu strate, con sider an au tom obile repair an d m ain ten an ce departm en t for

a provin cial govern m en t. Agen cies wh o u se th e departm en t’s service sh ou ld receive firm prices for variou s services. Im agin e th e reaction of an agen cy m an - ager wh o h ad an agen cy au tom obile repaired an d was told, “Norm ally you r repair wou ld h ave taken five h ou rs, bu t we h ad a n ew em ployee work on it, an d th e job took ten h ou rs. Th erefore, we m u st ch arge you for ten h ou rs of labou r tim e.”

Fixed-Cost Pool

The cost driver for the fixed-cost pool is the amount of capacity required when the computer facilities were acquired. Therefore, fixed costs could be allocated as follows:

bu dgeted fraction of capacity available for u se × total bu dgeted fixed costs Con sider again ou r exam ple of th e u n iversity com pu ter departm en t. Su ppose th e

dean h ad origin ally predicted th e followin g lon g-ru n average m on th ly u sage: Bu sin ess, 210 h ou rs, an d En gin eerin g, 490 h ou rs, for a total of 700 h ou rs. Th e fixed-cost pool wou ld be allocated as follows:

BU SIN ESS

EN GIN EERIN G

Fixed costs per month:

210/700, or 30% of $100,000

490/700, or 70% of $100,000

Th is predeterm in ed lu m p-su m approach is based on th e lon g-ru n capacity avail- able to th e u ser, regardless of actu al u sage from m on th to m on th . Th e reason in g is th at th e level of fixed costs is affected by lon g-ran ge plan n in g regardin g th e overall level of service an d th e relative expected u sage, n ot by short-run flu ctu ation s in service levels an d relative actual u sage.

A m ajor stren gth of u sin g capacity available rath er th an capacity u sed wh en allocatin g budgeted fixed costs is th at sh ort-ru n allocation s to u ser departm en ts

184 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS 184 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

In practice, fixed-cost pools are often in appropriately allocated on th e basis of capacity u sed, n ot capacity available. Su ppose th e com pu ter departm en t allo- cated th e total actu al costs after th e fact. At th e en d of th e m on th , total actual wou ld be allocated in proportion to th e actual h ou rs u sed by th e con su m in g departm en ts. Com pare th e costs born e by th e two sch ools wh en Bu sin ess u ses 200 h ou rs an d En gin eerin g 400 h ou rs:

Total costs incurred, $100,000 + 600($200) = $220,000 Business: 200/600 x $220,000 =

Engineering: 400/600 x $220,000 =

Total cost allocated

Wh at h appen s if Bu sin ess u ses on ly 100 h ou rs du rin g th e followin g m on th wh ile En gin eerin g still u ses 400 h ou rs?

Total costs incurred, $100,000 + 500(200) = $200,000 Business: 100/500 x $200,000 =

Engineering: 400/500 x $200,000 =

Total cost allocated

En gin eerin g h as don e n oth in g differen tly, bu t it m u st bear h igh er costs of $13,333, an in crease of 9 percen t. Its sh ort-ru n costs depen d on w h at other con su m ers h ave u sed, n ot solely on its ow n action s. Th is ph en om en on is cau sed by a fau lty allocation m eth od for th e fixed portion of th e total costs, a m eth od w h ereby th e allocation s are h igh ly sen sitive to flu ctu ation s in th e actu al volu m es u sed by th e variou s con su m in g departm en ts. Th is w eakn ess is avoided by u sin g a predeterm in ed lu m p-su m allocation of fixed costs, based on bu dgeted u sage.

Con sider th e au tom obile repair sh op exam ple in trodu ced above. You w ou ld n ot be h appy if you cam e to get you r car an d w ere told, “Ou r daily fixed overh ead is $1,000. You rs w as th e on ly car in ou r sh op today, so w e are

ch argin g you th e fu ll $1,000. If w e h ad processed 100 cars today, you r ch arge w ou ld h ave been on ly $10.”

Troubles with U sing Lump Sums

Th ere are problem s with u sin g lu m p-su m allocation s. If fixed costs are allocated on th e basis of lon g-ran ge plan s, th ere is a n atu ral ten den cy on th e part of con - su m ers to u n derestim ate th eir plan n ed u sage an d th u s obtain a sm aller fraction of th e cost allocation . Top m an agem en t can cou n teract th ese ten den cies by m on - itorin g prediction s an d by followin g u p an d u sin g feedback to keep fu tu re pre- diction s m ore h on est.

In som e organ ization s th ere are even rewards in th e form of salary in creases for m an agers wh o m ake accu rate prediction s. Moreover, som e cost- allocation m eth ods provide for pen alties for u n derprediction s. For exam ple, su p- pose a m an ager predicts u sage of 210 h ou rs an d th en dem an ds 300 h ou rs. Th e m an ager eith er doesn ’t get th e h ou rs or pays a price for every h ou r beyon d 210.

Chapter 5 Cost Allocation and Activity-Based Costing Systems

Allocating Central Costs O BJECTI V E 4

Th e n eed to allocate cen tral costs is a m an ifestation of a widespread, deep-seated belief th at all costs m u st som eh ow be fu lly allocated to th e reven u e-produ cin g

Identify methods

(operatin g) parts of th e organ ization . Su ch allocation s are n eith er n ecessary from

for allocating the

an accou n tin g viewpoin t n or u sefu l as m an agem en t in form ation . However, m ost

central costs of an

m an agers accept th em as a fact of life—as lon g as all m an agers are treated alike.

organization.

Wh en ever possible, th e preferred cost driver for cen tral services is u sage, eith er actu al or estim ated. Bu t th e costs of su ch services as pu blic relation s, top corporate-m an agem en t overh ead, real estate departm en ts, an d corporate-plan - n in g departm en ts are th e least likely to be allocated on th e basis of u sage. Data processin g, advertisin g, an d operation s research are th e m ost likely to ch oose u sage as a cost driver.

Com pan ies th at allocate cen tral costs by u sage ten d to gen erate less resen t-

J.C. Penney

ment. Consider the experience of J.C. Penney Co. as reported in Business Week :

www.jcpenney.com Business Week O nline

Th e con troller’s office wan ted su bsidiaries su ch as Th rift Dru g Co. an d

www.businessweek.com

th e in su ran ce operation s to base th eir sh are of corporate person n el, legal, an d au ditin g costs on th eir reven u es. Th e su bsidiaries con ten ded th at th ey m ain tain ed th eir own person n el an d legal departm en ts, an d sh ou ld be assessed far less.

Th e su bcom m ittee addressed th e issu e by askin g th e corporate departm en ts to approxim ate th e tim e an d costs in volved in servicin g th e su bsidiaries. Th e fin al allocation plan , based on th ese stu dies, cost th e division s less th an th ey were in itially assessed bu t m ore th an th ey

h ad wan ted to pay. Non eth eless, th e plan was im plem en ted easily. Usage is not always an economically viable way to allocate central costs, however.

Also, many central costs, such as the president’s salary and related expenses, public relations, legal services, income tax planning, company-wide advertising, and basic research, are difficult to allocate on the basis of cause and effect. As a result, some companies use cost drivers such as the revenue of each division, the cost of goods sold by each division, the total assets of each division, or the total costs of each divi- sion (before allocation of the central costs) to allocate central costs.

Th e u se of th e foregoin g cost drivers m igh t provide a rough in dication of cau se-an d-effect relation sh ip. Basically, h owever, th ey represen t an “ability to bear” ph ilosoph y of cost allocation . For exam ple, th e costs of com pan y-wide advertisin g, su ch as th e goodwill spon sorsh ip of a program on a n on -com m ercial television station , m igh t be allocated to all produ cts an d division s on th e basis of th e dollar sales in each . Bu t su ch costs precede sales. Th ey are discretion ary costs as determ in ed by m an agem en t policies, n ot by sales resu lts. Alth ou gh 60 percen t of th e com pan ies in a large su rvey treat sales reven u e as a cost driver for cost allocation pu rposes, it is n ot tru ly a cost driver in th e sen se of bein g an activity th at causes th e costs.

If th e costs of cen tral services are to be allocated based on sales even th ou gh th e costs do n ot vary in proportion to sales, th e u se of budgeted sales is preferable to th e u se of actual sales. At least th is m eth od m ean s th at th e sh ort-ru n costs of

a given con su m in g departm en t will n ot be affected by th e fortu n es of oth er con - su m in g departm en ts.

For exam ple, su ppose $100 of fixed cen tral advertisin g costs were allocated on th e basis of poten tial sales in two territories:

186 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

TERRITO RIES A B TOTAL

PERCEN T

Budgeted sales

Central advertising

Con sider th e possible differen ces in allocation s wh en actu al sales becom e kn own :

TERRITO RIES A B

Actual Sales

Central advertising:

1. Allocated on basis of budgeted sales $ 50

or

2. Allocated on basis of actual sales

Com pare allocation 1 with 2. Allocation 1 is preferable. It in dicates a low ratio of sales to advertisin g in territory A. It directs atten tion wh ere it is deserved. In con - trast, allocation 2 soaks territory B with m ore advertisin g cost becau se of th e achieved resu lts an d relieves territory A despite its lower su ccess. Th is is an oth er exam ple of th e an alytical con fu sion th at can arise wh en cost allocation s to on e con su m in g departm en t depen d on th e activity of oth er con su m in g departm en ts.

Reciprocal Services

Service departments often support other service departments as well as supporting producing departments. Consider a manufacturing company with two producing departments—moulding and finishing—and two service departments, facilities management (rent, heat, light, janitorial services, etc.) and personnel. All costs in a given service department are assumed to be caused by, and therefore vary in pro- portion to, a single cost driver. The company has decided that the best cost driver for facilities management costs is square metres occupied and the best cost drivers for personnel is the number of employees. Exhibit 5-2 shows the direct costs, square metres occupied, and number of employees for each department. Note that facilities management provides services for the personnel department in addition to provid- ing services for the producing departments, and that personnel aids employees in facilities management as well as those in production departments.

EX H I B I T 5 - 2

SERVICE

PRO D U CTIO N

D EPARTM EN TS

D EPARTM EN TS

Cost Drivers

FACILITIES M ANAGEM EN T PERSO N N EL

M O U LD IN G FIN ISH IN G

Direct department costs

Square metres

Number of employees

Direct labour hours

Chapter 5 Cost Allocation and Activity-Based Costing Systems

O BJECTI V E 5

Th ere are th ree popu lar m eth ods for allocatin g service departm en t costs in su ch cases: th e direct m eth od, th e step-down m eth od, an d th e reciprocal alloca-

Use the direct, step-

tion m eth od.

down, and reciprocal allocation methods to

D irect M ethod

allocate service

As its n am e im plies, th e d ire ct m e th o d ign ores oth er service departm en ts wh en

department costs to user departments.

an y given service departm en t’s costs are allocated to th e reven u e-produ cin g (operatin g) departm en ts. In oth er words, th e fact th at facilities m an agem en t pro- vides services for person n el is ign ored, as is th e su pport th at person n el provides

D irect M ethod. Ignores

to facilities m an agem en t. Facilities m an agem en t costs are allocated based on th e

other service departments

relative squ are m etres occupied by the production departments only :

when any given service department’s costs are

• Total squ are m etres in produ ction departm en ts:

allocated to the revenue-

producing departments.

• Facilities management cost allocated to moulding

= (15,000 ÷ 18,000) × $126,000 = $105,000 • Facilities m an agem en t cost allocated to fin ish in g = (3,000 ÷ 18,000) × $126,000 = $21,000

Likewise, personnel department costs are allocated only to the production departments on the basis of the relative number of employees in the production departments:

• Total employees in production departments = 80 + 320 = 400 • Person n el costs allocated to m ou ldin g

= (80 ÷ 400) × $24,000 = $4,800 • Personnel costs allocated to finishing = (320 ÷ 400) × $24,000 = $19,200

Step-D own M ethod

Step-D own M ethod.

Th e ste p -d o w n m e th o d recogn izes th at som e service departm en ts su pport th e

Recognizes that some ser-

activities in oth er service departm en ts as well as th ose in produ ction depart-

vice depçer service

m en ts. A sequ en ce of allocation s is ch osen , u su ally by startin g with th e service

departments as well as those in production

departm en t th at ren ders th e greatest service (as m easu red by costs) to th e great-

departments.

est n u m ber of oth er service departm en ts. Th e last service departm en t in th e sequ en ce is th e on e th at ren ders th e least service to th e least n u m ber of oth er service departm en ts. On ce a departm en t’s costs are allocated to oth er depart- m en ts, n o su bsequ en t service departm en t costs are allocated back to it.

In ou r exam ple, facilities m an agem en t costs are allocated first. Wh y? Becau se facilities m an agem en t ren ders m ore su pport to person n el th an person - n el provides for facilities m an agem en t. 1 Exam in e Exh ibit 5-3. After facilities m an agem en t costs are allocated, n o costs are allocated back to facilities m an age- m en t, even th ou gh person n el does provide som e services for facilities m an age- m en t. Th e person n el costs to be allocated to th e produ ction departm en ts in clu de th e am ou n t allocated to person n el from facilities m an agem en t ($42,000) in addi- tion to th e direct person n el departm en t costs of $24,000.

1 How sh ou ld we determ in e wh ich of th e two service departm en ts provides th e m ost service to th e oth er? On e way is to carry ou t step on e of th e step-down m eth od with facilities m an agem en t

allocated first, an d th en repeat it assu m in g person n el is allocated first. With facilities m an agem en t allocated first, $42,000 is allocated to person n el, as sh own in Exh ibit 5-3. If person n el h ad been allo- cated first, (20/ 420) × $24,000 = $1,143 wou ld h ave been allocated to facilities m an agem en t. Becau se $1,143 is sm aller th an $42,000, facilities m an agem en t is allocated first.

188 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

EX H I B I T 5 - 3

Step-Down Allocation

FACILITIES M ANAGEM EN T

PERSO N N EL

M O U LD IN G

FIN ISH IN G TOTAL

Direct department costs before allocation

$160,000 $410,000 Step 1: Facilities management

= $14,000 Step 2: Personnel

= $52,800 Total cost after allocation

Reciprocal Allocation Method

FACILITIES M ANAGEM EN T

PERSO N N EL

M O U LD IN G

FIN ISH IN G TOTAL

Direct department costs before allocation

$160,000 $410,000 Allocation of facilities

= $14,358 Allocation of personnel

= $51,070 Total cost after allocation

$225,428 $410,000 * due rounding

Direct versus Step- Down Method

M O U LD IN G

FIN ISH IN G

D IRECT

STEP-D OW N RECIPRO CAL

D IRECT

STEP-D OW N RECIPRO CAL

$160,000 $160,000 Allocated from facilities management

Direct department costs

14,000 14,358 Allocated from personnel

52,800 51,070 Total costs

Chapter 5 Cost Allocation and Activity-Based Costing Systems

Exam in e th e last colu m n of Exh ibit 5-3. Before allocation , th e fou r depart- m en ts in cu rred costs of $410,000. In step 1, $126,000 was dedu cted from facili- ties m an agem en t an d added to th e oth er th ree departm en ts. Th ere was n o n et effect on th e total cost. In step 2, $66,000 was dedu cted from person n el an d added to th e rem ain in g two departm en ts. Again , total cost was u n affected. After allocation , all $410,000 rem ain s, bu t it is all in m ou ldin g an d fin ish in g. Non e was left in facilities m an agem en t or person n el.

Reciprocal Allocation M ethod

Reciprocal Allocation

Th e re cip ro cal allo catio n m e th o d allocates costs by recogn izin g th at th e ser-

M ethod. Allocates costs

vice departm en ts provide services to each oth er as well as to th e produ ction

by recognizing that the service departments pro-

departm en ts. Th is m eth od is gen erally viewed as bein g th e m ost th eoretically

vide services to each

correct as it en ables u s to cost th e in terdepartm en tal relation sh ips fu lly in to th e

other as well as to the

service departm en t cost allocation s. In ou r exam ple, th e facilities m an agem en t

production departments.

cost is allocated to th e person n el departm en t an d th e person n el cost is allocated to th e facilities m an agem en t departm en t before th e costs of th e service depart- m en ts are allocated to th e produ ction departm en ts.

First, we m u st allocate th e costs of th e services provided between th e two service departm en ts. We do th is u sin g th e followin g two equ ation s in wh ich th e facilities m an agem en t costs are defin ed as FM an d th e person n el costs as P.

FM = $126,000 + 20/ 420 P = $126,000 + .048 P P = $24,000 + 9/ 27 FM = $24,000 + .333 FM

Th en we solve th e two sim u ltan eou s equ ation s to determ in e th e total am ou n t of costs for each service departm en t.

FM = $126,000 + (.048 [$24,000 + .333 FM]) FM = $126,000 + $1,152 + .016 FM .984 FM = $127,152 FM = $129,220 P = $24,000 + .333 ($129,220) P = $24,000 + $43,030 P = $67,030

Th u s, th e total costs to be allocated for facilities m an agem en t is $129,220 an d for person n el is $67,030. Exh ibit 5-4 provides th e details of th e allocation s of th e costs for th ese two service departm en ts to th e two produ ction departm en t. Note th at th e total of th e costs allocated is still $410,000 (after m in or adju stm en ts du e to rou n din g errors).

Com pare th e costs of th e produ ction departm en ts u n der direct, step-down an d reciprocal allocation m eth ods as sh own in Exh ibit 5-5. Note th at th e m eth od of allocation can greatly affect th e costs. Mou ldin g appears to be a m u ch m ore expen sive operation to a m an ager u sin g th e direct m eth od th an to on e u sin g th e step-dow n or reciprocal allocation m eth od. Con versely, fin ish in g seem s m ore expen sive to a m an ager u sin g th e n on - direct m eth od.

190 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

Which method is better? It is sometimes difficult to say. An advantage of the step-down method is that it recognizes the effects of the most significant support provided by service departments to other service departments. In our example, the direct method does not make any assumptions about the following possible cause- effect link: if the cost of facilities management is caused by the space used, then the space used by personnel causes $42,000 of facilities man agem en t costs. If th e space u sed in person n el is cau sed by th e n u m ber of produ ction -departm en t em ployees su pported, th en th e n u m ber of produ ction -departm en t em ployees, n ot th e squ are m etres, cau ses $42,000 of th e facilities m an agem en t cost. Th e produ cin g departm en t with th e m ost em ployees, n ot th e on e with th e m ost squ are m etres, sh ou ld bear th is cost.

Th e greatest virtu e of th e direct m eth od is its sim plicity. If th e th ree m eth - ods do n ot produ ce sign ifican tly differen t resu lts, m an y com pan ies opt for th e direct m eth od becau se it is easier for m an agers to u n derstan d.

ALLO CATI N G CO STS TO O U TPU TS

Up to th is poin t, we h ave con cen trated on cost allocation to division s, depart- m en ts, an d sim ilar segm en ts of a com pan y. Cost allocation is often carried on e step fu rth er—to th e ou tpu ts of th ese departm en ts, h owever defin ed. Exam ples

Cost Application. The allo- cation of total departmen-

are products , su ch as au tom obiles, fu rn itu re, an d n ewspapers, an d services , su ch as

tal costs to the revenue-

ban kin g, h ealth care, an d edu cation . Som etim es th e allocation of total depart-

producing products or

m en tal costs to th e reven u e-produ cin g produ cts or services is called co st ap p li-

services.

cat io n or cost attribution .

General Approach O BJECTI V E 6

Th e gen eral approach to allocatin g costs to fin al produ cts or services is as follows:

Describe the general

1. Allocate production-related costs to the operating (line), production, or

approach to allocating

revenue-producing departments. This includes allocating service depart-

costs to products or

ment costs to the production departments following the guidelines listed

services.

on page 182. The production departments then contain all the costs: their direct department costs and the service department costs.

2. Select on e or m ore cost drivers in each produ ction departm en t. Historically, most companies have used only one cost driver per depart- ment. Recently, a large number of companies have started using multiple costs pools and multiple cost drivers within a department. For example, a portion of the departmental costs may be allocated on the basis of direct- labour hours, another portion on the basis of machine hours, and the remainder on the basis of the number of machine setups.

3. Allocate (assign ) th e total costs accu m u lated in step 1 to produ cts or services th at are th e ou tpu ts of th e operatin g departm en ts u sin g th e cost drivers specified in step 2. If on ly on e cost driver is u sed, two cost pools sh ou ld be m ain tain ed, on e for variable costs an d on e for fixed costs. Variable costs sh ou ld be assign ed on th e basis of actu al cost dri- ver activity. Fixed costs sh ou ld eith er rem ain u n allocated or be allo- cated on th e basis of bu dgeted cost driver activity.

Chapter 5 Cost Allocation and Activity-Based Costing Systems

Con sider ou r m an u factu rin g exam ple, an d assu m e th at th e step-down m eth od was u sed to allocate service departm en t costs. Exh ibit 5-3 sh ows total costs of $183,200 accu m u lated in m ou ldin g an d $226,800 in fin ish in g. Note th at all $410,000 total m an u factu rin g costs reside in th e produ ction departm en ts. To allocate th ese costs to th e produ cts produ ced, cost drivers m u st be selected for each departm en t. We will u se a sin gle cost driver for each departm en t an d assu m e th at all costs are cau sed by th at cost driver. Su ppose m ach in e h ou rs is th e best m easu re of wh at cau ses costs in th e m ou ldin g departm en t, an d direct-labou r

h ou rs m easu res cau sation in fin ish in g. Exh ibit 5-2 sh owed 30,000 total m ach in e-

h ou rs u sed in m ou ldin g an d 10,000 direct labou r h ou rs in fin ish in g. Th erefore, costs are allocated to produ cts as follows:

Mou ldin g: $183,200 ÷ 30,000 m ach in e-h ou rs = $6.11 per m ach in e-h ou r Fin ish in g: $226,800 ÷ 10,000 direct labou r h ou rs = $22.68 per direct labou r h ou rs

A produ ct th at takes fou r m ach in e-h ou rs in m ou ldin g an d two direct labou r

h ou rs in fin ish in g wou ld h ave a cost of

P E R S P E CT I V E S O N

D E CI S I O N - M A K I N G

Phone Carriers Battle Over Accounting Methods

Bell Canada

The battle between Bell Canada and

Bell said Andersen Consulting Canada

www.bell.ca

long-distance rival Unitel Com m unications

undertook a cost comparison study on

U nitel

Inc. moved into the accounting field yes-

behalf of provincial telephone companies.

www.unitelcom.com

terday on the issue of how monthly phone

It fou n d Bell’s costs were 2.8¢ lower

rates break down.

per m in u te th an U.S. gian t AT&T. Th e dif-

Canadian Radio-television and Telecommunications

Th e Can adian Radio-television an d

feren ce was attribu ted to AT&T’s h igh er

Commission

Telecommunications Commission will hold

m arketin g an d cu stom er service costs,

www.crtc.gc.ca

hearings in May on the so-called “split rate

an d h igh er corporate operation s.

base” — the separation of a phone com-

Un itel said th at u sin g CRTC Ph ase III

pany’s costs for long-distance competitive

accou n tin g m eth ods, lon g-distan ce costs

services from local monopoly services.

for U.S. carriers are 12.3¢ per m in u te,

Com petitors ch arge th at Bell an d oth -

wh ile costs for Can adian carriers average

ers m isallocate costs of providin g com pet-

abou t 8.1¢ — a 52 percen t differen ce.

itive services to th e m on opoly costs. Th at

On e of th e problem s is th at teleph on e

allows for lower lon g-distan ce rates an d

com pan ies often m ake u se of th e sam e

h u rts rival com pan ies th at h ave to beat

person n el an d equ ipm en t for both local

th ose prices, drivin g u p th e su bsidy com -

an d lon g-distan ce bu sin ess. Un itel cites

petitors pay to th e local bu sin ess.

cu stom er billin g as an exam ple of wh en

Both sides will be offering their versions

both m on opoly an d com petitive services

of “benchmarks” — the per-minute cost

are ch arged on th e sam e bill, join tly

comparisons between Canadian and U.S.

in cu rrin g th e costs.

carriers. Un itel h as ch arged th at th e Canadian carriers’ costs are 40 percent to

Source: Joanne Chianello, “Phone carri-

50 percent lower than U.S. counterparts in

ers battle over accounting methods,” The

the most competitive market in the world.

Financial Post , (February 1, 1995), p. 7.

192 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

ALLO CATI N G JO I N T CO STS AN D BY-PRO D U CT CO STS

O BJECTI V E 7 Join t costs an d by-produ ct costs create especially difficu lt cost allocation prob-

lem s. By defin ition , su ch costs relate to m ore th an on e produ ct bu t can n ot be

Use the physical units

separately iden tified with an in dividu al produ ct.

and relative-sales-value methods to allocate joint costs to products.

Joint Costs

So far we h ave assu m ed th at cost drivers cou ld be iden tified with an in dividu al produ ct. For exam ple, if costs are bein g allocated to produ cts or services on th e basis of m ach in e h ou rs, we h ave assu m ed th at each m ach in e h ou r is u sed on a sin gle fin al produ ct or service. However, som etim es in pu ts are added to th e pro- du ction process before in dividu al produ cts are separately iden tifiable (th at is,

Joint Costs. Costs of inputs

before th e split-off point ). Su ch costs are called jo in t co sts. Join t costs in clu de all

added to a process before

in pu ts of m aterial, labou r, an d overh ead costs th at are in cu rred before th e split-

individual products are

off poin t.

separated.

Su ppose a departm en t h as m ore th an on e produ ct an d som e costs are join t costs. How sh ou ld su ch join t costs be allocated to th e produ cts? Allocation of join t costs sh ou ld n ot affect decision s abou t th e in dividu al produ cts. Neverth eless, join t produ ct costs are rou tin ely allocated to produ cts for pu rposes of inventory valuation an d income determination .

Assu m e a departm en t in Dow Ch em ical Com pan y produ ces two ch em icals,

D ow Chemical

www.dow.com

X an d Y. Th e join t cost is $100,000, an d produ ction is 1,000,000 litres of X an d 500,000 litres of Y. Produ ct X can be sold for $.09 per litre an d Y for $.06 per litre. Ordin arily, som e part of th e $100,000 join t cost will be allocated to th e in ven tory of X an d th e rest to th e in ven tory of Y. Su ch allocation s are u sefu l for in ven tory pu rposes on ly. Join t cost allocation s sh ou ld be ign ored for decision s su ch as sell- in g a join t produ ct or processin g it fu rth er.

Two con ven tion al ways of allocatin g join t costs to produ cts are widely u sed: physical units an d relative sales values . If ph ysical u n its were u sed, th e join t costs wou ld be allocated as follows:

ALLO CATIO N O F SALES VALU E AT

LITRES

W EIGH TIN G

JO IN T CO STS

SPLIT-O FF

Th is approach sh ows th at th e $33,333 join t cost of produ cin g Y exceeds its $30,000 sales valu e at split-off, wh ich seem s to in dicate th at Y sh ou ld n ot be pro- du ced. However, su ch an allocation is n ot h elpfu l in m akin g produ ction deci- sion s. Neith er of th e two produ cts cou ld be produ ced separately.