Service Department Cost Allocation - Anna Lee

LO1Service Department Cost Allocation• Intermediate cost center:Cost center whose costs are chargedto other departments in the organization.• Final cost center:Cost center, such as a production ormarketing department, whose costsare not allocated to another cost center.11 - 2

LO1Service Department Cost AllocationBasic Data for Service Department Cost AssociationCarlyle Coal CompanyInformationSystems (S1) aService DepartmentAdministration(S2) bDepartments:Administration (S2)Information Systems (S1)Hilltop Mine (P1)Pacific Mine (P2)Total (to be distributed)hours100,000-0-20,00080,000200,00050%01040100%employees)-0-2,0005,0003,00010,0000%205030100%aAllocation base for S1: Computer hours; Cost to be allocated: $800,000bAllocation base for S2: Number of employees; Cost to be allocated: $5,000,00011 - 4

Cost Allocation: Direct Method• Direct method:Charges costs of service departments to user departmentswithout making allocations among service departments.Service Department:Information Systems(S1)Service Department:Administration(S2)User Department:Hilltop Mine(P1)User Department:Pacific Mine(P2)11 - 5

LO2Cost Allocation: Direct MethodService DepartmentCost AllocationDirectCostHilltop Mine(P1)Percent Applicable toPacific Mine(P2)TotalService Department:Information Systems (S1)Administration (S2)Service Department:Information Systems (S1)Administration (S2)Total allocated$ 800,0005,000,000DirectCost$ 800,0005,000,000$5,800,000Note: Under this method, S1 costs doesn’t allocate to S2.20.0% a62.5% bHilltop Mine(P1)$ 160,000 c3,125,000 d$3,285,000a20.0% = 20,000 hours ÷ (20,000 hours + 80,000 hours)b62.5% = 5,000 employees ÷ (5,000 employees + 3,000 employees)c$160,000 = 20% × $800,000d$3,125,000 = 62.5% × $5,000,00080.0%37.5%Amount Applicable toPacific Mine(P2)$ 640,0001,875,000$2,515,000100.0%100.0%Total$ 800,0005,000,000$5,800,00011 - 6

Cost Allocation: Step Method• The step method allocates some servicedepartment costs to other service departments.• Once an allocation is made from a servicedepartment no further allocations are madeback to that service department.• Generally, allocate in order of proportion ofservices provided to other service departments.11 - 7

LO3Cost Allocation: Step MethodCost Flow Diagram: Step Method – Carlyle Coal CompanyService Department:Information Systems(S1)ComputerhoursUser Department:Hilltop Mine(P1)Service Department:Administration(S2)EmployeesUser Department:Pacific Mine(P2)11 - 8

LO3Cost Allocation: Step MethodService Department Cost AllocationDirectCost(S1)Percent Applicable to(S2)(P1)(P2)TotalService Dept.:(S1)(S2)$ 800,0005,000,0000.0%0.0%50.0% a0.0%10.0% b62.5% d40.0% c37.5% e100.0%100.0%a50.0% = 100,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)b10.0% = 20,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)c40.0% = 80,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hoursd62.5% = 5,000 employees ÷ (5,000 employees + 3,000 employees)e37.5% = 3,000 employees ÷ (5,000 employees + 3,000 employees)11 - 9

LO3Cost Allocation: Step MethodService Department Cost AllocationToFrom(S1)(S2)(P1)(P2)TotalDept. costs(S1)(S2)$800,000(800,000)-0-$ -0-$5,000,000400,000 f(5,400,000)$ -0-Note: Under Step method, S1 costs does allocate to S2.f50.0% × $800,000g10.0% × $800,000h40.0% × $800,000I62.5% × $5,400,000j37.5% × $5,400,000k$5,800,000 of service department costs wereultimately allocated to production departments.$ -0-80,000 g3,375,000 i$3,455,000$ -0-320,000 h2,025,000 j$2,345,000$5,800,000 k$5,800,000 k11 - 10

Cost Allocation: Reciprocal Method• The reciprocal method recognizes all servicesprovided by any service department, includingservices provided to other service departments.• It accounts for cost flows among servicedepartments providing services to each other.• It requires a simultaneous equation solution.11 - 11

LO4Cost Allocation: Reciprocal MethodCost Flow Diagram: Reciprocal Method – Carlyle Coal CompanyService Department:Information Systems(S1)ComputerhoursUser Department:Hilltop Mine(P1)Service Department:Administration(S2)EmployeesUser Department:Pacific Mine(P2)11 - 12

LO4Cost Allocation: Reciprocal Method1. Write the costs of each service departmentin equation form.Total ServiceDepartment costsDirect costs of the= +Service DepartmentCosts allocated to theService Department2. Solve equations simultaneously usingmatrix algebra.11 - 13

LO4Cost Allocation: Reciprocal MethodTotal ServiceDepartment costsDirect cost of the= +Service DepartmentCosts allocated to theService DepartmentS1 = $ 800,000 + 0.20 S2S2 = $5,000,000 + 0.50 S1Substituting the first equation into the second yields:S2 = $5,000,000 + 0.50($800,000 + 0.20 S2)S2 = $5,000,000 + $400,000 + 0.10 S20.9 S2 = $5,400,000 S2 = $6,000,000Substituting the value of S2 back into the first equation gives:S1 = $800,000 + 0.20($6,000,000)S1 = $2,000,00011 - 14

LO4Cost Allocation: Reciprocal MethodService Department Cost AllocationTotalCost(S1)Percent Applicable to(S2)(P1)(P2)TotalService Dept.:(S1)(S2)$2,000,0006,000,0000.0%20.0% d50.0% a0.0%10.0% b50.0% e40.0% c30.0% f100.0%100.0%a50.0% = 100,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)b10.0% = 20,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)c40.0% = 80,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hoursd20.0% = 2,000 employees ÷ (2,000 employees + 5,000 employees + 3,000 employees)e50.0% = 5,000 employees ÷ (2,000 employees + 5,000 employees + 3,000 employees)f30.0% = 3,000 employees ÷ (2,000 employees + 5,000 employees + 3,000 employees11 - 15

LO4Cost Allocation: Reciprocal MethodService Department Cost AllocationToFrom(S1)(S2)(P1)(P2)TotalDirect costs(S1)(S2)$ 800,000(2,000,000) a1,200,000 e$ -0-$5,000,0001,000,000 b(6,000,000) f$ -0-$ -0-200,000 c3,000,000 g$3,200,000$ -0-800,000 d1,800,000 h$2,600,000$5,800,000 i$5,800,000 iaTotal costs of S1bCosts allocated from S1 (50% × $2,000,000)c10.0% × $2,000,000d40.0% × $2,000,000eCosts allocated from S2 (20% × $6,000,000)fTotal costs of S2g50% × $6,000,000h30% × $6,000,000I$5,800,000 of service department costs were ultimatelyallocated to production departments.11 - 16

LO4Cost Allocation: Reciprocal MethodComparison of Direct, Step, and Reciprocal MethodsMethod Hilltop Mine Pacific Mine TotalDirectStepReciprocal$3,285,0003,455,0003,200,000$2,515,0002,345,0002,600,000$5,800,0005,800,0005,800,00011 - 17

The Reciprocal Methodand Decision MakingL.O. 5 Use the reciprocal method for decisions.• Suppose that the variable cost in Information Services (S1)is $200,000 (out of the total of $800,000) and the variablecost in Administration (S2) is $3,500,000 (out of $5,000,000).• Let's repeat the reciprocal cost analysis substitutingthe variable costs from the total costs.11 - 18

LO5The Reciprocal Methodand Decision MakingTotal ServiceDepartment costsDirect cost of the= +Service DepartmentCosts allocated to theService DepartmentS1 = $ 200,000 + 0.20 S2S2 = $3,500,000 + 0.50 S1Substituting the first equation into the second yields:S2 = $3,500,000 + 0.50($200,000 + 0.20 S2)S2 = $3,500,000 + $100,000 + 0.10 S20.9 S2 = $3,600,000 S2 = $4,000,000Substituting the value of S2 back into the first equation gives:S1 = $200,000 + 0.20($4,000,000)S1 = $1,000,00011 - 19

The Reciprocal Methodand Decision Making• The total variable cost of Information Services, when youconsider the use of Administration by Information Servicesis $1,000,000.• The total cost savings that would come from eliminatingInformation Services are the $1,000,000 variable costsplus any avoidable fixed costs.11 - 20

Allocation of Joint CostsJoint cost is the cost of a manufacturing process with two or moreoutputs produced together up to a split-off point.Split-offpointHi-grade coal: 15,000 unitsSales value: $300,000Mining costs$270,000(Joint Costs)Lo-grade coal: 30,000 unitsSales value: $450,000(Separable Costs)11 - 21

Allocation of Joint Costs2 Methods of Allocation:Net realizable value methodPhysical quantities method• Net realizable value method:Joint cost allocation based on the proportionalvalues of the products at the split-off point.• Net realizable value (NRV):Sales value of each product at the split-off pointminus disposable cost.• Estimated net realizable value:If the sales value at split-off is not available, use theestimated NRV method. That is sales price of a final productminus additional processing costs necessary to preparea product for sale (disposable cost).11 - 22

Net Realizable Value MethodFinal sales valueLess: Additional processing costsNet realizable value at split-off pointProportionate share:= $300,000 ÷ $750,000= $450,000 ÷ $750,000Allocated joint costs:= $270,000 × 40%= $270,000 × 60%ExampleCarlyle Coal CompanyJoint Allocation – NRV Method(no additional processing costs)Hi-Grade Lo-Grade Total$300,000-0-$300,00040%$108,000$450,000-0-$450,00060%$162,000$750,000-0-$750,00011 - 23

Net Realizable Value MethodCarlyle Coal CompanyFor the Month of MarchSales valueLess: Allocated joint costsGross marginGross margin as a percent of salesHi-Grade Lo-Grade Total$300,000108,000$192,00064%$450,000162,000$288,00064%$750,000270,000$480,00064%11 - 24

Estimating NRV• When no sales value exists for outputs at the split-off point,the estimated NRV should be determined.Further Processing of Coal:Cost Flows –Carlyle Coal CompanySplit-offpointHi-grade coal: 15,000 unitsSales value: $300,000Mining costs$270,000Lo- to Mid-grade coal:30,000 units$50,000 processing costSales value: $550,00011 - 25

Estimating NRVCarlyle Coal CompanyFor the Month of MarchSales valueLess: Additional cost to processEstimated NRV at split-offAllocation of joint costsGross marginGross margin as a percent of salesHi-Grade Mid-Grade Total$300,000 $550,000to mid-grade — coal 50,000$300,000 $500,000101,250 a —— 168,750 b$198,750 $331,25066% 60%$850,00050,000$800,000101,250168,750$530,00062%a($300,000 ÷ $800,000) × $270,000b($500,000 ÷ $800,000) × $270,00011 - 26

Physical Quantities Method• Joint cost allocation is based on measurement ofthe volume, weight, or other physical measure ofthe joint products at the split-off point.When to use:1. Output product prices are volatile.2. Significant processing occurs between thesplit-off point and the first point of marketability.3. Product prices are not set by the market.11 - 27

Physical Quantities MethodCarlyle Coal CompanyFor the Month of MarchQuantity (tons)Sales valueAllocation of joint costsGross marginGross margin as a percent of salesHi-Grade Lo-Grade Total15,000$300,00090,000 a$210,00070%30,000$450,000180,000 b$270,00060%45,000$750,000270,000$480,00064%a(15,000 tons ÷ 45,000 tons) × $270,000b(30,000 tons ÷ 45,000 tons) × $270,00011 - 28

By-products• By-products are outputs of joint production processesthat are relatively minor in quantity or value. Joint costsare usually not allocated to a by-product, instead,market value of by-product is reported as follows:• Method 1:The net realizable value from sale of the by-productsis deducted from the joint costs (as a contra productioncost) before allocation to the main products.• Method 2:The proceeds from sale of the by-product are treatedas other revenue (other income).11 - 29

By-products – Method 1Carlyle Coal CompanyFor the Month of MarchHi-GradeLo-GradeDustby-productTotalSales valueLess: Additional processing costsNet realizable value at split-off pointDeduct: Sales value of by-product aAllocated remaining joint costs aGross marginGross margin as a percent of sales$300,000-0-$300,000-0-102,000 b$198,00066%$450,000-0-$450,000-0-153,000 c$297,00066%$15,000-0-$15,00015,000-0--0-0%$765,000-0-$765,00015,000255,000$495,00065%a Note: Joint costs adjusted for sales value of by-product (dust) (765,000 – 15,000 = 750,000)b($300,000 ÷ $750,000) or 40% × ($270,000 Joint cost – $15,000)c($450,000 ÷ $750,000) or 60% × ($270,000 – $15,000)11 - 30

Carlyle Coal CompanyFor the Month of MarchQuantity (tons)Sales valueAllocation of joint costsGross marginGross margin as a percent of sales15,000$300,000108,000$192,00064%30,000$450,000162,000$288,00064%45,000$750,000270,000$480,00064%(300,000÷ 750,000) = 40% 270,000 x 40% = 108,000(450,000÷ 750,000) = 60% 270,000 x 60% = 162,000

By-products – Method 2Carlyle Coal CompanyFor the Month of MarchHi-GradeLo-GradeDustTotalSales valueLess: Additional processing costsNet realizable value at split-off pointAllocated joint costs aGross marginGross margin as a percent of sales$300,000-0-$300,000108,000 b$192,00064%$450,000-0-$450,000162,000 c$288,00064%$15,000-0-$15,000-0-$15,000100%$765,000-0-$765,000270,000$495,00065%aJoint costs adjusted for sales value of by-product (dust)b($300,000 ÷ $750,000) or 40% × $270,000 joint cost = 108,000. 15,000 is not deductedfrom joint cost, instead, it is reported as other income.c($450,000 ÷ $750,000) or 60% × $270,000 = 162,00011 - 32

Sell or Process Further• Suppose CCC can sell Lo-grade coal for $450,000at the split-off point or process it further to makemid-grade coal.• Mid-grade coal would sell for $550,000 andadditional processing costs would be $50,000.Additional revenue: $100,000?Additional cost: $ 50,00011 - 33

Sell or Process FurtherDifferential AnalysisCarlyle Coal CompanySellLo-GradeCoalProcessFurther(Mid-Grade)DifferentialRevenue/CostsRevenuesLess: Separate processing costsMargin$450,000-0-$450,000$550,00050,000$500,000$100,00050,000$ 50,000Net gain fromprocessingfurther11 - 34