Chapter Eight
Cost Allocation:
Practices
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
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 to the remaining users, 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.
8-2
Death Spiral Example: Internal
Services




Internal Telecommunications Department:
Telecommunications service department allocates
fixed costs to users.
If some users are allowed to switch to outside
phone company, the fixed costs allocated to
remaining users increase.
Eventually, the number of users of the
telecommunications department is so small that the
department is closed.
8-3
Death Spiral Example: Cost-based
Contracts



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Military Aircraft (not in text):
Defense contractors working on advanced
technology incur large fixed cost over-runs that are
allocated to each aircraft manufactured.
Government reduces number of aircraft purchased
and that causes average cost to increase on
remaining orders.
Government responds by ordering even fewer
aircraft.
Eventually, the entire project is abandoned before
all fixed costs are recovered.
8-4
Death Spiral in Reverse!




Clay Sprays:
Increasing the allocation base for fixed costs can
lead to misleading product line profit figures.
Decisions should be consistent with an overall
economic strategy and a meaningful understanding
of the impacts of accounting practices.
“I left this to the accountants” would not cut it in
today’s business environment.
8-5
Allocating Capacity Costs:
Depreciation




Accounting depreciation represents the annual
historical cost of acquired capacity.
Allocating depreciation involves a tradeoff - with
excess capacity, allocation causes underutilization.
However, allocation controls overinvestment.
Most firms allocate depreciation to users.
If confronted with a choice between control and
decision making - accounting systems usually
choose control.
8-6
Methods of Service Department
Allocation


Methods for complex firms with at least 2 service
departments and at least 2 operating departments
(see Figure 8-1).
Alternative methods:



Direct allocation
Step-down allocation
Reciprocal allocation
8-7
Service Allocation: Direct Method

Procedure:



Advantages:


Ignore each service department’s use of other service
departments.
Allocate service department costs only to operating
departments.
Simple to administer and explain.
Disadvantages:


Allocations are not accurate estimates of opportunity costs
when service departments use other service departments.
Incentives exist for service departments to make excessive
use of other service departments.
8-8
Service Allocation: Step-down Method

Procedure:




A good way of choosing the order of allocation is by (1)
most reliable “cause and effect” cost driver, (2) number
of other departments serviced, and (3) finally, as the
default, total budget of department.
Advantages:


Start with one service department and allocate all of its costs to
the remaining service and operating departments.
Continue one-by-one through each service department allocating
all direct costs of that department and costs allocated to it.
Considers some of the interdependence of service departments
Disadvantages:



Resulting allocations are inaccurate estimates of opportunity
costs.
Allocation less than opportunity cost for first department
Allocation more than opportunity cost for last department
8-9
Service Allocation: Reciprocal Method
(Appendix)

Procedure:




Advantages:


Write equations defining variable cost relationships among
divisions.
Solve system of simultaneous equations with linear algebra.
Allocate fixed costs based on each operating division’s planned
use of the service department’s capacity.
Most accurate method (best approximates opportunity costs)
Disadvantages:



Slightly harder to set up and compute solution
Difficult to explain results to unsophisticated managers
Prevents managers from “managing” cost allocations for financial
reporting and/or taxes.
8-10
Service Allocation Example
Allocation Method
Total Allocated to Car
Division (Millions)
Transfer price
($/phone)
$4.643
$1,143
Step-down –
Telecommunications first
4.648
889
Step-down – IT first
4.621
2,151
Reciprocal
4.623
1,492
Direct

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Each method allocates all service costs
Total allocation does not vary significantly in this case
Transfer prices do differ depending on allocation method
8-11
Service Allocation Example


As a thought question:
Under what conditions would you expect that
the service department allocations under
each of these methods would be materially
different from each other?
8-12
Reasons to Allocate Service Department
Costs

Encourages reduction of use of costly services


Reveals economic demand for services


With no cost allocation (zero transfer prices), management
must use non-price priority schemes to control use.
Rational users will pay a transfer price only when the
benefits are greater than or equal to that price.
Compare internal service departments to external
vendors

Gross inefficiency is revealed when internal transfer prices
greatly exceed external prices
8-13
Joint Costs Defined



Joint cost is incurred to produce two or more
outputs from the same input.
Joint costs occur only in disassembly processes,
such as refining and food processing.
Common costs occur in either disassembly or
assembly processes, such as building cars.
8-14
Joint Costs: Process Further?


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Split-off point: The point in the disassembly
processing at which all joint costs have been
incurred (See Figure 8-5).
Decision: Should each joint product be processed
further or sold as is at the split-off point?
Solution concept: The joint costs are sunk costs at
the split-off point. Do the incremental benefits of
further processing exceed the incremental costs?
8-15
Joint Costs: Net Realizable Value

Net realizable value (NRV) is the difference between
selling price and costs that would be incurred after the
split-off point.
1. Compute NRV of each product after the split-off point.
Decide to produce products with positive NRV, but not
with negative NRV.
2. For control and divisional reporting, allocate joint costs
to products in the ratio of the NRV of each product.

Example: Fillets have 64% of the sum of the NRV’s of
the three joint products. Therefore, allocate 64% of the
joint costs (64% x $2.00 = $1.28) to fillets.
8-16
Segment Reporting: Controllability
The following segment report format is based on
the controllability principle (managers should be
held responsible only for costs under their control).
Division A Division B
-
Division revenues
X,XXX
X,XXX
Division controllable expenses
- XXX
- XXX
XXX
XXX
- XXX
- XXX
XXX
XXX
= Controllable segment margin
-
Allocated common costs
= Net income
Proponents argue that performance rewards for
divisional managers should be based on the
division’s controllable segment margin.
8-17
Segment Reporting: Joint Benefits
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The segment margin approach does not consider
joint benefits (positive externalities) of one division
on another.
Separating controllable and noncontrollable costs on
segment margin reports will not show how
segments are interdependent.
Example:


Products of two different segments are sold to the
same customers Dropping one segment will adversely
affect customer demand for the products of the
surviving segment
See Self Study Problem.
8-18
Appendix: Reciprocal Method

Procedure:

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

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Write equations estimating variable cost functions among
service departments only.
Write equations estimating variable cost functions between
service and operating departments.
Solve system of simultaneous equations with linear algebra
to allocate variable costs.
Allocate fixed costs based on each operating division’s
planned use of the service department’s capacity.
Use:

Difficult to estimate cost functions in actual practice
8-19