Cost To Serve Hongren

Copyright 2014 Pearson Education, Inc.
publishing as Prentice 12 - 1
Chapter 12
Cost Allocation
Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 2

Chapter 12 Learning Objectives
1. Describe the general framework for cost allocation.
2. Allocate the variable and fixed costs of service

departments to other organizational units.
3. Use the direct and step-down methods to allocate

service department costs to user departments.

Chapter 12 Learning Objectives
4. Allocate costs from producing departments to products

or services using the traditional and ABC approaches.
5. Allocate costs associated with customer actions to

customers.
6. Allocate the central corporate costs of an organization.
7. Allocate joint costs to products using the physical-units

and relative-sales-value methods.

Learning General Framework
for Cost Allocation
Objective 1
Cost allocation methods comprise an important

part of a companys cost accounting system to
determine the cost of a product, service,
customer, or other cost object.
Less than half of most companies operating costs

can be traced directly to products and services.
The rest of a companys costs must be allocated

using a cost-allocation base or left unallocated.

General Framework for Cost Allocation
After developing a general framework for

cost allocation, companies assign
costs to cost objectives.
There are four types of cost

objectives:
1.service departments,
2.producing departments,
3.products/services, and
4.customers.

The cost accounting system first accumulates

costs and assigns them to organizational units,
which are also called departments.
There are two types of departments:

(1) producing departments, where
employees work on the organizations
products or services, and
(2) service departments, which exist only
to support other departments or
customers.

Direct costs can be physically

traced to each department.
Indirect costs must be allocated.
Many companies develop

allocation methods to assign
service department costs to the
producing departments.

Learning Allocation of Service
Department Costs
Objective 2

Service Department Example
University
computer department
serves two major users:
School of Business School of Engineering
Allocate the cost of a 5-year

lease on computer mainframe

Suppose there are two major

purposes for the allocation:
Motivating
Predicting departments
economic and individuals
effects of the to use its
use of the capabilities
computer more fully

The primary activity performed

is computer processing.
Resources consumed:
The budget formula for
1. Processing time
the forthcoming year
2. Operator time
is $100,000 monthly
3. Consulting time
fixed cost plus $200
4. Energy
variable cost per hour
5. Materials
of computer time used.
6. Building space


Variable-Cost Pool
The cost driver for the variable-cost pool

is actual hours of computer time used.
Variable costs should

be allocated as follows:
Cost-allocation rate per hour
Actual hours of
computer time used

Variable-Cost Pool
Consider the allocation of variable

costs to a department that uses
500 hours of computer time.
500 hours $200 = $100,000
Suppose inefficiencies in the

computer department caused the
variable costs to be $120,000
instead of $100,000.
Variable-Cost Pool
A good cost-allocation scheme would allocate

only the $100,000 to the consuming
department and would let the $20,000 remain
as an unallocated unfavorable budget
variance of the computer department.
This scheme holds computer department

managers responsible for the $20,000 and
reduces the resentment of user managers.

Fixed-Cost Pool
Allocation of fixed costs will be based

on the long-run capacity available
to the user, regardless of actual
Usage from month to month.
Long-range planning regarding the

expected required overall level of service,
not short-run fluctuations in actual usage,
affects the level of fixed costs

Fixed-Cost Pool
Suppose the deans had originally predicted the

long-run average monthly usage as follows:
School of Business: School of Engineering:

210 hours 490 hours
How is the fixed-cost pool allocated?

Fixed-Cost Pool
A major strength of using capacity available

rather than capacity used to allocate
budgeted fixed costs is that actual usage
by user departments does not affect the
short-run allocations to other departments.
Such a budgeted lump-sum approach

is more likely to have the desired
motivational effects with respect to
the ordering of services in both the
short run and the long run.

Learning
Objective 3 Direct and Step-Down Methods
Service departments often support

other service departments in addition
to production departments.
There are two popular methods for

allocating service department costs:
The direct method
The step-down method

Processing Facility:
Service Department Allocation

Direct Methods
The direct method ignores other service

departments when any given service
departments costs are allocated
to the producing departments.
Facilities management cost = $1,260,000
The direct method allocates these costs to the

processing and assembly departments based
on the relative square footage occupied by
each of the two departments.

Direct Methods
The direct method allocates these costs to

the processing and assembly departments
based on the relative square footage
occupied by each of the two departments.

Direct Methods
The direct method allocates human resources

department costs to the producing departments
on the basis of the relative number of
employees in the producing departments.
Human Resources costs = $48,000

Step-Down Methods
The step-down method recognizes

that some service departments
support the activities in other
service departments as well as
those in production departments.
To apply the step-down

method, choose the sequence
in which to allocate service
department costs.
Step-Down Method
Allocate facilities management department

costs then allocate human resources cost.

Allocation of Service
Department Costs
Costs not related to cost drivers?
Identify multiple cost pools, each with

its own cost-allocation base. Divide
facilities management costs into two or
more cost pools. Use a different cost-
allocation base to allocate costs in each
pool via the direct or step-down method.

Allocation of Service
Department Costs
Direct Versus Step-Down Method

Learning
Objective 4 Traditional Approach
1. Divide the costs in each

producing department.
2. Assign direct costs to the appropriate

products, services, or customers.

Traditional Approach
3. Select one or more cost pools and related

cost drivers in each production department.
Indirect departmental costs
Cost Cost Cost

pool pool pool

Traditional Approach
4. Allocate costs
Costs

Traditional Approach and Step-Down Method

Activity-Based Costing (ABC)
1. Determine the key components of the system

and the relationships among them.
2. Collect relevant data concerning costs and the
1. physical flow of the cost-allocation base units
2. among resources and activities.
3. Calculate and interpret the new ABC

1. information.

Activity-Based Costing

Allocation of Customer Costs
Customer profitability depends on the costs incurred

to fulfill customer orders and to provide
other customer services such as order changes,
returns, and expedited scheduling or delivery.
Customer Type 1 Customer Type 2

Low Cost to Serve High Cost to Serve
1. Buys a mix of 1. Buys a mix of
products with high products with lower
gross margins gross margins
2. Low cost-to-serve % 2. High cost-to-serve %
3. High profitability 3. Low profitability

Customer Type 1 Customer Type 2

Low Cost to Serve High Cost to Serve
1. Large order quantity 1. Small order quantity

2. Few order changes 2. Many order changes
3. Little pre- and 3. Large amounts of pre-
post-sales support and post-sales support
4. Regular scheduling 4. Expedited scheduling
5. Standard delivery 5. Special delivery
6. Few returns 6. Frequent returns

Learning
Objective 5 Allocation of Customer Costs
Customer profitability depends on more

than gross margin, it is a function of
customer gross margin and cost to serve.

Assume Cedar City Distributors (CCD)

distributes products to retail outlets.
The products are classified into

just two product groups
apparel and sports gear.
CCD has two types of

customers:
1. Small store
2. Large store
CCD uses a simple cost accounting

system to calculate both product
and customer profitability.
The only direct costs
Indirect costs are
are costs of the
allocated to the
purchase of apparel
product groups using
and sports gear
a single indirect cost
products.
pool for all indirect
costs with pounds of
product as the
Costs allocation base.
To determine customer profitability:

1. Calculate profit margin per case
for each product
2. Use the product mix ordered by each
customer to calculate profitability
Small stores product mix is 75% apparel.

Large stores product mix is 50% apparel.
Small store customers are expected to have
the larger profit margin percentage.
But, the refined cost-allocation system shows
large stores are the most profitable customers.
Profit Margin Per Case of Apparel and Sports Gear

Customer Profitability at Cedar City Distributors

Allocation of Costs-to-Serve
Might number of customer orders be a more

plausible cost-allocation base?
Include cost of order processing and customer

service activities in a separate cost pool and
allocate on a number of order basis.
Gives managers more insight into operations,

and a tool to measure and manage customer
profitability.

Allocation of Costs-to-Serve
Product and Customer Profitability Measures

Based on CCDs Refined Cost-Allocation System

Learning
Objective 6 Allocation of Central Costs
Many managers believe it is desirable

to fully allocate all costs to the revenue-
producing parts of the organization.
If a company allocates central support

costs, it is important to allocate them
in a way that managers accept as fair.
Some companies find measures that

managers believe are fair, such as
usage, either actual or estimated.

Allocation of Central Costs
Often used cost-allocation bases
Revenue
Total assets
Cost of goods sold
Total cost of each division

Use of Budgeted Sales for Allocation
If management allocates the costs of

central services based on sales, it should use
budgeted sales rather than actual sales.
The method has the advantage that the

fortunes of other departments will not affect
the costs allocated to a given department.
It has the disadvantage of providing

an incentive for the department to
under-predict their own sales.

Allocation of Joint Costs
Learning
Objective 7
Companies allocate joint product costs

to products for inventory valuation
purposes and income determination.
Two conventional ways of allocating

joint costs to products are widely used:
Physical Units and Relative Sales Values
Joint costs include all inputs of material,

labor, and overhead costs that
are incurred before the split-off point.
Allocation of Joint Costs
The physical-units The joint costs are

method requires a allocated based on
common physical each products
unit for measuring percentage of the
the output of each total physical
product. units produced.
Allocation of joint costs should not affect

decisions about the individual products.
Physical-Units Method
Dow Chemical produces two chemicals, X and Y. Joint

cost is $100,000. X sells for $.09 per liter and Y for $.06.
Two-thirds of the liters produced are chemical X; allocate

two-thirds of the joint cost to X. One-third of the liters are
chemical Y; allocate one-third of the cost to Y.

Relative-Sales-Value Method
If a common physical unit is lacking, many

companies use the relative-sales-value
method for allocating joint costs.
Weighting is based on the sales values of

the individual products at the split-off point.

By-Product Costs
By-product costs are not

individually identifiable until
manufacturing reaches
a split-off point.
By-product costs have a relatively

insignificant sales value
in comparison with other
products emerging at split-off.

By-Product Costs
Allocate only separable costs to

by-products. Allocate all joint costs
to the main products.
Deduct revenues from

by-products, less their
separable costs, from the
main products cost.

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Copyright 2014 Pearson Education, Inc.

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 2

1. Describe the general framework for cost allocation.

2. Allocate the variable and fixed costs of service

3. Use the direct and step-down methods to allocate

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 3

4. Allocate costs from producing departments to products

5. Allocate costs associated with customer actions to

6. Allocate the central corporate costs of an organization.

7. Allocate joint costs to products using the physical-units

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 4

Cost allocation methods comprise an important

Less than half of most companies operating costs

The rest of a companys costs must be allocated

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 5

After developing a general framework for

There are four types of cost

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 6

The cost accounting system first accumulates

There are two types of departments:

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 7

Direct costs can be physically

Indirect costs must be allocated.

Many companies develop

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 8

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 9

School of Business School of Engineering

Allocate the cost of a 5-year

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 10

Suppose there are two major

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 11

The primary activity performed

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 12

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 13

The cost driver for the variable-cost pool

Variable costs should

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 14

Consider the allocation of variable

500 hours $200 = $100,000

Suppose inefficiencies in the

A good cost-allocation scheme would allocate

This scheme holds computer department

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 16

Allocation of fixed costs will be based

Long-range planning regarding the

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 17

Suppose the deans had originally predicted the

School of Business: School of Engineering:

How is the fixed-cost pool allocated?

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 18

A major strength of using capacity available

Such a budgeted lump-sum approach

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 19

Service departments often support

There are two popular methods for

The direct method

The step-down method

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 20

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 21

The direct method ignores other service

Facilities management cost = $1,260,000

The direct method allocates these costs to the

Copyright 2014 Pearson Education, Inc. publishing as Prentice 12 - 22