Cost and Revenue Allocations

EMBA 5412 Fall 2010

We will 
emphasize the allocation of costs to divisions, plants, departments, and contracts;  also address
the common cost allocation the joint cost allocations; and the revenue allocations

Why allocate Cost?
We allocate indirect costs that can not be easily traced to products, services, etc. Why do managers allocate indirect costs to these cost objects?


Purposes of Cost Allocation 1 To provide information for economic decisions 2 To motivate managers and other employees 3 To justify costs or compute reimbursement 4 To measure income and assets for reporting to external parties 4 .

Criteria Cause-and-effect: identify the variable or variables that cause resources to be consumed Allocation based on this relation would be the most acceptable by the departments/managers 5 .

Criteria Benefits-received: managers identify the beneficiaries of the outputs of the cost object The costs of the cost object are allocated among the beneficiaries in proportion to the benefits each receives Have to convince the managers of departments 6 .

Cost allocation is viewed as a ³reasonable´ or ³fair´ means of establishing a selling price in the minds of the contracting parties.Criteria Fairness or equity: This criterion is often cited on government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers. 7 .

An example is the allocation of corporate executive salaries on the basis of division operating income.Criteria Ability to bear: This criterion advocates allocating costs in proportion to the cost object¶s ability to bear them. 8 .

Cost-Benefit Approach Companies place great importance on the cost-benefit approach when designing and implementing their cost-allocation system. 9 . The benefits from using a well-designed system are difficult to measure and are frequently less visible. The costs of designing and implementing a system are highly visible.

Allocating Costs of a Supporting Department to Operating Departments 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 10 .

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 11 .

Methods to Allocate Support Department Costs 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 costallocation base 12 .

Allocation Method Tradeoffs Single-rate method is simple to implement. but treats fixed costs in a manner similar to variable costs Dual-rate method treats fixed and variable costs more realistically. but is more complex to implement 13 .

allocation of support costs can be based on one of the three following scenarios: 1. Budgeted overhead rate and actual hours 3.Allocation Bases Under either method. while actual will not be known with certainty until the end of the period 14 . Budgeted overhead rate and budgeted hours 2. Actual overhead rate and actual hours Choosing between actual and budgeted rates: budgeted is known at the beginning of the period.

Direct 2. Step-Down 3.Methods of Allocating Support Costs to Production Departments 1. Reciprocal 15 .

Direct Method Allocates support costs only to Operating Departments No interaction between Support Departments prior to allocation 16 .

Direct Method 17 .

18 . Allocate service department costs only to operating departments. Advantages: 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.Service Allocation: Direct Method Procedure: Ignore each service department¶s use of other service departments.

Step-Down Method Allocates support costs to other support departments and to operating departments that partially recognizes the mutual services provided among all support departments One-way interaction between Support Departments prior to allocation 19 .

Step-Down Method 20 .

as the default.Service Allocation: Step-down Method Procedure: Start with one service department and allocate all of its costs to the remaining service and operating departments. Advantages: Considers some of the interdependence of service departments Disadvantages: Resulting allocations are inaccurate estimates of opportunity costs. total budget of department. (2) number of other departments serviced. Continue one-by-one through each service department allocating all direct costs of that department and costs allocated to it. A good way of choosing the order of allocation is by (1) most reliable ³cause and effect´ cost driver. Allocation less than opportunity cost for first department Allocation more than opportunity cost for last department 21 . and (3) finally.

Reciprocal Method
Allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments Full two-way interaction between Support Departments prior to allocation

Reciprocal Method


Service Allocation: Reciprocal Method
Procedure: 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. Advantages: 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 ³managing´ cost allocations for financial reporting and/or taxes.


Choosing Between Methods Reciprocal is the most precise Direct and Step-Down are simple to compute and understand Direct Method is widely used 25 .

Example DATA Support Depts Operating Depts Plant Information Maintenance Systems Machining Assembly Total Budgeted Manufacturing Overhead Cost before allocations (TL) Support work provided: By Plant Maintenance Budgeted Labor hours Percentage By Information Systems Budgeted Computer hours Percentage 600.000 100% 26 .000 1600 20% 200 10% 2400 30% 1600 80% 4000 50% 200 10% 8.000 1.000 400.000 116.316.000 200.000 100% 2.

889 0.000 375.000) 103.Direct Method Budgeted Cost Support Departments Budgeted Manufacturing Overhead Cost before allocations Plant Maintenance Labor Hours Percentage Allocated Plant Main Cost Information System Computer Hours Percentage Allocated Info System Cost Total Budgeted Overhead 1600/ 200/ (1600+200) (1600+200) 0.000 (600.889 1.000 600.316.111 (116.111 Budgeted Cost Operating Machining Depts Assembly Total 600.000 116.000 27 .000 587.316.889 728.000 1.375 0.000 400.000 200.000) 2400 / 4000/ (2400+4000) (2400+4000) 0.111 12.000 116.625 225.

 We can start with either one but would yield different results  Usually start with the service dept that provides a higher percentage of service to other service departments first  Rank the service departments in the order that they provide service to other service departments 28 .Step-down method Two service depts.

000 (600.222 89.000 1.889 0.000 116.000 2400 30% 180.000 er ead 526.000 8.316. 8 Budgeted t Op ting hining pt bl ot l 600.000 200.000) ost 236.000) 209.000 100% 600.step-down with plant maintenance first Budgeted t Support epart ent Budgeted anufactur ng er ead ost efore allocat ons Plant aintenance abor ours Percentage llocated Plant ain ost Infor ation System omputer ours Percentage llocated Info Sys Total Budgeted 1600/ 200/ (1600+200) (1600+200) 0. 16. 8 26.000 1600 20% 120.000 400.000 4000 50% 300.000 29 .222 1.111 (236.

000 100% 116.000) Labor Hours Percentage Allocated Plant Main Cost 2400 / 4000/ (2400+4000) (2400+4000) 38% 63% 611.600 400.600 229.316.000 200 10% 11.800 200.600 2.350 382.000 (116.000 1.000 200 10% 11.000 600.316.000 1600 80% 92.150 593.850 1.000 30 .250 100% 611.600 Total Budgeted Overhead 722.step-down with information system first Support Departments Budgeted Manufacturing Overhead Cost before allocations Information System Computer Hours Percentage Allocated Info Sys Cost Plant Maintenance Budgeted Cost INFO SYS Budgeted Cost PLANT Operating Machining Depts Assembly Total 116.

000 1.150 587.850 1.316.Comparison of Methods Ste d w Ste d w Pla t ai I f Sys Direct first first 728.000 1.316.111 789.778 722.222 593.889 526.000 ac i i sse ly tal 31 .316.

98 1.10 1.1 0 0 cost [C] = Plant Info 1 -0.A]= det [I-A] = 1/ det[I-A] = [I-A] inverse 0.082 240.20 0.2 1 0 1.00 m ltiply [I.0204 32 .000 116.00 -0.A] inverse x [C] = 600.204 0.102 1.02 0.816 [I] = [I.000 624.Reciprocal computation [A]= Plant Info 0 0.

.653 779.122 1.Reciprocal allocation Support epart ents Budgeted anufacturing verhead ost efore allocations .816) Total udgeted overhead for operating departments Budgeted st ant Budgeted st Info Sys Operati Machi i epts ssembl tal .878 . llocation of lant aintenance ercentage 20% ount 24.082) 124.316. 50% 312. .041 .000 33 .082 (240. 100% 10% 100% 24.082 536. 30% 187.224 80% 192.816 Allocation of Information System ercentage 10% Amount 24.

000 1.150 779.222 593.122 1.878 587.316.778 722.316.Comparison Step down Step down Plant Main Info Sys first first Direct Reciprocal 728.111 789.000 1.000 1.316.000 Machining Assembly Total 34 .316.889 526.850 536.

35 .

Service Department Cost Allocation assuming separate fixed and variable costs Example Dual rates are used Distributed in class 36 .

activity.Allocating Common Costs Common Cost ± the cost of operating a facility. or like cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user 37 .

and applied to the common cost 38 .Methods of Allocating Common Costs Stand-Alone Cost-Allocation Method ± uses information pertaining to each user of a cost object as a separate entity to determine the costallocation weights Individual costs are added together and allocation percentages are calculated from the whole.

Peterburg-Ankara costs TL 1300 Ankara-Dubna-St.Below are the possible fares for these trips individually or combined.Peterburg-Ankara costs TL 1900 How would you allocate the cost between these two sites? 39 . Dubna and St.Petersburg Ankara-Dubna-Ankara costs TL 800 Ankara-St. You will charge the cost of your plane ticket to these two sites.Example ± Common costs The manager of your plants in Russia wanted to consult you and wanted you to visit their sites.

90 St.9% 800  1300 Then costs are Dubna 38.Peterburg 69.Peterburg = 1300 ! 61.Example common costs ± stand alone Determine weights: Dubna = 800 ! 38.1% *1900 =1176.1% *1900= 723.1% 800  1300 St.10 40 .

Methods of Allocating Common Costs Incremental Cost-Allocation Method ranks the individual users of a cost object in the order of users most responsible for a common cost and then uses this ranking to allocate the cost among the users  The first ranked user is the Primary User and is allocated costs up to the costs of the primary user as a stand-alone user (typically gets the highest allocation of the common costs)  The second ranked user is the First Incremental User and is allocated the additional cost that arises from two users rather than one  Subsequent users handled in the same manner as the second ranked user 41 .

Dubna gets 1900 ± 1300 = 600 TL Probably have to agree with the management.Peterburg is the first  St.Example common cost Assuming Dubna plant is the first user  Dubna gets 800 TL.Peterburg gets 1900 ± 800 = 1100 TL Assuming St.Peterburg gets 1300 TL. 42 . St.

In some cases. The contractor is paid a set price without analysis of actual contract cost data 2. The contractor is paid after an analysis of actual contract cost data.Cost Allocations and Government Contracting two main ways: 1. the contract will state that the reimbursement amount is based on actual allowable costs plus a fixed fee (cost-plus contract) 43 .

some users choose to decrease use. This process repeats until no users are willing to pay the fixed costs. Then the fixed costs are allocated to the remaining users. Possible solutions to death spiral: When excess capacity exists.Death Spiral Death spiral occurs when large fixed costs of a common resource are allocated to users who could decline to use that resource. Reduce the total amount of fixed costs allocated. 44 . charge users only for variable costs. As the allocated costs increase. more of whom use less.

45 . Government responds by ordering even fewer aircraft. Government reduces number of aircraft purchased and that causes average cost to increase on remaining orders. the entire project is abandoned before all fixed costs are recovered.Death Spiral Example: Costbased Contracts Defense contractors working on advanced technology incur large fixed cost over-runs that are allocated to each aircraft manufactured. Eventually.

such as building cars 46 . Common costs occur in either disassembly or assembly processes. Joint costs occur only in disassembly processes.Joint cost allocation Joint cost is incurred to produce two or more outputs from the same input. such as refining and food processing.

Joint Costs: Process Further? Split-off point: the point in the disassembly processing at which all joint costs have been incurred Decision: Should each joint product be processed further or sold as is at the splitoff 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? 47 .

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. Decide to produce products with positive NRV.  For control and divisional reporting. allocate joint costs to products in the ratio of the NRV of each product. 48 . but not with negative NRV.  Compute NRV of each product after the split-off point.

example Yogurt Split off point Raw MILK Pasteurize MILK Process further White Cheese Sell as MILK 49 .Joint costs.

50 TL per kg.000 TL The company decides to sell half of pasteurized milk as is.Joint costs example In June 2008. and process the rest yielding 75.etc.000 TL . 50 . After the split off point.000 cheese losing 5.60 TL per kg Price of cheese 7 TL per kg further processing cost 2 TL per kg Joint cost of processing raw milk 100. Bizim Sut processes 220. the may be processed further to yogurt or cheese that share a second common processing which costs 200.000 lt are lost due to evaporation. Price of milk: 1.000 kg yogurt and 25. further processing cost 0.50 TL per lt Price of Yogurt 3. During processing until the split off point 10. spillage.000 lt of raw milk.000 lt more during the process.

50 157.000 1.48 Yogurt and C 105.000 4. kg) Total Sales value Weights of sales value JO NT COST 1 Allocation joint cost 1 per lt or kg Milk 105.000 (100.000 0.00 420.Joint cost example JOINT CO T 1 Sal s value at s lit off amount (lt.0% 50.0% 50.48 s 210.500 50.000 0.000) Based on physical units 51 .kg) sales price (lt.000 50.

3.Joint costs example J INT C T 2 ales value at split off a ount (lt.50 262. kg) Total Sales value Weights of sales value JOI T OST Allocation joint cost 1 per lt or kg Yogurt 75. . sales price (lt.500 60. 437.500 ( .60 heese 5. 7. 120. 175. 80. ) 52 . 40.

500 63. kg) Total Sales value Separable Costs per kg ess Separable Costs Net Realizable Value at Split-off eights of sales value J INT C ST 2 Allocation joint cost 1 per kg Yogurt 75.50% 72.500 0.000 3.92 53 437.Joint costs example Using NRV J INT CO T 2 Sales value at split off amount ( sales price (lt.69 Cheese 25.000) .500 342.000 2.00 50.993 2.50 262.000 36.00 175.007 1.000 125.50% 127.000 217.500 (200.000 7.60 45.

Joint costs comparison TOTAL COST per kg sales value NRV Yogurt Cheese 2.77 5.68 5.68 2.40 54 .

Revenue Allocation and Bundled Products Revenue Allocation occurs when revenues are related to a particular revenue object but cannot be traced to it in an economically feasible manner Revenue Object ± anything for which a separate measurement of revenue is desired Bundled Product ± a package of two or more products or services that are sold for single price. but individual components of the bundle also may be sold as separate items at their own ³stand-alone´ prices 55 .

Selling Prices 2. Physical Units 56 . Unit Costs 3. Three types of weights may be used: 1.Methods to Allocate Revenue to Bundled Products Stand-Alone (separate) Revenue Allocation Method uses productspecific information on the products in the bundle as weights for allocating the bundled revenues to the individual products.

and Graphperfect. Computeperfect.Example Cybersoft produces and sells three software programs: Writeperfect. Manufacturing Cost per Unit Selling rice TL TL 125 18 150 20 225 25 220 280 305 380 57 In ivi ually Writeperfect Computeperfect Graphperfect Bun le : Write and Compute Write and Graph Compute and Graph Write. Cybersoft sells these products individually as well as bundled products. Compute and Graph .

Example In ivi ual Revenue Allocation Use Selling rices total individual pri es 275 weights and pri es bundle pri e write 220 0.00 0.45 100.45 171.00 0.30 114.60 183.64 180.25 95.00 0. ompute and graph 500 380 .00 58 350 375 305 write.00 0.36 100.00 0.40 122.00 280 0.00 write and ompute pri es of individual produ ts write and graph pri es of individual produ ts ompute and graph ompute graph 0.00 0.55 120.

and so forth If the bundled price is less than or equal to the individual price of the primary product.Methods to Allocate Revenue to Bundled Products Incremental Revenue-Allocation Method ranks individual products in a bundle according to criteria determined by management and then uses this ranking to allocate bundled revenues to individual products    The first-ranked product is the primary product The second-ranked product is the first incremental product The third-ranked product is the second incremental product. the primary product is allocated 100% of revenue. If the bundled price is more than the individual price of the primary product. the primary product is allocated its regular price. etc. and then the secondary product gets its regular price. and the others in the same bundle receive no allocation 59 .

Example Incremental Revenue Allocation Method let's assume the following rank: Write Graph Compute Cumulative Revenue Allocated 125 220 Product Writeperfect Bundle Write and Compute Write Compute Write and Graph Write Graph Bundle Price 220 Revenue Allocated 125 95 280 125 155 305 150 155 125 280 Computeperfect Graphperfect Compute and Graph Compute Graph write.compute and graph Write Compute Graph 150 305 380 125 150 105 125 275 380 60 .

Example-Shapley allocation Primary Write Write ompute ompute Graph Graph rder First in remental ompute Graph Write Graph Write ompute evenues Allo ated to ea h produ t Se ond In remental Graph ompute Graph 220 150 Write 380 305 ompute 280 225 Write 380 305 75 55 100 380 280 80 305 225 75 150 305 Write 125 125 70 ompute 95 220 125 100 380 280 150 380 280 380 Graph 160 220 155 125 160 220 155 150 225 225 61 .

Assume equal weights on all products. . 62 .Example-Shapley value rd r irst Pri Writ Writ t t r r ry i r Writ r Writ t v r ric = r t t l R v n c nd Incr nt l r t r Writ t Writ l yv l Writ s ll c t d t t c r d ct r .